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– Two-period

1 c0 u00 (c0 ) dc

1

! !

r= −1 + − 0

ρ ρ u (c0 ) c0

– Multi-period

u0 (c0 )

−t

rt = ρ −1

E[u0 (ct )]

• Term Structure Hypothesis

– Expectation Hypothesis

– Liquidity Preference Hypothesis

1

Portfolio Theory

• Portfolio

– Weights wi

X

wi = 1

i

– Expected return

X

rp = wi ri

i

– Variance

σp2 =

XX

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

σiT

ri − rf = (rT − rf )

σT2

2

CAPM

• Derivation

– Foundations of portfolio theory

– Market clearing

• Implication

E(ri ) − rf = βi (E(rm ) − rf )

– α, zero according to CAPM

– statistical significance

– , measure of idiosyncratic risk

– R2 , how much variance can be explained by market risk

• Leverage

D E

βA = βD + βE

D+E D+E

• Pros and Cons

3

Arbitrage Pricing Theory

• Model

r̃i = E(ri ) + bi1 f˜1 + ... + bik f˜k + ũi

• Implication

• Weak form

• Semi-strong form

• Strong form

• Evidence

4

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

– IRR

– Profitability Index

– Payback period

5

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

6

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?

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.

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?

7

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.)

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?

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?

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