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# Class Note for Fin 437 at WSU

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Date Created: 02/06/15

Security Analysis revised 72009 Professor Richard Sias Outline Performance Drivers Market Ef ciency and What do you know that Gordon Gecko doesn t A Market ef ciency fundamental analysis technical analysis B Topdown versus bottom up C Growth stocksValue stocks ll Fundamental Valuation A Discounted dividend model B EdwardBellOhlson model lll Relative Valuation A PriceEarnings PEG Ratio B PriceBook Value Value Ratio C PriceSales Pricesalesnet margin lV Technical Analysis Bollinger Bands Stochastics Moving Averages MACD Linear Regression Momentum TWUQW V Earnings A Earnings Estimates B Earnings Surprises Vl Analysts Recommendations Vll Institutional Ownership Vlll Piotroski Score Fall 2009 Performance Drivers Market Efficiency and What do you know that Gordon Geeko doesn t A Market efficiency a What it means b What would overreaction look like Underreaction Efficient markets c Why should markets be efficient d Fundamental Analysis e Technical Analysis Fall 2009 f Forms of efficiency Weak Semistrong Strong B Two approaches to valuation process 1 Bottomup 2 Top down Fall 2009 C Growth Stocks versus Value Stocks Note PBvps MB 1BP 1BM 1 Definitions recognize difference between company growth and stock returns Value stock Growth stock 2 Relative performance All figures from Value and Growth Investing Review and Update Financial Analysts Journal Chan and Lakonishok 2004 19751995 Value top 30 Growth bottom BM 30 BM US 1455 775 Japan 1691 706 UK 1787 1325 France 1710 946 Doesn t always work 19961999 Russell 1000 Growth Index 31 3yr 19961999 Russell 1000 Value Index 195yr Fall 2009 Has worked overall based on a more complicated definition of valuegrowth that incorporate BP CFP EP and SIP US Only large Growth Value cap bottom 25 top 25 19692001 45 164 19792001 79 204 19902001 38 180 Update figures from Value vs Glamour Global Phenomenon Brandes Institute June 1980Dec 2008 report avail online at Brandes Institute US Only Growth Value 10 highest pb 10 lowest pb All 87 160 Large Cap 97 161 Small Cap 82 160 ll Fundamental Valuation A Discounted dividend model 1 Price 2 Single period DDM Example D111 p122 r14 P0 3 Two period DDM Fall 2009 Example 0111 D212 P223 r14 P0 4 Infinite Period DDM P0D11r Dg1r2 DOC1r 5 Constant growth DDM If dividends or earnings grow at a constant rate g so that D Do 1 g then Current value P0 General Case P1 Procter and Gamble Example D0 124 annual dividend r8 g63 5 years average V 6 2stage models g1 g2 growth rate during 1st year 2nd year g long term constant growth rate Do prior 12month dividends Example 3 year supernormal growth r 10 D0 167 Fall 2009 g1gZg325 g8 ear Dividends Price Y O 1 2 3 4 Estimated Price 7 Model works best when 8 Limitations B EBO model Edwards Bell Ohlson Mathematically this is the same as the discounted dividend model Note VEBO value VP EBO valuePrice 1 Motivation Subsequent return to VP portfolios Fall 2009 Fall 2009 V P 36 Mo Ret all VP Portfolios 19771992 36 Mo Ret Large lnLow VP bottom 20 lHigh VP top 20 l Why should we worry about EBO instead ofjust using a value strategy 36 month highlow return VP strategy 35 BP strategy 14 Data from Frankel and Lee 1988 Journal of Accounting and Economics Fall 2009 2 Model proof De ne Bt Book value per share at end of t ALshares E EPS over period t Nitshares dt Div per share at end of period t r constant discount rate Clean Surplus Equation Bt Bt1 Et dt gt dt Et Bt Bt1 1 ROEt EtBH gt E ROEtBH Bt1r Bt rBt1r 3 Bt1r2 Bt1r rBt1r2 4 Proof of 3 BtBt Bt1rBt1r Bt1r Bt1rr1r Bt1r Bt1r1r Bt r1r Bt1r Bt Bt r1r Proof of4 multiply 3 by 11r Discounted Dividend Model d P 2 0 Z In 1 substituting in 1 for d yields P iEz39Bz39BH 0 21 1r expand for t1 and t2 130E1B1F0E2B2fjiEl Bt trj 1r 1r 23 1r expanding terms E1 B BO E2 B2 B 0 E 39 B 39 BM 1r1 1r1 144 1r2 1r2 1r2 23 1rt substitute 3 in forthird term on RHS E1 B 30 E2 B2 B no E 39 B 39 BM B 144 1r1 0 1r11r2 1r21r2 1rt 0 0 substitute 4 in for the second to last term E11 B11BO r301Jr E22 322 B11 rBJZJrZEz39mi39 m 1r 1r 1r 1r 1r 1r 1r 23 1r rearranging terms yields 0 133 E139rBuE239rB1 Bz JriEr39 sr39Bm 1r1 1r2 1r2 H 1r Thus continuing the expansion w E 77B B m E 77B P0B0Z 47 TTB0Z 4 1 77 77 11 77 Also because ROEtEtBt1 Br ROE r PU5 UZ t 11r t1 Fall 2009 10 Fall 2009 3 Model inputs all the variables are easily measurable 4 Firm value and NPV projects 5 PriceBook Ratio and E80 Model Divide both side by Bo PoBo 6 Using the model a 1 Ba Ea or Expand terms ie take t1 apart from rest so 51 ROElrvZgR0Ew B0 B0 t2 B0 13 Given a firm s EPS estimates discount rates and book value at last fiscal yearend we can estimate first term Problem is the second term 11 One relatively simple solution forthe second term is to assume we always earn the same ROE and book value doesn t change ie we pay out all earnings as dividends Then equation 3a becomes P BJKROEmi KROEm 01 Ba Ba w ng Hr Note that the second term is just a perpetuity that starts paying in two years Recall the value of a perpetuity that starts in one year is PMTr Thus the value today is PMTr1r imlJrROEiydngROEi dT B0 1r 1r From spreadsheet ROE10243 r0096 Bo511 P N 1 02437 00 0245 r 0000 B 7 0 0 7 0 113 139 253 Given PoBo 253 and Bo511 P0 253 511 1293 Which should have been its price at the beginning of this fiscal year Now however we are two months into the fiscal year Thus assuming we earn the required rate of return Ptoday Po10096212 1312 So what did we do Took EPS estimates for next year figured the PV of next year s abnormal ROE and then Fall 2009 12 assumed we would earn that for perpetuity How could we do better Expand to two terms 5 57150137925ROECmig7ROEL7 B0 B0 1r B0 7r HBQ 7r And assume we earn the abnormal ROE the second year for perpetuity PgmugROEQv5 OE57i57ROEZy B7 B7 77 B7 77 77 ENHEKROErm KROEZ KROEzdr B0 B0 77 B0 72 B0 72 P0 1 0245 r 0 a 752 0250 r 00 a 752 0250 r 0000 B0 10096 5770 100962 5770 100962 P0 1Z9161 290 0 The Lee spreadsheet evaluates 12 year horizon assumes perpetuity beginning in 13th year Analyst forecasts are used for first seven years EPS and LTG estimates to forecast ROE For next five years company s ROE drifts to industry average A 12 year horizon Le 12 years outto the industry ROE Fall 2009 13 Home Depot as of32300 ROE Abnormal ROE growth mte forB Compounded growth growthquot AROE required mte r dis count me div payout mte k Add to PB CurnPB Add Perpetuity beyond current yr Total PB Implied price Check Beg BVShr Implied EPS Implied EPS growth Fall 2009 PARAMETERS EPS Forecasm Bodlt values hare las t fye Discount Rate Dividend Payout Ratio Next Fsc Year end Currenthc Mth 1 to 12 Target ROE industry avg Year Longterm EPS Growth Rate Ltg Forecasted EPS Beg ofyear BVShr Implied ROE Beg ROE fromEPS forecasts ROEr 1kROEt 1 0096 0160 PVgrowthAROE Assume this yrs AROE forever PB ifwe stop est this period 0243 0147 0000 1000 0147 0096 1096 013 113 139 253 1312 511 124 2002 154 6152 0250 0250 0154 0204 1204 0186 0096 1201 015 129 161 290 1505 615 154 0242 2003 02410 1 91 7445 0257 0257 0161 0210 1457 0234 0096 1317 018 147 185 3 32 1723 745 1 91 0241 2004 0 2410 237 9051 0262 0262 0166 0216 1771 0294 0096 1443 020 167 212 379 1969 905 237 0241 2005 02410 294 11043 0267 0267 0171 0220 2161 0369 0096 1581 023 190 243 433 2248 1104 294 0241 2006 02410 365 13515 0270 0270 0174 0224 2645 0461 0096 1733 027 217 277 494 2564 1352 365 0241 2007 02410 453 16583 0 273 0273 0177 0227 3 245 0576 0096 1 900 030 247 316 563 2922 1658 453 0 241 2008 0259 0163 0230 3990 0649 0096 2082 031 278 325 603 3131 2039 527 0164 2009 0244 0148 0217 4857 0719 0096 2282 032 310 328 638 3313 2482 606 0148 2010 0 229 0 133 0 205 5853 0780 0096 2 501 031 341 325 666 3459 2991 686 0 133 2011 0215 0119 0193 6981 0828 0096 2741 030 371 315 686 3562 3567 766 0116 14 2012 0200 0104 0180 8239 0857 0096 3004 029 400 297 697 3618 4210 842 0100 ll Relative Valuation Fundamental valuation Relative valuation Risk with using relative valuation A PriceEarnings or PE or PE ratio 1 Relation to DDM Given the DDM divide both sides by E0 to get Thus PE ratio depends on High PE means 1 OR 2 OR 3 Forward PE Fall 2009 15 2 PEG ratio Implicit assumptions a b From Motley Fool In a fully and fairly valued situation a growth stock39s pricetoearnings ratio should equal the percentage of the growth rate of its company39s earnings per share Also from Motley Fool use with caution PEG Suggests 050 or less Undervalued 0 50 to 100 Fairly valued 100 to 130 Richy valued 130 or more Potentially Overvalued High PEG means GARP Fall 2009 16 B PriceBook ratio 1 Relation to DDM divide both sides by B0 to get Thus PB ratio depends on High PB means 1 OR 2 OR 3 2 Value Ratio Higher Value Ratio C PriceSales ratio 1 Relation to DDM divide both sides by Soto get Fall 2009 17 Thus PS ratio depends Higher PS means 1 OR 2 OR 3 D Using Relative Valuations 1 Compare your firm s valuation to similar firms 2 Using comparable firms ratios plug in the values for your company to get your firm s valuation 3 Example BA s expected earnings are 447 and current price is 5165 BA s growth rate015 Lockheed s forward PE is 2292 lmplied BA price Fall 2009 18 Fall 2009 Interpretation Lockheed s forward PEG176 Note PEGPEG implies PEGPEG Implied BA price Interpretation 19 Boeing s was mm Fan39Ig Fm39mte Fuvsad MamIT IE PB ICE W12 In ied ioehasedm PE IE PB Wm PS 1 M Lodd md 10247 11828 1037 5206 4282 2 CD c mlrgmm 1147 110 5152 2578 1145 3 Km man 6921 9488 1181 2884 5547 4 IUC thq 5203 1194 1882 1613 406 H l 10247 11825 35152 35206 39 Low 52118 1194 1181 1613 5547 lVEdm 984 9524 2459 2101 4188 Fall 2009 20 lll Technical Analysis Assumes there are recurrent patterns in stock prices If you can identify these patterns you can earn abnormal returns Charts g V 7 7 7 immune 94w MA gg gay 75 73 94m am a iy am Esau ail ly am sum mm mm man 29 mm am am mu 7 5w eraA2525 1K6447wpa377 i mum mm man man am mm mu 2ou mm mm mgr 71m M zgp um um N ugimimy guilty 3 M m m M W Straw Fall 2009 21 121mnn6 aa an 74 an aa aa 54 an MA BA25 aaa1MAt A5 an 2n 9535 NMaAaa aaza ms BA255D15 as paw m v sap m NW am am m NW Au NW m M W saa Be An m 121mnn aa aa aa aa aa aa aa aa UN aa73 an 1an RUE BAwu 12u5 sap Dc NW m ua Feb MW Aw M m m AW Sev Dc NW am am AW m 22 Fall 2009 A Bollinger Bands John Bollinger a What it is b To compute c In our graph we use a 50 day moving average and 25 standard deviations d Interpretation If a stock is near either limit Fall 2009 23 B Stochastics a Idea b What it is the K line the D line c In our graph K and D are both over 25 days d Interpretation C Moving Averages a What it is Fall 2009 24 b Helps identify trends in stock prices by smoothing prices c In our graph we use 25 day and 50 day moving averages cl Interpretation i Compare Price to MA ii Direction of MA D MACD Moving Average ConvergenceDivergence aka Line Oscillator a What it is b In our graph 25 day short term MA 50 day longterm moving average and 15 day signal line c Interpretation i Signdirection of MACD ii MACD versus signal line Fall 2009 25 E Linear Regression a What it is b In our graph we use 100 days c Interpretation i Overall trend ii Divergence F Momentum Price Rate of Change a What it is b In our chart we use 100 days about 5 months c Interpretation i Point relative to 100 ii Slope Fall 2009 26 d Evidence of price momentum i Chan Jegadeesh and Lakonishok Journal of Finance 1996 08 06 04 02 04 Price Momentum 02 r 0 031 a39ll all Ret1to6 Ret0t06 Ret0to12 Ret0to12 all large only EIPrice Momentum Losers IPrice Momentum Winners Note Graph shows returns over six months prior to formation 1 to 6 subsequent six months and subsequent 12 months Updated evidence Henker Martens and Huynh working paper 2006 avail on ssrncom Averaqe monthly returns over next six months Portfolio 19932004 19931996 19972000 20012004 Winners 1758 1706 1756 1831 Losers 0748 0671 0636 1756 Difference 101 1035 2393 0075 Fall 2009 27 Earnings A Revisions in Analysts Forecasts gt Chan Jegadeesh and Lakonishok Journal of Finance 1996 Portfolios are formed monthly based on moving average of last 6 months change in estimated EPS divided by price Large stocks are those with capitalizationgtNYSE median Period 19771993 Revisions in Analysts Forecasts 03 025 02 015 01 005 005 et 1 to 67Ret 0 to 67Ret 0 to 127Ret 0 to 12 01 al all all large only EIAnalyst Revisions Losers IAnalyst Revisions Winners Fall 2009 28 B Earnings Surprises post announcement drift Fall 2009 gt Chan Jegadeesh and Lakonishok Journal of Finance 1996 Notes Portfolios are deciles formed monthly based on last SUE reranked each month based on SUE Large stocks are those with capitalizationgtNYSE median Period 19771993 025 02 015 01 005 005 01 n 77R Based on SUE 0213 0138 0119 01767 0147 005139 0052 WRet 1 to 6 alliRet 0 to 6 alliRet 0 to 12 allRet 0 to 12 large only EIEarnings Surprises Losers IEarnings Surprises Winners 29 IV Analyst Recommendations A Frequency of Buy and Sell recommendations B What recommendations really mean Strong Buy Buy Hold UnderperformSell C Do Analysts recommendations have value a Womack 1996 Journal of Finance Announcement 1month 6 months following following Median added to Buy Median added to Sell b Barber Lehavy McNichols and Trueman 2001 Journal of Finance The graph below shows the annualized geometric mean return based on daily rebalancing of portfolio formed on the basis of consensus analyst forecast Fall 2009 30 Fall 2009 Ann Geometric Mean Gross Return daily rebalancing 1 most 2 favorable 4 5 least Market favorable Monthly Raw Return 19861996 1483 1479 1Week delay 2week delay E1 most favorable 5 least favorable 18 16 14 12 08 06 04 02 Daily reblancing by firm size Big firms top 13 18 Small firms bottom 13 IE1 most favorable 5 least favorable 31 Institutional Ownership Changes in Institutional ownership and subsequent returns Correlation between lag current and subsequent quarter returns and changes in institutional ownership NYSE stocks 7996 shares held by Inst Prior Same Following Quarter Quarter Quarter Buyerstraders 011 018 0029 Change in 010 016 00076 Sources Sias Review of Financial Studies 2004 Sias Starks and Titman Journal of Business 2006 VIII The Piotroski Score 1 Value beats Growth a Explanations i Value stocks are riskier than growth stocks ii Investors overreact Fall 2009 32 b If value beats growth because of overreaction then the benefits of a value portfolio likely accrue to those securities with improving fundamentals In other words the market underreacts to these changes in fundamentals eg Value stocks with improving fundamentals will be good investments and Growth stocks with worsening fundamentals will be bad investments 2 Piotroski s FSCORE a simple measure of changes in financial health a Firms that meet a minimum level of financial health and have improving financial conditions score high Firms with worsening financial performance score low b Nine measures of financial health 1 point for each criteria met thus FSCORE ranges from 0 to 9 i Positive net income must be making money i Positive cash flow less susceptible to accounting shenanigans ii Earnings quality cash flow gt net income iv Decreasing debt debtTA declining v Increasing working capital current ratio CACL increasing Fall 2009 33 vi vii viii Improving productivity Asset turnover ratio revenuestotal assets increasing Growing profitability Return on Assets NItotal assets increasing Issuing stock No new stock issues firms have a tendency to issue stock when they are overvalued Competitive position Increasing gross margin Sales COGS 3 Results All graphs on based on the April 2005 working paper Further evidence on the relation between historical changes in financial condition future stock returns and the valueglamour effect a Low medium and high FSCORE Fall 2009 Low score 01 23 Medium score 456 High score 789 34 b Results for all stacks Annual Return by FSCORE all stdck s 19722001 Annual Retum Fall 2009 35 Annual Rallyquot Fall 2009 Results for large stocks Annual Return by FSCORE large39stucks only 19722001 395 LOW Score lMed Scorg ElHigh Score 36 Lecture outline revised 72009 IntroductionChapter lBackground and Issues 1 Maj or types of Financial Assets a Fixed income Money marketcapital market b Equity c Derivatives 2 The investment process a Asset allocation b Security analysis c Security selection 3 Competitive markets nofreelunch a Riskreturn tradeoff b Efficient markets Fall 2009 37 c Passive management and active management 4 Markets and market structure a Market classifications i Primary ii Secondary Fall 2009 38 Lecture outline Chapter 2 Financial Securities 1 Chapter Overview a Money Market b Capital Markets i LT debt ii equity 2 Money Market a Treasury Bills 28 91 182 days b Certificates of Deposit CDs Jumbo CDs c Commercial Paper 1 Bankers Acceptances e Eurodollars Fall 2009 39 f Repos and Reverses g Brokers call h Federal Funds i LIBOR London Interbank Offer Rate 3 The FixedIncome Capital Market ie Bonds a Treasury Notes amp Bonds Maturity Ask Rate M oY r Bid Asked Chg Y Id 6 Aug 09m 11006 11009 3 443 Reading quotes what is bid price ask price spread YTM if bought at ask price b TIPS c Federal Agency Debt d International Bonds Fall 2009 40 e Municipal Bonds quotMunisquot i General Obligations ii Revenue bonds i Taxes and Munis Example Investor A t25 Investor B t 1 5 corp bond has 10 coupon rnuni has 8 coupon rate Both sell at par 1000 Which will the investor buy At what tax rate would an investor be indifferent Fall 2009 41 f Corporate Bonds Current Fltch Type lssue Prlce Couponue Mammy vwwe WW Rams Callable Corp U15 7488 6375 15eFebe 12882 8514 B Yes v EGAS 2015 SANDS CORP g Mortgages and MortgageBacked Securities 4 Equity a Common Stock P zer Inc PFE 121713 qnnte Re me Quotes 1544 029 180m39 Volume 44 15 Ml Avg Dally Volume 55 21 Ml PFEI39IWMJ Chm Day s ngh 16 50 m m m m Day s Low 16 03 Opsn 16 05 Z Prevlous Close 16 15 Mn N 16 44 NYSE Exchange 131d slze 23900 Emmmmm Ask 545 Data Source 28103 51 PM ET Quotes delayed 15 mlnutes Ask Slze 30100 CunentDlv Yleld 3 96 52 Week ngh 20 13 Market Cap 110 9 B11 52 Week Low 1162 Tot Shares Out 6 748 1311 Fall 2009 42 Instit Ownership 676 Forward PE 830 PE 1460 Sales 4617 Bil Earnings Share 112 Return on Equity 1311 Li DiV Share 064 Beta 073 b Preferred Stock is equity but has characteristics of both bonds and stocks c ADRs 5 Stock and Bond Market Indices a DJIA the quotDOWquot divisor on 724 20090 132319125 b SampP 500 Example Two stocks Stk P0 P1 MVO MV1 Ret A 10 13 10 100 130 30 B 10 15 100 1000 1500 50 total 20 28 1200 1630 PWindeX Fall 2009 43 VWindeX change in avg price c Foreign lndices Nikkei 225 FTSE quotFootsiequot in market value 6 Derivative Markets Options and Futures a Options i call ii put MSFT Underlying stock price 285 OPTION Strike EXP CALL PUT Vol LAST Vol LAST MSFT 25 Oct 285 30 Oct 12245 030 4113 190 285 35 Oct Fall 2009 Example What would be the profit or loss for someone who bought 1 contract assume October price was 31 44 Call profit Put profit b Futures long position short position Example Pork Bellies 40000 lbs cents per pound CME MTH fff SESSION fff PT EST ffff PRIOR DAY ffff STRIKE OPEN HIGH LOW LAST SETT CHGE VOL SETT VOL INT FEB07 91150 91450 90600 91300 91300 f350 117 91650 215 799 MAR07 ffff ffff 91500A 91500A 91500 f400 91900 12 63 MAY07 ffff 91500B ffff 91500A 91000 UNCH 91000 81 JLY07 ffff 92850B ffff 92850B 92850 25 92825 2 90 AUG07 ffff 93325B ffff 93325B 93325 25 93300 8 TOTAL EST VOL VOL OPEN INT TOTAL 117 229 1041 Trade unit 40000 pounds of frozen pork bellies cut and trimmed l point001 per pound Thus 913 91300l 09l3lb If price increased to 923 0923 Fall 2009 45 Total increase O923O913400004OO Example buy take long position the Feb contract in Feb pork bellies at 946 What is profit What is profit of short position Fall 2009 46 Lecture Outline Chapter 3 Securities Markets 1 How firm issue Securities a primary market versus secondary market IPO Seasoned b Investment Banking Roles of IB i origination ii Firm commitmentBest efforts iii distribution See tombstone c Cost of issue and underpricing 2 Types of orders a Market Order b Limit Order limit buy or limit sell c StopLoss Order Fall 2009 47 d Stopbuy order 3 Trading Mechanisms a Dealer Markets b Electronic communications networks ECNs c Specialist markets 4 US Securities Markets a NYSE i SuperDot ii Program trading iii Block Sales iV Specialist system b Nasdaq Fall 2009 48 c ECNs 5 International Markets a London SETS b Euronext merge of Paris Amsterdam and Brussels exchanges c Tokyo saitori maintains public limit book and matches orders does not trade for own account 6 Trading costs commission spread price improvement payment for order ow 7 Buying on Margin Fall 2009 49 a margin customer39s equitymarket value of securities b Initial margin c returninc0me value of securities at sale cost of securities interest invested example you have 10000 to invest expect PT 10 What is profitreturn with no margin with 50 margin What if price falls 10 Fall 2009 50 example buy 100 shares at 50share 50 margin 10 annual interest diVidend 1 share every six months six month holding period six months later price75 price25 d Maintenance margin Fall 2009 Example time Mkt value amt borrowed equity day 1 10000 5000 5000 day 2 6000 margin 50 5k10k Example stock price100 number of sharesl 00 60 margin Maintenance margin 30 At what price do you get a margin call 51 8 Short Sales a Define Example borrow 100 shares of B of A selling at 40share What is profit if two weeks later price is 35share What is profit if two weeks later price is 45share b Return from short sale sale proceeds cost of securities dividends paidequity deposit Example 70 initial margin price today 60 diVidend in 6 months 1 Case 1 price in 6 months40 return Case 2 price in 6 months80 return Fall 2009 52 c Maintenance margin in short sale Bearish on Xerox currently 100 share short 1000 shares cash from short sale 100000 initial margin 50 50000 maintenance margin 30 at what price do you get a margin call Fall 2009 53 9 Regulation of Security Markets a Circuit Breakers In the event ofa 850 POINT decline in the DJIA 10 percent Before 2 pm l HOUR HALT 11 2230 pm 30 MIN HALT After 230 pm NO HALT In the event ofa 1700 POINT decline i the DJIA 20 percent a Before 1 pm 2 HO HALT l pm l HOUR HALT After 2 pm MARKET CLOSES In the event ofa 2600 POINT decline in the DJIA 30 percent regardless of the time MARKET CLOSES for the day Fall 2009 54 b 1933 Act c 1934 Act d Insider Trading from 1956 Uniform Securities Act versus insider trades Fall 2009 55 Lecture Outline Chapter 4 Mutual Funds and Other Investment Companies 1 Investment Companies a NAV b Benefits of investment companies i record keeping and administration ii diversification and divisibility iii professional management iv lower transactions cost 2 Types of investment companies a Managed investment companies i openend ii closedend Fall 2009 56 iii REITS b Unit investment trusts 3 Mutual funds openend investment companies a Investment policies money market funds equity funds fixed income funds balanced funds asset allocation funds index funds specialized or sector funds 4 Fee structure Fall 2009 57 a frontend load noload lowload load example With 85 how much does the fund need to earn before you get your load back b backend load c operating expenses d l2bl fees 5 ETFs exchange traded funds e g SPDR Spiders DIA diamonds ETFs Cougfund uses eg IYFiShares Dow Jones US Financial Sector Top holdings July 2009 994 JPMORGAN CHASEampCO 765 WELLS FARGOampCOMPAN Y 678 BANK OF AMERICA CORP 490 GOLDMAN SACHS GROUP INC 242 MORGAN STANLEY 239 US BANCORP Fall 2009 58 6 Mutual Fund Performance A First Look a average performance See figure 42 b Persistence table 44 Fall 2009 59 Lecture Outline Chapter 5 Risk and Return Past and Prologue 1 Rates of return a HPR b Average return return over multiple periods i Arithmetic average ii Geometric average example 1 50 in first period 100 in second period arithmetic average geometric average example 2 quarterly returns 10 25 20 25 Fall 2009 60 what is arithmetic average quarterly return what is geometric average quarterly return 2 Risk and Risk Premiums a Probability distributions i potential outcomes ii likelihood of each outcome b Summary measures i expected return Er ii risk Variance 62 E rEr2 Std dev 6 V62 How do you estimate expected return and standard deviation a scenario analysis Fall 2009 61 b historical data How do you interpret standard deviation Assuming normal distribution see figure 53 1 standard deViation 2 standard deViations Example US large cap stocks average return 1 2 with annual standard deViation of 21 Fall 2009 62 c relation between risk and return Example ErA 10 6Al2 EI39B 12 Gleo EI39C 6C212 d riskfree rate e risk premium f risk aversion 3Historical record Expected return Zrtn Risk 52 2 rt aver2nl 2 66 See figures 51 52 and table 53 Fall 2009 63 4 In ation and real rates of return a Real versus Nominal rates of interest i approximate relationship ii exact relationship example earn 10 on your money CPI 12 what is your real return 5 Asset Allocations across risky and riskfree portfolios a Define Riskfree asset Risky portfolio Complete portfolio Fall 2009 64 b Portfolio expected return and risk i Notation P risky portfolio y of your invested in risky portfolio ly of your invested in riskfree asset rp risky return earned on risky portfolio Erp expected return on risky portfolio 6p standard deViation of risky portfolio return rf riskfree rate note not Erf 6f0 ie riskfree Assume Erp 15 Up 22 rf 07 Fall 2009 65 what is the risk premium on the risky portfolio ii Complete portfolio return Em yEltrp 1ygtrf iii Complete portfolio risk A for any two assets 621 W002 W2622 2W1W26162p12 but 6f0 thus B for risky portfolio and riskfree asset iv Examples Case 1 All your money in risky portfolio ETC 2 6C Fall 2009 66 Case 2 All your money in riskfree portfolio Erc 6C Case 3 half in riskfree half in risky portfolio Erc 6C graph in Er 6 space V Capital allocation line CAL intercept slope riserun Fall 2009 67 vi Points to the right of P example 300000 budget investor borrows another 120000 and invests 420000 in risky This is a levered position in the risky portfolio What is Erc cc assuming cost of borrowing rf assuming cost of borrowing is 8 vii Risk aversion and the CAL 6 Passive strategies and the Capital Market Line a Passive strategy b Indexing 0 Capital Market line d Why use a passive strategy i costs iiefficiency e How has it paid off table 55 Fall 2009 68 Lecture Outline Chapter 6 Efficient Diversification l Diversification and Portfolio Risk a Market risk b Firmspecific risk c Diversification Invest in one company Invest in two companies d Graph of total risk standard deviation versus number of firms in portfolio Fall 2009 69 2 Asset Allocation with two risky assets a Correlation and covariance historical covariancerarb 2 raS Eral rbS 1300 n 1 Correlation covariancerarb 61 a6l b b3 Rules Rule 1 realized portfolio return Rule 2 expected portfolio return Rule 3 variance of portfolio return 6213 Z WBGB2 Ws s2 2WBGBWsGssz Z WBGB2 WsGs2 2WBWSCOVI SI B c Gains frorn diversification Example 1 Assume Security Er G sz W Bond 10 12 0 50 Stock 17 25 0 50 Fall 2009 70 Determine expected return and standard deviation given WB50 WS50 WB75 WS25 d Investment opportunity set We know four possible riskreturn combinations so far WB WS Erp 6p Fall 2009 71 e Other cases i perfect positive correlation sz 1 ii perfect negative correlation sz l f Graphs of relation between correlation and investment opportunity sets figure 64 3 Optimal Risky portfolio with a RiskFree Asset a Assume now that in addition to the bond and stock investment we can invest in 3 month Tbills a riskfree asset Erf8 What will the Er and G of that portfolio be b Possible CALs figure 65 c Optimal CAL figure 66 1 Optimal risky portfolio e Optimal complete portfolio Fall 2009 72 4 Efficient Diversification with Many Risky Assets a Form efficient frontier figure 610 b Determine optimal CAL c Choose complete portfolio d separation property 5 A SingleFactor Model a Factor models statistical model to measure firmspecific and systematic risk of a security b Excess return for stock R1 ri rf for market RM rM rf Fall 2009 73 c Single Index Model R1 061 BiRm 61 d Decomposing total risk total variance in return systematic risk unsystematic risk e Statistical and Graphical Representation of Single Index Model f Characteristic lines and B1 Aggressive stock Defensive stock Hedge stock Example What does characteristic line for SampP 500 look like Fall 2009 74 Lecture Outline Chapter 7 CAPM and APT 0 Notation B beta paMGaGMGM2 COV1 a1 mGM2 p correlation coefficient COVI a1 mGaGM covrarm covariance paMGaGM l CAPM a Assumptions i Investors are price takers no one investor moves the market iiInvestors have identical holding periods iii All assets are traded publicly iv No taxes or transactions cost vAll investors are rational meanvariance optimizers they only care about expected returns and variance of portfolio returns vi Investors have the same expectations vii There is only one risk factor common to all securities viii Riskfree lending and borrowing Fall 2009 75 b Then i All investors will hold the market portfolio iiThe market portfolio is on the efficient frontier iii Risk premium on individual asset is proportional to risk premium of market and beta of security higher market risk gt higher expected return iv Linear relationship between risk and return in equilibrium BUD Z If BilEfm ff c Why all investors hold the market portfolio i same infoanalysis assumption 5 and 6 iisame securities and time horizon assumptions 2 and 3 Fall 2009 76 d Capital Market Line CML e Passive versus Active Management f Expected Returns on individual Securities Total risk market risk firmspecific my In CAPM only market risk matters BUD Z If BilEfm ff Market risk premium price of risk beta units of risk security39s risk premium g Security Market Line graph of relationship between expected returns and betas SML versus CML Points abovebelow SML Fall 2009 77 h Why should all securities plot on SML Bp in ABA in BBb i Example 1 rf8 Erml333 expect Sl45 current price SO36 Bl8 D1O Is the stock overpriced underpriced or fairly priced Example 2 What should be the price ii alpha Fall 2009 78 Example 3 Consider Stock K Em 10 Em Erm11 BK13 Alternatively consider a portfolio 50 invested in stock A ErA 134 BA16 50 invested in market portfolio ErM 11 BM1 j Empirical Tests of the CAPM i CAPM is an eXante model ii If CAPM holds and expectations are realized on average then CAPM can be written In YOt Bryn er testable implications can estimate betas then test these things a higher beta higher return ie yl gt 0 Fall 2009 79 b linear in beta ie coefficient on B12 or higher order betas should be zero c y1 rm rf d W rf e Nothing else matters i firmspecific risk ii size iii value growth iV momentum k Estimating and Predicting Betas i how do you measure beta is historical the same as present 1 Joint Hypothesis Problem example say we find small firms are earning too great a return to be justified by Fall 2009 80 their betas risk What are two possible interpretations m Examples of using CAPM Example 1 Assume Security ER Std Dev Mkt Port 14 4 riskfree 8 0 A 10 2 p AM 8 Q should you buy or sell this asset Will it plot above or below the SML Example 2 Assume Security ER beta Mkt port 9 1 Riskfree 5 0 A 96 14 B 88 12 C 52 3 You have 1000 invested in A and 3000 invested in B You want to hold these positions but you want to lower your beta to 1 How much more money must you invest in C to do this n The Fama and French three factor model assumes bm effect ie the tendency for value stocks to beat growth stocks and size Fall 2009 81 effect ie the tendency for small stocks to beat large are related to risk It If on Bimrm H BLHMLUH IL BLSMBUS TB 61 2 Arbitrage Pricing Theory a Arbitrage Opportunity Pure Arbitrage example stock selling for 100 in NYSE and 110 in OTC Fall 2009 82 b Example 4 States Possible probability of each state is 25 High Real Interest Rates Low Real Interest Rates Stock High In Low In High In Low In A 20 20 40 60 B 0 70 30 20 C 90 20 10 70 D 15 23 15 3 6 Go Long in A B and C 1 million each and Short in D Mean Std DeV Correlation 3stock port2583 640 094 D 2225 858 Payoffs in each High Real Interest Rates Low Real Interest Rates Stk Invest High In Low In High In Low In A 1 Mil 200000 200000 400000 600000 B 1 Mil 0 700000 300000 200000 C 1 Mil 900000 200000 100000 700000 D 3 Mil 450000 690000 450000 l080000 Port 0 250000 10000 150000 20000 Fall 2009 83 c Critical properties of an arbitrage portfolio d Assumptions of APT i no taxes or transactions costs ii No limits on short sales iii investors have identical expectations iv number of assets is much greater than the number of factors e Well Diversified Portfolios and APT i two types of risk ii Realized returns for APT model a for an individual security b for a portfolio firmspecific risk becomes irrelevant We know that nonsystematic risk can be reduced to an arbitrarily low level through diversification Chapter 6 therefore investors do not require a risk premium as compensation for bearing nonsystematic risk page 208 Fall 2009 84 f Betas and Expected Returns i example Portfolios A and B sell for the same price A and B have same beta portfolio A outperforms B no matter what happens to M BA BB 2 l but ErAlO and ETB8 ie if M0 then rA10 and rB8 Arbitrage opportunity Sell 1000000 of B short Buy 1000000 of A implies zero net investment what are the net proceeds ii Two rules Rule 1 Portfolios with equal betas must have equal expected returns in equilibrium or arbitrage will occur Rule 2 Portfolios with unequal betas must have excess returns proportional to their betas or arbitrage will occur Fall 2009 85 Example Consider a case where it does not occur Port ER Beta A 10 1 F 04 0 C 06 5 g CAPM and APT i equivalency ii Advantages of APT over CAPM a No assumptions about meanvariance efficiency dist of stock returns bNo strong assumptions about form of utility function just risk averse and greed c Allows many factors Fall 2009 86 d Yields statement about the relative pricing of any subset of assets therefore you need not measure the entire universe of assets to test it e No special role for market portfolio in APT while CAPM requires market portfolio to be efficient h Multifactor APT Fall 2009 Example of twofactor model I EOE l BilMl l BizMz l 61 M1 is unexpected GDP M2 is unexpected in ation i Empirical Tests of APT i Factor Rotation Models iiGuess at some quotreasonable factors 87 3 Summary of CAPM and APT both valuation models a CAPM i investors are only compensated for bearing market risk ii the market portfolio is the optimal risky portfolio tangency portfolio iii investors Will hold some combination of the riskless asset and market pt iv in equilibrium all securities plot on SML v single source of risk market risk vi empirical validity Fall 2009 88 bAPT i less restrictive assumptions than CAPM iione rule expected excess returns on portfolios must be proportional to their betas iii can have multiple sources of systematic risk iV theory does NOT identify the risk factors What are they or how many V empirical validity hard to test Fall 2009 89

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