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Week Beginning 4 March 2019
1. What is Jyothi’s fee for the services he provides, expressed in percentage terms?
 Clients are paying Jyothi to store their money
 Negative interest rates are common in many parts of the world and will occur when
the cost of holding money is greater than the gain of money
2. Why would a slum-dweller wish to use Jyothi’s services?
 Poor people occasionally have large expenditures which are divided into three
o Lifecycle, emergency needs,
 Jyothi is acting as a bridge
 Clients are forced to save, temptation to spend on trivial things is removed
 Can transform small sums into large amounts
3. Do you think Jyothi’s fee is excessive, too low or just right? By way of comparison, a major
Australian bank was offering personal rates at around 14% per annum. To answer this
question, identify the costs that Jyothi has to bear to provide her service and compare them to
relative to the revenue she is likely to earn. You should also consider the scale of a loan.
 Costs – has to collect the money, book keeping fees, general labour, makes sure the
money is safe
 Jyothi clients cant access a bank, neither can Jyothi – theft = big issue
 Yes, fair. Demand and supply of deposits in sums, more demand for deposits then
there are people who can provide the service
 Options are scarce, good reputations are rare
4. What is the opportunity cost to Jyothi’s clients, i.e., if they didn’t use her services, how else
would they use their money?
 Opportunity cost – loss of an alternative when something else is offered
 Without Jyothi they will spend their money on other needs, may get stolen, husbands
may spend it
 Either save with Jyothi or save with themselves
5.Do you think it would be profitable for a large, commercial bank to enter the business of
lending to slum-dwellers? If so, why? If not, why? You should give specific reasons expressed
in economic tearms. For example: Yes, they should because a bank would make significant
profits: their expected profit would be 2x but their costs would be just 1x. Of course, you wont
be able to give precise estimates of costs, but you can make a good guess whether it is likely
to be profitable or not.
 Significant costs in transporting and keeping cash
 Large banks normally lend money not store it
 Compliance costs
 Won’t be profitable for a bank
 Economies of scale they would have access to in a different market wouldn’t exist in
this one
1. What is the moneylender’s fee, expressed in percentage terms?
2. Is the moneylender’s fee different to that charged by Jyothi? If so, why do you think the
difference arises? In answering this question, ask yourself, why would a slum-dweller wish to
use a moneylender services on the terms provided above rather than access the services of
Jyothi? If the money-lender is more expensive and people still use his services then there must
be something more attractive about the terms of his loan. What is that difference?
3. Why don’t more people complete with the moneylender? If his business is more profitbale
than Jyothi then you would expect more money-lenders to enter the business. Why don’t
they? Does the money-lender have higher risk or greater costs (or both)?
4. If the money lender had a reliable way of enforcing his contracts (say, by hiring thugs to
threaten borrowers who don’t pay up), would he generate more or less business? Would
potential borrowers be better or worse off?
1. In your opinion, was CBA acting as a partner, predator, parasite or per in its transactions
with Mr Harris? Justify your answer.
 Parasite – disregarding the information about him having a gambling problem for
their own gain
Parasite showed low warmth by seeking to gain from Mr Harris situation without
adding value to him
 Bankers were incompetent at assessing his credit competence
2. If you are borrowing money from a bank to buy a house, do you think the bank has a
responsibility to assess whether or not you can repay the loan? Justify your answer.
 Recourse on the mortgage
 Identify if a duty of care existed, would need tailored advice
 If you can prove a duty of care existed, and then was breached, need to show that
you relied on the advice of the bank which ultimately caused your loss
1. negative interest rates imply that depositors have to pay for leaving their wealth with the
swiss banks. In contrast in Australia, investors receive income in the form of interest if they
deposit their money in a local bank (e.g. the Bank of Melbourne is offering 2.6% per annum
for a two-year deposit). Why do you think investors find it attractive to leave their money in
Switzerland? Is your answer consistent with standard economic theory? Also, why would the
swiss bank wish to discourage foreigners from buying swiss assets?
 If foreigner buys swisse assets these are bought in swisse francs, changing the value
 Swisse bank can put explicit limits on how the exchange rate fluctuates
 Why would a central bank want to discourage foreigners from entering the
international market? If exchange rate is more stable, consumers will be more sure of
what it will be in the future
 Country risk factors, trade restrictions
 Consider the threat of war and terrorism, faith in countries banking system
 Safety of storage, convenience, desire to evade regulatory issues
 Interest rate measures money
 Consistent if the supply of the funds is greater then the demand
Week beginning 11 March 2019
1. (a) Why has finance been referred to as ‘ketchup economics’?
(b) what is the argument on Tuesday’s lecture that it is unhelpful to refer to intrinsic value in
the context of investment analysis? In your answer, you should define ‘intrinsic value’. An
example of the use of the term intrinsic value in the context of investment analysis is provide
below: on LMS.
2. (a) The chart below shows the yield on Australian government bonds with a ten-year
maturity. Does the chart have any relevance to the price of housing property in Australia?
Justify your answer.
(b) What is your opinion of the ability of the average investor to predict changes in the 10 year
government bond yield? Does it matter either way?
4. Question on LMS
Week beginning 18 March 2019
1. lithium-ion batteries are emerging as an instrumental part of the electric-car revolution,
resulting in significant disruption to the auto-industry. As a result the price of lithium has
increased substantially since 2015. However, some argue the lithium market lacks
transparency. What is meant by transparency in financial markets? What impact do you think
it will have on investors? Identify some reasons why the lithium market is considered opaque.
2. in last week’s lecture we discussed the value captured from unusual or ‘boring’
investments. Anthony Pratt (currently Aus richest person) recycles and manufactures
cardboard boxes. How has Pratt made his fortune?
3. In the lecture we discussed an alternative (indirect) approach to investing in lithium – a pick
and shovel strategy.
(a) what is a pick and shovel strategy?
(b) find a pick and shovel stock (historical or one you think might be one in the future) and
explain why it is a pick and shovel play.
4. Use porters 5 forces to analyse the competitiveness of mobile phone manufacturers and
discuss why Apple is so profitable.
Week beginning 25 March 2019
Question 1
What are the implications for investors of ‘bond markets underestimating the risk of wages
growth stoking higher inflation’?
 Bond markets are ignoring wages pick up
o Aus. 10-yr bond rate declined to <2%
o RBA assistant governor: ‘there is just no risk built into these rates for any
increase in inflation, and yet we see wages growth trending up around the
globe in a situation of fairly low unemployment.’ He said in response to
questions at a gathering of bond market participants in Sydney on Tuesday. He
said the unemployment rate was ‘especially low’ in the US, but was falling in
Europe and Japan, leading to a pick up in wages
How would a pick up in wages affect inflation?
 Wages are a factor of production
 Fairly low unemployment rates and upward trending wage growth should cause living
standards to increase
 This will then cause a natural increase in demand for middle income consumer goods
 In turn pushing prices higher, i.e. inflation
 If bond yields incorporate inflation risk, we would expect to see the (expected)
increase in future inflation be priced into bond yields
 Conflict: bond yields are falling which is indicative of lower expected inflation
Implications for asset allocation:
 Higher than expected inflation is:
o Good for borrowers, as the real cost of debt is cheaper, but
o Bad for lenders, i.e. bond holders
 They learn less than anticipated on their capital, as their real rate of
return is diminished
 If you believed the market was incorrectly pricing inflation risk in bonds, and that
wage/employment growth will occur, you may decide to increase your allocation of
capital to equities rather than to debt
How credible is it that bond market investors, who include large institutions with significant
resources at their disposal to use in analysis, have underestimated the risk of inflation?
 Dr Kent’s argument assumes that higher wages translates to higher consumption, and
that capital allocation is not moving to non-productive assets
 In reality, output cant be attributed to consumption alone
 Different countries have different ‘weightings’ on the distribution of consumption
 E.g. Japan: ‘real wages rose at their fastest pace in more than 21 years
o Reuters 07/08/2018
o Despite this, their inflation rate has been very low, hovering in the -1 to 1%
band from ~2016 to present
o Households have very high saving rates and low tendencies to spend
 Marginal propensity to consume
 Concept that the increase in personal consumer spending occurs with an increase in
disposable income
 US, Australia tend to have high MPC
 What data could we use to verify Dr Kents claims?
o Consumer confidence index, consumer spending, household spending,
saving/deposit rates
Question 2
Explain why it is a fallacy to identify ‘tight money’ with high interest rates and ‘easy money’
with low interest rates. Your answer should explain what is meant by ‘easy’ and ‘tight’ money
 Assume a constant/static risk acceptance by the economy
o i.e. ignore risk tolerance
because of this risk assumption, assume money is ‘easy’ during periods of low
interest rates, and vice-versa
low IR implies:
o low borrowing costs and low benefit of saving
o therefore, increased consumption of goods and services, lower discount rate
for business funding and improved liquidity
o resulting in improved economic growth
Question 3
David Bassanese refers to ‘real’ interest rates. What other kind of interest rate is there?
 Nominal interest rate = real rate of interest + rate of inflation
 High nominal rates do not imply money is expensive if inflation is also high
 If nominal interest rates are high due to high inflation, money is not necessarily tight
 That is, the economy may be more optimistic
 In contrast, when the economy is pessimistic nominal interest rates are decreased
 Negative interest rates mean a loss on savings, inflation erodes wealth faster than it is
created through interest
Why is distinction important?
 Need to know the real rate that lenders and borrowers are trading in
 The challenge for investors is predicting future inflation. If inflation is greater than
expected then investments will be discounted at a higher rate and prices will fall
Do high interest rates always mean that it will be difficult for riskier projects to get funding?
 High real interest rates imply that it is difficult to raise money
 But, higher (nominal) interest rates may be largely attributed to inflation. Inflation is
(usually) a sign of an optimistic market, with high levels of risk tolerance and
therefore greater investment in riskier projects
 If aggregate risk tolerance is high, then riskier assets have access to greater financing
liquidity. SO not always difficult for riskier projects to get funding
 Conversely, low interest rates do not always mean it will be easy for riskier projects to
get funding
Global excess of desired saving over desired capital investment
 Secular stagnation – Larry Summers
o Stagnationists tend to attribute weakness in capital investment to
fundamental economic factors
o E.g. slow population growth, the low capital needs of many new industries,
and the declining relative price of capital
 Savings glut – Ben Bernanke
o Government decisions, e.g. policy decisions to reduce the ability to borrow,
build international reserves, raise taxes etc
Why the ‘new normal’ is relevant for investors?
 Lowe: how long will the period of low IRs last?
o Am I being adequately compensated for that risk?
 Low long-term rates suggest that markets currently expect both low inflation and low
real interest rates to continue for many years
 Compensation for risk in shift of term premium
o Many financial prices do not obviously offer any compensation for the
uncertainty surrounding the future evolution of IR’s
 E.g. most estimates of the term premium in the 10-year US treasuries are around
zero, or are even negative – investors are not receiving any additional compensation
for holding an asset with duration
Context: subdued global recovery from GFC, low investment, subdued wages growth despite
low unemployment rates and low inflation. What should governments do?
 QE
o Mechanics
o Motivation – to increase MS until investors choose to invest in risky assets in
search for a yield
o Effectiveness? Hoarding cash in a risk averse environment, e.g. banks using
cash to increase their capital reserves if they fear increasing defaults in their
loan portfolios
Alternatives to QE
 Austerity approach
o Interventions are harmful – recessions are signs of economy organising itself
o Advocates of austerity (higher taxes, cut spending) argue that reducing
government deficit avoids default risk, boosts confidence and encourages
lower interest rates
o Keynesians argue the opposite – that government spending is exactly what the
economy needs in order to pick up the slack left behind by the private sector
and curb unemployment. The efficacy of stimulus spending comes from the
multiplier effect
 Keynesian solution
o Government stimulates demand by spending, and incurring budget deficits
o E.g. tax cuts, sending money to residents, etc.
Two main critiques
1. Government spending may ‘crowd out’ private investment
2. Governments cant print money forever without raising debt and interest rates
beyond the ability of the country to repay
1. The large cash stock piles of corporations suggest that the ‘crowding out’ of private
investment argument against government spending isn’t valid in the present times
2. If investors perceive that credit risk is a concern, it would be priced in bond yields
3. Ultra-low interest rates for US government securities indicate investors sleep easy;
they don’t lie awake worrying whether they will get paid
Question 4
Why is low inflation and high growth surprising to economists? What are some reasons we
are experiencing low inflation and high growth?
At this time, in the US, Europe and Japan, the actions of investors (in buying bonds) and of
corporations (in hoarding cash) (therefore resulting in low IRs) indicate they believe deflation
is a more serious threat than inflation
 If you believe that corporate earnings will revive, then investing a higher proportion in
equities is appropriate
 Recall: an increase in wages
o If it is met with higher employment, higher demand and confidence, then
would expect company profits to increase (higher cash flows/dividends –
higher price)
If you think deflation will remain a serious threat for some time, then you will prefer
to invest more in bonds
In a deflationary environment, with drastically falling prices, investors flee to the
perceived safe haven of government debt. Also, the reliable, fixed income stream is
worth more relative to the ongoing decline in equity prices. Investors are assured of
receiving the original face value of their bonds – a good insurance feature in a global
Why is low inflation and high growth surprising to economists?
 Context
o We see low inflation, however, strong equity performance
o Why is it surprising
o Prices can increase due to excessive demand i.e. when an economy is growing
and supply is struggling to meet demand
o When the economy is growing, spending is increased; prices for goods and
services expected to increase. We expect inflation to increase, because prices
are increasing
What are some reasons we are experiencing low inflation and high growth?
 Recall: inflation is an increase in the general level of prices for goods and services
 Prices can increase due to:
o Excess demand – consumer spending
o Increase in the costs of production
 Productivity growth – improvements in technology are able to increase output for the
same cost
o Given we can see increasing demand creating growth, the supply side in
wages and productivity improvements are enough to keep factors of
production stable
 Unemployment rate decreases without putting pressure on wages
o Therefore, the demand for labour (coming from increased growth) is met with
an increase supply keeping inflation in wages stable
 When demand (consumer spending) increases at the same rate that the supply
increases at the equilibrium does not change (and neither does price). If price is not
increasing then inflation is zero/low.
Week beginning 1 April 2019
Question 1
Why is increased correlation across asset classes bad news for investors?
 Define correlation – a historical measure of the tendency of the returns of one asset
to move in tandem with those of another asset
2 types of investment risk:
o Undiversifiable because it is risk inherent in the entire market. This risk is
immune to diversification, that is any portfolio of equities will be influenced by
systematic risk
o Measured by beta – how much an investment co-varies with the rest of the
o Diversifiable, and occurs on a company-specific or industry level. That is, the
risk that is brought about by the correlation in asset returns can be removed
through diversification
The aim of diversification is to reduce unsystematic risk as much as possible: ideally,
such that the only risk affecting the portfolio is systematic
How does it work? Invest in assets negatively correlated, to neutralise adverse
MPT: risk-averse, rational investors will want to maximise their portfolios E(R) for a
given level of risk
 MPT suggests we can construct an ‘efficient frontier’ whereby any portfolio of assets
along the frontier are optimal portfolio choices for the given level of risk
 There ‘optimal’ portfolios are only subject to systematic risk. Investments under the
efficient frontier will include an element of unsystematic risk
 When correlation increases across asset classes then all assets will fall in unison
 Alternatively – as correlation increases the effects of diversification become less
 E.g. GFC
Why do you think return correlation across asset classes increases during a financial crisis?
 Financial crisis – a factor that affects the whole market
 Drastic shift toward risk aversion
 A change in preference from holding risk to holding certainty. In periods of economic
crises, investors are concerned about the macro-environment
 Therefore, during a financial crisis, systematic risk swamps idiosyncratic risk
(unsystematic risk)
 Investors tend to sell a wide array of risk positions, reduce their risk and leverage and
increase their liquidity
 Thereby increasing correlation across asset classes
In the article, it is noted that ‘investment grade bonds… have just a 31% correlation to stocks,
much better than junk bonds, which are at 85%’. Why do you think junk bond returns are
more closely correlated with equity returns than investment grade bond returns?
Junk bonds:
 Bonds with a low credit rating, BB or lower
 Vs. ‘investment-grade’ bonds. High credit rated bonds are typically backed with
collateral guarantors and are issued by companies with reliable cash flows. Therefore,
investors are less concerned about the revenue generating ability of these firms
 The default risk on junk bonds is high and therefore they offer a high yield to
compensate for the higher level of risk
Why are junk bonds more closely correlated with equity?
o bonds are rated based on the companies’ ability to make principle and
interest payments which is a function of their revenue earning capability
o the likelihood of receiving the principle and interest will be determined on the
success of the company, which shares the same characteristic to shares
o as the companies’ earnings rise and fall, so does the probability of being paid
back on the junk bond (i.e. equity and junk bonds have similar risk/return
The article reports that Gold has a negative correlation with equities. Why do you think this is
the case?
 After the onset of the GFC we observed a fall in equities and rise in precious metals
(but note: historically speaking, the correlation between gold and equities is not quite
 During periods of increased risk aversion and uncertainty, the market has a tendency
to fly toward safe-haven assets
 ‘safe haven’ is an asset that is uncorrelated or negatively correlated with another
asset or portfolio in times of market stress or turmoil
o vs a hedge does not have the (specific) property of reducing losses in times of
market stress or turmoil, as the asset could exhibit a positive correlation in
such periods and a negative correlation in normal times with a negative
correlation on average
 Gold has always served as a safe-haven
 This is because it is tangible, rate and cannot be printed
 There are other alternative assets that investors may decide to purchase, however,
they are not as liquid as gold
Would diversifying your portfolio by also investing in alternative asset classes (e.g. foreign
equities or hedge funds or private equity) help you withstand a financial crisis? Why or why
 Alternative assets – ‘untraditional’ or illiquid forms of investments
 Why ‘alternative’ typically difficult to trade in, are unavailable to investors, or do not
have enough wealth fro them to diversify properly
o E.g. hedge funds, real estate
AA’s are very illiquid and therefore need to be sold at a significant discount if you’re in
need of liquidity during a crisis
But perhaps some AA’s can be used to diversify country or regional specific risks, for
example foreign currencies/equities. They may also be more liquid than other AA’s
Yet again, if a crisis was to occur in a significant country or region (such as the US and
Europe) and is allowed to spread to other economies, for example in Europe, then
alternative assets will unlikely help diversification
In summary, the effect of diversifying into AA’s depends on how pervasive the effect
of the financial crisis is on the global economy
Question 2
Provide a critique of the argument in the article below. ‘Modern Portfolio Theory is Dead’. In
particular, does the article provide an accurate summary of the implications of MPT?
Rational, wealth maximising, risk averse investors should
Should not select assets on characteristics that are unique to the security rather an
investor should consider how the asset co-varies with all other assets
 That is, optimal investment is not about ‘stock-picking’ rather it is selecting a
combination of assets whereby their correlations are closer to zero
 For every level of risk, there is a portfolio that offers the greatest expected return,
Plotting these portfolios forms the efficient frontier
 Article: ‘investors expect to be rewarded for the level of risk they are taking in a
particular market’
 MPT argues that investors need to be compensated for the risk they bear – it does
not make sense to hold an undiversified portfolio as you will not be entirely
compensated for the level of risk you bear
 The article is correct in saying diversification did not help investors during the GFC –
one of MPT’s pitfalls is that it wont work perfectly when systematic risk trumps
unsystematic risk
 But, the article ignores that MPT seeks to reduce unsystematic risk only. The risks that
assets share in common (systematic risk) cannot be diversified away
 Article: ‘investments results in 2008 showed clearly that correlation of asset classes
varied unpredictably and with no warning. This brings into question the very basis of
MPT and its ability to forecast an efficient frontier’
 Recall, MPT: when adding an asset to a portfolio, the investor should consider how
the asset co-varies with all other assets
 The article ignores that the challenge is identifying if asset co-variances are stable or if
it changes over time, and rebalancing the portfolio as required
 For example:
 During the GFC, US treasury bonds and cash portfolios had a positive return, US
equities had a substantial negative return
 However, would you want to hold cash or US treasuries all the time? They provide
liquidity in times of crisis, when correlations between asset classes are increasing, but
also lower returns in ‘normal’ times
 The challenge in MPT is identifying if asset co-variances are stable or if it changes over
time and rebalancing the portfolio as required
 What the proponents of MPT failure to ignore is that although assets may begin to
move in a similar direction, they do not move with the same magnitude
 In times of crises, investors will likely observe a fall in their portfolio value, however,
they are able to reduce their losses through rebalancing and diversification
What are the elements of the way MPT is implemented in practice that have prompted some
commentators to claim that MPT is dead or useless?
MPT assumes:
 Investors are rational
 In reality, investors are affected by behavioural heuristics, sell winning stocks, holding
onto closing stocks “herding”
 Volatility is constant across time
 Cant use past returns to back out volatility to then use as a proxy for future volatility
 Correlations between asset classes are constant across time
Not true in periods of economic distress, where the correlation between asset classes
 MPT assumes:
o Returns are normally distributed
o This assumption implies that major, unpredictable events that affect the
economy as a whole are outliers with a very small chance of occurring
o In reality these events may occur more frequently than would be expected
under this assumption
The last sentence of the article states ‘(b)ut before it broke, MPT caused investors to lose
trillions of dollars’ is this a fair or reasonable statement?
 MPT’s assumptions are not valid all the time but they are ‘good enough’ in ‘normal’
 The S&P (a diversified portfolio) has averaged approximately 10% per annum since its
inception in 1928
 In 2008 the S&P500 lost 38.49% and has since increased by 240%
 It is easy to cherry-pick a single event and claim MPT failed, yet the long-term
performance of the S&P500 suggests a different story
 Proponents of MPT failure ignore the idea that portfolios can be diversified with
alternative assets (i.e. not bonds and equity) including assets such as property,
precious metals ….., farmland can help reduce unsystematic risk
 However, when there is a global financial crisis, diversification is of limited use as
asset correlations increase
 In such times, identifying the relative movements between assets, and rebalancing
your portfolio, is key
Question 3
Assume you are a ASX-listed gold mining company, you have an opportunity to pre-sell your
gold, which will guarantee your revenue. The largest single investor in the company is an
individual who owns 20% of the company and these shares comprise 90% of her total
investment portfolio. The rest of the company is owned by several large investment funds who
have a diverse array of investors.
 A. if the gold mining company decides to pre-sell its production will this decision be
popular with the largest single investor?
 Assuming the investor is risk-averse (like MPT does) and does not have any
expectation of future gold price increases then the decision to pre-sell the gold would
likely be preferable
 By pre-selling the gold, the investor is able to lock in her profits today, eliminating the
risk of adverse movements in gold prices
 Because the investors’ portfolio is made 90% of the mining stock means her portfolio
performance is largely contingent on gold prices. That is, she does not receive much
benefit in the way of diversification
 The volatility in her portfolio would be predominantly driven by the price of gold
 So, it is likely that the elimination of price risk would be viewed favourably
 B. if the gold mining company decides to pre-sell its production, will this decision be
popular with the large investment funds?
Large investment funds motivation to invest in the gold mining company may be to
hedge against future market turmoil, or an expected increase in the price of gold
The weight of the mining company in the investment funds portfolio would be
relatively small
That is, their portfolios would be diversified more than the single investors, therefore
an adverse movement in gold prices is unlikely to cause a significant impact to the
fund portfolio value. They are less likely than the individual investor, to desire the
heding of price risk – especially if they are seeking to capture upside movement
Week beginning 9 April 2019
Asset pricing model:
o P* = intrinsic fundamental value
o E[P*] =  E(CFt) / (1+ E[R])t
o The hypothesis that the observed market price of an asset is equal to its
‘intrinsic fundamental value’
o EMH doesn’t comment on how E(CF) and E(R) ought to be derived, rather that
observed market prices are the best estimates for intrinsic value that can be
made given an information set
Theoretical foundations to the EMH:
o (A) investors are wealth-maximisers, rational and unbiased in their evaluation
of information and so value assets accordingly
o (B) even if some investors are not unbiased or irrational, their trades are
random and cancel each other out
o (C) Even if some investors are irrational in similar ways, smart investors
arbitrage away the influence of irrational investors. Irrational investors lose
money and cannot survive in the long-term
in identifying an arbitrage opportunity, we need to compare the observed market
price of an asset to its fundamental value
this in turn means that we need a model to calculate the fundamental value of an
the joint-hypothesis problem refers to the difficulty in judging whether the apparent
mispricing is due to the market price being correct, but the model being incorrect; or
the observed mispricing due to the assets actually being mispriced
We can’t test if the market is doing what it is supposed to do, if we cant specify what
it is supposed to do
2. Remind yourself, from the lecture, of the difference between ‘noise’ and ‘information’
 Noise: data or news that is not relevant to asset pricing
 Noise traders make trading decisions based on non-fundamental information. This
may include misinterpreting information, or trading from sentiment or emotion
 Do noise traders distort markets? Three conditions must be met:
o Noise traders must misinterpret available information or trade on noninformation reasons
o Noise traders must be systematically correlated, that is, noise traders must be
net buyers or net sellers of the same stocks, if, instead, noise traders buy and
sell randomly, their trades will on average, cancel, rather than reinforce, each
 E.g. AFR 13/02/2019: in 2015 a website designed to resemble Bloomberg.com with a
similar looking web address, published a phony story that Twitter had received a $31
billion takeover bid, sending shares surging – ‘noise’
 Information: data or news that accurately represents genuine underlying trends.
Drives fundamental changes in price
 Information has a permanent, as opposed to temporary, effect on price
What tests might you apply to confidently distinguish between ‘noise’ and information?
 Look at longer term trends – noise may cause price to fluctuate before returning to its
‘normal’ level in a short term horizon
 Whereas, information is likely to cause prices to rise/fall and keep it raisd/lowered,
that is information has a permanent as opposed to transient effect
 But this is an ex-poste observation. Difficult to judge on the spot?
 Fama:
o Weak form – all relevant, historical information is reflected in stocks prices.
o Semi-strong form – all relevant, publicly available information is reflected in
stock prices
o Strong form – all relevant information is reflected in stocks prices
 It is common for people to claim the share market is ‘semi strong form’ efficient
 Implication: it’s not possible to earn abnormal risk-adjusted returns by reviewing
publicly available information
 But identifying ‘public available information’ is problematic
 News may be ‘publicly available’ but it isn’t necessarily reliable ‘information” and,
even if reliable, there may be differing interpretations
3. Read the article ‘trader made billions from subprime’ and identify the risks and costs that
the ‘smart’ investor John Paulson faced in devising and implementing a strategy to profit from
what he identified as fundamentally mispriced asset class.
 Paulson believed the risk of these mortgages were substantially underestimated
 ABX – shorted the index that tracks a basked of ‘subprime’ mortgages
 Short bank stocks
 Risks borne
o Mistiming of the short sell
o Time horizon risk – staying in the market long enough for the prices to fall
o Noise trader risk – risk that mispricing may worsen before it gets better as a
result of uninformed investors dominating the market
o Fundamental risk – risk that bad news may emerge that causes an underpriced security to become even further under-priced (or good news can
emerge that causes an overpriced security to become even further
 Costs borne:
o Implementation cost of paying to borrow securities to short
o Possible reputation cost to his fund – trading against conventional wisdom of
the time
o Opportunity cost in identifying the assets worth shorting
(and the risk that the compensation for the opportunity cost is
Raymond da Silva Rosa’s view on market efficiency:
o Markets are not perfect, but better than almost ever single investor: it is
difficult to persistently beat the market’s capacity to analyse and evaluate
o So, when you point to XYZ successful investor and say ‘how do you explain
their record?’
o Investors earn higher return only by ‘bringing something to the table’ (i.e. no
‘free lunch’) in one or more of the following ways:
o (a) accepting higher risk
o (b) connecting savers to entrepreneurs
o (c) lowering the cost of parties transacting in the market (e.g. managed funds)
o (d) improving operating efficiency of assets (e.g. private equity)
o (e) enforcing or interpreting contracts more effectively (by politics or other
o XYZ investor is either providing a service related to (b), (c), (d) or (e) or they
are getting higher return by taking on more risk
Why do market inefficiencies persist?
o EMH suggests that market inefficiencies will be arbitraged away by ‘smart’
investors acting on ‘information’
o The arbitrage argument relies on two propositions
 As soon as there is a deviation from fundamental price, an attractive
investment opportunity is created
 Rational investors will exploit this opportunity and eventually the
mispricing will not exist
In reality, when an asset is grossly mispriced, strategies designed to correct the
mispricing can be both risky and costly, making them unattractive
Mispricing can remain for considerable time!
4. Those who say the market can be inefficient for long periods point to ‘implementation
costs’ faced by potential arbitrageurs as a barrier to smart investors correcting the
misevaluation of ‘noise’ investors. Examples of kinds of implementation costs include: (a) wide
bid-ask spreads (b) price impact costs (c) costs of borrowing stocks to short-sell
Explain and provide an example of each of these costs
 The bid-ask spread
o The market maker buys at the bid rate and sells at the ask rate
o A transaction cost: can reduce, or eliminate, arbitrage profits
o E.g. Akron bank and Zyn Bank serve the foreign exchange market. Assume that
there is no bid/ask spread. The exchange rate quoted at Akron bank for a
british pound is $1.60, while the exchange rate quoted at Zyn bank is $1.61.
You could conduct arbitrage by purchasing pounds at Akron for $1.60 per
pound and then selling them at Zyn for $1.61 per pound. Your gain would be
$.01 per pound
pound quote
pound quote
o Now in the presence of transaction costs an investor would just break even
o A wider bid-ask spread is indicative of lower liquidity of the underlying asset
o A potential signal for high information asymmetry. If relevant information is
harder to access, then the pricing inefficiency would be harder to correct, and
therefore persist longer
Price impact costs
o The relationship between the relative price change caused by a trade and the
size of that trade, i.e. the cost incurred due to the trade itself changing the
price of the asset
o Imagine an arbitrageur who buys a mispriced asset, however, because the
market is illiquid, closing the position is difficult without incurring significant
costs from market slippage
Costs of borrowing stocks to short sell
o Short selling: borrow stock, sell it, buy it back at a later date, profitable if the
buy back costs less than the selling cost (i.e. expect the stock to depreciate)
o But, pay a fee to the lender for the borrowed stock. What if the person could
call for the shares back, and you have to buy it back at a significantly higher
o What makes short-selling so risky is there is an unlimited downslide.
Theoretically, the stock price could continue to rise infinitely. Therefore, as
prices rise, short-sellers are continually required to top up their margin
5. on what grounds might Professor Keen be basing his assessment that the Australian
housing market is in a ‘bubble’ state?
 Define – a bubble is a ‘fundamentally unsound commercial undertaking accompanies
by a high degree of speculation’
 For Australian housing to be in a bubble state, housing prices must have been driven
by a level of irrationality
o As opposed to a change in fundamental demand and supply conditions
 An asset in a bubble state will show a deviation from its fundamental price
 What do you think?
o We can only confidentially state that an asset was in a bubble state after it has
o Supply of housing in city areas is by and large relatively finite compared to
demand e.g.
 Foreign demand for Aus investments – eastern states
 Changes in regulatory and economic conditions leading to greater
demand e.g.
 In the 1970s mortgages required a deposit of 30%, whilst now
it can be less than 10%
 RBA reduced IR since 2012
 Housing prices didn’t fall during GFC – Rudd government
introduced First Home Vendors Boost
When access to capital to fund purchases is greater there will
be greater demand
If Professor Keen’s prediction comes true and Australian housing prices fall 40% by
2023 would that vindicate his assessment?
o This question can only be answered after the fact, that is, after housing prices
have fallen or the so-called bubble has popped
o If we observe a fall in housing as a result of pervasive defaults on mortgage
debt after mortgage-holder were unable to withstand an increase in interest
rates, or if flat incomes are unable to service loans, then this may vindicate
Keen’s view that prices were driven by an irrational behaviour
o However, what if house prices fall for another reason (e.g. decrease in foreign
We can use iron ore as an example
o AFR April 9th 2019: China’s rebar at 7.5 year high, iron ore at record peak
“China’s steel future surged on a seasonal upturn in demand, lending support
to prices for steelmaking raw materials, including iron ore, which extended a
record-breaking rally fuelled by worries over lighting supply’
o The Australia business review April 9th 2019: ‘the price of iron ore has surged
to its highest level in almost 5 years’
o ‘the industry’s benchmark price, for ore with 62% iron content. Increased by
2.4% yesterday to $US95.05 a tonne for physical cargoes, according to S&P
Global Platts. That was the highest since July 2014, surpassing a February peak
of $US94.20
Restrictions in supply
o The jan collapse of a mine-waste dam in Brazil at an operation run by Vale, last
year the world’s single biggest iron-ore exporter, sparked substantial curbs to
production that are starting to bite in China; the worlds steelmaking centre
o Exports from Aus, which supplies more than half of all seaborne shipments of
the commodity, have been distributed by a tropical cyclone that lashed the
country’s biggest export terminals with heavy rain and strong winds
and upturn in demand
o china steel demand typically picks up at the end of winter, with April usually
the peak month as industrial and other activity starts back up as temperatures
o demand has also rise as construction activities have picked up, and there is
also buying as China is set to roll out more infrastructure projects
o Air pollution in 39 smog-prone northern Chinese cities soared in Feb, making it
increasingly unlikely they will meet their annual winter air quality targets,
based on Reuters analysis of official data
o With steel mills resuming production to rebuild stocks and fill buy orders,
demand for steelmaking ingredients such as iron ore and cooking coal has also
We can only confidently state that an asset was in a bubble state after it has burst
When changes to supply and demand conditions are obvious and information to this
regard is easily accessible and interpretable then it is easy to appraise asset pricing
When such conditions are not as apparent, artificially inflated, or influenced by
investor irrationality, it is harder to make an informed judgement… typically for
emerging sectors, e.g. cryptocurrency, lithium, etc.
Week beginning 15 April 2019
1. behavioural finance is arguably most useful in explain asset prices when there are
significant numbers of ‘noise traders’ and limits to arbitrage. Why is this so?
Noise traders: trade on data or news that has no relevance to stock/asset prices prime
example of people acting irrationally
Limits to arbitrage: obstacles that limit your ability to take advantage of mispricing
Behavioural finance: investigates human behaviour and human psychology in explaining
irrational financial decisions (investment behaviour)
Neoclassical economics: prices are efficient, investors aim to max returns and minimise risk,
full information and investors are rational and unbiased
Big difference between neoclassical and behavioural = neoclassical assumes everybody is
Limits to arbitrage is that if noise investors are pushing prices too high, smart investors
should sell when the higher price is reached. The assumption is that smart investors will have
sufficient funds to outweigh noise traders.
Limits to arbitrage: bid-ask spreads, cost to shorting, price market impacts ???
(exam – look at past questions on limits to arbitrage)
Behavioural believes noise traders outnumber the smart investors which deviates from the
fair asset price, which limits the arbitrage opportunity
Transaction costs can overwhelm non-noise investors
Behavioural model: explain things that fundamental aren’t explaining
Exam – net down the difference between neo-classical and behavioural finance
2. one of the points made in the lecture is that the gains from applying the insights of
behavioural finance are more reliable in personal finance rather than when investing in the
market. Explain this comment.
Personal finance has ability to correct biases, adjusting decision making with knowledge to
Investing in the market – more players
Very heard to say that the whole market is over confident – no mechanism to profit and
don’t know who is right or wrong
Joint hypothesis problem – don’t know whether it is the model or the market that is wrong
Why is behavioural finance easier to implement when it comes to personal finance then
when compared to trying to beat the market?
Hard to predict everybody’s behaviour in the market, could think market is mispriced but it
might be efficient – think it is biased
A lot of people in the market, you may assume everybody is wrong and not considering their
biases when in fact you could be wrong
If we can profit of other people’s biases when will we be able to profit off that? When they
acknowledge it
In personal finance, we can profit of our biases as soon as we recognise them.
In market, only about to profit when the market acknowledges the biases and corrects it.
Hard to judge with biases whether it is a negative or positive impact on the market, therefore
hard to profit, with personal finance its easier to measure.
In the market everybody will be acting in different ways and it is hard to recognise the overall
3. What is factor investing and is it best explained by behavioural finance or by neo-classical
1. ? It is a bit of both. – correct answer for an exam
Factor investing is a strategy that chooses securities on attributes that are associated with
higher returns.
Investing in the characteristics that can effect returns.
Examples of factors; macroeconomic (inflation, exchange rate), style factors (value, size)
Comparing stocks based on their returns.
Neo-classical finance is all about getting frameworks and models to try and prove our
theories. Yes it is assumes investors act rationally, not the only defining feature. The fact that
we have created a model to try and compare stocks and see clearly which stocks are able to
gives us the highest returns with minimising our risks.
Behavioural finance – nobody could agree on certain parts of neo-classical. All is dependent
on our own personal preference. An empirical model doesn’t mean that its free of biases.
Trying to show that neo-classical finance emits certain factors that are important.
4. Identify and describe an example of (a) and the representative heuristic and (b) the illusion
of truth heuristic. The examples must be different from those discussed in the lecture. You
should explain each bias.
Representative: judge the likelihood or a hypothesis by seeing how much it resembles
available data
Used when making judgements about the probability of an event under uncertainty.
Only looking at price trends etc.
Not looking at bigger picture
Seeing patterns in random data and the belief that future patterns are based upon
past one
Gold stocks from one company maybe the same price as gold stocks from another
Truth: people are more inclined to believe a statement when it comes in the form of info that
is easy to process Processing fluency – how likely are you to believe it
If things are repeated you are more likely to find it to be true, easy, repetitions believe it true
Safe Haven assets – people will flock to them
Repeatedly saying something is a good investment and that it is going to go up in value more
people will invest in it therefore making it go up in value.
5. explain how the ‘cheerleader effect’ may be related or influential in driving the demand for
People associate it as a group
Grouped into the idea of a crypto currency – bitcoin hype
Not looking at individual characteristics
Cheerleader effect – in a group things appear more attractive then looking at individually
People didn’t stop to look at what they were investing in, just knew that other people were
investing in it so people didn’t stop to look at the individual assets.
Quiz 2- same increase in pay off so they should all be valued the same
Option A – chance of winning is double
Option C – already high, no point in paying for the extra 1%
Quiz 5 – potential exam
Neoclassical – both would be equally upset, both have lost $10
Behavioural – B, interpret it as losing $50, loss has increased
A wont think they have lost any money, have only gained $50 – will view it as a positive even
though net gain is lower
Week beginning 29 April 2019
1. What is the difference between a real option and a financial option?
 Options provide the flexibility to undertake a course of action contingent on particular
events or outcomes
 Financial options:
o Refers to the derivative – e.g. call/put
o Holders have the right but not the obligation to buy/sell the underlying for a
specific exercise price
o Are a traded security
Real options
o Refers to a managers right but not the obligation to invest in a given project
2.Why is it said that the DCF method undervalues companies?
 Conventional view/DCF
 Firm’s market value is equal to PV of all after tax cash flows discounted at its WACC
 Real options critique (ASWATH DAMODARAN 200):
o NPV of a project typically does not capture the value of management’s ability
to expand the size or scope of the project should things work out particularly
well nor does it reflect the value of delaying the start of a project until
conditions become more favourable
o When comparing different investment opportunities, the traditional approach
of picking the model with the highest NPV is likely to short change
investments that offer management more flexibility in making operating
changes and add-on investments
o In valuing acquisitions, the strategic options that might be opened up for the
acquiring firm as a result of the transaction are often not considered in DCF
o A DCF valuation model is likely to ignore other options that might be owned
by the firm including patents, licenses and rights to natural reserves
3. if a company’s stock increases in value by $1 billion within a couple of weeks of its IPO and
then its value crashes to close to zero, is this a sign of an inefficient market?
 Why?
 The market responds to information in an irrational way – their expectations
regarding the potential value of the company are too high, or the chances of success
are too high
 Or why not?
 The market may be valuing the company as a real option, the value the market
attaches to the company may be contingent on an event occurring in the future
 Joint-hypothesis problem – don’t know if the model is wrong or the market is truly
5. would you use the discount cash flow model or an option pricing approach to value the
shares of a gold exploration company? Justify your answer
 Does the company have positive cash flows?
o If the company has no or negative cash flows then a DCF valuation is going to
produce a seriously misleading value
 Where is the companies value derived?
o From the uncertainty that they will find gold have the exclusive right to mine
that gold deposit
Key tests for real options – Aswath Damodaran
Is there an option embedded in this asset/decision?
Can you identify the underlying asset and specify the contingency in which we will get
Is there exclusivity?
Yes – there is option value. Real options are most valuable when you have an
exclusive right to take advantage of the contingency – real option modelling gives
prominence to the upside potential of risk. This volatility itself is a source of value
No – no option value
In between – need to scale value
Can you use an option pricing model to value the real option?
Oil company with exploration right to two tracts in the same geologic play. Probability
of success 30% in both cases. Drilling cost is $30 million both cases. Conditional
development NPV = $95 million both cases
DCF value: -$30 + [0.3 x $95] = -$1.5m
Now, assume we can decide to drill the second tract after getting information about
the first: if success on 1st tract, then profitability of success on the 2nd tract increases
from 0.3 to 0.5. If failure, probability of success decreases from 0.3 to 0.21.
in the case of negative news, we stop losses – second tract value is 0
in the case of positive news (with only 30% probability), the expected value of the 2nd
tract is: -$30 + [0.5 x $95] = +$17.5m
the value of the two tracts, considering the information revealed in the first drilling
and the optional mature of the second drilling is
-$1.5m (first drilling) + [(0.7 x 0) + (0.3 x $17.5)] (second drilling) = +3.75m
DCF analysis underestimates the value of projects where the owner has the owner
has the facility to exercise an option to expand the project or exercise an option to
abandon the project or exercise an option to delay further investment in response to
new information
6. use the option pricing model to value the shares of a gold exploration company. What
would be the factors you would identify as ‘the underlying asset’, ‘the exercise price’, ‘the
variance’, ‘the time to expiry’ and ‘interest rates’?
 Underlying asset: price of gold/PV of expected gold sales
 Exercise price: cost of investment infrastructure, earthworks, rehabilitation, drilling,
 Variance: quantity and quality of gold compared to similar companies, gold price in
the market
 Time to expiration: life of license to mine
 Interest rate: riskless rate
 Inputs into BSM
What sort of projects are appropriate to value using real options:
 R&D
 Investment in new capacity
 Geographical expansion
 Multi staged projects with decisions to proceed or drop a project depending on the
best information managers have at the time
7. why is it helpful to know how base metal discoveries grow over time to apply an option
pricing approach to the ‘blue sky’ potential of a discovery?
 Blue sky – the prospect of a really large gain, the chance that a massive reserve is
 Why is it helpful to know how base metal discoveries grow over time?
 Variance in value of the underlying asset – based upon the variability of the price of
the resources and variability of available resources
Better estimate for variance (option pricing model)
8. Wesfarmers is a large AsX-listed Australian conglomerate. In valuing Wesfarmers’ shares,
would you include a ‘real options’ component? If so, what would be the nature of the real
 Wesfarmers – conglomerate incorporating retail (Bunnings, officeworks, target,
coles), chemicals/fertilisers, mining, industrial and safety equipment
 SMH 26/03/2019: wesfarmers’ $1.5b bid for lynas could spark bidding war
 ‘Lynas produced a material, Neodymium and Praseodymium, which is a key ingredient
in electric vehicles’
 ‘lynas is the largest non-Chinese producer of rare earth minerals’
 ‘these rare earths are pretty key commodities when you look at the new energy
 growth option: the initial investment would be sizeable, but it may lead to the
opportunity to sell a string of products through wesfarmers’ established network
 rare earth materials are also crucial elements in new-economy products such as
mobile phone components, wind turbines and batteries. Lunas has some exclusivity in
this market.
9. If a sceptic were to say that Tesla’s valuation is absurd and an example of investors
‘irrational exuberance’, what might you say to show that Tesla’s valuation at the present time
is in fact reasonable:
 Article Tesla’s valuation is based on investors belief in the ability of the company to
revolutionise the way that people drive cars
 Their technology goes beyond the use of cars. The technology (storage of power) will
have far reaching uses and it is his that has the ability to disrupt many industries
 E.g. ‘even more futuristic is the idea that Tesla cars will be entirely self-driving, able to
cruise streets nearly full time (except when they are being charged at Tesla’s high
speed battery-charging stations). In this vision, Tesla owners will share their vehicles
with Tesla when not using them and during that time they will ferry other passengers
serving as Tesla’s version of Uber. Thus Tesla will disrupt Uber’s nascent market
 ‘And Tesla is no longer seen just as a vehicle manufacturer. With its solar and battery
technologies it is in a position to dominate two other enormous industry segments.
Tesla is reinventing the electric grid as Mr Baron said on CNBC. That’s a bigger
opportunity than cars’
 Tesla is an example of a are ‘story stocks’ who knows what application they will have
in future
Would you be proved wrong if Tesla’s share price fell to, say, $1 billion in a couple of years?
 Wouldn’t necessarily disprove Tesla’s valuation
 Someone else may have beaten Tesla to market or develop an improved piece of
 The application Tesla’s technology may be found to be limited to cars to a smaller
range of areas than first thought
 What would be irrational?
o Far fetched stories making their way into Tesla’s valuation, or that people
begin to exaggerate the potential Tesla’s technology has in industries they
have little to no knowledge in
Making real options really work by Alexander B. van Putten and Ian C. Macmillan Harvard
Business Review Dec 2004
 Problems with real options
o Good proxies for the input variables e.g. using historical variance of
underlying asset as a proxy for the variance of an innovative project
 The variability of profits in turn, is derived from estimates of how uncertain both
revenues and costs are likely to be
o Mindless option analysis will value at a project with relatively predictable
revenues but unpredictable costs more highly than a project with the same
predictable revenues but with predictable costs
o When the uncertainty about potential costs is higher than the uncertainty
about potential revenues cost volatility should decrease, not increase, the
value of a project
 Time to explanation
o There may be no specific period for which the firm has rights to the project.
For instance, a firm may have significant advantages over its competitors,
which may in turn provide it with the virtually exclusive rights to a project for a
period of time. The rights are not legal restrictions, however, and could erode
faster than expected in such cases the expected life of the project itself is
Where does the value in options come from?
 Delay/defer making the investment – if the project has a negative NPV/IRR exceed the
hurdle rate does not mean you shouldn’t pursue the project, if there is an embedded
 A project may have a negative NPV based upon currently expected cash flows, but it
may still be a ‘valuable’ project because of the option characteristics. Hence the
negative NPV should not lead it to conclude that the rights to this project are
 E.g. hold off investing in an oil project until the price of oil exceeds a given threshold
 Adjust or alter production schedules as price changes – take advantages of other
 Expand into new markets/products at a later stage in the process based on observing
favourable outcomes at early stages
 E.g. if the first stage was favourable, then there is the option to expand. Alternatively,
to abandon or scale down the investment
Week beginning 13 May 2019
1. Explain why economic growth is largely irrelevant to forecasting share prices?
 In the short run:
 P= [E(CF)/E(R)] + growth options
 E(R) is affected by economic policy
 For example, a change in the markets expectation on the probability of a recession
 Share prices can respond to unexpected changes in economic growth and in E(R), the
cost of money
 In order for economic growth to lead to profitability:
o Companies valued based on profit margin and potential to grow:
 P = [E(CF)/ E(R)] + growth options
o What matters is the proportion of profit from economic growth that is
captured by existing shareholders
o Companies need the exclusive right to the technologies and improvements in
productivity that encouraged economic growth
o If companies have no control over these factors, then the barriers preventing
new companies from entering the market may be sufficiently low to prevent
the level of competition from increasing
o Therefore, squeezing the margins of existing companies which translates into
lower profits and lower market valuation
 Profitability is a function of:
o Competitive pressure
o Efficiency
o Productivity
o Economies of scale
o Economic growth:
 GDP = C + I + G + (X-M)
 The economy can grow due to any of the above 4 factors increasing
 For example as a result of changes to monetary/fiscal policy
 Economic growth alone per se doesn’t translate to high profits
 China 2006:
o Growth of ec’y outpaced any others in world for 12 years leading to 2005
o Australian financial review (10/01/06)
o ‘the focus is on just how tough it is to do business out there. Margins are
being squeezed, pricing power is almost non-existent and there are new
players entering the field constantly’
o ‘If the benefits of the increases in expenditure and improvements in
technology that fuel economic growth are captured by new companies
entering the field or by consumers in the form of lower prices, existing
shareholders will not experience an increase in share returns’ – Raymond da
Silva Rosa
2. what is the liquidity trap?
 Tendency for investors to hoard cash rather than spend it on risky investments
 Represents a scenario where savings are high and interest rates are low
 When might his occur/
o QE:
 Under ‘normal’ economic conditions, central banks decrease interest
rates to encourage borrowing
 However, given the high levels of risk aversion investors have a
preference to save although interest rates are already low (i.e.
monetary policy is ineffective in stimulating the economy)
 Why is it relevant to investing strategy?
o Credit becomes tight for companies that are deemed too risky for the market
o Sound companies with high potential for future growth may never reach its
potential because credit is not flowing to areas of the economy that are
considered too risky
o Liquidity moves to low risk assets such as bonds and equities with bond-like
Rivalry among existing firms – high
o Hard to differentiate service – prices, amenities, travel experience, travel
o Fixed sunk costs and low profit margins
o Safety guidelines and technical standards limit potential for differentiation
o Public service requirements require serving unprofitable markets
Barriers to exit
Threat of new entrants – moderate/high
o High capital costs, regulatory barriers are numerous and complex – e.g. air
service agreements
Low barriers to entry:
o Access to distribution channels is easier for new entrants than in the past
o Government deregulation – legacy rights
o Customer switching costs are low. Loyalty programs by alliances provide some
cover across alliances but not between airlines within an alliance
o Growing presence of leasing companies – reduces capital requriements
Threat of substitutes – rising
o Air travel can be delayed, limited or done without
o Technology for web conferencing is improving
o Government financing for substitutes, e.g. high speed trains
o Inconvenience and delays created by air safety procedures
o Fast trains are competitive with airlines on short haul routes
o Environmental issues
Tutorial 10 (week beginning 20th May)
Value investing:
 Benjamin Graham
 Value criteria:
o Quality rating (credit rating score)  B minimum
o Total debt to CA  less than 1.1, this is important for liquidity purposes
o Current ratio  how easily can pay off debt/liabilities
o Companies with positive earnings per share with no earnings deficit over past 5 years
o 5 and 6 are best values, P/E of 9 or less, P/B of 1.2 or less
o low EPS, good value stocks
o high PE means company will grow a lot
o Myer low PE people won’t invest though
o Low P/B: could be undervalued, company worth less than assets,
1. What is the difference between a “comparable transaction” valuation and a “comparable
companies” valuation? Which is more appropriate?
 Identify publicly-traded companies with characteristics similar to those of the company being
 ‘spread’ the comps – i.e. map out the trading multiples (EV/sales, EV/EBITDA, and P/E) for
this set of comparable companies
 assign these multiples to company financial results to determine valuation ranges
Comparable transaction valuation = looks at recent takeover transactions to value the company in the
same industry. It looks at how much the company was paid for compared to metrics such as sales,
book value and net income.
 Company buying out another company  must pay market premium, not everyone willing
to pay at market price
 Higher then company’s valuation due to controlled premium that is built in
 Mechanics – similar to comp. companies, identify companies, spread multiples, etc.
 It is premised on multiples paid for comparable companies in prior M&A transactions
Comparable company’s valuation = simply using the financial metrics of comparable companies in the
same industry
Foundation of trading comps based on the premise that similar companies by performance
drivers, risk, business structure should have similar value.
Comparable transaction is more useful when acquiring a company
o Have to pay a market premium to acquire a company
Comparable companies are more useful when looking to invest small amount of cash
o More comparable companies than comparable transactions
Similar companies provide a highly relevant reference point for valuing a given target
Designed to reflect ‘current’ valuation based on prevailing conditions and sentiment
What if market conditions may be skewed by irrational investor sentiment, driving prices too
high or too low?
Which is more appropriate?
 Comparable transaction: more for valuing companies you are looking to acquire they can take
into account amounts paid for synergies
 Comparable companies: more useful for working out which company to invest in with small
amounts of money. This is because you will not have to pay a market premium. Therefore
you can invest in the best value stock
 There is also a greater amount of comparable companies than there are comparable
transactions, meaning the implied valuations might be more accurate
2. What might account for the substantial variation in the value of the Total Paid/Sales ratio for
Amoco, Texaco and Conoco?
 Total paid
o Expenses of companies acquired
o Debt levels
o Management expertise
o Human capital
o Amount of synergies
o Competition
o IP
 Total sales
o Production volume/quality
o Commodity price
o Market contracts
o Technology
 Extraction/drilling rights, patents
 Net income: accounting standards, includes noncash expenses (dp n, amortisation, depletion)
Claim to oil reserves, existing distribution networks, etc.
Synergies brought upon by the M&A – expertise, IP, human capital
High market sentiment
Once off yearly decreases/increases in output
o Oil search’s profit has dropped by nearly 40% after Papau new Guinea’s devastating
earthquake halted operations at its major project, but still managed to outperform
market expectations
3. Why might Amoco have been taken over for 22.46 times its net income whilst Conoco was taken
over for just 7.6 times its net income?
 Growth
 Costs/profits
 Synergies – they could be in different parts of the supply chain (e.g.2 companies operate in
same place but have varying expertise)
 Market timing
 Assets (no sales large number of assets)
 Governance (some firms could be governed well)
To generalise – the higher the multiple (total paid/net income), the higher the future expected
growth of the company
 How can company value differ:
o Oil reserves make up a large proportion of the value of oil and gas companies
o Extraction/drilling rights
o Synergies – they could be in different parts of the supply chain
o Intellectual capital/ patents
o Human capital
o Annual production
o Net income could be particularly low if expenses are particularly high – this could just
be very high depreciation, depletion and amortisation
4. In the example provided, the average value of the three reference companies is chosen as the
benchmark. Under what circumstances might one choose a different benchmark (e.g., why not
use the highest value)?
Take out outliers, square, median,
Models supporting
5. What might have been the reasons Exxon paid tens of billions more for Mobil than the highest
transaction multiple suggested was appropriate?
 Synergies  Exxon, how it can benefit 2 companies merging together, rights to
 Mobil: production and exportation rights off new
 3 years saved 3 billion
 heaps of R&D savings
the hgihest valuation arrived at using relative valuation on $66.6 billion, Exxon ended up
paying $83 billion
massive synergies
o the consolidation facilitated the combination of Exxons rich experience in deep water
exploration with Mobil’s production and exploration acreage in Nigeria and Equatorial
o the merger was expected to generate savings of $2.8B after 2 years of deal
o in terms of book value for Mobil in 1998, the deal value represented premium of
approximately 290%
o during the entire 282day period surrounding the merger period, the cumulative
returns for Exxon were approximately 16%
o the average growth rate of net income in the premerger period increased from 12.9%
to 19.76% in the post merger period
6. What are the strengths/weaknesses of the relative valuation approach when compared against
the discounted cash flow valuation method?
Comparables Valuation method
 Market based – information used to find valuation of target is based on actua market data.
This reflects the markets growth and risk expectations, and overall sentiment
 Relativity – easily measurable and comparable against other companies
 Current – valuation is based on prevailing market data
 Market based – valuation is susceptible in periods of irrational exuberance and overreaction
 Absence of relevant comparables – no relevant benchmarks, particularly troublesome if the
target operates in niche sector
 Potential disconnect from cash flows – given comps are susceptible to significant savings in
sentiment, there may be a disconnect between comps valuation and DCF
 Company specific issues – may fail to capture target specific strengths, weaknesses,
opportunities and risk
DCF Valuation Method = estimate FCF from investment (cash available to distribute to providers of
capital), estimate required rate of return and discount FCF recorded at each period at this rate and
sum PVs of FCFs
 cash flow based – reflects value of projected FCF, which represents a more fundamental
approach than using comps
 projected FCF (fundamental method)
 market independent - more insulated from significant swings in market sentiment
 self sufficient – does not rely on truly comparable companies (which might not exist) to derive
 flexible – run multiple performance scenarios
 depends on financial projections – forecasting accurately on financial metrics is challenging
 depends heavily on assumption - assumption have a significant influence on valuation
 terminal value – makes up the majority of the valuation, which decreases the relevance of the
forecst periods annual FCF
 assumes constant capital structure
accurate forecast is very difficult
relies on companies having a positive cash flow (not always the case e.g. uber, tesla)
7. Apple Inc has been referenced repeatedly in lectures. Which reference companies would you use
in a relative valuation exercise for Apple? What issues would you face? Would it be better to
undertake a DCF analysis? Why or why not?
 Fang stocks?
 Reference companies:
o Want to choose companies that are of similar size, have a similar business model;
operate in the same countries etc.
o Popular comparable for big tech companies are grouped under FAANG and MAAN
 Facebook, apple, amazon, Netflix, google and Microsoft, Apple, Amazon,
 What issues would you face?
o Still comparing apples to oranges
o Entire tech industry may be overvalued
 Dot-com bubble in early 2000s
o Circular valuations
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