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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 = PV(1 + R)t
R = Interest rate
1 t
Future Value of Multiple Cash Flows FV(t) = C(0)(1+R)t + C(1) (1+R)t-1 + + C(t) *if either paid later, make PV into FV, then calculate PV with given R and t
t = time periods (years)
= C PV factor
Perpetuity PV = Cr
Multiple Cash Flows C(0) + C(1) 1(1 + R)+ C(2) 1(1 + R)2 + C(t) 1(1 + R)t EAR (continuous) = eR 1 1
-1
t=
log(FVPV) log(1 + R)
C= cash flow/payments
HPR =
Multiple-Period Realized Return Methods r = return rate t = time periods (years, months, etc)
ann.HPR = (
ann.HPR= (1 + HPR)
1 t
1 t
1 1
Arithmetic Average =
C
C = cash flows
(1+IRR)t Ct
(1+IRR)1
=0
1=(
Expected Return E(R) (mean) for a security (in different economic conditions) ER p = n p(s)i R(s)i = p(s)1 R(s)1 + + p(s)n R(s)n i=1
i = investment/asset/security p = probability (< 1) s = security
Covariance (two variables) = Cov(R i , R j ) = n R i E(R i ) R j ER j p(s) covariance of a variable with itself is its variance i=1 Variance (portfolio with two risky assets) Correlation (two variables) = i,j = Utility Function
Cov(Ri,Rj ) i j
2
Expected Return E(R) (mean) for portfolio (multiple securities) ER p = n i R i = 1 R1 + + n R n where i=1 Given a correlation coefficient of -1 (perfect negative correlation) with two investments 1 =
U = utility / attractiveness A = risk aversion (A>0)
= weight
2 2 p =1 1
2 2 2 2
+ 21 2 1,2 1 2
= correlation
Investment Opportunity Set (2 Risky Investments) High Utility Medium Utility Low Utility Efficient Frontier R1
Short Security 2
UR p = ER p 0.5 AVar(R p )
es or rv st Cu ve e In nc e er iff nd
Optimal Portfolio
Given investor risk aversion values and characteristics of stocks (E(R) and ), calculate utility. Higher U means more utility.
2
Minimum Variance Portfolio
Short Security 1
R2 Standard Deviation (s )
E(R p )= i E(R i ) + (1 )E(R f ) = R f + f ) E (R i R Variance (one risky, one risk-free) 2 p = 2 i 2 Given that || = Sharpe Ratio SR i =
p i
Risk-Free Asset E(R f ) = R f , Variance (R f ) = 0, Cov(R i , R f ) = i,f = 0 for any other asset i Expected Return E(R) (mean) for portfolio (one risky and one risk-free) Portfolio Selection with One Risky and One Risk-free Asset
Excess Return Risk premium
, E(R p ) = R f +
E(Ri Rf) 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)
represents return premium per unit of risk highest SR = tangency portfolio CAL
Sharpe Ratio
E(Ri Rf )
Long Risk-Free
s K = 8%
s US = 15.98% s L = 24%
Risk-Reduction: As the number of independent assets in a portfolio increases (even with lower returns and higher individual risk), the portfolios 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) Regression Analysis Ri = i + i R M + ei Market Index Return R M = i Ri Total Variance var(Ri ) = Deviations of individual assets from points on the regression line represent negative or positive idiosyncratic risk. ( 2 + e 2 )2 M i idiosyncratic (variance)risk systematic (covariance) risk f = risk-free
systematic risk
ve or ur st C ve e In enc r fe Optimum Portfolio f di In
nt ie fic Ef
o Fr
R1
i =
Cov (R M , R i ) 2 M
idiosyncratic risk
Capital Asset Pricing Model (CAPM) 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)
R = return i = investment/asset/security M = market t = time periods e = error
Security Market Line (SML) shows estimated excess return of an asset in relation to its beta () value when compared to market. Built from CAPM equation E(R i ) = R f + i [E(R M ) + errori R f ] >1
Total Risk in a security i 2 = Equilibrium risk premium = size of compensation for systematic risk. Goes up w/ market volatility and degree of risk aversion
systematic (market) risk idiosyncratic (variance)risk
E(R M ) = R f +
Sharpe Ratio
[E(RM )Rf]
Cov (R M , R i ) Var(R M )
0.25
0.20
Underpriced (a > 0 )
the
0.15
M
( 2 )2M i
e 2
Percentage of idiosyncratic risk diversified away in an asset by the market portfolio R = return i = investment/asset/security f = risk-free
M = market
i 2
0 0 0.5 1 M = 1 1.5
Beta Coefficient () 2
t = time periods
e = excess returns
A securitys alpha () is = E(R i ) R f i [E(R M ) R f ] CAPM predicts that all = 0. > 0, security is underpriced vs. CAPM, < 0, security is overpriced vs. CAPM Capital Budgeting with CAPM E(R i ) = R f + i [E(R M ) R f ] + errori = IRR plug into NPV equation.
C (1+IRR)1 C1
Security Capital Line (SCL) regression line representing the security's actual excess return on the actual market excess return.
(1+IRR)2
C2
3 + (1+IRR)3 + +
(1+IRR)t
Ct