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Unformatted text preview: LOGIA FINS2624 Revision Disclaimer: This information is the strictly confidential. Please do no disseminate this information in any way without the consent of its
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1 2. Revision of CAPM, SIM,
APT
Session Topic Slide Session
1 1. Introduction Only available to
LOGIA students 2. Revision of CAPM, SIM, APT 2 3. Market Efficiency and Portfolio Evaluation 9 4. Valuation of Equity Securities 28 Session
2 Session
3 Session
4 5. Pricing Bonds
6. YTM and Term Structure of Interest Rate
7. Duration and Immunisation
8. Forwards and Futures
9. Options Only available to
LOGIA students Only available to
LOGIA students 2.Summary of Portfolio Theory
1. Form the efficient frontier.
Made up of the possible combination of risky assets
Use solver to maximise return given a certain risk or
minimise risk given a return. 2. Form the line from the riskfree which is tangential to the
portfolio opportunity set. This is the market portfolio. 3. Based on personal utility(risk level), find the mixture of
risky and riskfree.
Note: the risky portfolio will always be the same (market) 2. Summary of Portfolio
Theory
CML
Pm Rf σ 2. CAPM CAPM formula: Stock Beta: Measure the sensitivity of stock
compared to the “market”. So if the market moved up by 5%, a stock with beta 2
would move up twice as much as the market i.e. 10%
Market has beta of 1 2. Single Index Model (SIM) SIM formula: Similar to CAPM but with Error and Alpha
Beta means the same thing
Alpha means excess return Measures under price (α>0) or over price (α<0) Error: Firm specific risk (just take it as zero.) 2. SIM SML
E(Ra) A
α E(Rm) 1 β 2. APT and Multi Factor Model Multi Factor Model formula: Similar to SIM but more Betas Betas represents different factors (not just the market) Arbitrage: Riskless profit. What are the expected
rewards for exposing to different factors. 2. Introduction
Session
Session
1
Session
2 Session
3 Session
4 Topic
1. Introduction Slide
Only available to
LOGIA students 2. Revision of CAPM, SIM, APT 2 3. Market Efficiency and Portfolio Evaluation 9 4. Valuation of Equity Securities 28 5. Pricing Bonds
6. YTM and Term Structure of Interest Rate
7. Duration and Immunisation
8. Forwards and Futures
9. Options Only available to
LOGIA students Only available to
LOGIA students 3. Market Efficiency Three types of Efficiency Strong
Semistrong
Weak In an efficiency market, price of the market should
reflect ALL the information available to the market Should quickly change as new information come out. 3. Market Efficiency Weak form efficiency: Semistrong form efficiency: Current prices reflect all public information (market
expectation, historical prices, etc) Strong form efficiency: Current prices reflect all past securitymarket
information Current prices reflect all information (including private) If you are Strong form, you are also semistrong and
weak form 3. Market Efficiency
Weak Form Technical analysts disbelieve in
weak form, as they claim to use
historical information to earn
abnormal profits Semi Strong Form Fundamental analysts disbelieve
in semistrong form as they claim
to use macroeconomic data to
earn abnormal returns. However
some argue that stock analysts are
just simply better at researching
and using publicly available
information
Strong Form Insider traders disbelieve in
strong form 3. Market Efficiency If Market are efficiency, you cannot gain abnormal
return based on the information available. Abnormal return is return above the expected level. You will use different methods to find mispriced
shares depending on which form of efficiency you
believe in. 3. Market Efficiency Technical Analysis (does not believe weak form) Use past data to find patterns
Form trading rules Dow Theory
Filter Rule Fundamental (does not believe semistrong form) Use past data and current economic and accounting
information
Use asset pricing model to find underpriced stocks 3. Questions Q: The finding of a predictable pattern in stock prices
would violate which of the forms of efficiency? A: It would violate all three forms, as they all suggest
that you cannot earn abnormal returns based on
historical price/volume data 3. Questions Q: Do you believe that the share market is semistrong form efficient if you constantly call up your
broker to seek advice from his research team? A: Since you believe that you can profit from publicly
available data, (violating the assumptions of semistrong efficiency), you don’t believe in semistrong
form efficiency 3. Questions Q: Which of the following observations would provide
evidence against the semi strong form of the EMH A) Mutual fund managers do not on average make
superior returns
B) You cannot make superior profits by buying stocks
after the announcement of an abnormal rise in
dividends
C) Low P/E stocks tend to have positive abnormal
returns
D) In any year approximately 50% of pension funds
outperform the market 3. More on EMH Anomalies : Barriers to EMH: Small firm in Jan effect
Market to book effect
Cost Abnormal performance measurements Benchmarks
Market adjusted: rp  rm 3. Performance Measure Anomalies Barriers to EMH: Small firm in Jan effect
Market to book effect
Cost Abnormal performance measurements Benchmarks
Market adjusted: rp  rm 3. Sharpe Index The Sharpe index adjusts
excess market return for
total portfolio risk. Since
this incorporates both
systematic and
unsystematic risk, only
investors who are not well
diversified should use this 3. M2 Measure Used to compared a portfolio return with the market
return by reconstructing a portfolio with the same
market risk. Example: 3. Treynor Index The Treynor index adjusts
excess market return for
systematic portfolio risk.
This measure is used
when unsystematic risk is
considered irrelevant 3. Jensen Alpha The Jensen alpha is the alpha obtained from
regressing excess portfolio returns with excess
market returns (as covered in SIM)
o If the alpha is significantly different than zero this
reflects a fund managers ability to earn returns above
that implied by CAPM i.e. buy underpriced stocks 3. The Appraisal Ratio The appraisal ratio adjusts jensen’s alpha to
incorporate unsystematic risk. If a fund mangers sole
aim is to obtain a high alpha he may invest in a limited
number of stocks, introducing unsystematic risk. This
is why alpha needs to be adjusted 3. Which Measure to use: Sharpe ratio and M2: portfolio of asset Jensen’s and Appraisal ratio: Portfolio against an
index portfolio Treynor’s measure: Comparing portfolios in an
investment fund. 3. Exam Question Common MC question:
Calculate which portfolio has the highest Sharpe
index, Treynor index and Jensen Alpha
Portfolio P Portfolio Q Market
Standard
Deviation 5% 7% 4% Beta 1.1 1.5 1 Excess
Return 12% 18% 10% Alpha 2% 3% 3. Exam Question
Portfolio
P Portfolio
Q Sharpe =12%/5%
=2.4 =18%/7%
=2.57 Treynor =12%/1.1
=0.109 =18%/1.5
=0.12 2% 3% Jensen
Alpha 4. Valuation of Equity
Securities
Session
Session
1
Session
2 Session
3 Session
4 Topic
1. Introduction Slide
Only available to
LOGIA students 2. Revision of CAPM, SIM, APT 2 3. Market Efficiency and Portfolio Evaluation 9 4. Valuation of Equity Securities 28 5. Pricing Bonds
6. YTM and Term Structure of Interest Rate
7. Duration and Immunisation
8. Forwards and Futures
9. Options Only available to
LOGIA students Only available to
LOGIA students 4. Equity Valuation All about the value of the share (equity) Answer questions like how much is this share really
worth?
Main question: HOW TO VALUE EQUITY 4. Why is it so hard? Share can be under/over priced Share live “forever” Not Certain cashflows Very Risky 4. Different Values Market price (p0 ): Intrinsic value (V0): What the market think the price should be What the firm thinks the value is (estimation)
Based on how it models it If: V0 > p0
V0 < p0
V0 = p0 Buy
Sell
Fair Price 4. Different models to find
value Balance Sheet Method Dividend Discount Method Price/Earning Ratio Method 4. Balance Sheet Method Not too important Book Value per Share = (BV( Asset) – BV Liabilities)
# of Shares Liquidation Value per Share Replacement Value Per Share 4. Dividend Discount Method If you hold it for one year then the value is: Dividend: What dividend you expect to get at the end of
the year
Price: What is the price you expect after 1 year
Discount rate: Have to discount your cash flow back to
time zero. This is usually the one found in CAPM Note: Only Expectation 4. Dividend Discount Method
Tips: Try to understand it (visualise it)
Price
Discounting Dividend
Time 0 Time 1 Is very important i.e. will be tested in the exam
If you see question asking “Value of share” 4. Dividend Discount Method What about if you hold it for two years? Same idea: You get D1 in one year time so discount it back one year You get D2 in two years time so discount it back two years You also get P2 in two years time because you sell it, so
discount it back two years 4. Dividend Discount Method What if you never sell? Then all you get is dividends forever This means all you need to predict is future dividends and
not future share prices. However not too easy to predict the future dividends, but we
can predict how much we expect them to grow. 4. Constant Growth Model If dividends grow at a constant g: Tip: Just worry about the last part: Note: This IS D1 NOT D0 This means the expected dividend at end of year (or in 1
years time) 4. Example Stock A has a Beta of 1.4. The expected return of the
market is 12% and the risk free rate is 7%. Stock A
believes it will grow at 7% for the first three year and
then a steady 3% for the future. A dividend of $2 was
recently paid. Calculate the value of the share. List out the facts:
Rf = 7%
E(rm) = 12%
Beta = 1.4
Growth (13) = 7%
Growth (3+) = 3%
D0 = $2 4. Example Stock A has a Beta of 1.4. The expected return of the
market is 12% and the risk free rate is 7%. Stock A
believes it will grow at 7% for the first three year and then
a steady 3% for the future. A dividend of $2 was recently
paid. Calculate the value of the share. Tips: Beta usually means CAPM
Value of Share means Growth Model
Highlight important information 4. Example
1 Use CAPM to find expected return
E(ra) = 7 + 1.4(127) = 14% 2 Find D1
2 x 1.07 = 2.14 3 Find the value for the first 3 years of dividends
2.14/1.14 +(2.14*1.07)/1.142 + (2.14*1.072)/1.143 = 4 Find the price at time 3 using CGM
D4 = 2.14 x 1.072 x 1.03 =
V3 = / (0.12 – 0.03) = 5 Discount back to time zero
V0 = V3 / 1.143 + 4. Example
One of the hardest possible type of CGM question
Tips: Watch out for different growth rates
Remember to use CAPM first to find return
Break down the problem into smaller bits
Practice 4. Example
One of the hardest possible type of CGM question (MultiStage Growth Model)
Tips: Watch out for different growth rates
Remember to use CAPM first to find return
Break down the problem into smaller bits MultiStage Growth Model(don’t worry about the formula) 4. Example
One of the hardest possible type of CGM question (MultiStage Growth Model)
Tips: Watch out for different growth rates
Remember to use CAPM first to find return
Break down the problem into smaller bits MultiStage Growth Model(don’t worry about the formula) 4. Specific Holding Period
Model
Same as the CGM but we need to find a price at time n. Don’t worry about the formula too much, if you
understand CGM, you can do this: 4. ROE and retention More formulas to remember and understand: Return on Equity(ROE): Plowback (retention rate): b How much you keep as retain profits (percentage)
1  Dividend payout ratio Growth rate (g) = ROE x b 4. P/E ratio Price to Earning ratio If b is zero, Dividends = Earnings, and growth = 0 Another formula: Tips: Just remember the relationships between each other and
you can get these equation. Usually questions are just subbing in numbers to formulas 4. General Tips Try to understand what they are asking you and not
just memorise every single equation
Understand the relationship of different variables and
just sub it in.
Watch out for different growth rates
Remember to discount prices back to when it is asked
You may be asked to find the growth rate or the
discount rate (just swap the equations around)
Remember Beta usually means CAPM
Plowback rate usually means ROE and P/E ratio 4. General Tips Try to understand what they are asking you and not
just memorise every single equation
Understand the relationship of different variables and
just sub it in.
Watch out for different growth rates
Remember to discount prices back to when it is asked
You may be asked to find the growth rate or the
discount rate (just swap the equations around)
Remember Beta usually means CAPM
Plowback rate usually means ROE and P/E ratio ...
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This note was uploaded on 10/29/2010 for the course FINS 2624 taught by Professor Hneryyip during the Three '10 term at University of New South Wales.
 Three '10
 HneryYip

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