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Time Value of Money

• Theory of Real Interest Rates

– Two-period
1  c0 u00 (c0 )  dc
 
! !
r= −1 + − 0
ρ ρ u (c0 ) c0
– Multi-period
u0 (c0 )
rt = ρ −1
E[u0 (ct )]
• Term Structure Hypothesis
– Expectation Hypothesis
– Liquidity Preference Hypothesis

Portfolio Theory
• Portfolio
– Weights wi
wi = 1

– Expected return
rp = wi ri

– Variance
σp2 =
wi wj σij
i j

• Diversification
– Systematic risk
– Non-systematic risk
• Optimal Portfolio Selection
– Objective
∗ minimize variance given expected return
– Portfolio frontier with only risky assets
– Portfolio frontier with risky and riskless assets
∗ Tangent portfolio
∗ Implication
ri − rf = (rT − rf )

• Derivation
– Foundations of portfolio theory
– Market clearing
• Implication
E(ri ) − rf = βi (E(rm ) − rf )

• Measuring CAPM coefficients

r̃i − rf = αi + βi (r̃m − rf ) + ˜i

– βi , measure of systematic risk

– α, zero according to CAPM
– statistical significance
– , measure of idiosyncratic risk
– R2 , how much variance can be explained by market risk
• Leverage
βA = βD + βE
• Pros and Cons

Arbitrage Pricing Theory
• Model
r̃i = E(ri ) + bi1 f˜1 + ... + bik f˜k + ũi

• Implication

E(ri ) − rf = bi1 (E(F1 ) − rf ) + ... + bik (E(Fk ) − rf )

• Pros and Cons

Efficient Market Hypothesis

• Weak form
• Semi-strong form
• Strong form
• Evidence

Capital Budgeting
• NPV Rule
– Invest if NPV is positive
• Cash flow calculation
+ after-tax operating cash flow
+ depreciation tax shield
- change of working capital
- capital expenditure
• Option value
• Other inferior alternatives to NPV
– Profitability Index
– Payback period

Financing Decisions
• How should a company finance its operation? Equity vs Debt
• In a perfect world, does not matter
– Miller-Modigliani proposition
• With tax, debt is more favorable
• Static trade-off
– Problems associated with financial distress
Other theories:
• Pecking order
• Free cash flow theory

More Review Questions
These questions should help you focus on some of the important concepts covered in class.
They are not a complete catalog of what you should know.

28. Compare a safe investment strategy, for example investing in a series of Treasury bills,
with investment in the stock market. What determines the probability that the stock-
market strategy will beat the safe strategy? What happens to this probability as the
investment horizon is increased, say to 20 or 30 years?

29. Some people say that stocks are “safe in the long run”. In what sense is that true?
If true, does it mean that the future value of a portfolio of stocks is easy to forecast?
If true, does it mean that you should invest 100% of your wealth in stocks instead of
safer assets?

30. When we use past returns to estimate future expected return and risk of assets, what
assumptions are we making?

31. What is a random walk? Does it mean that successive stock prices are not correlated?

32. Why is the random walk a result of information-efficient markets?

33. What is the difference between the weak, semi-strong and strong forms of market
efficiency? What does the evidence on the performance of U.S. mutual funds tell us
about strong-form efficiency?

34. Give some examples of risks that are clearly diversifiable and would not add to risk
premiums required by investors.

35. Make sure that you understand how to calculate the variance and standard deviation
of a portfolio return.

36. The return on a portfolio is a weighted average of the returns on the stocks in the
portfolio. The beta of a portfolio is a weighted average of the stocks’ beta. (What are
the weights?) The standard deviation of a portfolio return is not a simple weighted
average of the stocks’ standard deviations. Why not?

37. Give a complete list of the assumptions required to derive the CAPM.

38. The CAPM formula

r − rf = β(rm − rf )
has no alpha (α), i.e., no constant term or intercept. Thus the CAPM predicts that
alpha is zero. But alphas estimated for individual stocks from historical returns are
almost never zero. Does that disprove the CAPM?

39. Why are investors interested in alphas for stocks or portfolios? How is alpha used to
measure performance, say for a mutual fund?

40. According to modern portfolio theory, investors with the same information will end up
holding the same portfolio of risky securities. Does that mean that all investors will
hold equally risky portfolios?

41. Portfolio theory says that the risk of individual assets depends on the assets’ betas
with respect to the market portfolio. Why is that true?

42. Does the CAPM provide a good explanation of past average rates of return? How
would you briefly summarize the evidence?

43. The CAPM says that investors will hold the market portfolio. Does it say what the
market portfolio is? Is it possible that some of the CAPM’s poor performance in
explaining past returns is attributable to a misidentification of the market portfolio?

44. The CAPM boils down to a prediction that the market portfolio is mean-variance
efficient. Explain.

45. Other things equal, is the cost of capital for a wildcat oil well (10% chance of finding
oil) higher than for a development well (80% chance of finding oil). Assume that the
two wells are economically identical if oil is found. (Convince yourself the two oil wells
have the same cost of capital.)

46. Write out the APT equation.

47. Does the APT assume that investors are well-diversified? Does APT apply better to
well-diversified portfolios or to individual assets?

48. Suppose you want to calculate the beta of a company’s assets. You have the beta of
the company’s common stock and also of its debt. How would you proceed?

49. Explain put-call parity.

50. The net supply of calls is always zero. What does that mean?

51. The value of a call increases with σ t, where σ is the standard deviation of the
underlying asset and t is the number of periods until the call’s expiration. Explain
why this is so.

52. What is the minimum list of inputs or parameters required to value a call?

53. How is the replicating portfolio for call option constructed? How does the replicating
portfolio help in determining the call value?

54. How would you use the Black-Scholes formula to value a European put?

55. What is an implied volatility and how is it calculated?