Principle of Investment

APT (Lecture 8)
Short sale
Short sale is a sale of stock that you do not own.
Short Sales in practice:
Suppose the price of ABC is $100 per share.
If you determine that the intrinsic value of the stock is $125, then the
stock is undervalued. Buy the stock at $100 and make a profit when
the stock price eventually rises to $125.
If you determine that the intrinsic value of the stock is $75, then the
stock is overvalued. How could you profit from the stock overvaluation
if you do not own the stock?

Date 0
Short seller borrows stock from an investor who owns ABC stock, with a
promise to return it at a later date.
Short seller sells the stock in market and receives $100.
Large investors and institutions have arrangements that allow them to earn
interest on proceeds from short sales. This interest payment is called short
rebate.
Small investors do not earn short rebate. Their brokers will keep the money
as collateral for the short sale, and the brokers will earn the short rebate.
Date t
Short seller covers the short position by buying the stock at the
prevailing market price. If the price converges to intrinsic value, then
the short seller buys the stock at $75.
Receives the short rebate.
Returns the stock to the lender
Arbitrage and market efficiency
One definition: Buying an asset and simultaneously selling another
asset with the exact same future cash flows (also called payoffs), in
order to profit from a price difference between the two assets.
The second asset in the definition above is called a replicating
portfolio
Another definition: Buying an asset in one market for immediate resale
in another market to profit from a price discrepancy.
No arbitrage and its implication for one factor APT

Zero beta portfolio

CAPM vs APT

Market Efficiency (Lecture 9)

-Different forms of Efficient Market Hypothesis (EMH), what do they mean?

Efficient Market Hypothesis (EMH): The efficient market hypothesis posits

that stock prices reflect all available information at any point in time
EMH implies that price changes would occur only due to new info reaching
the market, and by definition new information is unpredictable.
Stock price changes are unpredictable.
Error term is unpredictable and E(ei) = 0
Forms of EMH
o Weak form of EMH:
Current prices contain all of the info in past prices and past
patterns of trading volumes.
One cant predict future returns based on past returns or the
past trading volumes
Technical trading strategies will not be profitable
o Semi-strong form EMH:
Current price contain all public info.
Public info: past prices, trading vol, acct info, security
analyst forecasts, legal info, corporate governance info
Fundamental analysis would not be useful
Stock returns are not predictable based on past earnings
growth
o Strong form EMH:
Current prices contain all info, both public and private
Insider info should be reflected in stock prices

Violation of EMH: anomalies

Building blocks for quant strategies:

o Quant trading strategies: price momentum, earnings momentum,
value vs growth, and new stock issues
Violations of weak form efficiency:
o Reversals at short horizons (1 mth and 1 week)
Buy past losers, sell past winners contrarian strategy
o Momentum strategies at intermediate horizons (3 to 12 mth)
Buy past winners, sell past losers momentum strategy
Violations of semi-strong form efficiency
o Earnings momentum strategies:
Based on firms quarterly earnings surprise and revisions in
security analyst earnings forecasts
Buy stocks with + earnings surprises and short stocks with
earnings surprises
o Value/Glamour strategies:
Based on firms price multiples, B/M, E/P
Buy stock with high B/M or E/P ratio and short low
Spirit: similar to contrarian strategies
o New Stock issues:
Firms that issue new equity underperform non-issuers over a 35 year period
o Other anomalies of interest
Size effect, January effect, weekend effect holiday effect, turn-ofthe month

Bond Prices and Yields (Lecture 10, 11, 12)

Valuing a coupon bond using zero coupon bond prices/discount factor
Default-free fixed income securities
o ZC: single CF equal to face value at maturity
o Zeros are the building blocks of all securities with fixed CF
o Combining zeros -> asset with multiple fixed CFs
o Structure portfolios of zeros to replicate existing securities
(coupon bonds)
o Construct portfolio of CP bonds that replicates a zero.
o Absence of arbitrage
Calculation

o Discount function gives the discount factor as a function of

maturity.
o Longer zeroes have lower prices
Discount function is always downward-sloping
o Treasury STRIPS are fixed-income sec sold at a significant
discount to face value and offer no interest payments b/c they
mature at par.
Valuing a CB using zero prices
o V=C/2*d0.5+C/2*d1+(C/2+1)*d1.5
Constructuring the One-Year Zero
o Bonds 1 & 2, N1: # of bond 1, N2: # of bond 2
o At time 0.5 -> N1*(1+0.0425/2)+N2*0.04375/2 =0 <- means no
CP
o At time 1-> N1*0+N2*(1+0.04375/2) <- 100 (par value)
o N2=97.86 , N1=-2.1 (long 97.86 par value of the 1-year bond &
short 2.10 par value of the 0.5-year bond)
o Price = 97.86*price per par value(0.9896) 2.10*price per
value(0.9940) =$94.76
Implied zero prices
o Ppl work with T-CB than with STRIPS (b/c mkt is active)
o Get discount function frm T-bond prices instead of STRIPs to
value more complex securities
Annual v.s. semi-annual compounding

Key: (1+r/2)^2 = 1+rA

Definition of YTM and its relation to coupon rate
Calculation:

General definition:
o YTM: Rate at which CFs should be discounted so that price = pv
of future cf
o The higher the price, the lower the yield
o If c=y, p=1 (the bond is priced at par)
o C>y, P>1 (premium) / c<y, P<1 (discount)
o The yield on z zero is the zero rate (c=0 ; y=Rt)

Definition of the term structure of interest rates, yield curve, par rates
Term structure and Yield curves
o General relation bt yield and maturity that exists in a given bond
market
o The yield curve for zeroes is typically different than the yield
curve for CBs.
o We can derive one curve from the other
Par Rates
o Par rate for a given maturity T is the coupon rate that makes a Tyear coupon bond sell for par
o Yield on the bond will also be the par rate
o Par rates are yields on newly issued bonds

Differences between Yield v.s. rate of return

Yield
o single discount rate that sts the pv of a bonds CFs = given price
o can be computed when the assets CFs are fixed
o Given CFs, yield & price are equivalent info
o Computing yield requires only current info
Rate of return
o The growth of the investment value over a given horizon.
(horizon need not coincide w/ the maturity of the asset)
o Meaningful for any asset (not just an asset with fixed CFs)
o Generally unknown
Yield is a not a measure of value
o Higher yielding bond is a better value b/c it has lower price
o Yield contains no direct info ~ value
o
Spot rate and forward rate

Spot rates
o Expressed in annualized form (eg) yr3 = (1+y3)^3
Forward contracts
o Agreement to buy an asset at a future settlement date at a
forward price specified today
o No money changes hands today
o Pre-specified forward price is exchanged for the asset at the
settlement date
Forward rates
o Rates at which one can contract today for loans in the future
Expectation hypothesis and liquidity premium hypothesis

EH
o expected HPR on bonds of all maturities will be equal
o all investments are expected to earn the same rates of return
over the 1-year period from Yr 0 to Yr 1
o E(y1to2) = F1to2
Liquidity Preference Theory
o Demand risk premium for holding LT bonds
o The longer the maturity of the bond, the larger would be the
expected return
o Empirical basis

Upward sloping yield curve (normal)

Valuation (Lecture 13, 14, 15)

Gordon growth formula

Implications
o Higher dividends and growth rate increase IV
o Higher expected returns decrease IV
Value of a firm includes both for its current assets in place and for its future
growth opportunities. What is the relative importance of these resources of
value?
Plowback Ratio and Earnings
o Suppose a firm earns E and pays out a part of its earnings as
dividends.
o Fraction of the earnings that the firm retains after paying out
dividends = b (retention rate, plowback rate)
o Payout ratio = Dividend/Earnings = 1-b ( b= 1dividend/earnings)
o Earnings Growth is bigger when ROE & Plowback ratio is bigger
Value of a firm

Value of a firm = value of assets in place + PV of growth opportunities

o Value of asses in place: suppose thie firm paid out all its
earnings. Then earnings would not grow and any value for the
stock would only come from assets already in place (E1/k)
o PVGO
PE and PB ratio, PEG ratio

PEG Ratio
o Compare P/E ratios to the expected growth rate to identify under
and overvalued stocks
o PEG = P/E / g
PE and PB ratio and growth opportunities. What happens if ROE=k, if
ROE<k or if
ROE > k (the last slide of Lecture 13)
ROE =k
o P/E =1/k or P=E/k
o P/B =1
o Both P/E & P/B x depend on payout
ROE < k
o P/E< 1/k or P <E/k
o P/B <1
o Larger payouts are associated with bigger ratios
ROE > k
o P/E > 1/k or P> E/k
o P/B >1
o Larger payouts are associated with smaller ratios
Multi-stage growth model
Gordon Growth formula makes a number of simplifying assumptions. In
reality, firms go through life cycles.
Growth Stage:
Rapid growth in sales and profitability.
ROE > k
Large or small plowback?
Transition Stage:
Rapid growth in sales tapers off
Profitability declines with increased competition.
Increased payout

Mature Phase:
Firm reaches a steady state. Earnings growth, ROE and payout
ratio remain constant for the rest of its life.

Valuation of Honda

What are the potential problems using the dividend discount model,
compared
with free cash flow model?
Firms often do not pay any dividends, and generally dividend does not
grow smoothly over time
Investors, particularly in M&A situations, would like to examine how
firm values would change under different capital structure scenarios.
The DDM approach typically projects dividends based on existing
capital structure.

Enterprise value v.s equity value

Valuation of Walmart

See Walmart case

Options (Lecture 16)
European option v.s. American option

Option strategies: protective put, covered call, straddle, bullish spread

Put-call parity: relation between put and call prices

The put-call parity relation basically shows that the payoff from a
European put option can be replicated with payoffs from a portfolio
(both long and short position) of bond, stock and a European call.

Form two portfolios:

Portfolio A: 1 call + 1 zero coupon bond maturing on expiration
date T.
Portfolio B: 1 stock +1 put
What is portfolio B called?