ASSET PRICING

MSc Quantitative Finance

MSc Financial Mathematics
Cass 2014/15
Dirk Nitzsche (E-mail : d.nitzsche@city.ac.uk)
The Course
Introduce basic concepts used to price
financial assets
Analyse relationships between risk and
return
Diversification
CAPM and other factor models
Practical issues and empirical findings
Financial Markets
Financial Assets
Companies
Financial assets
Stocks, Equity
Fixed Income Securities : Bills and Bonds
FOREX
Derivatives : Options, Futures, Swaps
Annual Risk and Return (US
Assets : last 100 Years)
0
2
4
6
8
10
12
14
16
18
20
0 5 10 15 20 25 30 35 40 45
ER
Standard deviation
Small Company Stocks
Large Company Stocks
Treasury Bills
Medium Term T-bonds
Long Term
T-bonds
Website
Moddle (electronic platform) :
Teaching material can be found on the electronic
platform Moodle.
My website :
http://www.cass.city.ac.uk/experts/D.Nitzsche
includes links to co-authored textbooks, publications
and other research information. No teaching
material can be found here (see Moddle)
The Textbook
Textbook More Basic
Material
Main textbook
Cuthbertson, K. and
Nitzsche, D. (2008)
Investments, J. Wiley,
2
nd
edition
FINANCIAL SECURITIES,
FINANCIAL MARKETS : THE
BASICS
Asset Pricing
Dirk Nitzsche (E-mail : d.nitzsche@city.ac.uk)
Contents
Raising finance : corporate finance and
financial markets
Data : Prices, returns, HPR, yields
Data : Nominal and real variables
Basic concepts : compounding, discounting,
NPV, IRR
Key questions in finance
Applications : Investment appraisal and
valuation of a firm
Financial Securities
Various economic agents (i.e. firms,
government) need to borrow/raise money
Different ways to raise money
Debt
Bank loan
Money market instrument : commercial paper,
Treasury Bill, Interbank Deposit, Certificate of
Deposit
Bonds
Equity (i.e. different form of stocks)
Primary and Secondary
Markets
Primary market
Financing of (physical) investment projects (i.e.
expansion, company)
Money raised goes to issue of assets (i.e. stocks,
bonds)
Corporate Finance
Secondary market
Liquidity of markets ensures transfer of assets
Money goes to existing owner of assets
Financial Markets
Calculating Rate of
Return from Prices
Financial data is usually provided in
forms of prices (i.e. bond price, share
price, FX, stock price index, etc.)
Financial analysis is usually conducted
on rate of returns
Statistical issues (spurious regression
results can occur)
Easier to compare (more transparent)
Newspaper Quotes
Converting Prices Rate
of Returns
Arithmetic rate of return
R
t
= (P
t
- P
t-1
)/P
t-1
Geometric rate of return
R
t
= ln(P
t
/P
t-1
)
get similar results, especially for small price
changes
However, geometric rate of return preferred
more economic meaningful (no negative prices)
symmetric (important for FX)
Exercise : Prices Rate
of Returns
Assume 3 period horizon. Let
P
0
= 100
P
1
= 110
P
2
= 100
Then :
Geometric :
R
1
= ln(110/100) = ??? and R
2
= ln(100/110) = ???
Arithmetic :
R
1
= (110-100)/100 = ??? and R
2
= (100-110)/110 = ???
SEE EXCEL SPREADSHEET
SELF STUDY EXERCISE
Suppose you have the prices over the following 5 periods (i.e.
years), starting today.
PRICE
Today 100
Year 1 110
Year 2 105
Year 3 125
Year 4 118
a.) Suppose you buy 100 shares today, how much money would
you have made over the next 4 years if you by one share ?
b.) Calculate the one-period arithmetic returns and the one-
period geometric returns and show how you can get the same
answer as in (a.) using the one-period returns.
Holding Period Return
(Yield) : Stocks
H
t+1
= (P
t+1
P
t
)/P
t
+ D
t+1
/P
t
1+H
t+1
= (P
t+1
+ D
t+1
)/P
t
Y = A(1+H
t+1
(1)
)(1+H
t+2
(1)
) (1+H
t+n
(1)
)
Continuously compounded returns
One period h
t+1
= ln(P
t+1
/P
t
) = p
t+1
p
t
N periods h
t+n
= p
t+n
- p
t
= h
t
+ h
t+1
+ + h
t+n
where p
t
= ln(P
t
)
Nominal and Real Returns
W
1
r
W
1
/P
1
g
= [(W
0
r
P
0
g
) (1+R)] / P
1
g
(1+R
r
) W
1
r
/W
0
r
= (1 + R)/(1+p)
R
r
DW
1
r
/W
0
r
= (R p)/(1+p) R p
Continuously compounded returns
ln(W
1
r
/W
0
r
) R
c
r
= ln(1+R) ln(P
1
g
/P
0
g
)
= R
c
- p
c
Foreign Investment
W
1
= W
0
(1 + R
US
) S
1
/ S
0
R (UK US) W
1
/W
0
1 = R
US
+
DS
1
/S
0
+ R
US
(DS
1
/S
0
) R
US
+ R
FX
Nominal returns (UK residents) = local
currency (US) returns + appreciation of
USD
Continuously compounded
R
c
(UK US) = ln(W
1
/W
0
) = R
c
US
+ Ds
Summary : Risk Free Rate,
Nominal vs Real Returns
Risk Free Asset
Risk free asset = T-bill or bank deposit
Fisher equation :
Nominal risk free return = real return + expected inflation
Real return : rewards for waiting (e.g. 3% - fairly constant)
Indexed bonds earn a known real return (approx. equal to the
long run growth rate of real GDP).
Nominal Risky Return (e.g. equity)
Nominal risky return = risk free rate + risk premium
risk premium = market risk + liquidity risk + default risk +
FTSE All Share Index
(Nom.) : Jan. 1965 July
2013
FTSE All Share Index (Real)
: Jan. 1965 July 2013
0
50
100
150
200
250
300
M
a
y

M
a
y

M
a
y

M
a
y

M
a
y

M
a
y

M
a
y

M
a
y

M
a
y

M
a
y

M
a
y

M
a
y

M
a
y

M
a
y

M
a
y

M
a
y

M
a
y

M
a
y

RETURNS - FTSE All Share Index

(Nom.) : Jan. 1965 July 2013
RETURNS - FTSE All Share Index
(Real) : Jan. 1965 July 2013
Finance : What are the key
Questions ?
Big Questions : Valuation
How do we decide on whether
to undertake a new (physical) investment project ?
... to buy a potential takeover target ?
to buy stocks, bonds and other financial instruments
(including foreign assets) ?
To determine the above we need to calculate the
correct or fair value V of the future cash flows
from these assets.
If V > P (price of stock) or V > capital cost of
project then purchase asset.
Big Questions : Risk
How do we take account of the riskiness of the future
cash flows when determining the fair value of these
assets (e.g. stocks, investment project) ?
A. : Use Discounted Present Value Model (DPV) where
the discount rate should reflect the riskiness of the
future cash flows from the asset CAPM
Other Important
Questions
Portfolio Theory :
Can we combine several assets in order to reduce risk
while still maintaining some return ?
Portfolio theory, international diversification
Hedging :
Can we combine several assets in order to reduce risk to
(near) zero ?
hedging with derivatives
Speculation :
Can a financial adviser beat the market return (i.e. index
tracker on S&P500), over a run of days, after correcting
for risk and transaction costs ?
Compounding,
Discounting, NPV, IRR
Time Value of Money :
Cash Flows
Project 1
Time
Project 2
Project 3
Example : PV, FV, NPV,
IRR
Question : How much money must I invest in a
comparable investment of similar risk to
duplicate exactly the cash flows of this
investments ?
Case : You can invest in a company and your
investment (today) of 100,000 is expected to
be worth 160,000 one year from today.
Investments of similar risk earn 20% p.a. !
Example : PV, FV, NPV,
IRR (Cont.)
-100,000
+ 160,000
r = 20% (or 0.2)
Time 0
Time 1
Compounding
Example :
A
0
is the value today (say $1,000)
r is the interest rate (say 10% or 0.1)
Value of $1,000 today (t = 0) in 1 year :
TV1 = (1.10) $1,000 = $1,100
Value of $1,000 today (t = 0) in 2 years :
TV2 = (1.10) $1,100 = (1.10)
2
$1,000 = $ 1,210.
Breakdown of Future Value in 2 years
$ 100 = 1
st
years (interest) payments
$ 100 = 2
nd
year (interest) payments
$ 10 = 2
nd
year interest payments on $100 1
st
year (interest)
payments
Discounting
How much are $1,210 payable in 2 years
worth today ?
Suppose discount rate is 10% for the next 2 years.
DPV = V
2
/ (1+r)
2
= $1,210/(1.10)
2
Hence DPV of $1,210 is $1,000
Discount factor d
2
= 1/(1+r)
2
Compounding Frequencies
(Terminal Wealth)
Interest payment on a 10,000 deposit/loan (r = 6% p.a.)
Simple interest 10,000 (1 + 0.06) = 10,600
Half yearly compounding
10,000 (1 + 0.06/2)
2
= 10,609
Quarterly compounding
10,000 (1 + 0.06/4)
4
= 10,614
Monthly compounding
10,000 (1 + 0.06/12)
12
= 10,617
Daily compounding
10,000 (1 + 0.06/365)
365
= 10,618.31
Continuous compounding
10,000 e
0.06
= 10,618.37
SEE EXCEL SPREADSHEET
Effective Annual Rate
(1 + R
e
) = (1 + R/m)
m
R
e
= e
R
1
Simple and Compounded
Interest Rates
Suppose terminal wealth remains constant at 10,600,
initial investment 10,000. What simple rate will give
you a this TV for different compounding frequencies ?
Simple interest
10,000 (1 + 0.06) = 10,600 (r = 6%)
Half yearly compounding
10,000 (1 + 0.059126/2)
2
= 10,600 (r = 5.9126%)
Quarterly compounding
10,000 (1 + 0.058695/4)
4
= 10,600 (r = 5.8695%)
Monthly compounding
10,000 (1 + 0.058411/12)
12
= 10,600 (r = 5.8411%)
Daily compounding
10,000 (1 + 0.058274/365)
365
= 10,600 (r = 5.8274%)
Continuous comp. : 10,000 e
0.058269
= 10,600 (r = 5.8269%)
FV, Compounding :
Summary
Single payment
FV
n
= $A(1 + R)
n
FV
n
m
= $A(1 + R/m)
mn
FV
n
c
= $A e
Rn
Discounted Present Value
(DPV)
What is the value today of a stream of payments
(assuming constant discount factor and non-risky
receipts) ?
DPV = V
1
/(1+r) + V
2
/(1+r)
2
+
= d
1
V
1
+ d
2
V
2
+
d = discount factor < 1
Discounting converts all future cash flows on to a
common basis (so they can then be added up and
compared).
Annuity
Future payments are constant in each year :
FV
i
= $C
First payment is at the end of the first year
Ordinary annuity
DPV = C S 1/(1+r)
i
Formula for sum of geometric progression
DPV = CA
n,r
where A
n,r
= (1/r) [1- 1/(1+r)
n
]
DPV = C/r for n
Investment Appraisal
(NPV and DPV)
Consider the following investment
Capital Cost : Cost = $2,000 (at time t= 0)
Cashflows :
Year 1 : V
1
= $1,100
Year 2 : V
2
= $1,210
Net Present Value (NPV) is defined as the discounted
present value less the capital costs.
NPV = DPV - Cost
Investment Rule : If NPV > 0 then invest in the project.
Internal Rate of Return
(IRR)
Alternative way (to DPV) of evaluating investment
projects
Compares expected cash flows (CF) and capital costs
(KC)
Example :
KC = - $ 2,000 (t = 0)
CF1 = $ 1,100 (t = 1)
CF2 = $ 1,210 (t = 2)
NPV (or DPV) = -$2,000 + ($ 1,100)/(1 + r)
1
+ ($ 1,210)/(1 + r)
2
IRR : $ 2,000 = ($ 1,100)/(1 + y)
1
+ ($ 1,210)/(1 + y)
2
Graphical Presentation :
NPV and the Discount rate
Discount (loan) rate
NPV
0
8% 10% 12%
Internal rate
of return
Investment Decision
Invest in the project if :
DPV > KC or NPV > 0
IRR > r
if DPV = KC or if IRR is just equal the
opportunity cost of the fund, then
investment project will just pay back the
principal and interest on loan.
If DPV = KC IRR = r
Different Cash Flow
Profiles
Suppose the following three cash flow
profiles
Case A : (-$100, $130) Normal
Case B : ($100, -$130) Pop concert
Case C : (-$100, $230, -$132) Open cast mining
see next NPV / IRR diagrams
Problem :
NPV gives correct decision for A, B and C
IRR gives wrong decision for B and C.
Project A : Normal Cash
Flows
Loan or
discount rate
NPV
IRR
r
IRR = 30
r = current loan rate
1.) Invest if NPV > 0 or
2.) Invest if IRR > r
Project B : Pop Concert
Cash Flows
Loan or
discount rate
NPV
IRR
r
IRR = 30
r = current loan rate
Here (paradoxically) we
invest if IRR < r
Project C : Open Cast
Mining Cash Flows
Loan or
discount rate
NPV
IRR
1
= 10
r
Multiple IRR (10% and 20%)
r = current loan rate
Invest if IRR
1
(10%) < r < IRR
2
(20%)
IRR
2
= 20
Mutually Exclusive
Projects
Suppose two projects (Project A and Project B)
Under mutually exclusive projects we understand
that either Project A or Project B can be accepted
or both are reject, but both projects cannot be
accepted.
IRR criterion can give incorrect investment decision
Scale problem
Timing problem
Scale Problem (Mutually
Exclusive Projects)
CF0 ($) CF1 ($) NPV ($) IRR (%)
Project A -10 15 5 50
Project B -100 110 10 10


Project B has lower IRR, but higher NPV than Project A.
If projects are mutually exclusive should undertake
Project B, but IRR rule would suggest to undertake
Project A first.
Suppose interest rate / discount rate = 0
Timing Problem (Mutually
Exclusive Projects)
NPV NPV NPV
Year 0 1 2 3 0% 10% 15% IRR
(%)
Pro. E -10000 12000 1000 1000 4000 2487 1848 33.15
Pro. L -10000 1000 1000 14000 6000 2254 831 18.37


Project E has larger CF in the earlier years compared
to Project L.
Timing Problem (Mutually
Exclusive Projects) - Cont.
Discount (loan) rate
NPV
0
8.71%
18.36%
33.15%
NPV
L
> NPV
E
Project L
Project E
Switching point
NPV
L
< NPV
E
Summary of NPV and IRR
NPV and IRR give identical decisions for
independent projects with normal cash
flows
For cash flows which change sign more than
once, the IRR gives multiple solutions and
cannot be used use NPV
For mutually exclusive projects use the NPV
criterion
Valuation of a Firm : DPV
Enterprise Value and
Equity Value
Enterprise DCF
In practice investment costs occur every year so :
FCF = (Operating cash flows - gross physical investment) p.a.
V(whole firm) = DPV(FCFs to equity and FCFs to bondholders)
Value of Equity
V(Equity) = V(whole firm) - V(debt outstanding)
Fair value for one share = V(Equity) / N
N = number of shares outstanding.
In an efficient market, the quoted / market price of
the share(s) should equal its fair value as calculated
using DCF techniques
Valuing the Firm :
Continuing Value
To simplify : The DPV of all the firms future
cash flows is often split into two (or more)
planning horizons
Enterprise DCF
= DPV of FCF in year 1-5 (say)
+ DPV of Continuing Value after year 5.
Continuing Value is the value in year 5 or 6
of all FCFs from year 6 onwards.
Valuing the Firm :
Continuing Value
Special case A :
the discount rate is constant in each year
cash flows, FCF are constant in each year and persist for
ever (i.e. perpetuity) then
CV = FCF/r
This is often used to calculate continuing value, CV.
Special case B :
if the discount rate is constant in each year and
FCFs grow at a constant rate each year, say after year 5,
then
CV (at t=5) = FCF
5
(1+g)/(r-g) for r > g
Valuing the Firm :
Example
Special case A :
Project has FCF = 100 is constant in all years after year 5 and
r = 0.1 then
Continuing value CV (at t = 5) = 100 / 0.1 = 1,000
and DPV (at t = 0) of the CV = 1,000 / (1+r)
5
= 621
Special case B :
Project has FCF = 100 in year 5, FCF grows at rate g = 0.03
(3%) and r = 0.1, then
Continuing Value CV (at t=5) = 100 (1.03)/(0.1-0.03) = 1,471
and DPV (at t=0) of the CV = 1,471 / (1+r)
5
= 913
Company Valuation : M&A
Example
Suppose value of firm using DPV of FCFs is :
Enterprise DCF = DPV (FCF 1-5 y) + DPV (of CV)
= 679 (say) + 621 (say)
= $1,300
Suppose : all equity finance firm (N = 1,000 shares
outstanding), then fair value of 1-share
=$1,300/1,000 = $ 1.30.
Suppose current market price is $ 1.- (or market
capitalisation = $ 1,000), then
shares are undervalues by 30%
possible purchase or takeover target.
Continuing Value using
Earning Multiples
Another idea to summarise a series of cash flows (say in year 5) :
Multiple chosen = Price-Earnings ratio of comparables (i.e. sector
average, i.e. leisure and travel)
Weighted average (historic) PE ratio for specific industry =
(P/EPS)
Ind
= 25
Note : weights are market capitalisation proportions or sales
revenue proportions
CV at t=5 (which must then be discounted) :
CV
5
= (estimated earnings, EBIT at t=5) x 25
Other industry multiples used include average value of :
(Market value of equity + Debt) / Earnings(EBIT)
Estimated Earning x P/E Estimate of future Price
Discount Rate : All Equity
Financed Firm
All equity financed firm = unlevered firm - i.e. no debt
Discount rate should reflect business risk of project
Assume : same business risk as the firm as a whole.
Simple method :
use the average (historic) return on equity R
S
(e.g. 15%) for
this firm as the discount rate
This assumes the observed return on equity correctly reflects
the payment for risk, that shareholders require from this
company.
Shareholder Value : All
Equity Financed Firm
If NPV of the project > 0 (discounted using R
S
)
implies the managers are adding value for
shareholders (i.e. which exceeds the return they
could earn from investing their money in other
firms in the same industry).
This is value based management or creating
shareholder value.
Discount Rate : Levered
Firm
Levered firm = financed by mix of debt and equity
Assume debt-equity ratio will remain broadly
unchanged after the new project is completed.
Then discount FCF using :
(after tax) weighted average cost of capital, WACC
WACC = (1-z) R
S
+ zR
B
(1-t)
z = B/V = proportion of debt (bonds), (1-z) = S/V
V = market value of firm = S + B
weights, z sum to 1.
Discount Rate : Levered
Firm (Cont.)
S = market value of outstanding equity (= N x stock
price)
B = market value of outstanding debt (i.e. bonds issued
and bank loans)
R
S
= average return on equity in hamburger industry
R
B
= interest rate (yield to maturity) on say 10 year
corporate AA-rated bonds (if hamburger industry is rated
AA by Standard & Poors)
t = corporate tax rate
Note : market value (capitalisation) of the firm : V = S + B
Alternative Methods of
Valuating a Company
Economic Profits (EP) and
Economic Value Added (EVA)
EP and EVA are equivalent to Enterprise DCF if the
calculations are done consistently (i.e. before the accountants
gets at the figures)
EP = (ROC WACC) x Capital Stock, K
EVA = (Profit Capital Charge)
where Return on Capital (ROC) = Profit / K
Capital charge = WACC x Adjusted Capital, K
If ROC > WACC then the manager chosen investment projects
are earning a rate of return in excess of WACC and therefore the
investment projects are adding value.
Example : Economic Profits,
Economic Value Added
Profits = $150, K = $1,000,
Hence ROC = 15% p.a.
Let WACC = 10% p.a.
EP = (15% - 10%) x $1,000 = $ 50 p.a.
EVA = $150 (10%) $1,000 = $ 50 p.a.
Your current stock of capital is being used in such a
way as to generate $50 p.a. even after allowing for
an annual dollar capital charge of $100 p.a.
EP and EVA
You can compare different firms performance on EP
and EVA in any one year (or over several years).
The plus, compared to using just profits or ROC is
that EP and EVA assess profit in relation to the cost
of capital.
Value of the firm (at t=0) using EP or EVA
= (net) capital stock at t=0, K
0
+ DPV (of EP or EVA p.a., ~ WACC as discount rate).
Comparison : Alternative
Valuation Techniques
EVA Capital, K ROC WACC
General Electric 2515 51,017 17.7 12.7
General Motors -3527 94,268 5.9 9.7
Johnson & Johnson 1327 15,603 21.8 13.3
A positive return on capital of 5.9% for GM is not enough if
you have a WACC of 9.7%. It results in a negative EVA (or
EP).
(Source : Fortune Magazine, 10
th
Nov. 1997)
Summary
Financial Data : prices, returns, and other definitions
Basic concepts used for valuing financial
assets/companies/projects
Returns
Compounding and discounting
Discounted Present Value and Internal Rate of Return
Valuing investment projects
Valuing companies : levered and unlevered firm
Alternative valuation techniques
References
Cuthbertson and Nitzsche (2004)
Quantitative Financial Economics,
Chapter 1
Cuthbertson and Nitzsche (2008)
Investments, J.Wiley (2
nd
edition),
Chapters 6 and 8
Maths : Taylor Series
Expansion
Taylor Series Expansion
Method to approximate a function
using derivatives
U(x) U(a) + [U(a)/1] [x-a] +
[U/(2*1)] [x-a]
2
+ [U(a)/(3*2*1)] /
[x-a]
3
+
End of Lecture