Investments Merged

INTRO TO CORPORATE FINANCE AND INVESTMENTS
TOPIC: TIME VALUE OF MONEY AND CAPITAL BUDGETING

Professor
M. Max Croce
SDA Bocconi Asia Center I Capital Markets

Outline
 Future and Present Values

 Basic formulas
 How interest is Paid and Quoted
 Capital Budgeting
 Net Present Value
 Internal Rate of Return
 Payback Rule

Future and Present Values

General Concepts
Present Value
Value today of a
future cash flow.
Future Value
Amount to which
an investment will
grow after earning
interest
Future Values
FV  $100  (1  r) t
Example: What is the future value of $100 if interest is compounded

annually at a rate of 7% for two years?
FV  $100  (1.07)  (1.07)  114.49
FV  $100  (1  .07) 2  $114.49
What if the rate increases to 8% in the second year?
FV = $100x(1.07)x(1.08)= 115.56

Present Value (PV)
 Discount Factor (DF): PV of $1 paid t-periods ahead
DF  1
(1 r ) t
 PV formula: example with cash-flow paid in 2 periods
PV  DF2  C2
PV  1
(1.07 ) 2
 114.49  100

Multiple Cash Flows
 General formula: PV0  C1
(1 r ) 1  C2
(1 r ) 2  ....  Ct
(1 r ) t
 Perpetuity: Financial concept in which a constant cash flow, C, is theoretically received forever. PV = C/r
 Annuity: a constant payment C for t periods: 1 1 

PV of annuity  C    t
 r r 1  r  
 Perpetuity with constant growth (g): PV = C/(r-g)

Examples:
 What is the future value of $20,000 paid at the end of each of the following 5 years, assuming your
investment returns 8% per year? Hint: compute the PV first, then the FV.
 1  .085  1
FV  20,000   
 .08 
 $117,332
 What is the present value of $1 billion every year, for all eternity, if you estimate the perpetual discount rate
to be 10%? Use C/r = 1/0.10= 10 Bil.
 What if the investment is delayed by 3 years?
PV  $1 bil
0.10   1
1.10 3
  $7.51 billion

Examples:
 The state lottery advertises a jackpot prize of $590.5 million, paid in 30 installments over 30 years of
$19.683 million per year, at the end of each year. If interest rates are 3.6% what is the true value of the
lottery prize?
 1 1 
Lottery value  19.683    30 
 . 036 . 0361  . 036  
Value  $357.5 million
 What is the present value of $1 billion paid at the end of every year in perpetuity, assuming a rate of return
of 10% and a constant growth rate of 4%?
• $1 Bil/(.10-.04) = $1bil/.06 = $16.667 Bil

How to Quote an Interest Rate
 Annual Percentage Rate (APR) - Interest rate that is annualized using simple interest
APR  MR  12
 Effective Annual Interest Rate (EAR) - Interest rate that is annualized using compound interest
EAR  (1  MR )  1 12
 Why? You gain interest on interest

Example
Example:
 Given a monthly rate of 1%, what is the effective annual rate (EAR)?
12
EAR = (1 + .01) -1 = r
EAR = (1 + .01)12 -1 = .1268 or 12.68%
 What is the annual percentage rate (APR)?
APR = .01  12 = .12 or 12.00%

Units Matter: Nominal and Real Rates and Cash-Flows
 Real rate: it measures the percentage increase in purchasing power

1 + r_nominal = (1 + r_real)*(1+ expected inflation)
 Note: ignoring compounding,
r_nominal ≈ r_real+ expected inflation
 Real Cash Flow: nominal cash-flow adjusted for inflation over the next t-periods
NCF(t) = RCF(t) * (1+expected inflation)t
 Rule of Thumb: discount real CF by real rate and nominal cash flows by nominal rates

Nominal vs Real: Examples
 Assume that your sales in one period are estimated to be 2.12 INR. The nominal discount rate is 6% and expected inflation is
4%.
 Using nominal units, what is the PV?

2.12/(1+.06) = 2 INR
 How do you obtain the real cash flow?

RCF = 2.12/(1+.04)
 How do you define the real rate?
(1+r_real) = (1+.06)/(1+.04)
 Using real units, what is the PV?

RCF/(1+r_real) = [2.12/1.04]/[1.06/1.04] = 2.12/1.06 = 2
 Note: inflation cancels out!

Time-Varying Discount Rates.
 Assume that you want to compute the PV of $2,000 that you will receive in two years. The payment is risk-free, i.e.,
comparable to the face value of a US Treasury Bond.
 For the current year, the FED has set the interest rate to 0.50%. The have also announced that the rate will be
increased to 1% by the end of the year. What is the appropriate way to compute the PV?
 From year 2 to year 1: PV(1) = 2000/(1+0.01)

 From year 1 to present: PV(0) = PV(1)/(1+0.005)
2000
 Consolidating the math: PV(0) = 1.01∗1.005

Capital Budgeting

The Key Problem:
 Retain resources and invest in profitable projects or pay dividends
Cash
Investment Financial Shareholders Investment

(Project X) Manager (financial assets)
Invest Alternative: Pay Shareholders

dividend to invest for
shareholders themselves

Methods and Importance
 Graham and Harvey, “The Theory and Practice of Finance: Evidence from the Field,” run a survey of CFOs

Net Present Value (NPV)
 Steps:
 Estimate future cash-flows from the project
 Choose the appropriate discount rate

 Match riskiness of the project
 Match the duration of the project (long-/short-term rate)
 Match the units (nominal/real)
 More broadly, a good measure of alternative investment opportunities (opportunity cost of capital)
 Compute PV(future cash-flows)
 Subtract the initial costs required to start the project to get to the NPV
 Rule of thumb: invest if NPV>0

NPV and Market-to-Book (M/B)
NPV = -Cost + PV(future cash-flows)
 What is the market value of the assets in place?

PV(future cash flows)
 What is the book value of the investment?

Historical Cost
 The NPV rule can be restated as:

`Ìnvest in all projects with M/B greater or equal to 1”
 Rule of thumb: keep investing until the marginal project has a zero-NPV, that is, M/B=1.

Internal Rate of Return (IRR)
 Definition of Internal Rate of Return (IRR) - Discount rate at which NPV = 0

 Internal Rate of Return Rule - Invest in any project offering a rate of return that is higher than the opportunity cost
of capital
 Example: You can purchase a turbo powered machine tool gadget for $4,000. The investment will generate $2,000
and $4,000 in cash flows for two years, respectively. What is the IRR on this investment?
2,000 4,000
NPV  4,000   0
(1  IRR )1 (1  IRR ) 2
3000
IRR = 28%
2000
1000
NPV (,000s)
0
-1000
-2000
Discount rate (%)
IRR: Pitfall (I)
Multiple Rates of Return: Certain cash flows can generate NPV = 0 at two different discount rates (when positive
and negative cash flows alternate over time)
 Example: C(0) = -30; C(1)=…=C(9) = 10; C(10) = -65

IRR: Pitfall (II)
Mutually Exclusive Projects: IRR sometimes ignores the magnitude of the project
Example: assume both projects bear a discount rate of 10%
Project C0 C1 IRR NPV @ 10%

D  10,000  20,000 100%  8,182
E  20,000  35,000  75%  11,818

Capital Rationing
 Capital Rationing - Limited amount of funds available for investment

 Soft Rationing - Limits on available funds imposed by management
 Hard Rationing - Limits on available funds imposed by the unavailability of funds in the capital market
 Rule of thumbs:
 Choose projects that maximizes NPV;
 often (but not always!) that means high profitability index (PI=NPV/Investment) projects
 Try to anticipate the dynamics of cash-flow

Capital Rationing: Examples
 You can obtain only 10 Mil in each of years 0 and 1. Cash available and the following options. Maximize the NPV.
Cash Flows ($ millions) DRate

Project C(0) C(1) C(2) NPV at 10% PI 0.1
A -10 30 5 21 2.1
B -5 5 20 16 3.2
C -5 5 15 12 2.4
D 0 -40 60 13 0.3
 Optimal strategy: Invest in A and then in D.

Other Methods
 Book Rate of Return (Accounting Rate of Return): Average income divided by average book value over project
life. Managers rarely use this measurement to make decisions since it reflects tax and accounting figures, not
market values or cash flows.
 Payback Period: number of years required for the cumulative cash flow to equal the initial investment. Rule
prescribes investing if payback period is shorter than a given time-frame
 Problems:
 It ignores the time-value of money
 It ignores the cash-flows after the given time-frame
 It does not assess profitability

Exercises/Review

Compute the Profitability Index of the Following Projects:
 Assume that your opportunity cost of capital is 10%.
Cash Flows ($ millions)

Project C(0) C(1) C(2)
A -10 12 5
B -8 5 20
C -5 0 20
D 0 -10 10

Capital Rationing
 You have a budget of 1000 and the following menu of projects. Your opportunity cost of capital is 11%. Which
projects would you choose? How much value do you loose because of the budget limit?
Project Investment IRR NPV

1 -300 17.2 66
2 -200 10.7 -4
3 -250 16.6 43
4 -100 12.1 14
5 -100 11.8 7
6 -350 18 63
7 -400 13.5 48

THANKS YOU

TOPIC: VALUING BONDS
Professor
M. Max Croce

Outline
 Bonds
 How Bonds Are Priced and Quoted
 Term Structure of Interest rates
 Inflation Protected Bonds
 Why bonds are risky:

 Interest Rate Risk
 Risk and Term Structure
 Real rates and the capital market
 Inflation risk and monetary policy
 Risk of Default
 Corporate default
 Sovereign default

Bonds Valuation

Terminology
 Bond: Security that obligates the issuer to make specified payments to the bondholder.
 Face value (par value or principal value) - Payment at the maturity of the bond.
 Coupon - The interest payments made to the bondholder.
 Coupon rate - Annual interest payment, as a percentage of face value.
 Note on Coupon Rate:

 The coupon rate IS NOT the discount rate used in the present value calculations.
 The coupon rate merely tells us what cash flow the bond will produce
 Since the coupon rate is listed as a %, this misconception is quite common

Valuing a Bond
 The price of a bond is the present value of all cash flows generated by the bond (i.e. coupons and face value)
discounted at the required rate of return, i.e., yield to maturity
cpn cpn (cpn  par )

PV    .... 
(1  r ) (1  r )
1 2
(1  r ) t
 Note: “cpn” is commonly used as an abbreviation for “coupon”

 Note: given the market price of the bond and its cash-flow payment, the yield to maturity can be computed as the
internal rate of return (IRR)

Example - France
 In October 2014 you purchase 100 euros of bonds in France which pay a 4.25% coupon every year. If the
bond matures in 2018 and the YTM is 0.15%, what is the value of the bond?
4.25 4.25 4.25 104.25

PV    
1.0015 1.0015 1.0015 1.00154
2 3
 116.34 euros

An Alternative Pricing Equation
 PV(bond) = PV(annuity of coupons) + PV(principal)

 Previous example continued:
PV (bond)  (cpn  PVAF)  (final payment  discount factor)

 1 1  100
 4.25    4

 . 0015 . 00151  . 0015   1  . 0015 4
 116.34

Example: Corporate Bonds and Terminology
 If today is October 1, 2015, what is the value of the following bond? An IBM Bond pays $115 every
September 30 for 5 years. In September 2020 it pays an additional $1000 and retires the bond. The bond
is rated AAA (WSJ AAA YTM is 7.5%)
115 115 115 115 1,115

PV     
1.075 1.075 1.075 1.075 1.0755
2 3 4
 $1,161.84

How Bonds are Traded and Quoted
 Bonds prices are usually quoted as a % of the face value. For example, if the face value is 1000 and the price is 1100,
then the bond is quoted at 110%.
 If the current price is greater than the face value, the bond sells at a premium. Why? High coupons or safe asset
 If the current price is lower than the face value, the bond sells at a discount. Why? Low coupons or risky asset
 Bonds are usually traded Over-the-Counter not on exchanges. This means that buyers need to contact a dealer (big
intermediary). Retail-level buyers contact a broker who contacts the dealer.
 Since there is a 1-to-1 negative link between price of a bond and IRR, often only yields are quoted:
 Bloomberg indices for 10y gov. bonds: [here]
 Comparison across major countries: [here]
 Data on India [here]

How Bonds are Traded and Quoted (II)
 We saw before that some bonds may have a maturity shorter than one year (Bills)
 The US government pays coupon semiannually
 How do we think of the YTM in these cases?
 Rule: compute the YTM using the frequency of the cash-flow payments, then annualize it!
 Example: In November 2014 you purchase a 3 year US Government bond with Face value of 1000. The
bond has an annualized coupon rate of 4.25% (APR), paid semi-annually. If the annualized YTM is
0.965% (APR), what is the price of the bond?
21.25 21.25 21.25 21.25 21.25 1021.25

PV      
1.004825 1.0048252 1.0048253 1.0048254 1.0048255 1.0048256
 $1,096.90

Term Structure

Term Structure of Interest Rates
 Definition: a graph (or table) showing yields of bonds of different maturities measured at a given time
Maturity 1 2 5 10
1/1/2007 2 2.7 3 4
1/1/2017 0 0 2 5
Chart Title
6
0
1 2 5 10
1/1/2007 1/1/2017
 Updated data [here]

Short-Term Rates Change across Countries and over Time
 Central Banks and the Business Cycles are at work [From OECD here]

Long-Term Rates Change across Countries and over Time
 Long term rates are a reflection of long-run expected economic growth, inflation and uncertainty [From OECD here]

US Nominal Rates and Inflation
 Inflation is a common component: relevant for all maturities.

India Nominal Rates and Inflation

The U.K.

Term Structure of Interest Rates: Sources
 Term Structures Change daily! Many countries [here].

Real Bonds (Inflation-Indexed Cash-Flows)

Term Structure of Real Interest Rates
 Treasury Inflation-Protected Securities (TIPS): provide insurance against inflation because the payments are
increased (or decreased) with inflation (with deflation). The US government commits not to decrease the face value
if cumulative inflation has been negative.
 Not all government offer inflation-indexed bonds, but both the US and the UK.
 Example 1: consider a zero-coupon real bond with maturity of 2 periods. Assume that FV=100 at time zero and that
Inflation is 1% in period one and 2% in period 2.
 The government pays a final face value of
max (100, 100*(1.01)*(1.02))
that is about 103.
 Example 2: consider a zero-coupon real bond with maturity of 2 periods. Assume that FV=100 at time zero and that
Inflation is 1% in period one and -2% in period 2.
 The government pays a final face value of
max(100, 100*(1.01)/(1.02)) = 100

Real vs Nominal Yields

Inflation: Recent Times
 Recent updates on inflation in different areas [From OECD]

Take-Aways So Far
 The yield curve tells us which discount rate is appropriate according to the duration of the cash-flow you are
discounting
 Use short-term yields for short-duration projects
 Use long-term yields for long-duration projects
 Use real yields for cash-flows that tend to adjusts with inflation (say, for example, gold or real estate)
 Yields curve data are available for many-many countries, which is important for international corporation
 Inflation is a major determinant of nominal yields over time: Why bother?

 As nominal yields change, the value of the bond changes as well and exposes us to financial risk (see next
slides!)
 As nominal yields change, the NPV of your projects changes as well

The Riskiness of Bonds

Bond Holding Returns
 Assume to buy today, t, a bond with maturity of n>1 periods at price P(t,n). Assume to sell the bond tomorrow, t+1.
Your holding return is:
 R(t+1,n)=P(t+1,n-1)/P(t,n) for zero-coupon bonds
 R(t+1,n)=(P(t+1,n-1) + C(t+1))/P(t,n) for regular bonds
 Example 1: you buy a 2-period bond with FV=100 at 100. You sell it after one period at 98 and cash a coupon of 3.
Your gross return is (98+3)/100=1.01 -> 1% net return.
 Example 2: you buy a 2-period zero-coupon bond with FV=100 with a yield of 5%. You sell it after one period
knowing that the new yield curve gives you a yield of 4% for 2-period ZCBonds and 1% for 1-period ZC-bonds.
 Let’s prove in class that your net return is about 10%.
 Big lesson: as the yields (rates) change according to market forces, your wealth invested in bonds changes as well!
There is risk unless (1) you hold the bond until maturity, and (2) the bond issuer does not default.

Maturity and Price Sensitivity (Risk!)
Different maturity bonds have different interest rate risk
2 500
Blue line: long-term bond

2 000
Orange line: short-term bond
Bond price ($)
1 500
1 000
500
10
0
5
1
9
2.5
7.5
0.5
1.5
3.5
4.5
5.5
6.5
8.5
9.5
Interest rate (%) = YTM

Duration: Definition and Formula
 Def: it is a measure of the timing of the cash-flow payed by the bond. A (short) long duration means that most of the
cash-flow is paid in the far (near) future.
1 PV (C1 ) 2  PV (C2 ) 3  PV (C3 ) T  PV (CT )

Duration     ... 
PV PV PV PV

Example on Duration with xlsx Spreadsheet
Proportion of Total Proportion of Total

Year Ct PV(C t ) at 5.0% Value [PV(C t )/V ] Value Time
1 100 95.24 0.084 0.084
2 100 90.7 0.08 0.16
3 1100 950.22 0.836 2.509
V = 1136.16 1 Duration= 2.753 years

Modified Duration and Risk
 The elasticity (% variation) of the price of a bond w.r.t. the interest rate is equal to the modified duration
duration
Modified duration  volatility (%) 
1  yield
Bond price, percent
Interest rate, percent

Example on Modified Duration
 Calculate the modified duration of a 6 7/8% bond with a maturity of 5 periods @ 4.9% YTM
Year CF PV@YTM % of Total PV % × Year

1 68.75 65.54 .060 0.060
2 68.75 62.48 .058 0.115
3 68.75 59.56 .055 0.165
4 68.75 56.78 .052 0.209
5 1068.75 841.39 .775 3.875
1085.74 1.00 Duration 4.424
 Modified duration: 4.42/(1.049)= 4.21. What should the price be if the YTM goes to 5.9%?
Back to the Term Structure (I)
 Terminology:
 Spot Rate - The actual interest rate today (t = 0)
 Forward Rate - The interest rate, fixed today, on a loan made in the future at a fixed time
 Future Rate - The spot rate that is expected in the future
 Forward rates can be recovered from the yield curve recursively by no-arbitrage:
 Example: y(t,2) = 4% and y(t,1) = 2% implies a forward rate FR(t+1,1) = 4%*2-2% = 6% (approximately)
 Forward rates in the data are not identical to the expected future short-term rates because of uncertainty!
 In a forward contract we commit to a future interest rate before knowing whether it is convenient according to
future market forces

Back to the Term Structure (II)
 Assume to face an upward sloping term structure, here is what could be going on in the background:
 Expected future real rate are higher than the current ones
 Expected future inflation is higher than the current one
 Future uncertainty is higher than present one (on either real rate or inflation)
 Long-term bonds are less liquid than others and hence there is a liquidity premium
 Given these claims,

what do you think of this figure on US data?

A Simple Way to Think About Term Structure Risks

The Real and the Nominal Rates
 Nominal yields can always be thought as the sum of two components:

nominal yield = real interest rate + expected inflation
 Real rate:
 determined by the equilibrium of the capital markets
 Nominal rate:
 Once we know what is happening to the real real rate, we just need to think about forecasting inflation
 Think of the production costs (businesses set prices of goods and services)
 Think of the reaction of the Central Bank (Monetary Policy)

The Capital Market
Fixed Assets | Liabilities

Financial vs Real Investment: What is the difference?
Example 1
 Mary and friends decide to start their own company. To start their business, they need $5M to:
o Build a new commercial space
o Buy new office furniture, equipment and software
 Mary and friends have only $4M. They put this money down as equity. Joe lends $1M by buying a corporate bond
issued by Mary’s company.
 Is there financial volume? Is there real investment?
Example 2
 Joe suddenly needs cash and decides to sell his bond issued by Mary’s company. Ravi buys it, as he thinks that this
bond is a convenient investment vehicle.
 Is there financial investment? Is there real investment?

Whatever is produced but not
consumed is saved. The supply
A Chart for the Capital Markets of savings determines
investment.
Investment is a sizeable
component of GDP (15% in the
US) and is the key device to
accumulate capital
stock/infrastructures.
Consumers/Investors
Resources for Investment Savings
Firms
Financial (Capital) market

Cost of Capital Capital Income

National Accounting and Capital Markets
 In National Accounting, the following holds:

Stot = Spvt + Sgovt = I + NX
 In the Global Economy, NX=0 (at the world level all net exports cancel with net imports), and the capital market clear
when:
Stot = I
 What makes sure that the market clears?

 The real risk free rate adjusts!

A Way to think about Consumption/Saving Decisions
Ct = C(Yt-Tt, Yf - Tf, Wealth, risk, credit, r)

+ + + - + -
 Ct = current demand of real consumption goods and services
 Yt –Tt = current real income after taxes
 Yf –Tf = expected real future income after taxes
 Wealth = real value of wealth
 Risk = related to health, unemployment, natural disasters,…
 Credit = available credit in the financial sector
 r = real interest rate
o Substitution Effect (SE): r↑→more incentive to save, C↓

Total Savings in a Graph
SLOPE What shifts the

curve to the left?
r r↑→savings↑, as C t ↓ r Yt↓, G t↑, Y F↑, Wealth ↑, risk↓
Total Savings Total Savings

Desired Investment
 Desired investment is:

I = I( r, pK , MPKf , t, credit conditions)
 r is the interest rate:

o Capital Budget rules: As r↑→Net Present Value (NPV)↓→I↓
 pK is the price of equipment goods (initial cost of the project);
 MPKf is the expected future productivity of new capital (expected cash-flows);
 t is a measure of Effective Tax Rate on capital (ETR)

o sum of all taxes and shields affecting capital expressed in equivalents of corporate income tax (t)

Investment in a Graph
Id = I( r, pK , MPKf , t corp, credit)
- - + - +
SLOPE: r↓→NPV ↑ → I↑ What shifts the curve to the right?

pk↓, t↓, MPKf ↑ , credit ↑
r r
Investment Investment

The Equilibrium
Total Savings
Investment
S, I

Example: Better Health Care
 Think about Rural China: Chinese saving rate is expected to fall as soon as the country
will introduce better health insurance in the country side (where most of the savings
come from!)
Total Savings
Investment
S, I

Example: Increase in Government Deficit
 If G = government expenditure increases, there is crowding out of private investment.
Total Savings
Investment
S, I

Example: A Positive productivity Shock
 Think about the IT revolution: expected future productivity increases
Total Savings
Investment
S, I

Monetary Policy

Money Demand
 Demand of Money: comes from a portfolio allocation problem
 Trade-off: Given a certain amount of wealth, households have to decide how much cash to hold versus other
financial assets:
 BENEFITS OF CASH: liquidity services;
 COST of CASH: nominal interest rate i.

Supply of Money: the role of the Central Bank
 The Central Bank directly controls the monetary base, i.e., the currency component of M1
 The Central Bank changes the money supply through Open-Market Operations (OMO)
• Central bank purchases financial assets (e.g. government bonds) => Ms
• Central bank sells financial assets => Ms
 In practice, transmission of monetary policy is a bit more complicated and based on REPO rates
 (beyond the scope of our class)

Money (left) and Bonds (right) Market
Bonds
i
Money P of Available
Supply
bond
1
i1
1
P1
Money Bond Face Value

Expansionary OMO
i
Money P of
Supply Bonds
bond Available
1
i1 P2
2
2 1
i2 P1
Rember that P. of bond  when i  and viceversa.

Transmission Mechanism of Monetary Policy
 Prices of goods and services are somewhat sticky, i.e., they adjust with delay:
 Over the short run it is possible to have more (less) money growth without additional inflation adjustments, i.e.,
the real rate moves 1:1 with the nominal rate:
↑↓r = ↑↓i - inflation
 Over the short-run, controlling the nominal interest rate is equivalent to control the real rate, i.e., the main
determinant of consumption (C) and corporate investment (I).
 High rates, low demand of C+I
 Low rates, high demand of C+I

Objective of Monetary Policy
1. Stabilize GDP growth around its trend=potential/natural growth.

How?
 Avoid excessive growth by increasing the rates
 Avoid cyclical recessions by reducing the rates
 Output gap = Current GDP - Potential GDP
→ The central bank needs to stabilize the output gap
2. Stabilize inflation around target
 Avoid excessive inflation by increasing the rates
 Avoid deflation by reducing the rates

RBI and inflation
Global Great
Recession
Ordinary RBI Mon.

Pol. is back
SDA Bocconi
Copyright Asia-Hill
© 2017 McGraw Center I Capital
Education. MarketsNo reproduction or distribution w ithout the prior w ritten consent of McGraw-Hill Education.
All rights reserved.
Conventional vs Unconventional Monetary Policy
 Conventional:
 Move the short-term rates
 Unconventional Policies (Quantitative Easing):

 US ZLB: Dec 2008
 US QE 1 [Nov 2008 - March 2010]: lower long-term mortgage rate.
 US QE 2 [Nov 2010 – Dec 2013]: Buy 85 Bil.s of 10y Treasury Bonds every month.
 EU QE 1 [June 2012]: Buy Treasuries from PIGS [politically tricky]

 EU ZLB: June 2014
 EU QE 2 [Oct 2014]: Buy private long-term securities
 Tapering – beginning of exit strategy from QE, the Central Bank slowly reduces the injection of cash
 US: Dec 2013 – Oct 2014
 EU: promised to start in mid 2019

Why QE May Have Helped the Economy?
 EXAMPLE. Consider a project requiring an investment of $1 and paying $2 over 10 years.

 Assume the short-term rate over 1-year is equal to 1%, and a 10-year yield of 9%: NPV = -1 + 2/(1.09)^10 = -0.16
 Assume the short-term rate over 1-year is equal to 0%, and a 10-year yield of 8%: NPV = -1 + 2/(1.08)^10 = -
0.074
 Assume the central bank reduces the 10-year yield to 7%: NPV = -1 + 2/(1.07)^10 = +0.0167 → investment
increases by $1.
 Long-story-short: at the zero-lower-bound, central banks manipulate the entire yield curve!

Key Factors for the Yield Curve in India
 The article ``Factors causing movements of yield curve in India” by Kakali Kanjilal (IMI), published in Economic
Modeling:
 The article identifies principal reasons underlying the movements of yield curve for government debt market in
India for the period Jul '97 to Dec '11. […]
 99% of the movements in yield curves in India are explained by three factors which are ‘level’ (long-term
factor), ‘Slope’ (short-term factor) and ‘Curvature’ (medium-term factor) with ‘level’ contributing more than
90% of its variations.
This implies that in more than 90% of cases, the yield curves move parallel either in upward or in downward
direction bringing similar effects to all maturity spectrums. This means that yield curve movements in India mainly
reflect the monetary policy changes of central bank. […]
 [ADVANCED TOPIC:] This finding also suggests that a simple ‘duration and convexity’ hedging strategy should be
appropriate to cover maximum risk exposure of government debt market investors in India.

Default Risk

Definitions
 Default or Credit Risk - The risk that a bond issuer may default on its bonds
 Default premium - The additional yield on a bond that investors require for bearing credit risk
 Investment grade - Bonds rated Baa or above by Moody’s or BBB or above by Standard & Poor’s
 Junk bonds - Bond with a rating below Baa or BBB

Definitions (II)
Standard
Moody' s & Poor's Safety
Aaa AAA The strongest rating; ability to repay interest and principal
is very strong.
Aa AA Very strong likelihood that interest and principal will be
repaid
A A Strong ability to repay, but some vulnerability to changes in
circumstances
Baa BBB Adequate capacity to repay; more vulnerability to changes
in economic circumstances
Ba BB Considerable uncertainty about ability to repay.
B B Likelihood of interest and principal payments over
sustained periods is questionable.
Caa CCC Bonds in the Caa/CCC and Ca/CC classes may already be
Ca CC in default or in danger of imminent default
C C C-rated bonds offer little prospect for interest or principal
on the debt ever to be repaid.
SDA Bocconi
Copyright Asia-Hill
© 2017 McGraw Center I Capital
Education. MarketsNo reproduction or distribution w ithout the prior w ritten consent of McGraw-Hill Education.
All rights reserved.
Prices and Yields of Corporate Bonds

Credit Rating and Risk in India
 The article “Modelling Credit Risk in Indian Bond Markets” by Varma (IIM) and Raghunathan (IIM) on the Journal of
Applied Finance.
 […] In this paper therefore, we analyse credit rating migrations in Indian corporate bond market to bring about
greater understanding of its credit risk.
 Probability of an upgrade within a quarter: 1%-4%

 Probability of being upgraded by one notch: 80% (very rare 2 notches at the time)
 Probability of a downgrade within a quarter: 2%-8%

 Probability of being upgraded by one notch: 40% (2 notches at the time is frequent)
 Why do we care? Assume that you have a AAA bond with a yield of 5%. Assume that it may migrate to BBB and pay a
yield of 7% with probability 50%. What is your expected loss? Let’s do it in class!

Yield Spread
Yield Spreads between Corporate and 10-year Treasury Bonds

Corporate Credit Spread in India
 The Article “The impact of monetary policy on corporate bonds in India” by Sensarma (IIM) and Bhattacharyya (RBI)
published in Journal of Policy Modeling:
 [They] analyse the impact of monetary policy on the shape of the corporate yield curve and credit spread using
a macro-finance approach. […] we use market proxies of level, slope and curvature of the corporate yield curve
and credit spread.
 The results demonstrate that while monetary policy has the dominant impact among macroeconomic variables
on the entire term structure, it is particularly strong at the short end and on credit spreads.
 When RBI tightens monetary policy, the entire corporate yield curve shifts up for 8 months. The shifts is almost
parallel, but stronger on the short-term yields.
 Monetary policy tightening increases the corporate yields through 2 channels: it increases government yields,
but it also increases the credit spread with a delay of about 6 months.
 Monetary Policy explains most of the movements of the corporate yield curve as well, but with a delay of 6
months.

Sovereign Default Risk
 Government may default as well!

 `Developed’ Countries like Greece may default because they run our of fiscal capacity
 Èmerging Economies’ may default because:
 They feature poor economic growth
 Lack of fiscal capacity
 They have (``cheaper’’) debt in foreign currency and their domestic currency become too weak
 Other forms of default:

 Pay debt by issuing more money and have excessive inflation (real return to bond investors declines).
 Pay local currency denominated debt but after having devaluated the local currency

Relevance of the Problem [here]
 Sovereign external debt, 1800-2008: Percentage of countries in external default or restructuring weighted by their
share of world Production
45
Share of Countries in Default
40
35
As percentage of World Income
30
25
20
15
10
0
1800
1842
1849
1856
1905
1912
1961
1968
1807
1814
1821
1828
1835
1863
1870
1877
1884
1891
1898
1919
1926
1933
1940
1947
1954
1975
1982
1989
1996
2003
 Let’s see who-is-who [Europe and Latin America] [Africa and Asia]
THANKS YOU

TOPIC: VALUING EQUITIES AND RISK
Professor
M. Max Croce

Outline
 Common Stocks
 How Common Stocks Are Traded
 How Common Stocks Are Valued
 Multiples of Comparables
 Discounted Cash Flow Model
 Valuing a Business
 Risk and Returns

 Capital Market History
 Measuring Risk
 How Individual Securities Affect Portfolio Risk

Common Stocks

How Common Stocks Are Traded
 Common Stock: Ownership shares in a publicly held corporations. Pay random dividends (if any) and give you voting power
 Primary Market: Market for the sale of new securities by corporations (equity financing)
 Secondary Market: Market in which previously issued securities are traded among investors
 Huge trading volume
 Stock exchanges (e.g., NYSE in the USA; BSE and NSE in India)
 Computer-based auctions
 Limited order book: collects all buy/sell orders at a given limit price
 Over-the-Counter markets (e.g., and NASDAQ): dealers buy and sell securities
 Electronic Communication Networks (ECNs): A number of computer networks that connect traders with each other
(e.g., London exchange)
 Exchange-Traded Funds (ETFs): Portfolios of stocks that can be bought or sold in a single trade
 SPDRs (Standard & Poor’s Depository Receipts or “spiders”): ETFs, which are portfolios tracking several Standard & Poor’s
stock market indexes

How Common Stocks Are Quoted: Tata (NSE)

How Common Stocks Are Valued
 Valuation by comparables:
 Definitions
 Book Value: net worth of the firm according to the balance sheet
 Market Value Balance Sheet: financial statement that uses market value of assets and liabilities
 Relevant ratios (multiples)

 M/B Ratios= Market-to-Book (also denoted as P/B, price-to-book value of a share)
 P/E Ratios: Price per share divided by earnings per share
 Valuation using the Dividends Cash Flow (DCF) model:

 Dividends: Periodic cash distribution from the firm to the shareholders
 Present Value approach

Valuation by Comparables
 Notes:
 Useless for
 New firms in new industries (e.g., Facebook in 2010)
 Start-up companies (they do not have earnings)
 Useful for:
 pricing when there is no stock price (e.g., a sub-brench of a bigger company, a family business)
 Pricing growth-firms that do not pay dividends
 Sources: many-many on the web (ET, …)
 Tata Motor Example: P/E, P/B

Expected Return
 Definition: The percentage yield that an investor forecasts from a specific investment over a set period of time.
Sometimes called the market capitalization rate or the cost of equity (r).
 Gross return is R=1+r.
 For a common stock: R = (D_1 + P_1)/P_0.

This also implies P_0 = (P_1 + D_1)/R,
and (forward by one period) P_1 = (P_2 + D_2)/R.
Hence, we can write: P_0 = D_1/R + D_2/R^2 + P_2/R^2 ,
 More in general: Div1 Div 2 Div H  PH

P0    ... 
(1  r )1
(1  r ) 2
(1  r ) H
H - Time horizon for your investment.

Discounted Cash Flow Model: Constant Growth g
 Assume that dividends grow at a constant growth rate, g, and with some math you get:
Div1
Price  P0 
rg
Div1
Capitalization rate  r  g
P0

Examples (I)
 Example 1
If Fledgling Electronics is selling for $100 per share today and is expected to sell for $110 one year from now, what is
the expected return if the dividend one year from now is forecasted to be $5.00?
r = (5+110-100)/100 = (5+110)/100 - 1
 Example 2
Fledgling Electronics is forecasted to pay a $5.00 dividend at the end of year one and a $5.50 dividend at the end of
year two. At the end of the second year the stock will be sold for $121. If the discount rate is 15%, what is the price of
the stock?
5.00 5.50  121

PV  
(1  .15)1 (1  .15) 2
PV  $100.00

Examples (II)
 Example 3
Current forecasts are for XYZ Company to pay dividends of $3, $3.24, and $3.50 over the next three years,
respectively. At the end of three years you anticipate selling your stock at a market price of $94.48. What is the price
of the stock given a 12% expected return?
3.00 3.24 3.50  94.48

PV   
(1  .12)1 (1  .12) 2 (1  .12) 3
PV  $75.00
 Example 4
Northwest Natural Gas stock was selling for $49.43 per share at the start of 2015. Dividend payments for the next
year were expected to be $2.00 a share. What is the dividend yield, assuming no growth?
r= D/P + g = 2/49.43+0 = 4.1%

How do we think of g?
 Plowback ratio: 1 – DIV/EPS, i.e., the fraction of earnings that is reinvested

 Return On Equity (ROE): EPS/Book Equity
 Dividend Growth Rate can be derived from applying the return on equity to the percentage of earnings plowed back
into operations.
g = return on equity × plowback ratio
 Notes:
 Different analysists may have different forecasts
 Growth goes through stages, we will need to adjust our formulas for different values of g

Cost of Equity (r), E/P ratio, and PVGO
 Consider a firm with positive dividend growth: what is the value of the growth opportunities? How this relate to E/P?
 Definition: the Present Value of Growth Opportunities (PVGO)
PVGO = P_{true} – P_{g=0}
 First step: recall that P_{true} = D/(r-g).

 Second Step: pretend that the payout ratio is 100%, i.e., the firm does not reinvest earnings. Then,
 dividends equal earnings (D=E)
 and hence does not grow (g=0):
Using the perpetuity formula: P_{g=0} = D/r =E/r.
 With a bit of math:

P_{true} = E/r + PVGO <-> E/P_{true} = r*(1-PVGO/P_{true})

Example about PVGO:
 ToTi Inc. has Div=100, r = 15%, and g=10%. Assume that earnings are 150 in case of g=0.
 What is the fair true price?

 100/(.15-.10) = 2000
 What would be the price without growth?

 150/.15 = 1000
 What is PVGO?
 2,000 – 1000 = 1,000
 What is the E/P ratio? How does it compare to r?

 15%*(1- 1000/2000) = 7.5% < r = 15%

Back to Project Evaluation

Valuing a Business project
 You can always forecast cash-flows over a transition phase lasting H periods and then account for the horizon value
 Terminology:
FCF1 FCF2 FCFH PVH
PV    ...  
(1  r ) (1  r )
1 2
(1  r ) H
(1  r ) H
PV (free cash flows) PV (horizon value)
 Disclaimer: the next example is based on the “Concatenator Manufacturing Division” example from the BMA book.
That example requires accounting skills that are not essential at this point for us. I will simplify the case.

An Example with Sensitivity Analysis
 Assume to have a project for which you are confident PV(free cash flows) = 0.9. In this example, H = 6, the growth rate
after the transition is g=6%, and the discount rate is r=10%. Dividends at time 7 are estimated to be 1.09.
 DCF approach: using the perpetutity with growth model, Horizon Value = 1.09/(.10-.06) =27.3
P = 0.90 + 27.3/(1.1^6) = 16.3
 P/E ratio: Assume that after the first 6 years of transition, Concatenator will be comparable to other mature firms with a P/E
ratio of 11. If earnings in H periods are estimated to be 2.18, how does the value change?
P = 0.90 + 2.18*11/(1.1^6) = 14.4
 P/B ratio: Assume that after the first 6 years of transition, Concatenator will be comparable to other mature firms with a
P/B ratio of 1.5. If the book value at H=6 is estimated to be 16.69, how does the value change?
P = 0.90 + 16.69*1.5/(1.1^6) = 14.1
 Horizon as the year in which PVGO=0: assume that after the first 6-years, the industry is competitive and all remaining
projects have NPV=0. At this point, there is no longer growth and earnings at H=7 are estimated to be 2.18.
P=0.90 + (2.18/.10) /(1.1^6)= 13.2

Risk and Returns

The Value of Investing $1 in 1899 in US (Nominal)

The Value of Investing $1 in 1899 in US (Real)

Average Risk Premiums by Country (Developped)

Risk Premiums in Emerging Markets (EMs) (I)
 Problems/Limitations
 Stock markets started more recently (e.g., 1994 for India) and hence very short sample
 Difficult to find a risk-free rate (EM governments default)
 Salomons and Grootveld (2003) [1976-2001]:

 Measure all returns in USD and use the US risk-free rate [All nominal, not inflation adjusted!]
Country ERP
Brazil 12.48
Russia 24.00%
India 4.08%
China 8.04%
South Africa -4.20

Risk Premiums in Emerging Markets (EMs) (II)
 Damodaran (2018):
 Take the S&P500 ERP (5.08%) and add a country-specific premium
 Country-specific premium depends on default premium (CDS), relative variability of the equity returns …
Country ERP
Brazil 7.62%
Russia 6.92%
India 6.06%
China 5.73%
South Africa 7.61%

Historical Realized Return vs Changes in ERP
 Like for bonds, there is a negative link between realized returns and dividend yield!
Example:
 Assume that last year in India expected growth was g=0.02, r = 0.12 (annual figures), and expected dividend for this year
was 1. Then, last year we had: P0= 1/(.12-.02)=10.
 Assume that this year risks increases and investors find appropriate to charge r=0.22 going forward. Assume that this year
dividends were consistent with previous expectations (D1=1), and hence future dividends are expected to be 1.02
The new fair price is P1 = (1*(1.02))/(.22-.02) = 1.02/.2 = 1.02*5
 What is the realized historical return ex-dividends (without accounting for the dividends)?
 r = P1/P0-1 =5/10*1.02 – 1 = -49% (net realized return)
 What is the realized historical return cum-dividends (including the dividends)?
 r = (P1+D1)/P0 -1 = (5*1.02 + 1)/10 – 1 = -39% (net realized return)
 What is the new appropriate ER (expected return, it includes the risk-free rate)? 22%

Assessing Risk

A Simple Measure of Risk: Variability
 Variance: Average value of squared deviations from mean

 Standard Deviation: Squared root of average value of squared deviations from mean
 Example:

Average Variability across Countries (Developped)

Time-varying Vol: US vs BRIC

Portfolios
 Portfolio: bundle of assets.

 The realized return of a portfolio is the value-weighted average of the returns of the assets in the portfolio
 Example: Assume to have only 2 assets (asset 1 and 2). You invest 70% in the first asset and 30% in the second
one. Then:
rp = .70*r1 + .30*r2 (we write w1=70%; w2=30%).
 As a result of the identity above:

 The expected return of a portfolio is the value-weigthed average of the assets expected returns
E[rp] = w1*E[r1] + w2*E[r2]

Definitions of Risks
 The variance of a portfolio return, V[rp] accounts for co-movements:

 Example: assume the 2 assets are perfectly inversely related (correlated). What happens?
 ADVANCED MATH [not required at the moment]

 V[rp] = w1^2*V[r1] + w1^2*V[r2] +2*w1*w2*COV[r1,r]
 COV[r1,r2] =E[ (r1-E[r1])*(r2-E[r2])] = corr(r1,r2)*sqrt(V[r1]*V[r2])
 Key point: when co-movements are low/negative, the variance of the portfolio declines. Why? Diversification!
 Diversification - Strategy designed to reduce risk by spreading the portfolio across many investments.
 Unique Risk - Risk factors affecting only that firm. Also called “diversifiable risk.”
 Market Risk - Economy-wide sources of risk that affect the overall stock market. Also called “systematic risk.”
You cannot diversify it away.

Diversification at Work
 Average standard deviation when you randomly add stocks from the NYSE to your portfolio
Market Vol

Sharpe-Ratio
 A common way to rank investment strategies is to look at their Sharpe-ratio (SR):
SR = E[r-r_free] / StDev[r-r_free]
 Example across asset classes in the US:
Asset E[r – r_free] StDev[r] SR

Equity 7.7 19.5 0.39
Bonds 1.5 8.9 0.17

Another Way to Assess Risk: Beta
 Market Beta: Sensitivity of a stock’s return to the return on the market portfolio from regression:
r_i - r_free = B_i*(r_mkt - r_free) + resid
 im
Bi  2
m
Covariance with the
market
Variance of the market
 Note: the beta of a portfolio is a value-weighted average of the assets betas:

beta_portf. = w1*beta_1+w2*beta_2
CAPM and Examples
 CAPM: E[r_i - r_free] = B_i*E[r_mkt - r_free]
 These estimates of the returns expected by investors in November 2014 were based on the capital asset
pricing model. We assumed 2% for the interest rate rf and 7% for the expected risk premium rm − rf.
There is a typo in this

table of the BMA
book. Since it is a
return (not excess
return), you need to
add also the risk-free
rate
Ex:
1.66*7%+2%=13.6%

Fama French Three Factors: MKT, SMB, HML
 Fama and French have shown that:
 Small stocks pay a higher average return than big stocks
 Growth firms (firms with low book-to-market) pay a lower return than value firms (high book-to-market)
 Both the value and the size spread are almost as large as the market risk premium.

If We Have Time
(Very Advanced)

2-Stage Growth

Two-Stage Growth: A Temporary Boom
 Due to a reduction in oil prices, Happiness Airlines can make bigger margins. Oil prices are expected to increase again
in 3 years when the ROE will go back to its normal lower level. The example below is appropriate for developed
countries.
Year: 1 2 3 4 r
EPS growth -- 9% -64% 3.0% 10%
Earnigs per Share 1.5 1.635 0.5941 0.6119
ROE 15% 15% 5% 5.0%
Payout Ratio 40% 40% 40% 40%
Dividends 0.6 0.654 0.2376 0.2447
Div. growth 9% -64% 3.0%
Book Equity (PS) 10 10.9 11.881 12.237
Book Equity Growth 9% 9% 3%
Price 2nd Stage 3.4964
SUM
Time-0 P.V. 0.5455 0.5405 3.6749 4.7609

Two-Stage Growth: a Start-Up in an EM
 Your Company.Inc has just started operations and you have decided to retain all earnings in order to grow as fast as
possible. Within 3 years, you will be able to payout dividends and sustain a long-run growth of 7.5%, consistent with
the growth of production in your country.
Year: 1 2 3 4 r
EPS growth -- 15% 15% 7.5% 15%
Earnigs per Share 1.5 1.725 1.9838 2.1325
ROE 15% 15% 15% 15.0%
Payout Ratio 0% 0% 50% 50%
Dividends 0 0 0.9919 1.0663
Div. growth #DIV/0! #DIV/0! 7.5%
Book Equity (PS) 10 11.5 13.225 14.217
Book Equity Growth 15% 15% 8%
Price 2nd Stage 14.217
SUM
Time-0 P.V. 0 0 14.869 14.869

More about P/E and Discount Rate

The Connection between Cost of Equity and P/E
 Assume the payout ratio is 100%, i.e.,

 the firm does not reinvest earnings
 dividends equal earnings
 and hence does not grow:
P=E/r <-> r = E/P ratio
 Now assume that the firm reinvests part of the earnings in projects with IRR=r, i.e., all additional projects have
NPV=0. We know that in this case market value of additional assets = book value of additional assets. Hence:
ROE = E/book value of equity = E/P = IRR = r
 If the firm implements projects with IRR>r, then the Present Value of Growth Opportunities (PVGO) matters:
P = E/r + PVGO <-> E/P = r*(1-PVGO/P)

Example on PVGO
EXAMPLE:
 Our company forecasts earnings for $8.33 next year. If the payout ratio is 100%, then dividends = earnings. This will
provide investors with a 15% expected return.
 Instead, we decide to plowback 40% of the earnings at the firm’s current return on equity of 25%. What is the value
of the stock before and after the plowback decision? What is the implied PVGO?
 100% payout rate implies no growth. We use the perpetuity formula: P = 8.33/0.15 = 55.56
 A 60% payout rate implies g = (1-0.60)*.25 = 10%. Hence we have P = (8.33*.6)/(0.15-.10)= 100 (rounded).
 PVGO = 100-55.56 = 44.44

The Failure of the CAPM

The Failure of the CAPM in the cross section of Size and B/M
 If the CAPM held, all markers should be on the 45 straight line [source]

Other Important Factors and Arbitrage Pricing Theory (APT)
 Many researchers (among others, Fama, French, Zhang) have recently documented that
 Firms with high Operating Profits pay higher returns
 Firms with lower investment intensity pay higher returns
 Nowadays, we use a 5-factor model (MKT, HML, SMB, OP, INV):
Return  a  b1 (rfactor1 )  b2 (rfactor 2 )  b3 (rfactor 3 )  ....  noise
Expected risk premium  r  rf

 b1 (rfactor1  rf )  b2 (rfactor 2  rf )  ...

How Do These Concepts Apply in India?
 Bajpaia and Sharmab, “An Empirical Testing of Capital Asset Pricing Model in India”
[…] The results show that CAPM is very much significant in the Indian equity market and the model developed in this
study, performs better than the traditional model.
 Aziz and Ansari, “Size and Value Premiums in the Indian Stock Market ”
[…] This paper examines the performance of the three-factor model of Fama and French (1993) in the Indian stock
market for the period 2000-2012 using BSE-500 stocks as a sample. The results suggest the presence of significant size
and value premiums in the Indian stock market during the sample period. The three-factor model performs better than
the CAPM […]
The average return on factor portfolios SMB and HML are 1.82 per cent per month and 1.92 per cent per month
respectively. The standard deviation of the SMB and HML returns is 3.7 per cent and 4.8 per cent per month
respectively. The average market return is 1.22 per cent per month and risk free rate averages to 0.52 per cent per
month

THANKS YOU

TOPIC: MANAGING RISK (INTRODUCTION)
Professor
M. Max Croce

Managing Risk
 Managing Risk: buy or sell securities in order to achieve or keep a desired risk profile
 Sometimes new business activity changes your exposure to risks and you need to `hedge’
 Sometimes external forces make your assets or liabilities too risky and you need to `hedge’
 Derivative Contracts:
 Financial contracts that pay you under an “if condition”, i.e., only in a subset of possible scenarios
 Look a lot like insurance devices.
 Examples:
 Credit Default Swaps: the buyer pays a premium and receives a compensation in case of default of the
underlying asset. Compensation = notional amount – recovery value of the defaulted bond.
 Interest Rate Swaps: one party gives up fixed interest payments for floating payments on a common given
principal amount
 What we will do next:

 two examples to introduce the concept of managing risk
 International derivatives (many national derivative contracts are a special case of the international ones)

A situation in which you want a SWAP
 Managing Risk: Assume you are a car maker and you have just sold 100 (Mil.) Rupees of cars to a dealer who will
pay by the end of the year. You agreed to charge an additional interest of 5% (fixed!). Assume that there is no
default risk and that the 1-year rate is 5%.
Tomorrow RBI will meet to decide whether to keep the rate the same or to increase it to 6%.
 What is the current market value of your credit (r=5%)? What will happen to the market value of your credit if the
rate increases?
 Market value of your credit is (100+5)/1.05 = 100 and it may fall to about 99 ( 105/1.06).
 How can you hedge? SWAP your fixed coupon of 5 for a floating one, i.e., one that immediately adjusts with the
RBI’s one. Choose a principle of 100.
 Proof:
 R stays at 5%: your new payment is 0 because the floating coupon is equal to the fixed one. The mkt value of
assets is 100.
 R goes to 6%: you get a net payment of (6%-5%)*100=1. Your total value of assets is 99 + 1 = 100.

The Price of a CDS
 Price of a CDS: who buys insurance through a CDS needs to pay a premium expressed in % (or basis points) per
period (and sometimes an immediate fee). The price depends on the underlying bond features.
 Example: you own a bond issued by Trumpland with maturity of 1 period and a YTM of 5%. You are afraid of default
risk and are willing to buy a CDS to protect yourself. You know that Macroland is a risk-free (completely safe)
country and its 1-year bond pays 3%. Your bond’s Face Value is 100.
 Can you hedge yourself without the CDS? What can you do? What do you loose?
 Sell the Trumpland bond at 95 and buy the Macroland bond at 97 (your FV stays at 100). Your loss equals
the additional money spent (95-97) =2, that is 2% of the notional amount (FV).
 How much are you willing to pay for the CDS?

 Exactly the difference in bond yields: (5%-3%)*100

THANKS YOU

TOPIC: INTRO TO EXCHANGE RATES
Professor
M. Max Croce,
SDA Professor

Outline
 What is a Currency: Fiat Money
 Introduction to Nominal FX
 Definition
 Quotes
 Triangular Arbitrage
 Bid and Ask
 Real Exchange Rates

 Inflation Matters
 The Interbank Market (if we have time)

 Structure
 Settlement Risk
 Application: bitcoin

Money Market

Measures of Money
 Def of Money: any financial asset that is considered liquid and can function as a mean of exchange.
 Def of FIAT Money: no intrinsic value, only legal value

(recognizable; hard to counterfeit; transferable; divisible; fungible)
 Currency: bills and coins outside the Treasury, Reserve Banks, and vaults of depository institutions
 M1 measure: currency plus travelers’ checks, demand deposits, other checkable deposits

Exchange Rates

Nominal Exchange Rate
 Nominal exchange rate ( enom )
• Rate at which two currencies can be traded
• The relative price of two currencies
 Indirect Quote [European Quote]: enom = #Foreign Currency / #Home Currency

• Number of units of foreign currency that can be purchased with 1 unit of base currency
• If the exchange rate increases the domestic currency is stronger [my prefereed quoting in my slides]
• Take the Rupee as base currency and the USD: on 6/11/2018 enom = 0.015
 Direct Quote [American Quote]: enom = #Home Currency / #Foreign Currency

• Number of units of home (base) currency required to purchase 1 unit of foreign currency
• If the exchange rate decreases the domestic currency is stronger
• Take the Rupee as base currency and the USD: on 6/11/2018 enom = 67.37 = 1/0.015

Some ISO codes (I)
 Top-10 currencies
Country Currency ISO

USA US Dollar USD
EU Euro EUR
Japan Yen JPY
Great Britain British pound GBP
Switzerland Swiss Franc CHF
Canada Canadian Dollar CAD
Australia Australian Dollar AUD
New Zeland New Zeland Dollar NZD
Norway Krone NOK
Sweden Krona NOK

Some ISO codes (II)
 BRIC currencies
Country Currency ISO

Brazil Real BRL
Russia Ruble RUR
India Rupee INR
China Yuan CNY
 See www.iso.org

Vehicle Currencies and Cross-rates
 Def of Vehicle Currency: reference currency for most trades (Pre-WWII: british pound; Today: USD and EUR?)
 Def of Cross-rates: FX rates among non-vehicle currencies
Source: Ìnternational Currencies and

Capital Allocation’ by Maggiori,
Neiman, Schreger

Triangular (No) Arbitrage
 Def of Arbitrage
• Opportunity to make a profit for free (for `free’ must be interpreted broadly)
 Def of Traingular Arbitrage in the Currency Mkt

• Possibility to make a profit by swapping multiple currencies.
• Example: You have EUR100 and the FX rates are: GBP1/EUR; USD2/GBP; EUR1/USD. Here is the arbitrage:
1. Use EUR100 to buy GBP: EUR100×(GBP1/EUR)=GBP100
2. Use your GBP to buy USD: GBP100×(USD2/GBP)=USD200
3. Convert your USD in EUR: USD200 ×(EUR1/USD)=EUR200
Profit= EUR200 - EUR100=EUR100
 No Arbitrage condition:
• By market forces, prices adjust and nobody can have an arbitrage
• In the example above: everybody with EUR demands GBP, the GBP becomes stronger against the EUR until
we have GBP.50/EUR. If you repeat steps 1-3, you get EUR100. Why?
$/£ *£/€ = $/€

Bid-Ask Spread
 Like all dealers, FX dealers quote two-way rates
• Bid rate = Rate at which they are willing to Buy the Base currency from you
• Ask rate = Rate at which they are willing to sell the base currency to you
 Ask > Bid  Dealers earn spreads (buy low/sell high) in return for their intermediation services
 The bid-ask spread is

 very small among banks (they often do not transfer the paper currency)
 more sizeable at the commercial bank/retail level
 high outside of the banking network (airports, black markets, …)
 Small
 when big markets are open (US, EU)
 when uncertainty is low

Time for a Quick Review

USD Currency Quotes

What was the Japanese yen spot price of the U.S. dollar?
• The Japanese yen spot price of the U.S. dollar was ¥84.12/$
What was the U.S. dollar spot price of the Swiss franc?
• The U.S. dollar spot price of the Swiss franc was $1.0289/CHF
What was the euro price of the British pound according to triangular no-arbitrage?
€0.7636 $1.5477 €1.1818
• × = = €1.1818/£
$1 £1 £1

Mississippi Mud Pies, Inc. needs to buy 1,000,000 Swiss francs (CHF) to pay
its Swiss chocolate supplier. Its banker quotes bid–ask rates of CHF1.3990–
1.4000/USD. What will be the dollar cost of the CHF1,000,000?
• Mississippi Mud Pies must sell dollars to the bank to buy CHF.
• The bank’s bid rate is CHF1.3990/$. That is the price at which the bank is
willing to buy $1 in return for CHF1.3990.
• Mississippi Mud Pies will receive the bank’s bid rate of CHF1.3990/$.
• The dollar cost of CHF1,000,000 is
$1
CHF 1,000,000 × = $714,796
CHF1.399

If the Japanese yen–U.S. dollar exchange rate is ¥104.30/$, and it takes
25.15 Thai bahts to purchase 1 dollar, what is the yen price of the baht?
¥104.30 $1 ¥4.1471
× =
$1 THB25.15 THB1

Real Exchange Rates

Definitions
 Real exchange rate ( e )
Number of foreign goods and services (imports) that can be purchased with one representative basket of
domestic goods and services (exports)
 Definition (indirect quoting): e = enom *CPI/CPIforeign

Defined for a basket of goods and services, i.e., in real terms
If CPIfor increases, keeping everything else constant, we can buy less foreign goods, hence our currency is weaker
in real terms.

Nominal and Real (I)
As India’s inflation stays above that of the rest

of the world, the nominal index becomes
weaker
← Strong Rupee
These are indexes, they are normalized to be
100 at this time.
 Bank of International Settlements (61 countries)

http://www.bis.org/statistics/eer/
Nominal and Real (II)

100 at this time.
← Strong Yen
As Japan experiences deflation, the nominal
FX appreciates.

THANKS YOU

If We Have Time

Something about FX Market Structure

Communication and Fund Transfer
 To initiate a trade, a bank can
• Contact traders at other major banks
• Contact a FX broker
• Trade on a e-brokerage system
 Once a trade is agreed upon, it has to be confirmed

• Society for WorldWide Interbank Financial Telecommunications (SWIFT) links more than 10,000 banks
 After confirmation, it is time to settle the trade

• The transfers of USD are implemented by CHIPS (bank-owned Interbank Clearing House) and Fedwire
(managed by US FED)
• The transfer of EUR are implemented through TARGET and TARGET2 (managed by ECB)
 Herstatt Risk (06/26/1974, Germany): only one lag of the transfer is settled
 Solutions: (1) limit volumes; (2) settle just net flows, not gross flows.

Something about Bitcoin

Application: Bitcoin (I)
 A decentralized system to keep track of transactions
 Each one of us can be part of the system. Go to https://bitcoin.org/en/download and get:
 the history (blockchain) of all previous transactions (145GB as of 6/11/2018)
 the software to submit and verify new transactions and contribute to the history.
 The history is public and verifiable (via encryption)
 Verification of transactions:
 Verification is based on a mathematical protocol that requires (decentralized) computation effort
 As your hardware successfully verifies transactions, you earn the fees (in bitcoin units) on your account
 The fee can be zero, but transaction with higher fees are verified with little/no delay.
 A transaction order needs 4 inputs: sender id; receiver id; amount to transfer; offered fee.
 Your wallet is a collection of keypairs required for encryption [public key (for verification) and private key].
 Legally:
 a barter: bitcoins units vs currency/products/services
 The European Court of Justice exempted Bitcoin from VAT (treated like other currencies)
 Anonymous account are OK.
Application: Bitcoin (II)
 Cyprus 2013
Viral videos;
Patent Application
 Updated data:
 https://coinmarketcap.com/currencies/bitcoin/#charts
TOPIC: EXCHANGE RATES DETERMINANTS AND REGIMES
Professor
M. Max Croce,
SDA Professor

Outline
 Nominal FX:
 Market Forces and Flexible (Floating) Regimes
 Fixed FX Regimes
 Types of Pegged Regimes
 Benefits and Costs of Pegged FX
 Devaluation Risk

The Currency Market:
Demand and Supply Forces

A supply-demand model of exchange rates
 Value of the currency is determined by supply and demand for the currency in the foreign exchange market
 Demand for domestic currency (by foreign individuals & firms)

• To buy domestic goods and services (exports)
• Inflation above other that of countries reduces demand
• To be able to buy domestic assets (financial inflows)
• Risk above that of other countries reduces this channel
• For risk-free assets, low rates reduce demand
 Supply of domestic currency (by domestic individuals & firms)

• To buy foreign goods and services (imports)
• To be able to buy foreign assets (financial outflows)

FX Regimes and Policy Interventions

Examples

Terminology
Regime Currency Currency

strengthens weakens
Flexible Appreciation Depreciation
Fixed Revaluation Devaluation
enom Increase Decrease

To Peg Or Not To Peg?
 Benefits:
 less exchange rate uncertainty (if credible)
 Keep the currency to a low level to be competitive (unless there are currency/trade wars)
 Costs:
 May require to limit capital mobility (China; Brazil)
 May constrain monetary policy (interest rates set to control your currency)
 May substitute regular risk for huge-and-sudden devaluations

Exchange Rate Arrangements
 Floating currencies
 Determined by the market forces of supply and demand (i.e., U.S., Japan, European Union, Australia, and
Sweden)
 Target zone
 Forex rate is kept within band
 Crawling pegs
 Changes are kept lower than preset limits that are adjusted regularly (with inflation)
 Fixed/pegged currencies
 “Pegging” a currency to another or a basket of currencies
 Monetary Union (within the EU, the FX is fixed 1:1)

THANKS YOU

TOPIC: HEDGING EXCHANGE RATE RISKS
Professor
M. Max Croce,
SDA Professor

Outline
 Quantifying Exchange Rate Risk
 Mean, Variance, Skewness
 Co-Variance!
 Hedging tools
 Forwards
 Futures
 Options

FX Change: Mean, StDev, Skewness
USD depreciates
Peso depreciates

FX Change and Covariance
 Gulab Jamun Inc is based in Macroland.
 Assume that:
 Gulab Jamun Inc sales in Foreign-country fluctuate by +/-10%, depending on economic conditions
 the foreign currency appreciates by 10% exactly when sales decline by 10%, and depreciates by 10% when
sales increase by 10%
 What is the variance of the sales of Gulab Jamun Inc’s sales in local (Macroland) currency?
 Sometimes, the FX can be a natural hedge, i.e., it can stabilize your cash-flows in base currency units

Hedging

Forward Contracts
 Outright forward contracts: swap currencies at a pre-determined future date at a pre-determined rate (F)
 Only 13% of all transactions
 Over-the-counter (need to find an intermediary), but flexible
 Maturities of 30,60,90,180 days, but also custom-specific (illiquid)
 Amount is freely negotiable
 Time-line and cash-flows:

 Time-0: terms of the contract agreed, no exchange of cash-flows
 Maturity: swap of currency at forward rate
 Note:
 Traded at a premium when (F/S-1) > 0
 Traded at a discount when (F/S-1) < 0
 Annualized: (F/S-1) * # of days as per contract/ 360

Futures Contracts
Futures contracts: swap currencies at a pre-determined future date at a pre-determined rate (F)
About 40%-45% all transactions
Traded on Exchanges (CME group, NYSE Euronex, Tokyo Fin. Exchange), but rigid
Standardized, smaller amounts (buy multiple of them, but not necessarily enough)
CME offers only 3rd Wed. of March; Jun.; Sept; and Dec.
Solutions to Credit Risk:
clearing house imposes margin requirements (collateral) to all participants
The margin accounts are updated daily according to marking to market so that the
maintenance margin is preserved
Daily change of margin account: daily change in the forward price, i.e., what it costs to `get
out of the deal’
Time-line and cash-flows:

Time-0: terms of the contract agreed, no exchange of cash-flows. Assume you `buy’ the contract.
Intermediate periods: decide whether to continue or `sell’ the same contract to someone else in
order to close your position earlier
Maturity: contracts end 2 days prior to maturity to allow for delivery
Currency Swaps
Definition: agreement between two parties to exchange two borrowing-agreements
denominated in different currencies. Each party pays to the other the interest on the loan
received. At maturity the principle is exchanged at a pre-determined FX. Interest payments are
subject to FX risk.
 Low-transaction cost, perfect to hedge loans.
 Long-maturity
 Exploits advantages in local borrowing markets. For example:
In USA In India
Toto Inc. (US-based) 8% 7%
Tata (India-based) 9% 6%
 Toto wants to expand in India; Tata wants to expand in the USA. Toto borrows in USA at 8% and swaps it with
Tata (which would otherwise borrow at 9%) to secure a 6% financing rate (instead of 7%).

Currency Swaps: Diagram
If the FX does not change, interest payments are pre-determined. Otherwise, there is risk!

Currency Options
 Let the Rupee be the base currency. A Call (Put) Currency option gives to its owner the right,
not the obligation, to buy (sell) foreign currency against the rupee at a future time at the strike
exchange rate.
 A call (put) option is exercised only when the foreign currency in the spot market is more (less) expensive than
according to the strike exchange rate. If the option is not exercised, its final payoff is zero.
 With a call (put) option, you loose at most the price of the option, but you retain the opportunity to gain if
the foreign currency becomes weak (strong) at maturity in the spot market.
 Like with other contracts: (i) counterparty risk; (ii) limits and margins.
 European option: exercise ONLY at maturity; American option: exercise UNTIL maturity.

When to use options
 Importers: must pay in foreign currency at delivery. They are concerned about increased cost in their
base currency. Buy a Call Currency Option, to put an upper bound on their cost.
 Example: you will need to pay imports of oil for USD 1000 in 30 days. The spot FX is INR99/$, the
forward rate is INR100/$. You can buy a USD call option with a strike rate of INR105/$ paying INR10,000.
 Assume the spot FX drops to 50. Do *NOT* exercise and pay a total of 1000*50+10,000=60,000 Rupees
 Assume the spot FX goes to 200. Exercise the option and pay a total of 1000*105+10,000=115,000 Rupees
 Exporters: must receive foreign currency at delivery. They are concerned about reduced revenues in
their base currency. Buy a Put Currency Option, to put a lower bound on their cash inflow.
 Example: you will receive USD 1000 in 30 days from ATT. The spot FX is INR99/$, the forward rate is
INR100/$. You can buy a USD put option with a strike rate of INR95/$ paying INR10,000.
 Assume the spot FX drops to 50. Exercise and receive a net of 1000*95-10,000=85,000 Rupees
 Assume the spot FX goes to 200. Do *NOT* exercise the option and receive a net of 1000*200-10,000=190,000
Rupees

THANKS YOU

TOPIC: EXCHANGE RATES (DIS)PARITIES
Professor
M. Max Croce,
SDA Professor

Outline
 FX Parities
 Covered Interest Parity (CIRP)
 Why it does not to work anymore so well
 Purchasing Power Parity (PPP)
 Mac-Index
 Why relative PPP works in the long-run

CIRP

Covered Interest Parity
 By no arbitrage, two investment strategies with the same risk must pay the same return.
CIRP: the return of investing in a safe local bonds = return of investing in a safe foreign bond if
you are hedged with a forward contract
Example: consider a US investor and an FX quoted as GBP/USD
Nominal return to investing $1 in the U.S. for 1 year: 1+i
Return to investing $1 in the U.K. for 1 year:
Convert $1 into pounds today and obtain £1*S
Return to investing £S in U.K. for 1 year
£S(1 + iUK)
USD return after converting proceeds back into dollars after 1 period:
[£S *(1 + iUK)]/F = S/F * (1 + iUK)
By NA:
1 + i = S/F * (1 + iUK) which means: F = S * (1 + iUK) /(1 + i )

Covered Interest Parity: Example
 Assume i = 6% and iUK=2%. Assume S= 100. What will be the forward?
The correct formula is:

F = S * (1 + iUK) /(1 + i )
= 100 * 1.02/1.06
Using an approximation:
F ≈ 96

Covered Interest Parity: it almost holds
Basis := i – [iUK + (enom- f)/enom]
- Default Risk
- Regulation Constraints (BASEL)
- Capital Controls
- Commodity-rich countries: positive basis

PPP

Law of One Price
Law of one price

If there is no transaction cost, the relative price of traded goods
should be the same across countries to prevent arbitrage
opportunities:
 cpi * e_nom= cpi_foreign which implies e_nom= cpi_foreign/cpi
Implications of this theory:

If domestic prices, cpi, drop, domestic goods are more attractive,
hence people buy domestic currency and there is an appreciation
If foreign prices, cpiforeign, drop, domestic goods are less attractive,
hence people buy foreign currency and there is a depreciation

Law of One Price
Why absolute PPP does not hold
Not all goods in price basket are traded
Quality and tastes of goods may differ
Degree of competition in different markets may differ
Cost of shipping, taxes, ... may be important
What’s relative PPP?

Do not look at levels, just look at percentage changes!

FX and Inflation Rates
USD Stronger
USD Weaker

The Big Mac Index

THANKS YOU

TOPIC: INTERNATIONAL DEBT MARKETS
Professor
M. Max Croce,
SDA Professor

Outline
 Debt Financing overview
 All-In-Cost (AIC) principle

 Minimizing the cost of debt
 Monetary policy and market outlook (if we have time)

Overview

Sources of Long-Term Capital

Characteristics of Debt Financing
 Characteristics:
 Maturity
 Spread repayments over time; try to match duration of investments
 Fixed / Floating rates

 When do you go with a floating?
 Expectations matter
 International character:
 domestic vs. international placement
 Currency of denomination

Debt Denomination: De/Centralized
 Should we care if the UIP holds?
 What are the benefits of decentralizing?

 Lower costs
 Diversification across currencies

The Characteristics of Debt Instruments
The international character of debt

Domestic bonds
Bonds that are issued and traded in domestic market (country is country of currency
denomination)
International bonds
Bonds traded outside the country of the issuer
 Foreign Bonds – issued in domestic market by a foreign borrower (Ex. Indian company issuing $ bond
in the USA)
 Denominated in the currency of the targeted country [WHY?]
 Marketed to domestic residents
 Regulated by domestic authorities
 Eurobond – mature in less than 10 yrs (usually 5)
 Denominated in one or more currencies
 Traded in external markets outside the borders of the countries issuing the currencies

Bond Markets are HUGE!

International Bonds: Players and Tastes

Cost of Debt

All-in-Cost Principle
The Cost of a loan has 3 components:
Risk-free rate (driven by monetary policy and macro-factors)
Credit Spread (driven by both country- and company-specific default risk)
Transaction costs
Notice: hedging the currency on foreign debt matters!

Example for General Electric:
Credit spread = 1% in India or 1% in USA
US LIBOR 1.9%; M(umbai)IBOR = 6.3%; -> (Forward- Spot)/Spot ≈ -4.4%
 The INR (USD) is at a discount (premium) on forward market
If GE borrows in USA, the cost is: 2.9%
If GE borrows India, the cost is ≈ 6.3% + 1% - 4.4% = 2.9%

THANKS YOU

TOPIC: INTERNATIONAL STOCK MARKETS
Professor
M. Max Croce,
SDA Professor

Outline
 Equity market: overview
 Risk and Returns of International Investments
 Market outlook (if we have time)

Overview

Tour of International Stock Markets
The size of stock markets

U.S. stock market was about 35% of the world’s stock market capitalization (mid
2015)
China is second!
Cross-holding – firm owning shares in another firm
Can cause an overstating of market cap
Especially common in Japan and many European countries
Trends
Consolidation of exchanges across countries
The exchanges of some developing nations have become among the largest in the
world

Size

Risk and Returns of International investments
Let the USD be the base currency

r 𝑡 + 1, $ is the final return in $
r 𝑡 + 1, £ is the return in £ of an investment in the UK
S(t) be the spot exchange rate GBP per USD
Then:
s t −𝑠(𝑡+1)
1 + r 𝑡 + 1, $ = 1 + 𝑟 𝑡 + 1, £ ∗ 1+
s t+1
s t −𝑠(𝑡+1) s t −𝑠(𝑡+1)
= 1+ 𝑟 𝑡 + 1, £ + + 𝑟(𝑡 + 1, £) ×
s t+1 s t+1
s t −𝑠(𝑡+1)
the term 𝑟 𝑡 + 1, £ × is very small and often neglected
s t+1
Note:
Asset ↑ 10%, currency ↓ 10% = safe payoff
Asset ↑ 10%, currency ↑ 10% = even more volatile payoff
The Benefits of International Diversification
How to improve the Sharpe Ratio?
Reduce the volatility of your portfolio by diversifying!

More on Emerging Markets
Low correlation with

US/UK/JPN/GER -> diversify!
Free capital mobility brings `hot

money’ but also diversification
benefits!

International Return Correlations
What drives correlation of returns?

Trade links
Geographic proximity
Industrial structure
Irrational investors / Correlated beliefs (i.e., contagion)
 Correlations change with economic conditions
Correlations very high during crashes/crises
Hence, international diversification benefits evaporate when you need them the most
 In the after-math of the 2008-09 crash, BRIC did `well’.

The International Capital Asset Pricing Model

The CAPM: basic facts
Sharpe (1964); Lintner (1965); and Mossin (1966):
𝐸 𝑟𝑗 − 𝑟𝑓 = 𝛽𝑗,𝑚 [𝐸(𝑟𝑚 ) − 𝑟𝑓 ]
The market portfolio contains all securities at their respective market-valued weight
The market risk premium, 𝐸(𝑟𝑚) − 𝑟𝑓 , depends on the average risk aversion of its participants
The risk premium on an individual security, 𝐸 𝑟𝑗 − 𝑟𝑓 , depends on its covariance with the
market portfolio as measured by the OLS coefficient 𝛽𝑗,𝑚
Application of CAPM in our course:

Starting point for calculating expected returns and costs of capital

Domestic vs World CAPM
Domestic CAPM
“Market” is the aggregate asset holdings of all investors in domestic country
Assumes investors only hold domestic assets
World CAPM
Makes more sense given the prevalence of international diversification
Problematic given deviations from PPP and fluctuations of real exchange rates
Exchange rate fluctuations matter for risk determination:
Use foreign returns in local units, i.e., adjusted for FX

The CAPM in practice
The Benchmark Problem

 The market portfolio: How does one get this data?
Possible world market proxies:
Morgan Stanley Capital International (MSCI) Index
Financial Times Actuaries (FTA) Index
Beta estimation
Slope of regression line, it is obtained with estimation error

THANKS YOU

INTRO TO CORPORATE FINANCE AND INVESTMENT
BIRD EYE (RE)VIEW
Professor
M. Max Croce,
SDA Professor

Course Objectives
 Understand the following interactions:
Firm
Assets
Investment Decision
• Optimal Capital Budgeting

• Cost of Debt and Equity Debt Equity
• Risk Management
Financing Decision
Multiple Cash Flows
• General formula: PV0  C1
 C2
 ....  Ct
(1 r )1 (1 r ) 2 (1 r ) t
• Perpetuity: Financial concept in which a constant cash flow, C, is

theoretically received forever. PV = C/r
1 1 
• Annuity: a constant payment C for t periods: PV of annuity  C    t
 r r 1  r  
• Perpetuity with constant growth (g): PV = C/(r-g)

Net Present Value (NPV)
• Steps:
• Estimate future cash-flows from the project
• Choose the appropriate discount rate

• Match riskiness of the project
• Match the duration of the project (long-/short-term rate)
• Match the units (nominal/real)
• More broadly, a good measure of alternative investment opportunities (opportunity cost of capital)
• Compute PV(future cash-flows)
• Subtract the initial costs required to start the project to get to the NPV
• Rule of thumb: invest if NPV>0

Methods and Importance
• Graham and Harvey, “The Theory and Practice of Finance: Evidence

from the Field,” run a survey of CFOs

In search of ‘r’:
bond yields as a starting point for finding the discount rate

(risk-free benchmark)

Valuing a Bond
• The price of a bond is the present value of all cash flows generated by the bond (i.e.
coupons and face value) discounted at the required rate of return, i.e., yield to maturity
cpn cpn (cpn  par )

PV    .... 
(1  r ) (1  r )
1 2
(1  r ) t
• Note: “cpn” is commonly used as an abbreviation for “coupon”

• Note: given the market price of the bond and its cash-flow payment, the yield to
maturity can be computed as the internal rate of return (IRR)

Term Structure of Interest Rates
• Definition: a graph (or table) showing yields of bonds of different maturities measured at a given time
Maturity 1 2 5 10
1/1/2007 2 2.7 3 4
1/1/2017 0 0 2 5
Chart Title
6
0
1 2 5 10
1/1/2007 1/1/2017
• Updated data [here]

Maturity and Price Sensitivity (Risk!)
Different maturity bonds have different interest rate risk
2 500
Blue line: long-term bond

2 000
Orange line: short-term bond
Bond price ($)
1 500
1 000
500
10
0
5
1
9
2.5
7.5
0.5
1.5
3.5
4.5
5.5
6.5
8.5
9.5
Interest rate (%) = YTM

The Real and the Nominal Rates
• Nominal yields can always be thought as the sum of two components:

nominal yield = real interest rate + expected inflation
• Real rate:
• determined by the equilibrium of the capital markets
• Nominal rate:
• Once we know what is happening to the real real rate, we just need to think about
forecasting inflation
• Think of the production costs (businesses set prices of goods and services)
• Think of the reaction of the Central Bank (Monetary Policy)

The Equilibrium
Total Savings
Investment
S, I

Expansionary OMO
i
Money P of
Supply Bonds
bond Available
1
i1 P2
2
2 1
i2 P1
Rember that P. of bond  when i  and viceversa.

In search or ‘r’ (II):
Additing risk to the risk-free rate (ERP on equities)

How Common Stocks Are Valued
• Valuation by comparables:
• Definitions
• Book Value: net worth of the firm according to the balance sheet
• Market Value Balance Sheet: financial statement that uses market value of assets and
liabilities
• Relevant ratios (multiples)

• M/B Ratios= Market-to-Book (also denoted as P/B, price-to-book value of a share)
• P/E Ratios: Price per share divided by earnings per share
• Valuation using the Dividends Cash Flow (DCF) model:

• Dividends: Periodic cash distribution from the firm to the shareholders
• Present Value approach

Discounted Cash Flow Model: Constant Growth g
• Assume that dividends grow at a constant growth rate, g, and with some
math you get:
Div1
Price  P0 
rg
Div1
Capitalization rate  r  g
P0

Time-varying Vol: US vs BRIC

Diversification at Work
• Average standard deviation when you randomly add stocks from the NYSE
to your portfolio
Market Vol

The CAPM: basic facts
Sharpe (1964); Lintner (1965); and Mossin (1966):
𝐸 𝑟𝑗 − 𝑟𝑓 = 𝛽𝑗,𝑚 [𝐸(𝑟𝑚 ) − 𝑟𝑓 ]
The market portfolio contains all securities at their respective market-valued weight
The market risk premium, 𝐸(𝑟𝑚) − 𝑟𝑓 , depends on the average risk aversion of its participants
The risk premium on an individual security, 𝐸 𝑟𝑗 − 𝑟𝑓 , depends on its covariance with the
market portfolio as measured by the OLS coefficient 𝛽𝑗,𝑚
Application of CAPM in our course:

Starting point for calculating expected returns and costs of capital

Introduction to FX

Nominal and Real (I)
As India’s inflation stays above that of the rest

of the world, the nominal index becomes
weaker
← Strong Rupee
100 at this time.

Determinants of FX and Regimes

A supply-demand model of exchange rates
 Value of the currency is determined by supply and demand for the currency in the foreign exchange market
 Demand for domestic currency (by foreign individuals & firms)

• To buy domestic goods and services (exports)
• To be able to buy domestic assets (financial inflows)
 Supply of domestic currency (by domestic individuals & firms)

• To buy foreign goods and services (imports)
• To be able to buy foreign assets (financial outflows)
Key channels: GDP; interest rates; risk premia; inflation

Fixed FX Regime: a free forward contract, but at which cost?

Hedging FX

Hedging possibilities
Complete Hedging
Outright forward contracts (over-the-counter)
 Future contracts (exchange with collateral requirements)
Partial Hedging
Importers: buy a Call option to set a ceiling on the import cost
Exporters: buy a Put option to set a floor on the export revenue
Borrowers in foreign countries: SWAP contracts

FX (Dis)Parities
 FX Parities
 Covered Interest Parity (CIRP)
 No longer perfect (collateral cost), but pretty good
 Purchasing Power Parity (PPP)
 Mac-Index is a practical example
 Relative PPP works well in the long-run

International Bond and Equity Mkts

All-in-Cost Principle
The Cost of a loan has 3 components:
Risk-free rate (driven by monetary policy and macro-factors)
Credit Spread (driven by both country- and company-specific default risk)
Transaction costs
Notice: hedging the currency on foreign debt matters!

Example for General Electric:
Credit spread = 1% in India or 1% in USA
US LIBOR 1.9%; M(umbai)IBOR = 6.3%; -> (Forward- Spot)/Spot ≈ 1.019/1.063-1 ≈ -4.4%
 The INR (USD) is at a discount (premium) on forward market
If GE borrows in USA, the cost is: 2.9%
If GE borrows in India, the cost is ≈ 6.3% + 1% - 4.4% = 2.9%

The Benefits of International Diversification
How to improve the Sharpe Ratio?
Reduce the volatility of your portfolio by diversifying!

The Intl CAPM in practice
The Benchmark Problem

 The market portfolio: How does one get this data?
Possible world market proxies:
Morgan Stanley Capital International (MSCI) Index
Financial Times Actuaries (FTA) Index
Use the returns of equity expressed in your BASE currency!
Beta estimation
Slope of regression line, it is obtained with estimation error

Capital Budgeting
(if we had time)

Foreign Projects: Multiple Approaches
Approach #1:
discount all foreign cash-flows using foreign discounts rates
Convert the foreign NPV in local currency using the sport FX
Very often misleading!
Approach #2:
Convert all foreign cash-flows into local units accounting for FX expectations and co-movements
Discount future cash-flows using appropriate local discount rates

My own view

Grading
 Final Exam (80%)
Quiz (Multiple Choice)
Essay Question (changed so that it allows for MCs)
 Attitude toward the course (20%)

Participate, do not worry about wrong answers
Review in a timely way
Quizzes are useful devices
 Target for exam: average 85% and StDev of 10%

This Course
 Like sharing a steak with my wife:
 I like it rare, she likes it well-done. We get it `medium’ and …
 … we are both unhappy :-)
 Best mix of what done at Wharton/Duke/UNC/Columbia – NO DISCOUNT!
Me
 My pleasure to meet you and share what I know
 Stay in touch!
You
 Contact me if you have doubts
 Keep flourishing
THANKS YOU

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INTRO TO CORPORATE FINANCE AND INVESTMENTS

TOPIC: TIME VALUE OF MONEY AND CAPITAL BUDGETING

SDA Bocconi Asia Center I Capital Markets

 Future and Present Values

SDA Bocconi Asia Center I Capital Markets

SDA Bocconi Asia Center I Capital Markets

Example: What is the future value of $100 if interest is compounded

SDA Bocconi Asia Center I Capital Markets

 Discount Factor (DF): PV of $1 paid t-periods ahead

 PV formula: example with cash-flow paid in 2 periods

SDA Bocconi Asia Center I Capital Markets

 Annuity: a constant payment C for t periods: 1 1 

 Perpetuity with constant growth (g): PV = C/(r-g)

 What if the investment is delayed by 3 years?

SDA Bocconi Asia Center I Capital Markets

• $1 Bil/(.10-.04) = $1bil/.06 = $16.667 Bil

SDA Bocconi Asia Center I Capital Markets

 Why? You gain interest on interest

SDA Bocconi Asia Center I Capital Markets

APR = .01  12 = .12 or 12.00%

SDA Bocconi Asia Center I Capital Markets

 Real rate: it measures the percentage increase in purchasing power

NCF(t) = RCF(t) * (1+expected inflation)t

SDA Bocconi Asia Center I Capital Markets

 Using nominal units, what is the PV?

 How do you obtain the real cash flow?

 Using real units, what is the PV?

SDA Bocconi Asia Center I Capital Markets

 From year 2 to year 1: PV(1) = 2000/(1+0.01)

SDA Bocconi Asia Center I Capital Markets

SDA Bocconi Asia Center I Capital Markets

 Retain resources and invest in profitable projects or pay dividends

Investment Financial Shareholders Investment

Invest Alternative: Pay Shareholders

SDA Bocconi Asia Center I Capital Markets

SDA Bocconi Asia Center I Capital Markets

 Choose the appropriate discount rate

 Compute PV(future cash-flows)

 Rule of thumb: invest if NPV>0

SDA Bocconi Asia Center I Capital Markets

NPV = -Cost + PV(future cash-flows)

 What is the market value of the assets in place?

 What is the book value of the investment?

 The NPV rule can be restated as:

SDA Bocconi Asia Center I Capital Markets

 Definition of Internal Rate of Return (IRR) - Discount rate at which NPV = 0

SDA Bocconi Asia Center I Capital Markets

Project C0 C1 IRR NPV @ 10%

SDA Bocconi Asia Center I Capital Markets

 Capital Rationing - Limited amount of funds available for investment

SDA Bocconi Asia Center I Capital Markets

Cash Flows ($ millions) DRate

 Optimal strategy: Invest in A and then in D.

SDA Bocconi Asia Center I Capital Markets

SDA Bocconi Asia Center I Capital Markets

SDA Bocconi Asia Center I Capital Markets

 Assume that your opportunity cost of capital is 10%.

Cash Flows ($ millions)

SDA Bocconi Asia Center I Capital Markets

Project Investment IRR NPV

SDA Bocconi Asia Center I Capital Markets

SDA Bocconi Asia Center I Capital Markets

SDA Bocconi Asia Center I Capital Markets

 Why bonds are risky: