ASSET CLASSES & FINANCIAL INSTRUMENTS
(1) Money Market (subset of debt)
 Treasury Bills (Sg: SGS Bills)
Usually with maturity < 52 weeks
Default risk is low (≈ 0)
No coupon payment
Not callable
Pricing
Priced according to 360 days/yr
Sold at discount to par
Buyer → looks at ask price
Seller → looks at bid price
Price =
where r =ask % ( ) Interest will be paid on the loan.
Bond equivalent yield =
 LIBOR (Sg: SIBOR)
Average of interest rates that banks expect
to charge each other
Used as a basic reference rate
LIBOR as a financial barometer
- Optimistic → lower LIBOR
- Pessimistic → Higher LIBOR
Manipulation of LIBOR
Occurred during the FC 2008
To cover up the poor financial situation and
manipulate returns from contracts
referencing LIBOR
(2) Bond Market
 Private Issues: Corporate Bonds
 Govt Issues: Treasury Bonds/ TIPS (TIPS
not available in Sg)
TIPS have principal adjusted using CPI –
inflation protected (real R/r)
How to read bond price
Smallest unit = 1/64
102:20 = 102+20/64
YTM , Coupon Rate and Price
YTM < Coupon → Price > Par
YTM = Coupon → Price = Par
Computing Inflation Using TIPS
Inflation = YTM (Treasury)-YTM (TIPS)
 Mortgage Backed Securities
A security with cash-flows backed by a
stream of mortgage payments.
(E.g. of securitization: Creating a new
security by pooling together loans)
Why investors like MBS
MBS diversifies risk as low risk mortgages
offset high risk ones so that
final portfolio → lower risk
Why banks sell mortgages
Primary reason: free up capital
Why MBS led to FC 2008
Low quality (sub-prime) mortgages pooled
Default in selected pool of mortgages
(3) Stocks and Bond Indexes
Purpose of Index
Track Average returns
Compare performance of managers
Base of derivatives
Construction of Indexes
 Price Weighted Index (DJIA)
Buy one share of each stock
index value = (P1+P2+...+Pn)/n
In case of stock split:
Reconfigure denominator of last period
(P1+P2,new+...+Pn)/Index = Denominatornew
where P1 – Pn: prices of previous period
Index: Index value of previous period
P2, new: value of stock after stock split
If 2 new for 1 old (2:1) → value is 1/2
If 1 new for 2 old (1:2) → value is 2x
 Market-Value Weighted (S&P/NASDAQ)
(P1  Q1 )  (P2  Q 2 )  ...  (Pn  Q n )
indexV 
(P1  Q1 )  (P2  Q 2 )  ...  (Pn  Q n )
Q= quantity held
Numerator: t=1
Denominator: t=0
 Equally weighted
Invest the same amount in each
(P  Q1 )  (P2  Q 2 )  ...  (Pn  Q n )
indexE  1  100
(P1  Q1 )  (P2  Q 2 )  ...  (Pn  Q n )
Q= Amt invested in each/price
Numerator: t=1
Denominator: t=0
SECURITIES MARKET
(1)Types of Orders
 Market: execute immediately at best price
 Limit: Buy or sell at specific price or better
 Stop Loss: becomes a market sell order
when the trigger price is encountered
 Stop Buy: becomes a market buy order
when the trigger price is encountered
(2) Trading Costs
 Commission fee paid to broker
 Bid-Ask spread
(3) Margin Trading
Borrowing money to purchase stock.
Buy on margin to magnify gains/reduce risks
 Initial Margin Requirement: Minimum %
of initial investor equity (IMR)
 Investor equity = Position value –
borrowed money + additional cash (e.g.
dividends)
 Maintenance Margin Requirement:
Minimum % of equity before additional
funds needed (MMR)
 Margin call occurs if
 Margin call occur when
 Price = MV/No. of shares held
 Return on Investment
(4) Short Sales
1. Borrow stock from a broker/dealer
2. Broker sells sock and deposits proceeds
and margin into account (can't withdraw)
3. Buy back a stock to return broker later
Liable for any cashflows (e.g. dividends)
Required to post margin above proceeds
pledged to broker (i.e. proceeds: 6k, pledge:
50%, Total Margin Account: 9K)
Usually used in bearish markets
 Short sale equity = TMA – MV
 Margin call occurs if
 Margin call occurs when
 Price = MV/No. of shares held
 Rate of Return on Investment
MUTUAL FUNDS & OTHER INVESTMENT
(1) Mutual Funds
Mutual Funds are priced at the end of the
day (Exception: ETF traded on stock
exchange)
Active Funds: Tries to beat the market
Passive Funds: Mimics a benchmark
(2) Investment Companies provide:
 Administration & record keeping
 Diversification & divisibility
 Professional management
 Reduced transaction costs
Disadvantage of Active Mutual Funds
 Management Fees
 Take time to learn ability of manager
 Only one price per day
(3) Net Asset Value (NAV) ≈ Price per share
(4) Costs of Investing in Mutual Funds
 Operating Expenses
 Front End Load (as % of Offering Price)
 Back End Load
 12b-1 Charges (Only in US)
Calculating offering price with FEL
Offering Price = NAV/(1-Front End Load)
 100 (5) Mutual Fund R/r
(6) Comparing impact on performance
(7) Mutual Fund Investment Performance
Evidence shows that average mutual fund
performance < broad market
 mostly due to fees which magnify losses
Evidence that performance is consistent
from one period to the next is suggestive but
inconclusive.
 unlikely for top performance to persist
 tendency of poor performance to persist
RISK AND RETURN
(1) Rates of Return over Multiple Periods
 Arithmetic Average Return (AAR)
Investors will never achieve AAR
Used in estimates (looks higher)
 Geometric Average Return (GAR)
Better reflection of investors' true return
Reflects effects of compounding
 Dollar Weighted Return
Find the internal rate of return for the cash
flows (i.e. Use CF to find IRR)
(2) Risk and Risk Premiums
Normal distribution:
(3) Equity Risk Premium
Extra return for investing in equity because
of volatility and risk aversion
(4) Inflation premium
(5) Allocating Risky and Risk Free
y=weight in risky portfolio, =0
Beyond y=1: leverage at risk-free rate
(6) Risk Aversion and Allocation
High risk aversion → lower y
for a given portfolio Q
Risk Aversion of investing fully in mkt ≈ 2.5
EFFICIENT DIVERSIFICATION
(1) Diversification and Portfolio Risk
Diversification reduces Firm-Specific (Unique
/Idiosyncratic) Risk
Remaining is Systematic/Market Risk
(2) Asset Allocation with 2 Risky Assets
ρ = +1.0 → perfectly positively correlated
ρ = -1.0 → perfectly negatively correlated
 Benefits of Diversification decrease as
correlation between assets increase
(3) Asset Allocation (Many Risky Assets)
Q Q
σ p  [WI WJ Cov(rI , rJ )]
2
I 1 J 1
As more assets are included the efficient
frontier shifts to the North-West
 Efficient Frontier (EF) is the set of
portfolios that has highest return for a
given level of risk
Assuming no risk-free assets, all investors
should want a portfolio on the EF
 Minimum variance: turning point
(4) Optimal Risky Portfolio with Risk-Free
Capital Market Line (CML)
Tangent to EF with Rf as y-intercept
Optimal CAL as it has highest Sharpe Ratio
Any combination on CML > returns on EF
 Adjust between tangency portfolio and
risk-free asset according to aversion
(5) Single-Index Asset Market
 βi= sensitivity to market return
 αi= Risk-adjusted excess returns
 εi = idiosyncratic risk
 : systematic risk
 : idiosyncratic risk
Estimating idiosyncratic risk with SCL
 Compute epsilon of each plotted point
from SCL and compute variance of
epsilon
CAPM AND APT
(1) Capital Asset Pricing Model
Assumptions of the Model
 Individual Investors are "Price Taker"
 No taxes and no transaction cost
 People only care about mean and variance
of returns
 Homogeneous expectations
 Perfect information on means and variance
of returns
Implication of CAPM
 All investors will hold a combination of the
Market Portfolio and risk-free
o CML formed tangent to M
 Average investor has y=1 on CML
 Market: highest Sharpe Ratio
o Consists of all assets in universe
o Market-value weighted
o Optimal risky portfolio
Expected Return & Risk (Individual)
Investors only hold M, look at β only
 Do not care about σ, no firm-specific
In equilibrium,
SML: )
Disequilibrium of SML: α would exist
)
 +ve α → undervalued/-ve α → overvalued
(2) Evaluating the CAPM
Other factors such as firm size, B/M ratio can
be better predictors
 Validity of CAPM assumptions
 Untestable since true market portfolio can
never be observed (Roll Critique)
(3) Multifactor Models and CAPM
Multi-factor models used when returns
respond to > 1 systematic factors.
Farma-French 3 Factor Model
Firm size and B/M ratio incorporated
Higher B/M → Higher risk (default)
Smaller firms → Higher risk (liquidity)
(4) Arbitrage Pricing Theory
Exploiting mispricing of two or more securities
to achieve risk-free profits.
Assumptions
Well diversified portfolio so there s no
unsystematic risk
No arbitrage opportunities in an efficient
market
Implication
Alpha of well-diversified portfolio = 0
∴
APT vs. CAPM
APT applies to well-diversified only
APT has less restrictive assumptions
APT assumes one or more sources of
systematic risk (CAPM only market)
Arbitrage: 1 systematic factor
1. Set weight of greatest α asset (A)=1
a. If α not given use ratio of RP to β
2. Adjust weight of other asset such that βp=0
( )
3. Borrow risk-free so total weight = 0
Return per $1 invested in A:
Equilibrium in the APT
If any of the 3 conditions hold, no arbitrage
opportunities exist
1.
2.
3.
for any other well diversified portfolio
Arbitrage: 2 systematic factors
1. Set portfolio weight as 1
2. Weight of systematic factors = –β
3. Borrow risk-free so total weight = 0
EFFICIENT MARKET HYPOTHESIS
(1) Random Walk and EMH
EMH proposes that prices accurately reflect
all available information.
If markets are efficient, investors cannot
construct trading strategies that earn, on
average, a risk-adjusted positive profit.
 Weak form: Prices reflect info in historical
price data and other trading data
 Semi-strong form: Prices reflect all
publicly available information.
 Strong form: Prices reflect all information;
both public and private/inside information
Random Walk: The idea that stock price
changes are random and unpredictable
 If market efficient ⇒ changes in price has
to be due to new info about the firm
 News unpredictable ⇒ returns random
(2) Implications of EMH (Security Analysis)
 Technical Analysis: uses prices and volume
information to predict
o Violation of all forms
 Fundamental Analysis: Identify over/
under valued securities using firm's AR
o Violates strong/semi-strong form
 Passive vs Active Management
o Active: assumes inefficiency use TA/FA
o Passive: consistent with semi-strong
efficiency ⇒no point picking "winners"
(3) Are markets efficient?
Empirical Tests
 Testing trading rules
 Event Studies: Examine how quickly info is
integrated into prices
 Assessing performance of fund managers
Patterns in stock returns
 Short term returns: serial correlation
o Momentum effect ⇒EMH does not hold
 Long term reversal effects ⇒ EMH holds
Abnormal Returns (excess returns εi)
If EMH holds, returns spike immediately at
announcement; no momentum effect
Problems with these Empirical Tests
Selective bias: only know strategies that fail
Lucky Event Issue
Possible Model Misspecification
(4) Mutual Fund and Analyst Performance
Mean mutual fund return statistically = 0
PORTFOLIO EVALUATION
(1) Evaluating a Single Fund
Evaluation with a risk model
Single index model:
Jensen α:
if Jensen α > 0, fund is good :)
(2) Factors causing Abnormal Performance
1. Allocation across broad asset class
2. Allocation within asset class (industry)
3. Individual security selection (stocks)
(3) Decomposing Performance
Comparing against a "bogey" portfolio
Excess return of managed portfolio
= return of manage – return of bogey
1. Contribution of asset allocation (1)
Sum of: (Weight in managed – weight in
bogey)*bogey returns
2. Contribution of selection (2) + (3)
Sum of: (Return in managed – Return in
index)*weight in managed
3.Contribution of security selection (3)
Total equity selection derived from step 2
Security =total equity-sector allocation
(Note: 1 contribution basis point = 1/100 %)
(4) Evaluation of Complete Portfolios
Entire Wealth Portfolio (M2)
Rp*: complete portfolio consisting actively
managed and risk-free with same risk as M
Creating P*:
Weight in Managed fund =
Fund of Funds Treynor Ratio:
Better than sharpe ratio as effect of residual
risk can be ignored
Portfolio added to benchmark
Information Ratio:
: σ of difference between portfolio and
benchmark returns
BOND PRICES AND YIELDS
(1) Bond Characteristics
 Fixed income/debt securities: claim on a
specified periodic stream of income
 Face or par value or principal value
 Maturity date
 Coupon rate: Variable/Fixed/Zero
(2) Bond Price of Bond
 Annual Coupon
N $C  Par
P   T 

T 1 (1  YTM )  (1  YTM)
N inversely related to its current YTM
 Semi-annual Coupon
 2N ½$C 
Par
P   T
 a decrease in yield
 T 1 (1  ½r)  (1  ½r)
2N
 Bond Pricing Between Coupon Date
Invoice Price = Flat Price + Accrued Interest
Accrued Interest
* if semi annual bond → annual coupon/2
(3) Alternative Measures of Yield
 Current Yield: Annual coupon/Price
 Yield to Call: Call price replaces par, call
date replaces maturity
 Holding Period Yield: Use actual re-
investment rate instead of YTM
(3) Relationship between Price and Yield
Prices and yields have an inverse relationship
 High yield → Price low
 Relationship not linear (due to convexity)
(4) Types of Risk
Reinvestment Risk: interest rate falls such
that investors are unable to reinvest
coupons earned at promised YTM
Default Risk: risk that company defaults on
bond payments
 Can be negated by Credit Default Swap –
Insurance policy on default risk of bond
(Price approximates yield differences
between different rated bonds)
(5) Bond Price Over Time
 Premium Bond→Coupon>YTM→Price>Par
 Discount Bond→Coupon<YTM→Price<Par
(6) Term Structure of Interest Rates
 Long term rates are functions of expected
future short term rates
 Liquidity preference results in upward bias
over expectations → long-term rate
includes liquidity risk premium
 Forward rates implied in yield curves
EQUITY VALUATION
(1) Intrinsic Value
Intrinsic Value (V0): PV of firm's future net
cash flows discounted by required R/r
 If intrinsic value > market price → buy
(2) Dividend Discount Models
 Zero growth (e.g. Preferred Stock)
, k = required rate of return
 Constant growth model
, g=growth rate
Stocks under zero growth model and
constant growth model will have the R/r
 But constant growth will have higher
valuation because of expectation of
collecting higher future dividends
(3) P/E and Growth Opportunities
Where b = plowback ratio (if g=0, b=0)
Value of growth opportunities = V0 with
growth opportunities – V0 with zero growth
(4) P/E and Risk
Riskier firms have higher k → lower P/E
(5)Pitfalls in using P/E Ratios
 Hard to estimate future earnings
 High P/E implies high expected growth but
not necessarily high stock return
 Simplistic assumption that P/E only rise
 Better estimate: PEG Ratio → Ratio of P/E
to growth in dividends should ≈ 1
MANAGING BOND PORTFOLIOS
(1) Interest Rate Sensitivity
 Long-term bonds are more price sensitive
than short-term bonds
 Sensitivity of bond prices to changes in i/r
increases at a decreasing rate as maturity
increase
 Bond price sensitivity is inversely related
to coupon amount
 Sensitivity of bond price to change in i/r is
 Increase in bond's YTM results in smaller
price decline than the gain associated with
(2) Duration – effective maturity of bond
 Duration increases with maturity
 Higher coupon ⇒ lower duration
 Duration is shorter at higher i/r
 Duration is shorter than maturity for all
bonds except zero coupon bonds
 Duration=maturity for 0 coupon bonds
Duration for fixed coupon to perpetuity
Price change is proportional to duration
Modified Duration (D*)
(2) Interest Rate Risk
Interest Rate Risk is the possibility that an
investor does not earn the promised YTM
because of changes in i/r
(A) Price Risk: ↑ in i/r ↓ bond price ⇒ cannot
sell at expected price
(B) Reinvestment Risk: ↓ in i/r ↓ future value
of reinvested coupon ⇒ will not be able to
reinvest coupons at promised i/r
 Both types of risks are potentially
offsetting if i/r ↑, sales price ↓ but
reinvestment income ↑
(3) Convexity
Duration asserts that price change is linearly
related to change in bond yield
 Underestimates ↑ in price when i/r ↓
 Overestimates ↓ in price when i/r ↑
Prediction model including convexity
Pricing error if ignore convexity
Due to convexity,
 Price is more sensitive to ↓ in i/r
 Price is less sensitive to ↑ in i/r
OPTION MARKETS
(1) Option Contracts
 Call Option – option to buy a fixed quantity
of an asset by a fixed date for a fixed price
 Put Option – option to sell a fixed quantity
of an asset by a fixed date for a fixed price
(2) Option Payoffs
Payoff of CALL BUYER: Max(ST-X, 0)
Payoff of CALL SELLER: -Max(ST-X, 0)
Payoff of PUT BUYER: Max(X-ST, 0)
Payoff of PUT SELLER: -Max(X-ST, 0)
(3) Option Strategies
 Protective Put: Long Stock and Long Put
Strategy to limit risk of owning stock
 Covered Call: Long Stock and Short Call
Limit losses in writing a call option
 Straddle: Long Call and Long Put with same
exercise price and expiration date
Expect volatile prices in both direction
ST ≤ X ST ≥ X
Protective Put X ST
Covered Call ST X
Straddle X-ST ST-X
 Bullish Spread: Long call at X1, Short Call at
X2 OR Long put at X1, Short Put at X2
ST ≤ X1 X1 ≤ ST ≤ X2 ST ≥ X2
X ST-X1 X2-X1
 Collar: Long asset, Long Put option at X1
and Short Call option at X2
Limit downside losses and upside gain
OPTION VALUATION
(1) Intrinsic Value of an Option
 Call Option/Put Option: Max(S0 – X,0)
 Time Value of Option: Difference between
option's price and intrinsic value
o Measures probability that option will be
in-the-money
o Time Value is highest when option is at-
the-money (will never be negative)
 Determinants of Call Options Values
o Stock Price ↑ Value of Call Option ↑
o Exercise Price ↑ Value of Call Option ↓
o Volatility ↑ Value of Call Option ↑
o Time to expiration ↑ Value of Call Option↑
o Interest Rate ↑ Value of Call Option ↑
o Dividend Payout ↑ Value of Call Option ↓
(2) Binomial model
 Value of Call Option: Long H shares of Stock,
Short 1 Call Option (Find H such that
portfolio is riskless – same amt in the future)
When returns of an option and stock are
modelled in a two-state binomial option
model, H is the ratio of the range of option
outcomes to the range of stock outcomes
(3) Black-Scholes Option Pricing Formula
δ: Dividend Payout r: Risk-free σ: Implied vol
T: Number of days to maturity/365
 Implied volatility – std deviation of stock
returns consistent with option's MV
o What market expects volatility to be
(4) Put-Call Parity
 Payoff of long call + short put = buying stock
using loan of face value X
 If there is no arbitrage opportunities,
If the PV of the two strategies are not equal
- short more expensive portfolio
- long cheaper portfolio
FUTURES MARKETS
(1) Futures and Forwards
 Futures: Agreements to deliver (or take
delivery) of a fixed quantity of an asset at a
fixed date in the future for a fixed price
 Spot market – market where the actual
asset is trading for immediate delivery
Long Futures Short Futures
PT-F0 F0-PT
(2) Futures Contracts
Both sides to a future contracts are required
to post margin with exchange clearinghouse
 Balance in margin account is adjusted to
reflect daily settlement
 Cash flow in buyer margin acc =
 Cash flow in seller margin acc =
Futures exhibit the property of convergence
because price discrepancies would open
arbitrage opportunities for investors
 Hedging – using futures to manage risks
(removes all excess loss and gains)
o Protect against increase: long asset and
futures (when you want to buy asset)
o Protect against decline: short asset and
futures (when you want to sell asset)
(3) Basis Risk
Risk of unpredictable changes in basis
 Basis=Futures Price- Cash price
o Basis=0 at maturity
Hedgers bears risk if futures contract and
asset are liquidated before maturity but risk
still smaller than un-hedged position.
(4) Spots-Future Parity
 Payoff of long asset for 1 yr = investing S0 in
risk-free and long 1 unit of futures for 1 yr
(5) Pricing Futures Contract
Futures price= Spot Price x (1+ cost of carry)
Net Cost of Carry =