Class 1&2

Class 1: Introduction and Pre-Requisites
Investment Portfolio Management

Juan P Medina-Mora L
• Work Experience
- J.P. Morgan Asset Management – Business, Products (SMAs, Mutual Funds, ETFs, Advisories) – Mexico City
- J.P. Morgan (Private Bank) – Investment Solutions, Derivatives, Structured Products, Funds, Portfolios – Mexico City
- Goldman Sachs –Systematic Investment Strategies – Equity Derivatives, ETFs – New York
- BGI / BlackRock – Fixed income, Funds, ETFs – San Francisco, California
- ING Bank – Debt Market, Corporate Finance, Structured Products, Corporate Finance – Mexico City
- Banco de México – Investment Portfolio, Risk Management – Mexico City
• Education
- MBA – Stanford University – Stanford, California
- Applied Mathematics – ITAM
• Acknowledgments
- National Finance Award (IMEF – Mexico)
- ITAM Alumni Award Dissertation (First Place)
- Research Prize – Mexican Chapter of the Society for Industrial and Applied Math (SIAM)
• Personal
- Married with a son and a daughter
Roll Call and Introductions
• Name
• Program (s)
• Year / Semester
• Objective
Course Topics
• Introduction and Pre-Requisites • Risk Premia and Risk Parity
• Asset Classes, Utility Functions • Asset Allocation (Strategic vs. Tactical)
Behavioral Finance • Manager Research
• Portfolio Theory • Vehicles
• Factors and Styles • Clients
• Active Management and Performance • Special Topics (ESG, Taxes, Costs)
Measures
• Style Analysis – Clones Indices and
Indexing
Concepts and Useful Tools (Personal)
• Supply and Demand

• Opportunity Cost
• Interest Theory (Present Value)
• Value vs. Price
• Portfolio Theory: Risk – Return
• Optimization – Release the Restrictions
• Options Theory
• Uncertainty (Probability - Statistics)
• Excel – Modeling
• Education vs. Information
• Other disciplines: Mathematics, Accounting, Economics, …
• Languages: Mathematics, Spanish, English, Phyton, VBA, …
Personal Finance – Individual Balance
Moshe Milevsky: “Are you Stock or a Bond?”
Assets Liabilities
Equity
HUMAN CAPITAL
Milevsky, Moshe (2008). Are You a Stock or a Bond?: Create Your Own Pension Plan for a Secure Financial Future
Personal Finance – Life Cycle
• Modigliani - Life-Cycle Hypothesis
KEY CONCEPTS
The Time Value of Money
“One dollar today is different from a dollar tomorrow”
Present Value Future Value
= = ( + )
+
Annuity
Where: = −
( + )
=
= Number of Periods
=
Simple Interest Compound Interest
The interest is the same in equal time horizons It is based on the principal amount and the interest
that accumulates in every period.
=1+ ·
+ − = ( ) = 1+ ≥0;
The relative growth rate is constant
+ −
When an investment receives interest m times a year. We say that the interest rate is payable or convertible m times in
the year and denote it as: ( )
Nominal Rate: Determines the total interest paid at the end of the agreed period. Interest is paid more frequently
than once in the measured period.
Effective Rate: Is the amount of money that one unit invested at the beginning of the period will earn. It is expressed
in the same term as the investment.
• Accumulation Factor: the factor by which any principal must be multiplied to give its amount at compound
interest after n periods, i being the interest for one period.
(1 + )
• Discount Factor: determines how much should be invested at the beginning of the period to get 1 at the
end of the period.
1
= (1 + ) =
1+
• Discount Rate: the effective discount rate (d), expresses the amount of interest paid or earned as
a percentage of the balance at the end of the period. It is the division between the amount of interest
earned during the period and amount at the end of the period.
= = ; ≥1;
• Equivalent interest rates: two interest rates or discount rates are equivalent if an amount or principal
invested during the same period at each rate produces the same accumulated value.
= = = · = 1−
1− 1+
1+ =1+ = = 1− = 1− =
· ·
1+ = 1+ = = 1− = 1− = ·
• Force of interest: Continuous compounding can be thought of as making the compounding period
infinitesimally small, achieved by taking the limit as m goes to infinity.
= = = ln = ln = ln 1 +
1
lim 1+ =
→
• Continuous Compound Interest:
= ln 1 + = ln
= ×
• Real Interest Rate: is an interest rate that has been adjusted to remove the effects of inflation.
1+ = 1+ · 1+
• After-tax Interest Rate
= · 1− ; T = Tax rate
Summary
Interest Rate or Discount Accumulated Value from 1 to
Present Value of 1 to t=a-1(t)
Rate t=a(t)
Compound Interest
1+ 1+
· ·
1+ 1+
1− 1−
· ·
1− 1−
· ·
Simple Interest
1+ · 1+ ·
Discount Rate
1− · 1− ·
Risk
“All of life is the management of risk, not its elimination” (Walter Wriston)
“Risk comes from not knowing what you are doing” (Warren Buffett)
“Risk is like fire: If controlled, it will help you; if uncontrolled, it will rise up and destroy you”
(Theodore Roosevelt)
“The Banker's Function has evolved from Managing Money to Managing Credit and now to
Managing Risks” (Attributed to Walter Wriston)
Risk
• What is a risk?
- Danger, Threat, Damage, Loss …
- = ( )
- Maximize the returns of a portfolio for a given level of risk (Markowitz, 1952)
- = 12 ∗ ( ℎ )
• Probability ≠ Expectation
∗
- < (Roy, 1952)
Where < ∗ is the probability of (the actual return of asset ) being less than ∗
(the
minimum acceptable return)
Risk
Types and categories

- Market Risk
- Credit Risk
- Liquidity Risk
- Operational Risk
- Systematic risk
KEY CONCEPTS
Probability and Statistics
• Arithmetic mean: sum of all the numbers divided by the number of numbers.
1
= ( )
Measures of Dispersion
• Sample Variance:
1
= ( − )
−1
• Population Variance:
1
= ( − )
• Covariance:
1
= ( − − )
• Correlation:
Linear Algebra
• Matrix: A rectangular array of numbers or expressions commonly used to represent an object. The matrix is
arranged in rows and columns. If a matrix has only one row or only one column, it is called a vector.
Remember: = ; =
…
… … … is an m x n matrix; m is the number of rows and n is the number of columns
…
Represents the element at the second row and the first row
Optimization
A Decision Problem involving the selection of values for a number of interrelated

variables, by focusing attention on a single objective designed to quantify
performance and measure the quality of the decision. This objective is maximized
or minimized, depending on the formulation, subject to the constrains that may
limit the selection of cession variable values.
Objective Function
Decision Variables
Constrains
Optimization
• Global vs. Local Optimization
• Linear vs. Non-Linear Optimization
• Linear Programming
• Quadratic Programming
minimize
subject to ℎ = 0, = 1,2, …
( )≤ 0, = 1,2, … ,
∈
Optimization
• Size of Problem
• Small-Scale
• Intermediate-Scale
• Large-Scale
• Linear Programming
minimize
subject to
Linear Programming
Example:
• The Asset Allocation Team of Afore Optima estimates the Long-Term Returns, in Pesos, of the
following assets as follows:
• Mexican Equities: 9.10%
• US Equities: 6.00%
• Asian Equities: 8.90%
• Mexican Cash: 4.60%
• Mexican Nominal Rate Bonds: 6.50%
• Mexican Real Rate Bonds: 6.90%
• Mexican Corporates: 6.70%
• Private Equity: 10%
• Regulator imposes the following guidelines:
• A minimum investment of 50% in Mexican Government Bonds
• A maximum investment of 20% in International Equities
• A maximum investment of 10% in Private Equity
Theorem
Let Ω , Ω , Ω arbitrary sets such that Ω ⊂ Ω ⊂ Ω
Let : Ω ⟶ℝ
∗ ∗
Let and the maxima of in Ω ⊂ Ω , respectively.
Then,
( ∗) ≤ ( ∗)
Corollary:
• If the domain set is broad, then the maximum is greater (more alternatives)
• With more restrictions, we are always worse off
Real Assets vs. Financial Assets
Real Assets Financial Assets
• Used to produce goods and services • Claims to the income generated by

real assets or claims on income from
• Examples: Land, buildings, machines,
the government
intellectual property
• Do not directly contribute to the
productive capacity of the economy
• Examples: Stocks, bonds
The Investment Process
• Portfolio: Collection of investment assets
• Asset allocation
• Choice among broad asset classes (e.g., stocks, bonds, real estate, etc.)
• Security selection
• Choice of securities within each asset class
The Investment Process
• Security analysis involves the valuation of particular securities that might be

included in the portfolio
• “Top-down” approach
• Asset allocation followed by determination of particular securities to be held in each
asset class
• “Bottom-up” approach
• Investment based on attractively priced securities without as much concern for asset
allocation
Markets Are Competitive
• Financial markets are highly competitive
• There will almost always be risk associated with investments
• Risk-return trade-off - Higher-risk assets are priced to offer higher
expected returns than lower-risk assets
• You should rarely expect to find bargains in the security markets
• Efficient market hypothesis

• The prices of securities fully reflect available information
• If this were true, there would exist neither underpriced nor overpriced
securities
• Passive management
• Highly diversified portfolio
• No attempt to improve investment performance by identifying mispriced
securities
• Active management
• Focus on improving performance by finding mispriced securities or by timing
the performance of broad asset classes
The Players
1. Firms
- Net demanders of capital
- Raise capital now to pay for investments in plant and equipment
2. Households
- Typically, net suppliers of capital
- Purchase securities issued by firms that need to raise funds
3. Governments
- Can function as borrowers or lenders, depending on the relationship between tax revenue
and government expenditures
The Players
• Financial intermediaries bring the suppliers of capital (investors) together
with the demanders of capital (primarily corporations and the federal
government)
• Examples
- Investment companies
- Banks
- Insurance companies
- Credit unions
The Players
• Investment bankers specialize in the sale of new securities to the public,

typically by underwriting the issue
- Advise the issuing corporation on appropriate price, interest rates, etc.
• New issues of securities are offered to the public in the primary market
• Investors trade previously issued securities amongst themselves in the
secondary market
The Players
• Venture capital (VC) refers to money invested to finance a new, not yet
publicly traded firm
- VC investors commonly take an active role in the management of a start-
up firm
• Private equity refers to investments in companies whose shares are not

publicly traded in a stock market
Sell-Side vs. Buy-Side
Financial Industry
SELL-SIDE BUY-SIDE
Creation, Promotion, and Selling of Buyers and Investors (Bonds,

Financial Instruments (Bonds, Stocks, FX, Derivatives, …)
Stocks, FX, Derivatives, …)
Investment Funds
Investment Banking Pension Funds
Insurers
Assignment – Homework 1
1) Financial Mathematics
Mr. José Reynoso is 25 years old. He started working in a company that offered him the following pension plan:
• Accumulation period:
From the day of his hiring, he begins to save $5,000 pesos per month at the beginning of each month until one month before the day of
his retirement at 65 years old.
The guaranteed annual effective return on investments is 20% for the first 5 years (while José is in his 20’s), 15% for the next 10 years
(while José is in his 30’s), 10% for the next 10 years (while José is in his 40’s), and 5% during the last 15 years of work (while José is in his
50’s and 60’s).
• Retirement or dissaving period
From the retirement date, José will receive a monthly payment at the end of each month for the next 25 years using the resources
accumulated during the 40 years of work in the company.
In the event of death, José's beneficiaries will continue to receive the monthly payment at the end of each month. The return on
resources during the withdrawal period is 5%.
Calculate the monthly income so that the resources are exhausted at the end of the retirement period.
Assignment – Homework 1
2) Risk Tolerance
Answer and Send the results of following Risk Tolenace Questionaire:
https://www.schwab.com/resource/investment-questionnaire
3) Portfolio
Build a Portfolio that we will monitor during this academic term (i.e. ~3 months)
Provide the following Information:
• Identifiers of constituents: ISIN, CUIP, Ticker
• Weights or Number of Shares
• Benchmark (if applicable)
• Unit of account (MXN, USD, EUR, UID, …)
We will convert everything to MXN to make it comparable
Assignment – Book Reading
Class 2: Asset Classes
Utility Functions
Behavioral Finance
Investment Portfolio Management

Asset Classes
• Money Market
• Bond Market
• Equity Market
• Derivative Market
• Alternatives
Key Concepts
• Ask price is the price you would have to pay to buy an instrument from a
securities dealer
• Bid price is the slightly lower price you would receive if you wanted to sell an
instrument to a dealer
• Bid-ask spread is the difference in these prices, which is the dealer’s source of
profit
Money Market Securities
• Treasury Bills (i.e., T-bills)
• Simplest form of borrowing wherein the government raises money by selling bills to the
public
• Certificates of Deposit (CD)
• Bank pays interest and principal to the depositor only at maturity
• Time deposit cannot be withdrawn on demand
• Commercial paper
• Short-tern unsecured debt notes, often issued by large, well-known companies and backed
by a bank line of credit
• Bankers’ acceptance
• An order to a bank by a customer to pay a sum of money at a future date
• Eurodollars
• Dollar-denominated deposits at foreign banks or foreign branches of American banks
• Repurchase agreements
• Short-term, often over-night, sales of securities with an agreement to repurchase them at a slightly higher
price
• Federal funds
• Funds in a bank’s reserve account at the Federal Reserve Bank
• Brokers’ calls
• Investors may buy stocks on margin and brokers, in turn, may borrow the funds from a bank
• LIBOR • Yields on Money Market Instruments

- LIBOR is the premier short-term interest - Most money market securities are low risk,
rate quoted in the European money market but not risk-free
- Based on surveys of rates reported by - Money market funds are mutual funds that
participating banks rather than actual invest in money market instruments
transactions - Government funds hold short-term
- Regulators have proposed phasing out U.S. Treasury or agency securities
LIBOR by 2021 - Prime funds also hold other money
- Secured Overnight Financing Rate (SOFR) market instruments
Bond Market
• Bond market is composed of longer term borrowing or debt instruments than

those that trade in the money market
- Treasury notes and bonds

- Corporate bonds
- Municipal bonds
- Mortgage securities
- Federal agency debt
Debt Instruments
• Treasury notes and treasury bonds
- U.S. government borrows funds in large part by selling T-notes and T-bonds
- Notes – maturities range up to 10 years
- Bonds – maturities range from 10 to 30 years
- Inflation-protected treasury bonds
- Many countries’ governments issue bonds linked to an index of the cost of living in
order to provide their citizens with an effective way to hedge inflation risk
- In the U.S., inflation-protected T-bonds are called TIPS
Debt Instruments
• Federal agency debt
- Agencies formed to channel credit to a particular sector that Congress believes might not
receive adequate credit through private sources
- E.g., FHLB, FNMA, GNMA, FHLMC
• International bonds
- International capital market centered in London
- Eurobond is a bond denominated in a currency other than that of the country in
which it is issued
- Yankee bond is a dollar-denominated bond sold in the U.S. by a non-U.S. issuer
Debt Instruments
• Municipal Bonds
- Tax-exempt bonds issued by state and local governments
- Remember:
- General obligation – backed by general taxing power of issuer
- Revenue – backed by proceeds from the project or agency they are issued to finance
- Typically issued by airports, hospitals, etc.
- Industrial development – revenue bond issued to finance commercial enterprises
- Vary widely in maturity
Debt Instruments
• Corporate bonds
- Means by which private firms borrow money directly from the public
- Secured bonds
- Unsecured bonds (i.e., debentures)
- Subordinated debentures
- Similar to Treasury issued securities in that they usually pay semiannual coupons and return face
value to bondholder at maturity
- Larger default risk than Treasury issued securities
- May come with options attached
- Callable or convertible options

Debt Instruments
• Mortgage- and asset-backed securities
• Ownership claim in a pool of mortgages or an obligation that is secured by such a pool
• Conforming mortgages
• Loans must satisfy certain underwriting guidelines before they may be purchased by
Fannie Mae or Freddie Mac
• Subprime mortgages
• Riskier loans made to financially weaker borrowers
Equity Securities: Common Stock
• Represent ownership shares in a corporation
• Each share entitles owner to one vote
• Corporation controlled by board of directors elected by shareholders
• Residual claim
• Stockholders are last in line of all who have a claim on the assets and income of the
corporation
• Limited liability
• Most shareholders can lose in the event of failure of the corporation is their original
investment
Equity Securities: Stock Market Listings
• Dividend yield
- Annual dividend payment expressed as a percent of the stock price
• Capital gains
- Amount by which the sale price of a security exceeds the purchase price
• Price-earnings ratio
- Ratio of a stock’s price to its earnings per share
Equity Securities: Preferred Stock
• Preferred stock has features similar to both equity and debt

- Like a bond, promises to pay a fixed amount of income each year
- Does not convey voting power regarding the management of the firm
- Contractual obligation to pay interest, but not dividends
- Preferred stock payments are treated as dividends rather than interest, so
they are not a tax-deductible expense for the firm
Equity Securities: Depository Receipts
• American Depository Receipts (ADRs)
• Certificates traded in U.S. markets that represent ownership in shares of a

foreign company
• Each ADR may correspond to ownership of a fraction of a foreign share, one
share, or several shares of the foreign corporation
Derivative Markets
• Derivative asset is a claim whose value is directly dependent on or is contingent o the value of some
underlying assets
• Options
• Futures
• Call option
• Gives holder the right to purchase an asset for a specified price, called the exercise or strike price, on
or before a specified expiration date
• Put option
• Gives holder the right to sell an asset for a specified exercise price on or before a specified expiration
date
Derivative Markets
• Futures contract
• Calls for delivery of an asset (or cash value) at a specified delivery or maturity date for
an agreed-upon price, called the futures price, to be paid at contract maturity
• Long position held by the trader who commits to purchasing the asset on the
delivery date
• Short position held by trader who commits to delivering the asset at contract
maturity
Derivative Markets
• Options • Futures Contract
• Right, but not obligation, to buy or sell • Obliged to make or take delivery
• Option is exercised only when it is • Long (short) position must buy (sell) at
profitable the futures price
• Options must be purchased • Futures contracts are entered into
• The premium is the price of the without cost
option itself
Some Mexican Instruments
• CETES
• BONOS (M-Bonos)
• UDIBONOS
• Bondes (D, F, G)
• Certificados Bursátiles (TV 91)
• Borhis
• FIBRAS
• TRAC’s
• Warrants (Títulos Opcionales)
Merton Model (1974)
Market Sizes
• How can we measure / assess the size of a Market?

• Bond Market
• Equity Market
• Derivative Market
• Alternatives
Market Sizes
• How can we measure / assess the size of a Market?
• Bond Market
• Bloomberg Global Aggregate Index – USD 61,269 Billion
• FTSE Wold Government Bond Index (WGBI) – USD 23,154.64 (December 31, 2022)
• FTSE Wold Government Bond Index (WGBI) – USD 23,793 Billion (July 31, 2022)
• BONOS – MXN 3,503,196 Million ~ USD 171,691 Million
• UDIBONOS – MXN 327,583 Million ~ USD 16,055 Million
• S&P / BMV CORPTRAC Index – MXN 299,798.18 ~ USD 14,753 Million
• Equity Market
• MSCI ACWI – USD 56,217,099.08 Million (Dec 31, 2022)
• MSCI ACWI – USD 59,459,464.22 Million (July 29, 2022)
• S&P 500 – USD 33,781,377.66 (December 31, 2022)
• S&P 500 – USD 36,641,010.66 (July 29, 2022)
• MSCI Mexico – USD 144,384.50 Million (December 31, 2022) – Free Float
• MSCI Mexico – USD 137,244.86 Million (July 29, 2022) – Free Float
• S&P / BMV IPC – MXN 6,530,311 Million ~ USD 320,628 Million (July 29, 2022)
Utility Functions
• A procedure for ranking random wealth levels
• A Utility Function is a function U, defined on the real numbers and giving a real value
• Risk Neutral =
Utility Functions
·
• Exponential =− ; >0
Utility Functions
• Exponential =− · ; >0
• Logarithmic =
• Power = · ; ≤1, 0
• Quadratic = − · ; >0
• HARA – Hyperbolic Absolute Risk Aversion (Property)

Hyperbolic Absolute Risk Aversion (HARA) is a property of certain utility functions that makes the inverse
of an individual's level of risk aversion (their risk tolerance) a linear function of their total wealth.
1 1−
= = + = +
1− 1−
Utility Functions
• Arrow-Pratt absolute risk aversion coefficient:
• Certainty Equivalent
The certainty equivalent C of a random wealth variable x is that value C
satisfying:
Utility Functions
• Quadratic Utility
Definitions
denotes a random variable

is the return of a risky investment
is the risk-free rate (is certain, not random)
• Excess return is
• Risk premium is
• If an investor has mean – variance preferences, we can write a utility function:
))
Where and
( ̃) ( ̃)
• For example,
• The function is linear in and
• represents the degree of aversion. Each investor has their own and thus values the trade-
off between risk and return differently.
• Investors evaluate a portfolio by taking its expected return, and then subtracting a “penalty” fir its
The risk penalty depends on
-If , an investor is risk adverse. Investors consider risky portfolios only if they
provide compensation for risk via a risk premium (a standard assumption)
-If , an investor is risk neutral. Investors find the level of risk irrelevant and
consider only the expected return of risk prospects
-If , an investor is risk loving. Are willing to accept lower expected returns on
prospects with higher amounts of risk
Mean Variance Criterion
For any level of expected return, investors prefer portfolios with the lowest variance.
And for any level of variance, they prefer portfolios with highest mean. All they care
about is mean and variance.
Requirements for Portfolio A to dominate Portfolio B
At least one inequality is strict (to rule out indifference between the two portfolios)
• Certainty Equivalent:
• represents the degree of aversion. Each investor has their own and thus
values the trade-off between risk and return differently.
• More risk averse, smaller
The curves display the combinations of mean and standard deviation that provide an
investor with utility of 0.03 for three different levels of risk aversion
Indifference Curves
14.00
11.00
Expected Return
8.00
5.00
2.00
0.00 1.00 2.00 3.00 4.00 5.00

-1.00
Standard Deviation
A=1.00 A=0.78 A=0.50
Let be a fixed level of utility. Thus
= - =
Is the formula for an indifference curve
̃
Slope: ̃
upward sloping
̃
Curvature: ̃
convex
Estimating Risk Aversion
How can we estimate the levels of risk aversion of individual investors?

• Questionnaires
- Varying degrees of complexity
• Observations of how portfolio composition changes over time
• Average degrees of risk aversion from groups of individuals
Capital Allocation Across Risky and Risk-Free Portfolios
• Most basic asset allocation choice is risk-free money market securities

versus other risky asset classes
• Simplest way to control risk is to manipulate the ratio of risky assets to

risk-free assets
The Risk-Free Asset
• Only the government can issue default-free bonds
- A security is risk-free with a guaranteed real return only if
- Its’ price is indexed
- Maturity is equal to investor’s holding period
• T-bills viewed as “the” risk-free asset
• Broad range of money market instruments are considered effectively risk-free assets
It’s possible to create a complete portfolio by splitting investment funds between safe and risky
assets
Behavioral Finance
• Conventional Finance • Behavioral Finance

- Prices are correct and equal to - What if investors don’t behave
intrinsic value rationally?
- Resources are allocated efficiently - Arbitrageurs are limited and
- Consistent with EMH therefore insufficient to force

prices to match intrinsic value
Behavioral
• Behavioral Critique
• Information Processing
• Behavioral Biases
The Behavioral Critique
• Two broad categories of irrationalities

1. Investors do not always process information correctly and therefore infer
incorrect probability distributions of future returns
2. Even when given a probability distribution of returns, investors may make
inconsistent or suboptimal decisions
0%
5%
10%
15%
20%
25%
30%
35%
-12.0%
-11.0%
-10.0%
-9.0%
-8.0%
-7.0%
Biases
-6.0%
-5.0%
-4.0%
-3.0%
Frequency
-2.0%
-1.0%
0.0%
1.0%
2.0%
• Fat-Tails (Skewness and Kurtosis)
3.0%
4.0%
Daily Returns S&P500 Index
5.0%
Normal Distribution
6.0%
7.0%
8.0%
9.0%
10.0%
11.0%
12.0%
0
10
20
30
40
50
60
70
Nov-05
Jun-06
Jan-07
Aug-07
Mar-08
Oct-08
May-09
Dec-09
Jul-10
Feb-11
Sep-11
Apr-12
Nov-12
Jun-13
3m Realized
Jan-14
Aug-14
Mar-15
Oct-15
May-16
3m Implied
Dec-16
Jul-17
• Daily Returns S&P Index, 3m Realized and 3m Implied Vol , from Nov 2005 to August 2022
Feb-18
Sep-18
Apr-19
Nov-19
Jun-20
Jan-21
Aug-21
Mar-22
Information Processing
• Limited attention, underreaction, and overreaction
- Reliance on heuristics due to limited time/attention
• Overconfidence
- People tent to overestimate the precision of their beliefs or forecasts, and they tend to
overestimate their abilities
• Extrapolation and pattern recognition
- Representativeness bias
- Individuals are adept at discerning patterns, even perceiving patterns that may be illusory
- Overly prone to believe these patterns are likely to persist

Behavioral Biases
• Framing
- Decisions affected by how choices are described, such as whether uncertainty is posed as potential gains from a
low baseline levels, or as losses from a higher baseline value
• Mental accounting
- Specific form of framing in which people segregate certain decisions
• Regret avoidance
- Individuals who make decisions that turn out badly have more regret when that decision was more
unconventional
• Affect and feelings
- Investors tend to choose stocks with high affect, driving up prices while simultaneously driving down returns
Efficient Markets
• Efficient market hypothesis (EMH)
• Prices of securities fully reflect available information
• Investors buying securities in an efficient market should expect to obtain an
equilibrium rate of return
Versions of the EMH
1. Weak-form asserts that stock prices already reflect all information

contained in the history of past prices
2. Semistrong-form asserts that stock prices already reflect all publicly
available information
3. Strong-form asserts that stock prices reflect all relevant information,
including insider information
• All versions assert that prices should reflect available information

Portfolio Management in an Efficient Market
• Even if the market is efficient, a role exists for portfolio management:
• Diversification
• Tax considerations
• Risk profile of investor
• E.g., investors of different ages
Efficient Markets
• Are Markets efficient?
“Markets look a lot less efficient from the banks of the Hudson than from the banks of the Charles”
(Peter L. Bernstein)
Utility Functions
• Utility Scores
• Stochastic Dominance
• Mean Variance Criterion
• Investor Types
• Indifference Curves
• Graphs Formula
• Estimating Risk Aversion
Utility Functions
• Equivalent Utility Functions

• Risk Averse Derivative
• Risk Aversion Coefficient
• Certainty Equivalent
• Quadratic Utility
• Efficient Market Hypothesis
• Weak Form
• Semi-Strong
• Strong

Class 1&amp;2

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Class 1&amp;2

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Class 1: Introduction and Pre-Requisites

Investment Portfolio Management

• Supply and Demand

The relative growth rate is constant

• Continuous Compound Interest:

• After-tax Interest Rate

Types and categories

A Decision Problem involving the selection of values for a number of interrelated

• With more restrictions, we are always worse off

Real Assets Financial Assets

• Used to produce goods and services • Claims to the income generated by

• Examples: Stocks, bonds

• Portfolio: Collection of investment assets

• Security analysis involves the valuation of particular securities that might be

• Financial markets are highly competitive

• There will almost always be risk associated with investments

• Risk-return trade-off - Higher-risk assets are priced to offer higher

expected returns than lower-risk assets

• You should rarely expect to find bargains in the security markets

• Efficient market hypothesis

• Investment bankers specialize in the sale of new securities to the public,

• Private equity refers to investments in companies whose shares are not

Creation, Promotion, and Selling of Buyers and Investors (Bonds,

• Retirement or dissaving period

Investment Portfolio Management

• Certificates of Deposit (CD)

• Bank pays interest and principal to the depositor only at maturity

• Time deposit cannot be withdrawn on demand

• LIBOR • Yields on Money Market Instruments

• Bond market is composed of longer term borrowing or debt instruments than

- Treasury notes and bonds

- Federal agency debt

- Notes – maturities range up to 10 years

- Bonds – maturities range from 10 to 30 years

- Inflation-protected treasury bonds

- In the U.S., inflation-protected T-bonds are called TIPS

- Tax-exempt bonds issued by state and local governments

- General obligation – backed by general taxing power of issuer

- Typically issued by airports, hospitals, etc.

- Industrial development – revenue bond issued to finance commercial enterprises

- Vary widely in maturity

- Unsecured bonds (i.e., debentures)

- Larger default risk than Treasury issued securities

- May come with options attached

- Callable or convertible options

• Mortgage- and asset-backed securities

• Ownership claim in a pool of mortgages or an obligation that is secured by such a pool

• Riskier loans made to financially weaker borrowers

• Each share entitles owner to one vote

• Corporation controlled by board of directors elected by shareholders

- Annual dividend payment expressed as a percent of the stock price

• Preferred stock has features similar to both equity and debt

• American Depository Receipts (ADRs)

• Certificates traded in U.S. markets that represent ownership in shares of a

• Options • Futures Contract

• Options must be purchased • Futures contracts are entered into

• The premium is the price of the without cost

• How can we measure / assess the size of a Market?

• A procedure for ranking random wealth levels

• HARA – Hyperbolic Absolute Risk Aversion (Property)

• Arrow-Pratt absolute risk aversion coefficient:

denotes a random variable

is the risk-free rate (is certain, not random)

• The function is linear in and

Class 1&2

Class 1&2