Question 1 – Portfolio theory:

Return & Risk Measurement

Holding period return (HPR) – rate of return over a given investment Variance – the square deviation from the mean
period:

Ending price – Beginning price + Cash dividend/coupon payment

HPR = Beginning price

Expected returns – mean value of distribution of HPR: Interpretation = the expected value of the squared deviation
from the mean (the expected return)
E(r) = ∑𝑠 𝑝(𝑠) x 𝑟(𝑠)
• E(r) = mean return or expected rate of returns
• p(s) = Probability of a state
• r(s) = Return if a state occurs
Standard Deviation: = √σ2
• s=State
Interpretation = standard deviation is an appropriate
• The probability distribution lets us derive measurements for both measure of risk for a portfolio of assets with normally
the expected return and the risk of the investment. You can think of
distributed returns. Returns of an asset will deviate from the
expected return as the average HPR you would earn if you were average mean based on the Standard deviation calculated
to repeat an investment in the asset many times. The expected
return also is called the mean of the distribution of HPRs and often
is referred to as the mean return. Arithmetic average – Expected returns in a given period of
time when n=period e.g. monthly basis (does not account for
compounding)

Geometric average
• Geometric average takes into account of compounding

• Terminal value (TV) of the investment:

• Geometric average return (g) over n time periods:

Estimating variance & standard deviation: Normal distribution:

Population Variance: • Investment analysis can “appear” easier if we assume

• Instead of having the probability of each state, we use 1/n where n = asset returns follow a normal distribution:
number of observations (e.g. monthly returns of 3 years, n = 36) o Symmetric asset returns → Standard
• Then divided by n deviation is a good measure of risk
• r(s) = return of each state (e.g. months) o Symmetric asset returns → Portfolio returns
• 𝑟̅ = expected return will be as well
o Only mean and standard deviation needed to
estimate future scenarios
o Pairwise correlation coefficients summarize
the dependence of returns across securities
Sample Variance & standard deviation: • You need to be aware that we are making an
• We want to work with the sample variance and standard deviation so assumption when we focus only on means and
need to divide by ‘n-1’ standard deviation. We also need a confidence
interval & co-relation figure
o We use these measures to make forecast in
the future

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Utility function – Mean-variance preferences:
• Let us assume a utility function that contains JUST/ONLY the
mean and variance of an asset’s return:
Utility function:
• U = is the utility derived from an investment with a particular
expected return and variance (risk)
• A = is the risk aversion parameter
• This is important for the risk parameter of different investors
• A=0 is a risk neutral investor
o Risk neutral means the investor does not care about risk
• For a rational investor (risk averse) A > 0
• 1⁄2 is a scaling factor
• We are assuming that either returns are normally distributed or
that investors only care about mean and variance
Want to maximise a portfolio without a risk-free asset = maximise
utility
Want to maximise a portfolio with a risk free asset = maximise Sharpe
or CAL ratio for highest reward to risk ratio
Constructing portfolio with two risky assets:
There are three rules of two-risky assets portfolio:
• Rule 1 – The rate of return on a portfolio is the weighted average
of returns on the component securities, with the portfolio
proportions as weights.
o rP = wBrB + wSrS
• Rule 2 – The expected rate of return on a portfolio is similarly the
weighted average of the expected returns on the component
securities, with the portfolio proportions as weights.
o E(rP) = wBE(rB) + wSE(rS)
• Rule 3 - The variance of the rate of return on a two-risky-assets
portfolio is:
o σ2P = (wBσB)2 + (wSσS)2 + 2(wBσB)(wSσS)ρBS
Risk aversion characteristics:
• More risk averse investor = requires higher
compensation to offset higher risk they are obtaining
• Less risk averse investor = requires a lower
premium for the same risk
Mean variance criterion states that portfolio A is
preferable to portfolio B if the two conditions hold:
• E(rA)≥E(rB)
• σA ≤σB
• This is a mathematical statement that investors will
choose portfolios which have higher returns and
lower risk –
This provides the Northwest selection rule - Choosing
between portfolios:
• Northwest selection rule (graph) – investor will
pick portfolio with higher returns and less risk to
maximise utility
• The utility function is importance for illustrating
which investment is preferred to each other where
there is a difference between the risk (standard
deviation) and the E(R). For example Areas B is
preferred to Point X
For a portfolio with two risky assets, the expected return
and variance equations are:
Where x = is the weight
Correlation coefficient between two assets
• σ = standard deviation
• σ2 = variance
• σij = co-variance (Co-variance = variance of two
assets)
• ρ = correlation coefficient
• xA = weight in asset A
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 Constructing portfolio with n risky assets:
Expected return of portfolio & Variance of portfolio
Diversification:
Correlation Coefficient to achieve diversification & reduce firm-
specific risk:
• Degree to which two-security portfolio reduces variance of
returns depends on degree of correlation between the returns of
the securities
• The smaller the correlation between two risky assets, higher the
gains from diversification
o Investors can stabilise rate of return so that variance
decreases without reducing portfolio expected return
o Investors gain from diversification provided securities
are not perfectly correlated
• Diversification helps reduce risk by offsetting firm specific
risk/idiosyncratic risk among assets
• Mathematically speaking, this reduction in risk is attributable to
the less than perfect correlations (<1) among assets returns
Covariance of assets (Correlation coefficient = easier tool to interpret
data):
• Covariance = measure the average tendency of the asset returns
to vary in tandem/co-vary
• Negative Covariance = two assets, on average, vary inversely;
when one performs well, the other tends to perform poorly.
• Positive covariance = asset returns move together
Variance for two asset portfolio:
• ρ = correlation coefficient
o Principle - Provided the ρ is less than 1, then you have
some form of diversification
Choosing the optimal risky portfolio:
Mean-variance opportunity set:
• The combinations of risky assets where its objective is to
minimise portfolio variance for a given level of portfolio
expected return:
• Finding the optimal weight in assets to minimise variance of the
portfolio for a given portfolio return
Efficient Frontier – Graph representing a set of portfolios that maximises
expected return & minimising risk/standard deviation:
• Contains portfolio’s with lowest risk/standard deviation with the
highest portfolio returns
Interpretating correlation coefficient:
Correlation Coefficient – tendency of assets to vary together
Interpretation (-1 to +1) - Correlation co-efficient closer to
-1 reduces the overall risk of your portfolio or even obtain a
risk free portfolio if it is negatively perfectly correlated:
• Where the correlation coefficient = 1: there are no
gains from diversification as asset returns are
perfectly positive correlation meaning they have a
100% tendency to move together
• Where correlation coefficient = 0: assets returns are
unrelated
• Perfect positive correlation is the only case in which
there is no benefit from diversification
• Whenever ρ < 1, the portfolio standard deviation is
less than the weighted average of the standard
deviations of the component securities. Therefore,
there are benefits to diversification whenever asset
returns are less than perfectly positively correlated:
o Assets have inverse relationship and one
asset’s returns varies in the opposite
direction of the other
More stocks in portfolio = portfolio variance declines on
average
Does portfolio variance always decline as more stocks are
added to a portfolio?
• The Idiosyncratic removes as you add more stocks to
the portfolio and therefore less risk and are only left
over with systematic risk. The average variance
decreases, but the average co-variance, the
systematic risk does not disappear.
Choosing risky portfolio & accounting for risk aversion:
• The risky portfolio that investors select is based upon
their preferences:
• The portfolios on the efficient part of the mean-
variance frontier will be selected as other portfolios
are inefficient
• The optimal portfolio that they select will lie on the
efficient frontier as that will provide the maximum
expected return for a given level of risk
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 • Below or inside the envelope are inefficient portfolios as you can • Investors will seek to maximise expected utility
obtain portfolio’s with the same standard deviation and higher through their portfolio
returns on the efficient frontier • This is dependent on their risk aversion & their
utility function:

Choosing the optimal risky & risk-free portfolio:

Complete portfolio – Entire portfolio including risky & risk-free assets
Capital allocation to risky assets – the fraction of portfolio placed in
risky assets and speaks directly investor risk aversion
Asset allocation – investment in risky & risk free assets
Capital Allocation Line – plot of risk-return combinations
available by varying portfolio allocation between a risk-free
asset and risky portfolio
• Altering the weight of a risky & risk-free portfolio
moves you up & down the capital allocation line

Expected return of complete portfolio: Choosing/Calculating the OPTIMAL weight in risky

assets of complete portfolio by maximising utility:
E(Rc) = Rf + x[E(Rp) – Rf)
• Solving for X to
Where x = weight of risky portfolio & 1 – x = risk free allocation determine what
Standard deviation of complete portfolio: weight is allocated
in risky assets that
The standard deviation for this portfolio is: (x = the weight of the risky maximise
portfolio) investor’s utility while accounting for their risk
aversion & portfolio variance

Where weight in risk-free assets = 1 - x

Moving from the Optimal risky portfolio to the Optimal combined portfolio with
Rf:
• Investors will hold the same risky portfolio, but will not hold the same
combined portfolio as their different levels of risk aversion will mean
they will borrow or lend different amounts to maximise their utility.
• All investors will hold the same risky portfolio on their CAL tangent,
but for their maximised expected utility risky portfolio it will be
based on their risk aversion (above)
• The CAL is the tangent that finds the best portfolio, the investor can now
combine their risky portfolio with a risk free asset and end up holding a
portfolio on the CAL line with a higher or optimal utility with the
combined portfolio with Rf
• Moving to the Optimal combined portfolio with Rf - The investor
needs to borrow a risk free asset by borrowing 100% of their wealth at the
risk free rate and investing that amount to move it to the risky portfolio to be at 200%.
o Therefore to move up to the optimal risky portfolio on the CAL line – they need to borrow to get to the optimal
combined portfolio with Rf they will have a negative weight in Rf of -100% and a weight greater than 100% in the risky
portfolio.
• Moving down to their combined portfolio with Rf – the investor needs to lend to get there and have a positive weight in Rf & the
risky portfolio

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Optimal combined portfolio – SHARPE RATIO (reward to variability ratio)
• Slope of CAL is Sharpe Ratio of risky portfolio (we are trying to find the highest sharp ratio), so we can move up and down it
• Principle - The higher the Sharpe ratio, the greater is the expected return corresponding to any level of volatility.
• Key point – when we find this point, every investor is going to find that portfolio, if we can borrow at rf.
(𝐸(𝑅𝑖 ) – 𝑅𝑓)
• Sharpe Ratio: 𝜎𝑝
o 𝐸(𝑅𝑖 ) = Expected return on the portfolio or market
o 𝑅̅𝑓 = Average risk free rate
o 𝜎𝑝 = Standard deviation of portfolio return
• Sharpe ratio= An optimal portfolio allocation between risky and risk-free assets can be determined by maximising the Sharpe
Ratio, known as the capital allocation line (CAL). The Sharpe ratio calculates a portfolio’s risk premium to its standard deviation
or the reward-to-volatility ratio.
o The Sharpe ratio can be utilised to rank portfolios by quantifying the incremental reward or risk premium for each
increase of 1% in a portfolio’s standard deviation.
• Separation Property implies portfolio choice, separated into two tasks:
o Determination of optimal risky portfolio
o Personal choice of best mix of risky portfolio and risk-free asset depends on investors risk aversion (A)
• Investors will hold the same risky portfolio. But, they will not hold the same combined portfolio as their different levels of risk
aversion will mean they will borrow or lend different amounts to maximise their utility.

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 Question 2 – CAPM & Market efficiency:
CAPM:

Capital Asset Pricing Model & Measures

Background to CAPM derivation – CAPM assumptions: Therefore all investors who hold the market portfolio will be on the
Market assumptions tangent point of the efficient frontier due to the assumptions to
• All investors are price takers; All information relevant to maximise their utility:
security analysis is free and publicly available; All • All investors should have the same efficient frontier where
securities are publicly owned and traded; No taxes on M is the market portfolio, the best attainable capital
investment returns; No transaction costs; Lending and allocation line.
borrowing at the same risk-free rate are unlimited. o All investors hold M, the market portfolio as their
Investor assumptions: optimal risky portfolio, differing only in the amount
• Investors are rational, mean- variance optimizers; Investors invested in it versus the risk-free asset
plan for the same (single-period) horizon; Investors are • Assuming investors have
efficient users of analytical methods → investors have the same risk free rate,
homogeneous expectations; They aim to achieve the highest then they will have the
utility function/point same Capital asset
allocation line that is
Market portfolio (M) – The portfolio for which each stock is held in tangent to the efficient
proportion to its total market value of the stock: frontier.
• All investors will choose the market portfolio under the • They would therefore
CAPM model due to the assumptions arrive at the same market
portfolio (which is the
Risk premium of market portfolio = is proportional to the variance risky market portfolio,
of the market portfolio and investors’ typical degree of risk aversion a weighted average of all
assets invested)
according to CAPM

Risk premium of individual assets = the product of the risk

premium on the market portfolio (M) and the beta coefficient of the
security on the market portfolio.
• Beta measures the extent to which returns respond to the
market portfolio. In the index model, beta is the regression
(slope) coefficient of the security return on the market
return, representing sensitivity to fluctuations in the overall
security market.
Why use market portfolio? – the CAPM shows what an asset’s
expected return should be based on its amount of systematic risk.
Relationship between expected return and systematic risk = security
market line
Capital Asset pricing model (CAPM) – model that relates the
Capital Asset Pricing Model – for individual stocks: required rate of return on a security to its systematic risk as measured
by beta
𝐸(𝑟𝐵𝐻𝑃 ) = 𝑟𝑓 + 𝛽𝐵𝐻𝑃 [𝐸(𝑟𝑀 ) − 𝑟𝑓 ] • Beta measure the contribution of a stock to the variance of
market portfolio:
Measures the risk premium/expected return of a share to the o Beta = The sensitivity of a security’s return to the
benchmark market risk free rate and the share’s contribution (beta) to return on the market index.
the market • Therefore E(rBHP) = the risk premium (rate of return) of the
stock in respect to the stock’s beta & the market equilibrium
Calculating beta for an individual stock: premium rate of return
• The beta is the sensitivity of the stock's return to the market • An asset’s risk premium equals the asset’s systematic risk
return, or, the change in the stock return per unit change in measure (its beta) times the risk premium of the (benchmark)
the market return = ratio market portfolio. This expected return (equivalently, mean
𝐵𝑒𝑓𝑜𝑟𝑒 𝑟𝑒𝑡𝑢𝑟𝑛𝑠 & 𝑎𝑓𝑡𝑒𝑟 𝑟𝑒𝑡𝑢𝑟𝑛𝑠 𝑜𝑓 𝑠𝑡𝑜𝑐𝑘 return)–beta relationship is the most familiar expression of the
• 𝑀𝑎𝑟𝑘𝑒𝑡 𝑏𝑒𝑓𝑜𝑟𝑒 𝑟𝑒𝑡𝑢𝑟𝑛 & 𝑎𝑓𝑡𝑒𝑟 𝑟𝑒𝑡𝑢𝑟𝑛𝑠 CAPM.

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Capital Asset Pricing Model – for market portfolio:
𝐸(𝑟𝑀 ) = 𝑟𝑓 + 𝛽𝑀 [𝐸(𝑟𝑀 ) − 𝑟𝑓 ]
Risk premium of market portfolio = risk free rate + beta x risk
premium where beta naturally arrives at 1
• Therefore risk premium of BHP = product of benchmark
risk premium (risk premium) and relative risk of BHP
measured by beta
• This measures the risk premium of an individual asset
• In a rational market, investors receive high expected returns
only if they bear systematic risk

CAPM calculation of expected returns of portfolio:

Expected returns of market portfolio = weighted average of each

share return

CAPM calculation of Beta of portfolios:

Security Market Line (SML)

Security Market Line – represents the CAPM (mean-beta SML & Positive alpha stock (interpreting plots of securities on
relationship) – the graphical representation of the expected return-beta SML line):
relationship of CAPM: • Alpha  = actual expected return – return as predicted by
• Purpose – determines whether an investment would offer a CAPM (calculated by CAPM formula)
favourable expected return compared to its level of risk CAPM predicts that alpha should be zero for all assets. Investors will
• Illustrates – the expected return of securities of, plotted pursue positive alpha stocks ( prices) and short sale negative alpha
against different levels of systematic risk of securities (beta stocks (  prices)
= measure of risk for an individual asset)
• Slope of SML = E(rM) – Rf (MARKET RISK PREMIUM) Positive alpha/ undervalued -  = positive as it is above the SML &
CAPM predicts – that all assets lie on SML: (not all do) undervalued, buy and hold:
• Graphical representation of the CAPM to show whether the • (indicates the security is outperforming the market and offers
share is under-priced or overpriced a higher level of return than what is predicted by CAPM). The
risk that A is has, it is offering a much higher return &
therefore under-priced
o What happens next - investors will purchase the
share & cause the price to go up and lower the
expected return to reach the SML where equilibrium
is reached
Negative alpha/overvalued – overvalued, sell:
• Negative as it is below the SML (indicates the security is
under performing the market and offers a lower level of return
than what is predicted by CAPM). The risk that it has, it is
offering a much lower return & therefore over-priced
o What happens next - investors will short-sell the
share & cause the price to go down and lift the
expected return to reach the SML where equilibrium
is reached
For a single share – beta(systematic risk) is not an appropriate
measure, S.D. is. (look at tut question 5 for reference):
• Measuring excess return per unit of risk to determine
which stock is superior as a single stock portfolio (when
alpha cannot be utilise because it is not diversified
portfolio):
o Forecast returns – risk-free rate/standard deviation
(higher ratio = superior)

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 Estimating CAPM graphically:
The red line = security characteristic line (CAPM = the predicted return)
• Purpose = plot of a security’s expected excess return as a function of the excess
return of the market
• The slop of the line = beta and reflects the sensitivity of a stock’s return to
market’s return for every 1% increase or decrease in the return on the index.
Beta is a natural measure of systematic risk
o If beta is < 1, indicates the stock is less risky than the market
o Beta = 1 proportional to market
o Beta > 1% more sensitive and will exaggerate the response of the
portfolio to the market movement
o Beta = 0 no change to market change
• Steeper = stock more responsive to market movement
• Flatter = stock is less responsive to market movement and smaller return

• Understanding CAPM with the line:

o RESIDUAL RISK (Unsystematic risk) = Scattered points (shares actual returns) being returns of CBA compared to market
are not on the security characteristic line, it demonstrates the firm’s specific events have an impact on their market returns
o How do we measure this risk? = residual = measures the vertical distance from each point to the security characteristic line
▪ The actual returns also include a residual, ei, reflecting the firm-specific component of return.
▪ The vertical distance between the point of the scatter diagram and the regression line is the firm specific
risk
▪ Residual = actual return – predicted return (the security characteristic line)
• Example: CBA actual return -12% where predicted return -8%.
Portfolio risk & diversification
TOTAL RISK = sum of undiversifiable & diversifiable risk (firm
specific risk): Variance of an individual stock:
Systematic risk = standard
Variance of asset/stock = variance of market x beta of stock + deviation of the market x beta of
variance of residual/alpha (Firm specific risk – residual = difference the stock
between actual and predicted returns of the regression model =
therefore is firm specific risk) Firm-specific risk = the variance
• Therefore the actual returns also include a residual, ei, of the residual risk/returns
reflecting the firm-specific component of return.
Total risk = Systematic + firm specific risk
Diversification: Calculating & reducing portfolio risk:

• Assumption – portfolios are equally Total Variance of portfolio =

weighted (xi =1/N) where n = number of
Variance of the portfolio
shares/assets in portfolio
residual (firm specific risk) =
• Alpha, beta and residual risk of the portfolio
average variance of portfolio
are therefore equal to the weight average of
residual / n (number of shares)
the alpha, beta and residual risk of each
• Residual comprises of unsystematic risk/firm specific risk &
individual asset:
therefore a separate part of total risk (use below formula)
Calculating the returns of
portfolio =
Calculating variance of firm specific risk = residuals (ei ) are
• Weighted average of alpha of asset + weighted average of
beta of asset + weighted average of residual of asset uncorrelated, the non-systematic variance is: 2(ep) = w2A  2A (ef) +
w2B  2B (ef)+ w2f  2(ef )
Calculating Portfolio excess
returns: Total variance =
• Portfolio excess return = portfolio alpha + beta portfolio x
Market Risk premium + residual portfolio In relation to diversification for firm specific risk– as N increases,
firm specific risk decreases and the proportion of systematic risk
Variance of systematic risk (systematic risk only) = σp2 = βp2 σm2
increases & reaches it limit to only comprise of
(which is systematic risk) (because firm specific risk is reduced)

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 Question 2 – Market efficiency:
Understanding Market Efficiency:
Determination of share prices – Understanding Market Efficiency: Market efficiency:
• A share’s value is defined by – present value of expected • In an efficient market – new information is incorporated into
future cash flows: prices in an instantaneous and unbiased manner:
• Two components to efficiency:
o Informational efficiency - Reflects speed at which
new information in incorporated into prices with no
delays
• Price of share = Present value model depends on two o Market rationality - New information is correctly
pieces of information: responses & incorporated into stock prices
o 1. Future cash flows (i.e. dividends or FCF); & • If markets are efficient - investors cannot use information to
▪ Higher cash flows = higher value of consistently earn excess returns
share • New information is unpredictable - & investors cannot
o 2. Discount rate - Risk via cost of capital (risk of predict future prices or use it to their advantage to earn excess
FCFs & risk associated with the company) returns
▪ More risky company = lower value of o If it could be predicted, then the prediction would be
share part of today’s information
• Market is based on the expectations of this information &: • Stock prices are unpredictable because information is
o Prices respond to changes in expectations unpredictable
o Changes in expectations arise from new information Demonstration of new information in efficient & inefficient market
o Therefore, prices change as new information of the showing informational efficiency & market rationality:
company arrives - Over-reaction in inefficient market - market irrationality
because the price is greater than what the equilibrium price
is:
- Informational efficiency in efficient market = instant
equilibrium reached

Market efficiency continued: Efficient Market Hypothesis & Classes of information:

Market efficiency does not imply predictability EMH: prices of securities fully reflect available information about
• Market inefficiency that implies predictability: securities

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 o If market is inefficient – predictive factors (use of
technical & fundamental analysis) can be found to
predict stock prices & predict abnormal returns
• Prices in efficient market follow random walk -
Information arrives randomly and therefore prices move
randomly & therefore unpredictable
• Large movements in prices can be consistent with
efficiency markets & efficient market hypothesis because:
o This does not contradict the market efficiency
hypothesis, it illustrates that the information has a
substantial impact on a firm’s value that comes as a
shock
• Abnormal returns = Expected returns that do not need to
equal observed return
• Investors will all perform equally
o Some investors will win and some investors will
lose
Types of Stock Analysis (Technical v Fundamental Analysis) – Purpose is to use different analysis to find predicative factors to
predict stock prices & make excess returns:
1# Technical Analysis - using prices and volume information to
predict future prices by searching for repeated and predictable patterns
in prices
• Sluggish market response of stock prices - If the price
responds slowly enough, the analyst will be able to identify a
trend that can be exploited and makes profits during the
adjustment period.
o Success depends on a sluggish response of stock
prices to supply-and-demand factors
• Opposes efficient market & contradicts Weak form
efficiency market because:
o The past history of prices and trading volume is
publicly available at minimal cost – if technical
analysis is used then it contradicts a weak-form
efficient market because the previous prices and
volumes of the stock do not fully reflect the stock
price.
• The adjustment period is a predicative factor that can
lead to excess returns whereas in a weak-form market, as
investors compete to exploit their common knowledge of a
stock’s price history, they necessarily drive stock prices to
levels where expected rates of return are exactly
commensurate with risk. At those levels one cannot expect
abnormal returns.
• Part of the technical analysis involves finding the:
• Meaning – that investors cannot use any other information to
predict future stock prices and consistently make excess
returns
Different versions of EMF that differ by the classification of
information & what is available information there is:
• A market is Weak form efficiency if:
o The current market prices fully reflect information
contained in past stock prices and volume
• A market is Semi-strong form efficiency if the information
reflected in the stock prices include publicly available
information of:
o Market trading data including weak form
information + accounting information on the
company (financial reports, capital structure changes
and takeover announcements)
▪ This information includes financial reports,
press releases, stock exchange
announcements,
• A market is strong form efficiency if the information
reflected in the stock prices include:
o Weak form information + Semi-strong + private
information that is held by company insiders
• If private information is reflected in the stock price = strong
form efficiency
• If the possession of private information leads to excess returns
& the insider trading is profitable = strong form efficiency
does not exist
2# Fundamental Analysis: using economic and accounting
information to predict stock prices:
• It uses earnings and dividends of the firm, expectations of
future interest rates, and risk evaluation of the firm to
determine proper stock prices. Ultimately, it represents an
attempt to determine the present value of all the payments a
stockholder will receive from each share of stock.
o If that “intrinsic value” exceeds the stock price, the
fundamental analyst would recommend purchasing
the stock.
• Analysis relies on finding firms that are mispriced, i.e. find
poorly run firms that are not as bad as the market thinks
• Fundamental analysis contradicts Semi-strong form
efficiency:
o If the analyst relies on publicly available earnings
and industry information, his or her evaluation of the
firm’s prospects is not likely to be significantly more
accurate than those of rival analysts. There are many
well-informed, well-financed firms conducting such
market research, and in the face of such competition
it will be difficult to uncover data not also available
to other analysts.
• Finding firms that are better than what everyone thinks –
is critical to the success of fundamental analysis:
o The trick is not to identify firms that are good but to
find firms that are better than everyone else’s
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 o Resistance levels (upper bound of stock price
movements) - A price level above which it is
supposedly unlikely for a stock or stock index to
rise.
o Support levels (lower bound of stock price
movements) - A price level below which it is
supposedly unlikely for a stock or stock index to
fall.
Market Anomalies – Using Fundamental and Technical analysis to find anomalies to predict future stock prices:
Market Anomalies - Patterns of returns that contradict the efficient market hypothesis & can be used to predict future stock prices
• Once an anomaly is identified it signals a buy or sell signal
Anomaly 1# based on Fundamental Information - Firm size and
returns effects in the US market :
• Small firm effect – Stocks of small firms have earned
abnormal returns, primarily in the month of January.
o Average annual returns between 1926 and 2018 are
consistently higher on the small-firm portfolios.
o The smaller-firm portfolios tend to be riskier. But
even when returns are adjusted for risk using the
CAPM, there is still a consistent premium for the
smaller-sized portfolios.
o Not technically considered a market inefficiency
but rather a risk premium associated with small
firms caused by limited available information and
poor liquidity on such firms
• Small firm size & returns = market anomaly to EMH
Joint test problem associated with calculating returns on an anomaly
– requires a benchmark model to measure excess returns &
determine market efficiency or inefficiency:
• Any test of market efficiency returns compares returns
against some benchmark model:
o A benchmark is required to measure excess
returns/additional returns from the anomaly – A Determining whether a share is Growth OR Value shares through B/M
possible benchmark model = CAPM to measure ratio:
the difference from the additional returns of the
anomaly from the expected return of the CAPM
o Higher difference between excess returns =
market inefficiency
estimate. Similarly, troubled firms can be great
bargains if their prospects are not quite as bad as
their stock prices suggest.
Anomaly 2# based on Fundamental Information High Book to
market ratios (B/M) - Growth shares vs value shares:
• Book value = The book value is the value of assets minus the
value of the liabilities.
• Market value of a company is the market price of one of its
shares multiplied by the number of shares outstanding.
• B/M ratio - A predictor of returns across securities is the ratio
of the book value of the firm’s equity to the market value of
equity.
• Market anomaly rule – High ratios of book value to
market value of investments in shares of firms = generates
abnormal returns.
o The firms with the highest book-to-market ratio had
an average annual return of 16.5%, while the lowest-
ratio decile averaged only 11.0%
o The dependence of returns on book-to-market ratio
is independent of beta, suggesting either that high
book-to-market ratio firms are relatively under-
priced or that the book-to-market ratio is serving as
a proxy for a risk factor that affects equilibrium
expected returns.
• Growth shares have low book-to-market ratios
o Growth shares = shares will outperform the
market and provider greater than average-
returns in the future
• Value shares have high book-to-market ratios
o Value shares = means that the company is trading
cheaply compared to its market value & investors
are waiting to pay more for a coy that its net
assets are worse
o The results of Fama and French (1992) show that
forming portfolios ranked on the basis of book-to-
market ratios yields a differential in annual returns
between the value shares and growth shares
• RULE - In long-run, value outperforms growth:
o Market anomaly – Firms with High book-to-
market ratios generate more abnormal returns
compared to low book-to-market ratios companies
o The difference equals the value premium
• Each year stocks can be ranked into 10 portfolios based on
their book-to-market ratio to show the value premium
o The difference between the low vs high book ratio
companies = the value premium
11
 P/E (Price to earnings) ratio - Another method to determine whether
value or growth share:
• A high P/E ratio indicates the company is a growth share
because –
o Growth shares are normally associated with high
quality and high earning firms. These company
earnings are expected to continue to grow at an
above average rate relative to the market rate.
o This is why the growth shares normally come with
higher price to earning ratios and lower book to
market ratio
• High P/E ratio = growth share
• Low P/E ratio = value shares & greater returns
o These continue to generate higher levels of returns
compared to growth shares
• The difference between the low vs P/E ratio companies = the
value premium

Identify and provide reasons why, over an extended period of time,

value-stock investing might outperform growth-stock investing.

• Risk-based argument: Value stocks could be riskier than

growth stocks. That is value stocks have higher probability of
default (i.e. going bankrupt). To compensate for the higher
risk, they should provide a higher return.
• Behavioural argument: It is difficult to estimate growth rates
so growth stocks could be over valued because of optimistic
growth rate forecasts by investors. When actual growth rates
do not meet these overly optimistic growth rate forecasts then
returns on growth stocks will be lower.

3# Price Momentum anomaly – anomaly based on past price information:

• Momentum effect - The tendency of poorly performing stocks and well-performing stocks in one period to continue that abnormal
performance in following periods.
o Stocks with the highest returns in the past 3–12 months have higher returns in the future
o Jegadeesh and Titman (1993) strategy is to purchase stocks with the highest returns over the past 12 months and to short-sell
stocks with the lowest returns over the past 12 months which should average positive returns of 12% p.a.
• Good or bad recent performance of particular stocks continues over time. They conclude that while the performance of individual
stocks is highly unpredictable, portfolios of the best- performing stocks in the recent past appear to outperform other stocks with
enough reliability to offer profit opportunities.

Event Studies:
The study of the effect of an announcement (new information) on the abnormal returns it generates around announcements or particular events
(random news or schedule announcements):
High abnormal returns = good for the firm
If the value of abnormal returns is large = the announced value is a big surprise to the market or has a substantial impact on the stock
Calculating Abnormal returns from events: Equation to calculate abnormal returns (AR) using CAPM:
• Abnormal returns = the difference between actual returns • Abnormal Return =
and expected returns o = Actual Stock Return – Expected Return (from
o Abnormal returns are risk-adjusted returns CAPM)
• If CAPM is used as the benchmark to calculate excess o = Actual Stock Return - (Alpha + Beta * Actual
returns – we require two variables for CAPM model to Market Return)
estimate its expected returns: Interpretating the abnormal returns:
o beta and actual market risk premium • Negative abnormal returns = there was an event or
• Using the CAPM as our asset pricing model would account announcement in that period that caused the firm to have
for the firm’s beta and the actual market risk premium lower returns
• The study of abnormal returns around announcements or • Positive abnormal returns = there was an event or
particular events are called event studies: announcement that caused the firm to have higher returns
High abnormal returns = good for the firm

12
 o Expected returns is related to a firm’s beta and the • If the value of abnormal returns is large = the announced
actual market risk premium; therefore we need to value is a big surprise to the market or has a substantial
two variables for CAPM model to estimate expected impact on the stock
returns (beta and actual market risk premium)
Impact of Anomalies on Market Efficiency from News/information announcements:
Fundamental principle of EMH – any available news or information Announcement 1# - CAR of target firms before takeover
is reflected in the stock prices where the any new information is attempts:
introduced, a new stock price will reach equilibrium to correctly
reflect all available information where new pricing will be quickly • Pre-announcement effect on CARs - The benchmark date
adjusted by arbitrage used for this takeover announcement is -135 days prior to
takeover announcement. The abnormal returns (each dot) up
However if stock prices start to move before information was to the announcement date increases 20 days ahead of the
released or there is a sluggish response to stock price to new announcement date (straight line with date = 0)
information – we discover anomalies: o Contradicts semi-strong efficient market hypothesis
• These anomalies contradict with the semi-strong form of as a result of information leakage of the event
EMH because the information should be publicly • Post-announcement effect – satisfies Efficient market
available and reflected in the price hypothesis as it reaches a new equilibrium with no delay
Common types of announcements:
• M&A announcements
o Takeovers
• Accounting information
o Earnings announcements
o Components of earnings
o Dividend information
Purpose of event study methodology – to evaluate the cumulative
abnormal returns (CAR) surrounding an announcement period
• CAR = the sum of the abnormal returns from the benchmark
date to the each date surrounding the event

Announcement 2# - Post-earnings announcement drift:

• SUE is the earnings surprise – a factor to evaluate this information:
o The difference between actual earnings figure & previously expected announcement figure (calculated expected forecasted
figure by averaging all published earnings of the coy) of the coy
• Category 10 is the highest positive earnings surprise
• Category 1 is the most negative earnings surprise
• In an efficient market for earnings announcements we would see:
o Stock prices adjust to the new equilibrium price level without delay & new level is determined by size and sign of the earnings
surprise (The greater the absolute value of the SUE, the larger price adjustment).
o Positive news = price increase
o Negative news = price decrease
• In reality for earnings announcements – there is a post-earnings announcement drift
o The abnormal returns in the market for each level of SUE category
leading up to an announcement date (20 days prior) increases or
decreases (SUE 10# increases & SUE 1# decreases for example)
o 1st market anomaly (information leakage) - Therefore – pre-event
behaviour can be detected from the increases or decreases of abnormal
returns as a result of information leakage that demonstrates substantial
abnormal returns
o 2nd market anomaly (drift / sluggish response) – After the
announcement, the stock price does not reach its equilibrium
immediately, there is a sluggish response and takes 90 days to reach
the new equilibrium level to correctly reflect the relevant SUE
category
o Both anomalies contradict semi strong efficient market
Types of News & how market participates make profit from news (known as news trading)
Types of News: Algorithmic Trading: Pre-Trade Analysis:

13
 • Profitable news driven event trading requires gathering
information from the right sources, stories or other “textual
events” and assigning quality metadata to filter that
information.
• Early forms: easily quantifiable news – scheduled economic
and industry reports/announcements and company specific
announcement news(this was discussed before)
• Modern news: textual feeds (social media feeds) – provide
detailed topic information on a stock or industry, taxonomies
and entity extraction (helps determine the measure of news
analytics)
o News analytics (measure of entity extraction):
measure the relevance of the news feed (measure
how relevant news feed is to a specific company),
sentiment (is it positive or negative news for the
company or economy), relationships and novelty of
modern news (Whether the news is there for the first
time or been public for some time)
Impact of Technology on News Trading:
• Technology improvement = allowed traders to pick up
more relevant news than before which allowed news-driven
portfolio returns to increase than previous benchmark
portfolios
• Creating a News-driven portfolio = where buy and sell
decisions of stocks based on the news are generated by the
trading signals of the news trading. (Positive sentiment =
investors buy & Negative sentiment = investors short-sell or
sell stock)
• As news-analytic technology improves – investors are
able to make more abnormal returns for news-driven
portfolios to the benchmark.
Algorithmic Trading – As technology advances - trading is
executed by algorithms – Algorithm involves:
• 1. Pre-trade Analysis – analysis of financial (historical &
live data) and news information (based on relevance of the
news, sentiment of the news and normative of the news)
• 2. Creating Trading Signal – generates buy or sell signals of
a stock
• 3. Trade execution (different algorithm) – creates actions to
buy or sell stock based on the amount to buy or sell
o Trading Plan - Also aims to reduce transaction
costs and make a large order into small orders to
reduce market impact & minimise transaction
costs
How fake news affects the market:
• Fake news moves market such as fake bankruptcy news of a
company can result in its stock price to decrease and later
clarifications will bring it back to the pre-news equilibrium
• Effect – brings unnecessary volatility to investors that harms
market quality
Two different types of Pre-trading analysis exist to generate buy and
sell signals:
1. Theory-driven – Hypothesizing the way markets behave:
• Analyses price data, fundamental data and news feeds (the
behaviour & Sentiment of the news which = relevance,
normative, and sentiment of the feeds)
• Fundamental Information – covers dividend yield, growth
rate and earnings, and quality of the company’s operations
and its debts
• Price data – historical price of stocks which has two
different approaches to be analysed by the algorithms:
o 1. Trend Following – Assuming there is
momentum in price data and price patterns will
repeat
o 2. Mean Reversion (the opposite) – Assumes
market will revert to a previous level after a large
price movement
• Therefore – creates a trading strategy to generate buy and
sell signals
2. Empirical Data-drive – Using computer algorithms such as data
mining to identify certain patterns and behaviour in stock price data
(active trade prices or Historical data)
• Once patterns are identify – buy and sell signals will be
generated
Strong-form Market Efficiency – Impact of Insider Information:
• The ability of insiders to trade profitability in their own stock
has been documented in studies by Jaffe (1974), Seyhun
(1986), Givoly and Palmon (1985):
o We do not expect markets to be strong-form
efficient; we regulate and limit trades based on inside
information.
o If markets are efficient, fully and immediately
processing that information, investors should no
longer be able to profit from following those trades.
• SEC requires all insiders to register their trading activity
14
 Efficient Market Hypothesis Part 2:
• 1# How behavioural irrationalities can show how these tendencies applied to financial markets might
result in some of the anomalies discussed in the previous chapter.
• 2# Limits to Arbitrage on Anomalies- Consideration of the limitations of strategies designed to take
advantage of behaviourally induced mispricing.
• 3# Analysing the technical analysis and show how behavioural models give some support to techniques
that clearly would be useless in efficient markets.

Behaviour of Investors
Conventional Finance presumes that investors are:
• Risk averse utility maximisers
• “Rational” Investors
• Incorporate all information into decision making
• Resources are allocated efficiently
Behavioural Finance - Models of financial markets that emphasize potential implications of psychological factors affecting investor behavior.
o The premise that conventional financial theory ignores how real people make decisions and that people make a difference
• Assumes that investors are not rational & have biases that impact their financial decisions

Two categories of irrationalities of investors:

• 1# Investors do not always process information correctly and therefore infer incorrect probability distributions about future rates of
return
o E.g. Expected returns are different what they actually are
• 2# Even when given a probability distribution of returns (they have the correct returns, means, S.D., correlation co-efficient) people
often make inconsistent or systematically suboptimal decisions
o Why – They make incorrect decisions due to their behavioural biases

Errors and Investors Biases of two categories above:

Category 1# Errors/Bias in information processing that result in Category 2# Investor Biases that result in less than rational
misestimating true probabilities: decisions even with perfect information:

1. Forecasting Errors: 1. Framing:

• What has happened in the past/recent news is more
prominent than the data available has more weight and leads
to misuse of information & incorrect decisions
2. Overconfidence:
• Investors overestimate their abilities and precision of their
forecasts or belief
• Overconfidence – could be the reason why active
management is more prevalent than passive investment
management
• Overconfidence about the precision of one’s value-relevant
information would be consistent with value-versus-growth
(e.g., book-to-market) anomalies.
o If investors respond too strongly to signals about the
fundamental value of a stock, then those signals will
cause stock prices to overshoot their intrinsic
values.
o Stocks with high prices relative to proxies for
intrinsic value will be more prone to be overvalued
and therefore poor investments.
3. Conservatism:
• Investors are too slow (too conservative) in updating their
beliefs in response to recent evidence & information &
underreact
• Decisions are affected by how choices are posed, for example,
as gains relative to a low baseline level or losses relative to a
higher baseline.
o Individuals may act risk averse in terms of gains but
risk seeking in terms of losses. But in many cases,
the choice of how to frame a risky venture—as
involving gains or losses—can be arbitrary.
• How risk is described “risky losses” vs “risky gains” can
affect investor decisions even if expected outcome is the
identical
• Experimental evidence shows that people:
o People prefer risk-free gain than risk seeking (risk
averse behaviour); and
o People prefer risky loss than a risk-free loss with
the expected same outcome (risk seeking behaviour
if loss is associated)
• Key - People are risk seeking when a loss is associated
whereas prefer a risk free gain when there is risk associated
with a gain
• Loss aversion – people weigh losses more than gains in their
decision making
• Loss aversion suggests that decision making, is sensitive to
how alternatives are framed
1(b). Mental Accounting:
• Mental Accounting - a specific form of framing in which
people segregate certain decisions:

15
 • This means that they might initially underreact to news about
a firm, so that prices will fully reflect new information only
gradually. Such a bias would give rise to momentum in stock
market returns.
• Unlike an efficient market – new information results in
market to rapidly change reach a new equilibrium
4. Sample size neglect and representativeness bias:
• Investors are too quick to infer a pattern or trend from a
small sample & think it is representative of what the market
is going to be in the future
• In general – people evaluate the probability of an uncertain
event by the degree to which the event is representative or
similar (in their mind) to the population regardless of past
probabilities = stereotyping
• What do rational investors do for relying on probability
based decisions?
o Rational investors consider population
probabilities
o Possible criticism – the population probabilities
may be incorrect
o For example - an investor may take a lot of risk with
one investment account but establish a very
conservative position with another account that is
dedicated to her child’s education. Rationally, it
might be better to view both accounts as part of the
investor’s overall portfolio with the risk-return
profiles of each integrated into a unified framework.
• Argued that the distinction between conventional and
behavioural finance theory – is that the behavioural
approach views investors as building their portfolios in
“distinct mental account layers in a pyramid of assets,” where
each layer may be tied to particular goals and elicit different
levels of risk aversion.
2. Prospect Theory:
• Behavioural theory that investor utility depends on gains or
losses from investors’ starting position, rather than on their
levels of wealth.
• Prospect theory modifies conventional view of rational risk
averse investors in standard financial theory
Conventional view – Utility depends on level of wealth:
• Illustrates the
conventional description
of a risk-averse investor.
• Higher wealth provides
higher satisfaction or
“utility” - but at a
diminishing rate (the
curve flattens as the individual becomes wealthier).
• This gives rise to risk aversion: A gain of $1,000 increases
utility by less than a loss of $1,000 reduces it (means that
when difference in utility is less when you gain $1000, than
the utility in losing a $1000); therefore, investors will reject
risky prospects that don’t offer a risk premium.
Behavioural view – Utility depends on changes in current wealth:
• Shows a
competing
description of
preferences
characterized by
“loss aversion.”
• Utility depends
not on the level of
wealth, as in
conventional
graph, but on
changes in wealth from current levels.
• As wealth increases -utility increases at a diminishing rate
= risk aversion behaviour
• As wealth decreases (negative) – investors become more
risk seeking than risk averse for losses = risk seeking
behaviour
3. Fear of regret/Regret avoidance:
16

Limits to arbitrage – impediments exists for rational arbitrageurs taking advantage of the mispricing caused by investors of behavioural
biases or errors in information processing
3 limits to arbitrage that exist:
1. Fundamental risk:
• Markets can remain irrational longer than you remain
solvent:
o Meaning - Intrinsic value and market value may
take too long to converge to the predicted
value/fundamental value of the asset
o The fundamental risk incurred in exploiting
apparent profit opportunities presumably will limit
the activity of traders
o New information may arrive that affects
fundamental value that you cannot hedge e.g. if
take a short position for an overvalued asset
and the price of the asset keeps increasing and
you keep losing
• For example – even if a share is underpriced, it is hardly risk-
free because the presumed market underpricing can get worse
o While the price should eventually converge to its
intrinsic value, this may not happen until after the
trader’s investment horizon (e.g. mutual fund
manager loses clients if short-term performance is
poor or manager uses all their capital if market
turns against them, even temporarily)
2. Implementation costs:
• Transactions costs and restrictions on short selling can limit
arbitrage activity
o Exploiting overpricing can be particularly difficult.
Short- selling a security entails costs; short-sellers
may have to return the borrowed security on little
notice, rendering the horizon of the short sale
uncertain; other investors such as many pension or
• Regret avoidance - People blame themselves more for
unconventional choices that turn out badly so they avoid
regret by making conventional decisions.
o Unconventional decision – investing in an unknown
start up firm vs a T-bill
▪ Such firms require more courage on part of
the investor
• Investing through an unconventional choice would cause
more regret than a convention decision which would
attributed as bad luck.
4. Disposition effect:
• Disposition effect – the reluctance of investors to sell shares
in investments that have fallen in price:
o Evidence suggest that investors are more prone to
sell stocks with gains than those with losses
o Argued that behavioural motives are consistent with
some investors’ irrational preference for stocks with
high cash dividends (they feel free to spend dividend
income, but would not “dip into capital” by selling a
few shares of another stock with the same total rate
of return) and with a tendency to ride losing stock
positions for too long (because “behavioural
investors” are reluctant to realize losses).
Limits to arbitrage and the Law of One Price:
• Law of One Price - positing that effectively identical assets
(e.g. kilo of gold should have same price) should have
identical prices in rational markets
o There are instances where the law seems to have
been violated. These instances are good case studies
of the limits to arbitrage
• 1# Twin Companies – demonstration of fundamental risk:
o Royal Dutch Petroleum and Shell Transport merged
their operations into one firm. The two original
companies, which continued to trade separately,
agreed to split all profits from the joint company on
a 60/40 basis
o Meaning that Royal would receive 60% of cash
flows and Shell receive 40%
o One would assume that Royal Dutch should sell for
exactly 60/40 = 1.5 times the price of Shell (the
parity ratio)
▪ Parity ratio - The parity ratio is a
percentage relationship between the Index
of Prices Received and the Index of Prices
Paid
o However there were instances where Shell or
Royal were overvalued and undervalued
o Would this give rise to an opportunity to short-sell
overpriced Royal shares & buy under-priced Shell?
▪ This seems like a reasonable strategy, but if
you had followed it in February 1993 when
Royal sold for about 10% more than its
parity value, you would have lost a lot of
money
o Why did prices deviate from parity?
17
 mutual fund managers face strict limits on their ▪ Possible argument (but no clear
discretion to short securities. indication why) - Possibly because Royal
o This can limit the ability of arbitrage activity to Dutch was a member of the S&P500 so
force prices to fair value. index funds needed to own the Royal Dutch
3. Model risk: version of the stock (excess demand)
• What if you have a bad model and the market value is actually o Purpose – demonstrate that there is irrationality
correct? behind the value of the market, due to the
o Perhaps you are using a faulty model to value the irrationality of investors and the violation of the law
security, and the price or market is actually right. of one price
Mispricing may make a position a good bet, but it is
still a risky one, which limits the extent to which it
will be pursued.
Bubbles and behavioural economics:
• Purpose – demonstrating the interaction with behavioural finance and bubbles in the market
• The behavioural view of bubbles is that the prices of whatever asset in the bubble (e.g. houses/property) is always going to go up
because everyone thinks that the price will never go down:
o Purpose – Bubbles can be driven and developed by irrational investor sentiment, that feeds on itself as investors become
increasingly confident of their investment prowess (overconfidence bias) and apparently willing to extrapolate short-term
patterns into the distant future (representativeness bias).
▪ The price keeps going up until the point the market corrects itself and the bubble pops and price fall
▪ Demonstrates – this shows how hard to is to identity the fair value of stock investments
o The rational explanation for behavioural finance for stock market bubble using the dividend discount model:
▪ S&P 500 is worth $12,883 million if dividend growth rate is 8% (value at the peak of a bubble) (close to actual value
in 2000)
▪ S&P 500 is worth $8,589 million if dividend growth rate is 7.4% (close to actual value in 2002)
▪ Demonstrates that the 8% and 7.4% growth rates are fairly close, but do have a difference in the value in the S&P
500. Bubbles can be rationalized on underlying economic theory

Technical Analysis
• Technical Analysis – attempts to exploit recurring and Technical Trading – Moving average rules:
predictable patterns in stock prices to generate superior • Trends and Corrections – Technical Trading through analysis
investment performance in a weak form efficient market of Moving Averages
• Technicians believe that: • Moving average = the average level of prices over a given
o Prices adjust gradually or closely to a new interval of time:
equilibrium/the true intrinsic value of a stock/asset o Process – For example, a 50-day moving average
o The Market values and intrinsic values converge traces the average price over the previous 50 days.
slowly The average is recomputed each day by dropping the
• Therefore, the fact that these market values converge slowly oldest observation and adding the newest.
to the intrinsic value can be exploited Rules using the market and moving average:
• Important behavioural trait of technical Analysis: • Bullish signal – Market price breaks through the moving
o Overconfidence - a systematic tendency to average line from below = Time to buy
overestimate one’s abilities • Bearish signal – When prices fall below the moving average
▪ As traders become overconfident, they = time to sell
may trade more, inducing an association Rules using the STMA (could be one day) & LTMA (could be 500
between trading volume and market days)
returns (Gervais and Odean, 2001). • Moving average rules - Examine when a short-term moving
Technical analysis thus uses volume data average (STMA) crosses a long-term moving average (LTMA
as well as price history to direct trading o If STMA moves above LTMA then this is a buy
strategy. signal
o If STMA moves below LTMA then this is a sell
signal

18
 Question 3 – Short selling/Margin loans:
Margin Trading:
Types of security transactions an investor can make: Margin account – established to execute a margin transaction, an
investor must contribute equity in the form of cash or securities
1. Long Purchase – transactions in which investors buy securities
in the hope they will increase in value and sold later at a profit Initial margin – minimum amount of equity that must be provided
• Objective = buy low & sell high by the investor
• Returns = any dividends or interest received during the Margin = your % equity required, where remaining is debit
ownership period + plus capital gains = the difference leverage financing
(capital gain or loss) between the purchase and selling
prices Maintenance margin – absolute minimum amount of margin
• Transaction costs reduce profit (e.g. fees charge by (equity) that an investor must maintain in the margin account at all
broker) times
2. Margin Trading – investors use funds borrowed from brokerage • Margin call - Investor receives this when an insufficient
firms to make securities purchases: amount of maintenance margin exists and then has a short
• Margin requirement (margin % = your equity required) - period of time (few hour to few days) to bring equity up
the minimum amount of equity (either cash or securities) above the maintenance margin
that must be in the margin investor's own funds
o The margin requirement for stocks in the US is Calculations:
50%
o The margin requirement varies in Australia Basic Margin formula:
Essentials of margin trading: 𝑽𝒂𝒍𝒖𝒆 𝒐𝒇 𝒔𝒆𝒄𝒖𝒓𝒊𝒕𝒊𝒆𝒔 − 𝑫𝒆𝒃𝒊𝒕 𝒃𝒂𝒍𝒂𝒏𝒄𝒆
• Financial leverage – the use of debt financing to magnify 𝑴𝒂𝒓𝒈𝒊𝒏 =
𝑽𝒂𝒍𝒖𝒆 𝒐𝒇 𝒔𝒆𝒄𝒖𝒓𝒊𝒕𝒊𝒆𝒔
investment returns (by buying more assets) 𝑽−𝑫
• Margin loan = loan given by brokerage coy through which 𝑽
the borrowed funds are made available to investors in a Debit balance = amount borrowed & remains constant through
margin transaction holding period
• Debit balance = amount of funds borrowed (remains Value of securities - varies based on $ of share
constant)
Calculating the price at which a margin call will be made: (solve for
Effect = Lowers margins (more debt financing) results in P)
higher % return on investor’s equity when price of security
increases (Therefore higher leverage use magnifies gains and
losses)
Return on invested capital:
3. Short selling (below)

Amount of equity at purchase = amount you have paid out of your

own account: e.g. 50% margin
Total current income received = the dividends you receive from
the share: Note it could be only held for 6/12 months or 3/12
months
Total interest paid on margin loan = loan interest which could be for
6/12 months

Annualised rate of return =

19
 Short selling:
3. Short selling – Selling borrowed securities from a broker and Process of calculating short sale profit without margins:
purchasing it back in the secondary market to repay the broker
from a bearish security (objective = sell high and buy low to repay Step 1 – Investor takes a bearish bill from the market and investor
borrowed shares) borrows securities from a broker & then sells it to the secondary
• Process – Investor borrows security from a broker; broker market:
lends securities owned by other investors
Principles:
• Investor must make a deposit with the broker equal to the Step 2 – Short sale is covered by purchasing the share back from the
initial margin requirement applied to short-sale proceeds market to repay the broker:
o Broker retains proceeds from the short sale
• Short seller must repay lender any dividends

Process of short sale with margins:

The total deposit with broker will be return once

amount borrowed is repaid

Actual margin = Equity in account/current

value of shares borrowed

Note – current value of shares borrowed

decreases & increases
Note – any dividends or interests reduces your
equity

Calculate profit = Ending equity (Initial deposit of equity + proceeds from short sale – cost to cover short sale (the repurchase of shares))
– beginning equity (initial deposit)
• compare the equities in each share price drop or increase with initial short sale price
• If price subsequently increases = loss to investors
• If price subsequently decreases = gain to investors:
o Example – when share $ is $70, account equity = $500 vs $4,500 when share price = $30

Calculating margin with short sales:

Margin = Ending Equity (Initial deposit of equity + proceeds from short sale – cost to cover short sale (the repurchase of shares)) / cost to
cover

Margin calls – requires the investor to deposit more money to reach the maintenance margin:

Calculating the price at which a margin call will be made: (solve for P)

Note the 150,000 has to include the initial margin equity deposit + sale proceeds

RATE OF RETURN = Ending equity – Initial equity/ Initial equity

20
 Question 4 – Performance Evaluation:
Methods to compare portfolio returns to benchmarks
Method 1# Index Benchmarks – Comparing portfolio to
benchmark:
• Objective of fund is dependent on the investor:
o Passive investors = want to match index
o Active investors = want to beat the index
• Objective is to outperform the index of their asset (ASX
300 index or bond index)
• Passive managers – success is measured by whether
they can match the index which is measured by the
standard deviation of active return (TRACKING
ERROR)
• Active return = Taking the difference of portfolio &
benchmark returns
• Then we take standard deviation to obtain tracking error
TE = Std Dev(Rp,t – Rb,t)
• Where:
o Rp,t = portfolio return over time period t
o Rb,t = benchmark return over time period t
• We want a tracking error as low as possible to match the
benchmark.
Risk-adjusted measures to interpret portfolio performance (remember you want to use each method for the market returns (as the
benchmark) & each stock/asset)
Method 1# - Sharpe Ratio:
(𝑅̅𝑝 – 𝑅̅𝑓 )
• Sharpe Ratio:
𝜎𝑝
• 𝑅̅𝑝 = Average return on the portfolio
• 𝑅̅𝑓 = Average risk free rate
• 𝜎𝑝 = Standard deviation of portfolio return
• The Sharpe ratio divides average portfolio excess
return over the sample period by the standard
deviation of returns over that period. It measures the
reward to (total) volatility trade-off.
• Sharpe ratio = slope of capital allocation line
• Benchmark value = Sharpe index for the market
• Risk adjusting = accounting for returns and standard
deviation of portfolio
• Higher Sharpe ratio = better as it gives greater
returns per unit of risk
• Does not take into account beta or alpha
Method 3# - Jensen’s alpha:
• Jensen’s alpha: 𝑅𝑝,𝑡 + 𝑅𝑓,𝑡 = 𝛼𝑝 + 𝛽𝑝 (𝑅𝑚,𝑡 − 𝑅𝑓,𝑡 )
Method 2# Adjusting return for risk by comparing to other
funds:
• A simple way to adjust returns for risk is to compare the
portfolio’s return with the returns on a comparison
universe
• Compare your portfolio to other funds with the same
objective – either beat the index or match it to evaluate
their performance
o The comparison universe is a group of funds that
assumes the same or similar risk characteristics &
therefore we can compare to performance only &
conclude which fund performed best so that we
can match it.
• For example – the Schroder Equity Fund at different time
horizons is less than the 75% percentile in year 1, therefore
it is not performing within the top 25% of funds, & year 2
it is above.
• Disadvantage of comparison – Highest performing fund
may have the highest BETA & therefore only performed
well because the market went up – measures below
account for this
Method 2# - Treynor measure (measures return per unit of
systematic risk)
(𝑅̅𝑝 – 𝑅̅𝑓)
• Treynor measure:
𝛽𝑝
• 𝑅̅𝑝 = Average return on the portfolio
• 𝑅̅𝑓 = Average risk free rate
• 𝛽𝑝 = Beta of portfolio
• Like the Sharpe ratio, Treynor’s measure gives
excess return per unit of risk, but it focuses on
systematic risk instead of total risk.
o Steeper line on graph = better risk-return
trade off
• Treynor measure = Slope of security market line
• Superior performance indicated where the Treynor
index exceeds the market risk premium (MRP)
• Higher treynor measure = better as it gives greater
returns per unit of beta/systematic risk
• Compare to market – market beta = 1 & compare
excess returns
Method 4# - Information Ratio:
Interpretation 1#
21

o 𝑅𝑝 = Return on the portfolio
o 𝛽𝑝 = Beta of portfolio
o 𝑅𝑓 = Risk free rate
o 𝑅𝑚 = Return on market index portfolio
o 𝛼𝑝 = alpha of portfolio (on Excel, alpha = the
intercept of the y axis of the CAPM regression)
• Jensen’s alpha is the average return on the portfolio over
and above that predicted by the CAPM, given the
portfolio’s beta and the average market return.
• If a fund is performing to expectations (relative to
CAPM) then alpha would be zero
• Alpha is positive = Superior performance
• Alpha is negative = Under performance
• Alpha is 0 = performing the same as index taking into the
risk of the portfolio (beta)
Alpha of market always = 0, therefore if alpha is positive =
outperforming the market
Which measure is appropriate?
Choosing a measure is dependent on your portfolio:
• Sharpe ratio (measures total risk) (portfolio = one
asset) – use when the entire portfolio is the entire risky
investment (e.g. shares) because you wont get any
diversification benefits as it you would get the entire risk
of your portfolio
• When you have diversification (such as bonds fund,
and equity fund in your portfolio) – where your
portfolio is combined into a larger investment – use the
Jensen or Treynor measure because you have
diversification available:
o You wont use Sharpe ratio – as it measures
total risk & your idiosyncratic risk will be
diversified away
o Therefore – use measures accounting for
systematic risk
• Treynor measure or Jensen (rely on Treynor) = accounts
for systematic risk
𝛼
• Information ratio: 𝜎 𝑝
𝜀𝑝
• 𝛼𝑝 = alpha of portfolio
• 𝜎𝜀𝑝 = idiosyncratic risk
• The information ratio divides alpha by nonsystematic risk,
called “tracking error” in the industry. It measures abnormal
return per unit of risk that in principle could be diversified
away by holding a market index portfolio.
• The information ratio quantifies the trade-off between alpha
and diversifiable risk.
• How much alpha can you generate per unit of idiosyncratic
risk from deviating the benchmark or from your portfolio
• Higher alpha = superior as higher return per unit of
idiosyncratic risk
• Takes into account the fund’s beta
• Extra return for extra firm specific risk
Interpretation 2# (not used as much)
• 𝑅𝑏 = return on the
benchmark
• 𝑇𝐸= tracking error
• Assumes beta of fund = 1
EXAMPLE:
• Total Risk & Sharpe Ratio = If P or Q represents the
entire investment, Q is better because of its higher Sharpe
measure
• Systematic risk & Treynor measure = If P and Q are
competing for a role as one of a number of subportfolios,
Q also dominates because its Treynor measure is higher
• Information ratio = If we seek an active portfolio to mix
with an index portfolio (that is tracking the market or a
benchmark), P is better due to its higher information ratio
because it gives the higher alpha per unit of unsystematic
risk
Note – the measures can conflict such as a higher treynor measure
vs a lower treynor measure with a higher alpha
22
 Market timing
• One potential problem with risk-adjustment techniques is Model 1# - Treynor & Mazuy market timing model:
that they all assume that portfolio risk, whether measured
by standard deviation or beta, is constant over the relevant
time period. This isn’t necessarily true.
• Market timing is a source of variation in portfolio risk.
• Market timing - A strategy that moves funds between the
risky portfolio and cash, based on forecasts of relative
performance
a. In its pure form, market timing involves shifting
funds between a market-index portfolio and a safe
asset (e.g. T-bills), depending on whether the
market index is expected to outperform the safe
asset
b. Expectation that market returns will increase,
result in movement of funds in t-bills to market
with high BETA which will outperform due to
high sensitivity to the market causing a curve to
occur in the SML line such as panel B (This is beta Model 2# - Merton Model & Market Timing through Options:
of b + c)
c. However expectation market will decrease –
shift funds into risk-free assets such as T-bills
d. Through regression analysis, the impact on risk is
taken into account on whether the portfolio has
conducted timing to obtain higher returns when
the market is improving
Performance attribution:
Performance attribution – attributing where out-performance came
from:
• Decompose relative performance into security selection
(which assets, bonds, shares) and asset allocation (market
timing of investment into assets) – comprises of:
• Used in funds with a range of assets to determine which is
performing – where you can choose which asset class to
focus on:
o (Asset classes) Market: Equity, fixed income,
alternative investments, etc
o Industry: Industrials, Financials, Consumer
Discretionary
o Security: RIO, BHP
• How is this calculated:
• In its pure form, market timing involves shifting funds
between a market-index portfolio and a safe asset
• When excess returns (alpha) in market is positive = you
move assets risky assets
• When excess returns (alpha) in market is negative = you
move it into risk-free assets
• Effect – protect yourself from underperformance in market
and benefit from good performance of the market
• A positive value of p is indicative of superior stock
selection performance
• A positive value for Ψp indicates superior market timing
ability
• The key to valuing market timing ability is to recognize
that perfect foresight is equivalent to holding a call option
on the equity portfolio—but without having to pay for it!
• The perfect timer invests 100% in either the safe asset or
the equity portfolio, whichever will provide the higher
return. The rate of return is at least the risk-free rate
• Managers can switch between equity and bonds, so portfolio
return is comprised of a return on the equity market plus a
put option on the equity market
• Third term after theta: variable is either 0 (when excess
return in market = 0 or actual return when excess return is
positive)
• Purpose = you want to invest in beta when market is up
& invest in risk-free assets when market is down
• Total contribution from asset class i:
o NET RETURNS = wPirPi - wBirBi
o Difference in Weighted averaged return of
portfolio & benchmark for that given asset class i
• Do this for every return & then sum it to a total
The sum of the NET RETURNS should equal = asset allocation
total + security selection total:
• E.g. total sum of asset allocation of 2.2% with a net return
of 4.15% means that 2.2% can be attributed to the
outperformance in the 4.15% of net returns (picking the
right industry)
Trying to determine whether the NET RETURNS calculation is
from asset allocation (pick the right industry or type of asset) or
security selection (pick the right stocks)
23
 o Added the sum of the weights & returns of the
benchmark & sum of the weights & returns of the
portfolio to obtain the net return (difference)
o Net returns = did it beat the portfolio? (positive =
yes)
o i = asset class or security (whether industry or
equity or fixed income)
• Performance attribution – disentangles how difference in
the weighted average return of the portfolio & weighted
averaged return in benchmark across these different asset
classes or industry
Active weight = portfolio weight – benchmark weight
Purpose = shows whether your investment into that class is
underweight (negative value) or overweight (positive value)
• Contribution from asset allocation:
o ASSET ALLOCATION CALCULATION = (wPi
– wBi)rBi
o Difference between weights in portfolio &
weights in benchmark multiplied by return on
benchmark
o How much weight you allocated in an asset (e.g.
equity or fixed income) (overweight or
underweight)
o E.g. the benchmark may have a weight of 50% in
equity & your portfolio has 40% in equity =
therefore underweight, but return on equity in
benchmark may have been negative. Therefore
underweight was a good choice
o Value calculated = given the weights, the
amount% contributed to portfolio’s
outperformance
• Contribution from security selection (illustrating how the
return in the portfolio of that industry compare to the
industry you invested in)
o SECURITY SELECTION ALLOCATION =
wPi(rPi - rBi)
o Weight is fixed, and determine the difference in
return of portfolio vs benchmark for that
portfolio. Difference will drive security selection.
• Negative value = the security made a negative contribution

Asset allocation interpretation:

Health Care of -0.365% is negative because you are underweight in “active weight” and it gave positive returns: Therefore bad decision to
invest in this industry
Energy of 0.168% is positive because you were overweight in “active weight” and it gave positive returns: Therefore positive decision

Security Selection interpretation:

Industrials of -0.463% is negative because it gave less returns than the market and we were overweight; Therefore bad decision to invest
in this specific stocks in the industry
IT of 0.847% is positive contribution because overweight in the industry meaning positive returns from specific stocks in the industry

24
 Question 5 – Bond pricing:
• A variety of calculations for a Commonwealth Government Securities
• Characteristics of CGS:
o Always semi-annual
o Bond payments made on 21st of each month

Price of the bond (separate cash flow): Coupon Bonds:

100 (𝐹𝑎𝑐𝑒 𝑣𝑎𝑙𝑢𝑒) 𝐶 + 100 Variable 1 - CPN – Periodic interest payments made to bondholders
𝑃= +
(1 + 𝑦)𝑁 (1 + 𝑦)𝑁 (can be annual; semi-annual)

Zero coupon Bond: Face Value (= Principle of Bond) (FV) – the principal amount owed to
the bondholder at maturity
𝐹𝑉
𝑃= CPN = Coupon rate per period x Face Value
(1 + 𝑦)𝑛

Yield to maturity formula (rearranged): E.g. 8% Treasury bond (T-bond) paying interest semi-annual with a
1 face value of $1000:
100𝑁
Answer = CPN = 0.08/2 x 1000 = $40
𝑦 = [( ) ]−1 =
𝑃

Variable 2 - Yield to Maturity (Market interest rate) = discount rate (y)

Annuity formula (use for Integer period to maturity):

𝐶𝑃𝑁 𝐹𝑉 Annual y needs to be adjusted based on the number of coupon payments

𝑃= [1 − (1 + 𝑦)−𝑛 ] + per year
𝑦 (1 + 𝑦)𝑛 Example 3. 8% T-bond paying interest semi-annually with a current
market interest rate of 10%
Semi-annual coupon bonds: Answer: y= 0.1/2=5%

Variable 3 - Number of Periods (n):

Depends on the number of coupon payments per year and years to

maturity:

Example 4. 8% T-bond with 4 years to maturity paying interest semi-

annually:
Answer: n = 4x2=8

Settlement date (P0) = date bond is priced

Current yield:

Current yield = coupon/settlement price

Non-integer period to maturity (because its less than 6

months from the next coupon payment)
• Maturity date is 21st of maturity month
• All coupons occur on 21st of coupon payment
month and the month that is six months before/after

Step 1:
• Determine PCD & NCD
• Determine bond price (P') if settlement occurred on
NCD
• Exclude the coupon paid on the NCD date as the
purchaser may not be entitled to it
• This will reduce to an integer period to maturity
bond pricing problem

25
 • Use annuity formula to find P'
Step 2:
• Find fraction of period (f) between SD & NCD to
discount P' back to SD (DON’T INCLUDE THE
DATE of Settlement date)
• Note - fraction of period = whatever days/182 (182
is because semi annual = 182 days = 6 months – 6
month days ranges from 181-184)
o F = NCD−SD/NCD − PCD
Step 3 – Determine if Bond is cum-interest or ex-interest:
• Cum-interest = receives coupon on NCD
o Bond is cum-interest (CI) if more than 7
days between SD and NCD
• Ex-interest = does not include coupon on NCD
o Bond is ex-interest (XI) if 7 or less days
between SD and NCD
Step 4 – Cum interest bond price:

Or – Ex-interest bond:

THEN DETERMINE CLEAN QUOTE PRICE

Determining the clean quote price of a bond:
If bond is trading cum-interest then the accrued interest
between PCD and SD needs to be deducted:
Padj = P0 – C(1-f)
If bond is trading ex-interest then the accrued interest
between SD and NCD needs to be added back:
Padj = P0 – C(f)
Accrued interest = difference between settlement and quoted
prices
• Accrued interest = If a bond is purchased between coupon
payments, the buyer must pay the seller for accrued interest, the
prorated share of the upcoming semi-annual coupon.
As soon as you enter the ex-interest period (& lose the coupon
payment at NCD), the bond price decreases
• P0 is the invoice, settlement or dirty price that is paid by traders
• P is the quoted, flat or clean price adjusted for accrued interest
adj
• The adjustment for accrued interest depends on whether the bond
is trading cum-interest or ex-interest
For example – Cum-interest (seller entitled to the 30 days that has
passed= the accrued interest of the upcoming coupon payment)

Note – Bonds without the extra coupon will be less than a

bond with the extra coupon you are entitled to.

Note – on every CPD, the quoted and settlement price will be For example – Ex-interest (seller entitled to the 179 days that has
the same except every other day that isn’t a CPD passed= the accrued interest of the upcoming coupon payment)

26
Relationship Between Bond Price & Time:
• If interest rates are unchanged over time then (the
coupon rate = ytm (market):
o For a bond selling at par value, the coupon
rate equals the required yield
o As the bond moves closer to maturity, the
bond continues to sell at par
o Its price will remain constant as the bond
moves toward the maturity date
• If interest rates change over time:
o For premium bond (Coupon rate > ytm) =
the price of the bond decreases as it
approaches maturity, assuming yield does
not change (because it approaches its face
value of e.g. $100)
o For discount bond (Coupon rate < ytm) =
the price of the bond increases as it
approaches maturity, assuming yield does
not change
• At the maturity for the bond, both discount and
premium will = $100, the face value
Measuring yield of a bond:
• YTM or y = IRR of bond cash flows:
o The interest rate that makes PV of a bond’s payments equal to
its price
o The YTM (the % you would get only occurs when) = The rate
of return earned by an investor if the bond is held to maturity
and coupon payments are invested, and reinvested, at the YTM
o If you sell your bond before maturity, your ytm wont be the
same
Current yield:
• 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑌𝑖𝑒𝑙𝑑 =
𝐶𝑜𝑢𝑝𝑜𝑛 (𝑖𝑛 𝑎 𝑦𝑒𝑎𝑟)𝑁𝑜𝑡𝑒 𝑖𝑓 𝑖𝑡 𝑐𝑜𝑢𝑝𝑜𝑛 𝑖𝑠 6 𝑚𝑜𝑛𝑡ℎ𝑠 𝑡𝑖𝑚𝑒𝑠 𝑖𝑡 𝑏𝑦 2 𝑡𝑜 𝑔𝑒𝑡 𝑎𝑛𝑛𝑢𝑎𝑙)
𝑃 (𝑡ℎ𝑒 𝑐𝑎𝑙𝑐𝑢𝑙𝑎𝑡𝑒𝑑 𝑠𝑒𝑡𝑡𝑙𝑒𝑚𝑒𝑛𝑡 𝑝𝑟𝑖𝑐𝑒 )
• Premium bonds:
o Coupon rate > Current yield > YTM
• Discount bonds:
o Coupon rate < Current yield < YTM
Determining the bond’s returns due to the issue of reinvestment risk
(reinvestment risk = when you cant reinvest at the same coupon rate you
purchase the bond because the YTM (market has increased or decreased)
Sources of returns (you require all three sources to determine the HPR of
the bond:
1. Periodic coupon payments
C = CPN (Coupon rate per period x Face Value) x coupon
periods
2. Reinvestment of coupon payments
Note y for reinvestment is the rate you can reinvest your coupons
Note C = the calculated CPN above
3. Capital gain or loss (by selling the discount bond or premium bond at
the end or before they start increasing or decreasing their price as they
reach maturity):
𝐶𝑃𝑁 𝐹𝑉
𝑃0 = [1 − (1 + 𝑦)−𝑛 ] +
𝑦 (1 + 𝑦)𝑛
100 – P0 = capital gain you make because at maturity it = $100. If it is a
discount bond, you would make a capital gain OR THE SALE PRICE –
P0
CPN = figure calculated above
Holding period return:
• We use the holding period return to determine the rate of return
an investor would get for a bond at period t, maturity date:
𝐻𝑃𝑅 𝐻
𝑃0 (1 + ) = 𝐶𝑅𝐼𝑡 + 𝑃𝑡
𝑚
𝐻𝑃𝑅 4
99.450 (1 + ) = 14.119 + 100
2
Pt = SALE PRICE
m = number of coupon payment per year (m=2 for semi-annual coupon
paying bonds)
• Solve for HPR to find yield p.a.
Note CRI (Coupon reinvestment income) =
𝐶
𝐶𝑅𝐼 = ( ) [(1 + 𝑦)𝐻 − 1]
𝑦
27
 Question 6 – Term Structure:
• Term Structure is how we price bonds
Yield curve:
• Graphical relationship between the yield to maturity and the
term to maturity:
o Relationship also called – term structure of
interest rates (how we price bonds):
▪ The relationship between yields to
maturity and terms to maturity across
bonds.
• Shape of curves:
o Upward sloping yield curve - Indicates yields
tend to increase with longer maturities
o Inverted yield curve - Occurs when short-term
rates are higher than long term rates
o Flat yield curve - Rates for short- and long-term
debt are essentially the same
o Humped - Intermediate rates are the highest
Term Structure of interest rates:
• The term structure of interest rates refers to the
relationship between YTM and maturity of default-free zero
coupon bonds (pure discount bond) (each cash flow of a
bond & its particular YTM)
• Spot rate of interest (‘y’) – the YTM of a particular pure
discount bond
• Spot curve – Relationship between spot rate & maturity
(which determines pricing)
• FV = $1 (assumption for topic)
• Zj = current price of a pure discount bond with a $1 face
value (a particular cash flow discount back which is a zero-
coupon bond with the spot rate)
• Yj is the spot rate of interest on a zero coupon bond with j
periods to maturity (the time period to get that cashflow)
• 𝑧𝑗 = (1+𝑦 )𝑗
1 • To find the zj of a two year bond & so on:
𝑗 o Use the spot rate from the
Re-arrange to find spot rate (annual compounding) of zero coupon
bond for a single cash flow:
1
− payment 1 & solve for the
• 𝑦𝑗 = (𝑧𝑗 ) 𝑗
Price of bond if it was semi-annual compounding of zero coupon
bond for a single cash flow:
1 ytm 2. Then use spot rate
• 𝑧𝑗 = 𝑦𝑗
(1+ 2 )2×𝑗
YTM & bond pricing:
• Investors do not price a bond using the same discount rate (y)
for each cash flow
𝐶 𝐶
• 𝑃 = 1+𝑦 + (1+𝑦)2 + ⋯
•Principle - Each cash flow will have it’s own discount rate
that is dependent on the time taken for the investor to receive
the cash flow
• Principle – A coupon paying bond is equivalent to a package
of zero coupon bonds where each cash flow has its own Face
Value which has its own discount rate (y). Each discount
rate is the term structure of interest rates
• Bond pricing in previous topic involved pricing bonds with
YTM which was a fixed valued for each cash flow
Bootstrapping the spot curve (obtaining spot rates of ):
• Purpose - Using the coupon payments & prices of different
bonds to derive the spot rates for different maturities:
o We are only interested in a single coupon payment in a
year
• Assume that every coupon payment for one year is zero coupon
bond.
• To find the zj , the price of zero coupon
bond of one year:
o Find the ytm of the bond to
obtain the spot rate of the
individual one year cash flow,
then use the spot rate to find the
zj. (the price of the one year zero
coupon bond)
previous one year bond as
the ytm for coupon
spot rate for final and
single coupon payment of
to find zj for price of the
2nd cash flow/coupon
payment
• Repeat process for 3 year bond & 4 year bond etc..
Then we solve for the price of the bond of a 3 year bond using the
spot rate of each cash flow or the zj of each cashflow/zero coupon:
You can now use the spot rate of each zero coupon bond to price
any new issue 3 year bond in the market.
28
Forward rates – interest rates that can be calculated in the future:
• Given a set of pure discount bond prices (zj), we can
calculate a set of forward rates defined on date t as ft(j,k)
• Time period from period j to k - Forward rate can be
locked in on date t for a loan starting date j≥t and maturing
on date k≥j:
o This will remove investment uncertainty and risk
• t=the time to the forward rate is set (e.g. in 1 year or
calculated forward rate today t = 0)
• Forward rates allows you to calculate the interest rate/ytm
in the 2nd year of a bond to determine whether there is an
arbitrage opportunity (whatever the periods of j period, the
spot rate = the starting date & k period spot rate = the
maturity/end date)
o Obtaining a two year bond or one year bond and
then rolling over to obtain another one year bond
(which equals the two year bond) should have the
same yield to maturity as the 2 year bond &
obtaining one year and another one year bond
o If the yields don’t equal, then there is an
arbitrage opportunity to choose the bond with
the higher rate
• Note that below: y1 = the spot rate of 1 year zero coupon
bond & y2 = spot rate of 2 year zero coupon bond
• You are determining the forward rate in year 2 of (1 +
f0(1,2)) from year 0 to determine whether the ytm of a 2
year bond = the ytm of a one zero coupon bond & then
+ rolling over and reinvest in another 1 year zero coupon
bond:
• If (1+ y1) + (1 + f0(1,2)) does not equal (1+ y1)2 = arbitrage
opportunity
Calculating the forward rate:
• To preclude arbitrage, the following relationship between the
forward rate, the j-period spot rate & the k-period spot rate:
• This equations demonstrates that arbitrage is prevented when
you take the spot rate of one year (j) and the spot rate of the
2nd year (k), should equal the same as taking a two year bond
Re-arrange to find the forward rate:
Note – if semi-annual calculations make sure to x 2 to get annual rate
Illustration – it is the spot rate of period k and period j. From the
timeline on the left, the forward rate (ratio of the longer term spot rate
by the power of how far that period is divided by the shorter term spot
rate by the power of how far that spot rate is) & adjusting for holding
for multiple time periods of (1/k-j) (this gives a per annum value
because you would calculating the forward for e.g. two years)
determined at year 0 between year 1 & 2 is:
Therefore gives the forward rate/ytm at time today of a period you
want to roll over in. Slide 21 demonstrates that you could find the
forward rate of any period and roll over into that period by e.g.
purchasing a two year bond and rolling over for one year by calculating
the forward rate of one year which is the period between year 2 – 3.

Purpose – the forward rates of each option should give you the same
returns/yield and therefore prevent any arbitrage opportunity

• Spot of longer period / spot rate of shorter period

• 1/k-j = an adjustment to make the value per annum because
you are calculating f0(1,3) which is a two year period forward
rate
• yk = spot rates
• Note – you need to bootstrap first to get the spot rates to
calculate forward rates

Theories of term structure:

1# - Expectations theory: 2# Liquidity premium theory:
• Asserts that forward rates are market expectations of • Corporations & governments prefer issuing long-term
future interest rates or the spot rates (the forward rate of one securities (to ensure capital)
year time will be equal to the spot rate in that year) • Investors prefer shorter term securities

29
 • Principle - The forward rates will be the expectations of • Due to the different interests of investors & corporations – to
future spot rates entice investors to purchase bonds with maturities longer than
• This is based on unbiased expectations & zero average holding periods they offer a liquidity premium
forecast errors: • Why offer premium? They are more liquid and cheaper to
o On average that the expectations theory is true trade
• Asserts that the yields/holding period return of each • Therefore the forward rate = expected future spot rate &
investment option of either taking a 4 year bond or 4 liquidity premium (to encourage investors to hold longer
different one year bonds will be the same bonds):
• If yield curve is upward sloping, then interest rates are
expected to rise in the future
• Assumptions – risk neutrality of market participants • The liquidity premium is offered because – investors want
(therefore there is no risk aversion of investors), & does not compensation for the risk of uncertain selling prices when
consider reinvestment risk (where the forward rate will not investors purchase long term bonds that are beyond their
equal the spot rate in the future) intended holding period. If the bond is held to maturity,
• There is no risk premium built into bond prices under investors know their face value and coupon payments,
the expectations hypothesis however prior to that, they do not.
• Larger premium for longer maturity bonds
Note – the liquidity premiums may differ, may be constant, increasing
to time to maturity:
Do we need to cover the liquidity graphs?
3# Market segmentation theory (based on supply & demand of
different bond periods)
• The market for debt is segmented on the basis of the
maturity preferences (some investors want short or long
term bonds) of different financial institutions and investors:
• Principle – the yield curve changes based on the supply and
demand of fund for different bond periods that investors
want which determines the interest rate
• If supply of funds > than demand for short-term loans =
short term rates will be low
• If demand for long-term bonds > than supply for long-
term funds = long term rates will be high
• Therefore – cant use forward rates because everything is
based on supply and demand

30
 Question 7 – Interest Rate Risk:
• How to measure interest rate risk & bond price volatility which is duration
• How bond characteristics impact duration & interest rate risk
• Managing & hedge interest rate risk – use duration to hedge out interest rate risk
• Limitations of duration
Interest Rate Risk:
• Bond price volatility – the fluctuation of bond prices (non-
directional)
• Volatility focuses on the relationship between price & yield
& how a change in the yield of a bond affects its price
• Factors include - coupon rate, term to maturity and the pre-
existing yield impact on how volatile a bond price is to a
change in the yield
• As yields go up, price of bonds go down
• As yields go down, prices of bonds go up
• Higher maturity period = more sensitive
% change in price:
Lowest coupon & highest period to maturity = highest percentage
change with yield change
Purpose – when yields change, bond prices change for different
bonds:
• Focus on sensitivity of bond prices on changes in yield
Measure of Risk:
• Previous topic outlined that the term of structure of interest
rates implies that each cash flow is discounted at a spot rate
based on the timing of each cash flow
• HOWEVER – The measure of Duration focuses on one
single rate – the yield to maturity
• The yield to maturity represents the duration:
o The YTM represents the term structure (the yield to
maturity and yield of bonds) if:
o The term structure is flat (a flat term structure
represents that if the yield against the yield to
maturity is 5%, then spot rates of each coupon = 5%)
• Therefore – yield curve is assumed flat to measure interest
rate risk
Calculation the change in price of bond when yield changes:
• Requires differentiating the bond pricing equation to
determine what changes are in price of bond when yield
changes:
𝐶 𝐶 𝐶+𝑀
• 𝑃 = 1+𝑦 + (1+𝑦)2 + ⋯ (1+𝑦)𝑁
• Note that this is flat term structure = y = spot rates which are
equal
Method 1# - Dollar Duration (dollar change in price)
End product from differentiating the above equation = Dollar duration
formula (the dollar change in price of a bond from a change in yield)
• N = time period to receive cash flow
• C = cash flow
• M = Face value
Properties of changes in bond prices:
• Assumption that a flat term structure is adopted:
• Meaning – the YTM of all bonds are the same & the yield
curve is flat
Characteristics:
• 1. Bond prices move in opposite directions to yield:
o Increase yield = decrease bond price
o Decrease yield = increase in bond price
• 2. BUT percentage change is different for different bonds
• 3. For small changes in yield = the same percentage change in
price (symmetrical)
• 4. For large changes in yield = different percentage changes
in price for different bonds
• 5. For a given large change in yield = any percentage price
increase (any capital gain in a bond) will always be greater
than the percentage price decrease (any capital loss in a bond)
Duration concept:
• Duration – measure of interest rate risk (measures bond price
volatility)
• Adopting a flat term structure = changes in yields results in
shifts of term structure in parallel fashion
• Duration takes into account:
o Reinvestment risk (because you reinvest your
coupons) vs capital gain (or price) risk
• If yields go up then:
o Bond prices fall
o Reinvestment rate increases (because reinvesting
coupons at a higher yield is beneficial)
o Technically if the bonds were held for a amount of
time, the effects of bond prices and reinvestment rate
increases should cancel each other out as they work
opposite to each other)
Dollar duration interpretation:
• A higher measure of $duration implies greater interest rate
risk:
o A larger $ change in price of a bond will result from
a given change in the level of yield & therefore
riskier
• The negative sign implies that duration is a positive number
as the price-yield relationship is inverse
• Note: there are two assumptions
o Flat term structure (spot rates equal other = yield
curve)
o Therefore - Parallel shifts in the yield curve (bonds
with different maturities/periods but same yield
results in equal changes in the yield due yield
changes)
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Method 2# - Modified duration (% change in yield): Method 3# - Macaulay duration (D) (two possible interpretations):
• Modified duration (MD) scales the $duration by price to • Original equation scaled both sides by P (price)
give a relative change: • dP/P = % change in bond price
o Modified Duration = $Duration / P • dy/(1+y) = (change in yield / 1+ yield) = % change in bond
• Result = gives a percentage change in price for a level change yield
in yield • N = time to receive the cash flow
Interpretation: • M = maturity cashflow
• Higher modified duration → higher risk as percentage • C = cash flow
change in bond price will be higher for a given yield change

• For small changes in yield, we can use duration to estimate

the dollar change in price (dP) by rearranging:
o dP = −$duration dy = −MD P  dy Interpretation 1#:
OR (rearrange) to calculate new bond price due to basis • Macaulay duration can be interpreted as
the percentage change in price given a
point increase: percentage change in yield
𝑑𝑃
o 𝑃 = −𝑀𝑜𝑑𝑖𝑓𝑖𝑒𝑑 𝑑𝑢𝑟𝑎𝑡𝑖𝑜𝑛 ∗ 𝑑𝑦
𝑑𝑃
Then new price is (1 + )*P
𝑃
OR solve for change in price dP for basis point change:
o dP = −MD P  dy
Then you could use dP/P = to find the percentage change
in bond price
WHEN THE INTEREST RATE CHANGES USE MODIFIED
DURATION
Interpretation 2# (can be used in excel or hand written):
• Macaulay duration can be interpreted as the discounted-cash-flow- weighted time to receipt of all its promised cash flows divided by
the price of the security
• Note – semi annual compound in questions:
o C = coupon
o T = time period to receive cash flow
o N = time to maturity or time to receive the cash flow

• Wt = the present value of each individual cash flow at that time as

a percentage as price /sum of all present value of cash flows

• WN = the present value of face value + last coupon / sum of all

present value of cash flows

Use Annuity formula (use for Integer period to maturity): to find P (which
is P0:

𝐶𝑃𝑁 𝐹𝑉
𝑃= [1 − (1 + 𝑦)−𝑛 ] +
𝑦 (1 + 𝑦)𝑛

•Weight of individual cash flows = PV(CF)/sum of all cash flows

o Where sum of weights Wt + WN = 1
Then apply to obtain Macaulay duration through: weight x time to receive cash flow

• The weight = present value of the each cash flow, which are the coupons & the face value & last coupon
• Weights of each cash flow x t (time to receive cash flow) = years to receive: Must do this for every cash flow and add them up
to get the duration as it is the SUM

Interpretation of Macaulay duration:

• In this interpretation – Macaulay duration measures the average time taken for a bond to repay original investment (the price of the
bond), taking into account discounting

32
 • It is measured in units of time (years)
• Illustrates how it will take for a bond to repay its cash flows, the weights are multiplied by the time to receive the cash flows
• Risk interpretation = Higher duration = riskier
o A bond with duration of 5 years is riskier than a bond with duration of 3 years
Usually start from Macaulay duration to find the Modified duration & $ duration:

Properties of Duration – how measure of interest rate risk varies with characteristic of bonds:
• Focus on Macaulay duration (D) & Modified duration (MD)s
• Longer duration = higher price volatility (more sensitive to yield)
1# Maturity: Yield to maturity:
• Longer time to maturity = higher duration • Higher yield = lower duration
• Duration is increasing with maturity but not in direct • In terms of the Macaulay duration: the weights attached to
proportion except for zero coupon bond which will be the early cash flows are higher when discount rate is higher &
same therefore receive it quicker
• Macaulay duration approach – the weighted average time • Higher yield results in higher discount rate & therefore higher
represents how quickly the investor will receive his costs of yield bonds are less sensitivity to yields
purchasing the bond • Price sensitivity decreases as YTM increases:
• Therefore - Shorter the maturity, the sooner the investor is
going to recover costs of purchasing bond and shorter the
bond duration

Coupon rate:
• Higher coupon rate = lower duration = less risky
• Higher coupon, sooner investor is going to recover costs of
purchasing bond and shorter the bond duration
• A zero coupon bond represents the maximum period to
recover your costs of investing
• As ytm decreases, price becomes linear and illustrates its low
sensitivity
• Duration of bond changes over time/every day – it is not
static:
• Macaulay duration of zero-coupon bond = time to
maturity (because that’s the only time you receiver that cash
flow) & very sensitive to interest rate risk

Using duration in portfolio/banking context to hedge interest rate risk

Goal of Portfolio managers – maximise gains and minimise losses:
What should a portfolio manager do if interest rates expected to
decrease? Note the inverse relationship between bond prices & yield
• If interest rates go down - Move funds from bonds with
short duration to bonds with large duration because you want
bonds that are more sensitive to yield changes which are
bonds with larger duration
• All bond prices will increase but bonds with large duration
bonds will increase more in value because bonds with higher
durations are more sensitive
• Maximise gains from change in interest rates
What should a portfolio manager do if interest rates expected to
increase?
• If interest rates go up - Shift funds into short duration
bonds; or
Using duration for hedging for Portfolio duration:
• Duration of a portfolio = Weighted average of the duration of
securities that make up portfolio:
• The weights (xi) are based on the
market value of the securities, so
you need to use settlement prices
(price you pay for bond), not
quoted prices
Contribution of each security to portfolio duration = weight of security
* duration of individual security

33
 oBecause when interest rates go up, price of bonds
with less duration will be less sensitive to price
decreases than bonds with large durations
• You could move assets into shortest duration into cash (get
rid of interest rate risk because the duration is 0)
Therefore – KEY:
• Large durations bonds = more sensitive for when interest
rates go down
• Small duration bonds = less sensitive for when interest rates
go down
Assumption that yield curve is flat
Example of using duration to hedge risk (remove your exposure to interest rate risk):
• Liability hedging with asset portfolio = reducing the volatility of an asset’s present value to the value of the liabilities due to time

•Question on slide - A manager has a liability of $10m to be paid in 4 years. They want to hedge this liability by purchasing bonds.
There are no 4-year zero coupon bonds. There is a 2 year 8% bond and a 10 year 6% bond paying coupons semi-annually. The yield
curve is flat at 7%.
o Q: Find the number of 2 year bonds (n2) and the number of 10 year bonds (n10) needed to hedge the liability, assuming the
bonds have a face value of $100,000
• Goal – to make the change in the price on the liability = the change in the price of our asset as interest rates change to offset each other
USING DURATION to determine how bond prices will change to yield:
Macaulay duration equation can be rearranged to determine what the change in price
will be with a change in the bond’s yield (note /2 is for semi-annual)

Therefore it can be further rearranged to obtain a

approximation of what the change in price will be:

Meaning = change in price = how the price changes in respect to the yield → then dP/dy can be substituted in for negative duration x price/ 1+
semi-annual yield)

Effect – will tell us how the price changes with response to yield

• If we want ΔP(liability) = ΔP(asset), then the price of the asset (bond portfolio) should equal the price of the liability and the
duration of the portfolio should equal the duration of the liability
• EFFECT – if both the liability and asset have the same price and duration they will response in the same way to offset each other
when interest rates change

APPLICATION – require duration of liability and price & duration of bonds:

D (liability) = 4 years
𝐹𝑉 10,000,000
Price or value of (liability) = discount liability through zero-coupon bond 𝑃 = = = 7,594,116
(1+𝑦)𝑛 (1+0.07/2)8
D2 (Duration calculation for 2 year bond) = 1.889 (conducted from equations above or excel or given
𝐶𝑃𝑁 𝐹𝑉
P2 = (Price of 2 year bond through Annuity formula (use for Integer period to maturity) 𝑃 = [1 − (1 + 𝑦)−𝑛 ] + =
𝑦 (1+𝑦)𝑛
4000 −4 ] 100,000
[1 − (1 + 0.035) + (1+0.035)4
0.035
Repeat for 10 year bond:
D10 = 7.559 P10 = 92,893

NEXT STEP = we want the value of the assets to = value of liabilities & duration of assets
= duration of liability:
• Want to determine the weights of the two bonds that give the same value of the
portfolio and same duration as the liability:
• Where xi (weight of the asset)
o ni = number of bonds
o Pi = price of the bond
o Vp = value of the portfolio

• Principle - xi + xi = 1 (Meaning the sum of the weights in the bonds have to equal 1)

34
 • Therefore = the weight of bond x2 × duration of bond 2 + (1- x2 )× duration of
bond 10 = the duration of the liability which is 4
Therefore re-arrange to solve for
x2:

Question asks for the number of 2 year and 10 bonds required – therefore use to solve for ni (the number of
bonds):
• Rebalancing of weights of bonds required to maintain hedge – the duration of liability
will change with the duration of the assets over time as the liability is a zero-coupon bond &
was change linearly as it approaches maturity & the two-year & 10 year bond wont

Refer to solutions 9 for changes in interest rates and heddgin

Problems with duration:
Limit 1# - Changes in yield can only be small: Limit 2# - Yield curve is flat at time of investment:
• Duration calculation only works for small changes in yield to • Use initial yield to compute selling price and reinvestment
give a meaningful measure of interest rate risk. income
• The graphical relationship of bond prices to yields is convex • Expected return is the same as initial yield
where duration is linear-relationship. If yields changes are Limit 3# Small parallel change in yield curve is required
large, the duration measure will have errors. • If yield changes are extremely volatile then, duration is not
that helpful
Limit 4# - Only one change in interest rates is allowed after the next
coupon payment date & not any more:
• Different reinvestment rates violates parallel shift
• Duration changes after a change in interest rates
Limit 5# - Duration states price changes are symmetrical – this is not
true:
• If yield increases 10 basis points, then duration states change
in bond price will be proportional, which is not true

Limit 6# - Rebalancing is required as duration changes over time as it

is a non-linear fashion, except for zero coupon bonds which are linear.
Convexity – relationship between price & yield is convex & duration • The duration measures are linear approximations that do not
is a linear relationship: capture the convex relationship that exists between price and
yield
• Purpose – Get more accurate bond price changes in respect • Be aware of the principle – that BONDS HAVE DIFFERENT
to yield CONVEXITIES (the curvature of the bond)
• Blue line = duration approximation • More convexity = better (assuming bonds have same
• Concept of convexity - Bonds have different convexities, as duration)
Bond B is steeper (price change) when yield increases and • Consider two bonds, B and A with convexity B>A
decreases in-comparison to Bond A o B will have higher price whether market yield
• Bond B is the better bond, as yield increases, bond B increases or decreases
decreases its price less than Bond A & when ytm o Capital gains will be higher when yield falls and
decreases, Bond B increases quicker than Bond A due to o Capital losses will be lower when yield rises
its convexity (Both bonds have the same ytm & duration) • Bonds with higher convexity will have a premium - The
• market will price convexity as it is valuable → premium
o The premium will be higher when there is higher
expected volatility
o If yields are expected to be stable then investors will
not pay much for convexity

35
 Question 8 – Socially Responsible Investing:
• What is responsible investing?
• There are common elements but many differences in approaches
• Investors should care about Environmental, Social and Governance factors
• How has the responsible investing market grown?
• What is fiduciary duty and why is it important?
• Divestment vs engagement
• How should investors try to change corporate behaviour
• Do ESG factors impact risk?
• Is there a performance penalty for being green and responsible?
• What is “greenwashing”?

What is responsible investing:

• Responsible investing – consideration of non-finance impacts of Social (S) factors (how the company is treating their employees)
investments and call for firms/investors to respond or take action: • Human rights
• Investors engaging in responsible investing considers o Modern Slavery Acts around the world
environmental, social and corporate governance (ESG) criteria • Employee relations
in addition to the financial return being generated o Physical safety and mental health
o These criteria are incorporated in the portfolio o Labour strikes
construction process o Employee diversity
o These factors focus on the practices of companies • Local communities
/understand how companies are addressing these issues o Indigenous engagement
on employees, the environment and the company level • Businesses in conflict areas (businesses profiting from
(what are they doing or what could they do better) misconduct)
o They provide guidance on what types of companies to o E.g. current tensions Myanmar
include in a portfolio • Animal welfare
• A spectrum exists of responsible investment approach to cover
ESG factors into investments Governance (G) Factors (company’s and its board and their
• Who are responsible investors? behaviour)
o Individuals • Executive compensation (is it excessive compensation
o Institutional investors (managed funds and for executives)
superannuation/pension funds) • Corporate board composition
o Sovereign wealth funds and governments o Gender and diversity
o Foundations, family offices and university endowments o Independent directors
Environmental (E) factors: o Experience (are they experienced and fit for
• Climate change the work)
o Energy usage (reduction/more energy efficient products) • Tax avoidance – bad corporate behaviour
o Greenhouse gas emissions (different companies have • Corruption
different measures for the emission scores)
• Pollution (are companies trying to reduce their pollution through
their products)
• Water conservation and use
• Sustainable land use and deforestation
• Plastics
• Biodiversity (reduction in biodiversity/animals & plants in
ecosystems, is a concern as a result of their products or services)
• Waste
• The spectrum of responsible investment approaches with two extremes from traditional investment – no consideration for ESG factors
to philanthropy to targeting & making ESG goals with no direct financial return

36
 • In-between covers different Responsible & ethical
Investment approaches that can be taken:
• ESG Integration - Consideration of whether ESG
factors will affect the returns of your investment
• Norms-based screening – rewarding companies that
meeting and go above the minimum standards of
business practice & excluding companies that do not in
your investment
• Sustainability themed investing – Specifically
targeting investment themes such as low carbon
• Impact investing – trying to have a positive and social
and environmental impact & targets financial return
(the point is to have ESG impact through investments)
Spectrum of traditional Investment to Philanthropy
Investing that aims to contribution solutions:
• Apart from traditional investment, responsible &
ethical investment is trying to avoid harm
• Traditional Investment ignores harms
• Further to the right – Positive
screening/Sustainability investing & Impact
Investing: contributing to the solutions by
investing in companies that are making a
difference & pursuing better system stability &
economic sustainability

Growth in responsible investing options to investors:

• The growth in assets under management (AUM) has been increasing around the world where previously they haven’t
• The number of investment options in traditional investment products has been growing targeting specific themes:
o New managed fund options
o New exchange traded fund (ETF) options
• There has been an increase in new investment products focused on ESG issues:
o Greenbonds, sustainability-linked bonds
• The growth has been driven by:
o 1. Changing investor attitudes
▪ People starting to care more about ESG issues, climate change and its impact as a future generation, where
investments are driven with aligning with their beliefs & contributes to their investment utility
o 2. Recognition that ESG factors are related to risk and return:
The fact that ESG factors impact risk & return of investor’s portfolio (e.g. these factors being priced in the market & could lead to higher prices
or market risk
Fiduciary duty, screening & engagement:
Fiduciary duty (do managers need to consider ESG factors?) – the legal Is Divesting or Shareholder Activism the best method to make
duty of a fiduciary to act in the best interests of the beneficiary: a difference for ESG:
• Fiduciaries make financial decisions on behalf of someone else
(the beneficiary) (e.g. Superannuation & pension funds) Method 1# of engaging in ESG: Negative screening &
• Duty - Fiduciary duty means that asset managers need to act in the divestment approach:
best interest of their investors in funds • Negative screening involves excluding companies
o The tension is whether it is the responsibility of asset involved in certain industries or countries & excluded
managers to consider ESG factors (e.g. does the fund them from your portfolio due to their involvement of
manager not focusing on climate change or other ESG alcohol; gambling; military weapons etc
mean they are not acting in the investor’s best interests? • As a fund manager, taking this into account and taking
o Historically, the focus has been on returns to be the best part in negative screening and excluding them is
interests of investors divesting
• Disregarding the potential returns of the investment
& excluding them
Issues with divestment:

37
 • How does one identify companies?
• Issues of deciding whether to exclude gun retailers or
manufacturers in the US - Walmart? (e.g. Whitehaven =
coal pollution, easy to exclude one business)
• Gambling - Woolworths (WOW) owns a lot of gaming
outlets
Effectiveness
• For every buyer there is a seller
• Divestment can lead to a shareholder base that does
not care about the issue & you not making an effective
change
Financial costs
• The investor needs to design the divestment strategy
• It can impact on fund performance, & may not impact on
addressing the ESG issue at hand – this questions on
worth of divesting
• Does divestment line up with the expectations of
beneficiaries?
o It comes back to fiduciary duty
Method 2# of engaging in ESG investing – Shareholder activism: Example – Origin Energy Company:
• A more active approach is to retain ownership of the company’s
stock or bond and engage with company management (occurred Resolutions voted on:
with RioTinto where superfunds investors sat down with the
board) Point 9.(a) Amendment to Constitution
• Meetings with the board and management Point 9.(d) Public policy advocacy on climate change:
• Shareholder voting on proposals • Purpose - How Origin Energy was behaving in terms of
o e.g. voting against excessive executive remuneration to advocacy on climate change and what their associations
directors (Job-keeper) were doing
• Submit formal shareholder proposal/resolution to the • Effect – Shareholders grouping together to have an
company impact by telling directors that they want change & what
o These proposals/resolutions can be resolved with is happening
management or voted on at AGM to:
▪ Improve climate disclosure
▪ Improve GHG emissions targets
▪ Improve board diversity
ESG concerns & risk factors:
Consideration of ESG risk factors such as climate change risk that will impact the investments in these companies and ESG goals:
ESG concerns & risk factors: Risk 2# - Reputational risk:
• Cannot ignore ESG issues because they are risk factors that impact • If market participants care about ESG issues what
portfolio returns & asset values. Whether they affect them now or happens if your company is involved in a ESG
in the future: controversy?
Risk 1# - Climate Change risk: o BP Deepwater Horizon oil spill
• Physical risk: • Controversial events impact your reputational risk where
o Floods impacting insurance companies (larger payouts & investors do not want to be associated with the company
premiums or may not want to insure people prone to & result in repercussions
frequent floods) • Therefore investors do not want to be exposed to this
o Drought impacting agriculture companies (low supply & risk if companies are involved in misconduct
increase price of agriculture/farming and price of natural
goods) Risk 3# Social-related risks:
• Transition risk: • Underpaying workers
o Carbon tax pricing can impact high carbon firms • Safety record on mine sites
▪ Firms with higher carbon emissions are valued • Modern slavery and global supply chains
at a discount (Bolton and Kacperczyk (2020) – • These can have financial and reputational repercussions
people are paying a lower price because they are
worried as the economy is transiting to a low- Risk 4# - Regulatory risk:
carbon economy • Related to all the possible risks in the ESG area:
o Electric vehicles and technological innovations are • What is the chance that changes in regulation will have
disrupting incumbents – companies not moving to an adverse impact on company performance?
electric vehicles are adversely affected

38
 • Liability risk – where doing the wrong thing, you will be liability
from:
o Stakeholder litigation and regulatory enforcement
resulting in fines & orders of compensation for victims
Responsible investing & portfolio performance & returns:
• One argument - Responsible investing constrains/reduces Sin stocks:
investment opportunity set because we exclude companies that
have adverse impacts on ESG factors which leads to a mean-
variance inefficient portfolio (because diversification isn’t
possible)
o This would mean that responsible investing would Can compare sin stocks vs non-sin stocks & whether there is
underperform
• Alternative argument - socially responsible stocks could
outperform & better adjusted performed as they will avoid costs
associated with reputation loss, corporate social crisis or potential
litigation that may arise from ignoring socially responsible
practices
• Studies have been on stock returns & ESG ratings to
determine whether responsible investing outperforms
markets or traditional investing:
o Whether companies with high ESG ratings outperform
the market; or looking at
o Returns on managed funds focusing on responsible
investing (e.g. ESG funds) – whether the returns on these
funds are worse than funds that do not take into account
ESG
• Returns differ by:
o Time periods
o ESG ratings – different firms provide different ratings
for same firms
o Risk adjustment methods differ that give different
results/interpretations (Sharpe ratio v Treynor measure)
• Will the implementation of new regulations have
adverse impacts on companies
• Where companies will face reputational
repercussions & regulatory penalties which will
impact investor returns:
o Carbon pricing/tax on businesses with high
carbon emissions
o Modern Slavery Act
o APRA guidelines on climate change financial
risks
Risk 5# - Stranded assets:
• Assets that are unable to earn an economic return before
the end of their economic life
• Transition risk – where e.g. new commissioned coal-
fired power station will be rendered useless where we are
a electric power society
• Sin stocks are companies that engage ”in socially or
morally objectionable activities”, such as alcohol,
tobacco and gaming
o Investors can screen these out of their portfolio
performance difference:
• Hong and Kacperczyk (2009):
o Find that sin stocks outperform non-sin stocks
with an alpha of 0.30% per month in the US
o Higher returns are for compensation of risk
- They argue this reflects litigation risk and
neglect from certain investors who screen these
industries out of their portfolio
• Luo and Balvers (2017)
o Argue the return difference of sin stocks reflects
“investor boycott” risk
o The higher return is a result of higher
compensation due to investors who are
excluding these investments due to negative
screening (the boy-cotting)
o Non-screening investors demand a return
premium as they need to hold the boycotted
stocks

Does performance differences of sin & non-sin stocks matter?

• There is substantial evidence that investment decisions are not made solely on financial grounds
o Certain investors consider ethical and personal values when making investment decisions
• Investors can obtain a non-financial benefit that relates to the environmental and social considerations of the investment and are
willing to forgo an amount of financial return in exchange for holding socially responsible assets
• Bollen (2007) suggests that investors may ‘consume’ the socially responsible characteristic and as a result, it would enter the
individual’s utility function
Greenwashing
• Companies using marketing and public relations to appear to be
green or socially responsible
• Greenwashing by fund managers - Sceptics argue that fund
managers are trying to market themselves a “green” to attract
flows from investors into their funds & charge them a higher fee
for profit

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• Greenwashing by companies - Similarly, firms are trying to
make themselves “appear” green to appeal to investors & increase
share prices
• The different ESG rating companies might also be assisting this
practice
o Is the rating accurate and reliable?
o Can everything be quantified?
o Undertake your own verification...

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