Investments Portfolio Management Lecture Notes Lectures 1 10 Course Notes

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Investments & Portfolio Management - Lecture notes, lectures

1 - 10 - course notes
Investments and Portfolio Management (Monash University)
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INVESTMENTS & PORTFOLIO MANAGEMENT AFF3121

SEMESTER 1, 2012
Heading 1: Introduction to Investments
Investment has been defined in RBS, p.4 as:
“…the current commitment of dollars for a period of time in order to derive future
payments that will compensate the investor for:
(1) the time the funds are committed,

(2) the expected rate of inflation during this time, and
(3) the uncertainty of the future payments…”
An investment is a
deferment of current
consumption (saving =
investment) to some future
period. i.e. there is some trade-
off that exists:
The cost of deferring current

consumption (investment) for
future consumption is called
the pure (or real) rate of
interest.
Investments is the study of the process of committing funds to one or more assets
known as:
The Investment Process – a Two Stage Process
1. Security Analysis: Detection of undervalued securities (assets).

a. Does price = value?
Warren Buffet – “Price is what you pay and value is what you get”.
2. Portfolio Management: Combining and managing individuals securities to

form a group of assets as a unit (an optimal portfolio).
The Tradeoff Between Expected Return and Risk
 Investors are (typically risk averse and rational)

manage risk based on expected returns (ER).
 Any level of expected or required (nominal) return

and risk can be attained.
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 Nominal risk free rate of return is available to all investors for a riskless
asset such as Treasury Bills.
The required rate of return (RRR) = the nominal rate of return or nominal
interest rate.
This is the minimum expected rate of return necessary to induce an investor to

purchase a security and is the sum of 3 components (Fisher hypothesis – see index
in Jones at the end):
1. Pure or Real Risk Free Interest Rate (Real

Rate = ER) during investment:
 Real risk free rate (the exchange rate

between future consumption and present
consumption – based on zero inflation and
zero uncertainty) i.e. the expected return
minus the risk premium minus the expected
inflation.
2. Inflation Protection (Expected Inflation = EI) during investment:
 Nominal risk-free rate of interest (RF) adjusts the real risk-free rate
to reflect expected inflation over the life of the investment: RR + EI = RF.
3. Risk involves:
 Risk Premium (RP): Investors need sufficient expected additional

compensation in order to bear additional risk.
Required Return = IR = RR + EI + RP
Individual vs. Institutional Investors
Institutional Investors Individual Investors

- Maintain relatively constant - Life stage matters
profile over time
- Legal and regulatory constraints - Risk defined as “losing money”
- Well-defined and effective policy - Characterized by personalities
is critical
- Goals important
- Tax management is important
part of decisions
Managing Risk
Since risk drives expected return, investing involves managing risk rather than
managing return. In other words, portfolio management is nothing other than
risk management.
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Protection for Individual Investor Risk
 Life Insurance: Providing death benefits and, possibly, additional cash

values.
o Term life and whole life insurance
o Universal and variable life insurance
 Non-Life Insurance
o Health insurance & disability insurance
o Automobile insurance & home/rental insurance
 Cash Reserve
o To meet emergency needs
o Equal to six months living expenses
Individual Investor Life Cycle
The individual investors life cycle can often be described using four separate phases
or stages:
1. Accumulation phase
2. Consolidation phase
3. Spending phase
4. Gifting phase
Life Cycle Approach
There are different positions of risk/ return taken by an

investor at various life cycle stages:
A. Accumulation phase – early career
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B. Consolidation phase mid-to late career

C. Spending phase – spending and gifting
A. Accumulation Phase
 Early to middle years of careers where attempts are made to satisfy

intermediate and long-term goals.
 Net worth is usually small and debt may be heavy.
 Long-term investment horizon means usually willing to take moderately
high risks in order to make above-average returns.
 Life insurance is important in this phase and in the next phase.
 Start investing early in life to benefit from the magic of compounding and
being having more time available for compounding.
B. Consolidation Phase
 Past career midpoint

 Have paid off much of their accumulated debt
 Earnings now exceed living expenses, so the balance can be invested
 Time horizon is still long-term, so moderately high risk investments are still
attractive
C. Spending Phase
 Usually begins at retirement

 Saving before, prudent spending now
 Living expenses covered by Social Security and retirement plans
 Changing emphasis toward preservation of capital, but still want
investment values to keep pace with inflation: investor’s enemy
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Gifting Phase
 Can be concurrent with spending phase

 If resources allow, individuals can now use excess assets to provide gifts to
other individuals or organisations
 Estate planning becomes important, especially tax considerations
The Portfolio Management Process
The portfolio management process has four

steps:
1. Construct a policy statement

2. Study current financial conditions and
forecast future trends
3. Construct a portfolio
4. Monitor needs and conditions
Formulate Investment Policy
Investment policy summarises the objectives, constraints and preferences for the
investor (very important: risk tolerance).
Investment policy should contain a statement about return requirements and for
inflations adjusted returns.
The unique needs and circumstances of the investor may restrict certain asset
classes. Constrains and preferences may include:
 Time horizon – Objectives may require specific planning horizon

 Liquidity needs – Investors should know future cash needs
 Tax considerations – Ordinary income vs capital gains and retirement
programs that offer tax sheltering.
Investment Objectives
Possible broad goals include:
 Capital preservation - i.e. maintain purchasing power and minimize the risk
of loss
 Capital appreciation – i.e. achieve portfolio growth through capital gains
and accept greater risk
 Current income – Look to generate income rather than capital gains; may
be preferred in “spending phase” and may require relatively low risk.
 Total return – Combining income returns and reinvestment with capital
gains, generally with moderate risk.
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Legal and Regulatory Requirements
The Prudent Man Rule:
 Followed in fiduciary responsibility

 Interpretation can change with time and circumstances
 Standard applied to individual investments rather than the portfolio as a
whole.
Investment laws prohibit insider trade. Further, Employee Retirement Income

Security Act 1974 (ERISA) – USA: requires diversification and standards applied to
an entire portfolio.
Capital Market Expectations
Macro factors include expectations about the capital markets. Micro factors
include estimates that influence the selection of a particular asset for a particular
portfolio.
Rate of return assumptions must be realistic and historical returns should be

studied carefully.
Rate of Return Assumptions
How much influence should recent stock market returns have?
 Reversion to the mean arguments

 Stock returns involve considerable risk, probability of 10% return is 50%
regardless of the holding period. Probability of >10% return decreases over
longer investment horizons but expected returns are not guaranteed.
Constructing the Portfolio
Use investment policy and capital market expectations to choose a portfolio of

assets. Define the securities that are eligible for inclusion in a particular portfolio,
use an optimization procedure to select securities and determine the proper
portfolio weights (Markowitz provides a formal model).
Asset Allocation
This step involves deciding on weights for cash, bonds, and stocks. It is the most
important decision:
 Differences in allocation cause differences in portfolio performance.

 Because securities within asset classes tend to move together, asset
allocation is an important investment decision.
 Should consider international securities, real estate, and domestic Treasury
(government) securities.
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There are a number of factors to consider. They include; return requirements, risk
tolerance, time horizon and the age of the investor
Investment Strategy
Four decisions in an investment strategy:
1. What asset classes should be considered?

2. What should be the normal weight for each asset class?
3. What are the allowable ranges for the weights?
4. What specific securities should be purchased?
Monitoring Conditions and Circumstances
Investor circumstances can change for several reasons:
 Wealth changes affect risk tolerance

 Investment horizon changes
 Liquidity requirement changes
 Tax circumstance changes
 Regulatory considerations
 Unique needs and circumstances
Portfolio Adjustments
 Portfolios are not intended to stay fixed

 The key is to know when to rebalance them
 Rebalancing also involves costs, i.e. brokerage commissions, the possible
impact of trade on market price and the time involved in deciding to trade.
 There is also the cost of not rebalancing which involves holding in
unfavourable positions.
Performance Measurement
Performance measurement allows for analysis of the success of portfolio

management. Key part of monitoring strategy and evaluating risks. It is important
for those who employ a manager and those who invest personal funds.
Performance measurement also allows for discovery of reasons for success or
failure.
“The Financial System and its Workings” Notes (Ch 1, Viney)
Equity
Equity can take a number of forms. For example, if you buy a new car by paying a
deposit from your own funds and borrowing the remainder, your equity in the car is
the amount of the deposit paid. Paying off the loan will increase your level of equity.
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Equity in a business corporation is represented through the ownership of shares.

The principal form of equity issued by a corporation is an ordinary share or
common stock.
Another form of equity is known as a hybrid security. A hybrid security is a

financial instrument that incorporates the characteristics of both debt and equity
(preference shares). Preference shares, while being a form of equity finance, have
many characteristics in common with debt, i.e. holders are entitled to received
specified fixed dividend for a defined period and the dividend must be paid before
any dividend is paid to ordinary share holders. Also rank ahead of ordinary holders
in the case of liquidation.
Debt Instruments
Entitle the holder to a claim (ahead of equity holders) to the income stream
produced by the borrower and to the assets of the borrower if the borrower
defaults on payments. There is secured (specifying assets) and unsecured debt.
Derivatives
Used to manage an exposure to an identified risk. i.e. a borrower might be

concerned that interest rates on existing debt funding may rise and thus will seek
to reduce that risk by locking in an interest rate today using derivatives. Four
types:
 Futures – contract to buy a specified amount of a commodity or financial

instrument at a price determined today for future settlement
 Forwards – like a futures contract but typically more flexible. Establishes

currency exchange or interest rate in the future for the future.
 Options – gives the buyer the right to buy the designated asset at a
specified date or within a specified period during the life of the option at a
predetermined price.
 Swap –arrangement to exchange specified future cash flows, i.e. an interest

rate swap or cross currency swap.
Primary and Secondary Markets
Primary market transaction involves the issue of a new financial instrument

whereas a secondary market transaction involves the buying and selling of existing
financial securities which involves a transfer of ownership.
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The Benefits of Financial Intermediation
 Asset transformation – intermediaries offer customer a wide range of

financial products on both sides of the balance sheet.
 Maturity transformation – savers prefer liquidity and borrowers prefer

longer-term commitment/ Banks can pool funds and offer a range of
maturity termed products.
 Credit risk diversification – saver’s credit risk exposure is limited to the

intermediary; the intermediary is exposed to the credit risk of the ultimate
borrower.
 Liquidity transformation – measured by the ability of a saver to convert a

financial instrument into cash.
 Economies of scale – size and volume of business transactions allows for

development of cost-efficient distribution systems and technology based
systems such as ATMs, online and telephone banking.
Wholesale and Retail Markets
Wholesale markets provide for direct financial transactions between institutional

investors and borrowers. Retail markets comprise of transactions primarily of
individuals and small to medium-sized businesses.
Heading 2: Fixed Interest Securities
Fixed interest (income) securities (FISs) are debt instruments such as bonds,
notes and debentures showing fixed contractual obligations of issuers such as
governments and large corporations.
FISs indicate the interest rate, principal (or par value) and maturity period and the
buyer knows future stream of cash flows (to be received until maturity).
Important Concepts
 Coupon: Periodic (in general half yearly) interest payments that the issuer
pays to the holder.
 Zero coupon bond: has no coupons attached and sold at a discounted value
to be redeemed at face value on maturity date.
 Junk bonds: have (low) credit ratings of BB or lower (high risk) with high
yields.
 Face value (par value) of most bonds = $1,000 and the price of debt
instrument and yield are inversely related.
 Discount: market price ($900) < face value ($1,000), interest rate declined
after issue.
 Premium: market price ($1100) > face value ($1000), interest rate inclined
after issue.
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 Constant price (neither discount nor premium): market price = face value =
$1000 and the interest rate is unchanged after issue.
Note: In the Australian Financial Review there is a ‘Money & Bond Markets’ section
that has a Royal Bank of Scotland (RBS) bond index that will be used in the
assignment.
There is also an ‘Interest Rate Securities’ section with an index for these securities.
Risks of Fixed Interest Securities:
 Interest rate – fluctuation in the interest rate (if it increases, the bond value
goes down,
 Reinvestment rate,
 Default,
 Inflation – when issued loan, IR was 3%, inflation now up to 10%, to
maintain purchasing power, IR on the loan must go up in line with inflation,
 Maturity,
 Call (issuer has the right to call back the bond, high risk for the lender), and
 Liquidity.
FIS in the Australian Context
Types of FISs: three-year and ten-year Commonwealth Government Treasury

bonds, corporate debentures and notes.
Australian Corporations Law is applicable for companies raising funds through the
issue of bonds in Australia.
Explaining Bond Prices and Yields
 Bond prices are determined by supply and demand of loanable funds in the
economy.
 A crucial determinant of supply and demand of loanable funds is the interest
rate (yield).
 Fundamental determinants of interest rates are also known as the Fisher
Hypothesis.
 Nominal Interest Rate: i (nominal IR) = RFR (real risk free rate) + I
(expected inflation rate) + RP (risk premium)/
RFR + I is the economic (systemic) forces – macro – rate of economic growth

(reflecting investment opportunities), capital (loanable funds) market conditions
and expected rate of inflation.
RP = four components involves issue characteristics:
(1) Credit quality

(2) Term to maturity
(3) Indenture provisions
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(4) Foreign bonds (foreign exchange and country risks)
Term Structure of Interest Rates (TSIR)
The TSIR (yield curve): relationship between time to

maturity and yields for a particular category of
bonds at a given point in time.
Yield Curve – a graphical representation of the term

structure of interest rates – yield to maturity
(vertical axis) and time to maturity (horizontal
axis).
Types of Yield Curves – Upward

sloping (normal) yield curve, lower
yields for short dated securities
and higher yields for long dated
securities.
Downward sloping (inverse) yield

curve: higher yields for short-
dated securities and lower yields
for long-dated securities.
Flat yield curve: approximately

equal yields on short-dated and
long-dated securities.
Hump-backed yield curve: a mix of

the two features above.
Term Structure Theories
1. Expectations Hypothesis – The current interest rate (spot rate) reflects

the expectations about future interest (or forward) rates.
The long term interest rate is equivalent to the average of short term rates
prevailing over the long term.
Criticism: Reality is that expectations are NOT the sole basis for the term
structure. Central banks intervene in management of short term interest
rates.
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2. Liquidity Preference Theory – Interest rates are determined by adding a

liquidity premium to the short term rates. Future uncertainty causes an
upward or downward bias (liquidity premium is incorporated) in the yield
curve.
FIND THE LIQUIDITY PREFERENCE DIAGRAM AND INCLUDE
3. Segmented Market Hypothesis – Suggests that the market can be

subdivided into two segments: short term (money market) and long term
(capital market).
4. Preferred Habitat Theory – Emanates from ‘preferred habitats’ of major

(especially institutional) investors, over maturity range of securities.
a. Life insurance companies prefer long term (capital market)

instruments while money market dealers prefer short term
instruments. Yield depends on supply and demand within the
maturity segment.
b. But are segments and preferred habitats completely separated? No.
Most evidence supports the expectations and liquidity preference
theory and no the latter two theories.
Slope of the Yield Curve
The slope of the yield curve reflects expectations on short-term and long-term
rates. If an investor expects the slope of the yield curve to move downwards, then
invest for a long period and lock in the current high long-term rate.
If it is a borrower with the same expectation, then would not lock in the current
high long-term rate and rather borrow for a short-period (or even postpone
borrowing).
Risks inherent in yield curve movements can be managed and reduced by the use of
instruments such as financial futures.
Interest rate differences can be explained by risk structure of interest rate which is
called the yield spreads showing the relationships between bond yields and the
particular features on various bonds.
 Differences in quality or risk of default – a AAA-rate bond offer lower yield

compared to a BAA-rated bon offering a higher yield (look at risk structure
diagram, Rates of return (vertical) & risk (horizontal) with different types
of instruments or investments along the curve).
 Differences in time to maturity – longer the time period, the greater the
uncertainty.
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 Differences in call features – callable bonds have higher yields compared to

identical noncallable bonds.
 Differences in coupon rates – bonds with lower coupons have larger part of
their return in the form of capital gains.
Finish slides 17/18
Example: A corporate bond with a face value of $100,000 pays 10% per annum
half-yearly coupons and has exactly 6 years to maturity. If the current market yield
is 8% per annum, value the bond.
Value = $46,925.37 + $62,459.70 = $109,385.07
Assume current market price of the corporate bond under two scenarios: (a) $
108,000 or (b) $110,100
Is price = value? Is the bond under-priced (price < value) or over-priced (price >
value) from the perspective of the (a) buyer, (b) seller?
Would you buy the bond under(a)? (b)? Sell the bond if you have it ? Under (a)? (b)?
Heading 3: Valuation of Ordinary Shares
Equity Securities
Equity securities are the most common type and are known as ordinary shares or
common stocks that represent ownership of a firm with full participation in its
success or failure.
Total equity value

Book value (accounting value) of a share is equal to:
Number of shares
Market value of a share is equal to: ‘the current market price of a share’.
It is quite difficult to obtain reliable forecasts (or assigning probabilities) of

expected future cash flows and even more difficult when comparing risky
investments to fixed income securities.
Equity Securities Terminology
Recent $ dividend
Dividend yield (%)–
Market price
Earnings ($)– Operating income – taxes
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Payout ratio (%) – Ratio of dividends to earnings
Retention rate (%) – Complement of the payout ration (1 – payout ratio),

showing a firm’s reinvestment capacity.
Price earnings (P/E) ratio [earnings multiplier] – Ratio of share price to

earnings (using historical, current or estimated data as multiples of earnings).
Required Rate of Return (RRR or k) – Return that compensates investors for:
(1) Their time (time value of money – risk free rate);

(2) Expected rate of inflation; and
(3) Uncertainty (risk premium)
Total return – Dividend yield + capital gain (or loss)
Total risk – Market risk (non-diversifiable risk) + non-market risk (diversifiable

risk).
Investment Decision-Making Process
1. Determine the required rate of return (RRR).

2. Generate the intrinsic value (IV) of the investment at your RRR.
3. Compare the estimated value to the current market price (CMP).
a. If IV < CMP, the investment is over-priced (sell or do not buy)

b. If IV = CMP, equilibrium correctly priced (hold)
c. If IV > CMP, investment is under-priced (buy or hold)
4. The current market price depends on the market participants’ simultaneous

buy and sell operations in the market.
Approaches to Ordinary Share Valuation
Using Discounted Cash Flow Techniques
What are the cash flows?
(1) The cash flows can be dividends that go straight to the investor and can be
discounted at the RRR.
Discounted models are difficult to apply to firms that pay low or no

dividends of growth opportunities. It is most applicable to stable, mature
firms where the assumption of relatively constant growth for the long term
is appropriate.
(2) Can also be free cash flows to the firm, i.e. cash available to all suppliers of
capital to a firm discounted at the firm’s weighted average cost of capital
(WACC).
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(3) May also be free cash flow to equity, i.e. available to equity holders,
including those retained by the firm, discounted at the firm’s cost of equity.
Estimates of value are highly dependent on two important inputs:
 Growth rates (g) of cash flows, and

 The estimate of the appropriate discount rate (k).
A. Dividend Discount Models (DDM)
The value of a financial asset is the present value of its expected future cash flows:
DDM was initially proposed by Williams (1938) and later developed by Gordon
(1962): popularly known as the ‘Gordon Model’.
The expected dividends in the DDM means:
(i) There are no specified number of dividend payments (ordinary shares

have no maturity date); and
(ii) Dividends may be expected to grow over time.
Implications in (i) and (ii) above have prompted investment analysts to make
assumptions about holding periods and expected growth rate of dividends resulting
in three versions of the dividend discount model;
D0
1. Zero-Growth rate model: V = (where D0 is current dividend and k is
k
required rate of return on stock p).
E.g. Calculate current value of share with current dividend $3 per share
continuing into perpetuity with RRR of 17.5%.
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3
V= = $17.14
0.175
2. Infinite Period model (constant growth rate): Widely used in practice

for its simplicity.
a. Assumes dividends started at D0 (last year’s dividend) and will grow

at a constant growth rate.
b. The expected growth (g) will continue for an infinite period of time.
c. Required return (k) is greater than the constant (expected) rate of
growth (g).
The infinite holding period model:
D1
V= , where D1 = D0 (1+g)
k −g
E.g. Calculate the value of a share with current dividend of $3, expected to
grow at 5% p.a with a RRR of 17.5%.
3(1+0.05)
V=
0.175−0.05
3. Temporary Supernormal Growth Model: Also known as multiple-

growth model – used in valuation of growth company stocks.
This model incorporates all

the different non-constant
growth values until finally it
becomes a constant growth.
E.g. Valuing equity with growth of

30% for 3 years, then a long-run
constant growth of 6%.
Other Discounted Cash Flow Methods – PV of FCFF (OFCF)
OFCF = EBIT (1 – Rate) + Depreciation Expense – Capital Spending - ∆ in Working

Capital - ∆ in other assets.
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The formula to work out the PV of these cash flows is:
FCFF 1
Firm value=
WACC −gFCFF
OFCF1
Firm value=
WACC −gOFCF
Where:
 FCFF1 = the free cash flow in period 1

 OFCF1 = the firm’s operating free cash flow in period 1
 WACC = the firm’s weighted average cost of capital
 gFCFF = the constant growth rate of free cash flow
 gOFCF = the constant growth rate of operation free cash flow
FCFE
FCFE = Net Income + Depreciation Expense – Capital Expenditures - ∆ in Working

Capital – Principal Debt Repayments + New Debt Issues.
The Constant Growth Formula:
FCFE 1
Value=
k −gFCFE
Where:
 FCFE = the expected free cash flow in period 1

 K = the required rate of return on equity for the firm
 gFCFE = the expected constant growth rate of free cash flow to equity for
the firm.
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B. Using Target Price Relative Valuation Methods
These techniques assume that prices should have stable and consistent
relationships to various firm variables across groups of firms. The target price and
relative valuation approaches focus on how the market is currently valuing
financial assets.
It is appropriate to use RVM under two conditions:
1. You have a good set of comparable entities (similar size, risk, etc.)
2. The aggregate market or the relevant industry is not at a valuation extreme

(fairly valued) to compare the valuation ratio for the company to the
comparable ratio for the market, industry, and other firms.
a. Why is the ratio similar or different?

b. Do fundamental factors justify a difference in relative valuation?
P/E Ratio or Earnings Multiplier Approach
Alternative approach often used by security analysts. The P/E ratio is the strength
with which investors value earnings as expressed in stock price.
Current Market Price

Expected12−Month Earnings
Divide the current market price of the stock by the latest 12-month earnings and it
will show the price paid for each $1 of earnings.
Earnings Multiplier Approach – Combining DDM and P/E
Done so by combining the Constant DDM with the P/E ratio approach by dividing
earnings (E) in both sides of DDM formula to obtain:
D1 D 1 ¿ E1
P 0= ∨P0 ¿ E 1=
k −g k−g
Thus, the P/E ratio is determined by:
 Expected dividend payout ratio

 Required rate of return on the stock (k)
 Expected growth rate of dividends (g)
To estimate share value (valuation of share).
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P/E Ratio Approach
 The higher the payout ratio, the higher the justified P/E. (payout ratio is the
proportion of earnings that are paid out as dividends.
 The higher the expected growth rate, g, the higher the justified P/E.
 The higher the required rate of return, k, the lower the justified P/E.
Understanding the P/E Ration
 Can firms increase payout ratio to increase market price? The main concern
here is whether future growth prospects will be affected as a result.
 Does rapid growth affect the riskiness of earnings? i.e. will the required
return be affected? Are some growth factors more desirable than others?
 P/E ratios reflect expected growth and risk.
P/E Ratios and Interest Rates
 A P/E ratio reflects investor optimism and pessimism – related to the

required rate of return.
 As interest rates increase, required rates of return on all securities generally

increase.
 P/E rates and interest rates are indirectly related.
E.g. Calculate P/E ratio and assume a stock has an expected dividend payout of 50,
a required rate of return of 12%, and expected growth rate for dividend of 8%.
Pi D 1 / E1
=
E1 k −g
P 0.50
=
E 0.12−0.08
= 12.5
Which Approach is Best?
Best estimate is probably the present value of the (estimated) dividends.
 Can future dividends be estimated with accuracy? Investors like to focus on

capital gains not dividends.
P/E multiplier remains popular for its ease in use and the objections to the dividend
discount model.
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Are they complementary approaches? P/E ratio can be derived from the constant-
growth version of the dividend discount model. Further, dividends are paid out of
earnings and using both approaches increases the likelihood of obtaining
reasonable results.
Valuation of Growth Companies – Measures of Value Added
Economic Value-Added (EVA)
EVA is equal to the net operating profit less adjusted taxes (NOPLAT) minus the
firm’s total cost of capital in dollar terms, including the cost of equity.
EVA Return on Capital
Is equal to EVA/ Capital.
This is a ratio that can compare firms of different sizes and determine which firm
has the largest economic profit per dollar of capital.
Note: Can also then compare return on capital to cost of capital too.
Market Value Added (MVA)
MVA is a measure of external performance:
MVA = Market value of a firm – Capital – MV of Debt – MV of Equity
This is a measure of how the market has evaluated the firm’s performance in terms
of market value of debt and market value of equity compared to the capital
invested in the firm.
Heading 4A: Real Estate Investments
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Real estate includes tangible assets such as residential homes, vacant land and a
variety of forms of income property, including warehouses, office and apartment
buildings and condominiums. The must important factor in real estate is location
and the maximization of total return (income plus capital appreciation).
 Purpose of Private Residences – For family living

 Purpose of Commercial Property – For conducting business and receive
an income.
The purpose of purchasing real estate for investment reasons is for:
 Income – Mainly looking for periodic rental income, or

 Speculative – Looking for an extra return in the form of capital
appreciation.
Advantages of real estate investment
 Tangible Security – Land, bricks and mortar with an income stream.
 Income and Capital Growth – Like most other investments.
 Control – If needed an investor can manage the property themselves.
 Leverage – ‘Negative gearing’ provides tax benefits for an investor.
Concerns when investing in real estate
 Time Horizon – Knowing your investment horizon and taking into account
appropriate factors, e.g:
o Short term investors – Might be concerned with current interest

rate and market expectations, and
o Long term investors – Might consider economic factors, such as
population growth potential and long-term capital appreciation.
 Geographic Area – Property value is directly linked to what is going on

around it.
 Liquidity – Property investments are illiquid compared to investments in

financial securities.
 Speed of Transaction – Transaction may take time compared to that of a

transaction involving financial securities.
 Maintenance Management – Repairs and maintenance on buildings need

to be carried out by the investor.
 Government Controls – Town and country planning regulations, through

local government and city council building approvals and zoning laws:
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restrict the rights of all property owners with respect to pollution and
environmental protection.
 Economic Conditions – Economic growth rate, level of employment,

inflation, level of interest rates are important here.
 Legal Complexity – In buying and selling property legal documentation is

required.
 Availability of Information – Lack of investor information make the

property market a less efficient market compared to share market.
 Cost of Acquisition – Legal costs and stamp duty can be thousands of

dollars in property investments.
Forms of Real Estate Investment
There is both direct and indirect investment in real estate.
Direct Investment
 Involves the traditional method of purchasing a property.
 Property syndicates which are formed by a group of property investors

with a common interest and allows for diversification.
Advantages of Direct Investment Disadvantages of Direct Investment

Direct control over the investment Poor liquidity
No trust or fund management fees High transaction costs (stamp duty)
Tax effective – tax benefits are not High entry costs requiring a large
diluted like in trusts; amount of capital
 Non-trust (direct) property

investor can decide when to sell
assets (realize capital gains/
required to pay capital gain tax)
 But in a property trust (indirect)
investment, trust manager can
sell trust investments (realize
capital gains/ losses) – trust unit
holders (investors) are not
deciding capital gain realization.
Poor diversification
Management costs even if managed
personally
Indirect Investment
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Indirect investment involves investing in property via a property security, that is

through a listed property trust (now known as Australian Real Estate Investment
Trusts or A-REIT) and/ or property syndication.
V http://www.asx.com.au/products/real_estate_investment_trusts/index.htm
Advantages of Indirect Investment Disadvantages of Indirect

Investment
Low transaction costs High fees in the form of management
expenses ratios
High liquidity High correlation of returns to All
Ordinaries Index (AOI);
 Since listed trusts (A-REITs) are

included in the AOI.
Diversification
Low entry costs requiring as little as
$1,000 or $2,000
Professional asset management
Real Estate Valuation
Real estate valuation involves the estimation of the current market value of the
given property. In real estate investments, market value of a property is the price at
which it would sell under current market conditions.
The fair/ market value of the property should be the price agreed between a willing
buyer and the willing seller without any anxiety.
Property should be valued based on:
 Land use and potential utility,

 Location,
 Physical characteristics,
 Amenities and services,
 Title and tenure.
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Property Valuation Market Value
1. The Cost Approach
This approach is based on the idea that an investor should not pay more for a
property than it would cost to rebuild it at today’s prices for land, labour and
construction materials.
Some call this approach the summation method and it involves the aggregation of
various components of a property to arrive at its total value. The application of this
method is suitable for residential property and works well for new or relatively new
buildings.
In this approach, some amount of physical depreciation of building should be

allowed for. Most experts suggest that the cost approach should be used together
with other method/s.
2. The Direct Comparison Approach
This approach involves the analysis of comparable sales (sale price is the basic
input) to reveal dollar value rate per square metre, which can be applied to the
subject property.
This approach is straight forward and simple. It is based on the idea that the value
of a property is about the same as the prices for which other similar properties
have recently sold.
Application is suitable for properties where there are a number of recent sales of
similar properties. Since all properties are unique, some upward or downward
adjustment of price is still necessary.
Example – The direct comparison approach
Property to be valued is a vacant industrial land of 1200 square metres.
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Method: Analysis of 5 comparable sales reveals sale prices ranging from $575 per
square metre to $598 per square metre. Most recent and comparable sale at $587
per square metre. Adopt: $585 per square metre (often it is a subjective estimate).
1200 square metres at $585 per square metre provides a valuation of $702,000.
3. The Income Approach
In this approach (its popular version is known as direct capitalisation approach),

the value of the property is the present value of all its future income.
Thus, this approach is similar in logic and equation form (as given below) to the
zero-growth (perpetuity) dividend discount model used in the valuation of
company shares.
Annual net operating income NOI

Market value= =
Market capitalisation rate R
 Annual net operating income (NOI) is calculated by subtracting vacancy

and collection losses and property operating expenses, including property
insurance, and rates and taxes, from the gross potential rental income.
 Market capitalisation rate (R) or the discount rate is obtained by examining

recent market sales figures to determine the rate of return currently
required by property investors.
Example – The income approach
Property to be valued is a sub-regional shopping centre comprising supermarket,

discount department store (DDS), 40 specialty shops and 3 kiosks.
The market capitalisation rate (or

discount rate) is 9.50% (derived from
comparable sales). Thus, the market
value of this property is:
3,636,120
MV = =$ 38,274,947
0.095
Investment Analysis
Investment analysis not only

considers what similar properties
have sold for, but also looks at the
underlying determinants of value.
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Market Value Versus Investment Analysis
Retrospective versus Prospective
Market value appraisals look backward: they attempt to estimate what the
property will sell for by looking at the sales prices of similar properties in the
recent past.
Investment analysis approaches try to incorporate market and economic

conditions, e.g. interest rates, population and buyer expectations in the valuation
process.
Impersonal versus Personal
Market value estimates represent market average price: they do not consider a
unique set of needs of a buyer of seller.
Investment analysis approaches attempt to evaluate a property taking into account

personal conditions of a seller or buyer.
Unleveraged versus Leveraged
Market value approaches assume either a cash or an unleveraged purchase and do

not incorporate alternative financing plans that might be available (e.g. debt
financing).
Investment analysis approaches allow for the purchase price to be financed with
debt.
Net Operating Income versus After-Tax Cash Flows
Market value estimates take into account only NOI, which can have little meaning
especially when investors finance their purchase with debt.
Investment analysis approaches provide investors with the answer as to how much
cash they will be required to invest and how much (after-tax) cash they are likely to
receive from the investment.
After-Tax Cash Flows Investment Approach
This approach employs discounted cash flow models or yield models.
It involves calculating the discounted cash flow (DCF). DCF analysis (also known as
net present value approach) is a sophisticated method whereby account is taken of
net cash flows over the life of the investment.
DCF analysis is used in the assessment of larger and more complex investment
properties. Calculate the total present value of future period cash flows and
terminal value discounted by a specific rate known as the discount rate.
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A number of cash items would appear in the analysis including the following;
carefully identified as to timing as well as amount:
 Capital expenditures,
 Annual cash flows,
 Income growth,
 Terminal yield,
 Taxation,
 Funding,
 Discount rate,
 Transaction costs.
Calculate the net present value of an investment:
Where:
 I0 = the original required investment,

 CFi = annual after-tax cash flow for year i
 CFRn = the after-tax net proceeds from sale occurring in year n
 r = the discount rate.
Example – Discounted Cash Flow Analysis
A property has the following cash flow

stream, conduct a DCF analysis.
The sign of NPV tells whether the

proposed investment looks good
(positive NPV) or bad (negative NPV).
Leveraged Property Investment (LPI)
In real estate, leverage or gearing is the use of debt financing to acquire property.
The debt financing affects risk-return parameters of a real estate investment.
Positive leverage (gearing) is a position which, if the net rental income on property
investment is in excess of its debt cost, the investor’s return is increased to a level
well above what could have been earned from the investment without any debt
component.
Negative leverage (gearing) means borrowing in such a way that mortgage

interest exceeds the net rental income from the property, which creates tax losses.
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High taxable income investors may have ‘negatively geared’ property investment.
 Through ‘negatively geared’ investment, investors expect property will

produce a positive total return in later years or upon resale in the form of
capital appreciation.
Example – You purchase real estate using a 40% loan-to-value ratio and your
mortgage interest on an annual basis comes to $12,855. The net rent you receive
from the property is assumed to be $21,000 and you are in 40% tax bracket.
(i) Calculate the after-tax-cash flow from the rental property.

(ii) Supposing your loan-to-value ratio is increased to 80% (negative
leverage) how much would you save in taxes?
(iii) Calculate the after-tax cash flow for the situation in (ii) above.
Using Price/ Earning (P/E) Ratios in Property Valuations
You can use P/E ratios in property valuations. You do so by:
(i) Start with rental income,

(ii) Subtract operating costs – insurance, property tax & maintenance costs
(iii) This equals net rental value (earnings)
(iv) Divide price of the property by this earnings figure and we have the P/E
ratio if the property.
In addition to other property valuation methods, some banks in the USA use this P/
E ratio approach in evaluating commercial property investments.
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Heading 4B: International Investments
The available global investments with their risk and return are show in Exhibit
3.13, RBS p.89.
Return on domestic equity investment is equal to:
(1) Expected dividend yield, and

(2) Expected capital gain
Return on international equity investment is equal to:
(1) Expected dividend yield (in a situation where there is a net loss, prudent
companies will not pay dividends);
(2) Expected capital gain (capital loss is possible); and
(3) Expected change in the foreign exchange rate.
International Markets
V US equity and bond markets account for a decreasing share of world stock and
bond markets (dropped from about 65 percent of the total in 1969 to about 47
percent in 2010 – see Exhibit 3 in RBS, p.65).
Emerging markets are characterized as stable political systems with low

regulation and low standardization in trading activity. The risks in these markets
are:
 Illiquidity,
 Lack of information, and
 Political uncertainty.
The Case for Global Investments
There are three reasons investors should think of constructing global investment
portfolios:
1. Ignoring foreign markets (home bias in investments) can substantially

reduce the investment choices for investors. For example, the rates of return
on non-US securities often have substantially exceeded those for US-only
securities (RBS, page 66-67; Exhibits 3.2 and 3.3).
2. The low correlation between US stock (below) and bond markets (below)
and many foreign stock bond markets can help to substantially reduce
portfolio risk.
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Exhibit 3.6: Correlation Coefficient Between Equity Returns in the US and in

Foreign markets (1988 – 2010)
Australia 0.63
Canada 0.76
France 0.72
Germany 0.70
Italy 0.54
Japan 0.42
Netherlands 0.74
Spain 0.64
Sweden 0.68
Switzerland 0.61
United Kingdom 0.73
Average 0.65
Exhibit 3.6: Correlation Coefficient Between US Dollar Rates of Return on Bonds in

the US and in Major Foreign Markets (1986 – 2010)
Canada 0.75
France 0.61
Germany 0.63
Japan 0.34
United Kingdom 0.59
Average 0.58
Benefits of International Equity Investing
 Offer more opportunity than domestic focus,

 Offers lower level of risk for a given level of expected return (i.e. through
international diversification),
 International investment provides an opportunity to diversify across not
only industries but also markets, currencies and economic conditions.
Two Major Considerations in Diversification
Foreign Exchange Risk
Need to ensure that higher returns due to international diversification are not
eliminated by exchange rate volatility. Evidence shows that there was more
volatility from returns than exchange rates, therefore; including a number of
international securities in a portfolio can reduce foreign exchange risk (Odier and
Solnik – 1980s).
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Portfolio Risk Reduction
Total risk of a security’s return may be segmented into:
(i) Systematic; and

(ii) Non-systematic risk.
Calculating Portfolio Risk and Return
Calculation of Expected Portfolio Risk (p) (Two Asset Model)
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Calculation of Expected Return (Two Asset Model)
E ( R P )=wUS E ( RUS ) + wRW E ( R RW )
Where:
 E(RP) = portfolio expected return,

 E(RUS) = expected return on the US,
 E(RRW) = expected returns on the rest-of-world,
 WUS = weight of investment in US,
 WRW = weight of investment in the rest-of-world.
Risk of Combined Country Investments
To measure whether two investments will contribute to diversifying a portfolio is to

observe the correlation coefficient between their rates of return over time.
 Correlation coefficients can range from +1.00 to -1.00.

 A correlation of +1.00 means that the rates of return for the two
investments move exactly together.
 A correlation of -1.00 means that the rates of return for the two investments
move exactly opposite to each other.
 Correlation coefficients measure diversification contribution.
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Combining investments with large negative

correlation in a portfolio contribute to
diversification as it reduces variability of
returns and risk over time.
Research shows that international

correlation varies over time and across
countries.
Use the same valuation models as for

domestic bonds, stocks & real estate but
adjust returns for exchange rate changes.
Heading 5: Future and Options
Derivative Securities
Derivative instruments (traded in the derivative market) that have their value
determined by, or derived from, the value of another investment vehicle called the
underlying assets such as stocks, bonds or commodities.
The common derivative securities in the markets are forwards, futures, options and
warrants.
They are useful in risk management, price formation and reduction of investment
cost (arises from the margin invested).
Short (selling) position – Commits a seller to deliver an item at contract

maturity. Agree on the delivery price today, i.e. for a product that the seller does
not have today (farmer harvesting example).
Long (buying) position – Commits a buyer to purchase an item at contract

maturity.
To clear (offset or eliminate a contract) a position – Take the reverse position (in
the derivative market only) or alternatively deliver underlying asset at exercise
date (involves both physical (cash) and derivative markets).
Derivative contracts are traded in derivative markets.
Open interest – the number of contracts currently outstanding as measured by

either open long positions or short positions, but not both avoiding double counting
due to zero sum.
(i) Calls – Means to buy

underlying option.
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(ii) Puts – Means to sell underlying option.
Cash Contracts and Forward Contracts
Cash Contracts
Cash contracts require immediate delivery of physical commodities and financial

securities by supplier negotiated in the cash (or physical spot) market) such as
stocks, bonds and gold markets.
Spot price – The current market price of an item available for immediate delivery
in spot markets.
Forward Contracts in the Forward (Derivative) Market
Forward and futures contracts are not securities but trade agreements that enable
both buyers and sellers of an underlying commodity or security to lock in the
eventual price of their transaction.
Created when someone buys a commodity, security or other asset for future
delivery at a predetermined future date and at a predetermined price.
The delivery price is fixed when a contract is created, but not paid until delivery
date (which may be months or years after the contracting date) and is usually
different from the prevailing spot price.
The customer is buying the product – taking a long position, the market maker is a
trading bank and there is also a customer shorting, i.e. selling the product who has
excess reserves.
Features of Forward Contracts
 Not-standardised – buyers and sellers negotiate the price, the delivery date,
etc. in the over the counter (OTC) market.
 Agreements are between two private parties,
 May not require collateral, i.e. forward contracts involve credit (or default)
risk,
 Illiquid – i.e. might be difficult or costly for a counterparty to exit the
contract before it matures because there is no secondary market.
 Future contracts solve illiquidity problem by standardising the terms of the
agreement to the extent that it can be exchanged traded (and there is a
secondary market).
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Forwards Valuation Model
Suppose that at date 0 you contracted in the forward market to buy Q ounces of
gold at date T for F0,T.
That is, at date t you would agree to sell Q ounces of gold at date T for the price of
Ft,T and i = annualised discount rate.
The profit or loss on this pair of forward contracts is ( Q ) [ Ft ,T −F 0 ,T ], or the

different between the selling and purchase prices multiplied by the quantity
involved.
The value of the original long forward position when it is sold on Date t (its unwind
value) would be the present value of ( Q ) [ Ft ,T −F 0 ,T ] =
V t ,T =( Q ) [ F t , T −F 0 ,T ] ÷ ¿
The value V t ,T can be positive or negative, depending on whether F t ,T is great or

less than the original contract price, F 0 ,T .
If you had originally agreed to a long position in a six month gold forward at F 0,0.5 =
$1,350 and after three months the new forward contract price is F 0.25,0 .5 = $1,365,
the value of your position would be $1,464.68 [= (100)(1,365 – 1,350)/ (1.1) 0.25],
assuming a 10% discount rate. The original short position would be -$1,464.68.
Future Contracts
A futures contract is an agreement between a buyer and a seller made in the

futures market (in an organised exchange) now to exchange a specified amount of
cash for an asset at a specified future date.
Future contracts evolved from forward contract that had specific characteristics.
 The contract is standardised on size, delivery date, and condition,

 More marketable in secondary market and there is lower liquidity risk,
 Buyers and sellers (known as counterparties) are required to deposit funds
called margin at the futures exchange.
Mechanics of Futures
Futures exchange requires counterparties to deposit initial margin into a

collateral account to establish a futures position. The initial margin on futures
ranges from 3% to 6% of the contract value.
The margin accounts are held by the exchange’s clearinghouse and are marked-
to-market on a daily basis at the settlement price.
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 Marked-to-market: The process of establishing daily price gains and

losses in the futures market by the change in the settlement price of the
futures contracts on a daily basis.
 Settlement price: A price representative of futures transaction prices at
the close of daily trading on the exchange.
Marking-to-Market Settlement Process
 A buyer of a futures contract in which the settlement price is higher (lower)

than the previous day’s settlement price has a positive (negative) settlement
for the day.
 Since a long position entitles the owner to purchase the underlying asset, a
higher (lower) settlement price means the futures price of the underlying
asset has increased (decreased).
 Consequently, a long position in the contract is worth more (less).
 The change in settlement prices from one day to the next determines the
settlement amount to be added to (or subtracted from) the long’s margin
account
The seller of the futures contract (a short position holder) will have her/his margin
account decreased (or increased) by the amount the long’s margin account is
increased (or decreased).
Thus, futures trading between the long and the short is a zero-sum game, i.e. the
sum of the long and short’s daily settlement is zero.
If the investor’s margin account falls below a maintenance margin level (roughly
75% of the initial margin), which is usually less than 10% of contract value),
variation margin (margin call) must be added to the account in order to keep
the position open.
The marking-to-market feature of futures markets means that market participants

realize their profits or suffer their losses on a day-to-day basis rather than all at
once at maturity date as with a forward contract.
Valuation of Futures – Cost of Carry Model
The futures prices and spot prices must be related to one another in order to have
no arbitrage opportunities for investors.
If the carrying cost only amounts to forgone interest at a risk-free rate for T time
periods, then the following relationship must hold:
F 0 ,T =S 0 ¿
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Example
Suppose that you can buy gold in the spot market for $300. The monthly risk-free
rate is 0.25%. You need the gold in three months. What should be the current
futures price?
F 0 ,T =S 0 ¿
F 0 ,T =300 ¿
= $302.26
Example 2
What if the futures price is $305 in the example above?
 You have a risk-less profit opportunity,

 Buy gold at $300, sell futures at $305.
 In three months, deliver the gold, pay the known interest ($2.26), pocket the
difference (profit = $2.74).
Similar futures-spot price relationships can be derived when there are “market
imperfections” involved with carrying the commodity or financial asset.
Incorporating storage and insurance costs as a percentage of contract value (SI):
F 0 ,T =S 0 ¿
Incorporating cash flow dividends (d) received by owning the asset between dates 0
(now) and T (future delivery date):
F 0 ,T =S 0 ¿
Futures and Hedging
Futures trading is used for:
 Hedging: A strategy used to reduce or completely offset risk exposure to an

underlying asset, i.e. involves a physical market position,
 Arbitraging: Earn risk free profits by simultaneously purchasing and

selling the same security in different markets at different prices, and
 Speculating: Hope to earn profits by aggressively trading futures.
Futures can be used to hedge asset value to reduce risk in the cash or physical
market. Basic principle of hedging – futures position taken is opposite to the
position in the cash or physical market.
Two basic hedge positions:
1. Short Hedge
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 A long position (purchase of assets) in a physical or cash market, and

 A short position (sale) in the futures market,
 In order to protect the assets against a decline in price (investor’s/
lender’s/ physical asset owner’s perspective).
2. Long Hedge
 A short position (sale of assets) in a physical or cash market, and

 A long position (purchase) in the futures market,
 In order to lock in current (lower) prices and (higher) yield (Investors/
lenders – intending to buy physical assets.
Futures contracts can be settled in two ways:
(1) Delivery (less than 2% of transactions are done this way) involving two
markets – namely the futures market and the physical market.
(2) Offset: Liquidation of a prior position by an offsetting transaction, involving
only the futures market.
In order to hedge, portfolio manager must determine the appropriate number of

futures contracts to buy or sell. This number is known as hedge ratio.
The amount of asset hedged

Number of contracts=
The ¿ each contract
In the previous slide (short hedge): using each contract size as $250 x Index Quote,
the number of contracts is equal to [$285,000/($250 x 1140)] = 1.
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Hedging with Hedging is Imperfect
1. Futures available for hedging may not be exactly the same (due to
standardisation of contract) as the underlying (physical) asset.
2. Hedger may be uncertain of the exact date the asset will be bought or sold.
3. Hedging may require the futures contract to be closed out well before
expiration date.
These 3 problems give rise to basis risk of hedging.
Basis Risk
Basis is the difference between spot and futures price for a contract maturing at
date T.
BI ,T =S t−F t ,T
Where St = the date t spot price

F t ,T = the date t forward price for a contract maturing at date T
Example
Suppose the spot price of the asset to be hedged is $50 and the futures price of the
contract is $45, what is the basis?
= 50 – 45 = 5
If the spot price of asset ($50) and futures price ($50) are the same, then basis
should be zero, there is no basis risk.
Note: Narrowing the basis reduces hedging risk while expanding basis increases
hedging risk. Basis at maturity of a contract is zero.
Option Contracts
Instruments that grant their owners (holders) the right, but not the obligation, to
buy or sell an underlying asset at a specific price (exercise or strike price), either on
a specific date or any time up to a specific date (or expiration date).
Options Fall into Two Categories
1. Call option: give holder (buyer) the right to buy an underlying asset at a
specified price on or before a specified date.
2. Put options: give holder (buyer) the right to sell an underlying asset at a
specified price on or before a specified date.
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Other Key Definitions
 Exercise (strike) price: Pre-determined (contract) price at which the

underlying asset may be purchased (in the case of a call) or sold to a seller
or writer (in the case of a put).
 Expiration date: Last date at which an option can be exercised.
 Option premium: Price paid by the option buyer to the seller of the option,
whether put or call.
Option premium = Intrinsic value + Time value
 In-the-money option: The option has intrinsic value and would be

exercised if it were expiring.
 Out-of-the-money option: The option has no intrinsic value and would

not be exercised if expiring.
o If not expiring, could still have time value since it could later become
in-the-money.
 At-the-money option: If the spot market price of the underlying asset is

equal to the exercise price.
Option Mechanics
Exchange Traded Options
 Dealt on the floor of the exchange in designated ‘pits’,

 Exchange requires counterparties to deposit margins into a collateral
account,
 The exchanges create an instrument which people can trade without
worrying about the creditworthiness of the counterparty.
Over-the-counter (OTC) Traded Options
 Provided by a large number of banks,

 Banks do not provide trading floors for exchange of orders but quote prices
directly to customers,
 No secondary market.
Two Categories of Options
1. American options: Can be exercised any time before expiration date.

2. European options: Can be exercised only at expiration date.
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Why Option Markets?
 Allow investors to profit from the price upward (calls) and downward
(puts) movements without buying the stock or short selling the stock.
 Option markets allow for leverage – the investment amount is smaller and
profits are magnified.
Option Positions
It is important to understand the buyer’s point of view to not be misguided in

working out trading examples. Once a buyer’s point of view is understood, it is
easier to understand the seller’s point of view.
Basic Option Positions
 Long call position (buying a call option)

 Short call position (selling a call option)
 Long put position (buying a put option)
 Short put option (selling a put option)
Long Call Position (Buying a Call Option)
This position is taken in the expectation that prices will rise.
Example
Consider a call buyer with an exercise price of $70 and an option premium (option
price) paid of $6.13.
The diagram shows the different total dollar profits for buying a call option with a
strike price of $70 and a premium (option price) of $6.13.
 If the current price ($80) > exercise price ($70); call option is in the money.
 If the current price ($70) = exercise price ($70); call option is at the money.
 If the current share price ($60) < exercise price ($70); call option is out of
the money.
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Therefore, there is a profit realised when the share price rises above $76.13
(exercise price + premium).
Payoff does not equal profit. Payoff is the spot rate minus the exercise price, whilst
profit is the spot price minus the exercise price + premium.
Short Call Position (Selling a Call Option)
A position is taken in the expectation that the price will remain steady or decline.
At expiration the investment value or payoff (investment value) for the call seller:
( ST −X ) if ST > X , or 0 if ST ≤ X
Example
For a call seller (writer) with an exercise price of $70 and an option premium
(option price) earned by the call seller of $6.13, the call seller will suffer a loss as
soon as the share price increases beyond $76.13.
Long Put Position (Buying a Put Option)
A position is taken in the expectation that the price will decline (long put position =
short-selling). At expiration the investment value or payoff for the put buyer:
0 if ST ≥ X , or X −S T if ST < X
For a put buyer with an exercise price of $70 and an option premium (option price)
of $6.13, the put buyer will suffer a loss as soon as the share price increases beyond
$76.13.
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For a put buyer with an exercise price of $70:
 If the current share price ($60) < exercise price ($70); put option is in the
money.
 If the current share price ($70) = exercise price ($70); put option is at the
money.
 If the current share price ($80) > exercise price ($70); put option is out of
the money.
Short Put Position (Selling a Put Option)
The put writer bets that the price will not decline greatly – collects premium
income with no payoff.
At expiration the investment value or payoff for the put writer:
0 if ST ≥ X , or ( X −S T ) if S T <X
The payoff for the buyer is the amount owed by the writer (payoff loss limited to
the strike price since the stock’s value cannot fall below zero).
Example
For a put seller with an exercise price of $70 and an option premium (option price)
of $6.13, the put seller, the following diagram holds:
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Options on Futures (Futures Options)
The biggest different between a futures option and a futures contract is that the
option limits the option investor’s loss exposure to the price of the option
(premium); but, there is no limit to the amount of loss a futures investor can occur.
 Buying a put option (protective put) = short hedge (using futures) = short
selling outcome.
 Buying a call option = long hedge (using futures) = normal selling outcome.
Valuations of Options
The Binomial Model
In this model, the stock price can only have two outcomes in each period, i.e. an up
movement or a down movement. The binomial model price of the call is given in the
formula sheet:
C= ([ u−d
r−d
) C +( u−d
u
u−r
)C ] ÷ r d
r =1+ r f
Where:
 C= Call premium
 r= Rate of return = 1 + risk free rate of return
 d= Downside change
 u= Upside change
 Cd = Call value if stock price falls
 Cu = Call value if stock price rises
Example
A call option has been written on one share of AAF Ltd with an exercise price (P) of
$3.50. AAF’s current share price is $3.50 and it has an equal chance of rising (u) to
$5 and falling (d) to $3. The risk-free rate of return is 10% per annum. Calculate
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the price of the AAF call option.
The rate of return on the share has two possible values; u-1.00 or 1.00-d.
If P = $3.50 and the share price rises to $5.00, the upside change (u) is:
 (5.00/3.50 = 1.43) = u-1.00 = 1.43-1.00 = return of 43%, upside
change (u) of 1.43.
If the AAF share prices rises to $5.00, the call option will be exercised and the pay-
off is $1.50 = Cu = 1.50.
If the share price falls to $3.00, then the downside change (d) is:
 (3.00/3.50 = 0.86) = 1.00-d = 1.00-0.86 = return of 14% down,
downside change (d) of 0.86.
If the AAF share price declines to $3, the pay-off of the call option is zero – since the
call option will not be exercise = Cd = 0
C= ([ 1.10−0.86
1.43−0.86 ) 1.50+ (
1.43−0.86 ) ]
1.43−1.10
0 ÷ 1.10
C = price of the call option = $0.57
Black-Scholes (1973) Model
The Black-Scholes model uses stochastic calculus and the ‘heat exchange equation’
from physics:
The above Black-Scholes valuation is for call options.
Put-Call Parity
Put-call parity shows the relationship between call and put options if riskless
arbitrage is not possible:
X
S0 + P0 , T −C 0 ,T =[ ]
1+ RF R T
This is equal to: long stock + long put – short call = long T-Bill or riskless lending.
This equation can be rearranged to work out just long put:
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P0 ,T =
[ X
1+ RF RT ]
−S 0 +C0 , T
Example – Calculate the value of a call option using the following data:
 S = $40
 X = $40
 RFR = 9%
 T = 1 year
  = 0.3
Where:
 C = call price
 S = current market price of underlying ordinary shares
 X = exercise price of call option
 T = time to expiration
 RFR = current annualised market interest rate for prime commercial paper
  = standard deviation of annual return on underlying asset
 N(d1) = Cumulative density function of d1
 e = base of natural logarithm (~2.71828)
 N(d2) = cumulative density function of d2
 ln (S/E) = natural log of (S/E)
Variable Calls Puts
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(1) Share price + -

(2) Exercise price - +
(3) Time to expiration + +
(4) Share volatility + +
(5) Interest rate + -
(6) Cash dividends - +
(1) High price of underlying asset leads to upside (downside) profit potential of
call (put) options: higher (lower) call (put) premium.
(2) For call option higher exercise price (EP) meanshigher purchase price of the
underlying asset resulting in low premium, while for put option higher EP
means the underlying asset can be sold at a higher price after buying the
asset at the prevailing lower price resulting in higher premium.
(3) In the Table: for American options the greater the time to expiry, the
greater the opportunities to exercise resulting in higher premium.
(4) Positive relationship of risk/return: means higher premium.
(5) In the Table: since call holders do not have to pay the EP up until the time of
exercise or expiry of option, they earn increased interest on money set aside
to pay the EP: call premium increases.
 Put holders (who have to wait until the time of exercise or expiry of
option to receive the EP), however, are loosing interest during the
waiting time: put premiums decline.
(6) In the Table: on ex-dividend date (treat as a dividend increase), the

underlying asset price (UAP) will fall and call premium drops while the
drop in UAP (due to dividend increase) results in increased put premium.
Hedge Ratio for Options
In general, hedge ratio is the appropriate number of derivative contracts

(generally used with futures contracts) that should be bought or sold to hedge a
position.
The amount of asset hedged
Number of contracts=
The ¿ each contract
In the context of options, hedge ratios are known as option deltas (p.855). An
option delta is the ratio of the change in an option’s price to a given change in the
underlying asset.
 Call option delta: N(d1)

 Put option delta: N(d1) – 1
In the example above, N(d1) was 0.6736. Therefore, for every call option written,
0.67 of an ordinary share is required to hedge the position. If the standard options
contract is 100-share option contract, 67 shares would be required. The fact that
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hedge ratio are less than 1.00 indicates that option values change with stock prices
on a less than one-for-one basis.
Heading 6: Markowitz Portfolio Theory (MPT)
Risk Aversion
Portfolio theory assumes that investors are risk averse, i.e. if they are given a choice
between two assets with equal expected rates of return, risk averse investors will
select the asset with the lower level of risk. It also means that a riskier investment
has to offer a higher expected return or else nobody will buy it.
Risk aversion is evidenced by:
 Purchase of insurance products,

 Difference in promised yields with different bond ratings.
Definitions of Risk
 Uncertainty – Of future outcomes, says something about risk;

 Risk – Quantified uncertainty using a probability (usually of an adverse
outcome) distribution.
Assumptions of Markowitz Portfolio Theory
1. Expected Returns over the Period: Investors consider each investment

alternative as being presented by a probability distribution of expected
returns over some holding period.
2. Investors maximize one-period expected utility, and their utility curves

demonstrate diminishing marginal utility of wealth.
3. Investors estimate the risk of the portfolio on the basis of the variability of
expected returns.
4. Investors base decisions solely on expected return and risk, so their utility
curves are a function of expected return and the expected variance (or
standard deviation) of returns only.
5. For a given risk level, investors prefer higher returns to lower returns.
Similarly, for a given level of expected returns, investors prefer less risk to
more risk.
Using these five assumptions, a single asset or portfolio of assets is considered to be

efficient if no other asset or portfolio of assets offers higher expected return with
the same (or lower) risk, or lower risk with the same (or higher) expected return.
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Risk Reduction in Portfolios
 Insurance Principle: More securities (no need for a large number of

securities) means less risk in the portfolio.
 Random Diversification: Diversifying without looking at relevant

portfolio securities characteristics (not wise as chances are the risks will not
be diversified as stocks will be chosen from similar portfolios).
 Non-Random Diversification: Investigating relationships between

portfolio securities before investment decision.
Expected Rates of Return
For an Individual Asset
The E(R) for an individual asset is the sum of the potential returns multiplied with
the corresponding probability of the returns.
Where:
 E(R) = Expected return of security
 Ri = The return outcome i
 Pri = Probability of return outcome i
 m = Number of possible return outcomes
Example: Computation of Expected Return for an Individual Risky

Investment
Probability Possible Rate of Return Expected Return (%)

(%)
0.35 0.08 0.0280
0.30 0.10 0.0300
0.20 0.12 0.0240
0.15 0.14 0.0210
E(R) = 0.1030
Variance and Standard Deviation of Returns for an Individual Risky

Investment
Variance is a measure of the variation of possible rates of return Ri, form the
expected rate of return E(Ri).
In which Pi is the probability of the

possible rate of return, Ri.
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Standard deviation is the square root of the variance. The standard deviation of
returns:
 = (2) (½)
Ex ante rather than ex poste  relevant. (What?)
Example: Variance and standard deviation of returns for an individual risky

investment (asset).
σ=¿
Covariance of Returns
Covariance of returns is a measure of the degree to which two variables “move

together” relative to their individual mean values over time.
For two assets, A and B, calculating the covariance of rates of return on an

expected basis involves use of the formula for two securities i and j:
Co v ij =E {[ R i−E ( Ri ) ][ R j−E ( R j ) ] }
Correlation Coefficient
Correlation coefficient: ρ is a standardized measure of association. It is obtained by

dividing the covariance by the product of the individual standard deviations.
σ if Cov if
ρif = =r if =
σ iσ j σi σ j
Where:
 r if = the correlation coefficient of returns
 σ i = the standard deviation of Rit
 σ j = the standard deviation of R jt
That is, standardise by dividing the covariance of if by the standard deviation of i
and the standard deviation of f.
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In the assignment, we must discuss the correlation and covariance metrics. With
the correlation you can predict or measure the positive or negative movements
(interrelation) between stocks.
Covariance can’t be used to predict movements.
Note: the correlation coefficient can vary in range from +1 to -1.
 A value of +1 would indicate perfect positive correlation, i.e. returns for the
two asset move together in a completely linear manner, that is, there is no
need to include both assets in a portfolio (just include one asset only).
 A value of -1 would indicate perfect negative correlation, i.e. returns for two
assets have the same percentage movement, but in exact opposite
directions.
 A value of 0 would indicate no correlation – no relationship between the

two returns, but does not mean that they are independent.
Portfolio (Risk) Standard Deviation
Portfolio risk is always less than (in other words; not equal to) the weighted
average of the risk of the individual securities in the portfolio unless securities
included there have perfect correlation.
n
σ ≠ ∑ w i σ 2I
2
p
i=1
Any asset of a portfolio may be described by two characteristics:
 The expected rate of return,

 The expected standard deviation of returns.
The portfolio standard deviation is a function of:
 The expected standard deviation of returns of individual assets that make

up the portfolio,
 The covariances between all of the assets in the portfolio.
The larger the portfolio, the more the impact of covariance and the lower the
impact of the individual security variance.
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Implications for Portfolio Formation
 Assets may differ in expected rates of return, individual standard deviations

and correlations with one another.
 Negative correlation reduces portfolio risk.
 Combining two assets with perfect negative (-1.0) correlation reduces the
portfolio standard deviation to zero (= risk free portfolio) only when
negative covariance term exactly offsets the sum of individual variance
terms.
 The lower the correlation, the lower the portfolio standard deviation.
 Even for assets that are positively correlated (but not perfectly
correlated), the portfolio standard deviation tends to fall as assets are
added to the portfolio.
Correlation and Risk Diversification
With low, zero or negative correlations of

asset returns, it is possible to create
portfolios with much lower risk than
either single asset.
Note: +1.00 and -1.00 risk correlations

do not occur in reality.
The Efficient Frontier
According to Markowitz’s approach,

investors should evaluate portfolios
based on their return and risk. Risk averse investors should only be interested in
portfolios with the lowest possible risk for any given level of return.
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The efficient frontier of risky assets is the segment of the minimum variance
frontier above the minimum variance portfolio.
The Efficient Frontier And Alternative Portfolios
Portfolio B is better than

portfolio C at the same
level of risk as there is a
higher expected return.
Portfolio A is preferable to
portfolio C at the same
level of return as there is a
lower level of risk.
A is the minimum variance

portfolio.
Portfolios along the efficient frontier are equally “good”. Thus, no portfolio on the
efficient frontier can dominate any other portfolio on the efficient frontier.
All of these portfolios have different return and risk measures, with expected rates
of return that increase with higher risk.
The Efficient Frontier and Investor Utility
 An individual investor’s utility curve specifies the trade-offs s/he is willing to

make between expected return and risk.
 The higher utility curves (the one to the left) represent greater utility (more
return with lower risk).
 The interaction of the individual’s utility and the efficient frontier jointly
determines portfolio selection for individual investors.
The curve labelled (U) in the diagram is for

relatively more risk-averse investors
compared to that of (U’) labelled for less
risk-averse investors.
The optimal portfolio for investors occurs at

the point of tangency between their highest
indifference curve and the efficient set of
portfolios.
The Markowitz frontier (the middle curve – not either U or U’) deals with total risk.
Points X and Y are the points of tangency with the more and less risk-averse
investor.
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Investors Differences and Portfolio Selection (For Above Diagram)
A relatively more conservative investor would choose Portfolio X on the efficient

frontier and on the highest attainable utility curve.
A relatively more aggressive investor would perhaps choose Portfolio Y on the

efficient frontier and on the highest attainable utility curve.
Key Points on Markowitz Portfolio Theory (MPT)
Three important points about Markowitz model:
1. All portfolios on the efficient frontier are equally good.
2. The slope of the efficient frontier curve decreases steadily as one moves
upward – adding equal increments of risk as we move up the efficient
frontier gives diminish increments of expected return.
3. Input values (E(R), , correlations coefficients to calculate covariances)

used in the Markowitz model are different for different investors/ portfolio
managers since the expected returns differ amongst them.
Expected returns, variances and co-variances are used as inputs to estimate the
efficient frontier.
The arithmetic mean is used to estimate the expected returns, which is based on
historical returns in theory. In practice however, the expected return must be
modified to incorporate real factors and not just historical returns.
Main Results of Markowitz Portfolio Theory (MPT)
 It quantifies risk,
 It derives the expected rate of return for a portfolio of assets and an

expected risk measure,
 Shows that the variance of the rate of return is a meaningful measure of

portfolio risk,
 It derives the formula for computing the variance of a portfolio, showing

how to effectively diversify a portfolio.
MPT does not address the issue of pricing (or calculation of required rate of
return) of both risky and risk free assets.
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Example 1: Two Risky Assets
Probability Xi (%) Yi (%)

0.2 11 -3
0.2 9 15
0.2 25 2
0.2 7 20
0.2 -2 6
1. Compute the means and variances of the returns for the two assets
respectively.
2. Compute the covariance and the correlation between the returns of X and Y.
If your portfolio gives an equal

weight to X and Y, computer
the expected return and
variance of this portfolio.
Example 2: Three Assets
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Stock A Stock B Stock C

Expected Return 23.60% 20.40% 18.80%
Standard Deviation of Return (%) 60 50 40
Where:
 Standard deviation of return on the market is 15%

 Expected market return is 14%
 Risk free rate is 6%
 Correlation coefficient of return between stock A and stock B is 0.60
 Correlation coefficient of return between stock A and stock C is 0.40
 Correlation coefficient of return between stock B and stock C is 0.20
(i) Calculate the expected return and standard deviation of a portfolio

which invests one-third in stock A, one-third in stock B and one-third in
Stock C.
(ii) Calculate the expected return and standard deviation of a portfolio
which invests one-third in the risk free asset, one-third in stock B and on-
third in stock C.
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Heading 7: Asset Pricing Models
Capital Market Theory
Capital market theory extends portfolio theory and seeks to develops a model for
pricing all risky assets based on their relevant risks.
Asset Pricing Models:
(1) Capital asset pricing model (CAPM) in both of its standard and
nonstandard forms allows for the calculation of the required rate of
return for any risky asset based on the security’s beta.
(2) Arbitrage Pricing Theory (APT) is a multi-factor model for determining
the required rate of return.
(3) Other multifactor models to determine the required rate of return (to be
covered briefly)
Three steps to build a portfolio of financial assets:
1. Derive optimal risk-return combinations available from the set of risky

assets using Markowitz portfolio theory (Topic 6).
2. Examine the impact of a risk-free asset on the Markowitz efficient frontier

taking into account borrowing and lending possibilities.
3. Choose the final portfolio (combining risk-free assets and the risky assets
optimal portfolio) based on the investor’s preferences.
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Asset Pricing Theory
Asset pricing theory, or capital market theory as it is also known, is a natural

extension of the Markowitz portfolio theory (MPT).
The different is that Markowitz portfolio theory is normative – it describes how

investors should act in selecting an optimal portfolio of risky assets. This differs
from capital market theory which is positive – contains statements of what
actually is (prices and returns) rather than what ought to be.
CMT examines how optimal diversification affects security prices to determine the
required rate of return (price) for any risky asset. Three main asset pricing
theories have been put forward extending MPT:
1. Capital Asset Pricing Model (CAPM) in standard form

2. Non-Standard forms of CAPM
3. Multi-Factor Models – e.g. the Arbitrage Pricing Theory (APT)
Capital Market Theory
Assumptions of Capital Market Theory
 All investors are Markowitz efficient investors who target points on the
efficient frontier based on risk-return utility.
 There are many investors – no single investor can affect the price of a stock
(perfectly competitive).
 Investors can borrow or lend any amount of money at the risk-free rate
(something Markowitz does not consider).
 All investors have homogenous expectations and estimate identical
probability distributions for future rates of return, variance and
correlations.
 All investors have the same one-period time horizon, i.e. month, six months
or one year.
 All investments are infinitely divisible, it is possible to buy or sell fractional
shares of any asset or portfolio.
 No taxes or transaction costs involved (unrealistic).
 No inflation or any change in interest rates, or inflation is fully anticipated.
 Capital markets are in equilibrium, i.e. investments are properly priced (no
mispriced securities).
Nature of a Risk-Free Asset
The risk-free asset is one of zero-variance (zero default risk) and it also has zero
correlation with all other risky assets. It lies on the vertical axis of a portfolio
graph.
Combining the Risk-Free Asset with a Risky Markowitz Portfolio
Standard Deviation
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Expected variance for a two-risky-asset portfolio is:
E ( σ 2port ) =w21 σ 21 +w 22 σ 22+2 w 1 w 2 r 1,2 σ 1 σ 2
If you substitute the risk-free asset as security one the equation becomes:
E ( σ 2port ) =¿
The standard deviation is then:
E ( σ port ) =√ ¿ ¿
¿¿
The expected return and standard

deviation are linear combinations, that
is, a graph is simply a straight line of the
two assets (known as the capital market
line; CML).
In equilibrium, investors choose a

combination of the risk-free asset and a
risky market portfolio (M), which yields
the maximum expected return for that
given level of risk.
Where A, B and C are individual

investor’s utility curves.
Everybody wants to invest in portfolio M

and borrow or lend to be somewhere on
the CML. Because the market is in
equilibrium all assets are included in
this portfolio in proportion to their
market value.
To attain a higher expected return than is available at point M, either:
 Invest along the efficient frontier beyond point T (market portfolio), such as
point B, or
 Add leverage to the portfolio to move to point L, by borrowing money at the
risk-free rate and investing in the risky (market) portfolio at point T.
Note: All portfolios on the CML are perfectly positively correlated with each other
and with the completely diversified market portfolio (i.e. +1.00).
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Diversification and the Elimination of Unsystematic Risk
There are two sources of risk, which are

systematic and non-systematic risk. Proper
diversification of a portfolio will eliminate
non-systematic risk, i.e. reducing the
standard deviation of the portfolio.
As securities are added to a portfolio, the

average covariance is expected to decline,
which reduces the standard deviation of the
portfolio and begins to eliminate
unsystematic risk.
CML and the Separation Theorem
The CML leads all investors to invest in the

market portfolio, but investors should differ
in position based on risk preferences and
financing decisions.
Risk averse investors will lend part of the

portfolio at the risk-free rate and invest the
remainder in the market portfolio. More risk
tolerant investors will borrow funds at the
risk-free rate and invest everything in the
market portfolio.
Tobin (1958) calls this separation of the

investment decision from the financing
decision the separation theorem.
Capital Market Line Equation:
E¿
The capital market line can only be applied to efficient portfolios and cannot be
used to estimated the expected return on a single security.
Risk Measure for the CML – Single Index Model (SIM)
Covariance measures the extent to which returns of two securities (included in a

portfolio) move together. Under SIM, the only relevant portfolio is the M portfolio.
This means that the only important consideration is the asset’s covariance with the
market portfolio.
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Because all risky assets are part of the M portfolio, an asset’s rate of return in
relation to the return for the M portfolio may be described using the linear model
(SIM):
Rit =ai +bi R M + ε
Where:
 a i = Constant term for asset i

 b i = slope coefficient for asset i
 R M = return for the M portfolio during period t
 ε = random error term
1. Standard Form CAPM
The existence of a risk-free asset resulted in deriving a capital market line (CML)
that became the relevant portfolio frontier. An asset’s normalised covariance with
the market portfolio is the relevant risk measure – systematic risk (or beta). This
can be used to determine an appropriate expected rate of return on a risky asset –
resulting in the capital asset pricing model (CAPM).
The CAPM indicated what should be the expected or required rates of return on
risky assets. It helps to value an asset by providing an appropriate discount rate to
use in dividend valuation models.
Then, a comparison can be drawn between the estimated rate of return and the
required rate of return implied by CAPM.
Security Market Line (SML)
The relevant risk measure for an individual risky asset

is its covariance with the market portfolio (Covi,m).
The equation for the risk-return line is:
R M −RFR
E ( Ri ) =RFR+ (Co v i , M )
σ 2M
Co v i , M
¿ RFR+ ( RM −RFR)
σ 2M
Co v i , M
The beta (normalised covariance) is: ( β i)=
σ 2M
The risk premium is: ( R M −RFR)
Therefore: E ( i)
R =RFR+β i (R M −RFR)
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The same formula can be used for the expected return of a specific security using its
beta to the market.
Calculating Systematic Risk – The Characteristic Line
The systematic risk input of an individual asset is derived from a regression model,
referred to as the asset’s characteristic line with the model portfolio:
Ri , t=ai+ bi R M , t +ε
Where:
 Ri , t = rate of return for asset i during period t.

 R M ,t = rate of return for the market portfolio M during t
The characteristic line shows total returns for a security relative to total returns
for the market index.
An efficient portfolio has less standard

deviation of return than an inefficient
portfolio given the same level of expected
return. The extra SD in an inefficient
portfolio is called ‘diversifiable risk’ which
investors would not be compensated for.
Thus, CAPM (or SML) prices all risky

assets and portfolios (efficient and
inefficient), the CML only prices efficient
portfolios.
In equilibrium, all risky assets and portfolios should lie on the SML. Any security
with an estimated return that plots above the SML is under-priced. Remember that
yield (return) and price (value) are inversely related.
 When estimated return is lower, estimated price is higher – stock is over

priced.
 When estimated return is higher, estimated price is lower – stock is under-
priced.
Example – Price, Dividend and Expected and Required Rates of Return
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Required Rate of Return for a Risky Asset
Comparison of Required Rate of Return (using SML) with Expected Rate of Return
Empirical Issues and Problems in CAPM (SML)
1. Betas for individual stocks are not stable but portfolio betas are reasonably
stable
2. How well do returns conform to the SML equation?
3. Market proxy? Standard & Poor’s 500 Composite Index - Includes only U.S.
stocks: difficulties in selecting a proxy (whichone to select?)
4. Is the relationship between beta and expected return on risky assets is

positive and linear?
5. Effect of skewness on relationship

 Typically investors prefer stocks with high positive skewness that
provide an opportunity for very large returns: in general returns are not
normal in financial markets
6. Company size (small/large companies), book/market values (Fama and

French Study) and leverage impact on returns
 Empirical results of CAPM are mixed: some studies support and others
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do not
Non-Standard Forms of CAPMs & Macro/Micro Risk Factor Models Here
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Heading 8: Market Portfolios: Security Market Indexes
Market Indices
1. Price-Weighted Indices
(i) Dow Jones Industrial Average (DIJA) - Composed of 30 “blue-chip”

US company stocks and it is the oldest, most well-known measure.
(ii) Nikkei 225 Index: Includes 225 actively-traded company stocks on the
Tokyo Stock Exchange.
2. Value-Weighted Indexes
(i) New York Stock Exchange (NYSE): Composite Index
(ii) S&P500 Index: Composed of 500 “large” US company stocks
(iii) National Association of Securities Dealers Automated Quotations

(NASDAQ): Composite Indices
(iv) Australian S&P ASX500, S&PASX200
3. Unweighted (or Equally-Weighted) Indexes
(i) Value Line Averages
Uses of Security-Market Indexes
 Used for calculating the benchmark returns to judge portfolio performance,

 Development of an index portfolio,
 For examining factors that influence aggregate security price movements,
 For technical analysis to predict future price movements,
 To compute a security’s systematic risk by examining how its return
responds to changes in the market index (beta in CAPM).
Factors in Constructing Market Indexes
 How large a sample is needed for the index to be representative?

 Should weighting be based on (i) price, (ii) total firm value weighted, or
(iii) equally weighted?
 How should the values be reported,
tracked and computed (arithmetic or
geometric mean)?
Derive the initial total market value of all

stocks used in the series. The market value is
equal to:
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 (Number of Shares Outstanding x Current Market Price)
Assign a beginning index value (100) and new market values are then compared to
the base index.
Inde x t =
∑ Pt Qt x Beggining Index Value
∑ P b Qb
There is an automatic adjustments for “splits” – look in other Week 8 document for
example.
Where;
 Index = Index value on day t

 Pt = Ending prices for stocks on day t
 Qt = Number of outstanding shares on day t
 Pb = Ending price for stocks on base day
 Qb = Number of outstanding shares on base day
Unweighted (or Equally-Weighted) Price Indicator Series)
All stocks carry equal weight regardless of the price or market value. It may be
used by individuals who randomly select stocks and invest the same dollar amount
in each stock.
Some (e.g. Dow Jones Industrial Average Index) use arithmetic average of the
percent price changes for the stocks in the index.
Value Line and the Financial Times Ordinary Share Index compute a geometric
mean of the holding period returns and derive the holding period yield from this
calculation.
Bond-Market Indicator Series
Relatively new and not widely published. Growth in fixed-income mutual funds
increases the need for reliable benchmarks for evaluating performance,
Many managers have not matched aggregate bond return:

 Increasing interest in bond index funds,
 Requires an index to emulate.
In Australia, we have UBS Bond Indices – published daily in the AFR.
Equity Portfolio Management
This is the process of deciding how to distribute wealth among asset classes, sectors
and countries for investment purposes. It is not an isolated choice, but rather a
component of the portfolio management process.
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Even for a well-diversified portfolio, which may outperform the market, the
dominant factor affecting the variability of portfolio return is the market.
Asset allocation decisions involve a choice between two or more classes of assets –
some or all of which may be risky involving frequently ordinary shares and bonds.
There are four decisions in an investment strategy:
(1) What asset classes should be considered?

(2) What should be the normal weight for each asset class?
(3) What are the allowable ranges for the weights?
(4) What specific securities should be purchased?
Investment Management Process (RBS P.37)
Important to create a statement with the

needs, knowledge and expectations of the
investment.
It is also necessary to examine the current

climate and project future economic
movements and conditions.
Then, construct the portfolio based on the

guidelines of the investors risk tolerance.
(1) Set the investment policy

(2) Perform security analysis
(3) Construct a portfolio
(4) Revise the portfolio
(5) Evaluate the performance of the portfolio
a. See sections above
(1) Set Investment Policy and Investment Objectives (broad investment goals)
may include:
Capital Preservation
 Maintain purchasing power,
 Minimise the risk of loss
Capital Appreciation
 Achieve portfolio growth through capital gains
 Accept greater risk
Current Income
 Look to generate income rather than capital gains
 May be preferred in “spending phase”
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Total return
 Combining income returns and reinvestment with capital gains
 Moderate risk
The investor’s risk-return preference (indifference curve) can be approximated by

the use of different mixes of ordinary shares (risky) and bonds (risk-free) often
based on realised historical returns.
(4) Revise the Portfolio
With the passage of time the previously purchased portfolio held now may often be
viewed as suboptimal by the investment manager.
 This is because either the client’s attitude toward risk and return may have
change or more likely, the manager’s forecasts have changed requiring
revisions.
The most important consideration here would be transaction costs involving

brokerage commissions, price impacts, and bid-ask spreads.
Passive Versus Active Management
Total Actual Return= [ Expected Return ] + Alpha=[ Risk−Free Rate + Risk Premium ] +[ Alpha]
Where Alpha:
 Excess return over market return
1. Passive Equity Portfolio Management
Does not seek to outperform the market but seeks return on a risk-adjusted basis
[Risk-Free Rate + Risk Premium] at least equal to that of the market or stock index.
 Buy and hold strategy,

 Matches market performance,
 Manager judged on tracking target index.
Passive management may underperform the Market Index due to fees and
commissions.
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2. Active Equity Portfolio Management
Seeks mispriced securities and opportunities for trading (lack of faith in market
efficiency).
 Attempts to outperform passive benchmark, [Risk-Free Rate + Risk

Premium] + [Alpha],
 Security selection, sector rotation and market timing form active strategy,
Aims to exceed the return of a passive benchmark portfolio, net of transaction costs
on a risk-adjusted basis. Some of the practical difficulties of an active manager
include – the need to offset transaction costs, and managing risk which may exceed
the passive benchmark.
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Fundamental Strategies
(1) Top-Down Approach
 Broad country and asset class allocations,

 Sector allocation decisions,
 Individual securities selection.
(2) Bottom-Up Approach
 Emphasises the selection of securities without any initial market or sector

analysis,
 Forms a portfolio of equities that can be purchased at a substantial discount
to what his or her valuation model indicates they are worth.
Actives Equity Portfolio Management – Three Strategies
(i) Sector Rotation: Shifting funds among different equity sectors and
industries or among investment styles to catch hot concepts before the
market does.
Screening can be based on various stock characteristics:
 Value,
 Growth,
 Price earning (P/E) ratio,
 Capitalization,
 Sensitivity to economic variables.
(ii) Style Investing: Focusing on a particular investment style (large cap/

small cap; growth/ value).
Constructs a portfolio to capture one or more of the characteristics of

equity securities.
 Value stocks appear to be under-priced, i.e. low price/ earning

ratios.
Growth stocks enjoy above-average earnings per share (high P/E ratio)
increases.
(iii) Stock Picking: Examines individual stock issues to buy low and sell high
(attempts to find undervalued stocks).
Technical Strategies
(i) Contrarian Investment Strategy
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 The belief that the best time to buy (sell) a stock is when the majority
of other investors are the most bearish (bullish) about it,
 The concept of mean reverting,
 The overreaction hypothesis.
(ii) Price Momentum (Continuation) Strategy
 Assume that recent trends in past prices will continue,

 Focus on the trend of past prices alone and makes purchase and sale
decisions accordingly.
Anomalies and Attributes
Earnings Momentum Strategy
 Momentum is measured by the difference of actual earnings per share (EPS)

to expected EPS.
 Purchases stocks that have accelerating earnings and sells (or short sells)
stocks with disappointing earnings.
Calendar-Related Anomalies
 The weekend Effect,

 The January Effect.
Tax Efficiency - active portfolio managers especially need to consider taxes when
deciding whether to sell or hold a stock whose value has increased: in
buying/holding decisions capital gain tax as a cost adversely affect active portfolio
returns.
Heading 9A: Fixed Income (Bond) Portfolio Management
Bonds – Characteristics of Duration
Duration of a bond with coupons is always less than its term to maturity because
duration gives weight to interim (coupon) payments. A zero-coupon bond’s
duration equals its maturity.
1. An inverse relationship between duration and coupon.

2. A positive relationship exists between term to maturity and duration, but
duration increases at a decreasing rate with maturity.
3. An inverse relationship exists between yield and duration.
Characteristics of Convexity
1. Inverse relationship between convexity and coupon.

2. Positive relationship between term to maturity and convexity.
3. Inverse relationship between yield and convexity.
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Correlation Between Equity and US Fixed-Income Securities
In the USA, there is a low historical correlation between equity and FIS, making
bond portfolios an excellent tool for diversifying risk. There is only a 0.08
correlation between the two over a 20-year period ending 2010).
1. Passive Portfolio Strategies
Passive portfolio strategies try to earn the market (bond index) return rather than
beat the market return; but assess default and call risk while diversifying bond
holdings to match preferences.
Buy and Hold
 Buy a portfolio of bonds and hold them to maturity,

 Can be modified by trading into more desirable positions, but too much
modification may end up being active and not passive strategy.
Indexing
 Match performance of selected bond index,

 Performance analysis involves examining the tracking error for differences
between portfolio performance and index performance.
2. Active Management Strategies
The purpose of these strategies are to beat the market. Active management
strategies involve:
Interest-rate anticipation
There is an important relationship exists between bonds yields and inflation rates.
 Investors react to expectations about future inflation rather than current

actual inflation,
 Risky strategy relying on uncertain forecasts of future interest rates,
adjusting portfolio duration,
 Ladder strategy staggers maturities
 Barbell strategy splits funds between short duration and long duration
securities.
Valuation analysis
A form of fundamental analysis that selects bonds that are thought to be priced
below their estimated intrinsic value.
Credit analysis
Determines expected changes in default risk. When economies grow faster there is
a trend of upgrading credit ratings (both Government and private companies). Try
to predict rating changes and trade accordingly:
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 Buy bonds with expected upgrades,

 Sell bonds with expected downgrades.
Yield-spread analysis
Monitors the spread within and across sectors, bond ratings or industries. It is
important in terms of trading in anticipation of changing spreads.
Bond swaps
Involves selling one bond (S) and purchasing another (P) simultaneously.
Undertake swaps to increase current yield or YTM, take advantage of shifts in
interest rates or realignment of yield spreads, improve quality of portfolio or for
tax purposes.
 Pure yield pickup swap: swapping low-coupon bonds into higher coupon
bonds
 Substitution swap: swapping an identical bond for one that is currently
thought to be undervalued
 Tax swap: swap in order to manage tax liability (taxable and municipal
bonds)
 Swap strategies and market efficiency: bonds swaps by their nature suggest
market inefficiency
Active Global Bond Investing
An active approach to global fixed-income management must consider the

following three interrelated factors involving fundamental analysis:
1. The local economy in each country including the effects of domestic and
international demand,
2. The impact of total demand and domestic monetary policy on inflation and
interest rates,
3. The effect of the economy, inflation, and interest rates on the exchange rates
among countries.
Positions in foreign bonds are positions in both securities and currencies.
 In a passive strategy, the manager can hedge the risk exposure using
derivatives,
 In an active strategy, the manager can adjust the exposure to try to benefit
from expected changes in exchange rates.
Core-Plus Bond Management
A combination approach of passive and active bond management styles. A large

significant part of the portfolio is passively managed in one of two sectors:
(1) The U.S. aggregate sector, which includes mortgage-backed and asset-
backed securities,
(2) The U.S. Government/ Corporate sector alone.
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The rest of the portfolio is actively managed:
 Often focused on high yield bonds, foreign bonds, emerging market debt.
Matched-Funding Techniques
Used to protect a bond portfolio against interest rate risk. Must balance the
components of interest rate risk so that risk and reinvestment risk cancel each
other.
 Price risk: problem with rising interest rates

 Reinvestment risk: problem with falling interest rates (if it is a zero-
coupon bond portfolio there is zero reinvestment risk).
An investor can immunize a portfolio from interest rate risk by keeping the
modified duration of the portfolio equal to the investment horizon. Duration
considers both sources of interest rate risk.
Dedicated Portfolios
1. Dedication with exact cash match: This is a conservative strategy

matching portfolio cash flows to needs for cash. Reinvestment of prior
receipts may not occur.
2. Dedication with reinvestment: Does not require exact cash flow match
with liability stream and cash inflows that precede liability can be
reinvested at a reasonable conservative interest rate.
3. Horizon match: Project of bond performance over investment horizon

given reinvestment rates and future yield assumptions. It is a combination
of cash-matching (passive) and immunization (active).
Contingent Procedures
The contingent immunisation strategy encompasses the opportunity for bond

portfolio manager to engage in various active portfolio strategies if the client is
willing to accept a floor return (and ending-wealth value) that is below what is
currently available (“structured active management”).
Heading 9B: Evaluation of Portfolio Performance
Regardless of the style of management, it is important to evaluate whether

portfolio results match the goals of the portfolio managers. Three questions in
measuring portfolio performance:
1. Is the return after all expenses adequate compensation for the risk?
2. How much risk did the portfolio manager take in creating and managing
the portfolio?
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3. What return should have been earned, given the risk taken and the
alternative returns available on other investments over the same period?
Portfolio Performance Measures
Sharpe Portfolio Performance Measure
The Sharpe ratio is based on the Capital Market Line (CML) and considers the total
risk of the portfolio being evaluated:
R port −RFR
or S=( )
σ port
The Sharpe Ratio shows the risk premium earned over the risk free rate per unit of
total risk. Sharpe ratios greater than the ratio for the market portfolio indicate
superior performance.
Treynor Portfolio Performance Measure
Based on the CAPM (or SML), the Treynor considers the risk that cannot be
diversified, systematic risk.
R port −RFR
or T =( )
β port
The Treynor ratio shows the risk premium earned over the risk free rate per unit of
systematic risk. Treynor ratios greater than the market risk premium indicate
superior performance.
Extended Portfolio Performance Evaluations
Fama (1972) suggested overall performance, in excess of the risk-free rate,

consists of two components:
Overall Performance = Excess return = Portfolio Risk + Selectivity
The selectivity component represents the portion of the portfolio’s actual return
beyond that available to an unmanaged portfolio with identical systematic risk and
is used to assess the manager’s investment prowess.
The return due to selectivity can be measured as follows:
Selectivity=R a−R x ( β a)
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Where:
 Ra = actual return on the portfolio being evaluated

 R x ( β a) = return on the combination of the riskless asset and the market
portfolio that has risk β x equal to β a
R x =RFR+
[ R m−RFR
σ ( Rm )
βx
]
Evaluating Diversification
The gross selectivity component can be broken into two parts:
 Net selectivity
 Diversification
Where:
 R x (σ (R a)) = the return on the combination of the riskless asset and the
market portfolio that has return volatility equivalent to that of the portfolio
being evaluated.
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Heading 10A: Fundamental Analysis
Fundamental analysis is concerned with the calculation of the estimated (or

intrinsic) value (EV) of an investment by examining variables such as current and
future earnings, interest rates, expected inflation and other variables.
At its base level, fundamental analysis deals with individual company data, such as
earnings growth, dividends, retention ratios and the investor’s required rate of
return:
 DDM,
 P/E Ratios,
 Dividend yield,
 Earnings yield etc.
Estimates of these variables are significantly influenced by other areas of the

economy, markets and the industry.
Fundamental analysis involves a three-level process:
Both top-down and bottom-up analysis can be implemented by either

fundamentalists or technicians.
First Level – Analysis of the Economy or Market
Security markets reflect what is going on in an economy. Analysis of economic or

market variables can shine light on expected cash flow trends, interest rate trends
and risk premium analysis.
The top-down approach is regularly advocated as compared to the bottom-up

approach.
The macroeconomic framework of the domestic economy is equal to:
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GDP=C+ I +G+( EX−ℑ)
Where consumption expenditure (C) represents 65% of GDP or nominal income.

Macroeconomic policy is centred around fiscal and monetary policy.
Macroeconomic Policies Affecting Corporate Earnings
 The corporate tax rate (Fiscal)

 Changes in government expenditure (Fiscal)
 Changes in nominal money supply that affect interest rates (Monetary)
 Consumer and investor sentiments (Fiscal & Monetary)
 Overall potential output, i.e. GDP (Fiscal & Monetary)
Monetary Policy – Reading Yield Curves
Monetary policy shows the relationship between market yields and time to
maturity, holding all other characteristics, like credit risk, constant.
 An upward sloping and steepening curve implies accelerating economic

activity,
 Flat structure implies a slowing economy,
 Inverted curve may imply a recession,
 Actions of the central bank: expectations are important.
International Global Economy
The international economy influences the domestic

economy through the exchange rate which is
influenced by differences in interest rates, inflation
rates and GDP growth between countries.
To benefit from market timing, forecasting the

market by analysis and importantly forecasting of
general economic factors e.g. the business cycle is
necessary. This involves considering the business
cycle (from troughs to peaks and back to troughs)
before they occur.
Cyclical Approach to Forecasting
This involves an estimation of the turning points in the business cycle and thus a
more robust prediction of stock price direction.
There are three types of indicators to help forecast the business cycle:
 Leading Indicators: Anticipate the trends in the level of economic activity,

e.g. the All Ordinaries Index, new business formations, new building permits,
orders for plant and equipment.
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 Coincident Indicators: Occur contemporaneously with the level of

economic activity, e.g. the number of employees on non-agricultural
payrolls.
 Lagging Indicators: These adjust after changes in the level of economic

activity, e.g. the average duration of employment and consumer debt.
V Analytical measures of performance are known as diffusion indexes, which

indicate how pervasive a given movement is in data series:
V
 Trends
 Rates of change
 Direction of change
 Comparison with previous cycles
V
V Why is analysis of the economy (market) important? Because, if the market goes
up strongly, then most investors make money. Further, the market index is used to
calculate betas.
V
Empirical evidence: the market (incorporating systemic risk) is the largest single
factor explaining fluctuations in individual stocks and portfolios of stocks.
 For a diversified portfolio, 90% of return variability is due to the market
Australian Market Environment
The most quoted measure of market performance is the All Ordinaries Index (AOI),
which is the S&P/ASX500 in Australia. The S&P/ASX500 reflects daily changes in
share prices (capital gain or loss), but dividends are not taken directly into account.
The AOI has two popular sub-versions, which are:
 S&P/ASX200, and
 S&P/ASX300.
Using the earnings multiplier model, the value of the aggregate market index (AOI)
or any other index can be obtained:
Pi D 1 / E1
=
E1 k −g
Dividends Payable Next Period ( Payout Ratio)

Value of AOI today ¿ ¿
Required Rate of Return−Expected DividendGrowth ¿
Value of AOI Today = Estimated Earnings on the Index X Estimated P/E Ratio on
the Index
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 Estimated Earnings on the index: Company profits after taxes for all
listed companies in the index – determined by expected GDP growth rate for
the whole economy.
 Estimated P/E ratio on the index: Actual P/E rations (in general
inversely related to level of interest rates in the economy) are published by
RBA.
Second Level – Sector/ Industry Analysis
An industry is a set of businesses producing similar products. To obtain good

returns, promising sectors of the economy must be identified.
USA: The USA use old Standard Industrial Classification (SIC) and new North
American Industry Classifications (NAICS).
Australia has two sources of Australian industry classification:
1. Australian Stock Exchange industry segmentation: sectoral indices for

banking, mining, retailing, etc.
2. Australian Standard for Industry Classification (ASIC).
These old classifications were used until 8 July 2002. On that day, the Global
Industry Classification System (GICS) prepared by Standard and Poors (S&P)
replaced the ASX industry segmentation indices.
Stocks in different industries perform differently in the business cycle. There are
two components of industry analysis:
(i) macro-analysis of industry, and

(ii) micro-valuation of the industry.
Macro-Analysis: Focussed on inflation, interest rates, international economics,

consumer/ investor sentiments, social influences, technology and politics and
regulations.
Every industry has its unique characteristics and usually follows some form of life
cycle. The life cycle (five-stage model) allows analysts to estimate potential sales
growth for the industry.
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1. Step One – Pioneering Stage: Gradual growth in demand, sales and

earnings for some companies. There is tough competition and firms battle
for survival.
Highest potential returns; but investment risk is high, it is difficult to screen

out survivors.
2. Step Two – Expansion Stage: Expansion involves rapid growth and

mature growth stages combined (2&3). Here it is easier to identify the
survivors.
 Orderly growth continues at a more rapid rate.

 Firms are more stable and tend to improve their products, reduce
costs and lower prices.
 Investors interested in capital gains should avoid maturity stage.
3. Step Three – Stabilising Stage: Less growth and sales increase at a lower
rate; more product standardisation while competition is fierce.
4. Step Four – Declining Stage: Profit margins continue to be squeezed and

some firms experience losses.
Unique Characteristics of Industries
 Growth Industries: Earnings are expected to exceed the average of all

industries, e.g. cellular phones.
 Defensive Industries: Those least effected by recessions and economic

adversity, e.g. food.
 Cyclical Industries: Are most volatile and usually do well in a boom –

worse than average in a recession, e.g. durable goods.
 Counter Cyclical Industries: Move opposite to the prevailing economic

trend, e.g. gold mining industry.
 Interest Sensitive Industries: Highly sensitive to expected changes in

interest rates, e.g. banking.
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Preparing an industry analysis: RBS, (pg. 471-473)
Third Level – Company Analysis
The final level of analysis concentrates mostly on company financial statement

data published. It may also use more timely news announcements, i.e. financial
press and analysts’ reports etc.
Return on Equity (ROE) equation incorporates the DuPont System:
Net Income Net Income Net Sales Total Assets

= × ×
Common Equity Net Sales Total Assets Common E quity
An Extended DuPont System
Another perspective on ROE – depends on the product of the following:
EBIT
1. Profit margin on sales -
Sales
Sales
2. Total asset turnover -
Total Assets
Pretax ncome
3. Interest burden –
EBIT
Total Assets
4. Financial leverage –
Equity
Net Income
5. Tax burden –
Pre−Tax Income
ROE = EBIT efficiency x Asset turnover x Interest burden x Leverage x Tax burden
Estimating Internal Growth Rate
EPS 1=EPS0 (1+ g)
This equation measures the future expected growth rate, which matters in
estimating earnings and dividends:
g=ROE ×(1−Payout ratio)
The PEG ratio is the P/E ration divided by g.
 A fair valuation implies that PEG ratio – 1.

 If the PEG ratio is < 1 it implies the stock is undervalued.
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It is also essential to analyse the quality and integrity of management of the

particular company: a better run company should present itself as a less risky
investment.
Growth vs Value Stocks
 Growth stocks: Generate higher rates of return than other stocks in the
market with similar characteristics.
 Value stocks: Appear undervalued for reasons other than earnings growth
potential and have low P/E ratios for low price-to-book ratios.
Heading 10B: Technical Analysis
Technical analysis is a methodology of forecasting fluctuations in the prices of

securities whether individually or market as an aggregate.
Important Features
1. Based on published (historical) market (price and volume) data,

challenging the EMH.
2. Emphasis is on market timing and likely turning points.
3. Concentrates more on short-term movements.
Technical analysts restrict their information to the set of past prices (volumes) to
predict future prices (volumes).
In general, technical analysts use technical indicators, technical trading rules and
charts.
Contrary Opinion Rules
Using technical trading rules, trade against the crowd (who supposedly always
lose).
1. Mutual Fund Cash Positions

 Liquidity (ratio of cash plus Treasury bills to total fund assets) >
12% or 13% is bullish, while liquidity = 7% or 8% is bearish. Take
opinion contrary to that of mutual funds.
2. Credit Balances in Brokerage Accounts

 Build up of credit balances viewed as bullish and decline in credit
balances is bearish.
3. Investment Advisory Opinions

 If 60% of opinions are bearish (signals market trough), contrarians
take it as a bullish indicator.
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4. OTC (NASDAQ) Volumes versus NYSE Volumes

 Ratio of trading volumes in the two markets (NASDAQ and NYSE) is
used as a measure of speculative activity.
 Speculative trading peaks with the market peak.
 Higher ratio is bearish while lower ratio is bullish
5. CBOE Put/ Call Ratio

 This ratio (number of put options/ number of call options) used as a
new tool and a ratio above 50% is considered bullish.
6. Futures Traders Bullish on Stock Index Futures

 A bearish sign may be when more than 70% of the speculators are
bullish (based on surveys of individual futures traders).
7. Short-Interest Ration (SIR)

 Short-selling is the sale of a financial asset (not owned now) to take
advantage of its expected price decline.
 Short interest for a security is the number of shares that have been
sold short but not yet bought back.
 SIR = Total shares sold short/ Average daily trading volume.
 A high SIR is a bullish sign since short-sellers must repurchase later
putting upward pressure on prices then.
8. A Reputed Technical Trading Rule is ‘Filter Rule’

 Filter-rule: a trading breakpoint (price increase/ decline of greater
than 10%) for a share or a market index when buying/ selling takes
place.
Technical Indicators (Not Contrarian Strategies)
1. Advance-Decline Line
The ADL measures the breadth of the market. It involves subtracting the number of
shares declining in price from those advancing in price on a cumulative basis and
then comparing the resulting line with the All Ordinaries Index (AOI) on a daily
basis.
In a bull market, if the AOI rises while the advance-decline line declines, it signals
an expected market decline.
2. Moving Averages
Calculate 10-week or 30-week or 200-day moving average and compare with

current market rice to identify a buy or sell signal.
3. New highs and lows
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52-week high and low prices for each share are calculated and observe whether a
substantial number of shares rise (bullish) or decline (bearish) in price.
4. Volume – High volumes are bullish.
Charting
Charting of price patterns is one of the classic techniques of technical analysis.
 Support level – Significant increase in demand is expected (after profit-

taking = generally selling securities to make a profit).
 Resistance level – Significant decrease in demand is expected (with

profit-taking).
 Treadline – Identifies a trend or direction.
 Momentum – Speed of price changes.
The relative strength: ratio of a stock’s price to a market index –
 A rising ratio shows that the stock is outperforming the market and will
continue to do so.
Other aspects of charting involves bar charting, multiple indicator charts and
point-and-figure charts.
Stock Price and Volume Techniques ‘The Dow Theory’
Based on three types of price movements:
 Primary move: A broad market movement that lasts several years.

 Secondary moves: Occurring within primary move.
 Day-to-day moves: Occurring randomly around primary and secondary
moves.
Bull market occurs when successive rallies fail to penetrate previous highs.
Bear market occurs when successive rallies fail to penetrate previous highs.
 Declines penetrate previous lows
Secondary moves called technical corrections.

 Day-to-day “ripples” (of minor importance).
Advantages and Disadvantages of Technical Analysis
Advantages
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 Major advantage (often claimed by the supporters) but little use made of
financial statement data.
 Flexibility available to management in the preparation of financial
statements.
Disadvantages
 Support is severely impeded by the implications of the efficient market

hypothesis.
 The market is at least semi-strong form efficient: no need for technical
analysis.
Technical Analysis in Practice
 Lack of empirical evidence for the existence of patterns in the (historical)

security price data (weak-form efficiency).
 Success of a trading technique will encourage competition, which will
eventually erode the value of the trading rule.
 All of the rules or techniques use a great deal of subjective judgment rather
than statistical methodology.
 Two technical analysts, both using the same data source, can arrive
at widely different interpretations and investment decisions.
 Technical analysis is used in bond markets also.
Heading 11A: Capital Market Efficiency and Behavioural Finance
Capital Market Efficiency
Fama (1970, 1991) stated that in an efficient market, the current market price
reflects all available information about a security and the expected return based
upon this price is consistent with its risk (known as Fair Game Model).
In an efficient capital market, security prices adjust rapidly to the arrival of new
information, therefore the current unbiased prices reflect all information about the
security.
 In an efficient market securities are in equilibrium in that prices equal their

underlying economic values (market participants can make only ‘normal
profits’, no arbitrage opportunities since no ‘surprise’ exists) on the security
market line (SML).
EMH implies that investors are:
 Rational,
 Profit maximising price-takers, and
 Cannot earn excess profits or abnormal returns by using available
information (positive dividends – above expected, and negative dividends –
below expected are types of surprises).
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If the market reaction is not immediately responsive and not unbiased then semi-
strong/ weak forms of EMH exist.
Identification of Over-Priced and Under-Priced Securities: Is Price = Value?
Basic principle in finance: There is an inverse relationship between estimated

return and price (value).
Fama’s Three Types of Market Efficiency
1. Weak Form Efficiency
Weak form efficiency is where all information contained in the historical

prices (returns) and volume data of a security is fully reflected in its current
price.
 Thus, historical prices and volume data are of no value to predict

future price changes (random walk hypothesis).
 Successive price changes are independent and random –
independence between the past, the present and future prices.
2. Semi-Strong Form Efficiency
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Semi-strong form implies that all publicly available information is fully

reflected in a security’s market price (prices, earnings announcements, new
product developments, financial difficulties etc.).
3. Strong Form Efficiency
Implies that all information, whether public or private, is fully reflected in a

security’s price and there is no inside information (no insider trading).
 Investors receive only normal returns on all points shown on the SML
(no surprises).
 Even insider trading information will not result abnormal returns.
Each successive classification in EMH is cumulative and the strong form

encompasses both the other two forms.
Testing Market Efficiency
Empirical Tests on Weak Form
Empirical tests are designed to detect the presence of independence between prices
or rates of return (price patterns), which are essentially tests of random walk
hypothesis.
(i) Serial Correlation Tests
Measures the correlation between successive price changes – these test

results have provided mixed results but most of them support weak form
EMS.
(ii) Runs Tests
Examine the sign of price changes, then compare actual to expected,

supporting weak form EMS.
(iii) Filter Rules
Use the assumption once a price has changed by a given %, then it will
continue to move in the same direction.
Empirical Tests on Semi-Strong Form
(i) Return Prediction Studies
a. Times Series Tests: Attempt to determine whether any public

information such as dividend yield or term structure of interest rates
(yield curves) can be used to estimate future returns for stocks and
bonds.
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 Prediction of long-horizon (1-5 years) returns was quite possible but

short-horizon (1-6 months) was not easy.
b. Other Time Series Studies: Use quarterly earnings reports and generate
standardised unexpected earnings (SUE) and found that earnings
surprise contained in SUE is not immediately reflected in security prices
(does not support semi-strong form EMH).
c. Cross-Sectional: Cross-sectional returns using price earnings ratios, size

(total market value) and book value and market value ratios.
Note: If the market is efficient, the price of a company cannot be predicted.
(ii) Event Studies
Measure the presence of abnormal returns around the time of an

information announcement.
 The abnormal rate of return (AR) is the actual return less the
expected market return (ARit) = Rit – RMt.
 In practice (ARit) = Rit – E(Rit), where cumulative abnormal return is
the sum of ARit and E(Rit) =  + βRmt – eit.
o This is the ‘Market or Single Index Model.
These studies provide some support for semi-strong form EMH.
Empirical Tests on Strong Form
(i) Tests
Examine the performance of a specific group of investors (with access to

true non-public information) in different identifiable investor groups (result
of inside/ outsider problem.
 Tests performance of groups which have access to non-public

information (insiders),
 Corporate insiders (namely directors, executive officers and major
shareholders of companies), security analysts and professional
money managers have valuable private information,
 Evidence exists that many have consistently earned abnormal
returns on their stock transactions (which is a violation of strong
form EMH), i.e. Rivkin who committed insider trading.
There is a regulatory requirement that insider transactions must be publicly

reported.
Conclusion – Markets are efficient but not totally.
Market Anomalies
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A lot of evidence supports the EMH but a growing number shows exceptions or
market anomalies.
1. Earnings Announcements
Earnings announcements affect stock prices. An adjustment occurs before

announcement but more significantly after. Announcements are contrary to
efficient market theorem since lags should not exist.
2. Low P/E Ratio Stocks
Low P/E ratio stocks tend to outperform high P/E stocks.
 Low P/E stocks generally have higher risk-adjusted returns,

 But P/E ratios are public information, if they do have higher returns
the market is weak form inefficient
3. Size Effect
There is a tendency for small firms to have higher risk-adjusted returns than
large firms, compensated for illiquidity resulting from thin trading.
4. January Effect
Tendency for small firm stock returns to be higher in January. Of 30.5% size
premium, half of the effect occurs in January.
5. Value Line Ranking System
Advisory service that ranks 1700 stocks from best (1) to worst (2). Group 1
stocks had annualised return of 9.3%.
Conclusion – Markets are quite efficient but market anomalies exist.
Behavioural Finance
Behavioural finance is concerned with the analysis of various psychological traits

of individuals and how these traits affect the manner in which they act as investors,
analysts and portfolio managers. The emphasis is on identifying anomalies
attributable to various psychological traits.
The three “Tributaries”:
 Psychology
 Social psychology
 Neurofinance
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The overreaction diagram above is an example of Thaler’s ‘overreaction

hypothesis’, which looked at irrationality.
Behavioural finance has been useful for explaining various “anomalies” that we
observe in decision-making that are difficult to reconcile with rationality. There
may be trading opportunities created by persistent investor biases (irrationality)
and “herd mentality”.
Explaining Biases
Prospect Theory (Kahneman and Tversky 1972, 1979)
 Contends that utility depends on deviations from moving reference point

rather than absolute wealth.
Overconfidence (Confirmation Bias)
 Look for information that supports their prior opinions and decision.
Noise Traders
 Influenced strongly by sentiment, they tend to move together, which

increases the prices and the volatility.
Escalation Bias
 Put more money into a bad investment.
Fusion Investing
The integration of two elements of investment valuation-fundamental value and

investor sentiment. During some periods, investor sentiment is rather muted and
noise traders are inactive, so that fundamental valuation dominates market
returns.
In other periods, when investor sentiment is strong, noise traders are very active
and market returns are more heavily impacted by investor sentiments.
Efficient Markets and Technical Analysis
Assumptions of technical analysis directly oppose the notion of efficient markets.

Technicians believe that stock prices move in patterns that persist and are
predictable to the informed investor.
Technical analysts develop systems to detect trends and patterns in prices. If the
capital market is weak-form efficient, a trading system that depends on past
trading data can have no value.
Efficient Markets and Fundamental Analysis
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Fundamental analysis involves determining an investment’s intrinsic values based

on company and economic “fundamentals”. The intrinsic value is compared to the
market price to determine whether the investment is under-priced or over-priced.
In a semi-strong form efficient market, prices already reflect public information, so

determining “intrinsic value” using that information is not a worthwhile exercise.
 Superior analysts can do better in predicting uncertain future analysing

available information in a superior way by estimating precise future values
of securities.
Efficient Markets and Portfolio Management
Active Portfolio Management – Research indicates that most money managers

do keep pace with the market.
Superior Analysts – Opportunities may be present in smaller, neglected stocks

(although risk must be taken into account). Without superior analysts, passive
management may outperform active management.
Heading 11B: Chartered Financial Analyst (CFA) Institute Ethical and

Professional Standards
Ethics in Investments
Financial markets are vitally important to a well-functioning economy. As a result,

trust in information and faith in fairness are essential. Codes of ethics for financial
professionals and strict regulations attempt to create such an environment where
financial markets can efficiently fulfil their economic functions.
General Impositions of A Code of Ethics
1. Act properly i.e. with Integrity, Competence, Diligence, Respect and an

Ethical manner,
2. Maintain and Improve Competence,
3. Practice and encourage others to practice in an Ethical manner,
4. Exercise reasonable Care and independent professional Judgment,
5. Place integrity of profession and client interest before their own,
6. Promote the integrity of and uphold rules governing capital markets.
CFA Standards of Practice Handbook:
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What do you (as an investor) expect from a professional fund manager?
1. Help determine your investment objectives and develop a portfolio that is

consistent with them.
2. Diversify your portfolio to eliminate unsystematic risk.
3. Maintain your portfolio diversification and your desired risk class while
allowing flexibility so you could shift between alternative investment
instruments as desired.
4. Attempt to achieve a risk-adjusted performance level that is superior to that

of your relevant benchmark.
5. Administer the account, keep records of costs and transactions, provide

timely information for tax purposes, and reinvest dividends if desired.
6. Maintain ethical standards of behavior at all times.
Heading 12A: Fund Management in Practice
Money Management Industry Structure and Evolution – Two Organisation

Forms
1. Private Management Firms
Contract directly with a management and advisory firm.
 Relationship with client,

 Assets under management (add all accounts under investment),
 Separate accounts,
 Customised.
Private management and advisory firms are much smaller and focus on a
particular niche in the market.
Each client’s assets are held in separate accounts and the security portfolio
is likely to be guided by the firm’s overall investment philosophy.
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2. Investment (Fund) Company
Commingling (mix) of retail investment capital of several clients in an

investment company. When investors provide their money to fund
managers, they are issued ‘units’, which are the equivalent of shares in the
fund.
 Invest a pool of funds belonging to many individuals in a single

portfolio of securities.
 Issue new shares ‘units’ representing the proportional ownership of
the fund.
Differences Between the Two Forms
 Private management and advisory firms develop a personal relationship

with clients.
 An investment company offers a general solution.
Organisation and Management of Investment Companies
There are two main listed investment companies in Australia:
 The Australian Foundation Investment Company (AFIC), and

 ARGO Investments.
In order to take funds out of listed investment companies, the same process as
selling stock is taken. Holders must sell shares in the listed companies in the
secondary market (which exists because the companies are listed).
The major duties of these funds are:
 Investment research ($millions under management to do so),

 Management of the portfolio,
 Administrative duties, i.e. issue securities and handle redemptions an
dividends.
These fund companies are started with different characteristics to achieve

economies of scale.
Valuation of Investment Company Shares
The Net Asset Value (NAV) of an investment company is analogous to the share
price of a corporation’s common stock. The NAV of the fund shares will increase as
the value of the underlying assets (the fund security portfolio) increases.
The Fund NAV is equal to:
(Total Market Value of Fund Portfolio)−(Fund Expenses)

Total Fund Shares Outstanding
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Closed-End Versus Open-End Investment Companies
The difference here is in the way each operates after the initial public offering
(IPO).
Closed-End Investment Companies
 Stock trades on the secondary market like AFIC and ARGO in Australia
 The net asset value (NAV) is computed twice daily, but the market price is
determined by demand and supply.
 Many Funds sell at discounts to the NAV, otherwise known as at a premium
(discount).
Open-End Investment Companies
 Mutual funds (unlisted managed funds in Australia)

 Mutual fund managers sell and redeem (buy back) shares at NAV.
Load Versus No-Load Open-End Funds
‘Load’ relates to the fees imposed on a fund. The offering price for a share of a ‘load’
fund equals the NAV of the share plus a sale charge, which can range from 1%
upwards.
 A ‘no-load’ fund imposes no initial sales charge so it sells shares at the NAV.
Several variations exist between the full-load fund and the pure no-load fund Low-
load fund.
Fund Management Fees – Charge annual management fees to compensate

professional managers of the fund. Management fees are a major factor driving the
creation of new funds.
Investment Company Portfolio Objectives
There are four broad fund objective categories:
1. Common stock funds

2. Hybrid funds – a mix of stocks and bonds
3. Bond funds
4. Money market funds
Investing in Alternative Asset Classes
Alternative Assets
 Hedge funds
 Private equity
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 Real estate
 Natural resources and commodities
Management Structure
Structured as a limited partnership rather than as a mutual fund to manage the

commingled assets.
The Fund “alpha”
Alpha funds try to generate excess returns, implying superior performance by the
fund management.
1. Hedge Funds
Hedge fund industry has grown rapidly since early 2000.
 Involves forming a portfolio that combines both long and short

positions in the equity market with the use of financial leverage to
enhance return.
 Better able to produce superior returns than traditional investment
structures, such as mutual funds.
Hedge Fund Strategies
 Equity-based Strategies
o Long-short equity
o Equity market neutral
 Arbitrage-based Strategies
o Fixed-income arbitrage
o Convertible arbitrage
o Merger (risk) arbitrage
 Opportunistic Strategies
o High yield and distressed
o Global macro
o Managed futures
o Special situations
 Multiple Strategies
o Fund of funds – create mutual fund that includes multiple hedge
funds
Risk Arbitrage Investing
Take equity positions in companies that are the target of a merger or takeover
attempt. It requires managers to compare their own subjective judgment about the
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success o the proposed takeover with the success probability implied by the market
price of the target firm’s stock following the announcement of the prospective deal.
If the manager thinks the takeover is more likely to occur than the market does, he
or she will buy the target firm’s shares.
The manager might short sell the target firm shares if he or she thinks the proposed
deal is less likely to be completed.
Hedge Fund Performance and Private Equity
Not all hedge funds are the same when it comes to their risk and return profiles.
The returns to these strategies show a high degree of variability on a year-to-year
basis, in both an absolute and a relative sense.
Private Equity
Organised private equity investing began in the United States back in 1946. There
are three sub-categories to private equity (RBS, 914-915):
1. Venture capital
(i) Seed,
(ii) Early stage
(iii) Later stage
2. Buyouts
3. Special Situations
(i) Distressed Debt
(ii) Mezzanine Financing
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INVESTMENTS & PORTFOLIO MANAGEMENT AFF3121

Heading 1: Introduction to Investments

Investment has been defined in RBS, p.4 as:

(1) the time the funds are committed,

The cost of deferring current

The Investment Process – a Two Stage Process

1. Security Analysis: Detection of undervalued securities (assets).

2. Portfolio Management: Combining and managing individuals securities to

The Tradeoff Between Expected Return and Risk

 Investors are (typically risk averse and rational)

 Any level of expected or required (nominal) return

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This is the minimum expected rate of return necessary to induce an investor to

1. Pure or Real Risk Free Interest Rate (Real

 Real risk free rate (the exchange rate

2. Inflation Protection (Expected Inflation = EI) during investment:

 Risk Premium (RP): Investors need sufficient expected additional

Individual vs. Institutional Investors

Institutional Investors Individual Investors

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Protection for Individual Investor Risk

 Life Insurance: Providing death benefits and, possibly, additional cash

Individual Investor Life Cycle

Life Cycle Approach

There are different positions of risk/ return taken by an

A. Accumulation phase – early career

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B. Consolidation phase mid-to late career

 Early to middle years of careers where attempts are made to satisfy

 Past career midpoint

 Usually begins at retirement

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 Can be concurrent with spending phase

The Portfolio Management Process

The portfolio management process has four

1. Construct a policy statement

Formulate Investment Policy

 Time horizon – Objectives may require specific planning horizon

Possible broad goals include:

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Legal and Regulatory Requirements

The Prudent Man Rule:

 Followed in fiduciary responsibility

Investment laws prohibit insider trade. Further, Employee Retirement Income

Capital Market Expectations

Rate of return assumptions must be realistic and historical returns should be

Rate of Return Assumptions

How much influence should recent stock market returns have?

 Reversion to the mean arguments

Constructing the Portfolio

Use investment policy and capital market expectations to choose a portfolio of

 Differences in allocation cause differences in portfolio performance.

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Four decisions in an investment strategy:

1. What asset classes should be considered?

Monitoring Conditions and Circumstances

Investor circumstances can change for several reasons:

 Wealth changes affect risk tolerance

 Portfolios are not intended to stay fixed

Performance measurement allows for analysis of the success of portfolio

“The Financial System and its Workings” Notes (Ch 1, Viney)