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You are on page 1of 66

2790092

2009

Undergraduate study in

Economics, Management,

Finance and the Social Sciences

This guide was prepared for the University of London External System by:

Dr Pascal Frantz, Lecturer in Accountancy and Finance, The London School of Economics and

Political Science

and

R. Payne, former Lecturer in Finance, The London School of Economics and Political Science.

This is one of a series of subject guides published by the University. We regret that due to

pressure of work the authors are unable to enter into any correspondence relating to, or aris-

ing from, the guide. If you have any comments on this subject guide, favourable or unfavour-

able, please use the form at the back of this guide.

This subject guide is for the use of University of London External students registered for

programmes in the fields of Economics, Management, Finance and the Social Sciences (as

applicable). The programmes currently available in these subject areas are:

Access route

Diploma in Economics

Diploma in Social Sciences

Diplomas for Graduates

BSc Accounting and Finance

BSc Accounting with Law/Law with Accounting

BSc Banking and Finance

BSc Business

BSc Development and Economics

BSc Economics

BSc Economics and Finance

BSc Economics and Management

BSc Geography and Environment

BSc Information Systems and Management

BSc International Relations

BSc Management

BSc Management with Law/Law with Management

BSc Mathematics and Economics

BSc Politics

BSc Politics and International Relations

BSc Sociology

BSc Sociology with Law.

Publications Office

University of London

Stewart House

32 Russell Square

London WC1B 5DN

United Kingdom

Web site: www.londonexternal.ac.uk

© University of London 2009

Printed by: Central Printing Service, University of London, England

Contents

Contents

Introduction to the subject guide .......................................................................... 1

Aims of the unit............................................................................................................. 1

Learning objectives ........................................................................................................ 1

Syllabus......................................................................................................................... 2

Essential reading ........................................................................................................... 2

Further reading.............................................................................................................. 3

Subject guide structure and use ..................................................................................... 5

Examination structure .................................................................................................... 5

Glossary of abbreviations used in this subject guide ....................................................... 6

Chapter 1: Present-value calculations and the valuation of

physical investment projects .................................................................................. 7

Aim of the chapter......................................................................................................... 7

Learning objectives ........................................................................................................ 7

Essential reading ........................................................................................................... 7

Further reading.............................................................................................................. 7

Overview ....................................................................................................................... 7

Introduction .................................................................................................................. 8

Fisher separation and optimal decision-making .............................................................. 8

Fisher separation and project evaluation ...................................................................... 11

The time value of money .............................................................................................. 12

The net present-value rule............................................................................................ 13

Other project appraisal techniques ............................................................................... 15

Using present-value techniques to value stocks and bonds ........................................... 18

A reminder of your learning outcomes.......................................................................... 19

Key terms .................................................................................................................... 20

Sample examination questions ..................................................................................... 20

Chapter 2: Risk and return: mean–variance analysis and the CAPM.................... 21

Aim of the chapter....................................................................................................... 21

Learning objectives ...................................................................................................... 21

Essential reading ......................................................................................................... 21

Further reading............................................................................................................ 21

Introduction ................................................................................................................ 21

Statistical characteristics of portfolios ........................................................................... 22

Diversification.............................................................................................................. 24

Mean–variance analysis ............................................................................................... 25

The capital asset pricing model .................................................................................... 30

The Roll critique and empirical tests of the CAPM......................................................... 33

A reminder of your learning outcomes.......................................................................... 34

Key terms .................................................................................................................... 34

Sample examination questions ..................................................................................... 35

Solutions to activities ................................................................................................... 35

Chapter 3: The arbitrage pricing theory ............................................................... 37

Aim of the chapter....................................................................................................... 37

Learning objectives ...................................................................................................... 37

Essential reading ......................................................................................................... 37

Further reading............................................................................................................ 37

Overview ..................................................................................................................... 37

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92 Corporate finance

Introduction ................................................................................................................ 37

Single-factor models .................................................................................................... 38

Multi-factor models ..................................................................................................... 40

Broad-based portfolios and idiosyncratic returns........................................................... 41

Factor-replicating portfolios ......................................................................................... 41

The arbitrage pricing theory ......................................................................................... 42

Summary ..................................................................................................................... 43

A reminder of your learning outcomes.......................................................................... 44

Key terms .................................................................................................................... 44

Chapter 4: Derivative assets: properties and pricing ........................................... 45

Aim of the chapter....................................................................................................... 45

Learning objectives ...................................................................................................... 45

Essential reading ......................................................................................................... 45

Further reading............................................................................................................ 45

Overview ..................................................................................................................... 45

Varieties of derivatives ................................................................................................. 45

Derivative asset pay-off profiles ................................................................................... 47

Pricing forward contracts ............................................................................................. 49

Binomial option pricing setting .................................................................................... 50

Bounds on option prices and exercise strategies ........................................................... 53

Black–Scholes option pricing ....................................................................................... 55

Put–call parity ............................................................................................................. 56

Pricing interest rate swaps ........................................................................................... 58

Summary ..................................................................................................................... 58

A reminder of your learning outcomes.......................................................................... 58

Key terms .................................................................................................................... 59

Sample examination questions ..................................................................................... 59

Chapter 5: Efficient markets: theory and empirical evidence .............................. 61

Aim of the chapter....................................................................................................... 61

Learning objectives ...................................................................................................... 61

Essential reading ......................................................................................................... 61

Further reading............................................................................................................ 61

Overview ..................................................................................................................... 62

Varieties of efficiency ................................................................................................... 62

Risk adjustments and the joint hypothesis problem ...................................................... 63

Weak-form efficiency: implications and tests ................................................................ 64

Weak-form efficiency: empirical results......................................................................... 66

Semi-strong-form efficiency: event studies .................................................................... 69

Semi-strong-form efficiency: empirical evidence ............................................................ 71

Strong-form efficiency.................................................................................................. 71

Summary ..................................................................................................................... 71

A reminder of your learning outcomes.......................................................................... 72

Key terms .................................................................................................................... 72

Sample examination questions ..................................................................................... 72

Chapter 6: The choice of corporate capital structure ........................................... 73

Aim of the chapter....................................................................................................... 73

Learning objectives ...................................................................................................... 73

Essential reading ......................................................................................................... 73

Further reading............................................................................................................ 73

Overview ..................................................................................................................... 73

ii

Contents

The Modigliani–Miller theorem .................................................................................... 75

Modigliani–Miller and Black–Scholes ........................................................................... 77

Modigliani–Miller and corporate taxation..................................................................... 77

Modigliani–Miller with corporate and personal taxation ............................................... 79

Summary ..................................................................................................................... 81

A reminder of your learning outcomes.......................................................................... 81

Key terms .................................................................................................................... 81

Sample examination questions ..................................................................................... 81

Chapter 7: Asymmetric information, agency costs and

capital structure ................................................................................................... 83

Aim of the chapter....................................................................................................... 83

Learning objectives ...................................................................................................... 83

Essential reading ......................................................................................................... 83

Further reading............................................................................................................ 83

Overview ..................................................................................................................... 84

Capital structure, governance problems and agency costs ............................................. 84

Agency costs of outside equity and debt ...................................................................... 84

Agency costs of free cash flows.................................................................................... 87

Firm value and asymmetric information ........................................................................ 88

Summary ..................................................................................................................... 92

Key terms .................................................................................................................... 92

A reminder of your learning outcomes.......................................................................... 93

Sample examination questions ..................................................................................... 93

Chapter 8: Dividend policy ................................................................................... 95

Aim of the chapter....................................................................................................... 95

Learning objectives ...................................................................................................... 95

Essential reading ......................................................................................................... 95

Further reading............................................................................................................ 95

Overview ..................................................................................................................... 96

Modigliani–Miller meets dividends ............................................................................... 96

Prices, dividends and share repurchases ....................................................................... 97

Dividend policy: stylised facts ....................................................................................... 97

Taxation and clientele theory ....................................................................................... 99

Asymmetric information and dividends ....................................................................... 100

Agency costs and dividends ....................................................................................... 101

Summary ................................................................................................................... 101

A reminder of your learning outcomes........................................................................ 102

Key terms .................................................................................................................. 102

Sample examination questions ................................................................................... 102

Chapter 9: Mergers and takeovers ..................................................................... 103

Aim of the chapter..................................................................................................... 103

Learning objectives .................................................................................................... 103

Essential reading ....................................................................................................... 103

Further reading.......................................................................................................... 103

Overview ................................................................................................................... 104

Merger motivations ................................................................................................... 104

A numerical takeover example ................................................................................... 105

The market for corporate control ................................................................................ 106

The impossibility of efficient takeovers ....................................................................... 106

iii

92 Corporate finance

Empirical evidence ..................................................................................................... 109

Summary ................................................................................................................... 110

A reminder of your learning outcomes........................................................................ 111

Key terms .................................................................................................................. 111

Sample examination questions ................................................................................... 112

Appendix 1: Perpetuities and annuities.................................................................... 113

Perpetuities ............................................................................................................... 113

Annuities .................................................................................................................. 114

Appendix 2: Sample examination paper .................................................................. 115

iv

Introduction to the subject guide

This subject guide provides you with an introduction to the modern theory

of finance. As such, it covers a broad range of topics and aims to give a

general background to any student who wishes to do further academic or

practical work in finance or accounting after graduation.

The subject matter of the guide can be broken into two main areas.

1. The first section of material covers the valuation and pricing of real

and financial assets. This provides you with the methodologies you will

need to fairly assess the desirability of investment in physical capital,

and price spot and derivative assets. We employ a number of tools

in this analysis. The coverage of the risk-return trade-off in financial

assets and mean–variance optimisation will require you to apply some

basic statistical theory alongside the standard optimisation techniques

taught in basic economics courses. Another important part of this

section will be the use of absence-of-arbitrage techniques to price

financial assets.

2. In the second section, we will examine issues that come under the

broad heading of corporate finance. Here we will examine the key

decisions made by firms, how they affect firm value and empirical

evidence on these issues. The areas involved include the capital

structure decision, dividend policy, and mergers and acquisitions.

By studying these areas, you should gain an appreciation of optimal

financial policy on a firm level, conditions under which an optimal

policy actually exists and how the actual financial decisions of firms

may be explained in theoretical terms.

This unit is aimed at students interested in understanding asset pricing

and corporate finance. It provides a theoretical framework used to

address issues in project appraisal and financing, the pricing of risk,

securities valuation, market efficiency, capital structure and mergers and

acquisitions. It provides students with the tools required for further studies

in financial intermediation and investments.

Learning objectives

At the end of this unit, and having completed the essential reading and

activities, you should be able to:

explain how to value projects, and use the key capital budgeting

techniques (NPV and IRR)

understand the mathematics of portfolios and how risk affects the

value of the asset in equilibrium under the fundaments asset pricing

paradigms (CAPM and APT)

explain the characteristics of derivative assets (forwards, futures

and options), and how to use the main pricing techniques (binomial

methods in derivatives pricing and the Black–Scholes analysis)

discuss the theoretical framework of informational efficiency in

financial markets and evaluate the related empirical evidence

understand and explain the capital structure theory, and how

information asymmetries affect it

1

92 Corporate finance

understand and explain the relevance, facts and role of the dividend

policy

understand how corporate governance can contribute to firm value

discuss why merger and acquisition activities exist, and calculate the

related gains and losses.

Syllabus

Note: There has been a minor revision to this syllabus in 2009.

Students may bring into the examination hall their own hand-held

electronic calculator. If calculators are used they must satisfy the

requirements listed in paragraphs 10.5 to 10.7 of the General Regulations.

If you are taking this unit as part of a BSc degree, units which must be

passed before this unit may be attempted are 02 Introduction to

economics and either 05a Mathematics 1 or 05b Mathematics 2.

This unit may not be taken with unit 59 Financial management.

Project evaluation: Hirschleifer analysis and Fisher separation; the NPV rule

and IRR rules of investment appraisal; comparison of NPV and IRR; ‘wrong’

investment appraisal rules: payback and accounting rate of return.

Risk and return – the CAPM and APT: the mathematics of portfolios; mean-

variance analysis; two-fund separation and the CAPM; Roll’s critique of the

CAPM; factor models; the arbitrage pricing theory.

Derivative assets – characteristics and pricing: definitions: forwards and futures;

replication, arbitrage and pricing; a general approach to derivative pricing

using binomial methods; options: characteristics and types; bounding and

linking option prices; the Black–Scholes analysis.

Efficient markets – theory and empirical evidence: underpinning and definitions

of market efficiency; weak-form tests: return predictability; the joint

hypothesis problem; semi-strong form tests: the event study methodology

and examples; strong form tests: tests for private information.

Capital structure: the Modigliani–Miller theorem: capital structure irrelevancy;

taxation, bankruptcy costs and capital structure; the Miller equilibrium;

asymmetric information: 1) the under-investment problem, asymmetric

information; 2) the risk-shifting problem, asymmetric information; 3) free

cash-flow arguments; 4) the pecking order theory; 5) debt overhang.

Dividend theory: the Modigliani–Miller and dividend irrelevancy; Lintner’s

fact about dividend policy; dividends, taxes and clienteles; asymmetric

information and signalling through dividend policy.

Corporate governance: separation of ownership and control; management

incentives; management shareholdings and firm value; corporate

governance.

Mergers and acquisitions: motivations for merger activity; calculating the gains

and losses from merger/takeover; the free-rider problem and takeover

activity.

Essential reading

There are a number of excellent textbooks that cover this area. However,

the following text has been chosen as the core text for this unit due to

its extensive treatment of many of the issues covered and up-to-date

discussions:

Grinblatt, M. and S. Titman Financial Markets and Corporate Strategy. (Boston,

Mass.; London: McGraw-Hill, 2002) second edition

[ISBN 9780072294330].

At the start of each chapter of this guide, we will indicate the reading that

you need to do from Grinblatt and Titman (2002).

2

Introduction to the subject guide

Further reading

As further material, we will also direct you to the relevant chapters in

two other texts. You may wish to look at the following two texts that are

standard for many undergraduate finance courses:

Brealey, R., S. Myers and F. Allen Principles of Corporate Finance. (Boston,

Mass., London: McGraw-Hill, 2008) ninth international edition [ISBN

9780071266758].

Copeland, T., J. Weston and K. Shastri Financial Theory and Corporate Policy.

(Reading, Mass.; Wokingham: Addison-Wesley, 2005) fourth edition

[ISBN 9780321223531].

help you read extensively, all External System students have free access

to the University of London Online Library where you will find either the

full text or an abstract of many of the journal articles listed in this subject

guide. You will need to have a username and password to access this

resource and this is the same one you are sent for accessing the University

of London Student Portal where you can also find the Online library

website at http://my.londonexternal.ac.uk

presented here for ease of reference.

Journal articles

Asquith, P. and D. Mullins ‘The impact of initiating dividend payments on

shareholders’ wealth’, Journal of Business 56(1) 1983, pp.77–96.

Ball, R. and P. Brown ‘An empirical evaluation of accounting income numbers’,

Journal of Accounting Research 6(2) 1968, pp.159–78.

Blume, M., J. Crockett and I. Friend ‘Stock Ownership in the United States:

Characteristics and Trends’, Survey of Current Business 54(11) 1974,

pp.16–40.

Bradley, M., A. Desai and E. Kim ‘Synergistic Gains from Corporate Acquisitions

and Their Division Between the Stockholders of Target and Acquiring

Firms’, Journal of Financial Economics 21(1) 1988, pp.3–40.

Brock, W., J. Lakonishok and B. LeBaron ‘Simple technical trading rules and

stochastic properties of stock returns’, Journal of Finance 47(5) 1992,

pp.1731–764.

DeBondt, W. and R. Thaler ‘Does the stock market overreact?’, Journal of

Finance 40(3) 1984, pp.793–805.

Fama, E. ‘The behavior of stock market prices’, Journal of Business 38(1) 1965,

pp.34–105.

Fama, E. ‘Efficient capital markets: a review of theory and empirical work’,

Journal of Finance 25(2) 1970, pp.383–417.

Fama, E. ‘Efficient capital markets: II’, Journal of Finance 46(5) 1991,

pp.1575–617.

Fama, E. and K. French ‘Dividend yields and expected stock returns’, Journal of

Financial Economics 22(1) 1988, pp.3–25.

French, K. ‘Stock returns and the weekend effect’, Journal of Financial

Economics 8(1) 1980, pp.55–70.

Fama, E. and K. French ‘The cross-section of expected stock returns’, Journal of

Finance 47(2) 1992, pp.427–65.

Grossman, S. and O. Hart ‘Takeover Bids, the Free-Rider Problem and the

Theory of the Corporation’, Bell Journal of Economics 11(1) 1980, pp.42–64.

Healy, P. and K. Palepu ‘Earnings Information Conveyed by Dividend Initiations

and Omissions’, Journal of Financial Economics 21(2) 1988, pp.149–76.

Healy, P., K. Palepu and R. Ruback ‘Does Corporate Performance Improve after

Mergers?’, Journal of Financial Economics 31(2) 1992, pp.135–76.

3

92 Corporate finance

Evidence from Three Decades’, Financial Management 18(3) 1989,

pp.12–19.

Jarrell, G., J. Brickley and J. Netter ‘The Market for Corporate Control: The

Empirical Evidence since 1980’, Journal of Economic Perspectives 2(1) 1988,

pp.49–68.

Jensen, M. ‘Some anomalous evidence regarding market efficiency’, Journal of

Financial Economics 6(2–3) 1978, pp.95–101.

Jensen, M. ‘Agency costs of Free Cash Flow, Corporate Finance, and Takeovers’,

American Economic Review 76(2) 1986, pp.323–29.

Jensen, M. and R. Ruback ‘The Market for Corporate Control: The Scientific

Evidence’, Journal of Financial Economics 11(1–4) 1983, pp.5–50.

Jensen, M. and W. Meckling ‘Theory of the firm: managerial behaviour, agency

costs and capital structure’, Journal of Financial Economics 3(4) 1976,

pp.305–60.

Jensen, M. and W. Meckling ‘Theory of the Firm: Managerial Behaviour, Agency

Costs and Capital Structure’, Journal of Financial Economics 3(4) 1976,

pp.305–60.

Lakonishok, J., A. Shleifer and R. Vishny ‘Contrarian investment, extrapolation,

and risk’, Journal of Finance 49(5) 1994, pp.1541–578.

Levich, R. and L. Thomas ‘The significance of technical trading-rule profits in

the foreign exchange market: a bootstrap approach’, Journal of International

Money and Finance 12(5) 1993, pp.451–74.

Lintner, J. ‘Distribution of Incomes of Corporations among Dividends, Retained

Earnings and Taxes’ American Economic Review 46(2) 1956, pp.97–113.

Lo, A. and C. McKinlay ‘Stock market prices do not follow random walks:

evidence from a simple specification test’, Review of Financial Studies 1(1)

1988, pp.41–66.

Masulis, R. ‘The impact of capital structure change on firm value: some

estimates’, Journal of Finance 38(1) 1983, pp.107–26.

Miller, M. ‘Debt and taxes’, Journal of Finance 32, 1977, pp. 261–75.

Myers, S. ‘Determinants of corporate borrowing’, Journal of Financial Economics

5(2) 1977, pp.147–75.

Myers, S. and N. Majluf ‘Corporate financing and investment decisions when

firms have information that investors do not have’, Journal of Financial

Economics 13(2) 1984, pp.187–221.

Poterba, J. and L. Summers ‘Mean reversion in stock prices: evidence and

implications’, Journal of Financial Economics 22(1) 1988, pp.27–59.

Roll, R. ‘A Critique of the Asset Pricing Theory’s Texts. Part 1: On Past and

Potential Testability of the Theory’, Journal of Financial Economics 4(2)

1977, pp.129–76.

Ross, S. ‘The Determination of Financial Structure: The Incentive Signalling

Approach’, Bell Journal of Economics 8(1) 1977, pp.23–40.

Shleifer, A. and R. Vishny ‘Large Shareholders and Corporate Control,’

Journal of Political Economy 94(3) 1986, pp.461–88.

Travlos, N. ‘Corporate Takeover Bids, Methods of Payment, and Bidding Firms’

Stock Returns’, Journal of Finance 42(4) 1990, pp.943–63.

Warner, J. ‘Bankruptcy Costs: Some Evidence’, Journal of Finance 32(2) 1977,

pp.337–47.

Books

Allen, F. and R. Michaely ‘Dividend Policy’ in Jarrow, Maksimovic and Ziemba

(eds) Handbook of Finance. (Elsevier Science, 1995). [No ISBN available].

Haugen, R. and J. Lakonishok The incredible January effect. (Homewood, Ill.:

Dow Jones-Irwin, 1988) [ISBN 9781556230424].

Ravenscraft, D. and F. Scherer Mergers, Selloffs, and Economic Efficiency.

(Washington D.C.: Brookings Institution, 1987) [ISBN 9780815773481].

4

Introduction to the subject guide

You should note that, as indicated above, the study of the relevant chapter

should be complemented by at least the essential reading given at the

chapter head.

The content of the subject guide is as follows.

Chapter 1: here we focus on the evaluation of real investment

projects using the net present-value technique and provide a

comparison of NPV with alternative forms of project evaluation.

Chapter 2: we look at the basics of risk and return of primitive

financial assets and mean–variance optimisation. We go on to derive

and discuss the capital asset pricing model (CAPM).

Chapter 3: we present the arbitrage pricing theory, proposed as an

alternative to the CAPM for the calculation of expected returns on

financial assets.

Chapter 4: here we look at derivative assets. We begin with the

nature of forward, future, option and swap contracts, then move on to

pricing derivative assets via absence-of-arbitrage arguments. We also

include a description of binomial option pricing models and end with

the Black–Scholes analysis.

Chapter 5: in this chapter, we examine the efficiency of financial

markets. We present the concepts underlying market efficiency and

discuss the empirical evidence on efficient markets.

Chapter 6: here we turn to corporate finance issues, treating the decision

over a corporation’s capital structure. The essential issue is what levels of

debt and equity finance should be chosen in order to maximise firm value.

Chapter 7: we look at more advanced issues in capital structure

theory and focus on the use of capital structure to mitigate governance

problems known as agency costs and how capital structure and

financial decisions are affected by asymmetric information.

Chapter 8: here we examine dividend policy. What is the empirical

evidence on the dividend pay-out behaviour of firms, and theoretically,

how can we understand the empirical facts?

Chapter 9: we look at mergers and acquisitions, and ask what

motivates firms to merge or acquire, what are the potential gains from

this activity, and how can this be theoretically treated? We also explore

how hostile acquisitions may serve as a discipline device to mitigate

governance problems.

There is no specific chapter about corporate governance, but the

agency related topics of Chapters 7 and 9 are inherently motivated by

the existence of such problems. See also Grinblatt and Titman (2002)

Chapter 18 for a broad overview on governance-related issues.

Examination structure

Important: the information and advice given in the following section

are based on the examination structure used at the time this guide

was written. Please note that subject guides may be used for several

years. Because of this, we strongly advise you to always check both the

current Regulations for relevant information about the examination, and

the current Examiners’ commentaries where you should be advised of

any forthcoming changes. You should also carefully check the rubric/

instructions on the paper you actually sit and follow those instructions.

5

92 Corporate finance

You will have to answer four out of a choice of eight questions. Although

the Examiner will attempt to provide a fairly balanced coverage of the

unit, there is no guarantee that all of the topics covered in this guide

will appear in the examination. Examination questions may contain both

numerical and discursive elements. Finally, each question will carry equal

weight in marking and, in allocating your examination time, you should

pay attention to the breakdown of marks associated with the different

parts of each question.

APT arbitrage pricing theory

ARR accounting rate of return

B–S Black–Scholes

CAPM capital asset pricing model

CML capital market line

EMH efficient markets hypothesis

IRR internal rate of return

M&A mergers and acquisitions

M–M Modigliani–Miller

NPV net present value

OTC over the counter

RWM random walk model

SML security market line

6

Chapter 1: Present-value calculations and the valuation of physical investment projects

and the valuation of physical investment

projects

The aim of this chapter is to introduce the Fisher separation theorem,

which is the basis for using the net present value (NPV) for project

evaluation purposes. With this aim in mind, we discuss the optimality

of the NPV criterion and compare this criterion with alternative project

evaluation criteria.

Learning objectives

At the end of this chapter, and having completed the essential reading and

activities, you should be able to:

analyse optimal physical and financial investment in perfect capital

markets and derive the Fisher separation result

justify the use of the NPV rules via Fisher separation

compute present and future values of cash-flow streams and appraise

projects using the NPV rule

evaluate the NPV rule in relation to other commonly used evaluation

criteria

value stocks and bonds via NPV.

Essential reading

Grinblatt, M. and S. Titman Financial Markets and Corporate Strategy. (Boston,

Mass.; London: McGraw-Hill, 2002) Chapter 10.

Further reading

Brealey, R., S. Myers and F. Allen Principles of Corporate Finance. (Boston,

Mass.; London: McGraw-Hill, 2008) Chapters 2, 3, 5, 6 and 7.

Copeland, T. and J. Weston Financial Theory and Corporate Policy. (Reading,

Mass.; Wokingham: Addison-Wesley, 2005) Chapters 1 and 2.

Roll, R. ‘A Critique of the Asset Pricing Theory’s Texts. Part 1: On Past and

Potential Testability of the Theory’, Journal of Financial Economics 4(2)

1977, pp.129–76.

Overview

In this chapter we present the basics of the present-value methodology

for the valuation of investment projects. The chapter develops the net

present-value (NPV) technique before presenting a comparison with the

other project evaluation criteria that are common in practice. We will also

discuss the optimality of NPV and give a number of extensive examples.

7

92 Corporate finance

Introduction

Let us begin by defining how we are going to think about a firm in this

chapter. For the purposes of this chapter, we will consider a firm to be a

package of investment projects. The key question, therefore, is how do the

firm’s shareholders or managers decide on which investment projects to

undertake and which to discard? Developing the tools that should be used

for project evaluation is the emphasis of this chapter.

It may seem, at this point, that our definition of the firm is rather limited.

It is clear that, in only examining the investment operations of the firm,

we are ignoring a number of potentially important firm characteristics.

In particular, we have made no reference to the financial structure or

decisions of the firm (i.e. its capital structure, borrowing or lending

activities, or dividend policy). The first part of this chapter presents what

is known as the Fisher separation theorem. What follows is a statement

of the theorem. This theorem allows us to say the following: under

certain conditions (which will be presented in the following section), the

shareholders can delegate to the management the task of choosing which

projects to undertake (i.e. determining the optimal package of investment

projects), whereas they themselves determine the optimal financial

decisions. Hence, the theory implies that the investment and financing

choices can be completely disconnected from each other and justifies our

limited definition of the firm for the time being.

Consider the following scenario. A firm exists for two periods

(imaginatively named period 0 and period 1). The firm has current funds

of m and, without any investment, will receive no money in period 1.

Investments can be of two forms. The firm can invest in a number of

physical investment projects, each of which costs a certain amount of cash

in period 0 and delivers a known return in period 1. The second type of

investment is financial in nature and permits the firm to borrow or lend

unlimited amounts at rate of interest r. Finally the firm is assumed to have

a standard utility function in its period 0 and period 1 consumption. (By

consumption we mean the use of any funds available to the firm net of any

costs of investment.)

Let us first examine the set of physical investments available. The firm

will logically rank these investments in terms of their return, and this will

yield a production opportunity frontier that looks as given in Figure 1.1

(and is labelled POF). This curve represents one manner in which the firm

can transform its current funds into future income, where c0 is period 0

consumption, and c1 is period 1 consumption. Using the assumed utility

function for the firm, we can also plot an indifference map on the same

diagram to find the optimal physical investment plan of a given firm. The

optimal investment policies of two different firms are shown in Figure 1.1.

It is clear from Figure 1.1 that the specifics of the utility function of

the firm will impact upon the firm’s physical investment policy. The

implication of this is that the shareholders of a firm (i.e. those whose

utility function matters in forming optimal investment policy) must dictate

to the managers of the firm the point to which it invests. However, until

now we have ignored the fact that the firm has an alternative method for

investment (i.e. using the capital market).

8

Chapter 1: Present-value calculations and the valuation of physical investment projects

Figure 1.1

The financial investment allows firms to borrow or lend unlimited

amounts at rate r. Assuming that the firm undertakes no physical

investment, we can define the firm’s consumption opportunities quite

easily. Assume the firm neither borrows nor lends. This implies that

current consumption (c0) must be identically m, whereas period 1

consumption (c1) is zero. Alternatively the firm could lend all of its funds.

This leads to c0 being zero and c1 = (1 + r) m. The relationship between

period 0 and period 1 consumption is therefore given as below:

c1 = (1 + r)(m – c0 ). (1.1)

This implies that the curve which represents capital market investments is

a straight line with slope –(1+r). This curve is labeled CML on Figure 1.2.

Again, we have on Figure 1.2 plotted the optimal financial investments for

two different sets of preferences (assuming that no physical investment is

undertaken).

Figure 1.2

Now we can proceed to analyse optimal decision-making when firms

invest in both financial and physical assets. Assume the firm is at the

beginning of period 0 and trying to decide on its investment plan. It is

clear that, to maximise firm value, the projects undertaken should be those

9

92 Corporate finance

with the greatest return. Knowing that the return on financial investment

is always (1+r), the firm will first invest in all physical investment

projects with returns greater than (1+r ). These are those projects on the

production possibility frontier (PPF) between points m and I on Figure

1.3.1 Projects above I on the PPF have returns that are dominated by the 1

The absolute value of

return from financial investment. the slope of the PPF can

be equated with the

Hence the firm physically invests up to point I. Note that, at this point, return on physical

we have not mentioned the firm’s preferences over period 0 and period investment. For all points

1 consumption. Hence, the decision to physically invest to I will be taken below I on the PPF, this

by all firms regardless of the preferences of their owners. Preferences slope exceeds that of

the capital market line

come into play when we consider what financial investments should be

CPFJGPEGFGƂPGUVJG

undertaken. set of desirable physical

The firm’s physical investment policy takes it to point I, from where it can investment projects.

borrow or lend on the capital market. Borrowing will move the firm to

the south-east along a line starting at I and with slope –(1+r); lending will

take the firm north-west along a similarly sloped line. Two possible optima

are shown on Figure 1.3. The optimum at point X is that for a firm whose

owners prefer period 1 consumption relative to period 0 consumption (and

have hence lent on the capital market), whereas a firm locating at Y has

borrowed, as its owners prefer date 0 to date 1 consumption.

Figure 1.3 demonstrates the key insight of Fisher separation. All firms,

regardless of preferences, will have the same optimal physical investment

policy, investing to the point where the PPF and capital market line are

tangent. Preferences then dictate the firm’s borrowing or lending policy

and shift the optimum along the capital market line. The implication of

this is that, as it is physical investment that alters firm value, all agents

(i.e. regardless of preferences) agree on the physical investment policy that

will maximise firm value. More specifically, the shareholders of the firm

can delegate choice of investment policy to a manager whose preferences

may differ from their own, while controlling financial investment policy in

order to suit their preferences.

Figure 1.3

10

Chapter 1: Present-value calculations and the valuation of physical investment projects

Fisher separation can also be used to justify a certain method of project

appraisal. Figure 1.3 shows a sub-optimal physical investment decision (I’)

and the capital market line that borrowing and lending from point I’ would

trace out. Clearly this capital market line always lies below that achieved

through the optimal physical investment policy. Hence, one could say that

optimal physical investment should maximise the horizontal intercept of

the capital market line on which the firm ends up. Let us, then, assume a

firm that decides to invest a dollar amount of I0. Given that the firm has

date 0 income of m and no date 1 income, aside from that accruing from

physical investment, the horizontal intercept of the capital market line

upon which the firm has located is:

∏(I0)

m – I0 +

1+ r

where Ȇ(I0) is the date 1 income from the firm’s physical investment.

Maximising this is equivalent to the following maximisation problem:

∏(I0)

max – I0.

I0 1+ r

The prior objective is the net present-value rule for project appraisal. It

says that an optimal physical investment policy maximises the difference

between investment proceeds divided by one plus the interest rate and the

investment cost. Here, the term ‘optimal’ is being defined as that which leads

to maximisation of shareholder utility. We will discuss the NPV rule more

fully (and for cases involving more than one time period) later in this chapter.

The assumption of perfect capital markets is vital for our Fisher separation

results to hold. We have assumed that borrowing and lending occur at the

same rate and are unrestricted in amount and that there are no transaction

costs associated with the use of the capital market. However, in practical

situations, these conditions are unlikely to be met. A particular example is

given in Figure 1.4. Here we have assumed that the rate at which borrowing

occurs is greater than the rate of interest paid on lending (as the real world

would dictate). Figure 1.3 shows that there are now two points at which the

capital market lines and the production opportunities frontier are tangential.

This then implies that agents with different preferences will choose differing

physical investment decisions and, therefore, Fisher separation breaks down.

Figure 1.4

11

92 Corporate finance

invest to point X and then financially invest to an optimum on the

capital market lending line (CML). Those with strong preferences for

current consumption physically invest to point Y and borrow (along

CML’). Finally, a set of agents may exist who value current and future

consumption similarly, and these will optimise by locating directly on the

PPF and not using the capital market at all. An example of an optimum of

this type is point Z on Figure 1.4.

In the preceding section we demonstrated the Fisher separation theorem

and the manner in which physical and financial investment decisions can

be disconnected. The major implication of this theorem is that the set of

desirable physical investment projects does not depend on the preferences

of individuals. In the following sections we shall focus on the way in

which individual physical investment projects should be evaluated. Our

key methodology for this will be the NPV rule, mentioned in the preceding

section. In the following sections we will show you how to apply the rule

to situations involving more than one period and with time-varying cash

flows.

To begin, let us consider a straightforward question. Is $1 received today

worth the same as $1 received in one year’s time? A naïve response to

this question would assert that $1 is $1 regardless of when it is received,

and hence the answer to the question would be yes. A more careful

consideration of the question brings the opposite response however. Let’s

assume I receive $1 now. If I also assume that there is a risk-free asset in

which I can invest my dollar (e.g. a bank account), then in one year’s time

I will receive $(1+r), assuming I invest. Here, r is the rate of return on the

safe investment. Hence $1 received today is worth $(1+r) in one year. The

answer to the question is therefore no. A dollar received today is worth

more than a dollar received in one year or at any time in the future.

The above argument characterises the time value of money. Funds are

more valuable the earlier they are received. In the previous paragraph we

illustrated this by calculating the future value of $1. We can similarly

illustrate the time value of money by using present values. Assume I

am to receive $1 in one year’s time and further assume that the borrowing

and lending rate is r. How much is this dollar worth in today’s terms?

To answer this second question, put yourself in the position of a bank.

Knowing that someone is certain to receive $1 in one year, what is the

maximum amount you would lend him or her now? If I, as a bank, were to

lend someone money for one year, at the end of the year I would require

repayment of the loan plus interest (at rate r). Hence if I loaned the

individual $x I would require a repayment of $x(1+r). This implies that the

maximum amount I should be willing to lend is implicitly defined by the

following equation:

$x(1 + r) = $1 (1.2)

such that:

1 .

x =$ (1.3)

1+ r

The value for x defined in equation 1.3 is the present value of $1

received in one year’s time. This quantity is also termed the discounted

value of the $1.

12

Chapter 1: Present-value calculations and the valuation of physical investment projects

You can see the present and future value concepts pictured in Figure 1.2.

If you recall, Figure 1.2 just plots the CML for a given level of initial funds

(m) assuming no funds are to be received in the future. The future value

of this amount of money is simply the vertical intercept of the CML (i.e.

m(1+r)), and obviously the present value of m(1+r) is just m.

The present and future value concepts are straightforwardly extended

to cover more than one period. Assume an annual compound interest rate

of r. The present value of $100 to be received in k year’s time is:

(1 + r) K

whereas the future value of $100 received today and evaluated k years

hence is:

Activity

Below, there are a few applications of the present and future value concepts. You should

attempt to verify that you can replicate the calculations given below.

Assume a compound borrowing and lending rate of 10 per cent annually.

a. The present value of $2,000 to be received in three years time is $1,502.63.

b. The present value of $500 to be received in five years time is $310.46.

c. The future value of $6,000 evaluated four years hence is $8,784.60.

d. The future value of $250 evaluated 10 years hence is $648.44.

In the previous section we demonstrated that the value of funds depends

critically on the time those funds are received. If received immediately,

cash is more valuable than if it is to be received in the future.

The net present-value rule was introduced in simple form in the section

on Fisher separation. In its more general form, it uses the discounting

techniques provided in the previous section in order to generate a

method of evaluating investment projects. Consider a hypothetical

physical investment project, which has an immediate cost of I. The project

generates cash flows to the firm in each of the next k years, equal to Ck.

In words, all that the NPV rule does is to compute the present value of all

receipts or payments. This allows direct comparisons of monetary values,

as all are evaluated at the same point in time. The NPV of the project is

then just the sum of the present values of receipts, less the sum of the

present values of the payments.

Using the notation given above and again assuming a rate of return of r,

the NPV can be written as:

k Ci

NPV = ∑ − I. (1.6)

(

i =1 1 + r

)i

Note that the cash flows to the project can be positive and negative,

implying that the notation employed is flexible enough to embody both

cash inflows and outflows after initiation.

13

92 Corporate finance

Once we have calculated the NPV, what should we do? Clearly, if the NPV

is positive, it implies that the present value of receipts exceeds the present

value of payments. Hence, the project generates revenues that outweigh its

costs and should therefore be accepted. If the NPV is negative the project

should be rejected, and if it is zero the firm will be indifferent between

accepting and rejecting the project.

This gives a very straightforward method for project evaluation. Compute

the NPV of the project (which is a simple calculation), and if it is greater

than zero, the project is acceptable.

Example

Consider a manufacturing firm, which is contemplating the purchase of a new piece of

plant. The rate of interest relevant to the firm is 10 per cent. The purchase price is £1,000.

If purchased, the machine will last for three years and in each year generate extra revenue

equivalent to £750. The resale value of the machine at the end of its lifetime is zero. The

NPV of this project is:

(1.1)3 (1.1)2 (1.1)1

activities by calculating the NPV of each project and assessing its desirability.

Activity

Assume an interest rate of 5 per cent. Compute the NPV of each of the following projects,

and state whether each project should be accepted or not.

Project A has an immediate cost of $5,000, generates $1,000 for each of the next

six years and zero thereafter.

Project B costs £1,000 immediately, generates cash flows of £600 in year 1,

£300 in year 2 and £300 in year 3.

Project C costs ¥10,000 and generates ¥6,000 in year 1. Over the following years,

the cash flows decline by ¥2,000 each year, until the cash flow reaches zero.

Project D costs £1,500 immediately. In year 1 it generates £1,000. In year 2 there

is a further cost of £2,000. In years 3, 4 and 5 the project generates revenues of

£1,500 per annum.

assuming that our funds were enough to cover the costs involved. What

happens, first of all, if the members of a set of projects are mutually

exclusive?2 The answer is simple. Pick the project that has the greatest NPV. 2

By this we mean that

Second, what should we do if we have limited funds? It may be the case taking on any one of the

set of projects precludes

that we are faced with a pool of projects, all of which have positive NPVs,

us from accepting any of

but we only have access to an amount of money that is less than the total the others.

investment cost of the entire project pool. Here we can rely on another

nice feature of the NPV technique. NPVs are additive across projects (i.e.

the NPV of taking on projects A and B is identical to the NPV of A plus the

NPV of B). The reason for this should be obvious from the manner in which

NPVs are calculated. Hence, in this scenario, we should calculate all project

combinations that are feasible (i.e. the total investment in these projects

can be financed with our current funds). Then calculate the NPV of each

combination by summing the NPVs of its constituents, and finally choose

the combination that yields the greatest total NPV.

14

Chapter 1: Present-value calculations and the valuation of physical investment projects

have used to discount future cash flows. Until now we have just referred

to r as the rate at which one can borrow or lend funds. A more precise

definition of r is that r is the opportunity cost of capital. If we are

considering the use of the NPV rule within the context of a firm, we have

to recognise that the firm has several sources of capital, and the cost of

each of these should be taken into account when evaluating the firm’s

overall cost of capital. The firm can raise funds via equity issues and

debt issues, and it is likely that the costs of these two types of funds will

differ. Later on in this chapter and in those that follow, we will present

techniques by which the firm can compute the overall cost of capital for its

enterprise.

The NPV methodology for project appraisal is by no means the only

technique used by firms to decide on their physical investment policy. It is

however the optimal technique for corporate management to use if they

wish to maximise expected shareholder wealth. This result is obvious from

our Fisher separation analysis. In this section we talk about a couple of

NPV’s competitors, the payback and internal rate of return (IRR)

rules, which are sometimes used in practice.

Payback is a particularly simple criterion for deciding on the desirability

of an investment project. The firm chooses a fixed payback period, for

example, three years. If a project generates enough cash in the first three

years of its existence to repay the initial investment outlay, then it is

desirable, and if it doesn’t generate enough cash to cover the outlay, it

should be rejected. Take the cash-flow stream given in the following table

as an example.

Year 0 1 2 3 4

Cash flow –1,000 250 250 250 500

Table 1.1

A firm that has chosen a payback period of three years and is faced with

the project shown in Table 1.1 will reject it as the cash flow in years 1 to

3 (750) doesn’t cover the initial outlay of 1,000. Note, however, that if the

firm used a payback period of four years, the project would be acceptable,

as the total cash flow to the project would be 1,250, which exceeds the

outlay. Hence, it’s clear that the crucial choice by management is of the

payback period.

We can also use the preceding example to illustrate the weaknesses of

payback. First, assume the firm has a payback period of three years. Then,

as previously mentioned, the project in Table 1.1 will not be accepted.

However, assume also that, instead of being 500, the project cash flow in

year 4 is 500,000. Clearly, one would want to revise one’s opinion on the

desirability of the project, but the payback rule still says you should reject

it. Payback is flawed, as a portion of the cash-flow stream (that realised

after the payback period is up) is always ignored in project evaluation.

The second weakness of payback should be obvious, given our earlier

discussion of NPV. Payback ignores the time value of money. Sticking with

the example in Table 1.1, assume a firm has a payback period of four years.

Then the project as given should be accepted (as total cash flow of 1,250

exceeds investment outlay of 1,000). But what’s the NPV of this project?

15

92 Corporate finance

the NPV can be shown to be negative. (In fact the NPV is –36.78. As a

self-assessment activity, show that this is the case.) Hence application of

the payback rule tells us to accept a project that would decrease expected

shareholder wealth (as shown by application of the NPV rule). This flaw

could be eliminated by discounting project cash flows that accrue within

the payback period, giving a discounted payback rule, but such a

modification still wouldn’t solve the first problem we highlighted.

The IRR rule can be viewed as a variant on the apparatus we used in the

NPV formulation. The IRR of a project is the rate of return that solves the

following equation:

k C

∑ (1 + ri ) i − I = 0 (1.7)

i =1

where Ci is the project cash flow in year i, and I is the initial (i.e. year 0)

investment outlay. Comparison of equation 1.7 with 1.6 shows that the

project IRR is the discount rate that would set the project NPV to zero.

Once the IRR has been calculated, the project is evaluated by comparing

the IRR to a predetermined required rate of return known as a hurdle

rate. If the IRR exceeds the hurdle rate, then the project is acceptable,

and if the IRR is less than the hurdle rate it should be rejected. A graphical

analysis of this is presented in Figure 1.5, which plots project NPV against

the rate of return used in NPV calculation. If r* is the hurdle rate used

in project evaluation, then the project represented by the curve on the

figure is acceptable as the IRR exceeds r*. Clearly, if r* is also the correct

required rate of return, which would be used in NPV calculations, then

application of the IRR and NPV rules to assessment of the project in Figure

1.5 gives identical results (as at rate r* the NPV exceeds zero).

Figure 1.5

Calculation of the IRR need not be straightforward. Rearranging equation

1.7 shows us that the IRR is a solution to a kth order polynomial in r.

In general, the solution must be found by some iterative process, for

example, a (progressively finer) grid search method. This also points to

a first weakness of the IRR approach; as the solution to a polynomial,

the IRR may not be unique. Several different rates of return might satisfy

equation 1.7; in this case, which one should be used as the IRR? Figure 1.6

gives a graphical example of this case.

16

Chapter 1: Present-value calculations and the valuation of physical investment projects

Figure 1.6

The graphical approach can also be used to illustrate another weakness

of the IRR rule. Consider a firm that is faced with a choice between two

mutually exclusive investment projects (A and B). The locus of NPV-rate of

return pairings for each of these projects is given on Figure 1.7.

The first thing to note from the figure is that the IRR of project A

exceeds that of B. Also, both IRRs exceed the hurdle rate, r*. Hence,

both projects are acceptable but, using the IRR rule, one would choose

project A as its IRR is greatest. However, if we assume the hurdle rate is

the true opportunity cost of capital (which should be employed in an NPV

calculation), then Figure 1.7 indicates that the NPV of project B exceeds

that of project A. Hence, in the evaluation of mutually exclusive projects,

use of the IRR rule may lead to choices that do not maximise expected

shareholder wealth.

Figure 1.7

The lesson of this section is therefore as follows. The most commonly

used alternative project evaluation criteria to the NPV rule can lead to

poor decisions being made under some circumstances. By contrast, NPV

performs well under all circumstances and thus should be employed.

17

92 Corporate finance

bonds

To end this chapter, we will discuss very briefly how to value common

stocks and bonds through the application of present-value techniques.

Stocks

Consider holding a common equity share from a given corporation. To

what does this equity share entitle the holder? Aside from issues such as

voting rights, the share simply delivers a stream of future dividends to

the holder. Assume that we are currently at time t, that the corporation is

infinitely long-lived (such that the stream of dividends goes on forever)

and that we denote the dividend to be paid at time t+i by Dt+i. Also

assume that dividends are paid annually. Denoting the required annual

rate of return on this equity share to be re, then a present value argument

would dictate that the share price (P) should be defined by the following

formula:

∞ D

P= ∑ (1 + rt+i) i . (1.8)

i =1 e

dividend paid at the current time (i.e. the summation does not start at

zero). In plain terms, what equation 1.8 says is that an equity share is

worth only the discounted stream of annual dividends that it delivers.

A simplification of the preceding formula is available when we assume that

the dividend paid grows at constant percentage rate g per annum. Then,

assuming that a dividend of D0 has just been paid, the future stream of

dividends will be D0(1+g), D0(1+g)2, D0(1+g)3 and so on. This type of cash-

flow stream is known as a perpetuity with growth, and its present

value can be calculated very simply.3 In this setting the price of the equity 3

See Appendix 1.

share is:

D ( 1 + g)

P = 0 . (1.9)

re – g

from the preceding discussion, it is only valid if you can assert that

dividends grow at a constant rate.

Note also that if you have the share price, dividend just paid and an

estimate of dividend growth, you can rearrange equation 1.9 to give the

required rate of return on the stock – that is:

re = D0 ( 1 + ) + g .

g

(1.10)

P

The first term in 1.10 is the expected dividend yield on the stock, and the

second is expected dividend growth. Hence, with empirical estimates of

the previous two quantities, we can easily calculate the required rate of

return on any equity share.

Activity

Attempt the following questions:

1. An investor is considering buying a certain equity share. The stock has just paid

a dividend of £0.50, and both the investor and the market expect the future

dividend to be precisely at this level forever. The required rate of return on

similar equities is 8 per cent. What price should the investor be prepared to pay

for a single equity share?

18

Chapter 1: Present-value calculations and the valuation of physical investment projects

2. A stock has just paid a dividend of $0.25. Dividends are expected to grow at

a constant annual rate of 5 per cent. The required rate of return on the share

is 10 per cent. Calculate the price of the stock.

3. A single share of XYZ Corporation is priced at $25. Dividends are expected

to grow at a rate of 8 per cent, and the dividend just paid was $0.50. What is

the required rate of return on the stock?

Bonds

In principle, bonds are just as easy to value.

A discount or zero coupon bond is an instrument that promises

to pay the bearer a given sum (known as the principal) at the end of

the instrument’s lifetime. For example, a simple five-year discount bond

might pay the bearer $1,000 after five years have elapsed.

Slightly more complex instruments are coupon bonds. These not

only repay the principal at the end of the term but in the interim entitle

the bearer to coupon payments that are a specified percentage of

the principal. Assuming annual coupon payments, a three-year bond

with principal of £100 and coupon rate of 8 per cent will give annual

payments of £8, £8 and £108 in years 1, 2 and 3.

In more general terms, assuming the coupon rate is c, the principal is P

and the required annual rate of return on this type of bond is rb, the price

of the bond can be written as:4 4

In our notation a

coupon rate of 12

cP + p ( 1 + c) .

k –1

PB = ∑ (1 + rb ) i (1 + rb ) k

(1.11) per cent, for example,

i =1 implies that c = 0.12;

Note that it is straightforward to value discount bonds in this framework the discount rate used

here, rb, is called the

by setting c to zero.

yield to maturity of the

bond.

Activity

Using the previous formula, value a seven-year bond with principal $1,000, annual

coupon rate of 5 per cent and required annual rate of return of 12 per cent.

(Hint: the use of a set of annuity tables might help.)

Having completed this chapter, and the essential reading and activities,

you should be able to:

analyse optimal physical and financial investment in perfect capital

markets and derive the Fisher separation result

justify the use of the NPV rules via Fisher separation

compute present and future values of cash-flow streams and appraise

projects using the NPV rule

evaluate the NPV rule in relation to other commonly used evaluation

criteria

value stocks and bonds via NPV.

19

92 Corporate finance

Key terms

capital market line (CML)

consumption

Fisher separation theorem

Gordon growth model

indifference curve

internal rate of return (IRR) criterion

investment policy

net present value rule

payback rule

production opportunity frontier (POF)

production possibility frontier (PPF)

time value of money

utility function

1. The Toyundai Motor Company has the opportunity to invest in new

production line equipment, which would have a working lifetime of 10

years. The new equipment would generate the following increases in

Toyundai’s net cash flows.

In the first year of usage the new plant would decrease costs by

$200,000. For the following 6 years the cost saving would fall at a rate

of 5 per cent per annum. In the remaining years of the equipment’s

lifetime, the annual cost saving would be $140,000. Assuming that the

cost of the equipment is $1,000,000 and that Toyundai’s cost of capital

is 10 per cent, calculate the NPV of the project. Should Toyundai take

on the investment? (15%)

2. Describe two methods of project evaluation other than NPV. Discuss the

weaknesses of these methods when compared to NPV. (10%)

20

Chapter 2: Risk and return: mean–variance analysis and the CAPM

mean–variance analysis and the CAPM

The aim of this chapter is to derive the capital asset pricing model (CAPM)

enabling us to price financial assets. In order to do so, we introduce the

mean–variance analysis setting, in which investors care solely about

financial assets’ expected returns and variances of returns, as well as the

statistical tools enabling us to calculate portfolios’ expected returns and

variances of returns.

Learning objectives

At the end of this chapter, and having completed the essential reading and

activities, you should be able to:

discuss concepts such as a portfolio’s expected return and variance as

well as the covariance and correlation between portfolios’ returns

calculate portfolio expected return and variance from the expected

returns and return variances of constituent assets

describe the effects of diversification on portfolio characteristics

derive the CAPM using mean–variance analysis

describe some theoretical and practical limitations of the CAPM.

Essential reading

Grinblatt, M. and S. Titman Financial Markets and Corporate Strategy. (Boston,

Mass.; London: McGraw-Hill, 2002) Chapters 4 and 5.

Further reading

Brealey, R., S. Myers and F. Allen Principles of Corporate Finance. (Boston,

Mass.; London: McGraw-Hill, 2008) Chapters 8 and 9.

Copeland, T. and J. Weston Financial Theory and Corporate Policy.

(Reading, Mass.; Wokingham: Addison-Wesley, 2005) Chapters 5 and 6.

Roll, R. ‘A Critique of the Asset Pricing Theory’s Texts. Part 1: On Past and

Potential Testability of the Theory’, Journal of Financial Economics 4(2)

1977, pp.129–76.

Introduction

In Chapter 1 we examined the use of present-value techniques in the

evaluation of physical investment projects and in the valuation of primitive

financial assets (i.e. stocks and bonds). A key input into NPV calculations

is the rate of return used in the construction of the discount factor but,

thus far, we have said little regarding where this rate of return comes

from. Our objective in this chapter is to demonstrate how the risk of a

given security or project impacts on the rate of return required from it and

hence affects the value assigned to that asset in equilibrium.

We begin by introducing the basic statistical tools that will be needed

in our analysis, these being expected values, variances and

covariances. This leads to an analysis of the statistical characteristics

21

92 Corporate finance

standard mean–variance optimisation problem. The key result of mean–

variance analysis is known as two-fund separation, and this result

underlies the capital asset pricing model, which we will present next.

A portfolio is a collection of different assets held by a given investor.

For example, an American investor may hold 100 Microsoft shares and

650 shares of Bethlehem Steel and therefore holds a portfolio comprising

two assets. The objective of this section is to arrive at the statistical

characteristics of the return on the entire portfolio, given the statistical

features of each of the constituent assets. The key statistical measures used

are expected returns and return variances or standard deviations.

The expected return on a given asset can be thought of as the reward

gained from holding it, whereas the return variance is a measure of total

asset risk.

Let us define notation. First, we should clarify the way in which we are

thinking about asset returns. The return on an asset is assumed to be a

random variable with known distributional characteristics. Each individual

asset is assumed to have an expected return of E(rj) and return variance

ı2j. Assets i and j are assumed to have covariance ıij . Similarly, we denote

the expected return of the portfolio held as E(Rp) and its variance by ı2P.

Finally, we assume that an investor can pick from N different stocks when

forming his portfolio.

Returning to the example of the American investor given above, assume

that the market price of Microsoft shares is 130 and that of Bethlehem

Steel is 10.1 Hence, given the numbers of each share held, the total value 1

These prices are in US

of this investor’s portfolio is $195. We further assume that the expected cents.

returns on Microsoft and Bethlehem Steel are 10 per cent and 16 per cent

respectively, whereas their variances are 0.25 and 0.49.

We are now in a position to define the share of the entire portfolio value

that is contributed by each individual stockholding. These are referred

to as portfolio weights. The portfolio weight of Bethlehem Steel, for

example, is simply the value of the Bethlehem Steel holding divided by

$195 (i.e. 1/3 or approximately 33.3 per cent). Hence our US investor

allocates 1/3 of every dollar invested to Bethlehem Steel stock.

Activity

Calculate the portfolio weight for Microsoft, using the method presented above.

weights must be unity. Each portfolio weight represents the share of total

portfolio value contributed by a given asset. Obviously, aggregating these

shares across all assets held will give a result of unity. Hence, extending

the notation presented above, we denote the portfolio weight on asset i by

ai, and the preceding argument implies that 6Į1= 1.

Our American investor now knows the statistical characteristics of the

return on each of the assets she holds, plus how to calculate the portfolio

weight on each of the assets. What she would really like to know now is

how to construct the return characteristics for the entire portfolio (i.e.

she’s concerned about the risk and reward associated with her entire

investment). In order to do this we will need to introduce some basic

properties of expectations, variances and covariances.

22

Chapter 2: Risk and return: mean–variance analysis and the CAPM

Consider two random variables, x and y. The expected values and

variances of these variables are E(x), E(y), ı2x and ı2y. The covariance

between the random variables is ıxy.

Form an arbitrary linear combination of these two random variables and

denote it P (i.e. P = ax + by, where a and b are constants). We wish to

know the expected return and variance of the new random variable P.

These are calculated as follows:

E(P) = aE(x) + bE(y) (2.1)

ı = a ı + b ı + 2abıxy.

2

P

2 2

x

2 2

y

(2.2)

The preceding results are readily extended to the case where more than

two random variables are linearly combined. Consider N random variables

denoted xi, where i runs from 1 to N. Denote their expected values and

variances as E(xi) and ı2i. The covariance between xi and xj is ıij. Again

we form a linear combination of the random variables, denoted again by

P, using an arbitrary set of constants denoted ai. The expected value and

variance of the random variable P are given by:

N

E(P) = ∑ a1 E ( x1) (2.3)

i =1

N

σP2 = ∑ a i2 σ i2 + ∑a i a j σ ij. (2.4)

i =1 i≠ j

variables with known distributional characteristics, the statistical results

given above allow us to calculate portfolio returns and variances very

simply.

In addition to the data on Microsoft and Bethlehem Steel provided earlier,

we also need to know the covariance between Microsoft and Bethlehem

Steel returns in order to determine the statistical characteristics of

portfolios of these two assets. However, rather than using covariances, we

shall work throughout the rest of this analysis with correlation coefficients.

The relationship between correlations and covariances is given below.

Assume two random variables, x and y, with variances denoted by ı2x and

ı2y. The covariance between the random variables is ıxy. The correlation

coefficient is defined as follows:

σ

ρxy = xy , (2.5)

σx σy

that is, the correlation between the two random variables is simply the

covariance, divided by the product of the respective standard deviations.

Clearly, knowledge of the correlation and the variances of the two random

variables allows one to retrieve the covariance between the two random

variables.

If we again define a linear combination of the two random variables, P,

using arbitrary constants a and b, the expression for the variance of the

linear combination can be rewritten using the correlation as follows:

ı2p = a2ı2x + b2ı2y + 2abUxyıxıy. (2.6)

This is a straightforward substitution of equation 2.5 into equation 2.2.

Now we are in a position to calculate the characteristics of our American

investor’s portfolio. Let us take the simplest possible case first and assume

that the returns are uncorrelated (i.e. Uxy = 0). Recalling that the portfolio

weights on Microsoft and Bethlehem Steel are 2 and 1 respectively, we

3 3

23

92 Corporate finance

can use equations 2.1 and 2.6 to derive the expected return and variance

of the investor’s portfolio. These calculations yield:

E ( R p) = 2

3 (0.1) + 1

3 (0.16) = 0.12 = 12 % (2.7)

the returns on the individual assets. The portfolio variance, however, is

actually less than that on the return of either of the component assets (i.e.

the risk associated with the portfolio is lower than the risks associated

with either individual asset). This result is one that should be kept in mind

and is the focus of the next section.

Now let’s change our assumption regarding the correlation between the

two asset returns. Assume now that Uxy = 0.5. Obviously, the expected

portfolio return won’t change (as equation 2.1 doesn’t involve the

correlation or covariance at all). The portfolio variance now becomes:

σP2 = ( 23 ( 2 (0.25) + ( 13 ( 2 (0.49) + 2 ( 13 ( ( 23 ( × 0.5 × 0.5× 0.7 = 24.3%. (2.9)

The portfolio variance has obviously increased, although it is still less than

the return variances of either component assets.

Activity

Assume that Uxy = – 0.5. Calculate the portfolio return variance in this case, using the

data on portfolio weights and asset return variances given above.

Now, given the expected returns, return variances and covariances for

any set of assets, we should be able to calculate the expected return and

variance of any portfolio created from those assets. At the end of this

chapter, you will find activities that require you to do precisely this, along

with solutions to some of these activities.

Diversification

A point that we noted from the calculations of expected portfolio returns

and variances above was that, in all of our calculations, the variance of the

portfolio return was lower than that on any individual component’s asset

return.2 Hence, it seems as though, by forming bundles of assets, we can 2

Note that this result

eliminate risk. This is true and is known as diversification: through holding does not hold in general

(i.e. it may be the case

portfolios of assets, we can reduce the risk associated with our position.

that the return variance

Why is this the case? The key is that, in our prior analysis and in real stock of a portfolio exceeds

return data, the correlations between returns are less than perfect. If two the return variance of

returns are imperfectly correlated it implies that when returns on the first are one of the component

assets).

above average, those on the second need not be above average. Hence, to an

extent, the returns on such assets will tend to cancel each other out, implying

that the return variance for a portfolio of these stocks will be smaller than

the corresponding weighted average of the individual asset variances.

To illustrate this point in a general setting, consider the following scenario.

An investor holds a portfolio consisting of N stocks, with each stock having

the same portfolio weight (i.e. each stock has portfolio weight N-1). Denote

the return variances for the individual assets by ı2i where i = 1 to N, and

the covariance between returns on assets i and j by ıij. Using equation 2.4,

the variance of the investor’s portfolio return can be written as:

N

σP2 = 12 ∑ σi2 + N12 ∑ σij . (2.10)

N i =1 i≠ j

24

Chapter 2: Risk and return: mean–variance analysis and the CAPM

component assets implies that the summation for all i not equal to j

involves N(N – 1) terms. Obviously the summation in the first term of 2.10

involves N terms. Hence, defining the average variance of the N assets as

ı–2 and average covariance across all assets as C, 2.10 can be rewritten as:

( – 1(

σP2 = N2 σ 2 + N N 2 C. (2.11)

N N

Equation 2.11 obviously simplifies to the following:

N ( N (

σP2 = 12 σ 2 + 1 – 1 C . (2.12)

Now we ask the following question. How does the portfolio variance change

as the number of assets combined in the portfolio increases towards infinity

(i.e. N of). It is clear from 2.12 that, as the number of assets held increases,

the first term will shrink towards zero. Also, as N increases the second term

in 2.12 tends towards C. Together, these observations imply the following.

1. The portfolio variance falls as the number of assets held increases.

2. The limiting portfolio return variance is simply the average covariance

between asset returns: this average covariance can be thought of as

the risk of the market as a whole, with the influence of individual asset

return variances disappearing in the limit.

The moral of the preceding statistical story is clear. Holding portfolios

consisting of greater and greater numbers of assets allows an investor to reduce

the risk he or she bears. This is illustrated diagrammatically in Figure 2.1.

Figure 2.1

Mean–variance analysis

In the preceding two sections, we have demonstrated two important facts:

1. The expected return on a portfolio of assets is a linear combination of

the expected returns on the component assets.

2. An investor holding a diversified portfolio gains through the reduction

in portfolio variance, when asset returns are not perfectly correlated.

In this section, we use these facts to characterise the optimal holding of

risky assets for a risk-averse agent. Our fundamental assumption is that all

agents have preferences that only involve their expected portfolio return

and return variance. Utility is assumed to be increasing in the former

and decreasing in the latter. For illustrative purposes we begin using the

assumption that only two risky assets are available. The results presented,

however, generalise to the N asset case.

25

92 Corporate finance

To begin, assume there is no risk-free aset. The investor can hence only

form his or her portfolio from risky assets named X and Y. These assets

have expected returns of E(Rx) and E(Ry) and return variances of ı2x and ı2y.

The first question the investor wishes to answer is how the characteristics

of a portfolio of these assets (i.e. portfolio expected return and variance)

change as the portfolio weights on the assets change. Given equation 2.6,

the answer to this question is obviously dependent on the correlation

between the returns on the two assets.

First assume the assets are perfectly correlated and, further, assume asset

X has lower expected returns and return variance than asset Y. We form a

portfolio with weights Į on asset X and 1±Į on asset Y. Equation 2.6 then

implies that the portfolio variance can be written as follows:

ı2P = (Įıx + (1±Į)ıy )2. (2.13)

Taking the square root of equation 2.13, it is clear that the portfolio

standard deviation is linear in Į. As the portfolio expected return is linear

in Į, the locus of expected return–standard deviation combinations is a

straight line. This is shown in Figure 2.2.

Figure 2.2

If the correlation between returns is less than unity, however, the investor

can benefit from diversifying his portfolio. As previously discussed, in this

scenario, portfolio standard deviation is not a linear combination of ıx

and ıy. The reduction of portfolio risk through diversification will imply

that the mean–standard deviation frontier bows towards the y-axis. This

is also shown on Figure 2.2. The final curve on Figure 2.2 represents the

case where returns are perfectly negatively correlated. In this situation, a

portfolio can be constructed, which has zero standard deviation.

Activities

1. Assuming asset returns are perfectly negatively correlated, use equation 2.6

to find the portfolio weights that give a portfolio with zero standard deviation.

(Hint: write down 2.6 with the correlation set to minus one and a Į and

b ±Į. Then minimise portfolio variance with respect to Į.)

2. Assume that the returns on Microsoft and Bethlehem Steel have correlation of

0.5. Using the data provided earlier in the chapter, construct the mean–variance

frontier for portfolios of these two assets. Start with a portfolio consisting only

of Microsoft stock and then increase the portfolio weight on Bethlehem Steel by

0.1 repeatedly, until the portfolio consists of Bethlehem Steel stock only.

26

Chapter 2: Risk and return: mean–variance analysis and the CAPM

From here on we will assume that return correlation is between plus and

minus one. The expected return–standard deviation locus for this case

is redrawn in Figure 2.3. In the absence of a risk-free asset, this locus is

named the mean–variance frontier. As our investor’s preferences are

increasing in expected return and decreasing in standard deviation, it is

clear that his or her optimal portfolio will always lie on the frontier and

to the right of the point labelled V. This point represents the minimum-

variance portfolio. He or she will always choose a frontier portfolio at or

to the right of V, as these portfolios maximise expected return for a given

portfolio standard deviation. In the absence of a risk-free asset, this set of

portfolios is called the efficient set.

Figure 2.3

We can now, given a set of preferences for the investor, find his or her

optimal portfolio. The condition characterising the optimum is that

an investor’s indifference curve must be tangent to the mean–variance

frontier.3 Two such optima are identified on Figure 2.3 at R and S. The 3

In technical terms the

investor locating at equilibrium point R is relatively risk-averse (i.e. his optimum is characterised

by the marginal rate of

or her indifference curves are quite steep), whereas the equilibrium at

substitution being equal

S is that for a less risk-averse individual (with correspondingly flatter to the marginal rate of

indifference curves). Figure 2.3 also shows sub-optimal indifference curves transformation (i.e. the

for each set of preferences. slope of the indifference

curve equals the slope of

the frontier).

Figure 2.4

27

92 Corporate finance

risk-free asset, the optimal portfolio of risky assets held by an investor

depends on his or her preferences towards risk and return. The same is

true when there are N risky assets available. Figure 2.4 depicts the same

type of diagram for the N asset case.

Note that the mean–variance frontier is of the same shape as that in

Figure 2.3. However, unlike the two-asset case, the interior of the frontier

now consists of feasible but inefficient portfolios (i.e. those that do not

maximise expected return for given portfolio risk). The mean–variance

frontier now consists of those portfolios that minimise risk for a given

expected return, whereas those portfolios on the efficient set (i.e. on the

frontier but to the right of V) additionally maximise expected return for a

given level of risk.

We now reintroduce a risk-free asset to the analysis (i.e. we assume the

existence of an asset with return rf and zero return–standard deviation).

A key question to address at this juncture is as follows. Assume that

we form a portfolio consisting of the risk-free asset and an arbitrary

combination of risky assets. How do the expected return and return–

standard deviation of this portfolio alter as we vary the weights on the

risk-free asset and the risky assets respectively?

Denote our arbitrary risky portfolio by P. We combine P with the risk-free

asset using weights 1 – a and a to form a new portfolio Q. The expected

return and variance of Q are given by:

In order to analyse the variation in the risk and expected return of the

portfolio Q with respect to changes in the portfolio weights, we construct

the following expression:

dE(R Q) dE(R Q) /da

= . (2.16)

dσQ dσQ /da

Using equations 2.14 and 2.15 we find that:

dE(R Q) E(R p) – r f

= . (2.17)

dσQ σp

As this slope is independent of a, the risk–return profile of the portfolio Q

is linear. This is known as the capital market line, and two such CMLs are

shown in Figure 2.5 for two different portfolios of risky assets.

We now have all the components required to describe the optimal portfolio

choice of an investor faced with N risky assets and a risk-free investment.

Figure 2.6 replots the feasible set of risky asset portfolios. The key question

to answer is, what portfolio of risky assets should an investor hold? Using

the analysis from Figure 2.5, it is clear that the optimal choice of risky

asset portfolio is at K. Combining K with the risk-free asset places an

investor on a capital market line (labelled rfKZ), which dominates in utility

terms the CML generated by the choice of any other feasible portfolio of

risky assets.4 The optimal portfolio choice and a sub-optimal CML (labelled

4

That is, choosing

portfolio K places an

CML2) are shown on Figure 2.6 along with the indifference curves of two

investor on a CML with

investors. greater expected returns

Recall that we previously defined the efficient set as the group of at each level of return

portfolios that both minimised risk for a given level of expected return and variance than does any

other.

28

Chapter 2: Risk and return: mean–variance analysis and the CAPM

maximised expected return for a given level of risk. With the introduction

of the risk-free asset, the efficient set is exactly the optimal CML.

Figure 2.5

The key result that is depicted in Figure 2.6 is known as two-fund

separation. Any risk-averse investor (regardless of his or her degree

of risk-aversion) can form his or her optimal portfolio by combining two

mutual funds. The first of these is the tangency portfolio of risky assets,

labelled K, and the second is the risk-free asset. All that the degree of risk-

aversion dictates is the portfolio weights placed on each of the two funds.

The investor with the optimum depicted at X on Figure 2.6, for example, is

relatively risk-averse and has placed positive portfolio weights on both the

risk-free asset and K. An investor locating at Y, however, is less risk-averse

and has sold the risk-free asset short in order to invest more in K.5 5

A short sale is the sale

of an asset that one

does not actually own.

One borrows the asset

in order to complete the

transactions and imme-

diately receives the sale

price. Subsequently, one

uses the proceeds from

the sale to repurchase

a unit of the asset, and

deliver it to the creditor.

If the price of the asset

has dropped in the

interim, one makes a

ECUJRTQƂV

Figure 2.6

Two-fund separation is the result that underlies the capital asset pricing

model (CAPM), which is developed in the next section.

29

92 Corporate finance

To begin our derivation of the CAPM, we present the assumptions that

underlie the analysis. These assumptions formalise those implicit in the

preceding section.

Investors maximise utility defined over expected return and return

variance.

Unlimited amounts may be borrowed or loaned at the risk-free rate.

Investors have homogenous expectations regarding future asset returns.

Asset markets are perfect and frictionless (e.g. no taxes on sales or

purchases, no transaction costs and no short sales restrictions).

We next need to extend slightly our analysis of the previous section in

order to derive the familiar form of the CAPM.

Consider Figure 2.6, which graphically identifies the optimal portfolio

of risky assets (K), held by an arbitrary risk-averse investor. The key

condition for optimality is that the capital market line and the mean–

variance frontier are tangent. The following equations give a mathematical

description of this optimality condition.

From equation 2.17, we know that the slope of the capital market line at

the optimum is:

E(R K) – r f

. (2.18)

σK

We also need the slope of the mean–variance frontier at the point of

tangency. To derive this, consider a position (called I) with portfolio

weight a in an arbitrary portfolio of risky assets (called j) and (1 – a) in the

optimal portfolio K. The expected return and standard deviation of this

position are:

Using the same method as shown in equation 2.16 to derive the risk–

return trade-off at the point represented by portfolio I, we get:

dE(R 1) (2.21)

= E(R j) – E(R K) .

da

dσ 1

= 0.5[a 2σ j2+(1–a) 2σ K2+2a(1–a)σ jK] -0.5 (2aσ j2–2(1–a)σ K2+2(1–2a)σ jK).

da

(2.22)

2.22 in the limit as a o 0. Note that equation 2.21 does not depend on a.

Taking the limit of equation 2.22 as a o 0 we get:

1 (σ – σ 2) . (2.23)

σ K jK K

that is,

σK [E(R j ) – E(R K )]

. (2.24)

σJK – σK2

30

Chapter 2: Risk and return: mean–variance analysis and the CAPM

frontier at K with the slope of the CML. Hence, equating 2.18 and 2.24

and rearranging the resulting expression, we arrive at:

σjK

E(R j ) = r f + σ 2 [E(R K ) – r f ]. (2.25)

K

optimisation problem. The equation translates as follows: the expected return

on a given asset (or portfolio of assets) is equal to the risk-free rate plus a

risk premium multiplied by the asset’s ȕ6 Assets that have large values of ȕ 6

The risk premium is

will have large expected returns, whereas those with smaller values of ȕ will FGƂPGFCUVJGGZEGUUQH

the expected return on

have low expected returns with ȕ defined as the ratio of the covariance of an

the tangency portfolio

asset’s returns with those on the market to the variance of the market return. over the risk-free rate.

Equation 2.26 is simply derived from mean–variance analysis, and as

yet we have said nothing regarding equilibrium in asset markets. Capital

market equilibrium requires that the demand for risky securities be

identical to their supply. The supply of risky assets is summarised in the

market portfolio, which is defined below.

Definition

The market portfolio is the portfolio comprising all assets, where the

weights used in the construction of the portfolio are calculated as

the market capitalisation of each asset divided by the sum of market

capitalisations across all assets.

Two-fund separation gives us the fundamental result that all investors hold

efficient portfolios and, further, that all investors hold risky securities in the

same proportions (i.e. those proportions dictated by the tangency portfolio

(K)).7 For demand to be equal to supply in capital markets, it must be the case 7

All investors perceive

that the market portfolio is constructed with identical portfolio weights. The VJGUCOGGHƂEKGPVUGV

and tangency portfolio

implication of this is simple: the market portfolio and the tangency portfolio

due to our assumption

are identical. This allows us to express the CAPM in the following form. that they have homo-

geneous expectations

The capital asset pricing model regarding asset returns.

Under the prior assumptions, the following relationship holds for all

expected portfolio returns:

E(Rj ) = Rfȕj [E(rM ) – rf ], (2.27)

where E(RM ) is the expected return on the market portfolio, andȕj is the

covariance of the returns on asset j with those on the market divided by

the variance of the market return.

Equation 2.27 gives the equilibrium relationship between risk and return

under the CAPM assumptions. In the CAPM framework, the relevant

measure of an asset’s risk is its ȕ, and 2.27 implies that expected returns

increase linearly with risk.

To clarify the source of the CAPM equation, note that the identification of

the tangency portfolio and the linear ȕrepresentation are implied by mean–

variance analysis. The CAPM then imposes equilibrium on capital markets

and identifies the market portfolio as identical to the tangency portfolio.

31

92 Corporate finance

Given equation 2.27, the equilibrium relationship between risk and return

has a very simple graphical depiction. In equilibrium expected returns are

linear in ȕ. The expected return on an asset with a ȕ of zero is rf , whereas

an asset with a ȕ of unity has an expected return identical to that on the

market. Plotting this relationship, known as the security market line, we

get Figure 2.7.

Comparison of Figures 2.6 and 2.7 implies that, in equilibrium, two assets

with identical expected returns must have identical ȕs, although their return

variances can differ. The reason that their variances can differ is that a

proportion of asset return variance can be eliminated through diversification.

Agents should not be rewarded for bearing such risk, and hence, diversifiable

risk will not affect expected returns. Undiversifiable risk is that which is

driven by variation in the return on the market as a whole, and an asset’s

exposure to such risk is summarised by ȕ. Hence an asset’s ȕ measures its

relevant risk and, via equation 2.27, determines equilibrium expected returns.

The key message of the preceding paragraph is that ȕ measures asset risk.

A high ȕ asset is risky as it has high returns when market returns are high.

An asset with a low ȕ tends to have high returns when market returns are

low. Hence a low ȕ asset, when included in one’s portfolio, can provide

insurance against low market returns and hence is low risk.

Figure 2.7

To mathematically illustrate the sources of asset risk we can use the CAPM

equation to decompose the variance of a given asset. Equation 2.27 gives

the equilibrium expected return for asset j. Actual returns on asset j will

follow a similar relationship but will also include a random error term.

Denoting this error by İj we have the following equation:

rj = rfȕj [rM – rf ] + İj. (2.28)

The variance of the risk-free return is zero by definition. Assuming that ȕj

is fixed we can represent the variance of asset j as:

ı2j ȕ2jı2Mı2İ. (2.29)

32

Chapter 2: Risk and return: mean–variance analysis and the CAPM

The final term on the right-hand side of equation 2.29 is the variance of

the error term and represents diversifiable risk. This source of risk is also

known as unsystematic and idiosyncratic risk. As emphasised previously,

this risk is unrelated to market fluctuations and, therefore, does not affect

expected returns. The first term on the right-hand side of 2.29 represents

undiversifiable risk, also known as systematic risk. This is risk that cannot

be escaped and hence increases equilibrium expected returns.

Activities8 8

;QWYKNNƂPFVJG

solutions to these

1. An investor forms a portfolio of two assets, X and Y. These assets have activities at the end of

expected returns of 9 per cent and 6 per cent and standard deviations of 0.8 this chapter.

and 0.6 respectively. Assuming that the investor places a portfolio weight of

0.5 on each asset, calculate the portfolio expected return and variance if the

correlation between returns on X and Y is unity.

2. Using the data from Question 1, recalculate the portfolio expected return and

variance, assuming that the correlation between returns is 0.5.

3. An investor forms a portfolio from two assets, P and Q, using portfolio weights

of one-third and two-thirds respectively. The expected returns on P and Q are

5 per cent and 7 per cent, and their respective return standard deviations are

0.4 and 0.5. Assuming the return correlation is zero, calculate the expected

return and variance of the investor’s portfolio.

4. Assuming identical data to that in Question 3, recalculate the statistical

properties of the portfolio, assuming the return correlation for P and Q is –0.5.

The final topic we touch on in this chapter is the empirical validity of the

CAPM. The model of equilibrium expected returns that we have developed

in the preceding sections of this chapter is obviously not guaranteed to

hold in practice, and hence, rather than just blindly accepting its output,

we should examine how it holds up when applied to real data. However,

this task brings us face-to-face with a problem first pointed out by Richard

Roll and hence known as the Roll critique.9 9

See Roll (1977).

The statement of the CAPM is identical to the proposition that the market

portfolio is mean–variance efficient. Hence, Roll pointed out that empirical

tests of the CAPM should seek to examine whether this is indeed the case.

However, he also noted that the market portfolio (or the return on the

market) is not observable to an econometrician, who wishes to conduct a

test. Empirical researchers generally use a broad-based equity index such

as the FTSE-100, S&P-500 or Nikkei 250 to proxy the market. But the true

market portfolio will contain other financial assets (such as bonds and

stocks not included in such indices) as well as non-financial assets such as

real estate, durable goods and even human capital. Hence, the validity of

tests of the CAPM depend critically on the quality of the proxy used for the

market portfolio.

Based on the above, Roll’s critique is simply that, due to the fact that

the market portfolio is not observable, the CAPM is not testable. We can

understand this through the following arguments. First, it might be the

case that the market portfolio is efficient (and hence the CAPM is valid),

but our chosen proxy for the market is not efficient, and hence our

empirical test rejects the CAPM. Second, our proxy for the market might

be efficient whereas the market portfolio itself is not. In this case our test

33

92 Corporate finance

will falsely indicate that the CAPM is valid. Put simply, the fact that we

can’t guarantee the quality of our proxy for the market implies that we

can’t place any faith in the results that tests based upon it generate, and

hence it’s impossible to test the CAPM.

The Roll critique is clearly damaging in that it implies that we can’t judge

the predictions of the CAPM against reality and trust the results. However,

many researchers have disregarded the prior discussion and estimated

the empirical counterpart of equation 2.27. From these estimates such

researchers pass judgment on the CAPM.

One prediction of the CAPM upon which some have focused is that the

expected excess return of a given portfolio over the risk-free rate (the risk

premium) is linearly related to ȕ with the slope of this relationship given

by the market risk premium. Historically, however, when one plots actual

excess portfolio returns against their estimated ȕs one finds that the line

traced out is flatter than one would expect from the theory (i.e. low ȕ

portfolios earn greater expected returns than the CAPM predicts, and high

ȕ portfolios earn less). This is clearly evidence against the CAPM.10 10

See pp.185–86 of

Brealey and Myers

Another prediction of the CAPM, which is also empirically tested, is that (2008).

ȕ is the only factor that should cause expected returns to differ (i.e. no

other variable should explain expected returns once we’ve accounted for

the effects of ȕ). Again, the evidence from this line of attack is not good

for the CAPM. Among other factors, firm size, book-to-market ratios, P/E

ratios and dividend yields have all been shown to explain ex-post realised

returns (after accounting for ȕ).

Amalgamating the above evidence implies that, if you are willing to

disregard the Roll critique, you should probably conclude that the CAPM

does not hold. This has led certain authors to investigate other asset-

pricing paradigms such as the APT (which we discuss in the next chapter).

An alternative viewpoint would be to argue that such results tell us little or

nothing about the validity of the CAPM due to the insight of Roll (1977).

Having completed this chapter, and the essential reading and activities,

you should be able to:

discuss concepts such as a portfolio’s expected return and variance as

well as the covariance and correlation between portfolios’ returns

calculate portfolio expected return and variance from the expected

returns and return variances of constituent assets

describe the effects of diversification on portfolio characteristics

derive the CAPM using mean–variance analysis

describe some theoretical and practical limitations of the CAPM.

Key terms

beta (ȕ)

capital asset pricing model (CAPM)

correlation

covariance

diversification

expected return

34

Chapter 2: Risk and return: mean–variance analysis and the CAPM

market portfolio

mean–variance analysis

Roll critique

security market line

standard deviation

systematic risk

two-fund separation

unsystematic risk

variance

1. Detail the assumptions that underlie the CAPM and provide a

derivation of the CAPM equation. Support your derivation with

graphical evidence. (15%)

2. The returns on ABC stock and on the market portfolio in three

consecutive years are given in the following table:

Year ABC return Market return

1 8% 6%

2 24% 12%

3 28% 15%

Showing all your workings, compute the ȕ for ABC’s equity. (7%)

3. Assume that the risk-free rate is 5 per cent. What is the expected return

on ABC’s stock? (3%)

Solutions to activities

1. The expected return on the equally weighted portfolio is 7.5%. The

portfolio return variance is 0.49, and hence the portfolio return

standard deviation is 0.7.

2. Obviously, the expected return is the same as in Question 1. With

correlation of 0.5, the portfolio return variance is 0.37.

3. The expected return on the portfolio is 6.33%, and the portfolio has a

return variance of 0.1289.

4. When the correlation changes to –0.5, the portfolio return variance

drops to 0.0844. The expected return on the portfolio doesn’t change

from that calculated in Question 3.

35

92 Corporate finance

Notes

36

Chapter 3: The arbitrage pricing theory

The aim of this chapter is to derive arbitrage pricing theory, an alternative

to the capital asset pricing model, enabling us to price financial assets.

Learning objectives

At the end of this chapter, and having completed the essential reading and

activities, you should be able to:

understand single-factor and multi-factor model representations

derive factor-replicating portfolios from a set of asset returns

understand the notion of arbitrage strategies and that well-functioning

financial markets should be arbitrage-free

derive arbitrage pricing theory and calculate expected returns using the

pricing formula.

Essential reading

Grinblatt, M. and S. Titman Financial Markets and Corporate Strategy. (Boston,

Mass.; London: McGraw-Hill, 2002) Chapter 6.

Further reading

Brealey, R., S. Myers and F. Allen Principles of Corporate Finance. (Boston,

Mass.; London: McGraw-Hill, 2008) Chapter 9.

Chen, N-F. ‘Some Empirical Tests of the Theory of Arbitrage Pricing’, The

Journal of Finance 38(5) 1983, pp.1393–1414.

Chen, N-F., R. Roll and S. Ross ‘Economic Forces and the Stock Market’, Journal

of Business 59, 1986, pp.383–403.

Copeland, T., J. Weston and K. Shastri Financial Theory and Corporate Policy.

(Reading, Mass.; Wokingham: Addison-Wesley, 2005) Chapter 6.

Overview

The arbitrage pricing theory is an alternative paradigm used to calculate

equilibrium expected returns on financial assets. As its name suggests,

it rests on the notion that well-functioning financial markets should

be arbitrage-free. This, using a factor model of asset returns, implies

restrictions on the relationships between asset returns and generates an

equilibrium pricing relationship.

Introduction

The arbitrage pricing theory (APT) developed in this chapter gives an

alternative to the CAPM as a method to compute the expected returns on

stocks. The basis for the APT is a factor model of stock returns, and we will

define and discuss these models first. From there we will demonstrate how

to derive expected returns using the idea that the returns on stocks, which

are exposed to a common set of factors, must be mutually consistent, given

each stock’s sensitivity to each factor.

37

92 Corporate finance

the notion of an arbitrage. An arbitrage strategy can be one of two types.

It could involve investment in a set of assets (both buying and selling)

that yields an immediate, positive cash inflow (i.e. the receipts from our

sales exceed the cost of our purchases) and, further, is guaranteed not to

make a loss tomorrow. Faced by an investment strategy with this pay-

off structure, any investor who prefers more to less wealth would try to

invest on an infinite scale.

It could be an investment strategy that is costless today but guarantees

positive future returns. This is akin to receiving something for nothing,

and again, sensible investors would capitalise on the possibility by

investing as much as possible.

The idea that underpins the APT is that investment situations, such as those

described above, should not be permitted in well-functioning financial

markets. Then, if financial markets do not permit the existence of arbitrage

strategies, this places restrictions on the relationships between the expected

returns on assets given the factor structure underlying returns. We will

explain further in later sections of this chapter.

Single-factor models

Before using the notion of absence of arbitrage to provide pricing relations,

we need a basis for the generation of stock returns. Within the context of

the APT, this basis is given by the assumption that the population of stock

returns is generated by a factor model. The simplest factor model, given

below, is a one-factor model:

ri = Įi + ȕi ) İi E(İi) = 0. (3.1)

In equation 3.1, the returns on stock i are related to two main components:

1. The first of these is a component that involves the factor F. This factor

is posited to affect all stock returns, although with differing sensitivities.

The sensitivity of stock i’s return to F is ȕi. Stocks that have small values

for this parameter will react only slightly as F changes, whereas when ȕi

is large, variations in F cause very large movements in the return on stock

i. As a concrete example, think of F as the return on a market index (e.g.

the S&P-500 or the FTSE-100), the variations in which cause variations in

individual stock returns. Hence, this term causes movements in individual

stock returns that are related. If two stocks have positive sensitivities to

the factor, both will tend to move in the same direction.

2. The second term in the factor model is a random shock to returns, which

is assumed to be uncorrelated across different stocks. We have denoted

this term İi and call it the idiosyncratic return component for stock i. An

important property of the idiosyncratic component is that it is also assumed

to be uncorrelated with F, the common factor in stock returns. In statistical

terms we can write the conditions on the idiosyncratic component as follows:

An example of such an idiosyncratic stock return might be the unexpected

departure of a firm’s CEO or an unexpected legal action brought against the

company in question.

The partition of returns implied by equation 3.1 implies that all common

variation in stock returns is generated by movements in F (i.e. the

correlation between the returns on stocks i and j derives solely from F). As

the idiosyncratic components are uncorrelated across assets they do not

bring about covariation in stock price movements.

38

Chapter 3: The arbitrage pricing theory

Application exercise

Consider an economy in which the risk-free rate of return is 4% and the expected rate of

return on the market index is 9%. The variance of the return on the market index is 20%.

Two portfolios A and B have expected return 7% and 10%, and variance 20% and 50%,

respectively.

a) Work out the portfolios’ beta coefficients.

According to the CAPM:

E(rA) = rFȕA [E(rM) – rF]

and

E(rB) = rFȕB [E(rM) – rF].

Hence:

ȕA = [E(rA) – rF]/[E(rM) – rF@ íí

ȕB = [E(rB) – rF]/[E(rM) – rF@ íí

b) The risk of a portfolio can be decomposed into market risk and idiosyncratic

risk. What are the proportions of market risk and idiosyncratic risk for the two

portfolios A and B?

From the market model:

rA ĮAȕA rMİA

rB ĮBȕB rMİB

with cov(rMİA) = cov(rMİB) = 0.

It hence follows that the variance of portfolio A’s returns, ı2A, has two

components, systematic and idiosyncratic risk:

ı2A ȕ2Aı2Mı2İA.

Similarly:

ı2B ȕ2Bı2Mı2İB.

ȕ2Aı2Mı2A 2

í>ȕ2Aı2Mı2A] = 64%.

ȕ2Bı2Mı2B = (1.2)2*20%/50% = 58%.

í>ȕ2Bı2Mı2B@

Portfolio B is much riskier than portfolio A as the variance of its returns is 50%

compared with 20% for A. The main reason why it is riskier is that it is much

more sensitive to the return of the market index than portfolio A as its beta is

1.2 compared with 0.6 for portfolio A.

c) Assume the two portfolios have uncorrelated idiosyncratic risk. What is the

covariance between the returns on the two portfolios?

Cov(rA,rB &RYĮAȕA rMİAĮBȕB rMİB ȕA ȕB ı2M

The returns of portfolios A and B are hence (positively) correlated even though

their idiosyncratic return components are not. These returns are positively

correlated because they are positively correlated with the returns of the market

index.

39

92 Corporate finance

Multi-factor models

A generalisation of the structure presented in equation 3.1 posits k factors

or sources of common variation in stock returns.

ri =Įi + ȕ1iF1 + ȕ2iF2 + .... + ȕkiFk + İi E(İi) = 0. (3.2)

Again the idiosyncratic component is assumed uncorrelated across stocks

and with all of the factors. Further, we’ll assume that each of the factors

has a mean of zero. These factors can be thought of as representing news

on economic conditions, financial conditions or political events. Note that

this assumption implies that the expected return on asset i is just given by

the constant in equation 3.2 (i.e. E(ri) Įi). Each stock has a complement

of factor sensitivities or factor betas, which determine how sensitive the

return on the stock in question is to variations in each of the factors.

A pertinent question to ask at this point is how do we determine the return

on a portfolio of assets given the k-factor structure assumed? The answer

is surprisingly simple: the factor sensitivities for a portfolio of assets are

calculable as the portfolio weighted averages of the individual factor

sensitivities. The following example will demonstrate the point.

Example

The returns on stocks X, Y, and Z are determined by the following two-factor model:

rX = 0.05 + F1 – 0.5F2 + İX

rY = 0.03 + 0.75 F1 + 0.5F2 + İY

rz F1 – 0.3F2 + İz

Given the factor sensitivities in the prior three equations, we wish to derive the factor

structure followed by an equally weighted portfolio of the three assets (i.e. a portfolio

with one-third of the weights on each of the assets). Following the result mentioned

above, all we need to do is form a weighted average of the stock sensitivities on the

individual assets. Subscripting the coefficients for the equally weighted portfolio with a p

we have:

1

Įp =

3

ȕ1p = 1 (1 + 0.75 – 0.25) = 0.5

3

1

ȕ2p = (–0.5 + 0.5 –0.3) = –0.1;;

3

and hence; the factor representation for the portfolio return can be written as:

rp F1 – 0.1F2 + İp

where the final term is the idiosyncratic component in the portfolio return.

Activity

Using the data given in the previous example, compute the return representation for a

portfolio of assets X, Y and Z with portfolio weights –0.25, 0.5 and 0.75.

factor model, and also assume that we are given the factor representations

for three stocks. I can construct a portfolio of these three assets, which has

any desired set of factor sensitivities through appropriate choice of the

portfolio weights.1 What underlies this result? Well, to illustrate let’s use 1

In general, if I have

the data from the prior example. Assume I wish to construct a portfolio a k-factor model I will

need k+1 stocks to

with a sensitivity of 0.5 on the first factor and a sensitivity of 1 on the

do this.

second factor. Denoting the portfolio weights on the individual assets by

ȦX, ȦY and ȦZ it must be the case that:

40

Chapter 3: The arbitrage pricing theory

–0.05ȦX + 0.5ȦY – 0.3ȦZ = 1. (3.4)

Finally, it must also be the case that the portfolio weights add up to unity,

so we must also satisfy the following equation:

ȦX + ȦY + ȦZ = 1.

Equations 3.3, 3.4 and 3.5 are three equations in three unknowns, and

we can find values for the portfolio weights which satisfy all three

simultaneously. This illustrates the fact that (as the portfolio factor

sensitivities were arbitrarily set at 0.5 and 1) we can derive any constellation

of factor sensitivities. A particularly interesting case is when the portfolio is

sensitive to one of the factors only. We call this a factor-replicating portfolio

and discuss it below.

In what follows we will assume that the basic securities that we’re going

to work with are themselves broad-based portfolios. The reason for this

is that it allows us to lose the idiosyncratic risk terms associated with

single stocks. Why is this the case? Well, consider the idiosyncratic risk

term for an equally weighted portfolio of 100 stocks. Call the ith idiosyncratic

term İi and assume that all idiosyncratic terms have variance ı2. The variance

of the idiosyncratic element of the portfolio return is then:

100

ε 1

100

100 σ2

Var (εP) = Var ( ∑ i ) = Var (∑ εi) = = σ 2 = 100 .

i =1 100 10000 i =1 10000

Note that, under these assumptions the variance of the idiosyncratic portfolio

return is only one-hundredth of the variance of any individual asset’s

idiosyncratic return. In a general case, where one forms an equally weighted

portfolio of n assets, the variance of the idiosyncratic term for the portfolio

return is n-1ı2. This is a diversification result just like those we used in

Chapter 2. The fact that the idiosyncratic returns are uncorrelated with one

another means that their influence tends to disappear when one groups

assets into large portfolios.

Factor-replicating portfolios

An important application of the technology developed previously in this

chapter is the construction of factor-replicating portfolio. A factor-replicating

portfolio is a portfolio with unit exposure to one factor and zero exposure to

all others. For example, the portfolio replicating factor 1 in model 3.2 would

have ȕ1 = 1 and ȕj = 0 for all j = 2 to k.

Activity

Assume that stock returns are generated by a two-factor model. The returns on three

well-diversified portfolios, A, B and C, are given by the following representations:

rA = 0.10 F1 – 0.5F2

rB = 0.08 + 2F1 + F2

rC = 0.05 + 0.5F1 + 0.5F2.

Determine the portfolio weights you need to place on A, B and C in order to construct

the two factor-replicating portfolios plus a portfolio which has zero exposure to both

factors. What are the expected returns of the factor-replicating portfolios and what is the

expected return of the risk-free portfolio?

41

92 Corporate finance

The question to ask at this point is: why bother constructing factor-

replicating portfolios? The reason is as follows. Suppose I want to build a

portfolio that has identical factor exposures to a given asset, X. Assume a

two-factor world and that asset X has exposure of 0.75 to factor 1 and –0.3

to factor 2. Assume also that I know the two factor-replicating portfolios.

Building a portfolio with the same factor exposures as X is now simple.

Construct a new portfolio, Y, which has portfolio weight 0.75 on the

replicating portfolio for the first factor, portfolio weight –0.3 on the

replicating portfolio for the second factor and the rest of the portfolio

weight (i.e. a weight of 1 – 0.75 + 0.3 = 0.55) on the risk-free asset.

Via the results on the factor representations of a portfolio of assets and

the definition of a factor-replicating portfolio it is easy to see that Y is

guaranteed to have identical factor exposures to X.

The replication in the preceding paragraph forms the basis for the APT. For

absence of arbitrage we require all assets with identical factor exposures

to earn the same return. If they did not, then we would have the chance to

make unlimited amounts of money. For example, assume that the expected

return on the replicating portfolio Y was greater than that on asset X. Then

I should short X and buy Y. The risk exposures of the two portfolios are

identical and hence risks cancel out and I am left with an excess return

that is riskless (i.e. an arbitrage gain).

In order to progress, let us introduce some notation. Denote the risk-

free rate with rf. Denote the expected return on the ith factor-replicating

portfolio with rf + Ȝi such that Ȝi is the risk premium associated with the

ith factor. Again, for simplicity, assume that the world is generated by

a two-factor model, and assume that I wish to replicate asset X, which

has sensitivity ȕ1X to the first factor and ȕ2X to the second factor. Finally,

we will assume that the primary securities being worked with are well-

diversified portfolios themselves. Hence, we will ignore any idiosyncratic

risk in this derivation.

Using the prior argument, to replicate asset X’s factor sensitivities,

we construct a portfolio with weight ȕ1X on the first factor-replicating

portfolio, weight ȕ2X on the second factor-replicating portfolio and weight

1 – ȕ1X – ȕ2X on the risk-free asset. The expected return of the replicating

portfolio is hence:

ȕ1X (rf + Ȝ1) + ȕ2X (rf + Ȝ2) + (1 – ȕ1X – ȕ2X) rf = rf + ȕ1X Ȝ1+ ȕ2XȜ2. (3.6)

Hence, using our factor-replicating portfolios we can write the expected

return on a portfolio which replicates X’s factor exposures as the risk-free

rate plus each factor exposure multiplied by the risk premium on the

relevant factor-replicating portfolio.

Consider an arbitrary asset. The previous sub-section tells us that it’s

simple to replicate this asset’s risk (i.e. its factor exposures) using factor-

replicating portfolios. The key to the APT is that absence of arbitrage

requires that such a pair of portfolios must have identical expected returns

in a financial market equilibrium. If they did not, it would be possible to

make unlimited amounts of money without incurring any risk.

This implies that the expected return on asset X, rX, must be identical to

the expression arrived at in equation 3.6, that is:

E(rX) = rf + ȕ1X Ȝ1+ ȕ2XȜ2. (3.7)

42

Chapter 3: The arbitrage pricing theory

Equation 3.7 is the statement of the APT. The expected return on a financial

asset can be written as the risk-free rate plus sum of the asset’s factor

sensitivities multiplied by the factor-risk premiums (which are invariant

across assets). If such an expression does not hold at all times, arbitrage

opportunities exist. Note the assumptions that are required to achieve this

result. First, we require that asset returns are generated by a two-factor (or

in general k-factor) model. Second, we assume that arbitrage opportunities

cannot exist. Lastly, we assume that enough assets are available such that

firm-specific risk washes away when portfolios are formed.

Example

In the previous two-factor example, we determined the expected returns on the two

factor-replicating portfolios. Denoting the expected return on the ith factor-replicating

portfolio by E(ri) we have:

E(r1 E(r2) = 1.71% E(r3

Hence, the premiums associated with the two factors are:

Ȝ1 ± Ȝ2 ±

This implies that the expected return on any asset in this world can be written as:

E(ri ȕ1i±ȕ2i.

To check that this works, substitute portfolio C’s (for example) factor sensitivities into the

preceding expression. This gives:

E(rC ±

and hence, agrees with the expected return implied by the original representation for

asset C. Check that the expected returns on assets A and B also come out correctly.

the following Activity.

Activity

Assume that a new well-diversified portfolio, D, is added to our world. This asset has

sensitivities of 3 and –1 to the two factors and an expected return of 15 per cent.

Using the equilibrium expected return equation given above, derive the equilibrium

expected return on an asset with identical factor exposures to D. Is there now an

arbitrage opportunity available? If so, dictate a strategy that could be employed to exploit

the arbitrage opportunity.

Summary

The APT gives us a straightforward, alternative view of the world from

the CAPM. The CAPM implies that the only factor that is important

in generating expected returns is the market return and, further, that

expected stock returns are linear in the return on the market. The APT

allows there to be k sources of systematic risk in the economy. Some may

reflect macroeconomic factors, like inflation, and interest rate risk, whereas

others may reflect characteristics specific to a firm’s industry or sector.

Empirical research has indicated that some of the well-known empirical

problems with the CAPM are driven by the fact that the APT is really the

proper model of expected return generation. Chen (1983), for example,

argues that the size effect found in CAPM studies disappears in a multi-

factor setting. Chen, Roll and Ross (1986) argue that factors representing

default spreads, yield spreads and GDP growth are important in expected

return generation. Work in this area is still progressing.

43

92 Corporate finance

Having completed this chapter, and the essential reading and activities,

you should be able to:

understand single-factor and multi-factor model representations

derive factor-replicating portfolios from a set of asset returns

understand the notion of arbitrage strategies and that well-functioning

financial markets should be arbitrage-free

derive arbitrage pricing theory and calculate expected returns using the

pricing formula.

Key terms

arbitrage pricing theory

factor-replicating portfolio

factor sensitivity

multi-factor model

single-factor model

1. Assume that stock returns are generated by a two-factor model. The

returns on three well-diversified portfolios, A, B and C, are given by the

following representations:

rA = 0.10 + F1

rB = 0.08 + 2F1 – F2

rC = 0.05 – 0.5F1 + 0.5F2

a) Discuss what the factor representations above imply for the

variation and comovement in the three stock returns. Show how the

returns of the stocks should be correlated between themselves.

b) Find the portfolio weights that one must place on stocks A, B and

C to construct pure tracking portfolios for the two factors (i.e.

portfolios in which the loading on the relevant factor is +1 and the

loadings on all other factors are 0).

c) If one was to introduce a new portfolio, D, with loadings of +1 on

both of the factors, what would the expected return on D have to be

to rule out arbitrage?

d) Explain the concepts of idiosyncratic risk and factor risk in the APT.

What role does diversification play in the APT?

44

Chapter 4: Derivative assets: properties and pricing

and pricing

The aim of this chapter is to introduce and price derivatives. As in the

previous chapter on APT, the valuation of derivatives relies on a no riskless

arbitrage argument.

Learning objectives

At the end of this chapter, and having completed the essential reading and

activities, you should be able to:

discuss the main features of the most widely traded derivative securities

describe the pay-off profiles of such assets

understand absence-of-arbitrage pricing of forwards, futures and swaps

construct bounds on option prices and relationships between put and

call prices

price options in a binomial framework using the portfolio replicating

and the risk-neutral valuation methods.

Essential reading

Grinblatt, M. and S. Titman Financial Markets and Corporate Strategy. (Boston,

Mass.; London: McGraw-Hill, 2002) Chapters 7 and 8.

Further reading

Brealey, R., S. Myers and F. Allen Principles of Corporate Finance. (Boston,

Mass.; London: McGraw-Hill, 2008) Chapters 21, 22 and 23.

Copeland, T., J. Weston and K. Shastri Financial Theory and Corporate Policy.

(Reading, Mass.; Wokingham: Addison-Wesley, 2005) Chapters 8 and 9.

Overview

A derivative asset is one whose pay-off depends entirely on the value of

another asset, usually called the underlying asset. In the last 20 years,

traded volume in these assets has increased tremendously. Derivatives

are widely used for hedging purposes by financial institutions and are

also used for speculative purposes. In this chapter we discuss the most

commonly traded types of derivative. We go on to introduce the underlying

principles of derivative pricing. We devote the final section of the chapter

to a more detailed description of the features and pricing of options.

Varieties of derivatives

Forwards and futures

Perhaps the oldest type of derivative asset is the simple forward

contract. A forward is an agreement between two parties (called A and

B) and has the following features.

1. Party A agrees to supply party B with a specified amount of a specified

asset, k periods in the future.

45

92 Corporate finance

the goods are received.

Party A is said to hold a short position in the contract and party B a

long position.

Hence, the forward is just an agreement made today to undertake a given

transaction at some specified future date, known as the settlement

date. Currency and commodities are often traded using forwards, the

advantage of such transactions being that they allow an agent to remove

any price uncertainty regarding a transaction that must be undertaken in

the future.

Example

Assume that party B is American and that in three months he must pay ¥250,000 for a

Japanese machine he has purchased. Party B enters into a contract to buy yen three months

forward. Party A (the agent who is to supply the yen) specifies that the cost of ¥100 will be

$1.20. The total price that party B must pay in three months is therefore $3,000.

futures are refined versions of forwards. Although forwards are generally

bilaterally negotiated between two parties directly, futures are standardised

forward contracts that are exchange traded. The contracts give precise

specifications for the quality and quantity of the assets to be exchanged.

The major difference between futures and forwards is in the exchange of

monies involved. With a forward, the agent who is long pays the entire

forward price at the settlement date. Futures positions, however, are

marked to market. This occurs on a daily basis and means that any

increases/decreases in the value of the future are received/paid by the

party who is long day by day. At the settlement date, the current spot price

of the asset is transferred from the agent who is long to the agent who is

short.1 1

See pp.236–40 in

Grinblatt and Titman

Futures are traded on exchanges such as the London International (2002).

Financial Futures and Options Exchange (LIFFE), the Chicago Board of

Trade (CBOT) and the Chicago Mercantile Exchange (CME). Contracts

with very high volumes include those on government bonds, interest rates

and stock indices.

Options

The option is a less straightforward type of derivative. Although the

forward or future contract implies an obligation to trade once the contract

is entered into, the option (as its name suggests) gives the agent who is

long a right but not an obligation to buy or sell a given asset at a pre-

specified price. This price is known as the exercise price and is specified

in the option contract. Just as with the forward, another factor specified

in the contract is the date on which the exchange is to take place. If, on

the maturity date, the holder of an option decides to buy or sell in line

with the terms of the contract, he or she is said to have exercised his or

her right. A big difference between options and forwards is that, with an

option, the agent who is long must pay a price (or premium) at the outset.

This is essentially a price paid by the holder for the exercise choice he or

she faces at maturity.

Options to buy the specified asset are called call options. Options to sell

are called puts. Another distinction is made on the timing of the exercise

decision. With European options, the right can only be exercised on the

46

Chapter 4: Derivative assets: properties and pricing

maturity date itself. With American options, in contrast, the option can be

exercised on any date at or before maturity. American options are traded

far more frequently than their European counterpart, but for reasons of

simplicity, we will focus on the European variety.

Example

A 12-month European call option on IBM has exercise price $45. It gives me the right

to purchase IBM stock in one year at a cost of $45 per share. In line with the prior

discussion, I am under no obligation to buy at $45 such that, if the market price were less

than this amount, I could choose not to exercise and buy in the market instead.

Swaps

Swaps are another type of derivative, which do exactly what their name

says. Two counterparties agree to exchange (or swap) periodic interest

payments on a given notional amount of money (the notional principal)

for a given length of time.

A very common type of swap involves an exchange of interest payments

based on a market-determined floating rate (such as the London InterBank

Offer Rate (LIBOR)) for those calculated on a fixed-rate basis. Another

frequently traded variety of swap involves the exchange of interest

payments in different currencies. For example, fixed sterling interest

payments may be exchanged for fixed dollar interest payments.2 2

The notional principal

is not exchanged in an

interest rate swap (they

Derivative asset pay-off profiles would net out anyway)

but are generally

For now we are going to concentrate on forwards and options. As exchanged in currency

mentioned above, futures are closely related to forwards, and their pricing swaps.

is based on the technique presented below. The relationship between

forwards and swaps will be made clear later.

Before getting on to the principles of derivative pricing, let us take a look

at the pay-off profiles of the basic forward and option contracts. The pay-

off profile of a long forward position is shown in Figure 4.1. In the figure,

F is the price agreed upon in the forward contract, and S is the spot price

of the asset at the settlement date. Note that the pay-off profile is linear,

positive for values of S greater than F and negative when S is less than F.

Figure 4.1

47

92 Corporate finance

Understanding the forward pay-off is simple. If the spot price for the asset

at maturity exceeds the forward price, then the party that is long has

gained by entering into the forward (i.e. he’s got the asset for a lower price

than it would have cost if bought in the spot market). If the spot price at

maturity is lower than the forward price, then the long pay-off is negative,

as it would have been cheaper for the long party to buy the asset in the

spot market rather than entering into the forward. Obviously, the pay-off

of a short forward position is the negative of that shown in Figure 4.1.

Let’s now consider the pay-off to a holder of a European call option.

This is given in Figure 4.2 where the option’s exercise price is labelled

X. Remember that a call option gives the holder the right but not the

obligation to purchase the asset. What occurs when the price of the

spot asset at maturity exceeds the exercise price of the option? Well it is

cheaper to buy the asset using the option than in the spot market; hence

the option is exercised, and the holder makes a gain of the spot price less

the exercise price. When the spot price is lower than the exercise price,

then the holder would find it cheaper to buy the asset at spot and hence

does not exercise the option. The pay-off to the holder is then zero.

Figure 4.2

The pay-off to the holder of a European put is given in Figure 4.3. As the

put gives the holder the right to sell the underlying asset, the holder gains

when the exercise price exceeds the spot price and has a zero pay-off when

the spot price at maturity is greater than or equal to the exercise price.

Figure 4.3

48

Chapter 4: Derivative assets: properties and pricing

Each option must have one agent who is long and one who is short, with

the pay-offs to the long position given in Figures 4.2 and 4.3. An agent

who is short is said to have written the option, and his or her pay-offs

are the negative of those given above. Note that an agent with a long

option position never has a negative pay-off, whereas an agent who has

written an option never has a positive pay-off at maturity. The option

price, paid at the outset by the agent who is long to that who is short, is

the compensation to the writer of the option for holding a position that

exposes him or her to weakly negative cash flows.

The key to pricing options, and other derivative assets, is constructing

a portfolio of assets that is priced in the market and that has a pay-

off structure identical to that of the derivative. As the derivative and

replicating portfolio have identical pay-offs, absence-of-arbitrage

arguments imply that the cost of these portfolios must be identical. The

no-arbitrage price of the derivative is hence just the initial investment cost

needed to set up the replicating portfolio.

In the case of a forward contract, the derivation of the no-arbitrage price

is quite simple.3 Assume the current spot asset price is S0 and that the one- 3

Given the similarities

period, riskless rate of interest is r. We wish to value a k period forward discussed previously,

we can also use the

contract. It is easily verified that the k-period forward price (Fk) is given by

derived forward price to

the following expression: approximate the price of

Fk = S0(1 + r)k. (4.1) a futures contract.

Why is this the case? Well, consider the following pair of investment

strategies.

The first is simply a long position in the forward contract. This costs

nothing at the present time and yields Sk – Fk at maturity.

The second strategy involves buying a unit of the asset at spot and

borrowing Fk(1+r)–k at the risk-free rate for k periods. The k period pay-

off of this strategy is also Sk – Fk, and its net current cost is S0 – Fk(1+r)–k.

The pay-offs of the two strategies are identical. This implies that the two

investments should have identical costs. As the cost of investment in the

forward is zero, this implies that the following condition must hold:

S0 – Fk(1+r)–k = 0. (4.2)

Rearranging equation 4.2 we derive the no-arbitrage price for the k period

forward contract, which is precisely that given in equation 4.1.

Activity

The current value of a share in Robotronics is $12.50.

1. The one-year riskless rate is 6 per cent. What are the prices of three- and five-

year forward contracts on Robotronics stock?

2. Three-year forward contracts are currently being sold for $16 in the market.

Outline an investment strategy that could take advantage of the opportunities

this presents.

Some of the most active forward markets are those for foreign currency.

The forward pricing analysis above, however, is suited only for assets

valued in the domestic currency (e.g. individual stocks or stock indices).

To illustrate the pricing of currency forwards, consider the following

49

92 Corporate finance

the domestic currency is £) is assumed to face a spot exchange rate of

S and a k period forward rate of Fk. These rates are constructed as the

domestic currency price of one unit of foreign currency (i.e. the spot rate

implies an exchange rate of £S for $1). The one-period domestic interest

rate is denoted r and its foreign counterpart rf .

Again, let us compare two investment strategies that can be undertaken

assuming an investor currently holds £S. The first involves depositing this

cash in a domestic risk-free account for k periods. This yields £ S(1+r)k at

the maturity date of the investment. Alternatively, the investor could swap

his or her sterling for dollars at the spot exchange rate and invest the funds

at the US rate. As his or her £S is equivalent to $1 at the spot exchange

rate, this investment yields $ (1+rf)k in k periods. The investor can then sell

the proceeds for sterling using a forward contract yielding £ Fk(1+rf)k.

Note that both of these investments are riskless, assuming that the interest

rates are known and fixed and given that the spot and forward exchange

rates are known at the current date. Further, both investments cost £S.

This implies that the pay-offs from the two strategies should be identical.

Equating these returns we get:

S(1 + r)k = Fk(1 + rf )k. (4.3)

Rearranging equation 4.3, we get the no-arbitrage k period currency

forward price:

( (

1+r k

Fk = S 1 + r .

f

(4.4)

The gross interest rate in equation 4.1 is just replaced by the ratio of

domestic to foreign rates in equation 4.4. In the international finance

literature, the currency forward rate expression in 4.4 is known as the

covered interest rate parity relationship.

Activity

The current spot exchange rate is £0.64 = $1. The riskless rate in the UK is currently 6

per cent and that in the US is 4 per cent. Using equation 4.4, derive the implied five- and

10-year forward exchange rates.

Pricing options is far less straightforward than pricing forwards. To begin,

however, we introduce a binomial setting, in which the pricing of options 4

This is where the term binomial

turns out to be surprisingly straightforward. comes from in the name of our

method.

In order to make things as simple as possible, let us consider a binomial

setting in which all derivatives last only for one period (starting today and

ending tomorrow). Let us denote the current price of the underlying asset

by S0. Let us assume that uncertainty in this world is represented by the

price of the underlying asset, taking one of two values tomorrow.4 If the

state of the world is good, the price of the asset will rise tomorrow to SH,

with SH = (1+u)S0 and u>0. In contrast, if the state of the world is bad, the

price of the underlying asset will decrease to SL,, with SL = (1–d)S0 and d>0.

Let us now consider a one-period derivative asset. If the state of the world

is good tomorrow, then the derivative will pay KH, and if the state of the

world is bad tomorrow the derivative will pay KL. Finally we assume that

the one-period risk-free interest rate is rf (i.e. a safe bond costing one unit

of currency pays 1+ rf units of currency tomorrow).

50

Chapter 4: Derivative assets: properties and pricing

In order to price this derivate asset, we will consider two different methods:

the portfolio replicating method

the risk-neutral valuation method.

The portfolio replicating method prices the derivative asset using absence-

of-arbitrage arguments. First, this necessitates constructing a portfolio,

containing the underlying asset and the risk-free asset, that has identical

pay-offs to the derivative. Assume we purchase a units of the underlying

asset and b units of the risk-free asset.

If the state of the world tomorrow is good then the value of our portfolio

will be:

aSH + b(1 + rf ), (4.5)

when the pay-off of the derivative is KH. If the state tomorrow is bad the

portfolio is worth:

aSL + b(1 + rf ), (4.6)

and the derivative is worth KL. Note that equating the value of the

portfolio with the pay-off of the derivative in each state of the world

gives us two equations in two unknowns (a and b). These unknowns are

our initial holdings of the underlying and the risk-free asset. Solving the

two equations gives us precisely the portfolio weights we need to use to

replicate the option pay-off in both states of nature. This yields:

KH – KL

a= S –S . (4.7)

H L

and

SLKH – SHKL .

b= (4.8)

(1 + rf )(SL – SH)

that replicates that of the derivative (i.e. regardless of the state of the

world, the portfolio and the derivative have the same value). If two assets

have identical pay-offs then absence-of-arbitrage arguments tell us that the

price/cost of the two assets must be identical. The cost of the replicating

portfolio is aS0 + b. It hence follows that:

K0 = aS0 + b. (4.9)

A practical example of how this technique might work for a European call

option is given below.

Example

A one-period European call option on ABC stock has an exercise price of 120. The current

price of ABC stock is 100, and if things go well, the price in the following period will be

150. If things go badly over the coming period, the future price will be 90. The risk-free

rate is 10 per cent. What is the no-arbitrage price of this option?

First we need to know the option pay-offs. In the bad state it pays zero, as the underlying

price is less than the exercise price. In the good state it pays the excess of the underlying

price over the exercise price (i.e. 30).

Next we construct the replicating portfolio. Using equations 4.3 and 4.4, the quantities of 5

You should check

the underlying and risk-free asset we must buy are 0.5 and –40.91 (i.e. we buy half a unit all these calculations

of stock and short 40.91 units of the risk-free asset).5 This portfolio replicates the option and further check that

the portfolio we’ve

pay-off, and therefore the option price is given by the cost of constructing the portfolio.

constructed does indeed

The call price (c) is hence: replicate the option

c =± pay-off.

51

92 Corporate finance

Activity

Using the stock price data from the previous example, price a European put option on

ABC stock with a strike price of 100.

Using the portfolio replicating method, we find that the current price of

the derivative asset, relative to the current price of the underlying asset,

does not depend on the probability that the state of nature will be good

(or bad) tomorrow. Neither does it depend on investor risk preferences.

The reason for this is that information about probabilities or risk aversion

is already captured by the current price of the underlying asset on

which we base our valuation of the derivative asset. The fact that the

no-arbitrage price of the derivative asset in relation to the price of the

underlying asset is the same, regardless of risk preferences, serves as a

basis for a neat trick also known as the risk valuation method.

The risk-neutral valuation method is a procedure involving the following

steps.

1. Identifying the risk-neutral probabilities, that is, the probabilities which

are consistent with investors being risk-neutral. These probabilities are

the probabilities for which the current price of the underlying asset

is the present value of tomorrow’s asset prices, with the discount rate

being equal to the risk-free rate.

2. Calculating the current price of the derivative asset as the present value

of tomorrow’s derivative values using the risk-neutral probabilities

derived in the previous step and the risk-free rate as the discount rate.

Let us denote the risk-neutral probability that the state of nature will be

good tomorrow by q. It hence follows that:

qSH + (1 – q)SL

S0 = . (4.10)

1 + rf

Equivalently, the risk-neutral probability q is given by the following

identity:

S0(1 + rf ) – SL rf + d

q= = . (4.11)

SH – SL u+d

The current price of the derivative asset can be expressed as the present

value of tomorrow’s derivative values using the risk-neutral probabilities in

equation 4.11 and the risk-free rate as the discount rate:

qKH + (1 – q)KL

K0 = . (4.12)

1 + rf

After substituting q from equation 4.11, we obtain:

(d + rf )KH + (u – rf )KL

K0 = . (4.13)

(1 + rf )(u + d)

Activity

Using the risk-neutral valuation method, price both a European call option and a

European put option on the ABC stock (introduced in the previous example) with a strike

price of 100.

52

Chapter 4: Derivative assets: properties and pricing

Activity

Show that the current price of the derivative obtained from the portfolio replicating

method in equation 4.9 is the same as the one obtained from the risk-neutral valuation

method in equation 4.13.

The risk-neutral valuation method is very efficient at pricing multiple

derivative assets on the same underlying asset as the same risk-

neutral probabilities can be used to price all the derivatives. In these

circumstances, the portfolio replicating method is more tedious to use as

the replicating portfolio will typically be different for each derivative asset.

The assumptions we have made above may seem very restrictive. We

have restricted tomorrow’s price to take one of two values and assumed

that derivatives last only for one period. Extending the above model to

more than one period is straightforward, and this allows longer maturity

instruments to be priced. Also, we can shrink the length of time that we

have referred to as one period. It could represent one day, one hour or one

minute if we wanted. A binomial model for hourly prices, for example,

may be thought more reasonable than a binomial model for annual prices.

Then, using a multi-period derivative valuation we could price a one-

month option from a binomial model of hourly stock returns. The binomial

structure is not as restrictive as you might think.

The binomial model allows us to derive option prices under certain

assumptions on the behaviour of the price of the underlying asset. In this

section we present some arguments that place bounds on European option

prices and can be made without specification of a model for the underlying

price. In order to link up with the following section (on Black–Scholes

prices), we will present our arguments using a continuously compounded

risk-free rate, r. We assume unlimited borrowing and lending at this rate

along with our standard frictionless market assumptions of no transaction

costs and taxes. Finally, we also assume that the underlying asset pays out

no cash during the option lifetime (such that the option can’t be written on

dividend paying stock or coupon bonds, for example).

A call option is the right (but not the obligation) to purchase a unit of a

specified asset for price X. It should be obvious to you then that the option

can never be worth more than the stock. Hence, denoting the call option

price by c we have:

F6. (4.14)

As a European put gives the holder the right to sell a given quantity of

an asset for X, the put can never be worth more than X. Denoting the put

price by p we then have:6 6

Clearly both this and

the previous argument

S;. (4.15) hold for American

Further, if the put is European, we know that the value at maturity is at options as well as

European options.

most X. If there are T periods to maturity, a present-value argument then

implies that:

S;H–rT. (4.16)

53

92 Corporate finance

No-arbitrage arguments can be simply employed to develop lower bounds

for European puts and calls. A lower bound for a European call option

price is given by:

F6±;H–rT (4.17)

where X is the exercise price, and there are T periods to maturity. To show

this, consider the following argument. Assume I hold two portfolios.

Portfolio A consists of a European call option struck at price X, plus cash of

the amount Xe–rT. Portfolio B consists of the underlying stock.

Assume I invest the cash from portfolio A at the risk-free rate. This implies

that, when the option in portfolio A matures, I have cash worth X. If

at maturity the underlying price (ST) exceeds the exercise price, then I

exercise the call option using my cash, and the portfolio is worth ST. If at

maturity the underlying price is less than X, I do not exercise the option,

and hence my portfolio is worth X. The value of portfolio A at maturity can

be written as:

max(ST,X).

At the maturity date the value of portfolio B is always just ST. Hence,

portfolio A is always worth at least the same as portfolio B, and sometimes

(when exercise is not optimal) it is worth more. Reflecting this and to

prevent arbitrage, the price of buying portfolio A must exceed the cost of

portfolio B. This reasoning implies:

c + Xe–rT > S c > S – Xe–rT. (4.18)

Also, an option must have positive value since, at the very worst, it is

not exercised as it is out of the money. This implies that 4.18 can be

generalised to:

FPD[[0,S – Xe–rT]. (4.19)

A similar argument to the above can be used to establish a lower bound on

the price of a European put. It’s easy to show that:

p > Xe–rT – S. (4.20)

To demonstrate this, consider two more portfolios. Portfolio 1 consists of a

European put and a unit of the underlying stock, and portfolio 2 consists

of Xe–rT in cash.

At the date at which the put matures, portfolio 1 is worth either X (if it’s

profitable to exercise the put, and hence you sell the unit of the underlying

for X) or ST (when exercise isn’t optimal and you’re left with the stock, as

the put expires with zero value). We can then write the value of portfolio

1 as:

max(X,ST).

Portfolio 2 is always worth X at the date when the put matures and is

hence weakly dominated in pay-off terms by portfolio 1. Therefore, to

prevent arbitrage, portfolio 1 should cost more to set up than portfolio 2,

implying:

p + S > Xe–rT p > Xe–rT – S. (4.21)

Finally, again we know that the worst that can happen for a put option is

for it to expire, worth nothing. This implies that its value must exceed zero

in all circumstances. Thus:

SPD[[0,Xe–rT – S]. (4.22)

54

Chapter 4: Derivative assets: properties and pricing

A combination of the upper and lower bounds derived in the preceding

two sections can be formed graphically. This gives a set of permissible (in

the sense of not admitting arbitrage) put and call prices. As an example,

Figure 4.4 shows the permissible call price region (it is the shaded area of

the diagram).

Figure 4.4

Our previous pricing analysis was predicated on the assumption that stock

prices are well-represented by a discrete time, binomial model. In 1974,

Fischer Black and Myron Scholes presented an option pricing formula,

based on a continuous time process for the stock price. This analysis

gave exact prices for European puts and calls using a continuous time

version of the replication strategy followed in our binomial methodology.

Unfortunately, derivation of their pricing formula is beyond the scope of

the current presentation. However, due to its wide use in the financial

markets and the intuition it brings regarding the determinants of option

prices, we will describe the pricing formula below.

Assume we wish to price a European call on a stock that never pays

dividends. The current price of the stock is S, the exercise price of the

option under consideration is denoted X, and the option is to have a

maturity of T periods. The continuously compounded risk-free rate is

denoted r. One final parameter is needed to calculate the B–S price of the

call option. This is the instantaneous volatility of the stock price, and we

denote this parameter V. It is the standard deviation of the change in the

logarithm of the stock price.

The famous B–S formula for the price of a European call option is given

below:

c = SN(d1) – Xe–rT N(d2) (4.23)

where

1n (S / Xe−rT ) σ√T

d1= + (4.24) 7

The values of the

σ√T 2 cumulative standard

normal distribution

d2= d1 – σ√T (4.25)

function can be found

and N(.) represents the cumulative normal distribution function.7 in tables in the back

of any good statistical

textbook.

55

92 Corporate finance

Example

The current price of Glaxo Wellcome shares is £2.88. An investor writes a two-year call

option on Glaxo with exercise price £3.00. If the annualised, continuously compounded

interest rate is 8 per cent, and the volatility of Glaxo’s stock price is 25 per cent, what is

the B–S option price?

First we need to derive the values d1 and d2 defined as above. Using 4.24 and 4.25

these are 0.5139 and 0.1603. The values of the cumulative normal distribution function

at 0.5139 and 0.1603 are 0.696 and 0.564. Then, plugging all the available data into

equation 4.23 yields a call price of £0.5644.

What does equation 4.23 tell us about the determinants of call prices?

Well, there are clearly a number of influences on the price of an option,

and these are summarised below.

The effect of the current stock price: the B–S equation tells us

that call option prices increase as the current spot asset price increases.

This is pretty unsurprising as a higher underlying price implies that the

option gives one a claim on a more valuable asset.

The effect of the exercise price: again, as you would expect,

higher exercise prices imply lower option prices. The reason for this is

clear: a higher exercise price implies lower pay-offs from the option at

all underlying prices at maturity.

The effect of volatility: Figure 4.2 gives the pay-off function of a

European call option. Note that, although extremely good outcomes

(underlying price very high) are rewarded highly, extremely bad

outcomes are not penalised due to the kink in the option pay-off

function. This would imply that an increase in the likelihood of extreme

outcomes should increase option prices, as large pay-offs are increased

in likelihood. The B–S formula verifies this intuition, as it shows that

call prices increase with volatility, and increased volatility implies a

more diverse spread of future underlying price outcomes.

The effect of time to maturity: call option prices increase with time

to maturity for similar reasons that they increase with volatility. As the

horizon over which the option is written increases, the relevant future

underlying price distribution becomes more spread-out, implying increased

option prices. Furthermore, as the time to maturity increases, the present

value of the exercise that one must pay falls, reinforcing the first effect.

The effect of riskless interest rates: call option prices rise when

the risk-free rate rises. This is due to the same effect as above, in that the

discounted value of the exercise price to be paid falls when rates rise.

Put–call parity

The B–S formula gives us a closed-form solution for the price of a

European call option under certain assumptions on the underlying asset

price process. However, as yet, we have said nothing about the pricing of

put options. Fortunately, a simple arbitrage relationship involving put and

call options allows us to do this. This relationship is known as put–call

parity. In what follows we assume the options have the same strike price

(X), time to maturity (T) and are written on the same underlying stock.

Consider an investment consisting of a long position in the underlying

asset and a put option, called portfolio A. The cost of this position is

S0 + p. A second portfolio, denoted B, comprises a long position in a call

option and lending Xe–rT. Hence the cost of this position is c + Xe–rT.

56

Chapter 4: Derivative assets: properties and pricing

What are the possible pay-offs of these positions at maturity? Given the

pay-off structure on the put shown in Figure 4.3, the pay-off on portfolio A

can be written as follows:

max[X – ST,0] + ST = max[X,ST]. (4.26)

Similarly, the pay-off on portfolio B can be written as:

max[0,ST – X] + X = max[X,ST]. (4.27)

Comparison of equations 4.26 and 4.27 implies that the two portfolios

always pay identical amounts. Hence, using no-arbitrage arguments,

portfolios A and B must cost the same amount. Equating their costs we have:

S + p = c + Xe–rT. (4.28)

Equation 4.28 is the put–call parity relationship. Given the price of a call,

the value of the underlying asset and knowledge of the riskless rate, we

can deduce the price of a put. Similarly, given the put price, we can deduce

the price of a call with similar features.

Example

A call option on BAC stock, with an exercise price of £3.75, costs £0.25 and expires

in three years. The current price of BAC stock is £2.00. Assuming the continuously

compounded (annual) risk-free rate to be 10 per cent, calculate the price of a put option

with three years to expiry and exercise price of £3.75.

From equation 4.28 we have:

p = c + Xe–rT – S.

Plugging in the data we’re given yields:

p = 0.25 + 3.75e–0.1(3) – 2 = 1.03.

Hence, the no-arbitrage put price is £1.03.

for the put price. This equation allows us to deduce the effects of changing

the B–S parameters on put prices.

The effect of underlying price: for the opposite reason to that

given for the call, put prices drop as underlying prices increase.

The effect of the exercise price: similarly, put prices rise as

exercise prices rise.

The effect of volatility: put options and call options are affected in

identical ways by volatility. Hence, as volatility increases, put prices rise.

The effects of time to maturity: increased time to maturity will

lead to a greater dispersion in underlying prices at maturity, and hence

put prices should be pushed higher. However, as the holder of a put

receives the exercise price, discounting at higher rates makes puts less

valuable. The combined effect is ambiguous.

The effect of the risk-free rate: puts are less valuable as interest

rates rise, due to a greater degree of discounting of the cash received.

Activity

ABC corporation’s shares currently sell at $17.50 each. The volatility of ABC stock is 15

per cent. Given a risk-free rate of 7 per cent, price a European call with strike price of

$15 and time to maturity 5 years. Use put-call parity to price a put with similar

specifications. What are the no-arbitrage prices of the call and the put if the risk-free

rate rises to 10 per cent?

57

92 Corporate finance

Recall the definition of an interest rate swap given earlier in the chapter.

Agent A contracts to give fixed interest payments (on a given principal) to

agent B. In return agent B agrees to deliver to agent A interest payments

(on the same principal) based on an agreed floating exchange rate. The

frequency and duration of these interest payments are also agreed in

advance. A very common choice of floating interest rate used in such

contracts is the London Interbank Offer Rate (LIBOR).

An example of such an agreement is as follows. Agent A agrees to pay

agent B payments on a $1m principal at a fixed 8 per cent rate. Agent

B agrees to pay interest payments of LIBOR plus 0.25 per cent. These

payments are to be made annually for the next 10 years.

Note that, from the previous example, the payments made by agent A at

every date till maturity are known and fixed (i.e. 8 per cent of $1 m). His

or her receipts, however, are uncertain. He or she gains a 0.25 per cent

premium above an ex-ante uncertain interest rate. Consider, for example,

the transaction at the second payment date. Agent A pays $50,000 and

receives LIBOR + 0.25 per cent. This looks identical to the cash flows

from a forward contract. Indeed, we can regard the transaction at every

payment date as a forward transaction. Hence the swap in entirety can

be considered a package of forwards. Using the forward pricing equations

given above, the swap is simply priced.

In the situation where interest payments in different currencies are exchanged,

the situation is slightly more murky, but the same basic principle maintains.

Swaps are just packages of forward contracts and can be priced as such.

Summary

This chapter has treated the nature and pricing of the most important

and heavily traded derivative securities. We have looked at the basic

specifications of forward, futures, option and swap contracts and what

these specifications imply for the pay-off functions of long and short

positions. Further, we have looked at methods that can be used to price

these securities. The basis of pricing is absence of arbitrage in all cases. We

looked most deeply at option contracts, detailing the relationships between

put, and call prices, and bounds on option prices, and finally we examined

the continuous time option pricing formula of Black and Scholes.

Although we’ve covered a lot of material here, the continual evolution and

innovation of derivatives markets and assets means that we missed much

more than we’ve treated. However, the basic features of derivatives pricing

that we’ve looked at can be extended to new and more complex securities.

Having completed this chapter, and the essential reading and activities,

you should be able to:

discuss the main features of the most widely traded derivative securities

describe the pay-off profiles of such assets

understand absence-of-arbitrage pricing of forwards, futures and swaps

construct bounds on option prices and relationships between put and

call prices

price options in a binomial framework using the portfolio replicating

and the risk-neutral valuation methods.

58

Chapter 4: Derivative assets: properties and pricing

Key terms

American option

binomial method

Black–Scholes

call option

covered interest rate parity relationship

derivative

European option

exercise price

forward contract

futures contracts

long position

marked-to-market

notional pricing

put option

risk-neutral method

settlement date

short position time to maturity

underlying price

1. Describe the main features of forward and futures contracts. How do

forward and futures contracts differ? Derive the no-arbitrage price of a

forward contract. (10%)

2. Describe the main features of options contracts. Show how to price a

standard European call option using a single-period binomial model.

(10%)

3. British Telecom shares are currently trading at 312p. Historically, the

(annualised) volatility of BT shares has been 20 per cent. Compute the

Black–Scholes price of a European call on BT equity, assuming a strike

price of 350p and time to maturity of six months. Assume that the risk-

free rate is 5 per cent. (5%)

59

92 Corporate finance

Notes

60

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