bkm-last

8/6/2019 bkm-last

http://slidepdf.com/reader/full/bkm-last 1/100

Essentials of Investments

© 2001 The McGraw-Hill Companies, Inc. All rights reserved.

F ourth Edition

Irwin / McGraw-Hill

Bodie � Kane � Marcus1

Chapter 13

Equity Valuation

8/6/2019 bkm-last




F ourth Edition

Irwin / McGraw-Hill


Fundamental Stock Analysis: Modelsof Equity Valuation

� Basic Types of Models

± Balance Sheet Models

± Dividend Discount Models ± Price/Earning Ratios

� Estimating Growth Rates and

Opportunities

8/6/2019 bkm-last




F ourth Edition

Irwin / McGraw-Hill


Intrinsic Value and Market Price

� Intrinsic Value

± Self assigned Value

± Variety of models are used for estimation

� Market Price

± Consensus value of all potential traders

� Trading Signal

± IV > MP Buy ± IV < MP Sell or Short Sell

± IV = MP Hold or Fairly Priced

8/6/2019 bkm-last




F ourth Edition

Irwin / McGraw-Hill


Dividend Discount Models:General Model

V

D

k o

t

t

t ! !

g

§ ( )11

� V0 = Value of Stock

� Dt = Dividend

� k = required return

8/6/2019 bkm-last




F ourth Edition

Irwin / McGraw-Hill


No Growth Model

V D

k o

!

� Stocks that have earnings and dividends that

are expected to remain constant� Preferred Stock

8/6/2019 bkm-last




F ourth Edition

Irwin / McGraw-Hill


No Growth Model: Example

E1 = D1 = $5.00

k = .15

V0 = $5.00 / .15 = $33.33

V D

k o

!

8/6/2019 bkm-last




F ourth Edition

Irwin / McGraw-Hill


Constant Growth Model

Vo

D g

k g

o!

( )1

� g = constant perpetual growth rate

8/6/2019 bkm-last




F ourth Edition

Irwin / McGraw-Hill


Constant Growth Model: Example

Vo

D g

k g

o!

( )1

E1

= $5.00 b = 40% k = 15%

(1-b) = 60% D1 = $3.00 g = 8%

V0 = 3.00 / (.15 - .08) = $42.86

8/6/2019 bkm-last




F ourth Edition

Irwin / McGraw-Hill


Estimating Dividend Growth Rates

g ROE b! v

� g = growth rate in dividends

� ROE = Return on Equity for the firm

� b = plowback or retention percentage rate

± (1- dividend payout percentage rate)

8/6/2019 bkm-last




F ourth Edition

Irwin / McGraw-Hill


Shifting Growth Rate Model

V Dg

k

D g

k g k

o o

t

t t

T T

T !

!

§( )

( )

( )

( )( )

1

1

1

1

1

1

2

2

� g1 = first growth rate

� g2 = second growth rate� T = number of periods of growth at g1

8/6/2019 bkm-last




F ourth Edition

Irwin / McGraw-Hill


Shifting Growth Rate Model: Example

D0 = $2.00 g1 = 20% g2 = 5%

k = 15% T = 3 D1 = 2.40

D2 = 2.88 D3 = 3.46 D4 = 3.63

V0 = D1/(1.15) + D2/(1.15)2 + D3/(1.15)3 +

D4 / (.15 - .05) ( (1.15)3

V0 = 2.09 + 2.18 + 2.27 + 23.86 = $30.40

8/6/2019 bkm-last




F ourth Edition

Irwin / McGraw-Hill


Specified Holding Period Model

0

1

1

2

2

1 1 1V

D

k

D

k

D P

k

N N

N !

( ) ( ) ( )

...

� PN

= the expected sales price for the stock at

time N

� N = the specified number of years the stock isexpected to be held

8/6/2019 bkm-last




F ourth Edition

Irwin / McGraw-Hill


Partitioning Value: Growth and NoGrowth Components

V E

k PVGO

PVGOD g

k g

E

k

o

o

!

!

1

11( )

( )

� PVGO = Present Value of GrowthOpportunities

� E1 = Earnings Per Share for period 1

8/6/2019 bkm-last




F ourth Edition

Irwin / McGraw-Hill


Partitioning Value: Example

� ROE = 20% d = 60% b = 40%

� E1 = $5.00 D1 = $3.00 k = 15%

� g = .20 x .40 = .08 or 8%

8/6/2019 bkm-last




F ourth Edition

Irwin / McGraw-Hill


V

NGV

PVGO

o

o

!

!

! !

! !

3

15 0886

515

33

86 33 52

(. . )$42.

.$33.

$42. $33. $9.

Partitioning Value: Example

VVoo = value with growth= value with growthNGVNGVoo = no growth component value= no growth component value

PVGO = Present Value of Growth OpportunitiesPVGO = Present Value of Growth Opportunities

8/6/2019 bkm-last




F ourth Edition

Irwin / McGraw-Hill


Price Earnings Ratios

� P/E Ratios are a function of two factors

± Required Rates of Return (k)

± Expected growth in Dividends� Uses

± Relative valuation

± Extensive Use in industry

8/6/2019 bkm-last




F ourth Edition

Irwin / McGraw-Hill


P/E Ratio: No expected growth

P E

k

P

E k

0

1

0

1

1

!

!

� E1 - expected earnings for next year ± E1 is equal to D1 under no growth

� k - required rate of return

8/6/2019 bkm-last




F ourth Edition

Irwin / McGraw-Hill


P/E Ratio with Constant Growth

P D

k g

E b

k b ROE

P

E

b

k b ROE

0

1 1

0

1

1

1

!

!

v

!

v

( )

( )

( )

� b = retention ration� ROE = Return on Equity

8/6/2019 bkm-last




F ourth Edition

Irwin / McGraw-Hill


Numerical Example: No Growth

E0 = $2.50 g = 0 k = 12.5%

P0 = D/k = $2.50/.125 = $20.00

PE = 1/k = 1/.125 = 8

8/6/2019 bkm-last




F ourth Edition

Irwin / McGraw-Hill


Numerical Example with Growth

b = 60% ROE = 15% (1-b) = 40%

E1 = $2.50 (1 + (.6)(.15)) = $2.73

D1 = $2.73 (1-.6) = $1.09

k = 12.5% g = 9%

P0 = 1.09/(.125-.09) = $31.14

PE = 31.14/2.73 = 11.4

PE = (1 - .60) / (.125 - .09) = 11.4

8/6/2019 bkm-last




F ourth Edition

Irwin / McGraw-Hill


Chapter 10

Bond Prices and Yields

8/6/2019 bkm-last




F ourth Edition

Irwin / McGraw-Hill


Bond Characteristics

� Face or par value

� Coupon rate

± Zero coupon bond

� Compounding and payments

± Accrued Interest

� Indenture

8/6/2019 bkm-last




F ourth Edition

Irwin / McGraw-Hill


Provisions of Bonds

� Secured or unsecured

� Call provision

� Convertible provision� Put provision (putable bonds)

� Floating rate bonds

� Sinking funds

8/6/2019 bkm-last




F ourth Edition

Irwin / McGraw-Hill


Default Risk and Ratings

� Rating companies

± Moody¶s Investor Service

± Standard & Poor¶s ± Duff and Phelps

± Fitch

� Rating Categories ± Investment grade

± Speculative grade

8/6/2019 bkm-last




F ourth Edition

Irwin / McGraw-Hill


Factors Used by Rating Companies

� Coverage ratios

� Leverage ratios

� Liquidity ratios� Profitability ratios

� Cash flow to debt

8/6/2019 bkm-last




F ourth Edition

Irwin / McGraw-Hill


Bond Pricing

P C

r

ParValue

r B

t

T

t

T

T

T ! !§ ( ) ( )1 11

PB = Price of the bond

Ct = interest or coupon paymentsT = number of periods to maturity

r = semi-annual discount rate or the semi-annualyield to maturity

8/6/2019 bkm-last




F ourth Edition

Irwin / McGraw-Hill


CCtt = 40 (SA)= 40 (SA)PP = 1000= 1000

TT = 20 periods= 20 periodsr r = 3% (SA)= 3% (SA)

PB = $1,148.77

Solving for Price: 10-yr, 8% Coupon

Bond, Face = $1,000

tt=1=1

++772020

==PPBB 4040 11

(1+.03)) t1000 1

(1+.03) 20

8/6/2019 bkm-last




F ourth Edition

Irwin / McGraw-Hill


Bond Prices and Yields

Prices and Yields (required rates of return) have an inverse relationship

� When yields get very high the value of the bond will be very low

� When yields approach zero, the value of

the bond approaches the sum of thecash flows

8/6/2019 bkm-last




F ourth Edition

Irwin / McGraw-Hill


Prices and Coupon Rates

Price

Yield

8/6/2019 bkm-last




F ourth Edition

Irwin / McGraw-Hill


Approximate Yield to Maturity

YTM = (Avg. Income) / (Avg. Price)

Avg. Income = Int. +(Par-Price) / Yrs to maturity

Avg. Price = (Price + Par) / 2

Using the earlier example

Avg. Income = 80 + (1000-1149)/10 = 65.10

Avg. Price = (1000 + 1149)/2 = 1074.50 Approx. YTM = 65.10/1074.50 = .0606 or

6.06%

Actual YTM =6.00%

8/6/2019 bkm-last




F ourth Edition

Irwin / McGraw-Hill


Term Structure of Interest Rates

� Relationship between yields to maturityand maturity

� Yield curve - a graph of the yields onbonds relative to the number of years tomaturity

± Usually Treasury Bonds

± Have to be similar risk or other factorswould be influencing yields

8/6/2019 bkm-last




F ourth Edition

Irwin / McGraw-Hill


Yield Curves

Yields

Maturity

UpwardUpward

SlopingSloping

DownwardDownward

SlopingSloping

8/6/2019 bkm-last




F ourth Edition

Irwin / McGraw-Hill


Theories of Term Structure

� Expectations

� Liquidity Preference

± Upward bias over expectations� Market Segmentation

± Preferred Habitat

8/6/2019 bkm-last




F ourth Edition

Irwin / McGraw-Hill


Chapter 11

Managing Fixed-

Income Investments

8/6/2019 bkm-last




F ourth Edition

Irwin / McGraw-Hill


Managing Fixed Income Securities:

Basic Strategies

� Active strategy

± Trade on interest rate predictions ± Trade on market inefficiencies

� Passive strategy

± Control risk

± Balance risk and return

8/6/2019 bkm-last




F ourth Edition

Irwin / McGraw-Hill


Bond Pricing Relationships

� Inverse relationship between price andyield

� An increase in a bond¶s yield to maturityresults in a smaller price decline thanthe gain associated with a decrease inyield

� Long-term bonds tend to be more pricesensitive than short-term bonds

8/6/2019 bkm-last




F ourth Edition

Irwin / McGraw-Hill


Bond Pricing Relationships (cont.)

� As maturity increases, price sensitivityincreases at a decreasing rate

� Price sensitivity is inversely related to abond¶s coupon rate

� Price sensitivity is inversely related to

the yield to maturity at which the bond isselling

F h

8/6/2019 bkm-last




F ourth Edition

Irwin / McGraw-Hill


Duration

� A measure of the effective maturityof a bond

� The weighted average of the timesuntil each payment is received, withthe weights proportional to thepresent value of the payment

� Duration is shorter than maturity for all bonds except zero coupon bonds

� Duration is equal to maturity for zerocoupon bonds

F h

8/6/2019 bkm-last




F ourth Edition

Irwin / McGraw-Hill


Duration: Calculation

t t

t w CF y ice! ( )1 Pr

D t w

t

T

t ! v!

§1

CF Cash Flow for period t t !

F th

8/6/2019 bkm-last




F ourth Edition

Irwin / McGraw-Hill


Duration Calculation

8%Bond

Timeyears

Paymen PV o CF10%

Weigh C1 XC4

1 80 72.727 .0765 .0765

2 80 66.116 .0690 .1392

Sum

3 1080 811.420

950.263

.8539

1.0000

2.5617

2.7774

F th41

8/6/2019 bkm-last




F ourth Edition

Irwin / McGraw-Hill


Duration/Price Relationship

Price change is proportional to durationand not to maturity

(P/P = -D x [((1+y) / (1+y)D* = modified duration

D* = D / (1+y)

(P/P = - D* x (y

Fourth42

8/6/2019 bkm-last




F ourth Edition

Irwin / McGraw-Hill


Uses of Duration

� Summary measure of length or effectivematurity for a portfolio

� Immunization of interest rate risk(passive management)

± Net worth immunization

± Target date immunization

� Measure of price sensitivity for changesin interest rate

i l fFourth

B di K M43

8/6/2019 bkm-last




F ourth Edition

Irwin / McGraw-Hill


Chapter 16

O pti

ons Markets

E i l f IFourth

B di K M44

8/6/2019 bkm-last




F ourth Edition

Irwin / McGraw-Hill


Option Terminology

� Buy - Long

� Sell - Short

� Call� Put

� Key Elements

± Exercise or Strike Price ± Premium or Price

± Maturity or Expiration

E ti l f I t tFourth

B di K M45

8/6/2019 bkm-last




F ourth Edition

Irwin / McGraw-Hill


Market and Exercise Price

RelationshipsIn the Money - exercise of the option would be

profitable

Call: market price>exercise price

Put: exercise price>market priceOut of the Money - exercise of the option would

not be profitable

Call: market price>exercise price

Put: exercise price>market price

At the Money - exercise price and asset priceare equal


B di K M46

8/6/2019 bkm-last




F ourth Edition

Irwin / McGraw-Hill


American vs European Options

American - the option can be exercised atany time before expiration or maturity

European - the option can only beexercised on the expiration or maturitydate


B die Kane Marc s47

8/6/2019 bkm-last




F ourth Edition

Irwin / McGraw-Hill


Different Types of Options

� Stock Options

� Index Options

� Futures Options� Foreign Currency Options

� Interest Rate Options



8/6/2019 bkm-last




F ourth Edition

Irwin / McGraw-Hill


Payoffs and Profits on Options at

Expiration - CallsNotation

Stock Price = ST Exercise Price = X

Payoff to Call Holder

(ST - X) if ST >X

0 if ST < XProfit to Call Holder

Payoff - Purchase Price

Essentials f In estments F ourth


8/6/2019 bkm-last




Edition

Irwin / McGraw-Hill


Payoffs and Profits on Options at

Expiration - CallsPayoff to Call Writer

- (ST - X) if ST >X

0 if ST < XProfit to Call Writer

Payoff + Premium

Essentials of Investments F ourth


8/6/2019 bkm-last




Edition

Irwin / McGraw-Hill


ProfitProfit

Stock PriceStock Price

0

Call riter Call riter

Call Holder Call Holder

Profit Profiles for CallsProfit Profiles for Calls

Essentials of Investments F ourth


8/6/2019 bkm-last




Edition

Irwin / McGraw-Hill


Payoffs and Profits at Expiration -

PutsPayoffs to Put Holder

0 if ST > X

(X - ST) if ST < X

Profit to Put Holder

Payoff - Premium

Essentials of Investments F ourthdBodie � Kane � Marcus52

8/6/2019 bkm-last




Edition

Irwin / McGraw-Hill


Payoffs and Profits at Expiration -

PutsPayoffs to Put Writer

0 if ST > X

-(X - ST) if ST < X

Profits to Put Writer

Payoff + Premium

Essentials of Investments F ourthEdi iBodie � Kane � Marcus53

8/6/2019 bkm-last




Edition

Irwin / McGraw-Hill

Bodie Kane Marcus53

Profit Profiles for PutsProfit Profiles for Puts

0

Profits

Stock Price

Put riter

Put Holder

Essentials of Investments F ourthEdi iBodie � Kane � Marcus54

8/6/2019 bkm-last




Edition

Irwin / McGraw-Hill

Bodie Kane Marcus54

Equity, Options & Leveraged Equity -

Text ExampleInvestment Strategy Investment

Equity only Buy stock @ 80 100 shares $8,000

Options only Buy calls @ 10 800 options $8,000

Leveraged Buy calls @ 10 100 options $1,000

equity Buy T-bills @ 2% $7,000Yield

Essentials of Investments F ourthEditiBodie � Kane � Marcus55

8/6/2019 bkm-last




Edition

Irwin / McGraw-Hill

Bodie Kane Marcus55


PayoffsMicrosoft Stock PriceMicrosoft Stock Price

$75$75 $80$80 $100$100

All Stock All Stock $7,500$7,500 $8,000$8,000 $10,000$10,000

All OptionsAll Options $0$0 $0$0 $16,000$16,000

Lev EquityLev Equity $7,140$7,140 $7,140$7,140 $9,140$9,140

Essentials of Investments F ourthEditiBodie � Kane � Marcus56

8/6/2019 bkm-last




Edition

Irwin / McGraw-Hill

Bodie Kane Marcus56


Rates of ReturnMicrosoft Stock PriceMicrosoft Stock Price

$75$75 $80$80 $100$100

All Stock All Stock --6.25%6.25% 0%0% 25%25%

All OptionsAll Options --100%100% --100%100% 100%100%

Lev EquityLev Equity --10.75%10.75% --10.75%10.75% 14.25%14.25%

Essentials of Investments F ourthEditionBodie � Kane � Marcus57

8/6/2019 bkm-last




Edition

Irwin / McGraw-Hill

Put-Call Parity Relationship

ST < X ST > X

Payoff forCall Owned 0 ST - X

Payoff for

Put Written-( X -ST) 0

Total Payoff ST - X ST - X


8/6/2019 bkm-last




Edition

Irwin / McGraw-Hill

Payoff of Long Call & Short Put

Long Call

Short Put

Payoff

Stock Price

Combined =

Leveraged

Equity


8/6/2019 bkm-last




Edition

Irwin / McGraw-Hill

Arbitrage & Put Call Parity

Since the payoff on a combination of along call and a short put are equivalent

to leveraged equity, the prices must beequal.

C - P = S0 - X / (1 + r f )T

If the prices are not equal arbitrage will bepossible


8/6/2019 bkm-last




Edition

Irwin / McGraw-Hill

Put Call Parity - Disequilibrium

ExampleStock Price = 110 Call Price = 17

Put Price = 5 Risk Free = 10.25%

Maturity =.5

yr X = 105

C - P > S0 - X / (1 + r f )T

17- 5 > 110 - (105/1.05)

12 > 10

Since the leveraged equity is less expensive,acquire the low cost alternative and sell thehigh cost alternative


8/6/2019 bkm-last




Edition

Irwin / McGraw-Hill

Put-Call Parity Arbitrage

ImmediateImmediate Cashflow in Six

MonthsCashflow in Six

Months

PositionPosition CashflowCashflow SSTT<105<105 SSTT>> 105105

Buy Stock Buy Stock --110110 SSTT SSTT

BorrowBorrow

X/(1+r)X/(1+r)TT = 100= 100 +100+100 --105105 --105105

Sell CallSell Call +17+17 00 --(S(STT--105)105)

Buy PutBuy Put --55 105105--SSTT 00

TotalTotal 22 00 00


8/6/2019 bkm-last


f


Edition

Irwin / McGraw-Hill

Option Strategies

Protective Put

Long Stock

Long Put

Covered Call

Long Stock

Short Call

Straddle (Same Exercise Price)Long Call

Long Put


8/6/2019 bkm-last


f


Edition

Irwin / McGraw-Hill

Option Strategies

Spreads - A combination of two or more calloptions or put options on the same asset withdiffering exercise prices or times to expiration

Vertical or money spread

Same maturity

Different exercise price

Horizontal or time spreadDifferent maturity dates

Essentials of Investments F ourth EditionBodie � Kane � Marcus64

8/6/2019 bkm-last


f

© 2001 The McGraw-Hill Companies, Inc. All rights reserved. Irwin / McGraw-Hill

Chapter 17

O pti

on Valuati

on


8/6/2019 bkm-last


f


Option Values

� Intrinsic value - profit that could bemade if the option was immediately

exercised ± Call: stock price - exercise price

± Put: exercise price - stock price

� Time value - the difference between theoption price and the intrinsic value


8/6/2019 bkm-last


f


Time Value of Options: Call

O ption

value

XStock Price

Value of Call

Intrinsic Value

Time value


8/6/2019 bkm-last


f


Factors Influencing Option Values:

CallsFactor Effect on value

Stock price increases

Exercise price decreasesVolatility of stock price increases

Time to expiration increases

Interest rate increasesDividend Rate decreases


8/6/2019 bkm-last



Black-Scholes Option Valuation

Co = Soe-HTN(d1) - Xe-r TN(d2)

d1 = [ln(So/X) + (r ± H + W2/2)T] / (WT1/2)

d2 = d1 - (WT1/2)where

Co = Current call option value.

So = Current stock priceN(d) = probability that a random draw from a

normal dist. will be less than d.


8/6/2019 bkm-last



Black-Scholes Option Valuation

X = Exercise price.

H = Annual dividend yield of underlying stock

e = 2.71828, the base of the nat. log.

r = Risk-free interest rate (annualizescontinuously compounded with the samematurity as the option.

T = time to maturity of the option in years.

ln = Natural log function

W Standard deviation of annualized cont. compounded rate of return on the stock


8/6/2019 bkm-last



Call Option Example

So = 100 X = 95

r = .10 T = .25 (quarter)

W= .50 H = 0d1 = [ln(100/95)+(.10-0+(5 2/2))]/(5 .251/2)

= .43

d2 = .43 - ((5.251/2)= .18


8/6/2019 bkm-last



Probabilities from Normal Dist.

N (.43) = .6664

Table 17.2

d N(d).42 .6628

.43 .6664 Interpolation

.44 .6700


8/6/2019 bkm-last



Probabilities from Normal Dist.

N (.18) = .5714

Table 17.2

d N(d).16 .5636

.18 .5714

.20 .5793


8/6/2019 bkm-last



Call Option Value

Co = Soe-HTN(d1) - Xe-r TN(d2)

Co = 100 X .6664 - 95 e- .10 X .25 X .5714

Co = 13.70Implied Volatility

Using Black-Scholes and the actual price

of the option, solve for volatility.

Is the implied volatility consistent with thestock?


8/6/2019 bkm-last



Put Option Value: Black-Scholes

P=Xe-r T [1-N(d2)] - S0e-HT [1-N(d1)]

Using the sample data

P = $95e(-.10X.25)(1-.5714) - $100 (1-.6664)P = $6.35


8/6/2019 bkm-last



Put Option Valuation: Using Put-Call

ParityP = C + PV (X) - So

= C + Xe-rT - So

Using the example dataC = 13.70 X = 95 S = 100

r = .10 T = .25

P = 13.70 + 95 e -.10 X .25 - 100P = 6.35


8/6/2019 bkm-last



Using the Black-Scholes Formula

Hedging: Hedge ratio or delta

The number of stocks required to hedge againstthe price risk of holding one option

Call = N (d1)Put = N (d1) - 1

Option Elasticity

Percentage change in the option¶s valuegiven a 1% change in the value of theunderlying stock


8/6/2019 bkm-last



Portfolio Insurance - Protecting

Against Declines in Stock Value� Buying Puts - results in downside

protection with unlimited upsidepotential

� Limitations

± Tracking errors if indexes are used for theputs

± Maturity of puts may be too short

± Hedge ratios or deltas change as stockvalues change


8/6/2019 bkm-last



Chapter 18

Futures Markets


8/6/2019 bkm-last



Futures and Forwards

� Forward - an agreement calling for a futuredelivery of an asset at an agreed-upon price

� Futures - similar to forward but feature

formalized and standardized characteristics

� Key difference in futures

± Secondary trading - liquidity

± Marked to market ± Standardized contract units

± Clearinghouse warrants performance


8/6/2019 bkm-last



Key Terms for Futures Contracts

� Futures price - agreed-upon price atmaturity

� Long position - agree to purchase� Short position - agree to sell

� Profits on positions at maturity

Long = spot minus original futures priceShort = original futures price minus spot


8/6/2019 bkm-last



Types of Contracts

� Agricultural commodities

� Metals and minerals (including energy

contracts)� Foreign currencies

� Financial futures

Interest rate futuresStock index futures


8/6/2019 bkm-last



Trading Mechanics

� Clearinghouse - acts as a party to allbuyers and sellers.

± Obligated to deliver or supply delivery� Closing out positions

± Reversing the trade

± Take or make delivery

± Most trades are reversed and do notinvolve actual delivery


8/6/2019 bkm-last



Margin and Trading Arrangements

Initial Margin - funds deposited to providecapital to absorb losses

Marking to Market - each day the profitsor losses from the new futures price andreflected in the account.

Maintenance or variance margin - anestablished value below which atrader¶s margin may not fall.


8/6/2019 bkm-last



Margin and Trading Arrangements

Margin call - when the maintenancemargin is reached, broker will ask for additional margin funds

Convergence of Price - as maturityapproaches the spot and futures priceconverge

Delivery - Actual commodity of a certaingrade with a delivery location or for some contracts cash settlement


8/6/2019 bkm-last



Trading Strategies

� Speculation -

± short - believe price will fall

± long - believe price will rise� Hedging -

± long hedge - protecting against a rise inprice

± short hedge - protecting against a fall inprice


8/6/2019 bkm-last



Basis and Basis Risk

� Basis - the difference between thefutures price and the spot price

± over time the basis will likely change andwill eventually converge

� Basis Risk - the variability in the basisthat will affect profits and/or hedging

performance


8/6/2019 bkm-last



Futures Pricing

� Spot-futures parity theorem - two waysto acquire an asset for some date in thefuture

± Purchase it now and store it

± Take a long position in futures

± These two strategies must have the same

market determined costs


8/6/2019 bkm-last



Parity Example

Stock that pays no cash dividend

± no storage costs

± no seasonal patterns in pricesStrategy 1: Buy the stock now and hold it

until time T

Strategy 2: Put funds aside today toperform on a futures contract for delivery at time T that is acquired today


8/6/2019 bkm-last



Parity Example OutcomesParity Example Outcomes

Strategy A:Strategy A: ActionAction Initial flowsInitial flows Flows at TFlows at T

Buy stock Buy stock --SSoo SSTT

Strategy B:Strategy B: ActionAction Initial flowsInitial flows Flows at TFlows at T

Long futuresLong futures 00 SSTT -- FFOO

Invest in BillInvest in BillFFOO(1+r(1+rf f ))

TT -- FFOO(1+r(1+rf f ))TT FFOO

Total for BTotal for B -- FFOO(1+r(1+rf f ))TT SSTT


8/6/2019 bkm-last



Price of Futures with Parity

Since the strategies have the same flowsat time T

FO / (1 + r f )T

= SO

FO = SO (1 + r f )T

The futures price has to equal the

carrying cost of the stock


8/6/2019 bkm-last



Chapter 9

The Eff

icient MarketHypothesis


8/6/2019 bkm-last



Efficient Market Hypothesis (EMH)

� Do security prices reflect information ?

� Why look at market efficiency

± Implications for business and corporatefinance

± Implications for investment


8/6/2019 bkm-last



� Random Walk - stock prices are random

± Actually submartingale

� Expected price is positive over time

� Positive trend and random about the trend

Random Walk and the EMH


8/6/2019 bkm-last



SecuritSecuritPricesPrices

TimeTime

Random alk with Positive TrendRandom alk with Positive Trend


8/6/2019 bkm-last



� Why are price changes random?

± Prices react to information

± Flow of information is random

± Therefore, price changes are random

Random Price Changes


8/6/2019 bkm-last



EMH and Competition

� Stock prices fully and accurately reflectpublicly available information

� Once information becomes available,market participants analyze it

� Competition assures prices reflectinformation


8/6/2019 bkm-last



Forms of the EMH

� Weak

� Semi-strong

� Strong


8/6/2019 bkm-last



Types of Stock Analysis

� T ec hnical Analysis - using prices and volumeinformation to predict future prices

± Weak form efficiency & technical analysis

� Fundamental Analysis - using economic andaccounting information to predict stock prices

± Semi strong form efficiency & fundamentalanalysis


8/6/2019 bkm-last



� Active Management

± Security analysis

± Timing

� Passive Management

± Buy and Hold

± Index Funds

Implications of Efficiency for Active or

Passive Management


8/6/2019 bkm-last


Even if the market is efficient a roleexists for portfolio management

� Appropriate risk level� Tax considerations

� Other considerations

Market Efficiency and Portfolio

Management

Documents

bkm-last