Theory Covariance: how close two variables move Together The reward-to-volatility = sharpe ratio Serial correlation of daily

returns is close to zero => very hard to predict from their past Value-at-Risk (VaR): a measure of downside risk ->Measures the potential loss over a specified horizon such that there is a (low) probability that the actual loss will be larger No clear guidelines as to the choice of sample length m: small m means that the VaR will be more influenced by recent events; large m is needed for precise estimates - No way to extrapolate the 1-day VaR to a longer n-day horizon (except if nonoverlapping n-period returns are considered to re-calculate the n-day VaR) A risk-averse investor: - Accepts risk-free or speculative prospects with positive risk-premiums - Rejects portfolios that are fair games (or worse) The higher the indifference curve, the higher the utility levelT he steeper the indifference curve, the higher the risk aversion -> higher compensation required for the same level of risk Two major sources of uncertainty for the risky assets in a portfolio: 1. Market risk -? Systematic, non-diversifiable 2. Firm-specific risk -> Non-systematic, diversifiable The minimum-variance frontier, which gives the lowest variance that can be attained for any target level of expected portfolio return The separation property The portfolio choice problem may be separated into two independent tasks -Determination of the optimal risky portfolio: it does not depend on agents preferences, and is thus the same for all investors -Allocation of the complete portfolio to Tbills versus the risky portfolio: it depends on personal preferences (risk aversion) -The R-square of the regression: the portion of the variation in IBM excess returns that is explained by the variation in the market index - The standard error of the regression: the standard deviation of the residual (influence of the firmspecific factor) The alpha of a security helps determine whether it is a good or bad buy The Information Ratio measures the extra return we obtain from security analysis per unit of firm specific risk we are exposed to if we under or overweight securities relative to the market index

CAPM Investors are price takers: individual trades do not affect prices - Single-period investment horizon - Investments are limited to traded assets - No taxes or transaction costs - All investors are rational mean-variance optimizers - Information is costless and available to all - Investors have homogenous expectations The mutual fund theorem (the separation property): - All investors choose to hold a market index mutual fund - The allocation between the mutual fund and the riskfree asset depends on individual investors risk aversion The CAPM predicts that alpha should be zero The CAPM fails the tests of the expected return-beta relationship: - Low-beta securities have generally positive alphas, high-beta securities tend to have negative alphas Blacks zero-beta model - Absence of a risk-free asset (i.e. restrictions on borrowing or investing in the risk-free asset) - Combinations of portfolios on the efficient frontier are also efficient - Any portfolio on the efficient frontier has a companion (zero-beta) portfolio with which it is uncorrelated - Returns on the efficient frontier can be expressed as linear combinations of any two frontier portfolios: ARBITRAGE PRICING THEORY Recall that according to the single factor model, the risky assets return can be decomposed into: - An expected component - Two unexpected components: exposure to a common macroeconomic factor and firm-specific events - We have used the return of the market portfolio to summarize the impact of macro factors - Possible macro-economic factors: - Interest rates - Unexpected changes in GDP Multifactor models - Allow for more than one factor thus introduce different sensitivities of assets to the separate sources of systematic risk - Factors may include unanticipated changes in: - GDP - Interest rates - Inflation - Estimate the loadings for each factor using multiple regression

Main difference with the single-factor model:

- Factor risk premium can be negative Arbitrage Pricing Theory - An arbitrage opportunity: arises when an investor can construct a sure-profit portfolio with zero net investment - e.g. different prices of the same security on different exchanges - The law of one price: if two assets are equivalent, they should have the same market price - In efficient markets, profitable arbitrage opportunities will quickly disappear Equilibrium - The dominance argument of CAPM: - Investors hold mean-variance efficient portfolios - If under/over-priced securities: investors shift their portfolios which creates pressure on prices to restore equilibrium - The arbitrage argument of APT: - When there is an arbitrage opportunity, any investor, regardless of risk aversion, will want to take an infinite position in it -> pressure on equilibrium prices - NB. No assumption that investors have meanvariance preferences! Hence, a well-diversified portfolio is one that consists of a large number of securities, so that its nonsystematic risk is negligible Comparing APT and CAPM - APT applies to well diversified portfolios and not necessarily to individual stocks - With APT it is possible for some individual stocks to be mispriced - not lie on the SML - APT is more general in that it gets to an expected return and beta relationship without the assumption of the market portfolio - APT can be extended to multifactor models Random walks and the Efficient Market Hypothesis (EMH) - Are future changes in stock prices predictable? - Stock prices follow a random walk: price changes are random and unpredictable - Stocks already reflect all available Information -> The efficient market hypothesis EMH and competition - Stock prices fully reflect all publicly available information - If information is costly to uncover, it should lead to higher investment returns - Role of market analysts and their coverage of different markets - Competition among investors in uncovering relevant information assures that prices reflect information

Versions of the EMH

- Weak: stock prices reflect all information that can be derived by examining market trading data (e.g. prices, volume, etc.) - Semistrong: stock prices reflect all publicly available information regarding past performance and prospects of the firm (i.e. including e.g. earning forecasts) - Strong: stock prices reflect all information, including private information Types of stock analysis - Technical analysis - Using past trading info (e.g. price and volume) to predict future prices - The weak form of the EMH rules out its benefits - Fundamental analysis - Uses economic and accounting info (e.g. earnings, dividends, expectations of future interest rates) to predict prices - The semistrong form of the EMH rules out its Merits Active vs. Passive portfolio management - Active management - Involves security analysis, timing - Large vs. small investors - The EMH: no benefit from pursuing active management - Passive management - Involves the creation of an index fund, buy and hold - Supported by the EMH Intrinsic value vs. Market price - Intrinsic value (IV) - Investors estimate of what a stock is worth it is a self-assigned value by the investor - A variety of models to estimate it - Dividend discount models are commonly used - Market Price (MP) - Consensus value of all potential traders - Defining a trading signal: - IV > MP -> Buy - IV < MP -> Sell or Short Sell - IV = MP ->Hold (Fairly Priced) Which measure to use? It depends on investment assumptions 1) If the portfolio represents the entire investment for an individual: Sharpe Index compared to the Sharpe Index for the market 2) If many alternatives are possible, use the Jensen or the Treynor measure The Treynor measure is more complete because it adjusts for risk 3) If allocating between an active portfolio and an index: information ratio

Hedge funds vs. mutual funds

- Transparency (strategy, portfolio composition) - Investors - Investment strategies - Liquidity (lock-up periods, redemption notice) - Compensation structure (management + incentive fee) Hedge Fund Strategies - Directional - Bets that one sector or another will outperform other sectors - Non directional - Exploit temporary misalignments in security valuations - Buys one type of security and sells another - Strives to be market neutral Hedge fund performance - Hedge funds tend to outperform the market: - Significant positive alphas - Higher Sharpe ratios - Reasons? - Liquidity (lock-up periods; serial correlation of hedge fund returns as an indication of illiquid holdings) - Survivorship bias - Changing factor loadings Yield to maturity (YTM) - The YTM is the interest rate that makes the present value of the bonds payments equal to its price YTM = realized yield if coupons are reinvested at an interest rate that is equal to the yield of the bond Default (credit) risk: the risk that the issuer will default on his obligation Key ratios to determine bond ratings - Coverage ratios (earnings to fixed costs) - Leverage ratio Debt-to-equity ratio - Liquidity ratios: - Current ratio (current assets/current liabilities)

- Quick ratio (current assets without inventories/current liabilities) - Profitability ratios (ROA, ROE) - Cash flow-to-debt ratio

Default premium: - the difference between the promised yield of a corporate bond and the yield of an otherwise equivalent government riskless bond

Originator: institution that creates the underlying assets (e.g. mortgages, credit card receivables) - Pooling: the creation of large portfolio of loans which are standardized according to maturities, types of cash-flow streams, geographic location,

Credit enhancement: a guarantee against default (at individual or originator level) is produced - The securitized products are then marketed by a special purpose vehicle - Effect of standardization and credit enhancement: production of liquid and marketable financial securities Aim: reallocate credit risk in the fixed-income markets - Creating CDOs: Structured Investment Vehicles (SIV) - Mortgage-backed CDOs The yield curve: a graphic representation of the relationship between yield and maturity upward sloping yield curve implies that short term rates are going to be higher next year. An upward sloping yield curve is associated with the fact that the FWD rate for the coming period is higher than the current yield Traditional finance theory: the current value of a security is the present value of its cash flows or its future value: Derivatives valuation theory: we can compute the current price of a security using expectations under risk-neutral probabilities: Bond prices and yields are inversely related: when yields rise, bond prices fall - Long-term bonds are more sensitive to interest rate risk - Low-coupon bonds are more sensitive to interest rate risk The sensitivity of bond prices to changes in yields increases at a decreasing rate as maturity increases - An increase in a bonds yield to maturity results in a smaller price decline than the price gain associated with a decrease of equal magnitude in yield - Bond prices are more sensitive to changes in yields when the bond is selling at a lower initial yield to maturity Duration - The key tool to measure interest rate sensitivity - It is a measure of the effective maturity of a bond: the weighted average time to maturity of the cash flows from a bond What determines duration? 1. The duration of a zero-coupon bond is equal to its maturity 2. For bonds with the same maturity, duration decreases for higher coupons 3. For bonds with the same coupon rate, duration usually increases with time to maturity (except for some deep discount bonds) 4. The duration of a coupon bond is higher for a lower yield to maturity Verdict on duration Cons A key measure of interest rate sensitivity Gives good approximations only for small yield changes

pro Easy to compute Assumes parallel yield shifts Easy to interpret Applicable only for securities with fixed cash flows Convexity - The price-yield relationship is convex, while duration is a linear approximation Derivative contracts - A derivative contract is a financial contract whose value is derived from the value of an underlying asset The buyer of a futures/FWD contract has a long position and is obliged to buy the underlying security at the specified price The seller of a futures/FWD contract has a short position and is obliged to sell the underlying security at the specified price Call option: gives the holder the right to BUY an asset at a specified price Put option: gives the holder the right to SELL an asset at a specified price Key ingredients: - Underlying asset - Exercise (strike) price - Premium (price of the option) - Maturity (expiration of the option) There are different types of options depending on the time the option can be exercised: - European can be exercised only at expiration - American can be exercised at any time before expiration - Bermudan exercise is restricted to certain periods during the life of the option Moneyness of an option - In the money: - Call option: Market price > Exercise price - Put option: Exercise price > Market price - Out of the money: - Call option: Market price < Exercise price - Put option: Exercise price < Market price - At the money - Market price = Exercise price Straddle - Long call plus long put on a stock with the same strike price and the same expiration date - Used by investors who expect that the stock will move considerably away from todays price, butare not certain about the direction of the move Spread - A combination of several calls or puts on the same stock with different exercise prices or times to maturity

- Money spread: exercise prices differ - Time spread: expiration dates differ Collar - A strategy designed to keep the value of the portfolio between two bounds - Limits upside potential - Provides downside protection Intrinsic value of an option: the pay-off if immediate exercise - Call: stock price - exercise price - Put: exercise price - stock price - Intrinsic value adjustment: PV of the exercise price - Time value of an option = option price intrinsic value What determines the value of an option? - Stock price - Exercise price - Volatility

- Time to expiration - Interest rate - Dividends

The hedge ratio=options delta - Quantifies the overall exposure of a portfolio of options to change in the price of the underlying The option delta - The sensitivity of the price of the option towards changes in the underlying stock price The options gamma - The rate of change of delta with respect to the price of the underlying asset (the sensitivity of with respect to S Futures market strategies - Speculation - Short: bet on falling prices - Long: bet on rising prices - Futures and leverage (margin requirements)

- Hedging - Short: protect against falling prices - Long: protect against rising prices

Modern Portfolio Theory: if the underlying is positively exposed to systematic risk, futures prices must be lower than expected spot prices Swaps - Forward contracts in multiple periods - Interest rate swaps: exchange of a series of fixed cash-flows for a series of floating-rate sash-flows - FX swaps: exchange of currencies on several future dates