UNIT 1: MONEY AND CAPITAL MARKETS CHAPTER 1: INVESTMENT ENVIRONMENT

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1 UNIT 1: MONEY AND CAPITAL MARKETS Unit 1 presents an overview of what we frequently term the [stock] market. In addition to the standard material, we will also explore motives, methods, and means. CHAPTER 1: INVESTMENT ENVIRONMENT I. STUDENT LEARNING OBJECTIVES A. Why do people invest? B. Importance of investment decisions C. Steps to investing D. Investment management E. The Financial Crisis of 2008 II. WHY DO PEOPLE INVEST? A. Defer current consumption to increase future consumption or wealth B. Accumulate funds for a purpose C. Benefits to society and the economy 1. Capital formation 2. Job creation 3. Economic expansion III. IMPORTANCE OF INVESTMENT DECISIONS A. More choices now than ever 1. Thousands of mutual funds (> 5000) 2. Funds for specific investment goals B. People live longer 1. Longer retirement period 2. Social Security may not be enough C. Personal income growth is slower D. Labor market is less stable These notes are personal use of MBA536 students enrolled at CSB-UNCW Page 1 of 31

2 IV. STEPS TO INVESTING: PERSONAL FINANCIAL PLANNING A. Personal inventory: [See table 1.1: Balance Sheet of U.S. Households] 1. Real Assets (values respond positively to inflation) a. Precious metals: gold, silver, platinum b. Gems: diamonds, emeralds, rubies c. Collectibles: fine art, antiques, baseball cards d. Real estate: Owner occupied or investment property 2. Financial Assets (values respond negatively to inflation) a. Stocks and bonds 3. Assets minus Liabilities = Net Worth B. Investment goals: 1. Purpose and time frame 2. Post-Retirement life style expectations C. Insurance review 1. Life, health, disability, property, and liability D. Establish emergency fund E. Establishing priorities 1. Holding period - how long to invest a. Short-term volatility b. Long-term stability 2. Expected return to achieve goals a. Trade-off between risk and return 3. Risk tolerance - danger of possible loss a. I m not so worried about the return on my money as I am the return of my money. - (1) Will Rogers F. Other considerations 1. Tax status a. Marginal tax rate b. Tax deferred investments 2. Preference for income or capital gains a. Personal goals b. Tax preferences These notes are personal use of MBA536 students enrolled at CSB-UNCW Page 2 of 31

3 3. Personal time in managing investments a. Availability and desire 4. Investment selection: Allocation of Risk a. Portfolio mix - general guidelines (1) Stocks, bonds, money markets, or some combination b. Specific selections (1) Passive investor - market index funds (2) Active investor - seeks superior performance G. Investment management 1. Monitor performance a. Active portfolio management b. Buy and hold management 2. Making adjustments through life stages a. Changes in risk tolerance b. Changes in investment goals V. THE FINANCIAL CRISIS OF 2008 (AND EARLIER ANTECEDENTS) A. Whose Story do we believe? 1. Wall Street Greed: The CDO and CDS games (Michael Lewis: The Big Short, esp. Ch. 7) 2. Government without Consequences: C.R.A., Fannie and Freddie, OCC General Council. B. Building the Real estate Bubble: The Greenspan Years Lower rates, relatively easy money 1. Changes in home financing: from S&Ls to Mortgage Brokers MBS CDO CDS 2. Non-Conforming loans: growth of the sub-prime market, no documentation loans C. Banks Playing the Spread 1. Borrowing short-term, investing in long-term assets 2. Need to refinance as S-T loans matured. Credit markets collapse D. Bursting the Credit Bubble 1. Broad-based decline in housing prices 2. Rise in unemployment. 3. Defaults on mortgage loans 4. US troubles also exported to European banks and elsewhere. E. New Emphasis on Systemic Risk 1. Bank equity position: high leverage, low equity position 2. Fed and Basel III: Calling for increase in Equity (5 8% minimum) 3. The Too Big to Fail argument in wake of bailouts These notes are personal use of MBA536 students enrolled at CSB-UNCW Page 3 of 31

4 CHAPTER 2: ASSET CLASSES & FINANCIAL INSTRUMENTS I. STUDENT LEARNING OBJECTIVES A. Direct Investment Classes B. Marketable Securities C. Derivative Securities II. DIRECT INVESTMENT CLASSES A. Nonmarketable Financial Claims 1. Bank deposits including Credit Unions 2. U.S. savings bonds 3. Cash value of [whole] life insurance policies B. Marketable Financial Claims 1. Money market instruments 2. Capital market instruments 3. Derivative securities III. MONEY MARKET FINANCIAL CLAIMS A. Money market instruments: [Pure Discount Securities] 1. Treasury bills (maturities; 4, 13, 26 & 52 wks) $100 and up 2. Negotiable CD s (Certificates of Deposit) 3. Commercial paper (max mat. 270 days) 4. Banker s acceptances B. Hybrid Claims 1. Eurodollar 2. Repos, Term Repos, Reverse Repos C. LIBOR 1. UK version of Fed Funds rate 2. Frequently used as reference rate index D. Federal agency securities 1. $10,000 minimum face 2. Not backed by full faith and credit 3. Discount securities - no stated interest rate These notes are personal use of MBA536 students enrolled at CSB-UNCW Page 4 of 31

5 E. Commercial paper 1. Issued by most creditworthy corporations 2. Mature in less than one year 3. Large denominations - $100, Sold directly or through dealers 5. Pure Discount securities F. Taxable equivalent yield 1. Compares after tax yield of exempt to non-exempt investments TEY = yield / (1-T) Where: T is investor s marginal tax rate 2. Example: 6% tax-exempt yield and 40% marginal tax rate TEY =.06 / (1 -.4) = % tax-exempt = 10% taxable IV. CAPITAL MARKET DEBT INSTRUMENTS (LONG MATURITIES) A. Treasuries: Notes, Bonds ($7.1 Trillion*) B. Federal Agency Debt: FNMA, GNMA, FHLMC, FHLB C. Municipal Bonds 1. General obligation bond: Backed by the government that issues the bond 2. Revenue bond: Financed by revenue producing projects 3. Serial bond: Staggered maturity dates 4. Term bond: All bonds mature on the same date 5. Tax free income (may end after 1/1/2011) D. Corporate ($4.0 Trillion) 1. Collateralized: Mortgage, Equipment Trust certificates 2. Uncollateralized: Debentures (Senior or Subordinated) 3. Callable or Convertible E. Foreign/International Debt Securities 1. Yankee bonds: Foreign bonds issued in the United States 2. Bulldog bonds: Foreign bonds issued in the United Kingdom 3. Eurobonds: Dollar-denominated bonds issued outside the United States 4. Euroyen bonds: Issued in yen, but outside Japan These notes are personal use of MBA536 students enrolled at CSB-UNCW Page 5 of 31

6 F. Mortgage pass-through (MBS) 1. FNMA and FHLMC $5.1 Trillion issued by V. CAPITAL MARKET EQUITY CLAIMS A. Preferred stock 1. Hybrid security a. Characteristics of common stock (equity) and bonds (fixed payout) b. Represents equity ownership c. Yields fixed rates B. Common stock 1. Ownership of the corporation 2. Residual claim on assets 3. Limited liability 4. Potential for capital appreciation 5. Blue chip: Most consistently profitable companies 6. Voting rights a. Elect directors and vote on important company matters b. Making changes to corporate charter 7. Preemptive rights: Rights to retain a proportionate ownership in a company VI. DERIVATIVE FINANCIAL CLAIMS A. Derivative securities 1. Claims on financial claims - derived claim 2. Stock options (not to be confused with Executive stock options) a. Calls b. Puts 3. Futures B. Corporate created 1. Convertibles 2. Warrants These notes are personal use of MBA536 students enrolled at CSB-UNCW Page 6 of 31

7 CHAPTER 3: FINANCIAL MARKETS I. STUDENT LEARNING OBJECTIVES A. Characteristics of Financial Markets B. Perfect and Complete Markets C. Primary Financial Markets D. Secondary Financial Markets E. Trade Orders F. Foreign Markets G. Market Regulation II. CHARACTERISTICS OF FINANCIAL MARKETS A. Fair, open, and orderly trading B. [Instant] Liquidity C. Trading information readily available D. Price continuity E. Low transaction costs F. Regulatory oversight III. PERFECT AND COMPLETE MARKETS A. Perfect market - frictionless trading 1. No transaction costs 2. No taxes 3. No constraining regulations B. Complete Markets 1. All types, sizes, and maturities available 2. Infinitely divisible securities IV. PRIMARY FINANCIAL MARKETS A. Investors buy new issues directly 1. At preset (offering) prices 2. By sealed bid (treasuries) B. Investment Bankers 1. Financial intermediaries get providers and demanders of capital together (for a fee) 2. Help in pricing and issuing new securities 3. Bear risk of selling new securities 4. Distributes issue to the public These notes are personal use of MBA536 students enrolled at CSB-UNCW Page 7 of 31

8 C. Investment Banking Functions 1. Advising a. Timing b. Pricing c. Terms and Features 2. Underwriting a. Full b. Best Efforts 3. Distribution a. Selling syndicate D. Investment Banking 1. Initial Public Offerings (IPOs) a. The first sale of common stock to the public 2. Private Placements (SEC Rule 144) a. Private sale of securities directly to investors (Lettered stock) b. Reduced liquidity - no secondary market c. Secondary registration required to sell to public d. Avoids underwriting discount (concession) e. Avoids registration costs with SEC V. SECONDARY FINANCIAL MARKETS A. Trade seasoned securities 1. Provide liquidity and current price information 2. Cost of liquidity services = bid-ask spread a. Bid: the price # will pay to buy security b. Ask: the price # will take to sell security c. # = Market maker, Specialist, another trader d. Spread size a function of risk and activity VI. TYPES OF SECONDARY MARKETS A. General Classifications 1. Direct Search 2. Brokered (e.g. Investment bankers) 3. Dealer (OTC) (largest # of issues traded) 4. Auction These notes are personal use of MBA536 students enrolled at CSB-UNCW Page 8 of 31

9 B. Registered Exchanges 1. New York Stock Exchange (NYSE): The Big Board a. Stocks must meet listing requirements b. Auction market c. Only license holders can trade on the floor d. More than 3000 issues actively traded + bonds e. SuperDOT: electronic trading (Direct +) 2. American Stock Exchange (AMEX) a. Less stringent listing requirements b. Smaller issues, Lower volumes c. Less than 1000 issues actively traded. d. Acquired by Nasdaq 3. Regional Exchanges a. Five Major Regional Exchanges b. Boston, Philadelphia, Cincinnati (NMS), Midwest, Pacific c. Dual listing (regional & national exchanges) d. Typically lower transaction costs than OTC e. Different trading hours than NYSE, AMEX C. Over-the-Counter (OTC) markets 1. NASDAQ is primary player 2. Liquidity services more costly 3. Trading by computer (versus auction) 4. Most bonds traded OTC (Corps, Govts, Muni's) D. The NASDAQ Stock Market 1. National Association of Securities Dealers Automated Quotation system 2. Computer based system to serve OTC market for stocks 3. Must have at least two market makers 4. Provides better pricing information 5. Less restrictive listing requirements E. NYSE versus NASDAQ 1. Spreads generally smaller on NYSE 2. Limit orders posted publicly on NYSE 3. NASDAQ market makers support stock 4. Highest volume stocks on NASDAQ These notes are personal use of MBA536 students enrolled at CSB-UNCW Page 9 of 31

10 5. Small stocks handled better by NASDAQ 6. Getting off NYSE requires shareholder vote F. Foreign Exchanges (Tokyo, London, Toronto) VII. TYPES OF ORDERS A. Market B. Limit C. Stop D. Trailing E. Margin 1. Fed regulates margin requirement (50%) 2. Broker Call Loan Rate 3. Margined stocks held in street name 4. Maintenance Margin: when equity drops too low. 5. See Example 3.2 (pg. 78) VIII. SHORT SALES A. Profiting from decline in price B. Stocks borrowed from margined accounts. 1. When repurchased, stocks returned. IX. OTHER MARKETS A. Electronic Communication Networks 1. Archipelago (now part of NYX) B. Third market 1. OTC trading of listed stocks to overcome high costs of NYSE and AMEX transactions C. Fourth Market 1. Private trading of listed stocks X. FOREIGN STOCKS A. American Depository Receipt (ADR) 1. Denominated in US dollars 2. Trade on US stock exchanges 3. Trade in receipts for shares held in US bank 4. Value based on value of underlying shares 5. ADR may be sponsored or unsponsored B. Alternative: Buy directly on foreign stock exchanges These notes are personal use of MBA536 students enrolled at CSB-UNCW Page 10 of 31

11 XI. REGULATION OF SECURITIES MARKETS A. SEC primary oversight body 1. SEC established by 1934 act. 2. Authority to regulate registered exchanges 3. Defines insiders and behavior that is illegal B. Securities Investor Protection Corporation (SIPC) Act The FDIC for brokerage accounts if broker fails 2. Limit $500,000 per account C. FINRA: self-regulation (formerly NASD) 1. Rules of Conduct/Ethics 2. Know your customer 3. Specification of fines and penalties D. Sarbanes-Oxley (2002) 1. Securities Act of 1933 requires full disclosure 2. CEO/CFO certification of operating reports 3. Requirement for independent board of directors These notes are personal use of MBA536 students enrolled at CSB-UNCW Page 11 of 31

12 CHAPTER 4: MUTUAL FUNDS I. STUDENT LEARNING OBJECTIVES A. What are mutual funds? B. Advantages of Mutual Funds C. Regulation and Tax Status D. Selecting a mutual fund E. Managing mutual fund investments F. Alternatives to mutual funds II. MUTUAL FUNDS A. Mutual funds pool funds from many investors to buy securities B. Mutual funds have grown in importance C. Open-end investment companies, or mutual funds, continually issue and redeem shares D. Net asset value (NAV) 1. Value of the fund s net assets, divided shares outstanding at close of market trading 2. Shares may trade at NAV or at bid/ask prices for load funds III. ADVANTAGES OF MUTUAL FUNDS A. Diversification B. Smaller minimum investments to access large diversified portfolio C. Professional management IV. REGULATIONS AND TAXATION A. Mutual Fund Act of 1940 regulates U. S. fund operations through the SEC B. State approval is also required for sales C. Regulated Investment Companies 1. 90% of investment income must be distributed to shareholders each year 2. Tax liability [for gains] falls to individual shareholders V. GROWTH AND DEVELOPMENT OF MUTUAL FUNDS A. Massachusetts Investment Trust in 1924 B. Growth accelerated after World War II C. Funds grew in number and type in the 1970 s D s saw extraordinary growth E. Mutual funds in other countries have also grown rapidly in recent years These notes are personal use of MBA536 students enrolled at CSB-UNCW Page 12 of 31

13 VI. TYPES OF FUNDS A. Overall investment objectives 1. Growth, Income, Growth & Income, etc. B. Types of securities purchased 1. Equity funds, money market funds, bonds C. Load funds versus no-load funds 1. Load charges are assessed when shares are purchased (front-end) or sold (back-end) VII. SERVICES OFFERED BY MUTUAL FUNDS A. Automatic reinvestment of distributions B. Automatic investment plans C. Check writing (money market funds) D. Exchange privileges within fund families E. Periodic statements VIII. SELECTING AND EVALUATING MUTUAL FUNDS A. Assess risk and returns before selecting B. Evaluate services offered by the fund C. Examine fees and expenses 1. Load charges and operating expenses D. Load charges 1. Contingent deferred sales charge (CDSC) is a back-end load that declines over time 2. Back-end loads discourage trading by investors 3. Front-end loads compensate the broker 4. No-load funds have grown E. Operating expenses 1. Measured as percent of NAV 2. Management or advisory fees and other operating expenses 3. Paid out of investment income 4. 12b -1 fees cover distribution costs F. Compare loads and operating expenses for varying time periods in evaluating funds G. No evidence that higher fees or load charges bring superior performance These notes are personal use of MBA536 students enrolled at CSB-UNCW Page 13 of 31

14 IX. EVALUATING HISTORICAL PERFORMANCE A. Performance is important criteria B. Consider risk and return using standard deviation and beta to measure risk C. Absolute performance D. Relative performance to a benchmark such as S&P 500 or average return of mutual fund group E. Consistency of performance over time F. Assessing future performance 1. Past performance is a poor predictor since funds do not over the long term post better riskadjusted performance than the broad market averages 2. Others feel that past performance is a reasonable, though imperfect, predictor because past performance reflects more than mere luck G. Performance and taxes 1. Mutual funds are not taxed directly on income or capital gains as these are passed on to the shareholders 2. Returns can be broken down into distributions and change in NAV 3. Portfolio turnover relates to higher capital gains distributions and unrealized capital gains 4. Don t purchase just before a distribution X. MANAGING MUTUAL FUND INVESTMENTS A. Passive versus active B. Investment objectives change through time C. Dollar-cost averaging is investing equal dollar amounts at regular intervals and can be beneficial when prices fluctuate but if prices continually rise, buying more earlier is better D. Rebalancing means adjusting a portfolio return to its target asset allocation XI. SELLING A MUTUAL FUND A. Changes in investment objectives B. Poor performance - but have a long-term perspective C. Funds that have grown too much too fast XII. OTHER TYPES OF INVESTMENT COMPANIES A. Unit investment trust is an unmanaged portfolio of fixed income securities 1. Sponsor will usually buy and sell at NAV B. Closed-end investment company offers managed portfolios. 1. Market prices may vary from NAV and generally sell at discounts These notes are personal use of MBA536 students enrolled at CSB-UNCW Page 14 of 31

15 UNIT 2: PORTFOLIO [INVESTMENT] THEORY This unit begins our journey into the fundamental analysis of risk and return. As we delve into the statistical nature of risk measurement, we must remind ourselves that the market is always and everywhere an expectations phenomenon. We don t really know a lot about the future. We know quite a bit about the past and attempt to use it as a guide to discerning the future. A caution is warranted as we observe the elaborate mathematical and statistical models that purport to explain the market s behavior. We note with interest the disclaimer in every prospectus; past performance is no guarantee of future performance, investigate before you invest CHAPTER 5: RISK AND RETURN: PAST AND PROLOGUE I. STUDENT LEARNING OBJECTIVES A. Interest Rates and Equilibrium B. Risk and Risk Premiums C. Inflation and Real rates of Return (Fisher Effect) II. EQUILIBRIUM INTEREST RATE A. Equilibrium = point at which markets clear (no excess supply or demand). 1. Question: Is an (are) equilibrium point(s) observable? 2. Question: Is equilibrium an important concept? B. Changes in the Equilibrium Interest Rate 1. Change in response to changes in supply of funds 2. Change in response to changes in demand for funds C. The Fisher Effect 1. Preserving Purchasing Power 2. The Components of the Nominal Rate of Interest a. Real rate b. Inflation premium c. Default premium III. KEY ISSUES REGARDING INTEREST RATES A. Government Budget Deficits and Interest Rates 1. Does government competition for loanable funds increase the cost? 2. What arguments support deficit spending? B. Impact of Foreign Interest Rates 1. Effects of mobility of international capital on domestic rates 2. Differences in international investment opportunity sets C. Impact of Exogenous Events on Interest Rates These notes are personal use of MBA536 students enrolled at CSB-UNCW Page 15 of 31

16 D. Shortages in the commodities markets 1. Rumors of wars and other forms of civil/political unrest 2. Changes in the exchange rates (effects on net international investment) IV. RISK AND RISK PREMIUMS A. What is risk? 1. Uncertainty - the possibility that the actual return may differ from the expected return 2. Probability - the chance of something occurring 3. Expected Returns - the sum of possible returns times the probability of each return B. Measuring risk 1. Range: the difference between the highest and lowest values. 2. Standard deviation: statistical measure of dispersion around a mean. C. Required rate of return 1. Nominal rate of return = Real rate of return + Expected rate of inflation + Default premium 2. Time value of money 3. Related to Riskiness of investment D. Relationship between risk and return 1. Higher returns with higher risk 2. Risk aversion - incentives to accept risk E. Risk Premium 1. The difference between the return on a risky investment and the risk free rate 2. Example: The 40-year average return on the SP500 is approximately 11%. The 30-day T- Bill has average about 5% for the same period. That suggests a risk premium of about 6% for the SP500. F. The Normal Distribution of Events Fallacy (Taleb s Ludic Fallacy) These notes are personal use of MBA536 students enrolled at CSB-UNCW Page 16 of 31

17 CHAPTER 6: EFFICIENT DIVERSIFICATION I. STUDENT LEARNING OBJECTIVES A. Why Diversification is important B. What are the two principal sources of investment risk C. Standard deviation as a measure of risk for individual securities and portfolios D. Security correlation and portfolio risk E. Benefits of diversification F. Efficient diversification and modern portfolio theory (MPT) II. DIVERSIFICATION A. Portfolio diversification 1. Diversification can increase the risk/return 2. Benefits of diversification increase as average correlation decreases B. Diversification across securities 1. Portfolio risk decreases as the number of securities in a portfolio increases 2. Market risk is inherent from business cycles, inflation, interest rates, and economic factors 3. Firm-specific risk is tied to the company s contracts, products, etc. C. Forms of Diversification 1. Mathematical diversification a. Increasing the number of stocks reduces the portfolio risk from any individual stock 2. Diversification across time a. Annualized standard deviations decline as the investment horizon increases b. Uncertainty also increases and total return is not improved 3. Dollar cost averaging a. Strategy which invests a set dollar amount at regular intervals b. Depends upon diversification across time D. Naive Diversification 1. Occurs when investors select stocks at random 2. When N becomes large enough; a. Naive diversification averages out the unsystematic risk of the stocks b. As N becomes very large, only market (or systematic) risk remains E. Efficient Diversification 1. The portfolio with the lowest risk for a given return, or the largest return for a given risk 2. Eliminates all diversifiable risk These notes are personal use of MBA536 students enrolled at CSB-UNCW Page 17 of 31

18 3. Modern Portfolio Theory includes the concept of diversification III. MODERN PORTFOLIO THEORY (H. MARKOWITZ) A. The expected return of a portfolio is a weighted average of the expected returns of each of the securities in the portfolio B. The weights (Xi) are equal to the percentage of the portfolio s value which is invested in each security C. The variance of a portfolio is more complex; it is a weighted average of the variances of each security and the correlation between each pair of securities D. The covariance of historical returns from any pair of securities is measured by the following formula: E. Notice the similarity between the equation for the Cov(A,B) and the equation for the Var(A) F. The following conclusion can be drawn: 1. When the holding period returns of two securities move in the same direction, by the same amount at the same time, the pair is perfectly positively correlated 2. When the holding period returns of two securities are totally unrelated to each other, the pair is uncorrelated 3. The risk of a portfolio is the weighted average of the risk of each security in the portfolio, and the covariance between each pair of securities in the portfolio 4. Covariance terms increase rapidly as new securities are added to the portfolio IV. BENEFITS OF DIVERSIFICATION A. Efficient frontier 1. A line graphing the most efficient possible combinations of stocks for maximizing portfolio returns while minimizing portfolio risk - the best risk/return tradeoff B. Implications of Efficient Diversification 1. Grouping many securities together in a portfolio reduces the risk of the portfolio faster than the return is reduced 2. Holding a portfolio over time periods of five years or more reduces risk more than it reduces returns from the portfolio These notes are personal use of MBA536 students enrolled at CSB-UNCW Page 18 of 31

19 V. MEASURING RISK AND RETURN A. One way to estimate the price expected at the end of a future holding period is to identify the price which will exist under alternative assumptions about the future B. Ex-ante returns - predicted returns C. Ex-post returns - historical returns D. Standard Deviation as a measure of risk 1. Statistical measure of dispersion of distribution about a mean 2. 67% fall within one standard deviation 3. 95% lies within two standard deviations E. Since risk is the difference between the expected return on a security, and each of the possible future returns that may occur, it can be measured by the variance of expected returns. F. Variance is an accurate measure of risk when the possible future returns are normally distributed around the expected future return G. The range of returns, and the number of negative outcomes are non-parametric risk measures which are not influenced by the distribution of future returns H. A more straight forward way to measure risk and expected future returns is to compute the mean and the variance from a sample of ex-post returns, and make the assumption that the future will look like the past I. The coefficient of variation (CV) is usually computed from the ex-post mean and variance of an historical sample of returns J. The coefficient of variation is a useful estimate of the risk to reward ratio which can be expected to accrue to the owners of a given security K. Stocks can be grouped on the basis of either the expected return or the average risk L. Within each group, the stock which has the lowest CV is the stock which provides the highest reward per unit of risk in the group M. Mean Variance dominance is a property of the stock with the lowest CV in a group of stocks with identical risk or return VI. PORTFOLIO RISK AND RETURN A. In general, the purchase of a single stock is a speculation, rather than an investment 1. the owner of single security hopes to profit from an increase in the price of the security during the near term 2. profits and losses derived from near term changes in the price of a single asset are speculative in nature, and do not constitute investment returns B. Investing involves buying and holding a portfolio of securities, expecting to profit in the long term from the secular price trend of the market C. Portfolio diversification can reduce the risk an investor must bear without reducing the return an investor can expect to earn These notes are personal use of MBA536 students enrolled at CSB-UNCW Page 19 of 31

20 UNIT 3: ASSET PRICING, EFFICIENT MARKETS, TECHNICAL ANALYSIS In Unit 3 we get to the most important ideas in asset valuation theory. The simplest definition of price is the present value of future benefits to be received. The difficulty in this process is determining a suitable discount rate. Earlier we were exposed to the notion that return is tied to risk. The expected rate of return is fixed by the level of risk. In MPT, there were two sources of risk; variance and covariance. Sharpe (and later Lintner and Mossin) would reduce the variance-covariance matrix to a scalar (or column) of relative risk measures he called beta -. Securities would henceforth be characterized by their relation to the market s riskiness (the market s = 1). This breakthrough would soon be followed by Fama s Efficient Market Hypothesis (EMH). Joint testing of the EMH and CAPM would embroil the finance profession in heated debate about both concepts for the next 25 or 30 years. The technicians would view this debate with little interest. The essential philosophical position of the technicians is that most of what the academic theorists believed was irrelevant in a market largely moved by greed and fear. CHAPTER 7: CAPITAL ASSET PRICING MODEL I. STUDENT LEARNING OBJECTIVES A. Capital Asset Pricing Model (CAPM) B. Capital market line (CML) C. Beta compared to Standard Deviation D. Estimating Beta E. Beta - good news and bad news II. CAPITAL ASSET PRICING MODEL (CAPM) Asset Pricing Theory seeks to explain why certain assets have higher expected returns than other assets and why expected returns vary over time. Expected returns are those returns when assets are priced in equilibrium: demand for assets = supply of assets. A. Assumptions of the CAPM 1. The capital markets are characterized by perfect competition. 2. All investors choose the portfolio according to mean and variance efficiency 3. All investors have homogeneous expectations regarding future returns 4. All investors can borrow or lend at the risk-free rate (r f ) Implication of the CAPM assumptions: All investors face an identical efficient frontier B. CAPM has 2 elements: Risk-Free Asset and Risky [Mean & Variance Efficient] portfolio 1. Characteristics of the risk-free asset a. Its variance is zero (otherwise it would not be risk-free) r.= 0. b. Its covariance with all risky assets is also zero ( r,a ). 2. Characteristics of the Risky Asset Portfolio These notes are personal use of MBA536 students enrolled at CSB-UNCW Page 20 of 31

21 a. Risky asset portfolio is located on the efficient frontier b. Accordingly, the risky asset portfolio is mean and variance efficient 3. In the CAPM world, investments are comprised of combinations of R f and R a 4. Investors can construct different combinations (weights) of the risk-free asset and risky market portfolio in order to achieve an acceptable level of risk. 5. The line running from the risk-free asset to and beyond the risky market portfolio defines the investment opportunity line. Return Investment Opportunity Line Risky Market Portfolio Risk-Free Asset Risk C. Investment Opportunity Line (Efficient Frontier) and the [Optimal] Risky Portfolio 1. All portfolios lying on the Investment Opportunity Line are mean and variance efficient. 2. Optimal Efficient Portfolios depend on individual preferences for risk and return 3. Investor s utility curves drive the choice of portfolio held 4. The slope of the Investment Opportunity line is: [E(R a ) r f ] / a This definition is also the Sharpe ratio: [excess] return per unit of risk 5. The expected return for any portfolio is defined as: Where: R p = w R f + (1 w)r a w = weight of wealth endowment invested in R f (1 w) = weight invested in R a (risky asset) 6. The expected portfolio variance (risk) is defined as: 2 p = w 2 2 rf + (1 w) 2 2 a + 2 w (1-w) rf,a rf,a = covariance of r f and a Since the variance of the risk-free asset is assumed to be zero and its covariance with the risky portfolio is zero, then the riskiness of the portfolio reduces to: And: 2 p = (1 w) 2 2 a p = (1 w) a These notes are personal use of MBA536 students enrolled at CSB-UNCW Page 21 of 31

22 III. THE CAPITAL MARKET LINE (CML) A. The CML defines the locus all mean-variance efficient risky portfolios 1. The CML is composed of all possible combinations of the market portfolio (m) and the risk-free asset (r f ). 2. The expected return of any risky portfolio on the CML is: E (R p ) = r f + {[E (R m ) r f ] / m } p B. Borrowing and Lending at the Risk-free rate 1. Combinations of risk-free asset and risky market portfolio can be used to create portfolios along the CML 2. Borrowing-lending line is the CML, divided where it intersects the efficient frontier (point M) with the lending line on the left and borrowing on the right C. Portfolio Separation Theorem 1. Possibility of lending and borrowing at the R f rate permits the division of the investment decision into two parts a. Identifying the market portfolio b. Maximizing investor utility by mixing m and r f D. Market Portfolio 1. The Market Portfolio (point M) must be the only risky portfolio chosen by all risk-averse investors. Because it is demanded by all investors, it must contain all the securities and other traded assets 2. Portfolio M s risk = Market risk 3. Security risk = total risk 4. Security risk = Market risk + firm-specific risk IV. DEVELOPING THE CAPM A. Types of CAPM Risk 1. Systematic or non diversifiable risk (market risk) a. Beta is the measure of systematic risk 2. Non Systematic or diversifiable risk (non-market risk) a. Risk due to firm specific attributes b. Irrelevant in a well diversified portfolio 3. Decisions made by total risk (standard deviations) instead of beta ignore the systematic risk and diversifiable risk components of total risk These notes are personal use of MBA536 students enrolled at CSB-UNCW Page 22 of 31

23 B. Relative Risk 1. Relative risk contribution of security i a. Total risk contribution of security i divided by Total risk of market portfolio, M 2. Known as beta,, it measures security risk, or volatility relative to the market portfolio a. Beta greater than 1.0 is riskier than the market b. Beta less than 1.0 is less risky than the market 3. The value of beta implies something about returns relative to the market portfolio 4. The choice of a proxy affects beta. C. Deriving the CAPM 1. All risk averse investors will invest in one risky portfolio, M, which must be the market portfolio of all traded securities 2. M must have the same slope as the CML 3. ERi = RF + Risk premium 4. (ERi - RF) = Risk premium D. Risk/return relationships 1. Security systematic risk, beta, can be defined as a ratio to the market return 2. E(Ri) = R F + i (E(R M ) - R F ) 3. Security market line (SML) shows the risk/return relationship for securities and a graphical representation of the CAPM 4. Equation of a line is: Y = a + bx a. a is the y-intercept and b is the slope 5. The y-intercept becomes the risk-free rate 6. The slope is becomes beta ( ) 7. The equation of the SML is a. E(R i ) = R F + (E(R M ) - R F ) i b. Expected ROR = Risk Free Rate + Risk Premium c. Equal to equation for CAPM and similar to CML E. Differences between CML and SML 1. Capital market line measures risk by standard deviation, or total risk 2. SML measures risk by beta to find the security s risk contribution to portfolio M 3. CML defines efficient portfolios 4. SML defines efficient and non efficient portfolios 5. CML eliminates diversifiable risk for portfolios 6. SML includes all portfolios that lie on or below the CML, but only as a part of M, and the relevant risk is the security s contribution to M s risk These notes are personal use of MBA536 students enrolled at CSB-UNCW Page 23 of 31

24 7. Firm specific risk is irrelevant to each, but for different reasons F. CAPM and Security Analysis 1. With the equation: (Ri) = R F + i (E(R M ) - R F ) we can estimate the required return for a security, on an SML graph 2. Calculate the predicted return for the security based on today s price, a predicted price a year from today, and expected dividends in the coming year 3. Predict a holding period return and compare to the SML expected return 4. If a security seems likely to have a higher return than its risk level justifies, then it is undervalued (good investment) 5. A lower expected return than its risk would justify suggests a security is overvalued (not a good investment) G. Estimating Beta 1. A beta estimate measures the changes of a security s return relative to the market return 2. A security characteristic line graphs the relationship between the return on the market portfolio and a security return 3. The market model uses linear regression to estimate the relationship between the market return and the security return R i,t = a i + b i R M,t + e i,t 4. Beta estimates of are available from financial advisory services: i.e., Value Line, Merrill Lynch, etc. 5. Using the market model one can calculate systematic risk and diversifiable risk SD i2 = i2 SD M2 + SD e2 V. EMPIRICAL TESTING OF CAPM A. Implications must be jointly tested - any contradiction could come from either 1. Risk/return relationship is consistent with the data 2. The market is efficient B. Typical testing starts with the market model in a regression of excess returns for a security on the excess returns for the market portfolio over a 60-month period C. This first pass regression is used to estimate beta for a security and empirically testing CAPM D. Excess return is over and above the required return estimated by CAPM or actual return minus the CAPM return E. Time series regression uses data for one stock over time F. The second pass regression uses the estimated betas as independent variables in cross-sectional regression G. Cross-sectional regression uses data for many stocks at one time H. Results of testing by Black, Jensen, and Scholes found that CAPM understated low betas and overstated high betas from 1931 to 1965 These notes are personal use of MBA536 students enrolled at CSB-UNCW Page 24 of 31

25 I. The zero-beta model fit the data better than CAPM, but was not consistent and the average zero-beta return is much greater than the risk-free rate J. A major difficulty is the use of ex-post data to evaluate ex-ante returns VI. CRITICISM OF CAPM BY RICHARD ROLL A. Limits on tests: only testable implication from CAPM is whether the market portfolio lies on the efficient frontier B. Linear Risk/Return relationship require linear beta relationship, so second pass adds nothing C. Market Portfolio Composition cannot be observed, so is not testable D. Range of SML s - infinite number of possible SML s, each of which produces a unique estimate of beta E. Market efficiency effects - substituting a proxy, such as the S&P 500 creates two problems 1. Proxy does not represent the true market portfolio 2. Even if the proxy is not efficient, the market portfolio might be F. Conflicts between proxies - different substitutes may be highly correlated even though some may be efficient and others are not: Can lead to different conclusions regarding risk/return relationships G. So, CAPM is not testable - but it still has value and must be used carefully H. Stephen Ross devised an alternative way to look at asset pricing - APT VII. ARBITRAGE PRICING THEORY - APT A. Arbitrage principle is a process of buying a lower priced asset and selling a higher priced asset, both of similar risk, and capturing the difference in arbitrage profits B. The general arbitrage principles states that two identical securities will sell at identical prices C. Price differences will immediately disappear as arbitrage takes place D. Implications for investors E. Risk is important in evaluating investments F. Risk should be accounted for by models that help quantify that risk G. Qualitative factors can help overcome shortcomings of CAPM for measuring risk 1. Other strategies can be more successful than strictly investing in beta based strategies 2. Some choose to ignore beta - Beta is dead 3. Beta isn t perfect, but risk must be measured in making risk/return decisions 4. The assumptions of the CAPM were stringent, and not realistic and will be relaxed in the next chapter in developing a general risk/return relationship These notes are personal use of MBA536 students enrolled at CSB-UNCW Page 25 of 31

26 VIII. BETA: THE BAD NEWS A. Two issues with beta 1. How important is the market proxy? 2. How stable is beta? (inter-temporal stability) B. Research has shown little correlation between a security returns and market portfolio returns C. Historical betas can be better predictors of future betas for large portfolios than it is for individual securities 1. The more securities in the portfolio, the better predictor the portfolio s beta. These notes are personal use of MBA536 students enrolled at CSB-UNCW Page 26 of 31

27 CHAPTER 8: EFFICIENT MARKET HYPOTHESIS I. STUDENT LEARNING OBJECTIVES A. What is the Efficient Markets Hypothesis? (EMH) B. What are the implications of the EMH? C. Are there different forms of the EMH? D. How do we test for efficient markets? E. What is the evidence for and against the EMH? II. EFFICIENT MARKET HYPOTHESIS (EMH) A. Prices fully reflect all available information B. Prices adjust quickly to new information C. Implications of the EMH 1. Information cannot be used to earn abnormal returns 2. Short-term price movements cannot be predicted - a random walk a. Time series in which each change is independent from previous value b. Random series may appear to have patterns c. Use of runs test for randomness 3. Technical analysis is of no value even under weak-form EMH which requires that either the patterns are mere illusions, or other investors would also recognize any patterns 4. Fundamental analysis is only of value if one has superior forecasting skills and can act before the market can react to new public information 5. Active portfolio management probably cannot outperform passive portfolio management 6. Portfolio selection will depend upon risk preferences, age, income, etc. III. SOURCES OF MARKET EFFICIENCY A. Competition for best investments B. Large number of investors C. Ongoing research and market analysis keeps prices moving toward intrinsic values These notes are personal use of MBA536 students enrolled at CSB-UNCW Page 27 of 31

28 IV. FORMS OF E M H A. Weak-form market efficiency 1. Current prices reflect all historical information B. Semi-strong-form market efficiency 1. Prices fully reflect all public information C. Strong-form market efficiency 1. Prices fully reflect all public and private information D. Strong-form Market Efficiency and Insider Trading 1. Even insiders cannot use private information to earn abnormal profits. 2. Moreover - Prohibited by law (1934 Act) 3. Insiders monitored by SEC and financial markets V. TESTING MARKET EFFICIENCY A. Types of tests 1. Historical (ex post) 2. Ex ante B. Establish a benchmark (market portfolio) C. Length and selection of time periods affects results (artifacts). D. All tests are subject to criticism. E. Roll s Critique: knowledge of true market portfolio does not exist. F. Qualitative versus quantitative efficiency G. How efficient are the markets? H. Problem of market irrationality VI. TRADITIONAL TESTS OF THE EMH A. Usefulness of historical prices 1. Random nature of security prices and returns 2. Trading rules 3. Subjective 4. Objective B. Market reaction to new public information 1. Market may react before the announcement 2. Expectations - inside information 3. Market may delay in reacting to announcement These notes are personal use of MBA536 students enrolled at CSB-UNCW Page 28 of 31

29 VII. ANOMALIES EVIDENCE AGAINST MARKET EFFICIENCY A. Calendar anomalies 1. January effect 2. Weekend effect B. Small-firm effect 1. Stocks of small firms outperform large companies 2. Risk measure may not be adequate 3. Institutional investors overlook small firms C. Performance of Investment Professionals 1. Value Line rankings 2. Fund Manager performance VIII. ARE MARKETS EFFICIENT? A. Some Evidence supports the EMH 1. Cannot cover transaction expenses 2. Timing models inter-temporally unstable B. More Evidence contradicts the EMH 1. Serial properties of economic data 2. Improvements in data mining 3. Better analytical techniques These notes are personal use of MBA536 students enrolled at CSB-UNCW Page 29 of 31

30 CHAPTER 9: BEHAVIORAL FINANCE & TECHNICAL ANALYSIS I. LEARNING OBJECTIVES A. What do we mean by behavior? B. Why are the technicians so numerous? C. Is there any hope for Virginia? II. BEHAVIORAL CRITIQUE A. Investor Rationality 1. Does history repeat? Is history a problem? 2. How well do we analyze information? How do we know if we re doing it right? 3. Why the divergence of opinions given the same facts? 4. Do experts really exist? 5. Why are we slow to react? 6. Is arbitrage possible? 7. Why do bubbles occur? B. Technical Analysis 1. Figuring out which way the herd is moving the trend 2. How many theories are there? a. Dow Theory b. Elliott Wave Principle (Robt Prechter) c. Moving Averages (Simple, MACD) d. Momentum e. Sentiment Indicators f. Confidence Indicators g. Put/Call and Other Ratios h. Kondratiev Waves (50 to 60 year cycles) 3. Did you notice the shortness of this chapter? C. Principal Technical Indicators 1. Price Patterns a. Trend lines b. Moving Average 2. Investment Sentiment a. Contrary Opinion Theory b. Smart Money Indicators These notes are personal use of MBA536 students enrolled at CSB-UNCW Page 30 of 31

31 3. Market Momentum Indicators a. Advance/Decline Ratio b. Relative Strength Indicators III. TECHNICAL INDICATOR - DOW THEORY A. Dow Theory: trends continue until reversed 1. Primary movement 2. Secondary movement 3. Minor movements 4. Support levels - price should not drop below 5. Resistance levels - price should not rise above IV. PROBLEM AREAS IN TECHNICAL ANALYSIS A. Unequal access to [fundamental] information - lack of confirmatory analysis B. Inadequate [fundamental] information - sales and expenses, competitor initiatives C. Investor emotions and speculative bubbles D. Problem of self-fulfilling prophecy E. Do Technical Indicators Work? 1. Measuring performance is difficult - models are proprietary 2. Subjective forecasting - based on interpretation of recent data 3. Charting and moving averages have some validity but not fool proof. 4. Track records of technical analysts spotty V. YES VIRGINIA, THERE IS HOPE A. Fundamentalists vs. Technicians 1. The truth is out there. 2. Fundamental analysis can be used to reveal value 3. Technical analysis can be used to time These notes are personal use of MBA536 students enrolled at CSB-UNCW Page 31 of 31