Financial Analysis and Security Trading -FAST-

Transcription

1 Economics 970 Spring 2000 Lorenzo Isla Phone : (617) loren@kuznets.harvard.edu e-fax: (734) Financial Analysis and Security Trading -FAST- FAST is fun. This is because it is a tutorial that tries to develop your understanding of how financial markets work by analyzing the different perspectives we have to make sense of them. The emphasis will be on the growing field of Derivatives and on the extensive use of practitioneroriented materials and computational resources. The tutorial will also be an opportunity for every student to contribute to the discussion on FAST topics both in class and through written assignments. So if you want to understand the myriad worlds of financial markets and the new field of Derivatives you will find this tutorial fun and exciting. Tutorial Description The tutorial aims at developing an understanding of financial markets, how securities are valued and traded and how market participants manage their risks by trading in derivatives. More specifically we try to answer questions such as: What is an asset worth? We will develop a framework to think about this question, and apply this framework to stocks, bonds, and derivative securities. How portfolios of assets should be formed? Are returns predictable? We will study how academic research is applied in empirical finance, with an emphasis on quantitative portfolio management. How are financial derivative securities priced and how are they used to manage risk? What is financial engineering and what are the needs that new complex assets satisfy? What is different at FAST? Some of these topics are covered in greater depth in other courses (Ec 1423 and Ec 1450) and are merely introduced here and so emphasis will be given on: Combining the theory with real world examples as a way to motivate the material (and the discussion!). Student participation: every student is expected to be a valuable asset for the tutorial. Using Computational Methods to establish intuition on these otherwise technical topics. The development of sound economic intuition and analytical reasoning (though quantitative skills are used throughout the course): learning how to learn, think, reason and come up with questions and answers in the context of Finance will be a central part of the Tutorial. Gaining a broad exposure on the tools and topics involved when analyzing Financial Markets. 1

2 This is a tutorial that should prove specially valuable for those students with an interest in financial markets and in the growing field of derivatives and for those considering a career in the financial industry. Topics The topics to be covered in this course fall into the following broad categories: PART I: Portfolio Management This is the study of how individuals and professional investment managers decide which securities to hold in investment portfolios. It also considers how funds should be invested among broader asset classes, such as stocks versus bonds, domestic securities versus foreign securities... We start by giving an overview of the players, institutions and instruments that jointly define the different financial markets.then we go over the different ways we have to understand the main principle of modern portfolio management: maximizing return while minimizing risk. Finally we study the main theories we have to understand how securities are valued. There are also additional sections on: Fixed Income Securities, International Diversification and Emerging Markets, Performance Evaluation and even a class on Finance and Society. Other topics will be related to the problems that investment managers face: how do they control risk, value securities, measure performance or make investment decisions. PART II: Derivatives and Risk Management: the Use and Abuse of Derivatives In recent years the amount and sophistication of financial instruments has grown exponentially. As part of this trend the depth and breadth of the market for Derivatives has expanded dramatically: currently about $35 trillion face value of derivative instruments are outstanding, an explosion that has brought them into the mainstream of corporate America. As a result anyone interested in understanding the instruments and participants in the complex financial markets of today must understand derivatives. This part of the tutorial is an introduction to this exciting booming and dynamic arena of financial activity. Derivatives consist of options, futures, forwards and swaps, instruments that derive their values from the values of other underlying assets, such as stocks, bonds, currencies and commodities. The value of the derivative results from the relationship between the derivative itself and the underlying asset: usually is highly correlated with the underlying asset, making it such that a long or short position in the derivative can be used to protect against losses in a short or long position in the underlying asset. This leads us to the area of risk management: Value-at-Risk and Portfolio Immunization will be covered. However the misuse that some big companies make of Derivatives has sparked considerable controversy on their use. As we shall see in this course, if misused, they may be very dangerous; and if used properly for those who understand them, they are extremely helpful. As a consequence after learning the basics we focus on the tools investors and corporations they have to think about risk and effectively manage it. Materials 2

3 The textbook for this course is Bodie, Kane and Marcus Essentials of Investments (Irwin 1997) and it is available for purchase at the Coop. There is also a reading packet ON RESERVE AT Lamont Library or for purchase from Gnomon Copy, 1304 Mass Ave.. I will regularly distribute readings. They will either handed out, ed or available for downloading from the net. There will be also extensive use of financial software as an innovative learning tool in Finance, mainly Excel Templates for Investments that I will distribute. Background reading will be assigned for those who request it depending on the particular interests of every student, with special emphasis on Burton Malkiel s A Random Walk Wall Street (6th ed.1996) and Bernstein s Capital Ideas, (1992) for the Portfolio Management section. In the Derivatives section I will include material from specialized publications and from Hull, Options, Futures and Other Derivatives (3rd Edition, 1997). There will be regular short readings related to the topics covered in class, primarily from The Wall Street Journal, Business Week, The Economist or specialized publications such as Risk, Derivatives Strategy, or The Review of Futures Markets. Course Requirements Class Participation (25%): This is a discussion course and as class participation is a central component of the tutorial: you should read the assigned readings for each meeting and contribute to the general discussion. Every class we will stop five minutes before the scheduled stopping time. Then you will write a short summary of what you learned in that class, comments on the discussion and/or presentation and questions about things you did not understand. This very short and informal writing assignment will be a small part of the credit and will help me to stress the strengths and weaknesses of our work. Periodically I will hand in short readings related to the topics covered in class, primarily from The Wall Street Journal, Business Week, The Economist or specialized publications such as Risk, Derivatives Strategy, or The Review of Futures Markets. One or two students will be asked to share what they have learned. Assignments (45%): There will be four short papers of around 5 pages each and an empirical exercise (the fourth one) that can be done in pairs and will use Microsoft Excel. The objective of these assignments is to: - Give students practice with writing analytically and concisely and - Lay the groundwork for the long paper. 1. The first one will be an essay on the choice of alternative trading mechanisms (e.g. electronic versus open outcry trading) and it is due on February The second will analyze the issue of different investment styles: technical versus fundamental, CAPM or APT versus other pricing models, passive investment versus active investment Or maybe it will be related to submit a report on a given emerging market. It is due on March The third will be an electronic portfolio management project in which you will have to actively manage a portfolio consisting of securities traded in the US: stock and bonds. (An alternative would be to analyze a case on the use of forwards contracts (The Privatization of Rhône- Poulenc)). It is due on March 21. 3

4 4. The fourth will be an empirical exercise on derivatives and it will be due on April The last one will cover the issue of the misuse of a risk management widespread used tool: the use of Value-at-Risk in the Orange County Case. It is due on April 28. In addition to the main assignments, there will be also minor short response papers. Final Paper (35%). The work on the Final Paper will be organized around 4 deadlines: 1. Prospectus. A short (no more than one page) description of the topic you want to study will be due April Presentation and Proposal. A 3-5 pages work presenting your main work and relating it to the existing work in the area due April 21. This will be presented to the class. 3. Draft. A draft of the paper (less than 10 pages) is due April 28. The main findings will be presented to the class and discussed by another person. 4. Final paper. A pages final paper is due May 8 I will schedule one-on-one appointments to give ideas on the possible topics and to work closely in the process of learning about the topic and writing on it. Late Policy All the required work will be due in class. However each student can submit a required assignment within a day of the due date 3 times during the semester. Each additional late day would result in a 15% penalty. The reason for this policy is fairness: everyone should have the same time to complete the required assignments. Instructor-Student Communication There are not predetermined office hours. However I encourage all of you to reach me by or phone whenever you have specific questions, concerns or suggestions outside of class. Communication is essential for the tutorial to be fun and interesting for all of us. Therefore tell me whenever you disagree with the pace of the class or with the topics covered because I would like to emphasize those topics that are more interesting to you. There will be no examinations. Exams SYLLABUS PART I: PORTFOLIO MANAGEMENT 1. Introduction: Markets, Institutions and Instruments Meeting #1.Course Introduction and Overview. Handout: What is Finance? Meeting #2-3. Financial Markets and Institutions -BKM Chapters 1,2. 2 Handouts Meeting #4 Investors and the Investment Process: 4

5 Readings: BKM Chapters 3,4 Optional Readings: Stoll, Dealer versus auction markets Madhavan, Trading Mechanisms and Security Markets Godek Why Nasdaq Market makers Avoid Odd-Eight quotes We well cover two main topics: the needs of market participants (individual investors, corporate issuers, and financial intermediaries) and the different institutional arrangement by which securities are traded. 2.Is it the Market Efficient?Behavioral Finance and the Predictability of Returns Meetings #5-6Efficient Market Hypotheses versus Behavioral Finance Case: BKM Problem Readings: BKM Chapters and The Psychology of the Non-Professional Investor (Optional: Malkiel Chapters 5-8, Bernstein Chapters 1-3) 3. Portfolio Theory Meetings #7-8. Quantitative Portfolio Management Readings: -New Facts in Finance -Portfolio Advice in a Multifactor World Asset Allocation and Financial Economics Case: BKM Problem 5.7, 5.8. Readings: BKM Chapter 2.3,2.4,5 Case: BKM Problem 6.6; Readings: BKM Chapters Case: BKM Problem 6.14,6.15,6.16; Readings: BKM Chapter 6,7 4. Applied Empirical Finance: What can be learnt from recent developments in Financial Economics Meetings #9-10. Reading: Asset Pricing for the New Millenium Readings: BKM, Chapters 8,9,10. (Other: Malkiel, Chapters 9,10; Bernstein Chapters 4,10) Handout 1: Performance Evaluation. Handout 2: Portfolio and Risk Management. 5. International Investmentsand other Asset Classes Meeting #11. International Diversification: Emerging Markets Case: BKM Problem 19.1,19.2 Readings: BKM Chapter 19, pp and The surge in capital inflows to developing countries: An analytical overview and Financial market challenges and economic performance in developing countries. Does international diversification decrease portfolio risk? It will do so to the extent to which there are components of risk that can be diversified away. For that purpose we will answer the question by analyzing the different components of risk (country specific (political and currency risk), asset specific...). These ideas will be applied to the case of the increasingly popular investment in Emerging Markets. 6. Fixed Income Securities 5

6 Meeting #12. Fixed Income Analysis and Managing Fixed Income Investments Handouts: Duration Measures and Bond Inmunization. Fixed Income Analysis Case: BKM Problem 9.25 Readings: BKM Chapter 9 How do fixed income securities work and how are they valued? Why should bonds of different maturities offer different yields? The fact that longer term bonds usually offer higher yields, suggest that part of the difference is a premium for bearing interest rate risk, since exposure to this risk increases with time to maturity. Managing Fixed Income Investments Case: BKM Problem Readings: BKM Chapter 10 Duration measures how long investors tie their money up in fixed income securities. It is also for this reason, a measure of the investor's interest rate exposure. Immunization and related strategies attempt to minimize interest rate risk exposure by arranging the investment portfolio such that the duration of the assets matches the duration of the investor's liabilities. Meetings #13-14 The Term Structure of Interest Rates: Theories and Interpretations. Readings: BDM, Chapters 14,15. Possible Handouts: -The Term Structure: different shapes and explanations; -The Term Structure and the Business Cycle. PART II: DERIVATIVES AND RISK MANAGEMENT: THE USE AND ABUSE OF DERIVATIVES 1. Derivatives Meeting #15. Introduction to Derivatives. Handout: Derivatives. Optional readings: Hull, chapter 1. Bernstein, Chapters 11 and Futures and Forwards. Meetings #17&18. Futures and Forwards Readings: BKM, Chapter 21; Hull, Chapters 2-3. Handout:The Privatization of Rhône-Poulenc or Financial Futures or Applications for Financial Futures Futures contracts are a special case of a derivative security. The special features of these contracts are best understood by reference to related forward contracts and to the history of futures contracts trading in the US. In investment management, they are chiefly used to hedge security risk ("short positions") or to provide an inexpensive way to invest in the markets ("long positions"). 6

7 3. Options. Meetings #19&20. Options: Characteristics and Pricing Handout 1: Introduction to Options or Option Pricing or Option Applications. Handout 2: Advanced Option Valuation: Binomial and Monte Carlo as Valuation and Risk Management tools. Readings: BKM, Chapters 19 and 20 Optional Readings: Hull, Chapters 7,8,11, "Salomon Bids to Sell Options Based on Funds. Options: characteristics and payoffs Options and futures contracts are examples of derivative securities, whose value depends on the value of some other traded security. For some investors, derivative securities offer the cheapest way to capitalize on information that the underlying security will rise (or fall) in value. For other investors, derivative securities provide an insurance function. To understand derivative securities, it is first necessary to understand how the value of the derivative varies with the value of the underlying security. Option Valuation An analysis of the relationship between the value of the Derivative and the value of the underlying security suggests a simple approach to valuing the Derivative. We illustrate this in the context of option pricing, and introduce the notion of hedging. 4. Advanced topics: Swaps and Exotic Options Meeting #21. Advanced topics. Handout 1: Swaps (Reading: Hull, 5.1 and 5.2) Handout 2: Exotic Options Handout 3: Replicating and Hedging Exotic Options. Case: Citicorp. 5. Value-at-Risk Meeting #22. Value-at-Risk Handout : VAR Readings: - Beder, T. VAR: Seductive But Dangerous. - Duffie, D. and J. Pan. An Overview of Value at Risk. - Shimko, David. What is VAR? Meeting #23. Value-at-Risk: A Case. Case: Orange County Case: Using Value-at-Risk to Control Financial Risk Meeting #24. Discussion: Risk Management 6. Risk Management. 7

8 Readings: Jorion, Chapters 3-8 and Every student will prepare one of this Readings and give his view on the topic using the tools developed through the year: Liability Management at General Motors "Dangerous Derivatives." "Seat Prices Soar at Futures Exchanges in Chicago Due to Agricultural Options." "Bank of Tokyo's Write-Off Highlights Risk of Computer Models for Derivatives." Allure of the Contrarians. The Secret Money Machine. Time, April 11, 1995, pp Treasurers at the Casino, The Economist, June 4, 1995, pp Learning from Fund Losses in Derivatives. Portfolio Insurance Case: Portfolio Insurance Case Readings: BKM pp An analysis of this case provides a useful summary of the material covered in this course. 8