Extra Notes: Uninsured Insured D 156,250 156,250 E 100,000 100,000 F 100,000 100,000 G 64,000 100,000

Extra notes
Portfolio Insurance: An investor holds a highly diversified portfolio, who benefit from
movement stock market. Also protected from downwards movement
Insurance principles:
Purchase insurance policy: a $100,000 if it goes up keep your profit, if say by 5,000, insurance pay diff
(Loss)
Problem: insurance company rarely sign contract of this sort
Purchase protective put (married put)
100
Portfolio
Value
100
100
Ulnm. Portfolio
Value
Buy put on the index
Problem: you are not insured 100%. Ex. Index
10,000, portfolio 25,000
10,000/25000 = 40% only protected

Create a synthetic put: Allocation of funds between stock portfolio & riskless sec.
Now
Insured
D156,250
156,250
E100,000
100,000
F100,000
100,000
G64,000
100,000
125,000
Stock: A 100,000
C
Uninsured
89,000
6m.
12month
Assume $1 will yield $1.25 after 6.m in stock & Bond 5% after 6m.
1.25s + 1.05b =125,000
stocks 1) solve s&b
0.8s +1.05b = 95,238(100,000/1.05)
bonds 2) s= 66,138, b=40,312
1
Asset Allocation
Stock: 66,138
Bond: 40,312
Total: 106,350
B)
Stock:125,000
whenstock
Bond:0(sellbond,buystockswithproceeds)
Total:125,000
C)
Stock:0(sellstock,buybondw/proceeds)
Bond:95,238
Total:95,238
Problem: black Monday decrease fast 6 month. Allocation could not be performed
Financial Analysis (FA)

Involves determining the levels of risk $ expected return of:
Individual financial assets
Groups of F.A.: Rail, Aero, Computer, Banks
Stock Market (all its assets)
FA: Will be used by portfolio managers
Professional organizations: (see P.829 CFA Profession + Exam)
In the U.S.: FA belongs to ICFA (Institute of charted financial analysis) the member called
CFA
In Canada: the member CFA belongs to FPSCC (Financial Planners Standard Council of
Canada)
Reasons for financial analysis:
Try to determine certain characteristics of securities
Attempt to identify mispriced securities
Characteristics:
dividend yield D/P
if , P
Dividend Policy
Future cash flows (past)
How all above fit in portfolio objective
Companyspecificaspartofsector:oil,
telecom&whereinvestorwishesto
be!
Miss-priced securities: F.A. uses fundamental analysis to estimate: future earnings $ dividends of
stocks.
Two methods:
A. determine intrinsic value vs. market value in addition to using earning valuation:
overvalued or undervalued
Reasons why V = P
GDP, Industry sales, firm sales, IRR, P/F, future earning
*Accept Projects or shares: if IRR> Discount rate or K of this sector
B. Estimate one or two variables (ex. Earning)
Compare with others estimate
Market react to these estimates before actual announcement (+) or (-) reaction
FA is an essential activity if you consider capital market to be efficient
*IRR: Rate that makes NPV of Ini. Inv. = 0
NPV = 0 = C0 +
C1
(1+irr)
C2
(1+irr)2
3
Four principles (fund. Analysis, not technical)

Top-down vs. bottom-up forecasting:
Top down: GDP, SALES, E of industries, to find expected return of firm
Economy, Industries, Companies
Bottom Up
Nation Economy/global
Business cycle
Demand & supply of G&S
Sales
Currencies
Commodities
Probabilistic: Forecasting economy wide, a what-if analysis, top-down different scenarios impact
on portfolio
Risk & return, ex. GDP
Surprises from economy wave
Econometric models: statistical model focusing on endogenous variable forecasting as a result of
exogenous variables. Ex: car sales, Fed. Budget, CPI, unemployment
Financial statement Analysis:
A product of:
Management
Accountants
Tax authorities
Statement may look different because of GAAP
FIFO or LIFO or straight line or accelerated. Depreciation.
- CFA must be a financial detective. (clues, footnotes.)
- Values of outstanding claims on firms income
- Short cut procedures: Ex. Short term creditors paid in full by examining the ratio of liquid assets/short-term debt
- Interest payment to bond holders, by examining EBIT
- Earning after tax/book value: stock valuation
- Ratio analysis: of a target company vs. the industry, also look at several years of same company
to predict the future & detect potential weakness. (ex. Predicting the sale to find share price. But
your F/S may not balance inaccuracy. Ratio of inventory/Sale).
Operating Margin = [Operating income depreciation] / sales
Asset turnover = Sales/total assets
Share price = EPS x P/E
4
Acid test Ratio = (Cash + cash equiv. + Receivable)/ Curr. Liability

Analysis Recommendations and stock prices
Analyst following & stock return
Publication. Following, return
Given to client 1st (heard on the street) 0 publication day
Technical Analysis: They look backward to predict the future?
Volumes price, not concerned w/ external var, that produced these data
Predict short-term price move. Make recomm. of purch. & sales of sec.
In summary: Fundamental A.
What
Technical A.
When
Efficient market is out. History repeat itself.
Two groups:
Momentum
Contrarian Strategies
Buy stock
Sell stock
Sell stock
Buy stock
This was tested (-115%) return difference
weekly (between winners & losers)

-25%
+90%
Contrarian strategy has some merit: (S.T., L.T.)

Moving average & trading range breakout strategy
-Calculate average of last 200 day, closing
-Today closing/above = R
- if, R>1 buy, if R<1 sell (tomorrow)
-Repeat
-Calculate average daily return during buy and sell
To efficient market the diff between buy & sell (average return)
Should be zero. If more, then they have merit (Tech analyst) there is 16.8% difference
Imagine commission. All can be computerized, no need for us.
(if a buy signal is generated hold for 10 days)
Valuation of common stocks

Financial analysis is used to identify mispriced securities
Fundamental analysis is used to estimate future earnings and dividends
Capitalization of income method of valuation
Based on expected cash flow from owning the stock
V=
C1
+
C2
+
C3
...
2
3
1+K
1+K
1+K
Ct
1+Kt
CT: Cash flow, at time T & K is discount rate

NPV = V-P, t=0, V is its intrinsic value, P is cost of purchase (stock market price)
Similar to capital budgeting decisions:
1. If NPV>0 investor will undertake project
2. If NPV<0 forget about the project
Stock is
undervalued if
Ct
(1+K)t
Overvalued if
(1+K)t < P
>P
Ct
Buy
Short
Internal rate of return(IRR): K*

Ct
Set previous EQ = 0, 0 =
(1+K*)T
If K* > K
If K* < K
(K rate for similar investment) take project

Refuse it
Capital budgeting can be used for stocks as dividends are expected

in future
Dividend Discount Model (DDM)
V=
Ct
Stocks do not have fixed life time
(1+K)t
Then an infinitely long stream of D, must be forecast, Dt = Dt-1 (1+Gt)
Ex: T= 2 D=$4, T=3 D=$4.20

Gt = Dt Dt-1 G3=4.204 = 5%
Dt-1
Three DDM can be assumed:

0 growth model
Consistent growth model
Multiple growth model
0 growth : Dividend paid in the past D0 will be paid in future, D0 = D1 = D2..= D
G=0
V = D1
K
V = 8 = $80
0.1
Undervalued
Ex: X pays $8 to
K= 10%
If sell for 65, NPV = 80-65=15
Buy recommendation
1.2 IRR:
K* = D1 = 8 =12.3%, 12.3%>10%
P
65
Constant growth: D1 = D0(1+g)
D0(1+g)2
D2 = D1(1+g)
V = D1
K-g
EX: D=1.8/5, g=5%, , calculate V if K = 11%
D1 = 1.8(1.05) = 1.89
V= 1.89
= 31.50
0.11-0.05
IF V0 @ 40, NPV=31.5-40 = -8.50
Short it
K* = D1
+g
P
= 1.8(1.05)
+0.05 = 9.72%
40
The required rate (11%) > IRR (9.72%)
Company overpriced dont invest or short
2.2
IRR:
Multiple-Growth
Focus on T after which growth in g

Dt
VT- =
(1+k)t
VT+ =
(k-g)t+1(1+k)t
all dividends up to & including time T
V= VT- + VT+
EX: Mag. Comp., D0 = 0.75, D1 = 2, D2 = 3, After g = 10%

Solve for V if required rate of return is 15%
VT- =
VT+ =
2
+
3
= $4.01
(1+0.15)
(1+0.15)2
3(1+0.10)
= $ 49.91
(0.15-0.10)(1+0.15)2
V= 4.01-49.91 = $53.92
if Mag. is selling at 66 it is fairly price (close enough)
IRR: To solve for V & IRR we reuse multiple growth equation & substitute P for V &
K* for K
+
Dt+1
P = Dt
1
(1+K*)
(K*-g)(1+K*)t
55 =
2
+
3
+
3.3
1
2
(1+K*)
(K*-0.10)(1+K*)2
(1+K*)
K*= 14.9% (trial error)
IRR = required rate fairly price stock

8
Price- Earnings Ratio:

Expected return = (P1 - P) +D1
P
P: current price, P1= price earnings ratio x E1
E1: earnings /s (estimated)
D1: dividend
P1 = (P1/E1) x E1 , if P1> P ( buy the stock)
Dt = Pt Et,
V=
Pt Et
Pt: Payout ratio (we can forecast dividend)
(1+K)t
This equation focus on stocks earnings
Comparing these earning with wall street estimate

g could make or break the stock
Et = Et-1 (1+get) (get: growth rate in earning)
Cash Flow
B/S
Cash
A/R
Inv
C/A
NFA
Total assets
A/P
N/P
C/L
LTD
C/S
R/E
S/H equity
Total liabilities and shareholders equity
Beg End
100
150
200 250
300 300
600 700
400
500
1000 2000
100 100
200
200
300 350
400
420
50
60
250 370
300 430
1000 1200
I/S
Sale
Costs
Dep
EBIT
Int
Taxable inc.
Taxes
N.I
Div
Add R/E
Beg
2000
1400
100
500
100
400
200
200
80
120
10
DuPont Analysis
Roe = Net profit
Pretax profit
Tax burden
Pretax Profit
EBIT
EBIT interest exp.

EBIT
EBIT
Sales
ROS
Sales
Assets
ATO
Assets
Equity
Fin. leverage
11
Replicating the portfolio with appropriate combination of stock & bond can lead to a fair
value of option
EQ 1: 125 Ns +108.33Nb = 25
EQ 2: 80Ns + 108.33Nb=0
(Ns: no of shares, Nb: bond)
Ns = 0.5556,
Nb= -0.4103
UP.
DN.
solve
(Purchase)
(short sell)
For current price call value:

V0 = 0.5556 x 100 0.4103 x 100 = $14.53
V0 = NsPs + NbPb
@ time: current
(Ps: $stock, Pb: $bond)
Smart investor will recognize: once V0 is established then

If option overpriced say selling @20 the profit will be $5.47 (write the call for 20-14.53)
If option underpriced say selling @10 the profit will be $4.53 (buy the call, sell the stock, invest
in bond); 4.53 = [-10 + [0.5556 x 100] 41.03]
Hedge ratio: the expected change in the value of an option per $ 1 change in market price of
security. For every $1 change in price of stock the portfolio will change by Ns or 0.5556 the
price of the call will change by 0.5556 aswell.
Shares to purchase
h= Pou Pod = 25-0 = 0.5556 or delta

Psu Psd 125-80
(S-sell bond)
B = PV(hPsd-Pod) = PV(0.5556 x 8- 0) = 44.45 = 41.03

1.0833.
V0 = hPs-B, h & B are hedge ratio & current value = 14.53 of bond (short position)
$5.47 = $20 (0.5556 x 100) + $41.02
S.S.C
BuyS.
Payloan
12
Valuation of options:
Put@100
Call@100
100
$
option
200
100
200
100
200
Atexpirationdate.Intrinsicvalue:
IVCCall=MKTExercise=Ex:120100=20(sellfor25)
IVPPut=ExerciseMKT=Ex:10080=20
Profits&lossesoncalls$puts:
Buyacall,writeacall
Buyaput,writeaput
Straddle,Buyput&callorsellboth
ToestimatevalueofCorP:
13

Extra Notes: Uninsured Insured D 156,250 156,250 E 100,000 100,000 F 100,000 100,000 G 64,000 100,000

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Extra Notes: Uninsured Insured D 156,250 156,250 E 100,000 100,000 F 100,000 100,000 G 64,000 100,000

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Extra notes

Problem: you are not insured 100%. Ex. Index

10,000, portfolio 25,000

10,000/25000 = 40% only protected

Financial Analysis (FA)

Four principles (fund. Analysis, not technical)

Acid test Ratio = (Cash + cash equiv. + Receivable)/ Curr. Liability

weekly (between winners & losers)

Contrarian strategy has some merit: (S.T., L.T.)

Valuation of common stocks

CT: Cash flow, at time T & K is discount rate

Internal rate of return(IRR): K*

(K rate for similar investment) take project

Capital budgeting can be used for stocks as dividends are expected

Ex: T= 2 D=$4, T=3 D=$4.20

Three DDM can be assumed:

If sell for 65, NPV = 80-65=15

IF V0 @ 40, NPV=31.5-40 = -8.50

Focus on T after which growth in g

all dividends up to & including time T

EX: Mag. Comp., D0 = 0.75, D1 = 2, D2 = 3, After g = 10%

if Mag. is selling at 66 it is fairly price (close enough)

IRR = required rate fairly price stock

Price- Earnings Ratio:

Pt: Payout ratio (we can forecast dividend)

This equation focus on stocks earnings

Comparing these earning with wall street estimate

EBIT interest exp.

For current price call value:

(Ps: $stock, Pb: $bond)

Smart investor will recognize: once V0 is established then

h= Pou Pod = 25-0 = 0.5556 or delta

B = PV(hPsd-Pod) = PV(0.5556 x 8- 0) = 44.45 = 41.03

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