P(A) Payoff Wk6 IF u(x)=x & u(x)=x1/3, Expected Revenue (FV)

0.1 80,000 riskless payoff that makes FVr = (Current FVn= (Current
0.3 20,000 Value)*(1+gr) t
indifference btwn A and Riskless Value)*(1+gn) t
payoff) 1st-order approx. △ bond price by MD when i/r ↓1.5%
0.6 5,000 PV Sum
u(CE)=E[u(x)] | CE u-1(E[u(x)])PVr = FVr1/(1+rr) + PVn = FVn1/(1+rn) + ∆P = −PV × MD × ∆y = −106.77 × 4.41 × (−1.5%) =7.06
u(CE)= inv u-1(x)=x FVr2/(1+rr) 2 +... FVn2/(1+rn) 2 +.. 2nd-order approx. △ bond price by MD when i/r ↓ 1.5%
= 0.1*80,000 + 0.3*20,000 + 0.6*5,000 Wk 4 Price of Security A ∆P = PV*( −MD * ∆y + CX * ∆y2) (calc individually)
= 17,000 = CF/(1+Sr1) + CF/(1+Sr2) 2 +… OR 106.77 *(- 4.41* (−1.5%) + 12.38 *(−1.5%)2 =7.36
u(x)=x1/3=0.1*80,0001/3+0.3*20,0001/3+0.6*50001/3=22.71 =CF/(1+y) + CF/(1+y) 2 +… Actual △ bond price when i/r ↓1.5%
U(CE)= inv u-1(x1/3) = X3 = 22.713 =11712.55 EXCEL 3-year Bond, Principal Amt $100, Coupon Rate 1) Find new YTM (3-1.5%=2%)
−𝑥
T has u(x) = 1-EXP( ), P(0.5) that returns ±25% 5.25%. Sr1= 1.1% Sr2=1.15% Sr3=1.50%. Compute YTM. 2) Calculate PV using method in first part
3
-RRA, evaluated @initial wealth W=5 1) Find Price of Bond= $110.98 3) Change = Old PV-New PV
−𝑾𝒖”(𝑾) 2) Take $110.98 =
5.25
+
5.25
+
105.25 Wk 7 Consider 2-factor model ri = ri +βi1f1 +βi2f2 + ui
𝑹𝑹𝑨(𝑾) = ; Take X as W. (1+y%) 2 (1+y%) 3
(1+y%) {aka Ei} & Risk premia for f1: 20%, f2: 30%, rf= 2%.
𝒖’(𝑾)
𝟏 𝟏 −𝑾 3) To find Y on EXCEL, Whereby f1 is the common factors/systematic risk & βi is
−𝑾(− ∗ ∗ 𝑬𝑿𝑷( ) RATE(nper: 3, pmt: 5.25, pv: -110.98, fv: 100)
= 𝟑 𝟑 𝟑 1 factor sensivities/factor loadings/β
𝟏 −𝑾 = W =5/3 IRR(y0: -110.98, y1: 5.25, y2: 5.25, y3: 105.25) Expected Return E(Ri) given βi=0.20 & βi2=0.10
( ∗ 𝑬𝑿𝑷( ) 3
𝟑 𝟑 Y= 1.48% (Risk Premia) E[Ra]-rf =λ1βa1 + λ2βa2 +…
-Risk Premium, π Bond fairly-priced/mispricing/arbitrage op. E[Ra]=2% + 0.2*02 + 0.1*0.3 =9%
E[u(W*(1+r))] = u(W*(1-π)) For all bond types, find price of bond using YTM/Sr & Given stk A: βa1= 0.2, βa2= 0.1, SD(u) = 0.20
I) Find W*(1+r) compare with given price. and stk B: βb1=0.1, βb2=0.4, SD(u)= 0.25 Find the corr.
@P(0.5): 5(1+25%) = 6.25 | @P(0.5):5(1-25%) = 3.75 For zero-coupon/discount bond, make matrix (no y/sr) 1) Find S.D. of (Ra) & (Rb)
𝟏 −𝟔.𝟐𝟓 𝟏 (−𝟑.𝟕𝟓
II)u(W*(1+r))= (1-EXP( )+ (1-EXP ) = 0.7945 Var(Ra)= βa12Var(f1)+ βa22Var(f2)..+Var(u)
𝟐 𝟑 𝟐 𝟑
III) 0.7945=u(W*(1- π)=1-EXP(
−𝟓(𝟏−𝛑)
) 𝛑 = 5.06% (%) In this case, sys. risk are not given so
𝟑 Var(Ra)=0.22 + 0.12 +0.22=0.09
Have $20,000 to invest in A but can borrow $45,000 also. S.D (Ra) SQRT(0.09)=0.3 | S.D. (Rb)=0.48218
WA in prtfolio = (20,000+45,000)/20,000 2) Find Cov(A,B) = βa1*βb1*Var[f1]+ βa2*βb2*Var[f2]
= 325% (%) =0.2*0.1+0.1*0.4=6% (ignore f1/f2 as not given)
WLoan = -45,000/20,000 = -225% (%) 𝑪𝒐𝒗𝑨,𝑩 {𝒔𝒕𝒆𝒑 𝟐}
-Leverage Ratio of prtfolio 3) Corr= =0.414781
𝑺.𝑫.𝑨∗𝑺.𝑫.𝑩{ 𝒔𝒕𝒆𝒑 𝟏}
Asset Value/Net Investments = 65,000/20,000 = 3.25 Construct prtfolio A&B with w1 &w2, with E(Rp)=rf. What
-Stock A ↑ 25% return on prtfolio is w1?
Method 1 E(RA)= 9% (refer to previous) find E(Rb)=16%
Make Arbitrage Strategy that pays $100 @t=0 & 0 after
1) New Asset Value = 65,000 (1+25%) = 81,250 W1*9%+(1-W1)*16%=rf=2%
2) New Net Investments = 81,250-45,000 = 36,250 W1 is 2 and W2=1-W1=-1
Return = Percentage△= (36,250-20,000)/20,000 = 81.25% Bi of equally weighted portfolio
Method 2 Bi=1 for all, Bi=1
Leveraged Investment Return BA1 for stks 1 1-10,
Leveraged Ratio*Asset Return, +/- = 3.25*25%=81.25% 1.6 11-20
Prtfolio: Invest WA= 60% Stock E(R) S.D. 2.1 21-30
WB=40% (-ve: short position, sale of stock | +ve value: long 𝟏
BA = (1*10+1.6+2.1*10); N=30
A 20% 20% position, purchase) 𝑵
E[RP] =WAE[RA] Idiosyncratic/non-systematic/firm-specific volatility of
+WBE[RB] B 15% 25% Macaulay
𝟏 𝟏∗𝑪𝑭
Duration, D
𝟐∗𝑪𝑭 𝒕∗𝑪𝑭 equally weighted portfolio/S.D. of portfolio
= 60%*20% + 40%*15% D= [ + +… ] = MD(1+y)
Corr(A,B) 0.2 𝐩 (𝟏+𝐲) (𝟏+𝐲)𝟐 (𝟏+𝐲)𝒕 S.D 5% for stks 1-10
=18% −𝟏 𝒅𝒑
6% 11-20
Modified Duration, MD = MD = = D/(1+y), whereby
-S.D. 𝑷 𝒅𝒚
8% 21-30
2
Var[Rp] = wA *Var[RA] + wB *Var[RB]2 Y is discount/interest rate/YTM/term structure/yield
+ 2[wAwB*Cov(RA, RB)] curve flat @?% 𝟏
𝐒. 𝐃 = √ 𝟐 × (𝟏𝟎 + 𝟓%𝟐 ) + (𝟏𝟎 + 𝟔%𝟐 ) + (𝟏𝟎 + 𝟖%𝟐 )
=0.62*0.22 + 0.42*0.252 + (2*0.6*0.4)* (0.2*0.25*0.2) Discount/0-Coup. Perpetual Coup. 𝑵
=0.0292 D D=maturity D= (1+y)/y Consider 2-factor model; rf =1.5%
S.D.[Rp] = SQRT(0.0292) = 17.1% (%) MD MD = D/(1+y) MD = 1/y Portfolio E(R) F1 F2
- E(RP) & S.D. if ↑ corr to 0.6 Coupon D→refer below MD = D/(1+y) A 8% 0.95 1.15
E[RP] = 18% (unchanged) B 6% 0.85 0.70
S.D. =19.7%, Change bolded 0.2 to 0.6 Other Excel Functions- to find spot rates C 10.5% 1.20 1.50
- E(RP) = 19.5% so find weight in A & B 1) Find Current Price of Bonds (LHS) Arbitrage that makes $1000 today & 0 later.
Take Portfolio Q = A + B 2) Form the equations of the RHS with unknown spot -1 -1 -1 -1 XA 1000
Q Q
E[RQ]=WA E[RA] + WB E[RB] rates; select an empty cell for Sr1, Sr2, Sr3…etc
Q Q
WA + WB = 1 | WB = 1-WA Q Q
3) Repeat on all Sr; Data→What-if analysis→Goal-seek 1+8% 1+6% 1+10.5% 1+1.5% XB 0
19.5% = WAQ *20% + (1-WAQ)*15% Set Cell: RHS | To value: LHS | By △ cell: Sr1 0.95 0.85 1.20 0 Xc 0
WAQ =90% WBQ=10% YTM at 3.5%. $100 Face value, Coupon r=5%, tm=5yrs 1.15 0.70 1.50 0 Xrf 0
Prtfolio:1stock/200stock/500 stock (Equally weighted)
Avg volatility/SD 35% Risk Premia Qs
Avg Corr 25% Eqns based on risk premia formula & matrix
-Volatility of Prtfolio with 500 stocks Excel (data)
Make row btwn each firm; for each firm
Var [RP]= 1/n*avg var + (1-1/n)*avg covariance
=1/n*0.352+ (1-1/n)*0.25*0.352 1)Excess return= Return-Rf
For 500 stocks 2)Excess mkt return= Mkt Return-Rf
Modified Duration 3)Excess return GLD= GLD ETF return-Rf
1/500*0.35 + (1-1/500)*0.25*0.35 = 0.03081
2 2

Volatility = SQRT(0.03081) = 17.55% (%) 4)Linear Regression

-Pre-highlight 3 cells
Excel Math/Formulas
=linest(Excess R, Mkt R:R GLD,1,1) ctlshiftenter | Note:
Mean = AVERAGE d/dx: Values are in order of BGLD BMKt Balpha
Var = VAR.S ax = (ln a) ax 5) AVERAGE the values of all B for all firms
1
S.D. = STDEV.S ln(x) = Other formulas
𝑥 Sum PV*Year/PV
Corr = CORREL EXP X = EXP X Return Variance (σi2) = ba2σf2 +bb2 σf2 +Var(E)
MD= 4.562594/(1+3.5%) = 4.4083
Cov = COVARIANCE.S Factor-mimicking prtfolios for factor B2.
Convexity of Bond
CE = W(1- π) π = 1-CE/W π = ( )[
−𝟏 𝑾𝒖”(𝑾)
𝝈𝒙𝟐 A 2-factor model. Rf =1%, factor risk prices of f1 & f2 is
𝟐 𝒖’(𝑾)
λ1= 5% and λ2 =7%.
If portfolio P+Q =R, find Weight of X in portfolio R.
Loadings Factor 1, β1 Factor 2, β2
WxR = (Value of X in P + Value of X in Q) / (TV P + TVQ)
Asset A 1.1 (βa1) 2.3 (βa2)
Wk 2 (Current) Price of Security A= Φ1X1 + Φ2X2 +..
Asset B 3.3 (βb1) 1.5 (βb2)
Expected Rate of Return /Return on A, r = (E(A)-Price
Consider 2-factor model; rf =1.5%
of A)/Price of A (%) Note: E(A) = P1X1 + P2X2 +… 𝟏 𝟏 𝒅𝟐 𝑷
𝟏 Since Bond Convexity, 𝑪𝑿 = Portfolio E(R) F1 F2
Risk-free Rate = -1 | FV= PV(1+r)t 𝟐 𝑷 𝒅𝒚𝟐
A 8% 0.95 1.15
(𝚽𝟏 + 𝚽𝟐 +..)
Note: (1+gn)t = (1+gr) t (1+i) t | (1+rn) t = (1+rr) t (1+i) t Expanding, B 6% 0.85 0.70
PV is same in both real and nominal terms C 10.5% 1.20 1.50
Construct prtfolio including rf asset with 0 loading on For 5yr: 50,000 = (Annuity) of monthly payment ………………………………………………………
β1 and 1 loading on β2. Nper = 5*12=60 TMV= V a +Vb = 87mil = 2/(10%-3%) +2(rb-5%)
Form weight equations & Solve by matrix 𝐴 1 Thus, Rb = 8.42% (COC lower so less risky)
W1* βa1 +W2* βb1= 0 = [1 − 6.7% 60
]=982.9982 XYZ is 100% equity financed. In year 0, Earnings =
6.7%/12 (1+ )
W1* βa2+ W2* βb2 = 1 12
100mil, payout =0%, COC=10%. Without Inv, will
Do the same for 10yr =555.1025
W1=55.56%, W2=-18.52% generate 100M in perpetuity. In year 1 & 2, make $0.20
Find PV of payments on both loans (use mkt rates and A
WRf = 1-55.56%-(-18.52%)=62.96% (the nxt yr) for every $1 Inv. From year 2 onwards, make
from previous part)
Expected Return on Porfolio $0.10 (the nxt yr) for every $1 Inv. Payout ratio = 60%
Rmonthly= (1+4%)1/12-1=0.003274
By APT (Ra-Rf= λ1*B1 + λ2*B2…) 982.9982 1 year 2 onwards.
r = 1% +0*5%+1*7% = 8% [ ] [1 − (1+0.003274)60 ]=53,4612 Find Expected Earnings in Y1&Y2
0.003274
*Note: Questions may also ask for Risk Premium of on Do the same for 10yr = 55,011.24 Y2=E1 = E0 + Inv0 × 0.2 = $100 + $100 × 0.2 = $120
factor, B1 e.g Wk 5 Y1 = E2 = E1 + Inv1 × 0.2 = $120 + $120 × 0.2 = $144.
=[E(Ra)-Rf]*W1 +[E(Rb)-Rf]*W2 (no payout)
Fama-french Model ABC profitability Find Market Value as of yr0 and also the PVGO.
Ri-Rf=αi +Bi(Rm-Rf) +siSMB +hiHML +Ei EPS1= 120 EPS 2= 144 EPS3= 158.4
PV (Perpetuity) @P2=158.4/10% =1584
1584
𝑨 𝟏
Consider a firm, ABC PV @P0 = 2
= 1309.09 PVwith growth
(1+10%)
Wk 3 PV (Annuity) = [𝟏 − ] It= EPSt*bt EPSt+1= EPSt+ROIt*It 𝑬𝑷𝑺
𝟏 𝟏𝟐𝟎
𝒓 (𝟏+𝐫)𝐓 PVno growth= = = 𝟏𝟐𝟎𝟎
T
FV (Annuity) = (1+r) * PV (Annuity) BVPS t+1= BVPS t + It Dt = EPSt*(1-Bt) 𝑪𝑶𝑪 𝟏𝟎%
𝑨 𝟏+𝒈 𝒕 Find Current Share Price, Expected Return on Stock and PVGO= PVwith growth– PVno growth
PV (Annuity growth) × (𝟏 − ( ) ) if r ≠g PVGO. PVGO=1,309.09 – 1200 = 109.00
(𝐫−𝐠) 𝟏+𝐫
𝑨𝑻
if r=g Other Formulas:
(𝟏+𝐫) 𝒓𝒆𝒕𝒂𝒊𝒏𝒆𝒅 𝒆𝒂𝒓𝒏𝒊𝒏𝒈𝒔
PV (Perpetuity) = A/r 𝑷𝒍𝒐𝒘𝒃𝒂𝒄𝒌 𝑹𝒂𝒕𝒊𝒐 (𝒃) =
𝒕𝒐𝒕𝒂𝒍 𝒆𝒂𝒓𝒏𝒊𝒏𝒈𝒔
PV (Perpetuity growth) = A/(r-g), r>g = 𝟏 − 𝒑𝒂𝒚𝒐𝒖𝒕 𝒓𝒂𝒕𝒊𝒐
Delayed (annuity, perpetuity)-starts year 6 to 15
1) Execute PV formula: t= 10; 𝑫𝟏+𝑷𝟏 𝑫𝟏+𝑷𝟏 𝑫𝟏+𝑷𝟐
P0= a.k.a P0 = +
2) That would be PV at Year 5 (6-1) 𝟏+𝒓 𝟏+𝒓 (𝟏+𝒓)𝟐
3) Discount it to year 0
𝑋 PVGO= PVwith growth– PVno growth
5
(1+r%) Find current share price, when constant ROI P/E and PVGO
Note: Formulas take the A at Y1. 1) Do as normal till DPS column 𝟏
If qs wants A to start at y 0 2) Then find Dividend Growth Rate by: If PVGO = 0; then P/E ratio ; else
A + A/r (Perpetuity) 𝑫𝒕+𝟏 − 𝑫𝒕 𝑫𝒕+𝟏 𝒓
= −𝟏= 𝐫𝟎 𝟏 𝑷𝑽𝑮𝑶 𝟏
𝑪(𝟏+𝒈)
(Perpetuity+g), inflation = g 𝑫𝒕 𝑫𝒕 P/E ratio= ; P/E ratio= + >
𝐫−𝐠
𝟏 − 𝒃 × 𝑬𝑷𝑺𝒕 (𝟏 + 𝑹𝑶𝑰 × 𝒃) 𝐄𝐏𝐒 𝟏 𝒓 𝐄𝐏𝐒𝟏 𝒓
rear = (1+rAPR/k)k -1 EAR −𝟏=
For periodic payments, just use the (𝟏 − 𝒃) × 𝒃
rAPR/k = (rear +1)(1/k) -1 APR 𝑹𝑶𝑰 × 𝒃
Other Formulas 3) D1/r-g for PV (perpetuity with growth)
Bank loan- choose 10-yr, APR 6%, compounded monthly A firm XYZ has 2 divisions- A&B. A to get 2mil in Y1 and
OR 5yr, APR 6.7%, compounded monthly. Mkt I/r = 4% grow 3% yr aft till(perpetuity). B to get 2mil in Y 1 and
(EAR). Need to borrow 50,000. grow 5% yr till (perpetuity). Total Market Value, XYZ =
Find monthly payments on both loans 87mil. COC for A =10%. Find COC for B?
Wk 10 Working Capital/Net working capital = A/R +Inventory -A/P
ΔWorking Capital = 2019 WC -2018WC
Operating Profit (before tax) = Operative Rev – Exp, without depreciation
CF = (1-τ)*Operating Profit + τ*Depreciation –Capital Expenditure–
changes in working capital
NPV= Initial Investment – PV of all Expected Cashflows
To decide go or no-go for projects, other than by NPV
PAYBACK PERIOD= NO. OF PERIODS TO BREAK-EVEN
Payback period rule: Take projects that payback in 2 years (depends mngmet)
IRR RULE: INVEST ONLY IF IRR> COC (COST OF CAPITAL)
NPV RULE: INVEST IF NPV IS POSITIVE, HIGHER IS BETTER
𝑷𝑽 𝒐𝒇 𝑻𝒐𝒕𝒂𝒍 𝑪𝒂𝒔𝒉𝒍𝒐𝒘𝒔
Profitability Index =
𝑰𝒏𝒊𝒕𝒊𝒂𝒍 𝑰𝒏𝒗𝒆𝒔𝒕𝒎𝒆𝒏𝒕
Consulting Charges 125,000 (sunk cost so don’t include). Project to get Rev.
Y1 onwards =270,000. Exp. Y1 onwards =130,000. Equipment (Capital Inv.)
@Y0 =650,000 depreciates straight-line over 10 years. Tax rate, τ=21% and
COC=10% . So go or no-go for project?
Depreciation= cost of eqp/no. of years 650,000/10 = 65,000
CF= (1-21%)*140,000+21%*65,000=124,150 till year 10, PV (Annuity)
PV Annuity = (124,250/10%)*[1-(1/(1+10%)^10) = 763,462
NPV=-650,000+763,462=113,462
For NPV or After-tax CF, make a table

Project investment 30,000 in y 0 and makes 4,600 over next 10 yrs, Find IRR
Method 1: Excel function
IRR(Values: Select Cashflow array for all years (no need to PV), Guess; 0)
Method 2: NPV Profile, graph of projects NPV’s for a range of discount
rates
1) Make dummy discount rates in a column, in intervals of 0.25% from 0-15%
2) On next column, calculate the NPV using corresponding discount rates
NPV = -30,000 + (4,600/r)*[1-1/(1+r)10] and then form graph
Method 3:
1) Equate NPV = 0 and goal seek the r value