Topic 1
The Investment Environment and
Historical Record
BKM 15
Real Assets Versus Financial Assets
Real Assets
– Determine the productive capacity and net income of
the economy
– Examples: Land, buildings, machines, knowledge used
to produce goods and services
Financial Assets
– Claims on real assets
– Three types: Fixed income or debt, Common stock or
equity, Derivative securities
BUFN 740 Capital Markets Topic 1 2
Fixed Income
Payments fixed or determined by a formula
Money market debt: short term, highly marketable,
usually low credit risk
Capital market debt: long term bonds, can be safe or risky
BUFN 740 Capital Markets Topic 1 3
Common Stock and Derivatives
Common Stock is equity or ownership in a
corporation.
– Payments to stockholders are not fixed, but
depend on the success of the firm
Derivatives
– Value derives from prices of other securities, such
as stocks and bonds
– Used to transfer risk
BUFN 740 Capital Markets Topic 1 4
Financial Markets and the Economy
Information Role: Capital flows to companies with best
prospects
Consumption Timing: Use securities to store wealth and
transfer consumption to the future
Allocation of Risk: Investors can select securities
consistent with their tastes for risk
Separation of Ownership and Management: With stability
comes agency problems
BUFN 740 Capital Markets Topic 1 5
The Investment Process
Asset allocation
– Choice among broad asset classes
– Should you invest in stocks or in bonds and what’s the
optimal allocation between them?
– How to use futures and options to reduce risk or enhance
returns?
Security selection
– Choice of which securities to hold within asset class
– Why are some stocks more expensive than some others?
Are those cheap stocks bargains? How should we evaluate
securities? Their risks and their returns?
BUFN 740 Capital Markets Topic 1 6
How Securities are Traded
Types of Markets:
Direct search
– Buyers and sellers seek each other
Brokered markets
– Brokers search out buyers and sellers
Dealer markets
– Dealers have inventories of assets from which they buy and
sell
Auction markets
– traders converge at one place to trade
BUFN 740 Capital Markets Topic 1 7
Bid and Asked Prices
Bid Price
Bids are offers to buy.
In dealer markets, the bid
price is the price at which
the dealer is willing to buy.
Investors “sell to the bid”.
BidAsked spread is the
profit for making a market
in a security.
Ask Price
Asked prices represent
offers to sell.
In dealer markets, the asked
price is the price at which
the dealer is willing to sell.
Investors must pay the
asked price to buy the
security.
BUFN 740 Capital Markets Topic 1 8
Types of Orders
Market Order: Executed immediately
– Trader receives current market price
– A large order may be filled at multiple prices
Pricecontingent Order:
– Traders specify buying or selling price
BUFN 740 Capital Markets Topic 1 9
Trading Mechanisms
Dealer markets
Originally, NASDAQ was primarily a dealer market
with a price quotation system
Electronic communication networks (ECNs)
– True trading systems that can automatically execute
orders
Specialists markets
– maintain a “fair and orderly market”
BUFN 740 Capital Markets Topic 1 10
Buying on Margin
The margin in the account is the portion of the purchase price
contributed by the investor; the remainder is borrowed from the
broker.
The broker charges interest for the loan.
The securities purchased are used as collateral.
The board of Governors of the Federal Reserve sets limits on the
extent of margin purchases. Currently, the initial margin
requirement is 50%.
Example: An investor pays $6,000 toward the purchase of
$10,000 worth of stock (100 shares at $100 per share). The
initial percentage margin is 60%. If the stock price declines by
30%, the percentage margin falls to 3,000/7,000=43%.
BUFN 740 Capital Markets Topic 1 11
Maintenance margin
Maintenance Margin – a threshold percentage margin. If the
percentage margin falls below this level, the broker will issue a
margin call:
– Require additional capital added to the margin account.
– Can sell the stocks without the investor’s consent.
Example: Suppose the maintenance margin is 30%. How far
could the stock fall before the investor gets a margin call?
– Solve: (100 P4000)/ (100P)=0.3.
– The solution is P=$57.14.
– Conclusion: the price can fall 42.86% before a margin call is
issued.
Why do brokers lend loans? Should investors borrow to invest?
BUFN 740 Capital Markets Topic 1 12
Short Sales
One may sell a financial asset even though he does not own it.
How is it done?
– Borrow the asset through a broker.
– Sell it and deposit proceeds and margin in an account.
– Buy the asset in the future in the market, and return it to the
lender.
– The borrower must pay the lender any dividend paid during
the short sale.
– The short seller will reap a profit if the price decreases.
Is short selling good to the financial market?
BUFN 740 Capital Markets Topic 1 13
Short Sale: Initial Conditions Example 3.3
Dot Bomb 1000 Shares
50% Initial Margin
30% Maintenance Margin
$100 Initial Price
Sale Proceeds $100,000
Margin & Equity $50,000
Stock Owed 1000 shares
BUFN 740 Capital Markets Topic 1 14
Example 3.3 (Cont’d) Dot Bomb falls to $70 per share
Assets
$100,000 (sale proceeds)
$50,000 (initial margin)
Liabilities
$70,000 (buy shares)
Equity
$80,000
Profit = ending equity – beginning equity
= $80,000  $50,000 = $30,000
= decline in share price × number of shares sold short
BUFN 740 Capital Markets Topic 1 15
Short Sale  Margin Call
Suppose the maintenance margin is 30% on short sales, how much
can the stock price rise before a margin call?
($150,000
*
 1000P) / (1000P) = 30%
P = $115.38
* Initial margin plus sale proceeds
BUFN 740 Capital Markets Topic 1 16
Arbitrage in Real Life
Arbitrage: (potential) benefits without downside
Royal Dutch and Shell:
– Royal Dutch (60%) and Shell (40%)
– => Price
RD
= 1.5*Price
S
BUFN 740 Capital Markets Topic 1 17
Arbitrage in Real Life
Internet CarveOuts
– 3Com Sells 5% of Palm in IPO, will spin off remainder in 6
months
– 1 share of 3Com will own 1.5 shares of Palm
– P
Palm
= $95
– 3Com should be ≥ $142
– P
3Com
= $81
– Value of 3Com excluding Palm = $60
Limitations to arbitrage
– Very few shares of Palm available to short
– Arbitrage was limited
– Mispricing persisted
BUFN 740 Capital Markets Topic 1 18
Quant review
Risk projects: The stock price of ABC is currently $100.
Assume the stock price is either going to increase to $120 or
decrease to $90 over the next year. In both cases the firm will
pay a dividend of $5.
100
G
B
120
90
BUFN 740 Capital Markets Topic 1 19
Rate of return
The rate of return in the G state is:
The rate of return in the B state is:
In general, the rate of return is given by:
Or equivalently, by capital gains + dividend yield:
120 5 100
25%
100
G
r
+ ÷
= =
90 5 100
5%
100
B
r
+ ÷
= = ÷
1 1 0 1 1
0 0
1
P D P P D
r
P P
+ ÷ +
= = ÷
1 0 1
0 0
P P D
r
P P
÷
= +
BUFN 740 Capital Markets Topic 1 20
Expected Rate of Return
The probabilities of the G and B states are 0.4 and 0.6
respectively.
The expected rate of return is
In general, if there are n possibilities of outcome, the expected
rate of return is
( ) 0.4 25% 0.6 ( 5%) 7%
r
E r r µ = = = · + · ÷ =
1
( )
n
r j j
j
E r r p r µ
=
= = =
¿
BUFN 740 Capital Markets Topic 1 21
Example
The price of a Google share is $465 today. The expected return
is 4% per year for the next four years. If you buy a share today,
how much money will you expect to have after four years?
A zerocoupon bond from General Motors will expire after one
year and pay a face value of $1000. The expected return for a
GM bond is 12%. How much is the price of the bond right now?
BUFN 740 Capital Markets Topic 1 22
Variance of Rate of Return
The variance is defined as the expectation of the squared
deviations from the expectation. In our case:
In general, the variance is given by:
The standard deviation is defined as the squared root of the
variance. In our example:
2 2 2
( ) 0.4(0.25 0.07) 0.6( 0.05 0.07) 0.0216
r
Var r o = = ÷ + ÷ ÷ =
2 2 2
1
( ) ( ( )) ( )
n
r j j
j
Var r E r E r p r r o
=
= = ÷ = ÷
¿
0.0216 14.7%.
r
o = =
BUFN 740 Capital Markets Topic 1 23
Covariance
For two different assets i and j, covariance measures the
direction of comovement between their returns:
For example, suppose each return could take one of two values,
−5% or 15%, with the following probabilities:
( ) ( ) ( ) ( )( )
1 2 12 1 1 2 2 1 1 2 2
1
( , ) ( ) ( )
n
j j j
j
Cov r r E r E r r E r p r r r r o
=
= = ÷ ÷ = ÷ ÷
¿
r
i
r
j
Probability
5% 5% 30%
5% 15% 20%
15% 5% 20%
15% 15% 30%
BUFN 740 Capital Markets Topic 1 24
Covariance
Notice that Notice E(r
i
) = E(r
j
) = 5%
Now construct:
Taking the probabilityweighted average gives:
r
i
− E(r
i
) r
j
− E(r
j
) (r
i
− E(r
i
) ) (r
j
− E(r
j
) ) Probability
−10% −10% 0.01 0.30
−10% 10% −0.01 0.20
10% −10% −0.01 0.20
10% 10% 0.01 0.30
( ) ( )
ij 0.30 0.01 0.20 0.01 0.20 0.01 0.30 0.01 0.002
ij
o = = × + × ÷ + × ÷ + × =
BUFN 740 Capital Markets Topic 1 25
Correlation
Covariance tells us the direction of comovement but little about
its strength; standardizing the covariance by standard deviations
gives a unitless measure that conveys the strength of the
comovement.
Correlation coefficient:
In the above example, we can see Thus
Correlation satisfies
What is the meaning of
1 2
12
1 2
( , ) Cov r r
µ
o o
=
1 2
10%. o o = =
12
0.002
= = 0.20.
10% × 10%
µ
12
1 1 µ ÷ s s
0,1, 1? µ = ÷
BUFN 740 Capital Markets Topic 1 26
Some Useful Formulas
1 2 1 2
2
1 2 1 2 1 2
1 2 3 1 3 2 3
1 2 1 2
1 2 2 1
12
( ) ( ) ( ), ( ) ( )
( ) ( )
( ) ( ) ( ) 2 ( )
( , ) ( , ) ( , )
( , ) ( , )
( , ) ( , )
E r r E r E r E r E r
Var r Var r
Var r r Var r Var r Cov r r
Cov r r r Cov r r Cov r r
Cov r r Cov r r
Also
Cov r r Cov r r
o o
o o
o o
µ
+ = + =
=
+ = + +
+ = +
=
=
21
µ =
BUFN 740 Capital Markets Topic 1 27
Mean and Variance of Historical Return
Given a sample of T realized returns on stock q: r
q1
, r
q2
,r
q3
,
…,r
qT
. The estimate of expected return E(r
q
) is given by the
sample mean
The estimate of the variance of return is
Estimated standard deviation is just the square root:
_
1 2
1
...
1
T
q q qT
q qt
r r r
r r
T T
+ + +
= =
¿
2
_
2
1
1
1
T
q qt q
s r r
T
 
= ÷

÷
\ .
¿
2
q q
s s =
BUFN 740 Capital Markets Topic 1 28
Mean and Standard Deviation of S&P 500 Return
BUFN 740 Capital Markets Topic 1 29
Excess Return and Sharpe Ratio
Excess return is just return minus the riskfree rate. People usually
use the Tbill rate as the riskfree rate.
The excess return of a risky investment in a specific period can be
positive or negative.
The difference between the expected rate of return on a risky
asset and the risk free rate is called a risk premium.
Example: The estimated U.S. large stocks risk premium is 7.52%,
and SD is 19.54%. So the Sharpe ratio is 0.0752/0.1954=0.38.
Risk premium
Sharpe ratio .
SD of excess return
=
BUFN 740 Capital Markets Topic 1 30
Figure 5.4 The Normal Distribution
The normal distribution with mean=10% and standard
deviation=20%.
With 95% chance, the next draw is within +2 SD from the mean.
With 68% chance, the next draw is within +1 SD from the mean.
BUFN 740 Capital Markets Topic 1 31
Table 5.3 Statistics from the History of Portfolio
Returns, 19262009
BUFN 740 Capital Markets Topic 1 32
Historic Returns on Risky Portfolios
Returns appear normally distributed
Returns are lower over the most recent half of the period
(19682009)
SD for small stocks became smaller
Better diversified portfolios have higher Sharpe Ratios
BUFN 740 Capital Markets Topic 1 33
Statistical Significance
tstatistic is usually used for testing the null hypothesis that E(r
q
)
= 0:
If t exceeds 1.96, then the null is rejected at the 5% significance
level.
In Table 5.3, the annual returns on U.S. largecap stocks between
1926 and 2009:
The largecap portfolio has an average return reliably different
from zero.
_
q
q
r
t T
s
=
_
11.63%, 20.56%
0.1163
84 5.16
0.2056
q q
r s
T
= =
= × =
BUFN 740 Capital Markets Topic 1 34
Figure 5.7 Nominal and Real Equity Returns Around
the World, 19002000
BUFN 740 Capital Markets Topic 1
The difference
between
Sweden
and the
average return
across the 16
countries is
2.5%
The
difference
between
Belgium
and the
average
return
across the
16
countries is
2.6%
The tstatistic for a difference of 2.6% with standard deviation of 23% and 100
observations is 1.13<1.96. The difference between the real returns in different
countries is insignificant.
35