03finalreview

# 03finalreview - Time Value of Money Theory of Real Interest...

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Time Value of Money Theory of Real Interest Rates Two-period r = 1 ρ - 1 + 1 ρ - c 0 u ( c 0 ) u ( c 0 ) d c c 0 Multi-period r t = ρ - t u ( c 0 ) E[ u ( c t )] - 1 Term Structure Hypothesis Expectation Hypothesis Liquidity Preference Hypothesis 1

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Portfolio Theory Portfolio Weights w i i w i = 1 Expected return r p = i w i r i Variance σ 2 p = i j w i w j σ ij Diversification Systematic risk Non-systematic risk Optimal Portfolio Selection Objective * minimize variance given expected return Portfolio frontier with only risky assets Portfolio frontier with risky and riskless assets * Tangent portfolio * Implication r i - r f = σ iT σ 2 T ( r T - r f ) 2
CAPM Derivation Foundations of portfolio theory Market clearing Implication E( r i ) - r f = β i (E( r m ) - r f ) Measuring CAPM coefficients ˜ r i - r f = α i + β i r m - r f ) + ˜ i β i , measure of systematic risk α , zero according to CAPM statistical significance , measure of idiosyncratic risk R 2 , how much variance can be explained by market risk Leverage β A = D D + E β D + E D + E β E Pros and Cons 3

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Arbitrage Pricing Theory Model ˜ r i = E( r i ) + b i 1 ˜ f 1 + ... + b ik ˜ f k + ˜ u i Implication E( r i ) - r f = b i 1 (E( F 1 ) - r f ) + ... + b ik (E( F k ) - r f ) Pros and Cons Efficient Market Hypothesis Weak form Semi-strong form Strong form Evidence 4
Capital Budgeting NPV Rule Invest if NPV is positive Cash flow calculation + after-tax operating cash flow + depreciation tax shield - change of working capital

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