FINS2624 LOGIA Notes(Promo)

FINS2624 LOGIA Notes(Promo) - LOGIA FINS2624 Revision...

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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 proprietors. If you are an unintended recipient of this information, please destroy it as soon as possible. This information is copyrighted to LOGIA Tuition 2009. Please note LOGIA assumes no responsibility for errors, inaccuracies or omissions in these materials/information. LOGIA does not warrant the accuracy or completeness of the information, text, graphics, links or other items contained within these materials. LOGIA shall not be liable for any special, indirect, incidental, or consequential damages, including without limitation losses, lost revenues, or lost profits that may result from these materials. 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 risk-free 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 risk-free. 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: Risk-less 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 Semi-strong 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: Semi-strong form efficiency: Current prices reflect all public information (market expectation, historical prices, etc) Strong form efficiency: Current prices reflect all past security-market information Current prices reflect all information (including private) If you are Strong form, you are also semi-strong 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 semi-strong 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 semi-strong 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 semi-strong 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 (1-3) = 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(12-7) = 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 Multi-Stage 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 Multi-Stage 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.

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