Professional Documents
Culture Documents
INVESTMENTS:
ISSUES
BACKGROUND
AND
Eg: the value of the call option will depend on the price of Intel
Stock.
1.3FINANCIAL MARKETS AND THE ECONOMY
Financial Markets
Real assets determine the wealth of the economy while financial assets merely
represent claims on real assets. Financial assets allow us to make the most of the
economys real assets.
Consumption Timing
In high-earnings periods, people are likely to invest their savings in financial assets
such as stocks and bonds while in low-earnings periods they are likely to sell these
assets to provide funds for their consumption needs.
Financial assets help store your wealth, shift your purchasing power from highearnings periods to low-earnings periods (providing the greatest satisfaction by
allocating consumption)
Allocation of Risk
Risk can be allocated by investor:
+ Risk-tolerant investors can buy shares of stock -> bear most of the business risk
+ More conservative ones only buy bonds -> receive fixed payment -> safer
Separation of Ownership and Management
+ Many businesses are owned and managed by the same individual. Small
businesses are the most common example to this simple organization (also the most
common form of business organization before the Industrial Revolution).
+ However, today, along with global markets and large scale production, it became
very difficult to continue the same type of organizations. Therefore, in todays
corporations ownership and management are separated since it also became
impossible for an individual to run both duties.
Corporate Governance and Corporate Ethics
Business and market require trust to operate efficiently
o Without trust additional laws and regulations are required
o All laws and regulations are costly
Governance and ethics failures have cost our economy billions if not trillions of
dollars.
o Eroding public support and confidence in market based systems
Accounting Scandals
o Enron, WorldCom, Rite-Aid, HealthSouth, Global Crossing, Qwest
Misleading Research Reports
o Citicorp, Merrill Lynch, others
Auditors:
o Arthur Andersen and Enron
Sarbanes-Oxley Act
o Increases the number of independent directors on company boards
o Requires the CFO to personally verify the financial statements
o Created a new oversight board for the accounting/audit industry
o Charged the board with maintaining a culture of high ethical standards
1.4THE INVESTMENT PROCESS
2
Loans of a given type such as mortgages are placed into a pool and new
securities are issued that use the loan payments as collateral. Mortgages now
can be traded just like other securities (being marketable and are purchased by
many institutions)
payments that investors can buy. A CDO is also an unbundling example. A simpler
version of unbundling would be a Treasury Strip.
Computer Networks
Online low cost trading
Information made cheaply and widely available
Direct trading among investors via electronic communication networks
Computerization has pressured profit margins of Wall Street firms. Similarly
technological advances that promoted widespread securitization changed the
business model of commercial banks. Both responded by engaging in riskier
trading activities and increasing leverage to bolster rates of return. It could be
argued this helped set up the financial crisis of 2007-2008.
The Future
Globalization will continue and investors will have far more investment
opportunities than the past
Securitization will continue to grow after the crisis
Continued development of derivatives and exotics, more regulation for OTC
derivatives
Strong fundamental foundation of understanding is critical
Understanding corporate finance requires understanding investments
CHAPTER TWO
ASSET
CLASSES
INSTRUMENTS
AND
FINANCIAL
Chapter 2 features different asset classes and some of the instrument within asset
class:
+ Money market: short-term (one year or less); marketable (c th tiu th c);
liquid; low risk. Also called cash instrument
+ Capital market: long-term debt / equity / derivatives
2.1 T HE MONEY MARKET
Treasury bills (tn phiu)
Taxation taxable at the federal level, exempt from state and local taxes
Certificates of Deposit (chng nhn tin gi)
Interest type Add on
Default risk fairly safe (the firms condition can be predicted in one
month)
Originates when a purchaser of goods authorizes its bank to pay the seller
for the goods at a date in the future (time draft).
Eurodollars
Dax
Options
Basic Positions
Call (Buy)
Put (Sell)
Terms
Exercise Price
Expiration Date
Assets
Futures
Basic Positions
Long (Buy)
Short (Sell)
Terms
Delivery Date
Assets
Chap 3
SECURITIES MARKETS
3.1. HOW
SECURITIES MARKETS
- Primary Market: Market in which corporation raise funds through new issues of
securities.
- Secondary Market: The market in which stocks, once issued, are traded rebought
and resold.
- Common Stock:
o Initial Public Offerings first issue
o Seasoned Offerings other issues
- Bonds:
o Public Offerings issues to public
o Private Placements issues to private groups of investors
Private placements do not trade in secondary markets -> reduce liquidity
& thereby prices
3.2. HOW
- Brokered markets is the market in which trading in a good is active, and brokers
find it profitable to offer
search services to buyers and sellers.
- Dealers market is the market in which traders specializing in particular assets buy
and sell for their own
account.
- Auction market is a market where all traders meet at one place to buy and sell an
asset.
o Costly -> limit the shares to ones frequently traded
o Act as secondary market where investors trade their existing securities
b Types of orders :
- Market orders are buy or sell orders that are to be executed immediately.
o Bid price is the price at which a dealer or other traders are willing to purchase a
security.
o Ask price is the price at which a dealer or other traders are willing to sell a
security.
o Bid-ask spread is the difference between a dealers bid and asked price ->
profit source
- Price-contingent orders are orders specifying prices at which investors are willing
to buy or sell a security.
o Limit buy order: is an order at which or below which an investor is willing to
buy a security
o Limit sell order: is an order at which or above which an investor is willing to sell
a security
o Limit order book: a collection of limit orders waiting to be executed
o Stop order is an order at which trade is not to be executed unless stock hits a
price limit
+ Stop-loss order: the stock is to be sold if its price fall below a
stipulated level (to prevent
further losses from
accumulating)
+ Stop-buy order: the stock is to be bought when its price rises above a
limit
c Trading Mechanisms :
- Over-the-counter market an informal network of brokers and dealers who negotiate
sales of securities.
- ECNs computer networks that allow direct trading without the need for market
makers.
o Orders match from one against another = crossed
o Advantages: cheap / quick / offer anonymity
- Specialist a trader who makes a market in the share of one or more firms and who
maintains a fair and orderly market (by dealing personally in the market with their
own portfolio)
o Role: brokers / dealers / facilitators (in an auction market)
o Responsibility: strive to maintain a narrow bid-ask spread
1 TRADING COST
Explicit costs (Commission) - fee that is paid to the broker for making the
transaction.
11
Full Service: Full-service brokers usually depend on a research staff that prepares
analyses and fore- casts of general economic as well as industry and company
conditions and often makes specific buy or sell recommendations
Discount: They buy and sell securi- ties, hold them for safekeeping, offer margin loans,
facilitate short sales, and that is all
Implicit costs - fee collected in the form of the bid-ask spread when trading with
dealers.
2 BUY ON MARGIN
DEFINITION
Brokers call loans - a source of debt financing provided by brokers.
Buying on Margin - the act of purchasing securities with part of the purchasing
price borrowed from brokers.
Collateral - the securities purchased
The part contributed by the investor (NOT the part borrowed) is called Margin.
Initial margin requirement - 50% (set by Fed)
Purchasing price
Initial payment
Borrow
Margin=
-
Equity
=60
Value of Stock
Margin=
Equity
=43
Value of Stock
$4,000
$6,000
$4,000
$3,000
3 SHORT SALES :
Borrow stock through a dealer. (deposit cash or securities in an account as
collateral) and Sell it. Buy the stock and return to the party from which is was
borrowed.
Purpose - to make profit from a decline of a stock or security
Short-sellers must not only replace the shares but also pay the lender of the
security any dividends paid during the short sale.
Cash or collateral is required to cover possible losses in case the stock price goes
up.
13
CHAP 4
INVESTMENT COMPANIES
1
INVESTMENT COMPANIES:
NAV =
2
Unit
Trust
(UITs)
Investment
Issue
redeemable
securities (or "units")
Investors sell back at
its
approximate net
asset value or NAV.
Make
a
one-time
"public offering" of only
a specific, fixed number
of units.
(like closed-end funds)
Open-end fund
(mutual fund)
Closed-end fund
(publicly-traded fund)
Its
shares
redeemable.
on
are
not
Must
sell
to
other
investors,
just
like
common stock with the
prices could be differ from
NAV
To create the liquidity of
the fund, investors can
buy or sell shares through
secondary market.
a
Trade
in
secondary
market all day.
Managed by investment
adviser that are registered
with the SEC.
Managed by investment
adviser that are registered
with the SEC.
Commingled funds are partnerships of investors that pool their funds. The
management firm that organizes the partnership, for example, a bank or insurance
company, manages the funds for a fee. Typical partners in a commingled fund might be
trust or retirement accounts that have portfolios much larger than those of most
individual investors but are still too small to warrant managing on a separate basis.
Real Estate Investment Trusts (REITs) is similar to a closed-end fund. REITs
invest in real estate or loans secured by real estate. Besides issuing shares, they raise
capital by borrowing from banks and issuing bonds or mortgages. Most of them are
highly leveraged, with a typical debt ratio of 70%. There are two principal kinds of
REITs. REITs generally are established by banks, insurance companies, or mortgage
companies, which then serve as investment managers to earn a fee. REITs are exempt
from taxes as long as at least 95% of their taxable income is distributed to
shareholders. For shareholders, however, the dividends are taxable as personal income.
Hedge funds. A private investment pool, open to wealthy or institutional
investors, that is exempt from SEC regulation and can therefore pursue more
speculative policies than mutual funds.
3
MUTUAL FUND :
The common name of for an open-end investment company and Account for more
than 90% of investment company assets in the US
- $10 trillion in US mutual funds
- $9 trillion in non-US sponsor mutual funds
Investment Policies
Each mutual fund has a specified investment policy, which is described in the
funds prospectus. For example, money market mutual funds hold the short-term, lowrisk instruments of the money market, while bond funds hold fixed- income securities.
Some funds have even more narrowly defined mandates.
Some of the more important fund types, classified by investment policy
Money market funds
Investing in money market securities: commercial paper, repurchase agreement,
CDs.
Asset maturity: mostly 1-3 months
Net asset value (NAV) is fixed at $1 per share
No tax implications for capital gain or losses due to redemption of share.
Bond funds
Investing in fixed income sector: corporate bonds, Treasury bonds, mortgage-backed
securities, municipal bonds
Some bond funds specialize in:
Maturity: from intermediate to long-term
Issuers credit risk: from very safe to high yield bonds
Equity funds
Investing primarily in stock
15
Fee Structure:
Operating expenses: deducted periodically from funds assets
- administrative expenses
- advisory fees for investment managers
- marketing and distribution costs for brokers)
Front-end load (usually less than 6%): commission charged when shares are
purchased, paid to brokers selling the funds
- Low-load funds: less than 3% loads
- No-load funds: no front-end load (accounted for half of all funds today)
Back-end load: redemption fee incurred when shares are sold, typically reduced
by 1% for every year investors hold the shares
12b-1 charges : SEC allows managers to use fund assets to pay for distribution
costs
- Limited to 1% of funds net assets per year
- Must be added to operating expense to obtain true annual expense ratio.
16
Gross return =
A fund with a high portfolio turnover rate can be particularly tax inefficient.
Turnover is the ratio of the trading activity of a portfolio to the assets of the
portfolio. It measures the fraction of the portfolio that is replaced each year.
Turnover rate =
trading activity
portfolio assets
Fund tracks an index, a commodity or a basket of assets like an index fund, but
trades like a stock on an exchange. It does not have its net asset value (NAV)
calculated every day.
- bought and sold during the day like stocks on a securities exchange
- purchased through brokers lower management fees
- sell the shares on the open market
- gather enough shares of the ETF to form a creation unit and then exchange the
creation unit for the underlying securities.
Advantages :
- Traded continuously
- Can be sold short or purchased on margin
- Tax saving for the funds
- Lower management fees for the funds
Disadvantages :
- Price can depart by small amount from NAV arbitrage
17
The evidence on mutual fund performance does not show a consistent superior
performance to broad market indexes. Evidence shows a tendency for some persistence
in superior performance by funds but the evidence is far from conclusive. Mutual fund
marketing literature emphasizes past performance but the evidence indicates that
historical performance is not a good predictor of future performance. There is some
evidence that funds with higher expense ratios are more likely to be poorer performers.
8
As the popularity of mutual funds has grown in recent years, nearly all major
business publications feature some reporting on performance of mutual funds. Several
agencies or publications rank mutual fund performance, including
- Morningstar. However fund rankings which are based on historical data are not
necessarily good predictors of future fund performance
18
CHAPTER 5:
RISK AND RETURN: Past and Prologue
I. Rates of Return
A key measure of investors success is the rate at which their funds have grown
during the investment period. The total holding-period return (HPR) of a share of
stock depends on the increase (or decrease) in the price of the share over the
investment period as well as on any dividend income the share has provided. The rate
of return is defined as dollars earned over the investment period (price appreciation as
well as dividends) per dollar invested:
HPR=
A=
E ( r M )r f
2M
Risk aversion implies that investors will accept a lower reward (as measured by
their portfolio expected return) in exchange for a sufficient reduction in risk (as
measured by the standard deviation of their portfolio return). A statistic commonly used
to rank portfolios in terms of this risk-return trade-off is the Sharpe (or reward-tovolatility) measure, defined as:
S=
20
The geometric mean is the best measure of the compound historical rate of
return. Nevertheless the arithmetic average is the best measure of the expected return.
Notice the greater divergence of the GAR and AAR for small stocks. This is because of
the high variance and the higher proportion of negative returns in the small stock
portfolio. Although we dont have statistical significance it appears that some of the
portfolios exhibit kurtosis. Kurtosis of the normal distribution is zero. The world stock,
US small stock and world bond portfolio appear to exhibit kurtosis. This indicates a
higher percentage of observations in the tails that is predicted by the normal
distribution. Non-zero value of skewness are also apparent, although we cant tell if
they are significant. The world stock and US large stock portfolios may exhibit negative
skewness. This indicates a higher probability of extreme negative returns than is
predicted in a normal distribution.
If returns are normally distributed then the following relationship among
geometric and arithmetic averages holds:
Arithmetic Average Geometric Average = 2
IV. Inflation and Real Rates of Return
If prices have changed, the increase in your purchasing power will not equal the
increase in your dollar wealth. At any time, the prices of some goods may rise while the
prices of other goods may fall; the general trend in prices is measured by examining
changes in the consumer price index, or CPI. The CPI measures the cost of purchasing a
bundle of goods that is considered representative of the consumption basket of a
typical urban family of four. Increases in the cost of this standardized consumption
basket are indicative of a general trend toward higher prices. The inflation rate, or the
rate at which prices are rising, is measured as the rate of increase of the CPI.
We need to distinguish between a nominal interest rate - the growth rate of your
money, and a real interest rate - the growth rate of your purchasing power. If we call R
the nominal rate, r the real rate, and i the inflation rate, then we conclude:
r R i
In fact, the exact relationship between the real and nominal interest rate is given by:
r=
Ri
1+i
demand higher nominal rates of return on their investments. This higher rate is
necessary to maintain the expected real return offered by an investment.
V. Asset Allocation Across Risky and Risk-free Portfolios
Investors can choose to hold risky and riskless assets. We may consider
investments in a money market mutual fund as a proxy for the riskless investments
that an investor might actually engage in.
Asset allocation is the portfolio choice among broad investment classes, rather
than among the specific securities within each asset class.
The Risky Asset
When we shift wealth from the risky portfolio (P) to the risk-free asset, we do not
change the relative proportions of the various securities within the risky portfolio.
Rather, we reduce the relative weight of the risky portfolio as a whole in favour of riskfree assets.
The complete portfolio is the entire portfolio including risky and risk- free assets.
The Risk-Free Asset
The power to tax and to control the money supply lets the government, and only
the government, issue default-free (Treasury) bonds. The default-free guarantee by
itself is not sufficient to make the bonds risk-free in real terms, since inflation affects
the purchasing power of the proceeds from the bonds. The only risk-free asset in real
terms would be a price-indexed government bond. Even then, a default-free, perfectly
indexed bond offers a guaranteed real rate to an investor only if the maturity of the
bond is identical to the investors desired holding period.
Portfolio Expected Return and Risk
Now that we have specified the risky portfolio and the risk-free asset, we can
examine the risk-return combinations that result from various investment allocations
between these two assets.
To generalize, the risk premium of the complete portfolio, C, will equal the risk
premium of the risky asset times the fraction of the portfolio invested in the risky asset:
E(rC ) rf = y[E(rP ) rf ]
The standard deviation of the complete portfolio will equal the standard deviation
of the risky asset times the fraction of the portfolio invested in the risky asset:
oC = y*oP
22
In sum, both the risk premium and the standard deviation of the complete
portfolio increase in proportion to the investment in the risky portfolio.
E(r)
The investment opportunity set with a risky asset and a risk-free asset
CAL = Capital
allocation line
P y = 1.25
E(rP) = 15%
r = 7% F
y = .50
S = 8/22
E(rP) r = 8%
P = 22%
In fact, the reward-to-volatility ratio is the same for all complete portfolios that
plot on the capital allocation line. While the risk-return combinations differ, the ratio
of reward to risk is constant.
with all the stocks in a broad market index such as the Standard & Poors 500 index.
The rate of return on the portfolio then replicates the return on the index. We call the
capital allocation line provided by one-month T- bills and a broad index of common
stocks the capital market line (CML). That is, a passive strategy based on stocks and
bills generates an investment opportunity set that is represented by the CML.
24
Chapter 6
EFFICIENT DIVERSIFICATION
6.1 D IVERSIFICATION
SB
_ Using Historical Data is common alternative approach to produce the inputs such as
means, variance,etc.
The three rules od two-risky assets portfolios:
Rule 1: The rate of return on the portfolio is a weighted average of the returns on the
component securities, with the investment proportions as weights.
r p = wBrB + wSrS
( 4)
Rule 2: The expected rate of return on the portfolio is a weighted average of the
expected returns on the component securities, with the same portfolio proportions as
weights.
E(r p) = wBE(rB) + wSE(rS)
(5)
Rule 3: The variance of the rate of return on thee two risky assets portfolio is
Where
BS
= (wB
)2 + ( w S
)2 + 2( wB
) (ws
BS
is the correlation soefficient between the returns on the stock and bond
funds.
The variance of the portfolio is a sum of the contributions of the component security
variances plus a term that involves the correlation coefficient ( and hence, covariance)
between the returns on the component securities.
The risk-return trade off with two risky assets portfolios
25
A correlation coefficient of zero means that stock and bond returns vary independentl of
each other.
Investment opportunity set: set of available portfolio risk-return combination. This is the
set of all attainable combination of risk-return combinations.
The mean-variance criterion
6.3 T HE
Optimal risky portfolio :The best combination of risky assets to be mixed with safe
assets to form the complete portfolio.
1
Systematic risks is largely macroeconomic, affecting all securities, while firmspecific risk factors affect only one particular firm or. perhaps, its industry. Factor
model are statistical models designed to estimate these two components of risk
for a particular security or portfolio.
Excess return: Rate of return in excess of risk free rate.
Beta: The sensitivity of a securitys returns to the systematic or market factor.
Ri = E(Ri ) +
iM + ei
i)
i.
The variance attributable to fi rm-specifi c risk factors, the effects of which are
measured by e i . This is the variance in the part of the stocks return that is
independent of market performance.
This single-index model is convenient. It relates security returns to a market index that
investors follow. Moreover, as we soon shall see, its usefulness goes beyond mere
convenience.
Diversification in a Single-Factor Security Market
The systematic component of each security return is fully determined by the market
factor and therefore is perfectly correlated with the systematic part of any other
securitys return. Hence, there are no diversification effects on systematic risk no
matter how many securities are involved. As far as market risk goes, a single-security
portfolio with a small beta will result in a low market-risk portfolio. The number of
securities makes no difference.
It is quite different with firm-specific or unique risk. If you choose securities with small
residual variances for a portfolio, it, too, will have low unique risk. But you can do even
better simply by holding more securities, even if each has a large residual variance.
Because the firm-specific effects are independent of each other, their risk effects are
offsetting. This is the insurance principle applied to the firm-specific component of risk.
The portfolio ends up with
a negligible level of nonsystematic risk.
In sum, when we control the systematic risk of the portfolio by manipulating the
average beta of the component securities, the number of securities is of no
consequence. But in the case of nonsystematic risk, the number of securities involved
is more important than the firm-specific variance of the securities. Sufficient
diversification can virtually eliminate firmspecific risk. Understanding this distinction is
essential to understanding the role of diversification in portfolio construction.
27
Advocates of the notion that investment risk is lower over longer horizons apply the
logic of diversification across many risky assets to an investment in a risky portfolio
over many years. Because stock returns in successive years are almost uncorrelated,
they conclude that (1) the annual standard deviation of an investment in stocks falls
with the investment horizon, and hence, (2) investment risk in a stock portfolio declines
with the investment horizon.
The Fly in the Time Diversification Ointment (or More Accurately, the Snake Oil)
The flaw in the logic is the use of the annualized standard deviation to gauge the risk of
a long-term investment. Annualized standard deviation is an appropriate measure of
risk only for short-term (annual horizon) portfolios! It cannot serve to measure risk
when comparing investments of different horizons and different scales.
28
Chapter 7
Capital Asset Pricing and Arbitrage Pricing
Theory
7.1 C APITAL ASSET PRICING MODEL (CAPM)
Introduction of CAPM
Developed by Treynor, Sharpe, Lintner and Mossin in the early 1960s
To predict the relationship between the risk and equilibrium expected returns on
risky assets
CAPMs assumptions
1 Investors cannot affect prices by their individual trades.
2 All investors plan for one identical holding period.
3 Portfolios are formed with a universe of public traded financial assets and
investors have unlimited access to risk-free borrowing or lending opportunities.
4 Investors pay neither taxes nor transaction costs.
5 All investors attempt to construct efficient frontier portfolios.
6 All investors analyze securities in the same way and share the same economic
view of the world. Therefore, they all calculate the same figures about expected
return, standard deviation, correlation, etc. (homogeneous expectations)
Implications
1 All investors will choose to hold the market portfolio (M), which includes all
assets of the security universe.
The proportion of each stock in M equals the market value of the stock divided by the
total market value of all stocks.
2 The market portfolio will be on the efficient frontier, at which CAL touches the
efficient frontier.
3 The risk premium on the market portfolio will be proportional to the variance of
the market portfolio and investors typical degree of risk aversion or:
E ( r M )r f = A M
4
The risk premium on individual assets will be proportional to the risk premium on
the market portfolio and to the beta coefficient of the security on the market
portfolio.
E ( r M ) r f
1
E ( r D )r f
D
E ( r D )=r f + D [ E ( r M ) r f ]
Passive strategy
The CAPM suggest that a passive strategy is a powerful alternative to an active
one.
A passive investor can easily benefit from the efficiency of the market portfolio
while an active investor will end on a CAL that is less than the CML used by
passive investor.
29
Applications of CAPM
Investment management industry
Capital budgeting decision
7.2 T HE CAPM AND THE INDEX
In 1963, William Sharpe has launched the single index model (SIM) refers to a
linear relationship between the excess return on the asset and the excess return
on the market.
SIM is a risk analysis tool:
Simple
Easy to apply
The single-index equation:
ri
rf
i +
i ( r M
rf ) +
ei
E( e i ) = 0
Assumptions:
E ( ri ) =
i + rf
r
E( M )
rf
E ( ri ) = rf
r
E( M )
rf
CAPM
i 0
i =0
Predicting Betas
In order to forecast the rate of return of an asset:
in the future
in the future
Use a weighting average of the sample estimate with the value 1.0
7.4 MULTIFACTOR MODELS AND THE CAPM
Multifactor Models
Multifactor Models: Models of security returns positing that returns respond to
several systematic factors (business-cycle risk, interest or inflation rate risk,
energy price risk,...)
Multifactor Models can provide better descriptions of security returns.
Suppose two sources of risk:
Market index
Treasury-bond portfolio
The excess rate of return on stock i in some time period t will be:
Ri = ai + iMRMt + iTBRTBt + ei
Two-factor security market line for security I
E(ri ) = rf + iM [E(rM) - rf ] + iTB [E(rTB) - rf ]
Fama-French Three-factor Model
In 1996, Fama and French proposed a three-factor model.
Market index
Firm size (SMB small minus big)
Book-to-market ratio (HML high minus low)
Ri = ai + M(rM rf )+ HML * rHML + SMB * rSMB + ei
7.5 F ACTOR MODELS AND THE ARBITRAGE PRICING THEORY
Arbitrage Pricing Theory (APT)
Arbitrage:
Arises
if
an
investor
can
construct
a
zero
investment portfolio with a sure profit
Zero
investment:
Since
no
net
investment
outlay
is
required,
an
investor
can
create
arbitrarily
large
positions
to
secure
large levels of profit
Efficient
markets:
With
efficient
markets,
profitable
arbitrage
opportunities
will
quickly
disappear
APT: A theory of risk-return relationships derived from no-arbitrage
considerations in large capital markets.
In single form, the excess rate of return on each security using the APT is:
Ri = ai + iRM + ei
A well-diversified porfolio has zero firm-specific risk, so its return is:
Rp = ap + pRM
If the portfolio beta is 0, then:
Rp = ap
This portfolio has a return higher than the risk-free rate by the amount of ap
31
32
CHAPTER EIGHT
THE EFFICIENT MARKET HYPOTHESIS
8. 1 RANDOM WALKS AND THE EFFICIENT MARKET HYPOTHESIS
Definitions of informational and allocational efficiency are provided. Implications of
efficiency are then discussed and the idea of random walk is introduced and illustrated.
Note that we actually expect there to be a positive trend in stock prices albeit with
random movements about those positive trends. The reason that we would expect to
see price changes that are random is related to efficiency. If information that has
importance for stock values arrives or occurs in a random fashion, price
changes will occur randomly. If the market is efficient in its analysis, the change in
prices will reflect that information in a timely basis. The result will be random price
changes. The concept of market efficiency is related to the concept of competition. In
efficient markets, once information becomes available, participants will trade quickly on
that information. Competition assures that prices will reflect that information very
quickly. If the information does not become incorporated into price very quickly, market
participants would act to eliminate the inefficiency. Questions arise about efficiency
due to possible unequal access to information, structural market problems and
the psychology of investors (Behavioralism). Structural market problems refers to
market imperfections such as transaction costs limiting arbitrage, constraints on short
sales doing the same and recognizing that in volatile markets, most arbitrage strategies
are really risky arbitrage, not riskless arbitrage. We will have more to say on this later.
The forms of the efficient market are presented. In a weak form efficient market, prices
will reflect all information that can be derived from trading data such as prices and
volumes. In a semi-strong form market prices will reflect all publicly available
information regarding the firms prospects. In a strong form market, prices would
reflect all information relevant to the firms' prospects, even inside information. It
is important that students understand the following Venn diagram.
Many students struggle with this concept so it is worth taking the time to point
out the relationships among the different forms of efficiency.
8.2 I MPLICATIONS OF THE EMH (FOR SECURITY ANALYSIS)
Technical and fundamental analyses are defined in this section as well as the
implications of the different forms of market efficiency with respect to security
analysis. If markets are weak form efficient, technical analysis, such as charting,
should not result in superior profits. If markets are semi-strong form efficient,
fundamental
analysis
should
not
result
in
consistent
superior
profits.
Fundamental analysis involves using information on the economy as well as
information such as earning trends and profit trends to find undervalued securities.
If markets are at least semi-strong efficient, investors would tend to employ passive
strategies such as buying indexed funds or employing a diversified buy and hold
strategy. Active management such as security analysis or attempting to time the
market would not result in consistently superior profits if markets are efficient.
33
Even when markets are efficient portfolio management is required. For one thing, the
appropriate risk level will vary over an investor's life. Tax considerations will call for
different types of securities to be included in the portfolio. Other considerations could
be related to reinvestment risk associated with cash flow or considerations related to
diversifying employment related risk.
8.3 A RE MARKETS EFFICIENT?
Over time stock prices tend to follow a sub martingale. This has nothing to do with
efficiency, per se. It does however have serious implications for tests of efficiency.
This implies that a randomly chosen portfolio of stocks can be expected to have a
positive return. In practice this means that when trying to figure out if some portfolio
manager is earning abnormal returns we must compare their performance to the
performance of a randomly chosen portfolio. That is they must outperform the random
portfolio or in practice they must beat some benchmark rate of return. The PPT
illustrates the idea of an event study and how an event study might look in an efficient
and in an inefficient market and introduces a market model to provide the expected
return that is needed to assess whether the investor earns an abnormal return.
The magnitude, selection bias and lucky event issues are also covered as well as
possible model misspecification. Because a model of expected return is needed
to assess whether an investor or an investment rule earns excess return, tests of
market efficiency are joint tests of the model used to estimate expected returns and
market efficiency. Hence, even when an anomaly is discovered we have to be
careful in interpreting the results. Some apparent anomalies are discussed including
the Fama-French results, the Keim and Stambaugh findings and the Campbell and
Shiller work. Note that each of these results may also be consistent with changing risk
premiums and may have nothing to say about market efficiency.
Periodically stock prices appear to undergo a speculative bubble. A speculative bubble
is said to occur if prices do not equal the intrinsic value of the security. Does this imply
that markets are not efficient?
There is no definitive answer to this question. However we can make some
observations:
It is very difficult to predict if you are in a bubble and when the bubble will
burst. I have been through two bubbles now and you cant understate the
significance of this point.
Stock prices are estimates of future economic performance of the firm and
these estimates can change rapidly.
Risk premiums can change rapidly and dramatically. Nevertheless, with
hindsight there appear to be times when stock prices decouple from
intrinsic or fundamental value, sometimes for years. What does this imply?
Prices eventually conform once more to intrinsic value. Many who dont
believe in efficient markets anyway have jumped on this result to
pronounce the death of market efficiency. However, the bubbles bring into
question the allocational efficiency of the markets more than the informational
efficiency. Very few people will be able to consistently predict the extent
and duration of a bubble.
34
Some claim the bubbles imply that investors are irrational. Perhaps, but
think about what determines the price of gold. Is it irrational to buy an asset for
more than its fundamental value if you believe that you can sell it for more than
you paid for it? It is indeed risky to engage in this type transaction, but is it
irrational?
Bubbles seem to occur during two periods: 1) when technology is changing
rapidly and 2) during periods of cheap capital when interest rates are low for
extended periods. In the first case values will be more heavily determined by
future growth prospects rather than the value of assets in place. During
periods of cheap capital, new investments will be undertaken based on
future growth prospects as well. In both situations, new investors with less
investment knowledge and experience are likely to enter the markets, making a
bubble even more likely. When the bubble bursts, there will appear to be a
return to hardnosed rationality as investors look carefully to invest
according to their beliefs about fundamental values and will employ higher risk
premiums.
For more on thoughts on this topic (and more history about bubbles) read
Burton Malkeils book, A Random Walk Down Wall Street to learn how
Castles in the Air sometimes outweigh fundamental values in price setting.
Some of the major types of tests that researchers have done on market
efficiency are described. If markets are inefficient, then professionals who spend
considerable resources in investment should secure superior performance. The tests
are broken down in terms tests of the forms of efficiency. Tests have uncovered some
inefficiency in pricing but many possible interpretations of results are possible. Tests of
weak-form efficiency show small magnitudes of positive correlation for very short
term tests; hence prices do not strictly conform to a random walk. Studies of returns
for periods of 3 to 12 months offer evidence of positive momentum. Longer horizon
tests have uncovered some pronounced negative correlation. Tests do document
tendencies for long-term reversals in results. This may be because of information flow
in competitive markets. People rush to buy recent winners and in so doing drive up the
price enough so that future returns are not abnormal. This does not imply inefficiency
unless the same investors can consistently do this. Attempting to interpret the
results of test of efficiency has led to various explanations that arrange from model
misspecification to data mining.
8.4 MUTUAL FUND AND ANALYST PERFORMANCE
Some recent studies on mutual funds have documented some persistence in
positive and negative performance.
Some researchers question whether the
performance is abnormal or whether the studies have measurement errors or model
biases. The overall test results are mixed at best but the evidence shows that some
superstars exist. Note that Warren Buffets portfolio, (Buffet is one of the postulated
superstars) took quite a beating in the financial crisis of 2008. Although the evidence
isnt conclusive it appears safe to state that the ability to consistently earn abnormal
returns greater than one should for the risk level undertaken is very rare.
I also include a wrap up summary in this section to drive home the main points of the
chapter. I did this because students seem to have some trouble with the implications of
35
market efficiency and because in some cases it is difficult to get them past their own
prior beliefs in spite of what the evidence reveals.
36
CHAPTER NINE
BEHAVIORAL
ANALYSIS
FINANCE
AND
TECHNICAL
Information Processing
information correctly
Information Processing
Forecasting errors
o
De Bondt and Thaler (1990) employ this notion to explain the P/E ratio
effect.
Overconfidence
o
o
Conservatism
o
o
A conservatism bias means that investors are too slow (or said too
conservative) in updating their beliefs in response to new evidence
This under-reaction to news leads to momentum effect in stock returns
37
Representativeness bias
o
Behavioral Bias
Framing effect
o
People tend to avoid risk when a positive frame is presented but seek
risks when a negative frame is presented
Mental accounting
o
Investors have a safe part of their portfolio that they will not risk, and a
risky part of their portfolio that they can have fun with
Regret avoidance
o
o
Prospect theory
o
o
o
1. The results show that what affects people's decisions is not their wealth
level after the gamble, but the amount of gains or losses from the gamble
2. Loss averse attitude: people are more sensitive about the losses than
the gains
o
The decrease of the utility from $1 loss is larger than the increase of the
utility from $1 gain
In Prospect Theory, people are risk averse (thus with concave utility
function) when facing gains and risk loving (thus with convex utility
function) when facing losses (in Diagram B)
Limits to Arbitrage
Fundamental risk
The distortion could get worse or maintain for a long enough horizon such
that the exploitation of that distortion to profit is limited (e.g., a trader
may run out of his capital or a fund manager may lose his job before the
prices go back to the fair level)
Implementation costs
Or short-sellers may have to return the borrowed securities soon after the
notification from the broker, that makes the horizon of the short sale
uncertain
Model risk
In 1907, Royal Dutch Petroleum (RDP) and Shell Transport (ST) merged
their operations into one firm
RDP receives 60% cash income, and ST receives 40% cash income, so it
can be expected that the price of a RDP share is 1.5 times as high as the
price of a ST share (see the figure on the next slide)
The interaction of these two biases can explain the bubble from
1995 to 2001
Try to explain anomalies but does not give guidance of how to exploit these
irrationalities
Minor trend (swing): daily fluctuations which are with little importance in the
trend analysis of the Dow theory
Sentiment Indicators
Trin Statistic
Trin: TRading Index
Trin =
Confidence Index
This ratio is always smaller than 1 because higher rated bonds will offer
lower promised yields to maturity
Short Interest
Short interest : total number of shares that are sold-short in the market
Short sale: the sale of shares not owned by the investor but borrowed through a
broker and later purchased to replace the loan
2 ways of interpretation:
Put options do well in falling markets while call options do well in rising market
41
Chapter 10
Bond prices and yields
10.1 BOND
CHARACTERISTICS
Definition: a security that obligates the issuer to make specified payments to the holder
over a period of time.
Related terminologies
Face value, par value: the payment to the bondholder at the maturity of the bond.
Coupon rate: A bonds annual interest payment per dollar of par value.
Zero-coupon bond: A bond paying no coupons that sells at a discount and provides only
a payment of par value at maturity.
a Treasury Bonds and Notes
Both bonds and notes are issued in denominations of $1,000 or more and make
semiannual coupon payments.
Accrued interest and quoted bond prices
If a bond is purchased between coupon payments, the buyer must pay the seller for
accrued interest, the prorated share of the upcoming semiannual coupon. The
amount the buyer actually pays would equal the stated price plus the accrued interest.
annualcoupon payment
days since last coupon payment
=accrued interest
2
days seperating coupon payments
b Corporate bonds
Callable bond
Call provision allows the issuer to repurchase the bond at a specified call price before
the maturity date. The option to call the bond is valuable to the firm, allowing it to buy
back the bonds and refinance at lower interest rates when market rates fall. However
it is also the investors burden. Hence callable bonds are issued with higher coupons
and promised yields to maturity than non-callable bonds.
Convertible bond
Convertible bonds give bondholders an option to exchange each bond for a specified
number of shares of common stock of the firm.
Conversion ratio: the number of shares for which each bond may be exchanged.
Market conversion value: the current value of the shares for which the bonds may be
exchanged. At the $20 stock price, for example, the bonds conversion value is $800.
Conversion premium: the excess of the bond price over its conversion value.
Convertible bondholders benefit from price appreciation of the companys stock.
Puttable bonds
While the callable bond gives the issuer the option to extend or retire the bond at the
call date, the extendable or put bond gives this option to the bondholder. If the bonds
coupon rate exceeds current market yields, for instance, the bondholder will choose to
extend the bonds life. If the bonds coupon rate is too low, it will be optimal not to
extend; the bondholder instead reclaims principal, which can be invested at current
yields.
Floating-rate bonds
42
Floating-rate bonds make interest payments that are tied to some measure of current
market rates. For example, the rate might be adjusted annually to the current T-bill rate
plus 2%. If the one-year T-bill rate at the adjustment date is 4%, the bonds coupon rate
over the next year would then be 6%. This arrangement means that the bond always
pays approximately current market rates.
c Preferred stock
Preferred stock commonly pays a fixed dividend. Dividends on preferred stock are not
considered tax-deductible expenses to the firm. But a corporation pays taxes on only
30% of the dividend received when it buys preferred stock of another corporation.
In the event of bankruptcy, the claim of preferred stockholders to the firms assets
has lower priority than that of bondholders, but higher priority than that of common
stockholders.
d International bonds
International bonds are divided into two categories: foreign bonds and Eurobonds.
Foreign bonds:
E.g. foreign bonds sold in U.S. are called Yankee bonds. They are denominated in USD
and the issuers can be whatever country in the world except for U.S.
Foreign bonds sold in Japan are called Samurai bonds. They are denominated in Yen and
the issuers are non-Japanese ones.
Eurobonds: bonds issued in the currency of one country but sold in other national
markets.
E.g. the Eurodollar market refers to dollar-denominated bonds sold outside the U.S.
(not just in Europe), although London is the largest market for Eurodollar bonds.
e Innovation in the bond market
Inverse floaters: it is similar to the floating-rate bonds we described earlier, except
that the coupon rate on these bonds falls when the general level of interest rates rises.
Investors in these bonds suffer doubly when rates rise. Not only does the present value
of each dollar of cash flow from the bond fall as the discount rate rises but the level of
those cash flows falls as well. Of course investors in these bonds benefit doubly when
rates fall.
Asset-backed bonds: Bonds with coupon rates tied to the financial performance of
several of its films. The income from a specified group of assets is used to service
the debt. More conventional asset-backed securities are mortgage-backed securities
or securities backed by auto or credit card loans.
Pay-in-kind bonds: Issuers of pay-in-kind bonds may choose to pay interest either
in cash or in additional bonds. If the issuer is short on cash, it will likely choose to pay
with new bonds rather than scarce cash.
Catastrophe bonds: Bonds that have final payment depends on whether the
catastrophe sticking on it happens or not. These bonds are a way to transfer
catastrophe risk from insurance companies to the capital markets. Investors in these
bonds receive compensation in the form of higher coupon rates for taking on the risk.
But in the event of a catastrophe, the bondholders will give up all or part of their
investments.
43
Indexed bonds Indexed bonds make payments that are tied to a general price index or
the price of a particular commodity. For example, Mexico has issued bonds with
payments that depend on the price of oil.
1
Bond pricing
Bond value = Present value of coupons + Present value of par value
t
bond value=
t =1
YIELD
Price=
t=1
Where:
44
Interest rate and bond price have long-term negative relationship for all maturity. A
bond will be sold above its face value when the coupon rate is higher than the discount
rate (market interest rate), at the face value when the coupon rate is equal to the
market interest rate, and below its face value when the coupon rate is lower than the
market interest rate.
Yield to Maturity versus Holding-Period Return
If the yield to maturity is unchanged over the period, the rate of return on the bond will
equal that yield.
When the yields fluctuate, a bonds rate of returns will change accordingly.
An increase in the bonds yield to maturity will reduce its price, which means that the
holding-period return will be less than the initial yield.
Equivalently, a decline in the bonds yield to maturity results in the holding-period
return greater than the initial yield.
Zero-Coupon Bonds and Treasury STRIPS
Zero coupon bonds carry no coupons and present all its return in the form of price
appreciation.
When a Treasury fixed-principal note or bond (or a TIPS) is stripped, each interest
payment and the principal payment becomes a separate zero-coupon security.
Example: a Treasury note with 10 years remaining to maturity consists of a single
principal payment at maturity and 20 interest payments (paid semiannually). When this
note is converted to STRIPS form, each of the 20 interest payments and the principal
payment becomes a separate security.
STRIPS are also called zero-coupon securities because the only time an investor
receives a payment during the life of a STRIP is when it matures.
10.4 D EFAULT RISK AND
BOND PRICING
Bond default risk is measured by Moodys Investor Services, Standard & Poors
Corporation, and Fitch Investors Service, all of which provide financial information on
firms as well as the credit risk of large corporate and municipal bond issues.
Bond Ratings
Very
High
High Quality
Speculative
Very Poor
Quality
AAA
A
BB
CCC
Standard & Poors
AA
BBB
B
D
Aaa
A
Ba
Caa
Moodys
Aa
Baa
B
C
Investment grade bond A bond rated BBB and above by Standard & Poors, or Baa
and above by Moodys.
Speculative grade or junk bond A bond rated BB or lower by Standard & Poors, or Ba
or lower by Moodys, or an unrated bond.
Junk Bonds: they are also known as high-yield bonds and are nothing more than
speculative grade (low- rated or unrated) bonds.
Determinants of Bond Safety
a Coverage ratios. Ratios of company earnings to fixed costs. For example, the TIE ratio is
the ratio of earnings before interest payments and taxes to interest obligations. The
fixed-charge coverage ratio includes lease payments and sinking fund payments with
45
interest obligations to arrive at the ratio of earnings to all fixed cash obligations. Low or
falling coverage ratios signal possible cash flow difficulties.
b Leverage ratio. Debt-to-equity ratio. A too-high leverage ratio indicates excessive
indebtedness, signaling the possibility the firm will be unable to earn enough to satisfy
the obligations on its bonds.
c Liquidity ratios. These are current ratio (current assets/ current liabilities) and the quick
ratio (current assets excluding inventories/current liabilities). These ratios measure the
firms ability to pay bills coming due with its most liquid assets.
d Profitability ratios. Measures of rates of return on assets or equity. Profitability ratios are
indicators of a firms overall performance. The return on assets (earnings before interest
and taxes divided by total assets) or return on equity (net income/equity) are the most
popular of this measure.
e Cash flow-to-debt ratio. This is the ratio of total cash flow to outstanding debt.
Bond Indentures:
Bond indenture is the document defining the contract between the bond issuer and
the bondholder.
Protection Against Default:
Sinking funds
Issuer may repurchase a given fraction of the outstanding bonds each year
Issuer may either repurchase at the lower of open market price or at a pre-specified
price, usually par; bonds are chosen randomly
Serial bonds
Subordination of future debt: Senior debt holders must be paid in full before
junior debt holders.
Note that sinking funds and serial bonds are designed to help ensure the issue can pay
off the principal as it comes due. However a bond investor could be hurt by the second
type of sinking fund if interest rates fall. Serial bonds are not callable and this is a plus,
but the staggered maturities can reduce the liquidity of the bonds and make them more
expensive.
10.5 THE YIELD
CURVE
Expectations theory
Firstly, long term rates are a function of expected future short term rates. Secondly,
upward slope means that the market is expecting higher future short term rates and
downward slope means that the market is expecting lower future short term rates.
It is the theory that investors demand a risk premium on long-term bonds. It derives from
the fact that shorter term bonds have more liquidity than longer term bonds, in the
sense that they offer greater price certainty and trade in more active markets with lower
bid-ask spreads. The preference of investors for greater liquidity makes them willing to
hold these shorter term bonds even if they do not offer expected returns as high as
those of longer term bonds.
47
Chapter 11
Managing bond portfolio
11.1 I NTEREST RATE RISK
Interest Rate Sensitivity
Bond prices and yields are inversely related: As yields increase, bond prices fall; as
of short-term bonds.
If rates increase, for example, the bond is less valuable as its cash flows are discounted
at a now-higher rate. The impact of the higher discount rate will be greater as that rate
is applied to more-distant cash flows.
The sensitivity of bond prices to changes in yields increases at a decreasing rate as
maturity increases. In other words, interest rate risk is less than proportional to bond
maturity.
Interest rate risk is inversely related to the bonds coupon rate. Prices of low-coupon
bonds are more sensitive to changes in interest rates than prices of high-coupon bonds.
The sensitivity of a bonds price to a change in its yield is inversely related to the yield
CF ( t )
( 1+ y )t
w ( t )=
bond price
y: bonds yield to maturity.
The numerator: the present value of the cash flow occurring at time t, while
The denominator: the present value of all the payments forthcoming from the bond
Then we use w(t) to calculate Duration following the equation:
T
D= t w (t )
t =1
Duration is a key concept in bond portfolio management for at least three reasons
because it is a simple summary measure of the effective average maturity of the portfolio.
48
Besides, it represents an essential tool in immunizing portfolios from interest rate risk.
Modified duration: D* = D/(1 + y)
Because the percentage change in the bond price is proportional to modified
duration, modified duration is a natural measure of the bonds exposure to interest rate
volatility
Factors determine duration:
Rule 1: The duration of a zero-coupon bond equals its time to maturity.
Rule 2: With time to maturity and yield to maturity held constant, a bonds duration and
interest rate sensitivity are higher when the coupon rate is lower.
Rule 3: With the coupon rate held constant, a bonds duration and interest rate
sensitivity generally increase with time to maturity. Duration always increases with
maturity for bonds selling at par or at a premium to par.
Rule 4: With other factors held constant, the duration and interest rate sensitivity of a
coupon bond are higher when the bonds yield to maturity is lower.
Rule 5: The duration of a level perpetuity is
Duration of perpetuity=
1+ y
y
The substitution swap is an exchange of one bond for a nearly identical substitute.
The substituted bonds should be of essentially equal coupon, maturity, quality, call
features, sinking fund provisions, and so on. A substitution swap would be motivated
by a belief that the market has temporarily mispriced the two bonds, with a
discrepancy representing a profit opportunity.
The intermarket spread swap is an exchange of two bonds from different sectors of
the bond market. It is pursued when an investor believes the yield spread between
two sectors of the bond market is temporarily out of line.
E.g. If the yield spread between 10-year Treasury bonds and 10-year Baa- rated
corporate bonds is now 3%, and the historical spread has been only 2%, an investor
might consider selling holdings of Treasury bonds and replacing them with corporates.
If the yield spread eventually narrows, the Baa-rated corporate bonds will outperform
the Treasury bonds.
Of course, the investor must consider carefully whether there is a good reason that the
yield spread seems out of alignment. For example, the default premium on corporate
bonds might have increased because the market is expecting a severe recession. In this
case, the wider spread would not represent attractive pricing of corporates relative to
Treasuries, but would simply be an adjustment for a perceived increase in credit risk.
The pure yield pickup swap is an exchange of a shorter duration bond for a longer
dura- tion bond. This swap is pursued not in response to perceived mispricing but as a
means of increasing return by holding higher yielding, longer maturity bonds. The
investor is willing to bear the interest rate risk this strategy entails.
Contingent Immunization
It is a technique that immunizes a portfolio if necessary to guarantee a minimum
acceptable return but otherwise allows active management.
50
The idea is to allow the fixed-income manager to manage the portfolio actively
unless and until poor performance endangers the prospect of achieving a minimum
acceptable portfolio return. At that point, the portfolio is immunized, providing a
guaranteed rate of return over the remaining portion of the investment period.
51
Chapter 12
Macroeconomic and Industry Analysis
12.1 THE GLOBAL ECONOMY:
The international economy might affect a firms export prospects, the price
competition it faces from foreign competitors, or the profits it makes on investments
abroad. Certainly, despite the fact that the economies of most countries are linked in a
global macro economy, there is consider- able variation in economic performance
across countries at any time. The global environment presents political risks such as
currency and stock values swung with enormous volatility, protectionism and trade
policy, exchange rate. As exchange rates fluctuate, the dollar value of goods priced in
foreign currency similarly fluctuates.
12.2 THE DOMESTIC MACRO ECONOMY:
Gross domestic product: Gross domestic product, or GDP, is the measure of the
economys total production of goods and services. Rapidly growing GDP indicates an
expanding economy with ample opportunity for a firm to increase sales.
Employment: The unemployment rate is the percentage of the total labor force (i.e.,
those who are either working or actively seeking employment) yet to find work. The
unemployment rate measures if economy is operating at full capacity, the strength of
the economy can be gleaned from the employment rate of other factors of production
and the factory capacity utilization rate.
Inflation
Inflation is the rate at which the general level of prices is rising. High rates of inflation
often are associated with economies where the demand for goods and services is
outstripping productive capacity, which leads to upward pressure on prices. There is a
trade-off between inflation and unemployment .
Interest Rates
High interest rates reduce the present value of future cash flows, thereby reducing the
attractiveness of investment opportunities. Real interest rates are key determinants of
business investment expenditures.
Budget Deficit
The budget deficit of the federal government is the difference between government
spending and revenues. Government borrowing forces up interest rates by increasing
the total demand for credit in the economy. Excessive government borrowing will
crowd out private borrowing and investing.
Sentiment
2. The demand for funds from businesses to be used to finance physical investments in
plant, equipment, and inventories.
3. The governments net supply and/or demand for funds as modified by actions of the
Federal Reserve Bank.
4. The expected rate of inflation.
The supply curve slopes up from left to right because the higher the real interest rate
makes households postpone some current consumption and set aside or invest more.
The demand curve slopes down from left to right because the lower the real interest
rate, the more businesses will want to invest in physical capital. The government and
the central bank (the Federal Reserve) can shift these supply and demand curves either
to the right or to the left through fiscal and monetary policies. The fundamental
determinants of the real interest rate are the propensity of households to save and the
expected of firmsinvestment in physical capital as well as by government fiscal and
monetary policies.
12.4 DEMAND AND SUPPLY SHOCKS
A demand shock is an event that affects the demand for goods and services in the
economy. Demand shocks usually are characterized by aggregate output moving in the
same direction as interest rates and inflation. It also might increase interest rates by
increasing the demand for borrowed funds. It could increase the inflation rate if the
demand for goods and services is raised to a level at or beyond the total productive
capacity of the economy.
A supply shock is an event that influences production capacity and costs. Supply
shocks usually are characterized by aggregate output moving in the opposite direction
as inflation and interest rates. The increase in inflation rates over the near term can
lead to higher nominal interest rates. With raw materials more expensive, the
productive capacity of the economy is reduced as is the ability of individuals to
purchase goods at now-higher prices. GDP, therefore, tends to fall.
12.5 FEDERAL GOVERNMENT POLICY
Fiscal policy is the use of government spending and taxing for the specifi c purpose of
stabilizing the economy. Decreases in government spending directly deflate the
demand for goods and services. Similarly, increases in tax rates immediately siphon
income from consumers and result in fairly rapid decreases in consumption. while the
impact of fiscal policy is relatively immediate, its formulation is so cumbersome that
fiscal policy cannot in practice be used to fine-tune the economy. Much of government
spending is determined by formula rather than policy and cannot be changed in
response to economic conditions. A large deficit means the government is spending
considerably more than it is taking in by way of taxes. The net effect is to increase the
demand for goods (via spending) by more than it reduces the demand for goods (via
taxes), therefore, stimulating the economy.
Monetary policy is Actions taken by the Board of Governors of the Federal Reserve
System to influence the money supply or interest rates. Increases in the money supply
lower short-term interest rates, ultimately encouraging investment and consumption
demand Expansionary monetary policy probably will lower interest rates and thereby
stimulate investment and some consumption demand in the short run, but these
circumstances ultimately will lead only to higher prices. Implementation of monetary
policy through some tools. The first tool is the open market.operation, in which the Fed
buys or sells Treasury bonds for its own account. Other tools at the Feds disposal are
the discount rate, which is the interest rate it charges banks on short-term loans, and
the reserve requirement. Lowering reserve requirements allows banks to make more
53
loans with each dollar of deposits and stimulates the economy by increasing the
effective money supply.
Supply-side policies treat the issue of the productive capacity of the economy. The
goal is to create an environment in which workers and owners of capital have the
maximum incentive and ability to produce and develop goods. Supply-side economists
also pay considerable attention to tax policy. Lowering tax rates will elicit more
investment and improve incentives to work, thereby enhancing economic growth.
12.6 BUSINESS CYCLES
These recurring patterns of recession and recovery are called business cycles. A
peak is the transition from the end of an expansion to the start of a contraction. A
trough occurs at the bottom of a recession just as the economy enters a recovery. At a
trough, just before the economy begins to recover from a recession, one would expect
that cyclical industries, those with above-average sensitivity to the state of the
economy, would tend to outperform other industries. In contrast to cyclical firms,
defensive industries have little sensitivity to the business cycle. Defensive industries
include food producers and processors, pharmaceutical firms,
and public utilities. These industries will outperform others when the economy enters a
recession.
Economic Indicators:Leading economic indicators are those economic series that tend
to rise or fall in advance of the rest of the economy. Coincident and lagging indicators
move in tandem with or somewhat after the broad economy. The stock market price
index is a leading indicator. Stock prices are forward-looking predictors of future
profitability. The money supply is another leading indicator. Other leading indicators
focus directly on decisions made today that will affect production in the near future.
12.7 INDUSTRY ANALYSIS
We have seen that economic performance can vary widely across countries,
performance also can vary widely across industries.
Defining an Industry: A useful way to define industry groups in practice is given by the
North American Industry Classification System, or NAICS codes. These are codes
assigned to group firms for statistical analysis. The first two digits of the NAICS codes
denote very broad industry classifications. Another industry classification is Standard &
Poors reports on the performance of about 100 industry groups. The Value Line
Investment Survey reports on the conditions and prospects of about 1,700 firms,
grouped into about 90 industries.
Sensitivity to the Business Cycle: Not all industries are equally sensitive to the business
cycle. Three factors will determine the sensitivity of a firms earnings to the business
cycle. First is the sensitivity of sales. Necessities will show little sensitivity to business
conditions. The second factor determining business cycle sensitivity is operating
leverage, which refers to the division between fixed and variable costs. Firms with
greater amounts of variable as opposed to fixed costs will be less sensitive to business
conditions. The third factor influencing business cycle sensitivity is financial leverage,
which is the use of borrowing. Interest payments on debt must be paid regardless of
sales. Investors should not always prefer industries with lower sensitivity to the
business cycle.
Sector rotation is an investment strategy that entails shifting the portfolio into industry
sectors that are expected to outperform others based on macroeconomic forecasts. The
idea is to shift the portfolio more heavily into industry or sector groups that are
expected to outperform based on ones assessment of the state of the business cycle.
Near the peak of the business cycle, firms should engage in natural resource extraction
and processing such as minerals or petroleum. Following a peak, when the economy
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enters a contraction or recession, one would expect defensive industries that are less
sensitive to economic conditions. At the trough of a recession, firms might thus be
spending on purchases of new equipment or invest in capital goods industries.
Industry Life Cycles: Industry life cycle: Stages through which firms typically pass as
they mature .It might be described by four stages.
Start-up stage The early stages of an industry are often characterized by a new
technology or product. At this stage, it is difficult to predict which firms will emerge as
industry leaders.
Consolidation stage: At this point, the product has reached its potential for use by
consumers. The product has becomefar more standardized, and producers are forced to
compete to a greater extent on the basis of price.
Relative decline the industry might grow at less than the rate of the overall economy,
or it might even shrink.
Industry Structure and Performance
Threat of entry New entrants to an industry put pressure on price and profits.
Rivalry between existing competitors When there are several competitors in an
industry, there will generally be more price competition and lower profit margins as
competitors seek to expand their share of the market
Pressure from substitute products Substitute products means that the industry faces
competition from firms in related industries
Bargaining power of buyers If a buyer purchases a large fraction of an industrys output,
it will have considerable bargaining power and can demand price concessions.
Bargaining power of suppliers If a supplier of a key input has monopolistic control over
the product, it can demand higher prices for the good and squeeze profits out of the
industry.
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Chapter 13
Equity Valuation
13.1 V ALUATION BY COMPARABLES :
The purpose of fundamental analysis is to identify mispriced stocks. To assess whether
it is mispriced, they compare it with some measures of true value. True value is
estimated based on both observable market data and financial statement data.
Analysiss analyses the relationship between price and different determinants such as
operating earnings, book value, sales, etc. Those ratios will then be used to compare
with other firms in the same industry.
Book.value.is the value of common equity on the balance sheet and it is based on
historical values of assets and liabilities, which may not reflect current values. It may
not take into account for the future growth opportunities of the firm. Therefore, market
value of equity to book ratio is thought to be a better measure of market valuation over
the book value. Additionally, use the Liquidation value per share to set the stock price
floor rather than book value. Liquidation value is the net amount realized from sale of
assets and paying off all debt. The firm becomes a takeover target if the market value
of stock falls below this amount, so liquidation value may serve as floor to value.
13.2 I NTRINSIC VALUE VERSUS MARKET PRICE :
Intrinsic value is the present value of a firms expected future net cash flows discounted
by the required rate of return. The intrinsic value is the value that the analyst places on
a stock. Comparing intrinsic value and market price can generate buy or sell signals
Using CAPM model to calculate require rate of return:
k= rf + [E(rM)-rf) -> risk adjusted interest rate
Based on 1 year holding period to measure the intrinsic value: V o
E ( D 1 ) + E( P 1)
1+k
D1
D2
Vo= 1+ k + (1+k )2 ++
DH + PH
(1+ k )H
PH is the present value at the time H of all dividends expected to be paid after the
horizontal date. Then the equation turns to be:
Vo =
D2
D3
D1
2 +
+
1+ k
(1+k )
(1+k )3 +.
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That is the stock price equal the present value of all expected future dividends into
perpetuity. It is the dividend discount model of stock price.
- The constant growth DDM
The model above requires dividend forecasts for every year into the indefinite future.It
is not practical so analysts simplify it by an assumption that dividends are trending
upward at a stable growth rate (g)
D1
E1
Do(1+ g)
k
kg
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Vo = [Do
1+ k
(1+ g 1)t
(1+ k)t ] + ( kg 2 )
t =1
DT (1+ g 2)
1b
Po
=
E1
k( ROEb)
P/E increases with ROE: ROE<k: investors prefer pay out earnings as dividend
ROE>k: investors prefer pay out earnings as reinvest earnings
ROE=k: investors can either reinvest in firm or elsewhere
P/E increase for higher plowback. Market rewards firm with higher P/E multiple if it
exploits good investment opportunities more aggressively by plowing back more
earning into those opportunities. A higher P/E ratio implies a higher expected future
growth rate of earnings. If the earnings growth does not materialize, the P/E will fall
investors suffer losses.
Riskier stocks will have lower P/E multiples as riskier firms will have a higher required
rate of return.
13.5 F REE CASH FLOW VALUATION APPROACHES:
Free cash flow for the firm (FCFF) discounted at the weighted-average cost of capital to
obtain the value of the firm.
FCFF= EBIT (1-tc) + Depreciation - Capital expenditures - Increase in NWC
T
Firm value =
FCFFt
(1+W
ACC)t
t =1
PT
FCFF T +1
This method is used to analyse firms that dont pay dividends helps to understand
sources and uses of cash.
Value of equity can be found by subtracting the then existing value of debt from the
FCFF. (This is the fluctuation of long-term Liability)
FCFE= FCFF - Interest expense (1-tc) + Increases in net debt.
T
FCFE
(1+ k )tt
t =1
PT
+ (1+k )T
e
in which PT=
FCFE T +1
(ke is the cost
k E g
of equity) In theory free cash flow approaches should provide the same estimate of
intrinsic value as the dividend growth model.
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59
Chapter 14
Financial Statement Analysis
14.1 MAJOR FINANCIAL STATEMENT: 3 MAIN TYPES OF FINANCIAL STATEMENTS
Income Statement: a financial statement showing a firms revenues and expenses during a specified period
Balance sheet: An accounting statement of a firms financial position at a specified time
A statement of cash flows: a financial showing a firms cash receipts and cash payments during a specified
period. The statement of cash flows removes much of the effects of accrual accounting to give the analyst a
better look at the cash flows of the firm. The statement of cash flows recognizes only transactions in which
cash changes hands.
Cash Flow = Operating Cash Flow + Cash Flows From Investing + Cash Flow From Financing
Operating Cash Flow = Net income + Depreciation + Net Operating Sources of Funds
Net Operating Sources of Funds = Working capital operating sources of funds working capital
14.2 DIFFERENT RATIO :
Debt
Net . profit
= Pretax . profit
EBIT
Sales Assets Equity
Current ratio =Current assets/current liabilities-> measures the ability of the firm to pay off its current
liabilities by liquidating its current assets. It indicates the firms ability to avoid insolvency in the short run
Quick ratio= (cash + marketable securities + receivables)/current liabilities ->it is better measure of liquidity
than the current ratio for firm whose is not readily convertible into cash.
Cash ratio= (Cash + Marketable securities)/Current liabilities->receivables are less liquid than its holdings of
cash and marketable securities.
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Market price ratio: The price-to-earnings and market-to-book ratios are presented. These ratios are
regularly reported and discussed in the financial press. The relevance of the market to book ratio varies with
industries. The relevance depends on how accurately the book value reflects economic value and how
significant asset levels are in the production of profits and sales. Analysts also use the price-to-sales ratio as an
indicator of how a stock is valued, particularly if a firm has low or negative earnings.
-Leverage ratios: They are used to investigate the firms use of debt. Times-interest-earned and fixed-chargecoverage ratios are used to assess the firms ability to service debt. Debt to assets and debt to equity are used
to assess how much debt financing the firm is using.
14.3 C HOOSING A BENCHMARK:
To evaluate the performance of a given firm, however, we need a benchmark to which we can compare those
ratios. One obvious benchmark is the ratio for the same company in earlier years that is the past figures.
14.4 E CONOMIC VALUE ADDED:
The concept of economic value added is another tool that can be used to analyze a companys performance.
Economic value added compares return on assets with a cost to the capital that is required to make the
investment in assets. The main point of the analysis is management adds value to stockholders by retaining
earnings and reinvesting only if the ROE > k. The related point should also be made, namely that EPS growth
can be generated simply by retaining earnings, but this does not mean the firm is adding value or maximizing
shareholder wealth unless the return on the investment is greater than k.
14.5 A N ILLUSTRATION OF FINANCIAL STATEMENT ANALYSIS:
Some of the issues that short-term borrowing brings to analysis are illustrated by the example using Growth
Industries, Inc. Key ratios and the statement of cash flows for Growth Industries, Inc. show that careful
analysis of financial ratios can indicate problems that may not be presented in the annual report. The analysis
shows that ROE is declining while ROA is remaining steady. The firm is using large amounts of long-term
debt to maintain its 20% growth in assets and this is not sustainable for very long.
14.6 C OMPARABILITY PROBLEMS:
Since financial ratios are based on accounting data, an analyst must be aware of differences in accounting
methods that could affect comparison of ratios. Some of the key problems of comparability include different
inventory valuation methods. This is an important factor since it influences cost of goods sold, which is the
major component of costs on most income statements. There are also various problems related to depreciation.
Inventory Valuation: There are 2 different ways to value inventories. FIFO (last-in, first-out) LIFO
considers the last goods produced are the first ones to be sold. Therefore, it values the million units
used up during the year at the current cost of production. In contrast, FIFO (First in, first out) assumes
that the units used up or sold that were added to inventory first and goods sold should be valued at
original cost. A disadvantage is that FIFO accounting includes balance sheet distortions when it values
investment in inventories at original cost. This practice results in an upward bias in ROE because the
investment base on which return is earned is undervalued.
Depreciation: The problem should be mentioned here is the various measurement of depreciation.
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