FIN - 605 - Lecture Notes

Investment Theory and Analysis
Lecture Notes
FINANCE AND INVESTMENTS
 Understand the distinction between real vs. financial assets

 Understand the purpose of investment
 Understand the process of investment
 Understand the organization of the investment industry
 Understand the structure of investment institutions
 Understand the type of investment services and financial
instruments
 Understand opportunities for jobs in the investment
services industry
2
 Nature of the Investment

 What is an Investment?
 It is any vehicle into which funds can be placed with the expectation that it will
generate positive income and/or that its value will be preserved or increased.
In other words, it is a current commitment of money or other resources in the
expectation of reaping future benefits.
 It is also a (current) consumption sacrifice. Current commitment of money or
other resources in the expectation of reaping future benefits. Interestingly, the
two notions are interchangeable.
 Are there priorities of Investments? What are your most important

investments?
 Your family and your testimony
 Education and skills
 Knowledge and friendships
 Food storage and emergency funds
 Real and financial Investments
 Do not be too narrow in your view of investments. 3
 Real vs. Financial Assets

 What determines the wealth of a society?
 The wealth of a society is determined by the productive capacity of the economy
 Productive capacity is a function of the “real assets” in the economy
 What are Real Assets?
 Assets used to produce goods & services, e.g. land, machines, buildings, knowledge.
 What are Financial Assets?
 Legal claims on income of real assets. They take the form of financial instruments
(e.g., stocks, bonds, derivatives, warrants, etc.)
 Any financial asset (owner of claim) is offset by financial liability (issuer of claim).
 When aggregated over all issuers’ balance sheets, financial assets & liabilities cancel-
out; only real assets remain. The economy’s net wealth is the sum of all real assets.
 What are the purposes of financial assets?

a) Consumption timing: Shift consumption to the most optimal time period
b) Allocation of risk: Shift risk to those most willing to bear it (expecting higher return)
c) Separation of ownership and management: In joint stock companies, it separates
functions
and allows for large firms to be managed professionally – corporate governance. 4
 Real vs. Financial Assets: Balance sheets of US Households, 2008
5
 What is the investment process?

 The process by which decisions are made relating to all aspects of
investment, including planning, analysis, implementation, and review
 It’s a process of determining your current financial status, your
objectives, constraints, policy, investing, and then monitoring your
investments with the intent of reaching your specific goals
 It is not as simple as it seems
 There’s a whole industry set up to help you establish a framework
 Association for Investment Management and Research, AIMR (sponsors CFA
program)
 What are the four major steps to the investment process?

a) Specifying Investment Objectives
b) Specifying Capital and Risk-Return Trade-off Constraints
c) Formulating Policies (Active vs. passive, top vs. down, etc.)
d) Monitoring and Updating the Portfolio.
6
 Functions of Financial Markets in the Economy

1. Borrowing and Lending: they permit/mediate the transfer of funds (purchasing
power) from one agent to another for either investment or consumption purposes.
2. Price Determination: they provide trading venues where prices are determined
both for newly issued financial assets and for the existing stock of financ assets.
3. Information Collection, Aggregation and Dissemination: they require the
production and dissemination of information about financial asset values and
about the flow of funds from lenders to borrowers.
4. Risk-Sharing: they allow the transfer of risk (return volatility) from those who wish
to undertake risky investments to those who provide funds for those investments.
5. Liquidity: they provide the owners of financial assets a chance to re-sell or
liquidate these assets with easiness at fair values.
6. Efficiency: they reduce market transaction costs and information costs.
 These functions are performed through the actions of

market players, mediated by (licensed) financial institutions
which provide (licensed) financial services.
7
 Players in Financial Markets

 Public Sector
 Government – can be both a borrower and a saver of funds
 Other State-owned institutions and agencies
 Private Sector
 Business Firms – net borrowers of funds
 Households – net savers of funds
 Financial Intermediaries - connectors of borrowers and lenders:
 Commercial banks (offering banking services: traditional line of business)
 Insurance companies (offering insurance services)
 Investment firms (offering investment services)
 Collective investment schemes (large investors-owners of financial assets, such as: mutual
funds, portfolio investment companies, pension funds, hedge funds, sovereign wealth funds,
alternative investment funds – private equity funds).
8
 Financial markets and the real economy – circular

flow
9
 Financial Intermediaries / Institutions

 They are corporations that participate in the creation & exchange of
financial assets. Their business is to offer financial services on certain
financial instruments. They are classified into: investment firms,
credit institutions (banks), and insurance companies.
 Financial institutions have evolved over-time. Financial & technological
change is associated with both benefits and costs of this evolution:
 Benefits: new financial instruments, innovations in portfolio management & technology
in implementing new risk management strategies have offered opportunities to reduce
risk and to improve efficiency by allocating risk to those most willing to accept it.
 Costs: rapid technological change and innovative financing made it difficult for
investors and policymakers to evaluate the risks borne by individual institutions and
their impact on the economy. Complex interdependencies among global institutions and
markets have exacerbated the negative effects of poor investment and wrong policy
decisions globally. The recent crisis is an obvious manifestation of this.
 In this rapidly evolving world of both benefits and costs, the key question
is how to retain benefits from technological & financial innovation, while
simultaneously protecting institutions and markets against the new risks.
 Regulation has emerged to help shape private activity and mitigate ris1k0s.
 1. Credit Institutions (Banks)

 A bank engages in financial asset transformation. That is, it purchases
one type of financial asset from borrowers (generally some kind of long-
term loan contract whose terms are adapted to the specific circumstances of the
borrower, e.g., a mortgage) and sells a different type of financial asset to
savers (generally some kind of relatively liquid claim against the financial
intermediary - e.g., a deposit account).
 A bank makes profits by charging relatively high interest rates to (long-
term) borrowers and paying relatively low interest rates to (short-term)
savers (maturity mismatch). This mismatch shows a bank’s relative
competitiveness and may be a cause of banking (liquidity) crisis.
 A bank may be allowed to offer both banking & investment services. It
is then called an investment bank. Whether this is good policy is
debatable.
 A bank is typically not allowed to offer itself insurance services. But,
many banks set up subsidiary insurance firms, offering insurance
services. When it happens, banks are called financial conglomerate1s1.
 2. Investment Firms (or Broker-Dealers)

 An agent of buyers/sellers of financial instruments, by offering investment
services by locating sellers/buyers to complete the transaction.
 An investment firm makes profits through fees/commissions charged on
the provision of investment services to users. An investment firm is
typically allowed to take a position in the assets it trades, i.e. it can
maintain inventories in securities which it trades on own account for
profit.
 An investment firm may offer market-making services on less-liquid assets,
aiming at the facilitation of their trading by artificially creating liquidity, but
without engaging in asset transformation. Thus, a marker maker can "take
positions" (i.e. maintain inventories) on the assets it trades that permit it to
sell-out inventory rather than always having to locate sellers to match
every offer to buy.
 Market-makers do not receive sales commissions, but make profits by
buying assets at relatively low prices and reselling them at higher prices.
The price at which it offers to sell an asset (‘ask’ price) minus the price at
which it offers to buy an asset (‘bid’ price) is called the bid-ask spread
and represents the market-maker's gross profit margin on the asset
 3. Insurance Firms
 Insurance is an arrangement providing individual protection against the risk of loss
resulting from perils or hazards, through pooling of risks. The cause of insurance
‘real’
is events resulting in ‘physical’ loss to agents and other non-financial risks.
 Economic agents face risks daily, e.g. health risks, risk of invalidity or death,
unemployment, theft, fire, and more. Some risks may influence their economic well-
being (income, wealth, consumption opportunities) drastically and even endanger
survival in extreme cases. Thus, demand for insurance is a more fundamental
component of human behavior, compared to banking and investment services.
 Losses from (above defined) non-financial risks are usually characterized by a low
degree of correlation, as different individuals are affected at different times and to
different degrees (‘individual’, ‘idiosyncratic’, ‘nonsystematic’ risk).
 Losses from financial or market risks are often correlated to a considerable degree,
since changes in asset prices, interest rates and exchange rates are interrelated and
subject to the common influence of cyclical economic changes and financial
instability. Financial risks, therefore, are partly ‘systematic’ that cannot be eliminated
through diversification, but be traded in financial markets. Thus, banking/investment
are concerned with exposures to financial or market risk, whilst insurance is
concerned with ‘real’, nonfinancial risk.
 An insurance firm, by collecting and investing a large pool of insurance fees, is an
institutional investor with a substantial active investment role. 13
ASSET CLASSES & FINANCIAL INSTRUMENTS
 Understand the Definition of Financial Instruments
 Understand the Definition of Financial Assets & Financial

Liabilities
 Understand the Different Types of Financial Assets
 Money Market Instruments
 Fixed Income Securities
 Equity Securities
 Financial Derivatives
 Financial indices & benchmarks
 Types of indices
14
 Financial Instrument: a contract that gives rise to a financial

asset of one entity and (at the same time) a financial liability
of another entity (IAS 32.11 – accounting definition)
 Financial asset is cash, or an equity security, or a derivative
contract, or a contractual right to:
a) receive cash or other financial asset from another entity, or
b) exchange financial assets/liabilities with another entity.
 Financial liability is a contractual obligation to:
a) deliver cash or another financial asset to another entity, or
b) exchange financial assets/liabilities with another entity; or
a derivative contract.
15
 Asset Classes and Types of Instruments (IAS)

INSTRUMENT TYPE (IFRS 9)
ASSET CLASS Securities

Other cash Derivatives Derivatives
(value determined by buyer/seller
(value determined in markets)
transfer agreement)
(Exchange-traded) (OTC-traded)
Foreign exchange options,

Outright forwards
Foreign exchange N/A Spot foreign exchange Currency futures
Foreign exchange swaps
Currency swaps
Forward rate agreements,

Debt (short term) Notes, T-Bills, Deposits, Short term interest-rate
Repurchase agreements
≤ 1 year Commercial paper Certificates of Deposits futures
(repos?), Reverse-repos(?)
Interest-rate swaps Interest-

Debt (long term) Bond futures rate caps & floors, Interest-
Bonds Loans
> 1 year Options on bond futures rate options Exotic
instruments
Stock options Stock options

Equity Stock (common, preferred) N/A
Equity futures Exotic instruments
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 Financial asset characteristics

 Return and risk
 From an investor’s perspective, two crucial characteristics of financial assets are
the return it promises and the risk inherent in the return. Return is the gain made
from an investment, and risk is roughly the variability in the return. The return is
defined as the percentage increase in the value of investment.
 Tradability
 Financial assets are distinguished between tradable and non-tradable ones:
 Non-tradable assets: They cannot be traded once purchased. Despite not being
tradeable, they are important because they can compose significant parts of many
investors’ portfolios. Examples: savings account, non-negotiable CDs, etc.
 Tradable assets: They can be traded between investors through buying/selling.
Examples: foreign exchange, debt instruments, equity instruments, derivatives,
etc.
 Liquidity
 For tradable assets, liquidity reflects the ease with which an asset can be traded and
turned into cash. For liquid assets, there are highly developed markets with
considerable volumes of trade. Other assets are more specialized and may require
some effort
investor willto be made
always to match
prefer greaterbuyers and
liquidity insellers. All other things being equal,17an
their assets.
 Money Market Instruments (maturity ≤ 12 months)

 Definition
 Money Market Instruments (MMI) are debt securities with a maturity of 1 year or less.
 MMI are issued in the primary market through a electronic network by the Treasury,
corporations, and financial intermediaries that wish to obtain short-term financing.
 MMI are commonly purchased by households, corporations, and governments that
have funds available for a short time period.
 MMI can be sold in the secondary market and are liquid.
 Institutional use of MMI

 Financial institutions purchase MMI in order to earn a return while maintaining
adequate liquidity.
 MMI can be used to enhance liquidity in two ways:
 Newly issued MMI generate cash.
 Purchased MMI will generate cash upon liquidation (to take place soon).
 Financial institutions that purchase MMI are acting as creditors to the issuers of
MMIs. 18
 Money Market Instruments (maturity < 12 months)
 International markets
 Eurodollar markets
19
 Money market yields over-time (annualized yields, 1-month maturity)
20
 Money market yields over-time (international)
21
 Money Market Instruments (quotations)
22
 Money Market Instruments and the recent financial crisis

 During 2005-2008 Money Market Mutual Funds (MMMFs) grew by 88%. Why?
 When Lehman Brothers filed for bankruptcy on September 15, 2008, MMMFs suffered
their own crisis (see CDS spreads of T-Bills on the graph below)
 Some MMMFs had invested heavily in Lehman’s commercial paper.
 On Sept. 16, the Reserve Primary fund “broke the buck” (dropped to less than a $1)
 A run on money market funds followed.
 The U.S. Treasury temporarily offered to insure all MMMFs to stop the run, by
spending about $3.4 trillion in these funds.
23
 Debt Instruments (or Fixed Income Securities, or Bonds)

 A bond is a long-term debt instrument in which a borrower
agrees to make fixed payments of principal and interest (fixed-
income security), on specific dates, to the holders of the bond,
for as long as the maturity of the loan extends.
 When one purchases a bond issued by an organization (i.e.
the government or a corporation), one essentially lends the
organization a specified amount of money, which the borrower
agrees to repay at a designated time.
 Why buy a bond? In exchange for permission to borrow money
from the lender, the organization agrees to pay periodic interest
payments on the amount borrowed.
24
 Characteristics of Fixed Income Securities 1

 Face (par) value – The (face) amount of money that is paid to the
bondholders at maturity. For most bonds this amount is $1,000. It also
generally represents the amount of money borrowed by the bond issuer.
 Coupon interest rate (%) – the stated interest rate (generally fixed) paid by
the issuer on a periodic basis (annually, semi-annually, etc.). The coupon
interest (C) is expressed as a percent of a bond’s face value (F). It holds: C
= c(%) * F => 80 = 8%*1000. It represents the issuer cost on the bond.
 Maturity date – years until the bond must be repaid. It represents the date
on which the bond matures, i.e., the date on which the face value is
repaid. The last coupon payment is also paid on the maturity date
 Required Return (discount rate) - the rate of return that investors currently
require in order to buy and hold a bond.
 Yield to Maturity - The rate of return that an investor would earn if s/he
bought the bond at current market price and held it until maturity.
Alternatively, the rate which equates the discounted value of a bond's
future cash flows to its current market price.
25
 Characteristics of Fixed Income Securities 3

 Collateral bonds - secured by a pledge of financial assets, such
as common stock, other bonds or treasury bills
 Covenants
 Positive covenants – things the issuer agrees to do:
 Supply periodic financial statements
 Maintain certain ratios
 Negative covenants – things the issuer agrees not to do:
 Restrictions on the amount of debt the firm can take on
 Prevents the firm from acquiring or disposing of assets
 Example: A Treasury bond with coupon rate 3.5%, maturity date 11.15.2016 and a
nominal issued amount of $18.8 billion …
 … pays a semi-annual interest of $329 million ($18.8 bn * 3.5% / 2)
 … every 6 months until 11.15.2016 included, as well as $18.8 billion on maturity
date. 26
 Other types - Vanilla Bond (simplest form)

 Coupon payments are fixed for the life of the bond
 Principal is repaid and bonds are retired at maturity
 Annual or semiannual coupon payments
 Other types - Zero Coupon Bond
 No coupon payments
 Face value is paid at maturity
 They sell at deep discount
 Other types - Convertible Bond
 May be exchanged for Equity Shares of the firm’s stock
 It sells for a higher price than a comparable non-convertible bond
 Bondholders benefit if the market value of company’s stock increases
27
 Types of bonds by Issuer 1

 Corporate bonds are issued by companies to finance expansion
or raise funds for other expenses. They include:
 Senior debt - bonds that are backed by specific assets of the company.
 Debentures - bonds secured simply by the issuer’s promise to repay the loan
 Junk bonds - bonds with have high default rating (CCC, Caa or worse)
Also:
 Convertible corporate bonds - bonds that can be exchanged for other
securities
 Minimum denomination is $1,000.

 Maturity is typically between 10 and 30 years, but also lower.
 Interest paid to investors is tax deductible to the company (big
advantage).
 Interest income earned on corporate bonds represents ordinary income to
the bondholders and is subject to government/local tax.
28
 Types of bonds by Issuer 2

 Government or Treasury bonds, are especially noted for their lack of
risk since they are backed by the government.
 T-Bill - maturity of 12 months or less
 T-Note - maturity from 1 to 7 years
 T-Bond - maturity from 7+ to 20+ years
 The government issues securities to finance public expenditures.
 The minimum denomination for T-notes and T-bonds is $100.
 Note maturities < 10 years whereas Bond maturities ≥ 10 years.
 Receive semi-annual interest payments from the Treasury.
 Interest is taxed as ordinary income, but it is exempt from local taxes.
 The bond market is affected by Central Bank’s actions through:
 open-market operations: buying/selling T-Bonds in order to control money supply
 change the discount rate: raising/lowering the rate raises/lowers interest rates
 setting reserve requirements: increasing reserves and thereby raising interest
rates
or decreasing reserves and thereby decreasing rates 29
 Credit rating 1 (measure of issuer’s probability of default)

 Investors rely on outside (credit rating) agencies for the provision of
information on the default potential of bonds.
 Standard & Poor, Moody’s, Fitsch, and other firms (CRAs) score ‘the
probability of continued & uninterrupted streams of interest & principal
payments to investors’. The scoring comes from sophisticated methodology.
 Classes of credit rating:
 Moody’s Investment Grades: Aaa, Aa, A, Baa
 Moody’s Speculative Grades: Ba, B, Caa, Ca, C
 Moody’s Default Class: D
 Are Ratings Agencies better in assessing default risk or just react to events?
 CRAs own conflicts of interest may prevent objective rating
 CRAs credit rating methodologies may be questioned.
 The highest grade bonds have the lowest default risk (rated Aaa or AAA).
 Investment Grade bonds are rated Aaa to Baa.
30
 Credit rating 2 (measure of issuer’s probability of default)
31
 Fixed Income Securities (quotations)
32
 Equity Securities
 Common stock
 It is a residual claim (on net profits):
 Cash flows to common stock, only when all other obligations are paid (e.g. interest
to bondholders, wages to workers, taxes to government, etc.)
 In the event of good profits, all left after payments are made, goes to stockholders.
 In the event of bankruptcy, stockholders will receive what is left over (if any) after the
government, workers, bondholders etc. are paid first.
 It confers limited liability

 A liability that does not exceed the amount invested (percent of voting rights) in a company.
If the limited liability company is sued, the plaintiffs are suing the company, not its individual
owners.
 It confers rights: ownership, voting, participation, preemptive rights.

 right to vote on matters such as electing a board of directors, setting a capital budget,
and proposed mergers or acquisitions.
 right to share in the firm’s profits, in the form of dividends, that remains after
bondholders and preferred stockholders and others with higher priority claims
(employees,have
authorities) tax been paid (residual income) 33
 Common stock characteristics

 Agency costs
 In theory, common stockholders (owners) elect the Board of Directors (BoD) and
effectively control the firm through their representatives on the board.
 The BoD appoints professional managers who are delegated to run the company on
a day-to-day basis and execute the strategic decisions of the BoD. Top managers
(CEO, CFO) participate in the BoD as members.
 In reality, stockholders are given a list of nominees for the BoD mostly proposed by
management. As a result, management effectively elects the board and thus
controls BoD decision-making.
 However, appointed managers may put their interests ahead of the firm’s
stockholders. They (may) run the company to their own benefit rather the benefit of
stockholders. This is the Principal-Agent problem in corporate finance. The costs
associated with the stockholder efforts to control and contain the P-A problem are
called agency costs and they difficult to quantify.
 Corporate governance – aimed at reducing agency costs
 Strengthening shareholder rights
 Establishing duties and responsibilities for the members of the BoD
 Controlling managerial and executive compensation
 Enhancing corporate transparency and information disclosure 34
 Preferred stock characteristics

 Preferred stock is an equity security, which has properties of both an equity and
a debt instrument (hybrid instrument)
 It is senior (i.e. higher ranking) to common stock, but subordinate to bonds (in
terms of claims or rights to the assets of the company); typically it has
priority over common stock in payment of dividends and upon liquidation.
 It has no voting rights. The terms of the preferred stock are described in the articles of
association of the issuing company.
 It must be paid a fixed dividend before funds are distributed to common stockholders.
Dividends are due regardless of earnings.
 It often has a credit rating. The rating for preferred stock is generally lower, since preferred
dividends do not carry the same guarantees as interest payments from bonds.
 It may be convertible into common stock.
 Most preferred stock is not a “true perpetuity” – it may be called/retired by a firm.
 Equity-like securities
 American Depository Receipts (ADRs) - certificates traded in the US that
represent ownership in a foreign security. They are justified because of different
legal structures. In addition there are Global Depository Receipts (GDRs). 35
 Equity Securities (quotations) – typical broker’s screen
36
 Financial Derivatives
 A derivative is a financial contract which derives its value from the
performance of another entity (e.g. an asset, index, or interest rate, etc.),
called the "underlying".
 Derivatives include a variety of financial contracts, including futures,
forwards, swaps, options, and variations of these such as caps, floors,
collars, and credit default swaps.
 Most derivatives are traded either on an Exchange or Over-the-
Counter.
 Derivatives are used either for:
 speculation (making profit by good guessing – zero-sum game) or
 hedging (protection against risk) - by taking a position in a derivative, losses on
underlying assets may be minimized or offset by profits on the derivative.
 Derivatives can be used to gain quicker and efficient access to markets; e.g.
it may be easier & quicker to purchase an S&P 500 futures contract
(derivative) than invest in the underlying securities of the S&P500 index.
 The two most important types of derivatives are futures and options. 37
 Financial Derivatives – Futures contracts

 Futures Contract - definition
 In a futures contract, the contract buyer (going “long”) agrees to purchase a specified
quantity of the underlying asset/commodity at contract future expiration (00/00/00) at
the price (futures price) set in the contract today. The contract seller (going “short”)
agrees to deliver the underlying asset/commodity at contract expiration in exchange
for receiving the agreed upon price.
 The terms of a futures contract are standardized: They specify What to trade, Where to
trade, When to trade, How much to trade, What quality of assets to trade.
 A futures contract represents a zero-sum game between a buyer and a seller: Gains
realized by the buyer are offset by losses realized by the seller (and vice-versa). The
futures exchanges keep track of the gains and losses every day.
 Futures are an obligation (not a right) to buy/sell an asset in the future at preset
price.
 Futures are traded in regulated derivatives markets
 A typical future on, say, oil involves the specification of contract size (e.g. 1,000 tons
of crude oil) and price quote for Dec 2015 contract (e.g. $15 per tone of oil). So, if you
bought
2015 forthe Decx 2015
1,000 $15 =contract, you’d agree
$15,000 (value purchase 1,000 tones of oil in December
of contract). 38
 Financial Derivatives – Option contracts

 Option Contract - definition
 A financial option is a contract which gives the buyer (owner) the right, but not the
obligation, to buy or sell an underlying asset, index or commodity at a specified price
on or before a specified date. The contract gives the seller (writer) the corresponding
obligation to fulfill the transaction if the owner chooses to "exercise" the option.
 In order to get this right to buy/sell or not, the buyer pays a premium to the seller. The
premium is affected by the difference between the underlying asset price and the
strike price, the time remaining until exercise date, and the volatility of the underlying.
 An option which conveys to the owner the right to buy an asset (say, a 100 shares of
stock) on or before some specified expiration date is referred to as a call option; An
option which conveys to the owner the right to sell an asset (say, a 100 shares of
bonds) on or before some specified expiration date is referred to as a put option.
 Option contract specifications include: the quantity of the underlying asset(s) (e.g.,
100 shares of XYZ stock); the strike (exercise) price: the price at which the underlying
transaction will occur upon exercise; the expiration date: the last date the option can
be exercised; the settlement terms: whether the option writer must deliver the actual
asset on exercise, or simply tender the equivalent cash amount; and quotation terms:
the current best bid/ask prices
39
 Derivatives trading
40
MARKETS AND TRADING
 Markets, issuing and trading securities

• Lending and borrowing
• Direct vs. indirect finance
• Primary vs. secondary markets
• Initial vs. secondary public offerings markets
• Margin trading
• Short-selling
41
MARKETS AND TRADING
 The Borrowing & Lending Mechanism (direct / indirect)

 One key function of financial markets is to facilitate the financing of
new borrowing.
 Financial markets bring savers (agents with excess funds relative to
their desired expenditures) together with would-be borrowers
(agents who are short of funds relative to their desired expenditures
- corporations).
 The borrowers issue new financial liabilities in return for receiving
excess funds of savers, through the financial markets
mechanism.
 There are 2 central mechanisms for fund transfer from savers to
borrowers to facilitate new acts of borrowing:
 indirect finance (through banks – loans) and
 direct finance (through market –issuing securities).
42
MARKETS AND TRADING
 The Borrowing & Lending Mechanism (direct / indirect)

 Indirect Finance (direct or mediated loans through banks).
 Funds are channeled indirectly (mediated) from savers to borrowers
through banks.
 Banks also purchase new financial assets issued by borrowers,
transform (securitize/structure) them and sell them to new savers.
 Consequently, financial institutions hold financial claims against
(direct & indirect) borrowers whereas the savers hold claims
only against financial institutions.
 Studies show that firms in major developed countries have
traditionally relied more on indirect than on direct financing to obtain
their borrowed funds.
 We do not deal with indirect finance in this class.
43
MARKETS AND TRADING
 Direct Finance (by type of market).

 Primary markets. Savers directly finance successive rounds of funding by
purchasing newly issued financial assets issued by borrowers (corporations
in need of funds). Thus, savers directly buy & hold claims against borrowers.
 Transactions in the primary securities markets affect the size of the market
for a security, but not its liquidity.
 Secondary markets. Transactions involving purchase of existing financial
assets (e.g., investors purchasing securities sold by other investors –
change of ownership) do not involve new borrowing. Such transactions
simply reallocate among savers the existing stock of claims against
borrowers without creating new claims, in net terms.
 Transactions in secondary markets affect the money flow through the
market, thus its liquidity. If investors decide to turn their paper wealth into
cash, then someone else has to be willing to turn cash into paper wealth.
 Changes in securities prices are needed to ensure that there is a buyer for
every seller. Transactions in markets affect securities price formation (price
discovery) and thus capitalization and the shareholder’s wealth.
44
MARKETS AND TRADING
 Primary Markets
 Public offerings
 Sale of securities is made to external investors. May be either initial or secondary offerings.
 Offerings are registered with the Regulator; Approval of Prospectus;
 Use of underwriting and advising services (investment banking).
 Initial Public Offerings (IPOs)
 1st offering of securities by the issuer (company, government, municipality, etc.) to the public
 Evidence of underpricing initially (post-trade price higher than initial offer price); however,
generally have been poor long-term performers
 Exchange listing requirements must be complied with
 Secondary Public Offerings (SROs)
 2nd or 3rd or …nth (follow up) offering of new securities in the market by the same issuer
 Private Placements
 Sale to a limited number of sophisticated investors; no need for Prospectus
 Dominated by large-scale institutions 45

MARKETS AND TRADING
 Public offers – Why do companies go public?

 New capital: Almost all companies go public primarily because they need
funds to expand the business, finance working capital
 Future source of capital: Once public, firms have greater and easier access
to capital in the future (due to higher reputation & marketability of securities)
 Mergers and acquisitions: Its easier for other companies to notice and
evaluate a public firm for potential synergies. IPOs are often used to finance
acquisitions.
 Publicity – Once public, firms enjoy large publicity of their operations
 Public offers – Costs and Disadvantages
 Expensive: A typical firm may spend about 15-25% of the money raised on
direct expenses (to underwriters/advisors, regulator, exchange, etc.)
 Reporting obligations and governance responsibilities: Public companies
must continuously file reports with the Regulator and the Exchange
 Loss of corporate control: Ownership is transferred to outside investors
can take control and even fire the founding entrepreneur.
who 46
MARKETS AND TRADING
 Public offer – Best timing

 Determinants of time suitability:
 General market conditions (bearish vs bullish markets)
 Industry market condition (sectoral concerns)
 Frequency & size of all IPO’s in the financial cycle (too many IPOs, little money left)
 Public offer – Process and stages of completion

1. Select an underwriter/advisor (commitment vs. best effort)
2. Register IPO with the Securities Regulator
3. Prepare, have it approved, and print the Prospectus (material information)
4. Present issuer (to institutional investors) in roadshows
5. Price the securities (through a book-building procedure)
6. Sell the securities (avoid selective distribution)
7. Price stabilization efforts (underwriter’s obligation during the IPO)
47
MARKETS AND TRADING
 Public offers - underpricing

 Example. AAA Co has just sold 100,000 shares in an IPO. The Underwriter's
explicit fees were $70,000. The initial offering price for the shares was $50
p.s., but immediately after the issue, the share price jumped to $53 p.s.
 What is your best guess as to the total cost to AAA of the equity issue?
 Is the entire cost of underwriting a source of profit for the underwriter?
 Answer
a) In addition to explicit fees of $70,000, there appears to have been an implicit
underpricing of the IPO of $3 per share (= $53 - $50) or $300,000 (=
$3*100,000)(forgone revenue to the issuer AAA).
b) While the explicit costs ($70K) are profits to the Underwriters, the implicit
costs ($300K) are not. Generally, there are reasons, such as financial (to
make sure the entire IPO is sold), strategic (to make underwriters look good from a
successful IPO) and promotional (to give investors a quick return to encourage them
to continue to deal with the underwriting firm) ones, to underprice slightly an IPO
and to make sure an IPO is sold fully.
48
MARKETS AND TRADING
 Secondary markets
 Existing owner sells securities to another party who is willing to buy them
 Issuing firm doesn’t receive funds and is not directly involved
 In most cases, settlement of ownership change is merely an electronic entry
in a share registry.
 Why care about share price in secondary markets since no new
funds are raised?
 Liquidity (liquidity helps to buy/sell shares often and quickly)
 Prestige (wide recognition)
 Publicity (road shows, announcements)
 Help raise new capital in the future (marketability & liquidity of shares matter)
 Managerial effectiveness (compensation is sometimes tied to performance).
 Note: If I ever saw a Reuters or Bloomberg terminal on the CEO’s desk when visiting
companies, I took it as a negative sign. It showed that s/he was more worried about
the price of the stock than running the company! 49
MARKETS AND TRADING
 Secondary markets – types of client orders 1

 Instructions to brokers on how to complete the order can take various forms:
 Market Order: Buy/sell securities at current (best) market price: lowest
bid/highest ask:
 market orders are given priority in trading
 no guarantee of trade execution (price may rise/fall from time order is placed
to time it is executed)
 Limit Order: Buy/sell up to a specified price limit (specify limit, send
order, wait till execution within limits):
 buy/sell order where investor specifies price range: “buy at $50 or less” or
“sell at $52 or more”
 specialist records orders in the Exchange’s limit order book
 investor sets reservation price, BUT no guarantee that limit order will be
executed.
50
MARKETS AND TRADING
 Secondary markets – types of client orders 2

 Other order types:
 Stop (loss) Order: Buy/sell only if the price reaches a specified level
 order is routed, but it lies dormant (i.e.. “buy if price rises to $60” or “sell if price falls to
$58”)
 turns into market order when certain price (“the stop”) is reached
 investor does not have to watch market, but in a volatile market stop order could be
triggered prematurely, ending up in unnecessary trading
 Stop (limit) Order: Turns into limit order when ‘stop’ is reached.
 example: “buy if price rises to $60, but only execute at $65 or less”
 Block Trade Order: Buy/sell securities in a whole bunch at a specified
price
 Size of order may be large (say, 10,000 shares)
 Price of order deviates from market price
 Order is executed outside the normal exchange trading process, not to upset trade
price

 Computers are programmed to trade continuously
Program/Algorithmic Order: Buy/sell an entire portfolio at a specified 51
 Programmers
price hope to gain profits from exploiting the slightest difference in prices
MARKETS AND TRADING
 Secondary markets – transparency

 Pre-trade transparency: information on bid and ask prices
(flashing orders) as well as on intended to trade volumes before
trade execution
 You see this info in the Exchange’s trading board, or on your PC
 Real-time transparency: information on real-time while trading
takes place
 You see this info in the Exchange’s trading board, or on your PC
 Post-trade transparency: information on prices and volumes at
which trades were executed (after trade execution).
 Your broker calls you after the execution to confirm to you that your order
has been (or not, or partially) executed
52
MARKETS AND TRADING
 Secondary markets structure 1

 The costs of collecting & disseminating information determine, mostly, the types
of prevalent market structures. These structures take two basic forms:, organized
Exchanges (operating auction/call markets) and OTC markets.
 Organized Exchange is an institution which allows securities to be listed:
 in accordance with certain criteria (listing requirements),
 on its electronic trading platform, and
 be traded, in accordance with trading procedures (rulebooks), and
 mediated by investment firms (authorized Exchange Members) providing
investment services and marker-making services.
 Over-the-Counter (OTC) market is a public market where trading is conducted
through marker-makers (or primary dealers); it is not a centralized mechanism.
 Marker-makers are spread across a region, country, or indeed the world. They themselves
post bid and asked prices for this asset and then stand ready to buy or sell units of this
asset with anyone who chooses to trade at these posted prices. Marker-makers provide
customers more flexibility in trading than investment firms, because marker-makers can
offset imbalances in the demand and supply of assets by trading out of their own
accou53nts
MARKETS AND TRADING
 Secondary markets structure 2

 The Exchange operates various markets (for securities and derivatives). The
trading process includes order matching through auction markets and is
concluded in three stages: trading , clearing, settlement.
 Auction market constitutes a centralized facility (huge computer) on which
buyers/sellers, mediated by their investment firms, execute multilateral trades
through an open, competitive and anonymous bidding process. Two types:
 Continuous auction markets, where the electronic system is continuously matching orders.
Buyers/sellers set a maximum/minimum price at which they will buy/sell securities.
Advantages include better transparency, price discovery and liquidity.
 Call auction markets, where traders place orders to buy/sell securities at certain buying/selling
prices. Orders are collected during a call auction and then are matched to form a contract. Call
auction rules vary by auction. Advantages of call auctions include a decrease in price
instability.
 Trading process (three stages):

 Trading: Agreement to exchange securities for funds (buying/selling order matching)
 Clearing: Calculation of payment/delivery obligations, aggregation of obligations
 Settlement: Delivery of securities and payment of funds; ownership change registration

(depository)
54
MARKETS AND TRADING
Bank
Bank
account
account
(buyer) Pre-trade analysis (seller)
Fund Indication of interest EXCHANGE Indication of interest

Manager Fund
Request for price Request for price
(Buyer) Execution Execution Manager
Price Price
(Buyer)
Buy orders
Individual Order for buy Order for sell
Sell orders
Investor Execution Matching Execution
Trade Trade
Individual
notification notification
Allocation of trade in sub-accounts
(buyer) confirmation confirmation Investor
Allocation of trade in sub-accounts Deliver of contract notes (seller)
Deliver of contract notes Affirmation
Affirmation Broker A Broker B
Cash Securities
Statement of Settlement
Statement of Settlement
Settlement instructions
Settlement instructions
Post-trade reporting
New issues
Underwriter holdings
SETTLEMENT-REGISTRY
Settlement
Final settlement
Settlement
Settlement execution
Registry
Listing company execution

instructions Settlement
Settlement
of executed instructions
Settlement
trades Settlement
Statement of
affirmation
settlement affirmation Statement of
Clearing Clearing settlement
Settlement Settlement
Broker Broker Y
Corporate registry X affirmation affirmation
Settlement
Settlement execution
execution
Historic data flow
Global custodian 1 Order information flow Global custodian 2
Trade info flow
Settlement/registry info
55
MARKETS AND TRADING
 Secondary market – cost of trading

• Explicit
 Commission: fee paid to broker/Exchange for executing the transaction
 Spread: cost of trading with market-maker/dealer:
 Bid: price at which the broker-dealer will buy from you
 Ask: price at which the broker-dealer will sell to you
 Bid-Ask Spread: difference between the ask & bid prices
 Combination: on some trades both a commission and spread are paid. You
are responsible to watch and make sure you are getting the best execution.
• Implicit
 Market impact: increase (or decrease) in price resulting from the size of
the order vs. the average daily trading volume.In low liquidity markets, this
can often be greater than all other costs — Beware!
56
MARKETS AND TRADING
 Secondary market – cost of trading

 Example: You manage your personal portfolio of $500,000. Your largest stock
holding, BB Co., is getting expensive, so you sell your shares worth $50,000
and buy shares worth $50,000 of another stock, CC Co. Assuming that:
 this was your only trade for the quarter, what is your turnover for that quarter? and
 transactions costs were 90 basis points each way, how much did you spend to
complete that transaction?
 Answer: Turnover is defined as the average of buy & sell trade value, divided
by your total portfolio value: $[(50,000 sell + $50,000 buy) / 2] / $500,000 = 10%
• The cost to you of this transaction is:
 $50,000 sell * 0.0090 = $450
 $50,000 buy * 0.0090 = $450
 Total transactions cost = $450 + $450 = $900
 Total cost (loss of return) from this single trade: $900/$500,000 = - 0.2%!
 This may include other fees, commissions, taxes.
57
MARKETS AND TRADING
 Buying on Margin
 Buying on margin is a trading technique that aims to increase your
investment profits based on leverage (borrowing).
 What is margin trading or buying on margin?
 Margin trading is investing (speculating) with borrowed money (leverage).
 Purchasing power can increase hugely because of leverage
 If you trade on margin, what percent of original investment can
you lose?
 With trading on margin, more than your original investment is at risk.
 Can you lose more?
 Yes, you can loose much more.
 What is the most you can lose?
 Your risk is theoretically unlimited.
 Is the return worth the risk?
 For most individual investors, the answer is No! For sophisticated investors, it
is Yes.
58
MARKETS AND TRADING
 Buying on Margin - terms

• It is highly practiced during market boom times and when leverage
conditions are favorable (low interest rates, abundant credit).
• It involves using borrowed money by your broker (only) to either finance
a new investment or add leverage on an existing investment.
 In order to buy a given value of securities, the investor puts up a portion of
the investment cost and borrows the remaining cost. Margin arrangements
differ for stocks and futures.
 The terms used to analyze the mechanics of margin financing are:
 Initial margin = own portion / total value of equity investment (set by broker)
 Maximum margin: max amount of borrowing relative to total portfolio value. If MM
= 50%: you can borrow up to 50% of total investment value (set by Central Bank);
 Maintenance margin: min amount of own portion (equity) that must be maintained
all times in a margin account before additional funds must be put (set by broker)
 Margin call: notification that you must put up additional funds (issued by broker)
59
MARKETS AND TRADING
 Buying on Margin - return

• Profit profile (in %)
 Return on the acquired investment: (P1*N – P0*N + D*N ) / P0*N
 Return after investing on margin: (P1*N + D*N – B*i) / P0*N
 P0 = Initial price of the investment,
 P1 = Ending price of the investment,
 N = number of shares of the investment,
 D = Dividend per share,
 B = Amount of money borrowed
 ‘i’ = Interest rate to be paid on borrowed amount
 Iinitial = Initial Investment (P0*N)
60
MARKETS AND TRADING
 Buying on Margin – Example 1

• You open a Margin Account with your broker which is different than your
standard Cash Account.
• You deposit an initial amount, say $10,000 in your margin account. Your broker
offers you an initial margin, say 50%, so this allows you to purchase an
investment in stocks up to $20,000 total (broker will lend you another $10,000).
• If you buy $5,000 worth of stock, you still have $15,000 in buying power
remaining. You have enough cash to cover this transaction and haven't drawn
onto your margin (which is $10,000). If you buy $12,000 worth of stock, then you
borrowed money from your margin account ($2,000).
• Note that the buying power of a margin account changes daily, depending on the
price movement of the securities in your margin account. Example: if you
bought stock worth $12,000 today (by borrowing $2,000 from you margin), and
the marker value of your investment increases tomorrow to $13,000, you owe
$2,000 but now you need not borrow overall $10,000 but only $9,000 (you save
$1,000 because your investment increased in value). The opposite occurs if your
investment fell in value – things then get ugly.
61
MARKETS AND TRADING

• A look at the market shows that stock XYZ is trading at $100 per share. You feel that
the price will rise. Without a margin account, you can only buy 100 shares (100 x $100
=
$10,000). With a margin account (max margin = 50%), you borrow from your broker
$100 and
hence you can double your purchasing power, and buy 200 shares (200 x $100 =
$20,000).
• Suppose that the price of the stock XYZ, indeed, increases by 25% (from $100 to $125
p.s.). Your investment is now worth $25,000 (= 200 x $125), and you decide to cash out.
From the proceeds, you pay your broker the $10,000 you borrowed from plus $500 for
commissions and fees, and you are left with $14,500 (= $25K - $10K – $0.5K), of which
$4,500 is profit (=
$14,500 - $10,000). That's a 45% return, even though the stock went up by 25% only.
• Suppose, instead, that the price of the stock XYZ decreases and the value of your
investment falls from $20,000 to $15,000. Then, your own equity portion in your
margin account decreases to $5,000 (= $15,000 - $10,000 borrowed). Assuming a
maintenance margin of 25%, you must have a minimum of $3,750 (= 25% * $15,000) in
equity in your account. Thus, as the $5,000 of your own equity in your account is
greater than the maintenance margin of $3,750, you have no problem (the broker will
not call you).
either put down more money, that is another $1,000 (= $5,000 - $6,000), or you have to accept
62
• Now assume
a forced sale that your broker
(liquidation) is afraid
worth $1,000of
ofyour
yourability to payinhim
investment back
your and s/he raises the
margin
maintenance margin from 25% to 40%. Now the maintenance margin level rises to $6.000 (=
account.
MARKETS AND TRADING

 You have this overwhelming feeling (or new information, or inside information?) that the ABC stock will
increase in value. You only have $35,000, but you want to take a larger (and, of course, riskier) position
via buying on margin. Your starting information is the following:
ABC share price: $70 p.s.; Initial Margin = 50%; Maintenance Margin = 40%; Shares Purchased = 1,000
 Initial Position
Investment value $70,000 Borrowed equity $35,000 (50%)
Your Margin (%) 50.00% (= $35,000 / $70,000) Own equity $35,000 (50%)
Suppose you turned out to be wrong and the ABC stock price falls from $70 to $60 p.s.
 New Position:
Investment Value $60,000 (= $60 * 1000 shares) Borrowed equity $35,000 (unchanged)
Your Margin (%) 41.67% (= $25,000 / $60,000) Own Equity $25,000 (= $60,000 - $35,000)(low!)
Since 41.67% > 40% (maintenance margin), luckily, you are still above the margin limit, so there is will be
no margin call. Thus, you could wait until the price rises again.
 But the market downturn made you cautious: Just to be sure you won’t have to put more money (that you don’t have)
down, you want to calculate how far the stock price can fall further before you receive a margin call to put money down.
Here’s how to do it: Let Px be the price of the stock below which, the broker will ask you to put more money into your margin
account. Then, it holds:
Minimum threshold equation: (Px*N – Borrowing) / (Px*N) = 40% (maintenance margin)
Solve equation: (1,000*Px - $35,000) / (1,000*Px) = 40% => Px = $58.33
As long as the price doesn’t drop below $58.33 you have no problem. But, if the price drops below $58.33,
then you would receive a margin call from your broker and you have to either put up more money (that
you may not have) or sell out of your position at current market price (realizing a loss). 63
MARKETS AND TRADING
 Selling Short
 What is short-selling?
 Short selling is borrowing a security (at current price) you don’t own and selling it at a
lower price, after an expected decline in the price. You then repurchase the security at
the lower price and return it to the lender plus some interest, and you make a residual
profit.
 If you short-sell, what percent of your original investment can you lose?
 With short-selling, more than your original investment is at risk.
 Can you lose more than your original investment?

 Yes, you can lose much more.
 What is the most you can lose?

 Your risk is also theoretically unlimited.
 Is the return worth the risk?

 No. Many investors have gone bankrupt because they used these tools thinking their
risk was limited when it wasn’t.
64
MARKETS AND TRADING
 Selling Short - return

 It is highly practiced during market downturn (bust) times and when stock-
lending conditions are favorable (a pool of stock is available for lending).
 If the short-sale takes place after having borrowed the stock to finance its sale, the
short-sale is called a covered short-sale.
 If the short-sale takes place without having borrowed the stock (you sell “thin air”),
the short-sale is called naked short-sale: it’s very risky, and thus often banned!
 Short Selling Steps

 Borrow stock from another investor (lender) through a broker
 Sell the stock short and deposit the proceeds and the initial margin in a margin
account held with the broker
 Close out the open position: buy the stock (you sold sort) later and return it to the
lender, including reimbursing for any dividends paid.
 Profit profile
 Return on an investment: (P1 + D – P0)/P0,
 Return on short sale: (P0 – P1 + D) / P1 since P1 < P0
65
MARKETS, INDICES & TRADING
 Selling Short - mechanism
66
MARKETS AND TRADING
 Selling Short – Example 1.a

 Suppose that, after hours of thorough research, market rumor! or inside information! you
decide that company XYZ is going to face bad news. Its stock is currently trading at $65,
but you predict it will trade at a lower price in coming weeks. You want to capitalize on the
expected price decline, by sell shares of XYZ short. The transaction steps follow:
 Step 1: Set up a margin account. You can use only your own money or you can borrow
additional funds from your broker in order to finance larger short-selling transactions (with
more risk, of course).
 Step 2: Place your order by calling up the broker or entering the trade online. Most online
brokerages will have a check box that says "short sale" and “buy to cover”. In this case, you
decide to put in your order to sell 100 shares short.
 Step 3: The broker, depending on stock availability, borrows the shares. According to most
regulations, the borrowed shares can come from (a) the broker's own inventory, (b) the
margin account of one of the firm's clients, or (c) another broker.
 You should be mindful of the margin rules and know that fees and charges can apply. For
instance, if the stock has a dividend, you need to pay the person or firm making that
loan.
 Step 4: The broker sells your (borrowed) shares in the open market. The profits of the
sale
are then put into your margin account. 67
MARKETS AND TRADING
 Selling Short – Example 1.b

 One of two things can happen in the coming months:
The Stock Price Sinks (stock goes from $65 to $40)
You borrowed 100 shares of XYZ at $65 which you sold sort (open position) $6,500
You purchased back 100 shares of XYZ at $40 (to close open position after price drop) -$4,000
You made a profit $2,500
The Stock Price Rises (stock goes from $65 to $90)
You borrowed 100 shares of XYZ at $65 which you sold sort (open position) $6,500
You bought back 100 shares of XYZ at $90 (to close open position after price rise) -$9,000
You made a loss -$2,500
 Short selling can be profitable. But, there's no guarantee that the price of a stock will go
the way you expect it to (just as with buying long). The higher price goes, the higher your
loss.
 Shorter sellers use an endless number of methods to find shortable securities. Some use a
similar stock picking methodology to the long positions and sort the stocks that come out
worst. Others look for insider trading, changes in accounting, or bubbles waiting to burst.
 One indicator specific to short sales that is worth mentioning is short interest. Short
interest is the total number of securities in an account/market that have been sold short,
but haven't been repurchased yet in order to close the open position. Short interest serves
as a barometer for a bearish (high short interest) or bullish (low short interest) market.68
MARKETS AND TRADING
 Selling Short – Example 2

 You expect the share price of ZZZ Co. to fall dramatically after some bad news hit the
market. The stock currently trades at $100 per share. You want to profit from this bad news.
You have $5,000 that you are willing to invest. You take advantage of both margin borrowing
and short-selling mechanisms. With initial margin 50%, you can borrow another $5,000.
 Initial Position
ZZ Co. 100 shares Margin $5,000 (borrowed money)
Initial margin 50% Equity $5,000 (own money)
Maintenance margin 30% (Short) sale proceeds $10,000
Initial price per share $100 Stock owed back $10,000 (= $100*100)
 You sold short 100 shares. However, the bad news do not materialize and the stock price
rose from $100 to $110 per share. What is your new margin? Do you need to put up
more money? Assume that the maintenance margin is 30%.
 New position (after short-selling and price rise)
Sale Proceeds $10,000 (= $100*100 shares)
Initial Margin $5,000 (borrowed money) (has to be returned to broker)
Stock Owed $11,000 ($110*100 shares) (has to be covered)
Net Equity $4,000 [= $5,000 – ($11,000 – $10,000)]
Margin (%) $4,000 / $11,000 = 36%
 Since 36% > 30%, you do not need to put up new equity. But, you are concerned. How much
can the stock price rise before you will get a margin call at 30%? Your Equity / Market Value
= [($10,000 + $5,000) – 100*Px) / (100*Px) = 30% => Px = $115.38. 69
RISK AND RETURN
 Understand rates of return of financial investments

 Understand return using scenario, probabilities, and other
key statistics used to describe your portfolio return
 Understand risk of financial investments
 Understand portfolio of assets construction and optimization
 Understand the implications of using a risky and a risk-free asset
in a portfolio
 Understand the efficient frontier of optimal portfolios
70
RISK AND RETURN
 Financial investment typically involves the choice of various

financial assets and their inclusion into a portfolio of assets.
 Portfolio theory is an attempt to answer two critical questions:
 How do you price financial assets?
 How do you build an optimal (best) portfolio of financial assets?
 Which assets do we choose to invest in?
 What proportions of our capital do we invest in the different assets?
 Portfolio analysis focuses on trade-off between an asset’s return & risk
 Asset return: What is it? How is it measured?
 Accounting measures (ROI, ROA, ROE)
 Market-based measures (monthly, expected, geometric, arithmetic, dollar-weighted)
 Portfolio return: What is it? How is it measured?
 Expected return: What is it? How is it measured?
 Risk: What is it? How is it measured? 71
RISK AND RETURN
 Statistical background 1
ƒ Pi,t - Pi,t-1 +D i,t (known as holding period return -

Rare of return (R i,t )= Pi,t-1 HPR)
Actual Return  Ri,t , individual security
ƒExpected Return  E(Ri,t ), individual security, E: mathematical expectation
Expected Return  E(R M ,t ), market as a whole, E: mathematical expectation
Risk-free Rate = R f , rate of return without volatility (typically 1-year T-

bill)
Excess Return  Ri,t  R f
Risk Premium  E(Ri ,t )  R f

72
RISK AND RETURN
Mean Return (of pop observations): t  E(R i , t )
ƒ
Variance of Returns (of pop observations): σ 2  E[(R i,t   ) 2 ]
Standard Deviation of Returns (of pop observations): σ   2

N
 1
ƒSample estimator of the Mean Return:  = n 
i,t
n1 R
1 N
S am ple estim ator of the V ariance:   2
= 
n  1 n 1
(R i , t    ) 2
2
Sample estimator of the Standard Deviation:   =  
Co-Variance of Returns: Cov(R i , t , R j ,t )  E[(R i , t  i )(R j ,t   j ]
Correlation of Returns: Corr(R i ,t , R E[( R i ,t   i )( R j ,t   j ]

j ,t ) 
 i j
73
RISK AND RETURN
Examples of correlation between two random variables

4 3
ρ=0 3 ρ = .5 2
2
1
1
0
-4 -3 -2 -1 0 1 2 3 4
0
-1
-4 -3 -2 -1 0 1 2 3 4
-1
-2
-2
-3
-3
-4
-4
4 3
ρ = 0.8 3
ρ = –.5 2
2
1
1
0
-4 -3 -2 -1 0 1 2 3 4
0
-1
-4 -3 -2 -1 0 1 2 3 4
-1
-2
-2
-3
-3
-4
-4
74
RISK AND RETURN
 Predictable price / return changes
$ 80
70
60
50
40
30
20
75
RISK AND RETURN
 Random walks of prices / returns
$ 80
75
70
65
60
55
50
0 10 20 30 40 50 60 70 80 90 100
76
RISK AND RETURN
 Facts from US history of financial returns 1

Total returns of stocks, bonds, T-bills and inflation, 1946-2001
10000
CPI T- 10 T-note LCs SCs
bill
1000
100
10
0.1
Dec-45 Dec-53 Dec-61 Dec-69 Dec-77 Dec-85 Dec-93 Dec-01
77
RISK AND RETURN

Cumulative value of 1 USD invested in 1926
78
RISK AND RETURN

Annual Total Returns of US Stocks & Bonds, 1926-97
79
RISK AND RETURN

Total returns 10Y T-Bond, 1953-2001
25%
20%
15%
10%
5%
0%
-5%
-10%
-15%
-20%
-25%
Jan- Jan- Jan- Jan- Jan- Jan- Jan- Jan- Jan- Jan- Jan- Jan-
46 51 56 61 66 71 76 81 86 91 96 01
80
RISK AND RETURN

Total returns of stocks, 1953-2001
25%
20%
15%
10%
5%
0%
-5%
-10%
-15%
-20%
-25%
Jan- Jan- Jan- Jan- Jan- Jan- Jan- Jan- Jan- Jan- Jan- Jan-
46 51 56 61 66 71 76 81 86 91 96 01
81
RISK AND RETURN

Total returns of Motorola stock, 1953-2001
25%
20%
15%
10%
5%
0%
-5%
-10%
-15%
-20%
-25%
82
RISK AND RETURN

Scatterplot GM stock vs. S&P500 Index, 1926-1997
25% GM stock
17%
8%
S&P500 Index
0%
-35% -25% -15% -5% 5% 15% 25%
3 5%
-8%
-17%
-25%
83
RISK AND RETURN

 The real interest rate - slightly positive on average.
 The return on more risky assets - higher on average than the return on
less risky assets.
 The returns on risky assets - highly correlated to each other.
 The returns on risky assets - (usually) serially un-correlated.
US Basic Statistics, 1946 – 2001 (monthly, percent)

Avg Stdev Skew Min Max
Inflation 0.32 0.36 0.82 -0.84 1.85
Tbill (1 yr) 0.38 0.24 0.98 0.03 1.34
Tnote (10 yr) 0.46 2.63 0.61 -7.73 13.3
VW stock index 1.01 4.23 -0.47 -22.49 16.5
EW stock index 1.18 5.30 -0.17 -27.09 29.9
Motorola 1.66 10.02 0.01 -33.49 41.6
NYSE, Amex, NASDAQ: 6,700 firms, $16.4 trillion market cap

84
RISK AND RETURN
 Investment return
 Investment returns measure the financial performance of an investment. Returns
can be (a) historical or (b) prospective (expected) and can be expressed (i) in
nominal terms, or (ii) in percentage terms.
 Rate of return (single period)
 Holding period return (income adjusted): HPR  t 1t

P  Pt
Pt
D t 1
where Pt+1 = ending price, Pt = beginning price, Dt=1 = income earned

during the period
 Example. You paid $20 per share for Apple Co. stock at the
end of 2012. At the end of 2013,
it increased to $24. Assuming it distributed $1 in dividends,
the HPR for Apple stock is HPR
= ($24 - $20 + $1) / ($20) = 25%.
 Nominal vs. real1return - Therate

relation1 + nominal interest rate (i)
+ real interest (r) = between the nominal rate of return (i), the
real rate of return (r) and the rate of inflation (Δπ)rate
1 + inflation is (Δπ)
given as:
which simplifies into i = r + Δπ (approximated version).
 Example: If nominal rate of return is 6% and inflation rate is 3%, then r = 6% - 3% = 3%
approximation overstates
(approx. calculation), or r =the real return.
(1+0.6%) / (1+0.3%) – 1 = 2,9% (exact calculation). Thus, 85
the
RISK AND RETURN
 Rate of return – arithmetic vs. geometric return

 What is the Geometric & Arithmetic rate of return for assets below for the 4 years?
Year (end) Y1 Y2 Y3 Y4
Assets (beginning) 1.00 1.20 2.00 0.80
HPR (%) 0.10 0.25 (0.20) 0.25
Assets (ending, before net flows) 1.10 1.50 1.60 1.00
Net new flows (in/out) 0.10 0.50 (0.80) 0.00
Assets (ending, after net flows) 1.20 2.00 0.80 1.00
 Arithmetic mean return (average)
rarithr  r  ...  rn
 1 2 n = (0.10 + 0.25 - 0.20 + 0.25) / 4 = 0.10 or 10%
 Use Arithmetic Mean when you are not reinvesting any cash flows received before the
end of the period.
 Geometric mean return (cumulative)

r  [(1 r )(1 r )...(1 r )]1/ n 1 = [(1.10)(1.25)(0.80)(1.25)]1/4 - 1 = (1.5150)1/4 - 1 = 0.0829
geo 1 2 n
m
 Use Geometric Mean when you are reinvesting any cash flows received before the end
of the period.
86
RISK AND RETURN
 Rate of Return – other conventions

 Annualized Percent Rate (APR) – it is the annualized rate of return for an
investment which is the product of sub-period return times the number of sub-
periods. It is measured as: = HPR *n
r APR t
where n = number of sub-periods within a holding period (year)
 Effective Annualized Rate (compounded) (EAR) - it is the annualized rate of

return for an investment which is compounded (reinvested) monthly or daily. It
is measured as: rAPR n
rEA = 1 +
n
t - 1 = (1 ) -
HPR + n 1

Y
 Example: if monthly return of an investment is 1%, then APR = 1% * 12 = 12%

and EAR = (1+ 0.12/12)12 - 1 = 12.68%.
 Continuous Rate of Return (CRR). When securities are continuously trading,
then it’s best to use the CRR. The CRR associated with a HP is measured as:
= ln(1+HPR )
rcont t
 Example: If the HPR is 1 year and HPR return is 12%, the continuous rate of
return is ln(1 + 0.12) = 11.33% (approx). Thus, if 11.33% were continuously
compounded, its effective annual rate of return would be about 12%. 87
RISK AND RETURN
 Expected investment return

 It is the expectation of future cash flows. Since the future is unknown
(fundamental uncertainty) the expectation of future cash flows is
possible only under specific assumptions. These can be the result of:
 Making a wild guess
 Using stat probability distributions / scenario analysis (extrapolating the past)
 Using other logical methods (i.e. assimilating physical/nature patterns, etc.)
 We choose probability/scenario analysis:
 Estimate the probability of event (asset return) occurring in the future and the outcome
for each occurrence during a specific future period.
 In order to do so, we rely on subjective (?) assumptions about alternative future
scenarios of the economy and the market for the asset.
 But which statistical probability distribution should we use?

 Assume that financial returns are a random variable following the normal distribution.
This is a big simplification, but it makes the analysis possible. It is the object of
intensive research in finance (efficiency of markets worldwide).
 The normal distribution is fully described by 4 statistics: mean (most likely value),
variance (volatility), skewness (direction of tails), and kurtosis (fatness of 88
tails).
RISK AND RETURN
 Investment return and probability distribution
Stock X
Stock Y
Rate of
return (%)
-20 0 15 50
 The behavior of returns of individual securities is assumed to follow the normal
distribution pattern (returns are random variables). This pattern is explained by the
measures: (a) expected return, (b) variance (or stdev) and (c) covariance and correlation.
89
RISK AND RETURN
 Investment risk – rationale and measurement

 Since future investment returns (cash flows) are not known with certainty,
then investment risk is taken to reflect the probability of earning a return
which is less than what is expected.
 Thus, the greater the probability of a future return (cash flow) below
the expected return, the greater the risk.
 To measure risk, we need to understand the behavior of asset returns
 How volatile are security returns? (look at stylized facts in previous pages)
 How does volatility change over time? (look at stylized facts in previous pages)
 What properties do asset returns have in efficient / non-efficient
markets? (assumption to make the model work)
 Random, unpredictable (assumption to make the model work)
 Prices react quickly and correctly to news
 Once the empirical behavior of past asset returns is assessed, we can form
projections about the future course of the same asset’s returns (cash
flows) based on our assumptions about the future economic conditions.
 Then risk (in
statistical the sense
measure mentioned
of variance above) is deviation).
(or standard measured by the use of the90
RISK AND RETURN
 Scenario Analysis - basics

 The analysis starts by forming our preferred (subjective) scenario.
 The subjective scenario analysis is based on our personal assumptions
about the economy, industry and company. But:
 what happens when assumptions vary based on differing economic forecasts,
industry forecasts, and company ratios?
 what is be the outcome of company analysis under varying assumptions?
 Well, based on their preferred (subjective) scenaria, different investors

may form different probability distributions and hence different views
about the future course of the markets and accordingly of asset returns.
 Rational investors who seek an efficient portfolio of securities (one which
minimizes risk without impairing return, or maximizes return for a given
level of risk) by introducing new (or off-loading existing) investments, start
from the mean-variance analysis.
91
RISK AND RETURN
 Scenario Analysis – setting the stage

 We begin by illustrating a simple 2-asset portfolio that comprises two investments:
bonds B and stocks S. Suppose that their expected returns are ri(B) and ri(S)
respectively. Suppose too that there are two states in the economy that are expected
to occur: State 1 (optimistic) and State 2 (pessimistic), with an equal probability of
occurrence (50-50). Suppose, finally, that for each state, the expected returns ri(B)
and ri(S) are as follows:
 Return\State State 1 (50%) State 2 (50%)
ri(B) 20% 10%
ri(S) 10% 20%
 In order to form an optimum overall return for our portfolio of bonds B and stocks S,
the analysis asks two questions:
 should we include one, or the other, or both investments in the portfolio?
 how much (what proportion) of each should we include in the portfolio?
 To answer the above 2 questions, we use the concept of asset diversification. This
means that we focus on whether any portfolio diversification between the two
individual securities B and S can, for a given overall portfolio risk (StDev), improve
(optimize) the overall portfolio return and how much.
 To do that, we need specific measures of expected returns and their variance. 92

RISK AND RETURN
 Scenario Analysis – calculating expected return (single asset)

 Expected Return calculation.
E (ri / s )   p (s)  rs
s
where p(s) = probability of a state occurring, r(s) = asset return if that state ‘s’ occurs, over
the range from 1 to s states in the economy.
 Example: With respect to a given asset, suppose that the economy is described
by the following 5 states with the associated state probabilities and returns:
State Prob. of State Return in State
1 0.10 -0.05
2 0.20 0.05
3 0.40 0.15
4 0.20 0.25
5 0.10 0.35
The expected return of the above scenario (states 1 to 5) is given as:
E(r) = (0.1)(-0.05) + (0.2)(0.05) + (0.4)(0.15) + (0.2)(0.25) + (0.1)(0.35) = 0.15
93
RISK AND RETURN
 Scenario Analysis – calculating volatility of returns (single

asset)
 Variance of Expected Returns calculation.
V aris / = σi2/ s  s p(s)  [rs  E(r)] 2
where p(s) = probability of a state occurring, r(s) = return if that state occurs.
 Example: Based on the state of the economy described, the risk (volatility) of expected
returns is given as:
State Prob. of State Return in State

1 0.10 -0.05
2 0.20 0.05
3 0.40 0.15
4 0.20 0.25
5 0.10 0.35
Since E(r) = 0.15, the Variance of returns of our scenario (states 1 to 5) is given as:
VAR = σ2 = [(0.1)(-0.05 - 0.15)2 + (0.2)(0.05- 0.15)2+ ...+ 0.1(0.35 - 0.15)2] = 0.01199, or
SD = σ = [0.01199]1/2 = 0.1095 94
EFFICIENT DIVERSIFICATION
 Scenario Analysis – form a two-asset portfolio

 Special case - two risky assets
 Assume now you have 2 risky assets (bonds B and stocks S) to choose from,
and that both asset returns are normally distributed.
 Then assume that you invest a portion w1 of your total money in bonds and the
remaining portion w2 in stocks. It holds w1 + w2 = 1 (or 100% of your money).
 Two-asset Portfolio Expected Return is: E(rp) = E(w1rb + w2 rs)= w1 E(rb)+ w2 E(rs)
 Given E(rp) above, two-asset Portfolio Variance, σp2 , is:
σp = E[rp - E(rp)]
2 2 (use formula for variance)
= E{(w1rb + w2 rs) - E[w1rb + w2 rs]}2 (use expression for E(rp) above)
= E{(w1rb - w1E[rb]) + (w2 rs - w2E[rs])}2 (manipulate the terms …)
= E[w1 (rb - E[rb]) + w2 (rs - E[rs]) + 2w1 w2 (rb - E[rb])(rs - E[rs])]
2 2 2 2
= w 2σ 2 + w 2σ 2 + 2w w Cov(r , r ) = w 2σ2 + w 2σ2 + 2w w

Cov(r ,r )
1 b 2 s 1 2 b s 1 b 2 s 1 2
b s
= w1 σb + w2 σs + 2w1 w2 σbσsρbs, or
2 2 2 2
σp = √(w1 σb + w2 σs + 2w1 w2 σbσsρbs)
2 2 2 2
 The key rests with the variable ρbs (or Cov(rb,rs)). We turn to this next. 95
 Scenario Analysis – correlation among assets

 Special case – two risky assets
 The variable ρbs is the correlation coefficient between the returns of the bond and
the stock. It measures the degree to which two variables’ movements are
associated. Its value varies from -1 to +1. It is calculated as:
ρ B,S = Cov(rB ,rS )
σ Bσ S
 Proposition: A portfolio of less than perfectly correlated assets can always offer
better risk-return opportunities than the individual component assets on their own.
Thus, correlation among returns of bonds and stocks matters. The proof follows:
If ρbs = 1 (perfectly positively correlated), then σp = w1σb + w2σs (σp > σb, σs)
If ρbs < 1 (less than perfectly correlated), then σp < w1 σb + w2 σs
If ρbs = -1 (perfectly negatively correlated), then σp = w1σb - w2σs (σp < σb, σs)
 Thus, whether the addition of securities in the portfolio succeeds in reducing the
variance (risk) of the portfolio vs. the variance (risk) of the individual securities,
depends on the sign and value of correlation coefficient, ρ.
 Diversification: As a result, you want to maintain the portfolio expected return at a
given level, and reduce the portfolio risk you are exposed to, as much as possible.
 Action: you hedge your portfolio by including another asset of similar expected
return but highly negatively correlated one with your original asset. 96
 Scenario Analysis – Example 1

 Special case – two risky
assets
Original Scenario
Recession 1 0.25 +44%
Scenario Scenario Probability HPR
Normal 2 0.50 +14%
Boom 3 0.25 -16%
New Scenario
Scenario Scenario Probability HPR
Recession 1 0.30 +44%
Normal 2 0.40 +14%
Boom 3 0.30 -16%
 Suppose that your estimation of the course of the economy changes. Calculate and
compare the Mean and SD of each scenario. What do you observe?
Original: E(r) = 0.25 x 44 + 0.5 x 14 + 0.25 x (–0.16) = 14%
New: E(r) = 0.3 x 44 + 0.4 x 14 + 0.3 x (–0.16) = 14%
Original: StDev = (0.25 (44 - 14)2 + 0.5(14 - 14)2 + 0.25 (-16 -14)2 = 4501/2 = 21.21%
New: StDev = (0.3 (44 - 14)2 + 0.4(14 - 14)2 + 0.3 (-16 - 14)2 = 5401/2 = 23.24%
 Conclusion: The mean is unchanged, but the standard deviation has increased
(duegreater
the to probability of extreme returns). 97
 Case of 2 risky assets – Example 2a (extended)
Rate of Return
Scenario Probability Stock fund Bond fund
Recession 33.3% -7% 17%
Normal 33.3% 12% 7%
Boom 33.3% 28% -3%
 Consider the following 2 risky-asset world, which includes bonds

B and stocks S. There is a 1/3 chance of each state of the
economy and the only assets are a stock fund and a bond fund.
98
 Case of 2 risky assets – Example 2b

Stock fund Bond Fund
Rate of Rate of
Scenario Squared Return Squared Return
Recession -7%Deviation
3.24% 17%Deviation
1.00%
Normal 12% 0.01% 7% 0.00%
Boom 28% 2.89% -3% 1.00%
Expected return 11.00% 7.00%
Variance 0.0205 0.0067
Standard Deviation 14.3% 8.2%
 Calculate Expected return, Variance (St Dev) and Covariance
99
 Case of 2 risky assets – Example 2c

P(s) Rate of Rate of
Recession 1/3 -7%Deviation
3.24% 17%Deviation
1.00%
Normal 1/3 12% 0.01% 7% 0.00%
Boom 1/3 28% 2.89% -3% 1.00%
Variance 0.0205 0.0067
E sto c
) 1 × (-7 1 × (1 2 1 × (2 8 % )= 1
sk 3 3 3
(r = % )+ % )+ 1%
100
100
 Case of 2 risky assets – Example 2d

Rate of Rate of
3.24% 17%Deviation
1.00%
Normal 12% 0.01% 7% 0.00%
Boom 28% 2.89% -3% 1.00%
Variance 0.0205 0.0067
E bond
) 1 × (1 7 % 1 × (7 1 × (-3 % )=
s 3 3 3
(r = )+ % )+ 7%
101
 Case of 2 risky assets – Example 2e
Stock fund
Bond Fund
Rate of Squared Rate of Squared
Scenario Return Deviation Return Deviation
Recession -7% 3.24% 17% 1.00%
Normal 12% 0.01% 7% 0.00%
Boom 28% 2.89% -3% 1.00%
Variance 0.0205 0.0067
= [ 1 1 % -( -7 % ) ] 2 =
3 .2 4 %
102
 Case of 2 risky assets – Example 2f

Rate of Rate of
3.24% 17%Deviation
1.00%
Normal 12% 0.01% 7% 0.00%
Boom 28% 2.89% -3% 1.00%
Variance 0.0205 0.0067
= ( 1 1 % -1 2 % ) = 0 2
.0 1 %
103
 Case of 2 risky assets – Example 2g

Rate of Rate of
3.24% 17%Deviation
1.00%
Normal 12% 0.01% 7% 0.00%
Boom 28% 2.89% -3% 1.00%
Variance 0.0205 0.0067
= (1 1 % -2 8 % ) = 2
2 .8 9 % 104
 Case of 2 risky assets – Example 2h

Rate of Rate of
3.24% 17%Deviation
1.00%
Normal 12% 0.01% 7% 0.00%
Boom 28% 2.89% -3% 1.00%
Variance 0.0205 0.0067
1 1 1
= *3.24% + *0.01% +
3 *2.89% )=2.05%
3 3
105
 Case of 2 risky assets – Example 2i

S tock fund Bond Fund
Rate of Rate of
Scenario S q u a r e d Return S q u a r e d Return
Recession -7%
Deviation 3 .2 4 % 17%
Deviation 1 .0 0 %
Normal 12% 0 .0 1 % 7% 0 .0 0 %
Boom 28% 2 .8 9 % -3% 1 .0 0 %
E x p e c t e d return 11.0 0% 7 .0 0 %
Va r i a n c e 0.0205 0.0067
Standard Deviation 1 4.3 % 8.2%
= 0 .0 2 0 5 =
 Note that stocks1have
4 .3 % expected return than bonds and higher
a higher
risk. Let us turn now to the risk-return tradeoff of a portfolio that is
50% invested in bonds and 50% invested in stocks.
106
 Case of 2 risky assets – Example 2j
Rate of Return
Scenario Stock fund Bond fund Portfolio squared deviation
Recession -7% 17% 5.0% 0.160%
Normal 12% 7% 9.5% 0.003%
Boom 28% -3% 12.5% 0.123%
Expected return 11.00% 7.00% 9.0%

Variance 0.0205 0.0067 0.0010
Standard Deviation 14.31% 8.16% 3.08%
Assuming w1 = 50% of our total money is invested in bonds (and so w2

= 50% is invested in stocks), the rate of return on the portfolio in
recession is a weighted average of the returns on the stocks and bonds in
the portfolio P:
rP = w 1 rB + w 2 rS = 5 0 % × (-7 % )+ 5 0 % × (1 7 %
)= 5 % 107
 Case of 2 risky assets – Example 2k
Rate of Return
Recession -7% 17% 5.0% 0.160%
Normal 12% 7% 9.5% 0.003%
Boom 28% -3% 12.5% 0.123%

Variance 0.0205 0.0067 0.0010
Assuming w1 = 50% (and so w2 = 50%), the rate of return on the

portfolio in normal times is a weighted average of the returns on
the stocks and bonds in the portfolio P:
rP = w 1 rB + w 2 rS = 5 0 % × (1 2 % )+ 5 0 % × (7 % )=
9 .5 % 108
 Case of 2 risky assets – Example 2l
Rate of Return
Recession -7% 17% 5.0% 0.160%
Normal 12% 7% 9.5% 0.003%
Boom 28% -3% 12.5% 0.123%

Variance 0.0205 0.0067 0.0010
Assuming w1 = 50% (and so w2 = 50%), the rate of return on the

portfolio in boom times is a weighted average of the returns on
the stocks and bonds in the portfolio P:
=50%×(28%)+50%×(-3%)=12.
5% 109
 Case of 2 risky assets – Example 2m
Rate of Return
Recession -7% 17% 5.0% 0.160%
Normal 12% 7% 9.5% 0.003%
Boom 28% -3% 12.5% 0.123%

Variance 0.0205 0.0067 0.0010
Assuming w1 = 50% (and so w2 = 50%), the expected rate of the

portfolio in all times is a weighted average of the expected
returns on the individual securities in the portfolio.
E (rP )= w 1 E (rB )+ w 2 E (rS )= 5 0 % × (1 1 % )+ 5 0 % ×

(7 % )= 9 % 110
 Case of 2 risky assets – Example 2n

Rate of Return
Recession -7% 17% 5.0% 0.160%
Normal 12% 7% 9.5% 0.003%
Boom 28% -3% 12.5% 0.123%

Variance 0.0205 0.0067 0.0010
Assuming w1 = 50% (and so w2 = 50%), the variance of the expected return on

the 2 risky assets portfolio in all times is:
σ2=(w σ )2+(w σ )2+2(w σ ) ( w σ ) ρ = ....
P 1 B 2 S 1 B 2 S BS
where ρBS is the correlation coefficient between the returns on stock & bond
funds.
Thus, an equally-weighted portfolio (50% in stocks and 50% in bonds) 111
has less risk than the risk of stocks or bonds held taken individually.
 Case of 2 risky assets – Efficient set of portfolios

1
% of P0%
in stocks 8,2%
Risk 7,0%
Return Portfolo Risk and Return
Portfolio Return
5% 7,0% 7,2%
10% 5,9% 7,4% Combinations
12.0
15% 4,8% 7,6% %
100%
20% 3,7% 7,8% 11.0
stocks
25% 2,6% 8,0%
50/50
%
30% 1,4% 8,2% 10.0
35% 0,4% 8,4% % 100%
40% 0,9% 8,6% 9.0 bonds
45% 2,0% 8,8% %
50,00% 3,08 9,00 8.0
55% % % % 0.0% 5.0% 10.0%
60% 4,2% 9,2% 7.0 15.0% 20.0%
65% 5,3% 9,4% %
70% 6,4% 9,6% 6.0
Portfolio Risk (standard
75% 7,6% 9,8% % deviation)
80% 8,7% 10,0% 5.0
85% 9,8% 10,2% We repeat
% the analysis
by varying now the
90% 10,9% 10,4% portfolio weights of stocks and bonds, so w2
95% 12,1% 10,6%
100% 13,2% 10,8% goes from 0% to 100% and simultaneously w1
112
14,3% 11,0% goes from 100% to 0%. We keep ρBS

%2of P in stocks Risk Return
0% 8.2% 7.0% Portfolo Risk and Return
Portfolio Return
5% 7.0% 7.2%
12.0%
Combinations
10% 5.9% 7.4%
100%
15% 4.8% 7.6% 11.0%
stocks
20% 3.7% 7.8% 10.0%
25% 2.6% 8.0% 9.0
30% 1.4% 8.2% %
8.0
100%
35% 0.4% 8.4%
40% 0.9% 8.6% % bonds
45% 2.0% 8.8% 7.0
50.00% 3.08 9.00 % 0.0 5.0% 10.0% 15.0%
55% %4.2% %9.2% 6.0 % 20.0%
60% 5.3% 9.4% %
65% 6.4% 9.6% Portfolio Risk (standard
5.0
70% 7.6% 9.8% deviation)
Note that some
%
portfolios are “better” than
75% 8.7% 10.0%
80% 9.8% 10.2% others. They have higher returns for the
85% 10.9% 10.4% same level of risk or less. The locus of
90% 12.1% 10.6%
95% 13.2% 10.8%
upper curve portfolios (which are all better
100% 14.3 11.0 than the
curve ones)
lower
is called the efficient frontier.
% % 113
E(rp)
3
100%
 = -1.0 stocks
 = 1.0
100%
 = 0.2
bonds 
 We repeat the analysis by varying not the portfolio weights of stocks & bonds, but
the correlation coefficient ρ from -1 to +1. In this case, the efficient frontier changes
shape and becomes a straight blue line (if ρ = 1), or two straight green lines (if ρ = -
1), or the red curve (for -1 < ρ < 1). Why?
 Since σ = (w σ ) 2 + (w σ ) 2 + 2 (w σ)(w σ )ρ, = .... what
2
happens to σp2 if ρ varies?

 Relationship
P depends1 onB correlation
2 S coefficient,
1 B 2 S B ρ.
S The smaller is ρ, the greater the
risk reduction potential. If ρ = +1, no risk reduction is possible. 114

 Case of risky assets – Efficient set of portfolios 4

 Consider a world with many risky assets; we can identify the
opportunity set of risk-return combinations of various
portfolios.
 However, given the overall opportunity set, we can identify the
minimum variance portfolio, below which we have no interest
in investing. Why?
• Portfolio 1 dominates portfolio 4.
E(rp)
Why?
Why?
Minimum 4 Why?
2
Variance
Portfolio 1
3
Individual Assets
P
115
 Case of risky assets – Efficient set of portfolios 5

 The section of the opportunity set which lies above the minimum variance
portfolio (blue line) is the efficient frontier.
 The efficient frontier shows the optimal combinations of risk-return 2-asset
portfolios.
 But, in addition to stocks & bonds, an investor has a choice to invest
alternatively in risk-free assets, like T-bills. How can they choose?
E(rp)
100% stocks
MVP
Individual Assets
100% bonds
P
116
 Case of risky assets – Efficient frontier with short-selling 1

 An investor can short-sell a security that s/he does not own. If short sales are not allowed
then the quantity of security X is positive (xi ≥ 0). When short sales are allowed some of the
xi can be negative but as before always Σxi = 1. With short sales allowed the investor can
achieved larger expected returns but this large increase in the expected return is
associated with a very large increase in risk.
 If short sales are unrestricted, then by a continuous short selling of B and reinvesting in A,
the investor can generate an infinite expected return. The efficient frontier of unconstraint
portfolio is shown in the upper bound of the highest-return portfolio, going to infinity.
E(rp)
Short-selling
100% stocks
MVP
Individual Assets
100% bonds
Short-selling
P
117
 Case of risky assets – Efficient frontier with short-selling 2

 Example. Consider the following example with 2 stocks, A and B. for each, we
have: A B
E(r) 0.14 0.08
σ 0.06 0.03, and, in addition, assume that ρAB = 0.5.
 If short sales are not allowed the largest expected return the investor can have is 14%
(invest all his money in stock A). However, with short sales allowed higher expected
returns can be achieved by short selling stock B (borrow B and sell it). The proceeds are
used to buy more shares of stock A. For example, suppose the investor initially has $100 to
invest buying 1 share of A. The investor can borrow and short $1,000 worth of stock B and
now invest $1,100 in stock A.
 Therefore, xA = 11 and xB = −10. The expected return and standard deviation of this
combination are:
 E(rp) = xAE(rA) + xBE(rB) = 11(0.14) − 10(0.08) = 0.74
 σ2 = x A2σ A2 + xB 2σB 2 + 2xA xB σA σB ρΑB = 112(0.06)2 + 102(0.03)2 + 2(11)(−10)(0.06)(0.03)0.5 =
0.327184 or σ = 0.572.
118
 Case of risky assets – Investor preferences

 Investors are typically risk-averse and they use their utility (return!) measure to
choose their optimal risky portfolio.
 Investors’ marginal utility indifference curves are shown below
Indifference Curves
- Represent individual investor’s
willingness to trade-off return &
Increasing Utility risk
E(ri)
- Assumptions:
1) 5 Axioms
2) Prefer more to less (Greedy)
3) Risk aversion
4) Assets jointly normally
distributed
i
119
 Case of risky assets – Efficient portfolios

 Case 1: Investors choose a risky-asset portfolio without a risk-free
asset available to buy.
 Investors would choose those risky-asset portfolios that reflect their choice of
risk aversion. The latter is based on an investor’s indifference curve.
 Investor will choose the portfolio where their indifference curve is tangent to the
efficient frontier. U The utility function U(.) commonly
4
U employed by financial analysts,
E(ri)
3
U2 which is devised by the AIMR
U1 (Association of Investment
Risk-taker
investor Management and Research), takes
100% stocks the form below, where U is the
Risk-averse
utility value and A is some index of
investor the investor’s risk aversion:
Individual Assets
100% bonds
i
120
 Example – Risky portfolios of two different investors

 Suppose that the risk-free rate is 7%, the expected return of the optimal
portfolio is 15% and its standard deviation is 22%. Investor 1 is a risk
averse investor with A=4 and investor 2 is a risk-taker investor with A=1.
What portfolios will they choose, given their preferences?
 Remember that since U  E(rp )  ,2  then after mathematical
we get 1-wf = [E(rP) -0.005A
manipulation rf]/[0.01*A*σ
p
p ), where 1-wf is the proportion of risky
2
securities in our overall portfolio.

 Investor 1 (A = 4)
1-wf = (0.15 – 0.07) / (0.01 * 0.222 * 4) = 0.41 = 41%, and
E(rC) = 0.41 * 0.15 + 0.59 * 0.07 = 10.28%
σC = (1-wf)⋅σp = 0.41 * 0.22 = 9.02%
 Investor 2 (A = 1)
 1-wf = (0.15 – 0.07) / (0.01 * 0.222 * 1) = 1.10 = 110%
 E(rC) = 110 * 0.15 – 0.10 * 0.07 = 15.8%
 σC = (1-wf)*σp = 110 * 0.22 = 24.2% 121
 Case of risky assets and a risk-free asset – Efficient portfolios 1

 Case 2: We now introduce the existence of a risk-free asset (i.e. T-Bills). This is
shown in the horizontal axis, as rf.
 Assume that borrowing and lending is free and that borrowing rate = lending
rate. This, in effect, means that an investor can borrow money to buy risky
assets, or that s/he chooses to buy risk-free assets and lends (the remaining)
money to another investor to buy risky assets.
 Then the investment opportunity set is represented by any straight line from the
originating point of risk-free assets to any risky portfolio on the min-variance
opportunity set (why? see next slide)
 This line is called CAL (capital allocation line) or CML (capital market line). CAL
extends from the risk-free asset origin point to the Min-Variance opportunity set
(Efficient Frontier). It displays the return to be made by taking on a certain level
of risk. For different levels of risk there are different CALs, all departing from the
same risk-free origin. Its slope is known as the "reward-to-variability ratio”.
 However, only one CAL will be chosen by rational investors: the one
that
dominates all the other. This is the CAL that is tangent to the Efficient Frontier.

The tangency point on the efficient frontier = optimal risky-asset portfolio. 122

 To see why the CAL (new frontier) is a straight line, consider a portfolio in
which the risk-free asset has weight wf and the risky asset has weight 1−wf.
Then, the expected return of the portfolio rp is:
rP = wf rf + (1−wf) rj
 However, the covariance σfj between the risk-free asset (f) and the risky
asset (j) is zero since, from the covariance formula:
E[(rj −ṝj) (rf − ṝf) = 0 (because rf = ṝf, the risk-free rate has no volatility)
 The variance of the portfolio (of both risky and risk-free asset) is
σP2 = wf σrf + (1 − wf) σj +2 wf (1 −wf) σrf σj Cov(rf,rj),
2 2 2 2
 but since σrf 2 = 0 and Cov(rf ,rj ) = 0, then σP = |1f −w

j | r , which is a
line
straight
(CAL).
 Overall, the CAL is given by the equation: E(rC) = rf + σC [E(rp - rf] / σp,
 where P = risky portfolio, F = riskless portfolio, and C = combination of portfolios P and F.
123

 The investor is confronted with two choices regarding the investment of capital:
 How much to put in risk-free assets (wf = ?) and how much to put in risky assets (1-wf = ?)
 Of the capital chosen to put on risky assets (1-wf), how much should be spend on stocks
(risky asset 1) (ws = ?) and how much on bonds (risky asset 2) (wb = ?)?
 It’s like having to choose how much is spent on T-bills and how much on a
Balanced Fund including stocks and bonds? The CAL expresses this choice.
E(rp)
EFFICIENT FRONTIER
Balanced 100% stocks
fund
MVP
rf
Individual Assets
100% bonds
P
124

 Choice criterion: With a risk-free asset available and the efficient
frontier identified, the rational investor chooses the CAL with
(highest Sharpeslope
the steepest Ratio). The Sharpe Ratio is given as: SR = [E(rp) – rf] / σp.
 With the CAL identified, all (rational) investors choose a point along the CAL
(not necessarily M), which represents some combination of the risk-free asset
and the market portfolio M (balanced fund between stocks and bonds).
E(rp)
100% stocks
M
rf
Individual Assets
100% bonds
P
125

 The Separation Theorem (by James Tobin) states that, in a world of homogenous
expectations, the optimal market portfolio, M, is the same for all investors. Then,
investors can separate their choice of risk aversion from their choice of the risky
market portfolio. The Theorem implies that portfolio choice can be separated into two
tasks: (a) determine the optimal risky portfolio, and (b) selecting a point on the CAL.
 Investor risk aversion is revealed in their choice of portfolio along the CAL — not in
their choice of the line. However, all rational investors have the same CAL.
E(rp)
Borrowing at the risk-free rate
100% stocks
M
rf
Individual Assets
100% bonds
P
126

 All investors have the same CAL because they all choose the same optimal risky
portfolio, M, given the risk-free rate.
 All an investor needs to know is (a) the risk-free asset and (b) the combination of
assets that makes up the optimal risky-asset portfolio. This is true for any investor,
regardless of his degree of risk aversion.
E(rp)
Optimal
Risky 100% stocks
Porfolio
rf
Individual Assets
100% bonds
P
127

 The optimal risky portfolio depends on (a) the risk-free rate and (b) the risky assets. Thus,
when the risk-free rate changes the calculation of the optimal portfolio changes too.
 If 1-wf > 1 (or 0 > wf), then there is negative investment (!) in the risk-free asset. The
investor borrows at the risk-free rate and invests in the risky asset (leveraged position in
the risky asset) – some of the investment is financed by borrowing (e.g., buying on
margin). The complete portfolio will have higher expected return, but also higher risk.
E(rp)
100%
stocks
2nd Optimal Risky Portfolio

rf1 1st
Optimal Risky Portfolio
r0
f
100%
bonds P
128
 Examples - CAL
 If the risk-free rate is 7%, the expected return of the portfolio is 15% and its standard
deviation is 22%, then calculate the risk and return of the overall portfolio that will
result if we invest 75% of our money (1-wf) in the risky portfolio. What is the slope of
the CAL?
 It is E(rC) = 0.75*15% + 0.25*7% = 13% and
 σC = (1-wf)⋅σp = 0.75*22% = 16.5%, and finally,
 the slope of CAL = [E(rp) – rf ] / σp = (0.15 – 0.07) / 0.22 = 0.37.
 Suppose the investor decides to borrow at the risk-free rate and invest all her own
money plus 25% additional borrowed money in the risky asset (so, 1-wf = 125%).
Then, the risk and return of the overall portfolio that results is the following:
 It is E(rC) = 1.25*15% + (-0.25)*7% = 16.25% and
 σC = (1-wf)⋅σp = 1.25 * 22% = 27.5%, and finally,
 the slope of CAL = [E(rp) – rf ] / σp = 0.05 / 0.22 = 0.23.
129
ASSET PRICING - THE C.A.P.M.
 Understand systematic and non-systematic risk

 Understand the Capital Asset Pricing Model
 Understand the meaning of the “beta” coefficient
 Understand the meaning of the “alpha” coefficient
 Understand the relation between the CAPM and the cost of
equity
capital
130
 Many risky assets - Systematic and non-systematic risk 1

 In the portfolio analysis, it would be an onerous task to calculate
the correlations when we have thousands of possible
investments.
 The Markowitz mean-variance portfolio model also laid down
the foundation for the development of a model for asset
pricing, namely, the Capital Asset Pricing Model (CAPM),
pioneered by Nobel Laureate William Sharpe in 1964, and
developed independently by Jack Treynor, John Lintner and
Jan Mossin.
 The CAPM provides a relatively simple measure of risk for a single
asset or a portfolio of assets.
 CAPM assumes that investors choose to hold the optimally
diversified portfolio that includes all risky investments. This
optimally diversified portfolio that includes all of the market’s
assets is referred to as the market portfolio.
 The CAPM says that the risk of an investment relates to how 131
this investment contributes to the risk of the whole market
 Many risky assets – Systematic and non-systematic risk 1

 Portfolio risk decreases as the number of securities in it increases.
But how much? Up to what point? The relation is asymptotic.
p
Diversifiable Risk; Nonsystematic

Risk; Firm-specific Risk; Unique Risk
Non-diversifiable risk; Systematic Risk;

Market Risk
N
Diversification can eliminate some, but not all of the risk of
individual asset. 132
 Many risky assets – Probability distributions change

 Question: What would happen to the risk of a portfolio as more and
more randomly selected stocks are being added?
 Answer: σp would decrease if the added stocks would be
imperfectly correlated (ρ=1), but rp would not change very much.
133
 Case of more risky assets – Systematic and non-systematic risk 2

 According to CAMP, the overall risk of an investment has two
components:
 Systematic (market) risk is that part of a security’s stand-alone risk that cannot be
eliminated by portfolio diversification.
 Firm-specific, or diversifiable, risk is that part of a security’s stand-alone risk that
can be eliminated by portfolio diversification.
 Can an investor holding one stock earn a return matching its risk?
 No. Rational investors will minimize risk by holding portfolios of many assets.
 The single-stock investor bears higher (stand-alone) risk, so the return is less
than
that required by the associated risk.
 As more stocks are added, each new stock has a smaller risk-reducing
impact on the portfolio.
 In general σp falls very slowly after about 20 stocks are included.
 By forming
the well-diversified
riskiness portfolios,
of owning a single stock.investors can eliminate part of
134
 Capital Asset Pricing Model 1

 The CAPM holds under certain, assumptions regarding investor behavior:
 Individual investors are price-takers (cannot individually affect the market)
 Single-period investment horizon (is assumed)
 Investments are limited to traded financial assets
 No taxes and transaction costs.
 The CAPM is used to determine a theoretically appropriate required rate of
return of a financial asset, if that asset is to be added to a well-diversified
portfolio, given the asset's non-diversifiable market risk.
 In well-diversified portfolios, the only risk left to deal with, is market
(systematic) risk. Market risk is defined as the contribution of an individual
security risk to the overall portfolio risk.
 Market risk is reflected in a stock’s beta coefficient, which measures the
stock’s volatility as a proportion of market volatility. Beta measures the
responsiveness of a security to movements in the market portfolio.
 The CAPM captures the asset's sensitivity to non-diversifiable market risk
(or systematic risk, or market risk).
135
 Capital Asset Pricing Model 2 – interpreting beta

coefficient
 The beta coefficient is interpreted as follows:
Value of
Interpretation Example
Beta
Asset price generally moves in the opposite

β<0 A short position
direction as compared to the benchmark price
Movement of the asset price is uncorrelated Fixed-yield asset, whose growth is unrelated to
β=0
with the movement of the benchmark price the movement of the stock market
Movement of the asset price is generally in the Stable stock, such as a company that makes
soap. Moves in the same direction as the
0<β<1 same direction as, but less than the movement market, but less susceptible to day-to-day
of the benchmark price fluctuation.
Movement of the asset price is in the

A representative stock, or a stock that is a
β=1 same direction as, and the same amount strong contributor to the index itself.
as the movement of the benchmark price
Movement of the asset price is generally in the

Stocks which are strongly influenced by day-
β>1 same direction as, but more than the movement of to-day news, or the health of the economy.
the benchmark price
 Most stocks have betas in the range of 0.5 to 1.5. 136

 Capital Asset Pricing Model 3 – beta

coefficient Cov(ri, rM ) σr i

Mathematically, beta is calculated as: β i = ρ r ,r
σ (rM )
2 i M
σrM
=
 Since total individual asset risk, σ i 2 is divided into systematic (β i *σΜ ) (non-
diversifiable)and non-systematic risk (σ i 2,bar) (diversifiable), then after some
manipulation, we obtain:
   
2 2 2
2
i i 
i
 Example: ABC stock has a volatility (SD) of 90% and a beta coefficient of 3. The
market portfolio has an expected return of 14% and a volatility of 15%. How
much risk can we expect to reduce?
 Answer: from the equation above we get: (0.90)2 = 32 * (0.15)2 + σ i2,bar => σ i2,bar =
0.81 – 9 * 0.0225 = 0.81 – 0.2025 = 0.6076. Thus, a portion equal to σ i2,bar/σ 2i =
0.6076 / (0.90)2 = 75% of the variance of the individual ABC stock is diversified
away by holding the market portfolio; the rest 25% cannot be diversified.
137
 Capital Asset Pricing Model 4 – estimating beta coefficient

 Empirically, beta is estimated by running a regression of the individual stock
returns on the returns of the market (index) as a whole. The regression line
(Characteristic line) is plotted on the Y axis and returns on the market portfolio
plotted on the X axis. The slope of the regression line, which measures relative
volatility, is defined as the stock’s beta coefficient (“β”). Analysts typically use
4 or 5 years’ monthly returns to establish the regression line.
Return on security E(ri)
Slope = i
Return on market E(rM)
ri =  i + irm + ei
138
 Capital Asset Pricing Model 5 – estimating beta coefficient

 Example: Use historical returns to calculate beta for security ‘i’
Market Security RXYZ

Year
return return 40%
1 25.7% 40.0%
2 8.0% -15.0%
3 -11.0% -15.0% 20%

4 15.0% 35.0%
5 32.5% 10.0% 0% RM
6 13.7% 30.0%
-40% -20% 0% 20% 40%
7 40.0% 42.0%
8 10.0% -10.0% -20%

9 -10.8% -25.0%
10 -13.1% 25.0% = 0.03 + 0.83RM

-40% RXYZ
α β
R2 = 0.36
139
 Capital Asset Pricing Model 6 – estimating beta

coefficient
 Example: Google’s stock beta coefficient
140
 Capital Asset Pricing Model 7 – interpreting beta


coefficient
The beta coefficient of the portfolio as a whole is the weighted average of
the betas of the individual securities (1 … n) comprising the portfolio times
their respective weights (w1 … wn):
n
β(rp ) = β w i i = β1 w1 + β 2 w 2 + β 3 w 4 + ..... + β n w n
i=1
where w1+w2+w3+…+wn = 1
 Example 1: Suppose a portfolio contains three securities A, B and C with weights of
50%, 25% and 25% respectively. The ‘beta’ of security A is 1.25, of security B is 0.95,
and of security C is 1.05. Calculate the ‘beta’ of the portfolio as a whole.
Answer: Portfolio Beta = (0.5 * 1.25) + (0.25 * 0.95) + (0.25 * 1.05) = 1.125
 Example 2. A portfolio is made up of a risky asset A with an expected return of 20%
and a beta 1.6 and the risk-free asset. The risk-free rate is 8%. If 25% of the portfolio
is invested in asset A, then the:
Portfolio expected return: E(rP) = 0.25*E(rA) + (1 − 0.25)*rf = 0.25*20% + 0.75*8% = 11%
Portfolio beta: βP = 0.25*bA + (1 − 0.25)*0 = 0.25*1.6 = 0.40
141
 Capital Asset Pricing Model 8 – interpreting alpha parameter

 The “alpha” parameter is a risk-adjusted measure of the so-called active
return (or abnormal return) on an investment . It is the return in excess of
the compensation for the risk borne, and thus used to assess active
managers' performance. The return of a benchmark is subtracted in order to
see relative performance, which yields “alpha”.
 The “alpha” parameter is the intercept of the SML (see later), that is, the
coefficient of the constant in a market model regression.
 In efficient market, expected value of “alpha” = 0. Thus, alpha indicates how
an investment has performed after accounting for assumed risk:
 If ai < 0: the investment has earned a return too little for its risk (was too risky)
 If ai = 0: the investment has earned a return adequate for the risk assumed,
 If ai > 0: the investment has earned a return in excess of the reward for assumed risk.
 For instance, although a return of 20% may appear good, the investment
can still have a negative “alpha” if it involves an excessively risky position.
142
 Capital Asset Pricing Model 9 – Relationship between ‘β’ and E(ri)

 Recall that the expected return on the asset E(ri), as a function of all
market scenaria, is given as: i
n
E(r ) pi ri
  i1
 Recall that the expected return on the market E(rM) is given as:
E ( rM )  r f  m a r k e t r is k prem
iu m
where market risk premium is E(rM) - rf
 Then, the expected return on a asset, E(ri), as a function of market
risk ‘β’, is given as:
E(ri )  rf  i *[E(rM )
 rf ]
 If βi = 0 then E(ri) = rf.
 This relation applies to individual securities held within
 If βi = 1
well- then E(ri) = 143
E(r )

 The estimation of beta gives the Security Market Line (SML). The SML
originates in the risk-free rate and extends with a slope equal to “β”. Thus,
the SML shows expected return as a function of β.
 Individual securities are plotted along the SML graph with varying (ri,βi)
combinations. The following apply:
 If a security's expected return vs. market risk is above the SML, it is undervalued (price too
low)
since the investor expects a greater return for assumed risk [forecasted (ri) > required E(ri)]
 If a security’s return vs. market risk is below the SML, the security is overvalued (price too high)
E(r)
since the investor accepts less return for assumed risk [forecasted E(ri) < required E(ri)]
Undervalued
R i  RF  β i  ( R M  RF )
Overvalued
1.0
beta 144

 Example: if a stock has beta = 1.5, the risk-free rate is 3% and the
market rate of return is 10%, then the expected return of stock is
13.5%
E(ri)
ri  1
3 .5 %
rM  1 0
%
rf 
3%
beta
1 1.5
145
 Capital Asset Pricing Model 12 – Relationship between ‘a’ and ri

 In order to estimate “alpha” we need to move from a model cast in terms of
expectations to a realized-return framework. To do this, we start with a form of
the single-index equation in realized excess returns. This equation may be
interpreted as an empirical regression relationship:
ri   ai  i *(rM  rf ) 
 i
rf
where r is the holding-period
ei and α and β are the
return (HPR) on asset i, i i
intercept and slope, respectively, of the line that relates asset i’s realized excess
return to the realized excess return of the index (market), which is equal to rM.
 The error term, ei, measures firm-specific effects during the holding period; it is
the deviation of security i’s realized HPR from the regression line, that is, the
deviation from the forecast that accounts for the index’s HPR. The relationship
is set in terms of excess returns over the risk-free rate, rf, for consistency with
the CAPM’s logic of risk premiums.
 The error term appears only when we deal with realized returns, and not when
we use expectational returns. If the risk-free rate, rf, is not available, the
equation above collapses to a simpler regression equation (shown previous14ly6).
 Capital Asset Pricing Model 13 – Cost of equity capital

 This expected return on equity, or equivalently, a firm's cost of equity
capital, can be estimated using the CAPM. According to the model, the
expected return on equity is a function of a firm's equity beta (βE) which, in
turn, is a function of both leverage and asset risk (βA):
k e = rf + β e (rM -rf )
 where: ke = firm's cost of equity; rf = risk-free rate; rM = return on the market portfolio.
 Example: The yield on 1-year treasury bills as of 30.12.2013 is 0.72%. From

Yahoo Finance, we find that stock XYZ's share price as of 30.12.2013
is
$86.81 per share, while it has a beta coefficient of 1.86. The 12-month return
on S&P500 is 11.52%. Estimate the cost of equity.
 Under the CAPM, the rate of return on short-term treasury bonds is the
proxy used for risk-free rate. We have an estimate for beta coefficient and
market rate for return, so we can find the cost of equity:
 Cost of Equity = 0.72% + 1.86 * (11.52% − 0.72%) = 20.81%.
147
 Example - CAMP and Portfolio Returns

1
Below you find historical data (5 years) for a capital market, in which the rate of return of stock
J
(rj) and the market as a whole (rM) are given in the table below:

Year (t) (rj) (rM)
2001 -7 -10
2002 6 5
2003 15 25
2004 9 15
2005 22 30
1. Calculate the average return of both stock j and the market over the 5 years
rj =(-7+6+15+9+22)/5=0.09 or 9%
rM =(-10+5+25+15+30)/5=0.13 or 13%
2. Calculate the variance and the standard deviation of both the stock j and the market.
σ 2 (r )  [( 7  9) 2  (6  9) 2  (15  9) 2  (9  9) 2  (22  9) 2 ] / 4 
117.5
j
σ (r j )  1 17 .5  1 0.8 4 %
σ 2 (r )  [( 10  1 3 ) 2  (5  1 3 ) 2  (25  1 3 ) 2  (15  1 3 ) 2  (30  1 3 ) 2 ]

/4
M
σ (rM )  2 5 7 .5  1 6 .0 5 % 148
 Example - CAMP and Portfolio Returns

 2
Below you find historical data for a capital market, in which the rate of return of stock J (r ) j
the
andmarket as a whole (rM) are given in the table below:
3. Calculate the covariance and the correlation coefficient between the returns of stock j and the
market.


(7 9)(5 13) 
(69)(10
Cov(rj , rM ) 13)
 (15  9)(2513) /(5 1) 
171.25 
 (9  9)(1513)
  (22  9)(30

13) 171.2
ρ j,M  Cov(r j , rM ) 
5
σ(rj ) σ(r ) (10.84) 0.984
(16.05)
M

4. Calculate the Security Market Line of stock j. What is the rate of return of stock j when the rate of market return is
zero?
The security market line is given byˆ the Cov(r j ,Mr (regression
expression 171.2 equation): rj  αˆ j  βˆ jrM , where
The “beta” coefficient is given as jβ ) 2   0.665 ,
σ (rM ) and 5

257.5
the “alpha” coefficient is given as . αˆ j  rj  βˆ jrM  9  (0.665)(13)  0
.355
149
 Example - CAMP and Portfolio Returns 3

 Below you find historical data for a capital market:
5. Calculate the deviation of the rate of return of stock j from the Security Market Line for each year
Let’s denote these deviations by ε j,t . Then, we can determine the equation as:
ε j, t  rj, t  (αˆ j  βˆ jrM,t ) , from which we can calculate the deviations as:
2001: -7 - [0.355 + 0.665*(-10)] = -0.705
2002: 6 - [0.355 + 0.665*(05)] = + 2.32
2003: 15 - [0.355 + 0.665*(25)] = -1.98
2004: 9 - [0.355 + 0.665*(15)] = -1.33
2005: 22 - [0.355 + 0.665*(30)] = +1.695
6. Calculate the variance of these deviations of returns. How would you interpret these deviations?
The variance of these deviations is given by the formula:

n
ε2
 j, t
n 2 ,
σ 2 (ε j )  t1
which after substitution of values, gives:
σ2 (ε )  [(  0.705)2  (2.32)2  ( 1.98)2 + ( 1.33)2  (1.695)2 ]/3  4.814
j
These deviations show the difference between realized (actual) and expected (theoretical) return of stock j.
150
EFFICIENT MARKETS AND BEHAVIORAL FINANCE
 The Efficient Market Hypothesis

 Weak, semi-strong and strong forms of market efficiency
 Investment behavior
 Behavioral finance
 Human rationality and prospect theory
 Reasons for irrational berhavior
151
 The Efficient Market Hypothesis 1 - origin

 Eugene Fama: “The market price at any time instant reflects all available
information in the market” (Efficient Market Hypothesis – EMH).
 You cannot “make money” by trading using “stale (old) information”.
 Michael Jensen: “there is no other proposition in economics which has
more empirical support than the EMH”. But, that’s incorrect!
 Challenges to the EMH: Investors are not “fully rational”. They
exhibit “biases” and use simple “heuristics” (rules of thumb) in
making decisions.
 Empirical evidence on investor behavior:
 investors fail to diversify (stick to social/historical habits & customary
behavior)
 investors trade actively (thus, there are (still) opportunities to be
exploited)
 Investors may sell winning stocks and hold onto losing stocks
 Investors can make extrapolative and contrarian forecasts (guided by
past).
 The Efficient Market Hypothesis 2 - background

 Expected Utility Theory: it is a theory of individual choice under uncertainty
for a single decision-maker. Expected utility (return!!) is measured as:
E(U) = p1*u1 + p2*u2 + … + pn*un.
where p: probability of an event; u: personal utility (satisfaction) derived from event
 E(U) is based on strong assumptions about preferences (transitivity,
cancellation, etc.)
 Rational Expectations Theory: all investors make rational choices based on
the following assumptions:
 All investors are identical.
 All investors are rational utility maximizers.
 All investors use “Bayes rule” to adjust beliefs to new information.
 The Bayes's rule relates the odds of event A1 to the odds of event A2, before (prior to)
and after (posterior to) conditioning on another independent event B.
 All investor predictions are accurate (no methodology flaws, perfect
forecastability).
 Expected Utility + Rational Expectations => MARKET EFFICIENCY 153
 The Efficient Market Hypothesis 3 – reasons

 Reasons why the markets owe to be efficient
 Marginal investor determines prices based on analysis and forecastability
 Smart money dominates trading
 Survival of fittest
 Reasons why the markets may not be efficient
 Excessively high market volatility: extreme events (crises, booms)
 Stock price over-reaction: long time trends (1-3 years) reverse themselves (no random
walks)
 Momentum in stock prices: short-term trends (6-12 months) persist (gain momentum)
 Size and book-to-market ratio (stale information) may help predict returns (contrary to
EMH)
 Overconfidence
 Slowness to make money, futility of career trying to prove others of one’s ability
154
 The Efficient Market Hypothesis 4 – forms

 Forms of market efficiency:
 Weak form = prices reflect all past market level (price and volume) information
 Semi-strong form = prices also reflect all publicly available fundamental company and
economic information
 Strong form = prices also reflect all privately held information that would affect the
value of the company and its securities
 Random Walk Hypothesis
 Random walk is the approximate implication of unpredictability of returns
 Fair Value Pricing
 The fair price function of capital markets means that an investor can trust the
financial
system for producing accurate and fair valuation of securities
 The function removes the fear of buying or selling at an unreasonable (manipulated)
price
 The more participants and the more formal the marketplace, the greater the
likelihood
that the trase is executed on a fair price
155
 The Efficient Market Hypothesis 5a – weak form

 Weak form of market efficiency
 The weak form of the EMH states that it is impossible to predict future stock prices by
analyzing prices from the past
 The current price is a fair one that considers any information contained in past prices
 Technical analysis
 Charting techniques are of some use in predicting stock prices
 People who study charts are technical analysts or chartists
 Chartists look for patterns in a sequence of stock prices
 Many chartists have a behavioral element
 A runs test is a nonparametric statistical technique to test the likelihood that a series
of price movements occurred by chance
 A run is an uninterrupted sequence of the same observation
 A runs test calculates the number of ways an observed number of runs could occur
given the relative number of different observations and the probability of this number
 These tests have provided evidence in favor of weak form efficiency
156
 The Efficient Market Hypothesis 5b – weak form

 Technical analysis vs. fundamental analysis
 Technical analysis and fundamental analysis are the two main schools of
thought when it comes to analyzing the financial markets and stocks.
 Tools
 Fundamental analysts start with a company’s financial statements, whilst
technical analysts typically begin their analysis with charts
 Fundamental analysts try to determine a company’s value by looking at its income
statement, balance sheet, and cash flow statement.
 Analysts look at a company’s intrinsic value by discounting the value of future
projected cash flows to a net present value. A stock price that trades below a
company’s intrinsic value is considered a good investment opportunity and vice versa.
 Technical analysts believe that there’s no reason to analyze financial
statements since the stock price already includes all relevant information.
Instead, the analyst focuses on analyzing the stock pattern itself for hints into
where the price may be headed.
157
 The Efficient Market Hypothesis 5c – weak form

 Horizon
 Fundamental analysts take a long-term approach to investing.
 Technical analysts take a short-term approach. While stock charts can be
delimited in weeks, days, or even minutes, fundamental analysis often looks
at data over multiple quarters or years
 Fundamentally-focused investors often wait a long time before a company’s
intrinsic value is reflected in the market.
 For example, value investors assume that the market is mispricing a security over the
short-term, but that the price of the stock will correct itself over the long run. This
“long run” can represent a timeframe as long as several years, in some cases
 Fundamentally-focused investors also rely on financial statements that are
filed quarterly, as well as on changes in earnings per share that don’t emerge
on a daily basis like price and volume information.
 A company can’t implement sweeping changes overnight and it takes time to create
new products, marketing campaigns, and other strategies to turn around or improve a
business (fundamental data is generated much more slowly than price/volume data).
158
 The Efficient Market Hypothesis 5d – weak form

 Trading vs. investing
 Technical analysis and fundamental analysis have different goals in mind.
TAs try to identify short- to medium-term trades where they can flip a stock,
while FAs try to make long-term investment in a stock’s underlying business.
 A way to conceptualize the difference is to compare it to someone buying
a home to flip vs. someone buying a home to live in for years to come.
 The Critics
 Many critics view technical analysis as unproven at best or wishful thinking
at worst. While most analysts focus on the fundamentals, almost all
brokerage firms employ technical analysts. Professional certifications exist
for technical analysts and some techniques are included in the CFA exam.
 Much of the criticism of technical analysis is focused on the EMH. Taken to
the extreme, the ‘strong form efficiency’ hypothesis implies that both
technical and fundamental analysis are ‘useless’ because all information in
the market is accounted for in a stock’s price.
 The reality is that the EMH is still just that – a hypothesis. It’s up to
to decide who is correct and determine their own philosophy.
investors 159
 The Efficient Market Hypothesis 6 – semi-strong form

 Semi-strong form of market efficiency
 The semi-strong form of the EMH states that security prices fully reflect all publicly
available information (e.g., past stock prices, economic reports, brokerage firm
recommendations, investment advisory letters, etc.)
 Research supports the semi-strong form of EMH by investigating corporate
announcements (i.e. stock splits, cash dividends, stock dividends) and “event studies”
 Market predictability
 Market seems to do a relatively good job at adjusting a stock’s valuation for certain
types of new information
 Determining how much the new information will change the stock’s value and then
adjusting the price by an equivalent amount (this is what “event studies” examine)
 But it is difficult to develop an overall valuation for a stock (i.e. it is difficult to calculate
the correct value for IBM stock as a whole, but how much IBM’s value should change if
it is awarded a specific new contract is much easier to determine.
 Research has shown that about 2/3 (not all!!) of professionally managed portfolios are
consistently beaten by a low-cost index fund. This suggests that securities are
accurately priced and that in the long run returns will be consistent with the level of
systematic risk taken. 160
 The Efficient Market Hypothesis 7 – strong form

 Strong form of market efficiency
 The strong form of the EMH states that security prices fully reflect all relevant public
and private information. This would mean even corporate insiders cannot make
abnormal profits by using inside information about their company
 Inside information is information not available to the general public.
 Market predictability
 The unexpected portion of news follows a random walk
 News arrives randomly and security prices adjust to the arrival of the news
 We cannot forecast specifics of the news very accurately
 Anomalies
 A financial anomaly refers to unexplained results that deviate from those expected
under finance theory (especially those related to the efficient market hypothesis)
 Such anomalies include - Low-Priced Stocks, Small Firm and Neglected Firm Effect,
Market Overreaction, January Effect, Day-of-the-Week Effect, Turn-of-the Calendar
Effect, Joint Hypothesis Problem, Chaotic Behavior, Behavioral Finance, etc.)
161
BOND PRICES AND YIELDS
 Describe the market for corporate bonds and three types of

corporate bonds.
 Explain how to calculate the value of a bond and why bond
prices vary negatively with interest rate movements.
 Distinguish between a bond’s coupon rate, yield to
maturity, and effective annual yield.
 Explain why investors in bonds are subject to interest rate
risk and why it is important to understand the bond
theorems.
 Discuss the concept of default risk and know how to
compute a default risk premium.
 Describe the factors that determine the level and
shape of curve.
the yield 162
 Bond Price (rationale)

 In an efficient market, the fundamental price (intrinsic value) of
a
financial asset equals the Present Value of its future cash flows.
 Bond price calculation
 Determine the required rate-of-return (market sentiment)
 Determine expected future cash flows – the coupon payments
and par value, over its life-time (n years)
 Compute the fundamental price (P0) by calculating the present
value of all expected cash flows over a bond’s maturity:
P0 = PVCoupon Payments + PVPar Value
 General Formula of Bond Price Valuation
C1 C2 
P0    ... 
(1Fn i) (1
1
(1
Cn 163
i) 2
i) n
 Cash Flow for a Three -Year Bond
164
 Bond Valuation – expanded version

 When coupon rate is fixed over-time and prepaid, the formula for bond
valuation can be re-written as:
C C CF 1  (1 r )  n F
P0 
(1 r) 1  (1 r ) 2  ...  (1 r ) n  C  (1 r ) n
n
r
Where M is value at maturity, usually equaling face value
 Example: Company S has issued a bond having face value of $100,000 carrying
coupon rate of 9% to be paid semi-annually and maturing in 10 years. The market
interest rate is 8%.
 Since the interest is paid semi-annually the bond interest rate per period is 4.5%
(= 9% ÷ 2), the market interest rate is 4% (= 8% ÷ 2) and number of time periods
are 20 (= 2 × 10). Hence, the price of the bond is calculated as the present value of
all future cash flows as shown below:
1 (1 r)  n 1 (1 0.04) 20 $100,

P0  C   4.5% *$100,   $106,
F r (1 0.04 000
(1 
000* 795
r) n
0.04) 20
165
 Bond Valuation Example

 Calculator solution
 Determine the market price of a bond that has face value of 1000, pays a
coupon rate of 8%, has 3 years to maturity, and the required rate of
return is 10%
 ANSWER: 950.26
3 10 80
Enter
1,000
N i PV PMT FV
Answer
-950.26
166
 Bond Price calculation – EXCEL Solution 1

 Excel has a function that allows you to price straight bonds,
and it is called PRICE.
 =PRICE(“Today”,“Maturity”,Coupon Rate,YTM,100,2,3)
 Enter “Today” and “Maturity” in quotes, using mm/dd/yyyy format.
 Enter the Coupon Rate and the YTM as a decimal.
 The "100" tells Excel to use $100 as the par value.
 The "2" tells Excel to use semi-annual coupons.
 The "3" tells Excel to use an actual day count with 365
days per year.
167
 Bond Price calculation – EXCEL Solution 2
168
 Bond Valuation Example 2

 A company has issued 10-year bonds outstanding with a 13% annual
coupon rate. This bond has an annual coupon payment of $130.
Since the risk is the same the bond has the same yield to maturity
(10%). In
this case the bond sells at a premium because the coupon rate exceeds
the yield to maturity.
INPUTS 10 10 130
N I/YR PV 1000
OUTPUT -
1184.34 PMT FV
 The same company also has 10-year bonds outstanding with the same
risk but a 7% annual coupon rate
INPUTS 10 10 70 1000
PV PMT FV
OUTPUT N I/YR -815.6
169
 Par, Premium, and Discount Bonds

 If a bond’s coupon rate is equal to the its yield, its price equals its face
value; it is a par bond.
 If a bond’s coupon rate is less than its yield, its price is less than its face
value; it is a discount bond
 If a bond’s coupon rate is greater than its yield, its price is greater than its
face value; it is a premium bond
 Premium bonds
 price > par value
 YTM < coupon rate
 Discount bonds
 price < par value
 YTM > coupon rate
 Par bonds
 price = par value
 YTM = coupon rate
170
 Semi-annual Compounding
 Most bonds issued in Europe pay annual coupons, most issued in the US
pay semi-annual coupons
 Bond valuation formula with semi-annual coupon payments becomes:
C m C m C m
PB  1 2 3  ... 
C m  Fmn
(1 i m) (1 i m) (1 i m) (1 i
 m) mn
Example - What is the market price of a three-year, 5% coupon bond, with
a market yield of 8% and semi-annual coupon payments?
 Semi-annual market yield = 8% / 2 = 4%
 Semi-annual coupon payment = $50 / 2 = $25
 SOLUTION: 921.36
$25 $25
P    $25  $25  $25  $25  $1000
(1.04 ) (1.04 ) (1.04 ) (1.04 ) (1.04 ) (1.04 )
B
1 2 3 4 5 6
 $24.04  $23.11  $22.22  $21.37  $20.55  $810 .07

 $921.36 171
 Bond Valuation Example

 Calculator solution
 Determine the market price of a bond that has face value of 1000, pays a
coupon rate of 5% semi-annually, has 3 years to maturity, and the required
rate of return is 8%
 ANSWER: 921.37
Enter 6 4 25 1,000
N i PV PMT FV
Answer
-921.37
172
 Zero-Coupon Bonds
 Zero-coupon bonds do not make coupon payments but pay their
face value at maturity
 The price (or yield) of a zero-coupon bond is a special case of the
general pricing formula where all coupon payments equal zero.
So: P  Fmn
B
(1 i m) mn
 Zero-coupon bonds pay cash only at maturity and must sell for
less than similar bonds which make periodic interest
payments
 Example: What is the price of a zero-coupon bond with a $1,000
face value, 10-year maturity, and semi-annual compounding? The
required market rate on similar $1000
$1000
bonds is 12%.
PB   
(1 0.12 2) 2*10
(1
$311.80
0.06) 2*10
173
 Yield to Maturity (YTM)

 YTM is the discount rate that makes the present value of the
bond’s cash flows equal to the current price of bond:
C C C  Fn
P0    ...
(1  YT M )1  (1  YT M ) 2 (1 
YT M ) n
Fn - P
C 
YTM  n
or, alternatively, Fn  P
2
 YTM is the rate a bondholder earns if the bond is held to
maturity and all coupon and principal payments are made as
promised
 Changes daily as interest rates change
174
 Example: Yield to Maturity (YTM) 1

 What is the YTM on a 10-year, 9% annual coupon, $1,000 par
value bond, selling for $887?
 ANSWER: Must find the r that solves the following equation,
C C Fn
PB   ...  
(1  YTM )1 (1  (1  YTM ) n
YTM ) n90 90 1,000
$887   ...    YTM  r 
(1  YTM ) 1
(1  (1  YTM ) 10.91
10
 SolutionYTMby )using the calculator

10
INPUTS 10 - 887 90 1000

N I/YR PV PMT FV
OUTPUT 10.91
175
 Example: Yield to Maturity (YTM) 2

 What is the YTM on a 10-year, 9% annual coupon, $1,000 par
value bond, selling for $1,134.20?
 ANSWER: Must find the r that solves the following equation,
C C Fn
PB   ...  
(1  YTM )1 (1  (1  YTM ) n
YTM ) n 90 90 1,000
$1,134.20   ...    YTM  r 
(1  YTM ) 1
(1  (1  YTM ) 7.08
10
 Solution byYTM ) 10
using the calculator:
INPUTS 10 -1,134.20 90 1000

N I/YR PV FV
PMT
OUTPUT 7.08
176
 Realized Yield
 Sometimes you will be asked to find the realized rate of
return for a bond.
 This is the return earned on a bond given the cash flows
actually received by the investor. This is the return that the
investor actually realized from holding a bond.
 Using time value of money concepts, you are solving for the
required rate of return instead of the value of the bond.
 It is given by the interest rate at which the present value of
actual cash flows generated by the investment equals
bond’s price
 The realized yield is important because it allows investors
to see what they actually earned on their investments.
177
 Example: Realized Yield

 An investor purchased a bond for $800, 5-years ago and she
sold the bond today for $1200. The bond paid an annual
10% coupon. What is her realized rate of return?
 PV = Σnt=0 [CFt / (1+r)t] => $800 = [$100/(1+r) + $100/(1+r)2
+
$100/(1+r)3 + $100/(1+r)4 + $100/(1+r)5] + [$1200/(1+r)5]
 To solve, you need use a “trail and error” approach.
You plug in numbers until you find the rate of return that
solves the equation. The realized rate of return above is
19.31%.
Enter 5 -800 100 1,000
 Using the calculator:
N r PV PMT FV
Answer
19.31
178
 YIELD calculation – EXCEL Solution

 We can use the YIELD function in Excel:
 =YIELD(“Today”,“Maturity”,Coupon Rate,Price,100,2,3)
 Enter “Today” and “Maturity” in quotes, using mm/dd/yyyy format.
 Enter the Coupon Rate as a decimal.
 Enter the Price as per hundred dollars of face value.
 The "100" tells Excel to use $100 as the par value.
 The "2" tells Excel to use semi-annual coupons.
 The "3" tells Excel to use an actual day count with 365 days per year.
179
EQUITY SECURITIES
 Valuation of Equity Securities

 The value of common and preferred stock is estimated using
methodology employed for bond valuation – discounted cash flow
the
 Valuing common stock is more difficult than valuing bonds or
preferred stock because:
 Size and timing of dividends are less certain compared to
coupon payments.
 The required rate of return (discount factor) on common stock cannot
be observed directly from the market.
 Common stock is a true perpetuity because it has no maturity date.
180
EQUITY VALUATION
 Stock Valuation Method – various periods

 Single period pricing: The market value of a share of stock today equals
the combined present value of two future cash inflows: (a) the
expected end-of-period dividend and (b) the expected end-of-period
stock price.
Thus, we have: D1  1
P0 
P r)1
(1
 Two period pricing: It is a combination of two one-period models
P0  D1 D2 

(1 r)1 (1
r) 2P2
 Multi-period pricing: Can be viewed as an infinite series of one-period
stock pricing models (perpetuity - provided the company lives many years)
D1 D2 D3 D
P0     ... 
(1 r)1 (1 r)2 (1 r)3 (1 r )
 Though theoretically sound, an infinite number of items is impractical to
estimate. Thus, some assumptions need be made on the terminal value1.81
EQUITY VALUATION
 General Dividend Valuation Model (EQ1)

 The general perpetual model for valuing stock is given

as: D1 D2 D3 Dt  Dn
P0     ... 
(1 r)1  (1 r)2 (1 r)3 (1 r)t t 1 ( 1  r )
t
 The equation predicts – and common sense says – that the

shares of a company that will never pay cash to investors are
worthless.
 The discounted cash-flow model:
 does not include specific assumptions, such as:
 a constant growth rate, for estimating expected future cash dividends
 how to forecast dividends or when a share of stock might be sold
 requires dividend forecasts for an infinite number of periods

 implies the intrinsic value of a share of stock is determined by the market’s
expectations of a firm’s future cash-flows. 182
EQUITY VALUATION
 Growth Stock Pricing Paradox

 Growth stock - Stock of a company whose earnings are growing at an
above-average rate and are expected to continue to do so for some time.
 Rapidly-growing firms typically (a) pay no dividends on common stock during the
growth phase, and (b) have many high-return investment opportunities;
 In reality, high-growth firms eventually pay dividends. If investments
made with reinvested funds succeed, net cash flows increase significantly
 Investors can sell their stock at much higher price than what they paid.
 Value stock - Stock of a company whose earnings are growing at an below-
average rate and are expected to continue to do so for some time.
 Rapidly-growing firms typically pay high dividends on common stock and have
few high-return investment opportunities.
183
EQUITY VALUATION
 Simplifying Assumptions
 To make Equation EQ1 more applicable, some simplifying
assumptions about the pattern of dividends are necessary
 Three models / assumptions for describing growth
patterns
of dividends are therefore used:
 The dividend has a zero growth rate and it is always the same.
 The dividend has a positive growth rate, which is constant.
 The dividend has a positive growth rate, which is mixed: the rate
is higher in some periods and lower in others.
184
EQUITY VALUATION
 Case 1: Zero-Growth Dividend Model

 The dividend is constant over-time (zero growth): D1 = D2 = D3 = . . . = D∞
 Equation EQ1 becomes:
D D D D
P0     ...
(1  r )  (1  r )
1 2
(1  r ) 3
(1  r ) 
 This cash-flow pattern describes a perpetuity with a constant cash flow.

The theory of TVM shows the present value of a perpetuity with a
discounted constant cash flow.
 Then, the pricing formula for a zero-growth dividend stock becomes
(EQ2):
P0  D
r
 Example: Company A pays $5 dividend per year, and the board of directors
has no plans to change the dividend. The firm’s investors require a 20%
return on investment. What should be the market price of the firm’s stock?
 Answer: P0 = D / r = $5 / 0.20 = $25.
185
EQUITY VALUATION
 Case 1: Zero-Growth Dividend Model (cont)

 The exhibit below shows that distant dividends have small
present values and little influence on the current market price of a
stock
186
EQUITY VALUATION
 Case 2: Constant-Growth Dividend Model 1

 Cash dividends increase at the constant rate g from one period to the next,
forever. So, the general pricing formula becomes:
D D(1 g ) D(1  g ) 2 D (1 g ) n
  ...
P0  
(1  r ) 1 (1  r ) 2  (1  r ) 3 (1  r ) 
 Constant dividend growth is a reasonable assumption for mature companies

with a history of stable growth. The constant-growth dividend model
(CDGM) (Gordon’s dividend growth model) becomes:
CFi D1
P0  PV  
rg r
g
 The current price of a share of stock P0 is next period’s dividend D1 divided
by the difference between the discount rate r and the dividend growth rate g.
The dividend at any time in the future is given by: Dt = D0*(1+g)t. Thus, the
CDGM is generalized to value a share of stock at any point in time t (EQ3):
D t 1
Pt 
rg 187
EQUITY VALUATION
 Case 2: Constant-Growth Dividend Model 2

 Example 1: Company B paid a dividend of $4.81 at this year (end of
previous year). The dividend is expected to increase by 4% annually and
investors who own stock in similar firms require a return of 18%. What
is the market value of the firm’s stock?
D  D  (1  g )1  $4.81 (1  .04)1  $4.81 (1.04)1  $5.00
1 0
D1
P0  $5.00
R  g 0.18  0.04 0.14  $35.71

$5.00 
 Example 2: Company C paid a dividend of $2.50 today. Similar stocks in the

market yield 15% and the growth rate of dividends is 5%. Estimate the stock
price five years from today.
D
 6$ 3. 3D5 0  ( 1  g )6  $2.50 (1.05)  $2.50(1.34)
6
D6 $3.35
P5  $3.35
R  g  0 .1 5  0 .0 5  0 .1 0  $ 3 3 . 5 0
 Constraint: The constant-growth dividend model yields invalid solutions
when the dividend growth rate equals or exceeds the discount rate (g ≥ R)
 If g = R, the denominator is zero and the value of the stock is infinite – which cannot occur.
 If g > R, the denominator is negative and the stock price is negative – which cannot occur. 188
EQUITY VALUATION
 Case 3: Supernormal-Growth Dividend model 1

 Some firms experience a supernormal rate of growth in dividends early
in their lives.
 Assuming the supernormal growth occurs first and is followed by the
constant growth forever, EQ2 and EQ3 can be used to value the stock of
a firm with supernormal dividend growth.
189
EQUITY VALUATION

 There may be a period of time when the dividends issued on shares of a stock
are increasing at a higher-than-average rate. The higher growth rate of dividend
payouts are seen as above normal ("supernormal“). Because this growth rate
is expected to be unsustainable, it should eventually return to normal levels.
Supernormal dividend growth is projected based on a company and/or industry
analysis, which determines a period of increased earnings and thus payouts.
 Such stocks can be valued using a discounted cash flow model. Investors who
purchase stocks based on dividend growth should know three general
models:
 Dividend discount model with no growth in dividends.
 Dividend discount model with constant dividend growth.
 Dividend discount model with supernormal dividend growth.
 Even though "growth" is used, you should think about the change in dividend
payments, this will include decreases into you discount models.
 In this case, dividends corresponding to different rates of growth are
discounted separately, then combined to get the total value. In these
calculations, investors have to determine the required rate of return, the time
can
periods,
drastically
and rate
change
of growth.
the valuation
In practice,
of the of them are difficult to predict 190
all stock.
and
EQUITY VALUATION
191
EQUITY VALUATION

 The valuation model -
 P0 = PVNC (non-constant dividend growth) + PVC (constant dividend growth)
 Example: Calculate the value of the stock exhibiting the

dividend pattern of the previous Exhibit 9.4.
P0  dcf1  dcf 2  dcf 3  dP 3(d  discounted) or
P0  D 1 /(1 r)1  D 2 /(1 r) 2  D 3 /(1 r) 3  D 4 /(r 
g)/(1 r) 3
D4  $3.18
D34  D 3  (1 g)1  $3.00
P 
 $3.1 8 1  $3.18
(1.06)
Rg 0.15  0.06 0.09  $35.33. Thus, overall :
$1.00 $2.00 $3.00 $35.33
P0   2   3
(1.15) 1 (1.15) (1.15)3 (1.15)
 $0.87  $1.51  $1.97  $23.23 
$27.58 192
EQUITY VALUATION
 Preferred Stock Valuation 1

 To value preferred stock, one must know if it has an effective maturity.
 The most significant difference between preferred stock and a bond is
that the stock has greater risk of not receiving promised payments.
 Preferred stock dividends are payments to owners of the firm and
failure to pay does not constitute default on a obligation
 Failure to pay a preferred-stock dividend as promised has significant
financial consequences because it signals the market that the firm has
serious financial problems.
 Preferred stock with a fixed maturity is priced using the bond valuation
model.
193
EQUITY VALUATION
 Preferred Stock Valuation 2 – fixed maturity

 Preferred stock with a fixed maturity is priced like a bond. The valuation
equation is restated as the price of share of Preferred Stock (PS0).Then:
 PS0 = PV (dividend payments) + PV (par value)
 The general formula of preferred stock valuation is: (m = # of dividend

payments per year) Dm D Dm Dm
PS 
(1mr / m)1 (1 r m)2 (1
P r m)
3 ... 
0 mn
(1 r
m)mn
 Example: Company D’s preferred stock has a par value of $100, a
dividend of $10 paid semi-annually, and an effective maturity of 20
years. If similar stocks yield a return of 8%, find the value of the stock?
$10 2 $10 2 $10 2 
PS0    ... 
(1 0.08 / 2) (1 0.08 /
1
(1 0.08 /
2)$2.50
2 $100 2) 2*40
$2.50
  $2.50  $100
(1 0.02) (1
1  ...  (1 0.02)80  $119.87
0.02) 2 194
EQUITY VALUATION
 Preferred Stock Valuation 3 – no maturity

 A perpetual preferred stock has no maturity date.
 Dividends are fixed, so dividend growth is zero (g = 0)
 Dividend payments are made forever (as long as company is alive)
 The valuation of perpetual preferred stock is given by eq. EQ2:
PS0  D
r
 Example: Company E has perpetual preferred stock that pays a
dividend of $5 per year. Investors require an 18% return on
similar investments. What is the value of Company E’s
preferred stock?
 Answer: PS0 = D / r = $5/0.18 = $27.78
195

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Investment Theory and Analysis

 Understand the distinction between real vs. financial assets

 Nature of the Investment

 Are there priorities of Investments? What are your most important

 Real vs. Financial Assets

 What are the purposes of financial assets?

 Real vs. Financial Assets: Balance sheets of US Households, 2008

 What is the investment process?

 What are the four major steps to the investment process?

 Functions of Financial Markets in the Economy

 These functions are performed through the actions of

 Players in Financial Markets

 Financial markets and the real economy – circular

 Financial Intermediaries / Institutions

 1. Credit Institutions (Banks)

 2. Investment Firms (or Broker-Dealers)

 Understand the Definition of Financial Instruments

 Understand the Definition of Financial Assets & Financial

 Understand the Different Types of Financial Assets

 Money Market Instruments

 Fixed Income Securities

 Financial indices & benchmarks

 Financial Instrument: a contract that gives rise to a financial

 Asset Classes and Types of Instruments (IAS)

ASSET CLASS Securities

Foreign exchange options,

Forward rate agreements,

Interest-rate swaps Interest-

Stock options Stock options

 Financial asset characteristics

 Money Market Instruments (maturity ≤ 12 months)

 Institutional use of MMI

 Money Market Instruments (maturity < 12 months)

 Money market yields over-time (annualized yields, 1-month maturity)

 Money market yields over-time (international)

 Money Market Instruments (quotations)

 Money Market Instruments and the recent financial crisis

 Debt Instruments (or Fixed Income Securities, or Bonds)

 Characteristics of Fixed Income Securities 1

 Characteristics of Fixed Income Securities 3

 Other types - Vanilla Bond (simplest form)

 Types of bonds by Issuer 1

 Minimum denomination is $1,000.

 Types of bonds by Issuer 2

 Credit rating 1 (measure of issuer’s probability of default)

 CRAs credit rating methodologies may be questioned.

 Credit rating 2 (measure of issuer’s probability of default)

 Fixed Income Securities (quotations)

 It confers limited liability

 It confers rights: ownership, voting, participation, preemptive rights.

 Common stock characteristics

 Preferred stock characteristics

 Equity Securities (quotations) – typical broker’s screen

 Financial Derivatives – Futures contracts

 Financial Derivatives – Option contracts

 Markets, issuing and trading securities

 The Borrowing & Lending Mechanism (direct / indirect)