Chapter 1: The Investment Environment

 Real assets → land, buildings, machines, and knowledge that can be used to produce goods and services
 Financial assets → in contrast to real assets such as stocks and bonds
o Do not contribute directly to the productive capacity of the economy
o Means by which individuals hold their claim on real assets
 Financial assets to individuals are liabilities to companies (shares of stock are liabilities to the stock issuer) so when
aggregated over the balance sheet the two claims balance out, leaving only real assets.
 Three types of financial assets: fixed income, equity, and derivatives
o Fixed income or debt securities promise either a fixed stream of income or a stream of income determined by a
specified formula
 Corporate bond that promises a fixed amount of interest each year
 Floating-rate bonds promise payments that depend on current interest rates→ a bond may pay an
interest rate fixed at 2 percentage points above rate paid on U.S. treasury bills
 Investment performance of debt securities typically is least closely tied to the financial condition of the
issuer.
 Money market securities are short term, highly marketable, and very low risk (U.S) Treasury bills or
CDs.
 In contrast, he fixed-income capital market includes long term securities such as Treasury bonds, and
bonds issued by federal, state, and municipal governments and corporations. Range from very safe to
relatively risky (high-yield or “junk” bonds)
o Equity or common stock represents an ownership share in the corporation.
 Not promised any particular payment
 Receive any dividend the firm may pay and have prorate ownership in real assets of the firm
 If the firm is successful, the value of equity will increase.
 The performance of equity investments is tied directly to the success of the firm and its real assets.
o Derivative securities such as options and futures contracts provide payoffs that are determined by the prices of
other assets such as bond or stock prices.
 A call option on a share of Intel stock might turn out to be worthless if Intel’s share price remains below
a threshold or “exercise” price such as $50 a share, but can be quite valuable if the stock prices rises
above that level
 Integral part of the investment environment
 The primary use is to hedge risks or transfer them to other parties
 There are also commodity markets where you can buy gold or wheat and currency exchange markets
 Commodity and derivative markets allow firms to adjust their exposure to various business risks
o E.g. a construction firm may lock in the price of copper by buying copper futures contracts, thus eliminating
the risk of a jump in the price of its raw materials
 Stock prices reflect investor’s collective assessment of a firm’s current performance and future prospects
o Higher stock prices make it easier for the firm to raise capital and encourages investment
 Stock prices thus play a major role in the allocation of capital in market economies, directing it to the
firms and applications with the greatest perceived potential.
 Virtually all real assets involve some risk. Financial markets and the diverse financial instruments traded in those
markets allow investors with the greatest taste for risk to bear that risk, while other, less risk tolerant individuals can
stay on the sidelines.
o If Toyota raises the funds to build its auto plant by selling both stocks and bonds to the public, the more
optimistic or risk-tolerant investors can buy shares of the stick, while the more conservative ones can buy its
bonds.
o This allocation of risk also benefits the firms that need to raise capital to finance their investments.
 Financial markets provide clarity to how firm decisions can be made given firms have so many different owners.
o All shareholders will be better able to achieve goals when the firms acts to enhance the value of shares thus
value maximation has been widely accepted as a useful organizing principle for firms
o Agency problems – do managers really attempt to maximize the firm value or do they have personal interests?
 Compensation plans tie the income of managers to the success of the firm. Major part of total
compensation of top executives is in the form of shares or stock options. However, options can an
incentive for managers to manipulate information to prop up stock price temporarily.
o Bad performers are subject to the threat of takeover when unhappy shareholders elect a new vote through a
proxy contest.
  Odds of this happening has increased with the rise of activist investors that identify firms they think are
mismanaged, buy lots of shares, and re-elect new members.
 Firm transparency is incredibly important.
 An investor’s portfolio is his collection of investment assets.
o Asset allocation decision is the choice among broad asset classes (stocks, bonds, real estate, commodities)
while the security selection decision is the choice of which particular securities to hold within each asset class.
o Top-down portfolio construction starts with asset allocation.
 Security analysis involves the valuation of securities that might be included in the portfolio.
o Bottom-up strategy in which portfolio is constructed by combing assets that are attractively priced.
 If you want higher expected returns, you will have to pay a price in terms of accepting higher investment risk.
 Risk return trade off in securities market: higher risked assets priced to offer higher expected returns than lower risk
assets.
 Rarely find bargains in the financial markets, security price reflects all the information available to investors
concerning its value.
 Passive Management: hold highly diversified portfolios without spending effort or other resources attempting to
improve investment with security analysis.
 Active Management: the attempt to improve performance by identifying mispriced securities or by timing the
performance of broad asset classes.
 Three major players in the financial markets
o Firms are net demanders of capital. They raise capital now to pay for investments in plant and equipment. The
income generated by those real assets provides the returns to investors who purchase the securities issued by
the firm.
o Households are net suppliers of capital. They purchase the securities issued by firms looking to raise funds.
o Governments can be borrowers or lenders, depending on the relationship between tax revenue and government
expenditure.
 U.S. typically runs budget deficits so issues treasury bills, notes, and bonds to borrow money from the
public.
 Corporations and governments do not sell most of their securities to individuals. (half of all stock is held by pension
funds, mutual funds, insurance companies, and banks) These financial institutions stand between the issuer and
ultimate owner (individual) and are called financial intermediaries.
o Issue their own securities to raise funds to purchase the securities of other institutions.
o A bank raises funds by borrowing (taking deposits) and lending that money to other borrowers. The spread
between the interest rates paid to depositors and the rates charged to borrowers is the source of the bank’s
profit.
 Investment companies, which pool and manage the money of many investors, arise out of economies of scale. Most
household portfolios are not large enough to be spread across a wide variety of securities. Mutual funds take the
advantage of large-scale trading and portfolio management.
o Hedge funds do the same, but are more likely to pursue complex and higher risk strategies
 Typically keep portion of trading profit as fee whereas mutual funds charge a fixed percentage of
AUM.
 Firms raise much of their capital by selling securities such as stocks and bonds. Because these firms do not do so
frequently, investment bankers that specialize in such activities can offer their services at a cost below maintaining
an in-house securities division. Thus, called underwriters.
 While large firms can raise funds directly from stocks and bonds, smaller and younger firms rely on bank-loans and
Venture Capital who invest in return for equity.
Chapter 2: Asset Classes and Financial Instruments
 Money Market
o Treasury bills  government borrows money by selling bills to the public. Investors buy the bills at a discount
from the stated maturity (face) value. At maturity, gov pays face value of the bill.
 Highly liquid because easily converted into cash and sold at low transaction cost
 Exempt from state and local taxes
o Ask price  price you would have to pay to buy T-bill
o Bid price  slightly lower price you would receive to sell bill
to a dealer
o Bid-ask spread  dealer’s source of profit (the difference)
 DaysUntil Maturity
 Ask Price=1− ASKED x
360
o Certificates of Deposit  time deposit with a bank which may not be withdrawn on demand.
 Bank pays interest and principal to depositor only at maturity.
 Highly marketable, not much demand after 3 months.
o Commercial Paper  large companies issue their own short term unsecured debt notes rather than borrow
from bank.
 Backed by a bank line of credit.
 One to two months, issued in multiples of $100,000.
 Asset backed commercial paper – firms use the funds to invest in other assets (subprime mortgages)
o Banker Acceptances  starts as an order to a bank by a bank’s customer to pay a sum of money at a future
date which can then be traded in secondary markets.
 Used in foreign trade when creditworthiness not known.
o Eurodollars  dollar denominated deposits at foreign banks or foreign branches of American banks.
o Repurchase agreements (Repos)  dealers in government securities use them as a form of short-term, usually
overnight, borrowing. Dealer sells gov securities to an investor with an agreement to buy back those securities
at a slightly higher price. The dealer takes out a one-day loan from the investor, and the securities are
collateral.
 Repo is an identical transaction except term can be 30 days
 Very safe because loans are backed by government securities
 Reverse repos are when dealer finds an investor holding government securities and buys them, agreeing
to sell them back at a specified higher price on a future date.
o Federal Funds  funds in the bank’s reserve account at the fed
o Broker’s calls  people who buy stock on margin borrow part of the funds to pay for the stocks from their
broker. Broker may borrow from bank agreeing to pay back bank immediately if asked. Rate is 1% higher.
o London Interbank Offer Rate (LIBOR) was premier short term interest rate quoted in European money market
until 2021.
o Money Market Funds  mutual funds that invest in money market instruments. Major conduit for the funds
invested in the money market.
 The Bond Market
o Treasury Notes and Bonds
 US government borrows funds by selling treasury notes or treasury bonds
 Yield to maturity: A measure of the average return that will be earned on a
bond if held to maturity.
 Calculated by doubling semiannual yield.
 Bid and ask price calculated as percentage of par value (usually $1000)
 Coupon rate  the interest rate paid on a bond by its issuer for the term of
the security.
 Change  percentage change of par value ask price changed in that day
o Inflation Protected Treasury Bonds Bonds that are indexed to a measure of the cost of living to hedge
inflation risk
 TIPS (treasury inflation protected securities) in the US.
 Principal amount adjusted to changes in CPI
 Yields on TIPS bonds should be interpreted as real or inflation-adjusted interest rates
o Federal Agency Debt  when government agencies issue their own bonds to finance activities
 Fannie Mae, Freddie Mac
 Government is assumed to be responsible for these as well
o International Bonds  Eurobonds
o Municipal Bonds  bonds issued by state and local governments.
 Interest income exempt from federal taxation, and usually state and local tax.
 Capital gains tax is not exempt.
 GO bonds vs revenue bonds.
 Because investors don’t pay taxes, they are willing to accept lower yields  equivalent tax yield.
 r taxable =( 1−t ) r muni where t = investor’s combined federal and local tax bracket
 r muni
 Cutoff tax bracket =1−
r taxable
 The higher the yield ratio, the lower the cutoff and more people want to buy Muni bonds
o Corporate Bonds  means by which private firms borrow money directly from the public
 Higher yield
o Mortgage and Asset Backed Securities  either an ownership claim in a pool of mortgages or an obligation
that is secured by such a pool.
 Equity Securities
o Common Stock as Ownership Shares
 Common stocks, or equities, represent ownership shares in a corporation
 Corporation controlled by a board of directors elected by shareholders
 Compensation schemes that link success of firm to that of manager supports shareholders
o Characteristics of common stock
 Residual claim  stockholders are the last in line of all those who have a claim on the assets and
income of the corporation
 Creditors, employees, government, suppliers, bondholders for example come first
 Shareholders have a claim to the part of operating income left over after interest and taxes have
been paid (dividends)
 Limited liability  most shareholders can lose is their original investment. Not personally liable to
firm’s obligations
o Stock Market Listings
 Closing price of the stock
 Change from previous day
 Annual dividend yield- annual dividend per
dollar paid for this stock (1.81%)
 P/e ratio  ratio of the current stock price to
last year’s earnings per share.
 Tells you how much stock purchasers must pay per dollar of earning that the firm generates
o Preferred Stock  promises to pay a fixed amount of income each year (infinite maturity bond)
 The firm has no contractual obligation to make the dividend payments. Instead, preferred dividends are
usually cumulative; that is, unpaid dividends cumulate and must be paid in full before any dividends
may be paid to holders of common stock.
o American Depository Receipts (ADRs)  certificates traded in U.S. markets that represent ownership in
shares of a foreign country
 Allow foreign firms to satisfy U.S. regulations more easily
 Stock and Bond Market Indexes
o Dow Jones Industrial Average (DJIA) of 30 large “blue chip” corporations
 Originally Average price of the stocks included in the index
 Percentage change in DJIA measures the return on a portfolio that invests one share in each of the 30
stocks
 Price-weighted average
 DJIA no longer equals average price of the 30 stocks because the averaging procedure is adjusted
whenever a stock splits or pays a stock dividend of more than 10%
o Standard and Poor’s 500
 Broadly based index of 500 firms and is a market-value weighted index
 Looks at outstanding equity
 Computed by calculating the total market value of the 500 firms in the index and the total market value
of those firms on the previous trading day
o Index fund  mutual fund that holds shares in proportion to their representation in the S&P 500
o ETF  portfolio of shares that can be bought or sold as a unit
 Derivative Markets
o Options
 Call option gives its holder the right to purchase an asset for a specified price, called the exercise price
on or before a date
  Put option gives its holder the right to sell an asset for a specified exercise price on or before a specified
date
o Futures contract  calls for delivery of an asset (or, in some cases, its cash value) at a specified delivery or
maturity date for an agreed-upon price, called the futures price, to be paid at contract maturity
 Summary:
o Money market securities are very-short-term debt obligations. They are usually highly marketable and have
relatively low credit risk. Their low maturities and low credit risk ensure minimal capital gains or losses. These
securities trade in large denominations, but they may be purchased indirectly through money market mutual
funds.
o Much of U.S. government borrowing is in the form of Treasury bonds and notes. These are coupon-paying
bonds usually issued at or near par value. Treasury notes and bonds are similar in design to coupon-paying
corporate bonds.
o Municipal bonds are distinguished largely by their tax-exempt status. Interest payments (but not capital gains)
on these securities are exempt from federal income taxes. The equivalent taxable yield offered by a municipal
bond equals
o rmuni/1−t, where
o rmuni
o is the municipal yield and t is the investor’s tax bracket.
o Mortgage pass-through securities are pools of mortgages sold in one package. Owners of pass-throughs receive
the principal and interest payments made by the borrowers. The originator that issued the mortgage merely
services it and “passes through” the payments to the purchasers of the pool. A federal agency may guarantee
the payments of interest and principal on mortgages pooled into its pass-through securities, but these
guarantees are absent in private-label pass-throughs.
o stock is an ownership share in a corporation. Each share entitles its owner to one vote on matters of corporate
governance and to a prorated share of the dividends paid to shareholders. Stock (equivalently, equity) owners
are the residual claimants on the income earned by the firm.
o Preferred stock usually pays fixed dividends for the life of the firm; it is a perpetuity. A firm’s failure to pay
the dividend due on preferred stock, however, does not precipitate corporate bankruptcy. Instead, unpaid
dividends simply cumulate. Variants of preferred stock include convertible and adjustable-rate issues.
o Many stock market indexes measure the performance of the overall market. The Dow Jones averages, the
oldest and best-known indicators, are price-weighted indexes. Today, many broad-based, market-value-
weighted indexes are computed daily. These include the Standard & Poor’s 500 stock index, the NASDAQ
index, the Wilshire 5000 index, and indexes of many non-U.S. stock markets.
o A call option is a right to purchase an asset at a stipulated exercise price on or before an expiration date. A put
option is the right to sell an asset at some exercise price. Calls increase in value while puts decrease in value as
the price of the underlying asset increases.
o A futures contract is an obligation to buy or sell an asset at a stipulated futures price on a maturity date. The
long position, which commits to purchasing, gains if the asset value increases while the short position, which
commits to delivering, loses.

Chapter 3: How Securities are Traded

 Primary market  when securities are first traded

 Secondary market  trades of existing securities
 Privately held firms will sell shares directly to institutional or wealthy investors in a private placement
o Can have up to 2000 shareholders
 When privately trade companies wish to raise capital from a wide range of investors, it may decide to go public.
 IPO
o Public offerings of stocks and bonds prepared by investment bankers called underwriters
 Prospectus: the final preliminary registration form
 Shelf Registration: allows firms that are publicly traded to register securities and gradually sell them
 IPOs are commonly underpriced compared to the price at which they could be marketed
 Direct listings: shareholders of private companies sell shares to public
o Cost saving but forfeits aftermarket support meant to stabilize share prices such as lock-up periods
 SPACs vs IPOs
 o Special purpose acquisition company  sponsor of spac raises funds in its own IPO and looks for a company
to acquire.
 Types of Markets (by order of organization)
o Direct search markets: Least organized, buyers and seller must find each other on their own (Craigslist)
o Brokered markets: In markets where trading is active, brokers find it profitable to offer search services to
buyers and sellers (real estate market, primary market)
o Dealer markets: Dealers specialize in various assets, purchase these assets for their own accounts, and later
sell them for a profit (bonds)
o Auction market: all traders converge at one place to buy and sell assets (NYSE)
 Types of Orders
o Market Orders: buy or sell orders that are to be executed immediately at current market prices
o Price contingent orders: investors may place orders specifying prices at which they are willing to buy or sell
(limit orders)
 Trading mechanisms
o Dealer markets
 Tens of thousands of securities trade on the over the counter (OTC) market. Brokers register with
SEC as security dealer which quote prices at which they are willing to buy and sell
o Electronic Communication Networks (ECNs) allow participants to post market and limit orders over
computer networks
 Trades made at a modest cost, are fast, and offer traders anonymity
o Specialist/DMM markets: A designated market maker is a market maker that accepts the obligation to commit
its own capital to provide quotes and help maintain a fair and orderly market
 Needed level of human intervention to maintain a smooth and functioning market during periods of
stress
 NASDAQ lists around 3000 firms
o Three levels of subscribers , Market makers  can edit bid ask, level two which can see all bid and ask
prices, and level one who only see the best bid and ask
 NYSE
o Largest stock exchange measured by market value of listed stock. 3 billion shares per day
 New Trading Strategies
o Algorithmic trading: the use of computer programs to make trading decisions
o High-frequency trading: subset of algorithmic trading that relies on computer programs to make extremely
rapid decisions
o Dark pools: many people concerned about anonymity when trading large sums. Dark pools are private trading
systems in which participants can buy or sell large blocks of securities without showing their hand
o Internalization: order internalization represents a second major drain of trades away from exchanges. Brokers
match buy and sell orders internally rather than bringing them to exchanges
o Bond trading: directly connect buyers and sellers of bonds, have not yet displaced traditional bond markets
 Stock trading fees have fallen steadily in the last three decades
o Brokers profit from interest they earn from funds in brokerage accounts
and payment for order flow
 Buying on margin
o Purchasing stocks on margin means the investor borrows part of the
purchase price
 Margin – portion of the purchase price contributed by the investor,
remainder is borrowed
 Initial margin requirement is 50%, meaning that at least 50% of
the purchase price must be paid for in cash
Equity ∈ Account
o Margin=
Value of Stock
o Investors buy securities on margin when they wish to nvest an amount
greater than their own money allows
  Bigger risk, bigger reward

 Short Sales
o Order is reversed, first you sell then you buy the shares.
o Short sale allows investors to profit from a decline in a security’s price. An investor borrows a share of stock
from a broker and sells it. Later, the short-seller must purchase a share of the same stock in order to replace
the one that was borrowed. This is called covering the short position.
 Short seller is at risk if the shares are not readily available

  Regulation of Securities Market

o Self-Regulation (FINRA) (NASD)
o Sarbanes-Oxley Act
 Public company accounting oversight board, established rules requiring independent financial experts
to oversee audit committees
 Independent directors
 CEO and CFO must personally certify
o Insider trading

Chapter 4: Mutual Funds and Other Investment Companies

 Investment companies are financial intermediaries that collect funds from individual investors and invest those
funds in a wide range of securities
o Pooling of assets is the key idea behind investment companies
o Key functions: Recordkeeping and administration, Diversification and divisibility, professional
management, lower transaction costs
 While investment companies pool assets of individual investors, they also need to divide claims to those assets
among investors. Investors buy shares in investment companies, and ownership is proportional to the number of
shares purchased. The value of each share is called the net asset value.
 Net asset value (NAV) equals assets minus liabilities expressed on a per share basis
Market value of assets−Liabilities
o NAV =
Shares Outstanding
 Types of investment companies
o Unit Investment Trusts: pools of money invested in a portfolio that is fixed for the life of the fund
  Sponsor, a brokerage firm, buys a portfolio of securities that are deposited into a trust then sells
shares in the trust
 Unmanaged
 There is a premium on costs of shares to cost of acquiring the assets
o Managed Investment Companies: fund’s board of directors hires a management company to manage the
portfolio for an annual fee that ranges from .2% to 1.25% of assets.
 Open-end funds stand ready to redeem or issue shares at NAV
 Do not sell on exchanges
 Never go below NAV
 Closed-end funds do not redeem or issues shares
 investors must sell shares to other investors
 Typically sell below NAV
 Fund premiums or discounts dissipate over
time
o Exchange Traded Funds
 Similar to open-end mutual funds
 Classified and regulated as investment
companies
 Offer investors a prorated ownership share of a portfolio of stocks, bonds, and other assets and
report net asset value every day
 However, investors don’t buy shares with the investment company but instead buy and sell shares
with a broker like shares of stock
 Other Investment Organizations
o Commingled funds: Partnerships of investors that pool funds that are managed by a management firm
 Instead of shares they have units
o Real Estate Investment Trusts (REITs): similar to a closed-end fund. REITs invest in real estate (equity
trusts) or loans secured by real estate (mortgage trusts)
 Highly leveraged, with a typical debt ratio of 70%
o Hedge Funds: vehicles that allow private investors to pool assets to be invested by a fund manager
 Commonly structured as private partnerships and thus subject to minimal SEC regulation
 Open only to wealth or institutional investors
 Lock-ups
 Mutual Funds: common name for open-end investment companies
o Investment policy: each fund has a specified investment policy which is described in the fund’s prospectus
o Money Market Funds: funds invest in money market securities such as Treasury bills, commercial paper,
repurchase agreements, or CDs.
 Average maturity tends to be a bit more than a month
 Prime (commercial paper, Bank CDs) vs government (U.S.
Treasury or repurchase agreements)
o Equity Funds: invest primarily in stock but hold a small fraction in
money market to provide liquidity necessary to meet potential
redemption of shares
 Emphasis on capital appreciation vs current income
o Sector Funds: Equity funds that concentrate on a particular industry
o Bond Funds: Funds specialize in the fixed-income sector (corporate
bonds, Treasury, MBS, municipal)
o International Funds: invest in securities worldwide
o Balanced Funds: designed to be candidates for an individual’s entire
investment portfolio
 Life-cycle funds change the mix of equities and fixed-income based on person’s age
 Often fund of funds
o Asset Allocation and Flexible Funds: similar to balanced funds in that they hold stocks and bonds but may
dramatically vary proportions in accord with the forecast of their relative performance
o Index Funds: tries to match the performance of a broad market index
  Buys shares in securities included in a particular index in proportion to each security’s representation
in that index
 How funds are sold: funds are generally marketed to the public either by the fund underwriter or through brokers
 Costs of Investing in Mutual Funds
o Operating expenses: costs incurred by the mutual fund in operating the portfolio, range from .2% to 1.5%
annually
 Actively managed funds have higher fees
o Front end load: commission or sales charge paid when you purchase shares (no higher than 6% usually)
o Back-end load: exit fee incurred when you sell shares
 Typically reduced by 1% for each year funds are left invested
o 12b-1 charges: money used to pay for distribution, advertising, and promotional costs. Limited to 1%
 Fees and Mutual Fund Returns: rate of return on a mutual fund investment is the increase or decrease in NAV
plus income distributions such as distributions of capital gains, expressed a s a fraction of NAV at the beginning
go the period
NAV 1−NAV 0+ Income∧capital gaindistributions
o Rate of return=
NAV 0
o Fees can have a big effect on performance
o Hard to determine expenses of a mutual fund due to soft dollars, brokerages will give some services to
funds that invest with them (databases, computer hardware)
 Taxation of Mutual Fund Income: taxes are paid only by the investor, not the fund itself
o A fund with a higher portfolio turnover rate is “tax inefficient” capital gains and losses continually realized
 ETFs: offshoots of mutual funds that allow investors to trade index portfolios like shares of stock
o Can be traded throughout the day
o Required to track specified indexes until 2008 and those products still dominate the market but now can be
grouped on different attributes such as growth, dividend yield, or volatility.
o Can be non-transparent
o Exchange traded notes or vehicles (ETNs or ETVs) are based on debt securities with payoffs linked to the
performance of an index
o Advantages over mutual funds
 Can trade continuously
 Can be sold short or purchased on margin
 Tax advantage  When mutual fund investors sell shares, can trigger capital gains because fund has
to sell. ETF holders sell shares to other investors
 Cheaper: buy from broker instead of from funds themselves
o Disadvantages
 ETF entails a broker’s commission unlike mutual funds
 Their prices can depart from NAV, spike during bad economic condition

Chapter 9: Capital Asset Pricing Model

 CAPM: set of predictions concerning equilibrium expected returns on risky assets

o Two assumptions
 Investors are all mean-variance optimizers with a common time horizon and a common set of
information reflected in their use of an identical input use
 Markets are well-functioning with few impediments to trading
 Begin by supposing all investors optimize their portfolios using the Markowitz model of
efficient diversification
o Each investor uses an input list (expected returns and covariance matrix) to draw an
efficient frontier employing all available risky assets and identifies an efficient
risky portfolio P by drawing tangent CAL to the frontier.
o CAPM asks what would happen if all investors shared an identical investable
universe and used the same input list to draw their efficient frontiers.
 The Market Portfolio
 o Investors calculate identical efficient frontiers of risky assets and would draw identical CALs and arrive at
the same risky portfolio P. All investors would chose the same set of weights for each risky asset. What are
these weights?
o Key insight of CAPM: Because the market portfolio is the aggregation of all investors’ risky portfolios,
each of which is identical, it too will have those same weights.
 If all investors choose the same risky portfolio, it must be the market portfolio, the value-weighted
portfolio of all assets in the investable universe.
o The proportion of each stock equals the market value of the stock (pps * shares outstanding) divided by sum
of market value of each stock.
 If weight of stock in each common risky portfolio is 1%, Microsoft will make up 1% of the market
portfolio.
o CAL will also be the Capital market line (CML)
o All assets will be in the optimal portfolio because if demand is zero, price will fall and thus becomes
undervalued.
 The Passive Strategy is Efficient
o In simple CAPM scenario, investors can skip security analysis and simply hold the market. Passive
strategies efficient  mutual fund theorem
 The Risk Premium of the Market Portfolio
o Chapter 6  individual investors go about deciding capital allocations. If all investors choose to invest in
portfolio M and the risk-free asset what can we deduce about the equilibrium risk premium of portfolio M?
 Recall that each individual investors choose a proportion y allocated to the optimal portfolio M such
E ( r m )−r f
that y= 2 where E ( r m )−r f =E ( R M ) is the market risk premium.
AσM
o In the simple CAPM, risk free investments involved borrowing and lending amongst investors. Any
borrowing position must be offset by the lending position of the creditor.
 Net borrowing and lending across all investors must be zero, and thus the average position in the
risky portfolio is 100% or y = 1. Setting y = 1 into the equation above and substituting representative
investor’s risk aversion for A, we find that the risk premium on the market portfolio is related to its
variance by the average degree of risk aversion.
 E ( R M )= A σ 2M
o When investors purchase stocks, their demand drives up prices, reducing expected rates of returns and risk
premiums.
 When risk premiums fall, investors will shift some of their funds from the risky market portfolio into
the risk-free asset. In equilibrium, the risk premium on the market portfolio must be just high enough
to induce investors to hold available supply of stock.
 If risk premium is too high, excess demand for securities, prices will rise
 If risk premium is too low, investors will not hold enough stock to absorb supply, prices fall
 Expected Returns on Individual Securities
o CAPM built on the insight that the appropriate risk premium on an asset will be determined by its
contribution to the risk of investor’s overall portfolios.
o To calculate the variance of the market portfolio, we use the covariance matrix with the market portfolio
weights.
 Contribution of one stock to portfolio variance is sum of all covariance terms with all other stocks.
 o Due to math, GE’s contribution to variance of market portfolio can be simply stated as w ¿ Cov ( R M , R ¿ )
o Contribution of GE to the risk premium of the market portfolio is w ¿ E ( R¿ ) . Therefore the risk-to-reward
ratio for investments in GE can be expressed as
' ¿ w ¿ E ( R¿ ) E ( R ¿)
o G E s Contribution ¿ risk premium variance ¿= =
'
G E s contribution ¿ w¿ Cov ( R M , R ¿ ) Cov ( R¿ , R M )
o The market portfolio is the tangency (efficient mean-variance) portfolio. The risk-reward ratio for
Market Risk Premium E ( R M )
investment in the market portfolio is = 2
Market variance σM
 This is often called the market price of risk because it quantifies the extra return investors demand
to bear portfolio risk.
 At equilibrium, all investments should offer the same risk-reward ratio.
 Risk-reward ratios of GE and the market portfolio should be equal.

o o Above is the expected return-beta relationship.

 The total expected rate of return is the sum of the risk-free rate plus a risk premium.
 The risk premium is the product of a benchmark risk premium and the relative risk of the particular
asset as measured by its beta.
 Does not depend on the total volatility of the investment
 For the market portfolio: E ( R M )=r f + β M [E ( r M ) −r f ]
 Also establishes 1 as the weighted average value of beta across all assets
o In a well-functioning economy investor received high expected returns only if they are willing to risk.
 The security market line
o The expected return-beta relationship can be portrayed graphically as the security market line (SML)
 Because market beta = 1, the slope is the risk premium of the market
portfolio.
 At the point Beta = 1, we can read off the vertical axis the expected
return of the market portfolio.
o CML vs SML
 CML graphs risk premiums of efficient portfolios as a function of
portfolio standard deviation
 SML graphs individual asset risk premiums as a function of asset risk
o Fairly priced assets plot exactly on the SML
o The difference between the equilibrium and the actually expected rate of
return on a stock is call the stock’s alpha.
 Security analysis is about uncovering securities with nonzero alphas,
increase weights with positive alphas and decrease the weights with
negative alphas.
 o CAPM can also provide the required rate of return that the project needs to yield, based on its beta, to be
acceptable to investors. Managers can use the CAPM to obtain this cutoff IRR or “hurdle rate”
 The CAPM and the Single-Index Market
o .
 Assumptions and Extensions of CAPM
o Restrictions on short sales or different taxes can affect CAPM
o People have different optimal risk portfolios due to stage of life or wealth
 Consumption Based CAPM
o In a lifetime consumption/investment plan, the investor must in each period balance the allocation of
current wealth between today’s consumption and savings and the investment that will support future
consumption.
 Utility value from an additional dollar of consumption today must equal the utility value of the
expected future consumption that could be financed by investing that marginal dollar.
 Equilibrium risk premiums will be greater for assets that exhibit higher covariance with consumption
growth.
 E ( Ri ) =β iC R P C where c is a consumption-tracking portfolio that is the portfolio with the
highest correlation with consumption growth. Beta is is the slope coefficient in the regression
of asset I’s returns on those of the consumption tracking portfolio. RP is the risk premium
associated with the consumption uncertainty, which is measured by the expected excess return
on the consumption-tracking portfolio.
 There is a premium associated with less liquid stocks.
o The difference in returns between the most liquid stocks (lowest bid–
ask spread) and least liquid stocks (highest spread) is about .7% per
month. This is just about the same magnitude as the monthly market
risk premium! Liquidity clearly matters for asset pricing.
 Testing the CAPM is impossible
o Cannot even observe all assets that trade, least of all include them in
the market portfolio
o Must estimate beta coefficients
o Alpha and beta are time varying, and may vary related to certain economic conditions

Chapter 11: The Efficient Market Hypothesis

 Any information that could be used to predict stock performance should already be reflected in stock prices.
o New information must be unpredictable
 Stock prices should follow a random walk: price changes should be random and unpredictable
 Efficient market hypothesis: the notion that stocks already reflect all available information
 Price jumps immediately when takeover is announced, or when dividend announced (within 5 mins)
 Versions of the Efficient Market Hypothesis
o Weak-form: stock prices already reflect all information that can derived by examining market trading data
such as the history of past prices
o Semistrong-form: all publicly available information regarding the prospects of a firm must be reflected
already in the stock price. Such information includes, in addition to past trading data, fundamental data on
the firm’s product line, quality of management, balance sheet composition, patents held, earnings forecasts,
and accounting practices.
o Strong-form: stock prices reflect all relevant information, even including information available only to
company insiders.
 Technical Analysis: the research for recurrent and predictable patterns in stock prices.
o Key to TA is sluggish response of stock prices to supply and demand factors
o Resistance level: price level above which it is difficult to rise
o Support level: Price level below which is difficult to fall
o EMH implies technical analysis should be fruitless
 Fundamental Analysis: uses earnings and dividend prospects of the firm, expectations of future interest rates,
and risk evaluation of the firm to determine proper stock prices.
 o An attempt to determine the present value of all the payments a stockholder will received from each share
of the stock. If that value is greater than stock price, purchase
o EMH also implies this should not work
o The trick is not to identify firms that are good, but to find firms that are better than everyone else’s estimate.
 troubled firms can be great bargains if their prospects are not as bad as their stock prices suggest.
o Why fundamental analysis is difficult. It is not enough to do a good analysis of a firm; you can make money
only if your analysis is better than that of your competitors because the market price will already reflect all
commonly recognized information.
 The role of portfolio management in an efficient market
o Rational investment policy calls for construction of an efficiently diversified portfolio providing the
systematic level of risk investors want
 Don’t want to be over exposed to one company
o RIP also requires tax considerations be reflected in security chouse. High taxed want more muni bonds and
want tilted in capital gains rather than interest income (real estate)
 Valuations also affect resource allocation
 Event study: technique used to asses the impact of a particular event on a firm’s stock price.
o Abnormal return: the difference between the actual return and this benchmark

 Cumulative abnormal return: sum of all abnormal returns over time period of interest (leakage)
 Issues to EMH
o Magnitude issue: hard to detect improvements made by good managers
o Selection bias issue: Managers don’t want to share their secrets so they don’t publish findings
o Lucky event issue: Because so many investors, there statistically must be some large winners
 Weak Form Test: Patterns in Stock Returns
o Returns over short horizons
 No clear serial correlation (tendency of stock returns to be related to past returns) on the short term
 Stronger momentum at longer horizons
 Momentum effect: good or bad recent performance of particular stocks continues over time.
o Portfolios of the best-performing stocks outperform others over long periods of times
o Returns over long horizons
 Tests of long-horizon returns have found suggestions of pronounced negative long-term serial
correlation in the performance of the aggregate market
 Fads hypothesis: market overreacts to news
 Market risk premium varies over time:
 Reversal effect: in which losers rebound and winners fade back, suggests that the stock market
overreacts to relevant news.
 Predictors of Broad Market returns
o Several studies have documented the ability of easily observed variables to predict market returns. The
return on the aggregate stock market tends to be higher when the dividend/price ratio, the dividend yield, is
high.
o Predictability in returns is more an effect of risk premium than evidence of market inefficiency
 Semistrong Test: Market Anomalies
 o Anomalies: Several easily accessible statistics, for example, a stock’s market capitalization, seem to predict
abnormal risk-adjusted returns. This is difficult to reconcile with EMH
 Need to adjust for portfolio risk
 An alternative interpretation is that returns have not been properly adjusted for risk. If two firms have
the same expected earnings, the riskier stock will sell at a lower price and lower P/E ratio. Because of
its higher risk, the low P/E stock also will have higher expected returns. Therefore, unless the model
of expected return properly adjusts for risk, P/E will be a useful additional proxy for risk and will
appear to predict abnormal returns.
 Small firm effect: small firms portfolios are consistently higher on small firm portfolios. However
are riskier and an improperly adjusted CAPM for risk will lead to substantial premium for smaller-
sized portfolios.
 Neglected firm effect: neglected firms might be expected to earn higher equilibrium returns as
compensation for the risk associated with limited information
 Liquidity: harder to move, higher premium
o Book to market ratio has an effect on returns, challenge to EMH
o Other
 Volatility negatively associated with returns
 Accruals (amount of earnings that do not reflect stock returns) High accruals predict low future
returns
 Growth: more rapidly growing forms tend to have lower future returns
 Profitability: gross profitability seems to predict higher returns
 Q-factor: higher q associated with higher returns
o Summary:
 Statistical research has shown that to a close approximation stock prices seem to follow a random
walk with no discernible predictable patterns that investors can exploit. Such findings are now taken
to be evidence of market efficiency, that is, evidence that market prices reflect all currently available
information. Only new information will move stock prices, and this information is equally likely to be
good news or bad news.
 Market participants distinguish among three forms of the efficient market hypothesis. The weak form
asserts that all information to be derived from past trading data already is reflected in stock prices.
The semistrong form claims that all publicly available information is already reflected. The strong
form, which generally is acknowledged to be extreme, asserts that all information, including insider
information, is reflected in prices.
 Technical analysis focuses on stock price patterns and on proxies for buy or sell pressure in the
market. Fundamental analysis focuses on the determinants of the underlying value of the firm, such as
current profitability and growth prospects. Because both types of analysis are based on public
information, neither should generate excess profits if markets are operating efficiently.
 Proponents of the efficient market hypothesis often advocate passive as opposed to active investment
strategies. Passive investors buy and hold a broad-based market index. They expend resources neither
on market research nor on frequent purchase and sale of stocks. Passive strategies may be tailored to
meet individual investor requirements.
 Event studies are used to evaluate the economic impact of events of interest, using abnormal stock
returns. Such studies usually show that there is some leakage of inside information to some market
participants before the public announcement date. Therefore, insiders do seem to be able to exploit
their access to information to at least a limited extent.
 One notable exception to weak-form market efficiency is the apparent success of momentum-based
strategies over intermediate-term horizons.
 Several anomalies regarding fundamental analysis have been uncovered. These include the value-
versus-growth effect, the small-firm effect, the momentum effect, and post–earnings-announcement
price drift. Whether these anomalies represent market inefficiency or poorly understood risk
premiums is still a matter of debate.
 By and large, the performance record of professionally managed funds lends little credence to claims
that most professionals can consistently beat the market. Superior performance in one period does not
generally predict superior performance going forward

Chapter 14: Bond Prices and Yields

 Par value: face value of the bond
 Coupon rate: interest payment on semiannual coupon payments
 Yield to maturity: measure of the average rate of return to an investor who purchases the bond for the ask price
and holds it until maturity.
 If a bond is purchase between coupon payments, the buyer must pay the seller for accrued interest, the prorated
share of the upcoming semiannual bond on top of price of the bond
Annual coupon payment
∗Days since last coupon payment
o 2
Accrued Interest =
Days separating coupon payments ( 180 )
 Corporate bonds
o So many different bonds that market can be thin, not a ton of movement at a particular issue at a particular
time
o Some corporate bonds are issued with call provisions allowing the issuer to repurchase the bond at a
specified call price before the maturity date
o Callable bonds: typically come with some protection period before which they cannot be called
 Convertible Bonds: give owners the chance to exchange bonds for stock in company
o Conversion ratio: the number of shares for which each bond may be exchanged.
o Market conversion value: current value of the shares for which the bonds may be converted
o Offer lower coupon rates and ytms than nonconvertible bonds
 Puttable Bonds
o While a callable bond gives the issuer the option to extend or retire the bond at the call date, an extendable
or put bond gives this option to the bondholder. If the bond’s coupon rate exceeds current market yields,
for instance, the bondholder will choose to extend the bond’s life.
 Floating-rate bonds: make interest payments tied to some measure of current market rates
o Major risk: if firm does poorly, investors will demand higher yield and price of the bond will fall
 Preferred Stock
o Promises to pay a specified cash flow stream in perpetuity
o Unlike interest payments from bonds, dividends on preferred stock are no tax-deductible expenses
 Reduces their attractiveness to issuers
 Offers an off-setting tax advantages because when one firm buys PS of another it pays taxes on only
50% of the dividends received.
 Foreign bonds: issued by a borrowers from a country other than the one in which the bond is sold and
denominated in the currency of the country in which it is marketed.
 Eurobond: denominated in currency of issuer but sold in other national markets.
o Dollar denominated bonds sold in other countries
 Indexed Bonds: make payments that are tied to a general price index or the price of a particular commodity
o They are called Treasury Inflation Protected Securities (TIPS). By tying the par value of the bond to the
general level of prices, coupon payments as well as the final repayment of par value on these bonds increase
in direct proportion to the Consumer Price Index. Therefore, the interest rate on these bonds is a risk-free
real rate.
Interest + Price Appreciation
o Nominal return=
Initial Price
1+ Nominal Return
o Real Return= −1
1+inflation
 The price an investor is willing to pay for the bond depends on the value to be received in the furture compared to
dollars in hand today
o This present value calculation depends in turn on market interest rate
 Bond Value=Present value of couponds+ Present value of par value
T
Coupon Par value
 Bond Value=∑ t
+
t =1 (1+ r) (1+r )T
o T = maturity date
o r = interest rate appropriate for discounting the bond’s payments
o Present value of all future coupon payments plus the present value of par value
 1
o Present value of a $1 annuity that lasts for T periods when interest rate equals r is ¿]
r
o
Coupon∗1
Value=
r
1−
1
[
( 1+ r ) T
+ Par
]
Value∗1
( 1+r )T
o Value=Coupon∗Annuity factor ( r , T ) + Par Value∗PV factor (r , T )
 Negative relationship between bond values and the interest rate.
o Progressive increases in the interest rate lead to smaller
deductions in value
 Corporate bonds typically issued at par value
o Underwriters must choose a coupon rate that closely
approximates market yields
 The longer the maturity of the bond, the greater the sensitivity of value
to fluctuations in the interest rate
 Yield to Maturity (YTM) interest rate that makes the present value of
a bond’s payments equal to its price.
o Measure of the average rate of return that will be earned on a
bond if bought now and held to maturity
 Current Yield: bond’s annual coupon payment divided by price
 Coupon Rate: coupon payment divided by par value
o Current yield will be less than coupon rate if par value is less than bond price
o Current yield is greater than YTM because ytm accounts for the built in capital loss on the bond
 The bond bought today for $1276 will eventually fall in value to $1000
 Premium bonds: bonds selling above par value
 Discount bonds: bonds selling below par value
 Yield to Call
o When interest rates fall, the present value of the bond’s scheduled payments rises, but a call provision
allows the issuer to repurchase the bond at call price
 See graph above, at high rates, call risk is negligible, at low rates, the bond value is simply call price
o The yield to call is calculated just like the yield to maturity except that the time until call replaces time until
maturity, and the call price replaces par value.
o Premium bonds much more likely to be called if rates fall
 If interest rates fall, a callable premium bond is likely to provide a lower return than could be earned
on a discount bond whose potential price appreciation is not limited by the likelihood of a call.
 Realized Compound Return vs. Yield to Maturity
o Yield to maturity will equal the rate of return realized over the life of the bond if all coupons are reinvested
and earn the bond’s yield to maturity.
o Compound rate of return: V 0 (1+r )2=V 2
o With a reinvestment return equal to the coupon, the realized compound return equals yield to maturity
o Horizon analysis: forecasting the realized compound yield over various investment periods
 Bond will sell at par value when its coupon rate equals the market interest rate
o When the coupon rate is lower than the market interest rate, the coupon
payments alone will not provide bond investors as high a return as they could
earn elsewhere. Bonds must sell below par value to provide appreciation and
vice versa
o However, both premium and discount bonds offer investors the same total rate
of return
 However, they vary as longer-term bonds offer highly promised yields
 Yield to Maturity vs. Holding Period Return
o When the yield to maturity is unchanged over the period, the rate of return on
the bond will equal that yield
o When yields fluctuation, so will a bond’s rate of return
 An increase in the bond’s price will reduce its price, which reduces the holding period return.
 Coupon+(New Price−Old Price)
o HPR=
Old Price
 Yield to maturity is commonly interpreted as a measure of the average rate of return if the investment
in the bond is held until the bond matures.
 Holding-period return is the rate of return over a particular investment period and depends on the
market price of the bond at the end of that holding period; this price is not known today.
 Zero Coupon Bonds and Treasury Strips
o Original issue discount bonds: bonds that are issued intentionally with low coupon rates that cause the bond
to sell at a discount from par value
 U.S. Treasury bills are an example
o Some bonds may be turned into 20 separate zero coupon bonds
o Appreciate over time
 After-Tax Returns
o IRS calculates a price appreciation schedule to impute taxable interest for the built-in appreciation during a
tax year
 Any additional gains or losses that arise from changes in market interest rates are treated as capital
gains or losses if the OID bond is sold during the tax year.
 BBB is cutoff between investment grade and junk bonds
 Determinants of Bond Safety
o Coverage ratios – ratios of company earnings to fixed costs
o Leverage ratios – debt to equity
o Profitability ratios – measure a firm’s overall financial performance
o Cash flow to debt ratio
 Sinking Fund: to ensure cash flow crisis when bonds need to be repaid, company pays back par value over a few
years
 Subordinate bonds: restrict the firms from additional borrowing
 Dividend Restrictions
 Debenture Bonds: bonds issued that do not have collateral
 Yield to Maturity and Default Risk
o The expected yield to maturity must take into account the possibility of a default.
o Default premium: extra return offered to cover default risk
 difference between the promised yield on a corporate bond and the yield of an otherwise-identical
government bond that is riskless in terms of default
 Credit default swap (CDS): an insurance policy on the default risk of a bond or loan
o meaning that the CDS buyer would pay the seller an annual “insurance premium” of $3 for each $100 of
bond principal if 3%
 Collateralized debt obligations (CDOs) emerged in the last decade as a major mechanism to reallocate credit
risk in the fixed-income markets.
o To create a CDO, a financial institution, commonly a bank, first would establish a legally distinct entity to
buy and later resell a portfolio of bonds or other loans.

Chapter 18: Equity Valuation Models

 Book value: the net worth of the company as reported in the balance sheet
o A better measure of a floor for the stock price is the firm’s liquidation value per share. This is the amount
of money that could be realized by breaking up the firm, selling its assets, repaying its debt, and distributing
the remainder to the shareholders.
 If Market cap drops below liquidation value, it becomes an attractive takeover target
 Another measure of firm value is the replacement cost of assets less liabilities
E ( D1 ) + E (P1−P0 )
 Expected Holding Period Return of a Stock: E ( r )=
P0
o If greater then CAPM estimate, buy the stock.
 Intrinsic Value (V0): the present value of all the cash flows the investor will receive (on a per share basis),
including dividends as well as the proceeds from the ultimate sale of the stock, discounted at the appropriate risk-
adjusted rate, k.
o If the intrinsic value exceeds the market price, the stock is considered to be undervalued.
E ( D1 ) + E (P1)
o V 0=
1+ k
o k = appropriate risk adjusted interest rate
o k =r f + β [E ( r M ) −r f ]
o In equilibrium, the market price will reflect the intrinsic value estimates of all market participants
 Market Capitalization Rate (k): The market-consensus estimate of the appropriate discount rate for a firm’s
cash flows.
 For a holding period of H years, we can write the stock value as the present value of dividends over the H years,
plus the ultimate sale price of PH
D1 D2 D H + PH
o V 0= + +
1+k (1+ k)2 (1+ k )H
o With no horizon date.. the Dividend Discount Model (DDM)
D1 D2 D3
o V 0= + +
1+k (1+ k)2 (1+ k )3
 DDM asserts that stock prices are determined ultimately by the cash flows accruing to stockholders,
and those are dividends
 Constant Growth DDM: assumes that dividends are trending upward at a stable growth rate g.
D1
o V 0=
k −g
o Valid only when g is less than k. If dividends were expected to grow at a rate faster than k, the value of the
stock would be infinite. Thus, if g is greater than k, growth must be unsustainable in the long term
o Assumes stock price is expected to grow at the same rate as dividends
 P1=P0 (1+ g)
D1
o For a stock whose market price equals its intrinsic value ( P0=V 0 ¿ , the expected HPR = +g
P0
 This equals Dividend yield + Capital gains yield
 Convergence of Price to Intrinsic Value
o One common assumption is that the discrepancy between price
and intrinsic value will never disappear and that the market price
also will grow at the same rate
 Expected HPR will exceed the required rate because the
dividend yield is higher than it would be if P0 were equal to
V0
o An alternative assumption of complete catch-up to intrinsic value produces a much larger 1-year HPR. In
future years however, the stock is expected to generate only fair rate of return
 Many stock analysts assume that a stock’s price will approach its intrinsic value gradually over time,
for example in a five-year period.
 Stock Prices and Investment Opportunities
o Dividend payout ratio: the fraction of earnings paid out as dividends
o Plowback/earnings retention ratio (b): the fraction of earnings
reinvested in the firm
o g=ROE∗b
o Present Value of Growth Opportunities (PVGO) the present value of
future investment opportunities
 Price = no-growth value per share + PVGO
E1
 P 0= + PVGO
k
o ROE must be greater than k for firm to invest
 Life Cycles and Multistage Growth Models
o Dividend growth rate is not always constant
o Two-stage dividend discount model allows for initial high-growth period before the firm settles down to a
sustainable growth trajectory.
 The combined present value of dividends in the initial high-growth period is calculated first.
 Then, the constant growth DDM is applied to value the remaining streams of dividends
o Multistage growth models allow dividends to grow at several different rates as the firm matures
 Many analysts use three-stage growth models. They may assume an initial period of high dividend
growth (or instead make year-by-year forecasts of dividends for the short term), a final period of
sustainable growth, and a transition period between, during which dividend growth rates taper off
from the initial rapid rate to the ultimate sustainable rate.
 Price – earnings multiple: the ratio of price per share to earnings per share
P0 1 PVGO
= (1+ )
o E1 k E
k
 as PVGO becomes an increasingly dominant contributor to price, the P/E ratio can rise dramatically
 The ratio of PVGO to E/k has a straightforward interpretation. It is the ratio of the component of firm
value due to growth opportunities to the component reflecting assets already in place (i.e., the no-
growth value of the firm, E/k). When future growth opportunities dominate the estimate of total
value, the firm will command a high price relative to current earnings. Thus, a high P/E multiple
indicates that a firm enjoys ample growth opportunities
o P/E ratios reflect the market’s optimism concerning a firm’s future growth prospects
P0 1−b
o =
E1 k−ROE∗b
 High ROE projects give firm good opportunities for growth
 P/E increases for higher plowback, b, as long as ROE exceeds k
o Higher b does not necessarily mean a higher p/e ratio
 When expected ROE is less than required return k, investors prefer the firm pay out dividends.
 When ROE is less than k, value of firm falls as plowback increases
o P/E ratios frequently taken as proxies for the expected growth in dividends or earnings
 Wall Street Rule of Thumb is that growth rate ought to be roughly equal to P/E rate (PEG of 1.0)
 P/E Ratios and Stock Risk
o Risker stocks will have lower P/E multiples
 Can see this in the context of the constant growth model by examining the formular for the P/E ratio
P 1−b
 =
E k−g
 Riskier firms have higher values of K, so P/E multiple will be lower
 Pitfalls in P/E Analysis
o In times of high inflation, historic cost depreciation and inventory costs will tend to underrepresent true
economic values because the replacement cost of both goods and capital equipment will rise
o P/E ratios generally have been inversely related to the inflation rate.
 Also reflects the market’s assumption that earnings in periods of high inflation are of “lower quality”
o Earnings management: the practice of using flexibility in accounting rules to improve the apparent
profitability of a firm
o Forward P/E: the ratio of today’s price to the trend value of future earnings, E 1
o The P/E ratio reported in the financial press, by contrast, is the ratio of price to the most recent past
accounting earnings and is called the trailing P/E.
 Current earnings can differ considerably from their trend values
 Because ownership of stock conveys the right o future as well as current
ownings, the trailing P/E ratio can vary substantially over the business
cycle
o P/E ratio higher when earnings are temporarily depressed and lower when
earning temporarily higher.
o P/E ratios vary across industries
  Industries with highest multiples have attractive investment opportunities and high growth rate
 Lower industries are more mature and less profitable.
 The Cyclically adjusted P/E Ratio (CAPE)
o Divide the stock price by an estimate of sustainable long-term earnings rather than current earnings
o A lot smoother than traditional P/E ratio
 Other Comparative Valuation Ratios
o Price to book ratio: ratio of the price per share divided by book value per share
o Price to cash flow ratio: Some prefer this since cash flow is less subject to earnings management
o Price to sales ratio
 Many start-ups have no earnings, so p/e is useless.
 Free Cash Flow Valuation Approaches
o Alternative approach to the DDM values the firm using free cash flow, cash flow available to the firm or its
equity holders net of capital expenditures.
 Particularly useful for firms that pay no dividends, for which the DDM model would be difficult
o One approach is to discount the free cash flow for the firm (FCFF) at the weighted averaged cost of capital
(WACC) to find the value of the entire firm. Subtracting the debt results in the value of equity
o Another approach is to focus from the start on the free cash flow to equityholders (FCFE), discounting
those directly at the cost of equity to obtain the market value of equity

Chapter 20: Options Markets: Introduction

 Call option: a security that gives its holder the right to purchase an asset for a specified price, call the exercise or
strike price
o Value is higher when strike price is lower
 Premium: the purchase price of the option
o The compensation call buyers pay for the right to exercise only when it is in their
interest to do so
 Put Option: Gives its holder the right to sell an asset for a specified exercise or strike price
on or before some expiration date
o Value is higher when strike price is higher
 Options contracts traded on exchanges are standardized by allowable expiration dates and
exercise prices
o Each stock option contract provides for the right to buy or sell 100 shares of stock
 American options allow the holder to exercise the right to purchase on or before expiration date, European option
only allows you to exercise on the expiration date.
 Call option values are lower for high dividend payout policies and put values are higher for high dividend payout
policies
 Other listed options
o Index Options: call or put on a stock market index such as the S&P 5000
o Futures Options: give their holders the right to buy or sell a specified futures contract, using as a futures
price the exercise price of the option
o Foreign Currency Options: A currency option offers the right to buy or sell a specified quantity of foreign
currency for a specified number of U.S. dollars.
o Interest Rate Options
 Call Options

o o ST = value of stock at expiration, X = exercise price

o Solid line in graph is the value of the call at expiration, the net profit equals the expiration
value of the call less its initial price
 Put Options
o Put option is the right to sell an asset at the exercise price. The put holder will not exercise unless the asset
is worth less than the exercise price
 o Writing puts naked (writing a put without an offsetting short position in the stock) exposes the writer to
losses if the market falls
 Once popular, now considered very risky
 Graph of different investment strategies:
o Strategy A: Invest entirely in stock. Buy 100 shares, each selling for $100.
o Strategy B: Invest entirely in at-the-money call options. Buy 1,000 calls, each selling
for $10. (This would require 10 contracts, each for 100 shares.)
o Strategy C: Purchase 100 call options for $1,000. Invest your remaining $9,000 in 1-
year T-bills, to earn 3% interest. The bills will grow in value from $9,000 to $9,000 ×
1.03 = $9,270.
 Protective Put: Imagine you would like to invest in a stock but are unwilling to bear
potential losses beyond some level.
o Buy the stock and a “protective” put option on the stock so you are guaranteed
a payoff at least equal to the put option’s exercise price.
o However, you still have to pay the price of the put option, so if ST = S0 , then
you have no profit with stock only option, but a loss with the protective put
 Covered Call: the purchase of a share of stock coupled with a sale of a call option of the
stock
o Written call is “covered” because the potential obligation to deliver the stock can be
satisfied using the stock held in the portfolio
o Writing covered call options has been a popular investment strategy among
institutional investors. Consider the managers of a fund invested largely in stocks.
They might find it appealing to write calls on some or all of the stock in order to boost
income by the premiums collected. Although they thereby forfeit potential capital gains
should the stock price rise above the exercise price, if they view X as the price at which they plan to sell the
stock anyway, then they may rationalize the call as providing a kind of “sell discipline.”
 Straddle: A long straddle is established by buying both a call and a put, each with the same
exercise price, X, and the same expiration date, T.
o Useful for investors who believe a stock price will move a lot but are uncertain about the
direction of the move
o Worse-case scenario for a straddle is no movement in the stock price, as both call and put
options are worthless
 Spreads: combination of two or more call options (or two or more puts) on the same stock with
differing exercise prices or times to maturity
o Some options are bought, whereas others are sold, or written.
o A money spread involves the purchase of one option and the simultaneous sale of

another with a different exercise price.

o A time spread refers to the sale and purchase of options with differing expiration dates
 Collars: options strategy that brackets the value of a portfolio between two bounds
o investor obtains the downside protection represented by the exercise price of the put by
selling a claim to any upside potential beyond the exercise price of the call
 Put-Call Parity Relationship
o A call-plus-bills portfolio also can provide limited downside risk with unlimited upside
potential
o Consider buying a call option and Treasury bills with face value equal to the exercise price of the call, and
maturity date equal to the expiration date of the option
 If the exercise price of the call is $100, then each option contract
(which is written on 100 shares) would require payment of $10,000
upon exercise. Therefore, you would purchase a T-bill with a maturity
value of $10,000. More generally, for each option that you hold with
exercise price X, you would purchase a risk-free zero-coupon bond with face value X.
  Call-plus-bond portfolio must cost the same as the stock plus put portfolio (protective put)
X
o C 0+ T
=S 0+ P0
(1+r f )
X
 C 0 : Cost of call at time 0, :
T riskless zero-coupon bond, The stock costs S0 to purchase now
(1+r f )
(at time zero), while the put costs P0
o P0=C 0−S 0+ PV ( X )+ PV (dividends)
o Called the put-call parity theorem because it represents the proper relationship between put and call prices
 If ever violated, opportunity for arbitrages
 Callable bonds
o Bond issuer thus holds an implicit call option with exercise price equal to the price at
which the bond can be repurchased
o Usually can only be exercised after an initial period of call protection
 Convertible Securities
o A convertible security typically gives its holder the right to exchange each bond or
share of preferred stock for a fixed number of shares of common stock, regardless of the market prices of
the securities at the time.
o a bond with a conversion ratio of 10 allows its holder to convert one bond of par value $1,000 into 10
shares of common stock
o Alternatively, we say the conversion price in this case is
$100: To receive 10 shares of stock, the investor hands over
bonds with face value $1,000 or, put another way, $100 of
face value per share.
o Has two “floors”
 The value the bond would have if it were not
convertible into stock
 Conversion value equals the value it would have if you converted it into stock immediately.
 When stock prices are low, the straight bond value is the lower bound, when prices are high, the
bond’s price is determined by its conversion value.
 Warrants: essentially call options issued by a firm
o The important difference between calls and warrants is that exercise of a warrant requires the firm to issue a
new share of stock. Exercise of a call option requires only that the writer of the call deliver an already
issued share of the stock.
o Provide cash flow to the firm when the warrant holder pays the exercise price
 Collateralized Loans: loan arrangements that require the borrow to put up collateral to guarantee the loan will be
paid back.
o Assume the borrower is obligated to pay back L dollars at the maturity of the loan.
The collateral will be worth ST dollars at maturity. (Its value today is S0.) The
borrower has the option to wait until the loan is due and repay it only if the collateral
is worth more than L dollars. If the collateral is worth less than L, the borrower can
default on the loan and discharge the obligation by forfeiting the collateral, which is
worth only ST.
L
o S0 −C0 = T
−P 0
(1+r f )
 Same as put-call parity relationship
o Financial engineering: the creation of portfolios with specified payoff patterns
o Asian Options: options with payoffs that depend on the average price of the
underlying asset during at least some portion of the life of the option
o Barrier Options: have payoffs that depend not only on some asset price at option expiration, but also on
whether the underlying asset price has crossed through some “barrier.”
o Lookback Options: have payoffs that depend in part on the minimum or maximum price of the underlying
asset during the life of the option
o Currency Translated Options: have either asset or exercise prices denominated in a foreign currency
 o Digital options: have fixed payoffs that depend on whether a condition is satisfied by the price of the
underlying asset

Chapter 21: Option Valuation

 The value S0 − X is called the intrinsic value of in-the-money call options because it gives the payoff that could
be obtained by immediate exercise.
o The difference between price and intrinsic value is commonly called the
option’s time value
 difference between the option’s price and the value it would have if it
were expiring immediately.
 As stock prices increases, it becomes increasingly likely that the call will be
exercised by expiration, and time value gets minimal.
o Option value approaches the “adjusted” intrinsic value so the present value of
your obligation is the present value of X.
 Net value of the call option is S0 – PV(X)
 Determinants of Option Values
o Stock price
 Value of call option should increase with stock price
o Exercise price
 Value of call option should decrease with exercise
price
o Volatility of the stock price
 The more volatile, the higher the option value
o Time to expiration
 More time, the higher the value
o Interest rate
 Option values higher when interest rate is higher
o Dividend rate of the stock
 A high dividend payout policy puts a drag on the rate of growth of
the stock price so more dividends mean a lower value option.
 Restriction on the Value of a Call Option
o Value of the call option cannot be negative
 Payoff is zero at worst, and possibly positive so it has some positive
value
o Because the option’s payoff is always greater than or equal to that of a
leveraged equity position, its price must exceed the cost of establishing that
position
o Range of possible call value options 
X +D
 C 0 ≥ S0− T
=S 0−PV ( X )−PV (D)
( 1+r f )
 Early Exercise and Dividends
o A call option holder who wants to close out that position has two choices: call or sell it
 If exercised at time t, the call will provided a payoff of St −X
 Option can be sold for at least St −PV ( X )−PV (D)
 If stock does not pay dividend, call must be worth at least St −PV ( X )
 Because present value of X is less than X itself, it follows that
 C t ≥ S t−PV ( X ) > St −X
o Proceeds from the sale of the option must exceed the proceeds from an exercise
o It never pays to exercise a call option before expiration if the stock does not pay dividends
 Early Exercise of American Puts
o Early exercise of American put options sometimes will be rational
regardless of dividends
  Immediate exercise gives you immediate receipt of the exerciser price, which can be reinvested to
start generating income
 American put worth more than European put
 Two-State Option Pricing
o When a perfect hedge is established, the final stock price does not affect the portfolio’s payoff, so the stock
risk and return parameters have no bearing on the option’s value
o Hedge ratio equals the ratio of ranges because the option and stock are perfectly correlated in this two state
example. Because they are perfectly correlated, a perfect hedge requires that they be held in proportion to
relative volatility
Cu −Cd
o Hedge ratio for two state option problems: H=
u S 0−d S0
 C u−C d :the call option’s value when the stock goes up or down respectively. u S 0−d S0 :the stock
prices in the two states
 If the investor writes one option and holds H shares of stock, the value of the portfolio will be
unaffected by the stock price. In this case, option pricing is easy: Simply set the value of the hedged
portfolio equal to the present value of the known payoff.
 Given the possible end-of-year stock prices, uS0 = 120 and dS0 = 90, and the exercise price of
110, calculate that Cu = 10 and Cd = 0. The stock price range is 30, while the option price
range is 10.
 Find that the hedge ratio of 10/30 = ⅓.
 Find that a portfolio made up of ⅓ share with one written option would have an end-of-year
value of $30 with certainty.
 Show that the present value of $30 with a 1-year interest rate of 10% is $27.27.
 the value of the hedged position to the present value of the certain payoff:
1
 S −C 0=$ 27.27
3 0
 $ 33.33−C 0=$ 27.27
 Solve for the call’s value, C0 = $6.06.
 If the option is overpriced, you can make arbitrage profits by writing the overpriced optin and
hedging with shares

Translates to a profit of $.44 an option, which is exactly how much the options were
overpriced.
 Dynamic Hedging: the continued updating of the hedge ratio as time passes
o As the dynamic hedge becomes ever finer, the resulting option-valuation procedure becomes more precise

 Black-Scholes pricing formula for a call option:

 C0 = Current call option value.

  S0 = Current stock price.
 N(d) = The probability that a random draw from a standard normal distribution will be less than d.
This equals the area under the normal curve up to d, as in the shaded area of Figure 21.6
 X = Exercise price
 e = The base of the natural log function, approximately 2.71828. In Excel, ex can be evaluated using
the function EXP(x).
 r = risk-free interest rate (the annualized continuously compounded rate on a safe asset with the same
maturity as the expiration date of the option, which is to be distinguished from rf, the discrete period
risk-free interest rate).
 T = Time to expiration of option, in years.
 Ln = Natural logarithm function.
 σ = Standard deviation of the annualized continuously compounded rate of return of the stock.
o Assumes that this stock pays no dividends before option expiration
o Option value does not depend on the expected rate of return on the stock
 Information is already built into the formula with the inclusion of stock price, which reflects risk and
return characteristics
o N(d) terms can be roughly viewed as the risk adjusted probabilities that the call option will expire in the
money
o Assumptions:
 Stock will pay no dividends
 Both the interest rate and variance rate of the stock are constant
 Stock prices are continuous, meaning that sudden extreme jumps such as those in the aftermath of an
announcement
 Implied Volatility
o What standard deviation would be necessary for the option price that I observe to be consistent with the
Black-Scholes formula?  implied volatility of the option
 Dividends and Call Options Valuation
o If option is European, can replace S0 with S0 minus the present value of the dividends to be paid before
expiration.
o If the dividend yield, denoted δ, is constant, one can show that the present value of that dividend flow
accruing until the option expiration date is S0(1 − e−δT).14 In this case, S0 − PV(Div) = S0e−δT, and we can
use the Black-Scholes call option formula simply by substituting S 0e−δT for S0.
 Put Option Valuation of non dividend paying stock
o P0=C 0 + PV ( X )−S 0
o P0=C 0 + X e−rt −S 0
 European put option
o P0= X e−rt [ 1−N ( d 2 ) ]−S 0 [1−N ( d 1 ) ]
 Hedge Ratios and the Black-Scholes Formula
o We summarize the sensitivity of option prices to the value of the underlying asset
using the hedge ratio, the change in option price for a $1 increase in the stock price
 A call option has a positive hedge ratio and a put option has a negative hedge
ratio
 Hedge ratio is commonly called the option’s delta
 Slope of the curve evaluated at the current stock price –>
o For every call option written, .60 share of stock would be
needed to hedge the resulting stock price exposure
o Hedge ratio for a call is N(d1) and hedge ratio for a put is N(d1) – 1/
 N(d) stands for the area under the standard normal curve up to d.
 Call option hedge ratio is positive and less than 1.0 whereas the put option hedge ratio is negative
with smaller absolute value than 1.0
o Option elasticity: percentage change in option price per percentage change in stock price
o Sensitivity of the delta to the srock price is called the gamma of the option.
o Sensitivity of an option price to changes in volatility is called the option’s vega