FINA 6112 Investment and Portfolio Analysis

Lecture 2: Time Value of Money & Risk

Preference

LUO Dan
Short Sales
• Short sales allow investors to profit from a decline in a
security’s price.
• Mechanics

1
Short Selling Example
$100 Initial Stock Price
1000 Number of Shares Shorted
Initial Position
Cash $100,000 Short $100,000

$70 Final Stock Price

1000 Number of Shares Shorted
Ending Position
Cash $100,000 Short $70,000
Close short position by buying 1000 shares @ $70, a profit of
$30,000
Who are Short Sellers?
• If you want to make money from short sales, you need to
have negative information about the company
– It is hard because the company tries to hide negative information.

3
• Consider an investment opportunity with the following
certain cash flows
– Investment today: $100,000
– Payoff in one year: $105,000

• Are you willing to take this opportunity?

• If not, how much is the payoff in one year you demand?

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Money has Time Value

• Present money is more valuable than future money in

general. Why?
• Present bias: prefer immediate rewards to future rewards
• Option value: you can use present money now or in the
future, but you can use future money only in the future.
max 𝑅! , 𝑅" ≥ 𝑅"

• The difference between present money and future money

is referred to as the time value of money

5
The Interest Rate: An Exchange Rate
Across Time
• The rate at which we can exchange money today for
money in the future is determined by the current interest
rate
– Interest rate reflects the overall time value of money in the
economy.

• Risk-Free Interest Rate rf: The interest rate at which

money can be borrowed or lent without risk
– Used to discount future certain cash flow

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The Interest Rate: An Exchange Rate
Across Time
• Value of Investment Today
– Suppose the current annual interest rate is 7%.
– Consider the benefit of $105,000 in one year. What is the
equivalent amount in terms of dollars today?

Benefit = ($105,000 in one year)÷ 1.07

æ
ç $ in one year ö
÷
ç ÷
ç
è
$ today ÷
ø

= ($105,000 in one year)× 1 =$98,130.84 today

1.07

– the net value of the investment:

$98,130.84 - $100,000 = - $1869.16 today

– We should reject the investment.

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Exercise: the time value of money (1 of 2)
• Problem
– The cost of replacing a fleet of company trucks
with more energy efficient vehicles was $100 million in
2016.
– The cost is estimated to rise by 8.5% in 2017.
– If the interest rate is 4%, what is the cost of a delay
in terms of dollars in 2016?

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Exercise: the time value of money (2 of 2)
• Solution
– If the project were delayed, its cost in 2017 will be
§ $100 million× æçè1.085 ö÷ø = $108.5 million

– Compare this amount to the cost of $100 million in

2016 using the interest rate of 4%:
§ $108.5 million =$104.33 million in 2016 dollars.
1.04
– The cost of a delay of one year would be
§ $104.33 million -$100 million = $4.33 million in 2016 dollars.

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The Interest Rate: An Exchange Rate
Across Time
• Value of Investment in One Year
– By investing or borrowing at this rate, we can exchange $1.07 in
one year for each $1 today.
– we can express our costs as:

Cost = ($100,000 today)´ 1.07 $ in one year

æ ö
ç ÷
ç ÷
ç
è $ today ÷
ø
= $107,000 in one year
– Both costs and benefits are now in terms of “dollars in one year,”
so we can compare them and compute the investment’s net value:

$105,000 - $107,000 = - $2000 in one year

– We should reject the investment.

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The Interest Rate: An Exchange Rate
Across Time
• Present vs. Future Value
– When we express the value in terms of dollars today, we call it the
present value (PV) of the investment.
– If we express it in terms of dollars in the future, we call it the
future value (FV) of the investment.

• It is more popular to compare things in PV.

• The Discount Factor
1 = 1 = 0.93458
1+ r 1.07

– For certain future cash flows, the discount factor determines the
conversion between the present value and the future value.
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Compounding
• Compounding
– the process in which an asset’s earnings, from either capital
gains or interest, are reinvested to generate additional earnings
over time.
– Key: By investing your interest, you can earn interest on the
interest you have earned

• Problem
– Suppose you invest $1,000 in an account paying annual interest of
10% every half a year. How much will you have in a half year? In
one year? In three years?
– In a half year: In one year: In three years:
" #
10% 10% 10%
1000× 1 + 1000× 1 + 1000× 1 +
2 2 2

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Compounding
– If the account pays annual interest of 10% every quarter, how
much will you have in two years? What if it pays every month?
– Every quarter: Every month:
10% $ 10% "%
1000× 1 + 1000× 1 +
4 12

• If you receive the interest every

instant

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The Power of Compounding

• People tend to underestimate the power of compounding

– Interest is small, let alone the interest on interest

• Suppose you invest $1,000 in an account paying 10%

interest once per year. How much will you have in the
account in seven years? In 20 years ? In 75 years?

$1000 × (1.10 ) = $1948.72

7
7 years : – Double in 7 years
$1000 × (1.10 ) = $6727.50 – Sevenfold after 20 years
20
20 years :
75years : $1000 × (1.10 ) = $1, 271,895.37
75 – A million after 75 years

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The Power of Compounding

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The NPV Decision Rule

• The Net Present Value (NPV) of an investment

– The difference between the present value of its benefits and the
present value of its costs.

NPV = PV (Benefits) - PV (Costs)

• When making an investment decision, take the alternative
with the highest NPV .
• Accept those projects with positive NPV, Reject those
projects with negative NPV

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Exercise: applying the NPV rule (1 of 2)
Problem
Suppose you started a website hosting business and then decided to return to
school. Now that you are back in school, you are considering selling the business
within the next year. An investor has offered to buy the business for $200,000
whenever you are ready. If the interest rate is 10%, which of the following three
alternatives is the best choice?
1. Sell the business now.
2. Scale back the business and continue running it while you are in school for
one more year, and then sell the business (requiring you to spend $30,000 on
expenses now, but generating $50,000 in profit at the end of the year).
3. Hire someone to manage the business while you are in school for one more
year, and then sell the business (requiring you to spend $50,000 on expenses
now, but generating $100,000 in profit at the end of the year).

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Exercise: applying the NPV rule (2 of 2)
Solution

In One
Blank Today NPV
Year
Sell Now $200,000 0 $200,000

Scale Back −$30,000 $50,000 - $30,000 + $250,000 = $197,273

1.10
Operations $200,000
Hire a Manager −$50,000 $100,000 - $50,000 + $300,000 = $222,727
$200,000 1.10

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Exercise: applying the NPV rule (1 of 4)
• Problem
– You have $10,000 to invest and are considering three
one-year risk-free investment options.
1. Invest up to $10,000 in a T-Bill paying 2%.
2. Invest in a project that costs $6,000 and returns
$6,100 in one year.
3. Invest in a project that costs $4,000 and returns
$4,100 in one year.

– How should the $10,000 investment be allocated?

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Exercise: applying the NPV rule (2 of 3)
• Solution
– Since all of investment options are for one year and risk-
free, the appropriate discount rate is 2%. The PV of each
investment @ 2% is:
1. Investing $10,000 in the T-Bill

$10,000(1.02) - $10,000=$0.00
§ 1.02
2. Investing $6,000 and receiving $6,100
$6,100
§ NPV = 1.02 - $6,000 = -$19.61
3. Investing $4,000 and receiving $4,100
NPV = $4,100 - $4,000=$19.61
§ 1.02
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Exercise: applying the NPV rule (3 of 3)
• Solution
– Given that the #2 investment has a negative NPV, it should not be
considered. However, only investing in #3 uses just $4,000 of the
available funds to invest, yielding a total NPV of

($4,100+$6,000) - $10,000 = -$98.04

1.02

– The optimal strategy is to invest $4,000 in #3 and $6,000 in the T-

Bill. The NPV of this strategy is

[$4,100 + $6,000(1.02)] - $10,000 = $19.61

1.02
– Note that the NPV of not investing is negative. Hence, even
though the NPV of the T-Bill investment is $0, it is a better
investment than not investing those funds at all. 22
Valuing a Stream of Cash Flows

• Present Value of a Cash Flow Stream

N N
Cn
PV = å PV ( Cn ) = å
(1 + r )
n
n =0 n =0

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Annuities
• Annuities
– When a constant cash flow will occur at regular
intervals for a finite number of N periods, it is called an
annuity.

– Present Value of an Annuity

N
C C C C C
PV = + 2
+ 3
++ N
=å n
(1+r ) (1+r ) (1+r ) (1+r ) n =1 (1+ r )
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Growing Annuity
• Assume you expect the amount of your annuity payment to
increase at a constant rate, g.

• The present value of a growing annuity with the initial cash

flow c, growth rate g, and interest rate r is defined as:

1 æ æ 1+ g ö ö
N

PV = C × ç1 - ç ÷ ÷
(r - g ) ç è (1 + r ) ø ÷
è ø

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The Internal Rate of Return
• Internal rate of return (IRR)
– under which the net present value of the cash flows equal to zero.
– Reflects the overall return of a project
– Given the limited resources, we want to pick the projects with
highest IRR.

• Problem
– Baker was so impressed with Jessica that it has decided to fund
her business. In return for providing the initial capital of $1 million,
Jessica has agreed to pay them $125,000 at the end of each year
for the next 30 years. What is the internal rate of return on Baker’s
investment in Jessica’s company, assuming she fulfills her
commitment?

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The Internal Rate of Return
Solution
• Here is the timeline (from Baker’s perspective):

• The timeline shows that the future cash flows are a 30-
year annuity. Setting the NPV equal to zero requires
1æ 1 ö
1, 000, 000 = 125,× ç1 - ÷
r ç (1 + r ) ÷
30
è ø
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An Investment is Usually Risky
• So far, we have focused on risk-free investments
– The future payoffs of investments are certain

• However, an investment is usually risky: it may earn

different returns
• A typical investment looks like this
– Assume BFI stock currently trades for $100 per share

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Probability Distributions

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Expected vs. Realized Returns
• Expected returns and Expected Risk
– Forward-looking, what should happen on average
– Assumes some knowledge of the return distribution

• Realized Returns and Realized Risk

– Backward-looking, what did happen on average
– Analyses sample returns to learn the distribution
– Usually used to extrapolate what expected returns and risk are

• The returns of BFI we just saw are expected or realized?

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Expected Return & Standard Deviation
• Expected (Mean) Return
– The average of the possible returns weighted by the probabilities.
Expected Return = E [ R ] = å R PR × R

• Variance
– The expected squared deviation from the mean

Var ( R) = E ê( R - E [ R ]) ú = å R PR × ( R - E [ R ])
é ù
2 2

ë û
• Standard Deviation
– The square root of the variance

SD( R) = Var ( R)
– The standard deviation of a return is also referred to as its
volatility
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Realized Return & Standard Deviation
• Average Return
1 1 T
R = ( R1 + R2 +  + RT ) = å Rt
T T t =1

• Variance Estimate Using Realized Returns

1 T
å ( Rt - R )
2
Var ( R) =
T -1 t =1

• Standard Deviation
SD( R) = Var ( R)

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Estimation Error
• We can use a security’s average realized return to
estimate its expected return.
• This estimate has errors due to unobservable factors
• Standard Error
– A statistical measure of the degree of estimation error
– Calculating standard errors requires some assumptions about the
data we observed.

SD(Individual Risk)
SD(Average of Independent, Identical Risks) =
Number of Observations
– 95% Confidence Interval

Historical Average Return ± (2 × Standard Error)

Probability Distributions
• We often assume that stock returns follow a normal
distribution.
• Normal distribution is a bell-shaped probability distribution
that characterizes many natural phenomena.
• Nice features of normal distribution
– Symmetric.
– Only mean and standard deviation are needed to estimate future
scenarios.
– Statistical relation between returns can be summarized with a single
correlation coefficient.

• If returns are well approximated by the normal distribution,

risk can be completely captured variance-covariance.

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Probability Distributions
• The distribution of actual returns usually has fatter tails than normal
distributions.

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Risk Measure
• Left fat tail can have catastrophic impacts.
• Some measures are constructed to capture tail risk
–
é ( R - R )3 ù é R-R 4ù
( ) ú -3
Skew = Average ê ú Kurtosis = Average ê
ê sˆ 3
ú ê sˆ 4 ú
ë û ë û

– Value at risk (VaR): Loss that will be incurred in the event of an

extreme adverse price change with some given, usually low,
probability.

– Expected shortfall (ES): Expected loss on a security conditional on

returns being in the left tail of the probability distribution.

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Risk Aversion
• Risk aversion
– investors prefer to have a safe income rather than a risky one of
the same average amount.

• Which stock do you prefer to hold?

– BFI: 40% return with a 25% chance, 10% return with a 50%
chance, and -20% return with a 25% chance
– AM C: 45% return with 50% chance, and −25% return with 50%
chance

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Formulate Risk Aversion
• Suppose the utility (or the pleasure) you can get from
receiving a return of 𝑟 is
𝑢 𝑟

• Assume that 𝑢 𝑟 is concave in 𝑟

– The marginal value of additional wealth is decreasing.
𝑢 𝑟 −𝑢 𝑟−𝛿 >𝑢 𝑟+𝛿 −𝑢 𝑟

– Imagine that you are very hungry. The value of the first burger is
very high to you, and the value of one additional burger decreases
as you eat more burgers.

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Formulate Risk Aversion
• Risky investment may realize different returns in different
states, how do we aggregate the utility in different states?
– 𝑟̃ = 𝑟! in state 1 with probability 𝑝!
– 𝑟̃ = 𝑟" in state 2 with probability 𝑝"

• The expected utility hypothesis

𝑈 𝑟̃ = 𝐸 𝑢 𝑟̃ ≡ 𝑢 𝑟' ⋅ 𝑝' + 𝑢 𝑟( ⋅ 𝑝(

– Von Neumann and Morgenstern show that this formulation has

some nice properties.

• With concave 𝑢 𝑤 , risk aversion arises

𝐸 𝑢 𝑟̃ ≤ 𝑢 𝐸 𝑟̃
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Formulate Risk Aversion
• Risk brings us a mixture of high returns and low returns
instead of constant returns.
• With a concave utility function, the value of one additional
unit of return
– is low when returns are high
– is high when returns are low

• We care about what risk takes from us more than what it

gives us
• Risk aversion is an implication of concave utility functions

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Risk Premium
• Certainty equivalence: there exists 𝑟̅ such that
𝐸 𝑢 𝑟̃ = 𝑢 𝑟̅

– 𝑟̅ is referred to as the certainty equivalence of 𝑟̃

– Since 𝐸 𝑢 𝑟̃ ≤ 𝑢 𝐸 𝑟̃ , 𝐸 𝑟̃ − 𝑟̅ > 0

• Risk Premium: 𝐸 𝑟̃ − 𝑟)
– the additional return that investors expect to earn to compensate
them for an investment’s risk
– To justify holding a risky investment,
𝑟̅ − 𝑟& ≥ 0
– Risk premium must be positive
𝐸 𝑟̃ − 𝑟& > 0
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Exercise: Risk Premium
Problem
Consider a risky bond with a cash flow of $1,100 when the
economy is strong and $1,000 when the economy is weak.
The economy is strong or weak equally likely. Suppose a 1%
risk premium is appropriate for this bond. If the risk-free
interest rate is 4%, what is the price of the bond today?

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Exercise: Risk Premium
Solution

The appropriate discount rate for the bond is

rb = r f + (Risk Premium for the Bond) = 4% +1% = 5%
1 1
The expected cash flow of the bond is 2 ($1100) + 2 ($1000) = $1050
in one year. Thus, the price of the bond today is
Bond Price = (Average cash flow in one year)
(1+ rb $ in one year / $ today)

= ($1050 in one year) ÷ (1.05 $ in one year / $ today)

= $1000 today

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A Way To Model Risk Appetite in Investment

• We assume each investor assigns a utility to a portfolio

1 2
U = E ( r ) - Aσ
2

– 𝑈: Utility value.
– 𝐸 𝑟 : Expected return.
– 𝐴: Index of the investor’s risk aversion.
– 𝜎 " : Variance of returns.
– ½: scaling factor

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A Way To Model Risk Appetite in Investment

• 𝐴 > 0: Risk-averse
– Investors consider risky portfolios only if they provide
compensation for risk via a risk premium.

• 𝐴 = 0: Risk-neutral
– Investors find the level of risk irrelevant and consider only the
expected return of risk prospects.

• 𝐴 < 0: Risk-loving
– Investors are willing to accept lower expected returns on
prospects with higher amounts of risk.

• A typical investor is considered to have 𝐴 > 0.

– But the exact value of 𝐴 is not so clear.
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Mean–Variance (M–V) Criterion
• Requirements for Portfolio A to dominate Portfolio B:
E (rA ) ³ E (rB )
sA £sB
– At least one inequality is strict (to rule out indifference between the
two portfolios).

• Mean–variance (M–V) criterion.

– Choose the highest expected return portfolio for a given level of
variance
– Choose the lowest variance portfolio for a given expected return.

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The Indifference Curve
• Equally preferred portfolios lie in the mean–volatility plane on an
indifference curve, which connects all portfolio points with the same
utility value.

• Access the text alternative for slide images.

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Risk Averse Investors
• Investors like high expected returns and low volatility.
• However, assets with high expected returns and low
volatility cannot exist systematically. Why?
– A security with high expected returns and low volatility cannot exist
because investors will buy it, pushing up its price until its expected
return is low enough.
– A security with low expected returns and high volatility cannot exist
because investors will sell it, pushing down its price until its
expected return is high enough.

• There must a tradeoff between return and risk.

• Let’s see whether this is true in the real world.

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