Escolar Documentos
Profissional Documentos
Cultura Documentos
Aneel Keswani
COURSE OBJECTIVES
Course provides an overview of various
financial instruments and the marketplaces in
which they are traded and a detailed analysis of
stock, bond and derivative valuation.
Alternative pricing models and their
limitations, the tradeoffs between risk and
return will be analysed.
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CONTACTING ME:
a. Texts:
Investments, Bodie, Kane, and Marcus, 6th Edition,
Irwin/McGraw-Hill.
b.Additional Reading Material
i. Reading Pack available from undergraduate office.
ii. Any additional material will be distributed to you
before you require it.
c. Calculator:
A scientific calculator is required. Your calculator
must be able to calculate exponential functions and
natural log functions.
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Outline of Lecture 1
Real versus Financial investments
The players in the financial markets
The taxonomy of markets
Calculating returns
Realised versus expected returns
Real versus nominal rates of return
Arithmetic versus geometric returns
Returns on indices
Historical evidence on risk and return
characteristics of stocks & bonds
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Real Investment
Inputs
Capital Income
Labour Companies &
Final goods
Land Wealth
Raw materials
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Financial assets allow us to make the most of
the real assets in the economy by allowing:
1. Efficient risk allocation:
A diversity of financial assets means that
investors can self-select the securities with
the risk-return that suits them
The risk inherent in all investments is borne
by investors most willing to bear risk
Good for firms: means that each security
can be sold for the best possible price
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Financial assets allow us to make the most of
the real assets in the economy by allowing:
2. Separation of management and ownership
If a firm was managed and owned by the
same person, then if he chooses to sell it
affects the management of the firm
However if a firm is owned by shareholders
and run by managers, then shareholders can
sell without any impact on the management
of the firm
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Summary: Real vs Financial
1. Real assets are income generating. Financial
assets are claims on the income of real assets.
Financial assets define the allocation of
income or wealth among investors.
2. Financial Assets contribute to social welfare
by allowing:
Efficient risk allocation
Allow separation of ownership & management of
companies
Consumption Smoothing
The Players
Households
Non financial business sector
Financial intermediaries
Government sector
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Households
Households choose how much to consume and
how much to save.
Not interested in their consumption vs saving
decision. Our concern is with which assets
households wish to hold
What determines which financial assets
households want? Many things. Including:
Differences in risk tolerance-create demand for
assets with different risk-return combinations
Tax situation-High tax bracket investors seek tax
free investments.
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Financial Innovation
Development of new financial assets driven
by needs of people to protect themselves
against a variety of risks
E.g. Consider person from New York who
wishes to retire to Florida in 15 years.
Exposed to risk that relates to the relative price
of New York vs Florida housing
Florida real estate investment trusts (REITs)
developed as a result. They increase in value
when house prices in Florida increase
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Non-Financial Business sector
Financial Intermediaries
The financial problem facing households is
how to invest their funds
Difficult for a small investor to advertise
and say that they have funds available to
lend to companies
Financial intermediaries e.g. banks,
investment companies, pension funds, act to
bring the business sector and households
together
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The Matching Problem
HH 1 Project 1
Different Different
HH 2 Financial Project 2
wealth risks
HH 3 Intermediaries Project 3
and and
HH 4 Project 4
preferences sizes
HH 5 Project 5
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Government sector
Governments have existing stock of debt
(national debt) and also incur new debts each
year if expenditure exceeds tax receipts
Can use borrowing in financial markets to pay
debts
Raise money in financial markets
Cant sell shares in themselves
Borrow money via various types of debt market
securities that pay a pre-determined set of cash flows
Regulate financial markets
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Taxonomy of Markets
Debt Markets
US Treasury Bills, Notes, Bonds
UK Government Gilts
Corporate bonds
Equity Markets
Derivative Securities
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Debt Markets
Companies and governments can raise money by
selling debt or bond securities
The issuer sells the security to a buyer today
For the security, the issuer receives money today
The issuer is borrowing money from the buyer
Thus we can call the buyer the lender & the issuer the
borrower
The issuer will promise to repay the lender
either in one go in the future or will pay a sequence of
interest payments & then will repay the outstanding loan
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Debt vs Loans
Sells Debt Loan
Borrower Lender
Initially Borrower Lender
= =
Issuer Buyer
Pays for
debt security
interest interest
Time
interest interest
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Debt Markets
Size of cashflows paid on debt securities is
predetermined at the time of issue
Either fixed in advance in cash terms (10 per year)
Or determined as a function of a reference interest-rate
(market interest rate + premium)
Issuer or borrower can choose to default or not
default. Cant determine size of repayment
If required to pay 10 issuer cant decide to pay only 5
Market enhanced by fact that debt can be sold on by
initial buyer: sold on at price that reflects market
conditions at time of sale
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US Treasury market
The United States Treasury regularly issues
debt securities with maturities ranging from
a few days to 30 years
Such securities are known as Treasury
securities
These are regarded by the investment
community as risk free
This is because US government stands ready to
pay the necessary obligations to any investor
who buys the securities
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US Treasury market
Securities issued by the Treasury with the maturity of
less than or equal to one year at the time of issue are
called Treasury bills or T-Bills
such securities do not pay any coupons and may be purchased
at a discount to their face value
Treasury securities that pay coupons and have maturities
in the range of 1 to 10 years at the time of issuance are
called Treasury notes
Treasury securities that have maturities in excess of 10
years are called Treasury bonds .
Maturities of Treasury bonds generally extend to 30
years. The 30 year T-Bond is known as the Long Bond
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UK Government Gilts
Gilt edged stock or gilts are British government
debt securities
Standard gilts carry fixed, annual coupons and pay
the face amount at maturity
In addition to the standard gilts, the British
government issues:
Index-linked gilts: coupon and face amounts
indexed to the UK retail price index
Perpetuals: Perpetuals have no maturity date:
just pay coupons
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Corporate bonds
The main risk of investing in corporate bonds
is that the issuer may choose to default on the
bonds
This risk is known as default or credit risk
As a result if we were to compare a corporate
bond with identical cashflows to a US Treasury
bond, the corporate bond would trade at a
lower price reflecting these additional risks
Equity Securities
Represent shares in companies.
Most shares can be traded on stock exchanges
An investor earns money from equity
securities through
Dividends: Paid regularly: size at discretion of
company issuing shares
Capital gains-increase in price of the share
between buying and selling
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Two most important features of equity are:
Residual claim:
Shareholders are last in line of all of those who
have a claim on the company-if a firm goes
bankrupt then shareholders have a claim after tax
authorities, suppliers, bondholders have been paid
Limited Liability
Shareholders own part of the firms they invest in.
Thus shareholders are like owners
BUT shares are limited liability which means that
the most that can be lost by shareholders is the
value of the security: cant take their house
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Derivative Securities
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Derivative Securities
Options: Give the holder the right to buy or
sell an asset for a price called the strike or
exercise on or before the maturity date
A put option gives the option holder the
right to sell the asset at the strike
A call option gives the option holder the
right to buy the asset at the strike
Note: options do not have to be exercised
Derivative Securities
Futures
Buyer of future agrees to buy the underlying
at a fixed future date at an agreed upon price.
Seller of future agrees to sell the underlying at
a fixed future date at an agreed upon price.
Holder is obliged to buy/sell at the agreed
upon price.
He does not have the option to back out.
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The Form of Returns
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Calculating Realised Returns
Return on a security between date (t-1) and date (t) is
the sum of the change in value between the two dates
and any additional income earned between (t-1) and
(t) divided by the initial price
Pt Pt 1 + I t
Rt =
Pt 1
Rt=rate of return between t-1 and t
Pt = price of asset at t
It=income of asset between t-1 and t
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Calculating Expected Returns
E (r ) = s
p (s)r (s)
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Example expected returns:
Expected return?
= (0.25 x 44%)+(0.5 x 14% )+ (0.25 x-16%)
=11+7-4=14%
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Inflation Adjusted Rates of Return
Inflation causes investors to lose purchasing
power when they wish to sell their financial
assets to buy goods and services.
The consumer price index (CPI) measures
the cost of living and is useful for
determining the inflation rate.
The change in the CPI over a given time
period represents the percentage change in
the price of a specified basket of goods
during this time period.
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Inflation Adjusted Rates of Return
Inflation reduces the purchasing power of
an investment
e.g. You earn 10% on an investment project
and inflation is more than 10% over same
period. Your purchasing power has dropped.
To include inflation in our calculations we
must determine the real rate of return.
The real rate of return is the nominal rate of
return (what we have been calculating so
far) adjusted for inflation.
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Averages of returns:
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Geometric Average
What we have solved for is the geometric
average return
The general formula for the geometric
average return is the following:
(1 + rG ) = [(1 + r1 ) (1 + r2 ) ...(1 + rN )]
1
N
rG = [(1 + r1 ) (1 + r2 ) ...(1 + rN ) ] 1
1
N
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Arithmetic versus Geometric
Consider a stock that will either double in value
with Probability 0.5 (return =100%) or halve in
value with Probability 0.5 (return=-50%)
If we get these returns over 2 years, stock ends up
where it started
Geometric? [(1+1)(1-0.5)]1/2-1=0 rG=0%
Suppose that the stocks performance over a 2
year period is characteristic of the probability
distribution. Can calculate expected returns.
Expected returns in this case are (100-50)/2=25%
which is the size of the arithmetic average return
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Stock Indices
When we have a collection of securities, & we are
interested in measuring returns an index is often used.
Stock market indices provide guidance as to the
performance of the overall stock market.
In the UK the most commonly referred to stock index
is the FTSE-100
In the USA the most commonly reported indices are
the Dow Jones Industrial Average, Standard & Poors
Composite 500 (S&P 500), New York Stock
Exchange (NYSE) composite, National association of
securities dealers automatic quotations (NASDAQ)
service composite
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Equally Weighted Returns
Initial Final Shares Initial Value Final value
Stock Price Price (Million) outstanding stock outstanding stock
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Value Weighted Returns
Initial Final Shares Initial Value Final value
Stock Price Price (Million) outstanding stock outstanding stock
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Long and Short Positions
Definition: Long and short positions
A long position is one where you make
money when the price increases and a short
one is where you make money when the
price decreases.
Examples: Actual Position Description
You will receive a Ferrari today Long a Ferrari
You owe your friend a gold ring Short Gold
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Risk & Return Characteristics of Stocks
and Bonds
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Inflation was a major force in the 20th century
1 in 1900 had the same purchasing power as
54 today.
UK inflation averaged 4.1 per cent per annum
over the 20th century.
If you had invested 1 in 1900, your
purchasing power would have grown by
315 times in equities
3.5 times in bonds
2.6 times in bills (see figure 1 of Dimson article)
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Equities had highest risk
Although equities gave highest return in
each country, returns from shares far more
volatile than bonds
Volatility (standard deviation) of UK real
equity returns in the 20th century 20 per
cent per annum.
Although bonds had lower return had lower
risk in UK: 14.6% standard deviation for
govt bonds and 6.6% for govt bills
Bond Performance
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Summary
Financial versus real investments
The players in the financial markets
The taxonomy of markets
Calculating Returns
Realised versus expected returns
Real versus nominal rates of return
Arithmetic versus geometric returns
Returns on indices
Historical evidence on risk and return
characteristics of stocks & bonds
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