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Chapter 1 -- Introduction

- Real Assets
- Land
- Buildings
- Knowledge
- Machines
- Financial Assets
- Bonds
- Stocks
- Derivative Assets
- Options
- Futures

Financial Markets

- Consumption Timing
- In high earnings periods you invest
- In Low earnings period you withdraw
- Maximize expected utility
- How did September 11th affect the US economy?
- How did the war in Iraq affect the US economy?
- Allocation of Risk
- Allows those with the greatest tolerance for risk

to invest in appropriate asset classes - Asset Allocation vs. Security Selection
- Bonds, stocks, cash, real estate
- Diversification, Taxes, Income, Growth

Markets

- Direct Search Market
- buyers and sellers must meet
- Brokered Market
- Real Estate
- Dealer Market
- NASDAQ
- Auction Market
- NYSE
- ECNs Handle both NYSE and NASDAQ
- Real Time ECN Prices

Trends

- Technology
- Globalization
- ADRs
- Mutual Funds
- Direct Investment
- Financial Engineering
- Take primitive financial assets and make

something more appealing to the customer - bundling and unbundling

Agency Problems VERY Important

- Conflict between different stakeholders
- Bankruptcy stockholders/workers/bondholders
- Typically management and shareholders for

healthy firms. - Are these problems new?
- Why firms often offer CEOs options?
- Some people claim this makes CEOs do things with

only a short horizon instead of long term

The Investing Public

- Individual Investors
- Institutional Investors
- Mutual Funds
- Open-end
- Closed-end
- Pension Funds
- Defined Contribution
- Defined Benefit
- Life Insurance Companies

Who Invests?

In 2000 (still the latest as of 1/2004), the NYSE

published its latest survey of share-ownership in

the United States. Results

Chapter 2 -- Classification of Securities

- Fixed Income
- Money Market
- Bonds
- Equities (Primary emphasis of this course)
- Preferred Stock
- Common Stock
- Derivatives
- Options
- Futures
- Swaps

Returns Across Asset Classes

100 Invested in 1926 in Different Assets

Risk and Return Across Assets

If these terms are not familiar to you, I suggest

you learn about mean, variance (standard

deviation), covariance correlation coefficient

Risk and Return Across Assets

Small Stocks

Large Stocks

Corp Bonds

Govt Bonds

T-Bills

Has this changed since March, 2000? Has this

changed since September, 2001?

Money Market Securities - Treasury Bills

- Tax Considerations
- Auction Process
- Treasury Initial Maturities of 91 and 182 days

Competitive vs. Non-competitive

Money Market Securities - Treasury Bills

- Bankers Discount Yield
- Bond Equivalent Yield (APR)
- Effective Annual Yield (EAY)
- EAY ?? BEY ?? BDY

Treasury Notes and Bonds

- Different maturities, Semi-annual coupons,

callability - Coupon and Principal Strips
- Quotations (32nds of Par, Bond Equivalent Yields)
- N note // ci stripped of coupon // i indexed

for inflation

Other Fixed-Income Securities

- Corporate Bonds - Convertibility -- cv

- Covenants - Secured versus unsecured

debentures - Zero-coupon bonds -- zr - Extensive bond listings are no longer provided in

WSJ

Example Municipal Bond After-tax Yield

- Suppose short-term municipal yields are currently

4, while comparable taxable bonds pay 5. Which

gives you the higher after-tax yield if your tax

bracket is 0? 10? 20? 30? - At what tax rate would you be indifferent between

the two bonds? - 5(1-tax rate) 4 -- indifferent at tax rate

20

Equity Capital Markets

- Common Stocks
- Ownership shares
- Residual claims
- Limited liability
- Different with every paper etc. I use yahoo

Other Equity Securities

- Preferred Stock
- Cumulative Dividend
- Special Tax treatment corporations 70
- Dont really worry too much about for this class
- May use if you start a business for certain

ownership rights - Buffet used in mid 90s with USAIR

Stock and Bond Market Indices

- Price-weighted Index (DJIA, Nikkei 225)
- Value-weighted Index (SP 500)
- Others Equally-weighted, geometrically-weighted,

Bond market indices - Can we replicate returns on an index?

Example Index Calculations

- What are the returns on a price-weighted, a

value-weighted, and an equally-weighted index of

stocks A, B, C. - What if stock split occurs? must tell you when

Derivative Securities Markets

- Options Contracts
- A Call (Put) option gives the holder the right to

purchase (sell) an asset for a specified price on

or before a specified date - Futures/Forwards Contracts
- dont worry about too much for this class may

talk about at end of class - A Futures contract obligates the holder to

deliver an asset at a specified date for an

agreed upon price to be paid at maturity - Hybrid Contracts
- Index Options, Swaps

Chapter 3

- Markets and Trading Processes
- The Primary Market
- The Secondary Market
- NYSE, AMEX, Regional, NASDAQ, Foreign
- Trading Arrangements
- Types of orders, execution of trades, margin

trading and short sales

The Primary Market

- New issues of stocks, bonds and other securities

are marketed to the public by investment banks in

the Primary Market. - Initial Public Offering (IPO)
- Seasoned Offering
- Private Placement
- Shelf-Registration

Underwriting

- Public issues of securities are marketed to the

public through underwriters. - The Underwriting Process
- Select Underwriter
- Form Syndicate
- Registration Statement (Red Herring, Prospectus)
- Set Offer Price
- Stabilization (up to 10 days after offer date)
- Other Considerations
- Firm Commitment vs. Best Efforts
- Negotiated vs. Competitive bidding
- Cost is substantial
- Underwriter compensation
- Gross Spread (7.3 for IPOs, 5.4 for Seasoned

equity issues, and 1.6 for bonds) - Underpricing (12-18, 7, 2)
- Direct expenses (3.7, 1.7, and 0.6)
- Pecking order theory
- Have there been many IPOs lately?

The Secondary Market

- Definitions
- Agent versus Dealer markets
- Continuous versus Call (auction) markets
- The Third and Fourth markets
- ECNs
- Organized Exchanges vs. Over-the-Counter
- Centralized location
- Listing requirements
- Market makers
- Specialists

Trading in the U.S.

- The NYSE, NASDAQ and AMEX are national in scope.

- Proportions traded by other regional exchanges

are small - NASDAQ double counts some trades so not exactly

like this but close - Below is percent of dollar volume
- (Different than share volume)
- Market Capitalization of NASDAQ is 2.8 Trillion

and NYSE is 16 Trillion (11.7 US) what does this

tell you ?

NYSE Listing Requirements

- Listed firms must also meet continued listing

requirements - Current NYSE Listing requirements
- Dont worry about exact numbers There are

exceptions that make the rules not worth

knowing

NYSE-Listed Firms

- At the end of 2002 there were fewer companies
- 448 foreign companies had securities listed on

the NYSE

The NYSE Specialist

- Functions
- Provide Price Continuity and Stabilization
- Process Information
- Supply Immediacy (trader of last resort)
- Agent and Dealer Roles
- Obligations To provide a fair and orderly

market - Rights Exclusive market maker and Access to the

limit order book - Trading Restrictions
- Trades behind public orders

Specialist Profits

- Commissions
- on agency trades only (not dealer trades)
- commissions are a small part of specialist

revenues - Bid-Ask spread
- Returns on Inventory Positions
- Empirical Research
- Sofianos - spread revenues and position losses
- Hasbrouck/Sofianos and Madhavan/Smidt -

specialists appear to make short-term trading

profits

The Over-the-Counter (OTC) Market

- Self regulated by the National Association of

Securities Dealers (NASD) - The NASD owns and operates its own automated

quotation system (NASDAQ) - Markets at the end of 2000 and 2001
- National Market System (What you think of as

NASDAQ.) 3827gt 3351 - Small Cap 907 gt 758
- Total Market Capitalization
- 3.6 Trillion to 2.8 trillion (then NASDAQ was at

1950)

NASDAQ Characteristics

- A decentralized, electronically linked market
- Multiple market makers
- Different than the NYSE -- it is a decentralized

dealer market -- harder to control and regulate - Imperfect coordination between dealers
- 1996 try for more disclosure
- display all limit orders
- make public best quotes (dont pay for order

flow) - reveal the size of best customer limit orders

NASDAQ Listing Requirements

Types of Orders

- Market Order
- Limit Order
- Stop-loss (Stop-buy) Order
- Buying on Margin
- Short Sale

Order Qualifications

- Day Orders
- Good-till-canceled Orders
- Fill or Kill (FOK) --immediate execution of whole

order -- no NASDAQ - Immediate or Cancel (IOC) -- immediate execution

but accept partial order - All or None (AON) -- most likely to use in real

world -- 200 shares or greater with limit - Market-on-Close/Open

The Costs of Trading

- Commissions
- Brokers charge commissions in return for services

such as security analysis, investment advice,

deposit for securities, and access to trading. - Bid-Ask Spread
- What factors typically affect the spread?
- How do spreads compare across exchanges?

Margin Trading

- Margin is the capital put up by investors when

using credit from their broker to buy securities. - Call loan rate
- Initial vs. Maintenance Margins
- Minimum initial margins are set by the Federal

Reserve, they are currently 50. - Equity is the Market Value of the Position less

the amount of the loan.

Margin Trading Example

- Assume an initial margin requirement of 55 and

maintenance margin of 40. An investor has

5,500 in cash and wishes to purchase ABC stock.

ABC is currently trading at 100 per share. - Choices (1) buy 55 shares (2) buy 100 shares

on marginPrice is either good -- 120 or bad --

80 at the end - Ret (TV1-TV0)/(TV0-borrowed)
- Good -- just equity -- (6600-5500)/(5500-0)20
- Good -- margin -- (12000-10000)/(10000-4500)36.3

6 - Magnification factor is 1/.5536.36/20
- Bad is just opposite sign

Margin Example Continued

- At what price will you receive a Margin Call from

your broker?Mm(sharesP-borrowed

money)/sharesP0.4(100P-4500)/100P gtgt P75 - How does this example change if your broker

charges a call loan rate of 10? - Just subtract interest payment (will assume 1

year here) - (12000-10000-4500.1)/550029.82

Short-Sales

- Short sales allow investors to profit from a

decline in security price by selling a security

borrowed from another investor. - SEC Rules
- short sales must be identified to the exchange
- margin accounts are marked-to-market each day
- subject to the Tick Test Rule

Short-Sale Example

- You are bearish on ATT. The current market price

is 50 per share and you anticipate selling short

100 shares. - How much cash and securities must you put into

your brokerage account if the initial margin is

50? - 50 100 shares 50/share 2500
- How high can the price go before you get a margin

call if the maintenance margin is 30? - .3 (7500-100P)/100P 57.7

Circuit Breakers

- Trading Halts
- NASDAQ?
- NYSE
- Started after 1987 market crash
- Reviewed after 1997 market volatility
- End of 2001 gt 180 point move no index arbitrage
- program trading
- 10 - Halt of 1 hour before 2pm
- 20 - Halt of 2 hours before 1pm
- 30 - Halt for day

Chapter 4 -- Mutual Funds

- Investment Companies (financial intermediaries)
- Collect Funds from individuals
- Defined contribution vs. Defined Benefit
- Invest in wide range of securities
- Corporate Bonds Bond Quality
- Money Market
- Real Estate Commercial, Resid -- Mixed
- Equities, Index, special sector, value
- Yahoo Mutual Fund Center

Services of Investment Companies

- Administration and Record Keeping
- Diversification and Divisibility
- Professional Management
- Reduced Transaction Costs
- Usually small (250 to 3000 dollar minimum

investment -- less for retirement accounts) - Most of you will have a choice of mutual funds to

invest in for your retirement account - It will probably be or was the first investment

for many of you

Types of Investment Companies

- Unmanaged -- Unit Investment Trusts
- Managed -- Closed End Funds
- Can sell at a discount or premium
- Managed -- Open End Funds
- Always sell at NAV
- NAV Cash and Securities minus Liabilities Total

Number of Shares

Closed End Funds

- Number of Shares is Fixed
- Traded on Secondary Markets -- Just like other

equities - Prices can and do differ from NAV
- If traded at premium -- usually do to hard to

invest countries (Middle East, Africa, Asia) - Most traded at a discount
- Why might an investor choose closed end over open

end?

Open Ended Funds

- Shares issued and redeemed directly from

investment Company - Shares are bought and sold at NAV but may have

sales commission - Values Change Daily
- Number of Shares Change Daily
- ETFs are like mutual funds but they trade during

the day

Mutual Fund Fees (Open-End)

- Front-End -- Less than 8.5
- Back-End -- Start at 5 to 6 and can decrease

over time - Operating Fees are deducted from assets
- Operating Fees
- Usually shown as of Assets each year
- 12b-1 fees
- SEC rule that allows funds to charge investors

for distribution costs (Advertising, Annual

Report, Commissions)

Professional Management

- Most professionally managed mutual funds do worse

than the index they represent by the amount of

transaction costs - Professionally managed funds tend to outperform

indices for foreign mutual funds Why? - Most investment companies charge less than 2 per

year -- however 2 per year for many years can be

very substantial - Assume 12 return
- Assume 30 years till retirement
- Value of 1 dollar at 10 annual return is 17.45
- Value of 1 dollar at 12 annual return is 29.96

Why Invest?

- Primarily -- low transaction costs
- Can Choose passive index mutual funds that charge

0.3 - 0.5 management fee - Think segment will do better over a period of

time -- but not sure which company - Efficient markets and most finance professors

believe this is dangerous and should not bet on

one sector over another - energy
- health care
- technology

Other Things to Consider

- Bad performance persists more than good

performance - Be careful of front end loads
- Tax Efficiency of Mutual Funds
- if in a retirement account -- Dont care
- if in a taxable -- you care -- prefer they do not

turn over a portfolio much -- you have to pay

taxes!!!!!

Information

- Generally available at any library
- Most annual reports and prospectus available on

line - Morningstar -- Mutual Fund Source Book
- http//morningstar.com
- Mutual Fund Education Center
- http//www.mfea.com/
- Brills Mutual Fund
- http//www.brill.com/

Constraints

- Liquidity -- How soon you might need the money --

generally, the more liquidity you need, the less

risk you can take - Financial assets tend to be much more liquid than

real assets - Longer the horizon, the greater the risk you may

be able to take - Unique Needs
- if you worked for Boeing, would you want your

retirement fund or your other investments in

aerospace defense stocks? - Tax Deferred Retirement Plan
- IRA
- 401(k)
- Roth IRA
- Very confusing????

Chapter 11 Framework of Analysis

- Fundamental Analysis
- Approach to Fundamental Analysis
- Domestic and global economic analysis
- Has changed significantly 70s, 80s, 90s today
- Industry analysis
- Hard to compare across different industries
- Grocery stores Vs Aerospace
- Company analysis
- Top-down Vs Bottom-up approach
- (personal bias for Top-down)
- Top-Down Start with world and work down to

companies - Bottom-up Start with companies then try and

understand how state of world might affect them

Global Economic Considerations

- Performance in countries and regions is highly

variable - Political risk
- Middle east
- Emerging markets in Asia
- Maybe not followed that closely in the 1990s or

at least thought of as a local problem as

opposed to global - Exchange rate risk
- Sales
- Profits
- Stock returns

Key Economic Variables

- Gross domestic product
- Unemployment rates
- Think obvious and also impacts consumer sentiment
- What were people talking about two or three years

ago - Interest rates inflation
- Ability to borrow and general risk to economy
- International measures/exchange rates
- Can be important even if small amount of sales

overseas-- Boeing - Consumer sentiment
- Watched much more closely than it used to be
- Current recession vs. past recessions?

Federal Government Policy

- Fiscal Policy - government spending and taxing

actions -- Mostly impact demand - Direct policy
- Slowly implemented
- Argument that by the time the impact is felt it

is already too late????? - Can stimulate or slow the economy
- What are Bush and the Congress trying to do now

-- how?

Federal Government Policy

- Monetary Policy - manipulation of the money

supply to influence economic activity -- 14 year

terms (Board) - Initial feedback effects
- Tools of monetary policy
- Open market operations
- Buy put money into economy sell take out
- Discount rate
- Reduce discount rate makes it easier

(theoretically) for companies to borrow - True today?
- Reserve requirements
- May change to improve liquidity but can be

dangerous

Demand and Supply Shocks

- Demand shock - an event that affects demand for

goods and services in the economy - Tax rate cut
- Increases in government spending
- Supply shock - an event that influences

production capacity or production costs - Commodity price changes
- oil or electricity in the last year
- Educational level of economic participants
- Could argue corporate tax cuts

Business Cycles

- Business Cycle
- Peak -- Entering recession. Defensive industries

that are not sensitive to economic conditions

should do well (food producers, tobacco

companies, public utilities, pharmaceutical

companies). - Trough -- Economic recovery begins. Cyclical

industries that are sensitive to the economy

should do well (autos, washing machines, etc). - Industry relationship to business cycles
- Cyclical - Cars
- Defensive Sin/Consumer Staples

NBER Cyclical Indicators

- Leading Indicators - tend to rise and fall in

advance of the economy Yahoo Link - Examples
- Stock Prices
- Housing???
- Machine Orders????
- Coincident Indicators - indicators that tend to

change directly with the economy - Examples
- Industrial production
- Manufacturing and trade sales
- Lagging Indicators - indicators that tend to

follow the lag economic performance - Examples
- Ratio of consumer installment credit outstanding

to personal income - Inventories
- Credit Outstanding to Personal Income

Industry Analysis

- Sensitivity to business cycles
- Factors affecting sensitivity of earnings to

business cycles - Sensitivity of sales of the firms product to the

business cycles - Operating leverage
- Financial leverage
- What happened to the airlines after September 11,

2001? - Industry life cycles

Industry Life Cycles

- Stage Sales Growth
- Start-up Rapid Increasing
- Consolidation Stable
- Maturity Slowing
- Relative Decline Minimal or Negative

Industry/Firm Life Cycle

Sales

Rapid and Increasing Growth

Stable Growth

Slowing Growth

Minimal or Negative Growth

Age

Start Up

Consolidation

Maturity

Relative Decline

Industry/Firm Life Cycle

- Start Up - New technology, high risk, high

growth. - Consolidation - Survivors are more stable, market

share is more predictable, still grow faster than

the overall economy. - Maturity - Product reaches full potential, growth

tracks growth in economy, price competition.Cash

Cows - stable cash flows but little opportunity

for expansion. - Decline - Slow or no growth, competition or

obsolete product.

Chapter 12 Fundamental Stock Analysis Models

of Equity Valuation

- Basic Types of Models
- Balance Sheet Models
- Dividend Discount Models
- Price/Earning Ratios
- Estimating Growth Rates and Opportunities

Intrinsic Value and Market Price

- Intrinsic Value (IV) True Value?
- Self assigned Value
- Variety of models are used for estimation
- Market Price
- Consensus value of all potential traders
- Trading Signal
- IV gt MP Buy
- IV lt MP Sell or Short Sell
- IV MP Hold or Fairly Priced

Dividend Discount ModelsGeneral Model

- V0 Value of Stock
- Dt Dividend
- k required return

No Growth Model Example

No Growth Model

Stocks that have earnings and dividends that are

expected to remain constant Preferred Stock

- E1 D1 5.00
- k .15
- V0 5.00 / .15 33.33

Constant Growth Model g constant

perpetual growth rate Example

- E1 5.00 b 40 k 15
- (1-b) 60 D1 3.00 g 8
- V0 3.00 / (.15 - .08) 42.86

Estimating Dividend Growth Rates

- g growth rate in dividends
- ROE Return on Equity for the firm
- b plowback or retention percentage rate
- (1- dividend payout percentage rate)

Partitioning Value Growth and No Growth

Components

- PVGO Present Value of Growth Opportunities
- E1 Earnings Per Share for period 1

Partitioning Value Example

- ROE 20 d 60 b 40
- E1 5.00 D1 3.00 k 15
- g .20 x .40 .08 or 8

Vo value with growth NGVo no growth component

value PVGO Present Value of Growth Opportunities

Price Earnings Ratios

- P/E Ratios are a function of two factors
- Required Rates of Return (k)
- Expected growth in Dividends
- Uses
- Relative valuation
- Extensive Use in industry

P/E Ratio No Expected Growth

- E1 - expected earnings for next year
- E1 is equal to D1 under no growth
- k - required rate of return

P/E Ratio with Constant Growth

- b retention ratio
- ROE Return on Equity

Numerical Example No Growth

- E0 2.50 g 0 k 12.5
- P0 D/k 2.50/.125 20.00
- P/E 1/k 1/.125 8

Numerical Example with Growth

- b 60 ROE 15 (1-b) 40
- E1 2.50 (1 (.6)(.15)) 2.73
- D1 2.73 (1-.6) 1.09
- k 12.5 g 9
- P0 1.09/(.125-.09) 31.14
- P/E 31.14/2.73 11.4
- P/E (1 - .60) / (.125 - .09) 11.4

P/E Analysis

- Pitfalls
- Use of accounting earnings
- Historical costs
- May not reflect economic earnings
- Reported earnings fluctuate around the business

cycle - Things to think about
- We can also obtain a price estimate by

multiplying projected earnings by a forecast of

the price/earnings multiple (P/E). - Consider two firms from a previous exampleThe

firm with good growth opportunities (and b.6)

was worth P200, or P/E 200/5 40.The firm

with no growth opportunities was worth P50, or

P/E 50/5 10. - The Result P/E multiples can be good indicators

of growth opportunities.

Inflation and Equity Valuation

- Inflation has an impact on equity valuations
- Historical costs underestimate economic costs
- Empirical research shows that inflation has an

adverse effect on equity values - Research shows that real rates of return are

lower with high rates of inflation - Shocks cause expectation of lower earnings by

market participants - Returns are viewed as being riskier with higher

rates of inflation - Real dividends are lower because of taxes

Chapter 13 Firm-Specific analysis -

- How do we choose stock within an industry?
- Equity Value Definitions
- Book Value - The net worth of the firm as shown

on the balance sheet - Liquidation Value - The value of the firm if

broken up and sold off (after paying off all

obligations). This may provide a floor for the

stock price. - Replacement Cost - Cost to replace all assets

less the value of liabilities.Tobins Q

Market Price / Replacement Cost

Firm Specific Analysis

- In order to determine the value of a company, we

must move away from the balance sheet and

actually forecast cash flows. - Once we have cash flow forecasts, we can use

models such as the Dividend Discount Model or

Price to Earnings multiples to estimate firm

value. - Comparing our estimate of value to the current

market price tells us whether we should invest in

the security.Market Value - The price at which

a security is currently trading.Intrinsic Value

- The firm or the present value of expected

future cash flows. This represents the value of

the firm as an ongoing concern.

Financial Statements

- Balance Sheet Income Statement
- Common Sized -- vertical analysis
- Trend or Indexed -- horizontal analysis
- Common sized simply puts everything in a

percentage and allows comparison from year to

year -- all expenses add up to 100 - Trend Looks at percentage increase and decrease

from year to year hard to compare with other firms

Ratio Analysis

- Purpose of Ratio Analysis
- Uses
- Trend analysis
- Comparative analysis
- Combination
- Use by External Analysts
- Important information for investment community
- Important for credit markets

Type of Financial Ratios

- Liquidity Ratios
- Activity or Mgmt Efficiency Ratios
- Leverage Ratios
- Profitability Ratios
- Market Price Ratios

Comparability Problems

- Accounting Differences
- Inventory Valuation
- Depreciation
- Inflation
- International Accounting Conventions
- After we go through the theory models we will go

back to securities analysis and work on some

regressions.

P/B Analysis - ROE decomposition

- Are all ROEs created equal?
- Two Breakdowns
- DuPont
- ROE NI / Equity
- ROE NI/EBTEBT/EBITEBIT/SalesSales/AssetsAsse

ts/Equity - Which tend to matter most?

interest burden

operating margin

asset turnover

tax burden

leverage (1D/E)

P/E Analysis - PEG ratio

- A simple control is to divide P/E ratio by

earnings growth rate. - I took 1 year average forecast of earnings
- Yahoo uses five year forecast of earnings
- The Motley Fools say
- PEG 0-0.5 BUY PEG 0.5 - 0.65 WEAK BUY
- PEG 0.65 - 1.00 HOLD PEG gt 1.00 SELL

Examples with PEG P/E ratiosReturns are from

Oct 01 to Oct 02

Examples with PEG P/E ratiosReturns are from

Oct 02 to Oct 03

Conclusions

- Bottom line, its tough to tell (not withstanding

my data problems) - did not control for earning growth beyond t1
- did not do relative valuation against other

sectors - perhaps whole sector is overvalued...
- Best when performed on a lot of firms over time
- hold other factors constant as well
- market capitalization
- institutional ownership
- average trading volume
- these may control for liquidity premiums
- other risk-premiums unique from beta
- we would like to find a big, liquid, value stock,

with high growth, high payout, and low risk ---

good luck

Dow Dividend Strategies

- Dogs of the Dow
- Sort by d/P
- Invest in top 10 yielding stocks each year
- Rebalance annually
- Strategy from 1973 -1994 yielded 17.23 vs.

11.19 - Dow Five (OHiggins)
- Invest in lowest five priced stocks stocks each

year - Strategy from 1973-1994 yielded 21.1 vs 11.19
- Foolish Four (Motley Fools)
- Throw out the least expensive Dow component
- Invest 40 in 2, and 20 each in the remaining

three - Strategy yielded 25.2 vs. 11.19 from 1973 - 1994

Investing

- Many people have more pain from loses than

happiness they get from gains - specify objectives
- identify constraints
- formulate policy
- monitor performance
- reevaluate and modify portfolio as determined

from monitoring - Check out your own funds
- Dont do anything until you know the tax

implications

Chapter 5Interest Rates

- Supply
- Households
- Provide capital
- Most companies do not have large amounts of cash

like Microsoft - Demand
- Businesses
- Typically need investment established companies

used bonds - Governments Net Supply and/or Demand
- Federal Reserve Actions
- What is one of the things that is currently being

discussed by the Democratic candidates with

respect to supply and demand?

Real vs. Nominal Rates

- Fisher effect Approximation
- nominal rate real rate inflation premium
- R r i or r R - i
- Example r 3, i 6
- R 9 3 6 or 3 9 - 6
- Fisher effect Exact
- r (R - i) / (1 i)
- 2.83 (9-6) / (1.06)
- Empirical Relationship
- Inflation and interest rates move closely

together - Important for Risk Premiums

Probability Distributions

- 1) Mean most likely value µ or E(r)
- 2) Variance or standard deviation
- 1s 68.3 should be between µ /- s
- 2s 95.4

- 3s 99.7

- 3) Skewness
- If a distribution is approximately normal, the

distribution is described by characteristics 1

and 2 - We assume this at times such as portfolio theory

even though it is not true. Returns may be

normal for short time periods with a steady

drift. - Stocks can only decrease by 100 but can go up by

more hence equity returns are skewed right.

Measuring Mean Scenario or Subjective Returns

Subjective returns

p(s) probability of a state r(s) return if a

state occurs 1 to s states

Measuring Mean Scenario or Subjective Returns

State Prob. of State r in State 1 --

bad .1 -.05 2 -- ok .2 .05 3 -- good .4 .15 4

-- very good .2 .25 5 -- great .1 .35

E(r) (.1)(-.05) (.2)(.05)... (.1)(.35) E(r)

.15 What type of distribution here? What is the

E(r) without even doing the calculation?

Measuring Variance or Dispersion of Returns

- Subjective or Scenario

Standard deviation variance1/2

Using Our Example

Var (.1)(-.05-.15)2(.2)(.05- .15)2...

.1(.35-.15)2 Var .01199 S.D. .01199 1/2

.1095 10.95

Annual Holding Period Returns1926-2001

- Ann Ann
- Series Avg Dev.
- Lg Stk 10.5 20.3
- Sm Stk 12.2 39.3
- LT Gov 5.23 8.18
- T-Bills 3.80 3.25
- Inflation 3.06 4.40
- Avg return is for geometric

Annual Holding Period Risk Premiums and Real

Returns1926-1999

- Risk Real
- Series Premiums Returns
- Lg Stk 9.3 9.9
- Sm Stk - ? 15.0 15.6
- LT Gov 1.5 2.2
- T-Bills --- 0.6
- Inflation --- ---
- Real returns are minus inflation
- Risk Premiums are minus short term risk free or

T-Bills

Risk - Uncertain Outcomes

W1 150 Profit 50

p .6

W 100

1-p .4

W2 80 Profit -20

E(W) pW1 (1-p)W2 .6 (150) .4(80)

122 s2 pW1 - E(W)2 (1-p) W2 - E(W)2 .6

(150-122)2 .4(80-122)2 1,176 s 34.293

Risky Investments with Risk-Free Investment

W1 150 Profit 50

p .6

Risky Inv.

1-p .4

W2 80 Profit -20

100

Risk Free T-bills

Profit 5

Risk Premium 17

Risk Aversion Utility

- Investors view of risk
- Risk Averse
- Risk Neutral
- Risk Seeking
- Utility
- Utility Function
- U E ( r ) - .005 A s 2
- A measures the degree of risk aversion

Risk Aversion and Value Using the Sample

Investment

- U E ( r ) - .005 A s 2
- 22 - .005 A (34) 2
- Risk Aversion A Value
- High 5 -6.90
- 3 4.66
- Low 1 16.22

T-bill 5

Dominance Principle

Utility and Indifference Curves

- Represent an investors willingness to trade-off

return and risk - Example - here A4
- Exp Ret St Deviation UE ( r ) - .005As2
- 10 20.0 2
- 15 25.5 2
- 20 30.0 2
- 25 33.9 2

Indifference Curves

Expected Return

- Rule 1 The return for an asset is the

probability weighted average return in all

scenarios. - Rule 2 The variance of an assets return is the

expected value of the squared deviations from the

expected return.

Variance of Return

Return on a Portfolio

- Rule 3 The rate of return on a portfolio is a

weighted average of the rates of return of each

asset comprising the portfolio, with the

portfolio proportions as weights. - rp W1r1 W2r2
- W1 Proportion of funds in Security 1
- W2 Proportion of funds in Security 2
- r1 Expected return on Security 1
- r2 Expected return on Security 2

- Rule 4 When a risky asset is combined with a

risk-free asset, the portfolio standard deviation

equals the risky assets standard deviation

multiplied by the portfolio proportion invested

in the risky asset. - Rule 5 When two risky assets with variances s12

and s22, respectively, are combined into a

portfolio with portfolio weights w1 and w2,

respectively, the portfolio variance is given by - ?p2 w12?12 w22?22 2W1W2 Cov(r1r2)
- Cov(r1r2) Covariance of returns for Security 1

and Security 2 - Cov(r1r2) r 12 ? 1 ? 2

Chapter 6 Allocating Capital Between Risky

Risk Free Assets

- Possible to split investment funds between safe

and risky assets - Risk free asset proxy T-bills
- Risky asset stock (or a portfolio)
- Examine risk/ return tradeoff
- Demonstrate how different degrees of risk

aversion will affect allocations between risky

and risk free assets

Example

Possible Combinations

Variance on the Possible Combined Portfolios

s

s

?

?

?

Using Leverage with Capital Allocation Line

- Borrow at the Risk-Free Rate and invest in stock
- Using 50 Leverage
- rc (-.5) (.07) (1.5) (.15) .19
- ?c (1.5) (.22) .33

CAL (Capital Allocation Line)

Risk Aversion and Allocation

- Greater levels of risk aversion lead to larger

proportions of the risk free rate - Lower levels of risk aversion lead to larger

proportions of the portfolio of risky assets - Willingness to accept high levels of risk for

high levels of returns would result in leveraged

combinations

CAL with Risk Preferences

CAL with Higher Borrowing Rate

Risk Reduction with Diversification

How many equities to approach market risk and

get rid of non-systematic (unique risk)?

Covariance

? p2 w12 ? 12 w22 ? 22 2W1W2 Cov(r1r2)

Cov(r1r2) r 12 ? 1 ? 2

r1,2 Correlation coefficient of

returns

? 1 Standard deviation of returns for

Security 1 ? 2 Standard deviation of

returns for Security 2

Correlation Coefficients Possible Values

Range of values for ?1,2

1.0 gt ???? gt ?-1.0

If ?? 1.0, the securities would be perfectly

positively correlated If ?? - 1.0, the

securities would be perfectly negatively

correlated

Three-Security Portfolio

rp W1r1 W2r2 W3r3

?2p W12 ? 12

W22 ? ??

W32?32

2W1W2

Cov(r1r2)

Cov(r1r3)

2W1W3

Cov(r2r3)

2W2W3

In General, For an n-Security Portfolio

rp Weighted average of the n securities

?p2 (Consider all pairwise

covariance measures)

Setting up a variance covariance matrix

Minimum-Variance Combination You do not need to

know this formula for the quiz but you will have

to calculate the MVP graphically

1

??2

- Cov(r1r2)

2

W1

??2

??2

- 2Cov(r1r2)

1

2

W2

(1 - W1)

The Risky Portfolio

- Note the book has standard deviation on the

vertical axis I prefer horizontal to stay

consistent. - Consider the following examples of portfolio

expected returns and riskCase A Perfectly

POSITIVELY Correlated Returns

E(R)

E(R)

The Risky Portfolio

- Case B Perfectly NEGATIVELY Correlated Returns

E(R)

R

The Risky Portfolio

- Case C Returns that are not Perfectly

Correlated

E(R)

R

Two-Security Portfolios withDifferent

Correlations

Portfolio Risk/Return Two Securities Correlation

Effects

- Relationship depends on correlation coefficient
- -1.0 lt ? lt 1.0
- The smaller the correlation, the greater the risk

reduction potential - If??? 1.0, no risk reduction is possible

Extending Concepts to All Securities

- The optimal combinations result in lowest level

of risk for a given return - The optimal trade-off is described as the

efficient frontier - These portfolios are dominant

The Minimum-Variance Frontierof Risky Assets

Extending to Include Riskless Asset

- The optimal combination becomes linear
- A single combination of risky and riskless assets

will dominate - History
- Started with just returns and dominance
- Then one risky asset and one risk free asset
- SP 500 and Rf
- Then talked about two risk assets
- SP500 and Bonds
- Then two risky assets and risk free
- Now multiple risky assets and risk free
- Multiple assets ? get market portfolio will

argue later what is the market portfolio

Alternative CALs

Portfolio Selection Risk Aversion

Efficient Frontier with Lending Borrowing

Models- Chapter 7Math gets nasty I will try

and help you with what things mathematical

representations are important and what are not

- Capital Asset Pricing Model
- Passive Indexing Strategies
- Expected Returns and Betas
- Security Market Line
- CAPM and Market Models
- Statistical Implementation
- Security Characteristic Line
- Arbitrage Pricing Theory
- Concept of Arbitrage
- CAPM vs APT

1. Capital Asset Pricing Model

- The CAPM is a centerpiece of modern finance that

gives predictions about the relationship between

risk expected return - Based on original work on portfolio theory of

Harry Markowitz by Nobel laureate William Sharpe

John Lintner in 1965 - chapters 6-8 - Begins with simplistic assumptions for

hypothetical world of investors and builds into

reasonable comprehensive model

Assumptions - Can these be relaxed???

- Trades of individual investors do not affect

prices - Carl Icon
- Risk-averse utility-maximizing investors
- Some people live for risk
- One-period investment horizon (myopic)
- We are not!
- Fixed quantities of assets and all marketable
- IPOs
- No taxes, transactions costs, regulations, etc
- There are and you know my views
- Homogeneous Expectations - All investors analyze

securities in same way with same probabilistic

forecasts for each - We do not agree for every buyer there is a

seller

Implications

- All investors choose to hold the market portfolio
- Know it is not true many investors try and time

markets - The market portfolio is on the efficient frontier
- Probably true but impossible to define
- The Capital Market Line is the best attainable

Capital Allocation Line - True for most of us
- The Risk Premium on individual assets will be

proportional to the risk premium on the market

and the beta of the security (with the market). -

Just like Chapter 8 - but with beta

Investors hold Market Portfolio

- All investors will identify same optimal risky

portfolio, M to combine with riskless asset - For supply/demand to clear, the holdings of each

security will be by relative market value

outstanding - M Market portfolio

MMarket SP500? Wilshire 5000? World Equity

Index?

Passive Indexing is Efficient

- Market portfolio must be on efficient frontier

and it is tangent point for the best feasible

capital allocation line - Mutual Fund Theorem Rational investors will

passively hold an equity index fund a money

market fund

Capital Market Line

M

Equilibrium Expected Returns

- CAPM is built on insight that appropriate risk

premium on an asset is determined by contribution

to risk of investors overall portfolio, i.e.

portfolio risk is what matters - Market price of risk or

is the benchmark tradeoff for risk return,

because all investors holdings are on CML --

Sometimes you see it divided by variance as well

as standard deviation (Can use Standard Deviation

or Variance - How does any individual security contribute to

the risk (and return) of a well-diversified

portfolio like the market portfolio?

Expected Return/Beta Relation

- The relevant measure of risk is a securitys

return covariance with that of market - Beta is the measure of covariance risk
- Suppose historical risk premium for SP 500 index

is 8 with std dev of 22. - What is risk premium of Ford stock with beta of

1.10? GM with beta of 1.25? - Ford 1.10.088.8, GM1.250.0810
- What about portfolio of 50 Ford and 50 GM?
- Could multiply out or just half way between 9.4

Security Market Line

A

SML

M

If a security plots off the Security Market Line,

its expected return is different from its fair

return, or it is misplaced. May be true for

small periods of time

CAPM Example

- Two professional money managers are being

evaluated. One averaged 19 last year and the

other managed only 16. However, the first

managers beta was 1.3 and the second manager had

a beta of 1.0. - Which manager performed better?
- If the market risk premium were 8 and Tbills

were yielding 6, which is better? - What if market risk premium is 12 and Tbills

yield 3?

Example Numbers

Picture of Example

2. CAPM and the Market Model

- Alphas and betas are measured statistically using

historical returns on the security and the market

portfolio proxy, e.g. SP 500 - Simple regression model, known as Market Model,

is used (in excess returns) - Statistically, beta measures the sensitivity of

changes in securitys return to changes in market

portfolio proxys return - Sound like CAPM beta? What about alpha?

Security Characteristic Line

BetaSlope

AlphaIntercept

R-squared measures proportion of total variation

in securitys return explained by its

relationship to the market portfolio, or how

well SCL describes XYscatterplot of points

The CAPM Beta

- How does any individual security contribute to

the risk of a well-diversified portfolio like

RM? - What is the Beta of the Market Portfolio?
- Note that if the SML holds for individual

securities it also holds for portfolios. What is

?P?

Estimating Betas

- Alternatives 1 Excess, 2 total
- (1)
- (2)
- Alphas and betas are measured statistically using

historical returns on the security and the market

portfolio proxy, e.g. SP 500 - Statistically, beta measures the sensitivity of

changes in securitys return to changes in market

portfolio proxys return. - Model 1 is typically employed in tests of the

CAPM - Model 2 is used by many especially when the risk

free is so low

Estimating Beta - 2 years of weekly data

Weekly returns of MSFT on SP500

Weekly returns of DD on SP500

Estimating Beta

Weekly returns of VFINX on SP500

Weekly returns of VUSTX on SP500

Beta Estimation - continued

- DD regression
- RDD -0.0008 0.8620RSP500 R20.1546
- t-stat 4.32
- MSFT regression
- RMSFT 0.00579 1.2734RSP500 R20.3515
- t-stat 7.43
- VFINX regression (Vanguard 500)
- RVFINX -0.0002 0.9799RSP500 R20. 9811
- t-stat 72.95
- VUSTX regression (Vanguard Long Bonds)
- RVUSTX -0.0012 0.0569RSP500 R20.0127
- t-stat 1.15

Using the models

- Models employ ex-post returns
- CAPM is a statement about ex-ante returns
- If CAPM is true, the expected value of alpha0

from excess return model (1) - from market model regressions, we expect the

average alpha 0. - Most early studies show this to be true, Jensen

(1968) - But Black, Jensen, Scholes (1972) and Fama and

MacBeth (1972) find alpha gt 0. - Implication ??

Is Beta/CAPM Dead? Chapter 8 preview

- With Sharpes 1964 development, the popularity of

CAPM took off because of simplicity and powerful

predictability - Many critiques challenged premise of systematic

risk as only factor that differentiates average

returns of assets - Roll Critique of 1979 and market proxy
- Fama and French in 1992 uncovered new evidence

about beta and book/market ratio

CAPM and Beta

Common Sense Riskier assets must provide a

higher expected return ? CAPM attempt to

answer these questions! But How well does

the CAPM fulfill this task?

how should risk be measured?

which type of risk is priced in the market?

- DEFINITION OF RISK
- Conventional ApproachRisk Chance that actual

investment outcomes differ from expected outcome - But Positive outcomes are not unfavorable!
- However, if outcomes are symmetric the Variance

should work as a measure of risk

Average Monthly Returns vs. Beta (1963 - 1990)

BETAS DEATH

The Grundy and Malkiel Study (Dont worry about

name.)

- time frame 1968 -1992, declining market periods

with flexible duration - do a sort on market ?, form portfolio deciles
- regress the CAPM equation to determine portfolio

? - vary market proxies (SP 500 and Equal-weighted

market proxy) - vary lengths of time (preceding 24 and 60 month

periods - I just show the 24 month but same for

60 months) - find 4 decile ? and their returns during bear

markets

Grundy Malkiel Mean Decile Returns,

24-Month-Preceding Betas

Conclusions

- High-beta stocks suffer significantly greater

losses than low beta stocks in declining markets. - The above conclusion holds for each period and

does not change significantly when different

market proxies and lengths of time are used to

estimate beta. - Beta is a useful tool in forecasting short-term

risk in declining markets. - Value Line and Merrill Lynch Adjustment Equations
- High betas tend to over predict future betas

low betas tend to under predict - MLAdj. Beta 0.33753 0.66257(unadj. Beta)
- VL Adj. Beta 0.35 0.67(unadj. Beta)
- VL Betas are rounded to second decimal place of 0

or 5

Arbitrage Pricing Theory Introduction Chapter

7 Continued

- CAPM is derived from the Theory of Choice
- requires behavioral assumptions
- one factor explains cross-sectional expected

returns - What is that factor???
- APT is derived from the Law of One Price
- requires less behavioral assumptions
- allows for several systematic factors
- Like multifactor CAPM

Arbitrage Pricing Theory

- An arbitrage opportunity arises when an investor

can construct a zero-investment portfolio that

will yield sure profits in future - A zero-investment portfolio is one in which some

securities are long, others short with no

commitment of investors money - This fundamental concept lies at heart of an

alternative asset pricing model, known as the

APT, developed by Steve Ross in 1977.

Factor Models

- All security returns are pervasively affected by

several macroeconomic factors - Different stocks have different sensitivities (b

coefficients) to different factors, e.g. banks

and inflation, auto companies and national income

growth, etc. - Factor models can quantify these multiple sources

of risk

Factor Portfolios

- If we understood the attributes of factors, we

could construct portfolios of stocks for which

returns mimic factor movements - Consider well-diversified portfolios built to

have unique exposure to one factor and no

exposure to other factors. - Can we construct factor portfolios from these two

stocks A and B?

Individual Assets and APT

- Each well-diversified factor portfolio is

available to any investor and each has an

expected excess return, - Consider an individual security, Z.
- Can we construct a SUPER portfolio combining

T-bills and factor portfolios to have same

expected returns and no security-specific risk?

What is that portfolio? What should be the

expected return on security