Theory of Finance Notes

Download as docx, pdf, or txt
Download as docx, pdf, or txt
You are on page 1of 36

Theory of finance

Introduction to Financial Markets and Instruments


The real wealth of the economy is in tangible assets such as land, buildings and machinery and the
human capital that can help produce goods and services in the future. Financial Markets and
institutions channel funds to where they are likely to be most productive which may be individuals,
firms or the government.

We can identify two fundamental types of markets:


 Primary market: it means the market for new issues of securities. The money raised goes to
the issuer of the assets. ‘Corporate Finance’.
 Secondary market: it means the market for securities that have already been issued on the
primary market. The money raised goes to the existing owner of the claims and not to the
issuer. ‘Financial Markets’

Financial Markets facilitate the exchange of financial instruments such as stocks, bills and bonds,
foreign exchange, futures, options and swaps. These assets are the means by which claims are
transferred from one party to another, frequently across time. We can have Stock Markets, Money
Markets, Foreign Exchange Markets, Derivative Markets…
Prices on financial markets change ‘all the time’, and they respond to news and changing views about
the future.

Financial Instruments are generally referred to as securities. Securities differ in the timing of
payments, whether they can be readily sold prior to maturity in a secondary liquid market (e.g., via the
stock exchange), and in the legal obligations associated with each security (bondholders must be paid
before equity holders). Many securities are readily negotiable claims, which means that the owner of
the security can sell it quickly. Those are also known as liquid markets.

A financial instrument has no intrinsic value. Other financial instruments known as derivatives have
value because their payoff depends on the price of other financial assets (stocks, bonds) or real assets
(oil, silver, agricultural products).

Financial Assets (e.g. stocks and bonds) derive their value purely on the basis of the future
performance of the issuer (firm). Therefore, they represent claims on future cash flows. They may
differ in the following:
 Maturity
 Frequency of expected payment
 Uncertainty of cash flows (including the final payment)

Debt vs Equity
- Ownership and control:
 Shareholders own the firm and control the management via voting right over the
composition of BoD
 Debtholders, on the other hand, do not own the company but do have an influence on
managers as they can put the firm into liquidation
- Repayment in case of bankruptcy: equity is the last to be repaid back, and for this nature, they
are riskier; thus, they require higher returns.
- Cash flows:
 Shareholders: repayment depends on the capacity of the company to generate profits and
whether they are redistributed to shareholders or reinvested in the company
 Debtholders: they have pre-determined re-payments
Debt market:
- Money market instruments (treasury bills): they have short-term maturity and are issued by
governments, financial institutions or corporations – A maximum of 365 days.
o LIBOR: interest rate applied between banks to lend money
o Bills: discount instruments and provide payment at maturity. Discount vs Yield.
o Certificate of deposit: fixed term but tradeable on the secondary market.
- Bonds (treasury bonds, corporate bonds): they have a maturity longer than 1 year
o Government bonds: they are free from default risk. Bonds issued by the UK Gov are
called Gilts.
o Corporate bonds
o Collateral: to protect bondholders.
o Covenants: can be positive (things to do) and negative (things not to do)
o Callable bonds: the issuer can buy back the bonds at a fixed price (call value) at
specific times in the future. Generally, the call price is set above the face value. The
call premium declines as we get closer to the maturity date
o Convertible bonds: bonds that are convertible into shares of the issuer.

Exchanges
With the term exchanges, we indicate those marketplaces where different financial assets are traded.
We can have two types of marketplaces:
 Over the counter: “it is everywhere”. Different financial institutions create a market (dealer
market) for a particular product (foreign exchange, swaps, LIBOR [interest rate that
investment banks apply for borrowing/lending funds for short periods of time]). Over-the-
counter markets often give rise to non-marketable instruments that are held until maturity.
 Organised exchanges: there is a real physical place where exchanges happen. They are
auction markets are prices change continuously.
- Physical exchanges (NYSE)
- Computerised (NASDAQ, LSE)
Only the largest companies can afford to be listed on more than one exchange as it requires them to
comply with all the exchange-specific requirements, particularly when coming to accounting
standards. However, being listed on more than an exchange allows you to reach out to a wider poll of
investors and become more attractive.

There are also other marketplaces, one of which are the derivative exchanges. The most important are:
 Chicago Mercantile Exchange Group:
- Chicago Mercantile Exchange (CME) – part of CME Group
- Chicago Board of Trade (CBT) – part of CME Group
- Other
 Chicago Board Option Exchange (CBOE)
 Eurex (merger of DBT and SOFFEX)
 Euronext (formerly LIFFE)

Stock Market Indices


Index numbers can be constructed for different financial assets or economic values. Focusing on the
stock index. There are three purposes of indices:
 To measure the performance of the stock market or segment of it
 To create investable ‘portfolios’
 To act as a benchmark to beat (for actively managed portfolios)
Common indices are:
 Dow Jones Industrial Average
- 30 largest “blue-chip” corporations (it goes back to 1896)
- Value of ONE share invested in each of the 30 companies (price-weighted index, stocks
with the highest price have the highest weight)
 Standard & Poor Index
- S&P500: 500 ‘largest’ firms
- Market-value weighted (value of all 500 ‘largest’ companies)

In the UK we have different important indices:


 FTSE100: largest (market cap) companies listed on the LSE
 FTSE250: represents mid-cap companies, not included on the FTSE100
 FTSE All share: aggregate of FTSE100, FTSE250 and FTSE small cap Index
Others:
 FTSE350
 FTSE Small Cap
 FTSE fledging
There are also other UK Index providers as MSCI, Dow Jones, DAX…
Key Questions in Finance
Valuation
How do we decide on whether undertake a new investment project, buy a potential takeover target or
buy stocks, bonds, and other financial instruments?
To answer this question, we need to calculate the correct or fair value of the future cash flows from
these ‘assets.’ If the V > P, then we should buy or realise the project.

Risk
When we calculate the present value of the cash flows from a project/asset, we need to take into
account the riskiness linked to the operation. That means adjusting the future cash flows with a
discount rate which would consider the risk that those cash flows will not be as forecasted. We can
define the risk also as volatility. To assess volatility, we often use also the variance or standard
deviation.

Portfolio theory
The portfolio theory tries to reduce the risk associated with investments by combining several assets
and thus avoiding being exposed to a single or limited number of assets.

Hedging
It is a strategy to reduce the risk of adverse price movements of assets we have invested in. Popular
hedging techniques involve taking offsetting positions in derivatives that correspond to an existing
position. The most common way of hedging in the investment world is through derivatives.
Derivatives are securities that move in correspondence to one or more underlying assets. They include
options, swaps, futures, and forward contracts. The underlying assets can be stocks, bonds,
commodities, currencies, indexes, or interest rates.
Hedging is a technique used to reduce risk, but it’s important to keep in mind that nearly every
hedging practice will have its own downsides. First, as indicated above, hedging is imperfect and is
not a guarantee of future success, nor does it ensure that any losses will be mitigated. Rather,
investors should think of hedging in terms of pros and cons.

Speculation
Can a financial adviser ‘beat the market’ return over a run of days after correcting for risk and
transaction costs? Speculation is a sort of risky arbitrage.

Investment companies
We can identify different types of institutional investors:
 Pension funds
 Managed investment companies:
- Open-end funds (NAV=share price): an open-end fund is a diversified portfolio of pooled
investor money that can issue an unlimited number of shares. The fund sponsor sells
shares directly to investors and redeems them as well. These shares are priced daily based
on their current net asset value (NAV)
- Close-end funds (NAVshare price): A closed-end fund is launched through an initial
public offering (IPO) in order to raise money for investment. The fund trades in the open
market, just like a stock or an ETF. Only a set number of shares are issued. But since the
shares continue to trade, their market price is affected by supply and demand. That means
the shares may trade at a price above or below their net asset value (NAV), the price at
which it was issued.
 Hedge funds: A hedge fund is a limited partnership of private investors whose money is
managed by professional fund managers who use a wide range of strategies, including
leveraging or trading of non-traditional assets, to earn above-average investment returns.
Hedge fund investment is often considered a risky alternative investment choice and usually
requires a high minimum investment or net worth, often targeting wealthy clients.
 Insurance companies

Mutual funds
A mutual fund is a financial vehicle that pools assets from shareholders to invest in securities like
stocks, bonds, money market instruments, and other assets. Mutual funds are operated by professional
money managers, who allocate the fund's assets and attempt to produce capital gains or income for the
fund's investors. A mutual fund's portfolio is structured and maintained to match the investment
objectives stated in its prospectus.
Mutual funds give small or individual investors access to professionally managed portfolios of
equities, bonds, and other securities. Each shareholder, therefore, participates proportionally in the
gains or losses of the fund.

The mutual fund industry is much larger than the hedge fund industry. Indeed, in the US, more than
50% of households have investments in mutual funds. About 70%/80% of the industry is actively
managed, while the remaining part is passive.
There are differences between the two types of funds, in particular regarding the fees they charge:
 Actively managed: about 1-2% + load fees (front-end and back-end load)
 Passively managed: about 0.5%
Should we opt for an actively managed fund or a passive one?

ASSET RETURNS – LECTURE 2


Finance is the study of asset prices, and these prices are stochastic or random; that is, we cannot
predict with certainty what their values will be tomorrow. We can only make probabilities statements.

Most financial data are provided/reported in the form of prices, but some financial data are reported as
interest rates. In finance, the convention is using annual ‘returns’ reported as a percentage. Thus,
when we have the price of an asset, we can easily convert it to find the interest rate.

Holding period return


Arithmetic return
 Rt = (Pt – Pt-1)/Pt-1 without dividends
 Rt = (Pt – Pt-1 + Dt)/Pt-1 with dividends

Some rearrangements: Rt = (Pt/Pt-1) – 1

Continuously compounded return (or geometric return)


 Rt = ln (Pt/Pt-1) without dividends
 Rt = ln ((Pt + Dt)/Pt-1) with dividends

The two methods give similar results when using high-frequency data. However, the continuously
compounded return is widely used in finance as:
1. You can’t have negative prices
2. The symmetric outcome when measuring equal one-period consecutive price changes
3. It is used in many assets pricing models

The continuously compounded formula is only a mathematical formula that, however, doesn’t reflect
how the financial markets work. In the market, returns are indicated with the arithmetical formula. In
risk management, the convention is that the daily returns are continuously compounded because we
are interested in the symmetry of returns.

Example
Assume a three-period horizon. Let P0 =100, P1 =110 and P2 =100
 Continuously compounded (one-period) returns
R1 = ln(110/100) = 9.53% and R2 = ln(100/110) = -9.53%
 Arithmetic (one-period) returns
R1 = (110-100)/100 = 10% and R2 = (100-110)/110 = -9.09%

As we can see from the example the arithmetic return tells us that our final wealth is increased by
approximately 1%. This is not true and the reason behind this is that the arithmetic return is not
symmetric. On the other hand, the continuously compounded return gives us a better estimate and it
tells us that our wealth from 1 to 2 has not increased.
To calculate n-period (i.e. annual) returns using 1-period (i.e. monthly) continuously compounded
returns (Rgi)
 (Annual) n-period continuously comp. return = Rg1 + Rg2 + ... + Rg12

To calculate n-period returns using 1-period arithmetic returns (Ri)


 (Annual) n-period arithmetic return = [(1+R1) (1+R2) ... (1+R12)] - 1

We can easily convert arithmetic returns versus continuously compounding returns using the
following formulas:
Rcc
Return artihmetic=e −1

Return cc=ln ( 1+ Rarith )

Fisher effect

The Fisher Effect is an economic theory created by economist Irving Fisher that describes the
relationship between inflation and real and nominal interest rates. The Fisher Effect states that the real
interest rate equals the nominal interest rate minus the expected inflation rate. Therefore, real interest
rates fall as inflation increases unless nominal rates increase at the same rate.

Nominal and Real Returns


Foreign Investment Measured in Domestic Currency
Arithmetic returns

Continuously compounded

Measuring Expected Return

Holding Period Yield (‘Arithmetic Measure’)

Holding period yield (also called holding period return) is the yield an investor would obtain for
holding an asset over a certain period of time. (The investor sells the asset before it reaches maturity –
at an unknown price).

Capital Appreciation = Ending Value – Beginning Value

Calculating the HPR starts by subtracting the beginning value of an investment from the ending value
to arrive at the capital appreciation value, i.e. the capital gain.

The capital appreciation formula – i.e. ending value minus beginning value – measures how much an
investment how grown (or declined) in price since the initial purchase.

A capital gain occurs if the sale price exceeds the purchase price, whereas if the security was sold for
less than the initial price paid on the original date of purchase, the investment would be sold for a
capital loss.

The income received is then added to the capital appreciation in the next step.

The resulting figure represents the total return, i.e. the sum of the capital appreciation and income.

(Arithmetic) Expected Return


Arithmetic formula for calculating the expected return is the average of (successive) returns which
measures the average or “typical” return of this investment. Also known as mean return.
Measuring Risk
Volatility often refers to the amount of uncertainty or risk related to the size of changes in a security's
value. A higher volatility means that a security's value can potentially be spread out over a larger
range of values. This means that the price of the security can change dramatically over a short time
period in either direction. A lower volatility means that a security's value does not fluctuate
dramatically, and tends to be steadier.
Volatility is a statistical measure of the dispersion of returns for a given security or market index. In
most cases, the higher the volatility, the riskier the security. Volatility is often measured from either
the standard deviation or variance between returns from that same security or market index.

The Normal Distribution


Normal distribution, also known as the Gaussian distribution, is a probability distribution that is
symmetric about the mean, showing that data near the mean are more frequent in occurrence than data
far from the mean.
Properties of the normal distribution
 First, its mean (average), median (midpoint), and mode (most frequent observation) are all
equal to one another. Moreover, these values all represent the peak, or highest point, of the
distribution. The distribution then falls symmetrically around the mean, the width of which is
defined by the standard deviation.
 Skewness measures the degree of symmetry of a distribution. The normal distribution is
symmetric and has a skewness of zero.

If the distribution of a data set instead has a skewness less than zero, or negative skewness
(left-skewness), then the left tail of the distribution is longer than the right tail; positive
skewness (right-skewness) implies that the right tail of the distribution is longer than the left.

 Kurtosis measures the thickness of the tail ends of a distribution in relation to the tails of a
distribution. The normal distribution has a kurtosis equal to 3.0.

The Formula for the Normal Distribution

Co-Movements
Linear Relationship of Two Assets (Returns)
Correlation shows the strength of a relationship between two variables and is expressed numerically
by the correlation coefficient.

Correlation, in the finance and investment industries, is a statistic that measures the degree to which
two securities move in relation to each other. Correlations are used in advanced portfolio
management, computed as the correlation coefficient, which has a value that must fall between -1.0
and +1.0.
A perfect positive correlation means that the correlation coefficient is exactly 1. This implies that as
one security moves, either up or down, the other security moves in lockstep, in the same direction. A
perfect negative correlation means that two assets move in opposite directions, while a zero
correlation implies no linear relationship at all.
Portfolio – Risk and Return
Portfolio is a collection of financial investments like stocks, bonds, commodities, cash, and cash
equivalents, as well as their fund counterparts.
Stocks and bonds are generally considered a portfolio's core building blocks, though you may grow a
portfolio with many different types of assets—including real estate, gold, paintings, and other art
collectables.

EQUITY INVESTMENTS

Demand and supply of stock


The price of a stock is determined by demand and supply. However, stocks are traded by market
makers who have the “monopolistic” power of asking higher price when we buy or sell stocks.

Different attitudes towards risk


Investors differ in their attitude towards risk and, similarly,
assets differ for their expected return and risk. In the image
below, we can see different assets (A,B,C,D) and their
corresponding risk and expected return. Assets B, A, and D
offer different returns for the same level of risk. Therefore,
asset B would be preferred to the others two. Similarly, asset C
and A offer the same expected return but with a different level
of risk. In this situation, the investor would prefer asset C as it
provides the same return but for a lower risk.
Risk Premium and Risk Aversion
We define the risk premium as the return of an asset in excess of the risk-free rate.
The risk aversion indicates the reluctance of investors to accept more risk. The higher the number,
the more risk-averse the investor is. The more risk-averse an investor is, the higher will be the
required return from the investment.

We can calculate the risk aversion as follows:


A = (ERp – rf) / (Const ^2p)

Indifference curves
Assets that lie on the same indifference curve are equally desirable to the investor. We want to be
always on the highest possible indifference curve especially if the risk averse coefficient is high.

Fair value of a stock


To decide whether to invest or not invest in the stock market or in a stock portfolio, we need to know
the fair price of a stock. To do this, we use the discounted cash flow model to evaluate all the future
cash flows produced by an asset/stock. However, we have two problems:
 Future cash flows are uncertain
 Discount rate should reflect the riskiness of these cash flows
We can calculate the value of a stock at the time t by discounting all the future dividends it will
provide to the investor.

Rational Bubbles

This is the price today, that is, the discounted present value of the dividends at t+1 and the price at
t+1.

Contradictions 1 and 2  we are assuming that the bubble grows at the discount rate of k every
period. If the bubble grows at k every period, and there is no chance that the bubble will burst, then it
wouldn’t be a bubble. It would be part of the fundamental value. One day, in the future, the bubble
will burst.
If you believe that the bubble will burst in the future, then the value of such a bubble must be zero in
your calculation (you are discounting something that is worth zero at time t+n). You can put a
positive valuation on the bubble only if you believe that the bubble will not burst over your
investment horizon.

Outlook of the US Stock Market


Long-term outlook – next 20/30 years
We can see that for the first 100 years, the
stock had a slow linear trend, and then in
mid-1990, the stock market took off. We
can also see some stock crashes in 2000
and 2007. Since the financial crisis, the
stock market has increased substantially
(this is after inflation has been taken out).
We can say that over the last 20-25 years,
we have seen something completely
different from the past.

Let’s look at the dividend/price ratio. The


theory suggests that the D/P ratio is
constant. From the data, despite some
spikes and wings, we can say it is
reasonably constant. In the ’40s, the D/P
reached an all-time high. The lowest was
reached in the ‘70s. The D/P ratio should
be close to the expected return or a little bit
less. What would we expect from the ‘80s
going forward? D/P might go up a little bit,
and some moves around the mean value.

If we look at the data, we can see that the D/P


ratio has fallen and remained at a much
lower level over the last 30 years. There
might be a structural break around the
second half of the ‘80s.
If we look at the entire time series, we can
see a structural break, and the mean value
from the ‘90s going forwards was much
lower. This was around 2%. Remember
that this should be linked to the expected
return.
What’s going to happen next? Two
possibilities:
 Over the last 20/30 years, we have
seen a huge Pendola/swing
downwards, and maybe we can
expect that in the future 30 years,
this will reverse upwards. That means that the D/P ratio must increase. This can only happen
if dividends increase or if prices fall. So, if we are facing an upwards swing, then we can
expect stock prices to fall for the next 30 years. (Pessimistic outlook)
 There has been a structural break due to technological innovations, globalisation etc, and the
D/P ratio has found a sort of new mean value, which is much lower compared to the previous
one. That also means that for the next 30 years, we should be prepared to accept lower returns
from the stock market. This means that the increase in the stock prices will only be matched
by the increases in the growth rates of the dividends. This means that D/P will remain stable
over time. As both dividends and prices cannot go below zero, we can set zero as the lower
boundary.
Equity investments are risky, and we need to be rewarded for that risk, D/P can fall but cannot
go too close to zero.

EMH and forecasting stock returns


Under the efficient market hypothesis (EMH), the current share price incorporates all relevant
publicly available information. Hence, investment analysts cannot use publicly available information
to devise successful trading rules. The EMH implies that an investor should adopt a “buy-and-hold”
policy. He should spread his risk by diversifying and holding the “market portfolio” (or the 35 shares
that mimic the market portfolio). You should not try to pick undervalued and overvalued stocks or try
to time the market. Most people seem not to believe the EMH. Indeed, only 10% of mutual funds are
index trackers, while the remaining 90% are actively managed.

If the current share price doesn’t reflect future fundamentals (e.g. expected future cash flows) but is
influenced by the whim or fads of irrational investors, this link is broken.
The above reasoning also applies to takeovers. If the market is “myopic” – that is, it only considers
profits and dividends that accrue in the near future – then managers fearful of a takeover may
distribute more in current dividends rather than using retained profits to undertake profitable real
investments. This strategy will boost the share price and is known as short-termism. The view that
hostile takeovers are wealth-enhancing requires that markets are efficient and that takeovers enable
bad managers to be replaced and the company to be reorganised once acquired.

If the share price does reflect the fundamentals, but news occurs frequently and is expected to make a
substantial impact on a firm’s future performance, then one would still expect to observe highly
volatile asset prices, even if the market is efficient.

Abnormal Returns
EMH suggests that stock prices over a short horizon are unpredictable. What happened to stock prices
in the past is of no use in predicting what they might be tomorrow. This is often referred to as random
walk behaviour. Under the EMH, a prediction of favourable future performance is immediately
reflected in a higher price, so any future predictions are immediately eliminated.

When we move to longer horizons, for the EMH, stock returns are the focus rather than only stock
price changes. Moreover, the EMH recognises that there must be an average positive return over the

risk-free rate, as stocks are risky assets. Using the CAPM equation, we can define the expected return
between t and t+1 as:

Hence, we can estimate in part the future performance of a stock as the sum of the risk-free rate and
the risk premium, which is constant.
Assuming that expected returns are constant is the same as assuming that the stock price equals the
expected PV of all future dividends.

Hence, the EMH implies that stock returns are not unpredictable, but abnormal returns are.
Predictability
To predict stock return, we can use correlation, regression and various types of variance ratio
statistics. The most frequently used approach is to regress “tomorrow’s” stock returns (or returns in
excess of the risk-free rate) on a set of variables known today, which here we designate as .

As independent variables, we can use many different:


- GDP
- Inflation
- Interest rates
- Industrial production
- D/P ratio
- Past returns

PORTFOLIO THEORY – LECTURE 4


Introduction
Portfolio theory helps to ask the following questions:
1. Asset allocation:
- How much money are you going to put into risky assets and how much into risk-free
securities?
- Allowing you to borrow and lend, how does this change your choice?
2. Portfolio theory:
- How do you allocate the money which you invest into risky assets amongst different risky
securities?

To answer the first question, we need to introduce the concept of diversification. This answer to what
is referred to as an asset-allocation problem. The asset-allocation problem depends on the preferences
of the investor, and in particular his risk tolerance. We will see that diversifying investments can
reduce the risk exposure(non-systematic), also defined as hedging.

Portfolio risk and return


As we have seen, the expected return of a security is denoted as ERi and we assume the risk on
individual security can be adequacy measured by its variance VAR(Rp).
Then, the expected return of a risky portfolio is given by the following formula:

On the other hand, the risk (variance) of the risky portfolio will be given by:
In portfolio diversification, the concept of correlation is extremely important. Indeed, the correlation
tells us how two assets move simultaneously. For instance, if two assets have a correlation equal to -1
means that when one goes up by 2%, the other one will go down for the same amount by -2%. We can
see that this plays a fundamental role when trying to hedge the risk of our portfolio. For the purpose
of diversification, each value below 1 can reduce the overall risk of the portfolio. At this point, we can
see how expected returns, variances and correlations are the drivers of portfolio theory.
The above image shows that portfolio variance falls as soon as the number of stocks in the portfolio
increase. It is important to remember that you cannot get rid-off of all the risks. Indeed, you will

always be exposed to what we refer to as systematic risk, which is the intrinsic risk of the market. All
companies are affected by the factors that explain such risk; those are phenomena like inflation,
recession and other macro-factors.

Portfolio theory
Once discussed the asset allocation problem, we will see now how portfolio theory can help us in
determining the optimal proportions of wi to invest in each stock. This is also known as the optimal
diversification problem.

We start from the assumption that the investor would prefer and higher expected return rather than a
lower expected return, but that he dislikes risk (i.e. is risk averse).

The portfolios that satisfy the mean-variance criterion are known as the set of efficient portfolios.

The efficient frontier


As we alter the proportion of our own wealth in the two stocks, both the expected return and risk of
the portfolio will change. How do they change? This gives us the opportunity set available to the
investor (top right image).
High interest rates are detrimental to equity returns (the lower profits), while high economic growth
leads to high expected returns. The following images show us the expected return and variance of the
investor’s portfolio as we alter the proportion of money invested in the two stocks. If we plug into a
scatterplot all the possible combinations of the two stocks, we can derive the efficient frontier. The
investor will never choose combinations that lie in the lower part of the curve as they provide a lower
ER for the same risk as the combinations on the upper part of the curve. If the investor would
minimise the portfolio risk, he should hold portfolio 2, this is also defined as the global minimum
variance portfolio.

However, to evaluate which is the best portfolio, we cannot look only at the ERs and VARs. Rather,
we should introduce what is defined as Sharpe Ratio. This allows us to compare different
stocks/portfolios comparing their returns to a benchmark and adjusting for the risk.

The Capital Allocation Line (CAL)


If we consider investing wi proportion of our capital into risky assets and the remaining part (1-wi)
into the risk-free asset, the portfolio ER would be the following:

Suppose now that the investor is allowed to borrow or lend at the risk-free rate of interest. Thus, the
investor can:
1. Invest less than his total wealth in the risky portfolio and use the remainder to lend at the risk-
free rate.
2. Invest more than his total wealth in the risky portfolio by borrowing additional funds at the
risk-free rate and also investing these funds in the risky portfolio. In this case, he is said to
have a lowered portfolio.

The CAL has an intercept equal to the risk-free rate and a slope given by the Sharpe Ratio.
If the investor decides to borrow money from a bank at the risk free-rate and invest this money into
his risky portfolio, then he will have:
All the points on the CAL represent a fixed bundle of risky assets, what change is the amount of

money invested and whether we borrow or lend money. When we borrow money, we will have a wi
of e.g., 1.5 in the risky assets and -0.5 for the amount of money borrowed from the bank at the risk-
free rate. The levered portfolio will provide a higher ER and have a higher risk compared to the “no-
lend/no-borrow” portfolio. Each portfolio on the efficient frontier has its own CAL.
When a portfolio consists only of risky assets, then as we have seen the efficient frontier in (ERp , sp )
space is curved – ER p and sp vary as the wi are changed. But for any portfolio consisting of stocks
held in fixed proportions (i.e. a single fixed risky portfolio), combined with borrowing or lending at
the risk-free asset, the relationship between the expected return on this new portfolio ER N and its
standard deviation s N is linear.
The investor will always prefer the portfolio that lies on the highest CAL. Indeed, as from the above

image, portfolio B’ will provide a higher ER compared to A but for the same level of risk. The highest
CAL, which is tangent to the efficient frontier, provides the highest possible return for unit of risk
(Sharpe Ratio) and is known as Capital Market line. This portfolio is also called the optimal
diversified portfolio.

Mean-variance portfolio theory is a passive strategy because the investor does not look for
underpriced or overpriced stocks – the latter would be an active strategy. The MV approach, although
passive, still requires some action – you need to forecast the ‘inputs’ – that is variances, covariances
and expected returns – and then do the optimisation problem.
If the inputs change over time, then you have to find the new
optimum proportions and rebalance your portfolio – there is a
trade-off here since frequent rebalancing implies higher
transaction costs (e.g. broker’ commissions, bid–ask spreads).
To find the optimum portfolio we can thus look at the portfolio that provides the highest Sharpe Ratio.
To do so, we have to plug into excel the ER, Var and correlation of the stocks and using Solver we
can find the optimum wi subjected to the constraint that their sum must be equal to 1.

Efficient Frontier
We consider now the case in which we in invest in n stocks. When we vary the proportions wi (i =
1,2…n) to form portfolios, there would be a large number of these. Indeed, we can form portfolios
made by n assets, each in different proportions. All of these possible portfolios are represented by the
points on and inside the convex “egg”, where the
points represent the opportunity set available to the
investor by combining the risky assets in different
proportions.
All the points inside the curve, are dominated by
those who lay on the efficient frontier. Indeed, these
have a lower variance (risk) while providing the same
ER. Moreover, points in the higher part of the curve dominate those in the lower part (lower ER for
the same risk).

International diversification
Why should we diversify internationally? There are different benefits to doing so:
• Low correlation between domestic and international stock markets: different business cycles,
different industrial mix, etc…
• Low correlation between foreign stock markets and the exchange rate
However, there are also some negative aspects:
 Market risk – Equity risk (less developed, higher concentration, etc…)
 Exchange rate risk
 Political risk
 Information risk

Empirical evidence shows that investors tend to prefer to invest in the domestic market (home country
biasness).

Solnik (1974) studied the risk-reducing benefits of international diversification. His hey results were
that having about 20 randomly selected domestic securities achieves the minimum level of systematic
risk with any one country. If we look at the following table, we can see that the non-diversifiable risk
is quite different from country to country. We can see that by adding international stocks a US
investor can reduce the systematic risk from 27% to
11.7%.

When considering international diversification, studying


the correlation between the different markets plays a
fundamental role. Indeed, excluding potential benefits
from exchange rates, we will benefit from a risk reduction
only if the correlations are at a low level. This is what
Odier and Solnik (1993) have done to demonstrate their
theory that international diversification should be pursued
by US investors.

FINIRE

SINGLE-INDEX MODELS and CAPM– LECTURE 5


Factor models
We have seen that stock returns are influenced by specific risks of the company but also by changes in
macroeconomic variables, such as interest rates, economic growth, inflation or oil prices. If we
assume that movements in a company’s stock return are influenced by a single factor rather than
several different factors, we would have what we call a single-factor model.

It is unlikely that any single macroeconomic factor will explain the movements in a specific
company’s stock return accurately. Thus, the best single factor to explain the individual return of most
companies is a broad-market stock-return index, such as the S&P 500 or the FTSE All-share index.
This will be called a single-index model (SIM).
The tilde over a variable indicates an excess return (Ri-r). The model is more viewed as a statistical
model, which assumes that the return of any stock Ri may be partly explained by movements in the
market return. The SIM implies that a stock has two sources of risk, a systematic or market
component and a firm-specific component represented by ei. It follows that the variability in any
individual stock return depends on the variability of the market factor and the variability in the firm-
specific component.

The systematic risk of the stock is crucially dependent on the stock’s beta Bi and the volatility of the
stock market. We can say that beta tells us in what measure the market variability is transmitted to the
individual stock return.
Alpha as a performance measure
It can be shown that ‘alpha’, the constant term in the SIM, is given by:

According to the CAPM, the required return to compensate for market risk is Bi(Rm-r). So alpha
measures the actual average return minus the required return and is therefore a measure of the
abnormal return on the stock. If alpha>0 then the stock has an average excess return that is more than
required to compensate for the risk of the stock. The alpha is also known as Jensen’s alpha.

If alpha is equal to zero, then the regression model collapses to the CAPM equation .

Portfolio inputs and the SIM


For a portfolio of n securities, we have:

In this case, we would need large amounts of data to calculate the optimal proportions to hold in the
risky portfolio (forecast ER, variances and covariances). However, If the SIM is a good statistical
description of stock returns, we know that:

The CAPM
The capital asset pricing model provides an equation for determining the return on a stock. It states
that the expected (average) excess return on a stock (ER-r) depends on the expected (average) excess
market return according to the following relationship:

An estimate of beta can be obtained from a time-series regression of the stock’s excess return on the
excess market return. This measures the contribution of one stock to the overall portfolio variance.

How to derive the CAPM from portfolio theory


We first start from this diagram where we have the efficient frontier, the portfolio (as proxy based on
ass.1 we assume the aggregate stock market), the capital market line, expected return and standard
deviation as a measure of risk.

From here, we represent the CAPM in


terms of the variance rather than the
standard deviation. We are only
changing the scale.

If we want to express mathematically the


CAPM, that is the expected return on any
point on the CML and it is equal to the
risk free rate + the slope (risk
premium/deltax) multiplied by deltax

Now I’m substituting Var i with the


cov(im). Why? Because the CAPM
proposes that only the amount of risk
that cannot be diversified away should
be priced. This is the COV between
asset i and the market (m). This is
because the variance of the assets
converges to the covariance as long as
we form a large enough portfolio.
If we then define COV/var=Beta then
we will have the CAPM equation. If
our asset i is the market, then our beta
would be equal to 1. So, the CAPM normalises everything with respect to 1, which is the riskiness of
the average stock market (around 20% std. deviation). If an asset has a beta > 1 then it is riskier than
the market, hence the risk premium should be larger than the risk premium of the market.

In the security market line, we use beta as a measure of


risk rather than the standard deviation.
CAPM as a price equation
The CAPM equation can be expressed also in terms of stock prices. Indeed:
rate of return = (P’-P)/P which is equal to rf + B(Erm – rf)
or
P = P*/[1 + rf + B(Erm – rf)]

The ER on equity is often used as the discount rate in the DPV formula to asses a physical investment
project for an all-equity financed firm. Indeed, the price of a stock (or the PV of a project) today is
given by the future price (future value) discounted at the rate d.

FIXED INCOME SECURITIES– LECTURE 6

Fixed-income securities are financial assets which pay a specific cash flow over a specific period of
time. They can be classified into money market instruments and bonds. The main difference between
the two is maturity:
- Money market instruments  usually less than 12 months
- Bonds  usually 10 years and longer
Fixed-income securities can be issued by different economic agents such as governments, municipals,
corporations or financial institutions…

Money markets
Money markets are financial markets. Where companies/governments or other economic agents can
borrow or lend money on a short-term basis. There are a wide variety of conventions when coming to
money markets. The two most important relate to:
 Pricing convention:
- Discount basis
- Yield basis
 Day count convention:
- Actual/actual
- Actual/360
- 30/360

BONDS ARE FREE OF DEFAULT RISK BUT THEY ARE NOT RISK FREE

Suppose we purchase a 3 monthly bill at 98$, the face value is 100$. We can define 2$ as the “dollar
discount” and describe the bill as a “discount instrument”. If we calculate the return on such
instrument, then it would be 0.02048 [= (100-98)/98]. This method is referred to as being on a “yield
basis”. However, this convention doesn’t apply to Treasury Bills, on which the return is calculated as
follows: [(100-98)/100] = 0.02 or 2%. This is known as the discount rate and hence the instrument is
quoted on a discount basis. The discount basis means not the discounted present value, but it refers to
the discount you get on the face value.

Discount based instruments


Market maker (banks)  buys at the bid price, sells at the asked price
Investor  buys at the asked price
The ask yield is the return if I buy a treasury bill today from the market maker at the asked price and I
hold it until maturity. The bid yield would be the return the market maker would have if it held the
treasury bill until maturity.

Yield based instruments


Certificates of deposit (CDs) in the UK are priced on a yield basis. A CD is a bearer instrument
certifying that a sum of money has been deposited with the bank issuing the certificate, at a fixed
yield, and that on the stated maturity date the funds will be repaid by the issuing bank with interest.
Interest may accrue on a periodic basis or at maturity. The money is “locked in” until maturity but you
can trade the certificate on the secondary market. For this purpose, it is necessary to be able to
calculate the price of this certificate today.
UK conventions:
- Units of at least 500,000
- Min/max redemption period is 7 days/5 years
- Interest on 1-year (or less) CDs is paid on maturity
- Quotations are on a yield basis
- The day-count basis is actual/actual
Bond market
There are a wide variety of different types of bonds. Bonds are usually issued to obtain long-term
finance – initial maturities are from 1 year to 30 years. A conventional government bond pays a fixed
amount every six months to the holder plus the redemption value on a fixed maturity date. However,
some bonds can be redeemed prior to their maturity date, while other corporate bonds can be
exchanged for common stock of the issuer, at some future date.
Thus, bonds can be either issued by governments or their agencies and by the corporate sector.
Moreover, they may be denominated in the home currency or in a foreign currency. Generally
speaking, government-issued bonds are free of default risk but they still are risky!

As we can see from the above charts, starting from around 2016 volume of bonds issued with negative
yields increased dramatically, reaching almost 8-10% of the total volume of the bonds market.
In the second chart, we can see that the 10-year government bond yield, often used as a benchmark, of
Germany, Japan and Switzerland dipped into negative territory.

Pricing bonds
As opposed to the money market, the bond market utilises compounding when calculating yields. In
pricing bonds, we need to consider four different types of calculating bonds’ return:
- Zero-coupon bonds
- Running-yield
- Yield to maturity
- Total return

Zero-coupon bonds
Bonds that have a single payout but have a maturity greater than one year are usually classified as
pure discount or zero-coupon bonds.

Coupon-payingr = (Par value/Price) ^1/n -1


bonds
Coupon-paying bonds provide a stream of payments called coupons (C), which are known for all
future periods, at the time the bond is purchased. Most bonds are redeemable at a fixed date in the
future for a known price, namely, par value, redemption price or maturity value, M. There are some
bonds that are never redeemable, these are known also as perpetuities.

We can see a coupon-paying bond as a portfolio of zero-coupon bonds. Indeed, each coupon
represents a known amount of money that will be paid at a certain maturity date (for instance, semi-
annually or annually). Hence, we can calculate the price of a coupon-paying bond by calculating the
value of each zero-coupon bond using the spot rates.

Example: calculating coupon-paying price using the zero-coupon method.

We use this method in order to avoid any arbitrage profit.  the value of the 2-year coupon-paying
bond and that of the portfolio of the three zero-coupon is the same. If this would not be true then we
can realise an arbitrage profit  we can buy at the lower value and sell it to the higher one. To avoid
this, we need also to use spot rates.
In this case, we need to pay attention to adjusting
the coupon rate (calculated using the annual rate)
to the frequency of the coupon payments, say it
semi-annual.
For instance, 1000$ 5% coupon-paying semi-
annual  Need to adjust cash flows
[(1000*5%)/2] =50 and also the spot rate r=5%/
m=2.

Yield to maturity
The YTM is the discount rate that makes the present value of all the cash flows equal to the price. It is
what we call IRR when referring to projects.
To find the YTM we need to solve the equation for
Y. Whereas, if we have the YTM, we can use this
equation to calculate the fair value of the coupon-
paying bond.

Bond pricing, Yield to Maturity and Interest rate sensitivity


As we can see from the table, if the coupon rate is the same as the YTM, then the bond is selling at
par. On the other hand, if the coupon rate is lower than the YTM the bond is selling at a premium.
Lastly, if the coupon rate is higher the bond is selling at a discount (you will make a gain). There is an
inverse relationship between bond prices and YTM: if the YTM increases, the bond price decreases,
and vice versa. This effect is amplified in the long term (2% change in YTM causes 20% change in
the price).

Summary

FIXED INCOME SECURITIES 2– LECTURE 7

Duration and modified duration


The concept of duration has been developed by Macauly in 1938. The duration of a portfolio of bonds
is simply a weighted average of the duration of the constituent bonds in the portfolio (remember
coupon-paying bonds are considered a portfolio of zero-coupon bonds), where the weights wi are
determined by the market value of the individual bonds. The convention is that duration is expressed
in years, whether it is specified or not. Remember that if the bond is not selling at par, the price will
not be the face value of the bond. Secondly, you have to make sure that you calculate the cash flows
in the correct way and that you adjust the yield to match the paying frequency.
Duration in finance is used for different purposes:

- Measure the sensitivity of bond price changes following changes in yields


(approximation)
- Immunisation (bond portfolio management)  matching cash flows from the bonds with
future liabilities
- Hedging (derivatives)

Modified duration and price changes


Duration can be used to measure the interest rate sensitivity of bond prices. When interest rate
changes, the (approximate) percentage change in bond prices is proportional to its duration.

The following chart shows the relationship between the true change in bond price and the change in
YTM through the convex line. The approximate change in price, given by the duration formula, is
represented by the straight line. The actual price rise will exceed that given by the duration equation –
and the actual price fall will be less than that calculated using duration. For small changes in yield, the
actual price change and that given using the duration will be very close. What does determine
approximation error? The change in yield (the smaller, the smaller error) and the convexity of the
pricing curve. Three parameters determine the convexity of the such curve:
- Time to maturity
- Coupon rates
- Yield to maturity

The yield curve


The yield curve shows the relationship between spot rates and the maturity of the loan (bond). We
assume that we are dealing with risk-free investments; that is, there is no risk of default. The interplay
of the supply of funds by lenders and the demand for funds by borrowers determines spot rates at any
one time. If all spot rates happen to move up or down by the same absolute amount, this is called a
parallel shift in the yield curve. Usually, the yield curve is upward-sloping and flattens out at long
maturities, but it can be also downward-sloping, which implies that it costs less to borrow money for
one year than it does for five years, for example.

A negative yield curve means that there must be a higher demand for long-term bonds, which drives
prices down, as opposed to short-term bonds, where lower demand requires higher yield. What causes
this situation? If the economy is heading towards a recession, we might see a negative yield curve.
Why would the feeling of an economic recession drive up the demand for long-term bonds? There are
two answers to this. Firstly, in a recession, my labour income might be reduced, and the argument is
that I will need to use cash flows from coupon payments from bonds which compensate me for the
loss of my labour income. If we are expecting a recession, we are going to buy long-term bonds that
are going to save us during the recession. Secondly, speculators buy long-term bonds when expecting
an economic recession, as one of the main economic policies will be lowering interest rates, the yield
will fall, and prices will rise (providing a gain).

What determines the shape of the yield curve at any point in time? This analysis is known as the term
structure of interest rates, and broadly speaking, the shape is determined by the market’s expectations
about future price inflation.

Spot rates and forward rates


Spot rates all refer to borrowing (or lending) money starting today. Suppose instead that we go to a
bank today but offer to end 100$ in one year, with repayment one year later. The applied rate that
gives you the amount repaid one year later (two years from today) is called the forward rate. How
does the bank know the rate to apply? It calculates forward rates from observed spot rates of interest.

Immunisation – portfolio management


The idea behind portfolio immunisation is that you choose a portfolio of coupon-paying bonds so that
you can meet a known set of payments accruing in the future. We need to calculate the duration of the
liabilities and invest in a portfolio that has an identical duration (duration matching).
Corporate Bonds
A corporate bond is a fixed-income security with a maturity of more than 1 year and issued by large
corporations to raise money.

We can identify different types of corporate bonds:


 Fixed coupon corporate bond
 Floating rate notes (FRN)  future coupon payments vary with reference rate (i.e. LIBOR)
and are therefore uncertain (they sell very close to par value)
 Foreign bonds  issued by an international corporation in the jurisdiction what type of
currency they want to raise (ex. Toyota places bonds in US dollars in NY)
 Eurobonds  bonds placed on a 3rd country

There are corporate bonds which have embedded options:


- Convertible Bonds  can be converted by the holder for a known amount of
shares/equity at a specific point in time in the future. Usually have a lower yield
compared to conventional bonds (because you pay the privilege of the option)

- Callable Bonds  can be redeemed at a specific point in the future by the issuer (usually
at par value) If interest rates fall in the future and P > par value ‘call’ issue and reissue at
a lower rate (if interest rates have fallen). Usually have higher yields compared to
conventional bonds (you need to compensate the investor)

Corporate bonds are much more difficult to price due to various caveats:
- You need to forecast yields
- They are more innovative
- Difficult to forecast credit spread
- Changes in ratings
- Bankruptcy risk

Default risk and bond pricing


We have seen that bonds generally provide a fixed flow of income, also known as coupons and the
principal payment. However, that income stream we have already said is not riskless. In the case of
government-issued bonds, these are free of default risk. However, this does not apply to corporate
bonds. Indeed, corporate bonds are exposed to the risk of bankruptcy. More specifically, they are
exposed to:
- Outright default  bankruptcy from one day to the other  nothing left
- Partial default (restructuring)
- Late payments

As a result of those risks to which investors are exposed, there are rating agencies that give a
valuation of the bonds’ risk based on the corporates’ credit rating.

We can see a significant spread between US treasuries and Baa-rated bonds. This was, on average,
around 2%, but there were steep changes over a very short period of time. As we have seen, changes
in interest rates have an immediate effect on long-term bonds, this will be a massive hit for the
corporate.

Structured Products, CDO and CDS

Asset-backed securities finance pools of familiar


asset types, such as auto loans, aircraft leases,
credit card receivables, mortgages and business
loans. In one way or another, these assets types
represent contractual obligations to pay.

Securitisation begins with the creation of a


special purpose vehicle (SPV) that acquires a
pool of assets and simultaneously raises debt
financing to fund the purchase of those assets
through the issuance of ABS. ABS carry investor-
friendly features intended to help protect against
loss and improve liquidity, including bankruptcy remoteness, prioritisation of payments, over-
collateralization, excess spread, amortisation, professional servicing, and diversity of payers within
each underlying pool.

In the US, banks tend to operate geographically, determining “high concentration” of mortgages etc.,
highly correlated. As we know, high correlation causes a low grade of diversification. Thus, banks
started to sell part of their ‘local’ mortgages to financial institutions that were buying all across the
US similar asset types characterised by a lower correlation, achieving better diversification. Then
these financial institutions sold those “portfolios”, characterised by similar assets lower correlated,
again to banks.

Before the financial crisis, banks were selling their junk bonds to financial institutions creating asset-
backed securities composed of junk bonds from all across the US. Then they got those portfolios rated
by rating agencies and sold them on the market.

Credit Default Swap (CDS)


You can enter into a credit default swap with a financial institution. You agree to pay the swap dealer
a fixed amount of $Q per year. In return, the swap dealer agrees to buy the bond from you for 1$M
(face value) if the corporate bond is in default – even though it might only be worth 200,000$ in the
distressed debt market. Alternatively, the credit default swap could be cash settled, whereby you keep
the bond (worth 200,000$), and the swap dealer pays you 800,000$. If the bond does not default, you
pay the swap dealer $Q per year, and you receive nothing from the swap dealer. The $Q per year is
the cost of your insurance premium.
If you hold a corporate bond and the corporate suffers a cred-rating downgrade, the yield on the bond
will rise, and the market price of the bond will fall.

You might also like