ASSET CLASSES & FINANCIAL INSTRUMENTS

(1) Money Market (subset of debt)

- Treasury Bills (Sg: SGS Bills)
Usually with maturity < 52 weeks
Default risk is low ( 0)
No coupon payment
Not callable
Pricing
Priced according to 360 days/yr
Sold at discount to par
Buyer looks at ask price
Seller looks at bid price
Price =
where r =ask % (

)
Bond equivalent yield =

- LIBOR (Sg: SIBOR)
Average of interest rates that banks expect
to charge each other
Used as a basic reference rate
LIBOR as a financial barometer
- Optimistic lower LIBOR
- Pessimistic Higher LIBOR
Manipulation of LIBOR
Occurred during the FC 2008
To cover up the poor financial situation and
manipulate returns from contracts
referencing LIBOR
(2) Bond Market
- Private Issues: Corporate Bonds
- Govt Issues: Treasury Bonds/ TIPS (TIPS
not available in Sg)
TIPS have principal adjusted using CPI
inflation protected (real R/r)
How to read bond price
Smallest unit = 1/64
102:20 = 102+20/64
YTM , Coupon Rate and Price
YTM < Coupon Price > Par
YTM = Coupon Price = Par
Computing Inflation Using TIPS
Inflation = YTM (Treasury)-YTM (TIPS)
- Mortgage Backed Securities
A security with cash-flows backed by a
stream of mortgage payments.
(E.g. of securitization: Creating a new
security by pooling together loans)
Why investors like MBS
MBS diversifies risk as low risk mortgages
offset high risk ones so that
final portfolio lower risk
Why banks sell mortgages
Primary reason: free up capital
Why MBS led to FC 2008
Low quality (sub-prime) mortgages pooled
Default in selected pool of mortgages
(3) Stocks and Bond Indexes
Purpose of Index
Track Average returns
Compare performance of managers
Base of derivatives
Construction of Indexes
- Price Weighted Index (DJIA)
Buy one share of each stock
index value = (P1+P2+...+Pn)/n
In case of stock split:
Reconfigure denominator of last period
(P1+P2,new+...+Pn)/Index = Denominatornew
where P1 Pn: prices of previous period
Index: Index value of previous period
P2, new: value of stock after stock split
If 2 new for 1 old (2:1) value is 1/2
If 1 new for 2 old (1:2) value is 2x
- Market-Value Weighted (S&P/NASDAQ)
100
) Q (P ... ) Q (P ) Q (P
) Q (P ... ) Q (P ) Q (P
indexV
n n 2 2 1 1
n n 2 2 1 1

+ + +
+ + +
=

Q= quantity held
Numerator: t=1
Denominator: t=0
- Equally weighted
Invest the same amount in each
100
) Q (P ... ) Q (P ) Q (P
) Q (P ... ) Q (P ) Q (P
indexE
n n 2 2 1 1
n n 2 2 1 1

+ + +
+ + +
=

Q= Amt invested in each/price
Numerator: t=1
Denominator: t=0
SECURITIES MARKET
(1)Types of Orders
- Market: execute immediately at best price
- Limit: Buy or sell at specific price or better
- Stop Loss: becomes a market sell order
when the trigger price is encountered
- Stop Buy: becomes a market buy order
when the trigger price is encountered
(2) Trading Costs
- Commission fee paid to broker
- Bid-Ask spread
(3) Margin Trading
Borrowing money to purchase stock.
Interest will be paid on the loan.
Buy on margin to magnify gains/reduce risks
- Initial Margin Requirement: Minimum %
of initial investor equity (IMR)
- Investor equity = Position value
borrowed money + additional cash (e.g.
dividends)
- Maintenance Margin Requirement:
Minimum % of equity before additional
funds needed (MMR)
- Margin call occurs if

- Margin call occur when

- Price = MV/No. of shares held
- Return on Investment



(4) Short Sales
1. Borrow stock from a broker/dealer
2. Broker sells sock and deposits proceeds
and margin into account (can't withdraw)
3. Buy back a stock to return broker later
Liable for any cashflows (e.g. dividends)
Required to post margin above proceeds
pledged to broker (i.e. proceeds: 6k, pledge:
50%, Total Margin Account: 9K)
Usually used in bearish markets
- Short sale equity = TMA MV
- Margin call occurs if
- Margin call occurs when

- Price = MV/No. of shares held
- Rate of Return on Investment




MUTUAL FUNDS & OTHER INVESTMENT
(1) Mutual Funds
Mutual Funds are priced at the end of the
day (Exception: ETF traded on stock
exchange)
Active Funds: Tries to beat the market
Passive Funds: Mimics a benchmark
(2) Investment Companies provide:
- Administration & record keeping
- Diversification & divisibility
- Professional management
- Reduced transaction costs
Disadvantage of Active Mutual Funds
- Management Fees
- Take time to learn ability of manager
- Only one price per day
(3) Net Asset Value (NAV) Price per share



(4) Costs of Investing in Mutual Funds
- Operating Expenses
- Front End Load (as % of Offering Price)
- Back End Load
- 12b-1 Charges (Only in US)
Calculating offering price with FEL
Offering Price = NAV/(1-Front End Load)
(5) Mutual Fund R/r

(6) Comparing impact on performance

(7) Mutual Fund Investment Performance
Evidence shows that average mutual fund
performance < broad market
- mostly due to fees which magnify losses
Evidence that performance is consistent
from one period to the next is suggestive but
inconclusive.
- unlikely for top performance to persist
- tendency of poor performance to persist
RISK AND RETURN
(1) Rates of Return over Multiple Periods
- Arithmetic Average Return (AAR)

Investors will never achieve AAR
Used in estimates (looks higher)
- Geometric Average Return (GAR)

Better reflection of investors' true return
Reflects effects of compounding
- Dollar Weighted Return
Find the internal rate of return for the cash
flows (i.e. Use CF to find IRR)
(2) Risk and Risk Premiums

Normal distribution:

(3) Equity Risk Premium
Extra return for investing in equity because
of volatility and risk aversion

(4) Inflation premium

(5) Allocating Risky and Risk Free

y=weight in risky portfolio,

= 0

Beyond y=1: leverage at risk-free rate
(6) Risk Aversion and Allocation
High risk aversion lower y

for a given portfolio Q

Risk Aversion of investing fully in mkt 2.5

EFFICIENT DIVERSIFICATION
(1) Diversification and Portfolio Risk
Diversification reduces Firm-Specific (Unique
/Idiosyncratic) Risk
Remaining is Systematic/Market Risk

(2) Asset Allocation with 2 Risky Assets

= +1.0 perfectly positively correlated
= -1.0 perfectly negatively correlated
- Benefits of Diversification decrease as
correlation between assets increase
(3) Asset Allocation (Many Risky Assets)

= =
=
Q
1 I
Q
1 J
J I J I
2
p
)] r , Cov(r W [W

As more assets are included the efficient
frontier shifts to the North-West
- Efficient Frontier (EF) is the set of
portfolios that has highest return for a
given level of risk
Assuming no risk-free assets, all investors
should want a portfolio on the EF
- Minimum variance: turning point
(4) Optimal Risky Portfolio with Risk-Free
Capital Market Line (CML)
Tangent to EF with Rf as y-intercept
Optimal CAL as it has highest Sharpe Ratio
Any combination on CML > returns on EF
- Adjust between tangency portfolio and
risk-free asset according to aversion
(5) Single-Index Asset Market

- i= sensitivity to market return
- i= Risk-adjusted excess returns
- i = idiosyncratic risk

: systematic risk
-

: idiosyncratic risk
Estimating idiosyncratic risk with SCL
- Compute epsilon of each plotted point
from SCL and compute variance of
epsilon
CAPM AND APT
(1) Capital Asset Pricing Model
Assumptions of the Model
- Individual Investors are "Price Taker"
- No taxes and no transaction cost
- People only care about mean and variance
of returns
- Homogeneous expectations
- Perfect information on means and variance
of returns
Implication of CAPM
- All investors will hold a combination of the
Market Portfolio and risk-free
o CML formed tangent to M
- Average investor has y=1 on CML
- Market: highest Sharpe Ratio
o Consists of all assets in universe
o Market-value weighted
o Optimal risky portfolio
Expected Return & Risk (Individual)
Investors only hold M, look at only
- Do not care about , no firm-specific

In equilibrium,
SML:

)
Disequilibrium of SML: would exist

)
- +ve undervalued/-ve overvalued
(2) Evaluating the CAPM
Other factors such as firm size, B/M ratio can
be better predictors
- Validity of CAPM assumptions
- Untestable since true market portfolio can
never be observed (Roll Critique)
(3) Multifactor Models and CAPM
Multi-factor models used when returns
respond to > 1 systematic factors.
Farma-French 3 Factor Model
Firm size and B/M ratio incorporated
Higher B/M Higher risk (default)
Smaller firms Higher risk (liquidity)

(4) Arbitrage Pricing Theory
Exploiting mispricing of two or more securities
to achieve risk-free profits.
Assumptions
Well diversified portfolio so there s no
unsystematic risk
No arbitrage opportunities in an efficient
market
Implication
Alpha of well-diversified portfolio = 0

APT vs. CAPM
APT applies to well-diversified only
APT has less restrictive assumptions
APT assumes one or more sources of
systematic risk (CAPM only market)
Arbitrage: 1 systematic factor
1. Set weight of greatest asset (A)=1
a. If not given use ratio of RP to
2. Adjust weight of other asset such that p=0
(

)
3. Borrow risk-free so total weight = 0
Return per $1 invested in A:

Equilibrium in the APT
If any of the 3 conditions hold, no arbitrage
opportunities exist
1.

2.

3.

for any other well diversified portfolio
Arbitrage: 2 systematic factors
1. Set portfolio weight as 1
2. Weight of systematic factors =
3. Borrow risk-free so total weight = 0
EFFICIENT MARKET HYPOTHESIS
(1) Random Walk and EMH
EMH proposes that prices accurately reflect
all available information.
If markets are efficient, investors cannot
construct trading strategies that earn, on
average, a risk-adjusted positive profit.
- Weak form: Prices reflect info in historical
price data and other trading data
- Semi-strong form: Prices reflect all
publicly available information.
- Strong form: Prices reflect all information;
both public and private/inside information
Random Walk: The idea that stock price
changes are random and unpredictable
- If market efficient changes in price has
to be due to new info about the firm
- News unpredictable returns random
(2) Implications of EMH (Security Analysis)
- Technical Analysis: uses prices and volume
information to predict
o Violation of all forms
- Fundamental Analysis: Identify over/
under valued securities using firm's AR
o Violates strong/semi-strong form
- Passive vs Active Management
o Active: assumes inefficiency use TA/FA
o Passive: consistent with semi-strong
efficiency no point picking "winners"
(3) Are markets efficient?
Empirical Tests
- Testing trading rules
- Event Studies: Examine how quickly info is
integrated into prices
- Assessing performance of fund managers
Patterns in stock returns
- Short term returns: serial correlation
o Momentum effect EMH does not hold
- Long term reversal effects EMH holds
Abnormal Returns (excess returns i)
If EMH holds, returns spike immediately at
announcement; no momentum effect
Problems with these Empirical Tests
Selective bias: only know strategies that fail
Lucky Event Issue
Possible Model Misspecification
(4) Mutual Fund and Analyst Performance
Mean mutual fund return statistically = 0

PORTFOLIO EVALUATION
(1) Evaluating a Single Fund
Evaluation with a risk model
Single index model:

Jensen :

if Jensen > 0, fund is good :)
(2) Factors causing Abnormal Performance
1. Allocation across broad asset class
2. Allocation within asset class (industry)
3. Individual security selection (stocks)
(3) Decomposing Performance
Comparing against a "bogey" portfolio
Excess return of managed portfolio
= return of manage return of bogey
1. Contribution of asset allocation (1)
Sum of: (Weight in managed weight in
bogey)*bogey returns
2. Contribution of selection (2) + (3)
Sum of: (Return in managed Return in
index)*weight in managed
3.Contribution of security selection (3)
Total equity selection derived from step 2
Security =total equity-sector allocation
(Note: 1 contribution basis point = 1/100 %)
(4) Evaluation of Complete Portfolios
Entire Wealth Portfolio (M
2
)

Rp*: complete portfolio consisting actively
managed and risk-free with same risk as M
Creating P*:
Weight in Managed fund =

Fund of Funds Treynor Ratio:

Better than sharpe ratio as effect of residual
risk can be ignored
Portfolio added to benchmark
Information Ratio:

: of difference between portfolio and

benchmark returns

BOND PRICES AND YIELDS
(1) Bond Characteristics
- Fixed income/debt securities: claim on a
specified periodic stream of income
- Face or par value or principal value
- Maturity date
- Coupon rate: Variable/Fixed/Zero
(2) Bond Price of Bond
- Annual Coupon
N
N
1 T
T
YTM) (1
Par
) (1
$C
P
+
+
)
`

+
=

= YTM

- Semi-annual Coupon
2N
2N
1 T
T
r) (1
Par
r) (1
$C
P
+
+
)
`

+
=

=

- Bond Pricing Between Coupon Date
Invoice Price = Flat Price + Accrued Interest
Accrued Interest




* if semi annual bond annual coupon/2
(3) Alternative Measures of Yield
- Current Yield: Annual coupon/Price
- Yield to Call: Call price replaces par, call
date replaces maturity
- Holding Period Yield: Use actual re-
investment rate instead of YTM
(3) Relationship between Price and Yield
Prices and yields have an inverse relationship
- High yield Price low
- Relationship not linear (due to convexity)
(4) Types of Risk
Reinvestment Risk: interest rate falls such
that investors are unable to reinvest
coupons earned at promised YTM
Default Risk: risk that company defaults on
bond payments
- Can be negated by Credit Default Swap
Insurance policy on default risk of bond
(Price approximates yield differences
between different rated bonds)
(5) Bond Price Over Time
- Premium BondCoupon>YTMPrice>Par
- Discount BondCoupon<YTMPrice<Par
(6) Term Structure of Interest Rates
- Long term rates are functions of expected
future short term rates
- Liquidity preference results in upward bias
over expectations long-term rate
includes liquidity risk premium
- Forward rates implied in yield curves

EQUITY VALUATION
(1) Intrinsic Value
Intrinsic Value (V0): PV of firm's future net
cash flows discounted by required R/r
- If intrinsic value > market price buy
(2) Dividend Discount Models
- Zero growth (e.g. Preferred Stock)

, k = required rate of return

- Constant growth model

, g=growth rate
Stocks under zero growth model and
constant growth model will have the R/r
- But constant growth will have higher
valuation because of expectation of
collecting higher future dividends
(3) P/E and Growth Opportunities

Where b = plowback ratio (if g=0, b=0)

Value of growth opportunities = V0 with
growth opportunities V0 with zero growth
(4) P/E and Risk
Riskier firms have higher k lower P/E
(5)Pitfalls in using P/E Ratios
- Hard to estimate future earnings
- High P/E implies high expected growth but
not necessarily high stock return
- Simplistic assumption that P/E only rise
- Better estimate: PEG Ratio Ratio of P/E
to growth in dividends should 1
MANAGING BOND PORTFOLIOS
(1) Interest Rate Sensitivity
- Long-term bonds are more price sensitive
than short-term bonds
- Sensitivity of bond prices to changes in i/r
increases at a decreasing rate as maturity
increase
- Bond price sensitivity is inversely related
to coupon amount
- Sensitivity of bond price to change in i/r is
inversely related to its current YTM
- Increase in bond's YTM results in smaller
price decline than the gain associated with
a decrease in yield
(2) Duration effective maturity of bond

- Duration increases with maturity
- Higher coupon lower duration
- Duration is shorter at higher i/r
- Duration is shorter than maturity for all
bonds except zero coupon bonds
- Duration=maturity for 0 coupon bonds
Duration for fixed coupon to perpetuity

Price change is proportional to duration

Modified Duration (D*)


(2) Interest Rate Risk
Interest Rate Risk is the possibility that an
investor does not earn the promised YTM
because of changes in i/r
(A) Price Risk: in i/r bond price cannot
sell at expected price
(B) Reinvestment Risk: in i/r future value
of reinvested coupon will not be able to
reinvest coupons at promised i/r
- Both types of risks are potentially
offsetting if i/r , sales price but
reinvestment income
(3) Convexity
Duration asserts that price change is linearly
related to change in bond yield
- Underestimates in price when i/r
- Overestimates in price when i/r
Prediction model including convexity

Pricing error if ignore convexity

Due to convexity,
- Price is more sensitive to in i/r
- Price is less sensitive to in i/r

OPTION MARKETS
(1) Option Contracts
- Call Option option to buy a fixed quantity
of an asset by a fixed date for a fixed price
- Put Option option to sell a fixed quantity
of an asset by a fixed date for a fixed price
(2) Option Payoffs
Payoff of CALL BUYER: Max(ST-X, 0)
Payoff of CALL SELLER: -Max(ST-X, 0)
Payoff of PUT BUYER: Max(X-ST, 0)
Payoff of PUT SELLER: -Max(X-ST, 0)
(3) Option Strategies
- Protective Put: Long Stock and Long Put
Strategy to limit risk of owning stock
- Covered Call: Long Stock and Short Call
Limit losses in writing a call option
- Straddle: Long Call and Long Put with same
exercise price and expiration date
Expect volatile prices in both direction
ST X ST X
Protective Put X S
T

Covered Call ST X
Straddle X-ST ST-X
- Bullish Spread: Long call at X1, Short Call at
X2 OR Long put at X1, Short Put at X2
ST X1 X1 ST X2 ST X2
X ST-X1 X2-X1
- Collar: Long asset, Long Put option at X1
and Short Call option at X2
Limit downside losses and upside gain

OPTION VALUATION
(1) Intrinsic Value of an Option
- Call Option/Put Option: Max(S0 X,0)
- Time Value of Option: Difference between
option's price and intrinsic value
o Measures probability that option will be
in-the-money
o Time Value is highest when option is at-
the-money (will never be negative)
- Determinants of Call Options Values
o Stock Price Value of Call Option
o Exercise Price Value of Call Option
o Volatility Value of Call Option
o Time to expiration Value of Call Option
o Interest Rate Value of Call Option
o Dividend Payout Value of Call Option
(2) Binomial model
- Value of Call Option: Long H shares of Stock,
Short 1 Call Option (Find H such that
portfolio is riskless same amt in the future)

When returns of an option and stock are
modelled in a two-state binomial option
model, H is the ratio of the range of option
outcomes to the range of stock outcomes

(3) Black-Scholes Option Pricing Formula

: Dividend Payout r: Risk-free : Implied vol
T: Number of days to maturity/365
- Implied volatility std deviation of stock
returns consistent with option's MV
o What market expects volatility to be
(4) Put-Call Parity
- Payoff of long call + short put = buying stock
using loan of face value X
- If there is no arbitrage opportunities,

If the PV of the two strategies are not equal
- short more expensive portfolio
- long cheaper portfolio

FUTURES MARKETS
(1) Futures and Forwards
- Futures: Agreements to deliver (or take
delivery) of a fixed quantity of an asset at a
fixed date in the future for a fixed price
- Spot market market where the actual
asset is trading for immediate delivery
Long Futures Short Futures
PT-F0 F0-PT
(2) Futures Contracts
Both sides to a future contracts are required
to post margin with exchange clearinghouse
- Balance in margin account is adjusted to
reflect daily settlement
- Cash flow in buyer margin acc =

- Cash flow in seller margin acc =

Futures exhibit the property of convergence
because price discrepancies would open
arbitrage opportunities for investors
- Hedging using futures to manage risks
(removes all excess loss and gains)
o Protect against increase: long asset and
futures (when you want to buy asset)
o Protect against decline: short asset and
futures (when you want to sell asset)
(3) Basis Risk
Risk of unpredictable changes in basis
- Basis=Futures Price- Cash price
o Basis=0 at maturity
Hedgers bears risk if futures contract and
asset are liquidated before maturity but risk
still smaller than un-hedged position.
(4) Spots-Future Parity
- Payoff of long asset for 1 yr = investing S0 in
risk-free and long 1 unit of futures for 1 yr

(5) Pricing Futures Contract
Futures price= Spot Price x (1+ cost of carry)
Net Cost of Carry =