Business decision making under uncertainty

PART 1
1. Introduction
 The price of an asset does not matter much, but your profit or loss does: you need to take into account how
much you paid for that asset.
 What matters is the percentage increase in the value of your investment
2. Single-Period Returns
 Let Pt be the price of an asset at time t.
 Assuming no additional payments (such as dividends) are received from your investment, the profit (or loss) from
time t − 1 to time t is simply the difference in value, Pt −Pt−1
 Profits expressed in “price” (dollars, euros, ...) are not comparable, because they depend on how much was
invested in the first place. In contrast, returns are profits normalized as percentages.
 We call return the profit or loss divided by the price at the beginning of the period.

Note that

 Then ratio return (also called “gross return”) is defined as current price divided by the price at the end of the
previous period.

 Immediately we can see that:

 Where 1+R t , as we are going to see later, it is the basis of geometric compounding.
 Additionally, if you know what value to expect at t for an asset, the ratio return can also be seen as telling you
how much you should be willing to pay at t − 1 if you require a certain return:

 Returns are scale-free, meaning that they do not depend on monetary units (dollars, cents, etc.)

3. Multiple Periods Returns

 Starting at time step t = 0, the return at time t after T periods can be written as:

 We denote with Rt,k the the return at time t over k periods t − k, t − k + 1, . . . , t . The most accurate way to
compound returns, then, is geometric compounding:

 This leads to the equation:

Therefore R3,3 = 1.05 · 0.981 · 1.0291 - 1 = 0.06 = 6%

 We can obtain the Average Return by means of the geometric mean

 Therefore, the daily return can be annualized as follows:

 The Return over N days can be averaged into a daily return

4. Prices & Adjusted Prices

 Accurate calculation of a stock’s return requires taking into account dividends, corporate actions, etc; This is done
through adjusted prices.
 Companies can often offer regular cash payments, typically quarterly, to their shareholders. Such a payment is
called dividend.
 Is a dividend of 5€ a lot? It depends on the value of each share. If the value of each share is 100 €, then 5€, paid 4
times a year, is high in proportion to the share value. The dividend yield is the ratio of the euro dividend amount
paid in a year divided by the euro value of one share, and in this example, the
dividend yield is:

 The adjusted price is calculated backward in time, starting from today’s price and back. Today’price is not
adjusted, so today’s “adjusted price” is the price currently quoted.

 We can easily proof that the total return calculated from non-adjusted price equals to the total return calculated
from adjusted price.

Example: A stock’s price was 2€ at markets’ close yesterday and is 1.5€ today. The company paid out a dividend of 1€
this morning.
- Profit is:

- Yesterday adjusted price is:

- Total return results as:

PART 2
1. Volatility (Riskiness)
 A key measure of the riskiness of an investment is the volatility of its returns. Volatility is the standard deviation
of returns.
 Usually, volatility is presented as a daily number given that returns are daily. However, this number can be scaled
to the desired time frame:
- Monthly volatility involves multiplying it by the square root of number of trading days in a month, typically 22.
- Annualized volatility can be typically obtained from daily volatility or monthly volatility:
o Daily volatility can be annualized multiplied by the square root of the number of trading days per year,
typically 252
o Monthly volatility can be annualized by multiplying it by the square root of 12.
2. Sharpe
 What is best: More Return, or Less Risk?
 There’s a trade-off here, and what you probably want is the investment that offers the higher return per unit of
risk. This is the idea of Sharpe Ratio.
 There is something left to consider: Cash deposits at a bank earn a return (typically 3%) and cash deposits at a
bank are essentially risk-free (rf). A stock investment should thus be analyzed on its return beyond a “floor” of this
risk-free rate (typically 3%).

3. Drawdowns
 A drawdown is the loss in the value of your investment from its last peak.
 To calculate its value at any time:
- Find the maximum value this investment has had in the past, and subtract today’s price from that peak price:
The difference is the loss per share.
- A better metric, because it is comparable, is to divide that loss by the latest peak price, resulting in the
drawdown, a unit-less percentage that is always less than or equal to zero.
4. Rolling Correlations
 Rolling correlations are simply applying a correlation between two time series as a rolling window calculation.
One major benefit of a rolling correlation is that we can visualize the change in correlation over time.
 Rolling correlations are important because, in addition to their average value, they can reveal significant changes
in a business.

PART 3
1. Fixed Income
 There is a market for fixed income securities, but it’s far from being as transparent as it is for equities.
 The most widely known example of a fixed income security is the bond. Bonds are essentially receipts that a
company borrowed money. The company owes you to pay back its debt and interests, nothing more.
 When you buy a bond, you make a loan to the company. The corporation is obligated to pay back the principal
amount, called par, after a number of years (called maturity) specified by the contract, plus periodic payments
called coupon. Coupons are similar to dividends paid by stocks, except that coupons are specified contractually,
whereas stock dividends are at the discretion of the company’s management.
 Zero-coupon bonds pay no principal or interest until maturity. The par value is the payment made to the bond
holder at maturity.

2. Present Value
 The pricing of a bond (and any financial instrument, for that matter) is based on a simple principle called present
valuation. For a promised payment in the future, what amount should I be willing to pay today?
 Given prevailing interest rates, what amount would I need to invest today so that, after compounding, I get the
same payment at the same future date?
 Since x € today become x(1 + r) after one year if invested with annualized interest rate r, it follows that the value
today (the present value) of 1,000 € to be received in one year is:

 The rate r used in present valuation is called discount rate and the multiplicative factor, (1+r )−1 in this example,
is the discount factor.
What would be the present value of 1000 € if it was to be received two years from now?
The present value in one year would be 1000 × (1+r )−1, and that amount should be present-valued to today, resulting
in 1000 × (1+r )−1 × (1+r )−1, or 1000 × (1+r )−2

 The discount function depends today on the remaining time T until the maturity of the bond
 The value today (the present value) of 1,000 € to be received in one year is 1000/(1+r)
if we assume again that T is the time to maturity in years.

Example: For a 10-year coupon bond with a face value of 1000€ and interest rate at r=4%, the present value is

if the interest is compounded annually

 The price of a 20-year coupon bond with par value of 1000€ when the interest rate is r= 6% and compounded
annually is:

Semi-Annual Compounding: bonds are usually present-valued using semi-annual discount rates. What that means is
that instead of having T remaining years, we have 2T remaining periods. So, if we assume the interest rate r is per
year with semi-annual compounding, the price is:

Example: If the interest rate is r = 6% and is compounded every six months, the present value of the 20-year bond is:

Continuous Compounding: Compounding n times a year is:

for a T-year zero-coupon bond
 If n becomes arbitrarily large, it is called continuous compounding and it is the limit of the above function is an
exponential:

What would happen if the rate increases?

Assume you just bought for 306.56€ a 20-year zero with a face value of $1000. You assumed semi-annual
compounding, which gave you an interest rate of 6%. Six months later the interest rate increased to 7%.

The value of the investment dropped by 306.56 − 261.41 = 45.15. You will get 1000€ if you keep the bond for another
19.5 years, but if you sell it now, you lose 45.15€, a return of:

for a half-year or -29.46% per year. Therefore, the value of a bond decreases when interest rates increase.