L ECTURE 1: I NTRODUCTION

FINE 441 – Winter 2013

Investment Management

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 M Y CONTACT INFO

Instructor: Prof. Sebastien Betermier

Office: 1010 Sherbrooke Suite 1610, Office F (not open to students)
Office for OH: Bronfman 548 (subject to change)
Email: [email protected]
Phone: (514) 398 3762
OH: Tues/Thurs 12-1PM

Secretary: Gina Ceolin

Office: TBD
Email: [email protected]
Phone: (514) 398 4000 ext 09662
OH: 9-11AM, 2:30-3:30PM

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 A BOUT ME

blabla Position tenure-track faculty in Finance

blab Education Ph.D. Finance Berkeley 2010
Research (2/3) portfolio choice, asset pricing, real estate
• how does housing affect our portfolio decisions?
• do we hedge our human capital risk? evidence from Sweden
• test asset pricing theories with unique micro-level survey data

Teaching (1/3) FINE 441 since Winter 2011

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 R EQUIRED MATERIAL

Textbook customized version of Bodie, Kane, Marcus, Perrakis, Ryan:

“Investments” 7th Can Ed (“BKMPR”)
• 30% cheaper, soft cover, b&w, w/o 5 chapters
• 3 copies of full version on reserve @ library
• feel free to buy the full version @ www.amazon.com
• can also rent a digital version online @ www.coursesmart.com
• if you get a previous edition, watch out for the homework

Extra online readings on MyCourses (academic & news)

• some optional, some required

Software MyCourses
Excel
Rotman Portfolio Manager (one per group)

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 C OURSE WEBPAGE : M Y C OURSES

• Syllabus + schedule
I schedule continuously updated, includes all due dates

• Lecture material (slides & spreadsheets)

• Additional readings & interesting stuff

• Discussion boards

• All the homework info

• Exam prep

• Grades

• Some material for tutorial sessions

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 A NNOUNCEMENTS : E MAIL

• Expect lots of emails throughout the semester

• Create a specialized folder in your mailbox to keep track of it

• You’re responsible for making sure that you get my emails

I shouldn’t come to your inbox as spam
I your inbox should never be full

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 T EACHING A SSISTANTS

Tutor: Dylan Kristofic & Kevin Coles

Email: [email protected] & [email protected]
OH: Mon 1-3PM, room TBD
Tutorials: Mon 5:30PM-7PM Bronfman 423 ← practice, excel, data search

If you have a question, follow these steps:

1. Check the syllabus

2. Attend tutorial sessions
2. Go to office hours
3. Email

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 YOUR FINAL GRADE

5% Syllabus test
10% Homework
30% Group projects
20% Midterm
35% Final
+/- Participation

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 S YLLABUS TEST (5%)

Purpose is to set clear expectations about the course

• some of you shouldn’t stay in this class → figure it out before it’s too late

Available for 2 weeks on MyCourses

• 30 questions regarding the course outline
• have a calculator
• one-time submission

Don’t submit it on time ⇒ get a zero

• even if you enroll at the last minute

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 H OMEWORK (10%)

Purpose is to reward continuous work

• you’ll learn much more from the class

5 sets of homework
• modified problems from textbook
• additional real-world problems (download data, Excel stuff)
• find news related to the class material

I’ll grade a random 2/6 questions for each hwk

• good (90%), ok/incomplete (70%), poor/very incomplete (50%), very poor (0%)
• should be a guaranteed A if you spend the time!
• each graded question worth 1% of your final grade ⇒ total 10%

2 weeks notice for each hwk ⇒ NO LATE HWK

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 G ROUP P ROJECTS (30%)

You have 2 weeks to form a group

• choose groups of 4 by Add/Drop deadline
• don’t rush; it’s an important decision
• all groups members MUST be from the same section

What if you don’t pick a group

• I’ll do the rest of the matching
• you run the risk of being matched with peers who didn’t bother to respond

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 G ROUP P ROJECTS , C ONT. (30%)

Project #1: Portfolio Design (20%)

• design an investment strategy for a specific profile who are entering retirement
• involves interviews, data analysis, implementation, excel work, executive report
• prize for the top teams

Project #2: Trading (10%)

• trade various option strategies on RPM
• involves trading implementation, quantitative analysis, executive report
• prize for the top teams

Looking for a free-ride?

• your grade will be adjusted accordingly

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 E XAMS (55%)

Midterm (20%)
• Friday, February 22, 3-5PM
• NO make-up exam. Can’t make it? Need valid reason → 55% final
• option to drop midterm (requires written notice before final) → 55% final

Final (35%)
• date TBD
• cumulative

F.A.Q.
• my objective: hard but fair
• regrades:
I must be submitted within the week after exams have been returned
I need written request explaining why
I entire exam will be re-graded

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 PARTICIPATION (+/-)

You’re in business school ⇒ expected to act professionally

Suppose your grade is borderline, e.g. between 69 and 71?

• participation will determine whether B- or B
• depends on level of integrity, professionalism, attendance, general participation...
• don’t ask me for your participation +/- in advance

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 I S THIS THE RIGHT COURSE FOR YOU ?

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 W HAT YOU SHOULD EXPECT

1. To learn what it takes to become a good portfolio manager

• learn to be comfortable making decisions in the face of uncertainty
• develop a method for thinking about IM
• develop critical and independent thinking

2. A hard, intense, and time-consuming course

• lots of concepts that are hard to connect (i.e. hard part isn’t the math)
• requires a lot of effort
• requires lots of independent thinking (i.e. this isn’t a course about just learning formulas!)
I e.g. hwk problems harder than those covered in class
I e.g. few guidelines for the group projects
• check out the reviews from last year at the end of the syllabus

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 W HO SHOULD TAKE THIS COURSE ?

The Sherlock should be taking this course

• wants to connect theory to applications & understand the context behind models
• doesn’t give up until he/she finally understands it

The Spoon-Feeder should not be taking this course

• wants to be told exactly what to do to get an A
• memorizes a formula, does not try to understand the reasons behind it

The Excuse-Maker should avoid this course at all costs

• thinks he/she can get out of any assignment/exam with a sob story
• feels that the Prof is out to serve him/her
• thinks his/her actions won’t have any consequences beyond this course

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 W HAT I EXPECT OUT OF YOU

To work hard
• try to figure it out on your own before going to see me or TAs

To ask whenever you have questions

• expect to be confused when you start a hwk, it’s normal
• plenty of time for each assignment

To know that I want you to succeed

• grading scheme designed to be fair and diversify some of the risk
• plenty of OH (extra before exams) & practice questions
• I’m investing a lot of energy to make sure you get something out of this course

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 W HAT I EXPECT OUT OF YOU, C ONT.

To have integrity – zero toleration for unethical and rude behavior

• cheating is theft to all those who work hard in the course
• I will make your life miserable if you cheat
• you’re likely to fail the class ⇒ huge consequences for your career

What do I mean by cheating?

• cheating on exams
• plagiarism on assignments
• making up fake info on projects
• coming up with a fake excuse to avoid an assignment
• etc...

Any excuse without formal documentation is irrelevant

• I’ve already heard everything
• I hate whining → will make your case worse

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 H OW YOU SHOULD STUDY FOR THIS COURSE
Look for the story-line in the slides
• does it make sense? identify which link is broken
• force yourself to re-teach the story-line to one of your classmates

Pay attention to the details

• a huge number of mistakes on exams comes from lack of attention on details
• rewrite each question in your own words to make sure you didn’t miss anything

Practice, practice, practice

• get an early start on the assignments (expect to be confused at first)
• lots of opportunities for help (OH, tutorials, tutors’ OH, etc...)

Use the book as a dictionary

• don’t go reading it from A to Z

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H OW YOU SHOULD STUDY FOR THIS COURSE , C ONT.

Don’t take the midterm for granted

• even if you don’t do well, you can drop it and figure out what to do differently on the final

Make the practice exams as real as possible

• have a timer, hide the solutions, hide your notes

Read the chapter before lecture, come to lecture

• sounds trivial but huge efficiency gains

Don’t look for help right away

• expect to be confused when you start the hwk
• figure out a way to solve things by yourself
• learning doesn’t happen in one go, it requires lots of introspection

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 C OURSE OVERVIEW

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 T HE PARABLE OF THE COCONUTS

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 I MAGINE A WORLD WHERE ....

Nothing but a huge ocean and 50 islands (one for each of you)

Each island has only one coconut tree

• only source of consumption
• future output is unknown and risky
• each tree has its own output stream

Life without a coconut exchange is stressful

• fully exposed to the risk of your tree

What if there was a coconut exchange?

• all of us could now share the risks
• what’s left: systematic risk (tsunami affecting all islands together)

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 W HAT SHOULD YOU DO ?

What is your optimal allocation of coconut trees?

This is THE question we’ll ask in this course

• it’s a major life question on how to plan your future!

It’s a very hard question to answer

• harder than standard tradeoff from microeconomics
• the nature of the coconut exchange adds another dimension to the problem

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 1. H ARDER THAN STANDARD MICRO PROBLEM

Standard micro FINE 441

vs. vs. vs.

Need to know: Need to know:

• preference for each good (easy) • preference for each good (hard)
• type of each good (easy) • type of each good (hard)
• price of each good (easy) • price of each good (hard)

Then do marginal rate of substitution = relative price

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 W HAT ’ S HARD ABOUT THIS DECISION ?
1. Hard to figure out why we really want
• how risk averse are we?
• how should we value consumption in 10 years relative to today?
• how willing are we to substitute consumption across time if prices change?

2. Hard to identify the types of trees

• they all have different levels of risk → i.e. different quality
• is this tree more like a Mercedes or a Honda Civic?

2. Hard to figure out the “right” price of coconut trees

• quoted prices are not enough, need to scale by their estimated future output
• i.e. am I get a 1% average return from this tree or a 10% return?

It’s like going to a foreign supermarket where we don’t know what we want, we don’t know where
to find the items, and when we find them we can’t read how much they cost!

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 2. T HE NATURE OF THE COCONUT EXCHANGE
ADDS A SECOND DIMENSION

Exchange, not supermarket

• think of a giant used cars dealership
• if you spot good bargains, you can try to re-sell them later at a higher price

So there are two types of coconut tree management

1. passive management
• take prices as given and do your shopping based on your specific risk profile

2. active management
• take advantage of mispriced coconut trees
• extreme case: arbitrage

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 BACK TO REALITY

What did we learn here?

Financial markets allow us to share the risks

• no longer tied to the risk of my own coconut tree
• efficient allocation of risk based on who is more or less risk averse

Investment management is hard

• requires introspection of how we want to plan our life
• requires good knowledge of the various opportunities
• → real value in thinking about these issues very carefully

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 BACK TO REALITY

What the parable didn’t tell us

We assumed that coconut trees were growing on their own

• in reality, we have some control over the production

Financial markets have other key features

• they can provide an efficient allocation of capital for corporations
• they provide a separation between ownership and management (good or bad?)

Some coconut trees might be difficult to trade

• e.g. high transaction costs, tax issues...

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 C ONCLUSION : WAS THAT A SILLY EXAMPLE ?

• Welcome to economics’ reductionist philosophy!

• Simple models help us to disentangle all the different effects in a structured way

• This is the method we’ll develop in this course

Make inferences

Real world Model

very complex

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 WARNING : M ODELS ARE JUST MODELS

At the end of the day...

Extremely easy to rely on formulas blindly

• in my opinion, a huge danger of the reductionist approach
• see Emmanuel Derman’s article on WebCT

Models are by definition simplifications of reality

• financial market dynamics are the outcomes of human behavior
• human behavior is extremely complex
• lots and lots of market frictions and agency issues

Take these models for what they’re worth

• have some perspective
• use your common sense and intuition

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 W HAT THIS COURSE HAS TO SAY
PART I: The Theory PART II: The Microscope
Assume abstract financial assets providing future cash flows Analyze 3 types of financial assets

Mean-
Additional
Variance
Objectives
Preferences

1. STOCKS
Behavioural A. Portfo-
Playing Field
Biases lio Theory

2. DERIVATIVES
Inefficiencies
CAPM

3. BONDS

C. Market
B. Asset Pricing Efficiency

Active
Tests of Management
the CAPM
APT

Extensions EMH
of the CAPM

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 S TRUCTURE OF THE COURSE

Meeting Intro Part I Part II

lecture 2 9 9
workshop project 1 2
discussion project 1 1
discussion project 2 1
review session 1 1

TOTAL 2 12 12

Total of 26 meetings (13 weeks) + MIDTERM + FINAL

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 PART I: T HE FRAMEWORK , SPLIT INTO 3 PILLARS

Pillar A: Portfolio Theory (LEC 3, 4, 5, 8, 11)

• begin with passive management: take prices as given and optimize
• set up the playing field (horizon, units...)
• start with simple investment objectives and then extend

Pillar B: Asset Pricing (LEC 6, 7, 8, 9)

• study the proper relation between risk and return
• useful for passive management: helps to estimate future expected returns
• also useful for active management: helps to assess whether an asset is fairly priced

Pillar C: Market Efficiency (LEC 10, 11)

• passive vs. active management?
• benefits of active management depend on how efficient markets are
• efficiency of markets depends on limits to arbitrage and irrational behavior

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 PART II: S TOCKS , DERIVATIVES , & BONDS
UNDER THE MICROSCOPE

1. Stocks (LEC 12)

• regular stocks

2. Derivatives (LEC 13, 14, 15, 16)

• mostly plain options (calls / puts)
• one lecture on futures, forwards, and swaps

3. Bonds (LEC 17, 18, 19, 20)

• mostly government bonds (“risk-free” cash flows)
• briefly discuss about corporate bonds & bonds with option features

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 O BJECTIVES OF PART II

Identify sources of risk

• in the context of the framework from Part I
• super useful for passive management
• e.g. bonds are especially sensitive to interest rate risk

Develop models to forecast returns

• super useful for active management
• e.g. methods to model the stocks’ future dividends, models of the yield curve

Develop specific strategies

• super useful for both passive and active management
• e.g. arbitrage in options and futures markets
• e.g. immunization, portfolio insurance...

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 N EXT C LASS

• Second introductory lecture: go over the anatomy of the financial markets

I BKMPR Chapter 3
I microstructure of the markets, types of trades...

• Read BKMPR Chapters 1, 2, 3

• Make sure to carefully read the syllabus ⇒ syllabus test

I know what to expect out of this course
I is this course really for you?

• Start thinking about your groups

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