Investment Portfolio Management

WEEK 1: A Brief History of Risk and Return

Total Dollar Return

• Return on an investment measured in dollars ( accounting for all interim cash flows + capital
gains/losses)

𝑇𝑜𝑡𝑎𝑙 𝑑𝑜𝑙𝑙𝑎𝑟 𝑟𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝑠𝑡𝑜𝑐𝑘 = 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝐼𝑛𝑐𝑜𝑚𝑒 + 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝐺𝑎𝑖𝑛/𝐿𝑜𝑠𝑠

Total Percent Return (HPR)

• Return on an investment measured as % of original investment

• The return for each dollar invested
• This is the Holding Period Percentage Return (Unannualized)
𝑇𝑜𝑡𝑎𝑙 𝑑𝑜𝑙𝑙𝑎𝑟 𝑟𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝑠𝑡𝑜𝑐𝑘
𝑃𝑒𝑟𝑐𝑒𝑛𝑡 𝑟𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝑠𝑡𝑜𝑐𝑘 =
𝐵𝑒𝑔𝑖𝑛𝑛𝑖𝑛𝑔 𝑠𝑡𝑜𝑐𝑘 𝑝𝑟𝑖𝑐𝑒

OR

𝐻𝑃𝑅 = [(1 + 𝑅1 )(1 + 𝑅2 )] − 1

Effective Annual Return (Annualize the HPR)

• ROI expressed on annualized basis.

• Key Question: What is the number of holding periods in a year?

𝐸𝐴𝑅 = (1 + 𝐻𝑃𝑅)𝑚 − 1

• m = number of holding periods in a year

1 𝑦𝑒𝑎𝑟
𝑚 (𝑖𝑓 ℎ𝑜𝑙𝑑𝑖𝑛𝑔 𝑝𝑒𝑟𝑖𝑜𝑑 𝑑𝑒𝑛𝑜𝑚𝑖𝑛𝑎𝑡𝑒𝑑 𝑖𝑛 𝒚𝒆𝒂𝒓𝒔) =
𝑡𝑜𝑡𝑎𝑙 ℎ𝑜𝑙𝑑𝑖𝑛𝑔 𝑝𝑒𝑟𝑖𝑜𝑑 (𝑖𝑛 𝑦𝑒𝑎𝑟𝑠)

12 𝑚𝑜𝑛𝑡ℎ𝑠
𝑚 (𝑖𝑓 ℎ𝑜𝑙𝑑𝑖𝑛𝑔 𝑝𝑒𝑟𝑖𝑜𝑑 𝑑𝑒𝑛𝑜𝑚𝑖𝑛𝑎𝑡𝑒𝑑 𝑖𝑛 𝒎𝒐𝒏𝒕𝒉𝒔) =
𝑡𝑜𝑡𝑎𝑙 ℎ𝑜𝑙𝑑𝑖𝑛𝑔 𝑝𝑒𝑟𝑖𝑜𝑑 (𝑖𝑛 𝑚𝑜𝑛𝑡ℎ𝑠)

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Returns

Historical Average Return

𝑆𝑢𝑚 𝑜𝑓 𝑎𝑙𝑙 𝑦𝑒𝑎𝑟𝑙𝑦 𝑟𝑒𝑡𝑢𝑟𝑛𝑠
𝐻𝑖𝑠𝑡𝑜𝑟𝑖𝑐𝑎𝑙 𝑅𝑒𝑡𝑢𝑟𝑛 =
𝑛
• n = (Final year – First year) + 1 , if range too wide.
• Risk free rate = Rate of return on a risk free asset
• Risk premium = Extra return on a risky asset over the risk-free rate → reward for bearing risk
𝑅𝑖𝑠𝑘 𝑝𝑟𝑒𝑚𝑖𝑢𝑚 = 𝐴𝑠𝑠𝑒𝑡 ′ 𝑠 𝑟𝑒𝑡𝑢𝑟𝑛 − 𝑅𝑖𝑠𝑘 𝑓𝑟𝑒𝑒 𝑟𝑎𝑡𝑒

Return Variability (Individual Stocks)

Variance

• Measure of return dispersion

∑(𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝑠𝑡𝑜𝑐𝑘 − 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑟𝑒𝑡𝑢𝑟𝑛)2

2
𝑉𝑎𝑟(𝑅), 𝜎 =
𝑁−1
Standard Deviation

• Square root of the variance

• ‘Volatility’ measure → same ‘unit’ as average return
𝑆𝐷(𝑅), 𝜎 = √𝑉𝑎𝑟(𝑅)

Summary of Return Distribution Probabilities

±1 standard deviation ±2 standard deviations

Within range 2/3 of the time 95% of the time
Outside range 1/3 of time 5% of the time

Arithmetic Averages & Geometric Averages

Arithmetic (*most general) Geometric
• What was return in an average year over a particular • What was average compound return per year, over
period? particular period?
Step 1: HPR/ Cumulative return
𝐻𝑃𝑅 = [(1 + 𝑅1 )(1 + 𝑅2 )] − 1
𝑅1 + 𝑅2 +. . . 𝑅𝑇
R = Step 2: Geometric Average Return
𝑇
1
𝐺𝐴𝑅 = [(1 + 𝑅1 )(1 + 𝑅2 )]𝑇 − 1

• Dollar-weighted Average Return = Internal Rate of Return (IRR) on investment

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 WEEK 2: The Investment Process

2 Types of Brokerage Accounts

i) Cash Account → Securities paid in full

ii) Margin Account → Securities can be bought/sold on credit, subject to limits

Margin Accounts

• Portion NOT borrowed = margin

𝐸𝑞𝑢𝑖𝑡𝑦 𝑉𝑎𝑙𝑢𝑒
𝑀𝑎𝑟𝑔𝑖𝑛 𝑅𝑎𝑡𝑖𝑜 =
𝑃𝑜𝑠𝑖𝑡𝑖𝑜𝑛 𝑉𝑎𝑙𝑢𝑒 (𝑀𝑎𝑟𝑘𝑒𝑡 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑠ℎ𝑎𝑟𝑒𝑠 𝑏𝑜𝑢𝑔ℎ𝑡/𝑠ℎ𝑜𝑟𝑡𝑒𝑑)

• Equity Value = Investor’s own money

• Portion borrowed → incur interest charges based on broker’s call money rate.

Initial Margin Ratio

• Minimum margin to be supplied in beginning

Maintenance Margin Ratio

• Margin ratio that must be present at all times (lower than initial margin ratio)
• When margin ratio drops below maintenance margin → top up to initial margin ratio = Margin Call
at Margin Call Price

BUYING with Margin Account

At purchase
• To calculate maximum $ amount that can be bought :
𝐸𝑞𝑢𝑖𝑡𝑦 𝑣𝑎𝑙𝑢𝑒
𝑀𝑎𝑥 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 =
𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝑀𝑎𝑟𝑔𝑖𝑛 𝑅𝑎𝑡𝑖𝑜
• Margin Loan amount:
𝑀𝑎𝑟𝑔𝑖𝑛 𝐿𝑜𝑎𝑛 = 𝑀𝑎𝑥 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 − 𝐸𝑞𝑢𝑖𝑡𝑦 𝑉𝑎𝑙𝑢𝑒
• T-Account
Liabilities &
Assets Equity
n shares @ $ per Margin Loan
share $ value (fixed) $ value

Account Equity $ value

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 After $ of share change
• Update T-Account → changes ONLY reflected in Asset side and Account Equity
• Calculate new margin ratio, whether top-up needed.
𝑁𝑒𝑤 𝐸𝑞𝑢𝑖𝑡𝑦 𝑉𝑎𝑙𝑢𝑒
𝑁𝑒𝑤 𝑚𝑎𝑟𝑔𝑖𝑛 𝑟𝑎𝑡𝑖𝑜 =
𝑀𝑎𝑟𝑘𝑒𝑡 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑠𝑡𝑜𝑐𝑘𝑠 ℎ𝑒𝑙𝑑

• If margin ratio insufficient, subjected to margin call of:

𝑀𝑎𝑟𝑔𝑖𝑛 𝑐𝑎𝑙𝑙 = 𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝑚𝑎𝑟𝑔𝑖𝑛 𝑟𝑎𝑡𝑖𝑜 𝑥 𝑀𝑎𝑟𝑘𝑒𝑡 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑆𝑡𝑜𝑐𝑘𝑠 𝐻𝑒𝑙𝑑

Case with Interest Charged (Borrowing costs)

Liabilities &
Assets Equity
n shares @ $ per Margin Loan
share $ value (fixed) $ value

Loan Interest
(fixed) $ value

Account Equity $ value

• Amount to repay:
𝐴𝑚𝑜𝑢𝑛𝑡 𝑟𝑒𝑝𝑎𝑖𝑑 = 𝐴𝑚𝑜𝑢𝑛𝑡 𝑏𝑜𝑟𝑟𝑜𝑤𝑒𝑑 𝑥 (1 + 𝐴𝑃𝑅)𝑡

𝐻𝑜𝑙𝑑𝑖𝑛𝑔 𝑝𝑒𝑟𝑖𝑜𝑑 (𝑚𝑜𝑛𝑡ℎ𝑠)

Where, 𝑡 = 12 𝑚𝑜𝑛𝑡ℎ𝑠

Profit Calculation → Account Equity

𝑁𝑒𝑤 𝐴𝑐𝑐𝑜𝑢𝑛𝑡 𝐸𝑞𝑢𝑖𝑡𝑦
𝑃𝑟𝑜𝑓𝑖𝑡 (%), 𝐻𝑃𝑅 = −1
𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝑀𝑎𝑟𝑔𝑖𝑛 𝐷𝑒𝑝𝑜𝑠𝑖𝑡

Margin Call – At what price?

(𝑁𝑜. 𝑜𝑓 𝑠ℎ𝑎𝑟𝑒𝑠 𝑥 𝑃) − 𝐴𝑚𝑜𝑢𝑛𝑡 𝐵𝑜𝑟𝑟𝑜𝑤𝑒𝑑
𝑀𝑎𝑖𝑛𝑡𝑒𝑛𝑎𝑛𝑐𝑒 𝑀𝑎𝑟𝑔𝑖𝑛 𝐿𝑒𝑣𝑒𝑙 =
(𝑁𝑜. 𝑜𝑓 𝑠ℎ𝑎𝑟𝑒𝑠 𝑥 𝑃)

• Solve for P → the critical stock price.

𝐴𝑚𝑜𝑢𝑛𝑡 𝐵𝑜𝑟𝑟𝑜𝑤𝑒𝑑⁄
𝑁𝑜. 𝑜𝑓 𝑠ℎ𝑎𝑟𝑒𝑠
𝑃=
1 − 𝑀𝑎𝑖𝑛𝑡𝑒𝑛𝑎𝑛𝑐𝑒 𝑀𝑎𝑟𝑔𝑖𝑛

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SHORT SELLING with Margin Account
• Short sale → sale in which seller does not actually own the security that’s sold.
• Benefit from price decreases.

Assets Liabilities & Equity

Short Position (no. of
Sales Proceeds (fixed) $ value shares x MV) $ value

Initial Margin Deposit

(fixed) $ value Account Equity $ value

• NOTE: If sell short, required to have full sales proceeds from sale + initial margin deposit in
account to meet Regulation T (Asset side)

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 WEEK 3: Mutual Funds & Other Investment Companies
• Mutual funds→ means of combining/pooling funds of a large group of investors
• Investing decisions by funds manager (who will be compensated for service provided)
• Investment company → no need pay taxes on investment income
• To qualify, must:
i) Hold almost all assets as investments in stocks, bonds and other securities
ii) Use no more than 5% of its assets when acquiring a security
iii) Pass through all realized investment income to fund shareholders

Advantages Disadvantages
• Diversification • Risk
 Helps reduce risk  Mutual fund value can fall, and be worth
 But cannot eliminate all risks less than initial investment
 No government/private agency can
• Professional Management guarantee value of mutual fund.
 Professional money managers make  Do not eliminate ALL risks from
decisions on when to add/remove diversification
particular securities • Costs
 Investor no need make these crucial  Entails fees and expenses normally not
decisions accruing from direct individual
investment
• Minimum Initial Investment
 Most mutual funds have minimum initial • Taxes
purchase of $2500 but some as low as  Pay taxes on distributions (dividends and
$250 and $1000 capital gains) from mutual fund as
 After initial purchase, subsequent can be applicable to tax regimes of different
as low as $50 jurisdictions.
 Pay taxes on profit gained when mutual
fund shares sold.

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• 2 types of mutual funds
i) Open-end fund → Investment company that stands ready to buy/sell shares in itself with
its investors, at any time.
Trades with investment company itself so shares worth its Net Asset Value (NAV)
 If get too big might not take in new investors.
 It will still accept more money from current investors

ii) Closed-end fund → Investment company with fixed number of shares that are bought/sold
by investors, only in the open market (stock exchange)
Shares sold to investors, but fund does not repurchase them.
Trades in open market → Value diverges from NAV per share
Market price > NAV = trade at premium
Market price < NAV = trade at discount
 Fixed pool of shares
 New investors have to buy from investors within fund.
 No change in shares outstanding → old investors cash out by selling to new

Net Asset Value (NAV)

• Value of assets held by mutual fund, divided by number of shares.

• Shares in open-end fund worth their NAV → fund stands ready to redeem their shares anytime.
• Shares in close-end fund differ from NAV.
𝑀𝑎𝑟𝑘𝑒𝑡 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐴𝑠𝑠𝑒𝑡𝑠 − 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
𝑁𝐴𝑉 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒 =
𝑆ℎ𝑎𝑟𝑒𝑠 𝑂𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔

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Exchange Traded Funds (ETFs) → Index funds

• Trades like closed-end fund (without discount phenomenon)

Benefits Drawbacks
• Behave in market like stock • Value can differ from NAV
 Can be shorted • Some track narrow market sectors – can be
 Bought on margin very volatile.
 Have options traded on • Single country ETFs post double-digit returns
 Can buy just a single share – investors don’t realize they are assuming
• Allow investor access to different assets much higher risk, as a handful of large
• Low cost, diversification, tax efficiency companies dominate these ETFs
(Capital gain from ETFs generally not taxable) • Lack long term track records

Costs of Investing In Mutual Funds – FEE STRUCTURE

1. Load charges: One-time sales commissions (funds charging loads called load funds)
i) Front-end load → commission or sales charge paid when purchasing shares
ii) Back-end load → “Exit” fee incurred when selling shares
iii) No-load funds → Funds without front & back-end charges

2. Annual fund expenses

i) Management fee (Operating expense) → cost incurred by mutual fund in operating
portfolio
Usually ranges from 0.2% to 2% of fund’s total assets per year.
Usually based on fund’s performance/size
Lowest for money market mutual fund, highest for international stock fund.
Lowest for large, liquid funds.

ii) 12b-1 charges → Annual fees charged by mutual fund to pay for marketing/distribution
costs
Up to 1% and 0.25%

• When purchase funds in load fund → pay price in excess of the NAV = offering price

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Front-end load %
𝐿𝑜𝑎𝑑 𝑎𝑚𝑜𝑢𝑛𝑡
• 𝐹𝑟𝑜𝑛𝑡 − 𝑒𝑛𝑑 𝑙𝑜𝑎𝑑 % = 𝑂𝑓𝑓𝑒𝑟𝑖𝑛𝑔 𝑝𝑟𝑖𝑐𝑒

• 𝐿𝑜𝑎𝑑 𝑎𝑚𝑜𝑢𝑛𝑡 = 𝑂𝑓𝑓𝑒𝑟𝑖𝑛𝑔 𝑝𝑟𝑖𝑐𝑒 − 𝑁𝐴𝑉

Mutual Fund Turnover (Purchases or Sales?)

• Measure of how much trading a fund does.

• Calculated as: Smaller value between Total Purchases or Sales during the year, divided by total
assets
𝑆𝑚𝑎𝑙𝑙𝑒𝑟 𝑣𝑎𝑙𝑢𝑒 𝑏𝑒𝑡𝑤𝑒𝑒𝑛 𝑇𝑜𝑡𝑎𝑙 𝑃𝑢𝑟𝑐ℎ𝑎𝑠𝑒𝑠 𝑜𝑟 𝑆𝑎𝑙𝑒𝑠
𝑀𝑢𝑡𝑢𝑎𝑙 𝐹𝑢𝑛𝑑 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟 (𝑡𝑖𝑚𝑒𝑠) =
𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠

Open-end Fund Mutual Fund Return

𝐸𝑛𝑑 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 = 𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝑉𝑎𝑙𝑢𝑒 𝑥 (1 − 𝐹𝑟𝑜𝑛𝑡𝐸𝑛𝑑 𝑙𝑜𝑎𝑑) 𝑥 (1 + 𝑟 − 𝑡𝑟𝑢𝑒 𝑒𝑥𝑝𝑒𝑛𝑠𝑒 𝑟𝑎𝑡𝑖𝑜)𝑇 𝑥 (1 − 𝐵𝑎𝑐𝑘𝐸𝑛𝑑 𝑙𝑜𝑎𝑑)

• True expense ratio = other fees, 12b-1 fees, management fees etc.
• T = investment horizon
• r = portfolio return

Why pay loads and fees?

• Many good no-load funds exist

• People may want one run by a particular fund manager.
• All such funds = load funds
• Or may want specialized type of funds

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 WEEK 4: The Stock Market

Private Equity

• The equity financing for nonpublic companies

• Banks x interested in making loans to start-ups, especially → with no assets, inexperienced
entrepreneurs.

1. Venture Capital
• Financing → new, often high-risk start-ups
• Individual VC → invest own money
• VC firms → Pool funds from various sources like
o Individuals
o Pension funds
o Insurance companies
o Large corporations
o University endowments
• To limit risk → financing in stages + actively help manage company
• At each stage → enough money invested to reach next stage + value of founder’s stake grows +
probability of success rises
• Goals not met → VC withhold further financing
• Success is achieved when:
o Big payoff when company sold to another company OR goes public
Either way, investment banks involved

2. Middle Market
• Many small, regional private equity funds concentrate investments in these middle market
companies
o Ongoing concerns (i.e. not start ups)
o Known performance history
o Typically family owned and operated
• Reasons middle market companies seek more capital → Expansion or founder wants to ‘cash out’
• Private equity fund → might purchase portion of business so others may manage the company

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3. Leveraged Buyouts
• A company/someone purchases all shares of a listed company
• ‘Taking the company private’
• Cost of going private → HIGH
o Need to borrow significant amount of money
• LBO market activity level depends on credit market

Selling to Public

• Primary market → Where investors purchase newly issued stocks

o Initial Public Offering (IPO) → When company offers stock for sale for the first time
 Underwriter spread/discount = Difference in price underwriter bought and sold
shares for.
o Seasoned Equity Offering (SEO) → If company already has public shares, but wants to raise
even more equity
 General cash offer: securities sold on first come, first served
 Rights issue: securities initially offered only to existing owners
• Secondary market → Where investors trade previously issued securities
o Can trade:
 Directly with other investors
 Indirectly through broker who arranged transactions for others
 Directly through dealer who buys and sells from inventory

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3 Types of Underwriting for Stock Issue

1. Fixed commitment underwriting

• Underwriter assumes all inventory risk
• Purchase security directly from issuer for sale to public at specified price

2. Best efforts underwriting

• Underwriters will do their best to sell all securities offered by issuer
• Not obligated to purchase for their own account

3. Dutch auction underwriting

• Offer price set based on biding by investors.

Secondary Market

• Bid price → Dealer buy from investors

Dealer = buy, investors = sell
• Ask price → Dealer sell to investors
Dealer = sell, investors = buy
• Difference = bid-ask spread

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Stock Market Order Types

Order Type Buy Sell

Buy at best price available for Sell at best price available for
Market order immediate execution immediate execution

At lowest ask At highest bid

Buy at best price available, but not Sell at best price available, but not less
more than the preset limit price. than the preset limit price.

Forgo purchase if limit is not met. Forgo sale if limit is not met.

Only executed at limit price or lower Only executed at limit price or higher

Limit order

Convert to a market order to buy when Convert to a market order to sell when
the stock price crosses the stop price the stock price crosses the stop price
from below. from above.

Also known as a “stop-loss.”

Stop order

Guarantee
execution

But not price

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 Used when have short position and Used when have long position and need
need to protect from price rises to protect from price decline

RISK: Price suddenly increase, buy at RISK: Price suddenly decrease, liquidate
higher price than buy stop position at huge loss.

Stop-limit
order
Convert to a limit order to buy when
Convert to a limit order to sell when the
Guarantee the stock price crosses the stop price
stock price crosses the stop price from
price from below.
above.
Not execution RISK: Price plummets, might not get
RISK: Price rockets, might not get out.
out
Set 2 price
points*

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Stock Market Index

1. Value-Weighted Index
• Companies with larger market values have higher weights
𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 𝐴𝑚𝑜𝑢𝑛𝑡 𝑥 𝑊𝑒𝑖𝑔ℎ𝑡
𝑆ℎ𝑎𝑟𝑒𝑠 𝑡𝑜 𝑏𝑢𝑦 =
𝑃𝑟𝑖𝑐𝑒 𝑜𝑓 𝑠𝑡𝑜𝑐𝑘

• When ∆ in index:
𝑀𝑉 𝐷𝑎𝑦 2
𝐷𝑎𝑦 2 𝐼𝑛𝑑𝑒𝑥 = 𝑥 𝐼𝑛𝑑𝑒𝑥 𝐿𝑒𝑣𝑒𝑙 𝐷𝑎𝑦 1
𝑀𝑉 𝐷𝑎𝑦 1
Day 3,
𝑀𝑉 𝐷𝑎𝑦 3
𝐷𝑎𝑦 3 𝐼𝑛𝑑𝑒𝑥 = 𝑥 𝐼𝑛𝑑𝑒𝑥 𝐿𝑒𝑣𝑒𝑙 𝐷𝑎𝑦 2
𝑀𝑉 𝐷𝑎𝑦 2
Or,
𝑀𝑉 𝐷𝑎𝑦 3
𝐷𝑎𝑦 3 𝐼𝑑𝑒𝑥 = 𝑥 𝐼𝑛𝑑𝑒𝑥 𝐿𝑒𝑣𝑒𝑙 𝐷𝑎𝑦 1
𝑀𝑉 𝐷𝑎𝑦 1

2. Price-Weighted Index
• Higher prices stocks receive higher weights
• Stock splits→ cause issues
• Can be addressed by adjusting the index divisor.
• NOTE: 2-for-1 stock split → DIVIDE stock price by 2
• Shares to buy in index = All equal across stocks
𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 𝐴𝑚𝑜𝑢𝑛𝑡
𝑆ℎ𝑎𝑟𝑒𝑠 𝑡𝑜 𝑏𝑢𝑦 =
𝑇𝑜𝑡𝑎𝑙 𝑃𝑟𝑖𝑐𝑒

𝑇𝑜𝑡𝑎𝑙 𝑃𝑟𝑖𝑐𝑒 𝑜𝑓 𝑆𝑡𝑜𝑐𝑘𝑠

𝐼𝑛𝑑𝑒𝑥 𝑡𝑜 𝑚𝑎𝑖𝑛𝑡𝑎𝑖𝑛 =
𝐹𝑖𝑟𝑠𝑡 𝐷𝑖𝑣𝑖𝑠𝑜𝑟(𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑠𝑡𝑜𝑐𝑘𝑠)

𝑁𝑒𝑤 𝑇𝑜𝑡𝑎𝑙 𝑃𝑟𝑖𝑐𝑒 (𝐼𝑛𝑑𝑒𝑥 𝑣𝑎𝑙𝑢𝑒)

𝑁𝑒𝑤 𝐷𝑖𝑣𝑖𝑠𝑜𝑟 (𝑤ℎ𝑒𝑛 𝑛𝑒𝑤 𝑠𝑡𝑜𝑐𝑘 𝑎𝑑𝑑𝑒𝑑) =
𝐷𝑎𝑦 1 𝐼𝑛𝑑𝑒𝑥

15
 WEEK 5: Common Stock Valuation

DIVIDEND DISCOUNT MODEL

1. Dividend Discount Model (DDM)

• Estimate value of stock → discount all expected future dividend payments
𝐷1 𝐷2 𝐷𝑇
𝑃0 = + … .
(1 + 𝑘) (1 + 𝑘)2 (1 + 𝑘)𝑇

• k = appropriate risk adjusted discounted rate

2. DDM: The Constant Growth Rate Model

• Assume dividends grow at constant rate of g.
• Concept:
𝐷𝑡+1 = 𝐷𝑡 (1 + 𝑔)
• Constant dividend growth for T years
𝐷0 (1 + 𝑔) 1+𝑔 𝑇
𝑃0 , 𝑖𝑓 𝑘 ≠ 𝑔 = [1 − ( ) ]
𝑘−𝑔 1+𝑘

𝑃0 , 𝑖𝑓 𝑘 = 𝑔 = 𝑇 𝑥 𝐷0

3. DDM: The Constant Perpetual Growth Model

• Grow forever at rate g

𝐷1 𝐷0 (1 + 𝑔)
𝑃0 , 𝑔 < 𝑘 = =
𝑘−𝑔 𝑘−𝑔

16
 *** Estimating Growth Rate***
(i) Using historical average growth rate → Arithmetic or Geometric

(ii) Using industry median/ average growth rate

(iii) Using sustainable growth rate

 Can increase by:
 Decreasing dividend payout ratio
 Increasing profitability (Net Income / Sales)
 Increasing asset efficiency (Sales / Assets)
 Increasing debt (Assets / Equity)

𝑆𝑢𝑠𝑡𝑎𝑖𝑛𝑎𝑏𝑙𝑒 𝐺𝑟𝑜𝑤𝑡ℎ 𝑅𝑎𝑡𝑒 = 𝑅𝑂𝐸 𝑥 𝑅𝑒𝑡𝑒𝑛𝑡𝑖𝑜𝑛 𝑅𝑎𝑡𝑖𝑜

• 𝑅𝑒𝑡𝑒𝑛𝑡𝑖𝑜𝑛 𝑅𝑎𝑡𝑖𝑜 = (1 − 𝑃𝑎𝑦𝑜𝑢𝑡 𝑅𝑎𝑡𝑖𝑜)

𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒
• 𝑅𝑂𝐸 = 𝐸𝑞𝑢𝑖𝑡𝑦
𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒 𝑆𝑎𝑙𝑒𝑠 𝐴𝑠𝑠𝑒𝑡𝑠
• 𝐷𝑢𝑝𝑜𝑛𝑡 𝑅𝑂𝐸 = 𝑥 𝑥 𝐸𝑞𝑢𝑖𝑡𝑦
𝑆𝑎𝑙𝑒𝑠 𝐴𝑠𝑠𝑒𝑡𝑠

4. DDM: 2 Stage Growth Model

• Assumes will grow at g1 for T years, then perpetually at g2 < k.

𝐷0 (1 + 𝑔1 ) 1 + 𝑔1 𝑇 1 + 𝑔1 𝑇 𝐷0 (1 + 𝑔2 )
𝑃0 = [1 − ( ) ]+( )
𝑘 − 𝑔1 1+𝑘 1+𝑘 𝑘 − 𝑔2

Part 1: PV of first T dividends Part 2: PV of

subsequent
Constant growth model
dividends

17
5. DDM to value “Supernormal” Growth
• E.g. Grow at 30% for 3 more years, then drop to 10% per year.

i) Step 1: Using long run growth rate

𝐷3 𝑥 (1 + 𝑔)
𝑃3 =
𝑘−𝑔

ii) Step 2: PV of firm today → Need PV found above and PV of dividends paid in first 3 years
𝐷1 𝐷2 𝐷3 𝑃3
𝑃0 = + 2
+ 3
+
(1 + 𝑘) (1 + 𝑘) (1 + 𝑘) (1 + 𝑘)3

Take note: Dividend given is TOTAL or PER SHARE

6. H-Model → Assume linear growth rate decline

• E.g. If growth start at 30%, decrease to 10% in Year 4 and beyond
• Growth falls by (20%/ 3 years) 6.67% per year.
• Growth estimates: 30%, 23.33%, 16.66% and 10%.

Discount rates used → CAPM

𝐶𝐴𝑃𝑀 = 𝑅𝑓 + 𝛽(𝑅𝑚 − 𝑅𝑓 )

18
RESIDUAL INCOME MODEL

7. RESIDUAL INCOME MODEL (RIM)

• For valuing companies that do not pay dividends
• Major assumption: The Clean Surplus Relationship (CSR)
The change in BV per share is equal to EPS less dividends
𝐼𝑛𝑐𝑟𝑒𝑎𝑠𝑒/𝑑𝑒𝑐𝑟𝑒𝑎𝑠𝑒 𝑖𝑛 𝐵𝑉 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒 = 𝐸𝑃𝑆 – 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠

• 2 equivalent formulas
𝐸𝑃𝑆0 (1 + 𝑔) − 𝐵0 𝑥 𝑘
𝑃0 = 𝐵0 +
𝑘−𝑔

Or,
𝐸𝑃𝑆1 − 𝐵0 𝑥 𝑔
𝑃0 =
𝑘−𝑔

FREE CASH FLOW

8. Using Free Cash Flow (FCF)

𝐹𝐶𝐹 = 𝐸𝐵𝐼𝑇 (1 − 𝑇𝑎𝑥 𝑅𝑎𝑡𝑒) + 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 − 𝐶𝑎𝑝𝑒𝑥 − ∆ 𝑖𝑛 𝑊𝐶

• When using FCF method → formula same as DDM = instead of Dividends, use FCF
• However → change beta from Equity Beta (levered) to Asset Beta (unlevered) in CAPM
DDM: Accounts for equity only
FCF: Accounts for equity and debt holders as well → need to convert
• Equity beta (levered) → More debt, more volatile in relation to market
• Equity Beta → Asset Beta

𝛽𝐸𝑞𝑢𝑖𝑡𝑦
𝛽𝐴𝑠𝑠𝑒𝑡 =
𝑑𝑒𝑏𝑡
[1 + (𝑒𝑞𝑢𝑖𝑡𝑦) (1 − 𝑡𝑎𝑥 𝑟𝑎𝑡𝑒)

19
PRICE RATIO ANALYSIS

9. Price-earnings ratio (P/E ratio)

𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑠𝑡𝑜𝑐𝑘 𝑝𝑟𝑖𝑐𝑒
𝑃𝐸 𝑅𝑎𝑡𝑖𝑜 =
𝐸𝑃𝑆

Earnings yield
𝐸𝑃𝑆
𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑦𝑖𝑒𝑙𝑑 =
𝑃𝑟𝑖𝑐𝑒 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒

10. Price-Cash Flow ratio (P/CF ratio)

𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑠𝑡𝑜𝑐𝑘 𝑝𝑟𝑖𝑐𝑒
𝑃𝐶𝐹 𝑅𝑎𝑡𝑖𝑜 =
𝐶𝐹 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒
• CF = Net income + depreciation

11. Price-Sales Ratio (P/S Ratio)

𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑠𝑡𝑜𝑐𝑘 𝑝𝑟𝑖𝑐𝑒
𝑃𝑆 𝑅𝑎𝑡𝑖𝑜 =
𝐴𝑛𝑛𝑢𝑎𝑙 𝑠𝑎𝑙𝑒𝑠 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒

12. Price-Book Ratio (P/B Ratio)

𝑀𝑉 𝑜𝑓 𝑠𝑡𝑜𝑐𝑘
𝑃𝐵 𝑅𝑎𝑡𝑖𝑜 =
𝐵𝑉 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦

Expected stock price using price-ratio analysis

E.g. for PE Ratio
𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑠𝑡𝑜𝑐𝑘 𝑝𝑟𝑖𝑐𝑒 = 𝐻𝑖𝑠𝑡𝑜𝑟𝑖𝑐𝑎𝑙 𝑃𝐸 𝑟𝑎𝑡𝑖𝑜 𝑥 𝑃𝑟𝑜𝑗𝑒𝑐𝑡𝑒𝑑 𝐸𝑃𝑆

20
Enterprise Value Ratios

• To involve equity and debt

𝐸𝑛𝑡𝑒𝑟𝑝𝑟𝑖𝑠𝑒 𝑉𝑎𝑙𝑢𝑒 = 𝑀𝑉 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦 + 𝑀𝑉 𝑜𝑓 𝑑𝑒𝑏𝑡 − 𝐶𝑎𝑠ℎ

𝐸𝐵𝐼𝑇𝐷𝐴 = 𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑏𝑒𝑓𝑜𝑟𝑒 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡, 𝑡𝑎𝑥𝑒𝑠, 𝑑𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝑎𝑛𝑑 𝑎𝑚𝑜𝑟𝑡𝑖𝑧𝑎𝑡𝑖𝑜𝑛

• To estimate enterprise value

𝐸𝑠𝑡𝑖𝑚𝑎𝑡𝑒 𝐸𝑉 = 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐸𝑉/𝐸𝐵𝐼𝑇𝐷𝐴 𝑟𝑎𝑡𝑖𝑜 𝑥 𝐸𝐵𝐼𝑇𝐷𝐴

21
 WEEK 6: Diversification & Risky Asset Allocation

Individual Stock

Expected Return Variance

𝐸(𝑅𝑖 ) = ∑(𝑃𝑟𝑜𝑏𝑎𝑏𝑖𝑙𝑖𝑡𝑦𝑠𝑡𝑎𝑡𝑒 𝑥 𝑅𝑒𝑡𝑢𝑟𝑛𝑠𝑡𝑎𝑡𝑒 ) 𝑉𝑎𝑟(𝑅𝑖 ) = ∑[𝑃𝑟𝑜𝑏𝑎𝑏𝑖𝑙𝑖𝑡𝑦𝑠𝑡𝑎𝑡𝑒 𝑥 (𝑅𝑒𝑡𝑢𝑟𝑛𝑠𝑡𝑎𝑡𝑒 − 𝐸𝑅)2 ]

• Expected Risk Premium = ER – Rf rate

Portfolio

Expected Return Variance

2
𝐸(𝑅𝑝 ) = ∑(𝑊𝑖 𝑥 𝐸(𝑅)𝑖 ) 𝑉𝑎𝑟(𝑅𝑝 ) = ∑ [𝑃𝑟𝑜𝑏𝑎𝑏𝑖𝑙𝑖𝑡𝑦𝑠𝑡𝑎𝑡𝑒 𝑥 (𝐸(𝑅)𝑝𝑠 − 𝐸(𝑅)𝑝 ) ]

Where,
𝐸(𝑅)𝑝𝑠 = return of portfolio in a state

Why Diversification works? Correlation

• Correlation → The tendency of returns on 2 assets to move together.

• Imperfect correlation → key reason why diversification works (i.e. reduces portfolio risk – as
measured by the portfolio standard deviation)
o Positively correlated assets → move up and down together
o Negatively correlated assets → move in opposite directions
• Correlation coefficient → ranges from -1 to +1

22
Portfolio of 2 Assets

Variance with Covariance Variance with Correlation, (Correlation = 𝜌𝐴𝐵 )

𝜎𝑝2 = 𝑤𝐴2 𝜎𝐴2 + 𝑤𝐵2 𝜎𝐵2 + 2𝑤𝐴 𝑤𝐵 𝐶𝑜𝑣(𝐴, 𝐵) 𝜎𝑝2 = (𝑤𝐴 𝜎𝐴 )2 + (𝑤𝐵 𝜎𝐵 )2 + 2(𝑤𝐴 𝜎𝐴 )(𝑤𝐵 𝜎𝐵 )(𝜌𝐴𝐵 )

Calculations required for Covariance and Correlation figures

i) Return of 2 assets A and B

𝑟𝑝 = 𝑤𝐴 𝑟𝐴 + 𝑤𝐵 𝑟𝐵

ii) Expected return of 2 assets A and B

𝐸(𝑟𝑝) = 𝑊𝐴 𝐸(𝑟𝐴) + 𝑊𝐵 𝐸(𝑟𝐵)

iii) Covariance (with probability of state, hence, dividing by n-1 not needed)
𝐶𝑜𝑣(𝐴, 𝐵) = ∑ 𝑝(𝑠)[𝑟𝐴 (𝑠) − 𝐸(𝑟𝐴 )][𝑟𝐵 (𝑠) − 𝐸(𝑟𝐵 )]

Deviations of returns with expected returns over n years

∑ [𝑟𝐴 (𝑠) − 𝐸(𝑟𝐴 )][𝑟𝐵 (𝑠) − 𝐸(𝑟𝐵 )]
𝐶𝑜𝑣(𝐴, 𝐵) =
𝑛−1

iv) Correlation Coefficient

𝐶𝑜𝑣(𝐴, 𝐵)
𝜌𝐴𝐵 =
𝜎𝐴 𝑥 𝜎𝐵

𝐶𝑜𝑣 (𝐴, 𝐵) = 𝜌𝐴𝐵 𝜎𝐴 𝜎𝐵

23
Correlation & Diversification → Markowitz Efficient Frontier

Markowitz Efficient frontier line

Point with lowest risk for

return

• Markowitz Efficient Frontier → set of portfolios with the max return for a given risk and min risk
for given return
• Investment opportunity set → showing possible combinations of risk and return from portfolio
of these 2 assets
• Portfolio showing highest return for risk level → efficient portfolio
• Portfolios not located behind (to left of) efficient frontier line as the line is the maximum it can go
already.
• Minimum variance point → Lowest risk portfolio for that level of return (least possible variance)
• Anything not on the line = inefficient portfolio

2-Security Minimum Variance Portfolio (Proportions/Weightage to Invest)

24
  B2   A B  AB
xA  2
 A   B2  2 A B  AB

xB  1  x A

WEEK 7: Risk, Return & The Security Market Line

• Return of stock composed of:
o Normal/ Expected
o Uncertain/ Risky → from unexpected info during year.
𝑇𝑜𝑡𝑎𝑙 𝑟𝑒𝑡𝑢𝑟𝑛 = 𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑟𝑒𝑡𝑢𝑟𝑛 + 𝑈𝑛𝑒𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑟𝑒𝑡𝑢𝑟𝑛

• Risk of a stock:
o Systematic risk (non-diversifiable) → influences large number of assets (market risk)
o Unsystematic risk (diversifiable) → influences a single company or a small group of
companies (unique risk/firm-specific risk)
𝑇𝑜𝑡𝑎𝑙 𝑟𝑖𝑠𝑘 = 𝑆𝑦𝑠𝑡𝑒𝑚𝑎𝑡𝑖𝑐 𝑟𝑖𝑠𝑘 + 𝑈𝑛𝑠𝑦𝑠𝑡𝑒𝑚𝑎𝑡𝑖𝑐 𝑟𝑖𝑠𝑘

• 𝑇𝑜𝑡𝑎𝑙 𝑟𝑒𝑡𝑢𝑟𝑛 − 𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑟𝑒𝑡𝑢𝑟𝑛 = 𝑈𝑛𝑒𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑅𝑒𝑡𝑢𝑟𝑛

• 𝑇𝑜𝑡𝑎𝑙 𝑟𝑒𝑡𝑢𝑟𝑛 − 𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑟𝑒𝑡𝑢𝑟𝑛 = 𝑆𝑦𝑠𝑡𝑒𝑚𝑎𝑡𝑖𝑐 𝑝𝑜𝑟𝑡𝑖𝑜𝑛 + 𝑈𝑛𝑠𝑦𝑠𝑡𝑒𝑚𝑎𝑡𝑖𝑐 𝑝𝑜𝑟𝑡𝑖𝑜𝑛

Systematic Risk Principle

• The expected return on an asset depends on only its systematic risk.

• Regardless of total risk, only systematic portion relevant in determining expected return and risk
premium.
• Beta coefficient (β) → measures relative systematic risk of an asset.
o > 1 = more systematic risk than average, higher expected return
o < 1 = less systematic risk than average, lower expected return

25
 o Note: Risk-free asset has zero beta
• Portfolio Beta → calculated with weightage
• Risk premium / reward-to-risk ratio → E.g. if 7.50%, asset offers risk premium of 7.50% per unit of
systematic risk.

Note

Beta (β) Standard Deviation (σ)

Measures systematic risk Measures volatility of asset (total risk)

Security Market Line (SML)

• Graphical representation of linear relationship between systematic risk and expected return in
financial markets.

𝐸(𝑅) − 𝑅𝑓
𝑆𝑙𝑜𝑝𝑒 =
𝛽

• Slope for market portfolio, because market beta = 1

𝑆𝑙𝑜𝑝𝑒 = 𝐸(𝑅𝑚 ) − 𝑅𝑓
= market risk premium

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Capital Asset Pricing Model (CAPM)

• Theory of risk and return for securities in a competitive capital market.

• Formula:
𝐸(𝑅𝑖 ) = 𝑅𝑓 + 𝛽𝑖 [𝐸(𝑅𝑚 ) − 𝑅𝑓 ]

• This shows that expected return depends on:

o 𝑹𝒇 → Pure time value of money
o [𝑬(𝑹𝒎 ) − 𝑹𝒇 ] → market risk premium, reward for bearing systematic risk
o 𝜷𝒊 → amount of systematic risk

Beta, β

• Security’s beta depends on

o How closely correlated the security’s return is with overall market return
o How volatile the security is relative to market

• Beta calculation:
𝜎𝑖
𝛽𝑖 = 𝐶𝑜𝑟𝑟 (𝑅𝑖 , 𝑅𝑚𝑎𝑟𝑘𝑒𝑡 ) 𝑥
𝜎𝑚𝑎𝑟𝑘𝑒𝑡

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Market Efficiency Hypothesis

• Theory → major financial markets reflect all relevant information, at any given time, hence it is not
possible to beat the market.

i. Weak-form Efficient Market

o Past prices & volume figures cannot be used in beating the market
o Hence, technical analysis is of no use

ii. Semistrong-form Efficient Market

o Publicly available information cannot be used in beating market
o Hence, fundamental analysis is of no use

iii. Strong-form Efficient Market

o Information of any kind, public or private, cannot be used in beating market
o ‘Insider’ info cannot be used.

Economic Forces Behind Market Efficiency

1. Investors use information rationally

• They do not systematically over or undervalue financial assets
• All of them make rational decisions = meaning no excess returns

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2. Independent deviations from rationality
• Many irrational investors cancel out
• Irrationality diversified away

3. Arbitrageurs exist
• Collective irrationality do not balance out
• If rational > irrational = market still efficient

WEEK 9: Performance Evaluation & Risk Management

• Performance evaluation → assess how well money manager balances high returns and acceptable
risks
• Raw return → total percentage return on a portfolio
o Not adjusted for risk
o Not compared to any benchmark or standard
o Usefulness on portfolio is limited

Performance Evaluation Measures

1. The Sharpe Ratio

• Risk-to-reward ratio focusing on total risk.
• Computation: Portfolio risk premium divided by standard deviation of portfolio’s return
𝑅𝑝 − 𝑅𝑓
𝑆ℎ𝑎𝑟𝑝𝑒 𝑟𝑎𝑡𝑖𝑜 =
𝜎𝑝
2. The Treynor Ratio
• Risk-to-reward ratio focusing on systematic risk only.
• Computation: Portfolio risk premium divided by portfolio beta coefficient
𝑅𝑝 − 𝑅𝑓
𝑆ℎ𝑎𝑟𝑝𝑒 𝑟𝑎𝑡𝑖𝑜 =
𝛽𝑝

3. Jensen’s Alpha
• Excess return above or below security market line

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• A measure of how much the portfolio ‘beat the market’.
• Computation: Raw portfolio return less expected portfolio return (as predicted by CAPM)

𝛼𝑝 = 𝑅𝑝 − {𝑅𝑓 + 𝛽𝑖 [𝐸(𝑅𝑚 ) − 𝑅𝑓 ] }

Other Methods To Calculate Alpha

Characteristic Line

• The characteristic line graphs the relationship between the return of an investment (on the y-axis)
and the return of the market or benchmark (on the x- axis).
• The slope of this line = investment’s beta.
• This approach can be modified to = investment’s alpha (y-intercept)

Information Ratio

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• To evaluate if alpha is statistically significantly different from 0 or it simply represents result of
random chance
• Computation: Fund’s alpha divided by its tracking error.
𝐹𝑢𝑛𝑑′ 𝑠 𝑝𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜 𝑎𝑙𝑝ℎ𝑎
𝐼𝑛𝑓𝑜𝑟𝑚𝑎𝑡𝑖𝑜𝑛 𝑟𝑎𝑡𝑖𝑜 =
𝑇𝑟𝑎𝑐𝑘𝑖𝑛𝑔 𝑒𝑟𝑟𝑜𝑟/𝑆𝑡𝑎𝑛𝑑𝑎𝑟𝑑 𝑑𝑒𝑣𝑖𝑎𝑡𝑖𝑜𝑛
• Tracking error/Standard deviation → volatility of fund’s returns relative to benchmark.
The standard deviation of difference in returns (fund to market( = tracking error
• Allows comparison of investments that have same alpha → Higher information ratio = lower
tracking error (volatility) risk.

R-Squared → Role of correlation in performance measurement

• To see if it is due to pure macroeconomic factors and whether performance reflects good
management or future potential
• R-Squared = Squared correlation of fund to market
Represents % of fund’s movements that can be explained by movements in market.
• Correlation -1 to +1, R-Squared is 0 to 100%.
o R-squared = 100 means all movements in security driven by market (indicated correlation of
-1 or +1)
o High R-squared value (e.g. greater than 80%) may suggest that performance measures like
alpha are more representative of potential longer term performance.
o R-square of n means that n% of its returns driven by market’s return.

Comparing Performance Measures

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 Sharpe Ratio Treynor Ratio Jensen’s Alpha
• Appropriate for evaluation • Appropriate for evaluation of securities or portfolios for
of entire portfolio possible inclusion into existing portfolios.
• Penalizes portfolio for being • Both require beta estimate
undiversified, because • Weakness: Beta can differ a lot depending on source, leading
generally, to potential mismeasurement of risk adjusted return
Total risk  systematic risk • Only difference is:
only for well diversified o Treynor → standardizes returns, including excess
portfolios. returns, relative to beta.
• Inappropriate for evaluating
indiv. stocks as it uses total
risk not systematic risk.

WEEK 10: Bond Prices and Yields

Terminology
• Bond → Security that obligates the issuer to make specified payments to the bondholder
• Face Value/ Par Value/ Principal Value → Payment at the maturity of the bond
• Coupon → The interest payments made to the bondholder
• Coupon Rate → Annual interest payment, as a percentage of face value

Assume: Bond is semi-annual coupon bond if annual coupon bond not mentioned

Remember: Coupon rate ≠ discount rate

Annual Bond Valuation

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 𝑐𝑜𝑢𝑝𝑜𝑛 𝑐𝑜𝑢𝑝𝑜𝑛 (𝑐𝑜𝑢𝑝𝑜𝑛 + 𝑝𝑎𝑟 𝑣𝑎𝑙𝑢𝑒)
𝐵𝑜𝑛𝑑 𝑃𝑟𝑖𝑐𝑒 (𝑃𝑉) = 1
+ 2
+ ⋯+
(1 + 𝑟) (1 + 𝑟) (1 + 𝑟)𝑡

1 − (1 + 𝑟)−𝑡 𝐹𝑉
𝐵𝑜𝑛𝑑 𝑃𝑟𝑖𝑐𝑒 = 𝐶 [ ]+
𝑟 (1 + 𝑟)𝑡

NOTE: In case of change of periods, m

• E.g. Semi-annual coupon payments = divided by periods in a year
• Discount rate = divided by periods in a year
• Time to maturity = if semi-annual, times 2

E.g. Semi Annual Bond Pricing

𝑌𝑇𝑀 −2𝑀
1 − (1 +
𝐶
𝐵𝑜𝑛𝑑 𝑃𝑟𝑖𝑐𝑒 = [ 2 ) ]+
𝐹𝑉
2 𝑌𝑇𝑀 𝑌𝑇𝑀 2𝑀
(1 +
2 2 )
• If asked to calculate YTM with financial calculator, remember:
o If coupon is semi-annual/other period than annual, remember to multiply YTM found by
number of periods!

Rate of Return

• Total income per period per dollar invested

𝑐𝑜𝑢𝑝𝑜𝑛 𝑖𝑛𝑐𝑜𝑚𝑒 + 𝑝𝑟𝑖𝑐𝑒 𝑐ℎ𝑎𝑛𝑔𝑒
𝑅𝑎𝑡𝑒 𝑜𝑓 𝑟𝑒𝑡𝑢𝑟𝑛 =
𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡

Premium, Par and Discount Bonds

• Premium bonds → If Coupon rate > YTM then Price > Face (par value)
Coupon rate > current yield > YTM
Provides periodic income in form of coupon payments, in excess of that required by investors on
other similar bonds
• Discount bonds → If Coupon rate < YTM then Price < Face (par value)

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• Coupon rate < current yield < YTM
Insufficient coupon payments compared to what’s required by investors.
• Par bonds → If Coupon rate = YTM then Price = Face (par value)
Coupon rate = current yield = YTM
𝐴𝑛𝑛𝑢𝑎𝑙 𝑐𝑜𝑢𝑝𝑜𝑛 𝑝𝑎𝑦𝑚𝑒𝑛𝑡
Current yield = 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑏𝑜𝑛𝑑 𝑝𝑟𝑖𝑐𝑒

In all cases, premium, discount and par → current yield + expected one period capital gains yield of
bond must = required rate of return

Note on Bond Quotations

• If you buy a bond between coupon dates, you will receive the next coupon payment (and might
have to pay taxes on it).
• When you buy the bond between coupon payments, you must pay the seller for any accrued
interest.
• The convention in bond price quotes is to ignore accrued interest.
o This results in what is commonly called a clean price (i.e., a quoted price net of accrued
interest).
o Sometimes, this price is also known as a flat price.
• The price the buyer actually pays is called the dirty price.
o This is because accrued interest is added to the clean price.
o Note: The price the buyer actually pays is sometimes known as the full price, or invoice
price.

Callable Bonds

• Gives the issuer the option to buy back the bond at a specified call price any time after an initial
call protection period.
• YTM may not be useful for callable bonds. YTC used instead.

Interest Rate Risk

• Possibility that changes in interest rates will result in losses in the bond’s value.
• Lower coupon & longer maturity = greatest IRR

1. Macaulay Duration
• Stated in years
• Often described as bond’s effective maturity
• Price of bonds change when interest rates change, but how big is the change?
• Macaulay Duration → way to measure sensitivity of a bond price to changes in bond yields.

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•
𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑌𝑇𝑀
% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑏𝑜𝑛𝑑 𝑝𝑟𝑖𝑐𝑒 = −𝐷𝑢𝑟𝑎𝑡𝑖𝑜𝑛 𝑥
𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝑌𝑇𝑀
(1 + )
2

• 2 bonds with the same duration (not necessarily same maturity) → approximately same price
sensitivity to small changes in bond YTM.

Computation
• Zero-coupon bond → duration = maturity
• Coupon bond → duration = weighted average of individual maturities of all bond’s separate
cash flows
Weights = proportionate to PV of each cash flow.
For constant Semi-annual Coupon Bond:

𝑌𝑇𝑀 𝑌𝑇𝑀
1+ 1+
𝐷𝑢𝑟𝑎𝑡𝑖𝑜𝑛 = 2 − 2 + 𝑀(𝐶𝑜𝑢𝑝𝑜𝑛 − 𝑌𝑇𝑀)
𝑌𝑇𝑀 𝑌𝑇𝑀 2𝑀
𝑌𝑇𝑀 + 𝐶𝑜𝑢𝑝𝑜𝑛 [(1 + 2 ) − 1]
• In the formula, CPR is the annual coupon rate, M is the bond maturity (in years), and YTM is
the yield to maturity, assuming semiannual coupons.

For bonds selling at par value:

𝑌𝑇𝑀
1+ 1
𝑃𝑎𝑟 𝑉𝑎𝑙𝑢𝑒 𝐵𝑜𝑛𝑑 𝐷𝑢𝑟𝑎𝑡𝑖𝑜𝑛 = 2 + [1 − ]
𝑌𝑇𝑀 𝑌𝑇𝑀 2𝑀
(1 + 2 )

2. Modified Duration
𝑀𝑎𝑐𝑎𝑢𝑙𝑎𝑦 𝐷𝑢𝑟𝑎𝑡𝑖𝑜𝑛
𝑀𝑜𝑑𝑖𝑓𝑖𝑒𝑑 𝐷𝑢𝑟𝑎𝑡𝑖𝑜𝑛 =
𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝑌𝑇𝑀
(1 + )
2

35
 % 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑏𝑜𝑛𝑑 𝑝𝑟𝑖𝑐𝑒 = −𝑀𝑜𝑑𝑖𝑓𝑖𝑒𝑑 𝐷𝑢𝑟𝑎𝑡𝑖𝑜𝑛 𝑥 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑌𝑇𝑀

Duration is a good estimate for small IR changes but not for large changes!

WEEK 11: Stock Options

• Derivative securities → financial contracts deriving value from other securities

Also called contingent claims because their payoffs are contingent of the prices of other securities.
• NOTE: 1 option contract = 100 units of stock

CALL options

• A European call option → gives buyer right to purchase underlying asset at the contracted price
(exercise/strike price) on a contracted future date (expiration date).

*American call option → can exercise on or before expiration date.

36
• Seller → writes a call, receiving option’s price called premium.
Obligated to sell asset on expiration date for exercise price.
• To breakeven → strike price + option premium

Payoff – Benefits from price increase

Holder Writer

𝑀𝑎𝑥 (0, 𝑆𝑇 − 𝐾) − 𝑀𝑎𝑥 (0, 𝑆𝑇 − 𝐾)

With premium: With premium:

𝑀𝑎𝑥 (0, 𝑆𝑇 − 𝐾) − 𝑐 − 𝑀𝑎𝑥 (0, 𝑆𝑇 − 𝐾) + 𝑐

S > K = In the money

S < K = Out of the money

PUT options

• A European call option → gives buyer/holder right to sell underlying asset at the contracted price
(exercise/strike price) on a contracted future date (expiration date).

*American call option → can exercise on or before expiration date.

• Seller → writes a put, receiving option’s price called premium.

Obligated to buy asset on expiration date for exercise price.
• To breakeven → strike price – option premium

Payoff – Benefits from price decrease

Holder Writer

37
 𝑀𝑎𝑥 (0, 𝐾 − 𝑆𝑇 ) − 𝑀𝑎𝑥 (0, 𝐾 − 𝑆𝑇 )

With premium: With premium:

𝑀𝑎𝑥 (0, 𝐾 − 𝑆𝑇 ) − 𝑝 − 𝑀𝑎𝑥 (0, 𝐾 − 𝑆𝑇 ) + 𝑝

S < K = In the money

S > K = Out of the money

Valuation of Stock Options

• Option premium → quoted price the investor pays to buy listed put or call option.
• Option premiums (prices) are affected by
o Fundamental (Intrinsic) value → based on current market price of underlying asset.
The payoff that an option holder receives if option is exercised now.
Call: The call option intrinsic value is the maximum of zero or the stock price minus the
strike price.
Put: The put option intrinsic value is the maximum of zero or the strike price minus stock
price.

o Time value (Time premium) → difference between price of an option and its intrinsic value.
• In-the-money → Positive intrinsic value.
• Out-of-the-money → Zero intrinsic value.
• At-the-money → When stock price and strike price about the same

Investment Strategies

1. Protective Put → Long stock, Long Put

𝑺𝑻 < 𝑲 𝑺𝑻 > 𝑲
Long Stock 𝑆𝑇 − 𝑆0 𝑆𝑇 − 𝑆0
Long Put 𝐾 − 𝑆𝑇 0
Payoff 𝐾 − 𝑆0 𝑆𝑇 − 𝑆0
Profit 𝐾 − 𝑆0 − 𝑝 𝑆𝑇 − 𝑆0 − 𝑝
Graph __ /
• Intuition → possible losses of the long stock position are bounded by the long put position.

2. Covered Call → Long stock, Short Call

38
 𝑺𝑻 < 𝑲 𝑺𝑻 > 𝑲
Long Stock 𝑆𝑇 − 𝑆0 𝑆𝑇 − 𝑆0
Short Call 0 −(𝑆𝑇 − 𝐾)
Payoff 𝑆𝑇 − 𝑆0 𝐾 − 𝑆0
Profit 𝑆𝑇 − 𝑆0 + 𝑐 𝐾 − 𝑆0 + 𝑐
Graph / __
• Intuition → the call is “covered” since in case of delivery, the investor already owns the stock.

Put-Call Parity

• Most fundamental relationship in option pricing

• Generally used for options with European style exercise
• States:
The difference between call price and put price equals the difference between stock price and the
discounted strike price.
• Formula:
𝐾
𝑐−𝑝 =𝑆−
(1 + 𝑟)𝑇

𝐾
=𝑆+𝑝−𝑐
(1 + 𝑟)𝑇

Why It Works?

• If two securities have the same risk-free payoff in the future, they must sell for the same price
today
• Example:
o Buys 100 shares of Microsoft stock.
o Writes one Microsoft call option contract.
o Buys one Microsoft put option contract.

39
• Note → Portfolio always worth K on expiration i.e. it is risk-free.
𝐾
• Hence, value today is (1+𝑟)𝑇
• To prevent arbitrage
Today’s cost of buying 100 shares + buying one put (net of proceeds of writing call) should = price
of risk-free security with face value of $K and maturity of T.

WEEK 12: Futures Contracts

Futures Contracts Forward Agreements

• An agreement made today between buyer • An agreement made today between buyer
and seller who are obligated to complete and seller who are obligated to complete
transaction at a set date in the future. transaction at a set date in the future.
• Buyer and seller do not know each other

40
 • Terms of contract are standardized. • Buyer and seller know each other and they
• Contract price/delivery price determined negotiate terms of the contract.
when futures contract signed. • Terms of contract are customized
• No default risk even if other party has • Contract price/delivery price determined
incentive to default when agreement made.
Futures Exchange guarantees each trade – Generally, no cash changes hands until trade
no counterparty default is possible. is made.
• To cancel, an offsetting trade is made. • One party faces default risk because other
party may have incentive to default.
• To cancel, both parties must agree.
One side may have to make dollar payment
to other to agree to cancel.

Futures Contract: Basics

• Agreement must stipulate at least the following 5 terms:

i. Identity of underlying commodity/financial instrument
ii. Futures contract size
iii. Futures maturity date/ expiration date
iv. Delivery/settlement procedure
v. Delivery price

• Represents zero-sum game between buyer and seller

o Gains realized by buyer, offset by losses by seller (and vice versa)
o Futures exchange keeps track of gains and losses every day.

• Used for hedging and speculation

o Hedgers → shift price risk to speculators
o Speculators → absorb price risk

SPECULATING
Long Futures Short Futures
• Believe price will increase • Believe price will decrease
Profits from increase Profits from decrease

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 HEDGING
• Used to transfer price risk
• By adding a futures contract position that is opposite of an existing position in commodity/financial
instrument.

Long Hedge (Buying futures)

• Need to buy commodity in the future.

• Loss on commodity → if price of commodity increases, so use long hedge to fix the price.
• Gain on future → if price increases
• Offsets potential increases in price of commodity.
• REMEMBER: To cancel contract and take profits, sell to offset.

Computational format

Date Commodity Price Inventory Acq. Near-term Value of n

(per unit) (Total) Commodity commodity
Futures Price (per futures contract
contract) (total)
Now
N months later
Gain/(Loss)

Short Hedge (Selling futures)

• Need to sell commodity in future.

• Loss on commodity → if price of commodity decreases
• Gain on future → if price decreases

Perfect hedge → If gain offsets loss 100%

Cash Prices

• Cash price/ spot price of commodity or financial instrument → price for immediate delivery
• Cash market/spot market → market where commodities or financial instruments traded for
immediate delivery.

Cash-Futures Arbitrage

42
• Definition → earning risk-free profits from unusual differences between cash and futures prices.
• In a competitive market, cash-futures arbitrage have slim profit margins.
• Cash prices and futures prices are seldom equal.
• Difference between the cash price and the futures price for a commodity = basis.
𝐵𝑎𝑠𝑖𝑠 = 𝑐𝑎𝑠ℎ 𝑝𝑟𝑖𝑐𝑒 − 𝑓𝑢𝑡𝑢𝑟𝑒𝑠 𝑝𝑟𝑖𝑐𝑒
• For commodities with storage costs → cash price usually < than futures price
i.e. basis < 0
This is referred to as carrying-charge market.
• When cash price > futures price i.e. basis > 0
This is referred to as inverted market
• Basis is kept at economically appropriate level by arbitrage.

Spot-Futures Parity Theorem

• 2 ways to buy an asset:

o Strategy A → Buy now, pay spot price S0, and hold until time T, when spot price is ST.
o Strategy B → Hold long futures position, the future delivery price is FT.
• No-arbitrage condition

• Spot-futures parity condition → the relationship between spot prices and futures prices that must
hold to prevent arbitrage opportunities

𝐹𝑇 = 𝑆(1 + 𝑟)𝑇
• In the equation,
F = futures price, S = spot price, r = risk-free rate per period, and T = number of periods before
the futures contract expires.

43