Foundations of Modern Finance I Week 3: Discounting and Compounding Interest Risk, Bond Duration and Bond Convexity

Cheat sheet for MITx: 15.415.1x Foundations of Modern Finance I. Bond Duration
Special Cash Flows 1
Week 2: Market Prices and Present Value • Modified Duration (MD) for discount bond Bt = (1+y)t
Special Cash Flows
1 dBt t
State-space model for time and risk • Annuity: M D(Bt ) = − =
Bt dy 1+y
State-space model 1h 1 i
PV = A · 1−
r (1 + r)T • Macaulay Duration is the weighted average term to maturity
• Assets can be traded at time t = 0 with payoffs at time t = 1.
T
• The price of an asset is P at t = 0 with payoff X = (X1 , . . . , XN ) at t = 1. F V = P V · (1 + r) T T
X P V (CFT ) 1 X CFt
• X is a random variable. D= t=
• Annuity with constant growth: B B t=1 (1 + y)t
• A random payoff is given by the value of its payoff in each state and the t=1
corresponding probability: [(X1 , . . . , XN ); (p1 , . . . , pN )]
 h  T i
1
A · r−g 1 − 1+g if r 6= g

PV = 1+r • Modified Duration measures bond’s interest rate risk by its relative price
State Prices A · T change with respect to a unit change in yield (with a negative sign):
1+rif r = g
• Consider primitive state-contingent claims (Arrow-Debreu securities) that pay
$1 in a single state and nothing otherwise. 1 dB D
• Perpetuity: MD = − =
• Denote the price of the A-D claim on state j by φj , the state price for state j. B dy 1+y
A
PV =
• No arbitrage requires that all state prices must be positive: φj > 0 for all j. r • Convexity (CX) measure the curvature of the bond price as function of the
• The market is called complete if one can effectively trade A-D securities on yield:
• Perpetuity with constant growth:
each state.
1 1 d2 B
A CX =
Arbitrage pricing PV = , r>g 2 B dy 2
r−g
Arbitrage pricing • Taylor series approximation of bond price changes
• With the prices of A-D securities, we can price other assets/securities. Compounding 
∆B ≈ B −M D · ∆y + CX · (∆y)
2

• Law of One Price: Two assets with the same payoff must have the same market
APR / EAR
price.
• Suppose the firm is considering a project yielding time-1 cash flow: • EAR:Effective Annual Rate Week 5: Stocks
X = (X1 , X2 , . . . , XN )  k
• Using prices of A-D securities, we can attach value to this cash flow as: rAP R
rEAR = 1+ −1
P = φ1 X1 + · · · + φN XN = P V k Growth Opportunities and Stock Valuation
• Example for three assets: riskless bonds pays $100 in each state currently P/E and PVGO: price/earning and present value of growth opportunities
traded at B10 , stock 1 pays off [S11 , S12 , S13 ] and currently traded at S10 , • APR:Annual Percentage Rate
stock 2 pays off [S21 , S22 , S23 ] and currently traded at S20 : • P/E and PVGO:
h 1 i
rAP R = k (1 + rEAR ) k − 1 EP S1
     
100 100 100 φ1 B10 P0 = + P V GO
S11 S12 S13  · φ2  =  S10  r
S21 S22 S33 φ3 S20
solve system to find state prices φ1 , φ2 , φ3 .
Week 4: Fixed Income Securities • if P V GO = 0:
1
P/E =
r
Present value and future value Relative Bond Valuation • if P V GO > 0:
Present value and discount rate 1 P V GO 1
Arbitrage P/E = + >
E[CF ] r EP S2 r
• PV = 1+r̄
• Arbitrage: The key is to construct the payoffs so that we get $100 in year 0
Future Value and we get $0 payoffs in all of the subsequent years, i.e. the cashflows of the Investment and Growth
• F V in T years: F V = (1 + r)T bonds should offset each other at all times except year 0 when we realize the
arbitrage of $100. For example, suppose there are three bonds with prices P1 , plow-back ratio bt
Nominal vs. real cash flows and returns P2 and P2 with maturities 1, 2 and 3 years and coupons C1 , C2 , C3 ,
• Investments:
respectively, and all with face value F . There is a fourth bond with price P4
Nominal vs real CFs and coupon C4 with maturity 3 years (adjust cashflows if maturity is not 3 It = EP St · bt
• Nominal cash flows =⇒ expressed in actual-dollar cash flows. years) undervalued or overvalued. In order to find the arbitrage strategy we • Next year earnings EP St+1 :
need to solve the following system of equations:
• Real cash flows =⇒ expressed in constant purchasing power.
(N ominalCF )t
EP St+1 = EP St + ROIt · It
−P1 −P2 −P3 −P4 X1 100
     
• At an annual inflation rate of i, we have: (RealCF )t = (1+i)t
C1 + F C2 C3 C4  X2   0 
· = • Next year book value BV P St+1 :
Nominal vs real rates  0 C2 + F C3 C4  X3  0 
0 0 C3 + F C4 + F X4 0
• Nominal rates of return =⇒ prevailing market rates. BV P St+1 = BV P St + It
• Real rates of return =⇒ inflation adjusted rates In matrix notation: A · X = B =⇒ X = A−1 · B • Dividedns Dt :
1+rnominal
• Real rate of return: rreal = 1+i − 1 ≈ rnominal − i X=MMULT(MINVERSE(A),B) Dt = EP St (1 − bt )
Week 6: Risk Week 8: Market Efficiency • Cash Flow:
CF = (1 − τ )(OperatingP rof its) − CapEx + τ · Depreciation
Portfolio mean and variance, two assets Three forms of market efficiency hypothesis MEH − ∆W C
• Expected portfolio return: r̄p = w1 r̄1 + w2 r̄2 • Weak-form efficiency: security prices reflect all information contained in past τ : tax rate
• Unexpected portfolio return: r̃p − r̄p = w1 (r̃1 − r̄1 ) + w2 (r̃2 − r̄2 ) prices =⇒ Technical analysis does not provide excess returns. CapEx : Capital Expenditure
• Semi-strong-form efficiency : security prices reflect all publicly available ∆W C : Change in working capital
• The variance of the portfolio return: = σp2 w12 σ12 + w22 σ22 + 2w1 w2 σ12
information =⇒ Fundamental analysis does not provide excess returns.
σp2 = w12 σ12 + w22 σ22 + 2w1 w2 ρ12 σ1 σ2
σ12 • Strong-form efficiency : security prices reflect all information, whether • Working Capital:
• Correlation and covariance: ρ12 = σ1 σ2 publicly available or not =⇒ Inside information does not provide excess W C = Inventory + A/R − A/P
returns.
A/R : Accounts Receivable
Week 7: Arbitrage Pricing Theory
Strong-form EMH =⇒ Semistrong-form EMH =⇒ Weak-form EMH A/P : Accounts Payable

Factor Models
A single-factor model Payback period
Payback period is the minimum length of time s such that the sum of net cash flows
• Asset returns: r̃i = r̄i + bi f˜ + ˜i Strong- Semistrong- Weak-
|{z} | {z } form form form from a project becomes positive:
expected risk set set set
return CF1 + CF2 + · · · + CFS ≥ −CF0 = I0
2 2
• Return variance: σi2 = bi σf + V ar(˜
i ) Decision Criterion Using Payback Period
| {z } | {z }
systematic idiosyncratic • For independent projects: Accept if s is less than or equal to some fixed
risk risk threshold t∗ : s ≤ t∗ .
• Return covariance: Cov(r̃i , r̃j ) = Cov(bi f˜ + ˜i , bj f˜ + ˜j ) = bi bj σf2 Week 9: Introduction to Corporate Finance • For mutually exclusive projects: Among all the projects having s ≤ t∗ ,
accept the one that has the minimum payback period.
because of the assumptions: Cov(f˜, ˜i ) = 0 Cov(˜ i , ˜j ) = 0
What is corporate finance? Internal Rate of Return IRR
Multifactor models
• Capital budgeting: What projects (real investments) to invest in? Expansions, A project’s internal rate of return (IRR) is the number that satisfies:
• Asset returns: r̃i = r̄i + bi,1 f˜1 + bi,2 f˜1 + · · · + bi,K f˜K +˜
i
new products, new businesses, acquisitions, ...
CF1 CF2 CFt
|{z} | {z }
expected return systematic component
• Financing: How to finance a project? Selling financial assets/securities/claims 0 = CF0 + + + ··· +
1 + IRR (1 + IRR)2 (1 + IRR)t
• Assumptions: Cov(˜ i , ˜j ) = 0, ∀i 6= j (bank loans, public debt, stocks, convertibles, ...)
Decision Criterion Using IRR
E[f˜k ] = 0, k = 1, 2, . . . , K • Payout : What to pay back to shareholders? Paying dividends, buyback
shares, ... • For independent projects: Accept a project if its IRR is greater than some fixed
Portfolio return IRR∗ , the threshold rate/hurdle rate.
• Risk management: What risk to take/to avoid and how? • For mutually exclusive projects: Among the projects having IRR’s greater
• Portfolio return:
than IRR∗ , accept one with the highest IRR.
Task of financial manager
r̃p = r̄p + bp,1 f˜1 + bp,2 f˜1 + · · · + bp,K f˜K + ˜p
Asset side (LHS): Real investments. Profitability index (PI)
where, Liability side (RHS): Financing, payout and risk management.
N N N Profitability index (PI) is the ratio of the present value of future cash flows and the
initial cost of a project:
X X X
r̄p = wi r̄i bp,k = wi bi,k ˜p = wi ˜i
i=1 i=1 i=1 Week 10: Capital Budgeting 1 PV PV
PI = =
• Non-systematic variance: −CF0 I0
N
X
! N
X
NPV Rule Decision Criterion Using PI
2
V ar(˜
p ) = V ar wi ˜i = wi V ar(˜
i ) Investment Criteria for NPV and cash flow calculations • For independent projects: Accept all projects with PI greater than one (this is
i=1 i=1 identical to the NPV rule).
• For a single project: Take it if and only if its NPV is positive. • For mutually exclusive projects: Among the projects with PI greater than
Expected Returns on Diversified Portfolios
• For many independent projects: Take all those with positive NPV. one, accept the one with the highest PI.
• APT pricing relation:

r̃p − r̄f = λ · bp
• For mutually exclusive projects: Take the one with positive and highest NPV. Recommended Resources
| {z } |{z} |{z} • NPV:
Risk premium Price of risk Quantity of risk
CF1 CF2 CFT • Brealey, Myers, and Allen, Principles of Corporate Finance (13e),
N P V = CF0 + + + ··· +
λ tells us how much compensation one earns in the market for a unit of factor 1 + r1 (1 + r2 )2 (1 + rT )T Irwin/McGraw Hill. (BMA)
risk exposure. λ is called the market price of risk of the factor, or the factor risk • Bodie, Kane, and Marcus, Investments (11e), Irwin/McGraw Hill. (BKM)
premium. • Operating Profit:
• MITx 15.415.1x Foundations of Modern Finance I [Lecture Slides] (https:
• APT relation for multi-factor models: OperatingP rof its = OperatingRevenues //courses.edx.org/courses/course-v1:MITx+15.415.1x+1T2020/course/)
r̃p − r̄f = λ1 bp,1 + λ2 bp,2 + · · · + λK bp,K − OperatingExpensesW ithoutDepreciation Last Updated December 13, 2020