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ADM 2352
Finance Theory
Lecture 1
Overview
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• Readings:
– Chapter 1
• Group discussion:
This first online discussion gives you an opportunity to introduce yourself to your professor and your
group.
Post a brief personal profile of yourself where you describe your interests, hobbies and work
experience, and anything else that might help your group and professor to get to know you better.
For example:
• What do you think that this course will teach you about yourself and others?
• Any relevant experience you have with the subject of Finance
• Any interesting personal information you wish to share (For example, your favourite hobby,
interests, anecdotes, etc.)
• Why do you believe this course will be useful to you in your future (or present) career?
• What are your objectives for this course?
You have the option to type an introduction in the discussion and include a link to your personal
blog or website, or you may want to consider incorporating multimedia into your introduction by
posting a video or audio message to your classmates. Your typed profile should have a minimum of
200 to a maximum 500 words. Your video or audio message should not exceed 5 minutes.
Goal of Financial Management
• What should be the goal of a corporation?
– Maximize profit?
– Minimize costs?
– Maximize market share?
– Maximize the current value of the company’s stock?
• Does this mean we should do anything and
everything to maximize owner wealth?
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Amazon’s Revenue and Net Income from Q1 2009 to Q3 2013
(in million U.S. $)
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Primary Goal of Financial Management
• Three equivalent goals of financial management:
– Maximize shareholder wealth
– Maximize share price
– Maximize firm value
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Principal-Agent Relation
The Agency Problems
• Agency relationship
– Principal hires an agent to represent their interests
– Stockholders (principals) hire managers (agents) to run
the company
• Agency problems
– Problems due to conflicts of interest can exist between
the principal and the agent
• Agency costs
The costs associated with agency problems
– Direct agency costs
– Indirect agency costs
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On November 18, 2008…
the CEOs of the big three automakers flew to Washington in private
luxurious jets to make their case that the auto industry is running out
of cash and needs $25 billion in taxpayer money to avoid
bankruptcy…the cost of the roundtrip is about $20,000.
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Managing Managers
• Managerial compensation
– Incentives can be used to align management and
stockholder interests
– The incentives need to be structured carefully to
make sure that they achieve their goal
• Corporate control
– The threat of a takeover may result in better
management
• Conflicts with other stakeholders
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Executive compensation serves 3 main
purposes
1) It must attract executives with the skills, experiences,
and behavioral profile necessary to succeed in the
position.
2) It must be sufficient to retain these individuals, so they
do not leave for alternative employment.
3) It must motivate them to perform in a manner
consistent with the strategy and risk-profile of the
organization and discourage self-interested behavior.
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Managing Managers
• Managerial compensation
– Incentives can be used to align management and
stockholder interests
– The incentives need to be structured carefully to
make sure that they achieve their goal
• Corporate control
– The threat of a takeover may result in better
management
• Conflicts with other stakeholders
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CEO Turnover
• Different types of turnover:
– Voluntary turnover
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•
•
•
Due to poor health/death
Retirement
Resignation with succession in place
CEO stays as chairman after resignation
– Involuntary turnover
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•
•
Resignation due to poor performance
Merger (takeover)
Scandal
…
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Examples of Corporate Scandals
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Enron Corporation
Worldcom
Parmalat
GlobalCrossing
Aledphia
Fannie Mae & Freddie Mac
BearSterns
Meryl Lynch
AIG
Lehman Brothers
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“The cockroach theory of financial scandals says that, for every
one you see, hundreds more are hiding in the woodwork”
“When
Scandals Go Global,” Business Week, February 2, 2004, p. 96.
Only 1 in 4 corporate frauds is detected in the U.S. (Dyck, 2014)
Even the ones we knew of…
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Captured Board
Board of directors duties can be compromised by
connections, perceived loyalties to management or
compensation/incentive structure.
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Managing Managers
• Managerial compensation
– Incentives can be used to align management and
stockholder interests
– The incentives need to be structured carefully to
make sure that they achieve their goal
• Corporate control
– The threat of a takeover may result in better
management
• Conflicts with other stakeholders
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Stakeholders
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The Stakeholder Theory
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Social Responsibility and Ethical
Investing
• Investors are increasingly demanding that
corporations behave responsibly
• Issues include how a corporation treats the
community in which it operates, their customers,
corporate governance, their employees, the
environment and human rights
• Controversial business activities include alcohol,
gaming, genetic engineering, nuclear power,
pornography, tobacco and weapons
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Relation between CSR and Profitability ?
Ed Zander, former Chairman and CEO of Motorola:
“strong economic performance and good social and environmental
performance are not mutually exclusive. In fact, I believe that good
corporate citizenship improves our bottom line. It's not surprising
that many analysts and investors are paying closer attention to a
company's corporate citizenship efforts for purely fiduciary
reasons. Firms with social citizenship records and a real
commitment to corporate responsibility are arguably more
sustainable, better managed and, therefore, better long-term
investments.”
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Jantzi Social Index (JSI) Total Returns
(November 2013)
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How to Induce Executives to
Behave in a Socially Responsible
Manner ?
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Can Companies' CSR Policies Lead
to Corporate Irresponsibility?
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BP’s managers missed key safety warning signs,
causing worst offshore oil spill in US history
April 20, 2010
Tony Hayward, CEO, July 2010
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What is the role of financial markets in corporate
finance?
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•
Cash flows to and from the firm
Money vs. capital markets
Primary vs. secondary markets
One excellent site for information on Canadian
companies that trade in secondary markets is
www.tmx.com
• Click on the web surfer to go to the site, choose
a company and see what information you can
find!
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Cash Flows to and from the Firm
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Financial Institutions
• Financial institutions act as intermediaries
between suppliers and users of funds
• Institutions earn income on services provided:
– Indirect finance – Earn interest on the spread
between loans and deposits
– Direct finance – Service fees (i.e. bankers
acceptance and stamping fees)
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Trends in Financial Markets and
Management
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Financial Engineering
Derivative Securities
Advances in Technology – i.e. E-business
Deregulation
Corporate Governance Reform
Hedge Funds
Shareholder Activisms
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Summary
• You should know:
– The primary goal of the firm
– What an agency relationship and agency cost are
– What ethical investing is
– The role of financial markets
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ADM 2352
Finance Theory
Lecture 2
Arbitrage and Financial Decision
Making
• Readings:
– Chapter 3
• Group Discussion
– “In the presence of transactions costs, is it possible for
different investors to place different values on an
investment opportunity? Are there any limits on the
amount that their values can differ?”
Outline
• Interest Rates and the Time Value of Money
• Present Value and the NPV Decision Rule
• Arbitrage and the Law of One Price
• No-Arbitrage and Security Prices
Interest Rates and the
Time Value of Money
• Time Value of Money
– Consider an investment opportunity with the
following certain cash flows.
• Cost: $100,000 today
• Benefit: $105,000 in one year
– The difference in value between money today and
money in the future is due to the time value of
money.
Interest Rates and the
Time Value of Money (cont’d)
• The Interest Rate: An Exchange Rate Across Time
– The rate at which we can exchange money today for
money in the future is determined by the current
interest rate.
– Risk–free interest rate, rf, is the interest rate at which
money can be borrowed or lent without risk.
– Interest rate factor = 1 + r
– Discount factor = 1 / (1 + r)
Making Consumption Choices over Time
Consider a person who has an income of
$50,000 this year and an income of $60,000
next year.
The market allows him not only to consume
$50,000 worth of goods this year and $60,000
next year, but also to borrow and lend at the
equilibrium interest rate.
Making Consumption Choices over Time (cont’d)
If the rate of interest is 10 percent:
• What is the maximum amount available for
this person to consume this year?
• What is the maximum amount of wealth that
this person can spend in the second year?
Making Consumption Choices over Time (cont’d)
Figure below shows all of the consumption possibilities
open to the person through borrowing or lending, and the
shaded area contains all of the feasible choices.
Making Consumption Choices over Time (cont’d)
By borrowing and lending different amounts the person can achieve
any point on the line AB. For example, point C is a point where he
has chosen to lend $10,000 of today’s income.
This means that at point C he will have:
Consumption this year : $50,000 - $10,000 = $40,000 , and
Consumption next year : $60,000 + [$10,000 x(1+ r)] = $71,000
Similarly, at point D the individual has decided to borrow $10,000
and repay the loan next year. At point D:
Consumption this year: $50,000+$10,000=$60,000
and Consumption next year: $60,000-[$10,000 x(1+r)]=$49,000 at
an interest rate of 10 percent.
Making Consumption Choices over Time (cont’d)
In fact, this person can consume at any point on the line AB. This
line has a slope of -(1+r), which means that for each dollar that is
added to the x coordinate along the line, (1+r) dollars are
subtracted from the y coordinate.
Moving along the line from point A, the initial point of $50,000 this
year and $60,000 next year, toward point B gives the person more
consumption today and less next year. In other words, moving
toward point B is borrowing. Similarly, moving up toward point A,
he is consuming less today and more next year and is lending.
Making Consumption Choices over Time (cont’d)
Where will the person actually be? In A, B, C, D,…?
Making Consumption Choices over Time (cont’d)
Raising the interest rate to 20% or even 50%
Present Value and the
NPV Decision Rule
• Net Present Value
▪ The net present value (NPV) of a project or
investment is the difference between the present
value of its benefits and the present value of
its costs.
Present Value and the
NPV Decision Rule (cont’d)
The NPV Decision Rule
– When making an investment decision, take the
alternative with the highest NPV.
– Choosing this alternative is equivalent to receiving
its NPV in cash today.
Accepting or Rejecting a Project
– Accept those projects with positive NPV
– Reject those projects with negative NPV
Example
Example (cont'd)
Individual’s Consumption Preferences and
Optimal Investment Decision
Consider a person who is concerned only about this year and the
next. She has an income of $100,000 this year and expects to make
the same amount next year. The interest rate is 10%.
This individual is thinking about investing in a piece of land that costs
$70,000. She is certain that next year the land will be worth $75,000,
a sure $5,000 gain. Should she undertake the investment?
Individual’s Consumption Preferences and
Optimal Investment Decision (cont’d)
By investing $70,000 in the land, she will have $75,000 available next
year.
Suppose instead that she puts the same $70,000 into a loan in the
financial market (i.e. lending). At 10% this $70,000 would grow to:
$70,000 x (1+0.1) = $77,000, next year.
It would be foolish to buy the land when the same $70,000
investment in the financial market would beat it by $2,000 (that is,
$77,000 from the loan minus $75,000 from the land investment).
Individual’s Consumption Preferences and
Optimal Investment Decision (cont’d)
Figure below illustrates this situation. Notice that the $70,000 loan
gives no less income today and $2,000 more next year.
Individual’s Consumption Preferences and
Optimal Investment Decision (cont’d)
This example illustrates some amazing features of the financial
markets.
It is remarkable to consider all of the information that we did
not use when arriving at the decision not to invest in the land.
We did not need to know how much income the person has
this year or next year. We also did not need to know whether
the person preferred more income this year or next…
We did not need to know any of these other facts, and more
important, the person making the decision did not need to
know them either. She needed only to be able to compare the
investment with a relevant alternative available in the financial
market.
Present Value and the
NPV Decision Rule
• NPV and the Individual’s Consumption
Preferences
– Separation of the Individual’s Consumption
Preferences from the Optimal Investment Decision:
• Regardless of our preferences for cash today versus cash
in the future, we should always maximize NPV first.
• We can then borrow or lend to shift cash flows through
time and find our most preferred pattern of cash flows.
Arbitrage and the Law of One Price
• Arbitrage
– The practice of buying and selling equivalent goods in
different markets to take advantage of a price
difference.
– An arbitrage opportunity occurs when it is possible to
make a profit without taking any risk or making any
investment.
• Normal Market
– A competitive market in which there are no arbitrage
opportunities.
Arbitrage and the Law of
One Price (cont'd)
• Law of One Price
– If equivalent investment opportunities trade
simultaneously in different competitive markets,
then they must trade for the same price in both
markets.
No-Arbitrage and Security Prices
• Valuing a Security with the Law of One Price
– Assume a security promises a risk-free payment of
$1000 in one year. If the risk-free interest rate is
5%, what can we conclude about the price of this
bond in a normal market?
PV ($1000 in one year) = ($1000 in one year)  (1.05 $ in one year / $ today)
= $952.38 today
• Price(Bond) = $952.38
No-Arbitrage and Security Prices
(cont'd)
• Valuing a Security (cont’d)
– What if the price of the bond is not $952.38?
• Assume the price is $940.
• The opportunity for arbitrage will force the price of the
bond to rise until it is equal to $952.38.
No-Arbitrage and Security Prices
(cont'd)
• Valuing a Security (cont’d)
– What if the price of the bond is not $952.38?
• Assume the price is $960.
• The opportunity for arbitrage will force the price of the bond
to fall until it is equal to $952.38.
No-Arbitrage and Security Prices
(cont'd)
• Determining the No-Arbitrage Price
– Unless the price of the security equals the present
value of the security’s cash flows, an arbitrage
opportunity will appear.
– No Arbitrage Price of a Security
Example
Example (cont'd)
No-Arbitrage and Security Prices
(cont'd)
• Determining the Interest Rate From Bond
Prices
– If we know the price of a risk-free bond, we
can use
to determine what the risk-free interest rate must be if there
are no arbitrage opportunities.
No-Arbitrage and Security Prices
(cont'd)
• Determining the Interest Rate From Bond
Prices
– Suppose a risk-free bond that pays $1000 in one
year is currently trading with a competitive market
price of $929.80 today. The bond’s price must
equal the present value of the $1000 cash flow it
will pay.
No-Arbitrage and Security Prices
(cont'd)
• Determining the Interest Rate From
Bond Prices (cont'd)
$929.80 today = ($1000 in one year)  (1 + rf $ in one year / $ today)
1 + rf =
$1000 in one year
= 1.0755 $ in one year / $ today
$929.80 today
– The risk-free interest rate must be 7.55%.
No-Arbitrage and Security Prices
(cont'd)
• The NPV of Trading Securities and the Optimal
Investment Decision
– In a normal market, the NPV of buying or selling a
security is zero.
NPV (Buy security) = PV (All cash flows paid by the security) − Price(Security)
= 0
NPV (Sell security) = Price(Security) − PV (All cash flows paid by the security)
= 0
No-Arbitrage and Security Prices
(cont'd)
• The NPV of Trading Securities (cont’d)
– Separation of the Investment and Financing
Decisions:
• Security transactions in a normal market neither create
nor destroy value on their own.
• We can evaluate the NPV of an investment decision
separately from the decision the firm makes regarding
how to finance the investment or any other security
transactions the firm is considering.
Example
Example (cont'd)
No-Arbitrage and Security Prices
(cont'd)
• Valuing a Portfolio
– Portfolio is a collection of securities
– Consider two securities, A and B. Suppose a third
security, C, has the same cash flows as A and B
combined. In this case, security C is equivalent to
a portfolio, or combination, of the securities A and
B.
– Value Additivity
No-Arbitrage and Security Prices
(cont'd)
• Valuing a Portfolio
– Value Additivity and Firm Value:
• To maximize the value of the entire firm, managers
should make decisions that maximize NPV.
• The NPV of the decision represents its contribution to
the overall value of the firm.
Example
Example (cont'd)
The Price of Risk
Risk – when an actual outcome may be different
from its expected outcome
•Risky Versus Risk-free Cash Flows
– Suppose the risk-free rate is 4% and the economy
is equally likely to strengthen or weaken.
– A risk-free bond pays $1100 in one year.
– An investment in the market index will pay either
$1400 (strong economy) or $800 (weak economy).
The Price of Risk (cont’d)
• Risky Versus Risk-free Cash Flows (cont’d)
– Price today of the risk-free bond:
Price (Risk-free bond) = PV (Cash flows)
= ($1100 in one year) / (1.04$ in one year / $ today)
= $1057.69 today
– Expected payoff in one year:
1
1
$800
+
( ) ($1400) = $1100
2
2
….It is the same as the pay-off of the risk-free bond!
The Price of Risk (cont’d)
• Risk Aversion and the Risk Premium
– Investors will pay less to receive $1100 on average
than to receive $1100 with certainty because they
don’t like risk.
– Risk aversion
• The personal cost of losing a dollar in bad times is greater
than the benefit of an extra dollar in good times.
The Price of Risk (cont’d)
• Risk Aversion and the Risk Premium
▪ Expected Return
Market return in weak state =
Market return in strong state =
(800 − 1000) − 1 = −20%
1000
(1400 − 1000) − 1 = 40%
1000
1
1
Expected return = ( 40%) + ( −20%) = 10%
2
2
The Price of Risk (cont’d)
• The No-Arbitrage Price of a Risky Security
– Consider security A that pays $600 in a strong
economy and $0 in a weak economy
– According to the LOOP, what should be the price of
security A if the risk-free rate is 4%?
The Price of Risk (cont’d)
• The No-Arbitrage Price of a Risky Security
– Consider security A that pays $600 in a strong
economy and $0 in a weak economy
– The LOOP says security A must trade for $230.77
The Price of Risk (cont’d)
• Risk Premiums Depend on Risk
– Given more variable returns, security A pays
investors a higher risk premium
– Given an initial price of $230.77 and expected
payoff of ½* (0) + ½* (600) =300, security A has an
expected return of:
• (300-230.77)/230.77= 30%
– Security A’s risk premium is 30% – 4% = 26%
The Price of Risk (cont’d)
• Risk is Relative to the Overall Market
– The risk of a security must be evaluated in relation
to fluctuations of other investments in the
economy.
– A security’s risk premium will be higher the more
its returns tend to vary with the overall economy
and the market index.
– If the security’s returns vary in the opposite
direction of the market index, it offers insurance
and will have a negative risk premium.
Example
Example (cont’d)
The Price of Risk (cont’d)
• Risk, Return, and Market Prices
– The discount rate, rs, includes a risk premium
appropriate for the investment’s risk
Example
Example (cont’d)
Arbitrage with Transaction Costs
• Commissions paid to your broker
• Bid-ask spread
▪ Difference of the price you receive when you sell
(bid price) and when you buy (ask price) a security
• For most financial markets these costs are
small.
Example
Example (cont’d)
ADM 2352
Finance Theory
Lecture 3
Utility Theory, Risk Aversion and
The Pricing of Risk
• Readings:
– Chapter 10
• Group Discussion
– “Warren Buffett, the billionaire investor and chairman/CEO
of Berkshire Hathaway, stated that “diversification is
protection against ignorance”. Do you agree with his
statement? Why or Why not?
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So far….
• We’ve talked about individual decision making in the
absence of uncertainty.
• In reality, we usually make decision under uncertainty
Example:
1. uncertainty from product quality (second-hand vehicle)
2. uncertainty in dealing with others
-> often the outcome depends on what others do
3. purchase of financial assets (stocks and bonds) whose return is
contingent on which state is realized.
This is the essence of Financial Economics
Utility Theory
Utility theory is the foundation for the theory of choice under
uncertainty. It used by economists to determine how people
and societies choose to allocate scarce resources and to
distribute wealth among one another over time.
Economists defined the relation between psychological
satisfaction and wealth as utility.
The utility theory primary used in finance is developed by VonNeumann and Morgenstern (VNM, 1947). VNM define investor
utility as a function of rates of return or wealth.
Rational investors are expected to prefer a higher expected
future wealth to a lower value and are generally risk averse.
Goals
1) Individual maximizes their expected Utility
0.4
10
0.6
2
9
E(W) = 0.4(10) + 0.6(2) = 5.2
E[U(W)] = 0.4U(10) + 0.6U(2) = ?
Asset i
0.3
Asset j
0.7
4
Prefer the one with higher E[U(W)]
E(W) = 0.3(9) + 0.7(4) = 5.5
E[U(W)] = 0.3U(9) + 0.7U(4) = ?
2) Individual preferences over risk and return
y
C2
x
Return
C1
Risk
Example 1
Gamble (X) flip of a coin
• if heads, you receive $1
• if tails, you pay $1
• E(X) = (0.5) (1) + (0.5) (-1) = 0
X1 = +1
X2 = -1
• if you play this game many times, it is likely that you breakeven
Example 2
• Gamble (X) flip of a coin
• if heads, you receive $10
• if tails, you pay $1
X1 = +10
X2 = -1
• E(X) = (0.5) (10) + (0.5) (-1) = 4.50
• if you play this game many times, you will be a winner
• How much would you pay to play this game:
• perhaps as much as a $4.50
• But of course the answer depends upon your preference to risk
Fair Gambles
if the cost to play these gambles
=
expected value of the outcome
– then the gamble is said to be actuarially fair
• Common empirical findings:
1. individuals may agree to flip a coin for small amounts of money,
but usually refuse to bet large sums of money
2.
people will pay small amounts of money to play actuarially
unfair games (Lotto 649, where cost = $3, but E(X) < $3)
- but will avoid paying a lot
Why do these empirical findings occur? Because it is not about E(W):
Individuals do not make decisions based purely on wealth, but rather on
the utility of their expected wealth: max U(E[W])
Utility Functions
Utility functions must have 2 properties
1.
order preserving: if U(x) > U(y) => x > y
2.
Expected utility can be used to rank combinations of risky
alternatives: U[G(x,y:α)] = αU(x) + (1-α) U(y)
Deriving Expected utility theorem, one of the most elegant derivations in
Economics, is tough. Don’t worry about a formal derivation. Just apply it.
Remark:
Utility functions are unique to individuals
- there is no way to compare one individual's utility function with
another individual's utility
- interpersonal comparisons of utility are impossible
if we give 2 people $1,000 there is no way to determine who is happier
Risk Aversion
• Consider the following gamble:
• Prospect a
prob = α
• prospect b
prob = 1-α
• Question:
G(a,b:α)
Will we prefer the expected value of the gamble with
certainty, or will we prefer the gamble itself?
• i.e. consider the gamble with:
10% chance of winning $100
90% chance of winning $0
E(gamble) = $10
• would you prefer the $10 for sure or would you prefer the gamble?
if prefer the gamble, you are risk loving
if indifferent to the options, risk neutral
if prefer the expected value over the gamble, risk averse
Preferences to Risk
U(W)
U(W)
U(W)
U(b)
U(b)
U(a)
U(b)
U(a)
U(a)
a b
W
Risk Preferring
a
b
Risk Neutral
U'(W) > 0
U''(W) > 0
U'(W) > 0
U''(W) = 0
W
a b
W
Risk Aversion
U'(W) > 0
U''(W) < 0
Expected Utility
• Assume that the utility function is natural logs:
U(W) = ln(W)
• U(W) = ln(W)
• U'(W)=1/W => MU (W) is positive
• U''(W)= -1/W2 < 0 => MU(W) is decreasing
The Utility Function
U(W)
3.40
3.00
Let U(W) = ln(W)
2.30
U'(W) > 0
U''(W) < 0
1.61
U'(W) = 1/w
U''(W) = - 1/W2
MU positive
But diminishing
0
1
5
10
20
30
W
U[E(W)] and E[U(W)]
• U[(E(W)] is the utility associated with the known level
of expected wealth (although there is uncertainty
around what the level of wealth will be, there is no
such uncertainty about its expected value).
• E[U(W)] is the expected utility of wealth is utility
associated with level of wealth that may obtain.
• The relation between U[E(W)] and E[U(W)] is very
important
Risk Aversion
U[(E(W)] = U(1W1 + 2W2) AND E[U(W)]) = 1U(W1) + 2U(W2)
Where W1 and W2 are levels of wealth resulting from possible outcomes 1 and 2,
respectively
• Mathematically, for two possible states of nature, risk aversion
may be stated as
– U(1W1 + 2W2) > 1U(W1) + 2U(W2), (i.e. U[(E(W)] > E[U(W)])
– Level of utility associated with expected wealth, U(1W1 + 2W2), is
greater than state of nature resulting in expected utility of wealth,
1U(W1) + 2U(W2)
• If outcomes were an employee’s salary, a risk-averse employee
would prefer state of nature with certain salary resulting in
U(1W1 + 2W2)
– Over uncertain salary with an expected utility level of 1U(W1) + 2U(W2)
Risk-averse preferences:
U[E(W)] and E[U(W)]
Expected Utility
•
Assume that the utility function is natural logs: U(W) = ln(W)
Consider the following example:
80% chance of winning $5
20% chance of winning $30
E(W) = (.80)*(5) + (0.2)*(30) = $10
U[E(W)]
=
U(10) = ln (10) = 2.30
E[U(W)]
=
=
=
(0.8)*[U(5)] + (0.2)*[U(30)]
(0.8)*(1.61) + (0.2)*(3.40)
1.97
Therefore, U[(E(W)] > E[U(W)] -- uncertainty reduces utility
Utility and Risk-Preference
U(W)
3.40
U(W) = ln(W)
U[E(W)] = U(10) = 2.30
U[E(W)] = 2.30
E[U(W)]
= 0.8*U(5) + 0.2*U(30)
= 0.8*1.61 + 0.2*3.40
= 1.97
Therefore, U[E(W)] > E[U(W)]
Uncertainty reduces utility
E[U(W)] = 1.97
1.61
Certainty equivalent: 7.17
That is, this individual will take
7.17 with certainty rather than
the uncertainty around the gamble
2.83
0
1
5
CE
= 7.17
10
30
W
The Certainty Equivalent (C.E.)
• C.E. is the amount of payoff that an agent would have to
receive to be indifferent between that payoff and a given
gamble.
In our example:
• The Expected wealth is 10
• The E[U(W)] = 1.97
Then how much would this individual take with certainty
and be indifferent vis-à-vis of the gamble?
• Observe that Ln(CE) = 1.97 hence Exp(Ln(CE)) = CE = 7.17
• This individual would take 7.17 with certainty rather
than the gamble with expected payoff of 10
The Risk Premium
• Risk Premium:
– the amount that the individual is willing to give up in order to avoid the
gamble
• Recall the gamble
80% change of winning $5
20% chance of winning $30
E(W) = (.80)*(5) + (0.2)*(30) = $10
Suppose the individual has the choice now between the gamble and the
expected value of the gamble
E[U[W)] = 1.97
Certainty equivalent
=
$7.17
Investor would be willing to pay a maximum of $2.83 to avoid the gamble
($10 - $7.17) ie will pay an insurance premium of $2.83.
THIS IS CALLED THE MARKOWITZ PREMIUM
Ln(CE)=1.97, i.e U(CE)=E[U(W)], thus CE=7.17, RP=10-7.17=$2.83
The Risk Premium
Risk
Premium
=
an individual's
expected wealth,
given she plays
the gamble
In general,
if
U[E(W)] > E[U(W)]
if
U[E(W)] = E[U(W)]
if
U[E(W)] < E[U(W)]
-
level of wealth the individual
would accept with certainty
if the gamble were removed
(i.e. the certainty equivalent)
then risk averse individual
then risk neutral individual
then risk loving individual
risk aversion occurs when the utility function is strictly concave
risk neutrality occurs when the utility function is linear
risk loving occurs when the utility function is convex
(RP > 0)
(RP = 0)
(RP < 0)
A First Look at Risk and Return
1.
S&P/TSX Composite Index: A portfolio, constructed by Standard & Poor’s, of
the largest, most liquid stocks traded on the Toronto Stock Exchange (TSX).
At the end of October 2014, the average market capitalization of each firm
was about $5.7 billion and ranged from about $190 million to over $70
billion.
2.
Standard & Poor’s 500 (S&P 500): At the end of June 2014, the average
market capitalization of each firm was over $24.6 billion and ranged from
about $890 million to over $546 billion.
3.
Long-Term Government of Canada Bonds: These bonds have a maturity of
approximately 30 years.
4.
Government of Canada Treasury Bills: An investment in three-month
Government of Canada Treasury Bills.
Risk and Return: Insights from History
• How would $1 has grown by the end of 2014 if it
were placed in one of the following investments
on January 2, 1957?
– S&P/TSX Composite Index
– Long-Term Government of Canada Bonds
– Government of Canada Treasury Bills
If you invested $1 in 1957, how much would you
have in 2014?
Average Returns
1957 – 2014
Returns on US Stock, Government Bonds
and Bills, 1900 – 2010
Historical Returns and Standard Deviations
1957 – 2014
12-28
Risk-Return Tradeoff
(1957-2014)
12.00
11.00
Common Stocks
Annual Return Average
10.00
9.00
8.00
Long Bonds
7.00
6.00
5.00
T-Bills
4.00
3.00
2.00
0.00
5.00
10.00
15.00
20.00
Annual Return Standard Deviation
Higher expected return corresponds with higher risk exposure
25.00
Risk Premiums
• The “extra” return earned for taking on risk.
• The short-term government bill or bond, e.g., a
Treasury Bill, is usually considered to be a proxy for
the risk-free rate of return or rf.
• The required rate of return on any risky investment
is defined as the risk-free rate plus some extra
compensation or premium for the risk:
r = rf + Risk Premium
Average Returns and
Risk Premiums 1957 – 2014
Common Measures of Risk and Return
• Probability Distributions
– When an investment is risky, there are different
returns it may earn. Each possible return has some
likelihood of occurring. This information is
summarized with a probability distribution, which
assigns a probability, PR , that each possible return,
R , will occur.
• Assume BFI stock currently trades for $100 per share.
In one year, there is a 25% chance the share price will be
$140, a 50% chance it will be $110, and a 25% chance it
will be $80.
Expected Return
• Expected (Mean) Return
– Calculated as a weighted average of the
possible returns, where the weights correspond
to the probabilities.
Expected Return = E  R  =

R
PR  R
E  RBIN  = 25%( − 0.20) + 50%(0.10) + 25%(0.40) = 10%
Variance and Standard Deviation
• Variance
– The expected squared deviation from the mean
2

Var (R) = E ( R − E  R )  =



R
PR  ( R − E  R )
• Standard Deviation
– The square root of the variance
SD( R) =
Var ( R)
• Both are measures of the risk of a probability
distribution
2
Variance and Standard Deviation
(cont'd)
• The variance and standard deviation are:
Var  RBIN  = 25%  ( − 0.20 − 0.10) 2 + 50%  (0.10 − 0.10) 2
+ 25%  (0.40 − 0.10) 2 = 0.045
SD( R) =
Var ( R) =
0.045 = 21.2%
• In finance, the standard deviation of a return is also
referred to as its volatility. The standard deviation is
easier to interpret because it is in the same units as
the returns themselves.
Example
Example (cont’d)
Historical Returns of Stocks and Bonds
• Computing Historical Returns
– Realized Return
• The return that actually occurs over a particular time
period.
𝑅𝑡+1 =
𝐷𝑖𝑣𝑡+1 +𝑃𝑡+1
𝑃𝑡
−1=
𝐷𝑖𝑣𝑡+1
𝑃𝑡
+
𝑃𝑡+1 −𝑃𝑡
𝑃𝑡
= Dividend Yield + Capital Gain Rate
40
Average Annual Return
1
R =
T
( R1
+ R2 +
+ RT )
1 T
=
Rt

T t =1
where Rt is the realized return of a security in year t, for
the years 1 through T
The Variance and Volatility of Returns
• Variance Estimate Using Realized Returns
1
Var R =
T − 1
 (R
T
t
t =1
− R)
2
– The estimate of the standard deviation is the
square root of the variance.
Example – Variance and Standard Deviation
Year
Actual
Return
1
.15
2
.09
3
.06
4
.12
Example – Variance and Standard Deviation
Year
Actual
Return
1
.15
2
.09
3
.06
4
.12
Totals
.42
Average
Return
Deviation from
the Mean
Average Return = .42 / 4 = .105
Squared
Deviation
Example – Variance and Standard Deviation
Year
Actual
Return
Average
Return
Deviation from
the Mean
Squared
Deviation
1
.15
.105
.045
.002025
2
.09
.105
-.015
.000225
3
.06
.105
-.045
.002025
4
.12
.105
.015
.000225
Totals
.42
.00
.0045
Variance = .0045 / (4-1) = .0015
Standard Deviation = .00151/2 = .03873
Can we trust historical data?
• Historical data is helpful but should be used carefully
– “Lies, damned lies, and statistics” -Mark Twain
• Which data sample & frequency to use?
– 1 year, 5 years, 30 years, 100 years?
– Daily data, weekly, monthly, quarterly?
• “Difficult” to estimate expected return accurately
– Variance is more persistent → “easier” to estimate
• “Easier” to forecast average annual rate of return over
longer time periods
– Say, 5 to 10 years compared to just 1 year
S&P 500 index
Which subset of the data are you
sampling?
Nikkei index
Which subset of the data are you
sampling?
The Historical Tradeoff Between
Risk and Return
• The Returns of Large Portfolios
– Excess Returns
• The difference between the average return for an
investment and the average return for T-Bills
The Returns of Individual Stocks
• Is there a positive relationship between
volatility and average returns for individual
stocks?
– As shown on the figure in the next slide, there is
no precise relationship between volatility and
average return for individual stocks.
• Larger stocks tend to have lower volatility than
smaller stocks.
• All stocks tend to have higher risk and lower returns
than large portfolios.
Common Versus Independent Risk
Types of Risk:
• Common Risk
– Risk that is perfectly correlated
• Risk that affects all securities
• Independent Risk
– Risk that is uncorrelated
• Risk that affects a particular security
• Diversification
– The averaging out of independent risks in a large portfolio
Diversification in Stock Portfolios
• Firm-Specific versus Systematic Risk
– Firm-Specific News
• Good or bad news about an individual company
– Market-Wide News
• News that affects all stocks, such as news about the economy
Diversification
in Stock Portfolios (cont'd)
• Firm-Specific versus Systematic Risk
– Independent Risks
• Due to firm-specific news
– Also known as:
» Firm-Specific Risk
» Idiosyncratic Risk
» Unique Risk
» Unsystematic Risk
» Diversifiable Risk
Diversification
in Stock Portfolios (cont'd)
• Firm-Specific versus Systematic Risk
– Common Risks
• Due to market-wide news
– Also known as:
» Systematic Risk
» Undiversifiable Risk
» Market Risk
Diversification
in Stock Portfolios (cont'd)
• Firm-Specific versus Systematic Risk
– When many stocks are combined in a large
portfolio, the firm-specific risks for each stock will
average out and be diversified.
– The systematic risk, however, will affect all firms
and will not be diversified.
Example
Example (cont’d)
Diversification
in Stock Portfolios (cont'd)
• Firm-Specific versus Systematic Risk
– Consider two types of firms:
• Type S firms are affected only by systematic risk. There is a
50% chance the economy will be strong and type S stocks
will earn a return of 40%; there is a 50% chance the
economy will be weak and their return will be –20%.
Because all of these firms face the same systematic risk,
holding a large portfolio of type S firms will not diversify
the risk.
Diversification
in Stock Portfolios (cont'd)
• Firm-Specific versus Systematic Risk
– Consider two types of firms:
• Type I firms are affected only by firm-specific risks.
Their returns are equally likely to be 35% or –25%,
based on factors specific to each firm’s local market.
Because these risks are firm-specific, if we hold a
portfolio of the stocks of many type I firms, the risk is
diversified.
Diversification
in Stock Portfolios (cont'd)
• Firm-Specific versus Systematic Risk
– Actual firms are affected by both market-wide risks
and firm-specific risks. When firms carry both types
of risk, only the unsystematic risk will be diversified
when many firm’s stocks are combined into a
portfolio. The volatility will therefore decline until
only the systematic risk remains.
Power and Limit of Diversification

In a large portfolio the variance terms are effectively
diversified away but the covariance terms are not.
Diversifiable Risk
Unsystematic Risk
Firm-specific Risk
Idiosyncratic Risk
Portfolio risk
Non-diversifiable risk
Systematic Risk
Market Risk
n
Diversification can eliminate some but not all of the risk of
individual securities
Power and Limit of Diversification
No Arbitrage and the Risk Premium
• The risk premium for diversifiable risk is zero,
so investors are not compensated for holding
firm-specific risk.
– If the diversifiable risk of stocks was compensated
with an additional risk premium, then investors
could buy the stocks, earn the additional
premium, and simultaneously diversify and
eliminate the risk.
No Arbitrage
and the Risk Premium (cont'd)
By doing so, investors could earn an additional
premium without taking on additional risk. This
opportunity to earn something for nothing would
quickly be exploited and eliminated. Because
investors can eliminate firm-specific risk “for free”
by diversifying their portfolios, they will not require
or earn a reward or risk premium for holding it.
No Arbitrage
and the Risk Premium (cont'd)
• The risk premium of a security is determined
by its systematic risk and does not depend on
its diversifiable risk.
– This implies that a stock’s volatility, which is a
measure of total risk (that is, systematic risk plus
diversifiable risk), is not especially useful in
determining the risk premium that investors will
earn.
No Arbitrage
and the Risk Premium (cont'd)
• Standard deviation is not an appropriate measure
of risk for an individual security. There should be no
clear relationship between volatility and average
returns for individual securities. Consequently, to
estimate a security’s expected return, we need to
find a measure of a security’s systematic risk.
Measuring Systematic Risk
• Estimating the expected return will require
two steps:
– Measure the investment’s systematic risk
– Determine the risk premium required to
compensate for that amount of systematic risk
Measuring Systematic Risk
• To measure the systematic risk of a stock,
determine how much of the variability of its return
is due to systematic risk versus unsystematic risk.
– To determine how sensitive a stock is to systematic risk,
look at the average change in the return for each 1%
change in the return of a portfolio that fluctuates solely
due to systematic risk.
Measuring Systematic Risk (cont'd)
• Efficient Portfolio
– A portfolio that contains only systematic risk.
There is no way to reduce the volatility of the
portfolio without lowering its expected return.
• Market Portfolio
– An efficient portfolio that contains all shares and
securities in the market
• In Canada, the S&P/TSX Composite Index is often used
as a proxy for the market portfolio.
• In the U.S., the S&P 500 is often used as a proxy.
Beta and Systematic Risk
• Beta (β)
– The expected percent change in the excess return
of a security for a 1% change in the excess return
of the market portfolio.
• Beta differs from volatility. Volatility measures total risk
(systematic plus unsystematic risk), while beta is a
measure of only systematic risk.
Scatterplot of Monthly Excess Returns for
Cisco Versus the S&P 500, 1996–2014
Example
Example (cont’d)
Measuring Systematic Risk (cont'd)
• Beta (β)
– Beta measure the sensitivity of a security to marketwide risk factors.
– Stocks in cyclical industries are likely to be more
sensitive to systematic risk and have higher betas than
stocks in less sensitive industries.
Alternative Example
• Problem:
– Suppose the market portfolio tends to increase by
52% when the economy is strong and decline by
21% when the economy is weak.
– What is the beta of a type S firm whose return is
55% on average when the economy is strong and 24% when the economy is weak?
– What is the beta of a type I firm that bears only
idiosyncratic, firm-specific risk?
Alternative Example (cont’d)
• Solution:
– The systematic risk of the strength of the economy
produces a 52% – (– 21%) = 73% change in the return of
the market portfolio.
– The type S firm’s return changes by 55% – (– 24%) = 79%
on average.
– Thus the firm’s beta is βS = 79%/73% = 1.082. That is, each
1% change in the return of the market portfolio leads to a
1.082% change in the type S firm’s return on average.
Alternative Example (cont’d)
• Solution:
– The return of a type I firm has only firm-specific risk,
however, and so is not affected by the strength of the
economy. Its return is affected only by factors specific to
the firm.
– Because it will have the same expected return, whether
the economy is strong or weak, βI = 0%/72% = 0.
Measuring Systematic Risk (cont'd)
Measuring Systematic Risk (cont'd)
• Interpreting Beta (β)
– A security’s beta is related to how sensitive its
underlying revenues and cash flows are to
general economic conditions. Stocks in cyclical
industries are likely to be more sensitive to
systematic risk and have higher betas than
stocks in less sensitive industries.
Beta and the Cost of Capital
• Estimating the Risk Premium
• Market Risk Premium
– The market risk premium is the reward investors
expect to earn for holding a portfolio with a beta of 1.
Market Risk Premium = E  RMkt  − rf
Estimating the Risk Premium (cont'd)
• Adjusting for Beta
• Estimating a Traded Security’s Expected
Return from Its Beta
E  Ri  = Risk-Free Interest Rate + Risk Premium
= rf + i  (E  RMkt  − rf )
Alternative Example
– Assume the economy has a 60% chance that the
market return will 15% next year and a 40%
chance the market return will be 5% next year.
– Assume the risk-free rate is 6%.
– If Microsoft’s beta is 0.9, what is its expected
return next year?
Alternative Example (cont’d)
• Solution
– E[RMkt] = (60% × 15%) + (40% × 5%) = 11%
– E[R] = rf + β ×(E[RMkt] − rf )
– E[R] = 6% + 0.9 × (11% − 6%)
– E[R] = 6% + 4.5% = 10.5%
ADM 2352
Finance Theory
Lecture 4
Optimal Portfolio Choice and the
Capital Asset Pricing Model
(PART I)
1
• Readings:
– Chapter 11:
• Section 11.1 to section 11.4
• Recommended problems:
– 1, 6, 7, 8, 18, 20, 22, 23 and 31
• Group Discussion
– “In March 2020, in the wake of the COVID-19 pandemic, five European
countries (i.e., France, Italy, Spain, Greece and Belgium) have
temporary banned short selling in an attempt to stabilize financial
markets. Canadian authorities decided not follow suit. Were they
right? Why or Why not?”
2
Outline
(Part I & II)
• The Expected Return of a Portfolio
• The Volatility of a Two-Stock Portfolio
• The Volatility of a Large Portfolio
• Risk Versus Return: Choosing an Efficient Portfolio
• Risk-Free Saving and Borrowing
• The Efficient Portfolio and Required Returns
• The Capital Asset Pricing Model
• Determining the Risk Premium
3
The Expected Return of a Portfolio
• Portfolio Weights
– The fraction of the total investment in the
portfolio held in each individual investment in the
portfolio
• The portfolio weights must add up to 1.00 or 100%.
Value of investment i
xi =
Total value of portfolio
3-4
The Expected Return
of a Portfolio (cont'd)
• Then the return on the portfolio, Rp , is the
weighted average of the returns on the
investments in the portfolio, where the
weights correspond to portfolio weights.
RP = x1 R1 + x2 R2 +
+ xn Rn =  i xi Ri
3-5
Example
Suppose you buy 200 shares of Barrick Gold Corp.
at $30 per share and 100 shares of WestJet at $40
per share. If Barrick’s share price goes up to $36
and WestJet’s share price falls to $38,
• what is the new value of the portfolio?
• what return did the portfolio earn?
• After the price changes, what are the new
portfolio weights?
6
Example (cont’d)
3-7
The Expected Return
of a Portfolio (cont'd)
The expected return of a portfolio is the
weighted average of the expected returns of the
investments within it.




E  RP  = E   xi Ri  = E    xi R i  =  xi E  Ri 
i
 i

 i

3-8
Example
– Assume your portfolio consists of $25,000 of Intel
stock and $35,000 of ATP Oil & Gas.
– Your expected return is 18% for Intel and 25% for
ATP Oil and Gas.
– What is the expected return for your portfolio?
3-9
Example (cont’d)
• Solution
– Total Portfolio = $25,000 + 35,000= $60,000
– Portfolio Weights
• Intel: $25,000 ÷ $60,000 = .4167
• ATP: $35,000 ÷ $60,000 = .5833
– Expected Return
• E[R] = (.4167)(.18) + (.5833)(.25)
• E[R] = 0.075006 + 0.145825 = 0.220885 = 22.1%
3-10
Alternative Example
3-11
Alternative Example (cont’d)
3-12
The Volatility of a Two-Stock Portfolio
• Combining Risks
3-13
The Volatility of a Two-Stock
Portfolio (cont'd)
• Combining Risks
– While the three stocks in the previous table have
the same volatility and average return, the pattern
of their returns differs.
• For example, when the airline stocks performed well,
the oil stock tended to do poorly, and when the airlines
did poorly, the oil stock tended to do well.
3-14
The Volatility of a Two-Stock
Portfolio (cont'd)
• Combining Risks
– Consider the portfolio which consists of equal
investments in South Jet and Alberta Oil. The
average return of the portfolio is equal to the
average return of the two stocks
– However, the volatility of 5.1% is much less than
the volatility of the two individual stocks.
3-15
The Volatility of a Two-Stock Portfolio
• Combining Risks
3-16
The Volatility of a Two-Stock
Portfolio (cont'd)
• Combining Risks
– By combining stocks into a portfolio, we reduce
risk through diversification.
– The amount of risk that is eliminated in a portfolio
depends on the degree to which the stocks face
common risks and their prices move together.
3-17
Determining Covariance and
Correlation
To find the risk of a portfolio, one must know
the degree to which the stocks’ returns move
together.
3-18
Determining Covariance
and Correlation (cont'd)
• Covariance
– The expected product of the deviations of two returns from
their means
– Covariance between Returns Ri and Rj
Cov(Ri ,R j ) = E[(Ri − E[ Ri ]) (R j − E[ R j ])]
– Estimate of the Covariance from Historical Data
1
Cov(Ri ,R j ) =
(Ri ,t − Ri )(R j ,t − R j )

T −1 t
• If the covariance is positive, the two returns tend to move together.
• If the covariance is negative, the two returns tend to move in opposite
directions.
3-19
Determining Covariance
and Correlation (cont'd)
• Correlation
– A measure of the common risk shared by stocks
that does not depend on their volatility
Corr (Ri ,R j ) =
Cov(Ri ,R j )
SD(Ri ) SD(R j )
• The correlation between two stocks will always be
between –1 and +1.
3-20
Correlation Coefficient
3-21
Different Correlation Coefficients
3-22
Different Correlation Coefficients
3-23
Different Correlation Coefficients
3-24
Compute the Covariance and Correlation
between (NorthJet & SouthJet) and between
(SouthJet & AlbterOil)
3-25
Covariance and Correlation
between (NorthJet & SouthJet)
&
between (SouthJet & AlbterOil)
3-26
The Volatility of a Two-Stock Portfolio
• Combining Risks
3-27
What are the covariance and the
correlation of a stock’s return with
itself?
28
Covariance and the Correlation of a
Stock’s Return with Itself
29
Compute the covariance between
Microsoft and Dell
30
Solution
31
Computing a Portfolio’s Variance
and Volatility
• For a two-security portfolio:
Var (RP ) = Cov(RP ,RP )
= Cov(x1 R1 + x2 R2 ,x1 R1 + x2 R2 )
= x1 x1Cov(R1 ,R1 ) + x1 x2Cov(R1 ,R2 ) + x2 x1Cov (R2 ,R1 ) + x2 x2Cov (R2 ,R2 )
– The Variance of a Two-Stock Portfolio
Var (RP ) = x12Var (R1 ) + x22Var (R2 ) + 2 x1 x2Cov(R1 ,R2 )
32
Example
Assume your portfolio consists of 41.67% of Intel
stock and 58.33% of ATP Oil & Gas stock. The annual
standard deviation of returns is 43% for Intel and
68% for ATP Oil & Gas.
– If the correlation between Intel and ATP is .49,
what is the standard deviation of your portfolio?
3-33
Solution
SD(RP ) =
x12Var (R1 ) + x22Var (R2 ) + 2 x1 x2Cov(R1 ,R2 )
Corr (Ri ,R j ) =
Cov(Ri ,R j )
SD(Ri ) SD(R j )
SD(RP ) = (.4167) 2 (.43) 2 + (.5833) 2 (.68) 2 + 2(.4167)(.5833)(.49)(.43)(.68)
SD(RP ) = (.1736)(.1849) + (.3402)(.4624) + 2(.4167)(.5833)(.49)(.43)(.68)
SD(RP ) = .0321 + .1573 + .0696 = 0.259 = .5089 = 50.89%
34
What is the volatility of a portfolio with equal amounts
invested in Microsoft and Dell Stocks?
35
Solution
36
What is the volatility of a portfolio with equal amounts
invested in Dell and Alaska Air Stocks?
3-37
Solution
38
The Volatility of a Large Portfolio
The variance of a portfolio is equal to the weighted
average covariance of each stock with the portfolio:
Var (RP ) = Cov(RP ,RP ) = Cov
( x R ,R ) =  x Cov(R ,R
i
i
i
P
i
P
P
i
– which reduces to:
(
Var (RP ) =  xi Cov Ri , R p
)
 x Cov( R , x R )
=
i
i
=
i
i
j
j
j
 x x Cov( R ,R )
i
i
j
i
j
j
39
)
The Volatility of a Large Portfolio
40
Diversification
• The variance of the return on a portfolio with many securities is
more dependent on the covariances between the individual
securities than on the variances of the individual securities.
• There are many more covariance terms in a covariance matrix
than there are variance terms
   12

  12  22
 :
:

 
 n1 n 2
2
1
...
...
:
...
 1n 

 2n 
: 
 n2 
There are n-variance terms among n-assets on
the main diagonal
❑There are n(n-1) off-diagonal covariance terms
❑The number of covariance terms rises much
faster than the number of variance terms as n
increases
❑ e.g. A portfolio of 100 assets has 9,900
covariances but only 100 variances
❑
41
42
Diversification with an Equally Weighted
Portfolio of Many Stocks
• Equally Weighted Portfolio
– A portfolio in which the same amount is invested
in each stock
• Variance of an Equally Weighted Portfolio
of n Stocks
1
Var ( RP ) = (Average Variance of the Individual Stocks)
n
1

+ 1 −  (Average Covariance between the Stocks)
n

43
Volatility of an Equally Weighted Portfolio of
a Number of Stocks
44
What is the volatility of an equally
weighted average of n
independent, identical risks ?
45
46
Diversification with General Portfolios
• Recall that Var (RP ) = Cov(RP ,RP ) = Cov
( x R ,R ) =  x Cov(R ,R
i
i
i
P
i
P
i
• For a portfolio with arbitrary weights, the standard deviation is calculated
as:
– Volatility of a Portfolio with Arbitrary Weights
Security i’s contribution to the
volatility of the portfolio
SD( RP ) =

i
xi  SD( Ri )  Corr ( Ri ,R p )


Amount
of i held

Total
Risk of i
Fraction of i’s
risk that is
common to P
– Unless all of the stocks in a portfolio have a perfect positive
correlation of +1 with one another, the risk of the portfolio will be
lower than the weighted average volatility of the individual stocks:
SD( RP ) =
 x SD( R ) Corr (R ,R )
i
i
i
i
p

 x SD( R )
i
i
i
47
P
)
RECALL:
The Volatility of a Two-Stock Portfolio
• Combining Risks
Exercise
• You currently hold a portfolio of three stocks,
Delta, Gamma, and Omega.
• Delta, Gamma, and Omega have a volatility of
60%, 30% and 20% respectively.
• Suppose you invest 50% of your money in Delta,
and 25% in each of Gamma and Omega.
• What is the highest possible volatility of your
portfolio.
3-49
Solution
Max vol = weighted average = .5(60%) +
.25(30%) + .25(20%) = 42.5%
50
Risk Versus Return:
Choosing an Efficient Portfolio
• Efficient Portfolios with Two Stocks
– Recall that in an efficient portfolio there is no way
to reduce the volatility of the portfolio without
lowering its expected return.
– In an inefficient portfolio, it is possible to find
another portfolio that is better in terms of both
expected return and volatility.
51
Risk Versus Return:
Choosing an Efficient Portfolio (cont'd)
• Efficient Portfolios with Two Stocks
– Consider a portfolio of Intel and Coca-Cola
52
Volatility Versus Expected Return for
Portfolios of Intel and Coca-Cola Stock
(Labels indicate portfolio weights (Xi, Xc) for Intel and Coca-Cola stocks)
53
Volatility versus Expected Return for Portfolios of
Blackberry (BB) and Bell (BCE) Stock
Forming portfolios containing BB & BCE
54
Diversification Effects
▪By forming portfolios with
different weights of the two
assets, we can analyze how
portfolio expected returns and
standard deviations change
▪We compute expected returns
and standard deviations using
different weights of each asset
in the hypothesized portfolio
▪Financial economists often call this “mean-variance” analysis
55
Risk Versus Return:
Choosing an Efficient Portfolio (cont'd)
• Efficient Portfolios with Two Stocks
– Consider investing 100% in Coca-Cola stock. As
shown earlier, other portfolios—such as the
portfolio with 20% in Intel stock and 80% in CocaCola stock—make the investor better off in two
ways: It has a higher expected return, and it has
lower volatility. As a result, investing solely in
Coca-Cola stock is inefficient.
56
Risk Versus Return:
Choosing an Efficient Portfolio (cont'd)
• Identifying Inefficient Portfolios
– A portfolio is an inefficient portfolio whenever it is
possible to find another portfolio that is better in
terms of both expected return and volatility.
– In Figure shown earlier, a portfolio is inefficient if
there are other portfolios above and to the left.
57
Risk Versus Return:
Choosing an Efficient Portfolio (cont'd)
• Identifying Efficient Portfolios
• While inefficient portfolios can be ruled out as
inferior investment choices, the efficient ones
can not be easily ranked.
• Investors will choose among them based on
their own preferences for return versus risk.
58
Example
59
The Effect of Correlation
• Correlation has no effect on the expected return of a
portfolio. However, the volatility of the portfolio will
differ depending on the correlation.
• The lower the correlation, the lower the volatility we
can obtain. As the correlation decreases, the volatility of
the portfolio falls.
• The curve showing the portfolios will bend to
the left to a greater degree as shown on the
next slide.
60
Recall that the Volatility of a Portfolio with
Arbitrary Weights is …
Security i’s contribution to the
volatility of the portfolio
SD( RP ) =

i
xi  SD( Ri )  Corr ( Ri ,R p )

Amount
of i held

Total
Risk of i

Fraction of i’s
risk that is
common to P
61
Changing the Correlation between
Intel and Coca-Cola Stocks
62
Short Sales
• Long Position
– A positive investment in a security
• Short Position
– A negative investment in a security
– In a short sale, you sell a stock that you do not
own and then buy that stock back in the future.
– Short selling is an advantageous strategy if you
expect a stock price to decline in the future.
63
Example
Suppose you have $20,000 in cash to invest. You decide to short sell
$10,000 worth of Coca-Cola and invest the proceeds from your
short sale, plus your $20,000, in Intel. What is the expected return
and volatility of your portfolio?
Assume that:
• The expected return and volatility of Coca-Cola stocks are 6% and 0.25, respectively
• The expected return and volatility for Intel stocks are 26% and 0.50, respectively
• The correlation coefficient is equal to zero
3-64
65
Portfolios of Intel and Coca-Cola
Allowing for Short Sales
66
ADM 2352
Finance Theory
Lecture 5
Optimal Portfolio Choice and the
Capital Asset Pricing Model (Cont’d)
• Readings:
– Chapter 11:
• Section 11.5 to section 11.8
– Paper:
• “Corporate Finance Practices in Canada: Where Do We Stand” (Kent Baker,
Shantanu Dutta, and Samir Saadi, Multinational Finance Journal, 2011, vol. 15, no.
3/4, pp. 157–192)
• Recommended problems:
– 34, 35, 38, 45, 47 and 49.
• Group Discussion
– “What do you think of the evidence reported in Baker, Dutta and Saadi (2011) that
Canadian firms rely more on subjective judgment than on formal models when
computing the cost of equity capital?”
2
Efficient Portfolios with Many Stocks
• Consider adding Bore Industries to the two-stock
portfolio:
• Although Bore has a lower return and the same
volatility as Coca-Cola, it still may be beneficial to add
Bore to the portfolio for the diversification benefits.
Efficient Portfolios with Many Stocks
(cont'd)
• The efficient portfolios—those offering the
highest possible expected return for a given
level of volatility—are those on the northwest
edge of the shaded region, which is called the
efficient frontier for these three stocks.
– In this case none of the stocks, on its own, is on
the efficient frontier, so it would not be efficient to
put all our money in a single stock.
Risk-Free Saving and Borrowing
• Risk can also be reduced by investing a portion
of a portfolio in a risk-free investment, like TBills. However, doing so will likely reduce the
expected return.
• On the other hand, an aggressive investor who
is seeking high expected returns might decide
to borrow money to invest even more in the
stock market.
Investing in Risk-Free Securities
• Consider an arbitrary risky portfolio and the
effect on risk and return of putting a fraction of
the money in the portfolio, while leaving the
remaining fraction in risk-free Treasury bills.
– The expected return would be:
E [RxP ] = (1 − x)rf + xE[RP ]
= rf + x (E[RP ] − rf )
Investing in Risk-Free Securities
(cont'd)
• The standard deviation of the portfolio would
be calculated as:
SD[RxP ] =
=
(1 − x) 2Var (rf ) + x 2Var (RP ) + 2(1 − x)xCov(rf ,RP )
x 2Var (RP )
= xSD(RP )
0
– Note: The standard deviation is only a fraction of
the volatility of the risky portfolio, based on the
amount invested in the risky portfolio.
Borrowing and Buying Stocks on
Margin
• Buying Stocks on Margin
– Borrowing money to invest in a stock.
– A portfolio that consists of a short position in the
risk-free investment is known as a levered
portfolio. Margin investing is a risky investment
strategy.
Example
Example (cont’d)
E [RxP ] = (1 − x)rf + xE[RP ]
= rf + x (E[RP ] − rf )
Identifying the Tangent Portfolio
To earn the highest possible expected return for any
level of volatility we must find the portfolio that
generates the steepest possible line when
combined with the risk-free investment.
Identifying the Tangent Portfolio
(cont'd)
• Sharpe Ratio
– Measures the ratio of reward-to-volatility
provided by a portfolio
E[RP ] − rf
Portfolio Excess Return
Sharpe Ratio =
=
Portfolio Volatility
SD( RP )
• The portfolio with the highest Sharpe ratio is the
portfolio where the line with the risk-free investment is
tangent to the efficient frontier of risky investments.
The portfolio that generates this tangent line is known
as the tangent portfolio.
Identifying the Tangent Portfolio
(cont'd)
• Combinations of the risk-free asset and the
tangent portfolio provide the best risk and
return tradeoff available to an investor.
– This means that the tangent portfolio is efficient and that
all efficient portfolios are combinations of the risk-free
investment and the tangent portfolio. Every investor
should invest in the tangent portfolio independent of his or
her taste for risk.
Identifying the Tangent Portfolio
(cont'd)
• An investor’s preferences will determine only
how much to invest in the tangent portfolio
versus the risk-free investment.
– Conservative investors will invest a small amount
in the tangent portfolio.
– Aggressive investors will invest more in the
tangent portfolio.
– Both types of investors will choose to hold the same
portfolio of risky assets, the tangent portfolio, which
is the efficient portfolio.
Example
Your uncle asks for investment advice. Currently, he has $100,000
invested in portfolio P which has an expected return of 10.5% and a
volatility of 8%. Suppose the risk-free rate is 5%, and the tangent
portfolio has an expected return of 18.5% and a volatility of 13%. To
maximize his expected return without increasing his volatility, which
portfolio would you recommend?
Example (cont’d)
Example (cont`d)
If your uncle prefers to keep his expected return the same but
minimize his risk, which portfolio would you recommend?
Example (cont’d)
The Efficient Portfolio
and Required Returns
• How to Improve a Portfolio: Beta and the Required
Return
– Take an arbitrary portfolio P, and consider whether its
Sharpe ratio can be raised by selling some of the risk-free
assets and investing the proceeds in an investment i. There
are two consequences:
– Expected return: expected return will increase by i’s
excess return to the risk-free return.
– Volatility: The incremental risk by adding i to the portfolio
is measured by i’s volatility multiplied by its correlation
with P.
The Efficient Portfolio
and Required Returns (cont'd)
• How to Improve a Portfolio: Beta and the Required
Return
– If you were to purchase more of investment i by
borrowing, you would earn the expected return of
i minus the risk-free return. Thus adding i to the
portfolio P will improve our Sharpe ratio if:
E [Ri ] − rf  SD(Ri )  Corr (Ri ,RP ) 
Additional return
from investment i
Incremental volatility
from investment i
E[RP ] − rf
SD(RP )
Return per unit of volatilty
available from portfolio P
The Efficient Portfolio
and Required Returns (cont'd)
• How to Improve a Portfolio: Beta and the Required Return
– Beta of Portfolio i with Portfolio P
The Efficient Portfolio
and Required Returns (cont'd)
• Portfolio Improvement : Beta and the Required
Return
– Increasing the amount invested in i will increase the
Sharpe ratio of portfolio P if its expected return E[Ri]
exceeds the required return ri , which is given by:
ri = rf + 
P
i
 (E[ RP ] − rf )
The Efficient Portfolio
and Required Returns (cont'd)
• How to Improve a Portfolio: Beta and the
Required Return
– Required Return of i
• The expected return that is necessary to compensate
for the risk investment i will contribute to the portfolio.
Example
Assume you own a portfolio of 25 different “large
cap” stocks. You expect your portfolio will have a
return of 12% and a standard deviation of 15%. A
colleague suggests you add gold to your portfolio.
Gold has an expected return of 8%, a standard
deviation of 25%, and a correlation with your
portfolio of -0.05. If the risk-free rate is 2%, will
adding gold improve your portfolio’s Sharpe ratio?
Alternative Example (cont’d)
• Solution
– The beta of gold with your portfolio is:
Gold =
SD( RGold )Corr ( RGold , RYour Portfolio ) 25%  −0.05
=
= −.08333
SD( RYour Portfolio )
15%
– The required return that makes gold an attractive
addition to your portfolio is:
r gold = 2% + (-0.0833) x (12%-2%) = 1.17%
– Because the expected return of 8% exceeds the
required return of 1.17%, adding gold to your
portfolio will increase your Sharpe ratio.
Alternative Example
Alternative Example (cont’d)
Expected Returns and the Efficient
Portfolio
A portfolio is efficient if and only if the expected
return of every available security equals its required
return.
Expected Return of a Security
E[ Ri ] = ri  rf + 
eff
i
 (E[ Reff ] − rf )
Example
Omega Fund has an expected return of 15% and volatility of
20%. A real estate fund has an expected return of 9% and a
volatility of 35%, and a correlation of 10% with the Omega
Fund. Risk-free T-Bills pay 3%.
Suppose you have $100 million invested in Omega Fund. In
addition to this position, how much should you invest in the
real estate fund to form an efficient portfolio of these two
funds ?
Example (cont’d)
The Capital Asset Pricing Model
• The Capital Asset Pricing Model (CAPM) allows
us to identify the efficient portfolio of risky
assets without having any knowledge of the
expected return of each security.
• The CAPM uses the optimal choices investors
make to identify the efficient portfolio as the
market portfolio, the portfolio of all stocks and
securities in the market.
The CAPM Assumptions
• Three Main Assumptions
– Assumption 1
• Investors can buy and sell all securities at competitive
market prices (without incurring taxes or transactions costs)
and can borrow and lend at the risk-free interest rate.
The CAPM Assumptions (cont'd)
• Three Main Assumptions
– Assumption 2
• Investors hold only efficient portfolios of traded
securities—portfolios that yield the maximum expected
return for a given level of volatility.
The CAPM Assumptions (cont'd)
• Three Main Assumptions
– Assumption 3
• Investors have homogeneous expectations regarding
the volatilities, correlations, and expected returns of
securities.
• Homogeneous Expectations
– All investors have the same estimates concerning future
investments and returns.
Supply, Demand, and the Efficiency of the
Market Portfolio
• Given homogeneous expectations, all investors will demand
the same efficient portfolio of risky securities.
• The combined portfolio of risky securities of all investors
must equal the tangent portfolio.
• The sum of all investors’ portfolios must equal the portfolio
of all risky securities available in the market.
• The efficient, tangent portfolio of risky securities must equal
the market portfolio.
The Capital Asset Pricing Model (cont’d)
• The insight that the market portfolio is efficient is
really just the statement that demand must equal
supply.
Example
Example (cont’d)
Optimal Investing:
The Capital Market Line
• When the CAPM assumptions hold, an optimal
portfolio is a combination of the risk-free
investment and the market portfolio.
– When the tangent line goes through the market
portfolio, it is called the capital market line (CML).
Determining the Risk Premium
• Market Risk and Beta
– Given an efficient market portfolio, the expected
return of an investment is:
E[Ri ] = ri = rf + iMkt (E[RMkt ] − rf )
Risk premium for security i
– The beta is defined as:
Volatility of i that is common with the market
i =
SD(Ri )  Corr (Ri ,RMkt )
SD(RMkt )
Cov(Ri ,RMkt )
=
Var (RMkt )
Example
• Problem
– Assume the risk-free return is 5% and the market
portfolio has an expected return of 12% and a standard
deviation of 44%.
– ATP Oil and Gas has a standard deviation of 68% and a
correlation with the market of 0.91.
– What is ATP’s beta with the market?
– Under the CAPM assumptions, what is its expected
return?
Example (cont’d)
• Solution
SD(Ri )  Corr (Ri ,RMkt ) (.68)(.91)
i =
=
= 1.41
SD(RMkt )
.44
E[Ri ] = rf + iMkt (E[RMkt ] − rf ) = 5% + 1.41(12% − 5%) = 14.87%
Alternative Example
Alternative Example (cont’d)
The Security Market Line
• There is a linear relationship between a
stock’s beta and its expected return (see
figure on next slide). The security market line
(SML) is graphed as the line through the riskfree investment and the market.
– According to the CAPM, if the expected return and
beta for individual securities are plotted, they
should all fall along the SML.
Example
Assume that E(Rm) =8.5%, and Rf = 3%
Example (cont’d)
Beta of a Portfolio
• The beta of a portfolio is the weighted average
beta of the securities in the portfolio.
P
(
Cov  i xi Ri ,RMkt
Cov(RP ,RMkt )
=
=
Var (RMkt )
Var (RMkt )
)
=
 i xi
Cov(Ri ,RMkt )
=
Var (RMkt )
 x
i
i
i
Example
– Suppose the stock of the 3M Company (MMM)
has a beta of 0.69 and the beta of HewlettPackard Co. (HPQ) stock is 1.77.
– Assume the risk-free interest rate is 5% and the
expected return of the market portfolio is 12%.
– What is the expected return of a portfolio of
40% of 3M stock and 60% Hewlett-Packard
stock, according to the CAPM?
Example (cont’d)
• Solution
 P =  i xi i = (.40)(0.69) + (.60)(1.77) = 1.338
E[Ri ] = rf + 
Mkt
i
(E[RPortfolio ] − rf )
E[Ri ] = 5% + 1.338(12% − 5%) = 14.37%
Alternative Example
Alternative Example (cont’d)
Summary of the Capital Asset
Pricing Model
• The market portfolio is the efficient portfolio.
• The risk premium for any security is proportional
to its beta with the market.
Advantages and Disadvantages of
CAPM
• Advantages
– Explicitly adjusts for systematic risk
– Applicable to all companies, as long as we can compute beta
• Disadvantages
– Have to estimate the expected market risk premium, which
does vary over time
– Have to estimate beta, which also varies over time
– We are relying on the past to predict the future, which is not
always reliable
Corporate Finance Practices in Canada: Where Do We Stand?
(Multinational Finance Journal, 2011, vol. 15, no. 3/4, pp. 157-192)
by Samir Saadi, Kent Baker, and Shantanu Dutta
Corporate Finance Practices in Canada: Where Do We Stand?
(Multinational Finance Journal, 2011, vol. 15, no. 3/4, pp. 157-192)
by Samir Saadi, Kent Baker, and Shantanu Dutta
ADM 2352
Finance Theory
Lecture 6
Behavioural Finance (Part I)
1-1
• Readings:
– Chapter 13:
• Recommended problems:
– 2, 6, 8, 17, 28
• Group Discussion
– “Explain why a low-priced, low trading volume stock is more apt to present limits to
arbitrage than is a high-priced, high trading volume stock.”
1-2
Competition and Capital Markets
• Identifying a Stock’s Alpha
– To improve the performance of their portfolios,
investors will compare the expected return of a
security with its required return from the security
market line.
1-3
Competition and Capital Markets (cont'd)
• Identifying a Stock’s Alpha
– The difference between a stock’s expected return
and its required return according to the security
market line is called the stock’s alpha.
– When the market portfolio is efficient, all stocks
are on the security market line and have an alpha
of zero.
1-4
1-5
Competition and Capital Markets (cont'd)
• Profiting from Non-Zero Alpha Stocks
– Investors can improve the performance of their
portfolios by buying stocks with positive alphas
and by selling stocks with negative alphas.
1-6
1-7
Information and Rational Expectations
• Informed Versus Uninformed Investors
– In the CAPM framework, investors should hold the
market portfolio combined with risk-free investments
– This investment strategy does not depend on the
quality of an investor’s information or trading skill.
1-8
Information and Rational Expectations
(cont’d)
• Rational Expectations
– All investors correctly interpret and use their own
information, as well as information that can be
inferred from market prices or the trades of others.
– Regardless of how much information an investor has
access to, he can guarantee himself an alpha of zero
by holding the market portfolio.
1-9
Information and Rational Expectations
(cont’d)
• Because the average portfolio of all investors is
the market portfolio, the average alpha of all
investors is zero.
• If no investor earns a negative alpha, then no
investor can earn a positive alpha, and the
market portfolio must be efficient.
1-10
Information and Rational Expectations
(cont’d)
• The market portfolio can be inefficient only if a
significant number of investors either:
– Do not have rational expectations so that they
misinterpret information and believe they are
earning a positive alpha when they are actually
earning a negative alpha, or
– Care about aspects of their portfolios other than
expected return and volatility, and so are willing to
hold inefficient portfolios of securities.
1-11
Style-Based Techniques and the Market
Efficiency Debate
• Size Effect
– Excess Return and Market Capitalizations
• Small market capitalization stocks have historically
earned higher average returns than the market portfolio,
even after accounting for their higher betas
– Excess Return and Book-to-Market Ratio
• High book-to-market stocks have historically earned
higher average returns than low book-to-market stocks
1-12
1-13
1-14
Style-Based Techniques and the Market
Efficiency Debate (cont’d)
• Size Effect
– Size Effects and Empirical Evidence
• Data Snooping Bias
– Given enough characteristics, it will always be possible to find
some characteristic that by pure chance happens to be
correlated with the estimation error of average returns
1-15
Style-Based Techniques and the Market
Efficiency Debate (cont’d)
• Momentum
– Momentum Strategy
• Buying stocks that have had past high returns and (short)
selling stocks that have had past low returns
1-16
Style-Based Techniques and the Market
Efficiency Debate (cont’d)
• Implications of Positive-Alpha Trading Strategies
– The only way positive-alpha strategies can persist in a market is if
some barrier to entry restricts competition
• However, the existence of these trading strategies has been widely
known for more than 15 years
– Another possibility is that the market portfolio is not efficient, and
therefore a stock’s beta with the market is not an adequate
measure of its systematic risk.
1-17
Style-Based Techniques and the Market
Efficiency Debate (cont’d)
• Implications of Positive-Alpha Trading Strategies
– Proxy Error
• The true market portfolio may be efficient, but the proxy
we have used for it may be inaccurate
– Behavioural Biases
• By falling prey to behavioural biases, investors may hold
inefficient portfolios
1-18
Style-Based Techniques and the Market
Efficiency Debate (cont’d)
• Implications of Positive-Alpha Trading Strategies
– Alternative Risk Preferences and Non-Tradable
Wealth
• Investors may choose inefficient portfolios because they
care about risk characteristics other than the volatility of
their traded portfolio
1-19
Multifactor Models of Risk
• The expected return of any marketable security is:
– When the market portfolio is not efficient, we have to find a method to
identify an efficient portfolio before we can use the above equation.
However, it is not actually necessary to identify the efficient portfolio itself.
– All that is required is to identify a collection of well-diversified portfolios
from which the efficient portfolio can be constructed.
1-20
Multifactor Models of Risk (cont’d)
• Using Factor Portfolios
– Single-Factor Model
• A model that uses one portfolio
– Multi-Factor Model
• A model that uses more than one portfolio in the model
• The CAPM is an example of a single-factor model while
the Arbitrage Pricing Theory (APT) is an example of a
multifactor model
1-21
Multifactor Models of Risk (cont’d)
• Using Factor Portfolios
– If all factor portfolios are self-financing then:
1-22
Multifactor Models of Risk (cont’d)
• Selecting the Portfolios
– Market Capitalization Strategy
• A trading strategy that each year buys a portfolio of small
stocks and finances this position by short selling a
portfolio of big stocks has historically produced positive
risk-adjusted returns.
– This self-financing portfolio is widely known as the smallminus-big (SMB) portfolio.
1-23
Multifactor Models of Risk (cont’d)
• Selecting the Portfolios
– Book-to-market Ratio Strategy
• A trading strategy that each year short sells an equallyweighted portfolio of stocks with a book-to-market ratio
less than the 30th percentile of NYSE firms and finances
this position by buying an equally-weighted portfolio of
stocks with a book-to-market ratio greater than the 70th
percentile of NYSE stocks has historically produced
positive risk-adjusted returns.
• This self-financing portfolio is widely known as the highminus-low (HML) portfolio.
1-24
Multifactor Models of Risk (cont’d)
• Selecting the Portfolios
– Past Returns Strategy
• Each year, after ranking stocks by their return over the
last one year, a trading strategy that buys the top 30% of
stocks and finances this position by short selling bottom
30% of stocks has historically produced positive riskadjusted returns.
– This self-financing portfolio is widely known as the prior oneyear momentum (PR1YR) portfolio.
» This trading strategy requires holding the portfolio for a
year and the process is repeated annually.
1-25
Multifactor Models of Risk (cont’d)
• Selecting the Portfolios
– Fama-French-Carhart (FFC) Factor Specifications
1-26
1-27
Example
1-28
Example (cont’d)
1-29
Alternative Example
– You are considering making an investment in a project in the financial
services industry. The project has the same level of non-diversifiable
risk as investing in Bank of America stock.
– Assume you have calculated the following factor betas for Bank of
America stock and average monthly returns for FFC portfolios:
Mkt
 BAC
= 0.186
SMB
 BAC
= 0.514
HML
 BAC
= 0.382
PR1YR
 BAC
= 0.211
– Determine the cost of capital by using the FFC factor specification if
the monthly risk-free rate is 0.1%.
1-30
Alternative Example (cont’d)
• Solution
E[Rs ] = rf +  sMkt (E[RMkt ] − rf ) +  sSMB E[RSMB ]
+  sHML E[RHML ] +  sPR1YR E[RPR1YR ]
E[Rs ] = 0.1% + (0.186)(.61%) + (0.514)(0.25%)
+(0.382)(0.38%) + (0.211)(0.70%)
E[Rs ] = .001 + .001135 + .001285 + .001452 + .001477
E[Rs ] = .006348
The annual cost of capital is .006348 × 12 = 7.62%
1-31
Multifactor Models of Risk (cont’d)
• The Cost of Capital Using the Fama-French-Carhart
Factor Specification
– Although it is widely used in research to measure risk,
there is much debate about whether the FFC factor
specification is really a significant improvement over
the CAPM
1-32
Multifactor Models of Risk (cont’d)
• The Cost of Capital Using the Fama-French-Carhart Factor
Specification
– One area where researchers have found that the FFC factor
specification does appear to do better than the CAPM is measuring
the risk of actively managed mutual funds
• Researchers have found that funds with high returns in
the past have positive alphas under the CAPM. When the
same tests were repeated using the FFC factor
specification to compute alphas, no evidence was found
that mutual funds with high past returns had future
positive alphas.
1-33
Methods Used In Practice
• Canada (Saadi et al 2011) VS. The U.S. (Graham
and Harvey, 2001)
1-34
Corporate Finance Practices in Canada: Where Do We Stand?
(Multinational Finance Journal, 2011, vol. 15, no. 3/4, pp. 157-192)
by Samir Saadi, Kent Baker, and Shantanu Dutta
1-35
In the U.S.
1-36
1-0
ADM 2352
Finance Theory
Lecture 7
Behavioural Finance (Part II)
1-1
• Readings:
– Chapter 13
• Recommended problems:
– 1, 3, 4, 6, 11, 25, 26
• Group Discussion
– “In general, do you approve following Jim Cramer’s stock
recommendations? Why or Why not?”
(Jim Cramer is the host of the popular show "Mad Money" on CNBC)
1-2
Capital Market Efficiency
• Stock prices are in equilibrium or are “fairly” priced
• If this is true, then you should not be able to earn
“abnormal” or “excess” returns
• Efficient markets DO NOT imply that investors
cannot earn a positive return in the stock market
1-3
2013 Nobel Prize Laureate, Eugene F. Fama
Awarded for his ground-breaking work on the
Efficient Market Hypothesis (EMH)
1-4
Reaction to New Information
1-5
The slide that the Nobel committee showed while
presenting Fama with the award
1-6
SEC Sues Tesla's Musk for Fraud: Analyst Reaction
1-7
1-8
Levels of Efficient Market Hypothesis (EMH)
• Weak Form EMH
– Past data on stock prices are of no use in predicting future stock price
changes
– Everything is random
– Should simply use a “buy-and-hold” strategy
• Semi-strong Form EMH
– Abnormally large profits cannot be consistently earned using public
information
– Any price anomalies are quickly found out and the stock market adjusts
• Strong Form EMH
– There is no information, public or private, that allows investors to
consistently earn abnormally high returns
1-9
Three Economic Conditions that
Lead to Market Efficiency
1) Investor rationality
2) Independent deviations from rationality
3) Arbitrage
•
For a market to be inefficient, all three conditions must be absent. That is,
– it must be that many, many investors make irrational investment decisions, and
– the collective irrationality of these investors leads to an overly optimistic or
pessimistic market situation, and
– this situation cannot be corrected via arbitrage by rational, well-capitalized
investors.
•
Whether these conditions can all be absent is the subject of a raging
debate among financial market researchers.
1-10
Are Financial Markets Efficient?
• Weak form of market efficiency supported to a certain extent.
• Challenges:
–
–
–
–
–
Excess market volatility
Stock price over-reaction: long time trends (1-3 years) reverse themselves.
Momentum in stock prices: short-term trends (6-12 months) continue.
Size and B/M ratio (stale information) may help predict returns.
Stock Price Reaction to Non-Information. E.g. Inclusion of a stock in the S&P500
index results in significant share price reactions. On 12/23/1998, AOL rose 18% on the news of
its inclusion in the index.
– Investors are not “fully rational”. They exhibit “biases” and use simple
“heuristics” (rules of thumb) in making decisions.
• Empirical Evidence on investor behavior:
– investors fail to diversify.
– investors trade actively.
– Investors may sell winning stocks and hold onto losing stocks
1-11
The Dot-com boom: “Irrational
Exuberance”
NASDAQ Market Index
5000
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3000
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1000
500
0
12
(Recall)
Market Anomalies
• Small-Firm Effect
– Size of a firm impacts stock returns
– Small firms may offer higher returns than larger
firms, even after adjusting for risk
• Calendar Effects
– Stocks returns may be closely tied to the time of
year or time of week
– Questionable if really provide opportunity
– Examples: Day-of-the-week effect
1-13
1-14
Day-of-the-week effect
(Saadi 2013)
1-15
Market Anomalies
• Post Earnings Announcement Drift (Momentum)
– Stock price adjustments may continue after earnings
adjustments have been announced
• Value Effect
– Uses B/M ratio to value stocks
– High B/M stocks may outperform low B/M stocks,
even after adjusting for risk
1-16
Post-Earnings Announcement Drift
(Saadi, 2012)
1-17
1-18
Possible Explanations
• Stocks that appear to earn abnormally returns are
actually riskier, so higher returns merely represent
compensation for risk
• Some anomalies may simply be patterns in that data
that appeared by chance and are thus not likely to
persist over time
• Behavioural biases may cause investors to make
systematic mistakes when they invest, and those
mistakes create inefficiencies in the market
1-19
Traditional vs. Behavioural
• Traditional
– Rational
• Fully informed
• Make Choices Consistent
with Expected Utility
• Behavioural
– Some people, sometimes
are not fully rational by the
classically rational actor
utility model of economics
1-20
“The investor’s chief problem, and even his worst
enemy, is likely to be himself.”
— Benjamin Graham
“There are three factors that influence the market:
Fear, Greed, and Greed.”
— Market Folklore
1-21
Behavioural Finance, Definition
• Behavioural Finance The area of research that attempts to understand
and explain how reasoning errors influence investor decisions and market
prices.
• Much of behavioural finance research stems from the research in the area
of cognitive psychology.
– Cognitive psychology: the study of how people (including investors) think,
reason, and make decisions.
– Reasoning errors are often called cognitive errors.
• Some people believe that cognitive (reasoning) errors made by investors
will cause market inefficiencies.
1-22
Daniel Kahneman
2002-Nobel Prize in Economics Sciences
Prize motivation: "for having integrated insights
from psychological research into economic
science, especially concerning human judgment
and decision-making under uncertainty”
His book
“Thinking, Fast and Slow” is a
must read
23
Robert Shiller
2013-Nobel Prize in Economics Sciences
1-24
1-25
Prospect Theory
•
•
Prospect theory provides an alternative to classical, rational economic decisionmaking.
The foundation of prospect theory: investors are much more distressed by
prospective losses than they are happy about prospective gains.
–
–
–
8-26
Researchers have found that a typical investor considers the pain of a $1 loss to be about twice as
great as the pleasure received from the gain of $1.
Researchers have found that investors respond in different ways to identical situations.
The difference depends on whether the situation is presented in terms of losses or in terms of gains.
Prospect Theory Value Function
1-27
Prospect Theory Value Function
• Given a real probability of gain or loss, p, individuals
tend to rate probabilities as follows :
• Tversky and Kahneman (1992) find that :
28
How real probability of gain or loss is
perceived according to the Prospect Theory
29
How real probability of gain or loss is
perceived according to the Prospect Theory
1-30
Investor Behavior Consistent
with Prospect Theory Predictions
• There are three major judgment errors consistent with
the predictions of prospect theory.
1. Frame Dependence
2. Mental Accounting
3. The House Money Effect
• There are other judgment errors that are also
consistent with the predictions of prospect theory.
1-31
Frame Dependence
• Try this: Jot down your answers in the following two scenarios.
– Scenario One. Suppose you are given $1,000.
Then, you have the following choice to make:
A. You can receive another $500 for sure.
B. You can flip a fair coin. If the coin-flip comes up “heads,” you get
another $1,000, but if it comes up “tails,” you get nothing.
– Scenario Two. Suppose you are given $2,000.
Then, you have the following choice to make:
A. You can lose $500 for sure.
B. You can flip a fair coin. If the coin-flip comes up “heads,” you lose
another $1,000, but if it comes up “tails,” you lose nothing.
1-32
What were your answers?
(Frame Dependence)
Did you: choose option A in the first scenario and choose option B in the
second scenario?
If you did, you are guilty of focusing on gains and losses, and not paying
attention to what is important—the impact on your wealth.
However, you are not alone.
•
•
About 85 percent of the people who are presented with the first scenario choose option A.
About 70 percent of the people who are presented with the second scenario choose option B.
1-33
Frame Dependence
• If an investment problem is presented in two different (but really
equivalent) ways, investors often make inconsistent choices.
• That is, how a problem is described, or framed, seems to matter to
people.
• In each scenario:
– You end up with $1,500 for sure if you pick option A.
– You end up with a 50-50 chance of either $1,000 or $2,000 if you pick option B.
– So, you should pick the same option in both scenarios.
• Which option you prefer is up to you.
• But, if you are focusing on wealth, you should never pick option A in one
scenario and option B in the other.
• The reason people do is that the phrasing, or framing, of the question
causes people to answer the questions differently.
1-34
Frame Dependence (cont.d)
• The concept of framing involves attempts to overlay a
situation with an implied sense of gain or loss.
• Example: It is easier to pay $3,400 for something that you
expected to cost $3,300 than it is to pay $100 for
something you expected to be free.
1-35
Mental Accounting
• Businesses and governments use accounting systems to
track, separate, and categorize the flow of money.
• People, on the other hand, use a mental accounting system.
• Imagine that your brain uses a mental accounting system
similar to a file cabinet. Each decision, action, and outcome is
placed in a separate folder in the file cabinet.
• The folder contains the costs and benefits associated with a
particular decision.
• Once an outcome is assigned to a mental folder, it is difficult
to view that outcome in any other way.
• The ramifications of mental accounting are that it influences
1-36
your decisions in unexpected ways.
Mental Accounting
• Money does not come with labels, so people
put labels on it. We have designations like dirty
money, easy money, free money, and so on.
• Consider the following example:
“Mr. and Mrs. Smith have saved $45,000 toward their
dream vacation home. They hope to buy the home in five
years. The money earns 3% in a money market account.
They just bought a new car for $38,000 that they financed
with a four-year car loan at 7%”
1-37
Mental Accounting
• Compartments: current wage, asset, and future.
• Investors have a “safe” part of their portfolio that they will not risk,
and a “risky” part of their portfolio that they can have fun with
1-38
Mental Accounting and Matching Costs to Benefit
Imagine that six months from now, you are planning to
purchase a clothes washer and dryer for your new
residence. The two machines together will cost $1,200. You
have two options for financing the washer/dryer:
A. Six monthly payments of $200 each during the six
months before the washer and dryer arrive.
A. Six monthly payments of $200 each during the six
months beginning after the washer and dryer arrive.
Which option would you choose?
1-39
Mental Accounting and Matching Costs to Benefit
Imagine that you are planning to take a one-week vacation to
the Caribbean six months from now. The vacation will cost
$1,200. You have two options for financing the vacation:
A. Six monthly payments of $200 each during the six
months before the vacation.
B. Six monthly payments of $200 each during the six
months beginning after you return.
Which option would you choose?
1-40
Mental Accounting and Loss Aversion
• Mental Accounting: Associating a stock with its purchase price.
• If you are engaging in mental accounting:
– You find it is difficult to sell a stock at a price lower than your purchase price.
– If you sell a stock at a loss:
• It may be hard for you to think that purchasing the stock in the first place was
correct.
• You may feel this way even if the decision to buy was actually a very good decision.
– A further complication of mental accounting is loss aversion.
• Loss Aversion: A reluctance to sell investments after they have fallen in value.
Also known as the “breakeven” effect or “disposition” effect.
• If you suffer from Loss Aversion, you will think that if you can just somehow “get
even,” you will be able to sell the stock.
• 8-41
If you suffer from Loss Aversion, it is sometimes said that you have “get-evenitis.”
Do You Suffer from “Get-Evenitis?”
Consider the following two investments:
1. Investment One. A year ago, you bought shares in Fama Enterprises for
$40 per share. Today, these shares are worth $20 each.
2. Investment Two. A year ago, you bought shares in French Company for
$5 per share. Today, these shares are worth $20 each.
What will you do? Will you:
(1)
(2)
(3)
(4)
sell one of these stocks;
sell both of these stocks;
hold one of these stocks; or
hold both of these stocks?
1-42
Do You Suffer from “Get-Evenitis?”
• Suppose you are considering a new investment in Fama Enterprises.
• Does your rational analysis say that it is reasonable to purchase shares
at $20?
– If the rational answer is no, then you should sell.
– If the rational answer is yes, then you do not suffer from loss aversion.
1-43
Do You Suffer from “Get-Evenitis?”
• As humans, we hate to admit we made a mistake, so we stubbornly
hold onto our losers, hoping that they will at least get back to where
we bought in.
• There are two important lessons from the previous Example.
– Lesson One: The market says that shares in Fama Enterprises are worth $20. The
market does not care that you paid $40 a year ago.
– Lesson Two: You should not care about your purchase price of Fama Enterprises.
You must evaluate your shares at their current price.
• How about the shares in French Company?
– Once again, the lessons are the same.
– The market says that French Company shares are worth $20 today.
– The fact that you paid $5 a year ago is not relevant.
• Get-Evenitis can be destructive. Famous example: Nicholas Leeson
causing the collapse of the 233-year-old Barings Bank.
1-44
Herding
• Herding refers to the lemming-like behavior of investors and
analysts looking around, seeing what each other is doing, and
heading in that direction.
• There may not have been safety in numbers, but there probably
was some comfort in them.
1-45
Herding
• Watch this video on social conformity:
https://www.youtube.com/watch?v=-7iN0V-GbM0
1-46
The Dot-com boom: “Irrational
Exuberance”
NASDAQ Market Index
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0
47
The House Money Effect
• Las Vegas casinos have found that gamblers are far more likely to take big
risks with money that they have won from the casino (i.e., “house
money”).
• Also, casinos have found that gamblers are not as upset about losing
house money as they are about losing their own gambling money.
• It may seem natural for you to separate your money into two buckets:
– Your very precious money earned through hard work, sweat, and sacrifice.
– Your less precious windfall money (i.e., house money).
• But this separation is plainly irrational.
– Any dollar you have buys the same amount of goods and services.
– The buying power is the same for “your money” and for your “house money.”
1-48
The House Money Effect
• Let us return to the shares of Fama Enterprises and French Company.
• Suppose shares in both were to decline to $15.
• You might feel very differently about the decline depending on which
stock you looked at.
– With Fama Enterprises, the decline makes a bad situation even worse. Now
you are down $25 per share on your investment.
– On the other hand, with French Company, you only “give back” some of
your “paper profit.” You are still way ahead.
1-49
The House Money Effect
• Thinking this way means that you are guilty of playing with house money.
• Whether you lose money from your original investment or lose money
from your investment gains is irrelevant.
• There are two important investment lessons here:
– Lesson One. There are no “paper profits.” Your profits are yours.
– Lesson Two. All your money is your money. You should not separate your
money into bundles labeled “my money” and “house money.”
1-50
Anchoring
• Consider the following question:
– In 1928, the modern era of the Dow Jones Industrial Average (DJIA) began as
it expanded to 30 stocks. In 1929, the index started the year at 300. At the
end of 2011, the DJIA was at 12,218. The DJIA is a price-weighted average.
Dividends are omitted from the index. What would the DJIA average have
been at the end of 2011 if the dividends were reinvested each year?
• Our decisions can be influenced by extraneous information contained
in the problem statement.
• Subjects unaware of their own anchoring behavior
• Examples: stock prices anchored to past values, or to other stock
prices in same country.
1-51
Anchoring
• Are you ready for the answer? If dividends were reinvested in the DJIA, the
average would have been 332,130 at the end of 2011. Does this surprise
you? Does it seem impossible? Let me reframe the problem from prices to
returns.
• Using my financial calculator, I find that the average annual return of 300
growing to 332,130 over 83 years is 8.81 percent. Does a nearly 9 percent
average return in the stock market seem reasonable? Even after learning
that most people set their prediction range too narrowly and experiencing
the problem firsthand, most people continue to do it.
• Also notice how important is the framing of the problem. This example also
illustrates another aspect of investor psychology called anchoring. When you
read the question, you focused on the DJIA price level of 12,218; that is, you
anchored your thinking to 12,218.
• You probably made your guess by starting at this anchor and then trying to
add an appropriate amount to compensate for the dividends. Investors
anchor on their stock purchase price and the recent highest stock price.
1-52
Overconfidence
• A serious error in judgment you can make as an investor is
to be overconfident.
• Being overconfident
– Believing you know more that you think you know, or
– Believing you are better than most other investors
– The truth is we only see the “tip of the iceberg” regarding what is
happening within a company, an industry, and the economy
– And we are usually only average or mediocre investors at best…Especially if
we decide to become traders!
• We are all overconfident about our abilities in many areas.
– Example of new businesses.
• Most fail
• Entrepreneurs believe 70% chance of success
• Believe others have 30% chance of success
• How does overconfidence affect investment decisions?1-53
Overconfidence and Trading Frequency
• If you are overconfident about your investment skill, it is likely that
you will trade too much.
• Researchers have found that investors who make relatively more
trades have lower returns than investors who trade less frequently.
• Researchers have found that the average household earned an
annual return of 16.4 percent.
• Researchers have found that households that traded the most
earned an annual return of only 11.4 percent.
•
The moral is clear: Excessive trading is hazardous to your wealth.
1-54
1-55
Do you think of yourself as a better
than average driver?
1-56
Overconfidence and Trading Frequency
Is Overtrading “a Guy Thing?”
• Psychologists have found that men are more overconfident than women
in the area of finance. So,
– Do men trade more than women?
– Do portfolios of men under-perform the portfolios of women?
• Researchers show that the answer to both questions is yes.
• Men trade about 50 percent more than women.
• Researchers show that both men and women reduce their portfolio
returns when they trade excessively.
– The portfolio return for men is 94 basis points lower than portfolio returns for women.
– The portfolio return for single men is 144 basis points lower than the portfolio return
for single women.
• Accounting for the effects of marital status, age, and income, researchers
also show that men invest in riskier positions.
1-57
1-58
Overconfidence and Portfolio Diversification
• Investors tend to invest too heavily in shares of the company for which
they work.
• This loyalty can be very bad financially.
– Your earning power (income) depends on this company.
– Your retirement nest-egg also depends on this company.
• Another examples of the lack of diversification is investing too heavily
in the stocks of local companies (Familiarity Bias).
– Perhaps you know someone personally who works there.
– Perhaps you read about them in your local paper.
– Basically, you are unduly confident that you have a high degree of knowledge about
local companies.
1-59
Misperceiving Randomness
and Overreacting to Chance Events
• Cognitive psychologists have discovered that the human mind is a
pattern-seeking device.
• Humans conclude that there are causal factors or patterns at work
behind sequences of events even when the events are truly random.
• The representativeness heuristic: Concluding that there are causal
factors at work behind random sequences. Or, if something is
random, it should look random.
• But, what does random look like?
1-60
A Coin Flipping Experiment
• Suppose we flip a coin twenty times and write down whether we get
a “head” or a “tail.”
• Then, we do it all over again. The results of our two sets of twenty
flips are:
– 1st Twenty: T T T H T T T H T T H H H T H H T H H H
– 2nd Twenty: T H T H H T T H T H T H T T H T H T H H
• Do these sequences of heads and tails both look random to you?
• Most people would say that the 1st Twenty and the 2nd Twenty
somehow look “different.”
– Both are random sequences.
– Both have ten heads and ten tails.
1-61
A Coin Flipping Experiment, Graphed
• Do you think the line labeled “1st Twenty” has a pattern to it, but
the line labeled “2nd Twenty” appears to be random?
• If so, your mind saw a pattern in a random sequence of coin flips.
1-62
Technical Trading (Charting):
Head and Shoulders
1-63
Technical Trading (Charting):
Head and Shoulders
1-64
Charting Examples
1-65
You, Too, Can Be a Technical Analyst!
“The market’s rise after a period of re-accumulation is a bullish sign.
Nevertheless, fulcrum characteristics are not yet clearly present and a
resistance area exists 40 points higher in the Dow, so it is clearly
premature to say the next leg of the bull market is up. If, in the coming
weeks, a test of the lows holds and the market breaks out of its flag, a
further rise would be indicated. Should the lows be violated, a
continuation of the intermediate term downward trend is called for. In
view of the current situation, it is a distinct possibility that traders will sit
in the wings awaiting a clearer delineation of the trend and the market will
move in a narrow trading range.”
Translation?
“If the market does not go up or down,
it will remain unchanged.”
A Random Walk Down Wall Street 1-66
The Hot-Hand Fallacy
• Suppose we look at the recent shooting by two basketball players:
James LeBron and Kevin Durant.
• Assume both of these players make half of their shots.
– LeBron: has just made two shots in a row.
– Durant: has just missed two shots in a row.
• Researchers have found that if they ask basketball fans which player
has the better chance of making their next shot:
– 91 out of 100 will say LeBron.
– They say this because they think LeBron has a “hot-hand.”
• But researchers have found that the “hot hand” is an illusion.
– Players do not deviate much from their long-run shooting averages.
– However, fans, players, announcers, and coaches think that they do.
1-67
The Hot-Hand Fallacy
• It is an illusion that basketball players are either “hot” or “cold.”
– If you believe in the “hot hand,” you will likely reject this fact because you
“know better” from watching shooters.
– You are being fooled by randomness—randomness often appears in clusters.
• Clustering Illusion: Our human belief that random events that
occur in clusters are not really random.
– Example: If a fair coin is flipped 20 times, there is about a 50 percent chance of
flipping four heads in a row.
– If you flip four heads in a row, do you have a “hot hand” at coin flipping?
• Mutual fund investing and the clustering illusion.
– Every year, funds that have had exceptionally good performance receive large
inflows of money.
– There is a universal disclaimer: “Past performance is no guarantee of future
results.” Nonetheless, investors chase past returns.
1-68
Behavioural Finance
at Work in the Markets
• Investor Behavior
– Investors who believe they have superior information
tend to trade more, but earn lower returns
– Investors tend to sell stocks that have risen in value
rather than declined
– Investors acting on emotions instead of facts may
reduce market efficiency
1-69
Behavioural Finance
at Work in the Markets (cont’d)
• Analyst Behavior
– Analysts may be biased by “herding” behavior,
where they tend to issue similar recommendations
for stocks
– Analysts may be overly optimistic about a favorite
stock’s future
1-70
Using Behavioural Finance to Improve
Investment Results
• Sooner or later, you are going to make an investment decision that winds up
costing you a lot of money.
•
Why is this going to happen?
– You made a sound decision, but you are “unlucky.”
– You made a bad decision—one that could have been avoided.
• The beginning of investment wisdom:
– Learn to recognize circumstances leading to poor decisions.
– Then, you will reduce the damage from investment blunders.
• Do not hesitate to sell a losing stock
• Do not chase performance
• Be humble and open-minded
• Review the performance of your investment on a periodic basis
• Do not trade too much
1-71
1-0
ADM 2352
Finance Theory
Lecture 8
Financial Options (Part I)
1-1
• Readings:
– Chapter 14: Sections 1, 2 and 3
• Recommended problems:
– 3, 5, 8, 9, 16, 20
• Group Discussion
– “A study of derivatives use by Canadian corporations reported that, of
those firms that use derivatives, most use derivatives to manage foreign
exchange exposure. Why do you suppose this is? Why not manage
something more crucial such as the cost of inputs for production?”
1-2
Option Basics
• Financial Option
– A contract that gives its owner the right (but not
the obligation) to purchase or sell an asset at a
fixed price at some future date
• Call Option
– A financial option that gives its owner the right to
buy an asset
1-3
Option Basics (cont'd)
• Put Option
– A financial option that gives its owner the right to
sell an asset
• Option Writer
– The person who takes the other side of the option
contract
1-4
Understanding Option Contracts
• Exercising an Option
– When a holder of an option enforces the
agreement and buys or sells a share of stock at the
agreed-upon price
• Strike Price (Exercise Price)
– The price at which an option holder buys or sells a
share of stock when the option is exercised
• Expiration Date
– The last date on which an option holder has the
right to exercise the option
1-5
Understanding Option Contracts
(cont'd)
• American Option
– Options that allow their holders to exercise the
option on any date up to and including the
expiration date
• European Option
– Options that allow their holders to exercise the
option only on the expiration date
• Note: The names American and European have nothing
to do with the location where the options are traded.
1-6
Understanding Option Contracts
(cont'd)
• The option buyer (holder)
– Holds the right to exercise the option and has a
long position in the contract
• The option seller (writer)
– Sells (or writes) the option and has a short position
in the contract
– Because the long side has the option to exercise,
the short side has an obligation to fulfill the
contract if it is exercised.
1-7
Understanding Option Contracts
(cont'd)
• Option premium:
– The market price of the option which compensates
the seller for the risk of loss in the event that the
option holder chooses to exercise the option.
1-8
Interpreting Stock Option Quotations
• Stock options are traded on organized exchanges.
• By convention, all traded options expire on the
Saturday following the third Friday of the month.
• Open Interest
– The total number of contracts of a particular option
that have been written
1-9
1-10
Interpreting Stock Option
Quotations (cont'd)
• At-the-money
– Describes an option whose exercise price is equal
to the current stock price
• In-the-money
– Describes an option whose value if immediately
exercised would be positive
• Out-of-the-money
– Describes an option whose value if immediately
exercised would be negative
1-11
Interpreting Stock Option
Quotations (cont'd)
• Deep In-the-money
– Describes an option that is in-the-money and for
which the strike price and the stock price are very
far apart
• Deep Out-of-the-money
– Describes an option that is out-of–the-money and
for which the strike price and the stock price are
very far apart
1-12
Example
It is December 30, 2009 and you have decided to purchase 25
February put contracts on the DJIA with an exercise price of
$106.
• How much money will this purchase cost you?
• Is this option in-the-money or out-of-the-money?
DJX
105.49
(DOW JONES INDU AVG INDEX)
Dec 30, 2009 @ 17:19 ET
Calls
Last
Sale
Net
Bid
Open
Ask Vol Int Puts
10 Jan 104.00 (DJV1016A104-E)
10 Jan 105.00 (DJV1016A105-E)
10 Jan 106.00 (DJV1016A106-E)
10 Jan 107.00 (DJV1016A107-E)
2.06 -0.03 1.79
2.3
6 5411 10 Jan 104.00 (DJV1016M104-E)
1.2 1.62
14 3866 10 Jan 105.00 (DJV1016M105-E)
0.81 -0.11 0.67 1.04
1 1960 10 Jan 106.00 (DJV1016M106-E)
10 Feb 104.00 (DJV1020B104-E)
10 Feb 105.00 (DJV1020B105-E)
10 Feb 106.00 (DJV1020B106-E)
10 Feb 107.00 (DJV1020B107-E)
2.76
0
3.3
0 349 10 Feb 104.00 (DJV1020N104-E)
2.67
0 2.25 2.66
0 229 10 Feb 105.00 (DJV1020N105-E)
2.07
1.45
0 1.72 2.1
0 1.28 1.62
0 277 10 Feb 106.00 (DJV1020N106-E)
0 176 10 Feb 107.00 (DJV1020N107-E)
1.37 -0.13
0.48 -0.09 0.34 0.55 263 4657 10 Jan 107.00 (DJV1016M107-E)
2.8
Last
Sale
Open
Bid Ask Vol Int
Net
0.71 -0.07 0.6 0.9 164 2712
1.03 -0.07
1.44
1 1.3
25 3640
0 1.5 1.8
0
584
2.2 0.25 1.9 2.3
14
251
0 1.9 2.3
0
54
2.6 0.23 2.3 2.7
21
98
0 2.7 3.31-13 0
0
0 3.2 3.8
301
317
2.33
3.78
4.5
Alternative Example (cont’d)
• Solution
– The ask price is $3.30 per contract.
– The total cost is: 25 × $3.30 × 100 = $8,250
– Since the strike price exceeds the current price,
($105.49) the put option is in-the-money.
1-14
Options on Other Financial Securities
• Although the most commonly traded options are on stocks,
options on other financial assets do exist.
• The most well known are options on stock indexes in the United
States such as the S&P 100 index, the S&P 500 index, the Dow
Jones Industrial index, and the NYSE index.
• In Canada, the Montreal Exchange’s only broad index option is
on the S&P TSX 60.
• Montreal also offers options on exchange-traded funds that
track the S&P TSX 60, various industry sectors, fixed income
products, and selected commodity prices.
1-15
Options on Other Financial
Securities (cont'd)
• Hedge
– To reduce risk by holding contracts or securities
whose payoffs are negatively correlated with some
risk exposure
• Speculate
– When investors use contracts or securities to place
a bet on the direction in which they believe the
market is likely to move
1-16
Option Payoffs at Expiration
Long Position in an Option Contract
– The value of a call option at expiration is
C = max (S − K , 0)
• Where S is the stock price at expiration, K is the exercise
price, C is the value of the call option, and max is the
maximum of the two quantities in the parentheses
1-17
1-18
Option Payoffs at Expiration (cont'd)
Long Position in an Option Contract
– The value of a put option at expiration is
P = max (K − S , 0)
• Where S is the stock price at expiration, K is the exercise
price, P is the value of the put option, and max is the
maximum of the two quantities in the parentheses
1-19
Example
1-20
Example (cont’d)
1-21
Alternative Example
You own a put option on Dell stock with an exercise
price of $12.50 that expires today. Plot the value of
this option as a function of the stock price.
1-22
Alternative Example (cont'd)
• Solution
Let S be the stock price and P be the value of the put
option. The value of the option is P = max(12.50 – S,0)
14
12
Payoff ($)
10
8
6
4
2
0
0
-2
2
4
6
8
10
12
14
16
18
20
Stock Price ($)
1-23
Short Position in an Option Contract
An investor that sells an option has an obligation.
– This investor takes the opposite side of the contract
to the investor who bought the option. Thus the
seller’s cash flows are the negative of the buyer’s
cash flows.
1-24
1-25
Example
1-26
Example (cont’d)
1-27
Profits for Holding an Option to
Expiration
Although payouts on a long position in an option
contract are never negative, the profit from
purchasing an option and holding it to expiration
could be negative because the payout at expiration
might be less than the initial cost of the option.
1-28
1-29
Example
1-30
Example (cont’d)
1-31
Combinations of Options
• Straddle
– A portfolio that is long a call option and a put
option on the same stock with the same exercise
date and strike price
• This strategy may be used if investors expect the stock to
be very volatile and move up or down a large amount,
but do not necessarily have a view on which direction the
stock will move.
1-32
1-33
Combinations of Options (cont'd)
• Strangle
– A portfolio that is long a call option and a put
option on the same stock with the same exercise
date but the strike price on the call exceeds the
strike price on the put
1-34
Example
1-35
Example (cont’d)
1-36
Combinations of Options (cont'd)
• Butterfly Spread
– A portfolio that is long two call options with
differing strike prices, and short two call options
with a strike price equal to the average strike price
of the first two calls
• While a straddle strategy makes money when the stock
and strike prices are far apart, a butterfly spread makes
money when the stock and strike prices are close.
1-37
1-38
Combinations of Options (cont'd)
• Protective Put
– A long position in a put held on a stock you already
own
• Portfolio Insurance
– A protective put written on a portfolio rather than
a single stock. When the put does not itself trade,
it is synthetically created by constructing a
replicating portfolio
1-39
Combinations of Options (cont'd)
• Portfolio insurance can also be achieved by
purchasing a bond and a call option.
1-40
1-41
Put-Call Parity
• Consider the two different ways to construct
portfolio insurance discussed above.
– Purchase the stock and a put
– Purchase a bond and a call
• Because both positions provide exactly the same
payoff, the Law of One Price requires that they
must have the same price.
1-42
Put-Call Parity (cont'd)
• Therefore,
S + P = PV (K ) + C
– Where K is the strike price of the option (the price
you want to ensure that the stock will not drop
below), C is the call price, P is the put price, and S
is the stock price
1-43
Put-Call Parity (cont'd)
Rearranging the terms gives an expression for the
price of a European call option for a non-dividendpaying stock.
C = P + S − PV (K )
– This relationship between the value of the stock,
the bond, and call and put options is known as
put-call parity.
1-44
Example
Assume:
• You want to buy a one-year call option and put option on Dell.
• The strike price for each is $25.
• The current price per share of Dell is $21.87.
• The risk-free rate is 5.5%.
• The price of each call is $2.85
Using put-call parity, what should be the price of each put?
1-45
Example (cont’d)
• Solution
– Put-Call Parity states:
S + P = PV (K ) + C
$25
$21.87 + P =
+ $2.85
1.055
P = $4.68
1-46
Put-Call Parity (cont'd)
If the stock pays a dividend, put-call parity becomes
C = P + S − PV (K ) − PV (Div)
1-47
ADM 2352
Finance Theory
Lecture 9
Financial Options (Part II)
• Readings:
– Chapter 14: Sections 4, 5 and 6
• Recommended problems:
– 21, 24, 25, 22, 23, 26, 30
• Group Discussion
– “Explain to your group members the rationale behind the statement
that equity is a call option on the firm's assets. When would a
shareholder allow the call to expire? ”
Factors Affecting Option Prices
• Strike Price and Stock Price
– The value of a call option increases (decreases) as
the strike price decreases (increases), all other
things held constant.
– The value of a put option increases (decreases) as
the strike price increases (decreases), all other
things held constant.
Arbitrage Bounds on Option Prices
• An American option cannot be worth less than its European
counterpart.
• A call option cannot be worth more than the stock itself.
– The lower K, the higher is the value of C.
– If K = 0, then payoff = S
– In other words, if K =0, the holder of the call option would always exercise
and receive a stock at no cost (S). Accordingly, C can not be > S
• A put option cannot be worth more than its strike price:
– The maximum payoff for a put option occurs if S = 0, thus payoff = K
– Because payoff of K is the highest possible payoff, P cannot be > K
Arbitrage Bounds on Option
Prices (cont'd)
• Intrinsic Value of an option
– It is the value of the option if it expired immediately
– The amount by which an option is in-the-money, or zero
if the option is out-of-the-money
• An American option cannot be worth less than its
intrinsic value
– Otherwise, you could make arbitrage profits by purchasing the
option and immediately exercising it.
Arbitrage Bounds on Option
Prices (cont'd)
• Time Value of an option
– The difference between an option’s price and its
intrinsic value
• An American option cannot have a negative time value.
Option Prices and the Exercise Date
For American options, the longer the time to the
exercise date, the more valuable the option
– An American option with a later exercise date
cannot be worth less than an otherwise identical
American option with an earlier exercise date.
• However, a European option with a later exercise date
can be worth less than an otherwise identical European
option with an earlier exercise date
Option Prices and Volatility
The value of an option generally increases with the
volatility of the stock.
Example
Example (cont’d)
Exercising Options Early
Although an American option cannot be worth less than
its European counterpart, they may have equal value.
Non-Dividend-Paying Stocks
C = P + S − PV (K )
For a non-dividend paying stock, Put-Call Parity can
be written as
C = S - K + dis(K ) + P
Intrinsic value
Time value
where dis(K) is the amount of the discount from face
value of the zero-coupon bond K: dis (K) = K- PV(K)
Non-Dividend-Paying Stocks (cont'd)
Because dis(K) and P must be positive before the
expiration date, a European call always has a
positive time value.
– Since an American option is worth at least as much
as a European option, it must also have a positive
time value before expiration.
• Thus, the price of any call option on a non-dividendpaying stock always exceeds its intrinsic value prior to
expiration.
Non-Dividend-Paying Stocks (cont'd)
This implies that it is never optimal to exercise a
call option on a non-dividend-paying stock early.
– You are always better off just selling the option.
– Because it is never optimal to exercise an American
call on a non-dividend-paying stock early, an
American call on a non-dividend-paying stock has
the same price as its European counterpart.
Non-Dividend-Paying Stocks (cont'd)
However, it may be optimal to exercise a put option
on a non-dividend-paying stock early.
P = K – S – dis (K ) + C
Intrinsic value
Time value
Non-Dividend-Paying Stocks (cont'd)
When a put option is sufficiently deep in-themoney, dis(K) will be large relative to the value of
the call, and the time value of a European put
option will be negative. In that case, the European
put will sell for less than its intrinsic value.
– However, its American counterpart cannot sell for
less than its intrinsic value, which implies that an
American put option can be worth more than an
otherwise identical European option.
Example
Example (cont’d)
Dividend-Paying Stocks
The put-call parity relationship for a dividend-paying
stock can be written as
C = S – K + dis (K ) + P – PV (Div)
Intrinsic value
Time value
– If PV(Div) is large enough, the time value of a European
call option can be negative, implying that its price could
be less than its intrinsic value.
– Because an American option can never be worth less
than its intrinsic value, the price of the American option
can exceed the price of a European option.
Dividend-Paying Stocks (cont'd)
With a dividend-paying stock, it may be optimal
to exercise the American call option early.
– When a company pays a dividend, investors expect
the price of the stock to drop. When the stock
price falls, the owner of a call option loses. Unlike
the owner of the stock, the option holder does not
get the dividend as compensation.
• However, by exercising early and holding the stock, the
owner of the call option can capture the dividend.
Example
Example (cont'd)
Dividend-Paying Stocks (cont'd)
The put-call parity relationship for puts can be
written as
P = K – S + C – dis (K ) + PV (Div)
Intrinsic value
Time value
– As stated earlier, European options may trade for
less than their intrinsic value.
• On the next slide, note that all the puts with a strike price
of $1800 or higher trade for less than their exercise value.
Options and Corporate Finance
Equity as a Call Option
– A share of stock can be thought of as a call option on
the assets of the firm with a strike price equal to the
value of debt outstanding.
• If the firm’s value does not exceed the value of debt
outstanding at the end of the period, the firm must declare
bankruptcy and the equity holders receive nothing.
• If the value exceeds the value of debt outstanding,
the equity holders get whatever is left once the debt has
been repaid.
Options and Corporate Finance
A share of stock can be thought of as a call option on
the assets of the firm (A) with a K = D.
Long Position on Call Option
Total payoff to shareholders
If A < D
0
0
If A = D
0
0
If A > D
A-D
A-D
Debt as an Option Portfolio
Debt holders can be viewed as owners of the firm
having sold a call option with a strike price equal to the
required debt payment.
– If the value of the firm exceeds the required debt payment,
the call will be exercised; the debt holders will therefore
receive the strike price and give up the firm.
– If the value of the firm does not exceed the required debt
payment, the call will be worthless, the firm will declare
bankruptcy, and the debt holders will be entitled to the firm’s
assets.
Options and Corporate Finance
Debt holders can be viewed as owners of the firm
having sold a call option with a K = D
Short Position on Call Option
Asset of the firm (A)
Total payoff to debt holders
If A < .D
0
A
A
If A = D
0
A
A
If A > D
- (A – D)
A
D
Debt as an Option Portfolio (cont'd)
• Debt can also be viewed as a portfolio of riskless debt and a
short position in a put option on the firm’s assets with a strike
price equal to the required debt payment.
Risky debt = Risk-free debt – Put option on firm assets
– When the firm’s assets are worth less than the required
debt payment, the owner of the put option will exercise the
option and receive the difference between the required
debt payment and the firm’s asset value. This leaves the
debt holder with just the assets of the firm.
– If the firm’s value is greater than the required debt payment,
the debt holder only receives the required debt payment.
Debt as an Option Portfolio (cont'd)
Debt can also be viewed as a portfolio of riskless debt and a short
position in a put option on the firm’s assets with K = D
Risk-free debt : D
Short Position on Put Option
Total payoff to debt holders
If A < D
D
- (D - A)
A
If A = D
A=D
0
A
If A > D
D
0
D
Real Options:
An Introduction
ADM 2352
Finance Theory
Lecture 10
1-0
• Readings:
– Chapter 16: Sections 1 and 2
– “Management Views on Real Options in Capital
Budgeting ” (Kent Baker, Shantanu Dutta, and Samir Saadi, Journal
of Applied Finance, Spring/Summer 2011, 21 (1), pp. 18-29.)
• Recommended problems:
– 1, 2, 3, 4, and 5
• Group Discussion
– “Discuss whether the economic uncertainty induced
by COVID-19 would boost the use of real options in
capital budgeting process.”
Real Versus Financial Options
• Real Option
– The right to make a particular business decision,
such as a capital investment
– A key distinction between real options and
financial options is that real options, and the
underlying assets on which they are based, are
often not traded in competitive markets.
Use of Real Options in Canada
(Baker, Dutta and Saadi, 2011)
Why Canadian Firms Do Not Use Real Options
(Baker, Dutta and Saadi, 2011)
Decision Tree Analysis
Assume Sarah is financing part of her MBA
education by running a small business. She
purchases goods on eBay and resells them at
swap meets.
– Swap meets typically charge her $500 in advance
to set up her small booth. Ignoring the cost of the
booth, if she goes to every meet, her average
profit on the goods that she sells is $1100 per
meet.
Decision Tree Analysis (cont'd)
The decision tree showing Sarah’s options looks
like the one on the following slide.
– Because the NPV of setting up a booth is $600, the
optimal decision (shown in blue) would be to set
up the booth.
• $1100 – $500 = $600
Sarah’s Choices
Mapping Uncertainties on a Decision
Tree
Sarah is aware that attendance at swap meets is
weather-dependent.
– In good weather her profits are $1500.
– In bad weather she will incur a loss of $100.
• There is a 25% chance of bad weather.
This adds an element of uncertainty for Sarah to
consider.
The Effect of the Weather on Sarah’s
Options
Mapping Uncertainties
on a Decision Tree (cont'd)
• Decision Nodes
– A node on a decision tree at which a decision is made
– Corresponds to a real option
• Information Nodes
– A type of node on a decision tree indicating
uncertainty that is out of the control of the decision
maker
Mapping Uncertainties
on a Decision Tree (cont'd)
• In Sarah’s case
– The square node represents the decision to pay
the fee and go to the swap meet or do nothing.
– The round node represents the uncertain state of
nature, sunshine versus rain.
• In this case, Sarah must commit to going to the meet
before she knows what the weather will be.
Mapping Uncertainties
on a Decision Tree (cont'd)
In reality, Sarah does not have to commit to going
to the swap meet before she knows the weather
conditions.
– Sarah understands that the $500 loss for the booth
is unavoidable, but in bad weather she can simply
stay home and not incur the additional $100 loss
at the meet.
Sarah’s Decision Tree when She Can Observe the
Weather before She Makes the Decision to Go to
the Meet
Real Options
Sarah’s option to wait until she finds out what the
weather is like before she decides whether she
should go to the meet is a real option.
– This flexibility has value to Sarah.
Real Options (cont'd)
The value of the real option can be computed by
comparing her expected profit without the real
option to wait until the weather is revealed to the
value with the option to wait.
Real Options (cont'd)
• If Sarah commits to go regardless of the
weather, her expected profit is $1100.
0.75 × $1500 + 0.25 × (–$100) = $1100
• However, if she goes only when the weather is
good, her expected profit is $1125.
0.75 × $1500 + 0.25 × $0 = $1125
• The value of the real option is the difference, $25
Real Options (cont'd)
If Sarah has to pay for the booth only the day
before the meet, the NPV of paying for the booth
(ignoring discounting for one day) is $625.
$1125 – $500 = $625
• Since the NPV is positive, Sarah should always pay for
the booth.
Real Options (cont'd)
• Corporations face similar options.
– The option to delay an investment opportunity
– The option to grow
– The option to abandon an investment opportunity
NPV and Real Options
• NPV:
– Ignores strategic values
• Real Option Valuation:
– Values contingencies in project outcomes (i.e.,
alternative future uses of the asset).
Managerial (Real) Options
Management flexibility to make future
decisions that affect a project’s expected
cash flows, life, or future acceptance.
Project Worth = NPV + Option(s) Value
Type of Real Options
• Many Types of Real Options
– Key is to identify real options (if-then…)
– Often they are difficult to value – however, even
using judgment one can tell if they add value to
the project
Type of Real Options
• Initiation or Deferment Options
– The option to choose when to start a project is an
initiation or deferment option.
• Examples:
– Initiation options are particularly valuable in
natural resource exploration where a firm can
delay mining a deposit until market conditions are
favorable.
– The purchaser of an off-shore lease can choose
when, if at all, to develop property.
Type of Real Options
• Initiation or Deferment Options (Cont.)
Extracting Oil Sands
Type of Real Options
• Growth Options
– The value of the firm can exceed the market value of the
projects currently in place because the firm may have the
opportunity to undertake positive NPV projects in the future.
– Standard capital budgeting techniques involve establishing the
present value of these projects based on anticipated
implementation dates.
– However, this implicitly assumes that the firm is committed to
go ahead with the projects.
Type of Real Options
• Growth Options (Cont.)
– Since management need not make such a commitment,
they retain the option to exercise only those projects
that appear to be profitable at the time of initiation.
• Example:
– High-tech and software industries (where there are
significant first-mover advantages)
Types of Real Options
• Option to Contract
– Some projects can be engineered in such a way that
output can be contracted in future (e.g.
Modularization of project.
Types of Real Options
• Option to Expand
– Build production capacity or the infrastructure for the capacity
in excess of expected level of output (so it can produce at
higher rate if needed).
– Management has the right (not the obligation to expand). If
project conditions turn out to be favorable, management will
exercise this option.
Types of Real Options
• Option to Expand or Contract (Switching Option)
Example: A project whose operation can be dynamically
turned on and off (or switched to two distinct locations)
is worth more than the same project without the
flexibility to switch.
Types of Real Options
• Abandonment or Termination Options
– Whereas traditional capital budgeting analysis assumes that a
project will operate in each year of its lifetime, the firm may
have the option to cease a project during its life. This option is
known as an abandonment or termination option.
– Abandonment options are the right to sell the cash flows over
the remainder of the project's life for some salvage value.
Types of Real Options
• Abandonment or Termination Options
Examples
– These options are particularly important for large capitalintensive projects such as nuclear plants, airlines, and
railroads. They are also important for projects involving new
products where their acceptance in the market is uncertain.
Types of Real Options Used by Canadian Firms
(Dutta, Baker and Saadi, 2011)
ADM 2352
Finance Theory
Lecture 11
Raising Capital
• Readings:
– Chapter 23
• Recommended problems:
– 1, 2, 9, 10, 11, 13, 14, and 15.
• Group Discussion
– “Why is it so difficult to determine the appropriate price for an IPO?
Who do you think has the most input: the issuing firm, the
underwriter, or investors? Explain.”
Outline
• The Financing Life Cycle of a Firm: Early-Stage
Financing and Venture Capital.
• The Public Issue
• The Basic Procedure for a New Issue
• IPOs and Under-pricing
• New Equity Sales and the Value of the Firm
• Why Firms Go Public?
• Issuing Long-Term Debt
Equity Financing
for Private Companies
• The initial capital that is required to start a
business is usually provided by the entrepreneur
and their immediate family.
• Often, a private company must seek outside
sources that can provide additional capital
for growth.
– It is important to understand how the infusion of
outside capital will affect the control of the company.
A few rules of Nature…
• Nobody, in their right mind, wishes to purchase a
product from a new, unproven vendor
• Nobody wishes to gamble away precious resources
in an unproven model, company and/or team
• Visionaries are either 1) crazy or 2) dreamers until
proven to be visionaries
Intuitive statistics …
Assume a sample of 100 people who claim to desire
becoming entrepreneurs:
– 2 are genetic mutants that will pursue their dreams no matter what
– 8 are fence-sitters – they budge either side of the fence based on
surrounding culture
– 90 will dream their entire lives and/or support the 2-10 entrepreneurs
The miracle of Silicon Valley
– CULTURE that converts the 8 fence sitters into entrepreneurs
The challenge outside Silicon Valley
– Not losing the 2 freaks to Silicon Valley…
“Raison d’être” for a startup…
• Sole reason:
✓New problem looking for a yet non-existent solution
✓Greenfield opportunity where the rules of the game
get established and sustained (usually) by the first
mover
• Technology is only a means to an end
• The end is to provide a solution that is at first
“good-enough” because no one else is solving the
problem
• In order for value to be created, you need to solve
bigger problems than the ones you end up creating
Sources of Funding
• Angel Investors
– Individual Investors who buy equity in small private
firms
• Finding angels is typically difficult.
• Institutional Investors
– Institutional investors such as pension funds,
insurance companies, endowments, and foundations
are active investors in private companies
• Institutional investors may invest directly in private firms or
they may invest indirectly by becoming limited partners in
venture capital firms.
Sources of Funding (cont'd)
• Sovereign Wealth Funds (SWFs)
– Pools of money controlled by a government
– Usually raised from royalty, resource revenue, or taxes
that have been collected
– SWFs play an active role in the private equity market
and are the largest limited partners in global private
equity markets
– For Example, Kuwait Investment Board, the Alberta
Heritage Savings Trust Fund are both SWFs
– In 2013, the top 10 SWFs in terms of assets came from
Abu Dhabi, China (four funds), Singapore, Norway, Saudi
Arabia, Kuwait, and Russia
Sources of Funding (cont'd)
• Corporate Investors
– A corporation that invests in private companies
– Also known as Corporate Partner, Strategic Partner,
and Strategic Investor
• While most other types of investors in private firms are
primarily interested in the financial returns of their
investments, corporate investors might invest for
corporate strategic objectives, in addition to the financial
returns.
Sources of Funding (cont'd)
• Private Equity Firms
– Invest in the equity of existing privately held firms
rather than start-up companies.
– Private equity firms initiate their investment by
finding a publicly traded firm and purchasing the
outstanding equity, thereby taking the company
private in a transaction called a leveraged buyout
(LBO). In most cases, the private equity firms use
debt as well as equity to finance the purchase.
Largest Private Equity Firms in the World
Private Equity Firms in the World
Sources of Funding (cont'd)
• Venture Capital Firm
– A limited partnership that specializes in raising
money to invest in the private equity of young
firms
• Venture Capitalists
– One of the general partners who work for and run
a venture capital firm
Venture Capital
• Private financing of Greenfield opportunities (new
ideas, new businesses) in exchange for stock.
• The ultimate goal is usually to take the company
public and the VC will benefit from the capital raised
in the IPO.
• Many VC firms are formed from a group of investors
that pool capital and then have partners in the firm
decide which companies will receive financing.
• Usually entails some hands-on guidance.
Venture Capital
There are five types of suppliers of venture capital:
1. Old-line wealthy families.
2. Private partnerships and corporations.
3. Large industrial or financial corporations with established
venture-capital subsidiaries.
4. The federal government (through crown-related firms).
5. Individuals, typically with incomes in excess of $100,000 and
net worth over $1,000,000. Often these “angels” have
substantial business experience and are able to tolerate
high risks.
Top 5 Active Venture Capital Firms
VC Funding in Canada
Stages of Financing
1.
Seed-Money Stage:
Small amount of money to prove a concept or develop a product.
2.
Start-Up
Funds are likely to pay for marketing and product refinement.
3.
First-Round Financing
Additional money to begin sales and manufacturing.
4.
Second-Round Financing
Funds earmarked for working capital for a firm that is currently selling its
product but still losing money.
5.
Third-Round Financing
Financing for a firm that is at least breaking even and contemplating
expansion; a.k.a. mezzanine financing.
6.
Fourth-Round Financing
Financing for a firm that is likely to go public within six months; a.k.a.
bridge financing or pre-public stage
Risk and Stages of VC Financing
Stage of VC financing
Risk of Losing Investment Value
The Seed-stage
66%
The Start-up Stage
53%
The Second Round
34%
The Third Round
20%
The Fourth Round
20%
Choosing a Venture Capitalist
• Look for financial strength
• Choose a VC that has a management style that
is compatible with your own, but also a VC
that can recognize true entrepreneurs
• Obtain and check references
• What contacts does the VC have?
• What is the exit strategy?
21
What makes a good VC?
• Clarity of roles
✓ VCs do not manage companies
• Recognizing healthy cultures
✓ Self measured
✓ Transparent
✓ Ownership of issues (accountability)
• Strong financial network for future financing needs
• Strong human network to validate new trends and
opportunities = better quality of information
• Recognizing true entrepreneurs…
12-23
Outside Investors
• Preferred Stock
– Preferred stock issued by mature companies
usually has a preferential dividend and seniority in
any liquidation and sometimes special voting
rights.
– Preferred stock issued by young companies has
seniority in any liquidation but typically does not
pay regular cash dividends and often contains a
right to convert to common stock.
Outside Investors (cont'd)
• Convertible Preferred Stock
– Preferred stock that gives the owner an option to
convert it into common stock on some future date
Exiting an Investment
in a Private Company
• Exit Strategy
– It details how investors will eventually realize the
return from their investment.
– Investors exit in two main ways: through an
acquisition or through an initial public offering
(IPO).
– Often large corporations purchase successful startup companies by purchasing the outstanding stock
of the private company, allowing all investors to
cash out.
IPO Exit Strategy
12-27
The Public Issue
• Public issue – the creation and sale of
securities that are intended to be traded on
the public markets
• All companies on the TSE come under the
Ontario Securities Commission’s jurisdiction
Selling Securities to the Public
• Management must obtain permission from the Board of
Directors
• Firm must prepare and distribute copies of a preliminary
prospectus (red herring) to the OSC and to potential
investors
• OSC studies the preliminary prospectus and notifies the
company of required changes (usually takes 2 weeks)
• When the prospectus is approved, the price is
determined and security dealers can begin selling the
new issue
Alternative Issue Methods
• For equity sales, there are two kinds of public
issues:
– General Cash Offer – New securities offered for
sale to the general public on a cash basis.
– Rights Offer – New securities are first offered to
existing shareholders. These are more common
outside North America.
IPOs and SEOs
• IPO – Initial Public Offering (or unseasoned new
issue). A company’s first equity issue made
available to the public.
• SEO – Seasoned Equity Offering (a.k.a follow-on
offering). A new issue for a company that has
previously issued securities to the public.
10 Largest U.S. IPOs
12-32
Largest IPOs Worldwide
12-33
Largest IPOs Worldwide (details)
12-34
The World's Biggest IPO… Aramco
Proceeds: $29.4B for less than 2% of the company
Year: 2019
Investment bank(s): J.P. Morgan , Morgan Stanley and HSBC.
Underwriters
• Services provided by underwriters
–
–
–
–
Formulate method used to issue securities
Price the securities
Sell the securities
Price stabilization by lead underwriter
• Syndicate – group of underwriters that market the
securities and share the risk associated with selling
the issue
• Spread – difference between what the syndicate pays
the company and what the security sells for in the
market
Firm Commitment Underwriting
•
•
•
•
Also called a “bought deal”
Issuer sells entire issue to underwriting syndicate
The syndicate then resells the issue to the public
The underwriter makes money on the spread
between the price paid to the issuer and the price
received from investors when the stock is sold
• The syndicate bears the risk of not being able to sell
the entire issue for more than the cost
• Most common type of underwriting in Canada
Best Efforts Underwriting
• Underwriter must make their “best effort” to sell
the securities at an agreed-upon offering price
• The company bears the risk of the issue not being
sold
• The offer may be pulled if there is not enough
interest at the offer price. In this situation, the
company does not get the capital and they have still
incurred substantial flotation costs
Dutch Auction Underwriting
• Underwriter conducts an auction and investors bid for
shares
• Offer price is determined based on the submitted bids
• More commonly used in bond markets
• Also called uniform price auction
Example
– Ashton, Inc., is selling
900,000 shares of stock
in an auction IPO.
– At the end of the
bidding period,
Ashton’s investment
bank has received the
following bids.
Price ($)
Number of
Shares Bid
$10.00
$9.75
175,000
200,000
$9.50
275,000
$9.25
275,000
$9.00
300,000
What will the offer price of the shares be?
Example
Ashton is selling 900,000 shares
Price ($)
Number of Shares Bid
Cumulative number of Shares
Bid
$10.00
$9.75
$9.50
$9.25
$9.00
175,000
200,000
275,000
275,000
300,000
175,000
375,000
650,000
925,000
1,225,000
The offer price is $9.25 per share
Over Allotment Option
• Over allotment Option / Green Shoe provision
– Allows syndicate to purchase an additional 15% of
the issue from the issuer
– Allows the issue to be oversubscribed
– Provides some protection for the lead underwriter
as they perform their price stabilization function
Over Allotment Option
Additional Details
• Lockup Agreements – Specify how long insiders
must wait after an IPO before they can sell stock,
usually 180 days
• Quiet Period – For a few weeks before and
following an IPO, the OSC requires that all
communications with the public are limited to
ordinary announcements
IPO Puzzles
Four characteristics of IPOs puzzle financial
economists and are relevant for the financial
manager:
1.
2.
3.
4.
On average, IPOs appear to be underpriced.
The number of issues is highly cyclical.
The costs of the IPO are very high.
The long-run performance of a newly public
company (3 to 5 years from the date of issue) is poor.
IPO Underpricing
• May be difficult to price an IPO because there isn’t a
current market price available
• Additional asymmetric information associated with
companies going public
• Underwriters want to ensure that their clients earn a
good return on IPOs on average (avoid “winner’s curse”)
• Underpricing causes the issuer to “leave money on
the table”
IPO Underpricing
• Underpricing:
[Closing price on the first day - Offer price]/ Offer price
• “Money left on the table”:
[Closing price on the first day - Offer price] x N of shares sold
Examples
IPO year
Amount left on the
Table
Offer Price
First Closing Price
United Parcel Service
1999
$1,597,240,000
$50.00
$68.25
Corvis
2000
$1,539,512,500
$36.00
$84.72
Palm
2000
$1,312,437,500
$38.00
$184.75
Company
Average First-Day Returns
15-48
Average First-Day Returns—cont.
15-49
Average Initial Returns for SEC-Registered IPO’s:
1960 to 2011
Number of Offerings for SEC-Registered IPOs:
1960 to 2011
12-52
IPO Underpricing Around the World
“Every single country in the world
has IPOs underpriced on average.”
Jay Ritter, University of Florida
30%
20%
Average first-day returns
Average first-day returns on (mostly) European IPOs
50%
40%
10%
0%
Switzerland
Singapore
Sweden
Germany
Greece
Poland
Italy
United States
Finland
United Kingdom
Hong Kong
Israel
Belgium
Spain
Turkey
France
Netherlands
Norway
Chile
Denmark
Canada
Austria
Country
170%
160%
150%
140%
130%
120%
110%
100%
90%
80%
70%
60%
50%
40%
30%
20%
10%
0%
Average first-day returns
Average first-day returns on (mostly) non-European IPOs
China (A shares)
India
Malaysia
Korea
Brazil
Japan
Taiwan
Thailand
South Africa
Switzerland
Singapore
Iran
New Zealand
Australia
United States
Hong Kong
Mexico
Israel
Nigeria
Turkey
Chile
Canada
Country
Possible reasons for Under-pricing
• Compensation for investors (Signaling):
IPO firms “leave something on the table” as a quality signal.
• Compensation for underwriters:
Frequent story: “underwriters provide a difficult to measure
service to IPO firm”
• Book-building:
Investors will not truthfully demand (price and quantity),
unless there is some combination of more IPO allocation and
underpricing.
Possible reasons for Under-pricing
• Herding effects:
Based on the behaviour of others, investors make the same
choice, independent of his/her private signal.
• Litigation insurance:
There may be investors’ litigation if stock price drops after the IPO.
• Marketing expense:
A “hot” IPO gets a lot of press. Underpricing is a substitute for
costly marketing expenditures: An extra dollar left on the table
reduces other marketing expenses by a dollar.
• Hot Periods/Bubbles:
Irrational investors. Managers take advantage of investor overoptimism
Cyclicality
• The number of issues is highly cyclical.
– When times are good, the market is flooded with
new issues; when times are bad, the number of
issues dries up.
Cyclicality of IPO…
Costs of Issuing an IPO
• A typical spread is 7% of the issue price.
– By most standards this fee is large, especially
considering the additional cost to the firm
associated with underpricing.
– It is puzzling that there seems to be a lack of
sensitivity of fees to issue size.
• One possible explanation is that by charging lower fees,
an underwriter may risk signaling that it is not the same
quality as its higher-priced competitors.
Long-run IPO Under-performance
“By the middle of 2001, 97% of
Internet companies were trading
below the offer price.”
Jay Ritter, University of Florida
Long-run IPO (under)performance
during the first five years after issuing.
% returns on IPOs from 1970-2010
12-62
12-63
12-64
Long-run IPO (under)performance .
1970-1979.
1980-1989.
1990-1999
2000-2010
12-65
Why do firms go public?
• IPOs make firm shares more liquid, which increases firm value.
• Public companies subject themselves to monitoring by
outsiders (e.g. analysts, investors, OSC), activities which also
might enhance the value of the firm.
• Firms can learn from the information contained in stock prices.
High prices may signal increased growth opportunities
• Signals stability to customers and suppliers.
• Firms issue equity when it is “convenient” – when equity is
overvalued (Market Timing).
• Prestige
Costs of going public
• IPO creates substantial fees: Legal, accounting, investment
banking fees.
• Spread, i.e., difference between what the syndicate pays the
company and what the security sells for in the market.
• First day under-pricing.
• Greater degree of disclosure and scrutiny.
• Opportunity costs, i.e., management time spent working on
issue
Where Have All the IPOs Gone?
12-68
Is the IPO Market Dead?
The IPO market is largely viewed as a sentiment indicator
for the economy as a whole. Recently, discussions have
revolved around an the “death of the IPO market”:
Let’s take a look at key figures for the U.S. (as of March 22, 2015):
– 25 total IPOs year to date, compared to 47 IPOs at this point last
year (a 44% decline)
– 9 IPOs from the Biotechnology and Medical Specialties
(compared to 20 last year)
IPO activity this year is well below the pace of 2014. Is that
reason to be worried?
The Rise of Unicorns…
12-70
Types of Long-term Debt
• Bonds – public issue of long-term debt
• Private issues
– Term loans
• Direct business loans from commercial banks, insurance
companies, etc.
• Maturities 1 – 5 years
• Repayable during life of the loan
– Private placements
• Similar to term loans with longer maturity
• Involves investment dealer
• In the event of default, they are easier to renegotiate than
public issues (because fewer holders are involved)
• Lower costs than public issues (no OSC registration, no full
prospectus,…), but have more restrictive covenants
ADM 2352
Finance Theory
Lecture 12
Corporate Governance
• Readings:
– Chapter 29
• Group Discussion
– “What is the objective behind the stock option plan of
executives? In reality, does it achieve this objective?”
Principal-Agent Relation
Hire
and create
Principal-Agent Relation
Basics of Corporate Governance
• Principal and agent have divergent interests and goals
• Shareholders lack direct control of large, publicly traded
corporations
• Agent makes decisions that result in the pursuit of goals
that conflict with those of the principal
• It is difficult or expensive for the principal to verify that
the agent has behaved appropriately
• Agent falls prey to managerial opportunism
What is Corporate Governance?
It is the internal means by which a corporations are
operated and controlled … which involve a set of
relationships between a company’s management, its
board, its shareholders and other stakeholders.
Other Definitions
• "Corporate governance is about promoting corporate fairness,
transparency and accountability" J. Wolfensohn, president of
the Word bank, as quoted by an article in Financial Times, June
21, 2001.
• “Corporate governance deals with the ways in which suppliers
of finance to corporations assure themselves of getting a return
on their investment”, Shleifer and Vishny, The Journal of
Finance (1997, page 737).
• “The directors of companies, being managers of other people's
money than their own, it cannot well be expected that they
should watch over it with the same anxious vigilance with
which the partners in a private co-partnery frequently watch
over their own.” Adam Smith, The Wealth of Nations 1776
Corporate Governance and Agency
Problems
The system of controls, regulations, and incentives
designed to minimize agency costs between managers
and investors and prevent corporate fraud.
Hence, the role of the corporate governance system is
to mitigate the conflict of interest that results from
the separation of ownership and control without
unduly burdening managers with the risk of the firm.
Good Corporate Governance Practices
– Shareholder rights. Shareholders are the owners of the firm, and
their interests should take precedence over other stakeholders.
– Board responsibilities. The board of the company is recognized as
the individual entity with final full legal responsibility for the firm,
including proper oversight of management.
– Equitable treatment of shareholders. Equitable treatment is
specifically targeted toward domestic versus foreign residents as
shareholders, as well as majority and minority interests.
– Disclosure and transparency. The corporate governance framework
should ensure that timely and accurate disclosure is made on all
material matters regarding the corporation, including the financial
situation, performance, ownership, and governance of the company
Shareholder rights
• Secure ownership registration
• Capability to transfer ownership
• Access to relevant corporate
information
• Participation and voting at
shareholder meetings
• Election and removal of board
members
• Share in profits of the corporation
• Knowledge of extraordinary
transactions or decisions
• Disclosure of dual-class shares
• Capability to exercise ownership
rights
The Structure of Corporate Governance
1-11
Who is ultimately responsible…?
Principles of corporate governance make clear that
the board of directors has ultimate responsibility
for governance.
Monitoring by the Board of Directors
and Others
In principle, the board of directors hires the
executive team, sets its compensation, approves
major investments and acquisitions, and dismisses
executives if necessary.
Monitoring by the Board of Directors and
Others (cont’d)
– In Canada, the Canada Business Corporations Act (CBCA),
Section 122.1, defines the board’s duty to act in the best
interest of the Corporation.
– While the U.S. and Canadian board duties may sound
equivalent, Canadian courts have sometimes interpreted “the
corporation”to include stakeholders in addition to shareholders
(for example, bondholders).
– Most other countries give some weight to the interests of other
stakeholders in the firm, such as the employees.
Responsibilities of Board
• Board’s written mandate must include board’s
satisfaction with integrity of CEO and other
executives and that they are creating a culture
of integrity (Canadian Stock Exchanges)
• Board must apply high ethical standards and
take into account the interests of stakeholders
Board Structure
• Board committee examples:
– audit; finance; human resources; pension; compensation;
nominating; governance; and strategic planning.
• The Sarbanes-Oxley Act of 2002 (SOX) requires that
the audit committee of the board, charged with
overseeing the audit of the firms financial statements,
be composed entirely of independent directors.
• Most experts recommend separation between the
role of the board chair and the CEO.
Types of Directors
• Inside Directors
– Members of a board of directors who are
employees, former employees, or family members
of employees
• Grey Directors
– Members of a board of directors who are not as
directly connected to the firm as insiders are, but
who have existing or potential business relationships
with the firm
Types of Directors (cont'd)
• Outside (Independent) Directors
– Any member of a board of directors other than an
inside or gray director
Board Independence
• On a board composed of insider, gray, and independent
directors, the role of the independent director is really that of a
watchdog.
– However, because independent directors’personal wealth is likely
to be less sensitive to performance than that of insider and gray
directors, they have less incentive to closely monitor the firm.
– There has been a trend toward more equity-based pay for outside
directors. It is now standard for outside directors to be granted
shares of stock and/or options to more closely align their interests
with the shareholders they serve.
Board Independence (cont'd)
• Captured
– Describes a board of directors whose monitoring duties have
been compromised by connections, perceived loyalties to
management or compensation/incentive structure
Board Size and Performance
Researchers have found the surprisingly robust
result that smaller boards are associated with
greater firm value and performance.
– The likely explanation for this phenomenon comes
from the psychology and sociology research, which
finds that smaller groups make better decisions than
larger groups.
Other Monitors
• The board is complemented by other monitors,
both inside and outside the firm.
• Other monitors include
– Security analysts
– Lenders
– Auditors
– The securities commissions
– Employees within the firm itself
Managing Agency Conflict:
Executive Compensation
1) It must attract executives with the skills, experiences,
and behavioral profile necessary to succeed in the
position.
2) It must be sufficient to retain these individuals, so they
do not leave for alternative employment.
3) It must motivate them to perform in a manner
consistent with the strategy and risk-profile of the
organization and discourage self-interested behavior.
What High Performers Want?
(source: SAP Success Factors 2014)
1-25
Structure of CEO Pay
Executive compensation usually includes:
– Cash Compensation
• Salary and Bonuses
• Other cash
– Long-term incentives
• Stock options
• Restricted stock awards
– Other Long-Term Compensation
• Retirement contributions
• Tax reimbursement
• Life insurance premiums etc.
A good compensation package should be one that ties the managers’
interests to shareholders’ interests and thus reduces agency costs.
Compensation Policies
• Stock and Options
– Managers’ pay can be linked to the performance
of a firm in many ways.
• Many companies have adopted compensation policies
that include grants of stock or stock options to
executives.
– These grants give managers a direct incentive to increase
the stock price which ties managerial wealth to the wealth
of shareholders.
CEO Pay in Canada
Compared to the average salary of a Canadian worker, the top
100 CEOs made on average:
•
•
•
•
•
•
•
•
•
•
104 times more in 1998
.
168 times more in 2008
155 times more in 2009
189 times more in 2010
171 times more in 2012
195 times more in 2013
184 times more in 2014
192 times more in 2015
209 times more in 2016
In 2016, Canada’s 100 highest-paid CEOs made on average $10.4
million — 209 times the overall average income of $49,738 that year.
(Canadian Centre for Policy Alternatives)
How long does it take...?
According to the Canadian Centre for Policy
Alternatives (CCPA), by 12:18 p.m. on Jan. 4, 2016, the
first official working day of the year, the country's top
100 CEOs have already pocketed what it takes most
Canadians an entire year, working full-time, to earn.
“By 10:57 a.m. on Jan. 2, 2017 Canada’s average top-
100 CEO will have already taken home what the
average Canadian worker will make all year.” (CCPA,
2018)
The Pay Clock
Average Amount Earned So Far
Pay and Performance Sensitivity (cont'd)
Recent research has found evidence suggesting
that many executives have engaged in backdating
their option grants.
Pay and Performance Sensitivity (cont'd)
• Backdating
– Backdating is the practice of choosing the grant date
of a stock option retroactively, so that the date of the
grant would coincide with a date when the stock
price was at its low for the quarter or for the year.
• By backdating the option in this way, the executive receives
a stock option that is already in-the-money.
– Canadian rules require firms to report option grants
within ten days of the end of the month in which the
options were granted
Pay-for-Performance?
• Institute for Policy Studies (U.S.): in 2012, about
“40% of top-paid CEOs busted, bailed out or
booted”
– 22% received taxpayer bailouts after the 2008 financial
crash.
– 8% were fired for poor performance but received golden
parachutes valued, on average, at $48 million US.
– 8% ran afoul of the law and paid fraud-related fines or
settlements.
Two Competing Hypotheses on Managerial Pay
CEO Excess Power
or
Optimal Contracting
Are CEOs Overpaid?
CEO pay has decreased since 2000
Down over 40% in real terms
1-36
The Ratio between the Top and the
Bottom is Arbitrary
“Arguing over whether a CEO should or
shouldn't be earning 50, 100 or 1,000
times what a worker earns is meaningless,
because there is no objective standard,...
It's completely arbitrary”
(Edwin Locke, industrial organizational psychologist, U. of Maryland, 2016)
How much is too much?
There is a market for CEOs
• The question isn't whether CEOs are paid too much but
whether or not they are paid above their market value.
• Companies have to offer huge salaries to attract
candidates already earning millions of dollars elsewhere.
• Whether it's fair that a CEO's salary is so much higher
than that of an average worker is not a relevant question
for the board of directors...
• The relevant question is whether the board is paying the
CEO the market wage. If the board is paying the CEO
above a market wage, that is a problem.
Critics Focus on the Highest-paid CEOs
(Kaplan, 2012)
How about CEOs of Smaller Firms?
(Kaplan, 2012)
How Have CEOs Done Relative to Others?
Over last 20 years, CEO pay relative to top 0.1% has
remained relatively constant.
Top CEOs VS. Top Hedge Fund Managers
(Kaplan, 2012)
Top CEOs VS. Lawyers at Top Law Firms
(Kaplan, 2012)
1-43
Top CEOs VS. Top Athletes
(Kaplan, 2012)
CEO turnover has increased since 1997
Turnover levels including takeovers:
• 13% per year from 1992 to 1997
• 16% per year from 1998 to 2010
Turnover levels not including takeovers:
– 10% per year from 1992 to 1997
– 12% per year from 1998 to 2010
CEO tenures have declined.. CEO job appears riskier than
what it used to be!
Other Factors to Consider
• Firms size: A talented CEO creates more value as a
firm becomes larger. In a competitive market, CEO
pay will be bid up as firms become larger.
– The six-fold increase in U.S. CEO pay since 1980 can be
explained by the six-fold growth in firm size over the same
period (Gabaix and Landier, 2008)
– During 2007-2009, firm value decreased by 17%, and CEO
pay by 28%. During 2009-2011, firm value increased by 19%
and CEO pay by 22%. (Gabaix et al , 2014)
• Risk taking: CEOs in the U.S. vs. rest of the world.
Are CEOs Paid for Performance?
Frydman and Saks (2010) study correlation between
executive’s wealth and firm performance:
• CEO wealth strongly tied to firm performance since the 1930s.
• The relationship “strengthened considerably” after mid-1980s.
Murphy (2012) reports “equity at stake” – the change in
CEO wealth from a 1% change in stock price – for median
S&P 500 CEO is almost $600,000 in 2010.
Managing Agency Conflict:
Managerial Ownership
Academic studies have supported the notion that greater
managerial ownership is associated with fewer valuereducing actions by managers.
– But while increasing managerial ownership may
reduce perquisite consumption, it also makes
managers harder to fire.
Managing Agency Conflict:
Payout Policy
• Consider a firm with excess cash.
• Consider a firm that has $1 million in cash after selecting
all available positive NPV projects.
• Managers will find it easier to squander funds if they have
a low dividend payout.
• Paying dividends can lessen agency problems between
managers and shareholders.
Managing Agency Conflict:
Direct Action by Shareholders
• Shareholder Voice
– Any shareholder can submit a resolution that is put
to a vote at the annual meeting.
• Recently, unhappy shareholders have started to refuse to
vote to approve the slate of nominees for the board.
Managing Agency Conflict:
Direct Action by Shareholders (cont'd)
• Shareholder Approval
– Shareholders must approve many major actions
taken by the board.
• For example, target shareholders must approve merger
agreements.
– A recent movement is to let shareholders have a
“say on pay,” vote. Typically this is a non-binding
vote to approve or disapprove of the compensation
plan for senior executives each year.
Managing Agency Conflict:
Threat of Takeover
Many of the provisions listed in the IRRC index
concern protection from takeovers.
– One motivation for a takeover can be to replace
poorly performing management.
• An active takeover market is part of the system through
which the threat of dismissal is maintained.
Managing Agency Conflict:
Regulation
• The Sarbanes-Oxley Act (SOX)
– The overall intent of SOX was to improve the
accuracy of information given to both boards and
to shareholders.
• SOX attempted to achieve this goal in three ways:
1. By overhauling incentives and independence in the
auditing process
2. By stiffening penalties for providing false information
3. By forcing companies to validate their internal financial
control processes
Criticism of Corporate
Governance Reform
• Audit fees have increased
• Management attention diverted away from operation of
business
• Additional costs have made North American business
less competitive in global market
• Approach should be principles-based, not rule-based
• Less companies are going public (IPO)
• Changes may not make a difference to firm performance
or in protection of shareholders
Corporate Governance
and Performance
• Some research suggests that nature of the relation
between good corporate governance firm
performance is not clear.
• But market does pay attention to annual rankings
of governance practices:
– Criteria: board composition, compensation,
shareholder rights, disclosure, returns (Report on
Business, The Globe and Mail)
– Criteria: returns, independence, accountability,
disclosure (Canadian Business Magazine)
Corporate Governance
Around the World
• Protection of Shareholder Rights
– The degree to which investors are protected
against expropriation of company funds by
managers and even the degree to which their
rights are enforced vary widely across countries
and legal regimes.
Does Corporate Governance Matter?
The Tradeoff
of Corporate Governance
• Corporate governance is a system of checks and
balances that trades off costs and benefits.
– This tradeoff is very complicated. No one structure
works for all firms.
– Good governance is value enhancing and is
something investors in the firm should strive for.