BUFN 740: Capital Markets

Topic 1
The Investment Environment and
Historical Record
BKM 1-5
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”.
 Bid-Asked 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
 Price-contingent 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 P-4000)/ (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 Carve-Outs
– 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 zero-coupon 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 probability-weighted 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 T-bill 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, 1926-2009
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
(1968-2009)

 SD for small stocks became smaller

 Better diversified portfolios have higher Sharpe Ratios


BUFN 740 Capital Markets Topic 1 33
Statistical Significance
 t-statistic 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. large-cap stocks between
1926 and 2009:


 The large-cap 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, 1900-2000
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 t-statistic 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