Relationship of CAPM to former framework

$n(1)
$n(2)
$n(3)
PV0 $n(4)
$n(5)
$n(6)
$n(7)

time
 Relationship of CAPM to our framework

Elementary security prices: p1 , p2 ,..., p6 , p7

() ()
PV0 = ! n s p s
s=1

() ! R! m
E n! ! ! cov n, ( )
CAPM: PV0 =
1+ R f
 Relationship of CAPM to our framework
! R! ) = & P ( s)"#n ( s) ! n $%"# R ( s) ! R $% =
cov ( n, m r m m
s

= & Pr s n s "# Rm s ! Rm $% ! n & Pr s "# Rm s ! Rm $% =

() () () () ()
s s

"#
$1 $ %
() () () () () () () ()
= & Pr s n s Rm s ! Rm & Pr s n s ! n & Pr s Rm s + n ' Rm & Pr s =
s s s s

() () () () () () ()
= & Pr s n s Rm s ! Rm & Pr s n s ! n & Pr s Rm s + n ' Rm
s s s

() () ()
E n! = & Pr s n s
s
 Relationship of CAPM to our framework

1 #n s ! ! " n s R s ! R % =
PV0 =
1+ R f
P s
'r $ () () m m &( )( ( ) )
s
ps
!####"####$
# P s #1! ! R s ! R %%
( r $ () m m &) ( () )
= 'n s ( () 1+ R )
s ($ f )&

ps increases with Pr ( s ) , decreases with Rm ( s )

 Evolution of price and interest % in time
3
1

5
2

time
0 1 2

Q: What is price of e5 on branch 1?

What are prices of e2, e6 on branch 1?
What is price of e3 on branch 1?
 e3
3
1

2
At t = 0 6

Want to receive $1 on branch 3,

and $0 on all the other branches.
Two alternatives:

(1) At t = 0 simply buy 1 unit of e3. Cost = p3

(2) At t = 0 buy x units of e1

On branch 2 throw them out

But on branch 1 you get $x, and this is amount
needed to buy 1 unit of e3
Then cost of strategy (2) at t = 0 is x·p1

No arbitrage â costs are the same: p3 = x·p1

p3
x = p1 = price of e3 on branch 1 .
Recursive calculation of PV
identical to
direct calculation of PV
 n3
PVu

PV0 n4
n5

PVd
n6
 PVu n3
PV0
6 n4
Direct: PV0 = ∑ pi ni n5
i =3
PVd
n6
u
! p $ ! p $
Recursive: PV = # p & 3 # p && n4
# 3
& n + # 4

" 1% " 1%
d
! p $ ! p $
PV = ## 5 && n5 + ## 6 && n6
" p2 % " p2 %
6
PV0 = p1 ' PV u + p2 ' PV d = ( pi ni
!## #"### $ i=3
likeintented expectations
 3
1

2
6
 e3 e4 e5 e6

p3 p4
1 p1 p1
$0 $0
= $0.1 = $0.7
p5 p6
2 $0 $0 p2 p2
= $0.3 = $0.6
Riskless interest rates on branch 1 and on branch 2

If on branch 1 you want to buy a sure $1 payable at t =2,

then on branch 1,
buy: 1 ⊗ e3 + 1 ⊗ e4
pay: $0.1+ $0.7 = $0.8
Hence:
1
d1 = 0.8, r1 = !1 = 25%
1 1 0.8
1
d1 = 0.9, r1 = !1 = 11.1%
2 2 0.9
Viewed from t = 0,
the 1-year risk-less interest-rate
that will prevail at t = 1
is uncertain.

r1 = 25%
1

r1 = 11.1%
2
 25%

13.2%

11.1%

11.1%
 The Term Structure on the
different branches

Term Term Term

structure as structure on structure on
of t = 0 branch 1 branch 2
Riskless interest rate

14% 30% 14%

25%
13% 13%
20%
12% 15% 12%
10%
11% 11%
5%
10% 0% 10%
1 2 1 1
Time to maturity
 Treasury Yield Curve
“Yield curve” = “Term Structure”

Yields of selected Treasury securities, in percent.

9.5
9
8.5
8
Current
7.5
Month-ago
7
6.5
0.25 0.5 1 2 3 4 5 7 10 30
Years to Maturity
Source: Technical Data International
The New York Times / Oct. 5, 1998
 ‫עקום תשואות למק"מ ‬
‫גרף המבטא את התשואה של האג"ח מול מועדי פידיון שונים‪ .‬‬

‫‪2.60%‬‬

‫‪2.40%‬‬

‫‪2.20%‬‬
‫תשואה ‬

‫‪2.00%‬‬
‫יום מסחר אחרון‬
‫‪1.80%‬‬ ‫יום מסחר קודם‬
‫לפני שבוע‬
‫‪1.60%‬‬

‫‪1.40%‬‬
‫‪0.1‬‬ ‫‪0.2‬‬ ‫‪0.3‬‬ ‫‪0.4‬‬ ‫‪0.5‬‬ ‫‪0.6‬‬ ‫‪0.7‬‬ ‫‪0.8‬‬ ‫‪0.9‬‬ ‫‪1‬‬

‫‪25/10/2010‬‬
‫שנים ‬
 Treasury Yield Curve (WSJ)

8.20%

7.80%

Friday
4 weeks ago
1 week ago
7.40%
0.25 0.5 1 2 3 4 5 7 10 30
Years
Flat term structure
usually doesn’t occur
Years to Maturity

Usually:

Note: no meaning to: “interest rate changed”

Must specify what maturity.
Usually whole term structure will change.
16%
Yield Curve for March 1980 (Current Rate of Inflation: 12%)

14% Yield Curve for October 1988 (Current Rate of Inflation: 5.8%)

12%

10%

8%

6%
00 05 10 15 20
Years
Price of bonds over time
$1000
$0

$1000

$1000
$0

$1000
Payoffs
 Price of bonds over time
$1000
$1000 then $0
(0.8·1000)
$800
$0

(0.78·1000) $1000 then $0

$1000
$780
$1000
$1000 then $0
(0.9·1000)
$900
$0

$1000 then $0
$1000
Prices ; Payoffs
 Interest-rate risk (or price risk)
$1000

$800

$1000
$780
$1000

$900

$1000

No risk in last period!

On the long term (2-years) bond, there is price
risk.

The realized return on first period

is either: 2.56% or 15.38%.

But return from now (t = 0) to maturity is not risky:

( 1 + 2.56% ) ( 1 + 25% ) =
= ( 1 + 15.38% ) ( 1 + 11.1% ) =
= ( 1 + 13.2% ) 2
 Factors affecting bond prices

$800

$780
$780 k $800: Two forces in opposite directions

Force 1 Passage of Time.

On money committed for 2 years,
get 13.2% per year after 1 year:
$780 ( 1 + 13.2% ) = $882.96

But $780 grew to only $800…

Force 2 Increase in interest rate
from 11.1% to 25%
causes a decrease in bond’s price to $800.

For, suppose price is $882.96 at t = 1.

This means a buyer will get just 1000 − 1 = 13.2%
882.96

But buyer can get 25% elsewhere,

Nobody buys!

To sell, seller needs to lower price to $800.

Only then is price competitive!
$882.96

$800
$780
Comparing investment in long term bonds
with investment by ‘rolling-over’
short-term bonds

B1 = Pure discount, 1-year to maturity,

risk-less bond.

B2 = Pure discount, 2-year to maturity,

risk-less bond.
 Roll-over shorts Buy and hold
Buy B1 at t = 0;
long-term
Collect on it at t = 1, bond
and buy B2 Buy B2 at t = 0;
Hold it until t = 2 Hold it until t = 2

11.1%
2.56%
First year return
(sure)
15.38%
First 11.1% then 25% = 13.2% and again 13.2%
38.9% per 2-yr = 28.1% per 2-yr
Two year return First 11.1% then 11.1%
= 23.4% per 2-yr (sure)
(risky)

No strategy is dominant for either term!

 Price of bonds over time
0
$1000

Price = x 0
0

$1000
0
d1 discount a pure $1 at t = 1 to $0.9 at t = 0
d1 discount a pure $1000 at t = 1 to $900 at t = 0
d1 discount a pure PMT1 at t = 1 to d1·PMT1 at t = 0
!
! PMT $
## 1&
1+r &
" 1 %
d1·PMT1 PMT1
time

0 1 2

If risk-less payoffs – can collapse

 $1000
0

Price = x $1000
$1000

0
$1000
d2 discounts a pure $1 at t = 2 to $0.78 at t = 0
d2 discounts a pure $1000 at t = 2 to $780 at t = 0
d2 discounts a pure PMT2 at t = 2 to d2·PMT2 at t = 0
!
! $
# PMT2 &
# 2&
# 1+r &
( )
" 2 %
d2·PMT2 PMT2
time

0 1 2

If risk-less payoffs – again can collapse

 $1000
$100

Price = x $1000
$1000
$100

$1000
d1 d2
!#"# $ !## #"### $
( ) ( )
PV = 100 ! p1 + p2 +1100 p3 + p4 + p5 + p6 =
= 100d1 +1100d 2

100 1100
PV = + 2
= 100d1 +1100d 2
1+ r1 1+ r
(2 )
d2·PMT2 PMT1 PMTtime
2

0 1 2
PMT1 PMT2
PV = + 2
= PMT1 ⋅ d1 + PMT2 ⋅ d 2
1 + r1 (1 + r2 )
 More generally $80+1000
$80

$80
$80
Price?

d2 d3 d4
d1

0 1 2 3 4
Risk-less 4 years to maturity 8% coupon bond
Computing present value when term structure is not flat

PV = PMT1 ! d1 + PMT2 ! d 2 + PMT3 ! d3 + PMT4 ! d 4 =

t=0

PMT1 PMT2 PMT3 PMT4

= + 2
+ 3
+ 4
=
1+ r1 1+ r2 ( )
1+ r3 (
1+ r4 ) ( )
4 N
PMTn
= " PMTn ! d n = " n
n=1 n=1 (1+ r )
n
 KWWSZZZWKHPDUNHUFRPPLVFDUWLFOHSULQWSDJHLVQRWDYDLODEOH


ʭʩʰʣʩʱʴʮʤʺʧʮʹ
ʤʦʮʣʩʱʴʤʬʬʥʬʲʤʺʠʡʥʧʪʬʭʩʸʩʦʧʮʹʫʭʢ

ʺʩʮʲʩʢʧʺʠʮ  

ʷʬʧʬʹʭʣʷʥʮʯʥʩʣʴʬʲʸʡʲʹʲʥʡʹʡʤʲʩʣʥʤʯʩʩʰʡʥʺʥʲʷʹʤʩʷʱʡʥʷʹʸʴ
ʬʷʹʯʥʩʬʩʮʫʸʩʦʧʺʥʡʤʷʩʴʰʤʹ
ʣʤʸʣʱʮʧʢʠʯʩʢʡʤʡʥʧʮ
ʺʬʩʧʺʡʳʱʫʤʺʠʤʱʩʩʢʩʷʱʡʥʷʹʸʴʬʷʹʯʥʩʬʩʮʬʹʤʸʣʱʪʥʺʮ
ʭʩʲʩʷʹʮʤʥʠʸʹʯʥʫʩʱʤʺʠʤʴʷʩʹʹʫʬʹʤʤʥʡʢʺʩʺʰʹʺʩʡʩʸʡ
ʤʩʷʱʲʡʤʫʸʡʩʷʱʡʥʷʹʸʴʤʺʠʸʱʥʩʢʤʦʠʮʭʬʥʠʥʯʬʣʰʤʺʸʡʧʡ
ʪʥʮʱʤʧʩʬʶʮʡʹʥʮʡʤʰʥʡʠʩʤʹʤʰʥʫʹʤʠʥʤʤʸʡʧʤʬʹʭʩʨʷʩʥʸʴʤʣʧʠ
ʤʠʶʮʩʷʱʡʥʷʹʸʴʥʺʥʩʴʩʶʤʮʸʩʤʮʡʶʷʡʥʬʤʰʺʤʨʷʩʥʸʴʤʺʥʸʩʫʮʤʬʮʸʬ
ʩʧʫʥʰʤʯʥʤʤʷʥʹʡʤʴʥʷʡʳʣʥʲʭʲʭʦʩʬʫʬʹʥʮʥʬʧʠʥʤʹʡʶʮʡʤʮʶʲ
ʺʸʡʧʤʬʷʤʺʩʤʤʨʬʧʤʤʹʪʫʡʩʰʩʹʩʣʩʬʥʱʷʩʴʠʠʥʶʮʬʩʸʹʴʠʩʺʬʡ
ʭʣʷʥʮʯʥʩʣʴʲʶʡʬʤʬʸʹʠʮʤʺʥʰʮʠʰʤʸʨʹʡʳʩʲʱʤʺʠʤʬʶʩʰʯʬʣʰʤ
ʥʰʧʰʠʹʩʰʴʬʬʡʠʤʸʡʧʤʬʹʤʰʱʥʧʬʲʣʩʲʮʩʷʱʡʥʷʹʸʴʬʹʪʬʤʮʤ
ʳʱʫʤʺʠʸʩʦʧʮʹʩʮʹʩʺʥʡʥʧʭʩʨʮʥʹʭʩʰʥʷʩʩʨʤʹʯʮʦʡʹʪʫʬʲʭʩʧʮʹ
ʬʹʤʠʥʹʺʭʲʭʩʩʺʰʹʮʸʺʥʩʣʥʲʮʺʥʰʤʩʬʭʥʷʮʡʹʸʥʫʦʬʡʥʹʧʯʮʦʤʩʰʴʬ
ʤʹʣʧʤʲʷʹʤʹʴʧʬʥʳʱʫʤʺʠʺʧʷʬʧʢʠʤʩʬʲʡʥʩʹʫʲʭʩʫʩʸʶ
ʺʩʱʰʰʩʴʤʤʺʥʫʩʠʡʬʥʴʩʺʹʧʩʰʤʬʸʩʡʱʹ
ʭʣʷʥʮʯʥʩʣʴʲʶʡʮʠʥʤʭʠʱʰʷʭʬʹʮʷʰʡʮʤʠʥʥʬʤʬʨʥʰʤʩʨʸʴʧʥʷʬ
ʯʩʡʮʤʤʥʡʢʤʺʥʸʹʴʠʤʤʩʤʩʧʢʠʤʩʬʲʡʬʩʥʶʩʴʤʩʷʱʡʥʷʹʸʴʬʹʤʸʷʮʡ
ʯʥʩʣʴʤʲʢʸʬʣʲʺʩʡʩʸʤʩʮʥʬʹʺʥʯʸʷʤʭʥʬʹʺʺʥʠʡʤʺʥʩʶʴʥʠʤʹʥʬʹ
ʺʩʡʩʸʺʴʱʥʺʡʯʸʷʲʮʹʮʤʸʣʱʤʬʹʭʩʰʮʥʦʮʤʭʩʸʦʺʺʸʺʩʭʥʬʹʺ
ʷʥʹʤʩʥʥʹʭʥʬʹʺʥʠʺʴʱʥʺʡʺʩʺʬʹʮʮʧʢʠʺʠʥʹʺʩʴʬʺʰʥʥʤʮʤ
ʸʺʥʩʡʤʥʡʢʤʪʸʲʤʺʬʲʡʠʩʤʤʩʩʰʹʤʤʩʶʴʥʠʤʸʥʦʧʮʡʡʥʧʤʺʥʸʢʩʠʬʹ
ʯʥʩʬʩʮʭʺʥʠʬʲʬʹʺʩʺʰʹʺʩʡʩʸʧʢʠʤʩʬʲʡʬʷʩʰʲʺʠʩʤʯʩʩʣʲʥ
ʬʷʹʯʥʩʬʩʮʬʡʥʸʷʬʹʬʹʣʱʴʤʭʥʬʢʤʦʤʯʥʩʣʴʡʭʣʷʥʮʥʣʴʩʩʹʬʷʹ
ʭʥʫʱʤʮʨʲʮʫ
ʭʩʠʶʥʩʤʭʩʰʣʩʱʴʮʤʺʧʮʹʥʦʭʣʷʥʮʤʯʥʲʸʩʴʤʬʲʭʩʧʮʹʧʢʠʤʩʬʲʡʭʠ
ʺʥʲʷʹʤʬʥʤʩʰʡʤʮʫʥʧʤʲʢʸʬʫʡʣʥʡʩʠʬʺʫʬʬʬʥʬʲʭʴʱʫʹʤʧʰʤʺʣʥʷʰʮ
ʺʥʧʬʶʥʮʤʺʥʸʡʧʤʮʭʢʧʩʥʥʸʤʬʺʲʣʬʠʩʤʺʥʩʰʸʶʰʥʷʤʧʢʠʤʷʥʹʡ

ZZZWKHPDUNHUFRPPLVFDUWLFOHSULQWSDJH


 Callable Bonds
At t = 0, firm issues 2-year default riskless bond.
Want to set issue price to $1000 (at par).

Set coupon rate = x

Want:

1000 + x 1000x +1000

+ 2
= 1000
1.11 1.1322
x = 0.1312 = 13.12%
 $1131
$131
Price =
$1000 $1131
$1131
$131

$1131

Still planning, CFO thinks:

•  If promise at t = 0 to pay 13.12% for 2 years.
•  If at t = 1, I am on branch 1 , r1 = 25% Ú Happy!
•  But if on 2 , r1 = 11.1% Ú Sad!
I will want to refinance.
 Attach a “call provision”:
“At t = 1, after payment of first coupon,
issuer reserves right to call bond
for face-value + sweetener”
$1000 + $9 = $1009 ¡ call price

At time 1, issuer has option to call bond.

She will do whatever is best for her.
1. If on branch 1, then r1 1
= 25%
Call {pay $1009 at t = 1}
Decision
Call or not?

{!pay $1131 at t = 2}
###"###$
Don’t call equivalent to:
! $1131 $
" pay =$904.8 at t=1% ' better!
# 1.25 &

Must compare dollars at the same time!

Why equal? Because can pay $904.8 at t = 1,
or invest at 25% and get $1131 at t = 2.
1. If on branch= 2, then r1 2 = 11.1%

Call {pay $1009 at t = 1}

Decision !
Call or not?
better!

{!pay $1131 at t = 2}
###"###$
Don’t call equivalent to:
" $1131 %
# pay =$1018 at t=1&
$ 1.111 '
Can refinance:
at t = 1 borrow $1009,
call bond and pay borrowed amount as call price.

At t = 2 pay 1009*(1 + 1.11%) = $1121

Better than not to refinance
And having to pay then $1131.
Who profits from call provision?
Issuer inserts call. Does buyer lose?
No!
Market prices the bond taking account of call provision.
$1131
$131
Callable $1131
bond price =
$994.74 $0

$131 $0
+
$1009

As if issuer sold a regular bond to buyer,

but also bought from him an option to call back the bond
for $1000 – $994.74 = $5.26