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Essential nature of investment
Reduce current consumption in hopes of greater future consumption
Real Assets
Used to produce goods and services: Property, plant & equipment, human
Financial Assets
Claims on real assets or claims on asset income
Eg: You may not have your own auto plant (a real asset), but you can still
buy shares from Toyota (a financial asset) -> income comes from the
production of Toyota.
All financial assets (owner of claim) are offset by a financial liability (issuer of
claim). These liabilities are used to purchase real asset for production. Therefore:
+ When we aggregate overall balance sheets, only real assets remain (claims
cancel out)
+ The net wealth of an economy is the sum of its real assets.
Fixed-income (debt) securities pay a specified cash flow over a specific period
Money market instruments: short-term, very low risk
Eg: Bank certificates of deposit (CDs), U.S. Treasury bills
Captital market instrument: long-term, range from low to high risk (high
yield or junk bonds)
Eg: Treasury bonds (safe), bonds issued by corp, federal agencies
Common stock
+ Unlike fixed- income securities, common stock or equity represents an
ownership share in the corporation.
+ Equity holders are not promised any particular payment, instead, they
receive any dividends the firm may pay and have prorated ownership in
the real assets of the company.
+ The performance of equity investments is tied directly to the success of
the firm and its real assets. If the firm is successful, the value of equity will
increase, vice versa.
Therefore, equity investments are riskier than fixed income securities.
Derivative securities
+ They are commonly options and futures contracts whose value is
derived from some underlying market condition (provide payoffs which are
determined by the prices of other assets such as bond or stock
+ Derivative securities are so named because their values derive from the
prices of other assets.

Eg: the value of the call option will depend on the price of Intel
Financial Markets
Real assets determine the wealth of the economy while financial assets merely
represent claims on real assets. Financial assets allow us to make the most of the
economys real assets.
Consumption Timing
In high-earnings periods, people are likely to invest their savings in financial assets
such as stocks and bonds while in low-earnings periods they are likely to sell these
assets to provide funds for their consumption needs.
Financial assets help store your wealth, shift your purchasing power from highearnings periods to low-earnings periods (providing the greatest satisfaction by
allocating consumption)
Allocation of Risk
Risk can be allocated by investor:
+ Risk-tolerant investors can buy shares of stock -> bear most of the business risk
+ More conservative ones only buy bonds -> receive fixed payment -> safer
Separation of Ownership and Management
+ Many businesses are owned and managed by the same individual. Small
businesses are the most common example to this simple organization (also the most
common form of business organization before the Industrial Revolution).
+ However, today, along with global markets and large scale production, it became
very difficult to continue the same type of organizations. Therefore, in todays
corporations ownership and management are separated since it also became
impossible for an individual to run both duties.
Corporate Governance and Corporate Ethics
Business and market require trust to operate efficiently
o Without trust additional laws and regulations are required
o All laws and regulations are costly
Governance and ethics failures have cost our economy billions if not trillions of
o Eroding public support and confidence in market based systems
Accounting Scandals
o Enron, WorldCom, Rite-Aid, HealthSouth, Global Crossing, Qwest
Misleading Research Reports
o Citicorp, Merrill Lynch, others
o Arthur Andersen and Enron
Sarbanes-Oxley Act
o Increases the number of independent directors on company boards
o Requires the CFO to personally verify the financial statements
o Created a new oversight board for the accounting/audit industry
o Charged the board with maintaining a culture of high ethical standards

An investors portfolio is simply his/her collection of investment assets. Once the

portfolio is established, it is updated or rebalanced by selling or buying securities.
Investors make 2 types of decisions in constructing their portfolios:
1. The Asset Allocation decision is the choice among broad asset classes such
as stocks, bonds, real estates, commodities, etc.
2. The Security Selection decision is the choice of which particular securities
to hold within each
asset class.
Security analysis involves the valuation of particular securities that might be included
in the portfolio. For example, an investor might ask whether A or B is more attractively
1. The Risk-Return Trade -Of
The risk and return comparison should be made prior to making investment in
financial assets. That means that cost-benefit analysis should be done prior to
making investment in Money markets.
2. Market efficiency:
Securities should be neither underpriced nor overpriced on average
Security prices should reflect all information available to investors
Whether we believe markets are efficient or not affects our choice of
appropriate investment management style.
Efficient markets simply suggest that all the information about stocks, bonds and
shares should be available to investors. This is called Efficient Market
-> Thus, this hypothesis concerns the choice between active and passive
investment management strategies:
a. PassiveManagement calls for holding highly diversified portfolios,
without spending effort or other resources attempting to improve investment
performance through security analysis (applied when existing EMH)
b. Active-Management is the attempt to improve performance either by
identifying mispriced securities or by timing the performance of broad asset

Business Firms net borrowers

Households net savers
Governments can be both borrowers and savers
Financial Intermediaries Connectors of borrowers and lenders
o Commercial Banks: make loans funded by deposits
o Investment companies: pool and manage money of investors, take
advantage of economies of scale to make profit
o Insurance companies
o Pension funds / Hedge funds
Investment Bankers
o Firms that specialize in the sale of new securities to the public, typically by
underwriting the issue.
+ Primary market: a market where newly issued securities are offered to
the public.

+ Secondary market: a market where pre-existing securities are traded

among investors.
Domestic firms compete in global markets
Performance in one country or region depends on other regions
Opportunities for better returns & implications for risk
o Managing foreign exchange
o International diversification reduces risk
o Instruments and vehicles continue to develop (ADRs and WEBs)
o Information and analysis improves
ADR-American Depository Receipt: may be listed on an exchange or trade OTC in
the U.S.
+ A broker purchases a block of foreign shares, deposits them in a trust and
issues ADRs in the U.S.
+ They trade in dollars, receive dividends in dollars and have the same
commissions as any other stock (You can buy ADRs on Sony for example)
WEBS are World Equity Benchmark Shares, these are the same as ADRs but are
for portfolios of stocks. Typically WEBS track the performance of an index of
foreign stocks.
The investment world is moving forward rapidly and embracing new technology.
News is available virtually instantaneously. On-line trading has made trading
faster and cheaper.

Loans of a given type such as mortgages are placed into a pool and new
securities are issued that use the loan payments as collateral. Mortgages now
can be traded just like other securities (being marketable and are purchased by
many institutions)

End result is more investment opportunities for purchasers, and spreading

loan credit risk among more institutions
Securitization has grown rapidly due to

Changes in financial institutions and regulation permitting its growth,

particularly lower capital requirements on securitized loans,

Improvement in information capabilities,

Credit enhancement provided by pool issuers has improved marketability.

The Shadow banking system refers to the end result of securitization. Namely that
many institutions now provide the ultimate financing for loans that banks traditionally
Financial Engineering
Repackaging cash flows of a security to enhance marketability
Bundling and unbundling of cash flows
Bundling: combining more than one security into a composite security
Unbundling: allocating the cash flows from 1 security to create several
new securities
A CMO is a collateralized mortgage obligation. It is a type of mortgage backed security
that takes payments from a mortgage pool and separates them into separate classes of

payments that investors can buy. A CDO is also an unbundling example. A simpler
version of unbundling would be a Treasury Strip.
Computer Networks
Online low cost trading
Information made cheaply and widely available
Direct trading among investors via electronic communication networks
Computerization has pressured profit margins of Wall Street firms. Similarly
technological advances that promoted widespread securitization changed the
business model of commercial banks. Both responded by engaging in riskier
trading activities and increasing leverage to bolster rates of return. It could be
argued this helped set up the financial crisis of 2007-2008.
The Future
Globalization will continue and investors will have far more investment
opportunities than the past
Securitization will continue to grow after the crisis
Continued development of derivatives and exotics, more regulation for OTC
Strong fundamental foundation of understanding is critical
Understanding corporate finance requires understanding investments




Chapter 2 features different asset classes and some of the instrument within asset
+ Money market: short-term (one year or less); marketable (c th tiu th c);
liquid; low risk. Also called cash instrument
+ Capital market: long-term debt / equity / derivatives
Treasury bills (tn phiu)

Issued by Federal Government

Denomination (mnh gi) $1000, commonly $100,000

Maturity 4, 13, 26, or 52 weeks

Liquidity Highly liquid

Default risk None

Interest type Discount (at maturity, investors collect earning- the

difference between discounted price and face value of the bill)

Taxation taxable at the federal level, exempt from state and local taxes
Certificates of Deposit (chng nhn tin gi)

Issued by Depository Institutions

Denomination Any, $100,000 or more are marketable

Maturity Varies, typically 14 day minimum

Liquidity 3 months or less are liquid if marketable

Default risk First $100,000 is insured


Interest type Add on

Taxation Interest income is fully taxable

Commercial Paper

Issued by Large creditworthy corporations and financial institutions

Maturity Maximum 270 days, usually 1 to 2 months

Denomination Minimum $100,000

Liquidity 3 months or less are liquid if marketable

Default risk fairly safe (the firms condition can be predicted in one

Interest type Discount

Taxation Interest income is fully taxable

New Innovation: Asset backed commercial paper is backed by a loan or security. In
summer 2007 asset backed CP market collapsed when subprime collateral values
Bankers Acceptances

Originates when a purchaser of goods authorizes its bank to pay the seller
for the goods at a date in the future (time draft).

When the purchasers bank accepts the draft it becomes a contingent

liability of the bank and becomes a marketable security.


Dollar denominated (time) deposits held outside the U.S.

Pay a higher interest rate than U.S. deposits.

Federal Funds

Depository institutions must maintain deposits with the Federal Reserve


Federal funds represents trading in reserves held on deposit at the Federal


Key interest rate for the economy

LIBOR (London Interbank Ofer Rate)

Rate at which large banks in London (and elsewhere) lend to each other.
Base rate for many loans and derivatives.

Repurchase Agreements (RPs or repos) and Reverse RPs

Short term sales of securities arranged with an agreement to repurchase
the securities a set higher price.
A RP is a collateralized loan; many are overnight, although Term RPs may
have a one month maturity.
A Reverse Repo is lending money and obtaining security title as collateral.
Haircuts may be required depending on collateral quality

Call Money Rate

Investors who buy stock on margin borrow money from their brokers to
purchase stock. The borrowing rate is the call money rate.
The loan may be called in by the broker.

Money Market Instrument Yields

Yields on money market instruments are not always directly comparable
Factors influencing quoted yields
Par value vs. investment value
360 vs. 365 days assumed in a year (366 leap year)
Simple vs. Compound Interest
Treasury Notes and Bonds
Notes maturities up to 10 years
Bonds maturities in excess of 10 years
Par Value - $1,000
Quotes percentage of par
Federal Agency Debt
Major issuers
Federal Home Loan Bank
Federal National Mortgage Association
Government National Mortgage Association
Federal Home Loan Mortgage Corporation
Municipal Bonds
Issued by state and local governments
General obligation bonds
Revenue bonds
Industrial revenue bonds
Maturities range up to 30 years
Municipal Bond Yields

Interest income on municipal bonds is not subject to federal and

sometimes state and local tax

To compare yields on taxable securities a

Taxable Equivalent Yield is constructed

Corporate Bonds
Issued by private firms
Semi-annual interest payments
Subject to larger default risk than government securities
Options in corporate bonds
Mortgages and Mortgage-backed Securities

Developed in the 1970s to help liquidity of financial institutions

Proportional ownership of a pool or a specified obligation secured by a pool

Market has experienced very high rates of growth



+ Common stock
Residual claim
Limited liability
+ Preferred stock
Fixed dividends - limited
Priority over common
Tax treatment

Preferred & common dividends are not tax deductible to the

issuing firm

Corporate tax exclusion on 70% dividends earned

+ Depository receipts
American Depository Receipts (ADRs) also called American Depository Shares
(ADSs) are certificates traded in the U.S. that represent ownership in a foreign
There are several indexes worldwide such as:
Dow Jones Industrial Average (DJIA)
Nikkei Average
Offer ways of comparing performance of managers
Base of derivatives
Examples of Indexes - International

Nikkei 225 & Nikkei 300

FTSE (Financial Times of London)


Region and Country Indexes

Far East
United Kingdom
Listed Call Option:
Holder the right to buy 100
predetermined price on or before
Listed Put Option:
Holder the right to sell 100
predetermined price on or before

shares of the underlying stock at a

some specified expiration date.
shares of the underlying stock at a
some specified expiration date.


Basic Positions
Call (Buy)
Put (Sell)
Exercise Price
Expiration Date


Basic Positions
Long (Buy)
Short (Sell)
Delivery Date

Chap 3
3.1. HOW


- Primary Market: Market in which corporation raise funds through new issues of
- Secondary Market: The market in which stocks, once issued, are traded rebought
and resold.
- Common Stock:
o Initial Public Offerings first issue
o Seasoned Offerings other issues
- Bonds:
o Public Offerings issues to public
o Private Placements issues to private groups of investors
Private placements do not trade in secondary markets -> reduce liquidity
& thereby prices

UNDERWRITERS Investment Banks

- Underwriters: purchasing securities from the issuing company and resell them.
- Earn profit using firm commitment
- Organize road shows ( travel around the country to publicize the imminent
offering)to generate interests among investors & provide information about the
The process of polling potential investors is called bookbuilding
- Determine the preliminary offering price & the number of shares to be sold
- Provide analysts to increase the likelihood that there will be a liquid secondary
market for the stock and that its price will reflect the companys true value.
Underpriced in IPO, causing cost for the issuance
- Shelf registration: allow firms to register securities and gradually sell them to the
public for 2 years following the initial registration.
- Red Herring: a preliminary version of the prospectus (the statement is in its final
form and be approved by SEC) describing a new security issuance distributed to
potential buyers prior to the security registration.

IPO >< PRIVATE OFFERINGS: no advertisement / no registration


3.2. HOW


a Types of Markets:
- Direct markets is the market in which buyers and sellers must seek each other out
o Least organized market
o Characterized by sporadic (intermittent) participation / low-priced / nonstandard

- Brokered markets is the market in which trading in a good is active, and brokers
find it profitable to offer
search services to buyers and sellers.
- Dealers market is the market in which traders specializing in particular assets buy
and sell for their own
- Auction market is a market where all traders meet at one place to buy and sell an
o Costly -> limit the shares to ones frequently traded
o Act as secondary market where investors trade their existing securities
b Types of orders :
- Market orders are buy or sell orders that are to be executed immediately.
o Bid price is the price at which a dealer or other traders are willing to purchase a
o Ask price is the price at which a dealer or other traders are willing to sell a
o Bid-ask spread is the difference between a dealers bid and asked price ->
profit source
- Price-contingent orders are orders specifying prices at which investors are willing
to buy or sell a security.
o Limit buy order: is an order at which or below which an investor is willing to
buy a security
o Limit sell order: is an order at which or above which an investor is willing to sell
a security
o Limit order book: a collection of limit orders waiting to be executed
o Stop order is an order at which trade is not to be executed unless stock hits a
price limit
+ Stop-loss order: the stock is to be sold if its price fall below a
stipulated level (to prevent
further losses from
+ Stop-buy order: the stock is to be bought when its price rises above a
c Trading Mechanisms :
- Over-the-counter market an informal network of brokers and dealers who negotiate
sales of securities.
- ECNs computer networks that allow direct trading without the need for market
o Orders match from one against another = crossed
o Advantages: cheap / quick / offer anonymity
- Specialist a trader who makes a market in the share of one or more firms and who
maintains a fair and orderly market (by dealing personally in the market with their
own portfolio)
o Role: brokers / dealers / facilitators (in an auction market)
o Responsibility: strive to maintain a narrow bid-ask spread

Explicit costs (Commission) - fee that is paid to the broker for making the


Full Service: Full-service brokers usually depend on a research staff that prepares
analyses and fore- casts of general economic as well as industry and company
conditions and often makes specific buy or sell recommendations
Discount: They buy and sell securi- ties, hold them for safekeeping, offer margin loans,
facilitate short sales, and that is all
Implicit costs - fee collected in the form of the bid-ask spread when trading with


Brokers call loans - a source of debt financing provided by brokers.
Buying on Margin - the act of purchasing securities with part of the purchasing
price borrowed from brokers.
Collateral - the securities purchased
The part contributed by the investor (NOT the part borrowed) is called Margin.
Initial margin requirement - 50% (set by Fed)
Purchasing price
Initial payment

$10,000 (for 100 shares)


Initial Balance Sheet Position



Value of Stock

if the stock value falls to $7,000.

Balance Sheet Position:


Value of Stock



- if the stock price falls beyond $4,000?

The stocks purchased are no longer a sufficient collateral to cover the loan.
Brokers set up a Maintenance Margin
Maintenance Margin - the lowest accepted level of the Margin.
Margin call - broker requiring investor to put more cash or securities to the
margin account.

Borrow stock through a dealer. (deposit cash or securities in an account as
collateral) and Sell it. Buy the stock and return to the party from which is was
Purpose - to make profit from a decline of a stock or security


Short sales are permitted only when the last recorded change in the stock price
is positive.

Short-sellers must not only replace the shares but also pay the lender of the
security any dividends paid during the short sale.
Cash or collateral is required to cover possible losses in case the stock price goes


Securities Acts of 1933
Securities Acts of 1934
Securities Investor Protection Act of 1970
Sarbanes-Oxley Act
Creation of a Public accounting company to oversee the auditing of public firms.
CEOs and CFOs must be held responsible for misleading and distorted information of
their companies.
Board of Directors must be composed of independent directors and regular meeting is
not accompanied by company managers.
Insider trading - the act of transacting securities to profit from inside information.
(Nonpublic information of a firm that can only be accessed by privileged individuals).




Investment companies are financial intermediaries that collect funds from

individual inves- tors and invest those funds in a potentially wide range of
securities or other assets
Investment companies perform several important functions for their investors:
- Record keeping and administration. Investment companies issue periodic status
- Diversification and divisibility : enable investors to hold fractional shares of
many different securities
- Professional management : have full-time staffs of security analysts and
portfolio managers who attempt to achieve superior investment results for their
- Lower transaction costs: trade large blocks of securities.
Investors buy shares in investment companies, and ownership is proportional to
the number of shares purchased. The value of each share is called the net
asset value, or NAV.


Market value of assets minus liability

Shares outstanding




securities (or "units")
Investors sell back at
approximate net
asset value or NAV.

"public offering" of only
a specific, fixed number
of units.
(like closed-end funds)

Open-end fund
(mutual fund)

Closed-end fund
(publicly-traded fund)

Its shares are redeemable


At its current NAV per

share, minus any fees the
fund may charge

Investors purchase shares

from the fund itself; only
trade at the end of the day.
Cannot purchase
secondary market.




common stock with the
prices could be differ from
To create the liquidity of
the fund, investors can
buy or sell shares through
secondary market.

market all day.

Does not actively trade

its investment portfolio.

Does not have a BOD,

adviser to render advice
during the life of the

Managed by investment
adviser that are registered
with the SEC.

Managed by investment
adviser that are registered
with the SEC.


Commingled funds are partnerships of investors that pool their funds. The
management firm that organizes the partnership, for example, a bank or insurance
company, manages the funds for a fee. Typical partners in a commingled fund might be
trust or retirement accounts that have portfolios much larger than those of most
individual investors but are still too small to warrant managing on a separate basis.
Real Estate Investment Trusts (REITs) is similar to a closed-end fund. REITs
invest in real estate or loans secured by real estate. Besides issuing shares, they raise
capital by borrowing from banks and issuing bonds or mortgages. Most of them are
highly leveraged, with a typical debt ratio of 70%. There are two principal kinds of
REITs. REITs generally are established by banks, insurance companies, or mortgage
companies, which then serve as investment managers to earn a fee. REITs are exempt
from taxes as long as at least 95% of their taxable income is distributed to
shareholders. For shareholders, however, the dividends are taxable as personal income.
Hedge funds. A private investment pool, open to wealthy or institutional
investors, that is exempt from SEC regulation and can therefore pursue more
speculative policies than mutual funds.


The common name of for an open-end investment company and Account for more
than 90% of investment company assets in the US
- $10 trillion in US mutual funds
- $9 trillion in non-US sponsor mutual funds
Investment Policies
Each mutual fund has a specified investment policy, which is described in the
funds prospectus. For example, money market mutual funds hold the short-term, lowrisk instruments of the money market, while bond funds hold fixed- income securities.
Some funds have even more narrowly defined mandates.
Some of the more important fund types, classified by investment policy
Money market funds
Investing in money market securities: commercial paper, repurchase agreement,
Asset maturity: mostly 1-3 months
Net asset value (NAV) is fixed at $1 per share
No tax implications for capital gain or losses due to redemption of share.
Bond funds
Investing in fixed income sector: corporate bonds, Treasury bonds, mortgage-backed
securities, municipal bonds
Some bond funds specialize in:
Maturity: from intermediate to long-term
Issuers credit risk: from very safe to high yield bonds
Equity funds
Investing primarily in stock

Commonly holding 5% of total assets in money market securities in case of share

Income funds: focus on high dividend
Growth funds: focus on capital gains
Specialized funds: equity funds concentrate on particular industries/ particular
International funds have international focus
Global funds: securities worldwide
International funds: securities of non-US firms
Regional funds: securities in a particular part of the world
Emerging market funds: securities in developing countries
Balanced funds hold both equities and fixed income securities
Life-cycle funds:
- Aggressive asset mix (for young investors)
- Conservative asset mix (for older investors)
- Static allocation: stable mix across stocks and bonds
- Targeted maturity funds: gradually become more conservative as investors age
allocated to stocks and bonds change significantly in accord with portfolio
managers forecast of sectors performance
Index funds try to match the performance of a broad market index (both equity
and non-equity index). It is low cost, passive investment without securities analysis
How Funds Are Sold
Most mutual funds have an underwriter that has exclusive rights to distribute
shares to investors.
Mutual funds are generally marketed to the public
- Indirect- marketing through brokers acting on behalf of the underwriter.
- Direct-marketed funds are sold through the mail, various offices of the fund, over
the phone, and, increasingly, over the Internet.
Investors contact the fund directly to purchase shares.
About half of fund sales today are distributed through a sales force.


Fee Structure:
Operating expenses: deducted periodically from funds assets
- administrative expenses
- advisory fees for investment managers
- marketing and distribution costs for brokers)
Front-end load (usually less than 6%): commission charged when shares are
purchased, paid to brokers selling the funds
- Low-load funds: less than 3% loads
- No-load funds: no front-end load (accounted for half of all funds today)
Back-end load: redemption fee incurred when shares are sold, typically reduced
by 1% for every year investors hold the shares
12b-1 charges : SEC allows managers to use fund assets to pay for distribution
- Limited to 1% of funds net assets per year
- Must be added to operating expense to obtain true annual expense ratio.

ownership in the same portfolio of securities but with different

combination of fees
Mutual fund returns

Gross return =

NAV 1NAV 0+ IncomeCapital gain distribution


Rate of return = Gross return Total expense ratio

Late Trading and Market Timing:
Late trading: accepting buy or sell orders after the market closed and NAV is
Market timing: taking advantage of different time-zone to buy or sell a now-stale
NAV funds (because the international markets are closed) for a likely profit the
next day
- 4:00 PM hard cutoff
- Fair value pricing
- Redemption fees


A fund with a high portfolio turnover rate can be particularly tax inefficient.
Turnover is the ratio of the trading activity of a portfolio to the assets of the
portfolio. It measures the fraction of the portfolio that is replaced each year.

Measures the fraction of the portfolio that is replaced each year

Turnover rate =

High turnover rate capital gains/losses are being realized constantly

investors cannot time the realizations to manage overall tax obligation
Since 2000, SEC required funds to disclose tax impact of portfolio turnover

trading activity
portfolio assets


Fund tracks an index, a commodity or a basket of assets like an index fund, but
trades like a stock on an exchange. It does not have its net asset value (NAV)
calculated every day.
- bought and sold during the day like stocks on a securities exchange
- purchased through brokers lower management fees
- sell the shares on the open market
- gather enough shares of the ETF to form a creation unit and then exchange the
creation unit for the underlying securities.
Advantages :
- Traded continuously
- Can be sold short or purchased on margin
- Tax saving for the funds
- Lower management fees for the funds
Disadvantages :
- Price can depart by small amount from NAV arbitrage

Investors must buy an ETF from brokers with fees.


The evidence on mutual fund performance does not show a consistent superior
performance to broad market indexes. Evidence shows a tendency for some persistence
in superior performance by funds but the evidence is far from conclusive. Mutual fund
marketing literature emphasizes past performance but the evidence indicates that
historical performance is not a good predictor of future performance. There is some
evidence that funds with higher expense ratios are more likely to be poorer performers.


As the popularity of mutual funds has grown in recent years, nearly all major
business publications feature some reporting on performance of mutual funds. Several
agencies or publications rank mutual fund performance, including
- Morningstar. However fund rankings which are based on historical data are not
necessarily good predictors of future fund performance


RISK AND RETURN: Past and Prologue
I. Rates of Return
A key measure of investors success is the rate at which their funds have grown
during the investment period. The total holding-period return (HPR) of a share of
stock depends on the increase (or decrease) in the price of the share over the
investment period as well as on any dividend income the share has provided. The rate
of return is defined as dollars earned over the investment period (price appreciation as
well as dividends) per dollar invested:


Ending priceBeginning price+Cash dividend

Beginning price

Measuring Investment Returns over Multiple Periods

Arithmetic average. The sum of returns in each period divided by the number
of periods. The arithmetic average is useful, though, because it is the best forecast of
performance in future.
Geometric average. The single per-period return that gives the same
cumulative performance as the sequence of actual returns. The geometric return is also
called a time-weighted average return because it ignores the quarter-to-quarter
variation in funds under management.
Dollar-weighted return. The dollar-weighted average return is the internal rate
of return (IRR) of the project. The IRR is the interest rate that sets the present value of
the cash flows realized on the portfolio equal to the initial cost of establishing the

Conventions for Quoting Rates of Return

Returns on assets with regular cash flows, such as mortgages (with monthly
payments) and bonds (with semiannual coupons), usually are quoted as annual
percentage rates, or APRs, which annualize per-period rates using a simple interest
approach, ignoring compound inter- est. The APR can be translated to an effective
annual rate (EAR) by remembering that:
APR = Per-period rate Periods per year
APR = [ (1 + EAR)1/ n 1] n
With continuous compounding, the relationship between the APR and EAR becomes:
APR = ln(1 + EAR)

II. Risk and Risk Premiums

Scenario Analysis and Probability Distributions
Scenario analysis is the process of devising a list of possible economic
scenarios and specifying the likelihood of each one, as well as the HPR that will be
realized in each case. The list of possible HPRs with associated probabilities is called the
probability distribution of HPRs. The probability distribution lets us derive
measurements for both the reward and the risk of the investment. The reward from the
investment is its expected return, The mean value of the distribution of HPRs.
Uncertainty surrounding the investment is a function of the magnitudes of the
possible surprises. To summarize risk with a single number we first define the variance
as the expected value of the squared deviation from the mean.

Risk Premiums and Risk Aversion

Risk premium is an expected return in excess of that on risk-free securities. In
contrast, risk aversion is an investors reluctance to accept risk.


E ( r M )r f

The Sharpe (Reward-to-Volatility) Measure

Risk aversion implies that investors will accept a lower reward (as measured by
their portfolio expected return) in exchange for a sufficient reduction in risk (as
measured by the standard deviation of their portfolio return). A statistic commonly used
to rank portfolios in terms of this risk-return trade-off is the Sharpe (or reward-tovolatility) measure, defined as:


Portfolio risk premium

Standard deviation of portfolio excess return

III. The historical record

Annual Holding Period Returns Statistics 1926-2008


The geometric mean is the best measure of the compound historical rate of
return. Nevertheless the arithmetic average is the best measure of the expected return.
Notice the greater divergence of the GAR and AAR for small stocks. This is because of
the high variance and the higher proportion of negative returns in the small stock
portfolio. Although we dont have statistical significance it appears that some of the
portfolios exhibit kurtosis. Kurtosis of the normal distribution is zero. The world stock,
US small stock and world bond portfolio appear to exhibit kurtosis. This indicates a
higher percentage of observations in the tails that is predicted by the normal
distribution. Non-zero value of skewness are also apparent, although we cant tell if
they are significant. The world stock and US large stock portfolios may exhibit negative
skewness. This indicates a higher probability of extreme negative returns than is
predicted in a normal distribution.
If returns are normally distributed then the following relationship among
geometric and arithmetic averages holds:
Arithmetic Average Geometric Average = 2
IV. Inflation and Real Rates of Return
If prices have changed, the increase in your purchasing power will not equal the
increase in your dollar wealth. At any time, the prices of some goods may rise while the
prices of other goods may fall; the general trend in prices is measured by examining
changes in the consumer price index, or CPI. The CPI measures the cost of purchasing a
bundle of goods that is considered representative of the consumption basket of a
typical urban family of four. Increases in the cost of this standardized consumption
basket are indicative of a general trend toward higher prices. The inflation rate, or the
rate at which prices are rising, is measured as the rate of increase of the CPI.
We need to distinguish between a nominal interest rate - the growth rate of your
money, and a real interest rate - the growth rate of your purchasing power. If we call R
the nominal rate, r the real rate, and i the inflation rate, then we conclude:
r R i
In fact, the exact relationship between the real and nominal interest rate is given by:



The Equilibrium Nominal Rate of Interest

Because investors should be concerned with their real returnsthe increase in
their purchasing powerwe would expect that as inflation increases, investors will

demand higher nominal rates of return on their investments. This higher rate is
necessary to maintain the expected real return offered by an investment.
V. Asset Allocation Across Risky and Risk-free Portfolios
Investors can choose to hold risky and riskless assets. We may consider
investments in a money market mutual fund as a proxy for the riskless investments
that an investor might actually engage in.
Asset allocation is the portfolio choice among broad investment classes, rather
than among the specific securities within each asset class.
The Risky Asset
When we shift wealth from the risky portfolio (P) to the risk-free asset, we do not
change the relative proportions of the various securities within the risky portfolio.
Rather, we reduce the relative weight of the risky portfolio as a whole in favour of riskfree assets.
The complete portfolio is the entire portfolio including risky and risk- free assets.
The Risk-Free Asset
The power to tax and to control the money supply lets the government, and only
the government, issue default-free (Treasury) bonds. The default-free guarantee by
itself is not sufficient to make the bonds risk-free in real terms, since inflation affects
the purchasing power of the proceeds from the bonds. The only risk-free asset in real
terms would be a price-indexed government bond. Even then, a default-free, perfectly
indexed bond offers a guaranteed real rate to an investor only if the maturity of the
bond is identical to the investors desired holding period.
Portfolio Expected Return and Risk
Now that we have specified the risky portfolio and the risk-free asset, we can
examine the risk-return combinations that result from various investment allocations
between these two assets.
To generalize, the risk premium of the complete portfolio, C, will equal the risk
premium of the risky asset times the fraction of the portfolio invested in the risky asset:
E(rC ) rf = y[E(rP ) rf ]
The standard deviation of the complete portfolio will equal the standard deviation
of the risky asset times the fraction of the portfolio invested in the risky asset:
oC = y*oP

In sum, both the risk premium and the standard deviation of the complete
portfolio increase in proportion to the investment in the risky portfolio.

The Capital Allocation Line

The capital allocation line is the plot of risk-return combinations available by
varying portfolio allocation between a risk-free asset and a risky portfolio. The slope,
S, of the CAL equals the increase in expected return that an investor can obtain per
unit of additional standard deviation. In other words, it shows extra return per extra


The investment opportunity set with a risky asset and a risk-free asset

CAL = Capital
allocation line
P y = 1.25

E(rP) = 15%
r = 7% F

y = .50
S = 8/22

E(rP) r = 8%

P = 22%

In fact, the reward-to-volatility ratio is the same for all complete portfolios that
plot on the capital allocation line. While the risk-return combinations differ, the ratio
of reward to risk is constant.

Risk Tolerance and Asset Allocation

Individual investors with different levels of risk aversion, given an identical
capital allocation line, will choose different positions in the risky asset. Specifically, the
more risk-averse investors will choose to hold less of the risky asset and more of the
risk-free asset.
The investors asset allocation choice also will depend on the trade-off between
risk and return. If the reward-to-volatility ratio increases, then investors might well
decide to take on riskier positions.

VI. Passive Strategies and the Capital Market Line

A passive strategy is based on the premise that securities are fairly priced and
it avoids the costs involved in undertaking security analysis.
To avoid the costs of acquiring information on any individual stock or group of
stocks, we may follow a neutral diversification approach. A natural strategy is to
select a diversified portfolio of common stocks that mirrors the corporate sector of the
broad economy. Such strategies are called indexing. The investor chooses a portfolio

with all the stocks in a broad market index such as the Standard & Poors 500 index.
The rate of return on the portfolio then replicates the return on the index. We call the
capital allocation line provided by one-month T- bills and a broad index of common
stocks the capital market line (CML). That is, a passive strategy based on stocks and
bills generates an investment opportunity set that is represented by the CML.

Historical Evidence on the Capital Market Line

The notion that one can use historical returns to forecast the future seems
straightforward but actually is somewhat problematic. On one hand, you wish to use all
available data to obtain a large sample. But when using long time series, old data may
no longer be representative of future circumstances. Another reason for weeding out
sub periods is that some past events simply may be too improbable to be given equal
weight with results from other periods.

Costs and Benefits of Passive Investing

First, the alternative active strategy entails costs. The passive portfolio requires
only small commissions on purchases of U.S. T-bills (or zero commissions if you
purchase bills directly from the government) and management fees to a mutual fund
company that offers a market index fund to the public. An index fund has the lowest
operating expenses of all mutual stock funds because it requires the least effort.
A second argument supporting a passive strategy is the free-rider benefit. A welldiversified portfolio of common stock will be a reasonably fair buy, and the passive
strategy may not be inferior to that of the average active investor.
To summarize, a passive strategy involves investment in two passive portfolios:
virtually risk-free short-term T-bills (or a money market fund) and a fund of common
stocks that mimics a broad market index.


Chapter 6


Two broad sources of uncertainty:

The first is the risk that has to do with general economic conditions, such as the
business cycle, the inflation rate. interest rates, exchange rates, and so forth. In
addition, consider naive diversification strategy, adding another security to the risky
_ The risk that remains even after diversification is called market risk, risk that
attributable to marketwide risk sources. Other names are systematic risk or
nondiversifiable risk. The risk that can be eliminated by diversification is called unique
risk, firm-specific risk, nonsystematic risk, or diversifiable risk.
6.2 A SSET


Correlation and Covariance

_ Portfolio risk denpends on the correlation between the returns of the assets in the
portfolio. The variance is the probability weighted average across all scenarios of the
squared deviation, between the actual return of the fund and its expected return; the
standard deviation is the square root of the variance.
_ The covariance is calculated in a manner similar to the variance. A measure of the
extent to which the returns tend to vary with each other is called the covariance. The
formular for the covariance of the returns on the stock and bond portfolio is given in the
following equation:
Cov(r s, rB) =


_ Using Historical Data is common alternative approach to produce the inputs such as
means, variance,etc.
The three rules od two-risky assets portfolios:
Rule 1: The rate of return on the portfolio is a weighted average of the returns on the
component securities, with the investment proportions as weights.
r p = wBrB + wSrS
( 4)
Rule 2: The expected rate of return on the portfolio is a weighted average of the
expected returns on the component securities, with the same portfolio proportions as
E(r p) = wBE(rB) + wSE(rS)
Rule 3: The variance of the rate of return on thee two risky assets portfolio is



= (wB

)2 + ( w S

)2 + 2( wB

) (ws


is the correlation soefficient between the returns on the stock and bond

The variance of the portfolio is a sum of the contributions of the component security
variances plus a term that involves the correlation coefficient ( and hence, covariance)
between the returns on the component securities.
The risk-return trade off with two risky assets portfolios

A correlation coefficient of zero means that stock and bond returns vary independentl of
each other.
Investment opportunity set: set of available portfolio risk-return combination. This is the
set of all attainable combination of risk-return combinations.
The mean-variance criterion
6.3 T HE


Optimal risky portfolio :The best combination of risky assets to be mixed with safe
assets to form the complete portfolio.

Efficient Diversification with Many Risky Assets

The extension to include a risk-free asset results in a single combination of stock

and bonds that is optimal when that portfolio is combined with the risk-free
Efficient frontier is the graph representing a aset of portfolio that maximizes
expected return at each level of portfolio risk.
The second step of the optimization plan involves the risk-free asset. Using the current
riskfree rate, we search for the capital allocation line with the highest reward-tovariability ratio (the steepest slope).
Free asset with the efficient frontier as depicted below:
CAL(P) = Capital Market Line or CML dominates other lines because it has the largest
slope or equivalently, the largest Sharpe ratio
Slope = (E(rp) - rf) / sp
That is, the CML maximizes the slope or the return per unit of risk or it equivalently
maximizes the Sharpe ratio. Regardless of risk preferences some combinations of P & F
will dominate all other combinations. All investors complete portfolio will fall on the
Finally, in the third step, the investor chooses the appropriate mix between the optimal
risky portfolio ( O ) and T-bills. A portfolio manager will offer the same risky portfolio ( O
) to all clients, no matter what their degrees of risk aversion. Risk aversion comes into
play only when clients select their desired point on the CAL. More risk-averse clients will
invest more in the risk-free asset and less in the optimal risky portfolio O than less riskaverse clients, but both will use portfolio O as the optimal risky investment vehicle.
Separation property: the property that implies portfolio choice can be separated
into 2 independent tasks: (1) determination of the optimal risky portfolio, which
is a purely technical problem, and (2) the personal choice of the best mix of the
risky portfolio and the risk free asset.

A Single factor asset market

Systematic risks is largely macroeconomic, affecting all securities, while firmspecific risk factors affect only one particular firm or. perhaps, its industry. Factor
model are statistical models designed to estimate these two components of risk
for a particular security or portfolio.
Excess return: Rate of return in excess of risk free rate.
Beta: The sensitivity of a securitys returns to the systematic or market factor.

Ri = E(Ri ) +

iM + ei

E ( R i ) is the expected excess holding-period return (HPR) at the start of the

holding period. The next two terms reflect the impact of two sources of uncertainty. M
quantifies the market or macroeconomic surprises (with zero meaning that there is no

surprise) during the holding period.

i is the sensitivity of the security to the

macroeconomic factor. Finally, e i is the impact of unanticipated firm-specific events.

Both M and e i have zero expected values because each represents the impact of
unanticipated events, which by definition must average out to zero. The beta, (


denotes the responsiveness

of security.
Specification of a Single-Index Model of Security Returns
A factor model description of security returns is of little use if we cannot specify a way
to measure the factor that we say affects security returns. One reasonable approach is
to use the rate of return on a broad index of securities, such as the S&P 500, as a proxy
for the common macro factor. With this assumption, we can use the excess return on
the market index, R M , to measure the direction of macro shocks in any period.
Therefore, the total variability of the rate of return of each security depends on two
The variance attributable to the uncertainty common to the entire market. This
systematic risk is attributable to the uncertainty in R M . Notice that the systematic risk
of each stock depends on both the volatility in R M
and the sensitivity of the stock to fl uctuations in R M . That sensitivity is measured by


The variance attributable to fi rm-specifi c risk factors, the effects of which are
measured by e i . This is the variance in the part of the stocks return that is
independent of market performance.
This single-index model is convenient. It relates security returns to a market index that
investors follow. Moreover, as we soon shall see, its usefulness goes beyond mere
Diversification in a Single-Factor Security Market
The systematic component of each security return is fully determined by the market
factor and therefore is perfectly correlated with the systematic part of any other
securitys return. Hence, there are no diversification effects on systematic risk no
matter how many securities are involved. As far as market risk goes, a single-security
portfolio with a small beta will result in a low market-risk portfolio. The number of
securities makes no difference.
It is quite different with firm-specific or unique risk. If you choose securities with small
residual variances for a portfolio, it, too, will have low unique risk. But you can do even
better simply by holding more securities, even if each has a large residual variance.
Because the firm-specific effects are independent of each other, their risk effects are
offsetting. This is the insurance principle applied to the firm-specific component of risk.
The portfolio ends up with
a negligible level of nonsystematic risk.
In sum, when we control the systematic risk of the portfolio by manipulating the
average beta of the component securities, the number of securities is of no
consequence. But in the case of nonsystematic risk, the number of securities involved
is more important than the firm-specific variance of the securities. Sufficient
diversification can virtually eliminate firmspecific risk. Understanding this distinction is
essential to understanding the role of diversification in portfolio construction.


Are Stock Returns Less Risky in the Long Run?

Advocates of the notion that investment risk is lower over longer horizons apply the
logic of diversification across many risky assets to an investment in a risky portfolio
over many years. Because stock returns in successive years are almost uncorrelated,
they conclude that (1) the annual standard deviation of an investment in stocks falls
with the investment horizon, and hence, (2) investment risk in a stock portfolio declines
with the investment horizon.

The Fly in the Time Diversification Ointment (or More Accurately, the Snake Oil)

The flaw in the logic is the use of the annualized standard deviation to gauge the risk of
a long-term investment. Annualized standard deviation is an appropriate measure of
risk only for short-term (annual horizon) portfolios! It cannot serve to measure risk
when comparing investments of different horizons and different scales.


Chapter 7
Capital Asset Pricing and Arbitrage Pricing
Introduction of CAPM
Developed by Treynor, Sharpe, Lintner and Mossin in the early 1960s
To predict the relationship between the risk and equilibrium expected returns on
risky assets
CAPMs assumptions
1 Investors cannot affect prices by their individual trades.
2 All investors plan for one identical holding period.
3 Portfolios are formed with a universe of public traded financial assets and
investors have unlimited access to risk-free borrowing or lending opportunities.
4 Investors pay neither taxes nor transaction costs.
5 All investors attempt to construct efficient frontier portfolios.
6 All investors analyze securities in the same way and share the same economic
view of the world. Therefore, they all calculate the same figures about expected
return, standard deviation, correlation, etc. (homogeneous expectations)
1 All investors will choose to hold the market portfolio (M), which includes all
assets of the security universe.
The proportion of each stock in M equals the market value of the stock divided by the
total market value of all stocks.
2 The market portfolio will be on the efficient frontier, at which CAL touches the
efficient frontier.
3 The risk premium on the market portfolio will be proportional to the variance of
the market portfolio and investors typical degree of risk aversion or:

E ( r M )r f = A M

The risk premium on individual assets will be proportional to the risk premium on
the market portfolio and to the beta coefficient of the security on the market

E ( r M ) r f

E ( r D )r f

E ( r D )=r f + D [ E ( r M ) r f ]

Passive strategy
The CAPM suggest that a passive strategy is a powerful alternative to an active
A passive investor can easily benefit from the efficiency of the market portfolio
while an active investor will end on a CAL that is less than the CML used by
passive investor.

Applications of CAPM
Investment management industry
Capital budgeting decision
In 1963, William Sharpe has launched the single index model (SIM) refers to a
linear relationship between the excess return on the asset and the excess return
on the market.
SIM is a risk analysis tool:
Easy to apply
The single-index equation:



i +

i ( r M

rf ) +


E( e i ) = 0


The expected return of security i:

E ( ri ) =

i + rf

E( M )


The expected return of security i in the CAPM:

E ( ri ) = rf

E( M )


Compare SIM with CAPM



Uses realized return

Uses expected return

Relies on the index portfolio

Relies on the theoretical portfolio

i 0

i =0

Steps to conduct the analysis

Collecting and processing data
Estimation results
What we learn from this regression
The variance of the excess return
Required rate
The variance of the excess return

Variance ( Ri ) = Variance ( i R M ) + Variance ( e i )

= Systematic risk + Firm-specific risk
Required rate
Required rate = Risk-free rate +

x Expected excess return of index


Predicting Betas
In order to forecast the rate of return of an asset:

> 1: tend to exhibit a lower

< 1: tend to exhibit a higher

in the future
in the future

Use a weighting average of the sample estimate with the value 1.0
Multifactor Models
Multifactor Models: Models of security returns positing that returns respond to
several systematic factors (business-cycle risk, interest or inflation rate risk,
energy price risk,...)
Multifactor Models can provide better descriptions of security returns.
Suppose two sources of risk:
Market index
Treasury-bond portfolio
The excess rate of return on stock i in some time period t will be:
Ri = ai + iMRMt + iTBRTBt + ei
Two-factor security market line for security I
E(ri ) = rf + iM [E(rM) - rf ] + iTB [E(rTB) - rf ]
Fama-French Three-factor Model
In 1996, Fama and French proposed a three-factor model.
Market index
Firm size (SMB small minus big)
Book-to-market ratio (HML high minus low)
Ri = ai + M(rM rf )+ HML * rHML + SMB * rSMB + ei
Arbitrage Pricing Theory (APT)
investment portfolio with a sure profit
large levels of profit
APT: A theory of risk-return relationships derived from no-arbitrage
considerations in large capital markets.
In single form, the excess rate of return on each security using the APT is:
Ri = ai + iRM + ei
A well-diversified porfolio has zero firm-specific risk, so its return is:
Rp = ap + pRM
If the portfolio beta is 0, then:
Rp = ap
This portfolio has a return higher than the risk-free rate by the amount of ap

ap must be equal to 0, or else an immediate arbitrage opportunity opens up.

We will prove that ap must = 0, even if the beta is not 0.
The arbitrage strategy works
We combine 2 portfolios into a zero-beta riskless portfolio with a rate of return
not equal to the risk-free rate.
- Portfolio V has a beta of v , and an alpha of av
- Portfolio U has a beta of u , and an alpha of au
Our objective is to buy portfolio V and sell portfolio U in chosen proportions so that
the combination (V + U) will have a beta of zero.
The portfolio weights will be chosen as:
Wv = - u /(v - u )
Wu = v /(v - u)
We can easily point out:
Wv + Wu = 1
Beta (V + U) = 0
R (V + U) # 0
In conclusion, unless av and au equal 0, the new portfolio has a rate of return
differs from the risk-free rate an arbitrage opportunity.
The expected return-beta relationship model of APT
APT equation setting alpha is zero:
Rp = pRM
rp - rf = p (rM - rf )
E(rp ) = rf + p [E(rM) - rf ]
The same expected return-beta relationship as the CAPM.
The APT and the CAPM
APT applies to well diversified portfolios and not necessarily to individual stocks.
With APT it is possible for some individual stocks to be mispriced (not lie on the
APT is more general in that it gets to an expected return and beta relationship
without the assumption of the market portfolio.
APT and CAPM both can be extended to multifactor models.
Multifactor Generalization of the APT
Suppose we generalize the single-factor model to a two-factor model:
Ri = ai + i1Rm1 + i2Rm2 + ei
Factor Portfolios: Portfolios that have a beta of 1.0 on one factor and a beta of
0 on all others.


Definitions of informational and allocational efficiency are provided. Implications of
efficiency are then discussed and the idea of random walk is introduced and illustrated.
Note that we actually expect there to be a positive trend in stock prices albeit with
random movements about those positive trends. The reason that we would expect to
see price changes that are random is related to efficiency. If information that has
importance for stock values arrives or occurs in a random fashion, price
changes will occur randomly. If the market is efficient in its analysis, the change in
prices will reflect that information in a timely basis. The result will be random price
changes. The concept of market efficiency is related to the concept of competition. In
efficient markets, once information becomes available, participants will trade quickly on
that information. Competition assures that prices will reflect that information very
quickly. If the information does not become incorporated into price very quickly, market
participants would act to eliminate the inefficiency. Questions arise about efficiency
due to possible unequal access to information, structural market problems and
the psychology of investors (Behavioralism). Structural market problems refers to
market imperfections such as transaction costs limiting arbitrage, constraints on short
sales doing the same and recognizing that in volatile markets, most arbitrage strategies
are really risky arbitrage, not riskless arbitrage. We will have more to say on this later.
The forms of the efficient market are presented. In a weak form efficient market, prices
will reflect all information that can be derived from trading data such as prices and
volumes. In a semi-strong form market prices will reflect all publicly available
information regarding the firms prospects. In a strong form market, prices would
reflect all information relevant to the firms' prospects, even inside information. It
is important that students understand the following Venn diagram.
Many students struggle with this concept so it is worth taking the time to point
out the relationships among the different forms of efficiency.
Technical and fundamental analyses are defined in this section as well as the
implications of the different forms of market efficiency with respect to security
analysis. If markets are weak form efficient, technical analysis, such as charting,
should not result in superior profits. If markets are semi-strong form efficient,
Fundamental analysis involves using information on the economy as well as
information such as earning trends and profit trends to find undervalued securities.
If markets are at least semi-strong efficient, investors would tend to employ passive
strategies such as buying indexed funds or employing a diversified buy and hold
strategy. Active management such as security analysis or attempting to time the
market would not result in consistently superior profits if markets are efficient.

Even when markets are efficient portfolio management is required. For one thing, the
appropriate risk level will vary over an investor's life. Tax considerations will call for
different types of securities to be included in the portfolio. Other considerations could
be related to reinvestment risk associated with cash flow or considerations related to
diversifying employment related risk.
Over time stock prices tend to follow a sub martingale. This has nothing to do with
efficiency, per se. It does however have serious implications for tests of efficiency.
This implies that a randomly chosen portfolio of stocks can be expected to have a
positive return. In practice this means that when trying to figure out if some portfolio
manager is earning abnormal returns we must compare their performance to the
performance of a randomly chosen portfolio. That is they must outperform the random
portfolio or in practice they must beat some benchmark rate of return. The PPT
illustrates the idea of an event study and how an event study might look in an efficient
and in an inefficient market and introduces a market model to provide the expected
return that is needed to assess whether the investor earns an abnormal return.
The magnitude, selection bias and lucky event issues are also covered as well as
possible model misspecification. Because a model of expected return is needed
to assess whether an investor or an investment rule earns excess return, tests of
market efficiency are joint tests of the model used to estimate expected returns and
market efficiency. Hence, even when an anomaly is discovered we have to be
careful in interpreting the results. Some apparent anomalies are discussed including
the Fama-French results, the Keim and Stambaugh findings and the Campbell and
Shiller work. Note that each of these results may also be consistent with changing risk
premiums and may have nothing to say about market efficiency.
Periodically stock prices appear to undergo a speculative bubble. A speculative bubble
is said to occur if prices do not equal the intrinsic value of the security. Does this imply
that markets are not efficient?
There is no definitive answer to this question. However we can make some
It is very difficult to predict if you are in a bubble and when the bubble will
burst. I have been through two bubbles now and you cant understate the
significance of this point.
Stock prices are estimates of future economic performance of the firm and
these estimates can change rapidly.
Risk premiums can change rapidly and dramatically. Nevertheless, with
hindsight there appear to be times when stock prices decouple from
intrinsic or fundamental value, sometimes for years. What does this imply?
Prices eventually conform once more to intrinsic value. Many who dont
believe in efficient markets anyway have jumped on this result to
pronounce the death of market efficiency. However, the bubbles bring into
question the allocational efficiency of the markets more than the informational
efficiency. Very few people will be able to consistently predict the extent
and duration of a bubble.

Some claim the bubbles imply that investors are irrational. Perhaps, but
think about what determines the price of gold. Is it irrational to buy an asset for
more than its fundamental value if you believe that you can sell it for more than
you paid for it? It is indeed risky to engage in this type transaction, but is it
Bubbles seem to occur during two periods: 1) when technology is changing
rapidly and 2) during periods of cheap capital when interest rates are low for
extended periods. In the first case values will be more heavily determined by
future growth prospects rather than the value of assets in place. During
periods of cheap capital, new investments will be undertaken based on
future growth prospects as well. In both situations, new investors with less
investment knowledge and experience are likely to enter the markets, making a
bubble even more likely. When the bubble bursts, there will appear to be a
return to hardnosed rationality as investors look carefully to invest
according to their beliefs about fundamental values and will employ higher risk
For more on thoughts on this topic (and more history about bubbles) read
Burton Malkeils book, A Random Walk Down Wall Street to learn how
Castles in the Air sometimes outweigh fundamental values in price setting.
Some of the major types of tests that researchers have done on market
efficiency are described. If markets are inefficient, then professionals who spend
considerable resources in investment should secure superior performance. The tests
are broken down in terms tests of the forms of efficiency. Tests have uncovered some
inefficiency in pricing but many possible interpretations of results are possible. Tests of
weak-form efficiency show small magnitudes of positive correlation for very short
term tests; hence prices do not strictly conform to a random walk. Studies of returns
for periods of 3 to 12 months offer evidence of positive momentum. Longer horizon
tests have uncovered some pronounced negative correlation. Tests do document
tendencies for long-term reversals in results. This may be because of information flow
in competitive markets. People rush to buy recent winners and in so doing drive up the
price enough so that future returns are not abnormal. This does not imply inefficiency
unless the same investors can consistently do this. Attempting to interpret the
results of test of efficiency has led to various explanations that arrange from model
misspecification to data mining.
Some recent studies on mutual funds have documented some persistence in
positive and negative performance.
Some researchers question whether the
performance is abnormal or whether the studies have measurement errors or model
biases. The overall test results are mixed at best but the evidence shows that some
superstars exist. Note that Warren Buffets portfolio, (Buffet is one of the postulated
superstars) took quite a beating in the financial crisis of 2008. Although the evidence
isnt conclusive it appears safe to state that the ability to consistently earn abnormal
returns greater than one should for the risk level undertaken is very rare.
I also include a wrap up summary in this section to drive home the main points of the
chapter. I did this because students seem to have some trouble with the implications of

market efficiency and because in some cases it is difficult to get them past their own
prior beliefs in spite of what the evidence reveals.







Behavioral Finance

Investors do not always process information correctly

Investors often make inconsistent or systematically suboptimal decisions
Models of financial markets emphasize potential implications of psychological
factors affecting investor behavior
The irrationalities fall into two categories:

Information Processing
information correctly

Problems: Investors do not always process

Behavioral Biases: Investors often make inconsistent or suboptimal


Information Processing

Forecasting errors

People make forecasts based on the uncertainty inherent in their


De Bondt and Thaler (1990) employ this notion to explain the P/E ratio


People tend to overestimate the precision of their beliefs or forecasts, i.e.,

they tend to overestimate their abilities to predict future returns
For overconfident investors,

trading volume may be relatively high

adjust their portfolio very frequently

Overconfident individuals often exhibit risk-seeking behavior


A conservatism bias means that investors are too slow (or said too
conservative) in updating their beliefs in response to new evidence
This under-reaction to news leads to momentum effect in stock returns

Investors may underreact to news, so market prices, determined by

the consensus belief of investors, reflect news gradually

Representativeness bias

Definition: People are too prone to believe that a small sample is

representative of a population and thus infer patterns too quickly based on
small samples

Example: A short-lived good earning reports would lead investors think

about the bright future performance, they will invest more money in the
firm, exaggerating the price of stock

The forecasting errors (memory bias) can be viewed as a type of

representativeness bias

Behavioral Bias

Framing effect

Investment decisions are critically dependent on the decision-makers

reference point.

People tend to avoid risk when a positive frame is presented but seek
risks when a negative frame is presented

Mental accounting

Investors have a safe part of their portfolio that they will not risk, and a
risky part of their portfolio that they can have fun with

Investors segregate funds into mental accounts (e.g., dividends and

capital gains), maintain a set of separate mental accounts, and do not
combine outcomes; a loss in one account is treated separately from a loss
in another account

Regret avoidance

Is a specific form of framing, when people segregate certain decisions

Regret Prospect of regret generates avoidance behavior

Disposition effect: investors try to avoid regret by selling stocks that have
gone down in value, rush to sell those that have gone up

Prospect theory


We have an irrational tendency to be less willing to gamble with profits

than with losses. This means selling quickly when we earn profits but not
Tvede (1999, p. 169)
The most important theory in behavioral finance
They design some psychological experiments to examine how people
make decisions when they face different kinds of gambles

1. The results show that what affects people's decisions is not their wealth
level after the gamble, but the amount of gains or losses from the gamble
2. Loss averse attitude: people are more sensitive about the losses than
the gains

The decrease of the utility from $1 loss is larger than the increase of the
utility from $1 gain

In traditional economics, people are assumed to be risk averse and with a

concave utility function (in Diagram A)

In Prospect Theory, people are risk averse (thus with concave utility
function) when facing gains and risk loving (thus with convex utility
function) when facing losses (in Diagram B)

Limits to Arbitrage
Fundamental risk

The distortion could get worse or maintain for a long enough horizon such
that the exploitation of that distortion to profit is limited (e.g., a trader
may run out of his capital or a fund manager may lose his job before the
prices go back to the fair level)

Implementation costs

The short sell constraint for mutual fund managers

Or short-sellers may have to return the borrowed securities soon after the
notification from the broker, that makes the horizon of the short sale

Model risk

Shares of closed-end funds are traded at substantial discounts or

premiums from their net asset values

Siamese twin companies

In 1907, Royal Dutch Petroleum (RDP) and Shell Transport (ST) merged
their operations into one firm

RDP receives 60% cash income, and ST receives 40% cash income, so it
can be expected that the price of a RDP share is 1.5 times as high as the
price of a ST share (see the figure on the next slide)

Bubbles & Behavioral Economics

From 1995 to 2001, the Nasdaq index increased by a factor of more than 6. This dotcom boom development could be explained by some irrationalities in the behavioral

Investors were increasingly confident of their forecasts and

apparently extrapolate short-term patterns into the distant future
( representativeness bias)

The overconfidence arises from the situation in which investors

always earn huge capital gains regardless of what to buy and when to
buy( overconfidence bias)

The interaction of these two biases can explain the bubble from
1995 to 2001

Evaluating the Behavioral Critique

Try to explain anomalies but does not give guidance of how to exploit these

Explain each anomaly by some subjective combination of irrationalities from the

list of behavioral biases. There is not a unified behavioral theory to explain a
range of anomalies

It is possible to have conflicts between different theories, e.g., overreaction vs.



Trends and Corrections
Dow Theory Trends
Three forces simultaneously affecting stock price:

Primary trend: long-term movements, continuing from months to years

Intermediate trend (swing): short-term deviations from the underlying primary

trend, these deviations are eliminated via corrections (when prices come back
to trend value)

Minor trend (swing): daily fluctuations which are with little importance in the
trend analysis of the Dow theory

Sentiment Indicators
Trin Statistic
Trin: TRading Index

Volume declining/Number declining

Volume advancing/Number advancing
Average volume for falling stocks
Average volume for rising stocks

Trin =

Trin > 1: Bear market


Trin<1: Bull Market

Average Yield on 10 top - rated Corporate Bonds

Average Yield on 10 intermedia te grade Corporate Bonds

Confidence Index

This ratio is always smaller than 1 because higher rated bonds will offer
lower promised yields to maturity

Closer to 100% => investors should be bullish

Away from 100% => investors should be bearish

Short Interest

Short interest : total number of shares that are sold-short in the market

Short sale: the sale of shares not owned by the investor but borrowed through a
broker and later purchased to replace the loan

2 ways of interpretation:

High volume => investors should be bearish.

Low volume => investors should be bullish.
High volume: investors should be bullish.
Low volume: investors should be bearish.
Put/Call Ratio

Call option: the right to buy a stock at a fixed exercise price

A way of betting on stock price increases

Put option: the right to sell a stock at a fixed price

A way of betting on stock price decreases

Put/call ratio: ratio of put options to call options outstanding on a stock

Put options do well in falling markets while call options do well in rising market

Give a signal market sentiment and predictive of market movements:


Rising ratio: bearish

Declining ratio: bullish


Chapter 10
Bond prices and yields
10.1 BOND


Definition: a security that obligates the issuer to make specified payments to the holder
over a period of time.

Related terminologies
Face value, par value: the payment to the bondholder at the maturity of the bond.
Coupon rate: A bonds annual interest payment per dollar of par value.
Zero-coupon bond: A bond paying no coupons that sells at a discount and provides only
a payment of par value at maturity.
a Treasury Bonds and Notes
Both bonds and notes are issued in denominations of $1,000 or more and make
semiannual coupon payments.
Accrued interest and quoted bond prices
If a bond is purchased between coupon payments, the buyer must pay the seller for
accrued interest, the prorated share of the upcoming semiannual coupon. The
amount the buyer actually pays would equal the stated price plus the accrued interest.

annualcoupon payment
days since last coupon payment

=accrued interest
days seperating coupon payments

b Corporate bonds
Callable bond
Call provision allows the issuer to repurchase the bond at a specified call price before
the maturity date. The option to call the bond is valuable to the firm, allowing it to buy
back the bonds and refinance at lower interest rates when market rates fall. However
it is also the investors burden. Hence callable bonds are issued with higher coupons
and promised yields to maturity than non-callable bonds.
Convertible bond
Convertible bonds give bondholders an option to exchange each bond for a specified
number of shares of common stock of the firm.
Conversion ratio: the number of shares for which each bond may be exchanged.
Market conversion value: the current value of the shares for which the bonds may be
exchanged. At the $20 stock price, for example, the bonds conversion value is $800.
Conversion premium: the excess of the bond price over its conversion value.
Convertible bondholders benefit from price appreciation of the companys stock.
Puttable bonds
While the callable bond gives the issuer the option to extend or retire the bond at the
call date, the extendable or put bond gives this option to the bondholder. If the bonds
coupon rate exceeds current market yields, for instance, the bondholder will choose to
extend the bonds life. If the bonds coupon rate is too low, it will be optimal not to
extend; the bondholder instead reclaims principal, which can be invested at current
Floating-rate bonds

Floating-rate bonds make interest payments that are tied to some measure of current
market rates. For example, the rate might be adjusted annually to the current T-bill rate
plus 2%. If the one-year T-bill rate at the adjustment date is 4%, the bonds coupon rate
over the next year would then be 6%. This arrangement means that the bond always
pays approximately current market rates.
c Preferred stock
Preferred stock commonly pays a fixed dividend. Dividends on preferred stock are not
considered tax-deductible expenses to the firm. But a corporation pays taxes on only
30% of the dividend received when it buys preferred stock of another corporation.
In the event of bankruptcy, the claim of preferred stockholders to the firms assets
has lower priority than that of bondholders, but higher priority than that of common
d International bonds
International bonds are divided into two categories: foreign bonds and Eurobonds.

Foreign bonds:

E.g. foreign bonds sold in U.S. are called Yankee bonds. They are denominated in USD
and the issuers can be whatever country in the world except for U.S.
Foreign bonds sold in Japan are called Samurai bonds. They are denominated in Yen and
the issuers are non-Japanese ones.

Eurobonds: bonds issued in the currency of one country but sold in other national
E.g. the Eurodollar market refers to dollar-denominated bonds sold outside the U.S.
(not just in Europe), although London is the largest market for Eurodollar bonds.
e Innovation in the bond market
Inverse floaters: it is similar to the floating-rate bonds we described earlier, except
that the coupon rate on these bonds falls when the general level of interest rates rises.
Investors in these bonds suffer doubly when rates rise. Not only does the present value
of each dollar of cash flow from the bond fall as the discount rate rises but the level of
those cash flows falls as well. Of course investors in these bonds benefit doubly when
rates fall.
Asset-backed bonds: Bonds with coupon rates tied to the financial performance of
several of its films. The income from a specified group of assets is used to service
the debt. More conventional asset-backed securities are mortgage-backed securities
or securities backed by auto or credit card loans.
Pay-in-kind bonds: Issuers of pay-in-kind bonds may choose to pay interest either
in cash or in additional bonds. If the issuer is short on cash, it will likely choose to pay
with new bonds rather than scarce cash.
Catastrophe bonds: Bonds that have final payment depends on whether the
catastrophe sticking on it happens or not. These bonds are a way to transfer
catastrophe risk from insurance companies to the capital markets. Investors in these
bonds receive compensation in the form of higher coupon rates for taking on the risk.
But in the event of a catastrophe, the bondholders will give up all or part of their

Indexed bonds Indexed bonds make payments that are tied to a general price index or
the price of a particular commodity. For example, Mexico has issued bonds with
payments that depend on the price of oil.
Bond pricing
Bond value = Present value of coupons + Present value of par value

bond value=
t =1

coupon payment + par value

( 1+r )t
( 1+r )t

If the interest rate increases, the bond price decreases.

Bond pricing between coupon dates

Day between settlementlast coupon payment

Totaldays period
accrued interest =coupon x
10.2 BOND


Yield to maturity (YTM)

It is the discount rate that makes the present value of a bonds payments equal to its price.
This rate is often viewed as a measure of the average rate of return that will be earned on a
bond if it is bought now and held until maturity.
Yield to call
It is used to calculated yield in callable bond.
Callable bond could be retired prior to the maturity date.
If price of bond is higher than call price seller will call that bond and sell them to the
market for profit.
Calculate Yield to Call:


coupon payment + call price

( 1+YTC )t
( 1+YTC )t


t: number of period payment till the call date

Price: price of that bond at the call date
We use financial calculator or excel application to solve YTC
Realized Compound Return versus Yield to Maturity
Realized compound return: Compound rate of return on a bond with all coupons
reinvested until maturity.
With a reinvestment rate equal to the yield to maturity, the realized compound
return equals yield to maturity. If the reinvestment rate is not at yield to maturity,
there will be two circumstances. Firstly, if the coupon can be invested at more than
YTM, funds will grow larger, and the realized compound return will exceed YTM.
Secondly, if the reinvestment rate is less than YTM, investors will gain less. Hence, as
interest rates change, bond investors are actually subject to two sources of offsetting
risk. On the one hand, when rates rise, bond prices fall, which reduces the value of
the portfolio. On the other hand, reinvested coupon income will compound more
rapidly at those higher rates. This reinvestment rate risk will offset the impact of
price risk.
10.3 BOND



Interest rate and bond price have long-term negative relationship for all maturity. A
bond will be sold above its face value when the coupon rate is higher than the discount
rate (market interest rate), at the face value when the coupon rate is equal to the
market interest rate, and below its face value when the coupon rate is lower than the
market interest rate.
Yield to Maturity versus Holding-Period Return
If the yield to maturity is unchanged over the period, the rate of return on the bond will
equal that yield.
When the yields fluctuate, a bonds rate of returns will change accordingly.
An increase in the bonds yield to maturity will reduce its price, which means that the
holding-period return will be less than the initial yield.
Equivalently, a decline in the bonds yield to maturity results in the holding-period
return greater than the initial yield.
Zero-Coupon Bonds and Treasury STRIPS
Zero coupon bonds carry no coupons and present all its return in the form of price
When a Treasury fixed-principal note or bond (or a TIPS) is stripped, each interest
payment and the principal payment becomes a separate zero-coupon security.
Example: a Treasury note with 10 years remaining to maturity consists of a single
principal payment at maturity and 20 interest payments (paid semiannually). When this
note is converted to STRIPS form, each of the 20 interest payments and the principal
payment becomes a separate security.
STRIPS are also called zero-coupon securities because the only time an investor
receives a payment during the life of a STRIP is when it matures.


Bond default risk is measured by Moodys Investor Services, Standard & Poors
Corporation, and Fitch Investors Service, all of which provide financial information on
firms as well as the credit risk of large corporate and municipal bond issues.
Bond Ratings
High Quality
Very Poor
Standard & Poors
Investment grade bond A bond rated BBB and above by Standard & Poors, or Baa
and above by Moodys.
Speculative grade or junk bond A bond rated BB or lower by Standard & Poors, or Ba
or lower by Moodys, or an unrated bond.
Junk Bonds: they are also known as high-yield bonds and are nothing more than
speculative grade (low- rated or unrated) bonds.
Determinants of Bond Safety
a Coverage ratios. Ratios of company earnings to fixed costs. For example, the TIE ratio is
the ratio of earnings before interest payments and taxes to interest obligations. The
fixed-charge coverage ratio includes lease payments and sinking fund payments with

interest obligations to arrive at the ratio of earnings to all fixed cash obligations. Low or
falling coverage ratios signal possible cash flow difficulties.
b Leverage ratio. Debt-to-equity ratio. A too-high leverage ratio indicates excessive
indebtedness, signaling the possibility the firm will be unable to earn enough to satisfy
the obligations on its bonds.
c Liquidity ratios. These are current ratio (current assets/ current liabilities) and the quick
ratio (current assets excluding inventories/current liabilities). These ratios measure the
firms ability to pay bills coming due with its most liquid assets.
d Profitability ratios. Measures of rates of return on assets or equity. Profitability ratios are
indicators of a firms overall performance. The return on assets (earnings before interest
and taxes divided by total assets) or return on equity (net income/equity) are the most
popular of this measure.
e Cash flow-to-debt ratio. This is the ratio of total cash flow to outstanding debt.
Bond Indentures:
Bond indenture is the document defining the contract between the bond issuer and
the bondholder.
Protection Against Default:
Sinking funds

Issuer may repurchase a given fraction of the outstanding bonds each year
Issuer may either repurchase at the lower of open market price or at a pre-specified
price, usually par; bonds are chosen randomly

Serial bonds

Staggered maturity dates

Subordination of future debt: Senior debt holders must be paid in full before
junior debt holders.

Dividend restrictions: Limit on liquidating dividends

Collateral: A specific asset pledged against possible default on a bond.

Note that sinking funds and serial bonds are designed to help ensure the issue can pay
off the principal as it comes due. However a bond investor could be hurt by the second
type of sinking fund if interest rates fall. Serial bonds are not callable and this is a plus,
but the staggered maturities can reduce the liquidity of the bonds and make them more


Term structure of interest rate

Yield curve: a graph of the yields on bonds relative to the number of years to maturity,
hence it represent the relationship between yields to maturity and the term to maturity.

Expectations theory

Firstly, long term rates are a function of expected future short term rates. Secondly,
upward slope means that the market is expecting higher future short term rates and
downward slope means that the market is expecting lower future short term rates.

Liquidity Preference theory


It is the theory that investors demand a risk premium on long-term bonds. It derives from
the fact that shorter term bonds have more liquidity than longer term bonds, in the
sense that they offer greater price certainty and trade in more active markets with lower
bid-ask spreads. The preference of investors for greater liquidity makes them willing to
hold these shorter term bonds even if they do not offer expected returns as high as
those of longer term bonds.


Chapter 11
Managing bond portfolio
Interest Rate Sensitivity
Bond prices and yields are inversely related: As yields increase, bond prices fall; as

yields fall, bond prices rise.

An increase in a bonds yield to maturity results in a smaller price change than a

decrease in yield of equal magnitude.

Prices of long-term bonds tend to be more sensitive to interest rate changes than prices

of short-term bonds.
If rates increase, for example, the bond is less valuable as its cash flows are discounted
at a now-higher rate. The impact of the higher discount rate will be greater as that rate
is applied to more-distant cash flows.
The sensitivity of bond prices to changes in yields increases at a decreasing rate as

maturity increases. In other words, interest rate risk is less than proportional to bond
Interest rate risk is inversely related to the bonds coupon rate. Prices of low-coupon

bonds are more sensitive to changes in interest rates than prices of high-coupon bonds.
The sensitivity of a bonds price to a change in its yield is inversely related to the yield

to maturity at which the bond currently is selling.

Duration is a direct measure of the sensitivity of a bonds price to a change in its yield.
The proportional change in a bonds price approximately equals the negative of
duration times the proportional change in 1 + y.
Macaulays duration: A measure of the effective maturity of a bond, defined as the
weighted average of the times until each payment, with weights proportional to the
present value of the payment.

CF ( t )
( 1+ y )t
w ( t )=
bond price
y: bonds yield to maturity.
The numerator: the present value of the cash flow occurring at time t, while
The denominator: the present value of all the payments forthcoming from the bond
Then we use w(t) to calculate Duration following the equation:

D= t w (t )
t =1

Duration is a key concept in bond portfolio management for at least three reasons
because it is a simple summary measure of the effective average maturity of the portfolio.

Besides, it represents an essential tool in immunizing portfolios from interest rate risk.
Modified duration: D* = D/(1 + y)
Because the percentage change in the bond price is proportional to modified
duration, modified duration is a natural measure of the bonds exposure to interest rate
Factors determine duration:
Rule 1: The duration of a zero-coupon bond equals its time to maturity.
Rule 2: With time to maturity and yield to maturity held constant, a bonds duration and

interest rate sensitivity are higher when the coupon rate is lower.
Rule 3: With the coupon rate held constant, a bonds duration and interest rate
sensitivity generally increase with time to maturity. Duration always increases with
maturity for bonds selling at par or at a premium to par.
Rule 4: With other factors held constant, the duration and interest rate sensitivity of a
coupon bond are higher when the bonds yield to maturity is lower.
Rule 5: The duration of a level perpetuity is

Duration of perpetuity=

1+ y


Bank liabilities are primarily the deposits owed to customers; these liabilities are
short-term in nature and consequently of low duration. On the other hand, assets
largely comprise commercial and consumer loans or mortgages. These assets are of
longer duration than deposits, which means their values are correspondingly more
sensitive than deposits to interest rate fluctuation. So when interest rates increase
unexpectedly, banks can suffer serious decreases in net worth because their assets fall
in value by more than their liabilities. Hence, immunization is strategy to shield net
worth from interest rate movements.
Immunization strategies are characteristic of passive bond portfolio management.
Such strategies attempt to render the individual or firm immune from movements in
interest rates. This may take the form of immunizing net worth or, instead, immunizing
the future accumulated value of a bond portfolio.
Immunization of a fully funded plan is accomplished by matching the durations of
assets and liabilities. To maintain an immunized position as time passes and interest
rates change, the portfolio must be periodically rebalanced.
Cash Flow Matching and Dedication
Cash flow matching is matching cash flows from a fixed-income portfolio with those of an
obligation. For the one which is on a multi-period basis is referred to as a dedication
In this case, the manager selects either zero-coupon or coupon bonds providing
total cash flows that match a series of obligations in each period. The advantage of
dedication is that it is a once-and-for-all approach to eliminating interest rate risk.
Once the cash flows are matched, there is no need for rebalancing.

Convexity refers to the curvature of a bonds price-yield relationship. Accounting for

convexity can substantially improve on the accuracy of the duration approximation
for bond-price sensitivity to changes in yields.
We can quantify convexity as the rate of change of the slope of the price-yield
curve, expressed as a fraction of the bond price. As a practical rule, you can view bonds
with higher convexity as exhibiting higher curvature in the price-yield relationship.
Convexity allows us to improve the duration approximation for bond price changes.
P/P = -D y + Convexity (y)2
Active bond management can be decomposed into interest rate forecasting
techniques and intermarket spread analysis. One popular taxonomy classifies
active strategies as
substitution swaps, intermarket spread swaps, rate
anticipation swaps, or pure yield pickup swaps.

The substitution swap is an exchange of one bond for a nearly identical substitute.
The substituted bonds should be of essentially equal coupon, maturity, quality, call
features, sinking fund provisions, and so on. A substitution swap would be motivated
by a belief that the market has temporarily mispriced the two bonds, with a
discrepancy representing a profit opportunity.

The intermarket spread swap is an exchange of two bonds from different sectors of
the bond market. It is pursued when an investor believes the yield spread between
two sectors of the bond market is temporarily out of line.
E.g. If the yield spread between 10-year Treasury bonds and 10-year Baa- rated
corporate bonds is now 3%, and the historical spread has been only 2%, an investor
might consider selling holdings of Treasury bonds and replacing them with corporates.
If the yield spread eventually narrows, the Baa-rated corporate bonds will outperform
the Treasury bonds.
Of course, the investor must consider carefully whether there is a good reason that the
yield spread seems out of alignment. For example, the default premium on corporate
bonds might have increased because the market is expecting a severe recession. In this
case, the wider spread would not represent attractive pricing of corporates relative to
Treasuries, but would simply be an adjustment for a perceived increase in credit risk.

The rate anticipation swap is an exchange of bonds with different maturities. It is

pegged to interest rate forecasting. Investors who believe rates will fall will swap into
bonds of longer duration. For example, the investor might sell a five-year maturity
Treasury bond, replacing it with a 25-year maturity Treasury bond. The new bond has
the same lack of credit risk as the old one, but it has longer duration.

The pure yield pickup swap is an exchange of a shorter duration bond for a longer
dura- tion bond. This swap is pursued not in response to perceived mispricing but as a
means of increasing return by holding higher yielding, longer maturity bonds. The
investor is willing to bear the interest rate risk this strategy entails.
Contingent Immunization
It is a technique that immunizes a portfolio if necessary to guarantee a minimum
acceptable return but otherwise allows active management.

The idea is to allow the fixed-income manager to manage the portfolio actively
unless and until poor performance endangers the prospect of achieving a minimum
acceptable portfolio return. At that point, the portfolio is immunized, providing a
guaranteed rate of return over the remaining portion of the investment period.


Chapter 12
Macroeconomic and Industry Analysis
The international economy might affect a firms export prospects, the price
competition it faces from foreign competitors, or the profits it makes on investments
abroad. Certainly, despite the fact that the economies of most countries are linked in a
global macro economy, there is consider- able variation in economic performance
across countries at any time. The global environment presents political risks such as
currency and stock values swung with enormous volatility, protectionism and trade
policy, exchange rate. As exchange rates fluctuate, the dollar value of goods priced in
foreign currency similarly fluctuates.
Gross domestic product: Gross domestic product, or GDP, is the measure of the
economys total production of goods and services. Rapidly growing GDP indicates an
expanding economy with ample opportunity for a firm to increase sales.
Employment: The unemployment rate is the percentage of the total labor force (i.e.,
those who are either working or actively seeking employment) yet to find work. The
unemployment rate measures if economy is operating at full capacity, the strength of
the economy can be gleaned from the employment rate of other factors of production
and the factory capacity utilization rate.

Inflation is the rate at which the general level of prices is rising. High rates of inflation
often are associated with economies where the demand for goods and services is
outstripping productive capacity, which leads to upward pressure on prices. There is a
trade-off between inflation and unemployment .
Interest Rates

High interest rates reduce the present value of future cash flows, thereby reducing the
attractiveness of investment opportunities. Real interest rates are key determinants of
business investment expenditures.
Budget Deficit

The budget deficit of the federal government is the difference between government
spending and revenues. Government borrowing forces up interest rates by increasing
the total demand for credit in the economy. Excessive government borrowing will
crowd out private borrowing and investing.

Consumers and producers optimism or pessimism concerning the economy are

important determinants of economic performance. If consumers have confidence in
their future income levels, they are willing to expense more. Similarly, businesses will
increase production and inventory levels if they anticipate higher demand for their
products. It then influence level of consumption and investment.
Forecasts of interest rates directly affect the forecast of returns in the fixed-income
The fundamental factors that determine the level of interest rates:
1. The supply of funds from savers, primarily households.

2. The demand for funds from businesses to be used to finance physical investments in
plant, equipment, and inventories.
3. The governments net supply and/or demand for funds as modified by actions of the
Federal Reserve Bank.
4. The expected rate of inflation.
The supply curve slopes up from left to right because the higher the real interest rate
makes households postpone some current consumption and set aside or invest more.
The demand curve slopes down from left to right because the lower the real interest
rate, the more businesses will want to invest in physical capital. The government and
the central bank (the Federal Reserve) can shift these supply and demand curves either
to the right or to the left through fiscal and monetary policies. The fundamental
determinants of the real interest rate are the propensity of households to save and the
expected of firmsinvestment in physical capital as well as by government fiscal and
monetary policies.
A demand shock is an event that affects the demand for goods and services in the
economy. Demand shocks usually are characterized by aggregate output moving in the
same direction as interest rates and inflation. It also might increase interest rates by
increasing the demand for borrowed funds. It could increase the inflation rate if the
demand for goods and services is raised to a level at or beyond the total productive
capacity of the economy.
A supply shock is an event that influences production capacity and costs. Supply
shocks usually are characterized by aggregate output moving in the opposite direction
as inflation and interest rates. The increase in inflation rates over the near term can
lead to higher nominal interest rates. With raw materials more expensive, the
productive capacity of the economy is reduced as is the ability of individuals to
purchase goods at now-higher prices. GDP, therefore, tends to fall.
Fiscal policy is the use of government spending and taxing for the specifi c purpose of
stabilizing the economy. Decreases in government spending directly deflate the
demand for goods and services. Similarly, increases in tax rates immediately siphon
income from consumers and result in fairly rapid decreases in consumption. while the
impact of fiscal policy is relatively immediate, its formulation is so cumbersome that
fiscal policy cannot in practice be used to fine-tune the economy. Much of government
spending is determined by formula rather than policy and cannot be changed in
response to economic conditions. A large deficit means the government is spending
considerably more than it is taking in by way of taxes. The net effect is to increase the
demand for goods (via spending) by more than it reduces the demand for goods (via
taxes), therefore, stimulating the economy.
Monetary policy is Actions taken by the Board of Governors of the Federal Reserve
System to influence the money supply or interest rates. Increases in the money supply
lower short-term interest rates, ultimately encouraging investment and consumption
demand Expansionary monetary policy probably will lower interest rates and thereby
stimulate investment and some consumption demand in the short run, but these
circumstances ultimately will lead only to higher prices. Implementation of monetary
policy through some tools. The first tool is the open market.operation, in which the Fed
buys or sells Treasury bonds for its own account. Other tools at the Feds disposal are
the discount rate, which is the interest rate it charges banks on short-term loans, and
the reserve requirement. Lowering reserve requirements allows banks to make more

loans with each dollar of deposits and stimulates the economy by increasing the
effective money supply.
Supply-side policies treat the issue of the productive capacity of the economy. The
goal is to create an environment in which workers and owners of capital have the
maximum incentive and ability to produce and develop goods. Supply-side economists
also pay considerable attention to tax policy. Lowering tax rates will elicit more
investment and improve incentives to work, thereby enhancing economic growth.
These recurring patterns of recession and recovery are called business cycles. A
peak is the transition from the end of an expansion to the start of a contraction. A
trough occurs at the bottom of a recession just as the economy enters a recovery. At a
trough, just before the economy begins to recover from a recession, one would expect
that cyclical industries, those with above-average sensitivity to the state of the
economy, would tend to outperform other industries. In contrast to cyclical firms,
defensive industries have little sensitivity to the business cycle. Defensive industries
include food producers and processors, pharmaceutical firms,
and public utilities. These industries will outperform others when the economy enters a
Economic Indicators:Leading economic indicators are those economic series that tend
to rise or fall in advance of the rest of the economy. Coincident and lagging indicators
move in tandem with or somewhat after the broad economy. The stock market price
index is a leading indicator. Stock prices are forward-looking predictors of future
profitability. The money supply is another leading indicator. Other leading indicators
focus directly on decisions made today that will affect production in the near future.
We have seen that economic performance can vary widely across countries,
performance also can vary widely across industries.
Defining an Industry: A useful way to define industry groups in practice is given by the
North American Industry Classification System, or NAICS codes. These are codes
assigned to group firms for statistical analysis. The first two digits of the NAICS codes
denote very broad industry classifications. Another industry classification is Standard &
Poors reports on the performance of about 100 industry groups. The Value Line
Investment Survey reports on the conditions and prospects of about 1,700 firms,
grouped into about 90 industries.
Sensitivity to the Business Cycle: Not all industries are equally sensitive to the business
cycle. Three factors will determine the sensitivity of a firms earnings to the business
cycle. First is the sensitivity of sales. Necessities will show little sensitivity to business
conditions. The second factor determining business cycle sensitivity is operating
leverage, which refers to the division between fixed and variable costs. Firms with
greater amounts of variable as opposed to fixed costs will be less sensitive to business
conditions. The third factor influencing business cycle sensitivity is financial leverage,
which is the use of borrowing. Interest payments on debt must be paid regardless of
sales. Investors should not always prefer industries with lower sensitivity to the
business cycle.
Sector rotation is an investment strategy that entails shifting the portfolio into industry
sectors that are expected to outperform others based on macroeconomic forecasts. The
idea is to shift the portfolio more heavily into industry or sector groups that are
expected to outperform based on ones assessment of the state of the business cycle.
Near the peak of the business cycle, firms should engage in natural resource extraction
and processing such as minerals or petroleum. Following a peak, when the economy

enters a contraction or recession, one would expect defensive industries that are less
sensitive to economic conditions. At the trough of a recession, firms might thus be
spending on purchases of new equipment or invest in capital goods industries.
Industry Life Cycles: Industry life cycle: Stages through which firms typically pass as
they mature .It might be described by four stages.
Start-up stage The early stages of an industry are often characterized by a new
technology or product. At this stage, it is difficult to predict which firms will emerge as
industry leaders.
Consolidation stage: At this point, the product has reached its potential for use by
consumers. The product has becomefar more standardized, and producers are forced to
compete to a greater extent on the basis of price.
Relative decline the industry might grow at less than the rate of the overall economy,
or it might even shrink.
Industry Structure and Performance
Threat of entry New entrants to an industry put pressure on price and profits.
Rivalry between existing competitors When there are several competitors in an
industry, there will generally be more price competition and lower profit margins as
competitors seek to expand their share of the market
Pressure from substitute products Substitute products means that the industry faces
competition from firms in related industries
Bargaining power of buyers If a buyer purchases a large fraction of an industrys output,
it will have considerable bargaining power and can demand price concessions.
Bargaining power of suppliers If a supplier of a key input has monopolistic control over
the product, it can demand higher prices for the good and squeeze profits out of the


Chapter 13
Equity Valuation
The purpose of fundamental analysis is to identify mispriced stocks. To assess whether
it is mispriced, they compare it with some measures of true value. True value is
estimated based on both observable market data and financial statement data.
Analysiss analyses the relationship between price and different determinants such as
operating earnings, book value, sales, etc. Those ratios will then be used to compare
with other firms in the same industry. the value of common equity on the balance sheet and it is based on
historical values of assets and liabilities, which may not reflect current values. It may
not take into account for the future growth opportunities of the firm. Therefore, market
value of equity to book ratio is thought to be a better measure of market valuation over
the book value. Additionally, use the Liquidation value per share to set the stock price
floor rather than book value. Liquidation value is the net amount realized from sale of
assets and paying off all debt. The firm becomes a takeover target if the market value
of stock falls below this amount, so liquidation value may serve as floor to value.
Intrinsic value is the present value of a firms expected future net cash flows discounted
by the required rate of return. The intrinsic value is the value that the analyst places on
a stock. Comparing intrinsic value and market price can generate buy or sell signals
Using CAPM model to calculate require rate of return:
k= rf + [E(rM)-rf) -> risk adjusted interest rate
Based on 1 year holding period to measure the intrinsic value: V o

E ( D 1 ) + E( P 1)


Dividend discount mode (DDM)is a formula for the intrinsic value of a firm equal to the
present value of all expected future dividends.
Assume that the stock will be selling for its intrinsic value. The intrinsic value is the
present value of the dividend to be received at the end of the year and the expected
sales price. Hence, for a holding period of H years, the stock value can be calculated as



Vo= 1+ k + (1+k )2 ++

(1+ k )H

PH is the present value at the time H of all dividends expected to be paid after the
horizontal date. Then the equation turns to be:
Vo =

2 +
1+ k
(1+k )
(1+k )3 +.

That is the stock price equal the present value of all expected future dividends into
perpetuity. It is the dividend discount model of stock price.
- The constant growth DDM
The model above requires dividend forecasts for every year into the indefinite future.It
is not practical so analysts simplify it by an assumption that dividends are trending
upward at a stable growth rate (g)


Constant growth DDM: Vo= kg

If dividend were expected not to grow, Price will equal D 1/k
The model is valid only when g is less than k
Some implications of the model:.
The stocks value will be greater when: Dividend per share is larger,market
capitalization rate is lower and expected growth rate of dividends is higher
Stock price is expected to grow at the same rate as dividends: P 1=Po(1+g)
Expected holding period return will be: Er=D 1/Po+g=k when stock is sold at the intrinsic
-> Can compute k ->the discounted cash flow formula.
Stock prices and Investment opportunities:
Stocks with high growth cost more, you have to pay for expected growth. Buying stocks
that have high expected growth is risky because if the growth does not occur, the
stocks price will collapse.
The level of reinvestment has a significant impact on growth rates. The higher levels of
reinvestment,the higher levels of growth. The concept of partitioning the value of stock
into a no growth and a present value of growth opportunities component is presented...
The concept of using the PVGO approach is very useful in assessing how much of the
value is being attributed to growth and growth opportunities. If a substantial portion of
the value is attributed to growth, careful analysis of thegrowth assumptions is
appropriate. The PVGO model is given by:

Do(1+ g)

Life cycles and Multistage Growth Models:

Life cycles:
In early year many opportunities for profitable reinvestnent ->low payout ratio ->rapid
In later years:less attractive reinvestment opportunities ->increased dividend payout
->dividend grows at slower rate.
->This illustrates the difference from the assumption of constant growth dividend.
Multistage Growth Models:
The multistage growth model allows the analyst to model firms whose earnings and
dividends are expected to grow at high rates for a short time horizon. Following the
rapid growth, the rate of growth is expected to settle to a normal or constant growth


The multi-stage model is:

Vo = [Do

1+ k

(1+ g 1)t
(1+ k)t ] + ( kg 2 )
t =1
DT (1+ g 2)


The P/E method is used extensively in industry and is helpful in comparing relative
values of firms, particularly with respect to future growth opportunities. The appropriate
P/E is a function of two factors; the required rate of return and expected growth in
earnings, with the latter dominating. P/E appears easier to use. The appropriate P/E
multiplies is the ratio of a stocks price to its earnings per share and depends on

k( ROEb)
P/E increases with ROE: ROE<k: investors prefer pay out earnings as dividend
ROE>k: investors prefer pay out earnings as reinvest earnings
ROE=k: investors can either reinvest in firm or elsewhere
P/E increase for higher plowback. Market rewards firm with higher P/E multiple if it
exploits good investment opportunities more aggressively by plowing back more
earning into those opportunities. A higher P/E ratio implies a higher expected future
growth rate of earnings. If the earnings growth does not materialize, the P/E will fall
investors suffer losses.
Riskier stocks will have lower P/E multiples as riskier firms will have a higher required
rate of return.
Free cash flow for the firm (FCFF) discounted at the weighted-average cost of capital to
obtain the value of the firm.
FCFF= EBIT (1-tc) + Depreciation - Capital expenditures - Increase in NWC

Firm value =

t =1



+ (1+WACC )T .in.which.PT= WACC g

This method is used to analyse firms that dont pay dividends helps to understand
sources and uses of cash.
Value of equity can be found by subtracting the then existing value of debt from the
FCFF. (This is the fluctuation of long-term Liability)
FCFE= FCFF - Interest expense (1-tc) + Increases in net debt.

Market value of equity=


(1+ k )tt
t =1


+ (1+k )T

in which PT=

(ke is the cost
k E g

of equity) In theory free cash flow approaches should provide the same estimate of
intrinsic value as the dividend growth model.


The earnings multiplier approach takes a forecast of corporate profits for the coming
period for an index such as the S&P500. Derive an estimate for the aggregate P/E ratio
using long-term interest rates. This can be done based on the relationship between the
earnings yield or E/P ratio for the S&P 500 and the yield on 10 year Treasuries and this
graph is depicted in the PPT along with an example. The product of the two forecasts is
the estimate of the end-of-period level of the market.


Chapter 14
Financial Statement Analysis
Income Statement: a financial statement showing a firms revenues and expenses during a specified period
Balance sheet: An accounting statement of a firms financial position at a specified time
A statement of cash flows: a financial showing a firms cash receipts and cash payments during a specified
period. The statement of cash flows removes much of the effects of accrual accounting to give the analyst a
better look at the cash flows of the firm. The statement of cash flows recognizes only transactions in which
cash changes hands.
Cash Flow = Operating Cash Flow + Cash Flows From Investing + Cash Flow From Financing
Operating Cash Flow = Net income + Depreciation + Net Operating Sources of Funds
Net Operating Sources of Funds = Working capital operating sources of funds working capital


ROE: ROE= (1-tax) [ROA + (ROA - Interest rate) Equity ]

Net . profit

= Pretax . profit

Pretax . profit EBIT Sales


Sales Assets Equity

=Tax burden Interest . burden Margin Turnover Leverage

ROE is after tax and ROA is before interest and taxes (ROA = EBIT / Assets). This relationship illustrates the
leverage and return on equity. Using debt in the capital structure can increase the ROE if the ROA is greater
than the interest rate on the debt. Hence, the choice of the optimal capital structure will be dependent on
expected earnings on investments in relation to the cost of debt.
Tax Burden (TB) measures the percentage of pretax profit that the firm keeps after paying taxes. Interest
Burden (IB) measures the percent of EBIT kept after paying interest expense. This ratio is 1 if the firm has no
debt. Operating Profit Margin measures the percentage of sales revenue that remains after subtracting cost of
goods sold, selling and administrative expenses and depreciation. Asset Turnover Ratio (ATO) measures the
efficiency of the firm at generating sales per dollar invested in the assets.
Leverage ratio = 1 + Debt / Equity. The leverage ratio is a measure of the percentage of debt in total
Liquidity ratio: Liquidity ratios are designed to measure the firms ability to meet a short term obligation.

Current ratio =Current assets/current liabilities-> measures the ability of the firm to pay off its current
liabilities by liquidating its current assets. It indicates the firms ability to avoid insolvency in the short run
Quick ratio= (cash + marketable securities + receivables)/current liabilities ->it is better measure of liquidity
than the current ratio for firm whose is not readily convertible into cash.
Cash ratio= (Cash + Marketable securities)/Current liabilities->receivables are less liquid than its holdings of
cash and marketable securities.

Market price ratio: The price-to-earnings and market-to-book ratios are presented. These ratios are

regularly reported and discussed in the financial press. The relevance of the market to book ratio varies with
industries. The relevance depends on how accurately the book value reflects economic value and how
significant asset levels are in the production of profits and sales. Analysts also use the price-to-sales ratio as an
indicator of how a stock is valued, particularly if a firm has low or negative earnings.
-Leverage ratios: They are used to investigate the firms use of debt. Times-interest-earned and fixed-chargecoverage ratios are used to assess the firms ability to service debt. Debt to assets and debt to equity are used
to assess how much debt financing the firm is using.
To evaluate the performance of a given firm, however, we need a benchmark to which we can compare those
ratios. One obvious benchmark is the ratio for the same company in earlier years that is the past figures.
The concept of economic value added is another tool that can be used to analyze a companys performance.
Economic value added compares return on assets with a cost to the capital that is required to make the
investment in assets. The main point of the analysis is management adds value to stockholders by retaining
earnings and reinvesting only if the ROE > k. The related point should also be made, namely that EPS growth
can be generated simply by retaining earnings, but this does not mean the firm is adding value or maximizing
shareholder wealth unless the return on the investment is greater than k.
Some of the issues that short-term borrowing brings to analysis are illustrated by the example using Growth
Industries, Inc. Key ratios and the statement of cash flows for Growth Industries, Inc. show that careful
analysis of financial ratios can indicate problems that may not be presented in the annual report. The analysis
shows that ROE is declining while ROA is remaining steady. The firm is using large amounts of long-term
debt to maintain its 20% growth in assets and this is not sustainable for very long.
Since financial ratios are based on accounting data, an analyst must be aware of differences in accounting
methods that could affect comparison of ratios. Some of the key problems of comparability include different
inventory valuation methods. This is an important factor since it influences cost of goods sold, which is the
major component of costs on most income statements. There are also various problems related to depreciation.
Inventory Valuation: There are 2 different ways to value inventories. FIFO (last-in, first-out) LIFO
considers the last goods produced are the first ones to be sold. Therefore, it values the million units
used up during the year at the current cost of production. In contrast, FIFO (First in, first out) assumes
that the units used up or sold that were added to inventory first and goods sold should be valued at
original cost. A disadvantage is that FIFO accounting includes balance sheet distortions when it values
investment in inventories at original cost. This practice results in an upward bias in ROE because the
investment base on which return is earned is undervalued.
Depreciation: The problem should be mentioned here is the various measurement of depreciation.

Accounting depreciation is different from economic depreciation. According to economic definition,

depreciation is the amount of a firms operating cash flow that must be reinvested in the firm to sustain its real
cash flow at the current level. Accounting depreciation is the amount of original acquisition cost of an asset
that is allocated to each accounting period over an arbitrarily specified life of the asset. Firms can also choose
different methods of depreciation. Depreciation affects reported income and reported asset values. Inflation
can distort reported income and the balance sheet.

Quality of earnings and accounting practices:

A firm in the modern corporate environment has a great deal of flexibility in reporting and quality is a real
issue. Quality of earnings refers to the realism and sustainability of reported earnings. This implies that
Allowance for bad debts must be realistic
Extraordinary and Non-recurring items are sometimes pretty ordinary and common
Earnings smoothing is pervasive
Revenue & expense recognition options
Engaging in contingent off-balance sheet assets (certain leases) or liabilities (selling credit default swaps) that
have unknowable effects on earnings.
International Accounting Conventions
Overseas firms have far more discretion in their ability to set aside reserves for future contingencies (or not)
than U.S. firms have. This means foreign firms earnings are more subject to managerial manipulation.
Foreign firms typically use accelerated depreciation on their financial statements and U.S. firms dont, so
foreign firms have lower reported earnings, ceteris paribus. Treatment of intangibles varies widely between
countries as well, increasing comparability problems. The International Financial Reporting Standards (IFRS)
have been adopted by the European Union and by over 100 countries.
In 2007 the SEC began allowing foreign firms to list their securities in U.S. markets if they prepared their
statements using IFRS. In 2008 the SEC ruled that large U.S. multinational firms may start using IFRS rather
than GAAP in 2010 and that all firms should use IFRS by 2014. IFRS standards are principle based rather than
rules based. The IFRS standards will generally allow more flexibility in reporting standards.
The last section of the chapter provides a discussion of Benjamin Grahams techniques for investing. Graham
was the founder of modern fundamental analysis. Graham believed careful analysis of a firms financial
statements could turn up bargain stocks and his work was used by generations of analysts. He developed many
different rules for determining the most important financial ratios, as his ideas became popular they stopped