Investments Test 2

Global Economic Considerations

A top-down analysis of a company begins with an examination of global economic prospects. Factors that may have relevance include: -political risk -exchange-rate risk Exchance-rate risk has several elements that are important to global economic analysis. Unfavorable movements in exchange rates will affect a firm's sales and profits and can change relative competitive positions of firms. When investing in foreign markets, analysts must consider the effect that changes in exchange rates will have on returns. The extent to which exchange rates and other variables will impact a firm depend upon... -It's particular product market. -The extent of hedging the firm engages in. -The expected response by competitors. -The elasticity of demand of the firm's product. In 2008, stock market returns while most bad everywhere, showed a large range of performance in both local currency terms and US dollar terms. Performance in countries & regions is highly variable. Other variables of economic consideration are... -political risk -exchange rate risk on sales, profits, and stock returns

Tests of EMH

A. Early Tests Random Walk-Tests: prices change only when new info arrives. Thus, "new" info must be random. The 1st test was conducted in 1953 by Kendal. He looked at weekly changes in 19 British securities concluding: "The series looks like a wandering one, almost as if once a week the demon of chance drew a random number from a symmetrical population of fixed dispersion and added it to the current price to determine the next week's price." Many other studies reached the same conclusion. Thus, security prices have no meaning. Filter Trading Rules Tests: if a security price moves up by X% above a prior low, buy and hold until the price falls by Y% below a previous high. Alexander (1961) concluded: "In fact, at this point I should advise my reader who is not a floor trader and so must pay commissions, to turn to other sources on how to beat buy and hold." B. Recent Findings: Random Walked revisited-Recent research shows that future returns are more predictable than early studies suggest. Lo & McKinally (1988) formed portfolio based on firm capitalization & found that weekly returns are positively correlated, particularly for the smallest capitalization portfolios. Long Horizon Results- Debondt & Thaler (1990) created portfolios of past "losers" and past "winners." Examining the subsequent returns, they found the "loser" portfolio outperformed the previous "winner" portfolio. This is called the reversal effect. C. Return Patterns Recent studies have found persuasive evidence of systematic patterns in stock returns. 1. January effect 2. Monthly effect 3. Weekly effect 4. Daily effect Tests of Semi-strong form P/E Effect -Stocks with low P/E ratios outperform those with high P/E ratios. -See "What Works on Wall Street" by James P.O. Shaughnessy. Market to Book Ratios -Lower ratio and higher returns. -See Famer and French (1992) Journal of Finance (1963-1990) -Value stocks had lower beta than growth stocks. Stock Splits -Fama, French, Jensen, and Roll found that splits by themselves have no observable effect on security prices. Price to Sales (P/S) -Stocks with low price to sales ratios outperform the market, and stocks with high price to sales ratios. High Dividend Yield: Numerous studies have found that high yielding stocks tend to outperform. Neglected Stocks: -Commonly selected by those who follow a contrarian strategy. -A study by DeBondt and Thaler concluded that: "The best performers over the previous period subsequently underperformed, while the poor performers from the period before produced significantly greater returns than the NYSE index." Initial Public Offerings (IPO's): Studies have found that IPO's appear to have between the 11-12% abnormal return during the first month the security is held. However, by the 3rd month IPO's appear to have reached equilibrium levels. Test of Strong Form Market Efficiency: 1. Corporate insiders 2. Security analysts 3. Value line investment survey Fama 1990 "Over the 6.5 years form 1984 to mid 1990, group 1 stocks earned 16.9% per year compared with 15.2% for the Wilshire 5000 Index. During the same period,Value Line's Centurion Fund, which specializes in group 1 stocks, earned 12.7% per year-live testimony to the fact that there can be large gaps between the simulated profits from private info and what is available in practice."

Comparability Problems

Accounting differences, such as -inventory valuation -depreciation Inflation International Accounting Conventions

Constant Growth Model

Also called the Gordon model after the person who developped it. V₀ = D₀ (1 + g) / (k - g) where g is constant perpetual growth rate and k is the rate of required return by stockholders. Ex. E₁ = $5 E₁ is the expected earnings b = 40% k= 0.15 (1 - b) = 60% D₁ = $3 g=8% V₀ = 3 / (0.15 - 0.08) = $42.86

Market Price Ratios

Price to Earnings = Market Price of Stock / Earnings Market to Book Value = Market Price of Inventory / Book Value per Share

What Factors Affect SML?

----------------------Required Risk-------SML Effect--- Return ri---Stock Price 1. General---SML Economic----Pivots Pessimism---Upward-------↑---------↓ 2. Inflation--SML More Than-----Pivots Expected----Upward-------↑---------↓ 1. The Firm---Bi is Perceived--Increase------↑---------↓ Riskier. There is an inverse relationship between the required rate of return and the stock price.

Effects of the FRB's Activities

-----------Effect on--------Impact On Activity----Money Supply--Interest Rates Raise RR-----Decrease--------Raise Raise DR-----Decrease--------Raise Raise GS-----Decrease--------Raise Lower RR-----Increase--------Lower Lower DR-----Increase--------Lower Buy GS-------Increase--------Lower RR: Reserve Requirement DR: Discount Rate GS: Government selling of treasury securities. Analysis of the economy will often distinguish between demand and supply shocks. A demand shock is an even that affects demand for goods and services. A tax cut is a policy action designed to influence the demand for economic participants. A supply shock influences production capacity or production costs. Higher levels of education for the work force should have the effect of increasing productivity or reducing production costs. A change in the price and or availability of oil is another example of a supply shock. Demand V. Supply Shock Demand shock is an event that affects demand for goods and services in the economy. Some examples are: -tax rate cut -increases in government spending Supply shock is an event that influences production capacity or production costs. Some examples are: -commodity price changes -education level of economic participants

Key Economic Variables

-Gross domestic product (GDP) -Unemployment rates -Interest rates -Inflation -Budget deficits -Consumder sentiment Stock prices tend to rise and fall with earnings. In doing so, we would be relying on historical data. GDP data is published quarterly and is often revised. The CPI is the most commonly reported measure of inflation. It attempts to measure price changes for the typical urban consumer. So-called core inflation, as measured by the CPI, excludes more volatile items, such as energy prices. There are various PPI's that measure price changes of raw materials, intermediate and finished goods. These indices typically lead changes in the CPI. The GDP deflator is the broadest measure of inflation. It measures the changes in price for all goods and services in the economy.

Overconfidence and the Disposition Effect

-Invetors weight recent observations too heavily (representative heuristic). -Investors underweight prior information. -Investors commit the gambler's fallacy: expecting recent events (downturns in stock prices) to reverse. -Disposition effect: investors hold on to losers in their portfolios (because they can't be wrong) and sell winners. -Investors judge their decisions on the basis of the returns realized not paper money returns, then holding losers will avoid confronting their true abilities. -Investors won't learn from mistakes, continue as overconfident. -Odean's research confirm's Disposition Effect.

Fundamental Steps of Portfolio Construction

1. Identify the Efficient Frontier of risky assets. 2. Choose the optimal risky portfolio. 3. Find the optimal complete portfolio.

Business Cycles

-Peak -Trough Industry relationship to business cycles -cyclical -defensive Investors shoudl choose industries that will be helped by their expected economic scenario and avoid those that will be hurt. For example, choose consumer cyclicals if the economy is projected to do well, but not if the economy will weaken. One may choose more defensive investments such as consumer staples utilities if the economy is not expected to do well. To earn abnormal returns, investors must have better information (unlikely) or better analysis than the competition. Consumer cyclicals include consumer durables such as appliances, autos, luxury items. Also, dividends of phone companies and other utilities (necessities) look good during a recession. A business cycle refers to periods of expansion and contraction. A peak is the high point following a period of economic expansion. A trough is the low point following a period of economic decline. Some companies performance is very sensitive to the cycle while others are not heavily impacted by normal business-cycle fluctuations. Cyclical companies are firms whose sales and profits are negatively impacted by a decline in the economy. Examples of cyclical firms are capital goods manufacturers. A defensive firm is one whose performance is not as sensitive to teh performance of the economy. Cyclicals include durable goods and finished goods, the purchase of which is likely to be delayed during a recessoin. These might include discretionary goods like jewelry, expensive vacations, RV's, machine tools, steel, autos, and transportation. Defensive companies would include food producers and processors, pharmaceutical firms, medical services, and public utilities, tabacco, movies, and alcoholic beverages.

Advantages of the Single Index Model

1. Reduces the number of inputs for diversification. 2. Easier for security analysts to specialize and use this model. All we need to know is what that optimal risky portfolio is which we usually use the S&P 500.

Including Risk-Free Assets Extending to Include Riskless Assets -The optimal combination becomes linear. -A single combination of risky and riskless assets will dominate. Because the efficient frontier is nonlinear and it becomes more difficult to calculate, the more assets are included in the portfolio. Researchers have looked for a way to simplify this relatonship and one way to do it is to incude a riskless asset.

Alternate Capital Allocations There is a graph with E(r) on the vertical axis and σ on the horizontal axis. On the vertical axis, points M, P, A, and F are marked in that order. On the horizontal axis points P, P&F, M, and A&F are marked. The CAL (P) line goes from point F (0,F) through P (P,P) and up to the horizontal line M at point (M, P&F). Then there is the CAL (M) line which is underneath CAL (P) and goes from point F to point M (M,M). The bottom line is the CAL (Global Minimum Variance) line which goes from F through point A (A, P). It also goes through point G which is the bottom most point. Then a curved line goes through points G, P, and M. This line is the Efficient Frontier. P & M are both on the Efficient Frontier and when you connect them to the rF asset you get a CAL. P is the superior portfolio because you get the highest reward for level of risk (because it is almost as high as M but is a lot closer to the vertical axis). The optimal portfolio is the point of tagency between the CAL and the Efficient Frontier.

Assumptions & Tools Used in Technical Analysis

Assumptions -Trends in prices can be exploited. -Markets are somewhat efficient. Tools -Charting -Technical Indicators Evidence-very limited support of superior performance. Charting -Price movements- (open, high, low, and close) -Reoccuring trends Point & Figure Charts -Supports & resistance levels -Signals when support and resistance levels are confirmed. DOW Theory -The objective is to identify long-term trends in the stock market prices. -DJIA is the key indicator and DJIA serves as a check to confirm or reject a signal. There are 3 forces affecting stock prices: 1. Primary trends: long term movements of price. 2. Secondary trend: short term deviations of prices from the underlying trend line (corrections). 3. Minor trends- are daily fluctuations. Related graphs: DJIA over time: time on the horizontal axis, the DJIA line goes up and down but the trend is upward. Sample Price Chart with price on the vertical axis and Days on the horizontal axis, there are small vertical lines with a small dash to the right that form a wave. Point and Figure Chart, Price is on the vertical axis, there are bars with X's then O's alternating. At the bottom Sell is indicated and at the top Congestion Areas.

Interpretaton of Beta

B > 1 Investment is riskier than the market and should provide a greater return than the market. B = 1 Investment is as risky as the market and should provide the same return as the market. B < 1 Investment is less risky than the market and should provide less return than the market.

Behaviors

Bubbles & Behavioral Economics -As the dot com boom developed, it seemed to feed on itself. -Investors were increasingly confident of their investment prowess. Evaluation of the Behavioral Critiques -Arguments that the evidence does not support one type of irrationality. -Relatively new field. Technical Analysis & Behavioral Finance -Technician's believe that prices only gradually go back to their intrinsic value (consistent wiht the momentum effect and the conservatism bias) and they can exploit the slow adjustments to profit. -Behavioral biases may also be consistent with technical analysts use of volume data to form trading strategy. As traders become more overconfident, they may trade more, inducing an association between trading volume and market returns. -Technicians believe that market fundamentals could be affected by irrational or behavioral factors, sometimes labeled sentiment variables.

On a graoh with return on the vertical axis and standard deviation or risk on the horizontal axis, a point at (0,4%) is the risk free rate and forms a line with point P portfolio (σ, 36.27%) called the CAL. 36.27% - 4% = 32.27% is the RPm.

CAL is the capital allocation line and it connects the portfolio to the risk free asset. m= rise/run = reward to volatility ratio = (rp - rf) / σ = 32.27% / 30% = 1.075.

Ex.problem of Coefficient of Variation -------------Stock A-------Stock B Expected Return---------20%----------15% Standard Deviation-------25%----------19%

CV of A= 25/20 = 1.25 CV of B= 19/15 = 1.26

Ex. Consider 2 stocks, a large manufacturer of automobiles (Ford Motors) and an electric utility company (VA Power). Assume the stocks have the following characteristics: ----------Expected Return------Standard Deviation Ford (F)----------14%----------------6% VA (V)------------8%----------------3% Everything depends on the correlation coefficient between the 2 stocks. Case 1: Perfect Positive Correlation

Case 1: Perfect Positive Correlation p= +1 E(rp) = wF E(rF) + wV E(rV) E(rp) = wF 14% + wV 8% wF + wV = 1 or wV = 1 - wF E(rp) = wF 14% + (1 -wF) 8% ** **plug in so you have one variable E(rp) = 8% + 6% wF Portfolio return is not affected by p correlation coefficient. When the sum of the weights is equal to one, you are said to be "fully invested" into these assets and this is an assumption. Portfolio Risk: σp² = wF²σF² + wV² σV² + 2 wF wV σFV σp² = wF²σF² + wV² σV² + 2 wF wV pFV σF σV since p = 1 then... σp² = wF²σF² + wV² σV² + 2 wF wV pFV σF σV -------↓---------↓----------↓ ------A²---------B²--------2AB so... σp² = A² + B² + 2AB and this is a perfect square so.. σp² = (wF σF + wV σV)² From here it is relatively easy to calculate the standard deviation. Take the square root of both sides: σp = (wF σF + wV σV) σp = wF σF + σV (1 - wF) σp = 6% wF + 3% (1 - wF) σp = 3% + 3% wF Thus is in the case of perfectly positively correlated assets, the return and risk on the portfolio of the two assets is a weighted average of the return and risk on indvidual assets. There is no reduction in risk from purchasing both assets. The σ is stated in terms of one variable, wF. The idea here is if you look at this as increasing the weight in the portfolio from investing in Ford, then σ rises. So in the case of a perfectly correlated assets, you do not benefit at all from diversification. So you are actually better off away from Virginia Power. E(rp) = 8% + 6% wF σp = 3% +3% wF Expected Return of a Portfolio of Ford and VA Power when p = + 1 wF----0---.2----.4---.5----.6---.8----1 E(rp)--8%--9.2--10.4--11--11.6--12.8--14 σp----3%--3.6--4.2--4.5---4.8---5.4---6

Dividend Discount Model

Dividend Discount Model: General Model V0 = ∑∞ t = 1 Dₙ / (1 + k)ⁿ where... V0 is the value of the stock. Dₙ is the dividend k is the required return where k = rF + B* [E(rM) - rF]

Economy & Industry Analysis: Approach to Fundamental Analysis

Domestic & Global Economic Analysis ↓ Industry Analysis ↓ Company Analysis

Efficient Market Hypothesis (EMH)

EMH states that security prices always fully reflect all known information, or stated differently- the security market is a fair game. Types of Market Efficiency 1. Weak form and past prices are unrelated to future prices. 2. Semi-strong form: all publicly available information is reflected in security prices. 3. Strong-form: all available information is reflected in security prices.

Ex. Consider 2 stocks, a large manufacturer of automobiles (Ford Motors) and an electric utility company (VA Power). Assume the stocks have the following characteristics: ----------Expected Return------Standard Deviation Ford (F)----------14%----------------6% VA (V)------------8%----------------3% Everything depends on the correlation coefficient between the 2 stocks. Case 2: Perfect Negative Correlation

Case 2: Perfect Negative Correlation p = -1 Portfolio Return: E(rp) = 8% + 6% wF *It is the same because it is not affected by p. Portfolio risk: σp² = wF²σF² + wV² σV² + 2 wF wV σFV σp² = wF²σF² + wV² σV² + 2 wF wV pFV σF σV since p = - 1 then... σp² = wF²σF² + wV² σV² - 2 wF wV pFV σF σV -------↓---------↓----------↓ ------A²---------B²--------(2AB) so... σp² = A² + B² - 2AB and this is difference of squares.. σp² = (wF σF - wV σV)² σp² = (wF σF - σV (1 - wF)))² σp = (wF σF - σV (1 - wF)) ***σ can not be negative so that one is eliminated. σp = 6% wF - 3% (1 - wF) σp = 9% wF - 3% Note: If two securities are perfectly negatively correlated, it should be always possible to find some combination of these securities that has zero risk. σp = wF σF - σV (1 - wF) wF σF - σV (1 - wF) = 0 wF = σV / (σF + σV) σp = 9% wF - 3% 9% wF - 3% = 0 wF = 3%/9% = 33% E(rp) = 8% + 6% wF σp = 9% wF - 3% Expected Return of a Portfolio of Ford and VA Power when p = - 1 wF----0---.2--.33--.4---.6---.8----1 E(rp)--8%--9.2--10-10.4-11.6--12.8--14 σp----3%--1.2--0--0.6--2.4---4.2---6 when p = -1 and when wF = 33% then σ= 0. On a graph, we have our E(rp) on the vertical axis and 14%, 10%, and 8% marked. Our σp on the horizontal axis has 3% and 6% marked. Our CAL line starts at point V (3%, 8%), then goes to (0%, 10%), then to point F (6%, 14%). After wF=33%, as you keep investing in Ford, your returns will increase but so will your risk.

Ex. Consider 2 stocks, a large manufacturer of automobiles (Ford Motors) and an electric utility company (VA Power). Assume the stocks have the following characteristics: ----------Expected Return------Standard Deviation Ford (F)----------14%----------------6% VA (V)------------8%----------------3% Everything depends on the correlation coefficient between the 2 stocks. Case 3: No Relationship Between Return on the Assets p=0

Case 3: No Relationship Between Return on the Assets p = 0 Portfolio Return: E(rp) = 8% + 6% wF Portfolio risk: σp² = wF²σF² + wV² σV² + 2 wF wV σFV σp² = wF²σF² + wV² σV² + 2 wF wV pFV σF σV since p = 0 then... σp² = wF²σF² + wV² σV² In this case, the variance of the portfolio is simply weighted average of variances of individual securities. σp² = wF²σF² + (1 - wF)² σV² σp = [ wF²σF² + (1 - wF)² σV² ]^½ σp = [ wF² (6%) ² + (1 - wF)² (3%) ² ]^½ σp = ( 27% wF² + 9% )^½ ↓ Can't simplify any further. No relationship between return on the assets p=0. E(rp) = 8% + 6% wF σp = ( 27% wF² + 9% )^½ On a graph, we have our E(rp) on the vertical axis and 14%, 10%, and 8% marked. Our σp on the horizontal axis has 3% and 6% marked. Our CAL line starts at point V (3%, 8%), then curves toward but does not touch (0%, 10%), then goes to point F (6%, 14%). This is called a minimum variance portfolio.

Behavioral Finance Technical Analysis: Conventional Finance v. Behavioral Finance

Conventional Finance -Prices are correct and equal to intrinsic value. -Resources are allocated efficiently -Consistent with EMH Behavior Finance -Investors do not always process information correctly. -Investors often make inconsistent or systematically suboptimal decisions. Information Processsing Critique: -Forecasting errors: too much weight is placed on recent experiences. -Overconfidence: investors overestimate their abilities and the precision of their forecasts. -Conservation: investors are slow to update their beliefs and undereact to new info. -Sample size neglect & representativeness: investors are too quick to infer a pattern or trend from a small sample.

Liquidity Ratios

Current Ratio: CA/CL Quick Ratio: ( CA - Inventory ) / CL Cash Ratio = Cash / CL

Diversification

Diversification is the key to effective risk management. Can minimize risk (through proper diversification, risk exposure can be minimized without affecting expected portfolio returns and sometimes increasing the returns of a portfolio. Total Risk = Systematic Risk + Unsystematic Risk Systematic Risk is the component that cannot be eliminated by diversification. There is an underlying volatility of returns that is systematic to all risky securities. Can be due to factors that affect the market such as inflation, interest rates, GDP growth and other macroeconomic factors. Unsystematic risk can be eliminated by proper diversification and is referred to as uncertainties about returns on one firm that can be offset by holding securities of other firms in the portfolio. Company specific factors ex removing a CEO. Systematic Risk = Market Risk = Non-diversifiable Risk Unsystematic Risk = Firm Unique Risk = Diversifiable Risk

Capital Asset Pricing Model

Equilibrium Pricing Model derived from set of assumptions instrumental in the development of Modern Finance Theory. The CAPM defines the relationship between risk and return on securities when they are held in well-diversified portfolios. Assumptions: -Investors are risk-averse individuals who maximize the expected utility of their end of period wealth. -Investors are price takers and have homogenous expectations about asset returns and risks. -There exists a risk-free asset such that investors may borrow or lend unlimited amounts at the risk-free rate. -The quantify of assets are fixed. Also, all assets are marketable and perfectly divisible. -Information is costless and simultaneously available to all investors. -There are no market imperfections such as taxes, regulations, or restrictions on short selling (not as crucial of an assumption for the model. *The ability of investors to borrow or lend at the risk-free rate is crucial to the development of the CAPM. This means that an individual can invest not only in a portfolio of risky securities but also in a risk-free asset completely alters the shape of the Efficient Frontier. The model becomes linear and we can develop the model that relates risk to return, where the CML and the Efficient Frontier are tangent at point M. CAPM tries to explain the relationship in the graph.

Fundamental Stock Analysis

Equity Valuation Models Basic Types -Balance models -Dividend Discount models -PE Ratio models -FCF models Balance Sheet models Relates market value to an accounting value by calculating ratios, such as price to book value, price liquidation value, or market value replacement costs. The most difficult component of valuation is always estimating growth rates and opportunities. The assessment of the firm's growth rates and future opportunities. Since balance sheet models lie on historical values of assets and liabilities, we are going to skip it and focus on the other three.

Portfolio Risk & Return: The expected return from a portfolio is equal to the weighted average of the expected return from investment in the portfolio. Where Wi is the proportion of the total portfolio invested in asset i (portfolio weight). Kp = ∑ Wi Ki

Ex. Problem If we have $50 in one assetf adn $150 in another, then our total portfolio is worth $200. The % of our portfolio in the 1st asset is $50/$200 = 0.25 and the % in the 2nd asset is $150/$200= 0.75. Our portfolio weights are thus 0.25 and 0.75. Let's assume that the return on the 1st asset is 25% and on the second asset is 12%. What is the expected return on this portfolio? Rp = 0.25*25% + 0.75*12% = 15.25%

Financial Statement Analysis

Financial Statement Analysis uses the firm's accounting data. The financial statements are the starting point of a financial analysis. THe income statement contains flows that occur during the current period that relate to profitability primarily. The balance sheet gives an analyst a snapshot for the firm's financial position and a broad overview of the level of investments in major asset categories. Analysts typically work with common size statements to remove size distortions. Indexed or trend statements are used to analyze changes over time. Accounting earnings are earnings reported on the income statement that follow a set of generally accepted but widely divergent accounting practices. Economic earnings are the sustainable cash flows to the stockholders that does not impair the productive capacity of the firm. Because financial ratios are based on accounting data, an analyst must be aware of differences in accounting methods that could affect comparison of ratios. Some of the key problems of comparability include different inventory valuation methods. Tools used for the data are: -statements -ratio analysis

Federal Government Policy

Fiscal policy involves government spending and taxing actions. Fiscal policy is an attempt to inflluence the economy in a direct fashion. Monetary policy involves manipulation of the money supply to influence economic activity. Market participants pay substantial attention to monetary policy. Tools that are used by the Federal Reserve to influence the money supply and interest rates include open market operations, the discount rate and reserve requirements. Supply-side policies focus on incentives and marginal tax rates. Fiscal Policy v. Monetary Policy Fiscal policy is government spending and taxing actions. AD = C + I + G Fiscal policy comprises government spending and taxing actions to stabilize or spur growth in the economy. This is th emost direct policy method in terms of it's effect on the economy (Keynesian policy). Monetary policy is manipulation of the money supply to influence economic activity. It attempts to change the incentives to purchase and invest, but changing the money supply and interest rates still may not lead to the desired effect on demand. Japan went through several years of deflation. Deflation increases the real rate of interest above the nominal rate and increases the real debt burdens of borrowers. Incomes don't rise in this situation and may even fall, making it more difficult to pay down debts, much less engage in capital purchases. Tools of monetary policy are: -Open market operations -Discount rate -Reserve requirements Note: Changes in the discount rate are used as a signal of what direction the Fed wants interest rates to move, rather than as a direct policy tool. Changing reserve requirements changes the money multiplier and are not generally used to change the money supply. The most direct tool is open market operations, in which the Fed buys government securities from government securities dealers. To pay for the purchase, the Fed "hits a computer button" and creates more deposits on reserve at the Fed for the seller. This is the main way the money supply is expanded, rather than "printing money."

Interest Rates

Forecasting interest rates is one of the most difficult areas of applied macroeconomics yet is, perhaps, the most important to consider in analyzing investments. A very simply supply-and-demand framework is presented, along with a graphic display of supply and demand. While the graph is straight forward, the factors that go into forecasting rates are very difficult to predict. Fiscal and monerary policy can affect economic growth and interest rates. Fiscal policy is government spending designed to stimulate the economy. Monetary policy is manipulating the money supply to stimulate the economy or reduct inflationary pressures. In the financial crisis of 2008, the Fed brought interest rates down to essentially zero, but the economy continued to slide. The Fed then persued a policy of quantitative easing by directly buying debt from private entities. The Fed greatly expanded its balance sheets and bought or guaranteed hundreds of billions of dollars worth of private securities. Determinants of Interest Rates 1. Supply of Loanable Funds 2. Demand For Loanable Funds Real v. Nominal Interest Rate The calculation for nominal interest rate is experienced as: Nominal Rate = Real Rate + Expected Inflation

Minimum Variance Portfolio Min. Variance Combination Ex. Security 1: E(r1) = 0.10; σ1= 0.15 Security 2: E(r2) = 0.14; σ2= 0.2 p12= 0.2 w1 = [ σ2² - COV (r1, r2) ] / [ σ1² + σ2² - 2COV (r1, r2) ] w2 = (1 - w1) When combining 2 securities, you should be able to calculate where that minimum variance or minimum risk combination is: w1 = [ (.2)² - (.2)(.15)(.2) ] / [ (.15)² + (.2)² - 2(.2)(.15)(.2) ] w1 = 0.6733 w2 = (1 - 0.6733) = 0.3267 Minimum Variance Combination: Return & Risk with p= 0.2 rp = 0.6733 (.1) + 0.3267 (.14) = 0.1131 σp = [ (0.6733)²(.15)² + (0.3267)²(.2)² + 2(.6733)(.3267)(.2)(.15)(.2) ]^½ σp = (.0171)^½ = 0.1308

Graph of Minimum Variance: Frontier of Risky Assets E(r) is on the vertical axis and St. Dev on the horizontal axis. There is a straigh dashed horizontal line which is the Global Minimum Variance Portfolio that disects a parabola on it's side opening to the right. The top half of this parabola is the Efficient Frontier and the entire parabola is the Minimum Variance Frontier. Inside of the Minimum Variance Frontier are dots above and below the Global Minimum Variance Portfolio. The dots represent individual assets. The Efficient Frontier begins where the Minimum Variance Frontier crosses the Global Minimum Variance Portfolio.

Efficient Frontier of Risky Assets

If the investment opportunity set iis extended to the universe of all risky assets, the result is the Efficient Frontier. Portfolios on the Efficient Frontier provide max return for a given level of risk. Graph of Efficient Frontier of Risky Assets On a graph, we have E(r) on the vertical axis and σ on the horizontal axis. We have the CML which goes from rF to point M and beyond and we have the Efficient Frontier of Risky Assets which is a curve that goes towards rF then away through point M and beyond. Point M is the Market Portfolio and it is the point of tangency of the Efficient Frontier of RIsky Assets and the CML. The Efficient Frontier of RIsky Assets is what you get if you include all the risky assets you can think of. CML is the Capital Market Line. For any investor, you could invest all your assets in the rF asset or diversify and put some in the risky portfolio which is the market portfolio and some in the rF asset and then you move up and down the CML.

The Efficienty Market Hypothesis & Investment Policy

Implication of EMH for Investment Policy A. Technical Analysis Technical analysts (chartists) search for recurring & predictable patterns in security prices. B. Fundamental Analysis The fundamentalists examines all publicly available information about the firm in an attempt to identify undervalued securities. C. Active v. Passive Portfolio Management Only institutional investors may be able to outperform the market by identifying undervalued secruties. Thus passive investing may be the best alternative for individual investors. The Role of a Portfolio Manager in an Efficient Market 1. Determine the risk tolerance of the investor. 2. Match that risk tolerance with the systematic risk of the portfolio. 3. Ensure that the portfolio is well-diversified. 4. Consider the investor's tax status.

Intrinstic Value & Market Price

Intrinsic alue is a self assigned value (could be an analyst's estimate) or a variety of models are used for estimation of intrinsic value. Intrinsic value is then compared to the market price of the stock. Market price is a consensus value of all potential traders, determined in the market place. A trading signal will occur if the intrinsic value differs from market price. IV > MP Buy IV < MP Sell IV = MP Hold or Fairly Priced

Activity or Management Efficiency Ratios

Inventory Turnover = Sales/ Inventory or Inventory Turnover = COGS/ Inventory Total Asset Turnover = Sales / Total Assets Receivables Turnover = Sales / Account Receivable Average Collection Period = Accounts Receivable / Sales Per Day

Average Annual Returns & Risk Premiums: 1926 - 2014

Investment----Avg. Return------Risk Premium Common Stocks------------12.2%-----------8.5% Small Stocks------------17.4%------------13.7% L-Term Co. Bonds---------5.7%-------------2.0% L-Term Gov. Bonds-------5.2%-------------1.5% US T-Bills---------3.7%-------------0.0%

Ex. Assume an investor purchases 100 shares of a company's common stock for $100. The investor expects to receive cash dividends of $1 at the end of one year and expects teh stock price to be $112 at the end of the year. The investor expected return is:

K = [ (112 - 100) + 1 ] / 100 = 13%

Expected Rate of Return Formula

K = ∑ i=1ⁿ Pi Ki

Risk & Return With the Risk Free Asset Asset Allocation Across Risky and Risk Free Portfolios Assume you... -have $100K to invest in risky assets and risk free assets. -want to invest $20K in T-bills. You buy the following stocks, Jan. 1, 2005: -500 shares of Citicorp for $41.50/share. -500 shares of GM for $41.75/share. -500 share of IBM for $76.75/share. Risky portfolio weights: wCiti = 20,750/80K = 26% wGM= 20,875/ 80K = 27% wIBM = 38, 375/ 80K = 47% Complete Portfolio Weights: wCiti = 20,750/100K = 20.75% wGM= 20,875/ 100K = 20.88% wIBM = 38, 375/ 100K = 38.37% wT-bill= 20K / 100K = 20% ---------------------100%

Let's say a year has passed and our portfolio has these returns on Jan. 1, 2006. You sell your Citicorp shares for $61.75, GM for $48.75, and IBM for $109.62. To calculate the return on your risky portfolio, you take the weights of each investment times their return (P1 - P0)/P0. There are no dividends in this ex. rp = .26*48% + .27*15% + .47*42% = 36.27% Further assume σp = 30% and ri=4%. The risk premium on our risky portfolios is: 36.27% - 4% = 32.27%

Equity Valuation: Intro

Models to calculate intrinsic value of common stock. Fundamentals rather than technical analysis. Value a firm using one of these models: -constant growth -multistage dividend discount -PE ratio PE Ratio: asset's relative growth aspects of a stock based on PE ratio and should have a basic understanding of FCF models. Understand limitations of each: -Balance models -Dividend Discount models -PE Ratio models -FCF models

Profitability Ratios

Net Profit Margin = Net Income / Sales ROA = Net Income / Total Assets ROE = Net Income / Common Equity Operating Margin After Depreciation = Operating Profits / Sales

Borrowing & investing (levered portfolio) Suppose you have $100K to invest and borrow an additional $20K to invest. This is called investing on margin and it is simply borrowing and investing in the stock market. The leverage comes from borrowing. y = $120K / $100K = 1.2 (1-y) = (1 - 1.2) = -0.2 If the borrowing rate is also 4%, then rc = (1.2)(36.27%) + (-0.2)(4%) = 42.72% σc = (1.2)(0.3) = 0.36 m = (42.27% - 4%) / 36% = 1.075

Now on the same graph... On a graoh with return on the vertical axis and standard deviation or risk on the horizontal axis, a point at (0,4%) is the risk free rate and forms a line with point P portfolio (0.3, 36.27%) called the CAL. 36.27% - 4% = 32.27% is the RPm. There is now a new point on the CAL line called C at point (0.36, 42.72%). It has a higher return and higher risk. From P to C is borrowed money. The slope is the same, you just moved up the CAL. Borrowing allowed you to move higher than P.

Modern Portfolio Theory

Objectives: -Compute various measures of return on investments. -Use data on the past performance of stocks and bonds to analyze risk and return features of these investments. -Determine the expected return and risk of portfolios that are constructed by combining risky assets with risk free investments in T-bills. -Calculate mean, variance, and covariance using historical data. -Calculate the composition of the optimal risky portfolio. -Understand modern portfolio theory such as CAPM and APT. -Construct and use the SML. -Understand why security price change is unpredictable in an efficient market. -Describe several behavioral biases and technical analysis.

Real Rates

On a graph we have interest rates on the vertical axis. r1 is above r. Then we have a supply line with pos slope and demand D and then a higher demand line D1. Where D1 crosses the supply line is higher than D so has a higher interest rate. Calculation of real rates: (1+R) = (1+r)(1+i) (1+r)= (1+R)(1 + i) if... R= 5.7%, i=3.1% then... (1+r) = 1.057/1.031 = r=2.52% Equilibrium Real Rate of Interest The Federal government and the Federal Reserve Bank can shift these supply and demand curves via fiscal and monetary policies. The graph illustrates the shift in supply and demand.

Graph of Unsystematic Risk v. Systematic Risk

On the vertical axis we have σ and on the horizontal axis we have the number of stocks in the portfolio. We have a dashed line at the bottom a little above the horizontal axis. Below this line is Systematic Risk and above it is Unsystematic Risk. We have a curved line represenging Portfolio Risk that comes down from above near the vertical axis and curves down to the dashed line but never quite reaches it. So we can eliminate a lot of Unsystematic Risk but not all but we cannot eliminate any Systematic Risk. 30-40 random stocks is enough to get rid of most Unsystematic Risk.

Price Earnings Ratio

P/E Ratios are a funtion of 2 factors. 1. Required rates of return (k). 2. Expected growth in dividends. Uses: -Extensive use in industry. -Relative valuation. No expected growth P₀ = E₁ / K * P₀ / E₁ = 1/k 1/k is also called the foward P/E because in the denominator you see expected earnings. k is the required rate of return. E₁ is the expected earnings for next year and is equal to D₁ under no growth.

Optimism, Overconfidence, & Odean's Research

People are overly optimistic: People believe that they are less likely to get hit by a bus or be robbed than their neighbors. People are overconfident in their own abilities: -Driving skills & social skills are better. -New business owners believe thier business has a 70% chance but only 30% succeed. -Helps soldiers cope with war. Overconfidence & the stock market -Can lead to substantial losses when investors overestimate their ability to identify the next Microsoft or Amazon -Securities investors purchase underperform those they sell.

P/E Ratio with Constant Growth

P₀ = D₁ / (k-g) = E₁ (1-b) / [k - b* ROE] P₀/E₁ = (1-b) / (k - b*ROE) b is the retention ratio ROE return on equity Numerical Ex. no growth E₀= $2.50 g=0 k=12.5% P₀ = D/k = 2.5/ 0.125 = $20 P/E = 1/k = 1/0.125 = 8 Numerical Ex. with growth b = 60% ROE = 15% (1-b) = 40% E₁ = 2.5 (1 +(0.6)(0.15) = $2.73 D₁ = $2.73 (1-0.6) = $1.09 k= 12.5% g=9% P₀ = 1.09 / (0.125 - 0.09) = $31.14 PE = $31.14/ $2.73 = 11.4 PE = (1-0.6)/(0.125 - 0.09) = 11.4

Portfolio Thery Risk & Return: Expected Rate of Return

Rate of return is a percentage indicating how much an investor's wealth increases per dollar of an investment made. K= [ (P1 - P0) + CF1 ] / P0 CF1 is any CF in the period. K = r rate of return over a period of time such as a month, year, decade, etc.

Ratio Analysis

Ratio analysis is used to highlight specific aspects of performance. All ratios require a benchmark (although 'rules of thumb' have been developed for some) for comparison. The benchmark may be the same ratio in a different time period or the value of a competitor or group of competitors. Ratios use very important to the investment community and are used extensively in security analysis. They are also used by credit rating agencies to establish in security ratings. Uses are: -trend analysis -comparative analysis -combination Used for External Analysts for: -important info for investment community -important for credit markets

Relative Strength and Value Line System

Relative Strength -Measures the extent to which a security has outperformed or underperformed either the market or an industry. -Is recent stock price divided by an industry index. -Is a recent industry index divided by the market index. Value Line System -Widely followed by some evidence of superior performance. -Value line system is predominantly a technical system. Earnings momentum Relative Stock prices ratios of moving averages Paper v. Actual Performance Indicates That the System is Difficult to Implement -Value line fund has not shown superior performance. -High turnover costs are associated with the strategy. Evidence shows prices react quickly to reported ranking changes.

Security Market Line

SML: We have seen that the best measure of a stock's relevant or nondiversifiable risk is it's beta. To relate risk (B) to return, we use the SML which shows the risk-return trade off for an invidividual security or asset. The equation for the SML is: rj = rF + Bj (rM - rF) where rj is the required rate of return on any risky asset j held in a diversified portfolio. rF is the required risk free rate of return. Bj is the beta coefficient for the asset. rM is the expected rate of return on the market portfolio. (rM -rF) is the market risk premium required to encourage investors to invest in the market portfolio as opposed to investing in some risk-free security. Bj (rM -rF) is the risk premium for the stock in question.

Measuring Risk

The tigher the probability distribution of expected returns, the smaller the risk of investment. Therefore, we need a measure of the tightness of the probability distributions. One such measure is standard deviation (s). Calculate standard deviation: 1. Calculate expected rate of return. 2. Expected rate of return: K= Si=1 raised to n Pi Ki 3. Subtract expected rate of return from each possible outcome to obtain deviation about the expected rate of return. 4. Calculate variance S² = Si=1ⁿ (Ki - K)² Pi 5. Now take the square root: S = [ Si=1ⁿ (Ki - K)² Pi ] ^½

Continuous Probability Distributions:

The tighter the probability distributions of returns- -The more likely the actual outcome will be close to expected values. -The less likely the actual return will be far below the expected return. -The lower the risk assigned to a stock.

Industry Life Cycles

Sector rotation is a strategy that can be used to select companies that should perform well in 4 various stages of the business cycle. This strategy is referred to as sector rotation and some example investment types are provided for the phases of the business cycle. It is difficult to achieve above average returns this way, however, because often we don't know which phase of the cycle we are in until later and the duration of each phase is also unknown. Stage: Start-Up Sales Growth: Experience rapid and increasing growth. Ex. Cellphones in the 90's. Sales & earnings grow rapidly, no or small dividends. Note it is difficult to pick the eventual winners in this stage. Some firms won't make it and investments in these types of firms can be risky. Stage: Consolidation Sales Growth: Stable Growth Ex. Emergence of industry leaders (Verizon), survivors of the start-up phase become more stable, industry still growing faster than the economy overall. Stage: Maturity Sales Growth: Experience slowing growth. Ex. Product has reached saturation level (think McDonald's or perhaps basic cell phones today), generally more competition and less diversification so price competition emerges which further limits profitability. State: Relative Decline Sales Growth: Experience Minimal or Negative Growth. Ex. Growth is lower than the overall economy, may be facing product obsolescence (ex. VCR's). Biotech is closer to the start up phase and is enjoying high rates of investment, high rates of return on investment, and low dividends. High growth rates beget competition, however, & eventually growth must slow. Utilities are in the mature phase and have lower rates of investment and lower rates of return, as well as higher dividends.

Indicators

Sentiment Indicators Put/Call Ratio -Historical value 65% -When higher than 65% a signal occurs. Bearish view. Bullish view. Mutual Fund Cash Position -Cash levels are low-bearish sign. -Cash levels are high-bullish sign. Odd-Lot Trading -Ratio of odd-lot purchases to odd-lot sales. -When ratio exceeds 1.0, bearish sign. -Contrarians logic-small investors are the last to buy in bull markets. Flow of Fund Indicators Short intertest-total number of shares that are sold short. -When short sales are high, a signal occurs. -Bullish interpretation -Bearish interpretation Credit Balances in Brokerage Accounts -Investor leave balances when they plan to invest in the future. -When levels are high, a bullish sign. Moving Average Graph with Time on the horizontal axis. There is one line of waves then a trend line in the middle that is curved. Market Structure Indicators Moving Averages -Average price over some historical period (5 weeks or 200 days). -When current prices crosses the average, a trading signal occurs. -Bullish signal when the current price rises above the moving average. -Bearish sign when the current price falls below the moving average. Breadth -The extent to which movements in a broad index are reflected widely in movements of individual stocks. -The spread between advancing stocks and declining stocks. -Also used in industry indexes. Confidence Index -The average yield on 10 top-rated corporate bonds divided by the average yield on 10 medium grade corporate bonds. Smaller Default Premiums on Lower-Rated Bonds when the economy is doing well. Higher values are bullish signs.

Industry Analysis

Some industries, such as capital goods, are very sensitive to economic performance. The sale of capital goods is heavily influenced by the performance of the economy. Manufacturers do not purchase capital goods for expansion if the economy is not expected to perform well. In addition to sales sensitivity, industries that employ significant levels of operating and financial leverage are more sensitive to economic performance. Fixed costs are costs that do not vary with the level of production. Fixed costs contribute to higher profitability when sales are high, but will result in lower profitability when sales are lower. Operating leverage is measured by the proportion of fixed operating costs as a % of total costs. Greater operating leverage results in greater swings in profits over the business cycle. Examples of industries with high amounts of operating leverage includes airlines and automobiles. Financial leverage is the proportion of fixed financing costs as a percentage of total costs. Greater financial leverage results in greater swings in profits over the business cycle. Examples of industries that employ a high degree of financial leverage include airlines, banks, and investment banks. Industries have their own life cycles that will impact their performance, indpendent of the performance of the economy.

Shifting Growth Rate Model

Sometimes called supernatural growth. V₀ = D₀ ∑ n n=1 (1+g₁)ⁿ / (1 + k)ⁿ + Dₙ (1+g₂) / (k-g₂) (1 + k)ⁿ where g₁ is the first growth rate g₂ is the second growth rate and n is the number of periods of growth at g₁ Ex. D₀ = $2 g₁ = 20% g₂ = 5% k = 15% n=3 D₁ = $2.40 D₂ = $2.88 D₃ = $3.46 D₄ = $3.63 V₀ = D₁ / 1.15 + D₂ / 1.15² + D₃/1.15³ + D₄ / (.15 -.05)(1.15)³ V₀ = 2.09 + 2.18 + 2.27 + 23.86 = $30.40 Ex. D₀ = $2 g₁ = -10% g₂ = 28% g₃= 13% g₄= 5% k = 15% D₁ = $1.80 D₂ = $2.30 D₃ = $2.60 D₄ = $2.72 V₀ = D₁ / 1.15 + D₂ / 1.15² + D₃/1.15³ + D₄ / (.15 -.05)(1.15)³ V₀ =1.74 + 1.71 + 17.95 = 22.97

Financial Statements

Statement: Balance Sheet Types: -Common sized -Trend or indexed Statement: Income Statement Types: -Common sized -Trend or indexed Statement: Statement of CF Types: N/A Remember: income statements contian flows that occur during the current period, primarily relating to profitability. Balance sheets give an analyst a shapshot for the firm's financial position and a broad overview of the level of investments in major asset categories.

In finance, risk reflects uncertainty. Essentially "risk" is probability of earning less than some expected return. Ex. Stock A has a wide range of return so on the graph it is very wide and does not rise very high, and Stock B has a small range of return so on the graph it is skinny and rises high. If both have the same return, which is more risky?

Stock A because it has more deviation. Standard deviation is a measure of the tightness of distribution.

The CAPM and Index Models

The CAPM hs 2 limitations: 1. Theoretical Market Portfolio 2. Expected Returns It relies on measuring the market portfolio. In theory, the market portfolio is a portfolio that contains all the risky assets. In the real world that would be almost impossible to calculate the rate of return on this portfolio. CAPM relies on expected returns instead of future returns. The Index Model is the empiral form of the CAPM: rj - rF = aj + Bj (rM - rF) + ej *The expectation is that ej = 0. Compared to CAPM: E(rj) = rF + Bj (rM -rF) E(rj) - rF = Bj * E (rM -rF) Thus CAPM predicts that aj = 0 (the alpha of the stock = 0) or that all the securities should fall on the SML. However, in the real world, there are a few cases where stocks show positive significant alpha values. -Small stocks show a positive significant alpha compared to stocks of large companies. -Stocks of companies with unexpected gain in earnings. -Stocks with low M/B ratios, also called "value stocks." -Stocks that have fallen sharply (as they reverse course, it causes alpha to be positive.)

Equilibrium Nature of CAPM

The CAPM specifies what the required rate of return on any asset should be. In equilibrium, the required rate of return on an asset such as a stock should be equal to its expected return. What happens if this is not the case? Ex. Suppose we have 2 stocks, GM & DOW Chemical, that are improperly priced for some reason. GM is underpriced and DOW Chemical is overpriced. This occurs because GM expected rate of return is greater than its required rate of return (as specified by SML). Likewise, DOW Chemical is overpriced since its expected return is less than required return as specified by SML. On a graph with return on the vertical axis and risk on the horizontal axis, we have the rF and the SML line. GM is over the SML and DOW is under the SML. This signifies that GM is underpriced and DOW is overpriced. The distance of the stock's expected returns from the SML is alpha or a. a=the distance between the expected rate of return and the required rate of return (of the SML). Let us assume that GM does not pay any cash dividends, its current market price is $20 and its expected price at the end of the year is $28. The expected rate of return for GM is: r (hat) = (P1 - P0 + D ) / P0 = (28 - 20 + 0) / 20 = 40% If GM has a beta of 1.33, rF=5%, and rM- 20%, then the required rate of return prescribed by SML is: r=5% + 1.33(20% -5%) = 25% r hat = 40% r= 25% What will happen to the market price? Investors will see that the expected return is much higher than it should be and rush to buy the stock. In order to calculate what the price should be now, simply plug in the formula and see the r hadt = r. So the required rate of return is 25%. The expected rate of return would be the ending price that we know minus beginning price (today's price) over beginning price. r = r hat = (P1 - P0 + D) / P0 25% = (28 - P0) / P0 P0 = $22.40 The price rises from $20 as investors rush to buy the stock.

How do we measure the risk of individual assets? Beta as a measure of risk.

The CML applies only to efficient portfolios. We would now like to extend the analysis to indvidual securities. Indivudal securities bear the same direct relationship between risk and return as we observed for portfolios. Thus, the fundamental question is: How do we measure risk for indiviudal securities? For diversified investors, the appropriate measure of risk is how the return on an individual stock moves relative to the returns for the market portfolio. Nondiversifiable risk is measured by beta, B. Beta coefficient (B): measures the stock's volatility with respect to the market portfolio. In other words, it measures what the returns on the asset are expected to be relative to the returns on the market. Bi = COV (ri, rM) / σM² Beta is defined as the COV between return on an individual security and the market return over the variance of the market. So in other words, volatility of your stock relative to the market. Beta of the market portfolio is equal to the covariance between return on the market and itself over the variance of the market. The covariance of a variable and itself is the variance. BM = σM² / σM² = 1 So what does it mean when someone says that my stock's beta is 2? or 1.5?

NBER Cylinder Indicators

The Conferance Board publishes a set of cyclical indicators to help forecast, measure, and interpret short-term fluctuations in economic activity. Leading indicators tend to lead economic performance. Coincident indicators tend to change directly with the economy. Lagging indicators tend to lag performance. Information on economic variables is regularly reported in business publications such as the Wall Street Journal and online at Yahoo's website. Type---------Description--------Ex. Leading----Tend to rise-------*avg weekly hours Indicators--& fall in advance----of production ----------of the economy-----workers ----------------------------*stock prices Coincident--Tend to change---*industrial Indicators---directly with the---productoin ------------economy.-------*Manufacturing & ---------------------------trade sales. Lagging----Tend to follow----*Ratio of trade Indicators---the lag economic--inventories to ------------performance.----sales. ---------------------------*Ratio of consumer ---------------------------installment credit ---------------------------outstanding to ---------------------------personal income.

Portfolio Thery Risk & Return: Risk Premiums

The excess return required from an investor in a risky asset over a risk-free investment.

CML relates Return to Risk

The slope of the CML is called the market price of risk and can be thought of as the equilibrium expected reward per unit of risk. M of CML = (rM - rF) / σM = market price of risk Because all efficient portfolios must lie on the CML, the CML equation states that the required return on the efficient portfolio in equilibrium is equal to the rF plus the market price of risk multiplied by the amount of risk on the portfolio being considered.

Economy & Industry Analysis: Framework of Analysis

The top-down approach to fundamental analysis begins with analyzing the economy. The expected economic performance will influence the choice of industry and the specific firm chosen as an investment.

The Portfolio Separation Theorem

There is a single optimal risky (market) portfolio to own, regardless of the individual's risk preferences. The individual can obtain a desired risk/return profile by combining this optimal risky portfolio with borrowing or lending at rF.

The role of correlation coefficient in measuring risk and effecting the risk of a portfolio: Ex. ---------------------Expected Return of:--Portfolio Economy---Probability----A---------B------AB Recession-----0.2-------(9%)------35%-----13% Normal-------0.6-------13%------13%-----13% Boom---------0.2-------35%------(9%)-----13% -----------------------------------------100%

This portfolio has no risk at all, no matter what happens, your return is 13%.

Leverage Ratios

Times Interest Earned = EBIT / Interest Expense Cash Coverage = (EBIT + Depreciation) / Interest Expense Debt to Assets = Long Term Debt / Assets Debt to Equity = Long Term Debt / Shareholder's Equity

Security Analysis

Tools needed to analyze stocks. Info provides basic info on what stocks you should invest in & how to perform fundamental stock analysis. Objectives -Discuss the effect of macroeconomic policies on business conditions. -Identify which industries would be less sensitive to business cycles. -Calculate intrinsic value of a firm using different models. -Calculate financial statements & ratio analysis. -Calculate and interpretate performance measures. -Learn to perform ratio analysis. Relevance Provide a good understanding of how security analysts perform stock analysis.

Types of Financial Ratio Analysis

Type: Liquidity Ratios What It Measures: The firm's ability to pay it's bills over the short run. Type: Activity or Management Efficiency Ratios What It Measures: How efficiently a firm uses it's assets to generate sales. Type: Leverage Ratios What It Measures: The firm's ability to manage it's borrowed capital. Type: Profitability Ratios What It Measures: The profits to sales, assets, or equity. Type: Market Price Ratios What It Measures: The value of a company by comparing book value of a firm to its market value.

No Growth Model

V0 = D / k -Stocks that have earnings and dividends that are expected to remain constant. -Preferred stock Ex. E₁ = D₁ = $5 k= 0.15 V0 = 5/ 0.15 = $33.33

Free Cash Flow Approach

Value the firm by discounting FCF at WACC. FCF - After tax EBIT + Depreciation - CAPX + Increase in NWC FCF Approach.... Should yield the same intrinsic value.. Yields Different Values ↑-----------------↑ FCF Model-------Dividend Discount Model ↑-------------------↑ Uses Different Assumptions

Partioning: Value & Growth & No Growth Components

V₀ = E₁ / K + PVGO PVGO = D₀ (1 + g) / (k - g) * E₁ / k PVGO is the PV of growth opportunities. E₁ earnings per share for period 1. Partitioning Value: Ex. ROE = 20% d=60% b=40% E₁ = $5 D₁ = $3 k = 15% g = 0.2 * 0.4 = 0.08 = 8% V₀ = 3 / (.15 - .08) = $42.86 NGV₀ = 5 / .15 = $33.33 PVGO = $42.86 - 33.33 = $9.52 V₀ is value with growth NGV₀ is the no growth component value PVGO is the PV of growth opportunities.

Portfolio Betas

We have been examining beta's for invidividual stocks. A portfolio of stocks also has a beta. This portfolio beta is a weighted average of the betas of individual securities. BP = ∑ j=1ⁿ wj Bj Ex. Suppose you have $10K invested in each of 10 stocks, so that your total investment is $100K. The amount invested in each stock is 10% or 0.10. If all stocks have a beta of 1.2, the portfolio beta is also 1.2. What happens if you sell one of the stocks & reinvest in another stock with a different beta? If the new stock has a beta of 0.60, the new portfolio beta will be: New Portfolio Beta = BP = ∑ j=1ⁿ wj Bj = 0.9 (1.2) + 0.1 (0.6) = 1.14

Odean's Study of Overconfidence in the Marketplace

What happens in financial markets when people are overconfident? -Trading volume increases: overconfidence generates trading. Those who trade more frequently fare worse than those who trade less. -Overconfident traders hold under-diversified portfolios; riskier portfolios although they have some degree of risk aversion. -Men are more overconfident than women; men trade more frequently (45% more) than women, men earn less returns than women (1%). -Single men and single women, the results are larger (67% ore trading, 4% less).

Correlation Coefficient: The correlation coefficient is the degree and direction of the relationship between stock returns. pAB = COV(AB) / σA σB -1 ≤ p ≤ 1

When the return of 2 securities always move in exactly opposite directions, they are said to be perfectly negatively correlated (p = -1). If the return from 2 securities always move in the same directions, they are said to be perfectly positively correlated (p = +1).

Estimating Dividend Growth Rates

g = ROE * b g is the growth rate in dividends ROE is the ROE for the firm b is the plowback or retention % rate b = 1 - dividend payout % rate

Equation for CAPM

rP = rF + [ (rM - rF) / σM ] σP where... rP is the required rate of return on any efficient portfolio on the CML. rF is the required rate of return (of the rF asset?) rM is the expected rate of return on the market portfolio. σM is the σ of the return on the market portfolio. σP is the σ of the return on the efficient portfolio being considered.

The recent model in finance that is often used is the Single Factor Model:

ri = E(Ri) + Bi F + e Bi is the index of a securities particular return to the factor. F is some microfactor, in this case F is unanticipated movement. F is commonly related to security returns. Assumption: A broad market index like the S&P 500 is the common factor. So we can say that the return of a particular security is a fct of it's expected return and what the market return would be. To estimate a single factor model, we use this relatonship: ri - rf = ai + Bi (rm - rf) + ei ↓---------------↓------↓ Risk --------Market----some firm specific Premium-----Risk-----componenet not due to ----------Premium---market movement ri = E(Ri) + Bi F + e Bi is the index of a securities' particular return to the factor. F is some macrofactor, in this case F is unanticipated movement. F is commonly related to security returns. Assumption: a broad market index like the S&P 500 is the common factor.