FIN 435 Exam 1 Slides

FIN 435
Exam 1 content
Chapter 1 The investment environment

Chapter 2 Asset classes and financial instruments
Chapter 3 How securities are traded

Chapter 5 Introduction to risk and return
Chapter 1
Topics
1.1 Real Assets versus Financial Assets

1.2 Financial Assets
1.3 Financial Markets and the Economy

1.4 The Investment Process
1.5 Markets Are Competitive

1.6 The Players
Investment
The commitment of funds to one or more assets

that will be held over some future time period
Why do we study investment theory?
• Essential part of a career in the field
– Security analyst, portfolio manager, stock broker –
Chartered Financial Analyst (CFA)
• Most individuals make investment decisions some time

– Need sound framework for managing and
increasing wealth
Real assets
– tangible (or physical) assets used
to produce goods and services.
–Examples: gold, real estate, art,
etc.
Financial assets
– Claims on real assets.
– Examples: stocks, bonds, etc.
Real asset
– This Rothko painting was
sold for $186 million in an
auction to a Russian billionaire.
Is cash a real asset or a financial asset?
Why?
A financial asset.
Because its value is based on what it represents.
The paper it is printed on has very little inherent value by itself.
Net wealth of the economy
Financial assets of the holders (e.g., households) represent
financial liabilities of the issuers (e.g., businesses) and hence,
cancel out each other at the aggregate national level, leaving only
real assets as the net wealth of the economy.
Marketable securities
– Financial assets that are easily and cheaply tradable in
organized markets.
Marketable
securities
Money market Capital market Indirect

securities securities Derivatives investments
Common
Treasury Stock Options Unit trusts
bills
Preferred
Stock
Euro Dollars Investment
Futures trusts
Commercial Treasury
paper Bonds
Forwards Hedge funds
Negotiable Treasury
certificates Notes
Swaps
Banker's
Municipal
acceptance
Bonds
Repurchase
agreement
Corporate
Bonds
Underlying investment decisions: the
tradeoff between expected return and risk
– Expected return is not usually the same as realized return
Risk: the possibility that the realized
return will be different than the expected
return
– Investor risk tolerance affects expected return
The tradeoff between expected return and
risk
– Investors manage risk at a cost - lower expected returns (ER)
– Any level of expected return and risk can be attained
Stocks
ER Bonds
Risk-free Rate
Risk
The investment decision process:
– Asset allocation
– Choice among broad asset classes (stocks, bonds, real
estate, commodities and so on).
– Security selection
– Choice of which securities to hold within asset class.
– Conducted to value securities and determine investment
attractiveness.
Uncertainty in returns
Problem #1
Assume that when you are 25 years old you plan to aggressively
save for your retirement by contributing $5,000 a year to a tax-
sheltered account.
A relative of yours tells you to forget about earning 10 percent or

more a year, because that is very unlikely to happen. He also tells
you that you should not worry too much about whether you
earn, for example, 6 or 7 percent, because it won’t make a lot of
difference in your final wealth.
You decide to see for yourself the various results that could occur
by doing some calculations.
Problem #1
C = $5,000
6% 7% 10%
20 years
30 years
40 years
Problem #1 (solution)
C = $5,000
6% 7% 10%
20 years
183,928 204,977 286,375
30 years
395,291 472,304 822,470
40 years
773,810 998,176 2,212,963
Chapter 2
Topics
2.4 Stock and Bond Market Indexes

2.5 Derivative Markets
Market index
– A measure of the performance of the stock market.
– Price-weighted average: Dow Jones Industrial Average (DJIA
or “Dow”)
– Value-weighted index: Standard & Poor’s Composite 500 (S&P
500)
Price-weighted average
Initial value of Final value of
Initial Final Shares outstanding outstanding
Stock
price price (million) stock ($ stock ($
million) million)
ABC $25 $30 20 $500 $600
XYZ 100 90 1 100 90
Total $600 $690
a) Calculate the percentage change in the value of the index.

b) Calculate the final value of the index if the initial index value is
1,000 points.
– Initial index value = (25 + 100)/2 = 125/2 = 62.50
– Final index value = (30 + 90)/2 = 120/2 = 60
– Percentage change in index = (60 – 62.50) / 62.50 = –4.00%

Stock
million) million)
ABC $25 $30 20 $500 $600
XYZ 100 90 1 100 90
Total $600 $690

Set initial index value = 1,000 points
Final index value
= 1,000 * (60/62.5)
= 960 points

Stock
million) million)
ABC $25 $30 20 $500 $600
XYZ 100 90 1 100 90
Total $600 $690

Price-weighted average (stock split)
Initial Final Shares
Stock outstanding outstanding
price price (million)
stock ($ million) stock ($ million)
ABC $25 $30 20 $500 $600
XYZ 50 60 2 100 120
Total $600 $720
XYZ had a 2:1 stock split.

a) Calculate the percentage change in the value of the index.
b) Calculate the final value of the index if the initial index value is 1,000
points.
Index value before split = (25 + 100)/2 = 125/2 = 62.50
Index value after split = (25 + 50)/divisor = 62.50
Divisor = 1.20
Index value after split = (30 + 60)/1.2 = 75
Percentage change in index = (75 – 62.50) / 62.50 = 20.00%

ABC $25 $30 20 $500 $600
XYZ 50 60 2 100 120
Total $600 $720

Set initial index value = 1,000 points
Final index value
= 1,000 * (75/62.5)
= 1,200 points

ABC $25 $30 20 $500 $600
XYZ 50 60 2 100 120
Total $600 $720

Value-weighted average
Stock
million) million)
ABC $25 $30 20 $500 $600
XYZ 100 90 1 100 90
Total $600 $690
a) Calculate the final value of the index if the initial index value is
100 points.
– Initial value of all stocks
= ($25 * 20 million) + ($100 * 1 million) = $600 million
– Final value of all stocks

Stock
million) million)
ABC $25 $30 20 $500 $600
XYZ 100 90 1 100 90
Total $600 $690

– Initial value of all stocks
– Final value of all stocks
Set initial index value = 100 points

Final index value
= 100 * ($690 million / $600 million)
= 115 points
Markets and their indexes
New York Stock Exchange S&P 500, Dow
NASDAQ Nasdaq
Tokyo Stock Exchange Nikkei 225
London Stock Exchange FTSE 100
NYSE Euronext CAC 40
Hong Kong Stock Exchange Hang Seng
Taiwan Stock Exchange TSEC
Toronto Stock ExchangeS&P TSX
Australian Securities Exchange S&P ASX
Bombay Stock Exchange BSE Sensex
Dhaka Stock Exchange DSE X
The Dhaka Stock Exchange
– Located in Motijheel, Dhaka.
– The main stock exchange of Bangladesh
– Market cap of about $45 billion.
Website
DSE market cap (2005 – 2018, in billions USD)
51
42
40
29
13
2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018
The Chittagong Stock Exchange
– Trading started in 1995
– Automated trading started in 1998
– Online (internet) trading started in 2004
The market crash of 1996
– The DSE index gained 140% between 1991 and 1995
– In 1996, the index rose by 337% (DSE) and 258% (CSE)
respectively
– New records almost every day in September, October and early
November
– Market was overheated
– The DSE index reached 3,627 points, up from around 1,000
points in June
– dropped by 233 points on November 6, 1996
– The DSE index (DGEN) dropped to 957 points by April 1997
DGEN – 1990 - 2011
8,250
7,250
6,250
5,250
4,250
3,250
2,250
1,250
250
9 9 0 9 9 0 9 9 1 9 92 9 93 99 4 99 5 9 9 5 9 9 6 9 97 9 98 99 9 00 0 0 0 0 0 0 1 0 0 2 0 03 0 04 00 5 00 5 0 0 6 0 0 7 0 08 0 0 9 01 0 01 0 0 1 1
1 1 1 1 1 1 1 1 1 1 1 1 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2
– Number of BO account holders in Dec. 2009 = 1.25 million
– Number of BO account holders in Dec. 2010 = 3.21 million

OTC markets
– Network of dealers standing ready to either buy or sell
securities at specified prices
– Handle unlisted securities
– OTC Bulletin Board
Foreign markets
– US equity markets account for a decreasing share of world’s
stock market capitalization
– Many different equity markets exist
– Emerging market: Stable political system, low regulation, low
standardization in trading activity
– Risks: Illiquidity, lack of information, political uncertainty
Secondary bond markets
– Secondary bond market is primarily an over-the-counter
network of dealers
– NYSE features an automated bond system to execute orders.
– Mostly corporate bonds, thinly traded
– Treasury and agency bonds actively trade in dealer markets
– Municipal bonds less actively traded
Useful sites
LankaBangla Financial Portal
Stock Bangladesh
Chapter 3
Topics
3.2 How Securities Are Traded

3.8 Buying on Margin
3.9 Short Sales

Secondary markets
– Markets where investors trade previously issued securities
– Auction markets involve bidding in a specific physical location
– Negotiated markets consist of decentralized dealer network
Types of orders
– Market orders
Buy or sell orders that are to be executed immediately at
current market prices
– Price-contingent orders
Buy or sell orders that are executed at prices specified by the
investor.
Market orders
– Buy or sell orders that are to be executed immediately at
current market prices
– Example: you instruct your broker to buy 100 shares of BATBC
at the market price.
Price-contingent orders
– Limit-buy order
– Limit-sell order
– Stop-buy order
– Stop-loss order
– Limit-buy order
Example: buy shares of BATBC at or below BDT 2,800
Current market price – BDT 3,000
– Allows investors to specify the price that they are willing to
pay for a share; the investor is guaranteed to pay that specified
price or less.
– Limit-sell order
Example: You purchased BANKASIA stock at BDT 14 per
share. The stock is currently selling at BDT 15. Your gains may
be protected by placing a limit sell order.
– Allows investors to specify the price that they are willing to sell
a share for; the investor is guaranteed to receive that specified
price or above.
– Stop-buy order
Example: You sold NCCBANK stock short at BDT 10 per
share. Your losses could be minimized by placing a stop-buy
order at 12 per share.
– An order to buy a security which is entered at a price above the
current offering price, triggered when the market price touches
or goes through the buy stop price.
–
– Stop-loss order
Example: Sell shares of BANKASIA at or below BDT 13
Current market price – BDT 15
– You own a losing stock that continues to drop, but rather than
sell and take the loss, you stubbornly hold on and wait for a
bounce that never comes.
– To stem this scenario, you can use the stop-loss order , an order
to sell shares you own below the current market price, should
that level ever be hit.
Trading costs
– Commission
fee paid to broker for making the transaction
– Spread
cost of trading with dealer (ask – bid)
– Combination
on some trades, both commission and spread are paid
Buying on margin
– The investor borrows part of the purchase price from the

broker
– The margin in the account is the portion of the purchase price
contributed by the investor; the remainder is borrowed from the
broker.
– Initial margin requirements in the US = 50%; at least 50% of the
purchase price must be paid for in cash.
Buying on margin
– An investor wants to buy 100 shares of a company at BDT

100/share.
– He can only afford to pay BDT 6,000 up front.
Buying on margin
– An investor wants to buy 100 shares of a company at BDT

100/share.
– He can only afford to pay BDT 6,000 up front.
Assets Liabilities and Owner’s Equity

Value of stock 10,000 Loan from broker 4,000
Equity 6,000
Initial margin = Equity/Value = 6,000 / 10,000 = 60.00%

Buying on margin
– Suppose the share price falls from BDT 100/share to BDT

70/share.
Buying on margin

70/share.

Value of stock 7,000 Loan from broker 4,000
Equity 3,000
What would happen if the price were to fall below BDT 40/share?
Buying on margin

70/share.
What would happen if the price were to fall below BDT 40/share?
Buying on margin
– What would happen if the price were to fall below BDT

40/share?
– Owner’s equity would become negative; thus, the value of the
stock would not be sufficient collateral to cover the loan from the
broker.
Buying on margin
– Brokers set a maintenance margin to guard against this.

– If the percentage margin falls below the maintenance margin,
the broker will issue a margin call.
– The investor would be required to add new cash or securities
to the margin account.
Why investors buy on margin
– To use leverage to achieve greater upside potential (at the

expense of greater downside risk)
– Suppose you bought 200 shares of a firm for BDT 250/share.

– You expect the firm’s share price to rise by 20% next year.
– Assume you can borrow another BDT 50,000 from the broker at
10% interest/ year.
– What happens if the share price increases by 20%?
– Buying price = BDT 100,000

– Selling price = BDT 120,000
– Loan = BDT 50,000

– Interest payment = 10% of BDT 50,000 = BDT 5,000
– Total loan + interest payment = BDT 55,000
– After paying loan + interest, money left = BDT 120,000 – 55,000

= BDT 65,000
– Rate of return = (65,000 – 50,000) / (50,000)

= 15,000 / 50,000
= 30.00%
Calculate the rate of return, given that
a) there is no price increase (so, share price is BDT 250/share)
b) there is a price decrease of 20% (so, share price is BDT
200/share)
Calculate the rate of return, given that
a) there is no price increase (so, share price is BDT 250/share)
b) there is a price decrease of 20% (so, share price is BDT
200/share)
Answer
c) -10.00%
d) -50.00%
Change in stock price Rate of return
+20.00% +30.00%
0.00% - 10.00%
-20.00% - 50.00%
Maintenance margin
– An investor buys 100 shares at BDT 100/share.

– She pays 6,000 toward the purchase, borrowing the remainder
from her broker.
– The maintenance margin is 30%.
– How far could the stock price fall before the investor would get
a margin call?
Maintenance margin
– Let P be the price of the stock.

– The value of the shares is BDT 100P.
– The total liabilities are BDT 4,000.
– Therefore, total equity = BDT 100P – BDT 4,000
Maintenance margin
Value of stock 100P Loan from broker 4,000
Equity 100P-4,000
Account margin
= Equity/Value
= (100P – 4,000)/ (100P)
Maintenance margin
Account margin = Equity/Value = (100P – 4,000)/ (100P)
Maintenance margin = 30%
(100P – 4,000) / 100P = 30%
P = BDT 57.14
Maintenance margin
– An investor buys 200 shares at BDT 50/share.

– She pays 7,000 toward the purchase, borrowing the remainder
from her broker.
– The maintenance margin is 25%.
– How far could the stock price fall before the investor would get
a margin call?
Maintenance margin

– The value of the shares is BDT 200P.
– The total liabilities are BDT 3,000.
– Therefore, total equity = BDT 200P – BDT 3,000
Maintenance margin
Value of stock 200P Loan from broker 3,000
Equity 200P-3,000
Account margin
= Equity/Value
= (200P – 3,000)/ (200P)
Maintenance margin
Account margin = Equity/Value = (200P – 3,000)/ (200P)
(200P – 3,000)/ (200P) = 25%
P = BDT 20.00
Short sale
– In a long sale, an investor would buy a share and then sell it.
– In a short sale, first the investor sells the share and then he
buys it.
– A short sale allows the investor to profit from a decline in a
security’s price. An investor borrows a share from a broker and
sells it; later, the short-seller must purchase a share of the same
stock in order to replace the share that was borrowed.
Short sale
– The short seller must replace the share he borrowed, and also
pay any dividends paid during the short sale.
– Short sellers are required to post collateral (cash or securities)
with the broker to cover losses should the stock price rise.
Short sale
– You expect share prices of a firm to decline. Current market

price is BDT 100/share.
– You tell your broker to sell short 1,000 shares of the company.
– If the broker has 50% margin requirement, you must deposit
50% of the short sales as collateral (cash or securities).
Short sale
Cash from short sale

= 1,000 * BDT 100
= BDT 100,000
Collateral (in T-bills)

= 50% of cash from short sale
= 50% * BDT 100,000
= BDT 50,000
Short sale
Cash 100,000 Short position 100,000
T-bills 50,000 Equity 50,000

Short sale
– Suppose the share price falls to BDT 70/share.

– You close out your position by buying back 1,000 shares at BDT
70/share.
– Selling price = BDT 100,000
– Buying price = BDT 70,000
– Capital gain = BDT 100,000 – BDT 70,000 = BDT 30,000

Margin call on short position
– An investor tells her broker to sell short 1,000 shares of ACI at

BDT 100/share.
– The broker has a 50% margin requirement. The investor has
BDT 50,000 in Treasury bills.
– The maintenance margin on the account for short sales is 30%.
– How much can the price of ACI shares rise before the investor
gets a margin call?
Maintenance margin

– The value of the shares is BDT 1,000P.
Maintenance margin
Cash 100,000 Short position 1000P
T-bills 50,000 Equity ……….
150,000 150,000
Equity
=A–L
= 150,000 – 1,000P
Maintenance margin
Account margin = (150,000 – 1,000P)/ (1,000P)
(150,000 – 1,000P)/ (1,000P) = 30%
P = BDT 115.38
Chapter 5
The Fisher Equation
Irving Fisher suggested that
R = r + E(i)
where
R = nominal interest rate
r = real interest rate
E(i) = expected rate of inflation
Problem #1
Solve the problem

Suppose the real interest rate is 3% per year and the expected
inflation rate is 8%. Using the Fisher Equation, what is the
nominal interest rate?
Problem #1 (solution)
Suppose the real interest rate is 3% per year and the expected
inflation rate is 8%. Using the Fisher Equation, what is the
nominal interest rate?
R = r + E(i)
R = 3% + 8%
R = 11%
Real and nominal
interest rates
Real interest rate

R–i
r=
1+i
where
r = real interest rate
R = nominal interest rate
E(i) = expected rate of inflation
Real and nominal
interest rates
Solve the problem

Suppose the nominal interest rate on a 1-year CD is 8% and you
expect inflation to be 5% over the coming year. What is the real
interest rate?
Real and nominal
interest rates
Solution
Suppose the nominal interest rate on a 1-year CD is 8% and you
expect inflation to be 5% over the coming year. What is the real
interest rate?
r = (R – i) / (1 + i)
r = (8% – 5%) / (1 + 5%)
r = 2.86%
Return
Holding period return (HPR)

Holding period return is calculated using the following formula
Ending price of a share – Beginning price + Dividends

HPR = -------------------------------------------------------------------------
Beginning price
Return

Holding period return is calculated using the following formula
Ending price of a share – Beginning price Dividends

HPR = -------------------------------------------------------- + ---------------
Beginning price Beg. Price
HPR = Capital gains yield + Dividend yield

Return

Suppose you bought a share for BDT 100. The share price goes
up 10% by the end of the year, and cash dividends over the year
amounts to BDT 4.
Ending price of a share – Beginning price + Dividends

HPR = -------------------------------------------------------------------------
Beginning price
= (BDT 110 – BDT 100 + BDT 4) / BDT 100

= 0.14
= 14.00%
Return
Calculate HPR
State of the Year-end Cash

Economy Probability Price Dividends
Excellent 0.25 126.50 4.50
Good 0.45 110.00 4.00
Poor 0.25 89.75 3.50
Crash 0.05 46.00 2.00
Return
Calculate HPR
Excellent = 31.00%
Good = 14.00%
Poor = – 6.75%
Crash = – 52.00%
Return
Expected return
E (r )   p ( s )r ( s )
s
where
p(s) = probability of a state
r(s) = return if a state occurs
s = state
Return
Calculate E(r)

Excellent 0.25 126.50 4.50
Good 0.45 110.00 4.00
Poor 0.25 89.75 3.50
Crash 0.05 46.00 2.00
Return
Solution: E(r) = 0.0976 = 9.76%

Excellent 0.25 126.50 4.50
Good 0.45 110.00 4.00
Poor 0.25 89.75 3.50
Crash 0.05 46.00 2.00
Return
Calculate expected return

State Prob. of State r in State
1 .1 -.05
2 .2 .05
3 .4 .15
4 .2 .25
5 .1 .35
Return
Solution
1 .1 -.05
2 .2 .05
3 .4 .15
4 .2 .25
5 .1 .35
E(r) = (.1)(-.05) + (.2)(.05) + (.4)(.15) + (.2)(.25) + (.1)(.35)

E(r) = .15
Measurements of risk
Variance
   p ( s )  r ( s )  E (r ) 
2 2
Standard deviation = √ variance

Calculate variance and standard deviation

Excellent 0.25 126.50 4.50
Good 0.45 110.00 4.00
Poor 0.25 89.75 3.50
Crash 0.05 46.00 2.00
Solution: variance = 0.0380

standard deviation = 0.1949
Excellent 0.25 126.50 4.50
Good 0.45 110.00 4.00
Poor 0.25 89.75 3.50
Crash 0.05 46.00 2.00
Calculate variance and standard deviation

1 .1 -.05
2 .2 .05
3 .4 .15
4 .2 .25
5 .1 .35
Variance = 0.0120, st. dev = 0.1095

1 .1 -.05
2 .2 .05
3 .4 .15
4 .2 .25
5 .1 .35
Risk premium
Risk premium
The risk premium of an asset is the excess return you would receive
by investing in the asset over and above what you would have
received if you had invested in a risk-free asset.
Risk premium = Expected return – risk free rate

Risk premium
Solve the problem

If a portfolio had a return of 15%, the risk free asset return was
3%, and the standard deviation of the portfolio's excess returns
was 34%, what would be the risk premium?
Risk premium
Solution
was 34%, what would be the risk premium?
Risk premium = Expected return – risk free rate

= 15% – 3%
= 12%
Sharpe ratio
The reward-to-volatility ratio

William Sharpe came up with the Sharpe ratio, which measures the
reward to volatility ratio of an investment.
Risk premium
----------------------------
Sharpe ratio =
SD of excess return
Sharpe ratio
Solve the problem

was 20%, what is the Sharpe ratio?
Sharpe ratio
Solution
Risk premium
Sharpe ratio = ----------------------------
SD of excess return
Sharpe ratio = (8% – 3%) / 20% = 0.25

Sharpe ratio
Solve the problem

Sharpe ratio
Solve the problem

Risk premium
Sharpe ratio = ----------------------------
SD of excess return
Sharpe ratio = (12% – 4%) / 25% = 0.32

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FIN 435

Chapter 1 The investment environment

Chapter 3 How securities are traded

1.1 Real Assets versus Financial Assets

1.3 Financial Markets and the Economy

1.5 Markets Are Competitive

The commitment of funds to one or more assets

• Most individuals make investment decisions some time

Money market Capital market Indirect

A relative of yours tells you to forget about earning 10 percent or

2.4 Stock and Bond Market Indexes

XYZ 100 90 1 100 90

Total $600 $690

a) Calculate the percentage change in the value of the index.

Initial value of Final value of

XYZ 100 90 1 100 90

Total $600 $690

Initial value of Final value of

XYZ 100 90 1 100 90

Total $600 $690

XYZ 50 60 2 100 120

Total $600 $720

XYZ had a 2:1 stock split.

Initial value of Final value of

XYZ 50 60 2 100 120

Total $600 $720

Initial value of Final value of

XYZ 50 60 2 100 120

Total $600 $720

XYZ 100 90 1 100 90

Total $600 $690

Initial value of Final value of

XYZ 100 90 1 100 90

Total $600 $690

Set initial index value = 100 points

– Number of BO account holders in Dec. 2010 = 3.21 million

3.2 How Securities Are Traded

3.9 Short Sales

– The investor borrows part of the purchase price from the

– An investor wants to buy 100 shares of a company at BDT

– An investor wants to buy 100 shares of a company at BDT

Assets Liabilities and Owner’s Equity

Initial margin = Equity/Value = 6,000 / 10,000 = 60.00%

– Suppose the share price falls from BDT 100/share to BDT

– Suppose the share price falls from BDT 100/share to BDT

Assets Liabilities and Owner’s Equity

Initial margin = Equity/Value = 3,000 / 7,000 = 42.86%

– Suppose the share price falls from BDT 100/share to BDT

Initial margin = Equity/Value = 3,000 / 7,000 = 42.86%

– What would happen if the price were to fall below BDT

– Brokers set a maintenance margin to guard against this.

– To use leverage to achieve greater upside potential (at the

– Suppose you bought 200 shares of a firm for BDT 250/share.

– Buying price = BDT 100,000

– Loan = BDT 50,000

– After paying loan + interest, money left = BDT 120,000 – 55,000

– Rate of return = (65,000 – 50,000) / (50,000)

– An investor buys 100 shares at BDT 100/share.

– Let P be the price of the stock.

Maintenance margin = 30%

(100P – 4,000) / 100P = 30%

– An investor buys 200 shares at BDT 50/share.

– Let P be the price of the stock.