Table of Contents
Lecture Outlines …. ………………………………………………………………………. 2
Firms, Corporations, Stocks and Bonds ...…………………………………………………. 2
Investment Returns, Stock Reports, and Stock Indexes .…………………………………... 7
Primary Market for Stocks…………………………………………………………………..12
Secondary Market for Stocks…….. ……………………………………………………….. 15
What Determines Stock Prices: Fundamentals or Psychology…..…………………………. 22
Stock Market Analysis and Investment Strategies: Are Stock Prices Predictable?………… 28
Mutual Funds: Can Professional Portfolio Managers Beat the Market…………………….. 30
Stock Market Reaction to News…………………………... ……………………………….. 34
Stock Market Performance: 1982 – Present………….…………………………………….. 35
Principles of Modern Portfolio Theory ………….………………………………………….. 37
1
FIRMS, CORPORATIONS, STOCKS, AND BONDS
1. Objective of the Firm
a. Profit maximization
b. Profit = Total Revenue – Total Cost
c. Profit = Earnings = Income
2. Forms of Business Organization
a. Proprietorship
b. Partnership
c. Corporation
3. Proprietorship
a. Firm that is owned by a single individual
b. Advantages
1.
Easy to start
2.
Individual makes all decisions
3.
Individual receives all profit
4.
Profit is taxed only once
c. Disadvantages
1. Difficult to obtain money to grow the firm
2. Unlimited liability
4. Partnership
a. Firm that is owned by two or more individuals
b. Advantages
1.
Easy to start
2.
Partners receive all profit
3.
Profit is taxed only once
4.
Can raise more money than proprietorship
c. Disadvantages
1. Difficult to obtain large amounts of money to grow the firm
2. Unlimited liability
5. Corporation
a. Firm that is a legal person
b. Starting a corporation
c. Stockholders or shareholders
d. Limited liability
e. Potentially able to raise large amounts of money to grow the firm
f. Board of Directors and Management
6. Corporate Profits (Earnings)
a. Profit = Total Revenue – Total Cost
b. After tax profit
c. Two things a corporation can do with after tax profit
1. Dividends
2. Retained Earnings
7. Corporate Finance
a. Three ways a corporation can obtain money
1. Retained earnings
2. Borrowing
3. Issuing new stock
b. Retained earnings
c. Borrowing
i. Two ways to borrow money
2
1. Loan from a bank
2. Issue corporate bonds
ii. Corporate bonds
1. Face value
2. Coupon rate
3. Term to maturity
4. callable feature
d. Issuing new stock
8. Two types of stock
a. Common Stock
b. Preferred Stock
9. Common stock
a. Defines the stockholders rights
b. Three types of rights
1. Voting rights
2. Dividend rights
3. Residual rights
10. Preferred Stock
a. Stock issued at a specific par value that pays a fixed dividend
b. Dividend and initial investment priority rights
c. Cumulative preferred stock
d. Callable preferred stock
e. Convertible preferred stock
1. conversion ratio
2. conversion price
10. Stock Rights
a. The right to buy or sell a fixed amount of a stock at a fixed price for a fixed period of
time
b. Most stock rights are marketable
c. 3 major types of stock rights
1. Preemptive rights
2. Stock warrants
3. Stock options
i.
Incentive stock options
ii. Tradable stock options
11. Preemptive Rights
a. Gives existing stockholders the right to buy a fixed number of shares of newly issued
stock at a fixed price for a short period of time
b. Issued by corporation
c. Subscription price Vs market price
12. Stock Warrants
a. Gives the holder the right to buy a fixed number of shares of stock at a fixed price for a
fixed period of time
b. Issued by corporation
c. Often times issued with bonds
13. Incentive Stock Options
a. Gives management and/or employees of a company the right to buy a fixed number of
shares of stock at a fixed price for a fixed period of time
b. Issued by corporation
c. Not marketable
d. Possible reasons for issuing incentive stock options
3
14.
15.
16.
17.
18.
1. Provides an incentive to increase productivity
2. Attract new employees and keep existing employees
3. Substitute for higher wages and salaries
Tradable Stock Options
a. Gives holder the right to buy or sell a fixed number of shares of stock at a fixed price for
a fixed period of time
b. Not issued by corporation, issued by investors
c. Call option – the right to buy
d. Put option – the right to sell
e. Strike (exercise) price
f. Expiration date
g. Writers and buyers
h. Speculation, hedging and leverage
Derivatives
a. Financial instrument that derives its value from the value of an underlying asset
b. Preemptive rights, warrants, stock options, forward contracts, futures contracts, swap
contracts
c. Long-Term Capital Management and derivatives
Primary Market for Securities
a. Market for newly issued securities
Secondary Market for Securities
a. Market for previously issued securities
b. Secondary market for bonds and the inverse relationship between bond prices and interest
rates
Supply and Demand
4
EXAMPLES: FIRMS, CORPORATIONS, STOCKS, AND BONDS
Example: Stockholders and Ownership
Total Shares: 100,000
Stockholder
Founder 1
Founder 2
Investor 1
Investor 2
Investor 3
Shares
30,000
30,000
5,000
10,000
25,000
% Ownership
30%
30%
5%
10%
25%
Price
Investment
$10
$10
$10
$50,000
$100,000
$250,000
Example: Corporate Profits
Total revenue:
Total cost:
Profit:
Tax:
After tax profit:
Earnings per share:
Dividends:
Dividends per share:
Retained earnings:
$240,000
$100,000
$140,000
$40,000
$100,000
$1/share
$50,000
$0.50
$50,000
Example: Coupon Bond
Face value:
Coupon rate
Maturity
Annual interest payment:
$1,000
10%
10 years
$100
Example: Convertible Preferred Stock
Par value:
Dividend rate:
Conversion ratio:
Conversion price:
Market price of common stock (case 1):
Market price of common stock (case 2):
Market price of Preferred stock:
$100
5%
2
$50
$40
$70
Example: Preemptive Rights
Investor shares:
Share right:
Subscription price:
Expiration:
Market Price of common stock:
Market value of preemptive right:
1,000
1 new share for each existing share owned
$49
Two weeks after date of new stock issuance
$50
5
Example: Stock Warrants
Share right:
Subscription price:
Expiration:
Market price of common stock (case 1):
Market price of common stock (case 2):
Market value of warrant:
100 shares
$30
10 years
$30 or less
greater than $30
Example: Call Option (one contract)
Corporation:
Share right:
Strike price:
Expiration:
Call price:
Call premium:
Market price of common stock:
Future market price of common stock (case 1):
Future market price of common stock (case 2):
Future call price:
Dell Computer
100 shares
$50
6 months
$3/share
$300
$48
$60
$50
Example: Put Option (one contract)
Corporation:
Share right:
Strike price:
Expiration:
Put price:
Put premium:
Market price of common stock:
Future market price of common stock (case 1):
Future market price of common stock (case 2):
Future call price:
Dell Computer
100 shares
$50
6 months
$3/share
$300
$48
$60
$40
Example: Bond Prices and Interest Rates
Your Bond Today
Face value:
$1,000
Coupon rate
8%
Maturity
2 years
Annual interest payment:
$80
Market price:
$1,000
Capital Gain/loss for buyer:
$0
Yield to maturity:
8%
New Bond Next Year
$1,000
10%
1 year
$100
$1,000
$0
10%
Your Bond Next Year
$1,000
8%
1 year
$80
$981.82
$18.18
10%
6
INVESTMENT RETURNS, STOCK REPORTS, AND STOCK INDEXES
INVESTMENT RETURNS
1. Measuring the Performance of an Investment
a. Most often used measure of performance is return
2. Two Measures of Return
a. Total return
b. Rate of return
3. Total Return for an Individual Stock
a. Definitions
P0 = Beginning of period price
P1 = End of period price
D = Dividends received during period
b. Formula
Total return = P1 – P0 + D
c. P1 – P0 > 0 then capital gain
d. P1 – P0 < 0 then capital loss
e. Not a good measure of performance because it doesn’t take into account size of
investment
4. Rate of Return for an Individual Stock
a. Formula
P1 – P0 + D
Rate of return = 
P1
b. Price of stock at beginning of period takes into account initial size of investment
5. Rate of Return for a Portfolio
a. Weighted average of the rates of return of the stocks in the portfolio
b. Weight of a stock is the market value of the stock as a proportion of the market value of
the portfolio
6. Nominal Return Vs Real Return
a. Nominal return does not make adjustment for inflation
b. Real return makes an adjustment for inflation
c. Real rate of return = Nominal rate of return – Inflation rate
7. Compounding
a. The process of earning a return on a return
8. Historical Returns: Stocks Vs Bonds
a. Historically stocks have been the best long-term investment
STOCK PRICE INDEXES
1. Measuring the Performance of the Stock Market
b. Most often used measure of performance is a stock price index
2. Stock Price Index
a. Weighted average of the prices of a group of stocks
b. Price weight Vs Market capitalization
3. Market capitalization
a. Market capitalization = Stock price x Shares outstanding
b. Large-cap stock (greater than $1 billion)
7
4.
5.
6.
7.
8.
9.
10.
11.
c. Mid-cap stock ($500 million to $1 billion)
d. Small-cap stock (Less than $500 million)
Often Cited Measures of the Performance of the Stock Market
a. Dow Jones Industrial Average
b. Standard and Poor’s 500 Index
c. Wilshire 5000 Index
d. Russell 3000 Index
e. Russell 1000 Index
f. Russell 2000 Index
g. Nasdaq Index
Dow Jones Industrial Average
a. Group of stocks: 30 large of the largest corporations traded on the N.Y. Stock Exchange
b. Calculation and interpretation
c. Price weighted average
d. Adjusted for stock splits, stock dividends of more than 10%, and spin-offs
e. Represents 20% of total market value (capitalization) of all stocks
Standard and Poor’s (S&P) 500 Index
a. Group of stocks: 500 corporations in 100 different industry groups
b. Represents 75% of the total market value of all stocks
c. Calculation and interpretation
d. Capitalization weighted index
e. Measure of performance of stock market used most often by portfolio managers and
academicians
Wilshire 5000
a. Group of stocks: 7,340 corporations of all sizes in all industries
b. Represents close to 100% of the total market value of all stocks
c. Capitalization weighted index
d. Broadest measure of performance of stock market
Russell 3000
a. Group of stocks: 3000 largest corporations
b. Represents 96% of total market value of stocks
c. Capitalization weighted index
d. Broad measure of performance of stock market
Russell 1000
a. Group of stocks: 1000 largest corporations
b. Represents 85% of total market value of stocks
c. Capitalization weighted index
d. Measure of performance of large-cap stocks
Russell 2000
a. Group of stocks: 2000 smallest corporations
b. Represents 11% of total market value of stocks
c. Capitalization weighted index
d. Measure of performance of mid-cap and small-cap stocks
Nasdaq Index
a. Group of Stocks: 6400 corporations whose stock is traded on the Nasdaq over-thecounter market
b. Heavily weighted by technology stocks
c. Capitalization weighted index
8
EXAMPLES: INVESTMENT RETURNS, STOCK REPORTS, AND STOCK INDEXES
Example: Reading a Stock Report
52 Weeks
Hi
Low
Stock
43 1/8 30 ¾ AT&T
Sym
Div
Yld %
PE
Vol
100s
Hi
T
1.32
3.7
10
37244
35 5/8 35 ½
Low
Close
Net Chg
35 ½
+3/8
Example: Calculating Total Return and Rate of Return for Individual stocks
Period: Jan 1, 2000 to December 31, 2000
Stock
IBM
Intel
Beginning Price (P0) Ending Price (P1) Dividends Total Return Rate of Return
$100
$115
$5
$20
20%
$50
$65
$0
$15
30%
Example: Calculating Rate of Return for a Portfolio of 3 Stocks
Period: Jan 1, 2000 to Dec 31, 2000
Stock
Citigroup
Dell
GE
Total
Beginning Value
$10,000
$30,000
$60,000
$100,000
Weight
(10,000/100,000) =0.10
(30,000/100,000) = 0.30
(60,000/100,000) = 0.60
1.00
Rate of Return
50%
10%
15%
Rate of Return = (0.10)50% + (0.30)10% + (0.60)15%
=
5%
+
3%
+
9%
= 17%
9
Example: Calculation of Stock Price Average (e.g., Dow Jones Industrial Average) and Stock Price Index
(e.g., S&P 500 Index, Wilshire 5000 Index, Russell 3000 Index, etc.)
Stock
January 1, 1998
Price Shares Market Cap
WalMart
IBM
Equifax
$20
$10
$30
Avg. Price
(20 + 10 + 30)/3 = 20
Total Market
Capitalization
1,000
700
100
$20,000
$7,000
$3,000
20,000 + 7,000 + 3,000
= 30,000
January 1, 1998
Dow Jones Avg
Calculation
Annual % change
Calculation
20
(20 + 10 + 30)/3 = 20
-----
January 1, 1999
Price Shares Market Cap
$18
$15
$42
1,000
700
100
$18,000
$10,500
$4,200
(18 + 15 + 42)/3 = 25
January 1, 2000
Price Shares Market Cap
$25
$15
$14
1,000
700
100
$25,000
$10,500
$1,400
(25 + 15 + 14)/3 = 18
18,000 + 10,500 + 4,200
= 32,700
25,000 + 10,500 + 1,400
= 36,900
January 1, 1999
January 1, 2000
25
(18 + 15 + 42)/3 = 25
25%
(25 – 20)/20 = 0.25
18
(25 + 15 + 14)/3 = 18
- 28%
(18 – 25)/25 = -0.28
S&P 3 Index
100
108
123
Calculation
(30,000/ 30,000)100 = 100 (32,700 / 30,000)100 = 109 (36,900 / 30,000)100 = 123
Annual % change
----9%
13.9%
Calculation
(109 – 100)/100 =0.09
(123 – 108)/108 = 13.9%
10
Historical Returns: Stock Vs Bonds 1802 – 1997
__________________________________________________________________________________
Stocks
Nominal
Return
Bonds
Div Cap
Real
Return
Nominal
Return
8.4
3.0 5.4
7.0
4.8
4.7
0.1
3.5
1802-1870
7.1
6.4
0.7
7.0
4.9
4.9
0
4.8
1871-1925
7.2
5.2 1.9
6.6
4.3
4.0
0.3
3.7
1926-1997
10.6
4.6 6.0
7.2
5.2
5.2
0
2.0
1946-1997
12.2
4.3 7.9
7.5
5.4
6.1
-0.7
1.1
1966-1981
6.6
4.1
-0.4
2.5
7.2
- 4.7
-4.2
Coup Cap
Real
Return
Period
1802-1997
Sub-Periods
Post-War Periods
2.6
1982-1997
16.7
3.8 12.9
12.8
13.4
8.7
4.7
9.6
__________________________________________________________________________________
Source: Jeremy Siegel, Stocks for the Long-Run.
Example: Investment in Stocks
Investment Type:
Initial Investment 1982:
Value of Investment 1996:
Diversified portfolio of stocks (e.g., S&P 500 Index Fund)
$10,000
$118,340
Example: Investment in Bonds
Investment:
Initial Investment 1982:
Value of Investment 1996:
Diversified portfolio of bonds (e.g., Total bond market Index Fund)
$10,000
$74,784
11
THE PRIMARY MARKET FOR STOCKS
1. Primary Market For Stocks
a. The market for newly issued stock
2. The 4 Major Players
a. Corporations
b. Investors
c. Brokers
d. Dealers
3. Corporations
a. Sellers of newly issued stock
4. Investors
a. Buyers of newly issued stock
b. Primarily institutional investors, some individual investors
5. Brokers
a. Middleman function
b. Provides a pure search service
c. Receives income from a commission
6. Dealers
a. Middleman function
b. Buys newly issued stock for own inventory and attempts to sell to investors
c. Underwriting a stock issue
d. Receives income from the spread between the purchase and sale price
7. Investment Banks (Investment Houses)
a. Broker/dealer firm
b. Six major departments
1. Banking Department
2. Capital Markets Department
3. Research Department
4. Institutional Sales Department
5. Retail Brokerage Department
6. Trading Operations Department
8. Two Types of New Stock Issuances
a. Private placement
b. Public offering
9. Private Placement
a. New issue of stock is sold to 35 or fewer investors
b. Does not have to be registered with the Securities and Exchange Commission (SEC)
10. Public Offering
a. New issue of stock is sold to the public in general, more than 35 investors
b. Must be registered with the SEC
c. Two types of public offerings
1. Initial Public Offering (IPO)
2. Secondary Public Offering
11. Initial Public Offerings: The Key to Wealth?
a. Study by Loughran and Ritter
12
EXAMPLE: AN INITIAL PUBLIC OFFERING (IPO)
1. Starting an Online Bookstore
a. Books.com
2. Proprietorship
3. Partnership
4. Venture Capitalist
a. Private investment firm that provides money and managerial expertise to young,
promising companies
5. Incorporating the Business
a. Total shares of stock: 300,000
b. Original proprietor shares of stock: 100,000
c. Partner shares of stock: 100,000
d. Venture capitalist shares of stock: 100,000
6. Private Corporation
a. How much is the stock of a private corporation worth?
7. Taking the Corporation Public
a. Selling new shares of stock to the public in general
b. Listing the stock on an organized stock exchange
8. Finding an Investment Bank
a. Underwriting the stock
9. Two Types of Underwritings
a. Firm commitment underwriting
b. Best efforts underwriting
10. Forming an Underwriting Syndicate
a. Lead underwriter
12. SEC Registration Process
13. Registration Statement
a. Prospectus
b. Other information
14. Red Herring and Cooling-Off Period
a. Draft of registration statement
b. SEC review period: 20 to 30 days
15. Circling the Stock
a. Institutional Sales and Retail Sales Departments contact potential investors
16. Due Diligence Meeting
a. Final verification of information in registration statement
b. Allocation of shares to investment banks in syndicate
17. Road Show
18. Pricing Meeting
a. Setting IPO stock price
b. Comparable multiples analysis
c. Perceived demand for stock
d. Current stock market conditions
19. Effective Date
a. SEC declares registration statement effective
b. IPO can take place
20. Underwriting Agreement
a. Investment banks formally agree to buy stock
21. Listing the Stock
a. Arranging to have the stock listed on an exchange
13
22. Closing
a. Investment banks buy stock
23. Lock-Up Agreement
a. Original stock holders agree not to sell stock for at least 6 months
24. Trading on the Secondary Market
25. Instant Millionaires: An Example
Financial Position of Proprietor and Partner
Shares
100,000
IPO Price
$16
Market Value of Shares
$1.6 million
Secondary Market Price Market Value of Shares
$25
$2.5 million
14
THE SECONDARY MARKET FOR STOCKS
INTRODUCTION
1. The Secondary Market for Stocks
a. Market for previously issued stock
2. Function of the Secondary Market for Stocks
a. Allows investors to easily convert stocks to cash, thereby increasing liquidity
b. Allows investors to buy stock, even if new shares are not issued
3. The Players
a. Investors
b. Brokers
c. Dealers
4. Investors
a. Buyers and sellers of previously issued stock
b. Can be individuals, institutional investors (mutual funds, hedge funds, insurance companies,
university endowments, etc.), corporations
5. Brokers
a. Middleman function
b. Provides a pure search service
c. Receives income from a commission
6. Dealers
a. Middleman function
b. “Make” secondary markets in stocks
c. Bid price and asked (offer) price
d. Receives income from the spread between the bid price and asked price
e. Benefits for investors
7. Classification of Secondary Markets
a. Two general types of secondary markets
1. Organized exchange
2. Over-the-counter market
b. Electronic trading systems
1. Instinet
BUYING AND SELLING STOCK ON THE SECONDARY MARKET
1. Choosing a Brokerage Firm
a. Full service broker
b. Discount broker
c. Online broker
2. Opening a Brokerage Account
a. Cash account
b. Margin account
3. Cash Account
a. Payment in full within 5 business days
b. Can choose to hold stock in “street name” or take physical possession of certificates
4. Margin Account
a. Can make 3 types of stock transactions
1. Cash transaction
2. Margin transaction
3. Short sale transaction
15
b. Customer’s agreement
1. Stock in margin account is used as collateral for margin loans
2. Stock purchased on margin can be loaned to others for short sales
3. Stock must be held in street name
c. Margin transaction
1. Borrowing money to buy stock
2. Leverage
3. Regulation T
4. Initial requirement
5. Maintenance requirement
6. Equity = Market value of stocks + Cash – Amount borrowed
7. Margin call
8. Call money rate
9. Example
d. Short-Sale transaction
1. Borrowing stock to sell for money
2. Selling “high” and buying back “low”
3. Short interest
4. Example
5. Submitting an Order to Buy or Sell Stock
a. Buy Order
1. Go long, long, long position
b. Sell Order
1. Sell long
2. Sell short, go short, short
c. Order Size
1. Round lot
2. Odd lot
d. Types of orders
1. Market order
2. Limit order
i. Buy limit order
ii. Sell limit order
3. Stop order
i. Buy stop order
ii. Sell stop order
4. Day order
5. Good-til-Canceled Order
TRACKING A SECONDARY MARKET TRANSACTION
1. Investor
a. Wishes to buy 100 shares of AT&T and 100 shares of Dell
2. Brokerage Firm
a. Full-service brokerage firm Merrill Lynch
b. Margin account
3. Order
a. Cash transactions
b. Market order
4. Account Executive
a. Investor phones broker and gives stock orders
16
b. Broker contacts order room
5. Order Room
a. Checks orders for obvious mistakes
b. Sends orders to appropriate stock exchange or OTC trading room
New York Stock Exchange
6. Background
a. Three rooms: main room, blue room, garage
b. Walls of each room are lined with telephones
c. Only members can do business on the floor of the exchange
7. Telephone Clerks, Floor Brokers, and Independent Brokers
8. Trading Posts
a. 17 trading posts on the floor
b. Stocks are traded in round lotts
9. Specialist
a. 20 to 25 specialists at each trading post
b. Each specialist is assigned 10 to 15 different stocks
c. Role of specialist is to “maintain a fair and orderly market”
d. Specialist performs 3 major functions
1. Quotes a bid price and asked (offer) price for the stock
i. Example of quote: 20 bid, 20 ½ asked, 200 by 100
2. Serves as a broker for floor brokers and independent brokers
3. Serves as a dealer to “make a market”
e. SuperDOT Electronic System
1. Computer system used to execute small round lot orders (5,099 shares or less) and
odd lot orders
2. Handles 85% of all orders and 40% of volume
Over-the-Counter Market
10. Background
a. Vast majority of stocks are traded on the over-the-counter market
b. Market is organized by hundreds of brokerage firms and “market maker firms” that trade
stocks via computer and over the telephone
11. Dealers
a. Market maker firms make a market in a stock by holding an inventory of the stock, quoting bid
and asked prices, and standing ready to buy at the bid price and sell at the asked price
b. As many as 20 to 30 dealers make a market in large, well-known stocks, such as Microsoft,
Intel, and Dell
c. Two types of dealers
1. Retail dealers
2. Wholesale dealers
d. Top Ten Nasdaq Market Makers (March 2000)
1. See Table 1
12. Three Segments of the Over-the-Counter Market
a. Nasdaq Market
1. Computer market
2. National Association of Securities Dealers Automated Quotations System
3. Approximately 6,400 stocks traded
b. Bulletin Board Market
17
c. Pink Sheet Market
13. How are Dealer Bid/Asked Prices Determined?
a. Supply and Demand
14. Example
a. Four dealers make a market in Dell
b. See Table 2
15. Electronic Communications Networks (ECN)
a. A computerized trading system that does not require the use of a specialist or dealer
b. Will ECN’s replace organized exchanges and the over-the-counter market?
Table 1
Firm
1. Knight Trading Group
2. Charles Schwab
3. Herzog Heine Geduld
4. Spear Leeds & Kellogg
5. Salomon Smith Barney
6. Merrill Lynch
7. Morgan Stanley Dean Witter
8. Goldman Sachs
9. Credit Suisse First Boston
10. National Discount Brokers
Stocks Traded
Market Share
6,602
6,978
6,064
5,003
723
729
867
381
773
3,472
12.8%
10.3%
7.7%
5.4%
5.1%
4.4%
4.0%
3.5%
3.3%
3.1%
Table 2
Knight
Schwab
Goldman Sachs
Spear Leeds Kellogg
20
20
19 7/8
20
20 1/2
20 3/8
20 3/8
20 1/2
10 – 10
10 – 10
10 – 10
10 – 10
18
EXAMPLE: MARGIN TRANSACTION
Margin Account Requirements
Initial margin requirement:
Maintenance requirement:
Margin interest rate:
50%
25%
10%
Open Margin Account
Account Information:
Cash:
Market value of Stocks:
Amount borrowed:
Equity:
$4,000
$0
$0
$4,000
Margin Transaction Vs Cash Transaction
Transactions Information:
Margin Transaction
Cash Transaction
Apple Computer
Price per share:
Shares:
Market value:
Cash paid:
Amount borrowed:
$10
800
$8,000
$4,000
$4,000
$10
400
$4,000
$4,000
$0
$0
$8,000
$4,000
$4,000
$0
$4,000
$0
$4,000
$1,000
$5,000
Stock price below $6.25
N/A
N/A
N/A
Account Information:
Cash:
Market Value of Stocks:
Amount Borrowed:
Equity:
Requirements:
Required equity:
Required stocks and cash:
Margin call:
19
Scenario 1: Stock Price Rises to $20
Transactions Information:
Margin Transaction
Cash Transaction
Apple Computer
Price per share:
Shares:
Market value:
Cash paid:
Amount borrowed:
$10
($20)
800
$8,000 ($16,000)
$4,000
$4,000
$10
($20)
400
$4,000 ($8,000)
$4,000
$0
$0
$8,000 ($16,000)
$4,000
$4,000 ($12,000)
$0
$4,000 ($8,000)
$0
$4,000 ($8,000)
$1,000
$5,000
Stock price below $6.25
N/A
N/A
N/A
Account Information:
Cash:
Market Value of Stocks:
Amount Borrowed:
Equity:
Requirements:
Required equity:
Required stocks and cash:
Margin call:
Performance:
Profit:
Return:
($8,000)
(200%)
($4,000)
(100%)
20
Scenario 2: Stock Price Falls to $6
Transactions Information:
Margin Transaction
Cash Transaction
Apple Computer
Price per share:
Shares:
Market value:
Cash paid:
Amount borrowed:
$10
($6)
800
$8,000 ($4,800)
$4,000
$4,000
$10
($6)
400
$4,000 ($2,400)
$4,000
$0
$0
$8,000 ($4,800)
$4,000
$4,000 ($800)
$0
$4,000 ($2,400)
$0
$4,000 ($2,400)
$1,000
$5,000
Stock price below $6.25
N/A
N/A
N/A
Account Information:
Cash:
Market Value of Stocks:
Amount Borrowed:
Equity:
Requirements:
Required equity:
Required stocks and cash:
Margin call:
Performance:
Profit:
Return:
(-$3,200)
(-80%)
(-$1,600)
(-40%)
3 Ways to Satisfy Margin Call:
1. Deposit cash of $200 or more
2. Deposit stocks with market value of $200 or more
3. Broker sells enough shares of Apple Computer to decrease loan to satisfy maintenance
requirement.
21
WHAT DETERMINES STOCK PRICES: FUNDAMENTALS OR PSYCHOLOGY?
INTRODUCTION
1. What Determines the Price of a Stock?
a. Supply and demand
2. What Determines the Supply and Demand for a Stock?
a. Topic that has been long debated
3. Two Theories of Stock (Asset) Valuation
a. Firm-foundation theory
b. Market psychology (Castle-in-the-Air Theory)
FIRM-FOUNDATION THEORY
1. Basic Premise
a. Firm foundation of value, fundamental value, intrinsic value
1. Price that a rational investor is willing to pay for a share of stock
b. Fairly valued stock – intrinsic value is equal to market price
c. Undervalued stock – intrinsic value is greater than market price
d. Overvalued stock – intrinsic value is less than market price
2. Intrinsic Value of a Stock
a. 4 fundamental factors determine the intrinsic value of a stock
1. Expected growth rate of earnings per share
2. Expected dividend payout
3. Level of market interest rates
4. Degree of risk
b. Stock price fundamentals
3. Expected Growth Rate of Earnings Per Share
a. Four components (Profits, shares, expectations, growth)
4. Profit/Earnings
a. Earnings = Total Revenue – Total Cost
5. Who Do the Earnings Belong To?
a. Stockholders have a claim to the earnings of the firm
b. Earnings per share (EPS)
1. EPS = Earnings / Shares
c. Dividends Vs retained earnings
6. Current Earnings Vs Future Earnings
a. Intrinsic value is determined by the future stream of earnings
b. Current earnings are worth more than future earnings
c. Intrinsic value is equal to the present value of the future stream of earnings
7. Time Value of Money and the Intrinsic Value of a Stock
a. Present value and future value
b. Calculating the future value of a payment received today
FVn = PV(1 + i)n
c. Calculating the present value of a payment received in the future
FVn
PV = 
(1 + i)n
22
d. Intrinsic value of a stock with a finite future stream of earnings
EPS1
EPS2
EPS3
EPSn
Intrinsic value =  +  +  + … + 
(1 + i)1
(1 + i)2
(1 + i)3
(1 + i)n
e. Intrinsic value of a stock with an infinite future steam of earnings
EPS
Intrinsic value = 
i
8. Actual Earnings Vs Expected earnings
a. Intrinsic value depends upon expected earnings
b. Expected earnings, reported earnings, and earnings surprise
9. Growth Rate of Earnings
a. As economy grows earnings should grow
b. Higher growth Vs lower growth
c. Longer growth Vs shorter growth
10. Forecasting Future Earnings
`
a. Factors that influence earnings
b. Industry analysts
1. Estimates of future earnings
2. Consensus earnings estimates
11. Expected Dividend Payout
a. Stockholders prefer dividends now
12. Level of Market Interest Rates
a. Intrinsic value = EPS / i
b. Market interest rates, present value of earnings, and higher bond yields
c. Market interest rates, borrowing cost, and earnings
13. Degree of Risk
a. Discount rate, risk-free interest rate, and the risk premium
b. Intrinsic value = EPS / (i + r)
14. Firm-Foundation Theory: Short-Run Vs Long-Run
a. Short-run: undervalued stocks, and overvalued stocks
b. Long-run: fairly valued stocks
14. Firm-Foundation Theory and Investment Strategy
a. Undervalued, overvalued, and fairly valued stocks
MARKET PSYCHOLOGY (CASTLE-IN-THE-AIR) THEORY
1. Basic Premise
a. Psychic value
b. Price that an emotional investor is willing to pay for a share of stock
2. Psychic Value of a Stock
a. Psychological factors that determine the psychic value of a stock
1. Crowd psychology
2. Optimism and pessimism
3. Momentum
4. “Greater fools”
3. Feedback Loop Theory
a. Self-fulfilling prophecy or bandwagon effect
23
b. Chaos theory
4. Speculative Bubbles
a. Price of an asset is bid up to extremely high levels in a relatively short period of time, and then
falls dramatically
b. Speculative bubble as a “naturally occurring Ponzi process
5. Market Psychology Theory and Investment Strategy
a. Analyze market psychology and “beat the crowd”
b. No rational basis for stock prices
c. Don’t waste time analyzing fundamentals and estimating intrinsic value
PRICE-EARNINGS RATIO
1. Definition of Price-Earnings Ratio
Stock Price
a. P/E = 
Earnings Per Share
b. P/E on a trailing basis
c. P/E on a forward basis
2. Measure of Market Value of a Share of Stock
a. Stock price – amount investors are willing to pay for one share of stock
b. P/E ratio – amount investors are willing to pay for one dollar of current earnings
c. Example
3. Important Points about the P/E Ratio
a. Good yardstick by which to compare stocks that have different market prices and different
current earnings
b. If the P/E ratio increases, then the market is placing a higher value on a stock
c. If the P/E ratio decreases, then the market is placing a lower value on a stock
4. What Determines the P/E ratio?
a. Firm-foundation theory
b. Market psychology theory
EVIDENCE FOR AND AGAINST THE TWO THEORIES OF STOCK VALUATION
1. Which Theory Provides a Better Explanation of Stock Prices?
a. Firm Foundation Theory
1. Forecasted 5-year growth rates and P/E ratios
2. Examples: 1998
Firm
Ford
Bell Atlantic
Citigroup
IBM
Schwab
Home Depot
Microsoft
b. Market Psychology Theory
1. Speculative Bubbles
Projected 5-Year Growth Rate Actual P/E Ratio
7%
8%
10%
11%
18%
20%
25%
12
15
22
23
32
40
55
24
RECONCILING THE TWO THEORIES
1. Both Theories Tell Us Something about How Stock Prices Are Determined
a. Stocks appear to have a firm-foundation of value determined by the 4 fundamental factors
b. Actual stock prices are tied to their firm foundation of value, but this cord can be very elastic
c. Actual stock prices can deviate significantly from their firm foundation of value because of
market psychology
d. Short-run movements in stock prices may be better explained by psychological factors
e. Long-run movements in stock prices may be better explained by fundamental factors
2. A Schematic that Combines the Two Theories
Fundamental Factors

Intrinsic Value


Willingness
To
Pay
Psychological Factors

Psychic Value


Supply
and

Demand
Actual
Market
Price

25
EXAMPLES: WHAT DETERMINES STOCK PRICS?
Example: Calculating the Future Value of a Payment Received Today
Payment Received Today:
Interest rate:
$10
10%
Value in 1 year:
FV1 = PV(1+i) = 10(1.10) = $11
Value in 2 years:
FV2 = PV(1+i)2 = 10(1.10)(1.10) = 10(1.21) = $12.10
Value in 3 years:
FV3 = PV(1+i)3 = 10(1.10)(1.10)(1.10) = 10(1.331) = $13.31
Example: Calculating the Present Value of a Payment Received in the Future
Payment Received in Future:
Discount Rate:
$10
10%
Value Today of Payment Received in 1 Year:
FV1
10
PV =  =  = $9.09
(1+i)
(1.10)
Value Today of Payment Received in 2 Years:
FV2
10
10
PV =  =  =  = $8.26
(1+i)2
(1.10)(1.10)
1.21
Value Today of Payment Received in 3 Years:
FV3
10
10
PV =  =  =  = $7.51
(1+i)3
(1.10)(1.10)(1.10)
1.331
Example: Intrinsic Value of a Stock with a Finite Future Stream of Earnings
Assumptions:
1. Firm will be in business for next 5 years.
2. Firm will have earnings per share of $10 each year.
3. Discount rate of 10%
Year 1
Future value of earnings per share
Present value of earnings per share
$10
$9.09
Year 2
$10
$8.26
Year 3
$10
$7.51
Year 4
$10
$6.83
Year 5
$10
$6.21
Intrinsic value = 9.09 + 8.26 + 7.51 + 6.83 + 6.21 = $37.90/share
26
Example: Price/Earnings Ratio as a Measure of the Market Value of a Share of Stock
Firm A
Stock Price:
Shares:
Earnings:
Earnings per share:
Price-Earnings ratio:
$60
400,000
$800,000
$2
30
Firm B
Before Stock Split
After 2 for 1 Stock Split
Stock Price:
Shares:
Earnings:
Earnings per share:
Price-Earnings ratio:
$100
250,000
$1,000,000
$4
25
$50
500,000
$1,000,000
$2
25
27
STOCK MARKET ANALYSIS AND INVESTMENT STRATEGIES: ARE STOCK PRICES
PREDICTABLE?
1. The Role of Stock Market Analysts
a. Stock market analysts make recommendations about what stocks to buy and sell
b. To make recommendations stock market analysts must predict stock prices
2. Two Major Approaches Used to Predict Stock Prices
a. Fundamental analysis
b. Technical analysis
3. Fundamental Analysis
a. Based on the firm-foundation theory
b. Assumption: Stock market is 90% rational, 10% psychological
c. Steps involved in fundamental analysis
1. Estimate the intrinsic value of a stock
i. Forecast future earnings, dividend payouts, interest rates, and assess degree of
risk.
ii. Study industry, read trade publications, visit companies, talk with
management, study general economic conditions, Federal Reserve System,
government policy
2. Compare estimate of intrinsic value of stock to actual market price of stock
3. If intrinsic value is greater than market price, conclude stock is undervalued, predict
price will rise, and make buy recommendation
4. If intrinsic value is less than market price, conclude stock is overvalued, predict price
will fall, and make sell recommendation
4. Technical Analysis
a. Based on market psychology theory
b. Assumption: Stock market is 90% psychological, 10% rational
c. Steps involved in technical analysis
1. Collect data on past stock prices, trading volume, and possibly other market statistics
2. Look for patterns in data
3. Use patterns in data to identify changes in market psychology
4. If patterns in data indicate investors are becoming optimistic about a stock, predict
price will rise, and make buy recommendation
5. If patterns in data indicate investors are becoming pessimistic about a stock, predict
price will fall, and make sell recommendation
5. Random Walk Theory
a. Most academicians and many people on Wall Street believe that stock prices are not
predictable in the short-run
b. This view is formally expressed as the random walk theory of stock prices
6. What is a Random Walk?
a. A variable follows a random walk if its value next period is equal to its value this period plus
some random amount
b. Price of a stock tomorrow is equal to price of stock today plus some random amount
7. Two Important Questions
a. Why are stock prices not predictable in the short-run?
b. If stock prices are not predictable in the short-run, is investing in the stock market a pure
gamble and not worthwhile?
8. Why Stock Prices Are Not Predictable: The Efficient Market Hypothesis
a. At any give time, stock prices reflect all publicly available information about factors that
investors believe influence those prices.
b. Only new information (which is unknown to investors) can influence stock prices
28
9. Two Reasons Why Investing in Stocks Is Not a Pure Gamble
a. In the long-run, the average level of stock prices tends to increase
b. Three versions of the random walk theory
1. Weak version
i. Past information on stock prices cannot be used to predict future stock prices
ii. Technical analysis is useless
2. Semi-strong version
i. Publicly available information cannot be used to predict future stock prices
ii. Fundamental analysis is useless
3. Strong version
i. Neither public nor private information can be used to predict future stock
prices
ii. Insider information is useless
10. Are Stock Prices Predictable: The Evidence
a. Empirical studies have neither refuted nor fully supported the random walk theory
b. Two-thirds of professional money managers under-perform the market
1. Monkeys throwing darts beat the majority of professional money managers
c. One-third of professional money managers that outperform the market are not predictable
1. The story of the coin tossing expert
c. Some evidence that a group of highly intelligent and informed investors can beat the market
1. Ben Grahm, Warren Buffet, Peter Lynch
d. Some evidence that small cap stocks and value stocks achieve above average returns
e. Some evidence of a momentum effect
1. This year’s best performing stocks have better than average returns next year
2. This year’s worst performing stocks have worse than average returns next year
f. Some evidence of “reversion to the mean”
29
MUTUAL FUNDS: CAN PROFESSIONAL PORTFOLIO MANAGERS BEAT THE MARKET?
ESSENTIALS OF MUTUAL FUNDS
1. What is a Mutual Fund?
a. Investment company
b. Sells shares to investors
c. Invests in a portfolio of stocks, bonds, or money market instruments
2. Types of Funds
a. Stock funds, bond funds, money market funds, balanced funds, etc.
3. Stock Funds
a. Growth funds, value funds, small-cap funds, mid-cap funds, large-cap funds, sector funds,
global funds, index funds, etc.
4. Why Purchase Stocks Indirectly through an Investment Company?
a. Professional money management
b. Diversification
c. Small minimum investment requirements
d. Paperwork
5. Mutual Fund Regulations
a. Register as an investment company
b. SEC oversees
c. Prospectus and shareholder reports
d. No more than 5% of portfolio in single stock
6. How Does a Mutual Fund Obtain Money to Invest?
a. Sells shares to investors
7. What is the Price of a Mutual Fund Share?
a. Net asset value – assets minus expenses divided by shares outstanding
b. Example
Market value of stock portfolio
$9 million
Cash
$1.5 million
Expenses
$0.5 million
Shares outstanding
1 million
Net Asset Value = ($9 + $1.5 - $0.5)/ 1 = $10 share.
8. How do Investors Make Money When Investing in a Mutual Fund?
a. Dividends from the stock portfolio
b. Capital gains from the stock portfolio
c. Price appreciation of mutual fund shares
9. Dividends and Capital Gains
a. Distribution
b. Tax considerations
10. Price Appreciation of Mutual Fund Shares
a. Determinants of net asset value
b. Redemption of shares
11. How do Mutual Funds Make Money?
a. Loads
1. Front-end load
2. Back-end load
3. Deferred load
4. Reinvestment load
30
5. No load
b. Fees
1. Expense fees
2. 12b-1 fees
12. Turnover Ratio
a. Turnover ratio = Dollar value of stock sold and replaced during year / Total assets for year
b. 3 reasons turnover ratio is important
1. High turnover ratio may indicate short-term speculation
2. High turnover ratio leads to high capital gains distributions and high taxes
3. High turnover ratio results in high trading costs and lower returns
13. Assessing the Performance of Mutual Funds
a. Rate of return
D + C + (P1 – P0) – E
Return = 
P0
b.
c.
d.
e.
f.
g.
h.
D = dividend distribution per share
C = capital gains distribution per share
P1 = end of period net asset value (price per share)
P0 = beginning of period net asset value (price per share)
E = expenses per share
An increase in D + C lowers P1 by an equivalent amount
Annual return
Total return
Tax adjusted return
Load adjusted return
Relative return
Example
Safeco Equity Fund
1-year
3-year
5-year
Annual Return Total Return
29.5%
29.5%
19.2%
69.4%
13.5%
88.4%
Standard & Poor’s 500 Index
1-year
3-year
5-year
Annual Return Total Return
41.0%
41.0%
24.8%
94.4%
17.5%
124.0%
ACTIVELY MANAGED FUNDS VS INDEX FUNDS
1. Index Funds
a. Mutual fund that buys all of the stocks listed in a particular stock index, and holds them in the
proportion that they are represented in the index
b. Types of index funds
c. Goal of index funds
d. Passive management
31
2. Actively Managed Funds
a. Mutual fund that employees one or more portfolio managers who decide what stocks to
buy, sell, and hold
b. Types of actively managed funds
c. Goal of actively managed funds
d. Active management
CAN MUTUAL FUND PORTFOLIO MANAGERS BEAT THE MARKET?
1. Results of Studies
a. Average return on the S&P 500 Index has exceeded the average return on actively managed
large cap growth and income funds for the last 10, 20, 30, 40, and 50 years.
Period
S&P 500
50 years
40 years
30 years
20 years
10 years
13.6%
12.0%
12.7%
17.7%
19.2%
Stock Mutual Funds
11.8%
10.5%
10.7%
15.1%
15.2%
$10,000 invested in an S&P 500 stock portfolio (average large cap mutual fund) in 1950
would have been worth $5,782,000 ($2,589,000) by 2000
b. In a typical year, only 33% of stock mutual funds beat the market
c. Past performance of a mutual fund is not a good predictor of future performance
2. Reasons Why Mutual Funds Can’t Beat the Market
a. Actively managed mutual funds compete in a zero-sum game
b. Actively managed mutual funds have higher costs than index funds
1. Gross return Vs net return
2. Load charges, expenses, trading costs, opportunity cost of cash, tax cost
Average Annual Investment and Tax Costs: 1984 to 1998
Actively Managed Funds
Load Charges
Expenses
Trading Costs
Opp Cost Cash
Total Non-Tax Cost
Tax Cost
Total Cost
Index Funds
0.5%
1.2%
0.7%
0.6%
------3.0%
0
0.2%
0.1%
0%
------0.3%
2.7%
------5.7%
0.9%
-------1.2%
3. When Are Actively Managed Funds Likely to Beat the Market?
a. Small cap and mid cap stocks do better than large cap stocks
4. Performance of Other Portfolio Managers
a. Other types of portfolio managers cannot consistently beat the market
32
5. Hedge Funds: The Possible Exception?
a. An investment pool that uses complex investment strategies to invest money for wealthy
individuals, and institutions.
b. Average Annual Return: 1996 to 1999
1. Average Hedge Fund:
20%
2. Standard and Poor’s 500 Index:
22%
6. The Quest to Beat the Market
33
STOCK MARKET REACTION TO NEWS
1. Types of News that Affects the Stock Market
a. Economic News
b. Political News
c. Other News
2. Economic News
a. Over 300 scheduled releases of economic data each year
b. Important news releases by government and private agencies
1. Employment report
2. Consumer prices
3. Producer prices
4. Gross Domestic Product
5. Housing starts
6. Conference Board Index of Consumer Confidence
c. Important news releases by corporations
1. Quarterly earnings
2. Press releases about various aspects of their business
3. Principles of Market Reaction to News
a. News is only news if it is unexpected
b. The market reacts to the difference between what is expected to be announced and what is
actually announced
c. The market may or may not react to news in a predictable fashion
d. The market hates uncertainty
4. Examples of Market Reaction to News
a. Inflation news
b. Employment report
5. To What Extent Does News Affect Stock Prices
a. Between 1885 and 1997 there were 123 days when the DJIA changed by more than 5%. Of
these, only 28 days can be attributed to a specific economic or political event
b. Of the 5 largest one day changes in the DJIA for which a news event can be associated, 4 of
these can be attributed to the actions of the Federal Reserve
c. Of the 10 largest one day changes in the DJIA, only 2 can be attributed to a specific news
event
d. On October 19, 1987 when the DJIA dropped a record 23%, there was no specific news event
to which this could be attributed.
34
STOCK MARKET PERFORMANCE: 1982 – PRESENT
1. Questions Addressed
a. What factors caused the dramatic increase in the stock market between 1982 and 2000?
b. What role did fundamental factors played?
c. What role did psychological factors played?
d. Is the stock market fairly valued, overvalued, or undervalued?
e. How might the stock market perform in the near future?
2. At Look at the Data
a. Historical behavior of stock prices and corporate earnings
b. Historical behavior of the price/earnings ratio
c. Price/earnings ratio as a predictor of 10 year returns
3. Possible Causes of the Increase in the Stock Market
a. 14 possible factors
4. Steady Economic Growth
a. Longest economic expansion in history
5. Low Inflation and Interest Rates
a. Rule of 19
6. The Public Has Learned That Stocks Are Less Risky than Previously Thought
a. James Glassman and Kevin Hassert argument
1. Dow 36,000: The New Strategy for Profiting from the Coming Rise in the Stock
Market
b. Robert Shiller counterargument
7. Advancements in Technology, the Internet, and the New Economy
a. Expected future corporate profits
b. 10-year average annual growth EPS growth rates required to justify Jan. 2000 P/E ratios
1. Microsoft 42%
2. Cisco 54%
3. AOL 67%
4. Yahoo 95%
8. Baby Boomer Effect
a. Harry Dent argument
b. Jeremy Siegel argument
9. Increase in Defined Contribution Pension Plans
a. Defined benefit pension plan
b. Defined contribution pension plan
c. 401(k), 403(b), Traditional IRA, Roth IRA
10. Growth of Stock Mutual Funds
11. Dominance of U.S. in World Economy
12. More Favorable Capital Gains Taxes
13. More Information about Investing in the Stock Market
a. Internet, CNBC, etc.
14. Discount Brokers, Day Traders, and Twenty-Four Hour Trading
15. Increase in Incentive Stock Option Plans
16. Overly Optimistic Earnings Forecasts
a. Increasingly optimistic 1 and 5 year earnings forecasts
1. 1979 to 1996: In 16 of 18 years forecasted EPS growth rates exceeded actual rates
b. Quarterly earnings forecasts that are too low
c. Few sell recommendations
17. More Opportunities to Gamble
35
18. What Role Did Fundamental Factors Play?
a. Expected growth in earnings per share
b. Expected dividend payout rate
c. Interest rates
d. Risk
19. What Role Did Psychological Factors Play?
a. Robert Shiller argument
1. Irrational Exuberance
20. How Might the Stock Market Perform in the Near Future?
a. Existing factors
1. Stock prices remain at current levels
2. Stock prices rise
3. Stock prices fall
b. New factors
36
PRINCIPLES OF MODERN PORTFOLIO THEORY
1. Objective
a. Develop a set of guidelines that can be used to construct an investment portfolio
2. Modern Portfolio Theory
a. Focuses on the risk-return tradeoff
b. Tells you how to construct the best investment portfolio
c. The best investment portfolio is the portfolio that gives you the highest possible return for the
level of risk you are willing to take
3. Asset Allocation Vs Security Selection
a. When constructing an investment portfolio, an investor must make two important decisions
1. Asset allocation decision
i. Stocks
ii. Bonds
iii. Cash
2. Security selection decision
4. Risk and Expected Return
a. Risk and expected return are the two major building blocks of modern portfolio theory
5. Uncertainty
a. Risk and expected return apply to situations when an investor makes decisions under
conditions of uncertainty
b. Uncertainty exists when there are two or more possible outcomes and you don’t know for sure
which outcome will occur
6. Definition of Expected Return
a. An investor’s “best guess” of what the return on a security will be
7. Definition of Risk
a. The potential loss from holding a security
b. Two alternative definitions of potential loss
1. A negative return
2. A return less than expected
8. Measurement of Uncertainty
a. Random variable
1. Variable whose value is uncertain
2. Return on a security is a random variable
b. Probability
1. Quantitative measure of uncertainty
2. Number between 0 and 1
c. Probability distribution
1. A rule that assigns a probability to each possible value of a random variable. The sum
of the probabilities is equal to 1.
2. Example: Probability distribution for the annual return on IBM stock
Annual Return
30%
10%
-10%
Probability
.20
.60
.20
State of the Economy
Strong
Normal
Weak
9. Measurement of Expected Return for an Individual Security
a. Mean of the probability distribution of the annual return for a security
b. Probability weighted average of all possible returns for a security
37
b. Example: Expected return for IBM stock
Expected Return = (0.20)(30%) + (0.60)(10%) + (0.20)(-10%)
= 6% + 6% - 2%
= 10%
10. Measurement of Risk for an Individual Security
a. Volatility of the return for a security
b. Standard deviation of the return
1. Calculate the variance of the returns
i. Calculate the mean return (expected return)
ii. Calculate the deviation between each return and the mean return
iii. Square each deviation
iv. Multiply each squared deviation by the probability for the return
v. Sum the products
2. Find the square root of the variance
c. Example: Calculating the standard deviation of the return for IBM and Cisco stock
IBM
Cisco
Annual Return
Probability
30%
10%
-10%
.20
.60
.20
Annual Return Probability
60%
10%
-40%
State of the Economy
.20
.60
.20
Strong
Normal
Weak
Expected Return IBM = (0.20)(30%) + (0.60)(10%) + (0.20)(-10%) = 6% + 6% - 2% = 10%
Expected Return Cisco = (0.20)(60%) + (0.60)(10%) + (0.20)(-40%) = 12% + 6% - 8% = 10%
Variance IBM = (.20)(30% - 10%)2 + (.60)(10% -10%)2 + (.20)(-10% - 10%)2
= 80 + 0 + 80
= 160
Variance Cisco = (.20)(60% - 10%)2 + (.60)(10% - 10%)2 + (-40% - 10%)2
= 500 + 0 + 500
= 1,000
Standard deviation IBM = 160 = 12.65%
Standard deviation Cisco = 1,000 = 31.62%
11. Relationship between Risk and Expected Return
a. Modern portfolio theory predicts a positive relationship between risk and expected return
b. Empirical evidence: Roger Ibbotson and Rex Sinquefield
Average Annual Return and Standard Deviation of Returns: 1926 – 1997
Investment
Small cap stocks
Large cap stocks
Long-term corporate bonds
Long-term govt bonds
Intermediate term govt bonds
U.S. Treasury bills
Average Annual Return
17.7%
13.0%
6.1%
5.6%
5.4%
3.8%
Standard Deviation
33.9%
20.3%
8.7%
9.2%
5.7%
3.2%
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12. Measurement of Expected Return for a Portfolio of Securities
a. Expected return for a portfolio is a weighted average of the expected returns on the
individual securities that make up the portfolio.
b. The weight assigned to each security is equal to the dollar value of the security as a proportion
of the total dollar value of the portfolio
c. The expected return for a portfolio depends upon 2 factors:
1. Expected returns for the individual securities
2. Weights of the individual securities
13. Measurement of Risk for a Portfolio of Securities
a. The risk of a portfolio is measured by the standard deviation of the return for the portfolio
b. The standard deviation of the return for a portfolio depends upon 3 factors:
1. Standard deviations of the returns for the individual securities
2. Correlation coefficients of the returns for all pairs of securities
3. Weights of the individual securities
c. Correlation coefficient
1. Measure of linear association between two variables (e.g., the returns on two
securities)
2. Can take any value between –1 and +1
3. +1 indicates two variables have a perfect positive linear relationship
4. –1 indicates two variables have a perfect negative linear relationship
5. 0 indicates two variables two variables are not correlated
6. The larger the absolute value of the correlation coefficient, the more closely correlated
the two variables.
d. Example: Expected Return and Standard Deviation for a Portfolio of Two Stocks
Security
Market Value
Weight
Expected Return
Stock A
Stock B
$4,000
$6,000
0.40
0.60
5%
10%
Standard Deviation
15%
20%
Expected return = (0.40)(5%) + (0.60)(10%) = 2% + 6% = 8%
Incorrect standard deviation = (0.40)(15%) + (0.60)(20%) = 6% + 12% = 18%
Correlation Coefficient Standard Deviation of Portfolio
1.0
0.5
0
-0.5
-1.0
18.00%
15.87%
13.42%
10.34%
6.00%
e. Risk and the number of stocks in a portfolio
15. Portfolio Diversification
a. Portfolio diversification depends upon the number of securities in the portfolio and the
correlation of returns among those securities
b. Portfolio diversification allows investors to combine a number of risky (volatile) securities in a
portfolio in such a way that the portfolio as a whole is less risky than any individual security in
the portfolio
c. Portfolio diversification allows investors to achieve the same return at a lower risk.
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16. The Number of Stocks Needed for a Well-Diversified Stock Portfolio
a. Early studies
1. Old diversification rule
b. Recent studies
17. Market Risk Vs Firm Specific Risk
a. Total Risk = Market Risk + Firm-Specific Risk
b. Market risk
1. Also called systematic risk and non-diversifiable risk
2. Movement in the return on a security caused by common factors (factors that
influence the returns on all stocks, e.g., state of the economy, inflation, interest rates)
3. Cannot be diversified away
c. Firm specific risk
1. Also called unsystematic risk, unique risk, and diversifiable risk
2. Movement in the return on a security caused by firm-specific factors (factors that
unique to the corporation that issued the security, e.g., new product, new contract,
labor problems, quality of management)
3. Can be diversified away
18. Beta Coefficient
a. Quantitative measure of market risk
1. Total Risk = Beta + Firm-Specific Risk
b. Allows an investor to compare the market risk of a single stock or portfolio of stocks to the
market risk of the stock market as a whole
c. Calculation of beta
d. Why different stocks and different portfolios have different betas
e. Aggressive Vs Defensive Stocks
f. Examples of betas for individual stocks and mutual funds
Stocks
Lucent Technologies
Cisco Systems
MCI Worldcom
Intel
Citigroup
AT&T
Home Depot
Pfizer
Quaker Oats
Archer Daniels Midland
Mattel
Mutual Funds
2.1
1.8
1.7
1.6
1.5
1.1
1.0
0.7
0.4
0.3
0.2
Janus Venture Fund
Alliance Premier Growth Fund
S&P 500 Index Fund
Merrill Lynch Basic Value Fund
Vanguard Asset Allocation Fund
1.6
1.3
1.0
0.7
0.6
19. Capital Asset Pricing Model (CAPM)
a. A cornerstone of modern portfolio theory
b. Focuses on the relationship between risk and expected return
c. Basic hypothesis: There exists a positive linear relationship between market risk and expected
return
d. Investors are not compensated for firm-specific risk because it can be eliminated by
diversification.
e. Investors are compensated for market risk because it cannot be eliminated by diversification
d. The relevant measure of risk is beta
e. Graphic representation
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f. CAPM as a guide to constructing the best investment portfolio
g. Empirical studies of CAPM
1. Some studies suggest beta is the single best measure of risk
2. Many studies suggest beta is not the single best measure of risk
3. Fama and French Study
20. Conclusions from Modern Portfolio Theory
a. Portfolio diversification allows investors to minimize the risk of achieve a desired expected
return
b. To make a higher rate of return, an investor must be willing to take greater risk
c. Beta is an important measure of risk, but it is probably not the single best measure of risk
d. A perfect measure of risk does not exist
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