Investment cheat sheet

Chapter 1-2 investment basics

Margin = Equity/Value of Security
= (Value of Security – Loan) / Value of Security
ROI = total percentage return x original value
= (dividend yield + capital gains yield) x original value
Total percentage return = (P1-P0)/P0 + D1/P0
Holding period return =(1+R1) (1+R2) (1+R3) – 1
Effective annual return = (1+HPR)m-1
Annual percentage rate = HPR* m

Chapter 3-4 risk and return

Risk premium = Total risk – risk free rate
E(Rf) = W1R1 + W2R2
n n
Variance of return= σ =∑ ( Ri−R ) )/(N-1) ¿ ∑ p ( Ri−R ) )
2 2 2

1 1
Standard deviation of return = sq root var(r)
Skewness: aggregate daily stock returns over time is negatively skewed (tilts to the right),
more server market falls than market rises

Optimal allocation utility U=E(r) – 1/2A2

A>0 risk aversion A=0 risk neutral A<0 risk lover
Return of optimal portfolio c E(r)= rf + 𝛽i(Rp-Rf)

Chapter 5-6 CAPM single factor and multi-factor models

Single factor model : 𝑟i =𝛼i +𝛽i𝑚+𝑒i

Modern portfolio theory: asset allocation between risky and risk-free portfolio, how do we
allocate the weight between them?
Draw CAL line intersect with indifference curve (optimal utility)
Efficient frontier which represents set of opportunities of risky assets

Max wrt to optimal allocation utility,

Get YmaxU= (E(rp)-Rf) / (Ap2)
CAL Sp = excess return/volatility = (E(Rp) – Rf) /p

Markowitz portfolio selection model: amount of possible risk reduction through

diversification. Concludes that everyone will come to same portfolio set, where CAL touch
efficient frontier

Assumptions of MPT:
1. mean variance criterion E(rA)>E(rB) and a< b
Where
Mean = wE(r1) + (1-w)E(r2)
Variance = 2 = w212 + (1-w)222 + 2w(1-w)p12
2. same universe of securities
3. same input list
4. same time horizon

CAPM E(r) = a + rf + 𝛽I + (m-rf)

CAPM advantage:
1. to forecast risk premium
2. compared to MPT, reduces number of inputs, more realistic

CAPM assumptions:
1. equilibrium (market clear): the financial markets are in a state of equilibrium
2. Perfectly competitive market where everyone is optimizing
3. all assets are tradable
4. Homogenous expectations: All investors have the same expectations about future
returns, volatilities, and correlations of securities
5. Markowitz (MPT assumptions)

Variance = systematic risk + firm-specific risk

2=i22m +2(ei)
Covariance = product of betas x market index risk
Cov (ri,rj) = ij2m
Correlation = product of correlations with the market index
Corr(ri,rj) = cov(ri,rj)/ ij = cov(ri,rm)* cov(rj,rm)
The lower the correlation, and closer to -1, the higher the risk diversification potential

Diversification 2 ( ep ) = n (1/n) 2 2 (ei) = 1/n 2 (e)

When n gets large, σ2 (ep) becomes negligible and firm specific risk is diversified away

2
E(R ) = Ᾱσ
Market risk premium: M M
Reward to risk ratio = 𝑀𝑎𝑟𝑘𝑒𝑡𝑟𝑖𝑠𝑘𝑝𝑟𝑒𝑚𝑖𝑢𝑚/ 𝑀𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑟𝑖𝑎𝑛𝑐𝑒 = 𝐸(𝑅𝑀) / 𝜎2𝑀

Regression to estimate CAPM:

1. Identify an index as the market portfolio. Typical choice: the CRSP value-weighted
index (e.g., the academics), the S&P 500 index (e.g., Merrill Lynch’s beta book), and
the NYSE index (e.g., Value- line).
2. Identify the stock or portfolio of interest.
3. Collect time-series of returns:
 For the market portfolio: 𝑅𝑀, t = 1, 2, 3, . . . T. 𝑡
 For the test portfolio: 𝑅𝐺𝐸, t = 1, 2, 3, . . . T. 𝑡
4. Run the following regression (typically monthly data over a three or five-year rolling
window): RtGE -rf = a + b(RtM – rf) + et
By running this regression, we break the total uncertainty in a stock into two components:
By construction, the residual of a regression is uncorrelated with
the explanatory variable: cov(𝑅𝑀, 𝜖 ) = 0. 𝑡𝑡
The R-squared tells us how much of GE’s variance can be explained by the variance in the
market portfolio:
α is the expected excess stock return, after taking out the reward associated with the
systematic component.
So testing the CAPM pricing formula is the same as testing whether or not α is zero.
• Conversely, if we can construct many portfolios with positive and statistically significant
α’s, then the CAPM pricing formula is under a severe challenge.

Ways CAPM is applied in practice:

1. setting IPO share price: higher beta indicates expected return on IPO shares should be
higher.
2. Mergers and Acquisitions: assessing the risk and return implications of potential MnA,
helps determine required rate of return for target company based on its beta
3. portfolio management: compare the expected returns of different assets or projects,
providing a basis for decision-making
4. Asset Pricing and Valuation: The CAPM is widely used to estimate the cost of equity
capital for valuation purposes. When valuing a company or asset
5. determination of Discount Rates: determine the appropriate discount rate to value future
cash flows in financial analysis like iscounted cash flow (DCF) analysis,

′
Multi-Factor Model: 𝑅𝑖=𝛼𝑖 +𝛽 𝑖𝑅𝐹 +𝑒𝑖

Eg. 𝑟i =𝛼i +𝛽𝑖𝐺𝐷𝑃 ∗𝐺𝐷𝑃+𝛽𝑖𝐼𝑅 ∗𝐼𝑅+𝑒i

APT: developed the APT as an alternative to the CAPM.

. Well-functioning security markets do not allow for the persistence of arbitrage
opportunities;
2. Investors agree that security returns are generated by a linear k- factor model;
3. There are sufficient securities to diversify away idiosyncratic risk, so not return premium
for this risk.

E(R) APT = rf + b1 (Er1-rf) + b2 (Er2-rf)

Advantages of APT over the CAPM: (1) no assumptions about the empirical distribution of
security returns, (2) no special role for the market portfolio in the APT.

1. 𝑖 𝑀 𝑆𝑀𝐵 𝐻𝑀𝐿 𝑖
Fama-french= 𝑅t −𝑟f=𝛼i+𝛽i𝑅t −𝑟f+𝑠i𝑅t +hi𝑅t +𝜖t

Size factor and value factor. Stocks with higher book to market ratio (undervalued) have
higher returns
This is more refined risk-return framework
2. chen, roll, ross. Factor: economic indicators, i/r, industry-specific variable

Chapter 7.1 behavoural finance

Investors do not always process information correctly

Result: Incorrect probability distributions of future returns
Even when given a probability distribution of returns, investors may make inconsistent or
suboptimal decisions
Result: They have behavioral biases

Forecasting Errors:
1. Too much weight is placed on recent experiences
2. Overconfidence: Investors overestimate their abilities and the precision of their forecasts
3. Conservatism: Investors are slow to update their beliefs and under react to new
information
4. Sample Size Neglect and Representativeness: Investors are too quick to infer a pattern or
trend from a small sample

Behavioral finance:
1. Technical analysis: using prices and volume information to predict future prices .
Technical analysis attempts to exploit recurring and predictable patterns in stock
prices/volume: It has measures such as relative strength (security price/industry price
index), trin statistic, sentiment indicator
2. Fundamental analysis: using economic accounting information to predict stock prices

Prospect Theory
✓ Conventional view: Utility depends on level of
wealth
✓ Behavioral view: Utility depends on changes in current wealth

Disposition: underreaction to news. Individual investors are more likely to sell their
winners than their losers. Stocks that investors choose to sell subsequently outperform the
stocks that investors retain.

Chapter 7.2 EMH

Efficient Market Hypothesis (EMH) says stock prices already reflect all available information

3 main forms of market efficiency:

- Weak form: market information
- Semi-strong form: all publicly available info
- Strong form: all information is reflected
To test market efficiency:
1. Event study: test semi-strong form, any abnormal returns observed after the event are
due to information that was not available to the market before the event occurred

abnormal return= stock’s actual return - proxy for the stock’s return in the absence of the
event

Objective: Examine if new (company specific) information is incorporated into the stock
price in one single price jump upon public release?

1. Define as day “zero” the day the information is released

2. Calculate the daily returns Rit the 30 days around day “zero”: t = -30, -29,...-1, 0, 1,...,
29, 30
3. Calculate the daily returns Rmt for the same days on the market (or a comparison
group of firms of similar industry and risk)
4. Define abnormal returns as the difference ARit= Rit –ai – biRmt (could use other
alternatives, for instance, FF3 model)
5. Calculate average abnormal returns over all N events in the sample for all 60
reference days
6. Cumulate the returns on the first T days to CAAR

N
Average abnormal returns (AAR) AARt = 1/N i=1 AR it

Cumulative average abnormal returns (CAAR) CAART = T AARt
t=-30

2. return predicton: test weak form

Returns over the Short Horizon
✓ Short-term reversal: short-term overshooting
followed by correction
✓ Momentum: Good or bad recent performance continues over short to intermediate time
horizons (6-12 months)
Returns over Long Horizons
✓ Long-term reversal: long-term overshooting followed by correction

Tests often conducted to test the semi strong form of market efficiency:
 Small Firm Effect
 Book-to-Market Ratios
 Post-Earnings Announcement Price Drift

Insider trading is a strong-form test

Chapter 8 bonds

C
T Par value
+
∑ ( 1+r ) ( 1+r )T ¿
t
t =1
¿
Current yield = annual coupon payment / coupon price

Bond price = Par / (1+Rn)n

Discount bonds:
Price < face value
Coupon rate < market rate
Premium bonds:
Price > face value
Coupon rate > market rate

n n−1
Forward rate: (1+ f ) = (1+y ) /(1+y )
n n n−1

Theories of term structure

1. expectations hypothesis theory: observed long term rate is a function of today’s short
term rate and expected future short term rates

f = E(r ) and liquidity premiums are zero

n n

2. liquidity preference theory: Long term bonds are more risky, therefore f
n usually exceeds
E(r )
n
3. market segmentation: Different investors have preferences holding bonds with different
maturities
Buyers and sellers in different maturity categories cannot be substituted for one another,
and hence the markets for different maturities are relatively separated from one another.

Bond risk factors (Factors affecting spot rates)

1. (level) parallel shifts of the spot rate curve (abt 72%)
2. changes in the slope of the spot rate curve (abt 26%)
3. changes in the curvature of the spot rate curve (abt 2%)

Duration is a measure of sensitivity of price to a change in interest rate. It is the slope of the
price-yield curve.
Duration = (-1) * (1/P) * dP/dY

Continuous:

Discrete:

DV01 = dollar change in bond price when interest rate changes by 1bp (0.01%)

Convexity: measures curvature of bond price wrt ytm. Positive convexity means price
increase when yield fall is larger than price fall when yield rise
(1/P) * d2P/dY2

Duration hedging: zero-duration strategy. In this approach, an investor aims to offset the
interest rate risk of a bond portfolio by creating an overall duration of zero through a
combination of long (buy) and short (sell) positions in bonds

Procedure:
1. Determine the initial portfolio duration
2. Select bonds for short-selling: Identify bonds with similar duration characteristics to
the existing portfolio
3. Determine the quantity for short-selling to offset the duration of the long positions
and achieve a zero-duration overall.
4. Implement the long and short positions: Purchase the desired long positions to
maintain exposure to specific bond sectors or segments of the yield curve.
Simultaneously, sell short to neutralize the portfolio's duration.

measure the performance:

1. Total return: Calculate the total return of the portfolio, including income from coupon
payments and any capital appreciation or depreciation. Compare the total return to your
investment objectives and benchmarks.
2. Tracking error: Assess the deviation of the portfolio's returns from a benchmark or target
duration-neutral index.

Measuring Risk:
1. Market risk: credit spreads, or market volatility.
2. Credit risk: default risk. Consider credit ratings and perform fundamental analysis on
individual bond issuers.

Economic Theories: builds on the concept of immunization, which aims to eliminate or

minimize interest rate risk. Duration=zero, the strategy seeks to neutralize the impact of
interest rate movements on the value of the portfolio.

Chapter 9 foreign exchange

Direct terms: USD 1.3840 = EUR 1
(pricing currency ? = base currency 1)
Direct increase, pricing dep, base currency app

Bilateral FX rate = A/B = (USD/B)/(USD/A)

Bid/ask:
For makers,
Ask rate: the rate at which dealer is willing to sell
Bid rate: rate at which dealer is willing to buy
For customers, its vice versa
The spread is the difference between ask and bid rate, measured in pips

Spot exchange rate: quotation for immediate exchange of currencies

Forward exchange rate: a rate agreed today for the delivery of a currency at a specified date
in the future
- Premium quotation: forward rate> spot rate
- Discount quotation: forward rate < spot rate

Covered interest rate parity (CIP)

- Arbitrage strategy
- Exploit price differences across identical assets
- RISKLESS
(1+it) = (Ft/St) (1+it*)

Uncovered interest rate parity (UIP)

- Speculation strategy
- Take advantage of a mispricing across assets based on expectations
Risky

Chapter 10 derivatives: futures and options

Forwards: (OTC market)

long position: involves ownership of the derivative contract with an expectation of price
increase
Profit: K=delivery price = forward price at time contract is entered

short position: involves selling or borrowing the derivative contract with an expectation of
price decrease
Profit: K=delivery price = forward price at time contract is entered
Futures: (exchange market)
Spot-Futures Parity Theorem
F0=S0 (1+r+u-y)T

Option payoff:
1. In the Money - exercise of the option produces a positive cash flow
Call: exercise price < asset price
Put: exercise price > asset price
2. Out of the Money - exercise of the option would not be profitable
Call: asset price < exercise price.
Put: asset price > exercise price.
3. At the Money - exercise price and asset price are equal