Вы находитесь на странице: 1из 2

Important Financial Assets:

I. Fixed Income Securities – borrowing instruments - in order of riskiness -Treasury Bonds, Municipal Bonds (tax exempt), Corporate Bonds

II. Equity – ownership in a firm - common stock (voting rights – junior), preferred stock (non-voting – senior) bankruptcy (Government, Employees, Bondholders, Preferred, Common)

III. Derivatives – securities depend on other assets (options, futures, swaps, bonds – energy, gold) – call (put) right to buy (sell) asset; long (short) future obligation to buy (sell) asset

IV. Mutual Funds – pools funds from investors and buys assets. Provides management and diversity with lower transaction costs.

V. Asset-backed securities

Market Types: Determine by how standard the asset is and the trade volume

I. Direct Search: requires buyers and sellers to search for each other. Non-standardized assets, low volume of trade, high effort of search (craigslist)

II. Dealer Market: Dealers hold inventory and stand ready to quote prices for buying and selling. Increased standardization, modest trade volume, easier market (cars)

III. Exchange: Standardized assets, high trade volume, central location for buyers and sellers, aggregates supply and demand (NYSE)

Liquidity: market is liquid if the asset can be traded immediately and without a big impact on price Provision of liquidity: can be provided by dealers or limit orders from other investors (limit orders provide a price and quantity at which you can buy or sell immediately) (mkt orders use up liquidity) Bid-ask spread: Market maker makes a profit buy buying at bid price and selling at ask-price- compensation for the services they provide- providing liquidity has risk High volume of trade: leads to smaller bid-ask spread: reduces inventory risk, dealers need less compensation for the risk they take Higher equilibrium price volatility: increases bid-ask spread: greater fluctuations in price increase risk for dealer therefore dealer demands more compensation Greater competition amongst dealers: leads to lower bid-ask spreads

Time Value of Money PV = present value, P = price

PV = FV

(1 + R)

t

FV = future value, F = face value

R = Interest rate

FV = PV(1 + R) t

R = YTM (bonds) = ( FV PV

) 1

t

- 1

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

C= cash flow/payments

t = log( FV

PV

)

log(1 + R)

Discount Factor = 1

(1 + R)

t

Zero Coupon Bonds  P = F � 1 (1 – (1+R) t ) Annuity
Zero Coupon Bonds  P = F
1
(1 –
(1+R) t )
Annuity  PV = C ×
R

(1 + R)

t

= C × PV factor

Multiple Cash Flows C(0) + C(1) 1

(1 + R)

+ C(2) 1

(1 + R) 2

… + C(t) 1

(1 + R)

t

Future Value of Multiple Cash Flows FV(t) = C(0)(1+R) t + C(1) (1+R) t-1 + … + C(t)

Perpetuity PV = C

r

*if either paid later, make PV into FV, then calculate PV with given R and t

Return Measures APR = R = quoted rate

EAR = effective annual rate

EAR (Number of times per year) = (1+( R

m

)) m

1

m = # of times compounded per year

EAR (continuous) = e R 1

t = time periods (years)

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

FV (continuous compounding) = PV × e Rt

HPR = Holding Period Return

HPR = ending price+cash dividend 1

beginning price

ann.HPR = Annualized Holding Period Return

ann.HPR = ( ending price+cash dividend

beginning price

)

1

t

1

t = time periods (years)

ann.HPR= (1 + HPR) 1

t

1

Multiple-Period Realized Return Methods

r = return rate

t = time periods (years, months, etc)

Arithmetic Average = (r 1 +r 2 +r 3 + +r t )

t

Geometric Average = [(1 + r 1 )(1 + r 2 )(1 + r 3 ) … (1 + r t )] 1

t

1 = ( accumulated value t

value 0

)

1

t

1

IRR = Internal Rate of Return

NPV =

t=1

C

t

=

(1+IRR) t

C 0 +

NPV = Net Present Value

C

1

(1+IRR) 1

+

(1+IRR) 2 +

C

2

(1+IRR) 3 +

C

3

C = cash flows

+

(1+IRR) t = 0

C

t

C 0 = Initial cash flow

t = time periods (years, months, etc)

Portfolio Selection with Two Risky Assets

R = return

i = investment/asset/security

p = probability (< 1)

= weight

s = security

n = number of assets in portfolio

= correlation

Expected Return E(R) (mean) for a security (in different economic conditions) ER p =

Variance (security) σ 2 i =

n

i=1

p(s) i R(s) i =

p(s) 1 R(s) 1 + … + p(s) n R(s) n

n

i=1

R i ER p 2 p(s)

Standard deviation (security) σ i R = σ i 2 volatility

Expected Return E(R) (mean) for portfolio (multiple securities) ER p =

Variance (portfolio with two risky assets) σ 2 p =ω 1 2 σ 1 2 + ω 2

Covariance (two variables) = Cov(R i , R j ) =

Correlation (two variables) = ρ i,j = Cov(R i ,R j )

n

i=1

ω i R i =

ω 1 R 1 + … + ω n R n where

Standard deviation

ω = value of stock i position

total $value of portfolio

2

2

σ 2

+ 2ω 1 ω 2 ρ 1,2 σ 1 σ 2

(portfolio) σ i = ω 1 σ 1 + ω 2 σ 2

n

i=1

R i E(R i )��R j ER j p(s) covariance of a variable with itself is its variance

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

+ω 2 , ω 2 =

ω 1

ω

1

ω 2

ω 1 2

Expected

Return

E(R)

σ

i σ j

Investment Opportunity Set (2 Risky Investments)

High Utility Medium Utility Low Utility Efficient Frontier R 1 Short Security 2 Optimal Portfolio
High Utility
Medium Utility
Low Utility
Efficient
Frontier
R 1
Short Security 2
Optimal Portfolio
Minimum Variance
Portfolio
Short Security 1
R 2
Investor Curves
Indifference

Given a correlation coefficient of -1 (perfect negative correlation) with two investmentsω 1 =

Utility Function

U = utility / attractiveness

A = risk aversion (A>0)

UR p = ER p 0.5 × AVar(R p )

Given investor risk aversion values and characteristics of stocks (E(R) and σ 2 ), calculate utility. Higher U means more utility.

Standard

Deviation

(s )

Portfolio Selection with One Risky and One Risk-free Asset

Expected

Return

E(R)

E(R L ) = 15.7%

E(R US ) = 12.13%

E(R K ) = 8.57%

R f = 5%

Risk-Free Asset E(R f ) = R f , Variance (R f ) = 0, Cov(R i , R f ) = ρ i,f = 0 for any other asset i Expected Return E(R) (mean) for portfolio (one risky and one risk-free)

Excess Return

E(R p )= ω i E(R i ) + (1 −ω)E(R f ) = R f + ω × ������� E (R ����� i R f )

Risk premium

Variance (one risky, one risk-free) σ 2 p = ω 2 σ i 2

Given that |ω| =

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

σ p , E(R p ) = R f +

σ

i

E(R i R f )

σ

i

× σ p E(R p ) =

R f + SR i × σ p forms Capital Allocation Line(CAL)

�����

Sharpe Ratio

Sharpe Ratio SR i = E(R i R f ) represents return premium per unit of risk highest SR = tangency portfolio CAL

σ

i

The tangency point is the point on the CAL tangent to the efficient frontier where 100% of assets are invested in the risky assets. Portfolios above this point on the CAL short risk-free assets (negative percentage of R f in the portfolio) and portfolios below this point on the CAL are long in the risk-free asset (positive percentage of R f in the portfolio) Risk aversion drives % of risk-free (R f ) assets.

Portfolio Selection with Two Risky and One Risk-free Asset or Many Risky and One Risk-free Asset

Find highest Sharpe Ratio (SR) for risky asset pairs and select tangency portfolio.

Expected

Return

E(R)

Risk-Reduction: As the number of independent assets in a portfolio increases (even with lower returns and higher individual risk), the portfolio’s overall risk decreases (insurance assets). Diversification can eliminate idiosyncratic, variance, and/or company-specific risk.

Separating Idiosyncratic Risk from Systematic Risk

Total stock risk = idiosyncratic risk (diversified away/not compensated) + systematic risk (cannot be diversified away/compensated)

Market Index Return R M

=

∑ω i R i

Regression Analysis R i = α i +

systematic risk

β i R M

+

idiosyncratic risk

e i

Total Variance var(R i ) =

(β ����� i ) 2 σ M 2

systematic (covariance) risk

+

σ e

2

idiosyncratic (variance)risk

β i = Cov (R M , R i )

σ

M 2

Deviations of individual assets from points on the regression line represent negative or positive idiosyncratic risk.

Capital Asset Pricing Model (CAPM)

R f

Investment Opportunity Set (Capital Allocation Line) L Riskier Investor (flatter) K Risk-Averse Investor (steeper)
Investment Opportunity Set
(Capital Allocation Line)
L
Riskier Investor
(flatter)
K
Risk-Averse Investor
(steeper)
Long Risk-Free
Short Risk Free
Standard
Deviation
(s )
s K = 8% = 15.98% s L = 24% s US Investment Opportunity Set
s K = 8%
= 15.98%
s L = 24%
s US
Investment Opportunity Set
(2 Risky Investments, 1 Risk-Free Investment)
R
1
Optimum Portfolio
Tangency Portfolio
Minimum Variance
Portfolio
R
2
Risk-Free
Standard
Deviation
(s )
Investor Curve
Indifference
Efficient Frontier
R = return i = investment/asset/security f = risk-free M = market t = time
R = return
i = investment/asset/security
f = risk-free
M = market
t = time periods
e = error
All investors fall on the tangency portfolio (CAL) for ALL assets and, for the overall market portfolio, this CAL is
the Capital Market Line (CML)
Security Market Line (SML)
Expected
Return
E(R)
E(R M ) = R f + [E(R M )−R f ]
×
Security’s sensitivity to market movements  β i = Cov (R M , R i ) � Var(R M )
σ M
�����
0.30
σ
i
Sharpe Ratio
0.25
Security Market Line (SML) – shows estimated excess return of an asset in relation to its beta (β) value when compared to
the
0.20
market.
Built from CAPM equation  E(R i ) = R f +
×
[E(R ��������� M ) − R f ]
+ error i
β i
ß M > 1
Underpriced (a > 0 )
equilibrium risk
systematic (market)
0.15
premium
risk
M
Equilibrium risk premium = size of compensation for systematic risk. Goes up w/ market volatility and degree of risk aversion
0.10
Overpriced (a < 0 )
R f = 5%
2
Total Risk in a security  σ i 2 =
(β ����� i ) 2 σ M 2
+
σ e
0.05
-1< ß M < 1
systematic (market) risk
idiosyncratic (variance)risk
Beta Coefficient
(ß)
0
0
0.5
1
1.5
2
Percentage of idiosyncratic risk “diversified away” in an asset by the market portfolio  σ e 2
ß M = 1
σ
i 2
R = return
i = investment/asset/security
f = risk-free
M = market
t = time periods
e = excess returns

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

Given by following equation R e (t) = α i + β i R

i

e

M

(t) + error i

A security’s alpha (α) is = E(R i ) R f −β i [E(R M ) R f ] CAPM predicts that all α = 0.

Capital Budgeting with CAPM

α > 0, security is underpriced vs. CAPM, α < 0, security is overpriced vs. CAPM

E(R i ) = R f + β i × [E(R M ) R f ] + error i = IRR plug into NPV equation.

NPV =

t=1

C

t

=

(1+IRR) t

C 0 +

C

1

(1+IRR) 1

+

(1+IRR) 2 +

C

2

(1+IRR) 3 +

C

3

+

C t

(1+IRR) t =? If NPV < 0, do NOT accept the project