Topic 0: Intro Treasuries: Bills (Maturity under a year), Notes prevent speculative stock price declines and portfolio
event speculative stock price declines and
Four Axioms of Finance: 1. Investors prefer
more to less 2. Investors are risk averse
(IMPORTANT FOR INVESTOR PREFERENCES)
3. Money paid in the future is worth more than the
same amount today 4. Fin. markets are
competitive, no arbitrage
Arbitrage Opportunity: Possibility of making
money from no money (e.g. borrowing at a risk
free rate and buying a risk-free asset with a higher
rate of return)
Relevant Statistics
Random Variable: Value representing outcome
of an uncertain event. Discreet (e.g. coin flip) or
Continuous (e.g. weight, returns)
Distribution: Likelihood of each possible event
(e.g. 50% heads, 50% tails for a discreet outcome,
normal distribution for continuous outcome).
Normal dist.: 68% within 1 SD, 95% within 2 SD
Expected Value (E[Ri]): Avg outcome if an
event is repeated infinitely often. Probability-
weighted avg of possible outcomes; p(s) =
probability of event s happening
Variance (σ2ι): How much a variable fluctuates
around its mean
Standard Deviation (σi): Sqrt of variance.
ALSO KNOWN AS VOLATILITY
Covariance(Cov[Ri,Rj]): Avg. Of the products of
their deviations from the mean. Positive if the two
random variables tend to be unusually high at the
same time, negative if one variable tends to be
high when the other is low. The covariance of
something with itself is its variance.
Solving for CAPM covariance:
Correlation(ρij): Always between -1 and +1
To estimate mean, variance and covariance from
historical data, use sample counterparts of their
definitions:
Portfolio: Combination of N assets, with returns
R1, R2,...,RN
Portfolio P has portfolio weights (percentage of
wealth invested in asset i) of w1...wN. These
weights sum to 1; A negative weight indicates a
short position on an asset
Portfolio return is the sum of each asset’s return
multiplied by its corresponding portfolio weight;
Expected portfolio return substitutes E[R] for R
Portfolio Variance for Two Securities:
Recall: ρ12•σ2•σ2 = covariance(R1,R2)
Portfolio Variance for N Securities:
Topic 1A: Financial Instruments
Real Assets: Assets used to produce goods and
services (PPE, human capital, etc.)
Financial Assets: Claims on real assets (stocks,
bonds, derivatives, etc.)
Diversification: Investing across multiple assets
(instead of one) to reduce risk
Hedging: Taking an offsetting position in fin mkts
to offset given risk
FIXED INCOME SECURITIES: Bonds and
borrowing instruments (e.g. treasuries) with FIXED
cash flows (e.g. coupons or interest payments).
Must be valued using a time value of money (TVM)
adjustment. Payment schedule for $1k, 10 yr, 8%
semi annual coupon bond:
portfolio (MVP): Portfolios that provide the
(1-10 yr maturity), Bonds (10-30 yr maturity) w/
semi annual coupon payments
Municipal Bonds: Bonds issued by state & local
govts, exempt from federal income tax & state
taxes in issuing states (T bills are not exempt
from state taxes). General Obligation Bonds are
backed by taxation power of the municipality, while
Revenue Bonds are issued to finance specific
projects (e.g. airports) and are riskier.
Commercial paper: Short term corp loan
agreement (30-90 days)
Corporate Bonds: Longer term, typically semi
annual coupons, “senior” and “junior” classes of
payout order in case of default
EQUITY (STOCK): Ownership in a firm. Dividends
are uncertain, indefinite maturity, risky with variable
liquidity. Valuation: TVM + RISK ADJUSTMENT
Common Stock: Voting Rights (JR)
Preferred Stock: Non-Voting (SR)
Bankruptcy Payout Order: 1. Govt (IRS) 2.
Employees (Wages) 3. Senior Bondholders 4. Junior
Bondholders 5. Pref Stockholders 6. Com stockholders
Derivatives: Securities whose cash flows depend on
the values of other financial assets, valued at TVM +
risk + option adjustment. (e.g. options, futures)
Call Option: Right to buy the underlying asset at a
specified price (Strike Price) on a specified date
(Maturity) Put Option: Right to sell the underlying
asset…
Long Future: Obligation to buy the underlying
asset… Short Future: Obligation to sell the
underlying asset… (Two kinds of futures: Commodities
or financial)
Mutual Fund: Financial intermediary that pools
investor funds to buy assets. Offer record
keeping/administration, diversification and divisibility,
professional management, and lower transaction
costs. Compete with ETFs (which trade all day)
Asset-Backed Securities: Bundling of existing
securities (mortgages, corporate bonds, credit card
receivables), an example of Securitization
Securitization: Creating a security out of an asset
that was previously untraded
Topic 1B: Financial Markets
Equilibrium Price: Price at which the supply and
demand for something are equivalent
Primary Mkt: Market for new issues of securities.
Govt securities typically auctioned, corporate securities
typically underwritten by inv. Banks. Uniform Price
Sealed Bid Auctions > Multiple Price SBAs; people bid
lower when they know they’re paying what they bid.
Underwriters: Syndicate of investment banks.
Purchase securities from issuing company and resell to
public Firm Commitment = Deliverable Contract,
Best Effort = implicit
Bookbuilding: Draw of investors committing to buy
Preliminary Prospectus (“Red Herring”) becomes
prospectus after SEC approval which the IBs help with
Secondary Mkt: Market for already existing
securities. Investors generally trade through brokers;
they allow investors to trade without taking a position
themselves. Guarantee counterparty that investor can
pay for a security or deliver it
3 Means of Broker Trade: Exchanges (NYSE), Over
the Counter Markets (which trade with dealers)
(NASDAQ) and Electronic Communication Networks
(Direct trade among investors)
Call Auction: All investors get together at a fixed
time, orders are aggregated into S & D curves, and an
equilibrium price is chosen (e.g. eBay, NYSE opening,
Sotheby’s)
Continuous Auction: Investors want to trade
immediately on new information and for liquidity
reasons. Order flow is fragmented and the price
bounces around the equilibrium price; being a dealer
becomes profitable
Ask Price: Dealer sell, investor buy price
Bid Price: Dealer buy, investor sell price
Dealer is a market maker; holds inventory. In
exchange for the immediacy and liquidity he provides,
he takes a profit off of his bid ask spread
Limit Order: Buy x shares if price falls to P, sell x
shares if price rises to P
Market Order: Buy/sell x shares at current price
Stop-Loss/Stop-Buy Order: Sell if price falls to P,
Buy if price rises to P
Determinants of the B-A Spread: Volume of trade
(high volume => narrower spread), Volatility of
equilibrium price (High volatility => Wider Spread)
and competition between market makers (aka dealers)
(More competition => Narrower spread)
Trading Costs: Explicit cost (commission to
broker), Implicit cost (B-A Spread), Implicit cost
for large orders (market impact; deep market =
small market impact, thin market = big market
impact)
Short Sale: Sell something by borrowing it then
later replacing it; profit comes if the price of the
security drops. Bearish/hedge investment. Three
requirements: Short sale proceeds must remain
with broker, investor must deposit collateral (post
margin) as a guarantee to pay if price rises, and
short selling is subject to the Uptick Rule: Short
can only be initiated after an uptick ($1/16) to
reduce volatility. For a short sale, the bank profit
is a fee. The investor profit is the initial price
minus the final price minus the fee minus
dividends paid out while the stock was borrowed
(P0 – P1 – FEE – Dividends)
In 2007, SEC abolished it because the price
should reflect both positive and negative views,
and the rule was easy to circumvent. 2010:
Uptick rule instated for stocks that have fallen
10% or more in a day
Topic 2A: Time Value of Money
FV = Future Value, PV = Present Value, R =
Yield: FV = PV • (1 + R)T
Discount Factor (PV Factor): 1/(1+R)T
Yield to Maturity: R for a bond over multiple
periods
Zero Coupon Bonds: Implicit. Issued in primary
markets (T bonds), or financially engineered by
“stripping” coupon bonds.
Think of multiple payment bonds as an
amalgamation of single payments of different
amounts, all using the FV formula.
Annuity: Pays a fixed cash flow C for T periods.
PV = C • PV Factor
PV Factor =
Perpetuity: Pays a fixed cash flow C every
period for ever (ie. T = ∞). Example: Consol
bond. PV = C/R
THE RELATIONSHIP BETWEEN INTEREST
RATE AND PRICE IS NEGATIVE
Federal Funds Rate: Rate that commercial
banks charge on overnight loans among
themselves. Set by the Federal Open Market
Committee (FOMC) which in turn is chaired by
Janet Yellen. Stock market rallies generally after
unexpected rate cut announcements.
Topic 2B: Return Measures
Effective Annual Rate (EAR): A way to
calculate total interest over a year given that
interest is compounded m times per year.
EAR = (1 + Quoted Rate / m)m – 1
EAR (Continuous Compounding):
EARContCom = eQuoted Rate – 1
Annual Compounding, T years:
FV = PV • (1 + R)T
Continuously Compounding, T years:
FV = PV • eR•T
Annual Percentage Rate (APR): Quoted rate.
Lenders are required by law to report it.
APR = Interest Per Period • # of Periods per
Year
Annual Holding Period Return (ann.HPR):
At time 0, you buy an investment for V(0) = PV.
You reinvest all intermediate cash flows until date
T. At time T, you sell the investment and the
reinvested cash flows for a total price of V(T) =
FV
Holding Period Return (HPR):
HPR = (Ending Price + Cash
Dividend)/Beginning Price – 1
V(T) = Ending Price + Cash Dividend
V(0) = Beginning Price; Therefore:
ann.HPR = (1 + HPR)1/T – 1
For T in the ann.HPR equation, T should always
be in terms of years; semi annual means T = 0.5
Mult Period Realized Rtns, Arithmetic Avg:
1/T(r1 + r2 + r3 + … + rT)
Used for forecasting return next period. NOT
equivalent per period return
MPRR, Geometric Avg:
Gives equivalent per period return
MPRR, Internal Rate of Return (IRR):
C(t): Fixed cash flow at period t.
Dollar-weighted average return; return if one can
reinvest cash flows at this rate
Topic 3: Portfolio Choice w/ 2 Risky Assets
Investment Opportunity Set: All available
risk-return combinations
Efficient Portfolio: Port. w/ highest possible E[R]
for a given σ Efficient Frontier: Set of efficient
portfolios, upper portion of the minimum variance
frontier starting at the minimum variance
lowest variacne among all possible portfolios of
risky assets (vertex of the efficient frontier)
If a two-asset portfolio is on the efficient
frontier, adjusting the weights will cause both
returns and standard deviation to move in the
same direction. If it is not, they will move in
opposite directions.
Perfect Positive Correlation: ρ12 = 1. Only
case with no gains from diversification
Perfect Negative Correlation: ρ12 = -1. Gains
from diversification are maximal; Able to create a
risk free portfolio. As ρ12 = 1 goes from 1 to -1,
gains from diversification rise (and the arc of the
efficient frontier widens)
Investor Preferences
Any mean variance investor should choose an
efficient portfolio to benefit from diversification.
The optimal portfolio along the efficient
frontier depends on the investor’s preferences, in
particular their risk aversion
Mean-variance investors want higher E[Ri] and
lower σi, and will trade off risk and return to
maximize expected utility.
Indifference Curve: graph of all combinations
of two things (e.g. goods, securities) that offer
the same utility level U0 = U(E[RP], σP). People
like being on the HIGHEST POSSIBLE
INDIFFERENCE CURVE (people prefer more to
less). The more vertical an investor’s set of
indifference curves, the more risk averse
they are (slope of ICs = risk aversion). A risk
neutral investor has totally vertical indifference
curves
Mean-Variance Utility Equation:
U(RP) = E(RP) – 0.5•A•Var(RP)
A = Risk Aversion when A > 0
When A = 0, investor is risk-neutral (doesn’t care
about risk), making the second part of the
equation equal to zero.
Certainty Equivalent Rate of Return: Utility
Score of Risky Portfolios
NOW WE SEE what the optimal portfolio is:
Optimal Portfolio reconciles what is DESIRABLE
(indifference curves) with what is FEASIBLE
(efficient frontier). The point of tangency between
the efficient frontier and one of the investor’s
indifference curves indicates the optimal portfolio.
T. 4A: Portfolio Selection w/ Riskless
Security
KEY TAKEAWAY: A risk free asset Rf added to N
risky assets changes the efficient frontier to a
straight line through the risk free rate, tangent to
the efficient frontier calculated from risky assets
only. The mixture of stocks that anyone is holding
is constant; it’s the weightings of the risk free
asset that vary.
Risk-Free Return (Rf): A guaranteed return
that is known for certain.
E[Rf] = Rf
σf 2 = 0
σf,I = 0 for any asset i
Constant over time. Proxy for Rf: Treasury Bills
One risky, one risk free asset:
w = fraction of wealth invested in risky asset
E[RP] =
E[Ri – Rf] = E[Ri] – E[Rf]
Since σf,I = 0, σP2 = w2 σi
σP = |w| • σi
Sharpe Ratio (SRi): Return
premium per unit of risk; ie. The
“Price of Risk”
SRi = E[Ri – Rf]/σi
USE TO DETERMINE WHICH OF
A GIVEN SET OF
SECURITIES/PORTFOLIOS IS
THE BEST
Capital Allocation Line: Risk-Return
Relationship for a portfolio with a risk free and a
risky asset
CAL = Rf + SRi • σP
Two Risky, One Risk Free Asset:
Tangency Portfolio maximizes SR.
Mean-Variance Efficient (MVE) = Tangency Port.
All investors hold combinations of the same two
“mutual funds”: The risk free asset and the
tangency portfolio. Risk aversion determines
fraction of wealth invested in the risk free
portfolio; remainder invested in the tangency
portfolio
T. 4B: Port. Sel. w/ Multiple Risky Assets
Insurance Principle: As the number of non-
perfectly correlated assets in a portfolio increases,
the risk is diversified away.
For a portfolio of N independent stocks with
weights 1/N each (ρij = 0):
σP2 = 1/N • Avg. Variance

For a portfolio of N stocks with weights 1/N
each (ρij ≠ 0):
σP2 = [1/N • Avg. Variance] + [(1-
(1/N) )• Avg. Covariance]
As N approaches infinity, variance of the
portfolio return approaches the average
covariance of returns, and the portfolio risk
approaches the non-diversifiable risk
(aka covariance risk or systematic
risk): Implicit. E.g. market risk,
macroeconomic risk, industry specific risk
Idiosyncratic risk (aka variance risk,
unique risk, diversifiable risk or non-
systematic risk): Part of the risk of a large
portfolio that can be diversified away (e.g.
individual company earnings announcements)
Therefore, total risk in holding a stock =
systematic risk + idiosyncratic risk.
Investors need to be compensated for
holding systematic risk.
Implementation Issues: With N stocks,
one needs to estimate E[Rp], σP2, correlation
between returns, and keep in mind that not
all sets of estimates are internally consistent.
Two solutions:
1. Index Models: All co-movement of
returns is captured by a few common factors
2. Capital Asset Pricing Model (CAPM):
Implied expected returns in equilibrium
SINGLE INDEX MODEL:
To separate idiosyncratic risk from systematic
risk for security i, we can use regression
analysis:
Beta (βι): Systematic risk of holding something
βι = Cov(RM,Ri)/(σM2)
For two risky assets I and j, Cov(ei,ej) = 0.
Topic 5: The CAPM
KEY CAPM TAKEAWAYS:
1. CAPM follows from equilibrium conditions in a
frictionless mean-variance economy with rational
investors
2. Prediction I: Everyone should hold a risk of the
market portfolio and the risk-free asset (ie.
Everyone should hold a portfolio of stocks on the
CML). Under CAPM, the market portfolio is the
tangency portfolio.
3. Prediction II: E[Ri] is a linear function of its
beta (ie. Stocks should be on the SML)
4. A stock’s beta can be estimated using historical
data by linear regression (ie. Estimating SCL)
CAPM EQUATIONS:
E[Ri] = Rf + βi • (E[RM] – Rf) + errori
(This equation can also be used for
portfolios)
βι = Cov(RM,Ri)/(σM2)
E(errori) = 0
Cov(errori, RM) = 0
EQUILIBRIUM MODEL: SUPPLY = DEMAND
•Predicts the relationship between risk and E[R]
and optimal portfolio choices
•Invented in the 90s, Underlies much of modern
finance and most real financial decision making
•Answers two key questions:
1.Which portfolios should investors hold in
equilibrium?
2. What is the Equilibrium retired return,
E[R], or the equilibrium price of an
individual stock?
The CAPM identifies the tangency portfolio in
equilibrium (hence, identifies investor portfolios)
1.
and derives equilibrium returns (hence, prices)
SIX ASSUMPTIONS (some of which can be
relaxed):
1. Mkt is competitive equilibrium 2. Common 2.
single-period investment horizon 3. All assets are
tradeable (mkt portfolio) 4. NO TRANSACTION
COSTS OR TAXES 5. Investors are rational mean-
variance optimizers with… 6. Homogenous
expectations (all investors agree on investment
opportunity set)
Because in equilibrium, supply = demand,
tangency portfolio must be the portfolio of
all existing risky assets, the “market
portfolio”
Pi = Price of one share of risky asset i
Ni = # of shares outstanding for risky asset i
Market Portfolio = Portfolio in which each risky
asset I has weight wiM = Market capitalization of
security/Total Market Capitalization; ie. Market
Portfolio consists of all assets
Capital Market Line (CML): Market portfolio’s CAL
in equilibrium (in equilibrium, the tangency
portfolio is the market portfolio)
CML =
CAPM also predicts the relationship between risk
and E[R] for individual securities:
1.
2.
Extra return is proportional to risk contribution of
that security to the overall market.
CAPM Predicts that expected excess return
of a security is linear in its beta: this is the
Security Markets Line (SML)
SML = E[Ri] = Rf + βi • E[RM – Rf]
Under CAPM, all securities lie on the SML. Slope
of the CAPM is βi • E[RM – Rf]
SML LINE IS THE CAPM EQUATION LESS
THE ERROR COMPONENT
Y-INT OF SML: Rf
Recall that beta measures the systematic risk of
holding a stock; the higher the risk, the more an
investor must be compensated for holding it.
Depends on the
Equilibrium Risk Premium = E[RM] - Rf
The excess return on the market portfolio
Flight to Quality: Investors moving their assets
into more stable assets (eg securities to gold)
Security Characteristic Line: The “regression
line”
SCL = Ri(t) – Rf = αi + βi(RM(t) – Rf) + errori(t)
CAPM IMPLIES THAT ALPHA = 0
SCL graph shows relationship between
excess return of stock vs. excess return of
market and solves for a slope of Bi.
In fact, beta can be estimated using linear
regressions, typically using 60 months of data:
ALPHA: Pos. or Neg. Difference between a security’s
performance at a given beta and the SML. CAPM
predicts all alphas to be 0. Alpha of the market
portfolio is 0.
Αι = E[Ri] – Rf – βi[E[RM] – Rf], OR, rearranged:
Portfolio Alpha Formula:
Active management strategy: beat the market by
stock picking, timing, etc. However CAPM implies
analysis is unnecessary, and that every investor
should simply adopt a passive strategy.
GROSSMAN-STIGLITZ PARADOX: How can
market be efficient if everyone uses a passive
strategy?
Net Present Value (NPV): Only undertake projects
with NPV>0 (ie. E[Ri] < IRR
aka Cost of Capital < IRR; HOWEVER, ALWAYS
USE THE NPV RULE WHEN NPV RULE AND IRR
RULE DIFFER. NPV uses the ‘correct’ rate, the cost
of capital, to discount cash flows; IRR uses arbitrary
rate that makes NPV = 0. Further, when IRR is very
high relative to cost of capital, it is unrealistic to
assume reinvestment at a very high rate)
Recall IRR Formula:
Shareholders need to be diversified
Topic 5B: Beyond the CAPM
Testing CAPM: Fama-McBeth (1973)
Regress excess returns of asset I on the excess
return of the market (SCL), delivering a beta for
each asset i
Regress the average excess return on the beta
and an intercept (SML) (ie. a graph with average
excess return on the y and beta on the x for each
stock)
If the CAPM holds, then the intercept should be
equal to zero and R2 should be high.
The slope of this second regression should equal
E[RM – Rf]
Because individual stocks are too “noisy” in their
data, in practice testing the CAPM requires
forming portfolios of stocks (because betas are
estimated more precisely for portfolios): Form 10
deciles of lowest to highest beta stocks
As the graph shows, the deciles don’t lie along
the SML. INCONSISTENT WITH CAPM, as alpha
≠0
CAPM IS STRONGLY REJECTED BY DATA
•Intercept (alpha) ≠ 0
•Avg. portfolio returns deviate systematically
from SML; higher the beta, higher the deviation
Fama-French (1992): Firms’ returns depend
on their size (mkt cap) and book/market (B/M)
ratio
B/M = Book value of equity/Market Cap
Market Capitalization = Size
Avg annual returns higher for lower market cap
deciles, lower Mkt Cap deciles and higher B/M
deciles
Fama-French (1993): Two new sources of
systematic risk:
Size Factor (RSMB): Rtrn on a portfolio that
goes long small stocks and short big stocks
Value Factor (RHML): Rtrn on a portfolio that
goes long high B/M stocks and short low B/M
stocks.
This produces the “Three Factor Model”
AKA the AUGMENTED SML:
Testing the three factor model: Regress excess
return of asset I on excess return of the mkt, on
RSMB and on RHML, delivering 3 betas for each
asset: βiM, βiS, and βih. Then, regress average
excess returns of the assets on the 3 betas in a
cross sectional regression.
This causes R2 to go from .25 to .75 and alphas
don’t differ from 0. (FAMA FRENCH ALPHA)
Cahart 4 Factor Model: Adds a momentum
factor (sort stocks by return over TTM: long a
portfolio of winners, short a portfolio of losers)
Delivers a return of 10% per year and a similar
alpha to the 3 factor model.
Problem with these strategies: Theoretical
motivation absent
Return Anomalies & Market Efficiency
Efficient Market Hypothesis (EMH): Market
efficiency that results from competition. PRICES
FULLY REFLECT ALL AVAILABLE
INFORMATION. Does not mean that stock
prices must go up on good news (must be
unexpected), or that the market cannot be
outperformed (insider trading/risk adjustment)
Weak Form Efficiency: Prices reflect all
information contained in the history of past
prices, including trends in prices. Evidence:
suggests that simple trading rules based on past
prices don’t work; returns aren’t correlated over
time
Random Walk: Stock price is a random walk:
Pt+1 = Pt + et+1. Returns are unpredictable, prices
reflect “fair” fundamental values, and prices react
to news immediately. Evidence: Stock prices
close to random walk; returns nearly
unpredictable at short horizons
SHORT TERM: Returns are functionally
unpredictable
LONG TERM: Some evidence that returns are
predictable. Dividend Yield D/P is positively
correlated with subsequent returns. This does
NOT necessarily imply that the market is
inefficient.
Semi-Strong Form Efficiency: Prices reflect all
publicly available information (ie earnings
announcements, stock splits, mergers, etc.).
Empirical test: EVENT STUDY. EVIDENCE:
Abnormal returns to trading on publicly available
info are zero on average and disappear quickly.
Exceptions to SSFE: January Effect (increase in
stock prices for small caps in January),
Momentum, Post-Earnings Announcement/Post-
IPO Drift (doing well or poorly in the short run
tends to impact the long run)
Problems with Testing EMH:
Data Mining: You’ll find what you’re looking for
(even random samples appear to have patterns)
Joint-Test Issue: Is the market inefficient or
did you just adjust for risk incorrectly?
Strong Form Efficiency: Do prices reflect all
relevant information, including inside
information? EVIDENCE: Corporate insiders earn
abnormal returns. Markets are NOT strong
form efficient.
Topic 6: Equity Valuation
KEY TAKEAWAY: The key story of equity
valuation is growth.
Book Value of Equity:
Recall from FA: A = L + SE, ergo:
Backward looking accounting measure
Equity = Assets – Liabilities
(not generally equal to mkt value)
Book Value per share:
Equity/Shares outstanding
Market Value Per Share = Stock Price
Forward looking measure
Book to Mkt Ratio:
Book value per share/Stock Price
For every dollar you pay for a stock, you’re
getting a certain amount of book value.
Price to Book Ratio (Mkt to Book):
Market/Book
Growth Firms: Low book to mkt ratio;
investors think it’s worth a lot even though there
isn’t much value on the books (Apple)
Value Firms: High B/M ratio; investors think it’s
worth little even though there’s a lot of value on
the books (Yahoo, GM)
Liquidation Value: Cash that can be extracted
selling/liquidating a firm’s assets
Replacement Cost: Cost of replicating a firm’s
assets. If mkt price >>> replacement cost,
competitors will move into this business
Tobin’s q:
q = Market Value/Replacement Cost
(Equals 1 in the long run or you’ll see migration
into/out of businesses until it equals 1)
Intrinsic Value (Fundamental Value): The
discounted value of the cash that can be taken
out of a business during its remaining life
(Warren Buffett).
Fundamental value of a stock at time 0:
If P0 < V0, E(HPR) > R and the stock is
underrated
If P0 > V0, E(HPR) < R and the stock is
overrated
Dividend Discount Model
(DDM):
Assume efficient market; P0 = V0
Use fundamental value equation repeatedly
Note: E(Pn) = E(Dn+1)+E(Pn+1)/(1+R)
Case I: Zero Dividend
Growth:
Assume constant expected Dividends
V0 = E(D1)/R
P/E = 1/R
Case II: Constant
Dividend Growth
AKA Gordon’s Growth
Model (GGM)
Assume expected dividends grow at rate g
The Gordon Growth Equation:
V0 = E(D1)/(R – g), ie.
P0 = D0(1+g)/(R-g)
Price Dividend Ratio: Under GGM:
Price-Earnings Ratio: Under GGM:
D0 = (1-b)•E0
g = growth rate
b = “earning retention ratio”
The amount of earnings that aren’t paid out as
dividends
Earnings Retention Ratio = Plowback
b = 1 – D0/E0
(Recognize that D0 was subbed out for E0(1-b))
Practical impact of R: As E[R] rises, P must fall in
order to allow investors to be compensated
more. P/E ratio and long term interest rates tend
to be inverses.
Price/Sales Ratio: Useful for companies that
massage their earnings (sales are harder to
fudge)
Topic 6: Equity Valuation (Cont.)
Growth Rate (g): g = b • ROE
The better a company’s returns (given some of
those returns being reinvested in the company,
not handed out as dividends) the faster a
company will grow.
Return on Equity (ROE): Return on equity inside
the firm
ROE = Earnings/(BV of Equity)
The higher a company’s P/E ratio, the faster it is
growing.
Forward Looking P/E Ratio: P0/E1
Can be derived from the following equation
stream:
Sensitivity of P/E ratio w/ respect to b:
In other words:
= ROE-R/(R-g)2
HOW SHOULD I SET MY DIVIDEND RATE?
If ROE > R: As B rises, forward looking PE ratio
rises. Raise b, in effect plowing back more. The
firm is more profitable than investors require;
plow back more to grow more.
If ROE < R: As B rises, forward looking PE ratio
falls. Lower b, in effect plowing back less. The
firm is less profitable than investors require;
plow back less to compensate investors more.
Price and NPV:
P0 = PV(future dividends)
= PV(future net cash flows from assets in place)
+ NPV(new projects)
NPV(new projects) also known as NPV(growth
opportunities)
NEVER INVEST IN NEW PROJECTS WITH
NPV ≤ 0
NPV(growth opps) =
P0 of a stock – P0 w/ g=0
DDM CASE III: Two-
Stage DDM
In short: g doesn’t grow constantly forever. g
eventually tapers off.
Consider 3 years of unconstrained growth
(GGM) followed by a steady state starting
at 3 years after present at rate g.
This can be used to estimate future P/D, P/E and
b ratios.
Remember: you only need the final growth
rate (it’s implied by all dividends you have to
that date).
Remember: Simply extend (or contract) the
formula for longer/shorter terms to the final
constant g.
Topic 7: Arbitrage
Financial theory:
Arbitrage: Zero-investment trading strategy
that generates profit.
No initial investment, non-negative cash flows at
all times, positive cash flows at some times.
On Wall Street, arbitrage can also refer to a
trading strategy that is expected to make a
profit (statistical arbitrage).
Recall: NO-ARBITRAGE CONDITION
There cannot be arb. opportunities; arbitrageurs
would trade aggressively to exploit them.
WE CAN USE THE NO ARB CONDITION TO
COMPUTE RESTRICTIONS ON PRICES OF
SECURITIES, AS WELL AS EXACT
DERIVATIVE PRICES
Three implications of no arbitrage:
Law of One Price: Two securities with the
same payoffs must have the same price.
Replicating Portfolios: If a portfolio has the
same payoff as a security, the price of the
security must be equal to the price of the
portfolio.
Dynamic Hedging Strategies: If a self-
financing trading strategy has the same final
payoff as a security, the price of the security
must be equal to the cost of the strategy.
(Think finding the two year zero price from
two given one year zero prices, today and
a year from now)
We can’t determine securities prices exactly
from No-Arbitrage because of unclear
transactions costs.
We can determine upper and lower bounds
for the price.
•Note that the total transactional cost matters
for these limits, not only the cost of shorting or
buying.
USEFUL STRATEGIES FOR THESE
PROBLEMS:
1. TIME CHARTS
Different cash flows (neg and pos) below,
different times above.
2. ARB TABLES
Topic 8: Fixed Income Securities
KEY EQUATIONS:
Coupon Rate = Coupon/Face Value
Current Yield = Coupon/Price
Yield to Maturity = IRR
9 MAIN FEATURES OF BONDS:
1. Issuer (e.g. govt, states, corporations)
2. Term (# of years to maturity)
•Short is < 1 year (T bills, CDs)
•Long is > 1 year (Consols, corporate bonds)
3. Price v. Par Value
•Par value = Face Value = Principal = Par
•Par Bond: P = F
•Discount Bond: P < F (YTM is higher than
the coupon rate)
•Premium Bond: P > F (YTM is lower than
the coupon rate)
4. Coupon (period, fixed/variable,
nominal/inflation indexed)
•Coupon Rate: Total annual interest payment
per dollar face value (C/F)
5. Currency (Yankee Bonds, Samurai Bonds)
6. Credit Risk (Risk free or defaultable)
7. Seniority & Security (senior, junior)
•Secured by some other assets/assets of the
issuer? Some income stream?
8. Covenants (restrictions on additional issues,
dividends, and other actions)
9. Option Provisions
•Callability: After a certain period, issuer has
the right to pay back the loan before it matures
•Putability: After a certain period, bondholder
has the right to demand payment of the loan
before maturity
•Convertibility: After a certain period,
bondholder has the right to exchange the bond
for stocks of the issuer
Yield to Maturity (YTM)
on annual pay coupon
bonds: Solve for the IRR
Ct = Coupons
FT = Face Value
Effective Annual Yield = YTM
YTM ON SEMI-ANNUAL
PAY COUPON BONDS:
1. Find the semi annual IRR using the equation
from before with r substituted for YTM
2. YTM is the corresponding APR: YTM = 2r
•Correspodning Effective Annual Yield:
(1+YTM/2)2-1 = (1+r)2 – 1
NEGATIVE CONVEX
RELATIONSHIP BETWEEN
YTM AND PRICE
Bond Notes:
Realized Return on a bond = YTM IF AND
ONLY IF:
1. Reinvest coupons at same rate (YTM)
2. Hold the bond until maturity
Because of thse conditions, Realized Return and
YTM are generally different
Realized Holding Period Return:
Buy bond for V(0) at time 0. Reinvest all
coupons until date t (t can be < T). At time t,
sell the bond and the reinvested coupons for
V(t).
•To find future value of the bond with reinvested
coupons, multiply each payment by the
appropriate compounded interest rate
V(t) = V(0)(1 + ann.HPR)t
ann.HPR = (V(t)/V(0))1/t - 1
Fixed Income Securities (Cont.)
Forward Rate: Interest rate on a future loan
that is fixed today. The rate that would need to
prevail in the second year to make the long and
short term investments equally attractive.
f0(t) = forward 1 year lending rate t years
from now.
f0(1) = (1+y0(2))2/(1+y0(1)) – 1
More Generally:
Pt(n): Price at time t of an n-year ZCB
Yt(n): Yield at time t of an n-year ZCB
If you have a ZCB for 1 year and 2 years,
you can approximate f(1) by subtracting
2•ZCB2 – ZCB1
Yield Curve (Term Structure of Interest):
The collection of YTMs on zero-coupon bonds.
•Empirically, the slope of the yield curve is
actually a good predictor of GDP growth rate
Expectations Hypothesis:
A benchmark model of the yield curve.
EH says that the long-term rate is a
geometric average of current and expected
future short rates.
1.03: 2 year ZCB rate at time 0
1.02: 1 year ZCB rate at time 0
1.04: Expected 1 year ZCB rate at time 1
Typical yield curve shape is flat.
•All expected HPR are equalized in equilibrium.
•ST interest rates are more volatile than LT
interest rates.
ASSUMPTIONS:
•No transaction costs
•No default
•Remember: Still interest rate risk
•Investors are risk-neutral profit maximizers
(investors choose the maturity of their bonds to
maximize holding period returns)
•CONTROVERSIAL
•All bonds are ZCBs
Consider the links between the forward rate (the
no arbitrage equation):
…and the EH theory’s prediction (not a no
arbitrage equation):
UNDER EH THEORY, forward rate =
expected future 1 year interest rate.
Liquidity Preference
Theory (LPH):
Problem with EH theory: Predicts a yield curve
that is flat on average.
•In fact, it is upward sloping 90% of time
•This derives from the risk-neutrality
assumption in the EH theory; investors are not
risk neutral
•Expected returns for the next period are not
known; they are risky
RISK AVERSE investors care about both
expected short rate AND volatility
Investors in long term bonds want to be
compensated more for:
•tying up money for a long time
•facing price risk if they need to sell before
maturity
Issuers of LT bonds will pay higher interest rates
because they can lock it in for many years
LIQUIDITY PREMIUM (LP): Risk premium
associated with EH.
•This makes the yield curve typically upward
sloping.
•Forward rate is now greater than the
expected future short rate (you’re locked in).
In effect, E is yield spread due to expected
future changes in short rate (possibly pos or
neg), while LP is yield spread due to liquidity
premium (positive). YC is total yield spread.
Segmented Markets Theory (Preferred
Habitat Theory):
•Different investors trade different term length
bonds, creating different S/D spectrums
•May explain why 30 year rates are typically
lower than 20 year rates.
Topic 8D: Interest Rate Management
Interest Rate Sensitivity: Three factors:
First Order Effect: Bond prices and interest
rates are negatively correlated
Maturity Matters: Prices of long term bonds
are more sensitive to interest rate than those of
short term bonds.
Convexity: An increase in a bond’s YTM results
in a smaller price decline than the price gain
associated with a decrease in equal magnitude
of the YTM.
Duration (Macaulay’s Duration) (D): The
average time you have to wait for your
payments. Duration of a portfolio is a
weighted average of the durations of the
constituents.
•Used to determine how sensitive the price
of a bond is to changes in yield
•All else equal, as the coupon rate increases,
duration decreases, and vice versa.
•Think “Zero coupon bond has a duration of t
years”, “coupon bond has a duration < t years”
•Duration of a perpetuity: (1+y)/y
D = Average of cash flow times, weighted by
their contribution to the PV of the bond.
To track relative changes in price when
YTM changes:
y = initial yield
Implications: For a given yield change, LT
bonds are more sensitive. However, long term
YIELDS are more stable (“anchored”).
Convexity: curvature of a security’s price-yield
relationship.
•Duration approximates this relationship in
a linear way, but in fact, it is convex.
•When yields decline, price increase in bonds
is underestimated by the duration formula. This
corrects for that.
•The more convex a bond, the greater the
expected price increase for a given decrease in
yield and the smaller the expected price
decrease.
•With volatile interest rates, this is an
attractive asymmetry. Investors will have to pay
more/accept lower yields for bonds with more
convexity.
We can augment our relative change to yield
equation to make it more accurate now.
Change in interest rate: Price risk and re-
investment risk.
Duration Matching: Making the duration of
assets and liabilities equal, making interest rate
sensitivity 0 (asset and liabilities change by the
same amount from changes in interest rates).
•Example: GM Pension fund has liabilities
with duration of 15 years, assets with duration
of 5 years. DURATION MISMATCH. Why do we
care?
•Price Risk. When the interest rate falls,
the present value of the liabilities increases more
than those of the assets.
•Reinvestment Risk. At the new interest
rate, the assets could not be reinvested to make
the future payments.
Immunization Problems: Rebalancing
required. Approximation that assumes flat term
structure of interest, no risk from changing slope
of term structures/other shape changes, small
interest rate changes (matching convexity will
further improve duration matching).
Weights will be w and 1-w, solve for DP using
the durations of the two different securities (e.g.
1 yr 30 yr). Once you have weights, multiply by
PV of the current assets and divide by PV of the
securities.
Topic 9: Options & Derivatives
Derivative: Security with a payoff that depends
on the price of another security (the
underlying).
CALL OPTION: Right to BUY underlying at. At
expiration:
PUT OPTION: Right to SELL underlying at. At
Expiration:
European Option: Can only be exercised at
expiration (Index options)
American Option: Can be exercised at or
before expiration (Single Stock Options)
•Call W/O Dividends: Never exercise
before expiration. Lose downside protection and
interest on the strike (converting from liquid
asset that can accrue interest into the stock).
This interest factor makes exercising early for
puts a positive.
•Call W/ Dividends: MAYBE exercise
before expiration. Potentially exercise to get
dividends. Do it right before the dividend gets
paid.
IN THE MONEY: One would exercise the
option. For a call: Stock Price > Strike. For a
put: Stock Price < Strike.
OUT OF THE MONEY: One would not exercise
the option. For a call: Stock Price < Strike. For a
put: Stock Price > Strike.
Remember: Calls get you leverage.
Protective Put: Own a stock, afraid its price
will drop. Buy a put on the stock at X=P0, paying
the cost of the option in exchange for downside
protection.
•The same payoff as a long call with X=P0
and a bond with a face value of X.
Covered Call: At the money call options for a
stock you own seem expensive. Short a call on
the stock at the money. Sell your upside in
exchange for the cost of the option.
Straddle and Strangle: You believe the price
of the stock will either spike or tank very soon.
Bet on volatility: buy a call and a put. Pay the
cost of the options for profit if the stock
plummets or rises in value.
•Short Straddle: Short a call and a put,
betting that the market will not change much in
the near future.
Collar: Hold the stock, a put, and a short call.
Guarantees that the position won’t dip below a
certain price at the cost of a certain amount of
upside.
• X = $70, want to guarantee position is worth
at least $60 in 6 months. You believe price will
rise, but not past 80.
Options (Cont.)
Bull Spread: Long call X1, Short call X2. X1<X2
Bear Spread: Long call X2, Short Call X1,
X1<X2
Butterfly Spread: Long Call X1 + 2•Short Call
X2 + Long Call X3. X1<X2<X3
Intrinsic Value (of a call option): The value
of the right to exercise now. = max(0,S0 – X)
•Option price is always greater than its
intrinsic value.
•Time Value of the option: Difference
between option price and intrinsic value.
Minimum value of a call option (adjusted
intrinsic value): Present value of the payoff
when forced today to decide whether to
exercise at T. = max(0,S0 – X•e-r•T)
•As you are not forced to decide whether or
not to exercise at T, the AIV acts as a LOWER
BOUND for the value of the call option.
PUT CALL PARITY (stocks w/o dividends
before expiration): Create a “synthetic” stock
by buying a portfolio of European options and
the RF asset (in this case, a ZCB).
•Buy a call with strike X and expiration
T, sell a put with strike X and expiration T,
buy a ZCB with face X and maturity T.
Returns form a straight line that lines up with a
stock.
Payoff:
No Arbitrage implies PCP for European
options with strike X and exp. T:
Example of Arb. Opp:
S = $110, X = $100, r = 0, C = $12, P = $5
PCP WITH DIVIDENDS BEFORE
EXPIRATION:
Remember: If we know the call price, we
know the put price for the same strike and
expiration date.
Binomial Model: Line graphs that illustrate the
different options/probabilities of different
changes happening
We don’t need to know p exactly; we’re
solving for something that creates the same
result regardless of outcome.
Remember HW 3: X in the Xe-rT in the bond
portion is equal to the loaned amount, not the
strike price of the call or put.
BLACK-SCHOLES-
MERTON FORMULA:
FOUR ASSUMPTIONS:
•Risk free interest rate is r. Constant and
continuously compounded.
•Log of stock prices follows a normal distribution
with no jumps and a constant SD of σ
•Stock pays a constant dividend yield of δ
•The stock and the RF asset can be traded all
the time at no cost.
Price of a European Call
Option Under BSM:
N(x) = Percentage of normal distribution
contained within x standard deviations to the
right of the mean (negative x means to the left).
TABLE LOOKUP
Intuition: If the stock is almost certain to be in
the money at maturity (S0 > X), N(d1) roughly
equals N(d2) roughly equals 1. Option price is
the adjusted intrinsic value:
If the option is almost certain to be out of the
money, the option price is close to zero (as
N(d1) and N(d2) are roughly zero).
•In general, the price is the risk adjusted
expected payment at maturity.
FIVE IMPACTS ON OPTION VALUES
(Increases):
Today’s stock price (S0):
•Value of call RISES.
•Value of put FALLS. As stock price rises
relative to strike price, call value rises and put
value falls.
Exercise Price (X):
•Value of call FALLS.
•Value of put RISES. As strike price rises
relative to current price, call value falls and put
value rises.
SD of stock (σ):
•Value of call RISES.
•Value of put RISES. d1 rises and d2 falls as
SD rises, causing C0 for both calls and puts to
rise due to increased volatility.
Time to Expiration (T):
•Value of call RISES. More time means more
downside protection, more time means more
time to accrue interest on liquid assets before
striking.
•Value of put is INDETERMINATE. More
time means more downside protection, but it
also means delaying the receipt of the strike by
longer, missing out on interest. Depends upon r.
Interest Rate (r):
•Value of call RISES.
•Value of put FALLS. As the interest rate
rises, holding liquid investible assets becomes
more lucrative. Having the option to buy means
holding liquid capital that can be reinvested
(making the call value greater to compete);
having the option to sell means you’re holding
an asset that cannot be reinvested at the higher
interest rate, lowering its value.
Implied Volatility: Every volatility has a
corresponding BSM option price, and vice versa.
Implied volatility of options on the same
stock should be equal, even with different
strikes and expirations.
Smile/Smirk Skew: Graph of ITM/OTM calls
and puts relative to their implied volatility.
Hedge Ratio (Δ): Number of stocks (volume, •Example: $2mil for 1mil pounds for
not type) in the replicating portfolio. each of the next five years (Exchange rate
swap)
•$1mil • short term interest rate
(floating leg) for $1mil • fixed rate of 8%
(fixed leg) for each of the next seven years
(Interest Rate Swap).
•Derivatives market is $582Tril as of June
•Dynamic Hedging: Adjusting the number
2010, $452T of which is interest rate swaps
of shares held to account for a changing hedge
For interest rate swaps, Party A pays
ratio.
floating rate and party B pays fixed rate on
Price of a European Put a notional principal (say, $100mil).
•Fixed Rate C is set so that PV of party A’s
Option Under BSM: leg = PV of Party B’s leg. NPV of all futures cash
flows is 0.
For interest rate swaps, per example
Topic 10: Futures & Swaps
(knowing the one year ZCB yield and the 2YZCB
Futures & Forwards: Deferred delivery
contract of underlying assets.
•Unlike options, buyers and sellers are
yield), find the forward rates first, then calculate
PV of the floating leg, then set it equal to PV of
OBLIGATED to buy and sell at the agreed upon the fixed leg.
price at the agreed upon date. GRAPHS:
•Future: Traded on exchange. Marking to
market (daily cash settlement), often
standardized contract.
•Forward: Over the counter. No cash
transfer made until maturity, tailor made
contract.
•More customizable than options at the
cost of liquidity.
Hedger: Combines position in cash market (C)
with futures position (F) to minimize risk from
cash price fluctuations.
Hedge Ratio: H = ΔPC / ΔPF
A ΔPC change in spot commodity price leads to:
•A C• ΔPC change in wealth
•A F• ΔPF change in a position of F futures.
No Arb:
•Convergence on settlement date of PFT and
P CT
•Cost of Carry Pricing prior to settlement
date. Includes Time Value of money (annual rate
r), physical storage cost (annual rate s), and the
leasing benefit (annual benefit l; aka the
convenience yield).
Implications:
•Futures prices are more volatile than cash
(spot) prices.
•Long term futures prices are more volatile than
short term futures prices
Financial Futures:
Lease rate = delta, the dividend yield rate.
Storage rate s = 0.
Futures & Swaps (Cont.)
Currency Futures & Options Extremely
popular, though they bear currency
volatility risk.
•US 5 year t bill yield of 2%, Japanese 5 year
BOJ yield of 1%; profit by borrowing in Japan
and lending in US.
•With this method, one can find an exchange
rate in five years at which one breaks even
through this borrowing process (in this case, so
long as the Japanese currency doesn’t
appreciate too much, you stand to profit).
Interest Rate Parity: Exchange rate futures
being used to hedge.
This formula can be used in a sigma-style
equation, a-la:
P0C = 2.03$/£
rUS = .05
rUK = .07
P1F = 2.03(1.05/1.07)1 = 1.9921 $/£
•(exchange rate 1 year later)
P2F = 2.03(1.05/1.07)2 = 1.9548 $/£
•(exchange rate 2 years later)
PV (£) = (1£ • 1.9921$/£)/(1.05) +
(1£•1.9548$/£)/(1.05)2 = $3.6703
PV ($) = C/1.05 + C/1.052 =$3.6703
C = $1.974
This formula guarantees no arb.
Swap: Contract where two counterparties agree
to exchange one stream of cash flows against
another (legs), calculated on a principal