Chapter 1 - Investments: Background and Issues
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Investment vs. investments
Real assets vs. financial assets
Financial markets and the economy
Investment process
Competitive markets
Players in investment markets
Recent trends
Investments as a profession
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Investment vs. investments
Investment: the commitment of current resources in the expectation of deriving
greater resources in the future
For example:
You cut current consumption to purchase stocks and anticipate that stock prices
will rise in the future
You forgo current leisure and income to take the investments class and expect that
a degree from CSUN will enhance your future career
Investments
The detailed study of the investment process - focus of this class
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Real assets vs. financial assets
Real assets: assets used to produce goods and services
Financial assets: claims on real assets or income generated by real assets
Financial assets
Fixed-income securities: paying a fixed stream of income over a specified period CDs, bonds, T-bills, etc
Equity: ownership in a corporation - stocks
Derivative securities: their payoffs depend on the values of other assets - futures,
options, swaps, etc (FIN 436 - Futures and Options for more details)
Balance sheet for U.S. households, 2008 (Table 1.1 - Digital Image)
Real assets:
$26,395 billion (37.5%)
Liabilities: $14,496 billion (20.6%)
Financial assets: $44,071 billion (62.5%)
Net worth: $55,970 billion (79.4%)
Total
Total
$70,466 billion (100%)
1
$70,466 billion (100%)
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Financial markets and the economy
Informational role of financial markets
Consumption timing
Allocation of risk
Separation of ownership and management: agency problem
Corporate governance: accounting scandal, analyst scandal, IPO share allocation
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Investment process
(1) Investment policy: objective, risk-return trade-off
(2) Asset allocation: choice of broad asset classes
(3) Security selection: choice of particular securities to be held in the portfolio
(4) Security analysis: valuation of securities
(5) Portfolio construction and analysis: selection of the best portfolio
(6) Portfolio rebalancing: adjustment of the portfolio
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Competitive markets
Risk-return trade off: no free lunch rule indicates that assets with higher expected
returns entail greater risk
Efficient markets: security prices should reflect all the information available in the
market quickly and efficiently
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Players in investment markets
Government: federal, state, and local
Business: firms and corporations, including financial intermediaries
Individuals: individual investors, institutional investors
Financial intermediaries: institutions that connect borrowers and lenders such as
banks, investment companies, insurance companies, and credit unions, etc
Investment bankers: specializing in the sale of new securities to the public in the
primary market
Primary markets vs. secondary markets
Primary markets are markets for new issues of securities
Secondary markets are markets for trading previously issued securities
2
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Recent trends
Globalization: integration of global financial markets
Securitization: pooling loans into standardized securities
Financial engineering: creation of new securities by combining primitive and
derivative securities into one composite hybrid (for example, combining stocks
and options) or by separating returns on an asset into classes (for example,
separating principal from interest payment in a fixed income security)
Computer network
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Investments as a profession
Investment bankers
Traders and brokers
Security analysts and/or CFA (Chartered Financial Analyst)
Portfolio managers
Financial planners
Financial managers
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ASSIGNMENTS
1.
2.
2.
Concept Checks and Summary
Key Terms
Intermediate: 9 and 10
3
Chapter 2 - Asset Classes and Financial Instruments
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Money markets
Bond markets
Equity markets
Market indexes
Derivative markets
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Money markets
Money markets vs. capital markets
Money markets: short-term, highly liquid, and less-risky debt instruments
Capital markets: long-term debt and stocks
Securities in money markets:
T-bills: short-term government securities issued at a discount from face value and
returning the face amount at maturity
T-bills are issued weekly with initial maturities of 4 weeks, 13 weeks, 26 weeks,
and 52 weeks. The minimum denomination is $100, even though $10,000
denominations are more common. It is only subject to federal taxes and is tax
exempt from state and local taxes.
Bid vs. asked price
Bid price is the price you will receive if you sell a T-bill to a dealer
Asked price is the price you pay to buy a T-bill from a dealer
Asked price > bid price, the difference is called bid-ask spread - profit for a dealer
T-bills are quoted in yields based on prices (Figure 2.2 - Digital Image)
For example, a 161 day T-bill sells to yield 1.19% means that a dealer is willing to
sell the T-bill at a discount of 1.19%*(161/360) = 0.532% from its face value of
$10,000, or at $9,946.80 [10,000*(1 – 0.00532) = 9,946.80]. If an investor buys
this T-bill, the return over 161 days will be ($10,000/$9,946.80) - 1 = 0.535%.
The annualized return will be 0.535%*(365/161) = 1.213%.
Similarly, a dealer is willing to buy the 161 day T-bill at a discount of 1.20% or at
$9,946.33 for a face value of $10,000.
[10,000*(1 – 0.0120*(161/360)) = $9,946.33]
CDs: a bank time deposit
Commercial paper: a shot-term unsecured debt issued by large corporations
4
Banker’s acceptance: an order to a bank by a customer to pay a sum of money in a
future date
Repurchase agreements (Repos): short-term sales of government securities with
an agreement to buy them back later at a higher price
Other short-term debts
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Bond markets
T-notes and T-bonds: debt issued by the federal government with original
maturity of more than one year. The minimum denomination is $1,000.
T-notes: up to 10 years in maturity and pay semiannual interests
T-bonds: up to 30 years in maturity and pay semiannual interests
Coupon rate and coupon payments
Prices are quoted as a percentage of $100 face value (in units of 1/32 of a point)
(Figure 2.4 - Digital Image)
For example, a quoted price of 96:10 means a price of $96 10 32 (or $96.3125) for a
face value of $100, or $963.125 for a $1,000 face value bond.
Inflation-protected T-bonds (TIPS): the principal amount is adjusted in proportion
to increases in the Consumer Price Index to earn a constant stream of income in
real dollars
Municipal bonds: tax-exempt bonds issued by state and local governments
Equivalent taxable yield: r = rm /(1 – t)
After tax return: rm = r*(1 – t)
Example: suppose your marginal tax rate is 28%. Would you prefer to earn a 6%
taxable return or 4% tax-free yield? What is the equivalent taxable yield of the 4%
tax-free yield?
Answer: 6%*(1-28%) = 4.32%
or
4%/(1-28%) = 5.56%
You should prefer 6% taxable return because you get a higher return after tax,
ignoring the risk
5
Federal agency debt: issued by government agencies, such as Freddie Mac, Fannie
Mac, and Ginnie Mac
Corporate bonds: issued by corporations (rated from AAA, AA, A, BBB, BB, …)
Mortgages and mortgage-backed securities
Mortgage lenders originate different loans, including fixed or variable loans and
then bundle them in packages and sell them in the secondary market.
International bonds
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Equity markets
Common stock: ownership of a corporation
Characteristics: residual claim and limited liability
Stock market listing for General Electric (Figure 2.8 - Digital Image)
Stock Symbol (GE)
Close (Closing price is $25.25)
Net Change (-$0.43, the change from the closing price on the previous day)
Volume (trading volume is 44,302,631 shares)
52 week high and low (range of price, for GE, $42.15 - $22.16)
Dividend ($1.24 is the annual dividend, or $0.31 last quarter)
Dividend yield (1.24/25.25 = 4.9%)
P/E (price to earnings ratio is 12)
Preferred stock: hybrid security with both bond and common stock features
Cumulative and. non-cumulative preferred stocks
Tax treatment for firms: 70% of preferred stock dividends received by a firm is
tax-exempt (70% exclusion)
70% exclusion doesn’t apply to individuals
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Market indexes
Averages vs. indexes
Averages: reflect general price behavior in the market using the arithmetic
average, price weighted
Indexes: reflect general price behavior in the market relative to a base value,
market value weighted
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Dow Jones Industrial Average (DJIA): a stock market average made up of 30
high-quality industrial stocks and believed to reflect the overall stock market
Current Dow Companies (Table 2.6 - Digital Image)
Closing P1 + Closing P2 + ------ + Closing P30
DJIA = ---------------------------------------------------------DJIA divisor
S&P 500 index: a market value-weighted index made up of 500 big company
stocks and believed to reflect the overall market
 Current closing market value of stocks
S&P indexes = ----------------------------------------------------------- Based period closing market value of stocks
Market value (market cap) = market price * number of shares outstanding
Note: stocks in DJIA and S&P indexes can change
Other averages and indexes
Dow Jones transportation average (20 transportation stocks, price weighted)
Dow Jones utility average (15 utility stocks, price weighted)
Dow Jones composite average (65 stocks, including 30 industrial, 20
transportation, and 15 utility stocks, price weighted)
NYSE composite index: behavior of stocks listed on the NYSE
Nasdaq 100 index: OTC market stock behavior
Russell 2000 index: small stock behavior
Wilshire 5000 index (NYSE and OTC): overall stock market behavior
Market indexes, example 1
You are given the following information regarding stocks X, Y, and Z:
Date
0
1
2
X*
$50
26
27
Stock price
Y
Z
$50
$50
51
51
52
52
X*
100
200
200
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# of shares outstanding
Y
Z
100
100
100
100
100
100
* Stock X has a 2-for-1 stock split before trading on day 1. Date 0 is the base date.
The current divisor is 3.0 and the base value for an S&P type of index is supposed
to be10.
Q1. What would be the value of an S&P type index at the end of date 1?
26*200 + 51*100 + 51*100
S&P index = ------------------------------------- x 10 = 10.27
50*100 + 50*100 + 50*100
Rate of return on date 1 = (10.27/10) – 1 = 2.7%
Q2. What would be the value of an S&P type index at the end of date 2?
27*200 + 52*100 + 52*100
S&P index = ------------------------------------- * 10 = 10.53
50*100 + 50*100 + 50*100
Rate of return on two days = (10.53/10) – 1 = 5.3%
Q3. What would be the value of a DJIA type average at the end of date 2?
At the end of date 0: DJIA type average = (50 + 50 + 50) / 3 = 50
Before date 1: DJIA type average = (25 + 50 + 50) / d = 50, solve for d = 2.5
(Rational: A 2-for-1 stock split for stock X will split the price in half but it should
not affect the average itself. Therefore, the divisor should be adjusted.)
At the end of date 2: DJIA type average = (27 + 52 + 52) / 2.5 = 52.4
Rate of return on two days = (52.4 / 50) – 1 = 4.8%
Market indexes, example 2
Consider a price weighted market average composed of three securities, A, B, and
C, with prices of 20, 30 and 40 respectively. The current divisor is 3.00. What will
be the new divisor if stock B issues a 10% stock dividend?
Answer: closing average before stock dividend = (20 + 30 + 40) / 3.00 = 30.00
Adjust the price of stock B: 30 / (1 + 0.1) = 27.27 (new stock price for B if B
issues 10% stock dividend)
Calculate the new divisor: (20 + 27.27 + 40) / d = 30.00 (stock dividend should
not affect the closing average) and solve for the new divisor, d = 2.91
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Derivative markets
Derivative assets or contingent claims: payoffs depend on the prices of other
(underlying) assets
Options: the rights to buy or sell an asset at a specified price on or before a
specified expiration date (rights)
A call option gives the right to buy an asset
A put option gives the right to sell an asset
Example1 - you buy a March 140 IBM call option at $5.00
Call option: right to buy
Stock option: underlying asset is IBM stock
Contract size: 100 shares
Exercises price: $140 to buy one share of IBM stock
Expiration date: the third Friday in March
Option premium: $500
Rationale: you expect IBM stock price is going to rise
Example 2 - you buy a March 25 Intel put option for $2.00
Put option: right to sell
Stock option: underlying asset is Intel stock
Contract size: 100 shares
Exercises price: $25 to sell one share of Intel stock
Expiration date: the third Friday in March
Option premium: $200
Rationale: you expect that Intel stock price is going to fall
Futures contracts: call for the exchange of certain goods for cash at an arrangedupon price (future’s price) at a specified future date (obligations)
Example 3 - you buy a June gold futures contract at $1,300 per ounce
Commodity futures contract: underlying asset is a commodity
Contract size: 100 ounces
Futures price: $1,300 per ounce to buy gold
Delivery month: June
Rationale: you expect gold price is going to rise
Example 4 - a farmer sells an October corn futures contract at 475
Commodity futures contract: underlying asset is a commodity
Contract size: 5,000 bushels
Futures price: $4.75 per bushel to sell corn
Delivery month: October
Rationale: the farmer wants to lock in the price, hedging
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
1.
2.
3.
ASSIGNMENTS
Concept Checks and Summary
Key Terms
Intermediate: 12, 13, 14, 18, 19, and CFA1
10
Chapter 3 - Securities Markets
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New issues
How securities are traded
U.S. securities markets
Trading costs
Margin trading and short sales
New issues
Recall primary markets and secondary markets
Primary markets: for new issues, either IPOs or existing firms issuing new
securities (seasoned offerings)
IPOs: initial public offerings, shares being sold to the public for the first time
Investment banker: firm specializing in the sale of new securities
Underwriting: the process of purchase new shares from the issuing firm and resell
the shares to the public
Prospectus: a document that describes the firm issuing the security and provides
the information about the firm
Selling process for large new issues: the role of investment bankers
Underwriting; Advising; Distributing
Best efforts vs. underwritten issues
Underwriting syndicate: a group of investment bankers formed by a leading
underwriter to spread the financial risk associated with selling new securities
Issuing firm
(Figure 3.1 - Digital Image)
Lead underwriter
Investment banker A
Investment banker B
Individual/Private Investors
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Underwriting
syndicate
Investment banker B
Private placement: new securities are sold directly to a small group of individuals
or wealthy investors
Initial return of IPOs: very high first day returns all over the world
(Figure 3.2 - Digital Image)
IPOs in the long run: in general poor performance, especially in next three years
(Figure 3.3 - Digital Image)
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How securities are traded
Types of markets
Direct search markets: buyers and sellers seek each other directly, which are the
least organized markets, for example, a student buys a used car from another
student
Brokered markets: brokers offer search services for profits/commissions, for
example, the real estate market
Dealer markets: dealers specializing in particular assets buy and sell them in their
own accounts for profits, for example, the over-the-counter (OTC) markets
Auction markets: traders converge at one place to buy and sell assets, for example,
the New York Stock Exchange (NYSE). Auction markets are the most efficient
markets because all traders will get the best price possible.
Types of brokers
Full service broker vs. discount broker
Types of accounts
Cash account vs. margin account (without or with borrowing capacity)
Bid price - the highest price a dealer is willing to pay for a given security
Asked price - the lowest price a dealer is willing to sell a given security
Bid-ask spread: the difference of the two prices, which is the profit for a dealer
Types of orders:
Market order: to buy or sell at the best price available
Limit order: to buy at or below a specified price or sell at or above a specified
price
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Stop order (stop-loss order): to sell when price reaches or drops below a specified
level or to buy when price reaches or rises above a specified level. It becomes a
market order when the stop price is reached.
Stop-limit order: a combination of stop and limit orders
Comparison of a limit order and a stop order (Figure 3.5 - Digital Image)
Buy
Sell
Price falls below the limit
Limit-buy order
Stop-loss order
Price rises above the limit
Stop-buy order
Limit-sell order
Trading mechanics
Dealer markets: trade through dealers, for example, in OTC markets
Electronic communication networks (ECNs): direct trade over computer network
without market makers or dealers
Specialist markets: trade through specialists, for example, in NYSE
Specialist: a trader who makes a market in the shares of one or more stocks and
maintains a fair and orderly market by dealing personally in the market
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U.S. securities markets
Nasdaq: National Association Security Dealers Automated Quotations System
Nasdaq stock market: a computer-linked price quotation system for the OTC
markets with about 3,200 firms listed for trading
NYSE: New York Stock Exchange, the largest exchange in the U.S. with about
2,800 firms listed for trading
Block trade: a large transaction in which at least 10,000 shares of stock are bought
or sold
Program trade: a coordinated purchase or sale of an entire portfolio
Settlement: a trade must be settled in 3 working days, called T+3 settlement
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Trading costs
Full service brokers charge more than discount brokers
Fixed-commission schedule - small transactions, for example, $7.95 a trade for up
to 1,000 shares
Negotiated commissions - large transactions (block trade)
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Explicit vs. implicit cost
Commissions are explicit costs while bid-ask spread is an implicit (hidden) cost
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Margin trading and short sales
Types of transactions:
Long purchase - direct buy
Short selling - sale of borrowed securities
Margins:
Margin trading - borrow money and buy stock to magnify returns by reducing the
amount of capital that must be put in by investors
Margin requirements - the minimum amount of equity put in by an investor
Initial margin - the minimum amount of equity that must be provided by an
investor at the time of purchase, 50% minimum
Maintenance margin - the minimum amount of equity that must be maintained in
the margin account at all time, 25% minimum
Margin call - notification of the need to bring additional equity
(1) Buying on margin (borrow money and buy stock):
Market value of stock - Loan
Equity in account
Margin = -------------------------------------- = -----------------------------Market value of stock
Market value of stock
(1)
Buying on margin, example 1
Suppose you bought 100 shares of XYZ at $50.00 per shares in your margin
account. The initial margin is 50% and the maintenance margin is 25%.
a) At what price, will you receive a margin call?
b) If the price drops to $40, what will happen to your account?
c) If the price drops to $30, how much money should you provide to retain the
minimum margin requirement?
a) 100*50 = $5,000 (total cost to purchase 100 shares)
Equity = $2,500 (the amount you provide which is 50% of total cost)
Loan = $2,500 (the amount you borrow which is 50% of total cost)
Let P be the price at which your maintenance margin drops to 25%, using (1),
100*P - 2,500
----------------------- = 0.25, solve for P = $33.33
100*P
If the price drops below $33.33, you will receive a margin call.
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b) If the price drops to $40 > $33.33, your account is restricted but there is no
margin call.
c) Let X be the amount of money you need to provide to reduce the loan,
100*30 - (2,500 - X)
------------------------------ = 0.25, solve for X = $250
100*30
(2) Short sale on margin (you borrow shares from your broker and sell them now)
Rational: you believe the stock is currently overpriced in the market and expect
the price will drop in the future.
Up-tick (a price that is higher than that of the previous trade)
Up-tick rule in short sale: a rule designed to restrict short selling from further
driving down the price of a stock that has dropped more than 10% in one day. At
that point, short selling would be permitted if the price of the security is above the
current national best bid (uptick). It will enable long sellers to stand in the front of
the line and sell their shares before any short sellers once the circuit breaker (a
10% drop in one day) is triggered.
Value of assets - Loan
Equity
Margin = ---------------------------------- = -------------Value of stock owed
Loan
(2)
Short sale on margin, example 2
Suppose you short sell 100 shares of ABC at $100 per share in your margin
account. The initial margin is 60% and the maintenance margin is 30%.
a) At what price, will you receive a margin call?
b) What will happen if the price rises to $110 per share?
c) If the price drops to $80 per share after your short sale, what is the return from
short sale if the interest charge totals $500?
a) 100*100 = $10,000 (short sale proceeds)
10,000*60% = $6,000 (the initial margin you should provide which is 60% of
short sale proceeds)
Value of assets = $16,000
Let P be the price at which your margin drops to 30%, using (2),
16,000 - 100*P
------------------------ = 0.30, solve for P = $123.08
100*P
If the price rises above $123.08 you will receive a margin call.
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b) If the price rises to $110 < $123.08, your account is restricted but you will
not receive a margin call.
Money made
100*(100 - 80) - 500
c) Rate of return = ---------------------- = ------------------------------ = 25%
Money invested
6,000

1.
2.
3.
ASSIGNMENTS
Concept Checks and Summary
Key Terms
Intermediate: 14, 15, 21, and CFA 1, 2, 3
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Chapter 4 - Mutual Funds and Other Investment Companies
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Investment companies
Mutual funds
Costs of investing in mutual funds
Mutual fund returns
Investing in mutual funds
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Investment companies
An investment company is a type of financial intermediary. It sells itself to the
public and uses the funds to invest in a portfolio of securities.
Mutual funds are investment companies (open-end).
Advantages of investing in mutual funds:
Economies of scale
Professional management
Diversification and divisibility
Record keeping and administration
NAV: the underlying value on a per share basis of a mutual fund
It is determined by the closing-bell prices and it varies every day
NAV = (market value of assets - liabilities) / number of shares outstanding
For example, a mutual fund has $120 million in assets and 5 million of liabilities.
If it has 5 million shares outstanding, the net asset value (NAV) is $23 per share.
Managed investment companies: open-end vs. closed-end
Open-end fund: investors can buy shares from or sell shares back to the fund at
NAV (it may involve in purchase or redemption charges), with no limit on the
number of shares the fund can issue
Closed-end fund: it is traded at prices that can differ from NAV and the number of
shares outstanding is fixed
Unit investment trust: money pooled from many investors that is invested in a
portfolio fixed for the life of the fund
Hedge fund: a private investment pool, open to wealthy or institutional investors,
that is exempt from SEC regulations
Real estate investment trusts (REITs): similar to closed-end funds that invest in
real estate or loans secured by real estate
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Mutual funds
Mutual funds are common names for open-end investment companies
More than 90% of mutual funds are open-end funds
Capital gains vs. current income
Investment policy: each fund has its policy contained in the fund’s prospectus
Money market funds: invested in short-term and low-risk instruments
Equity funds: mainly invested in stocks, growth funds vs. income funds
Balanced funds: a balanced return from fixed income securities and long-term
capital gains
Bond funds: invested in various bonds, more current income
Index funds: mimic market indexes (for example, S&P 500 index)
Sector funds: restrict investments in particular sectors (for example, financial
service sector)
International funds: invested in international stocks
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Costs of investing in mutual funds
Operating expenses: costs to operate the fund, including administrative expenses,
ranging from 0.2% to 2.0%
Loads: commission charges, sales charges, or redemption charges
Front-end load: deduct a % charge from the initial investment (for example, 5%)
Low-load fund: less than 3% of front charge
Offering price = NAV / (1 – load) or NAV = offering price * (1 - load)
No-load fund: selling at NAV, or offering price = NAV
Back-end load: a commission change on the sale of shares
Other fees: for example, 12b-1 fees to cover marketing and distribution costs
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Mutual fund returns
Sources of return: dividend income; capital gains distributions; unrealized capital
gains
NAV1 – NAV0 + I1 + G1
Rate of return = ------------------------------------NAV0
I1: income distribution during the period
G1: capital gains distribution during the period
Note: All fees are deducted directly from NAV
Example on return of a mutual fund, problem 4-21 on page 105
At the start of the year: $200 million in assets with no liabilities and 10 million
shares outstanding
At the end of the year: dividend income $2 million; no capital gains distribution;
fund price rises by 8%, and 1% of 12b-1 fees is charged at the end of the year
Answer:
NAV0 = $20
NAV1 = 20(1.08)*(1-0.01) = $21.384
I1 = $0.2 and G1 = 0
21.384 – 20.00 + 0.2
Rate of return = ------------------------------ = 7.92%
20.00
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Investing in mutual funds
Wealth accumulation
Diversification
Professional management
Low cost
Speculation and short-term trading
Selection process
Objectives
What a fund offers – investment policy
Main holdings
Load vs. no-load funds
Open-end vs. closed-end funds
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Taxation on mutual fund income
Turnover ratio: the ratio of the trading activity of a portfolio to the assets of the
portfolio
Example: see concept check 4.3
Long-term capital gains
Short-term capital gains
Dividends
If it is a retirement account (Roth IRA, regular IRA, 401K or 403B): all taxes are
either exempt or deferred
Exchange-traded funds (ETFs): offshoots of mutual funds that allow investors to
trade index portfolios, for example, Spider (SPDR) for S&P 500, Diamonds
(DIA) for Dow Jones Industrial Average, Qubes (QQQQ) for NASDAQ 100

1.
2.
3.
ASSIGNMENTS
Concept Checks and Summary
Key Terms
Intermediate: 11, 12, 13, 21, 22, and 24
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Chapter 5 - Return and Risk
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Rates of return
Risk and risk premium
Historical return
Inflation and real return
Asset allocation
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Rates of return
Components of return: cash dividend and capital gains (or capital losses)
Total return ($) = return from cash dividend + return from capital gains (or losses)
Total return (%) = dividend yield + capital gain yield
Holding period return (HPR):
Ending price – Beginning price + Cash dividend
HPR = -------------------------------------------------------------Beginning price
Example
P0 = $100
0
Div = $4
P1= $110
1
110 – 100 + 4
10
4
HPR = ----------------------- = -------- + -------- = 10% + 4% = 14%
100
100
100
Capital gains yield: % change in price, 10%
Dividend yield: % return from dividend, 4%
Returns over multiple periods
Table 5-1: Quarterly cash flows and rates of return of a mutual fund
1st quarter 2nd quarter 3rd quarter
Assets at the start of quarter
1.0 mil
1.2 mil
2.0 mil
Holding period return (HPR)
10.0%
25.0%
(20%)
Total assets before net inflow
1.1 mil
1.5 mil
1.6 mil
Net inflow
0.1 mil
0.5 mil
(0.8 mil)
Assets at the end of quarter
1.2 mil
2.0 mil
0.8 mil
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4th quarter
0.8 mil
25.0%
1.0 mil
0.0 mil
1.0 mil
Arithmetic mean: simple average, the sum of returns in each period divided by the
number of periods - best forecast of performance in the future
Arithmetic mean = (10 + 25 – 20 + 25) / 4 = 10%
Geometric mean: time-weighted average return (considers compounding)
(1 + 0.1)*(1+0.25)*(1-0.2)*(1+0.25) = (1 + rG)4
Solve for rG = 8.29%
Dollar-weighted average return: internal rate of return for a project
Quarter
1
2
-0.1 -0.5
0
-1.0
Net cash flow
3
0.8
4
1.0
IRR = 4.17%
APR (annual percentage rate) vs. EAR (effective annual rate)
EAR  (1 
APR n
) 1
n
For example, APR = 6%, n = 4 (quarterly compounding), EAR = 6.14%

Risk and risk premium
Probability distribution: a list of possible outcomes with associated probabilities
Expected return: the mean value of the distribution
Variance and standard deviation: measure of dispersion around the mean (risk)
Example
State of the Economy
Boom
Normal
Recession
Scenario, s
1
2
3
Probability, p(s)
0.25
0.50
0.25
S
Expected return = E (r )   p( s ) * r ( s ) = 14%
s 1
S
Variance =  2   p( s) *[r ( s)  E (r )] 2 = 450;
s 1
Standard deviation =    2  450 = 21.21%
22
HPR, r(s)
44%
14%
- 16%
Risk premium: expected return in excess of the risk-free rate, an additional return
to compensate for taking risk
Risk aversion: reluctant to accept risk
E(rp )  r f  1 2 A 2p , where A is the risk aversion coefficient or A 
E (r p )  r f
1
2
 2p
For example, if the risk premium is 8%, the standard deviation is 20%, then the
risk aversion coefficient A = 4. The higher the risk aversion is for an investor, the
higher the value of A, and the higher the risk premium.
Sharpe (reward-to-volatility) measure = S =
E (r p )  r f
p
=
8%
= 0.4
20 %
(more discussions in Chapter 18)

Historical return
Using historical data to estimate mean and standard deviation
Example: MO
Historical returns: summary statistics for the U.S market and the world during
1926 - 2008 (Table 5.2 - Digital Image)
Interpretation of the numbers
Normal distribution: 68.26% (1  rule), 95.44% (2  rule), and 99.74%
(3  rule)
68. 26%
95. 44%
99. 74%
mean-2 
mean+2 
mean
Size effect: average returns generally are higher as firm size declines
(Figure 5.1 - Digital Image)
23

Inflation and real return
Nominal interest rate vs. real interest rate
r  R – i (the real rate, r is approximately equal to the nominal rate, R minus the
inflation rate, i)
R = r + E(i)
Nominal interest rate = the real interest rate + expected inflation rate
Inflation rate is measured by consumer price index (CPI)
U.S. history of interest rates, inflation, and real interest rates
(Figure 5.5 and Table 5.4 - Digital Image)

Asset allocation
Asset allocation: portfolio choice among different investment classes
Risky assets vs. risk-free assets
All risky assets form a value-weighted risky portfolio, P
All risk-free assets form a risk-free asset with a risk-free rate, rf
Complete portfolio: a portfolio including risky assets and risk-free assets
Complete portfolio’s expected return and risk:
E(rc )  y * E(r p )  (1  y) * r f
and
 c  y * p
Where E(rc) and c are the expected rate of return and standard deviation for a
complete portfolio, E(rp) and p are the expected rate of return and standard
deviation for the risky assets, rf is the return on the risk-free asset, y is the weight
on risky-assets, and 1-y is the weight on the risk-free asset.
E(rc)
P
E(rp)
y = 1.5
CAL
rf
y = 0.5
p

24
The capital allocation line (CAL): a plot of risk-return combinations available by
varying portfolio allocation (weights) between the risk-free asset and the risky
portfolio
Example: E(rp) = 15%, p = 22%, rf = 7%, y = 50%, then
E(rc) = 11%, c = 11%, the Sharpe measure = S 
15%  7%
 0.36
22%
Challenge: if y = 1.5 what will happen to the complete portfolio? Where is it
located on CAL? What is S? What does it mean (y = 1.5)?
Risk aversion vs. risk tolerance
Passive investment strategy: holding a combination of a well-diversified market
portfolio and a risk-free portfolio, assuming all risky assets are fairly priced in the
market.
Capital market line (CML): a capital allocation line using the market index
portfolio as the risky portfolio (more discussions in Chapters 6 and 7)
E(rc)
M
E(rM)
y = 1.5
CML
rf
y = 0.5
M

1.
2.
3.

ASSIGNMENTS
Concept Checks
Key Terms
Intermediate: 5, 6, 12-16, and CFA 1-6
25
Chapters 6&7 - Efficient Diversification, CAPM and APT






Diversification and portfolio risk
Portfolio construction with two risky assets
Modern portfolio theory
Beta coefficient
Capital asset pricing model (CAPM)
Arbitrage pricing theory (APT)

Diversification and portfolio risk
Risk of holding a single asset:
Probability distribution (a revisit)
Expected return: E(r)
Variance (  2 ) and standard deviation (  )
68. 26%
95. 44%
.
99. 74%
Mean or E(r)
Mean or E(r) determines the center of the distribution while  (or  2 )
determines how wide the distribution is. The large the  , the wider the
distribution, and the higher the risk.
Risk of holding a portfolio: standard deviation of returns of the portfolio
As the number of stocks increases in a portfolio, the portfolio’s total risk,  p
decreases. It is known as the diversification effect.
Portfolio’s total risk = firm’s specific risk + market risk
= Diversifiable risk + non-diversifiable risk
= non-systematic risk + systematic risk
(Figure 6.1 - Digital Image)
26
p
Firm’s specific risk
Market risk
# of securities
in a portfolio

Portfolio construction with two risky assets
Example: portfolio construction with two risky assets
State of economy
Recession
Normal
Boom
Probability (p)
0.3
0.4
0.3
rA
100%
15%
-70%
rB
-10%
0%
30%
Estimate the distribution for each stock
E(rA) = 15%,  A2 = 4,335
E(rB) = 6%,
 B2 = 264
and
 A = 65.84% (refer to Chapter 5)
and
 B = 16.25% (refer to Chapter 5)
Estimate the correlation between two risky assets
S
Covariance:  AB   p(i ) * [rA (i )  E (rA )] * [rB (i )  E (rB )] = -1,020
i 1
Since  AB = (  AB )*(  A )*(  B ), where  AB is called correlation coefficient
Correlation coefficient,  AB = -0.953
 AB = 1  perfectly and positively; 0 <  AB <1  positively but not perfectly;
 AB = 0  no correlation;
-1 <  AB < 0  negatively but not perfectly;
 AB = -1  perfectly and negatively
27
rA
rA
*
*
 AB = 1
*
*
*
*
 AB = -1
*
*
rB
rB
*
*
*
What will the diagrams look like if 0 <  AB <1, -1 <  AB < 0, and  AB = 0?
Portfolio’s return and risk
Three rules for two-risky-assets portfolio
(1) The return on a portfolio is a weighted average of the returns on the
component securities (A and B), with the investment proportion as weights;
rp  w A rA  wB rB
(2) The expected return on a portfolio is a weighted average of the expected
returns on the component securities (A and B), with the investment proportion
as weights;
E (r p )  w A E (rA )  wB E (rB )
(3) The variance of the portfolio is given by
 2p  (wA A ) 2  (wB B ) 2  2(wA A )(wB B )  AB
= (w A ) 2 ( A ) 2  (wB ) 2 ( B ) 2  2(w A wB ) AB
= (w A ) 2 ( A ) 2  (wB ) 2 ( B ) 2  2(w A wB ) A B  AB
Suppose you invest 10% in stock A and 90% in stock B. What is the expected rate
of return of the portfolio? What is the standard deviation of the return of the
portfolio?
E(rp) = 6.9%,  2p = 73.59, and  p = 8.58%
28
If you compare stock B with the portfolio, what do you find? The portfolio
dominates stock B in both risk (lower risk) and return (higher expected return)
Let us construct more portfolios by changing weights
Portfolio
% in A
% in B
E(rp), %
1
100
0
15.00
2
75
25
12.75
3
50
50
10.50
4
25
75
8.25
5
0
100
6.00
6
19.34
80.66
7.74
p,%
65.84
45.52
25.29
6.08
16.25
3.96
Plot all the portfolios in a diagram
E(rp)
A
MVP
*
B
p
How to determine the weights for MVP?
By choosing the optimal weights you minimize the variance (risk)
wB 
 A2   AB
;
 A2   B2  2 AB
and w A 1  wB
(for two risky assets)
Effect of  AB (correlation coefficient), refer to Figure 6.4 - Digital Image
E(rp)
 AB = -1
A
 AB = 1
 AB = -1
B
p
29
 AB = -1, perfectly negative correlation, perfect diversification
 AB = 1, perfectly positive correlation, no diversification
-1<  AB <1, there are benefits to diversification. Where negative correlation is
present, there will be even greater diversification benefits.

Modern portfolio theory
Markowitz mean-variance model (for n risky assets)
Efficient portfolio - a portfolio with the highest expected return for a given level
of risk or a portfolio with the lowest risk for a given expected return
Efficient frontier – the set of efficient portfolios
MVP – minimum variance (risk) portfolio
Investment opportunity set: the set of all attainable portfolios, including efficient
and inefficient portfolios
E(rp)
Efficient set
Investment opportunity set
MVP
Inefficient set
p
Indifference curves: curves describing investor’s preferences for risk and return,
or representing a set of combinations of risk and return that provides the same
level of satisfaction
Nonsatiation: more is preferred to less
Risk aversion: most investors are risk-averse
Utility: a measure of the level of satisfaction
30
E(rp)
I2
I1
Favorite
A
B
C
D
p
Mean-variance criterion: investors desire portfolios that lie to the “northwest”,
which means that investors prefer higher return with less risk
I2 is preferred to I1 because I2 provides a higher level of satisfaction (lower risk
with same return, i.e., A is better than B, or higher return with same risk, i.e., C is
better than D)
Choosing the optimal portfolio by combining the indifference curves with the
efficient set
E(rp)
O*
p
O* is the optimal choice (tangency point) where the utility (satisfaction) is
maximized
Points to remember:
All portfolios on the efficient set are “equally” good
All risky assets with no borrowing or lending opportunities
Different investors may have different estimated efficient set
Different investors may have different indifference curves
31
When there is a risk-free asset in the market and borrowing and lending are
allowed
Portfolio returns and risk
E(rp)
New efficient set
CML
O*
M
rf
p
When a risk-free asset exists, there is a risk a free rate, rf. We can draw a line from
rf, which is tangent to the original efficient set at point M. The line is called the
Capital Market Line (CML), which becomes the new efficient set. The optimal
choice for the investor is point O* because the indifference curve is tangent to the
new efficient set (CML) at that point.
Capital Market Line (CML) - concepts, formulas, and implication
E(rp)
CML
M
E(rm)
E(rm) - rf
rf
p
m
E (r p )  r f 
( E (rm )  r f
m
 P : It is the Capital Market Line (CML) formula
CML has the risk-free rate as the intercept and the reward-to-variability ratio as
the slope
32
Two-fund separation theorem - all investors hold a combination of the risk-free
asset and a well-diversified market portfolio, which includes all risky assets in the
market (market value weighted)
Asset allocation line revisited: the risky portfolio actually is a well-diversified
market portfolio
E(r)
M
E(r m)
CML
E(r m) - rf
rf

m
E(rC) = y*E(r m) + (1-y)*rf
Where y is the weight on the market portfolio and (1-y) is the weight on the riskfree asset
Rearranging: E(rC) - rf = y*(E(r m) - rf) = y*E(r m) – y*rf
C = y*m
For example, given E(r m) = 12%, m = 20%, rf = 5%
If y = 60%, E(rC) = y*E(r m) + (1-y)*rf = 0.6*12% + 0.4*5% = 9.2%
C = y*m = 0.6*20% = 12%

Beta coefficient
A measure of the market risk (systematic risk) for a stock or a portfolio
 i ,m 
 i ,m

2
m
  i,m
i
m
Characteristic line (CL): a regression line used to estimate the beta coefficient
The slope of the CL is the estimated beta coefficient for stock i
Example: MO
33
Single index model
Asset returns are related to the returns of a market index
Excess return: rate of return in excess of the risk-free rate (R = r - rf)
Ri  a i   i * R m   i , where  i is an error term and the average of error terms is
zero.
Ri
i
*
i
ai
Rm
Taking the variance on both sides of the single index model:
 i2   i2 m2   2i
Total risk = market risk + specific risk
= systematic risk + firm’s specific risk
2 
 2 m2
is the proportion of total variance attributed to market fluctuations
 i2
Example: In a CAPM equilibrium, the risk-free rate is 5% and the expected rate of
return on the market is 10% with a standard deviation of 18% (  m = 18%). A
common stock i has an expected return of 12% with a standard deviation of 30%
(  i = 30%). What percentage of the total risk for stock i is the firm’s specific
risk? What percentage is due to the market risk?
Answer
Step 1: Solve for the beta of stock i, using CAPM
12% = 5% + i (10% - 5%), solving for i = 1.4
Step 2: Solve for the firm’s specific risk, using the formula above,
900 = (1.4)2(18) 2 +  2i , solving for  2i = 264.96
Step 3: Calculate the percentages,
264.96/900 = 29.44% (firm’s specific), 635.04/900 = 70.56% (market)
34

Capital asset pricing model (CAPM)
Assumptions: many investors, homogeneous expectations, one-period utility
maximization, perfect capital markets, risk-free borrowing and lending, and
capital markets in equilibrium
It relates the required (expected) return to the market risk, or beta
E (ri )  r f   i [ E (rm )  r f ]
CAPM model
E(ri)
SML
Slope = E(rm) - rf
rf
i
Intercept = risk-free rate
Slope = market risk premium
SML - the graphical presentation of CAPM
Over-and-under valued securities
Example: MO
Beta of MO is 0.86, if expected return on the market is 12% and the risk free rate
is 5%, the required rate of return for MO is
5% + 0.86*(12% - 5%) = 11.02%
Checking the average return over the past 5 years we find that it is 1.22% per
month or 14.64% per year (simple interest)
The stock’s alpha = 14.64% – 11.02% = 3.62% (under priced) since the realized
return is higher than the CAPM predicts (above the SML)
Limitations with CAPM: rely on the market portfolio and expected returns
35

Arbitrage pricing theory (APT)
An equilibrium model of expected returns with multi-factors
Multi-factor model:
Ri  ai   i1 Rm1   i 2 Rm 2  ...   ik Rmk   i
For example, firm size, book-to-market ratio, default-risk, etc.
Arbitrage: the process of earning risk-free profit by taking the advantage of
mispricing in a particular asset
Three characteristics for arbitrage
1. No initial investment from pocket
2. No risk
3. Positive return
APT model
ri  r f   i1 ( 1  r f )   i 2 ( 2  r f )  ...   ik ( k  r f )   i
Applications
Single index model: consider market factor to estimate beta of GM and use
CAPM to estimate the required rate of return of GM
1. Collect data (monthly returns of GM, S&P 500 index monthly returns, and
monthly T-bill rates from January 1999 to December 2003, 60 observations)
2. Calculate Excess returns of GM and S&P 500 (R = r - rf)
3. Run the regression: RGM  aGM  GM * Rm   i
4. Look for slope = 1.24
5. Then use CAPM to estimate the expected return of GM:
E (ri )  r f   iM ( E (rM )  r f )
6. Assume rf = 4.00%, market risk premium = 5.5%, expected return = 10.82%
Two factor model of Merton: consider market factor and interest rate factor to
estimate betas and use multifactor model to estimate expected return of GM
1. Collect data
2. Run the regression: Ri  ai   im Rm   iTB RTB   i to estimate betas
3. Use the two-factor model to estimate expected rate of return
E (ri )  r f   iM ( E (rM )  r f )   iTB ( E (rTB )  r f )
36
Assume that the risk-free rate is 4.00%, the expected market risk premium is 6%
and the expected interest rate risk premium is 3%. If the market beta of stock i is
1.2 and interest rate beta of the stock is 0.7, the expected return for stock i is
E(ri) = 4% + 1.2*(6%) + 0.7*(3%) = 13.3%
Three factor model of Fama and French: considers market factor, size factor, and
book-to-market ratio
1. Collect data and run a multifactor regression:
ri  r f   i   iM * (rM  r f )   HML * rHML   SMB * rSMB   i to estimate betas for
stock i
2. Use three-factor model to estimate expected rate of return for stock i
E (ri )  r f   iM * [ E (rM )  r f ]   HML * E (rHML )   SMB * E (rSMB )
3.
Assuming for Dell (using monthly data over the period 2002-2006),
 i,M  1.132 ,  HML  0.8026 , and  SMB  0.2742
From French’s website, rM  r f  7.99% , rHML  4.40% , and rSMB  2.94% ,
then Dell’s expected risk premium
E (rDell )  r f  1.132*7.99% - 0.8026*4.40% + 0.2742*2.94% = 6.32%

ASSIGNMENTS
Chapter 6
1.
Concept Checks
2.
Key Terms
3.
Intermediate: 8-12 and CFA 1-3
Chapter 7
1.
Concept Checks
2.
Key Terms
3.
Intermediate: 4-7, 17-19, and CFA 1-14
37
Chapter 8 - Market Efficiency





Random walks and efficient market hypothesis (EMH)
Implications of EMH
The role of portfolio manager in an efficient market
Evidence of market efficiency and anomalies
Interpretation of EMH

Random walks and efficient market hypothesis (EMH)
Random walk: stock price changes are random and unpredictable
Efficient market: prices of securities in the market fully and quickly reflect all
available information, which means that there is no arbitrage opportunity
Figures 8.1 and 8.2 - Digital Image
Forms of efficiency:
Weak-form efficiency: stock prices already reflect all information contained in the
history of past trading
Semistrong-form efficiency: stock prices already reflect all publicly available
information in the market
Strong-form efficiency: stock prices already reflect all relevant information in the
market, including inside information

Implications of EMH
Technical analysis vs. fundamental analysis
Technical analysis: research on recurrent and predictable patterns in the market
Relative strength: compare the recent performance of a stock with that of the
market or other stocks
Resistance level: a price level above which it is supposedly unlikely for a stock or
stock index to rise
Support level: a price level below which it is supposedly unlikely for a stock or
stock index to fall
Moving averages: 50-day and 200-day moving averages
If the market is efficient, what will happen to technical analysis?
38
Fundamental analysis: research on determinants of stock value, such as earnings
and dividends prospects, expectations of future interest rates, and risk of the firm
Active vs. passive portfolio management
Active: search for mispriced (overvalued or undervalued) securities, buy and sell
often to timing the market
Passive: buy and hold a well-diversified portfolio, buy and hold strategy

The role of portfolio manager in efficient market
Diversification to reduce firm’s specific risks
Tax consideration for different investors
Resource allocation
Demand for investment varies with age, tax bracket, risk aversion, and
employment, etc., so portfolio managers can tailor portfolios for different
investors.

Evidence of market efficiency and anomalies
Three main issues
(1) The magnitude issue: fund managers deal with portfolios worth hundreds of
millions. Only one tenth of 1% will be worth a lot.
(2) Selection bias: if a manager knows a way to make money for sure, he/she will
keep it secret.
(3) Lucky event: sometimes, a fund has a superior performance. It can just be a
lucky event (bet the right stocks).
Weak-form tests: patterns in stock returns
Serial correlation test: involves measuring the correlation between stock returns
for various lags and the results indicate fairly weak and positive correlation for
short-horizon returns and fairly strong and negative correlation for long-horizon
returns
Momentum effect: the tendency of poorly-performing stocks and well-performing
stocks in one period to continue that abnormal pattern in following periods
Buying past winners and selling past losers will make abnormal profits
Reversal effect: the tendency of poorly performing stocks and well-performing
stocks in one period to experience reversals in the following period
39
Implication: short- and intermediate-horizon momentum and long-run reversal
Semi-strong form tests: market anomalies
Anomalies: patterns that seem to contradict the EMH
P/E ratio effect: low P/E ratio stocks have earned higher average risk-adjusted
returns than high P/E ratio stocks
Small-firm effect: small firm stocks have earned higher abnormal returns, primary
in January
Figure 8.3 - Digital Image
Neglected-firm effect: less well-known firm stocks have earned abnormal returns
Book-to-market effect : high book-to-market value stocks have earned abnormal
returns
Figure 8.4 - Digital Image
Post-earnings-announcement price effect: stock prices don’t reflect new
information rapidly
Figure 8.5 - Digital Image
Strong-form tests: inside information
Insiders make superior profits with inside information: the market is not strongform efficient

Interpretation of EMH
Risk premium or inefficiency?
For example, Fama and French’s three factor model indicates higher returns are
associated with more risks
Anomalies or data mining?

1.
2.
3.
ASSIGNMENT
Concept Checks
Key Terms
Intermediate: 10-16 and CFA 1-6
40
Chapters 10&11 - Debt Securities








Bond characteristics
Interest rate risk
Bond rating
Bond pricing
Term structure theories
Bond price behavior to interest rate changes
Duration and immunization
Bond investment strategies

Bond characteristics
Bond: long-term debt security that the issuer makes specified payments of interest
(coupon payments) over a specific time period and repays a fixed amount of
principal (par or face value) at maturity
Face value or par value: usually $1,000
Coupon rate and interest payment
Zero-coupon bond: coupon rate is zero, no coupon payment, sells at a discount.
For example: a 10 year zero-coupon bond sells at $550 and yields 6.16% per year
Maturity date
Call provision: the issuer can repurchase bonds during the call period
Call premium and call price
Convertible bonds: can be converted into common stocks
Puttable bonds: bondholders can sell bonds back to the issuer before maturity
Floating-rate bonds: coupon rates vary with some market rates
Indexed bonds: payments are tied to a general price index
Junk bonds: high yields with high default risk
Government bonds, corporate bonds, international bonds
Preferred stocks: hybrid security, often considered as an equity but usually
included in fixed-income securities
41

Interest rate risk
Interest rate price risk vs. interest rate reinvestment risk (reinvestment risk)
Interest rate price risk: risk that a bond value (price) falls when market interest
rates rise
Reinvestment risk: risk that the interests received from a bond will be reinvested
at a lower rate if market interest rates fall

Bond rating
Letter grades that designate quality (safety) of bonds (Figure 10.8 - Digital Image)
AAA
AA
Investment grade bonds with low default risk
A
BBB
BB
B Speculative grade (junk) bonds with high default risk
.
Why bond rating? Firm's credit; Borrowing capacity
Determinants:
Coverage ratios - ratios of earnings to fixed costs
Leverage ratio - debt to equity ratio
Liquidity ratios - current ratio and quick ratio
Profitability ratios - ROA and ROE
Cash-flow-to debt ratio - ratio of total cash to outstanding debt

Bond pricing
Accrued interest and quoted price
Invoice price = quoted (flat) price + accrued interest
0
182 days
40 days
142 days remaining until next coupon
Suppose annual coupon is $80 and the quoted price is $990,
Invoice price = 990 + (40/182)*40 = $998.79
Bond price = present value of coupons + present value of par value
The required rate of return serves as the discount rate
42
Premium bonds vs. discount bonds
A premium bond sells for more than its face value ($1,000)
A discount bond sells for less than its face value ($1,000)
Annual interest payment valuation model
P = present value of coupons + present value of par value
= C (PVIFAr,n) + PV (PVIFr,n),
P: intrinsic value of the bond
C: annual coupon payment
r: the required rate of return, the market interest rate for the bond
n: the number of years until the bond matures
PV: par value (face value, $1,000 usually)
Semiannual interest payment valuation model: adjust the annual coupon to
semiannual (C to C/2), the annual required rate of return to semiannual (r to r/2),
and the number of years to maturity to semiannual periods (n to 2n)
Overpriced securities vs. underpriced securities
If the intrinsic value > the market price, the bond in the market is underpriced
If the intrinsic value < the market price, the bond in the market is overpriced
If the intrinsic value = the market price, the bond in the market is fairly priced
Example: A 30-year 8% coupon bond pays semiannual coupon payments. The
market interest rate (required rate of return) on the bond is 10%. What should be
the bond price (fair value)? If the market price of the bond is $850.00, should you
buy the bond?
Answer: n = 60, i/y = 5%, FV = 1,000, PMT = 40, solve for PV = -810.71
No, you should not buy the bond since the intrinsic value ($810.71) < the market
price ($850.00)
If the market interest rate for the bond is 8%, what should be the bond price?
Answer: PV = -1,000
If the market interest rate for the bond is 7%, what should be the bond price?
Answer: PV = -1,124.72
Bond price and market interest rates have an inverse relationship: keeping other
things constant, the higher the market interest rate, the lower the bond price
(Figure 10.3 - Digital Image)
43
Yield to maturity (YTM): rate of return from a bond if it is held to maturity
Example (continued): what is YTM of the bond?
Answer: PV = -850, FV = 1,000, PMT = 40, n = 60, solve for i/y = 4.76%,
YTM = 4.76*2 = 9.52%
Yield to call (YTC): rate of return from a bond until it is called
Example (continued): suppose the bond can be called after 5 years at a call price
of $1,050, what is YTC?
Answer: PV = -850, FV = 1,050, PMT = 40, n = 10, solve for i/y = 6.45%,
YTC = 6.45*2 = 12.91%
Current yield (CY): annual coupon payment divided by the current bond price
Example (continued): what is the current yield of the bond?
CY = 80/850 = 9.41%
If market interest rates rise what would happen to the current yield of a bond?
Answer: the current yield would increase since the bond price would decrease
Realized compound return: compound rate of return on a bond with all coupons
reinvested until maturity
Example: 10.5 (Figure 10.5 - Digital Image)
Consider a two-year bond selling at par and paying 10% coupon once a year. The
YTM is 10%. If the coupon payment is reinvested at an interest rate of 8% per
year, the realized compound return will be less than 10% (actually it will be
9.91%)

Term structure theories
Term structure of interest rates: relationship between time to maturity and yields
for a particular fixed-income security
Yield curve: a graphical presentation of the term structure
Expectation theory: the yield curve is determined solely by expectations of future
short-term interest rates
Forward rates: implied short-term interest rates in the future
44
Example: suppose that two-year maturity bonds offer yields to maturity of 6% and
three-year bonds have yields of 7%. What is the forward rate for the third year?
Using the formula: (1  yn )n  (1  yn 1)n 1(1  f n) and solving for fn = 9.02%
Approximation: fn = 7%*3 – 2*6% = 9.00%
Liquidity preference theory: investors demand a risk premium on long-term bonds
Liquidity premium: the extra expected return to compensate for higher risk of
holding longer term bonds
Market segmentation theory: investors have their preferences to specific maturity
sectors and unwilling to shift from one sector to another

Bond price behavior to interest rate changes
(1)
The value of a bond is inversely related to its yield.: As yields increase,
bond prices fall; as yields fall, bond prices rise.
(2)
An increase in a bond’s yield to maturity results in a smaller price change
than a decrease in yield of equal magnitude.
(3)
As the maturity date approaches, the value of a bond approaches to its par
value.
(4)
Prices of long-term bonds tend to be more sensitive to interest rate
changes than prices of short-term bonds.
(5)
The sensitivity of bond prices to changes in yields increases at a deceasing
rate as maturity increases.
(6)
Interest rate risk is inversely related to the bond’s coupon rate. Prices of
low-coupon bonds are more sensitive to changes in interest rates than
prices of high-coupon bonds.
(7)
The sensitivity of a bond’s price to a change in its yield is inversely
related to the yield to maturity at which the bond is currently selling.
(Figure 11.1 - Digital Image)
45

Duration and immunization
Duration: a measure of the effective maturity of a bond, defined as the weighted
average of the times until each payment is made, with weights proportional to the
present value of the payment.
T
Measuring duration: Macaulay duration = D =
 t * w , where w
t
t 1
t

CFt /(1  y) t
P0
Note: T is the number of years until the bond matures, y is the yield to maturity,
and P0 is the market price of the bond
Example: A 3-year bond with coupon rate of 8%, payable annually, sells for
$950.25 (face value is $1,000). What is yield to maturity? What is D?
Answer: y = 10%, D = 2.78 years (Spreadsheet 11.1 - Digital Image)
Relationship between duration and bond price volatility
(1  y )
P
=-D
= - D*  y
P
1 y
where D* =
D
, is the modified duration
1 y
Example (continued): What is D*?
Answer: D* = D/(1+y) = 2.53 years
If the yield drops by 1%, what will happen to the bond price?
Answer: the price will increase by 2.53%
If the yield rises by 1%, what will happen to the bond price?
Answer: the price will decrease by 2.53%
Rules for duration
(1) for a zero-coupon bond, the duration is equal to the time to maturity
(2) the lower the coupon rate, the higher the D
(3) the longer the time to maturity, the higher the D
(4) the lower the yield, the higher the D
(5) for a perpetuity, the D = (1+y)/y
46
Bond immunization: a strategy to shield net worth from interest rate movements;
to get interest rate price risk and interest rate reinvestment risk to cancel each
other over a certain time period to meet a given promised stream of cash outflows
See the example (Table 11.4 - digital Image)
Note: immunization works only for small changes in interest rates
Cash flow matching: matching cash flows from a fixed-income portfolio with
those of an obligation
Dedication strategy: refers to multi-period cash flow matching
Application of bond immunization: banking management, pension fund
management

Bond investment strategies
Passive strategy: lock in specified rates given the risk, or buy and hold
Active management strategy: more aggressive and risky; try to timing the market
Bond swaps: an investment strategy where an investor liquidates one bond
holding and simultaneously buys a different issue (more in FIN 436)
Interest rate swaps: a contract between two parties to exchange a series of cash
flows based on fixed-income securities (more in FIN 436)
Tax swaps: replace a bond that has a capital loss for a similar security in order to
offset a gain in another part of an investment portfolio

ASSIGNMENTS
Chapter 10
1.
Concept Checks
2.
Key Terms
3.
Intermediate: 10-15, CFA 1 and 5
Chapter 11
1.
Concept Checks
2.
Key Terms
3.
Intermediate: 10-11, CFA 1-2, and 10
47
Chapter 12 - Macroeconomic and Industry Analysis




Global economy
Domestic macro economy
Industry analysis
Company analysis

Global Economy
Top-down analysis starts with the global economy: overview of the economic
conditions around the world
Exchange rate and exchange rate risk
Political risk (country risk)

Domestic macro economy
To develop an economic outlook for domestic economy
Gross domestic product (GDP): total value of goods and services produced
High grow rate of GDP indicates rapid expansion – check for inflation
Negative grow rate of GDP indicates contraction – check for recession
Demand and/or supply shocks
Unemployment rate
Inflation: general level of prices for goods and services
Interest rates
Nominal interest rates vs. real interest rates (Figure 12.3 - Digital Image)
Determinants of interest rates
Supply side: from savers, mainly households
Demand side: from borrowers, mainly business
Government side: borrower or saver, through Fed
The expected inflation rate
Budget deficit: spending exceeds revenue
Sentiment: optimism or pessimism of the economy
Federal government policy: fiscal and monetary policies
48
Fiscal polity - the government uses spending and taxing to stabilize the economy
Monetary policy – the Fed uses money supply and interest rate to stabilize the
economy (price level)
Consumer spending
Exchange rates
Business cycle: repetitive cycles of recession and recovery
(Figure 12.4 - Digital Image)
Peak vs. trough
Cyclical industries: with above average sensitivity to the state of the economy
Defensive industries: with below average sensitivity of the state of the economy
Economic indicators (Table 12.2 - Digital Image)
Leading indicators: rise or fall in advance of the rest of the economy
Coincident indicators: rise or fall with the economy
Lagging indicators: rise or fall following the economy

Industrial analysis
To develop an industrial outlook
NAICS code to classify industries (Table 12.3 - Digital Image)
Sensitivity to the business cycle
Sector rotation
Industry life cycle
Industry structure and performance
Threat of entry; Competitors; Substitutes; Bargaining power
Technology development
Future demand
Labor problem
Regulations
49

Company analysis
Fundamental analysis: intrinsic value, financial statements, ratio analysis,
earnings and growth forecast, P/E ratio, and required rate of return (risk)
Valuation models (covered in Chapter 13)

4.
5.
6.
ASSIGNMENT
Concept Checks
Key Terms
Intermediate: 12, 14, and CFA 6
50
Chapter 13 - Equity Valuations





Characteristics of common stock
Valuation by comparables
Dividend discount model (DDM)
Alternative models
Free cash flow valuation approach

Characteristics of common stocks
Ownership with residual claims
Advantages and disadvantages of common stock ownership
Higher returns
Easy to buy and sell (liquidity)
Higher risk
Less current income
Cash dividend, stock dividend, and stock split
Treasury stocks - repurchased stocks held by a firm
Capital gains yield and dividend yield

Valuation by comparables
Stocks with similar characteristics should sell for similar prices
Book value: the net worth of common equity according to a firm’s balance sheet
Liquidation value: net amount that can be realized by selling the assets of a firm
and paying off the debt
Replacement cost: cost to replace a firm’s assets
Tobin’s q: the ratio of market value of the firm to replacement cost
P/E ratio approach
Price-to-sales ratio approach
Market-to-book value approach
Price-to-cash flow approach
Example (Table 13.1 - Digital Image)
51

Dividend discount model (DDM)
Market price vs. intrinsic value
Market price: the actual price that is determined by the demand and supply in the
market
Intrinsic value: the present value of a firm’s expected future net cash flows
discounted by the required rate of return
In market equilibrium, the required rate of return is the market capitalization rate
Net income, retained earnings, and cash dividends

General formula: V0  
t 1
Dt
(1  k ) t
Forecasting sales and growth rate: g = ROE * b (b is the retention ratio)
Estimating EPS and DPS
(1) Zero growth DDM (g = 0), which means that dividend is a constant (D)
V0 
D
k
or
E (r ) 
D
P0
where k is the required rate of return and E(r) is the expected rate of return
Example: if D = $2.00 (constant) and k = 10%, then V0 = $20.00
Preferred stocks can be treated as common stocks with zero growth (g = 0)
(2) Constant growth DDM (g = a constant)
D1 = D0*(1+g)
D2 = D1*(1+g) = D0*(1+g)2, and in general,
Dt = Dt-1*(1+g) = D0*(1+g)t
V0 
D (1  g )
D1
 0
kg
kg
or
E (r ) 
D (1  g )
D1
g  0
g
P0
P0
Example: assume D0 = 3.81, g = 5%, k = 12%, then V0 = 57.15
52
Stock price and PVGO (present value of growth opportunity)
Dividend payout ratio (1-b) vs. plowback ratio (b, earnings retention ratio)
Price = no-growth value per share + PVGO
P0 
E1
E
 PVGO , where 1 is the no-growth value per share
k
k
Example: assume E1 = $5.00, k = 12.5%, ROE = 15%
If D1 = $5.00, then g = 0% (g = ROE * b, b = 0)
P0 = 5/0.125 = $40.00
If b = 60%, then g = 15%*0.6 = 9%, D1 = 5*(1-0.6) = $2.00
P0 = $57.14 (from constant DDM)
PVGO = 57.14 – 40.00 = $17.14
(3) Life cycle and multistage growth models: the growth rates are different at
different stages, but eventually it will be a constant
Two-stage growth DDM
Example: Honda Motor Co.
Expected dividend in next four years:
$0.90 in 2009
$0.98 in 2010
$1.06 in 2011
Dividend growth rate will be steady beyond 2012
$1.15 in 2012
Assume ROE = 11%, b = 70%, then long-term growth rate g = 7.7%
Honda’s beta is 1.05, if the risk-free rate is 3.5% and the market premium is 8%,
then k = 11.9% (from CAPM)
Using constant DDM, P2010 = 1.15*(1 + 0.077) / (0.119 - 0.077) = $29.49
2008
$0.90
2009
$0.98
2010
$1.06
2011
$29.49
$1.15
2012
Discount all the cash flows to the present at 11.9%, V2008 = $21.88
Multistage growth DDM: extension of two stage DDM
53

Alternatives models
P/E ratio approach
If g = ROE*b, the constant growth DDM is
P0
1 b
, with k>ROE*b.

E1 k  ( ROE * b)
Since P/E ratio indicates firm’s growth opportunity, P/E over g (call PEG ratio)
should be close to 1.
If PEG ratio is less than 1, it is a good bargain. For the S&P index over the past
20 years, the PEG ratio is between 1 and 1.5.
Price-to-book ratio approach
Price-to-cash flow ratio approach
Price-to-sales ratio approach

Free cash flow valuation approach
Free cash flow: cash flow available to the firm or to the shareholders net of capital
expenditures
Free cash flow to the firm (FCFF)
FCFF = EBIT*(1-tc) + depreciation – capital expenditures – increase in NWC
Use FCFF to estimate firm’s value by discounting all future FCFF (including a
terminal value, PT) to the present
Free cash flow to equity holders
FCFE = FCFF – interest expense*(1-tc) + increases in net debt
Use FCFE to estimate equity value by discounting all future FCFE (including a
terminal value, PT) to the present
Examples

1.
2.
3.
ASSIGNMENTS
Concept Checks
Key Terms
Intermediate: 12, 13, 14, and CFA 1-4
54
Chapter 18 - Portfolio Performance and Evaluation





Risk-adjusted returns
M2 measure
T2 measure
Active and passive portfolio management
Market timing

Risk-adjusted returns
Comparison groups: portfolios are classified into similar risk groups
Basic performance-evaluation statistics
Starting from the single index model
R Pt   P RMt   P   Pt
Where R Pt is the portfolio P’s excess return over the risk-free rate, R Mt is the
excess return on the market portfolio over the risk-free rate,  P is the portfolio
beta (sensitivity),  P   Pt is the nonsystematic component, which includes the
portfolio’s alpha  P and the residual term  Pt (the residual term  Pt has a mean
of zero)
The expected return and the standard deviation of the returns on portfolio P
E ( R Pt )   P E ( R Mt )   P
 P2   P2 M2   2
and
Estimation procedure
(1) Obtain the time series of RPt and RMt (enough observations)


(2) Calculate the average of RPt and RMt ( R P and R M )
(3) Calculate the standard deviation of returns for P and M (  P and  M )
(4) Run a linear regression to estimate  P


(5) Compute portfolio P’s alpha:  P  E( RPt )  P E( RMt )  R P   P R M
(6) Calculate the standard deviation of the residual:     P2   P2 M2
55
Risk-adjusted portfolio performance measurement (Table 18.1 - Digital Image)
(1) The Sharpe measure: measures the risk premium of a portfolio per unit of total
risk, reward-to-volatility ratio

Sharpe measure = S 
R

(2) The Jensen measure (alpha): uses the portfolio’s beta and CAPM to calculate
its excess return, which may be positive, zero, or negative. It is the difference
between actual return and required return


 P  E( RPt )  P E ( RMt )  R P   P R M
(3) The Treynor measure: measures the risk premium of a portfolio per unit of
systematic risk

Treynor measure = T 

R

M2 measure
M2 measure: is to adjust portfolio P such that its risk (volatility) matches the risk
(volatility) of a benchmark index, then calculate the difference in returns
between the adjusted portfolio and the market
M 2  (S P  S M ) M
Example: Given the flowing information of a portfolio and the market, calculate
M2, assuming the risk-free rate is 6%.
Average return
Beta
Standard deviation
Portfolio (P)
35%
1.2
42%
Market (M)
28%
1.0
30%
S for P = (0.35 - 0.06) / 0.42 = 0.69
S for M = (0.28 - 0.06) / 0.30 = 0.73
M2 = (0.69 - 0.73)*0.30 = -0.0129 = -1.29%
(Figure 18.2 - Digital Image)
56
E(r)
CML
rP = 35%
P
M
rM = 28%
rP* =26.71%
M2
P*
CAL
rf = 6%
 M =30%
 P =42%
Alternative way: adjust P to P* (to match the risk of the market)
Determining the weights to match the risk of the market portfolio
30/42 = 0.7143 in portfolio
1-0.7143 = 0.2857 in risk-free asset
Adjusted portfolio risk = 30%
Adjusted portfolio return = 0.7143*35% + 0.2857*6% = 26.71% < 28%
M2 = 26.7% – 28% = -1.29%
The portfolio underperforms the market

T2 measure
T2 measure: is similar to M2 measure but by adjusting the market risk - beta
T 2  rp*  rM
Example (continued)
Weights: 1/1.2 = 0.8333 in P and 1 – 0.8333 = 0.1667 in risk-free asset
The adjusted portfolio has a beta of 1: 1.2*0.8333 + 0*0.1667 = 1
Adjusted portfolio return = 0.8333*35% + 0.1667*6% = 30.17% > 28%
T2 = 30.17% – 28% = 2.17%
57
E(r)
P
rP = 35%
P*
rP* = 30.17%
rM = 28%
T2
M
SML
rf = 6%
 m =1
 p =1.2
The portfolio outperforms the market
Why M2 and T2 are different?
Because P is not fully diversified and the standard deviation is too high

Active and passive portfolio management
Active: attempt to improve portfolio performance either by identifying mispriced
securities or by timing the market; it is an aggressive portfolio management
technique
Passive: attempt of holding diversified portfolios; it is a buy and hold strategy

Market timing
A strategy that moves funds between the risky portfolio and cash, based on
forecasts of relative performance
(Table 18.7 - Digital Image)
When can we time the market?
(Figure 18.9 - Digital Image)
Can we time the market?
58
Example: Intermediate 6 (Figure - Digital Image)
We first distinguish between timing ability and selection ability. The intercept of
the scatter diagram is a measure of stock selection ability. If the manager tends to
have a positive excess return even when the market’s performance is merely
“neutral” (i.e., the market has zero excess return) then we conclude that the
manager has, on average, made good stock picks. In other words, stock selection
must be the source of the positive excess returns.
Timing ability is indicated by the curvature of the plotted line. Lines that become
steeper as you move to the right of the graph show good timing ability. The
steeper slope shows that the manager maintained higher portfolio sensitivity to
market swings (i.e., a higher beta) in periods when the market performed well.
This ability to choose more market-sensitive securities in anticipation of market
upturns is the essence of good timing. In contrast, a declining slope as you move
to the right indicates that the portfolio was more sensitive to the market when the
market performed poorly, and less sensitive to the market when the market
performed well. This indicates poor timing.
We can therefore classify performance ability for the four managers as follows:
A
B
C
D

1.
2.
3.
Selection Ability
Bad
Good
Good
Bad
Timing Ability
Good
Good
Bad
Bad
ASSIGNMENTS
Concept Checks
Key Terms
Intermediate: 5, 6, and CFA 1-4
59
Chapter 19 - International Investing




Global equity markets
Risk factors in international investing
International diversification
Exchange rate risk and political risk

Global equity markets
Developed markets vs. emerging markets
(Tables 19.1 and 19.2 - Digital Image)
Market capitalization and GDP: positive relationship, the slope is 0.66 and R2 is
0.28, suggesting that an increase of 1% in the ratio of market capitalization to
GDP is associated with an increase in per capita GDP by 0.66%
Home-country bias: investors prefer to invest in home-country stocks

Risk factors in international investing
Exchange rare risk
Direct quote vs. indirect quote
Direct quote: $ for one unit of foreign currency, for example, $2 for one pound
Indirect quote: foreign currency for $1, for example, 0.5 pound for $1
Interest rate parity:
F0 1  r f (US )

E 0 1  r f (UK )
Example: 19.1 - 19.3
Given: you have $20,000 to invest, rUk = 10%, E0 = $2 per pound, the exchange
rate after one year is E1 = $1.80 per pound, what is your rate of return in $?
$20,000 = 10,000 pounds, invested at 10% for one year, to get 11,000 pounds
Exchange 11,000 pounds at $1.80 per pound, to get $19800, a loss of $200
So your rate of return for the year in $ is -1% = (19,800 - 20,000) / 20,000
If E1 = $2.00 per pound, what is your return? How about E1 = $2.20 per pound?
60
If F0 = $1.93 (futures rate for one year delivery) per pound, what should be the
risk-free rate in the U.S.?
Answer: rUS = 6.15%, using the interest rate parity
If F0 = $1.90 per pound and rUS = 6.15%, how can you arbitrage?
Step 1: borrow 100 pounds at 10% for one year and convert it to $200 and invest
it in U.S. at 6.15% for one year (will receive 200*(1 + 0.0615) = $212.3)
Step 2: enter a contract (one year delivery) to sell $212.3 at F0
Step 3: in one year, you collect $212.3 and covert it to111.74 pounds
Step 4: repay the loan plus interest of 110 pounds and count for risk-free profit of
1.74 pounds
Country-specific risk (political risk)

International diversification
Adding international equities in domestic portfolios can further diversify domestic
portfolios’ risk (Figure 19.10 - Digital Image)
Portfolio Risk
With US stocks only
US and international stocks
# of stocks in portfolio
Adding international stocks expands the opportunity set which enhances portfolio
performance (Figure 19.10 - Digital Image)
E(rP)
US and international stocks
With US stocks only
P
61
(Way? Because investors with more options (choices) will not be worse off)
World CML (Figure 19.2 - Digital Image)
World CAMP
Choice of an international diversified portfolio (Figure 19.14 - Digital Image)

4.
5.
6.
ASSIGNMENTS
Concept Checks
Key Terms
Intermediate: 5-7 and CFA 1-2
62