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Corporate finance

P. Frantz and R. Payne


2790092
2009

Undergraduate study in
Economics, Management,
Finance and the Social Sciences
This guide was prepared for the University of London External System by:
Dr Pascal Frantz, Lecturer in Accountancy and Finance, The London School of Economics and
Political Science
and
R. Payne, former Lecturer in Finance, The London School of Economics and Political Science.
This is one of a series of subject guides published by the University. We regret that due to
pressure of work the authors are unable to enter into any correspondence relating to, or aris-
ing from, the guide. If you have any comments on this subject guide, favourable or unfavour-
able, please use the form at the back of this guide.
This subject guide is for the use of University of London External students registered for
programmes in the fields of Economics, Management, Finance and the Social Sciences (as
applicable). The programmes currently available in these subject areas are:
Access route
Diploma in Economics
Diploma in Social Sciences
Diplomas for Graduates
BSc Accounting and Finance
BSc Accounting with Law/Law with Accounting
BSc Banking and Finance
BSc Business
BSc Development and Economics
BSc Economics
BSc Economics and Finance
BSc Economics and Management
BSc Geography and Environment
BSc Information Systems and Management
BSc International Relations
BSc Management
BSc Management with Law/Law with Management
BSc Mathematics and Economics
BSc Politics
BSc Politics and International Relations
BSc Sociology
BSc Sociology with Law.

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Contents

Contents
Introduction to the subject guide .......................................................................... 1
Aims of the unit............................................................................................................. 1
Learning objectives ........................................................................................................ 1
Syllabus......................................................................................................................... 2
Essential reading ........................................................................................................... 2
Further reading.............................................................................................................. 3
Subject guide structure and use ..................................................................................... 5
Examination structure .................................................................................................... 5
Glossary of abbreviations used in this subject guide ....................................................... 6
Chapter 1: Present-value calculations and the valuation of
physical investment projects .................................................................................. 7
Aim of the chapter......................................................................................................... 7
Learning objectives ........................................................................................................ 7
Essential reading ........................................................................................................... 7
Further reading.............................................................................................................. 7
Overview ....................................................................................................................... 7
Introduction .................................................................................................................. 8
Fisher separation and optimal decision-making .............................................................. 8
Fisher separation and project evaluation ...................................................................... 11
The time value of money .............................................................................................. 12
The net present-value rule............................................................................................ 13
Other project appraisal techniques ............................................................................... 15
Using present-value techniques to value stocks and bonds ........................................... 18
A reminder of your learning outcomes.......................................................................... 19
Key terms .................................................................................................................... 20
Sample examination questions ..................................................................................... 20
Chapter 2: Risk and return: mean–variance analysis and the CAPM.................... 21
Aim of the chapter....................................................................................................... 21
Learning objectives ...................................................................................................... 21
Essential reading ......................................................................................................... 21
Further reading............................................................................................................ 21
Introduction ................................................................................................................ 21
Statistical characteristics of portfolios ........................................................................... 22
Diversification.............................................................................................................. 24
Mean–variance analysis ............................................................................................... 25
The capital asset pricing model .................................................................................... 30
The Roll critique and empirical tests of the CAPM......................................................... 33
A reminder of your learning outcomes.......................................................................... 34
Key terms .................................................................................................................... 34
Sample examination questions ..................................................................................... 35
Solutions to activities ................................................................................................... 35
Chapter 3: The arbitrage pricing theory ............................................................... 37
Aim of the chapter....................................................................................................... 37
Learning objectives ...................................................................................................... 37
Essential reading ......................................................................................................... 37
Further reading............................................................................................................ 37
Overview ..................................................................................................................... 37
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92 Corporate finance

Introduction ................................................................................................................ 37
Single-factor models .................................................................................................... 38
Multi-factor models ..................................................................................................... 40
Broad-based portfolios and idiosyncratic returns........................................................... 41
Factor-replicating portfolios ......................................................................................... 41
The arbitrage pricing theory ......................................................................................... 42
Summary ..................................................................................................................... 43
A reminder of your learning outcomes.......................................................................... 44
Key terms .................................................................................................................... 44
Chapter 4: Derivative assets: properties and pricing ........................................... 45
Aim of the chapter....................................................................................................... 45
Learning objectives ...................................................................................................... 45
Essential reading ......................................................................................................... 45
Further reading............................................................................................................ 45
Overview ..................................................................................................................... 45
Varieties of derivatives ................................................................................................. 45
Derivative asset pay-off profiles ................................................................................... 47
Pricing forward contracts ............................................................................................. 49
Binomial option pricing setting .................................................................................... 50
Bounds on option prices and exercise strategies ........................................................... 53
Black–Scholes option pricing ....................................................................................... 55
Put–call parity ............................................................................................................. 56
Pricing interest rate swaps ........................................................................................... 58
Summary ..................................................................................................................... 58
A reminder of your learning outcomes.......................................................................... 58
Key terms .................................................................................................................... 59
Sample examination questions ..................................................................................... 59
Chapter 5: Efficient markets: theory and empirical evidence .............................. 61
Aim of the chapter....................................................................................................... 61
Learning objectives ...................................................................................................... 61
Essential reading ......................................................................................................... 61
Further reading............................................................................................................ 61
Overview ..................................................................................................................... 62
Varieties of efficiency ................................................................................................... 62
Risk adjustments and the joint hypothesis problem ...................................................... 63
Weak-form efficiency: implications and tests ................................................................ 64
Weak-form efficiency: empirical results......................................................................... 66
Semi-strong-form efficiency: event studies .................................................................... 69
Semi-strong-form efficiency: empirical evidence ............................................................ 71
Strong-form efficiency.................................................................................................. 71
Summary ..................................................................................................................... 71
A reminder of your learning outcomes.......................................................................... 72
Key terms .................................................................................................................... 72
Sample examination questions ..................................................................................... 72
Chapter 6: The choice of corporate capital structure ........................................... 73
Aim of the chapter....................................................................................................... 73
Learning objectives ...................................................................................................... 73
Essential reading ......................................................................................................... 73
Further reading............................................................................................................ 73
Overview ..................................................................................................................... 73

ii
Contents

Basic features of debt and equity ................................................................................. 74


The Modigliani–Miller theorem .................................................................................... 75
Modigliani–Miller and Black–Scholes ........................................................................... 77
Modigliani–Miller and corporate taxation..................................................................... 77
Modigliani–Miller with corporate and personal taxation ............................................... 79
Summary ..................................................................................................................... 81
A reminder of your learning outcomes.......................................................................... 81
Key terms .................................................................................................................... 81
Sample examination questions ..................................................................................... 81
Chapter 7: Asymmetric information, agency costs and
capital structure ................................................................................................... 83
Aim of the chapter....................................................................................................... 83
Learning objectives ...................................................................................................... 83
Essential reading ......................................................................................................... 83
Further reading............................................................................................................ 83
Overview ..................................................................................................................... 84
Capital structure, governance problems and agency costs ............................................. 84
Agency costs of outside equity and debt ...................................................................... 84
Agency costs of free cash flows.................................................................................... 87
Firm value and asymmetric information ........................................................................ 88
Summary ..................................................................................................................... 92
Key terms .................................................................................................................... 92
A reminder of your learning outcomes.......................................................................... 93
Sample examination questions ..................................................................................... 93
Chapter 8: Dividend policy ................................................................................... 95
Aim of the chapter....................................................................................................... 95
Learning objectives ...................................................................................................... 95
Essential reading ......................................................................................................... 95
Further reading............................................................................................................ 95
Overview ..................................................................................................................... 96
Modigliani–Miller meets dividends ............................................................................... 96
Prices, dividends and share repurchases ....................................................................... 97
Dividend policy: stylised facts ....................................................................................... 97
Taxation and clientele theory ....................................................................................... 99
Asymmetric information and dividends ....................................................................... 100
Agency costs and dividends ....................................................................................... 101
Summary ................................................................................................................... 101
A reminder of your learning outcomes........................................................................ 102
Key terms .................................................................................................................. 102
Sample examination questions ................................................................................... 102
Chapter 9: Mergers and takeovers ..................................................................... 103
Aim of the chapter..................................................................................................... 103
Learning objectives .................................................................................................... 103
Essential reading ....................................................................................................... 103
Further reading.......................................................................................................... 103
Overview ................................................................................................................... 104
Merger motivations ................................................................................................... 104
A numerical takeover example ................................................................................... 105
The market for corporate control ................................................................................ 106
The impossibility of efficient takeovers ....................................................................... 106

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Two ways to get efficient takeovers ............................................................................ 108


Empirical evidence ..................................................................................................... 109
Summary ................................................................................................................... 110
A reminder of your learning outcomes........................................................................ 111
Key terms .................................................................................................................. 111
Sample examination questions ................................................................................... 112
Appendix 1: Perpetuities and annuities.................................................................... 113
Perpetuities ............................................................................................................... 113
Annuities .................................................................................................................. 114
Appendix 2: Sample examination paper .................................................................. 115

iv
Introduction to the subject guide

Introduction to the subject guide


This subject guide provides you with an introduction to the modern theory
of finance. As such, it covers a broad range of topics and aims to give a
general background to any student who wishes to do further academic or
practical work in finance or accounting after graduation.
The subject matter of the guide can be broken into two main areas.
1. The first section of material covers the valuation and pricing of real
and financial assets. This provides you with the methodologies you will
need to fairly assess the desirability of investment in physical capital,
and price spot and derivative assets. We employ a number of tools
in this analysis. The coverage of the risk-return trade-off in financial
assets and mean–variance optimisation will require you to apply some
basic statistical theory alongside the standard optimisation techniques
taught in basic economics courses. Another important part of this
section will be the use of absence-of-arbitrage techniques to price
financial assets.
2. In the second section, we will examine issues that come under the
broad heading of corporate finance. Here we will examine the key
decisions made by firms, how they affect firm value and empirical
evidence on these issues. The areas involved include the capital
structure decision, dividend policy, and mergers and acquisitions.
By studying these areas, you should gain an appreciation of optimal
financial policy on a firm level, conditions under which an optimal
policy actually exists and how the actual financial decisions of firms
may be explained in theoretical terms.

Aims of the unit


This unit is aimed at students interested in understanding asset pricing
and corporate finance. It provides a theoretical framework used to
address issues in project appraisal and financing, the pricing of risk,
securities valuation, market efficiency, capital structure and mergers and
acquisitions. It provides students with the tools required for further studies
in financial intermediation and investments.

Learning objectives
At the end of this unit, and having completed the essential reading and
activities, you should be able to:
‡ explain how to value projects, and use the key capital budgeting
techniques (NPV and IRR)
‡ understand the mathematics of portfolios and how risk affects the
value of the asset in equilibrium under the fundaments asset pricing
paradigms (CAPM and APT)
‡ explain the characteristics of derivative assets (forwards, futures
and options), and how to use the main pricing techniques (binomial
methods in derivatives pricing and the Black–Scholes analysis)
‡ discuss the theoretical framework of informational efficiency in
financial markets and evaluate the related empirical evidence
‡ understand and explain the capital structure theory, and how
information asymmetries affect it

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‡ understand and explain the relevance, facts and role of the dividend
policy
‡ understand how corporate governance can contribute to firm value
‡ discuss why merger and acquisition activities exist, and calculate the
related gains and losses.

Syllabus
Note: There has been a minor revision to this syllabus in 2009.
Students may bring into the examination hall their own hand-held
electronic calculator. If calculators are used they must satisfy the
requirements listed in paragraphs 10.5 to 10.7 of the General Regulations.
If you are taking this unit as part of a BSc degree, units which must be
passed before this unit may be attempted are 02 Introduction to
economics and either 05a Mathematics 1 or 05b Mathematics 2.
This unit may not be taken with unit 59 Financial management.
Project evaluation: Hirschleifer analysis and Fisher separation; the NPV rule
and IRR rules of investment appraisal; comparison of NPV and IRR; ‘wrong’
investment appraisal rules: payback and accounting rate of return.
Risk and return – the CAPM and APT: the mathematics of portfolios; mean-
variance analysis; two-fund separation and the CAPM; Roll’s critique of the
CAPM; factor models; the arbitrage pricing theory.
Derivative assets – characteristics and pricing: definitions: forwards and futures;
replication, arbitrage and pricing; a general approach to derivative pricing
using binomial methods; options: characteristics and types; bounding and
linking option prices; the Black–Scholes analysis.
Efficient markets – theory and empirical evidence: underpinning and definitions
of market efficiency; weak-form tests: return predictability; the joint
hypothesis problem; semi-strong form tests: the event study methodology
and examples; strong form tests: tests for private information.
Capital structure: the Modigliani–Miller theorem: capital structure irrelevancy;
taxation, bankruptcy costs and capital structure; the Miller equilibrium;
asymmetric information: 1) the under-investment problem, asymmetric
information; 2) the risk-shifting problem, asymmetric information; 3) free
cash-flow arguments; 4) the pecking order theory; 5) debt overhang.
Dividend theory: the Modigliani–Miller and dividend irrelevancy; Lintner’s
fact about dividend policy; dividends, taxes and clienteles; asymmetric
information and signalling through dividend policy.
Corporate governance: separation of ownership and control; management
incentives; management shareholdings and firm value; corporate
governance.
Mergers and acquisitions: motivations for merger activity; calculating the gains
and losses from merger/takeover; the free-rider problem and takeover
activity.

Essential reading
There are a number of excellent textbooks that cover this area. However,
the following text has been chosen as the core text for this unit due to
its extensive treatment of many of the issues covered and up-to-date
discussions:
Grinblatt, M. and S. Titman Financial Markets and Corporate Strategy. (Boston,
Mass.; London: McGraw-Hill, 2002) second edition
[ISBN 9780072294330].
At the start of each chapter of this guide, we will indicate the reading that
you need to do from Grinblatt and Titman (2002).
2
Introduction to the subject guide

Further reading
As further material, we will also direct you to the relevant chapters in
two other texts. You may wish to look at the following two texts that are
standard for many undergraduate finance courses:
Brealey, R., S. Myers and F. Allen Principles of Corporate Finance. (Boston,
Mass., London: McGraw-Hill, 2008) ninth international edition [ISBN
9780071266758].
Copeland, T., J. Weston and K. Shastri Financial Theory and Corporate Policy.
(Reading, Mass.; Wokingham: Addison-Wesley, 2005) fourth edition
[ISBN 9780321223531].

For certain topics, we also list journal articles as Further reading. To


help you read extensively, all External System students have free access
to the University of London Online Library where you will find either the
full text or an abstract of many of the journal articles listed in this subject
guide. You will need to have a username and password to access this
resource and this is the same one you are sent for accessing the University
of London Student Portal where you can also find the Online library
website at http://my.londonexternal.ac.uk

A full list of all Further reading referred to in the subject guide is


presented here for ease of reference.

Journal articles
Asquith, P. and D. Mullins ‘The impact of initiating dividend payments on
shareholders’ wealth’, Journal of Business 56(1) 1983, pp.77–96.
Ball, R. and P. Brown ‘An empirical evaluation of accounting income numbers’,
Journal of Accounting Research 6(2) 1968, pp.159–78.
Blume, M., J. Crockett and I. Friend ‘Stock Ownership in the United States:
Characteristics and Trends’, Survey of Current Business 54(11) 1974,
pp.16–40.
Bradley, M., A. Desai and E. Kim ‘Synergistic Gains from Corporate Acquisitions
and Their Division Between the Stockholders of Target and Acquiring
Firms’, Journal of Financial Economics 21(1) 1988, pp.3–40.
Brock, W., J. Lakonishok and B. LeBaron ‘Simple technical trading rules and
stochastic properties of stock returns’, Journal of Finance 47(5) 1992,
pp.1731–764.
DeBondt, W. and R. Thaler ‘Does the stock market overreact?’, Journal of
Finance 40(3) 1984, pp.793–805.
Fama, E. ‘The behavior of stock market prices’, Journal of Business 38(1) 1965,
pp.34–105.
Fama, E. ‘Efficient capital markets: a review of theory and empirical work’,
Journal of Finance 25(2) 1970, pp.383–417.
Fama, E. ‘Efficient capital markets: II’, Journal of Finance 46(5) 1991,
pp.1575–617.
Fama, E. and K. French ‘Dividend yields and expected stock returns’, Journal of
Financial Economics 22(1) 1988, pp.3–25.
French, K. ‘Stock returns and the weekend effect’, Journal of Financial
Economics 8(1) 1980, pp.55–70.
Fama, E. and K. French ‘The cross-section of expected stock returns’, Journal of
Finance 47(2) 1992, pp.427–65.
Grossman, S. and O. Hart ‘Takeover Bids, the Free-Rider Problem and the
Theory of the Corporation’, Bell Journal of Economics 11(1) 1980, pp.42–64.
Healy, P. and K. Palepu ‘Earnings Information Conveyed by Dividend Initiations
and Omissions’, Journal of Financial Economics 21(2) 1988, pp.149–76.
Healy, P., K. Palepu and R. Ruback ‘Does Corporate Performance Improve after
Mergers?’, Journal of Financial Economics 31(2) 1992, pp.135–76.
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92 Corporate finance

Jarrell, G. and A. Poulsen ‘Returns to Acquiring Firms in Tender Offers:


Evidence from Three Decades’, Financial Management 18(3) 1989,
pp.12–19.
Jarrell, G., J. Brickley and J. Netter ‘The Market for Corporate Control: The
Empirical Evidence since 1980’, Journal of Economic Perspectives 2(1) 1988,
pp.49–68.
Jensen, M. ‘Some anomalous evidence regarding market efficiency’, Journal of
Financial Economics 6(2–3) 1978, pp.95–101.
Jensen, M. ‘Agency costs of Free Cash Flow, Corporate Finance, and Takeovers’,
American Economic Review 76(2) 1986, pp.323–29.
Jensen, M. and R. Ruback ‘The Market for Corporate Control: The Scientific
Evidence’, Journal of Financial Economics 11(1–4) 1983, pp.5–50.
Jensen, M. and W. Meckling ‘Theory of the firm: managerial behaviour, agency
costs and capital structure’, Journal of Financial Economics 3(4) 1976,
pp.305–60.
Jensen, M. and W. Meckling ‘Theory of the Firm: Managerial Behaviour, Agency
Costs and Capital Structure’, Journal of Financial Economics 3(4) 1976,
pp.305–60.
Lakonishok, J., A. Shleifer and R. Vishny ‘Contrarian investment, extrapolation,
and risk’, Journal of Finance 49(5) 1994, pp.1541–578.
Levich, R. and L. Thomas ‘The significance of technical trading-rule profits in
the foreign exchange market: a bootstrap approach’, Journal of International
Money and Finance 12(5) 1993, pp.451–74.
Lintner, J. ‘Distribution of Incomes of Corporations among Dividends, Retained
Earnings and Taxes’ American Economic Review 46(2) 1956, pp.97–113.
Lo, A. and C. McKinlay ‘Stock market prices do not follow random walks:
evidence from a simple specification test’, Review of Financial Studies 1(1)
1988, pp.41–66.
Masulis, R. ‘The impact of capital structure change on firm value: some
estimates’, Journal of Finance 38(1) 1983, pp.107–26.
Miller, M. ‘Debt and taxes’, Journal of Finance 32, 1977, pp. 261–75.
Myers, S. ‘Determinants of corporate borrowing’, Journal of Financial Economics
5(2) 1977, pp.147–75.
Myers, S. and N. Majluf ‘Corporate financing and investment decisions when
firms have information that investors do not have’, Journal of Financial
Economics 13(2) 1984, pp.187–221.
Poterba, J. and L. Summers ‘Mean reversion in stock prices: evidence and
implications’, Journal of Financial Economics 22(1) 1988, pp.27–59.
Roll, R. ‘A Critique of the Asset Pricing Theory’s Texts. Part 1: On Past and
Potential Testability of the Theory’, Journal of Financial Economics 4(2)
1977, pp.129–76.
Ross, S. ‘The Determination of Financial Structure: The Incentive Signalling
Approach’, Bell Journal of Economics 8(1) 1977, pp.23–40.
Shleifer, A. and R. Vishny ‘Large Shareholders and Corporate Control,’
Journal of Political Economy 94(3) 1986, pp.461–88.
Travlos, N. ‘Corporate Takeover Bids, Methods of Payment, and Bidding Firms’
Stock Returns’, Journal of Finance 42(4) 1990, pp.943–63.
Warner, J. ‘Bankruptcy Costs: Some Evidence’, Journal of Finance 32(2) 1977,
pp.337–47.

Books
Allen, F. and R. Michaely ‘Dividend Policy’ in Jarrow, Maksimovic and Ziemba
(eds) Handbook of Finance. (Elsevier Science, 1995). [No ISBN available].
Haugen, R. and J. Lakonishok The incredible January effect. (Homewood, Ill.:
Dow Jones-Irwin, 1988) [ISBN 9781556230424].
Ravenscraft, D. and F. Scherer Mergers, Selloffs, and Economic Efficiency.
(Washington D.C.: Brookings Institution, 1987) [ISBN 9780815773481].

4
Introduction to the subject guide

Subject guide structure and use


You should note that, as indicated above, the study of the relevant chapter
should be complemented by at least the essential reading given at the
chapter head.
The content of the subject guide is as follows.
‡ Chapter 1: here we focus on the evaluation of real investment
projects using the net present-value technique and provide a
comparison of NPV with alternative forms of project evaluation.
‡ Chapter 2: we look at the basics of risk and return of primitive
financial assets and mean–variance optimisation. We go on to derive
and discuss the capital asset pricing model (CAPM).
‡ Chapter 3: we present the arbitrage pricing theory, proposed as an
alternative to the CAPM for the calculation of expected returns on
financial assets.
‡ Chapter 4: here we look at derivative assets. We begin with the
nature of forward, future, option and swap contracts, then move on to
pricing derivative assets via absence-of-arbitrage arguments. We also
include a description of binomial option pricing models and end with
the Black–Scholes analysis.
‡ Chapter 5: in this chapter, we examine the efficiency of financial
markets. We present the concepts underlying market efficiency and
discuss the empirical evidence on efficient markets.
‡ Chapter 6: here we turn to corporate finance issues, treating the decision
over a corporation’s capital structure. The essential issue is what levels of
debt and equity finance should be chosen in order to maximise firm value.
‡ Chapter 7: we look at more advanced issues in capital structure
theory and focus on the use of capital structure to mitigate governance
problems known as agency costs and how capital structure and
financial decisions are affected by asymmetric information.
‡ Chapter 8: here we examine dividend policy. What is the empirical
evidence on the dividend pay-out behaviour of firms, and theoretically,
how can we understand the empirical facts?
‡ Chapter 9: we look at mergers and acquisitions, and ask what
motivates firms to merge or acquire, what are the potential gains from
this activity, and how can this be theoretically treated? We also explore
how hostile acquisitions may serve as a discipline device to mitigate
governance problems.
‡ There is no specific chapter about corporate governance, but the
agency related topics of Chapters 7 and 9 are inherently motivated by
the existence of such problems. See also Grinblatt and Titman (2002)
Chapter 18 for a broad overview on governance-related issues.

Examination structure
Important: the information and advice given in the following section
are based on the examination structure used at the time this guide
was written. Please note that subject guides may be used for several
years. Because of this, we strongly advise you to always check both the
current Regulations for relevant information about the examination, and
the current Examiners’ commentaries where you should be advised of
any forthcoming changes. You should also carefully check the rubric/
instructions on the paper you actually sit and follow those instructions.
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92 Corporate finance

This unit will be evaluated solely on the basis of a three-hour examination.


You will have to answer four out of a choice of eight questions. Although
the Examiner will attempt to provide a fairly balanced coverage of the
unit, there is no guarantee that all of the topics covered in this guide
will appear in the examination. Examination questions may contain both
numerical and discursive elements. Finally, each question will carry equal
weight in marking and, in allocating your examination time, you should
pay attention to the breakdown of marks associated with the different
parts of each question.

Glossary of abbreviations used in this subject guide


APT arbitrage pricing theory
ARR accounting rate of return
B–S Black–Scholes
CAPM capital asset pricing model
CML capital market line
EMH efficient markets hypothesis
IRR internal rate of return
M&A mergers and acquisitions
M–M Modigliani–Miller
NPV net present value
OTC over the counter
RWM random walk model
SML security market line

6
Chapter 1: Present-value calculations and the valuation of physical investment projects

Chapter 1: Present-value calculations


and the valuation of physical investment
projects

Aim of the chapter


The aim of this chapter is to introduce the Fisher separation theorem,
which is the basis for using the net present value (NPV) for project
evaluation purposes. With this aim in mind, we discuss the optimality
of the NPV criterion and compare this criterion with alternative project
evaluation criteria.

Learning objectives
At the end of this chapter, and having completed the essential reading and
activities, you should be able to:
‡ analyse optimal physical and financial investment in perfect capital
markets and derive the Fisher separation result
‡ justify the use of the NPV rules via Fisher separation
‡ compute present and future values of cash-flow streams and appraise
projects using the NPV rule
‡ evaluate the NPV rule in relation to other commonly used evaluation
criteria
‡ value stocks and bonds via NPV.

Essential reading
Grinblatt, M. and S. Titman Financial Markets and Corporate Strategy. (Boston,
Mass.; London: McGraw-Hill, 2002) Chapter 10.

Further reading
Brealey, R., S. Myers and F. Allen Principles of Corporate Finance. (Boston,
Mass.; London: McGraw-Hill, 2008) Chapters 2, 3, 5, 6 and 7.
Copeland, T. and J. Weston Financial Theory and Corporate Policy. (Reading,
Mass.; Wokingham: Addison-Wesley, 2005) Chapters 1 and 2.
Roll, R. ‘A Critique of the Asset Pricing Theory’s Texts. Part 1: On Past and
Potential Testability of the Theory’, Journal of Financial Economics 4(2)
1977, pp.129–76.

Overview
In this chapter we present the basics of the present-value methodology
for the valuation of investment projects. The chapter develops the net
present-value (NPV) technique before presenting a comparison with the
other project evaluation criteria that are common in practice. We will also
discuss the optimality of NPV and give a number of extensive examples.

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92 Corporate finance

Introduction
Let us begin by defining how we are going to think about a firm in this
chapter. For the purposes of this chapter, we will consider a firm to be a
package of investment projects. The key question, therefore, is how do the
firm’s shareholders or managers decide on which investment projects to
undertake and which to discard? Developing the tools that should be used
for project evaluation is the emphasis of this chapter.
It may seem, at this point, that our definition of the firm is rather limited.
It is clear that, in only examining the investment operations of the firm,
we are ignoring a number of potentially important firm characteristics.
In particular, we have made no reference to the financial structure or
decisions of the firm (i.e. its capital structure, borrowing or lending
activities, or dividend policy). The first part of this chapter presents what
is known as the Fisher separation theorem. What follows is a statement
of the theorem. This theorem allows us to say the following: under
certain conditions (which will be presented in the following section), the
shareholders can delegate to the management the task of choosing which
projects to undertake (i.e. determining the optimal package of investment
projects), whereas they themselves determine the optimal financial
decisions. Hence, the theory implies that the investment and financing
choices can be completely disconnected from each other and justifies our
limited definition of the firm for the time being.

Fisher separation and optimal decision-making


Consider the following scenario. A firm exists for two periods
(imaginatively named period 0 and period 1). The firm has current funds
of m and, without any investment, will receive no money in period 1.
Investments can be of two forms. The firm can invest in a number of
physical investment projects, each of which costs a certain amount of cash
in period 0 and delivers a known return in period 1. The second type of
investment is financial in nature and permits the firm to borrow or lend
unlimited amounts at rate of interest r. Finally the firm is assumed to have
a standard utility function in its period 0 and period 1 consumption. (By
consumption we mean the use of any funds available to the firm net of any
costs of investment.)
Let us first examine the set of physical investments available. The firm
will logically rank these investments in terms of their return, and this will
yield a production opportunity frontier that looks as given in Figure 1.1
(and is labelled POF). This curve represents one manner in which the firm
can transform its current funds into future income, where c0 is period 0
consumption, and c1 is period 1 consumption. Using the assumed utility
function for the firm, we can also plot an indifference map on the same
diagram to find the optimal physical investment plan of a given firm. The
optimal investment policies of two different firms are shown in Figure 1.1.
It is clear from Figure 1.1 that the specifics of the utility function of
the firm will impact upon the firm’s physical investment policy. The
implication of this is that the shareholders of a firm (i.e. those whose
utility function matters in forming optimal investment policy) must dictate
to the managers of the firm the point to which it invests. However, until
now we have ignored the fact that the firm has an alternative method for
investment (i.e. using the capital market).

8
Chapter 1: Present-value calculations and the valuation of physical investment projects

Figure 1.1
The financial investment allows firms to borrow or lend unlimited
amounts at rate r. Assuming that the firm undertakes no physical
investment, we can define the firm’s consumption opportunities quite
easily. Assume the firm neither borrows nor lends. This implies that
current consumption (c0) must be identically m, whereas period 1
consumption (c1) is zero. Alternatively the firm could lend all of its funds.
This leads to c0 being zero and c1  =  (1  +  r)  m. The relationship between
period 0 and period 1 consumption is therefore given as below:
c1  =  (1  +  r)(m  –  c0  ).                                                        (1.1)
This implies that the curve which represents capital market investments is
a straight line with slope –(1+r). This curve is labeled CML on Figure 1.2.
Again, we have on Figure 1.2 plotted the optimal financial investments for
two different sets of preferences (assuming that no physical investment is
undertaken).

Figure 1.2
Now we can proceed to analyse optimal decision-making when firms
invest in both financial and physical assets. Assume the firm is at the
beginning of period 0 and trying to decide on its investment plan. It is
clear that, to maximise firm value, the projects undertaken should be those

9
92 Corporate finance

with the greatest return. Knowing that the return on financial investment
is always (1+r), the firm will first invest in all physical investment
projects with returns greater than (1+r  ). These are those projects on the
production possibility frontier (PPF) between points m and I on Figure
1.3.1 Projects above I on the PPF have returns that are dominated by the 1
The absolute value of
return from financial investment. the slope of the PPF can
be equated with the
Hence the firm physically invests up to point I. Note that, at this point, return on physical
we have not mentioned the firm’s preferences over period 0 and period investment. For all points
1 consumption. Hence, the decision to physically invest to I will be taken below I on the PPF, this
by all firms regardless of the preferences of their owners. Preferences slope exceeds that of
the capital market line
come into play when we consider what financial investments should be
CPFJGPEGFGƂPGUVJG
undertaken. set of desirable physical
The firm’s physical investment policy takes it to point I, from where it can investment projects.

borrow or lend on the capital market. Borrowing will move the firm to
the south-east along a line starting at I and with slope –(1+r); lending will
take the firm north-west along a similarly sloped line. Two possible optima
are shown on Figure 1.3. The optimum at point X is that for a firm whose
owners prefer period 1 consumption relative to period 0 consumption (and
have hence lent on the capital market), whereas a firm locating at Y has
borrowed, as its owners prefer date 0 to date 1 consumption.
Figure 1.3 demonstrates the key insight of Fisher separation. All firms,
regardless of preferences, will have the same optimal physical investment
policy, investing to the point where the PPF and capital market line are
tangent. Preferences then dictate the firm’s borrowing or lending policy
and shift the optimum along the capital market line. The implication of
this is that, as it is physical investment that alters firm value, all agents
(i.e. regardless of preferences) agree on the physical investment policy that
will maximise firm value. More specifically, the shareholders of the firm
can delegate choice of investment policy to a manager whose preferences
may differ from their own, while controlling financial investment policy in
order to suit their preferences.

Figure 1.3

10
Chapter 1: Present-value calculations and the valuation of physical investment projects

Fisher separation and project evaluation


Fisher separation can also be used to justify a certain method of project
appraisal. Figure 1.3 shows a sub-optimal physical investment decision (I’)
and the capital market line that borrowing and lending from point I’ would
trace out. Clearly this capital market line always lies below that achieved
through the optimal physical investment policy. Hence, one could say that
optimal physical investment should maximise the horizontal intercept of
the capital market line on which the firm ends up. Let us, then, assume a
firm that decides to invest a dollar amount of I0. Given that the firm has
date 0 income of m and no date 1 income, aside from that accruing from
physical investment, the horizontal intercept of the capital market line
upon which the firm has located is:
∏(I0)
m – I0 +
1+ r
where Ȇ(I0) is the date 1 income from the firm’s physical investment.
Maximising this is equivalent to the following maximisation problem:
∏(I0)
max – I0.
I0 1+ r

The prior objective is the net present-value rule for project appraisal. It
says that an optimal physical investment policy maximises the difference
between investment proceeds divided by one plus the interest rate and the
investment cost. Here, the term ‘optimal’ is being defined as that which leads
to maximisation of shareholder utility. We will discuss the NPV rule more
fully (and for cases involving more than one time period) later in this chapter.
The assumption of perfect capital markets is vital for our Fisher separation
results to hold. We have assumed that borrowing and lending occur at the
same rate and are unrestricted in amount and that there are no transaction
costs associated with the use of the capital market. However, in practical
situations, these conditions are unlikely to be met. A particular example is
given in Figure 1.4. Here we have assumed that the rate at which borrowing
occurs is greater than the rate of interest paid on lending (as the real world
would dictate). Figure 1.3 shows that there are now two points at which the
capital market lines and the production opportunities frontier are tangential.
This then implies that agents with different preferences will choose differing
physical investment decisions and, therefore, Fisher separation breaks down.

Figure 1.4

11
92 Corporate finance

Agents with strong preferences for future consumption will physically


invest to point X and then financially invest to an optimum on the
capital market lending line (CML). Those with strong preferences for
current consumption physically invest to point Y and borrow (along
CML’). Finally, a set of agents may exist who value current and future
consumption similarly, and these will optimise by locating directly on the
PPF and not using the capital market at all. An example of an optimum of
this type is point Z on Figure 1.4.

The time value of money


In the preceding section we demonstrated the Fisher separation theorem
and the manner in which physical and financial investment decisions can
be disconnected. The major implication of this theorem is that the set of
desirable physical investment projects does not depend on the preferences
of individuals. In the following sections we shall focus on the way in
which individual physical investment projects should be evaluated. Our
key methodology for this will be the NPV rule, mentioned in the preceding
section. In the following sections we will show you how to apply the rule
to situations involving more than one period and with time-varying cash
flows.
To begin, let us consider a straightforward question. Is $1 received today
worth the same as $1 received in one year’s time? A naïve response to
this question would assert that $1 is $1 regardless of when it is received,
and hence the answer to the question would be yes. A more careful
consideration of the question brings the opposite response however. Let’s
assume I receive $1 now. If I also assume that there is a risk-free asset in
which I can invest my dollar (e.g. a bank account), then in one year’s time
I will receive $(1+r), assuming I invest. Here, r is the rate of return on the
safe investment. Hence $1 received today is worth $(1+r) in one year. The
answer to the question is therefore no. A dollar received today is worth
more than a dollar received in one year or at any time in the future.
The above argument characterises the time value of money. Funds are
more valuable the earlier they are received. In the previous paragraph we
illustrated this by calculating the future value of $1. We can similarly
illustrate the time value of money by using present values. Assume I
am to receive $1 in one year’s time and further assume that the borrowing
and lending rate is r. How much is this dollar worth in today’s terms?
To answer this second question, put yourself in the position of a bank.
Knowing that someone is certain to receive $1 in one year, what is the
maximum amount you would lend him or her now? If I, as a bank, were to
lend someone money for one year, at the end of the year I would require
repayment of the loan plus interest (at rate r). Hence if I loaned the
individual $x I would require a repayment of $x(1+r). This implies that the
maximum amount I should be willing to lend is implicitly defined by the
following equation:
$x(1  +  r)  =  $1   (1.2)
such that:
1 .
x =$ (1.3)
1+ r
The value for x defined in equation 1.3 is the present value of $1
received in one year’s time. This quantity is also termed the discounted
value of the $1.

12
Chapter 1: Present-value calculations and the valuation of physical investment projects

You can see the present and future value concepts pictured in Figure 1.2.
If you recall, Figure 1.2 just plots the CML for a given level of initial funds
(m) assuming no funds are to be received in the future. The future value
of this amount of money is simply the vertical intercept of the CML (i.e.
m(1+r)), and obviously the present value of m(1+r) is just  m.
The present and future value concepts are straightforwardly extended
to cover more than one period. Assume an annual compound interest rate
of r. The present value of $100 to be received in k year’s time is:

PVK (100 ) =100 (1.4)


(1 + r) K
whereas the future value of $100 received today and evaluated k years
hence is:

FVK  (100)  =  100(1  +  r)K.   (1.5)

Activity
Below, there are a few applications of the present and future value concepts. You should
attempt to verify that you can replicate the calculations given below.
Assume a compound borrowing and lending rate of 10 per cent annually.
a. The present value of $2,000 to be received in three years time is $1,502.63.
b. The present value of $500 to be received in five years time is $310.46.
c. The future value of $6,000 evaluated four years hence is $8,784.60.
d. The future value of $250 evaluated 10 years hence is $648.44.

The net present-value rule


In the previous section we demonstrated that the value of funds depends
critically on the time those funds are received. If received immediately,
cash is more valuable than if it is to be received in the future.
The net present-value rule was introduced in simple form in the section
on Fisher separation. In its more general form, it uses the discounting
techniques provided in the previous section in order to generate a
method of evaluating investment projects. Consider a hypothetical
physical investment project, which has an immediate cost of  I. The project
generates cash flows to the firm in each of the next k years, equal to Ck.
In words, all that the NPV rule does is to compute the present value of all
receipts or payments. This allows direct comparisons of monetary values,
as all are evaluated at the same point in time. The NPV of the project is
then just the sum of the present values of receipts, less the sum of the
present values of the payments.
Using the notation given above and again assuming a rate of return of r,
the NPV can be written as:
k Ci
NPV = ∑ − I. (1.6)
(
i =1 1 + r
)i
Note that the cash flows to the project can be positive and negative,
implying that the notation employed is flexible enough to embody both
cash inflows and outflows after initiation.

13
92 Corporate finance

Once we have calculated the NPV, what should we do? Clearly, if the NPV
is positive, it implies that the present value of receipts exceeds the present
value of payments. Hence, the project generates revenues that outweigh its
costs and should therefore be accepted. If the NPV is negative the project
should be rejected, and if it is zero the firm will be indifferent between
accepting and rejecting the project.
This gives a very straightforward method for project evaluation. Compute
the NPV of the project (which is a simple calculation), and if it is greater
than zero, the project is acceptable.

Example
Consider a manufacturing firm, which is contemplating the purchase of a new piece of
plant. The rate of interest relevant to the firm is 10 per cent. The purchase price is £1,000.
If purchased, the machine will last for three years and in each year generate extra revenue
equivalent to £750. The resale value of the machine at the end of its lifetime is zero. The
NPV of this project is:

NPV = 750 + 750 + 750 – 1000 = 865.14.


(1.1)3 (1.1)2 (1.1)1

As the NPV of the project exceeds zero, it should be accepted.

In order to familiarise yourself with NPV calculations, attempt the following


activities by calculating the NPV of each project and assessing its desirability.

Activity
Assume an interest rate of 5 per cent. Compute the NPV of each of the following projects,
and state whether each project should be accepted or not.
‡ Project A has an immediate cost of $5,000, generates $1,000 for each of the next
six years and zero thereafter.
‡ Project B costs £1,000 immediately, generates cash flows of £600 in year 1,
£300 in year 2 and £300 in year 3.
‡ Project C costs ¥10,000 and generates ¥6,000 in year 1. Over the following years,
the cash flows decline by ¥2,000 each year, until the cash flow reaches zero.
‡ Project D costs £1,500 immediately. In year 1 it generates £1,000. In year 2 there
is a further cost of £2,000. In years 3, 4 and 5 the project generates revenues of
£1,500 per annum.

Up to this point we have just considered single projects in isolation,


assuming that our funds were enough to cover the costs involved. What
happens, first of all, if the members of a set of projects are mutually
exclusive?2 The answer is simple. Pick the project that has the greatest NPV. 2
By this we mean that
Second, what should we do if we have limited funds? It may be the case taking on any one of the
set of projects precludes
that we are faced with a pool of projects, all of which have positive NPVs,
us from accepting any of
but we only have access to an amount of money that is less than the total the others.
investment cost of the entire project pool. Here we can rely on another
nice feature of the NPV technique. NPVs are additive across projects (i.e.
the NPV of taking on projects A and B is identical to the NPV of A plus the
NPV of B). The reason for this should be obvious from the manner in which
NPVs are calculated. Hence, in this scenario, we should calculate all project
combinations that are feasible (i.e. the total investment in these projects
can be financed with our current funds). Then calculate the NPV of each
combination by summing the NPVs of its constituents, and finally choose
the combination that yields the greatest total NPV.

14
Chapter 1: Present-value calculations and the valuation of physical investment projects

Finally, we should devote some time to discussion of the ‘interest rate’ we


have used to discount future cash flows. Until now we have just referred
to r as the rate at which one can borrow or lend funds. A more precise
definition of r is that r is the opportunity cost of capital. If we are
considering the use of the NPV rule within the context of a firm, we have
to recognise that the firm has several sources of capital, and the cost of
each of these should be taken into account when evaluating the firm’s
overall cost of capital. The firm can raise funds via equity issues and
debt issues, and it is likely that the costs of these two types of funds will
differ. Later on in this chapter and in those that follow, we will present
techniques by which the firm can compute the overall cost of capital for its
enterprise.

Other project appraisal techniques


The NPV methodology for project appraisal is by no means the only
technique used by firms to decide on their physical investment policy. It is
however the optimal technique for corporate management to use if they
wish to maximise expected shareholder wealth. This result is obvious from
our Fisher separation analysis. In this section we talk about a couple of
NPV’s competitors, the payback and internal rate of return (IRR)
rules, which are sometimes used in practice.

The payback rule


Payback is a particularly simple criterion for deciding on the desirability
of an investment project. The firm chooses a fixed payback period, for
example, three years. If a project generates enough cash in the first three
years of its existence to repay the initial investment outlay, then it is
desirable, and if it doesn’t generate enough cash to cover the outlay, it
should be rejected. Take the cash-flow stream given in the following table
as an example.
Year 0 1 2 3 4
Cash flow –1,000 250 250 250 500
Table 1.1
A firm that has chosen a payback period of three years and is faced with
the project shown in Table 1.1 will reject it as the cash flow in years 1 to
3 (750) doesn’t cover the initial outlay of 1,000. Note, however, that if the
firm used a payback period of four years, the project would be acceptable,
as the total cash flow to the project would be 1,250, which exceeds the
outlay. Hence, it’s clear that the crucial choice by management is of the
payback period.
We can also use the preceding example to illustrate the weaknesses of
payback. First, assume the firm has a payback period of three years. Then,
as previously mentioned, the project in Table 1.1 will not be accepted.
However, assume also that, instead of being 500, the project cash flow in
year 4 is 500,000. Clearly, one would want to revise one’s opinion on the
desirability of the project, but the payback rule still says you should reject
it. Payback is flawed, as a portion of the cash-flow stream (that realised
after the payback period is up) is always ignored in project evaluation.
The second weakness of payback should be obvious, given our earlier
discussion of NPV. Payback ignores the time value of money. Sticking with
the example in Table 1.1, assume a firm has a payback period of four years.
Then the project as given should be accepted (as total cash flow of 1,250
exceeds investment outlay of 1,000). But what’s the NPV of this project?

15
92 Corporate finance

If we assume, for example, a required rate of return of 10 per cent, then


the NPV can be shown to be negative. (In fact the NPV is –36.78. As a
self-assessment activity, show that this is the case.) Hence application of
the payback rule tells us to accept a project that would decrease expected
shareholder wealth (as shown by application of the NPV rule). This flaw
could be eliminated by discounting project cash flows that accrue within
the payback period, giving a discounted payback rule, but such a
modification still wouldn’t solve the first problem we highlighted.

The internal rate of return criterion


The IRR rule can be viewed as a variant on the apparatus we used in the
NPV formulation. The IRR of a project is the rate of return that solves the
following equation:
k C
∑ (1 + ri ) i − I = 0 (1.7)
i =1

where Ci is the project cash flow in year i, and I is the initial (i.e. year 0)
investment outlay. Comparison of equation 1.7 with 1.6 shows that the
project IRR is the discount rate that would set the project NPV to zero.
Once the IRR has been calculated, the project is evaluated by comparing
the IRR to a predetermined required rate of return known as a hurdle
rate. If the IRR exceeds the hurdle rate, then the project is acceptable,
and if the IRR is less than the hurdle rate it should be rejected. A graphical
analysis of this is presented in Figure 1.5, which plots project NPV against
the rate of return used in NPV calculation. If r* is the hurdle rate used
in project evaluation, then the project represented by the curve on the
figure is acceptable as the IRR exceeds r*. Clearly, if r* is also the correct
required rate of return, which would be used in NPV calculations, then
application of the IRR and NPV rules to assessment of the project in Figure
1.5 gives identical results (as at rate r* the NPV exceeds zero).

Figure 1.5
Calculation of the IRR need not be straightforward. Rearranging equation
1.7 shows us that the IRR is a solution to a kth order polynomial in r.
In general, the solution must be found by some iterative process, for
example, a (progressively finer) grid search method. This also points to
a first weakness of the IRR approach; as the solution to a polynomial,
the IRR may not be unique. Several different rates of return might satisfy
equation 1.7; in this case, which one should be used as the IRR? Figure 1.6
gives a graphical example of this case.

16
Chapter 1: Present-value calculations and the valuation of physical investment projects

Figure 1.6
The graphical approach can also be used to illustrate another weakness
of the IRR rule. Consider a firm that is faced with a choice between two
mutually exclusive investment projects (A and B). The locus of NPV-rate of
return pairings for each of these projects is given on Figure 1.7.
The first thing to note from the figure is that the IRR of project A
exceeds that of B. Also, both IRRs exceed the hurdle rate, r*. Hence,
both projects are acceptable but, using the IRR rule, one would choose
project A as its IRR is greatest. However, if we assume the hurdle rate is
the true opportunity cost of capital (which should be employed in an NPV
calculation), then Figure 1.7 indicates that the NPV of project B exceeds
that of project A. Hence, in the evaluation of mutually exclusive projects,
use of the IRR rule may lead to choices that do not maximise expected
shareholder wealth.

Figure 1.7
The lesson of this section is therefore as follows. The most commonly
used alternative project evaluation criteria to the NPV rule can lead to
poor decisions being made under some circumstances. By contrast, NPV
performs well under all circumstances and thus should be employed.

17
92 Corporate finance

Using present-value techniques to value stocks and


bonds
To end this chapter, we will discuss very briefly how to value common
stocks and bonds through the application of present-value techniques.

Stocks
Consider holding a common equity share from a given corporation. To
what does this equity share entitle the holder? Aside from issues such as
voting rights, the share simply delivers a stream of future dividends to
the holder. Assume that we are currently at time t, that the corporation is
infinitely long-lived (such that the stream of dividends goes on forever)
and that we denote the dividend to be paid at time  t+i by Dt+i. Also
assume that dividends are paid annually. Denoting the required annual
rate of return on this equity share to be  re, then a present value argument
would dictate that the share price (P) should be defined by the following
formula:
∞ D
P= ∑ (1 + rt+i) i . (1.8)
i =1 e

Note that in the above representation we have assumed that there is no


dividend paid at the current time (i.e. the summation does not start at
zero). In plain terms, what equation 1.8 says is that an equity share is
worth only the discounted stream of annual dividends that it delivers.
A simplification of the preceding formula is available when we assume that
the dividend paid grows at constant percentage rate g per annum. Then,
assuming that a dividend of D0 has just been paid, the future stream of
dividends will be D0(1+g), D0(1+g)2, D0(1+g)3 and so on. This type of cash-
flow stream is known as a perpetuity with growth, and its present
value can be calculated very simply.3 In this setting the price of the equity 3
See Appendix 1.
share is:
D ( 1 + g)
P = 0 . (1.9)
re – g

This is the Gordon growth model of equity valuation. As is obvious


from the preceding discussion, it is only valid if you can assert that
dividends grow at a constant rate.
Note also that if you have the share price, dividend just paid and an
estimate of dividend growth, you can rearrange equation 1.9 to give the
required rate of return on the stock – that is:

re = D0 ( 1 + ) + g .
g
(1.10)
P
The first term in 1.10 is the expected dividend yield on the stock, and the
second is expected dividend growth. Hence, with empirical estimates of
the previous two quantities, we can easily calculate the required rate of
return on any equity share.

Activity
Attempt the following questions:
1. An investor is considering buying a certain equity share. The stock has just paid
a dividend of £0.50, and both the investor and the market expect the future
dividend to be precisely at this level forever. The required rate of return on
similar equities is 8 per cent. What price should the investor be prepared to pay
for a single equity share?

18
Chapter 1: Present-value calculations and the valuation of physical investment projects

2. A stock has just paid a dividend of $0.25. Dividends are expected to grow at
a constant annual rate of 5 per cent. The required rate of return on the share
is 10 per cent. Calculate the price of the stock.
3. A single share of XYZ Corporation is priced at $25. Dividends are expected
to grow at a rate of 8 per cent, and the dividend just paid was $0.50. What is
the required rate of return on the stock?

Bonds
In principle, bonds are just as easy to value.
‡ A discount or zero coupon bond is an instrument that promises
to pay the bearer a given sum (known as the principal) at the end of
the instrument’s lifetime. For example, a simple five-year discount bond
might pay the bearer $1,000 after five years have elapsed.
‡ Slightly more complex instruments are coupon bonds. These not
only repay the principal at the end of the term but in the interim entitle
the bearer to coupon payments that are a specified percentage of
the principal. Assuming annual coupon payments, a three-year bond
with principal of £100 and coupon rate of 8 per cent will give annual
payments of £8, £8 and £108 in years 1, 2 and 3.
In more general terms, assuming the coupon rate is c, the principal is P
and the required annual rate of return on this type of bond is rb, the price
of the bond can be written as:4 4
In our notation a
coupon rate of 12
cP + p ( 1 + c) .
k –1
PB = ∑ (1 + rb ) i (1 + rb ) k
(1.11) per cent, for example,
i =1 implies that c = 0.12;
Note that it is straightforward to value discount bonds in this framework the discount rate used
here, rb, is called the
by setting c to zero.
yield to maturity of the
bond.
Activity
Using the previous formula, value a seven-year bond with principal $1,000, annual
coupon rate of 5 per cent and required annual rate of return of 12 per cent.
(Hint: the use of a set of annuity tables might help.)

A reminder of your learning outcomes


Having completed this chapter, and the essential reading and activities,
you should be able to:
‡ analyse optimal physical and financial investment in perfect capital
markets and derive the Fisher separation result
‡ justify the use of the NPV rules via Fisher separation
‡ compute present and future values of cash-flow streams and appraise
projects using the NPV rule
‡ evaluate the NPV rule in relation to other commonly used evaluation
criteria
‡ value stocks and bonds via NPV.

19
92 Corporate finance

Key terms
capital market line (CML)
consumption
Fisher separation theorem
Gordon growth model
indifference curve
internal rate of return (IRR) criterion
investment policy
net present value rule
payback rule
production opportunity frontier (POF)
production possibility frontier (PPF)
time value of money
utility function

Sample examination questions


1. The Toyundai Motor Company has the opportunity to invest in new
production line equipment, which would have a working lifetime of 10
years. The new equipment would generate the following increases in
Toyundai’s net cash flows.
In the first year of usage the new plant would decrease costs by
$200,000. For the following 6 years the cost saving would fall at a rate
of 5 per cent per annum. In the remaining years of the equipment’s
lifetime, the annual cost saving would be $140,000. Assuming that the
cost of the equipment is $1,000,000 and that Toyundai’s cost of capital
is 10 per cent, calculate the NPV of the project. Should Toyundai take
on the investment? (15%)
2. Describe two methods of project evaluation other than NPV. Discuss the
weaknesses of these methods when compared to NPV. (10%)

20
Chapter 2: Risk and return: mean–variance analysis and the CAPM

Chapter 2: Risk and return:


mean–variance analysis and the CAPM

Aim of the chapter


The aim of this chapter is to derive the capital asset pricing model (CAPM)
enabling us to price financial assets. In order to do so, we introduce the
mean–variance analysis setting, in which investors care solely about
financial assets’ expected returns and variances of returns, as well as the
statistical tools enabling us to calculate portfolios’ expected returns and
variances of returns.

Learning objectives
At the end of this chapter, and having completed the essential reading and
activities, you should be able to:
‡ discuss concepts such as a portfolio’s expected return and variance as
well as the covariance and correlation between portfolios’ returns
‡ calculate portfolio expected return and variance from the expected
returns and return variances of constituent assets
‡ describe the effects of diversification on portfolio characteristics
‡ derive the CAPM using mean–variance analysis
‡ describe some theoretical and practical limitations of the CAPM.

Essential reading
Grinblatt, M. and S. Titman Financial Markets and Corporate Strategy. (Boston,
Mass.; London: McGraw-Hill, 2002) Chapters 4 and 5.

Further reading
Brealey, R., S. Myers and F. Allen Principles of Corporate Finance. (Boston,
Mass.; London: McGraw-Hill, 2008) Chapters 8 and 9.
Copeland, T. and J. Weston Financial Theory and Corporate Policy.
(Reading, Mass.; Wokingham: Addison-Wesley, 2005) Chapters 5 and 6.
Roll, R. ‘A Critique of the Asset Pricing Theory’s Texts. Part 1: On Past and
Potential Testability of the Theory’, Journal of Financial Economics 4(2)
1977, pp.129–76.

Introduction
In Chapter 1 we examined the use of present-value techniques in the
evaluation of physical investment projects and in the valuation of primitive
financial assets (i.e. stocks and bonds). A key input into NPV calculations
is the rate of return used in the construction of the discount factor but,
thus far, we have said little regarding where this rate of return comes
from. Our objective in this chapter is to demonstrate how the risk of a
given security or project impacts on the rate of return required from it and
hence affects the value assigned to that asset in equilibrium.
We begin by introducing the basic statistical tools that will be needed
in our analysis, these being expected values, variances and
covariances. This leads to an analysis of the statistical characteristics
21
92 Corporate finance

of portfolios of financial assets and ultimately to a presentation of the


standard mean–variance optimisation problem. The key result of mean–
variance analysis is known as two-fund separation, and this result
underlies the capital asset pricing model, which we will present next.

Statistical characteristics of portfolios


A portfolio is a collection of different assets held by a given investor.
For example, an American investor may hold 100 Microsoft shares and
650 shares of Bethlehem Steel and therefore holds a portfolio comprising
two assets. The objective of this section is to arrive at the statistical
characteristics of the return on the entire portfolio, given the statistical
features of each of the constituent assets. The key statistical measures used
are expected returns and return variances or standard deviations.
The expected return on a given asset can be thought of as the reward
gained from holding it, whereas the return variance is a measure of total
asset risk.
Let us define notation. First, we should clarify the way in which we are
thinking about asset returns. The return on an asset is assumed to be a
random variable with known distributional characteristics. Each individual
asset is assumed to have an expected return of E(rj) and return variance
ı2j. Assets i and j are assumed to have covariance ıij . Similarly, we denote
the expected return of the portfolio held as E(Rp) and its variance by ı2P.
Finally, we assume that an investor can pick from N different stocks when
forming his portfolio.
Returning to the example of the American investor given above, assume
that the market price of Microsoft shares is 130 and that of Bethlehem
Steel is 10.1 Hence, given the numbers of each share held, the total value 1
These prices are in US
of this investor’s portfolio is $195. We further assume that the expected cents.
returns on Microsoft and Bethlehem Steel are 10 per cent and 16 per cent
respectively, whereas their variances are 0.25 and 0.49.
We are now in a position to define the share of the entire portfolio value
that is contributed by each individual stockholding. These are referred
to as portfolio weights. The portfolio weight of Bethlehem Steel, for
example, is simply the value of the Bethlehem Steel holding divided by
$195 (i.e. 1/3 or approximately 33.3 per cent). Hence our US investor
allocates 1/3 of every dollar invested to Bethlehem Steel stock.

Activity
Calculate the portfolio weight for Microsoft, using the method presented above.

From the calculations undertaken it is clear that the sum of portfolio


weights must be unity. Each portfolio weight represents the share of total
portfolio value contributed by a given asset. Obviously, aggregating these
shares across all assets held will give a result of unity. Hence, extending
the notation presented above, we denote the portfolio weight on asset i by
ai, and the preceding argument implies that 6Į1= 1.
Our American investor now knows the statistical characteristics of the
return on each of the assets she holds, plus how to calculate the portfolio
weight on each of the assets. What she would really like to know now is
how to construct the return characteristics for the entire portfolio (i.e.
she’s concerned about the risk and reward associated with her entire
investment). In order to do this we will need to introduce some basic
properties of expectations, variances and covariances.

22
Chapter 2: Risk and return: mean–variance analysis and the CAPM

Expectations, variances and covariances


Consider two random variables, x and y. The expected values and
variances of these variables are E(x),  E(y),  ı2x and ı2y. The covariance
between the random variables is ıxy.
Form an arbitrary linear combination of these two random variables and
denote it P (i.e. P  =  ax  +  by, where a and b are constants). We wish to
know the expected return and variance of the new random variable P.
These are calculated as follows:
E(P)  =  aE(x)  +  bE(y)   (2.1)
ı  =  a ı  +  b ı  +  2abıxy.
2
P
2 2
x
2 2
y
(2.2)
The preceding results are readily extended to the case where more than
two random variables are linearly combined. Consider N random variables
denoted xi, where i runs from 1 to N. Denote their expected values and
variances as E(xi) and ı2i. The covariance between xi and xj is ıij. Again
we form a linear combination of the random variables, denoted again by
P, using an arbitrary set of constants denoted ai. The expected value and
variance of the random variable P are given by:
N
E(P) = ∑ a1 E ( x1)        (2.3)
i =1
N
σP2 = ∑ a i2 σ i2 + ∑a i a j σ ij. (2.4)
i =1 i≠ j

Given that the returns on individual assets are assumed to be random


variables with known distributional characteristics, the statistical results
given above allow us to calculate portfolio returns and variances very
simply.
In addition to the data on Microsoft and Bethlehem Steel provided earlier,
we also need to know the covariance between Microsoft and Bethlehem
Steel returns in order to determine the statistical characteristics of
portfolios of these two assets. However, rather than using covariances, we
shall work throughout the rest of this analysis with correlation coefficients.
The relationship between correlations and covariances is given below.

Covariances and correlations


Assume two random variables, x and y, with variances denoted by ı2x and
ı2y. The covariance between the random variables is ıxy. The correlation
coefficient is defined as follows:
σ
ρxy = xy , (2.5)
σx σy
that is, the correlation between the two random variables is simply the
covariance, divided by the product of the respective standard deviations.
Clearly, knowledge of the correlation and the variances of the two random
variables allows one to retrieve the covariance between the two random
variables.
If we again define a linear combination of the two random variables, P,
using arbitrary constants a and b, the expression for the variance of the
linear combination can be rewritten using the correlation as follows:
ı2p  =  a2ı2x  +  b2ı2y  +  2abUxyıxıy.   (2.6)
This is a straightforward substitution of equation 2.5 into equation 2.2.
Now we are in a position to calculate the characteristics of our American
investor’s portfolio. Let us take the simplest possible case first and assume
that the returns are uncorrelated (i.e. Uxy  =  0). Recalling that the portfolio
weights on Microsoft and Bethlehem Steel are 2  and 1 respectively, we
3 3
23
92 Corporate finance

can use equations 2.1 and 2.6 to derive the expected return and variance
of the investor’s portfolio. These calculations yield:

E ( R p) = 2
3 (0.1) + 1
3 (0.16) = 0.12 = 12 % (2.7)

σP2 = ( 23 ( 2 (0.25) + ( 13 ( 2 (0.49) = 16.6 %. (2.8)

Hence, as we would expect, the expected portfolio return lies between


the returns on the individual assets. The portfolio variance, however, is
actually less than that on the return of either of the component assets (i.e.
the risk associated with the portfolio is lower than the risks associated
with either individual asset). This result is one that should be kept in mind
and is the focus of the next section.
Now let’s change our assumption regarding the correlation between the
two asset returns. Assume now that Uxy  =  0.5. Obviously, the expected
portfolio return won’t change (as equation 2.1 doesn’t involve the
correlation or covariance at all). The portfolio variance now becomes:
σP2 = ( 23 ( 2 (0.25) + ( 13 ( 2 (0.49) + 2 ( 13 ( ( 23 ( × 0.5 × 0.5× 0.7 = 24.3%. (2.9)
The portfolio variance has obviously increased, although it is still less than
the return variances of either component assets.

Activity
Assume that Uxy  =  –  0.5. Calculate the portfolio return variance in this case, using the
data on portfolio weights and asset return variances given above.

Now, given the expected returns, return variances and covariances for
any set of assets, we should be able to calculate the expected return and
variance of any portfolio created from those assets. At the end of this
chapter, you will find activities that require you to do precisely this, along
with solutions to some of these activities.

Diversification
A point that we noted from the calculations of expected portfolio returns
and variances above was that, in all of our calculations, the variance of the
portfolio return was lower than that on any individual component’s asset
return.2 Hence, it seems as though, by forming bundles of assets, we can 2
Note that this result
eliminate risk. This is true and is known as diversification: through holding does not hold in general
(i.e. it may be the case
portfolios of assets, we can reduce the risk associated with our position.
that the return variance
Why is this the case? The key is that, in our prior analysis and in real stock of a portfolio exceeds
return data, the correlations between returns are less than perfect. If two the return variance of
returns are imperfectly correlated it implies that when returns on the first are one of the component
assets).
above average, those on the second need not be above average. Hence, to an
extent, the returns on such assets will tend to cancel each other out, implying
that the return variance for a portfolio of these stocks will be smaller than
the corresponding weighted average of the individual asset variances.
To illustrate this point in a general setting, consider the following scenario.
An investor holds a portfolio consisting of N stocks, with each stock having
the same portfolio weight (i.e. each stock has portfolio weight N-­1). Denote
the return variances for the individual assets by ı2i where i  =  1 to N, and
the covariance between returns on assets i and  j by ıij. Using equation 2.4,
the variance of the investor’s portfolio return can be written as:
N
σP2 = 12 ∑ σi2 + N12 ∑ σij . (2.10)
N i =1 i≠ j

24
Chapter 2: Risk and return: mean–variance analysis and the CAPM

Examining the second term of equation 2.10, the existence of N


component assets implies that the summation for all i not equal to j  
involves N(N  –  1) terms. Obviously the summation in the first term of 2.10
involves N terms. Hence, defining the average variance of the N assets as
ı–2 and average covariance across all assets as C, 2.10 can be rewritten as:
( – 1(
σP2 = N2 σ 2 + N N 2 C. (2.11)
N N
Equation 2.11 obviously simplifies to the following:

N ( N (
σP2 = 12 σ 2 + 1 – 1 C . (2.12)

Now we ask the following question. How does the portfolio variance change
as the number of assets combined in the portfolio increases towards infinity
(i.e. N  of). It is clear from 2.12 that, as the number of assets held increases,
the first term will shrink towards zero. Also, as N increases the second term
in 2.12 tends towards  C. Together, these observations imply the following.
1. The portfolio variance falls as the number of assets held increases.
2. The limiting portfolio return variance is simply the average covariance
between asset returns: this average covariance can be thought of as
the risk of the market as a whole, with the influence of individual asset
return variances disappearing in the limit.
The moral of the preceding statistical story is clear. Holding portfolios
consisting of greater and greater numbers of assets allows an investor to reduce
the risk he or she bears. This is illustrated diagrammatically in Figure 2.1.

Figure 2.1

Mean–variance analysis
In the preceding two sections, we have demonstrated two important facts:
1. The expected return on a portfolio of assets is a linear combination of
the expected returns on the component assets.
2. An investor holding a diversified portfolio gains through the reduction
in portfolio variance, when asset returns are not perfectly correlated.
In this section, we use these facts to characterise the optimal holding of
risky assets for a risk-averse agent. Our fundamental assumption is that all
agents have preferences that only involve their expected portfolio return
and return variance. Utility is assumed to be increasing in the former
and decreasing in the latter. For illustrative purposes we begin using the
assumption that only two risky assets are available. The results presented,
however, generalise to the N asset case.
25
92 Corporate finance

To begin, assume there is no risk-free aset. The investor can hence only
form his or her portfolio from risky assets named X and Y. These assets
have expected returns of E(Rx) and E(Ry) and return variances of ı2x and ı2y.
The first question the investor wishes to answer is how the characteristics
of a portfolio of these assets (i.e. portfolio expected return and variance)
change as the portfolio weights on the assets change. Given equation 2.6,
the answer to this question is obviously dependent on the correlation
between the returns on the two assets.
First assume the assets are perfectly correlated and, further, assume asset
X has lower expected returns and return variance than asset Y. We form a
portfolio with weights Į on asset X and 1±Į on asset Y. Equation 2.6 then
implies that the portfolio variance can be written as follows:
ı2P  =  (Įıx  +  (1±Į)ıy )2.   (2.13)
Taking the square root of equation 2.13, it is clear that the portfolio
standard deviation is linear in  Į. As the portfolio expected return is linear
in Į, the locus of expected return–standard deviation combinations is a
straight line. This is shown in Figure 2.2.
Figure 2.2

If the correlation between returns is less than unity, however, the investor
can benefit from diversifying his portfolio. As previously discussed, in this
scenario, portfolio standard deviation is not a linear combination of ıx
and ıy. The reduction of portfolio risk through diversification will imply
that the mean–standard deviation frontier bows towards the y-axis. This
is also shown on Figure 2.2. The final curve on Figure 2.2 represents the
case where returns are perfectly negatively correlated. In this situation, a
portfolio can be constructed, which has zero standard deviation.

Activities
1. Assuming asset returns are perfectly negatively correlated, use equation 2.6
to find the portfolio weights that give a portfolio with zero standard deviation.
(Hint: write down 2.6 with the correlation set to minus one and a Į and
b ±Į. Then minimise portfolio variance with respect to Į.)
2. Assume that the returns on Microsoft and Bethlehem Steel have correlation of
0.5. Using the data provided earlier in the chapter, construct the mean–variance
frontier for portfolios of these two assets. Start with a portfolio consisting only
of Microsoft stock and then increase the portfolio weight on Bethlehem Steel by
0.1 repeatedly, until the portfolio consists of Bethlehem Steel stock only.

26
Chapter 2: Risk and return: mean–variance analysis and the CAPM

From here on we will assume that return correlation is between plus and
minus one. The expected return–standard deviation locus for this case
is redrawn in Figure 2.3. In the absence of a risk-free asset, this locus is
named the mean–variance frontier. As our investor’s preferences are
increasing in expected return and decreasing in standard deviation, it is
clear that his or her optimal portfolio will always lie on the frontier and
to the right of the point labelled V. This point represents the minimum-
variance portfolio. He or she will always choose a frontier portfolio at or
to the right of V, as these portfolios maximise expected return for a given
portfolio standard deviation. In the absence of a risk-free asset, this set of
portfolios is called the efficient set.

Figure 2.3
We can now, given a set of preferences for the investor, find his or her
optimal portfolio. The condition characterising the optimum is that
an investor’s indifference curve must be tangent to the mean–variance
frontier.3 Two such optima are identified on Figure 2.3 at R and S. The 3
In technical terms the
investor locating at equilibrium point R is relatively risk-averse (i.e. his optimum is characterised
by the marginal rate of
or her indifference curves are quite steep), whereas the equilibrium at
substitution being equal
S  is that for a less risk-averse individual (with correspondingly flatter to the marginal rate of
indifference curves). Figure 2.3 also shows sub-optimal indifference curves transformation (i.e. the
for each set of preferences. slope of the indifference
curve equals the slope of
the frontier).

Figure 2.4
27
92 Corporate finance

Hence, as Figure 2.3 demonstrates, in a world of two risky assets and no


risk-free asset, the optimal portfolio of risky assets held by an investor
depends on his or her preferences towards risk and return. The same is
true when there are N risky assets available. Figure 2.4 depicts the same
type of diagram for the N asset case.
Note that the mean–variance frontier is of the same shape as that in
Figure 2.3. However, unlike the two-asset case, the interior of the frontier
now consists of feasible but inefficient portfolios (i.e. those that do not
maximise expected return for given portfolio risk). The mean–variance
frontier now consists of those portfolios that minimise risk for a given
expected return, whereas those portfolios on the efficient set (i.e. on the
frontier but to the right of V) additionally maximise expected return for a
given level of risk.
We now reintroduce a risk-free asset to the analysis (i.e. we assume the
existence of an asset with return rf and zero return–standard deviation).
A key question to address at this juncture is as follows. Assume that
we form a portfolio consisting of the risk-free asset and an arbitrary
combination of risky assets. How do the expected return and return–
standard deviation of this portfolio alter as we vary the weights on the
risk-free asset and the risky assets respectively?
Denote our arbitrary risky portfolio by P. We combine P with the risk-free
asset using weights 1  –  a and a to form a new portfolio Q. The expected
return and variance of Q are given by:

E(RQ)  =  (1  –  a)rf  +  aE(RP)  =  rf  +  a[E(RP)  –  rf  ]   (2.14)

ı2Q  =  a2ı2P .   (2.15)

In order to analyse the variation in the risk and expected return of the
portfolio Q with respect to changes in the portfolio weights, we construct
the following expression:
dE(R Q) dE(R Q) /da
= . (2.16)
dσQ dσQ /da
Using equations 2.14 and 2.15 we find that:
dE(R Q) E(R p) – r f
= . (2.17)
dσQ σp
As this slope is independent of a, the risk–return profile of the portfolio Q
is linear. This is known as the capital market line, and two such CMLs are
shown in Figure 2.5 for two different portfolios of risky assets.
We now have all the components required to describe the optimal portfolio
choice of an investor faced with N risky assets and a risk-free investment.
Figure 2.6 replots the feasible set of risky asset portfolios. The key question
to answer is, what portfolio of risky assets should an investor hold? Using
the analysis from Figure 2.5, it is clear that the optimal choice of risky
asset portfolio is at K. Combining K with the risk-free asset places an
investor on a capital market line (labelled rfKZ), which dominates in utility
terms the CML generated by the choice of any other feasible portfolio of
risky assets.4 The optimal portfolio choice and a sub-optimal CML (labelled
4
That is, choosing
portfolio K places an
CML2) are shown on Figure 2.6 along with the indifference curves of two
investor on a CML with
investors. greater expected returns
Recall that we previously defined the efficient set as the group of at each level of return
portfolios that both minimised risk for a given level of expected return and variance than does any
other.

28
Chapter 2: Risk and return: mean–variance analysis and the CAPM

maximised expected return for a given level of risk. With the introduction
of the risk-free asset, the efficient set is exactly the optimal CML.

Figure 2.5
The key result that is depicted in Figure 2.6 is known as two-fund
separation. Any risk-averse investor (regardless of his or her degree
of risk-aversion) can form his or her optimal portfolio by combining two
mutual funds. The first of these is the tangency portfolio of risky assets,
labelled K, and the second is the risk-free asset. All that the degree of risk-
aversion dictates is the portfolio weights placed on each of the two funds.
The investor with the optimum depicted at X on Figure 2.6, for example, is
relatively risk-averse and has placed positive portfolio weights on both the
risk-free asset and  K. An investor locating at Y, however, is less risk-averse
and has sold the risk-free asset short in order to invest more in K.5 5
A short sale is the sale
of an asset that one
does not actually own.
One borrows the asset
in order to complete the
transactions and imme-
diately receives the sale
price. Subsequently, one
uses the proceeds from
the sale to repurchase
a unit of the asset, and
deliver it to the creditor.
If the price of the asset
has dropped in the
interim, one makes a
ECUJRTQƂV

Figure 2.6
Two-fund separation is the result that underlies the capital asset pricing
model (CAPM), which is developed in the next section.

29
92 Corporate finance

The capital asset pricing model


To begin our derivation of the CAPM, we present the assumptions that
underlie the analysis. These assumptions formalise those implicit in the
preceding section.
‡ Investors maximise utility defined over expected return and return
variance.
‡ Unlimited amounts may be borrowed or loaned at the risk-free rate.
‡ Investors have homogenous expectations regarding future asset returns.
‡ Asset markets are perfect and frictionless (e.g. no taxes on sales or
purchases, no transaction costs and no short sales restrictions).
We next need to extend slightly our analysis of the previous section in
order to derive the familiar form of the CAPM.

A mathematical characterisation of mean–variance optimisation


Consider Figure 2.6, which graphically identifies the optimal portfolio
of risky assets (K), held by an arbitrary risk-averse investor. The key
condition for optimality is that the capital market line and the mean–
variance frontier are tangent. The following equations give a mathematical
description of this optimality condition.
From equation 2.17, we know that the slope of the capital market line at
the optimum is:
E(R K) – r f
. (2.18)
σK
We also need the slope of the mean–variance frontier at the point of
tangency. To derive this, consider a position (called I) with portfolio
weight a in an arbitrary portfolio of risky assets (called j) and (1  –  a) in the
optimal portfolio K. The expected return and standard deviation of this
position are:

E(RI)  =  aE(Rj)  +  (1  –  a)E(RK)   (2.19)

ı1  =  [a2ı2j  +  (1  –  a)2ı2K  +  2a(1  –  a)ıjK]0.5.   (2.20)

Using the same method as shown in equation 2.16 to derive the risk–
return trade-off at the point represented by portfolio I, we get:
dE(R 1) (2.21)
= E(R j) – E(R K) .
da

dσ 1
= 0.5[a 2σ j2+(1–a) 2σ K2+2a(1–a)σ jK] -0.5 (2aσ j2–2(1–a)σ K2+2(1–2a)σ jK).
da
(2.22)

The slope of the mean–variance frontier at K will be the ratio of 2.21 to


2.22 in the limit as a o  0. Note that equation 2.21 does not depend on a.
Taking the limit of equation 2.22 as a o  0 we get:
1 (σ – σ 2) . (2.23)
σ K jK K

The slope of the mean–variance frontier at K is the ratio of 2.21 to 2.23,


that is,
σK [E(R j ) – E(R K )]
. (2.24)
σJK – σK2

30
Chapter 2: Risk and return: mean–variance analysis and the CAPM

The optimum in Figure 2.6 equates the slope of the mean–variance


frontier at K with the slope of the CML. Hence, equating 2.18 and 2.24
and rearranging the resulting expression, we arrive at:
σjK
E(R j ) = r f + σ 2 [E(R K ) – r f ]. (2.25)
K

Defining ȕj ıjKı2K, equation 2.26 can be rewritten as:

E(Rj)  =  rjȕj[E(RK)  –  rf  ].   (2.26)

Equation 2.26 is the standard ȕrepresentation of the mean–variance


optimisation problem. The equation translates as follows: the expected return
on a given asset (or portfolio of assets) is equal to the risk-free rate plus a
risk premium multiplied by the asset’s ȕ6 Assets that have large values of ȕ 6
The risk premium is
will have large expected returns, whereas those with smaller values of ȕ will FGƂPGFCUVJGGZEGUUQH
the expected return on
have low expected returns with ȕ defined as the ratio of the covariance of an
the tangency portfolio
asset’s returns with those on the market to the variance of the market return. over the risk-free rate.

Equilibrium and the CAPM


Equation 2.26 is simply derived from mean–variance analysis, and as
yet we have said nothing regarding equilibrium in asset markets. Capital
market equilibrium requires that the demand for risky securities be
identical to their supply. The supply of risky assets is summarised in the
market portfolio, which is defined below.

Definition
The market portfolio is the portfolio comprising all assets, where the
weights used in the construction of the portfolio are calculated as
the market capitalisation of each asset divided by the sum of market
capitalisations across all assets.

Two-fund separation gives us the fundamental result that all investors hold
efficient portfolios and, further, that all investors hold risky securities in the
same proportions (i.e. those proportions dictated by the tangency portfolio
(K)).7 For demand to be equal to supply in capital markets, it must be the case 7
All investors perceive
that the market portfolio is constructed with identical portfolio weights. The VJGUCOGGHƂEKGPVUGV
and tangency portfolio
implication of this is simple: the market portfolio and the tangency portfolio
due to our assumption
are identical. This allows us to express the CAPM in the following form. that they have homo-
geneous expectations
The capital asset pricing model regarding asset returns.
Under the prior assumptions, the following relationship holds for all
expected portfolio returns:
E(Rj  )  =  Rfȕj  [E(rM  )  –  rf  ],   (2.27)
where E(RM  ) is the expected return on the market portfolio, andȕj is the
covariance of the returns on asset j with those on the market divided by
the variance of the market return.
Equation 2.27 gives the equilibrium relationship between risk and return
under the CAPM assumptions. In the CAPM framework, the relevant
measure of an asset’s risk is its ȕ, and 2.27 implies that expected returns
increase linearly with risk.
To clarify the source of the CAPM equation, note that the identification of
the tangency portfolio and the linear ȕrepresentation are implied by mean–
variance analysis. The CAPM then imposes equilibrium on capital markets
and identifies the market portfolio as identical to the tangency portfolio.

31
92 Corporate finance

The security market line


Given equation 2.27, the equilibrium relationship between risk and return
has a very simple graphical depiction. In equilibrium expected returns are
linear in ȕ. The expected return on an asset with a ȕ of zero is rf  , whereas
an asset with a ȕ of unity has an expected return identical to that on the
market. Plotting this relationship, known as the security market line, we
get Figure 2.7.
Comparison of Figures 2.6 and 2.7 implies that, in equilibrium, two assets
with identical expected returns must have identical ȕs, although their return
variances can differ. The reason that their variances can differ is that a
proportion of asset return variance can be eliminated through diversification.
Agents should not be rewarded for bearing such risk, and hence, diversifiable
risk will not affect expected returns. Undiversifiable risk is that which is
driven by variation in the return on the market as a whole, and an asset’s
exposure to such risk is summarised by ȕ. Hence an asset’s ȕ measures its
relevant risk and, via equation 2.27, determines equilibrium expected returns.
The key message of the preceding paragraph is that ȕ measures asset risk.
A high ȕ asset is risky as it has high returns when market returns are high.
An asset with a low ȕ tends to have high returns when market returns are
low. Hence a low ȕ asset, when included in one’s portfolio, can provide
insurance against low market returns and hence is low risk.

Figure 2.7

Systematic and unsystematic risk


To mathematically illustrate the sources of asset risk we can use the CAPM
equation to decompose the variance of a given asset. Equation 2.27 gives
the equilibrium expected return for asset j. Actual returns on asset  j will
follow a similar relationship but will also include a random error term.
Denoting this error by İj we have the following equation:
rj  =  rfȕj  [rM  –  rf  ]  +  İj.   (2.28)
The variance of the risk-free return is zero by definition. Assuming that ȕj
is fixed we can represent the variance of asset j  as:
ı2j ȕ2jı2Mı2İ.   (2.29)

32
Chapter 2: Risk and return: mean–variance analysis and the CAPM

The final term on the right-hand side of equation 2.29 is the variance of
the error term and represents diversifiable risk. This source of risk is also
known as unsystematic and idiosyncratic risk. As emphasised previously,
this risk is unrelated to market fluctuations and, therefore, does not affect
expected returns. The first term on the right-hand side of 2.29 represents
undiversifiable risk, also known as systematic risk. This is risk that cannot
be escaped and hence increases equilibrium expected returns.

Activities8 8
;QWYKNNƂPFVJG
solutions to these
1. An investor forms a portfolio of two assets, X and  Y. These assets have activities at the end of
expected returns of 9 per cent and 6 per cent and standard deviations of 0.8 this chapter.
and 0.6 respectively. Assuming that the investor places a portfolio weight of
0.5 on each asset, calculate the portfolio expected return and variance if the
correlation between returns on X and Y is unity.
2. Using the data from Question 1, recalculate the portfolio expected return and
variance, assuming that the correlation between returns is 0.5.
3. An investor forms a portfolio from two assets, P and Q, using portfolio weights
of one-third and two-thirds respectively. The expected returns on P and Q are
5 per cent and 7 per cent, and their respective return standard deviations are
0.4 and 0.5. Assuming the return correlation is zero, calculate the expected
return and variance of the investor’s portfolio.
4. Assuming identical data to that in Question 3, recalculate the statistical
properties of the portfolio, assuming the return correlation for P and Q is –0.5.

The Roll critique and empirical tests of the CAPM


The final topic we touch on in this chapter is the empirical validity of the
CAPM. The model of equilibrium expected returns that we have developed
in the preceding sections of this chapter is obviously not guaranteed to
hold in practice, and hence, rather than just blindly accepting its output,
we should examine how it holds up when applied to real data. However,
this task brings us face-to-face with a problem first pointed out by Richard
Roll and hence known as the Roll critique.9 9
See Roll (1977).

The statement of the CAPM is identical to the proposition that the market
portfolio is mean–variance efficient. Hence, Roll pointed out that empirical
tests of the CAPM should seek to examine whether this is indeed the case.
However, he also noted that the market portfolio (or the return on the
market) is not observable to an econometrician, who wishes to conduct a
test. Empirical researchers generally use a broad-based equity index such
as the FTSE-100, S&P-500 or Nikkei 250 to proxy the market. But the true
market portfolio will contain other financial assets (such as bonds and
stocks not included in such indices) as well as non-financial assets such as
real estate, durable goods and even human capital. Hence, the validity of
tests of the CAPM depend critically on the quality of the proxy used for the
market portfolio.
Based on the above, Roll’s critique is simply that, due to the fact that
the market portfolio is not observable, the CAPM is not testable. We can
understand this through the following arguments. First, it might be the
case that the market portfolio is efficient (and hence the CAPM is valid),
but our chosen proxy for the market is not efficient, and hence our
empirical test rejects the CAPM. Second, our proxy for the market might
be efficient whereas the market portfolio itself is not. In this case our test

33
92 Corporate finance

will falsely indicate that the CAPM is valid. Put simply, the fact that we
can’t guarantee the quality of our proxy for the market implies that we
can’t place any faith in the results that tests based upon it generate, and
hence it’s impossible to test the CAPM.
The Roll critique is clearly damaging in that it implies that we can’t judge
the predictions of the CAPM against reality and trust the results. However,
many researchers have disregarded the prior discussion and estimated
the empirical counterpart of equation 2.27. From these estimates such
researchers pass judgment on the CAPM.
One prediction of the CAPM upon which some have focused is that the
expected excess return of a given portfolio over the risk-free rate (the risk
premium) is linearly related to ȕ with the slope of this relationship given
by the market risk premium. Historically, however, when one plots actual
excess portfolio returns against their estimated ȕs one finds that the line
traced out is flatter than one would expect from the theory (i.e. low ȕ
portfolios earn greater expected returns than the CAPM predicts, and high
ȕ portfolios earn less). This is clearly evidence against the CAPM.10 10
See pp.185–86 of
Brealey and Myers
Another prediction of the CAPM, which is also empirically tested, is that (2008).
ȕ is the only factor that should cause expected returns to differ (i.e. no
other variable should explain expected returns once we’ve accounted for
the effects of ȕ). Again, the evidence from this line of attack is not good
for the CAPM. Among other factors, firm size, book-to-market ratios, P/E
ratios and dividend yields have all been shown to explain ex-post realised
returns (after accounting for ȕ).
Amalgamating the above evidence implies that, if you are willing to
disregard the Roll critique, you should probably conclude that the CAPM
does not hold. This has led certain authors to investigate other asset-
pricing paradigms such as the APT (which we discuss in the next chapter).
An alternative viewpoint would be to argue that such results tell us little or
nothing about the validity of the CAPM due to the insight of Roll (1977).

A reminder of your learning outcomes


Having completed this chapter, and the essential reading and activities,
you should be able to:
‡ discuss concepts such as a portfolio’s expected return and variance as
well as the covariance and correlation between portfolios’ returns
‡ calculate portfolio expected return and variance from the expected
returns and return variances of constituent assets
‡ describe the effects of diversification on portfolio characteristics
‡ derive the CAPM using mean–variance analysis
‡ describe some theoretical and practical limitations of the CAPM.

Key terms
beta (ȕ)
capital asset pricing model (CAPM)
correlation
covariance
diversification
expected return

34
Chapter 2: Risk and return: mean–variance analysis and the CAPM

market portfolio
mean–variance analysis
Roll critique
security market line
standard deviation
systematic risk
two-fund separation
unsystematic risk
variance

Sample examination questions


1. Detail the assumptions that underlie the CAPM and provide a
derivation of the CAPM equation. Support your derivation with
graphical evidence. (15%)
2. The returns on ABC stock and on the market portfolio in three
consecutive years are given in the following table:
Year ABC return Market return
1 8% 6%
2 24% 12%
3 28% 15%

Showing all your workings, compute the ȕ for ABC’s equity. (7%)
3. Assume that the risk-free rate is 5 per cent. What is the expected return
on ABC’s stock? (3%)

Solutions to activities
1. The expected return on the equally weighted portfolio is 7.5%. The
portfolio return variance is 0.49, and hence the portfolio return
standard deviation is 0.7.
2. Obviously, the expected return is the same as in Question 1. With
correlation of 0.5, the portfolio return variance is 0.37.
3. The expected return on the portfolio is 6.33%, and the portfolio has a
return variance of 0.1289.
4. When the correlation changes to –0.5, the portfolio return variance
drops to 0.0844. The expected return on the portfolio doesn’t change
from that calculated in Question 3.

35
92 Corporate finance

Notes

36
Chapter 3: The arbitrage pricing theory

Chapter 3: The arbitrage pricing theory

Aim of the chapter


The aim of this chapter is to derive arbitrage pricing theory, an alternative
to the capital asset pricing model, enabling us to price financial assets.

Learning objectives
At the end of this chapter, and having completed the essential reading and
activities, you should be able to:
‡ understand single-factor and multi-factor model representations
‡ derive factor-replicating portfolios from a set of asset returns
‡ understand the notion of arbitrage strategies and that well-functioning
financial markets should be arbitrage-free
‡ derive arbitrage pricing theory and calculate expected returns using the
pricing formula.

Essential reading
Grinblatt, M. and S. Titman Financial Markets and Corporate Strategy. (Boston,
Mass.; London: McGraw-Hill, 2002) Chapter 6.

Further reading
Brealey, R., S. Myers and F. Allen Principles of Corporate Finance. (Boston,
Mass.; London: McGraw-Hill, 2008) Chapter 9.
Chen, N-F. ‘Some Empirical Tests of the Theory of Arbitrage Pricing’, The
Journal of Finance 38(5) 1983, pp.1393–1414.
Chen, N-F., R. Roll and S. Ross ‘Economic Forces and the Stock Market’, Journal
of Business 59, 1986, pp.383–403.
Copeland, T., J. Weston and K. Shastri Financial Theory and Corporate Policy.
(Reading, Mass.; Wokingham: Addison-Wesley, 2005) Chapter 6.

Overview
The arbitrage pricing theory is an alternative paradigm used to calculate
equilibrium expected returns on financial assets. As its name suggests,
it rests on the notion that well-functioning financial markets should
be arbitrage-free. This, using a factor model of asset returns, implies
restrictions on the relationships between asset returns and generates an
equilibrium pricing relationship.

Introduction
The arbitrage pricing theory (APT) developed in this chapter gives an
alternative to the CAPM as a method to compute the expected returns on
stocks. The basis for the APT is a factor model of stock returns, and we will
define and discuss these models first. From there we will demonstrate how
to derive expected returns using the idea that the returns on stocks, which
are exposed to a common set of factors, must be mutually consistent, given
each stock’s sensitivity to each factor.

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92 Corporate finance

To give structure to what we mean by ‘mutually consistent’, we need to define


the notion of an arbitrage. An arbitrage strategy can be one of two types.
‡ It could involve investment in a set of assets (both buying and selling)
that yields an immediate, positive cash inflow (i.e. the receipts from our
sales exceed the cost of our purchases) and, further, is guaranteed not to
make a loss tomorrow. Faced by an investment strategy with this pay-
off structure, any investor who prefers more to less wealth would try to
invest on an infinite scale.
‡ It could be an investment strategy that is costless today but guarantees
positive future returns. This is akin to receiving something for nothing,
and again, sensible investors would capitalise on the possibility by
investing as much as possible.
The idea that underpins the APT is that investment situations, such as those
described above, should not be permitted in well-functioning financial
markets. Then, if financial markets do not permit the existence of arbitrage
strategies, this places restrictions on the relationships between the expected
returns on assets given the factor structure underlying returns. We will
explain further in later sections of this chapter.

Single-factor models
Before using the notion of absence of arbitrage to provide pricing relations,
we need a basis for the generation of stock returns. Within the context of
the APT, this basis is given by the assumption that the population of stock
returns is generated by a factor model. The simplest factor model, given
below, is a one-factor model:
ri  =  Įi  +  ȕi ) İi                  E(İi)  =  0.   (3.1)
In equation 3.1, the returns on stock i are related to two main components:
1. The first of these is a component that involves the factor F. This factor
is posited to affect all stock returns, although with differing sensitivities.
The sensitivity of stock i’s return to F is ȕi. Stocks that have small values
for this parameter will react only slightly as F changes, whereas when ȕi
is large, variations in F cause very large movements in the return on stock
i. As a concrete example, think of F as the return on a market index (e.g.
the S&P-500 or the FTSE-100), the variations in which cause variations in
individual stock returns. Hence, this term causes movements in individual
stock returns that are related. If two stocks have positive sensitivities to
the factor, both will tend to move in the same direction.
2. The second term in the factor model is a random shock to returns, which
is assumed to be uncorrelated across different stocks. We have denoted
this term İi and call it the idiosyncratic return component for stock i. An
important property of the idiosyncratic component is that it is also assumed
to be uncorrelated with F, the common factor in stock returns. In statistical
terms we can write the conditions on the idiosyncratic component as follows:

Cov(İi İj) = 0 ij Cov(İi ,  F) = 0 i


An example of such an idiosyncratic stock return might be the unexpected
departure of a firm’s CEO or an unexpected legal action brought against the
company in question.
The partition of returns implied by equation 3.1 implies that all common
variation in stock returns is generated by movements in F (i.e. the
correlation between the returns on stocks i and j derives solely from F). As
the idiosyncratic components are uncorrelated across assets they do not
bring about covariation in stock price movements.
38
Chapter 3: The arbitrage pricing theory

Application exercise
Consider an economy in which the risk-free rate of return is 4% and the expected rate of
return on the market index is 9%. The variance of the return on the market index is 20%.
Two portfolios A and B have expected return 7% and 10%, and variance 20% and 50%,
respectively.
a) Work out the portfolios’ beta coefficients.
According to the CAPM:
  E(rA)  =  rFȕA  [E(rM)  –  rF]
and
  E(rB)  =  rFȕB  [E(rM)  –  rF].
Hence:
 ȕA    =      [E(rA)  –  rF]/[E(rM)  –  rF@  í  í  
 ȕB    =      [E(rB)  –  rF]/[E(rM)  –  rF@  í  í  
b) The risk of a portfolio can be decomposed into market risk and idiosyncratic
risk. What are the proportions of market risk and idiosyncratic risk for the two
portfolios A and B?
From the market model:
  rA ĮAȕA  rMİA
  rB ĮBȕB  rMİB
with cov(rMİA)  =  cov(rMİB)  =  0.

It hence follows that the variance of portfolio A’s returns, ı2A, has two
components, systematic and idiosyncratic risk:
 ı2A ȕ2Aı2Mı2İA.

Similarly:
 ı2B ȕ2Bı2Mı2İB.

The proportion of systematic risk for A is hence


ȕ2Aı2Mı2A   2  

The proportion of idiosyncratic risk for A is hence


í>ȕ2Aı2Mı2A] = 64%.

The proportion of systematic risk for B is hence  


 ȕ2Bı2Mı2B  =  (1.2)2*20%/50%  =  58%.

The proportion of idiosyncratic risk for B is hence


í>ȕ2Bı2Mı2B@ 

Portfolio B is much riskier than portfolio A as the variance of its returns is 50%
compared with 20% for A. The main reason why it is riskier is that it is much
more sensitive to the return of the market index than portfolio A as its beta is
1.2 compared with 0.6 for portfolio A.
c) Assume the two portfolios have uncorrelated idiosyncratic risk. What is the
covariance between the returns on the two portfolios?
Cov(rA,rB  &RY ĮAȕA  rMİAĮBȕB  rMİB  ȕA  ȕB  ı2M    

The returns of portfolios A and B are hence (positively) correlated even though
their idiosyncratic return components are not. These returns are positively
correlated because they are positively correlated with the returns of the market
index.
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92 Corporate finance

Multi-factor models
A generalisation of the structure presented in equation 3.1 posits k factors
or sources of common variation in stock returns.
ri  =Įi  +  ȕ1iF1  +  ȕ2iF2  +  ....  +  ȕkiFk  +  İi     E(İi)  =  0.                    (3.2)
Again the idiosyncratic component is assumed uncorrelated across stocks
and with all of the factors. Further, we’ll assume that each of the factors
has a mean of zero. These factors can be thought of as representing news
on economic conditions, financial conditions or political events. Note that
this assumption implies that the expected return on asset i is just given by
the constant in equation 3.2 (i.e. E(ri) Įi). Each stock has a complement
of factor sensitivities or factor betas, which determine how sensitive the
return on the stock in question is to variations in each of the factors.
A pertinent question to ask at this point is how do we determine the return
on a portfolio of assets given the k-factor structure assumed? The answer
is surprisingly simple: the factor sensitivities for a portfolio of assets are
calculable as the portfolio weighted averages of the individual factor
sensitivities. The following example will demonstrate the point.

Example
The returns on stocks X, Y, and Z are determined by the following two-factor model:
  rX  =  0.05  +  F1  –  0.5F2  + İX

 
rY  =  0.03  +  0.75  F1  +  0.5F2  + İY

 
rz F1  –  0.3F2  + İz
Given the factor sensitivities in the prior three equations, we wish to derive the factor
structure followed by an equally weighted portfolio of the three assets (i.e. a portfolio
with one-third of the weights on each of the assets). Following the result mentioned
above, all we need to do is form a weighted average of the stock sensitivities on the
individual assets. Subscripting the coefficients for the equally weighted portfolio with a p
we have:
1
 Įp  =       
3
 ȕ1p  =   1  (1  +  0.75  –  0.25)  =  0.5
3
1
 ȕ2p  =    (–0.5  +  0.5  –0.3)  =  –0.1;;
3
and hence; the factor representation for the portfolio return can be written as:
  rp F1  –  0.1F2  +  İp
where the final term is the idiosyncratic component in the portfolio return.

Activity
Using the data given in the previous example, compute the return representation for a
portfolio of assets X, Y and Z with portfolio weights –0.25, 0.5 and 0.75.

An important implication of the result is the following. Assume a two-


factor model, and also assume that we are given the factor representations
for three stocks. I can construct a portfolio of these three assets, which has
any desired set of factor sensitivities through appropriate choice of the
portfolio weights.1 What underlies this result? Well, to illustrate let’s use 1
In general, if I have
the data from the prior example. Assume I wish to construct a portfolio a k-factor model I will
need k+1 stocks to
with a sensitivity of 0.5 on the first factor and a sensitivity of 1 on the
do this.
second factor. Denoting the portfolio weights on the individual assets by
ȦX, ȦY and ȦZ it must be the case that:

40
Chapter 3: The arbitrage pricing theory

ȦX + 0.75ȦY – 0.25ȦZ = 0.5 (3.3)


–0.05ȦX + 0.5ȦY – 0.3ȦZ = 1. (3.4)
Finally, it must also be the case that the portfolio weights add up to unity,
so we must also satisfy the following equation:
 ȦX + ȦY + ȦZ = 1.
Equations 3.3, 3.4 and 3.5 are three equations in three unknowns, and
we can find values for the portfolio weights which satisfy all three
simultaneously. This illustrates the fact that (as the portfolio factor
sensitivities were arbitrarily set at 0.5 and 1) we can derive any constellation
of factor sensitivities. A particularly interesting case is when the portfolio is
sensitive to one of the factors only. We call this a factor-replicating portfolio
and discuss it below.

Broad-based portfolios and idiosyncratic returns


In what follows we will assume that the basic securities that we’re going
to work with are themselves broad-based portfolios. The reason for this
is that it allows us to lose the idiosyncratic risk terms associated with
single stocks. Why is this the case? Well, consider the idiosyncratic risk
term for an equally weighted portfolio of 100 stocks. Call the ith idiosyncratic
term İi and assume that all idiosyncratic terms have variance ı2. The variance
of the idiosyncratic element of the portfolio return is then:
100
ε 1
100
100 σ2
Var (εP) = Var ( ∑ i ) = Var (∑ εi) = = σ 2 = 100 .
i =1 100 10000 i =1 10000
Note that, under these assumptions the variance of the idiosyncratic portfolio
return is only one-hundredth of the variance of any individual asset’s
idiosyncratic return. In a general case, where one forms an equally weighted
portfolio of n assets, the variance of the idiosyncratic term for the portfolio
return is n-­1ı2. This is a diversification result just like those we used in
Chapter 2. The fact that the idiosyncratic returns are uncorrelated with one
another means that their influence tends to disappear when one groups
assets into large portfolios.

Factor-replicating portfolios
An important application of the technology developed previously in this
chapter is the construction of factor-replicating portfolio. A factor-replicating
portfolio is a portfolio with unit exposure to one factor and zero exposure to
all others. For example, the portfolio replicating factor 1 in model 3.2 would
have ȕ1  =  1 and ȕj  =  0 for all j  =  2 to k.

Activity
Assume that stock returns are generated by a two-factor model. The returns on three
well-diversified portfolios, A, B and C, are given by the following representations:
  rA  =  0.10  F1  –  0.5F2
  rB  =  0.08  +  2F1  +  F2
  rC  =  0.05  +  0.5F1  +  0.5F2.
Determine the portfolio weights you need to place on A, B and C in order to construct
the two factor-replicating portfolios plus a portfolio which has zero exposure to both
factors. What are the expected returns of the factor-replicating portfolios and what is the
expected return of the risk-free portfolio?

41
92 Corporate finance

The question to ask at this point is: why bother constructing factor-
replicating portfolios? The reason is as follows. Suppose I want to build a
portfolio that has identical factor exposures to a given asset, X. Assume a
two-factor world and that asset X has exposure of 0.75 to factor 1 and –0.3
to factor 2. Assume also that I know the two factor-replicating portfolios.
Building a portfolio with the same factor exposures as X is now simple.
Construct a new portfolio, Y, which has portfolio weight 0.75 on the
replicating portfolio for the first factor, portfolio weight –0.3 on the
replicating portfolio for the second factor and the rest of the portfolio
weight (i.e. a weight of 1 – 0.75 + 0.3 = 0.55) on the risk-free asset.
Via the results on the factor representations of a portfolio of assets and
the definition of a factor-replicating portfolio it is easy to see that Y is
guaranteed to have identical factor exposures to X.
The replication in the preceding paragraph forms the basis for the APT. For
absence of arbitrage we require all assets with identical factor exposures
to earn the same return. If they did not, then we would have the chance to
make unlimited amounts of money. For example, assume that the expected
return on the replicating portfolio Y was greater than that on asset X. Then
I should short X and buy Y. The risk exposures of the two portfolios are
identical and hence risks cancel out and I am left with an excess return
that is riskless (i.e. an arbitrage gain).
In order to progress, let us introduce some notation. Denote the risk-
free rate with rf. Denote the expected return on the ith factor-replicating
portfolio with rf  +  Ȝi such that Ȝi is the risk premium associated with the
ith factor. Again, for simplicity, assume that the world is generated by
a two-factor model, and assume that I wish to replicate asset X, which
has sensitivity ȕ1X to the first factor and ȕ2X to the second factor. Finally,
we will assume that the primary securities being worked with are well-
diversified portfolios themselves. Hence, we will ignore any idiosyncratic
risk in this derivation.
Using the prior argument, to replicate asset X’s factor sensitivities,
we construct a portfolio with weight ȕ1X on the first factor-replicating
portfolio, weight ȕ2X on the second factor-replicating portfolio and weight
1  –  ȕ1X  –  ȕ2X on the risk-free asset. The expected return of the replicating
portfolio is hence:
 ȕ1X  (rf  +  Ȝ1)  +  ȕ2X  (rf  +  Ȝ2)  +  (1  –  ȕ1X  –  ȕ2X)  rf  =  rf  +  ȕ1X  Ȝ1+  ȕ2XȜ2.   (3.6)
Hence, using our factor-replicating portfolios we can write the expected
return on a portfolio which replicates X’s factor exposures as the risk-free
rate plus each factor exposure multiplied by the risk premium on the
relevant factor-replicating portfolio.

The arbitrage pricing theory


Consider an arbitrary asset. The previous sub-section tells us that it’s
simple to replicate this asset’s risk (i.e. its factor exposures) using factor-
replicating portfolios. The key to the APT is that absence of arbitrage
requires that such a pair of portfolios must have identical expected returns
in a financial market equilibrium. If they did not, it would be possible to
make unlimited amounts of money without incurring any risk.
This implies that the expected return on asset X, rX, must be identical to
the expression arrived at in equation 3.6, that is:
  E(rX)  =  rf  +  ȕ1X  Ȝ1+  ȕ2XȜ2.   (3.7)

42
Chapter 3: The arbitrage pricing theory

Equation 3.7 is the statement of the APT. The expected return on a financial
asset can be written as the risk-free rate plus sum of the asset’s factor
sensitivities multiplied by the factor-risk premiums (which are invariant
across assets). If such an expression does not hold at all times, arbitrage
opportunities exist. Note the assumptions that are required to achieve this
result. First, we require that asset returns are generated by a two-factor (or
in general k-factor) model. Second, we assume that arbitrage opportunities
cannot exist. Lastly, we assume that enough assets are available such that
firm-specific risk washes away when portfolios are formed.

Example
In the previous two-factor example, we determined the expected returns on the two
factor-replicating portfolios. Denoting the expected return on the ith factor-replicating
portfolio by E(ri) we have:
  E(r1    E(r2)  =  1.71%     E(r3  
Hence, the premiums associated with the two factors are:
 Ȝ1 ±  Ȝ2 ± 
This implies that the expected return on any asset in this world can be written as:
  E(ri  ȕ1i±ȕ2i.
To check that this works, substitute portfolio C’s (for example) factor sensitivities into the
preceding expression. This gives:
  E(rC    ±   
and hence, agrees with the expected return implied by the original representation for
asset C. Check that the expected returns on assets A and B also come out correctly.

To analyse an arbitrage opportunity that might arise in markets, attempt


the following Activity.

Activity
Assume that a new well-diversified portfolio, D, is added to our world. This asset has
sensitivities of 3 and –1 to the two factors and an expected return of 15 per cent.
Using the equilibrium expected return equation given above, derive the equilibrium
expected return on an asset with identical factor exposures to D. Is there now an
arbitrage opportunity available? If so, dictate a strategy that could be employed to exploit
the arbitrage opportunity.

Summary
The APT gives us a straightforward, alternative view of the world from
the CAPM. The CAPM implies that the only factor that is important
in generating expected returns is the market return and, further, that
expected stock returns are linear in the return on the market. The APT
allows there to be k sources of systematic risk in the economy. Some may
reflect macroeconomic factors, like inflation, and interest rate risk, whereas
others may reflect characteristics specific to a firm’s industry or sector.
Empirical research has indicated that some of the well-known empirical
problems with the CAPM are driven by the fact that the APT is really the
proper model of expected return generation. Chen (1983), for example,
argues that the size effect found in CAPM studies disappears in a multi-
factor setting. Chen, Roll and Ross (1986) argue that factors representing
default spreads, yield spreads and GDP growth are important in expected
return generation. Work in this area is still progressing.

43
92 Corporate finance

A reminder of your learning outcomes


Having completed this chapter, and the essential reading and activities,
you should be able to:
‡ understand single-factor and multi-factor model representations
‡ derive factor-replicating portfolios from a set of asset returns
‡ understand the notion of arbitrage strategies and that well-functioning
financial markets should be arbitrage-free
‡ derive arbitrage pricing theory and calculate expected returns using the
pricing formula.

Key terms
arbitrage pricing theory
factor-replicating portfolio
factor sensitivity
multi-factor model
single-factor model

Sample examination question


1. Assume that stock returns are generated by a two-factor model. The
returns on three well-diversified portfolios, A, B and C, are given by the
following representations:
rA = 0.10 + F1
rB = 0.08 + 2F1 – F2
rC = 0.05 – 0.5F1 + 0.5F2
a) Discuss what the factor representations above imply for the
variation and comovement in the three stock returns. Show how the
returns of the stocks should be correlated between themselves.
b) Find the portfolio weights that one must place on stocks A, B and
C to construct pure tracking portfolios for the two factors (i.e.
portfolios in which the loading on the relevant factor is +1 and the
loadings on all other factors are 0).
c) If one was to introduce a new portfolio, D, with loadings of +1 on
both of the factors, what would the expected return on D have to be
to rule out arbitrage?
d) Explain the concepts of idiosyncratic risk and factor risk in the APT.
What role does diversification play in the APT?

44
Chapter 4: Derivative assets: properties and pricing

Chapter 4: Derivative assets: properties


and pricing

Aim of the chapter


The aim of this chapter is to introduce and price derivatives. As in the
previous chapter on APT, the valuation of derivatives relies on a no riskless
arbitrage argument.

Learning objectives
At the end of this chapter, and having completed the essential reading and
activities, you should be able to:
‡ discuss the main features of the most widely traded derivative securities
‡ describe the pay-off profiles of such assets
‡ understand absence-of-arbitrage pricing of forwards, futures and swaps
‡ construct bounds on option prices and relationships between put and
call prices
‡ price options in a binomial framework using the portfolio replicating
and the risk-neutral valuation methods.

Essential reading
Grinblatt, M. and S. Titman Financial Markets and Corporate Strategy. (Boston,
Mass.; London: McGraw-Hill, 2002) Chapters 7 and 8.

Further reading
Brealey, R., S. Myers and F. Allen Principles of Corporate Finance. (Boston,
Mass.; London: McGraw-Hill, 2008) Chapters 21, 22 and 23.
Copeland, T., J. Weston and K. Shastri Financial Theory and Corporate Policy.
(Reading, Mass.; Wokingham: Addison-Wesley, 2005) Chapters 8 and 9.

Overview
A derivative asset is one whose pay-off depends entirely on the value of
another asset, usually called the underlying asset. In the last 20 years,
traded volume in these assets has increased tremendously. Derivatives
are widely used for hedging purposes by financial institutions and are
also used for speculative purposes. In this chapter we discuss the most
commonly traded types of derivative. We go on to introduce the underlying
principles of derivative pricing. We devote the final section of the chapter
to a more detailed description of the features and pricing of options.

Varieties of derivatives
Forwards and futures
Perhaps the oldest type of derivative asset is the simple forward
contract. A forward is an agreement between two parties (called A and
B) and has the following features.
1. Party A agrees to supply party B with a specified amount of a specified
asset, k periods in the future.
45
92 Corporate finance

2. In return, party B agrees to pay party A $F (the forward price) when


the goods are received.
Party A is said to hold a short position in the contract and party B a
long position.
Hence, the forward is just an agreement made today to undertake a given
transaction at some specified future date, known as the settlement
date. Currency and commodities are often traded using forwards, the
advantage of such transactions being that they allow an agent to remove
any price uncertainty regarding a transaction that must be undertaken in
the future.

Example
Assume that party B is American and that in three months he must pay ¥250,000 for a
Japanese machine he has purchased. Party B enters into a contract to buy yen three months
forward. Party A (the agent who is to supply the yen) specifies that the cost of ¥100 will be
$1.20. The total price that party B must pay in three months is therefore $3,000.

Closely related to forward contracts are futures contracts. In fact,


futures are refined versions of forwards. Although forwards are generally
bilaterally negotiated between two parties directly, futures are standardised
forward contracts that are exchange traded. The contracts give precise
specifications for the quality and quantity of the assets to be exchanged.
The major difference between futures and forwards is in the exchange of
monies involved. With a forward, the agent who is long pays the entire
forward price at the settlement date. Futures positions, however, are
marked to market. This occurs on a daily basis and means that any
increases/decreases in the value of the future are received/paid by the
party who is long day by day. At the settlement date, the current spot price
of the asset is transferred from the agent who is long to the agent who is
short.1 1
See pp.236–40 in
Grinblatt and Titman
Futures are traded on exchanges such as the London International (2002).
Financial Futures and Options Exchange (LIFFE), the Chicago Board of
Trade (CBOT) and the Chicago Mercantile Exchange (CME). Contracts
with very high volumes include those on government bonds, interest rates
and stock indices.

Options
The option is a less straightforward type of derivative. Although the
forward or future contract implies an obligation to trade once the contract
is entered into, the option (as its name suggests) gives the agent who is
long a right but not an obligation to buy or sell a given asset at a pre-
specified price. This price is known as the exercise price and is specified
in the option contract. Just as with the forward, another factor specified
in the contract is the date on which the exchange is to take place. If, on
the maturity date, the holder of an option decides to buy or sell in line
with the terms of the contract, he or she is said to have exercised his or
her right. A big difference between options and forwards is that, with an
option, the agent who is long must pay a price (or premium) at the outset.
This is essentially a price paid by the holder for the exercise choice he or
she faces at maturity.
Options to buy the specified asset are called call options. Options to sell
are called puts. Another distinction is made on the timing of the exercise
decision. With European options, the right can only be exercised on the

46
Chapter 4: Derivative assets: properties and pricing

maturity date itself. With American options, in contrast, the option can be
exercised on any date at or before maturity. American options are traded
far more frequently than their European counterpart, but for reasons of
simplicity, we will focus on the European variety.

Example
A 12-month European call option on IBM has exercise price $45. It gives me the right
to purchase IBM stock in one year at a cost of $45 per share. In line with the prior
discussion, I am under no obligation to buy at $45 such that, if the market price were less
than this amount, I could choose not to exercise and buy in the market instead.

Swaps
Swaps are another type of derivative, which do exactly what their name
says. Two counterparties agree to exchange (or swap) periodic interest
payments on a given notional amount of money (the notional principal)
for a given length of time.
A very common type of swap involves an exchange of interest payments
based on a market-determined floating rate (such as the London InterBank
Offer Rate (LIBOR)) for those calculated on a fixed-rate basis. Another
frequently traded variety of swap involves the exchange of interest
payments in different currencies. For example, fixed sterling interest
payments may be exchanged for fixed dollar interest payments.2 2
The notional principal
is not exchanged in an
interest rate swap (they
Derivative asset pay-off profiles would net out anyway)
but are generally
For now we are going to concentrate on forwards and options. As exchanged in currency
mentioned above, futures are closely related to forwards, and their pricing swaps.
is based on the technique presented below. The relationship between
forwards and swaps will be made clear later.
Before getting on to the principles of derivative pricing, let us take a look
at the pay-off profiles of the basic forward and option contracts. The pay-
off profile of a long forward position is shown in Figure 4.1. In the figure,
F is the price agreed upon in the forward contract, and S is the spot price
of the asset at the settlement date. Note that the pay-off profile is linear,
positive for values of S greater than F and negative when S is less than F.

Figure 4.1

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92 Corporate finance

Understanding the forward pay-off is simple. If the spot price for the asset
at maturity exceeds the forward price, then the party that is long has
gained by entering into the forward (i.e. he’s got the asset for a lower price
than it would have cost if bought in the spot market). If the spot price at
maturity is lower than the forward price, then the long pay-off is negative,
as it would have been cheaper for the long party to buy the asset in the
spot market rather than entering into the forward. Obviously, the pay-off
of a short forward position is the negative of that shown in Figure 4.1.
Let’s now consider the pay-off to a holder of a European call option.
This is given in Figure 4.2 where the option’s exercise price is labelled
X. Remember that a call option gives the holder the right but not the
obligation to purchase the asset. What occurs when the price of the
spot asset at maturity exceeds the exercise price of the option? Well it is
cheaper to buy the asset using the option than in the spot market; hence
the option is exercised, and the holder makes a gain of the spot price less
the exercise price. When the spot price is lower than the exercise price,
then the holder would find it cheaper to buy the asset at spot and hence
does not exercise the option. The pay-off to the holder is then zero.

Figure 4.2
The pay-off to the holder of a European put is given in Figure 4.3. As the
put gives the holder the right to sell the underlying asset, the holder gains
when the exercise price exceeds the spot price and has a zero pay-off when
the spot price at maturity is greater than or equal to the exercise price.

Figure 4.3

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Chapter 4: Derivative assets: properties and pricing

Each option must have one agent who is long and one who is short, with
the pay-offs to the long position given in Figures 4.2 and 4.3. An agent
who is short is said to have written the option, and his or her pay-offs
are the negative of those given above. Note that an agent with a long
option position never has a negative pay-off, whereas an agent who has
written an option never has a positive pay-off at maturity. The option
price, paid at the outset by the agent who is long to that who is short, is
the compensation to the writer of the option for holding a position that
exposes him or her to weakly negative cash flows.
The key to pricing options, and other derivative assets, is constructing
a portfolio of assets that is priced in the market and that has a pay-
off structure identical to that of the derivative. As the derivative and
replicating portfolio have identical pay-offs, absence-of-arbitrage
arguments imply that the cost of these portfolios must be identical. The
no-arbitrage price of the derivative is hence just the initial investment cost
needed to set up the replicating portfolio.

Pricing forward contracts


In the case of a forward contract, the derivation of the no-arbitrage price
is quite simple.3 Assume the current spot asset price is S0 and that the one- 3
Given the similarities
period, riskless rate of interest is r. We wish to value a k period forward discussed previously,
we can also use the
contract. It is easily verified that the k-period forward price (Fk) is given by
derived forward price to
the following expression: approximate the price of
Fk  =  S0(1  +  r)k.   (4.1) a futures contract.

Why is this the case? Well, consider the following pair of investment
strategies.
‡ The first is simply a long position in the forward contract. This costs
nothing at the present time and yields Sk  –  Fk at maturity.
‡ The second strategy involves buying a unit of the asset at spot and
borrowing Fk(1+r)–k at the risk-free rate for k periods. The k period pay-
off of this strategy is also Sk  –  Fk, and its net current cost is S0  –  Fk(1+r)–k.
The pay-offs of the two strategies are identical. This implies that the two
investments should have identical costs. As the cost of investment in the
forward is zero, this implies that the following condition must hold:
S0  –  Fk(1+r)–k  =  0. (4.2)
Rearranging equation 4.2 we derive the no-arbitrage price for the k period
forward contract, which is precisely that given in equation 4.1.

Activity
The current value of a share in Robotronics is $12.50.
1. The one-year riskless rate is 6 per cent. What are the prices of three- and five-
year forward contracts on Robotronics stock?
2. Three-year forward contracts are currently being sold for $16 in the market.
Outline an investment strategy that could take advantage of the opportunities
this presents.

Some of the most active forward markets are those for foreign currency.
The forward pricing analysis above, however, is suited only for assets
valued in the domestic currency (e.g. individual stocks or stock indices).
To illustrate the pricing of currency forwards, consider the following

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92 Corporate finance

analysis. A domestic investor (assumed to be located in the UK such that


the domestic currency is £) is assumed to face a spot exchange rate of
S and a k period forward rate of Fk. These rates are constructed as the
domestic currency price of one unit of foreign currency (i.e. the spot rate
implies an exchange rate of £S for $1). The one-period domestic interest
rate is denoted r and its foreign counterpart  rf    .
Again, let us compare two investment strategies that can be undertaken
assuming an investor currently holds £S. The first involves depositing this
cash in a domestic risk-free account for k periods. This yields £ S(1+r)k at
the maturity date of the investment. Alternatively, the investor could swap
his or her sterling for dollars at the spot exchange rate and invest the funds
at the US rate. As his or her £S is equivalent to $1 at the spot exchange
rate, this investment yields $ (1+rf)k in k periods. The investor can then sell
the proceeds for sterling using a forward contract yielding £ Fk(1+rf)k.
Note that both of these investments are riskless, assuming that the interest
rates are known and fixed and given that the spot and forward exchange
rates are known at the current date. Further, both investments cost £S.
This implies that the pay-offs from the two strategies should be identical.
Equating these returns we get:
S(1  +  r)k  =  Fk(1  +  rf    )k.   (4.3)
Rearranging equation 4.3, we get the no-arbitrage k period currency
forward price:

( (
1+r k
Fk = S 1 + r .
f
(4.4)

Note the simple generalisation of equation 4.1 implicit in equation 4.4.


The gross interest rate in equation 4.1 is just replaced by the ratio of
domestic to foreign rates in equation 4.4. In the international finance
literature, the currency forward rate expression in 4.4 is known as the
covered interest rate parity relationship.

Activity
The current spot exchange rate is £0.64 = $1. The riskless rate in the UK is currently 6
per cent and that in the US is 4 per cent. Using equation 4.4, derive the implied five- and
10-year forward exchange rates.

Binomial option pricing setting


Pricing options is far less straightforward than pricing forwards. To begin,
however, we introduce a binomial setting, in which the pricing of options 4
This is where the term binomial
turns out to be surprisingly straightforward. comes from in the name of our
method.
In order to make things as simple as possible, let us consider a binomial
setting in which all derivatives last only for one period (starting today and
ending tomorrow). Let us denote the current price of the underlying asset
by S0. Let us assume that uncertainty in this world is represented by the
price of the underlying asset, taking one of two values tomorrow.4 If the
state of the world is good, the price of the asset will rise tomorrow to SH,
with SH  =  (1+u)S0 and u>0. In contrast, if the state of the world is bad, the
price of the underlying asset will decrease to SL,, with SL  =  (1–d)S0 and d>0.
Let us now consider a one-period derivative asset. If the state of the world
is good tomorrow, then the derivative will pay KH, and if the state of the
world is bad tomorrow the derivative will pay KL. Finally we assume that
the one-period risk-free interest rate is rf (i.e. a safe bond costing one unit
of currency pays 1+  rf units of currency tomorrow).

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Chapter 4: Derivative assets: properties and pricing

In order to price this derivate asset, we will consider two different methods:
‡ the portfolio replicating method
‡ the risk-neutral valuation method.

The portfolio replicating method


The portfolio replicating method prices the derivative asset using absence-
of-arbitrage arguments. First, this necessitates constructing a portfolio,
containing the underlying asset and the risk-free asset, that has identical
pay-offs to the derivative. Assume we purchase a units of the underlying
asset and b units of the risk-free asset.
If the state of the world tomorrow is good then the value of our portfolio
will be:
aSH  +  b(1  +  rf    ),   (4.5)
when the pay-off of the derivative is KH. If the state tomorrow is bad the
portfolio is worth:
aSL  +  b(1  +  rf    ),   (4.6)
and the derivative is worth KL. Note that equating the value of the
portfolio with the pay-off of the derivative in each state of the world
gives us two equations in two unknowns (a and b). These unknowns are
our initial holdings of the underlying and the risk-free asset. Solving the
two equations gives us precisely the portfolio weights we need to use to
replicate the option pay-off in both states of nature. This yields:
KH – KL
a= S –S . (4.7)
H L

and
SLKH – SHKL .
b= (4.8)
(1 + rf )(SL – SH)

We now know how to construct a portfolio, which has a pay-off profile


that replicates that of the derivative (i.e. regardless of the state of the
world, the portfolio and the derivative have the same value). If two assets
have identical pay-offs then absence-of-arbitrage arguments tell us that the
price/cost of the two assets must be identical. The cost of the replicating
portfolio is aS0 + b. It hence follows that:
K0  =  aS0  +  b.   (4.9)
A practical example of how this technique might work for a European call
option is given below.

Example
A one-period European call option on ABC stock has an exercise price of 120. The current
price of ABC stock is 100, and if things go well, the price in the following period will be
150. If things go badly over the coming period, the future price will be 90. The risk-free
rate is 10 per cent. What is the no-arbitrage price of this option?
First we need to know the option pay-offs. In the bad state it pays zero, as the underlying
price is less than the exercise price. In the good state it pays the excess of the underlying
price over the exercise price (i.e. 30).
Next we construct the replicating portfolio. Using equations 4.3 and 4.4, the quantities of 5
You should check
the underlying and risk-free asset we must buy are 0.5 and –40.91 (i.e. we buy half a unit all these calculations
of stock and short 40.91 units of the risk-free asset).5 This portfolio replicates the option and further check that
the portfolio we’ve
pay-off, and therefore the option price is given by the cost of constructing the portfolio.
constructed does indeed
The call price (c) is hence: replicate the option
c  =  ±  pay-off.

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92 Corporate finance

Activity
Using the stock price data from the previous example, price a European put option on
ABC stock with a strike price of 100.

The Risk-neutral valuation method


Using the portfolio replicating method, we find that the current price of
the derivative asset, relative to the current price of the underlying asset,
does not depend on the probability that the state of nature will be good
(or bad) tomorrow. Neither does it depend on investor risk preferences.
The reason for this is that information about probabilities or risk aversion
is already captured by the current price of the underlying asset on
which we base our valuation of the derivative asset. The fact that the
no-arbitrage price of the derivative asset in relation to the price of the
underlying asset is the same, regardless of risk preferences, serves as a
basis for a neat trick also known as the risk valuation method.
The risk-neutral valuation method is a procedure involving the following
steps.
1. Identifying the risk-neutral probabilities, that is, the probabilities which
are consistent with investors being risk-neutral. These probabilities are
the probabilities for which the current price of the underlying asset
is the present value of tomorrow’s asset prices, with the discount rate
being equal to the risk-free rate.
2. Calculating the current price of the derivative asset as the present value
of tomorrow’s derivative values using the risk-neutral probabilities
derived in the previous step and the risk-free rate as the discount rate.

Step 1: Obtaining risk-neutral probabilities


Let us denote the risk-neutral probability that the state of nature will be
good tomorrow by q. It hence follows that:
qSH + (1 – q)SL
S0 = . (4.10)
1 + rf
Equivalently, the risk-neutral probability q is given by the following
identity:
S0(1 + rf ) – SL rf + d
q= = . (4.11)
SH – SL u+d

Step 2: Calculating the current price of the derivative asset


The current price of the derivative asset can be expressed as the present
value of tomorrow’s derivative values using the risk-neutral probabilities in
equation 4.11 and the risk-free rate as the discount rate:
qKH + (1 – q)KL
K0 = . (4.12)
1 + rf
After substituting q from equation 4.11, we obtain:
(d + rf )KH + (u – rf )KL
K0 = . (4.13)
(1 + rf )(u + d)

Activity
Using the risk-neutral valuation method, price both a European call option and a
European put option on the ABC stock (introduced in the previous example) with a strike
price of 100.

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Chapter 4: Derivative assets: properties and pricing

Activity
Show that the current price of the derivative obtained from the portfolio replicating
method in equation 4.9 is the same as the one obtained from the risk-neutral valuation
method in equation 4.13.

Comments on the binomial option pricing setting


The risk-neutral valuation method is very efficient at pricing multiple
derivative assets on the same underlying asset as the same risk-
neutral probabilities can be used to price all the derivatives. In these
circumstances, the portfolio replicating method is more tedious to use as
the replicating portfolio will typically be different for each derivative asset.
The assumptions we have made above may seem very restrictive. We
have restricted tomorrow’s price to take one of two values and assumed
that derivatives last only for one period. Extending the above model to
more than one period is straightforward, and this allows longer maturity
instruments to be priced. Also, we can shrink the length of time that we
have referred to as one period. It could represent one day, one hour or one
minute if we wanted. A binomial model for hourly prices, for example,
may be thought more reasonable than a binomial model for annual prices.
Then, using a multi-period derivative valuation we could price a one-
month option from a binomial model of hourly stock returns. The binomial
structure is not as restrictive as you might think.

Bounds on option prices and exercise strategies


The binomial model allows us to derive option prices under certain
assumptions on the behaviour of the price of the underlying asset. In this
section we present some arguments that place bounds on European option
prices and can be made without specification of a model for the underlying
price. In order to link up with the following section (on Black–Scholes
prices), we will present our arguments using a continuously compounded
risk-free rate, r. We assume unlimited borrowing and lending at this rate
along with our standard frictionless market assumptions of no transaction
costs and taxes. Finally, we also assume that the underlying asset pays out
no cash during the option lifetime (such that the option can’t be written on
dividend paying stock or coupon bonds, for example).

Upper bounds on European option prices


A call option is the right (but not the obligation) to purchase a unit of a
specified asset for price X. It should be obvious to you then that the option
can never be worth more than the stock. Hence, denoting the call option
price by c we have:
F”6.   (4.14)
As a European put gives the holder the right to sell a given quantity of
an asset for X, the put can never be worth more than  X. Denoting the put
price by p we then have:6 6
Clearly both this and
the previous argument
  S”;.     (4.15) hold for American
Further, if the put is European, we know that the value at maturity is at options as well as
European options.
most X. If there are T periods to maturity, a present-value argument then
implies that:
S”;H–rT.     (4.16)

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92 Corporate finance

Lower bounds on European option prices


No-arbitrage arguments can be simply employed to develop lower bounds
for European puts and calls. A lower bound for a European call option
price is given by:
F•6±;H–rT   (4.17)
where  X is the exercise price, and there are T periods to maturity. To show
this, consider the following argument. Assume I hold two portfolios.
Portfolio A consists of a European call option struck at price X, plus cash of
the amount Xe–rT. Portfolio B consists of the underlying stock.
Assume I invest the cash from portfolio A at the risk-free rate. This implies
that, when the option in portfolio A matures, I have cash worth X. If
at maturity the underlying price (ST) exceeds the exercise price, then I
exercise the call option using my cash, and the portfolio is worth ST. If at
maturity the underlying price is less than X, I do not exercise the option,
and hence my portfolio is worth X. The value of portfolio A at maturity can
be written as:
  max(ST,X).
At the maturity date the value of portfolio B is always just ST. Hence,
portfolio A is always worth at least the same as portfolio B, and sometimes
(when exercise is not optimal) it is worth more. Reflecting this and to
prevent arbitrage, the price of buying portfolio A must exceed the cost of
portfolio B. This reasoning implies:
c  +  Xe–rT  >  S  Ÿ  c  >  S  –  Xe–rT.   (4.18)
Also, an option must have positive value since, at the very worst, it is
not exercised as it is out of the money. This implies that 4.18 can be
generalised to:
F•PD[[0,S  –  Xe–rT].   (4.19)
A similar argument to the above can be used to establish a lower bound on
the price of a European put. It’s easy to show that:
p  >  Xe–rT  –  S.     (4.20)
To demonstrate this, consider two more portfolios. Portfolio 1 consists of a
European put and a unit of the underlying stock, and portfolio 2 consists
of Xe–rT in cash.
At the date at which the put matures, portfolio 1 is worth either X (if it’s
profitable to exercise the put, and hence you sell the unit of the underlying
for X) or ST (when exercise isn’t optimal and you’re left with the stock, as
the put expires with zero value). We can then write the value of portfolio
1 as:
  max(X,ST).
Portfolio 2 is always worth X at the date when the put matures and is
hence weakly dominated in pay-off terms by portfolio 1. Therefore, to
prevent arbitrage, portfolio 1 should cost more to set up than portfolio 2,
implying:
  p  +  S  >  Xe–rT  Ÿ  p  >  Xe–rT  –  S.   (4.21)
Finally, again we know that the worst that can happen for a put option is
for it to expire, worth nothing. This implies that its value must exceed zero
in all circumstances. Thus:
S•PD[[0,Xe–rT  –  S].     (4.22)

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Chapter 4: Derivative assets: properties and pricing

Combining upper and lower bounds


A combination of the upper and lower bounds derived in the preceding
two sections can be formed graphically. This gives a set of permissible (in
the sense of not admitting arbitrage) put and call prices. As an example,
Figure 4.4 shows the permissible call price region (it is the shaded area of
the diagram).

Figure 4.4

Black–Scholes option pricing


Our previous pricing analysis was predicated on the assumption that stock
prices are well-represented by a discrete time, binomial model. In 1974,
Fischer Black and Myron Scholes presented an option pricing formula,
based on a continuous time process for the stock price. This analysis
gave exact prices for European puts and calls using a continuous time
version of the replication strategy followed in our binomial methodology.
Unfortunately, derivation of their pricing formula is beyond the scope of
the current presentation. However, due to its wide use in the financial
markets and the intuition it brings regarding the determinants of option
prices, we will describe the pricing formula below.
Assume we wish to price a European call on a stock that never pays
dividends. The current price of the stock is S, the exercise price of the
option under consideration is denoted X, and the option is to have a
maturity of T periods. The continuously compounded risk-free rate is
denoted r. One final parameter is needed to calculate the B–S price of the
call option. This is the instantaneous volatility of the stock price, and we
denote this parameter V. It is the standard deviation of the change in the
logarithm of the stock price.
The famous B–S formula for the price of a European call option is given
below:
c  =  SN(d1)  –  Xe–rT  N(d2)   (4.23)
where
1n (S / Xe−rT ) σ√T  
  d1= + (4.24) 7
The values of the
σ√T 2 cumulative standard
normal distribution
  d2= d1 – σ√T   (4.25)
function can be found
and N(.) represents the cumulative normal distribution function.7 in tables in the back
of any good statistical
textbook.

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92 Corporate finance

Example
The current price of Glaxo Wellcome shares is £2.88. An investor writes a two-year call
option on Glaxo with exercise price £3.00. If the annualised, continuously compounded
interest rate is 8 per cent, and the volatility of Glaxo’s stock price is 25 per cent, what is
the B–S option price?
First we need to derive the values d1 and d2 defined as above. Using 4.24 and 4.25
these are 0.5139 and 0.1603. The values of the cumulative normal distribution function
at 0.5139 and 0.1603 are 0.696 and 0.564. Then, plugging all the available data into
equation 4.23 yields a call price of £0.5644.

What does equation 4.23 tell us about the determinants of call prices?
Well, there are clearly a number of influences on the price of an option,
and these are summarised below.
‡ The effect of the current stock price: the B–S equation tells us
that call option prices increase as the current spot asset price increases.
This is pretty unsurprising as a higher underlying price implies that the
option gives one a claim on a more valuable asset.
‡ The effect of the exercise price: again, as you would expect,
higher exercise prices imply lower option prices. The reason for this is
clear: a higher exercise price implies lower pay-offs from the option at
all underlying prices at maturity.
‡ The effect of volatility: Figure 4.2 gives the pay-off function of a
European call option. Note that, although extremely good outcomes
(underlying price very high) are rewarded highly, extremely bad
outcomes are not penalised due to the kink in the option pay-off
function. This would imply that an increase in the likelihood of extreme
outcomes should increase option prices, as large pay-offs are increased
in likelihood. The B–S formula verifies this intuition, as it shows that
call prices increase with volatility, and increased volatility implies a
more diverse spread of future underlying price outcomes.
‡ The effect of time to maturity: call option prices increase with time
to maturity for similar reasons that they increase with volatility. As the
horizon over which the option is written increases, the relevant future
underlying price distribution becomes more spread-out, implying increased
option prices. Furthermore, as the time to maturity increases, the present
value of the exercise that one must pay falls, reinforcing the first effect.
‡ The effect of riskless interest rates: call option prices rise when
the risk-free rate rises. This is due to the same effect as above, in that the
discounted value of the exercise price to be paid falls when rates rise.

Put–call parity
The B–S formula gives us a closed-form solution for the price of a
European call option under certain assumptions on the underlying asset
price process. However, as yet, we have said nothing about the pricing of
put options. Fortunately, a simple arbitrage relationship involving put and
call options allows us to do this. This relationship is known as put–call
parity. In what follows we assume the options have the same strike price
(X), time to maturity (T) and are written on the same underlying stock.
Consider an investment consisting of a long position in the underlying
asset and a put option, called portfolio A. The cost of this position is
S0  +  p. A second portfolio, denoted B, comprises a long position in a call
option and lending Xe–rT. Hence the cost of this position is c  +  Xe–rT.

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Chapter 4: Derivative assets: properties and pricing

What are the possible pay-offs of these positions at maturity? Given the
pay-off structure on the put shown in Figure 4.3, the pay-off on portfolio A
can be written as follows:
max[X  –  ST,0]  +  ST  =  max[X,ST].     (4.26)
Similarly, the pay-off on portfolio B can be written as:
max[0,ST  –  X]  +  X  =  max[X,ST].     (4.27)
Comparison of equations 4.26 and 4.27 implies that the two portfolios
always pay identical amounts. Hence, using no-arbitrage arguments,
portfolios A and B must cost the same amount. Equating their costs we have:
S  +  p  =  c  +  Xe–rT.   (4.28)
Equation 4.28 is the put–call parity relationship. Given the price of a call,
the value of the underlying asset and knowledge of the riskless rate, we
can deduce the price of a put. Similarly, given the put price, we can deduce
the price of a call with similar features.

Example
A call option on BAC stock, with an exercise price of £3.75, costs £0.25 and expires
in three years. The current price of BAC stock is £2.00. Assuming the continuously
compounded (annual) risk-free rate to be 10 per cent, calculate the price of a put option
with three years to expiry and exercise price of £3.75.
From equation 4.28 we have:
  p  =  c  +  Xe–rT  –  S.
Plugging in the data we’re given yields:
  p  =  0.25  +  3.75e–0.1(3)  –  2  =  1.03.
Hence, the no-arbitrage put price is £1.03.

Substitution of the B–S call pricing equation gives a closed-form solution


for the put price. This equation allows us to deduce the effects of changing
the B–S parameters on put prices.
‡ The effect of underlying price: for the opposite reason to that
given for the call, put prices drop as underlying prices increase.
‡ The effect of the exercise price: similarly, put prices rise as
exercise prices rise.
‡ The effect of volatility: put options and call options are affected in
identical ways by volatility. Hence, as volatility increases, put prices rise.
‡ The effects of time to maturity: increased time to maturity will
lead to a greater dispersion in underlying prices at maturity, and hence
put prices should be pushed higher. However, as the holder of a put
receives the exercise price, discounting at higher rates makes puts less
valuable. The combined effect is ambiguous.
‡ The effect of the risk-free rate: puts are less valuable as interest
rates rise, due to a greater degree of discounting of the cash received.

Activity
ABC corporation’s shares currently sell at $17.50 each. The volatility of ABC stock is 15
per cent. Given a risk-free rate of 7 per cent, price a European call with strike price of
$15 and time to maturity 5 years. Use put-call parity to price a put with similar
specifications. What are the no-arbitrage prices of the call and the put if the risk-free
rate rises to 10 per cent?

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92 Corporate finance

Pricing interest rate swaps


Recall the definition of an interest rate swap given earlier in the chapter.
Agent A contracts to give fixed interest payments (on a given principal) to
agent B. In return agent B agrees to deliver to agent A interest payments
(on the same principal) based on an agreed floating exchange rate. The
frequency and duration of these interest payments are also agreed in
advance. A very common choice of floating interest rate used in such
contracts is the London Interbank Offer Rate (LIBOR).
An example of such an agreement is as follows. Agent A agrees to pay
agent B payments on a $1m principal at a fixed 8 per cent rate. Agent
B agrees to pay interest payments of LIBOR plus 0.25 per cent. These
payments are to be made annually for the next 10 years.
Note that, from the previous example, the payments made by agent A at
every date till maturity are known and fixed (i.e. 8 per cent of $1 m). His
or her receipts, however, are uncertain. He or she gains a 0.25 per cent
premium above an ex-ante uncertain interest rate. Consider, for example,
the transaction at the second payment date. Agent A pays $50,000 and
receives LIBOR + 0.25 per cent. This looks identical to the cash flows
from a forward contract. Indeed, we can regard the transaction at every
payment date as a forward transaction. Hence the swap in entirety can
be considered a package of forwards. Using the forward pricing equations
given above, the swap is simply priced.
In the situation where interest payments in different currencies are exchanged,
the situation is slightly more murky, but the same basic principle maintains.
Swaps are just packages of forward contracts and can be priced as such.

Summary
This chapter has treated the nature and pricing of the most important
and heavily traded derivative securities. We have looked at the basic
specifications of forward, futures, option and swap contracts and what
these specifications imply for the pay-off functions of long and short
positions. Further, we have looked at methods that can be used to price
these securities. The basis of pricing is absence of arbitrage in all cases. We
looked most deeply at option contracts, detailing the relationships between
put, and call prices, and bounds on option prices, and finally we examined
the continuous time option pricing formula of Black and Scholes.
Although we’ve covered a lot of material here, the continual evolution and
innovation of derivatives markets and assets means that we missed much
more than we’ve treated. However, the basic features of derivatives pricing
that we’ve looked at can be extended to new and more complex securities.

A reminder of your learning outcomes


Having completed this chapter, and the essential reading and activities,
you should be able to:
‡ discuss the main features of the most widely traded derivative securities
‡ describe the pay-off profiles of such assets
‡ understand absence-of-arbitrage pricing of forwards, futures and swaps
‡ construct bounds on option prices and relationships between put and
call prices
‡ price options in a binomial framework using the portfolio replicating
and the risk-neutral valuation methods.
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Chapter 4: Derivative assets: properties and pricing

Key terms
American option
binomial method
Black–Scholes
call option
covered interest rate parity relationship
derivative
European option
exercise price
forward contract
futures contracts
long position
marked-to-market
notional pricing
put option
risk-neutral method
settlement date
short position time to maturity
underlying price

Sample examination questions


1. Describe the main features of forward and futures contracts. How do
forward and futures contracts differ? Derive the no-arbitrage price of a
forward contract. (10%)
2. Describe the main features of options contracts. Show how to price a
standard European call option using a single-period binomial model.
(10%)
3. British Telecom shares are currently trading at 312p. Historically, the
(annualised) volatility of BT shares has been 20 per cent. Compute the
Black–Scholes price of a European call on BT equity, assuming a strike
price of 350p and time to maturity of six months. Assume that the risk-
free rate is 5 per cent. (5%)

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92 Corporate finance

Notes

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