Important Financial Assets: I.

Fixed Income Securities borrowing instruments - in order of riskiness -Treasury Bonds, Municipal Bonds (tax exempt), Corporate Bonds II. Equity ownership in a firm - common stock (voting rights junior), preferred stock (non-voting senior) bankruptcy (Government, Employees, Bondholders, Preferred, Common) III. Derivatives securities depend on other assets (options, futures, swaps, bonds energy, gold) call (put) right to buy (sell) asset; long (short) future obligation to buy (sell) asset IV. Mutual Funds pools funds from investors and buys assets. Provides management and diversity with lower transaction costs. V. Asset-backed securities Market Types: Determine by how standard the asset is and the trade volume I. Direct Search: requires buyers and sellers to search for each other. Non-standardized assets, low volume of trade, high effort of search (craigslist) II. Dealer Market: Dealers hold inventory and stand ready to quote prices for buying and selling. Increased standardization, modest trade volume, easier market (cars) III. Exchange: Standardized assets, high trade volume, central location for buyers and sellers, aggregates supply and demand (NYSE) Liquidity: market is liquid if the asset can be traded immediately and without a big impact on price Provision of liquidity: can be provided by dealers or limit orders from other investors (limit orders provide a price and quantity at which you can buy or sell immediately) (mkt orders use up liquidity) Bid-ask spread: Market maker makes a profit buy buying at bid price and selling at ask-price- compensation for the services they provide- providing liquidity has risk High volume of trade: leads to smaller bid-ask spread: reduces inventory risk, dealers need less compensation for the risk they take Higher equilibrium price volatility: increases bid-ask spread: greater fluctuations in price increase risk for dealer therefore dealer demands more compensation Greater competition amongst dealers: leads to lower bid-ask spreads Time Value of Money PV = present value, P = price

Zero Coupon Bonds P = F(1 + R)t Annuity PV = C

PV = FV(1 + R)t

FV = future value, F = face value

FV = PV(1 + R)t

R = YTM (bonds) = (FVPV)

R = Interest rate
1 t

t = time periods (years, months, etc.)

Future Value of Multiple Cash Flows FV(t) = C(0)(1+R)t + C(1) (1+R)t-1 + + C(t) *if either paid later, make PV into FV, then calculate PV with given R and t
t = time periods (years)

FV (annual compounding) = PV (1 + R)t

EAR (Number of times per year) = (1+(Rm))m 1

= C PV factor

EAR = effective annual rate

Perpetuity PV = Cr

Multiple Cash Flows C(0) + C(1) 1(1 + R)+ C(2) 1(1 + R)2 + C(t) 1(1 + R)t EAR (continuous) = eR 1 1

-1

t=

log(FVPV) log(1 + R)

Discount Factor = 1(1 + R)t

C= cash flow/payments

m = # of times compounded per year

HPR =

Multiple-Period Realized Return Methods r = return rate t = time periods (years, months, etc)

ann.HPR = (

ann.HPR = Annualized Holding Period Return

FV (continuous compounding) = PV eRt

t = time periods (years)

ann.HPR= (1 + HPR)
1 t

1 t

1 1

Arithmetic Average =
C

(r1 +r2 +r3 + + rt ) t C1

IRR = Internal Rate of Return

NPV = Net Present Value +

Geometric Average = [(1 + r1 )(1 + r2 )(1 + r3 ) (1 + rt )]

C = cash flows
(1+IRR)t Ct

Portfolio Selection with Two Risky Assets

(1+IRR)1

=0

C 0 = Initial cash flow

1=(

accumulated valuet 1 ) t value0

t = time periods (years, months, etc)

Expected Return E(R) (mean) for a security (in different economic conditions) ER p = n p(s)i R(s)i = p(s)1 R(s)1 + + p(s)n R(s)n i=1
i = investment/asset/security p = probability (< 1) s = security

Covariance (two variables) = Cov(R i , R j ) = n R i E(R i ) R j ER j p(s) covariance of a variable with itself is its variance i=1 Variance (portfolio with two risky assets) Correlation (two variables) = i,j = Utility Function
Cov(Ri,Rj ) i j
2

Expected Return E(R) (mean) for portfolio (multiple securities) ER p = n i R i = 1 R1 + + n R n where i=1 Given a correlation coefficient of -1 (perfect negative correlation) with two investments 1 =
U = utility / attractiveness A = risk aversion (A>0)

Variance (security) 2 i = n R i ER p p(s) i=1

= weight

n = number of assets in portfolio

-1 i,j 1 covariance of the something with itself is 1

2 2 p =1 1

2 2 2 2

+ 21 2 1,2 1 2

Standard deviation (portfolio) i = 1 1 + 2 2 , 2 =

Standard deviation (security) i = i 2 volatility =

= correlation

value of stock i position total $value of portfolio

Investment Opportunity Set (2 Risky Investments) High Utility Medium Utility Low Utility Efficient Frontier R1
Short Security 2

UR p = ER p 0.5 AVar(R p )

es or rv st Cu ve e In nc e er iff nd

Optimal Portfolio

Given investor risk aversion values and characteristics of stocks (E(R) and ), calculate utility. Higher U means more utility.
2
Minimum Variance Portfolio
Short Security 1

R2 Standard Deviation (s )

 E(R p )= i E(R i ) + (1 )E(R f ) = R f + f ) E (R i R Variance (one risky, one risk-free) 2 p = 2 i 2 Given that || = Sharpe Ratio SR i =
p i

Risk-Free Asset E(R f ) = R f , Variance (R f ) = 0, Cov(R i , R f ) = i,f = 0 for any other asset i Expected Return E(R) (mean) for portfolio (one risky and one risk-free) Portfolio Selection with One Risky and One Risk-free Asset
Excess Return Risk premium

Expected Return E(R)

Investment Opportunity Set (Capital Allocation Line)

E(RL) = 15.7% E(RUS) = 12.13% L Riskier Investor (flatter)

, E(R p ) = R f +
E(Ri Rf) i

The tangency point is the point on the CAL tangent to the efficient frontier where 100% of assets are invested in the risky assets. Portfolios above this point on the CAL short risk-free assets (negative percentage of R f in the portfolio) and portfolios below this point on the CAL are long in the risk-free asset (positive percentage of R f in the portfolio) Risk aversion drives % of risk-free (R f ) assets. Portfolio Selection with Two Risky and One Risk-free Asset or Many Risky and One Risk-free Asset Find highest Sharpe Ratio (SR) for risky asset pairs and select tangency portfolio.
Expected Return E(R)

represents return premium per unit of risk highest SR = tangency portfolio CAL

Sharpe Ratio

E(Ri Rf )

p E(R p ) = R f + SR i p forms Capital Allocation Line(CAL)

Standard deviation (portfolio) p = ||(i ) volatility

E(RK) = 8.57% Rf= 5% K Risk-Averse Investor (steeper)

Long Risk-Free

Short Risk Free Standard Deviation (s )

s K = 8%

s US = 15.98% s L = 24%

Investment Opportunity Set (2 Risky Investments, 1 Risk-Free Investment)

Risk-Reduction: As the number of independent assets in a portfolio increases (even with lower returns and higher individual risk), the portfolios overall risk decreases (insurance assets). Diversification can eliminate idiosyncratic, variance, and/or company-specific risk. Separating Idiosyncratic Risk from Systematic Risk Total stock risk = idiosyncratic risk (diversified away/not compensated) + systematic risk (cannot be diversified away/compensated) Regression Analysis Ri = i + i R M + ei Market Index Return R M = i Ri Total Variance var(Ri ) = Deviations of individual assets from points on the regression line represent negative or positive idiosyncratic risk. ( 2 + e 2 )2 M i idiosyncratic (variance)risk systematic (covariance) risk f = risk-free
systematic risk
ve or ur st C ve e In enc r fe Optimum Portfolio f di In

nt ie fic Ef

o Fr

R1

i =

Cov (R M , R i ) 2 M

idiosyncratic risk

Tangency Portfolio Minimum Variance Portfolio

R2 Rf Risk-Free Standard Deviation (s )

Capital Asset Pricing Model (CAPM) All investors fall on the tangency portfolio (CAL) for ALL assets and, for the overall market portfolio, this CAL is the Capital Market Line (CML)
R = return i = investment/asset/security M = market t = time periods e = error

Security Market Line (SML) shows estimated excess return of an asset in relation to its beta () value when compared to market. Built from CAPM equation E(R i ) = R f + i [E(R M ) + errori R f ] >1
Total Risk in a security i 2 = Equilibrium risk premium = size of compensation for systematic risk. Goes up w/ market volatility and degree of risk aversion
systematic (market) risk idiosyncratic (variance)risk

E(R M ) = R f +

Sharpe Ratio

[E(RM )Rf]

Securitys sensitivity to market movements i =

Cov (R M , R i ) Var(R M )

Security Market Line (SML) Expected Return E(R) 0.30

0.25

0.20
Underpriced (a > 0 )

the

0.15
M

( 2 )2M i

e 2

0.10 Rf= 5% 0.05 -1< M < 1

Percentage of idiosyncratic risk diversified away in an asset by the market portfolio R = return i = investment/asset/security f = risk-free

M = market

i 2

0 0 0.5 1 M = 1 1.5

Beta Coefficient () 2

t = time periods

e = excess returns

A securitys alpha () is = E(R i ) R f i [E(R M ) R f ] CAPM predicts that all = 0. > 0, security is underpriced vs. CAPM, < 0, security is overpriced vs. CAPM Capital Budgeting with CAPM E(R i ) = R f + i [E(R M ) R f ] + errori = IRR plug into NPV equation.
C (1+IRR)1 C1

Given by following equation Re (t) = i + i Re (t) + errori M i

Security Capital Line (SCL) regression line representing the security's actual excess return on the actual market excess return.

t NPV = (1+IRR)t = C0 + t=1

(1+IRR)2

C2

3 + (1+IRR)3 + +

(1+IRR)t

Ct

=? If NPV < 0, do NOT accept the project