FE323 Final Study Guide
Topic 7: Efcicnt Markcts
Efcicnt markcts hypkpothcsis:
Implics that sccuritcs ill bc fairlypk priccd, bascd on thcir futurc cash fo , iicn all informaton that is aiailablc to inicstors
Implics that 2 sccuritcs ith thc samc cash fo and thc samc risk must haic thc samc pricc
Public, casilypk aiailablc informaton:
Informaton aiailablc to all inicstors includcs informaton in nc s rcports, fnancial
statcmcnts, corporatc prcss rclcascs, or othcr public data sourccs
Priiatc or difcultltolintcrprct informaton
Various forms of effienfy
Ineffient
Effient
o Weak form: incorporatcs onlypk past stock pricc historypk
o Semi-strong: incorporatcs all kno n publif informaton
o Strong form: incorporatcs all informaton includin insidc informaton (includin
nonlpublic informaton)
Problcm: Mypkox Labs announccs that it is pullin onc of its lcadin dru s from thc markct, o in
to thc potcntal sidc cfccts associatcd ith thc dru . As a rcsult, its futurc cxpcctcd frcc cash fo ill dcclinc bypk $85 million pcr ypkcar
for thc ncxt 10 ypkcars. Mypkox has 50 million sharcs outstandin , no dcbt, and an cquitypk cost of capital of 8%. If this nc s camc as a
complctc surprisc to inicstors, hat should happcn to Mypkox’s stock pricc upon thc announccmcnt?
Plan:
In this casc, c can usc thc discountcd frcc cash fo mcthod. With no dcbt, r acc = rE = 8%.
Thc cfcct on thc Mypkox’s cntcrprisc ialuc ill bc thc loss of a tcnlypkcar annuitypk of $85 million.
Wc can computc thc cfcct todaypk as thc prcscnt ialuc of that annuitypk.
Exccutc:
o Usin thc annuitypk formula, thc dcclinc in cxpcctcd frcc cash fo ill rcducc
Mypkox’s cntcrprisc ialuc bypk
o N = 10; I/Yr = 8%; PMT = 85; FV = 0; PV =??
o Thus thc sharc pricc should fall bypk $570.36/50 = $11.41 pcr sharc.
Eialuatc:
Bccausc this nc s is public and its cfcct on thc frm’s cxpcctcd frcc cash fo is clcar, c ould cxpcct thc stock pricc to drop bypk
$11.41 pcr sharc ncarlypk instantancouslypk, as it comcs as a surprisc to thc markct.
Priiatc or Difcultltolintcrprct informaton
Examplc: Phcnypkx Pharmaccutcals had just announccd thc dciclopmcnt of a nc dru
for hich thc companypk is scckin approial from thc FDA. If thc dru is approicd futurc
profts ill incrcasc Phcnypkx’s markct ialuc bypk $15 pcr sharc. Eupposc thc announccmcnt
comcs as a surprisc to inicstors, and aicra c likclihood of FDA approial is 10%.
Eoluton: Thc announccmcnt should lcad to a 10% × $15.00 = $1.50 pcr sharc
immcdiatc stock pricc incrcasc
Oicr tmc, inicstors ill makc thcir o n asscssmcnts of thc probablc cfcacypk of thc
dru
If thcypk concludc that thc dru looks morc (lcss) promisin than aicra c, thcypk ill
buypk (scll) thc stock and thc pricc ill drif hi hcr (lo cr) oicr tmc
At thc tmc of thc announccmcnt, uninformcd inicstors do not kno hich aypk it ill o
Conscqucnccs for inicstors
Inicstors must haic somc compcttic adianta c
o Expcrtsc or acccss to informaton kno n to onlypk a fc pcoplc
o Lo cr tradin costs than othcrs
o If stocks arc fairlypk priccd accordin to ialuaton modcls, thcn inicstors ho buypk stocks can cxpcct air compcnsaton
for thc risk thcypk takc
Thc Efcicnt Markct Hypkpothcsis and No Arbitrage
Arbitra c opportunitypk: a situaton in hich 2 sccuritcs (or portolios) ith idcntcal cash fo s haic difcrcnt priccs
, o Bccausc anypkonc can carn a surc proft in this situaton bypk buypkin thc lo lpriccd sccuritypk and scllin thc hi hlpriccd
onc, c cxpcct inicstors to immcdiatclypk cxploit and climinatc thcsc opportunitcs
o Thus, in a normal (cfcicnt) markct, arbitra c opportunitcs ill not bc found
Thc cfcicnt markcts hypkpothcsis statcs that sccuritcs ith cquiialcnt risk should haic thc samc cxpcctcd rcturn
Difcrcnt inicstors maypk pcrcciic risks and rcturns difcrcntlypk (bascd on thcir informaton and prcfcrcnccs)
Thcrc is no rcason to cxpcct thc cfcicnt markcts hypkpothcsis to hold pcrfcctlypk; rathcr, it is bcst iic cd as an idcalizcd
approximaton for hi hlypk compcttic markcts
Topif 8: risk and return
Rcquircd rcturn on an inicstmcnt dcpcnds upon thc riskincss of thc inicstmcnt
Thcrc is a rc ard to takin risk and it is cqual to thc risk prcmium/risk frcc ratc
Thc rcatcr thc risk, thc rcatcr thc rcquircd rcturn ypkou nccd to cntcc (thc rcatcr thc prcmium/risk frcc ratc)
Whcn faccd ith 2 inicsctmcnts, samc risk, choosc thc onc ith hi hcr rcturn
Whcn faccd ith 2 inicstmcnts, samc cxpcctcd rcturn choosc thc onc ith lcss risk
Rcturn
Giic up opportunitypk cost
Giic up thc abilitypk to consumc or spcnd moncypk
Haic infaton risk
Haic crcdit risk (Dcfault risk)
risk
Eccuritypk rcturn: ypkicld (diiidcnds or intcrcst) + capital ain (chan c in pricc bc innin of ypkcar to cnd)
Etock: diiidcnds + ain/loss
Bonds: intcrcst + ain/loss or coupon+ ain/loss
Hi hcr prcmium/risk frcc= hi hcr iolatlitypk of rcturns
Calculatn rcturn
Non diiidcnd paypkin inicstmcnts
1. Aicra c rcturn (just capital ain)
2. Gcomctric or compound annual rcturn (CAGR)
Diiidcnd paypkin inicstmcnts
3. Rcalizcd rcturn
, A.Aicra c = 80.5/10 = 8.05%
B.Easier to do part C frst:
C.Assume you invest $100 at tme 0
Afcr Thc frst ypkcar thc 100 ould haic ro n to $100 x (1 – 19.9%) = 80.10
For thc sccond ypkcar ypkou inicst thc $80.10 and it should ro n to $80.10 x (1 + 16.6%) = $93.39 ctc. ctc.
For thc full 10 ypkcars thc cquaton is:
100 x (0.801 x 1.166 x 1.18 x 0.50 x 1.433 x 1.012 x 0.835 x 1.456 x 1.452 x 0.97) = 100 x 1.3683
You should have $136.83 at the end of the 10 years
Do part B now: Wc nccd thc Gcomctric mcan or thc compoundcd ro th ratc – usc ypkour fnancial calculator
PV = l$100 FV = $136.88 N = 10 ypkcars PMT = 0 I/Yr = ??
I/ypkcar = 3.185%
Altcrnaticlypk, nccd to fnd thc ratc that makc thc compoundcd rcturn of $100 cqual to $136.83 oicr 10 ypkcars
100 x (1 + r)10 = 136.83 solic for r
1 + r = (1.3683) 1/10 = 1.03185 r = 3.185% samc rcsult as aboic.
Risk: lar c rcturns for incrcasin risk
l Emall stock haic thc lar cst prcmium and corporatc bonds has lo cst prcmium
o Volatlitypk of rcturns/iariancc of rcturns
1
Var R
T1
( R1 R )2 ( R2 R )2 ... ( RT R ) 2
Topic 9: Portolio Risk & Rcturn
Portolio:
A combinaton of stocks or bonds
% inicstcd in assct 1+% inicstcd in assct 2
To an almost unlimitcd numbcr of asscts
A sin lc mutual fund can bc a portolio
A portolio can bc madc up of difcrcnt mutual fund
Diicrsifypk can climinatc risk
Problcm:
•Eupposc ypkou buypk 2,000 sharcs of Microsof at $25 pcr sharc and 3,000 sharcs of Pcpsi at $36 pcr sharc
•If Microsof’s stock ocs up to $33 pcr sharc and Pcpsi stock falls to $32 pcr sharc and ncithcr paid diiidcnds, hat is thc nc ialuc
of thc portolio?
•What rcturn did thc portolio carn?
•What arc thc nc portolio ci hts?
•Thc inital portolio ci hts crc $50,000/$158,000 = 31.6% for Microsof and $108,000/$158,000 = 68.4% for Pcpsi
•Eincc ncithcr stock paid anypk diiidcnds, c calculatc thcir rcturns as thc capital ain or loss diiidcd bypk thc purchasc pricc. Thc rcturn
on Microsof stock as $8/$25 = 32%, and thc rcturn on Pcpsi stock as l$4/$36 = l11.1%.
Portolio Rcturn:
R P w M i c r o so f t R M i c r o so f t w P e p s i R P e p s i 0 . 3 1 6 ´ 3 2 % 0 . 6 8 4 ´ 1 1 . 1 % 2 . 5 %
Risk and Diicrsifcaton
• Risk chan cs as c add stocks to a portolio, dccrcasc iolatlitypk
Indiiidual Etock risk
l Eypkstcmatc riskl afcctn thc sypkstcm undcrlypkin thc cntrc markct
l Unsypkstcmatcl uniquc to thc sin lc companypk, onlypk impacts onc companypk
Topic 7: Efcicnt Markcts
Efcicnt markcts hypkpothcsis:
Implics that sccuritcs ill bc fairlypk priccd, bascd on thcir futurc cash fo , iicn all informaton that is aiailablc to inicstors
Implics that 2 sccuritcs ith thc samc cash fo and thc samc risk must haic thc samc pricc
Public, casilypk aiailablc informaton:
Informaton aiailablc to all inicstors includcs informaton in nc s rcports, fnancial
statcmcnts, corporatc prcss rclcascs, or othcr public data sourccs
Priiatc or difcultltolintcrprct informaton
Various forms of effienfy
Ineffient
Effient
o Weak form: incorporatcs onlypk past stock pricc historypk
o Semi-strong: incorporatcs all kno n publif informaton
o Strong form: incorporatcs all informaton includin insidc informaton (includin
nonlpublic informaton)
Problcm: Mypkox Labs announccs that it is pullin onc of its lcadin dru s from thc markct, o in
to thc potcntal sidc cfccts associatcd ith thc dru . As a rcsult, its futurc cxpcctcd frcc cash fo ill dcclinc bypk $85 million pcr ypkcar
for thc ncxt 10 ypkcars. Mypkox has 50 million sharcs outstandin , no dcbt, and an cquitypk cost of capital of 8%. If this nc s camc as a
complctc surprisc to inicstors, hat should happcn to Mypkox’s stock pricc upon thc announccmcnt?
Plan:
In this casc, c can usc thc discountcd frcc cash fo mcthod. With no dcbt, r acc = rE = 8%.
Thc cfcct on thc Mypkox’s cntcrprisc ialuc ill bc thc loss of a tcnlypkcar annuitypk of $85 million.
Wc can computc thc cfcct todaypk as thc prcscnt ialuc of that annuitypk.
Exccutc:
o Usin thc annuitypk formula, thc dcclinc in cxpcctcd frcc cash fo ill rcducc
Mypkox’s cntcrprisc ialuc bypk
o N = 10; I/Yr = 8%; PMT = 85; FV = 0; PV =??
o Thus thc sharc pricc should fall bypk $570.36/50 = $11.41 pcr sharc.
Eialuatc:
Bccausc this nc s is public and its cfcct on thc frm’s cxpcctcd frcc cash fo is clcar, c ould cxpcct thc stock pricc to drop bypk
$11.41 pcr sharc ncarlypk instantancouslypk, as it comcs as a surprisc to thc markct.
Priiatc or Difcultltolintcrprct informaton
Examplc: Phcnypkx Pharmaccutcals had just announccd thc dciclopmcnt of a nc dru
for hich thc companypk is scckin approial from thc FDA. If thc dru is approicd futurc
profts ill incrcasc Phcnypkx’s markct ialuc bypk $15 pcr sharc. Eupposc thc announccmcnt
comcs as a surprisc to inicstors, and aicra c likclihood of FDA approial is 10%.
Eoluton: Thc announccmcnt should lcad to a 10% × $15.00 = $1.50 pcr sharc
immcdiatc stock pricc incrcasc
Oicr tmc, inicstors ill makc thcir o n asscssmcnts of thc probablc cfcacypk of thc
dru
If thcypk concludc that thc dru looks morc (lcss) promisin than aicra c, thcypk ill
buypk (scll) thc stock and thc pricc ill drif hi hcr (lo cr) oicr tmc
At thc tmc of thc announccmcnt, uninformcd inicstors do not kno hich aypk it ill o
Conscqucnccs for inicstors
Inicstors must haic somc compcttic adianta c
o Expcrtsc or acccss to informaton kno n to onlypk a fc pcoplc
o Lo cr tradin costs than othcrs
o If stocks arc fairlypk priccd accordin to ialuaton modcls, thcn inicstors ho buypk stocks can cxpcct air compcnsaton
for thc risk thcypk takc
Thc Efcicnt Markct Hypkpothcsis and No Arbitrage
Arbitra c opportunitypk: a situaton in hich 2 sccuritcs (or portolios) ith idcntcal cash fo s haic difcrcnt priccs
, o Bccausc anypkonc can carn a surc proft in this situaton bypk buypkin thc lo lpriccd sccuritypk and scllin thc hi hlpriccd
onc, c cxpcct inicstors to immcdiatclypk cxploit and climinatc thcsc opportunitcs
o Thus, in a normal (cfcicnt) markct, arbitra c opportunitcs ill not bc found
Thc cfcicnt markcts hypkpothcsis statcs that sccuritcs ith cquiialcnt risk should haic thc samc cxpcctcd rcturn
Difcrcnt inicstors maypk pcrcciic risks and rcturns difcrcntlypk (bascd on thcir informaton and prcfcrcnccs)
Thcrc is no rcason to cxpcct thc cfcicnt markcts hypkpothcsis to hold pcrfcctlypk; rathcr, it is bcst iic cd as an idcalizcd
approximaton for hi hlypk compcttic markcts
Topif 8: risk and return
Rcquircd rcturn on an inicstmcnt dcpcnds upon thc riskincss of thc inicstmcnt
Thcrc is a rc ard to takin risk and it is cqual to thc risk prcmium/risk frcc ratc
Thc rcatcr thc risk, thc rcatcr thc rcquircd rcturn ypkou nccd to cntcc (thc rcatcr thc prcmium/risk frcc ratc)
Whcn faccd ith 2 inicsctmcnts, samc risk, choosc thc onc ith hi hcr rcturn
Whcn faccd ith 2 inicstmcnts, samc cxpcctcd rcturn choosc thc onc ith lcss risk
Rcturn
Giic up opportunitypk cost
Giic up thc abilitypk to consumc or spcnd moncypk
Haic infaton risk
Haic crcdit risk (Dcfault risk)
risk
Eccuritypk rcturn: ypkicld (diiidcnds or intcrcst) + capital ain (chan c in pricc bc innin of ypkcar to cnd)
Etock: diiidcnds + ain/loss
Bonds: intcrcst + ain/loss or coupon+ ain/loss
Hi hcr prcmium/risk frcc= hi hcr iolatlitypk of rcturns
Calculatn rcturn
Non diiidcnd paypkin inicstmcnts
1. Aicra c rcturn (just capital ain)
2. Gcomctric or compound annual rcturn (CAGR)
Diiidcnd paypkin inicstmcnts
3. Rcalizcd rcturn
, A.Aicra c = 80.5/10 = 8.05%
B.Easier to do part C frst:
C.Assume you invest $100 at tme 0
Afcr Thc frst ypkcar thc 100 ould haic ro n to $100 x (1 – 19.9%) = 80.10
For thc sccond ypkcar ypkou inicst thc $80.10 and it should ro n to $80.10 x (1 + 16.6%) = $93.39 ctc. ctc.
For thc full 10 ypkcars thc cquaton is:
100 x (0.801 x 1.166 x 1.18 x 0.50 x 1.433 x 1.012 x 0.835 x 1.456 x 1.452 x 0.97) = 100 x 1.3683
You should have $136.83 at the end of the 10 years
Do part B now: Wc nccd thc Gcomctric mcan or thc compoundcd ro th ratc – usc ypkour fnancial calculator
PV = l$100 FV = $136.88 N = 10 ypkcars PMT = 0 I/Yr = ??
I/ypkcar = 3.185%
Altcrnaticlypk, nccd to fnd thc ratc that makc thc compoundcd rcturn of $100 cqual to $136.83 oicr 10 ypkcars
100 x (1 + r)10 = 136.83 solic for r
1 + r = (1.3683) 1/10 = 1.03185 r = 3.185% samc rcsult as aboic.
Risk: lar c rcturns for incrcasin risk
l Emall stock haic thc lar cst prcmium and corporatc bonds has lo cst prcmium
o Volatlitypk of rcturns/iariancc of rcturns
1
Var R
T1
( R1 R )2 ( R2 R )2 ... ( RT R ) 2
Topic 9: Portolio Risk & Rcturn
Portolio:
A combinaton of stocks or bonds
% inicstcd in assct 1+% inicstcd in assct 2
To an almost unlimitcd numbcr of asscts
A sin lc mutual fund can bc a portolio
A portolio can bc madc up of difcrcnt mutual fund
Diicrsifypk can climinatc risk
Problcm:
•Eupposc ypkou buypk 2,000 sharcs of Microsof at $25 pcr sharc and 3,000 sharcs of Pcpsi at $36 pcr sharc
•If Microsof’s stock ocs up to $33 pcr sharc and Pcpsi stock falls to $32 pcr sharc and ncithcr paid diiidcnds, hat is thc nc ialuc
of thc portolio?
•What rcturn did thc portolio carn?
•What arc thc nc portolio ci hts?
•Thc inital portolio ci hts crc $50,000/$158,000 = 31.6% for Microsof and $108,000/$158,000 = 68.4% for Pcpsi
•Eincc ncithcr stock paid anypk diiidcnds, c calculatc thcir rcturns as thc capital ain or loss diiidcd bypk thc purchasc pricc. Thc rcturn
on Microsof stock as $8/$25 = 32%, and thc rcturn on Pcpsi stock as l$4/$36 = l11.1%.
Portolio Rcturn:
R P w M i c r o so f t R M i c r o so f t w P e p s i R P e p s i 0 . 3 1 6 ´ 3 2 % 0 . 6 8 4 ´ 1 1 . 1 % 2 . 5 %
Risk and Diicrsifcaton
• Risk chan cs as c add stocks to a portolio, dccrcasc iolatlitypk
Indiiidual Etock risk
l Eypkstcmatc riskl afcctn thc sypkstcm undcrlypkin thc cntrc markct
l Unsypkstcmatcl uniquc to thc sin lc companypk, onlypk impacts onc companypk
