COMM371 - Lecture 1 - Introduction To Financial Markets

COMM371/COEC371 – Investment Theory
Lecture 1
Introduction to Financial Markets
Instructors
Prof.LOGO
Alberto Mokak Teguia
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1/30
Overview
Course Outline
Financial Assets and Valuation
Risk-Return Tradeoff
Computing Realized Returns
2/30
Why Study Finance?
Make good financial decisions yourself; help others
Understand the financial system and its impact on the economy
Career prospects
Support causes you believe in as an investor
Fun and engaging; constantly innovating industry
3/30
Goal of COMM 371
By the end of this course, students are expected to

Know the basic definitions, concepts, and facts about financial
markets and three main asset classes: stocks, bonds, and
derivatives.
Be able to apply different asset pricing methods.
Understand diversification and hedging and be able to apply

these concepts in practice.
Gain trading experience in different asset classes in a simulated

but realistic environment.
4/30
Outline of Future Classes
Class Topic
2-5 Asset returns, trading and market efficiency
6-10 Equities: optimal portfolio choice, valuation
11 Investment strategies for individual investors
Midterm: November 9, from 7:00 pm to 9:00 pm
12-17 Fixed-income securities: valuation and risk management
18-22 Derivatives (futures and options): valuation and hedging
23 Behavioral finance
5/30
Assessment
Trade Simulation Assignment 10%

Assignments 30%
Midterm exam 30%
Final exam 30%
Total 100%
6/30
Assignments
There will be seven individual assignments

Each assignments will cover one or two of the class topics
These assignments will be personal, open book, online Canvas
quizzes
You will have 1 hr. on average to complete the assignment once
started
The assignment grade will be calculated considering the best six
out of seven assignments
7/30
Assignments
Assignment Topics Date

Intro to Financial Markets
Assignment 1 September 16
Empirical facts on asset returns
Assignment 2 Trading and market efficiency September 23
Assignment 3 Portfolio theory October 14
CAPM
Assignment 4 October 28
Investment strategies for individual investors
Assignment 5 Valuation of fixed-income securities November 11
Hedging Interest Rate Risk
Assignment 6 November 25
Futures and forwards
Assignment 7 Options December 9
8/30
The Trade Simulation Assignment
You learn by managing a virtual portfolio of $100,000 in a

simulated but realistic environment
You have access to a real-time market information and
up-to-date financial statements and ratios
Trade three different classes of securities: stocks, ETFs and
derivatives (options)
You will be graded on your engagement with the platform, not on
performance of your portfolio. See syllabus and Canvas module
for more details
For more information on the platform visit Wall Street Survivor
9/30
How to Do Well in This Course
Attend lectures. Ask questions if something is unclear.
Complete all the practice quizzes and practice problems yourself,

don’t just glance over the solutions
Form a study group and discuss lecture material, practice

quizzes, practice problems, recent financial news, etc. with your
classmates
Attend weekly tutorials (post questions beforehand on Canvas)
Further questions?
– consult the textbook (it is very well written)
– come to my office hours
– post to the discussion board on Canvas
10/30
Questions?
11/30
Financial Assets and Valuation
12/30
Assets: Real and Financial

Real vs. financial assets
1. Real assets: Used to produce goods & services
Example: factory, machines, equipment, ...
2. Financial assets: Claims on cash flows from real assets

Example: stocks, bonds, derivatives (futures, options, etc.)
Benefits of financial assets

1. Consumption timing
Example: Saving for retirement, borrowing for college,...
2. Allocation of risk
Example: An oil producer wants to hedge oil price risk; a pension
fund manager wants to hedge interest rate risk; an entrepreneur
wants to diversify, ...
3. Raising capital
Example: A firm issues equity or debt to finance an investment
project; a household takes a mortgage to buy a house, ...
13/30
How to Evaluate Financial Assets?
Example: Microsoft’s stock is traded at about $340. Would you

buy it? Why / why not?
Holding a stock allows one to receive the following cash flows

– Dividends
– Future price upon sale.
Then, today’s value of such investment is simply a discounted

stream of cash flows.
14/30
Dividend Discount Model (DDM)

Notation:
– Pt : expected market price per share at the end of period t
– Dt : expected dividend per share paid at the end of period t
– r : equity (or opportunity) cost of capital, or discount rate: the
market return on investments with same risk as the firm’s shares
One-period investor:
D1 + P1
V0 ≡ P0 =
1+r
– The return on equity r can be decomposed

D1 P1 − P0
r= +
P0 P
|{z} | {z0 }
Dividend yield Capital gain
Two-period investor:
D1 D2 P2
P0 = + 2
+
1+r (1 + r ) (1 + r )2
15/30
Dividend Discount Model (DDM), Cont-d
N-period investor:
D1 DN PN
P0 = + ... + N
+
1+r (1 + r ) (1 + r )N
N
X Dt PN
= +
(1 + r )t (1 + r )N
t=1
Infinite horizon investor:

D1 D2 D3
V0 ≡ P0 = + + + ···
1+r (1 + r )2 (1 + r )3
16/30
Gordon Growth Model: DDM with Constant Growth

Suppose that dividends grow at a constant rate g < r . This
means:
– D1 = D0 (1 + g); D2 = D1 (1 + g) = D0 (1 + g)2
– In general, Dt = D0 (1 + g)t
The DDM in this case yields

(1 + g)2 (1 + g)3

1+g
V0 = D0 + + + ···
1+r (1 + r )2 (1 + r )3
Constant dividend growth model by Myron J. Gordon (Gordon

Growth Model) of the firm’s intrinsic value:
1+g D1
V0 = D0 =
r −g r −g
What happens when g > r ?

17/30
Required Rate of Return

When the market price, P0 , is presumed to reflect value, then the
required rate of return is:
D1
r = +g
P0
D1
where P0 is dividend yield and g is capital gain.
MSFT example
– Market data
current price $335.19 (as of August 1st, 2023)
quarterly dividend 68 cents
dividend growth over past 10 years 15% =⇒ assume g = 0.15
– Using market data to compute MSFT’s discount rate (the required
rate of return)
4 × 0.68
r= + 0.15 =⇒ r = 15.81%
335.19
18/30
Risk-Return Tradeoff
19/30
Risk-Return Tradeoff: Main Principle
Risk-return tradeoff is a fundamental principle
Expected returns on riskier investments are higher

– Or we say that riskier investments are discounted at higher rates.
– Or in other words, they are cheaper today.
20/30
Example of Risk-Return Tradeoff
You have $100 to invest and decide between securities A and B.

In one year from now security:
A pays either $100 or $140, both with 50% probability.
B pays either $40 or $200, both with 50% probability.
If today both securities had the same price, let’s say $100, which
one would you buy?
21/30
Example of Risk-Return Tradeoff, Cont-d
The expected payoff (cash flow) for both A and B is $120.

But B is riskier than A because its cash flows, $40 and $200 are
much “farther” from its expected payoff $120 than $100 and
$140.
Most investors are risk-averse, so they prefer A. Since more
investors demand A, its price today has to be higher than B’s
price: PA > PB .
What does it mean for expected returns?
Because investors require compensation for taking risks, A’s

expected return has to be lower than the expected return for B:
120 120
E[RA ] = −1< − 1 = E[RB ]
PA PB
22/30
Measuring Risk
The riskiness of cash flows of an asset is essential for
determining its today’s price and as a result the asset’s expected
return.
In finance, we usually measure risk as volatility (aka standard

deviation) of asset returns.
Knowing about asset’s risks and expected returns is crucial for

investment decisions: Should I buy/sell this asset?
In practice, we typically can’t determine riskiness of an asset

directly because we don’t know future cash flows.
We use historical data to construct estimates of future risks

and expected returns.
23/30
Computing Realized Returns
24/30
Computing Realized (or Holding Period) Return of an

Investment
Example 1: If you bought Goldman Sachs (ticker: GS) stock at
NYSE on July 1, 2023 when the market opened, you paid
$322.41 per share.
If you sold the stock the same day at the market closing price,
you received $326.61. The return on investment was:
$326.61 − $322.41
= 1.30% over that day.
$322.41
Example 2: If you bought GS stock on July 1, 2023 when the

market opened at $322.41 and held it for one month (say, you
sold it at closing price on August 1, 2023) you received $357.72.
The return on investment was:
357.72 − 322.41
= 10.95% over that month.
322.41
25/30
Computing Realized Returns: Generalization

The net realized return from holding an asset is the return
achieved by an investor who bought the asset last period (time
t − 1) and sold it today (time t):
Dt + Pt − Pt−1 Dt + Pt
Rt = = −1
Pt−1 Pt−1
Pt is the price of the asset at time t (the end of the investing

period), Pt−1 is the price of the asset at time t − 1 (the beginning
of the investing period), and Dt is dividend (or other income)
received at time t
Returns can be decomposed into a dividend payment and a

capital gain component:
Dt Pt − Pt−1
Rt = +
Pt−1 Pt−1
| {z } | {z }
Dividend Yield Capital Gain
26/30
Gross, Logarithmic, and Excess Returns

There are different, still informationally equivalent, ways of
expressing asset returns
Let Rt be the net return on an asset over time period t
The gross return is given by

Rg,t = 1 + Rt
– A net return of -4% is equivalent to a gross return of 0.96
The logarithmic (or log or continuously compounded) return is

given by
rt = log(1 + Rt )
– A net return of 4% is equivalent to a log return of 3.92%
If Rf ,t is the net return on a risk-free asset over the same time

period t, then the excess return is given by
Rte = Rt − Rf ,t
27/30
Realized Returns: Important Points
Realized return is a historical return, i.e., it is based on past

prices of assets
Realized return is a known and certain quantity
In the above examples, returns on investment are not referring to

an investment periods of the same length. This makes returns
not directly comparable.
To ease comparison, returns are almost always quoted on

annualized basis. The conversion is done taking compounding
into account.
28/30
How to Annualize Returns?

Example 2 continued: Assume that you start with $100, 000
and each month you get return of 10.95% from investing into GS
stock over the whole next year (12 months). In addition, assume
that at the end of each month you take the result of your previous
month investment and reinvest it for the next month (reinvesting
monthly = monthly compounding).
What return would you earn over the whole year?
Answer: 248%
Same exercise in terms of daily returns: in a typical year, there
are about 250 trading days when equity markets are open, so we
use 250 periods to annualize daily returns. So, the annualized
return in Example 1 is 2,442% (!)
29/30
Summary
Real and financial assets are vehicles for saving and investment.
Financial assets provide future cash flows. We can price those

cash flows using Gordon model.
Before investing we need to assess assets’ risks and expected

returns.
30/30

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COMM371/COEC371 – Investment Theory

FULL COLOUR ON WHITE FULL COLOUR ON LIGHT

When the background is black or dark, the logo reverses to white.

Financial Assets and Valuation

Computing Realized Returns

Why Study Finance?

Make good financial decisions yourself; help others

Understand the financial system and its impact on the economy

Support causes you believe in as an investor

Fun and engaging; constantly innovating industry

Goal of COMM 371

By the end of this course, students are expected to

Be able to apply different asset pricing methods.

Understand diversification and hedging and be able to apply

Gain trading experience in different asset classes in a simulated

Outline of Future Classes

2-5 Asset returns, trading and market efficiency

6-10 Equities: optimal portfolio choice, valuation

11 Investment strategies for individual investors

Midterm: November 9, from 7:00 pm to 9:00 pm

12-17 Fixed-income securities: valuation and risk management

18-22 Derivatives (futures and options): valuation and hedging

Trade Simulation Assignment 10%

There will be seven individual assignments

Assignment Topics Date

The Trade Simulation Assignment

You learn by managing a virtual portfolio of $100,000 in a

How to Do Well in This Course

Attend lectures. Ask questions if something is unclear.

Complete all the practice quizzes and practice problems yourself,

Form a study group and discuss lecture material, practice

Attend weekly tutorials (post questions beforehand on Canvas)

Financial Assets and Valuation

Assets: Real and Financial

2. Financial assets: Claims on cash flows from real assets

Benefits of financial assets

How to Evaluate Financial Assets?

Example: Microsoft’s stock is traded at about $340. Would you

Holding a stock allows one to receive the following cash flows

Then, today’s value of such investment is simply a discounted

Dividend Discount Model (DDM)

– The return on equity r can be decomposed

Dividend Discount Model (DDM), Cont-d

Infinite horizon investor:

Gordon Growth Model: DDM with Constant Growth

The DDM in this case yields

Constant dividend growth model by Myron J. Gordon (Gordon

What happens when g > r ?

Required Rate of Return

Risk-Return Tradeoff: Main Principle

Risk-return tradeoff is a fundamental principle

Expected returns on riskier investments are higher

Example of Risk-Return Tradeoff

You have $100 to invest and decide between securities A and B.

A pays either $100 or $140, both with 50% probability.

B pays either $40 or $200, both with 50% probability.

Example of Risk-Return Tradeoff, Cont-d

The expected payoff (cash flow) for both A and B is $120.

Because investors require compensation for taking risks, A’s

In finance, we usually measure risk as volatility (aka standard

Knowing about asset’s risks and expected returns is crucial for

In practice, we typically can’t determine riskiness of an asset