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Ravi Shukla

Contents

Preface Introduction 1 Securities Markets 1.1 The Securities . . . . . . . . . . . 1.1.1 Money Market Securities . 1.1.2 Capital Market Securities 1.1.3 Mutual Funds . . . . . . . 1.1.4 Options and Futures . . . 1.2 Security Prices . . . . . . . . . . 1.3 Investment Prots and Returns . 1.4 Investors and their Motives . . . 1.5 The Markets . . . . . . . . . . . . 1.5.1 Primary Market . . . . . . 1.5.2 Secondary Market . . . . . 1.6 The Trading Process . . . . . . . 1.7 Long and Short Positions . . . . . 1.8 Cash and Margin Accounts . . . . 1.8.1 Long Position . . . . . . . 1.8.2 Short Position . . . . . . . 1.8.3 Mixed Position . . . . . . 1.8.4 Account Closing . . . . . . 1.9 Investment Information . . . . . . 1.10 Market Regulation . . . . . . . . 1.11 Conclusion . . . . . . . . . . . . . ii 1 3 3 3 4 4 5 6 6 7 8 8 10 12 14 16 17 20 21 22 23 24 24 30 30 32 34

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2 Return and Risk 2.1 Return . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.2 Conversion of Units of Return . . . . . . . . . . . . . . . . . . . . . . . . . . 2.2.1 Subperiod and Continuous Compounding . . . . . . . . . . . . . . . . i

Contents 2.3 2.4 2.5 2.6 Leverage and Return . . . . . . . . . . . . . Return as a Random Variable . . . . . . . . Investment Decision Making under Risk . . Estimating Return Statistics . . . . . . . . . 2.6.1 Using the Statistics . . . . . . . . . . 2.7 Sources of Risk . . . . . . . . . . . . . . . . 2.8 Risk Aversion . . . . . . . . . . . . . . . . . 2.8.1 Investors Objective . . . . . . . . . . 2.8.2 Risk Aversion and Dominance . . . . 2.8.3 Risk and Return: Historical Evidence 2.9 Other Determinants of Rates of Return . . . 2.9.1 Basic Rate . . . . . . . . . . . . . . . 2.9.2 Expected Ination . . . . . . . . . . 2.9.3 Time to Maturity . . . . . . . . . . . 2.9.4 Taxes . . . . . . . . . . . . . . . . . 2.10 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

ii 36 37 38 40 43 44 46 48 48 49 50 51 51 52 53 54 58 58 60 61 63 65 66 67 71 75 79 79 80 80 81 85 87 90 91 93 96 97 97 98

3 Portfolio Analysis 3.1 Portfolios . . . . . . . . . . . . . . . . . . . . . . . . 3.2 Portfolio Returns . . . . . . . . . . . . . . . . . . . . 3.3 Diversication . . . . . . . . . . . . . . . . . . . . . . 3.3.1 Correlation . . . . . . . . . . . . . . . . . . . 3.3.2 Diversication Eciency . . . . . . . . . . . . 3.4 An Overview of the Portfolio Selection Process . . . . 3.5 Calculating Portfolio Statistics . . . . . . . . . . . . . 3.6 Identifying the Optimal Portfolio . . . . . . . . . . . 3.7 Optimal Portfolio with Risky and Risk-free Securities 3.7.1 Ecient Frontier and Tangency Line . . . . . 3.7.2 Constrained Portfolios . . . . . . . . . . . . . 3.7.3 Portfolio Revision . . . . . . . . . . . . . . . . 3.8 Analysis of Diversication . . . . . . . . . . . . . . . 3.8.1 The Eect of Correlation . . . . . . . . . . . . 3.8.2 The Eect of the Number of Securities . . . . 3.9 Mutual Funds . . . . . . . . . . . . . . . . . . . . . . 3.10 Portfolio Selection in a Perfect Market . . . . . . . . 3.11 Systematic and Unsystematic Risks . . . . . . . . . . 3.12 Capital Asset Pricing Model . . . . . . . . . . . . . . 3.12.1 CAPM and Risk . . . . . . . . . . . . . . . . 3.12.2 Using the CAPM . . . . . . . . . . . . . . . . 3.12.3 Problems with the CAPM . . . . . . . . . . . 3.13 Conclusion . . . . . . . . . . . . . . . . . . . . . . . .

Contents 4 Security Selection and Performance Evaluation 4.1 Valuation . . . . . . . . . . . . . . . . . . . . . . . . . . 4.2 Calculating Present Values . . . . . . . . . . . . . . . . . 4.2.1 Special Cases . . . . . . . . . . . . . . . . . . . . 4.2.2 Some Hints . . . . . . . . . . . . . . . . . . . . . 4.3 Return . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.3.1 Security Selection using Rates of Return . . . . . 4.4 Market Eciency . . . . . . . . . . . . . . . . . . . . . . 4.4.1 Ecient Market Hypothesis . . . . . . . . . . . . 4.4.2 Are Securities Markets Ecient? . . . . . . . . . 4.4.3 Investing in an Ecient Securities Market . . . . 4.5 Performance Evaluation . . . . . . . . . . . . . . . . . . 4.5.1 Do Mutual Funds Exhibit Superior Performance? 4.6 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . 5 Common Stocks 5.1 Stockholder Rights . . . . . . . . . . . . . . . 5.2 Issue and Repurchase of Shares . . . . . . . . 5.3 Cash Dividends . . . . . . . . . . . . . . . . . 5.4 Reading Stock Quotations . . . . . . . . . . . 5.5 Common Stock Valuation . . . . . . . . . . . 5.5.1 Mature Firm . . . . . . . . . . . . . . 5.5.2 Growth Firm . . . . . . . . . . . . . . 5.5.3 Finite Holding Period . . . . . . . . . . 5.6 Obtaining Information for Valuation Decisions 5.7 Factors Aecting Stock Prices . . . . . . . . . 5.8 Conclusion . . . . . . . . . . . . . . . . . . . . 6 Fixed Income Securities 6.1 Basic Terminology and Valuation 6.2 Bond Features . . . . . . . . . . . 6.3 Risks of Fixed Income Securities . 6.4 Bond Issuers . . . . . . . . . . . . 6.5 Reading Bond Tables . . . . . . . 6.5.1 Corporate Bonds . . . . . 6.5.2 Treasury Securities . . . . 6.6 Bond Portfolios . . . . . . . . . . 6.7 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

iii 104 104 106 108 109 111 115 117 118 120 121 122 127 127 133 133 134 136 139 141 141 141 143 143 143 144 149 149 151 152 153 154 155 156 159 160

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Contents 6AInterest Rate Risk and Duration 6A.1 Introduction . . . . . . . . . . . . . . . . . . . . . 6A.2 Interest Rate Changes and Realized Return . . . 6A.2.1 Case 1: Interest Rates Remain Unchanged 6A.2.2 Case 2: Interest Rates Go Up . . . . . . . 6A.2.3 Case 3: Interest Rates Go Down . . . . . . 6A.2.4 Summary . . . . . . . . . . . . . . . . . . 6A.3 Duration . . . . . . . . . . . . . . . . . . . . . . . 6A.3.1 Sensitivity of Duration . . . . . . . . . . . 6A.3.2 Duration for a Zero Coupon Bond . . . . . 6A.4 Applications of Duration . . . . . . . . . . . . . . 7 Options 7.1 Terminology . . . . . . . . . . . . . . . . . . . . . 7.2 Option as Risk Transferring Contracts . . . . . . 7.3 Option vs. Stock . . . . . . . . . . . . . . . . . . 7.4 Option Strategies . . . . . . . . . . . . . . . . . . 7.5 Option Valuation . . . . . . . . . . . . . . . . . . 7.5.1 American Options vs. European Options . 7.5.2 Payo Diagrams . . . . . . . . . . . . . . 7.5.3 Put-Call Parity . . . . . . . . . . . . . . . 7.5.4 Call ValuationBinomial Formulation . . 7.5.5 Call ValuationBlack-Scholes Formulation 7.6 Conclusion . . . . . . . . . . . . . . . . . . . . . . 7AFutures Normal Distribution Table Data

iv 164 164 165 165 166 167 168 168 169 170 170 171 171 175 175 178 179 182 183 185 187 189 191 193 195 197

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Preface

These notes are intended to be used in a one semester course in investments. The students are expected to have knowledge of algebra, statistics, and basic nance. The objective of these notes is to present a concise introduction to the fundamentals of investments. The notes take a risk-return valuation approach in an ecient markets framework and do not delve into technical and fundamental analyses. To keep the notes to reasonable length so that they can be covered in a one semester course, some secondary topics have been presented briey or omitted entirely. Also, many ideas have been brought out only through the end-of-the-chapter exercises. It is extremely important for students to try out these exercises for a better understanding of the subject. I would like to express my gratitude to my teachers: Professors Donald Bosshardt, Sris Chatterjee, Robert Hagerman, Philip Perry, and Charles Trzcinka, who taught me nance and encouraged me to learn more about this exciting eld of study. I would also like to acknowledge the inuence of seminal textbooks in nance and investments by authors such as Brealey and Myers, Copeland and Weston, Sharpe, and Francis, that may be evident in my presentation. I have used these notes as a basis for my lectures during the past few semesters at SUNY Brockport and Syracuse University. Feedback from students has signicantly improved the quality of these notes. I am obliged to James Cordeiro, Roberta Klein, Joan Norton and Mike Tomas who read the notes patiently and provided detailed comments. August 16, 1995 Ravi Shukla

Preface

vi

Introduction

Welcome to the exciting world of investments. When you think of investment, you probably imagine men and women in dark pinstripe suits, talking about millions of dollars as if it were pocket change; or maybe you think of the traders in stock or futures exchanges (as seen in movies such as Wall Street, Trading Places, Blue Steel , etc.); or maybe you think of the ticker tape running at the bottom of the screen in CNN Headline News with those seemingly endless symbols and numbers. Those are the glamorous, the chaotic, and the mysterious sides of investments. In this course, we will take some of the mystery out of the world of investments. When you nish this course, you may not become a smooth talking investment banker or a frenzied trader, but you will have an understanding of the investment fundamentals that are used by the investment bankers and traders. You will learn the language of investments and the process of investment analysis and decision making. You may apply this knowledge to your personal investments or become an investment professional and manage other peoples money. This course is about stocks, bonds, mutual funds, options, and futures. More importantly, it is about risk and reward; about portfolios and diversication; about value and price. These are the fundamental tools of investment decision making. Once you know these fundamentals, you will have the background to make proper investment decisions. I have no doubt that sooner or later you will be faced with an investment decision making situation, if you havent done so already. Someday, you may want to set some money aside either with a denite motive of using it as a down payment for a house or a car, or with a general motive of having it for emergencies. You will examine alternative places to put this money: a savings account, a money market mutual fund, a stock mutual fund, or maybe stock or bond of your favorite company. To make an intelligent decision you should be able to evaluate these alternatives. This course gives you the background to make that evaluation. Let us begin by dening investment. When we make an investment, we are using the money that could otherwise have been consumed. We could have used it to buy groceries, buy a car, take a vacation, or build a house. By making the investment, we are sacricing these pleasures. There ought to be some reward for this sacrice. The reward is that we expect to get back more than what we put in. We can then consume the amount that we get back. In economic terms, when we invest, we trade current consumption for future consumption. For an investment to be acceptable, the trade-o should be favorable, i.e., we must expect that 1

Introduction

the pleasure derived from the future consumption will be more than the pleasure foregone. Since the economic term for pleasure is utility, we can dene investment as the act of giving up current consumption and using it so that the resulting future consumption may provide an improvement in utility. For an investment to be acceptable it is not enough that the amount received in the future be more than what we invested. It should be more by such an amount that it compensates for the inconvenience caused by the postponement of consumption. Investments are classied into two categories: real and nancial. Real investments are made in tangible assets. If you invest $100,000 in a factory or a restaurant, you are making a real investment. Real investments are made by people who have technical knowledge or insight that can lead to a valuable product or service. Often, these people do not have enough capital to make the investment and therefore they look elsewhere for nancial support. Financial investors invest in the companies formed for the sake of real investment, and thus, support real investment activity in the economy. Financial markets bring the real and nancial investors together. When you make a nancial investment, you receive a piece of paper known as a security that outlines the terms and conditions of the investment. This course deals with nancial investments and therefore concentrates on securities such as stocks and bonds. Securities may be marketable or privately placed. A marketable security is one that can be bought and sold in an open market. Most corporations and governments issue marketable securities. Privately placed securities are issued by companies to family, friends, relatives and acquaintances, and are not traded publicly. Our focus will be on the marketable securities issued by the governments (federal, state, and local) and corporations. These notes are organized as follows: Chapter 1 describes the dierent kind of securities, how the securities are issued and traded, and where one can get information about the securities. Chapter 2 explores the concepts of return and risk. Chapter 3 shows how investors can reduce risk by investing in portfolios of several securities. Chapter 4 discusses the process of security selection and performance evaluation. Chapters 5, 6, and 7 are devoted to the individual securities: stocks, bonds, and options and futures, respectively.

In this Chapter you will learn about the dierent kind of securities, how the securities are issued and traded in the market, how investors buy and sell securities, and where one can get investment information. The description focuses on the important aspects of these topics. For detailed information you should consult the additional readings listed at the end of the Chapter.

1.1

The Securities

Securities, also called nancial instruments, are the medium of nancial investments. Common stock, preferred stock, bonds, mutual funds, and options and futures contracts are examples of securities. Common and preferred stock, and bonds are issued by corporations or governments to raise capital. Mutual funds are created by nancial companies using existing securities. Options and futures contracts are created by the investors and involve other securities. Brief descriptions of these securities are provided later in this section.

1.1.1

Short term securities issued by corporations and governments to borrow money are known as money market securities and are traded in the money market. Securities are classied as short term if they have a life of one year or less, i.e., all the obligations associated with the security are paid o within a year. Commercial paper (issued by corporations) and Treasury bills (issued by the U.S. Treasury for the federal government) are examples of short term securities. Money market securities do not pay any interim interest. They are sold at a discount, the discount being the interest. Consider an investor who buys GMAC commercial paper for $98,000. On maturity, three months later, GMAC pays back $100,000 to the investor. The $2,000 dierence is the interest amount.

Securities Markets

1.1.2

Long term securities issued by corporations and governments are known as capital market securities and are traded in the capital market. Bonds, preferred stocks, and common stocks are capital market securities. Bonds and preferred stocks are debt securities.1 By buying these securities, investors lend money to the issuer. In return, the issuer promises to pay interest periodically till the maturity date and to pay the face value on the maturity date. The interest and face value payments to be made by the issuer are usually xed and known at the time the security is issued. For this reason, bonds and preferred stock are also known as xed income securities. Common stocks are issued by corporations. By buying shares of common stock, investors become part owners of the issuing corporation. Common stockholders are entitled to certain ownership privileges, most important of which is a claim to the corporations assets and earnings net of the payments to the bondholders and other lenders. Since common stockholders receive what is left over after paying the bondholders and lenders, common stock is also known as a residual income security. Even though common stock gives the investor the privileges of ownership, the liability from the ownership is limited to the amount invested in the common stock. For example, if you bought 100 shares of Kodak at $50, and Kodak were to go bankrupt (because of a lawsuit, for example), the maximum you could lose is the $5,000 you already invested. For this reason, common stock is known to have a limited liability. Corporations pass their earnings to the common stockholders in form of dividend payments. A corporation, however, is not obligated to pay dividends. It may retain the earnings for reinvestment purposes. Retained earnings increase the value of the corporations assets and therefore the market price of the stock. Common stock is the most popular form of investment among individuals. Therefore, majority of the nancial news is concentrated on common stock. Keeping with this spirit, common stock will be used to illustrate the concepts in Chapters 1 through 4 of these notes, although many of the concepts apply to other securities also.

1.1.3

Mutual Funds

Investors like to diversify by distributing their money over several dierent securities so that the losses on some securities may be compensated by the gains on the others. Forming such portfolios, however, is time consuming and expensive for individual investors. Financial companies such as Fidelity Investments and Vanguard create and manage portfolios known as mutual funds. Investors buy shares in these mutual funds and receive the benets of

While preferred stock is treated in the same manner as common stock for accounting purposes, it shares more investment characteristics with bonds than with common stocks. Therefore, it is treated as a bond here.

1

Securities Markets

diversication. Mutual fund companies aggregate the shareholders wealth and invest it in securities. Investing in mutual funds is considered an indirect investment because individuals are investing in funds which in turn are investing in securities. If individual investors buy securities directly, it is known as a direct investment. There are many kind of mutual funds: funds that invest in stocks, funds that invest in short term bonds (money market funds), funds that invest in municipal bonds, etc. Investors can choose the funds that meet their objectives and preferences. Mutual funds have become immensely popular during the last twenty years. The number of mutual funds available has grown from 477 in 1977 to 5,375 at the end of 1994. The total assets invested in mutual funds amount to $2,164.5 billion. About 31% of the US households invest in mutual funds.

1.1.4

Options and futures are contracts between investors. An option or a futures contract is created if there are two investors who want to enter the contract: one wants to buy it and the other wants to sell it. A futures contract involves the sale of an asset on a future date at a price agreed upon now. For example, we may enter a futures contract which states that you will sell me 5,000 bushels of corn 3 months from now at $2.40 per bushel. Why would we enter this contract? Suppose the current price of corn is $2.36 per bushel. I know that I will need 5,000 bushels of corn three months later but I dont want to face the risk of the price going up too much. You, on the other hand, are willing to take that risk. So you oer to sell me the corn for $2.40. Three months later, if the corn price goes up to $2.50, I will save $0.10 per bushel. If the price goes down to $2.30, you will make $0.10 per bushel. An option contract involves one person giving the other a right for a transaction in the future. For example, we may enter the following option contract. For a small fee (say $1) that I pay you now, you give me the right to buy from you a share of Kodak for $45 any time during the next 2 months. Why would we enter this contract? I may do it because I believe that the price of Kodak will go up during the next two months and will be more than $45. You may enter the contract because you believe that the share price will not go above $45. If the price goes above $45, I will exercise the right you gave me and buy a share of Kodak for $45 while it is worth a lot more. On the other hand, if the price does not go above $45, I will not exercise the right you gave me and you will make $1. Options and futures allow security risk to be transferred from one person to another. In the corn futures example, I transferred the risk of corn price going up to you for a small fee ($0.04 per bushel). Similarly, in the Kodak option example, I transferred the risk of share price going up to you for $1. In popular literature, options and futures are viewed as risky investments and investing in these securities is considered similar to gambling. However, judicious use of options and futures with other securities such as stocks and bonds can be extremely useful to investors.

Securities Markets

1.2

Security Prices

Security prices are determined by the process of supply and demand. Under ideal conditions, the market price of a security should be equal to the intrinsic value of the security. The intrinsic value of a security comes from the cashows expected from the security in the future. Investors estimate the value of a security using the information available to them. Since investors dier from each other in information, age, attitudes, tax brackets, and needs, they arrive at dierent estimates for the same security. These dierential estimates create supply and demand for securities. If the market price is below the estimated value, investors want to buy the security, and if the price is above the estimated value, they want to sell it. The market price of the security responds to demand and supply: it goes up if the demand exceeds supply, and it goes down if the supply exceeds demand. The condition when supply equals demand, i.e., the market clears, is known as equilibrium. The securities markets are very dynamic. New information and interpretations arrive in the market constantly which causes the demand and supply to uctuate continuously. As a result, market equilibrium does not last very long. The market moves from one equilibrium to another. For our discussion we will often freeze the market at a particular point. Otherwise, by the time we nish our discussion the market would be at a dierent point!

1.3

Buying and selling securities creates prots or losses for investors. If an investor buys a security at a low price and sells at a high price, he makes a prot. On the other hand, if he buys high and sells low, he realizes a negative prot, i.e., a loss. Any cash distributions (dividends or interest) that the investor receives from the security add to the prots. To be able to compare the prots from one security with another, the prots are scaled by dividing by the investment amount. The resulting number is known as the rate of return on investment, or simply return. Other things being the same, investments with higher returns are more desirable. Suppose you bought 100 shares of a stock at $60 a share, held them for one year, received a dividend of $2 per share, and sold the shares at $70 a share after receiving the dividend, then your prot per share was ($70 $60) + $2 = $12. The prot of $12 was made up of two parts: a capital gain of ($70 $60) = $10 from the increase in price and an income of $2 in form of the dividend. Since you made $12 on your investment of $60, your return was 12/60 = 0.20 or 20%. It is important to associate a time unit with the rate of return. Since you made this prot over a one year period, your return was 20% per year. To generalize the above example, suppose at the beginning of a period, you make an investment of w0 and at the end of the period the securities are worth w1 , then the prot

Securities Markets

from the investment is w1 w0 and the return r is: w1 w0 r= (1.1) w0 For a security, let us express the initial price by p0 , the nal price by p1 , and the interest or dividend by d, then the total prot is p1 p0 + d and the return is: r= p1 p0 + d p0 (1.2)

1.4

The investment marketplace is lled with many dierent kind of investors: Individual investors like you and me who mostly use investments as a vehicle for savings. About 51 million Americans owned shares in 1994, either directly or indirectly through mutual funds, etc. Corporations who purchase securities when they have excess funds. Sometimes they may do it to gain ownership and control of other companies. Institutional investors such as insurance companies, pension funds, college endowment funds, and mutual funds whose professional function is to invest. Individual investors usually make relatively small trades. For example, an individual investor may buy 100 shares of AT&T, or sell 200 shares of Kodak. Institutional investors deal with large amounts of money and therefore often trade shares in large quantities. If a trade involves 10,000 shares or more, it is known as a block trade. Block trades usually cause the market prices to uctuate signicantly. In this way, institutional investors exercise great inuence on the market. In 1994, 55.5% of the shares traded in the New York Stock Exchange were through block trades. Block trades, however, accounted for only 5.8% of all trades conducted on the NYSE. 78.8% of the trades involved 2,000 or fewer shares. Dierent investors have dierent motives for trading in securities. The motives can be classied as follows: Need for liquidity: Liquidity motivated investors buy securities when they have excess funds and sell them when they need funds. Most trades by individual investors are liquidity motivated. Speculation: An investor who speculates is betting on the movement of the price of a security. Speculators believe that they can predict the movement of security prices. Therefore, they invest in specic securities at specic times. If you were to buy 100 shares of Microsoft Corporation because of a hot tip, you would be speculating. While liquidity motivated investors use their own money, speculators may even borrow money for investment.

Securities Markets

Hedging: An investment that is made to reduce risk is called hedging. Hedging is similar to buying insurance to protect against loss. Options and futures contracts are used for hedging purposes. Options, for example, allow investors to recover some or all the losses from unfavorable price movements.

1.5

The Markets

Investors buy and sell securities in securities markets. The securities markets can be classied as primary and secondary.

1.5.1

Primary Market

Corporations and governments that need capital sell securities in the primary market. Rather than being an actual place, primary market refers to the process through which securities are exchanged for money between investors and the issuer. The process of issuing securities is managed by investment banking rms. Merrill Lynch, Salomon Brothers, Smith Barney, and CS First Boston are some of the well known investment banking rms. Investment banking rms advise the issuing corporations on the following matters related to the security issue: The kind of security to issue: Stock or bond? Common or preferred stock? Serial or term bonds? The proper time to issue the securities: Should we issue the securities now or will the market respond better in three months? The price at which to sell the securities: The market price of the existing common stock is $8.50. Should we try to sell the issue at $8.00? Will a discount of $0.50 guarantee the sale of all the shares the corporation wants to sell? Fullling the legal requirements: Designing the prospectus. Filing necessary papers with the Securities and Exchange Commission (SEC). Making necessary announcements. Actual selling of the securities: In addition to the basic salesmanship, the investment bankers may also act as risk takers or underwriters for the issue. The two major types of agreements between the issuing corporation and the investment banking rms for selling the securities are rm commitment and best eorts. Under a rm commitment agreement, the corporation sells the securities to investment banker(s) at a price below the issue price. The dierence being the commission. For example, if the oering price is $8.00 a share, the corporation

Securities Markets

This announcement is not an oer of securities for sale or a solicitation of an oer to buy securities. June 17, 1991

1,650,000 Shares

Ecogen Inc.

Common Stock

Price $8 per share

Copies of the prospectus may be obtained from such of the undersigned (who are among the underwriters named in the prospectus) as may legally oer these securities under applicable securities laws.

Dillon, Read & Co. Inc. Prudential Securities Incorporated Piper, Jaray & Hopwood

Incorporated

Securities Corporation

Incorporated

Incorporated

Incorporated

Montgomery Securities Robertson, Stephens & Company Wertheim Schroder & Co.

Incorporated

Incorporated

Corporation

Advest. Inc.

Arnhold and S. Bleichroeder, Inc. Janney Montgomery Scott Inc. Ladenburg, Thalmann & Co. Inc.

Interstate/Johnson Lane

Corporation

Incorporated

Raymond James & Associates, Inc. W. H. Newbolds Son & Co., Inc. Pennsylvania Merchant Group Ltd

Capital Markets

Securities Markets

10

may sell the securities to the investment banker for $7.25 a share. Thus, if one million shares are to be issued, the potential income to the investment bankers is $0.75 million. Of course, the realized income will depend on how many shares are sold. The issuing corporation is not concerned with the number of shares sold because it will get the money from the investment bankers. Firm commitment is the common method of issue for large corporations. In the best eorts arrangement, investment banking rms do not take any risk. Their commission is either xed regardless of how many shares are sold, or is a combination of a xed fee plus a commission on each share sold. Any unsold shares are returned to the issuing corporation. Best eorts arrangements are used for smaller, lesser known rms. Investors are informed about security issues through announcements in The Wall Street Journal and other business publications. An announcement that appeared in the Journal on June 17, 1991 is shown in Figure 1.1. Note that the advertisement refers to a prospectus. The prospectus outlines the history of the company, its current nancial situation, and its plans. If investors nd the prospectus appealing, they may purchase the shares from the investment bankers. Usually, many investment bankers are involved in selling the securities even though they do not act as advisors. In the announcement in Figure 1.1, Dillon, Read & Co. Inc., Prudential Securities Incorporated, and Piper, Jaray & Hopwood, Incorporated are the primary investment bankers, i.e., they advised Ecogen Inc. throughout the issue. The remaining investment bankers only acted as sellers. The securities issue process is a very time consuming activity. From start to nish, it may take as long as four to six months. It is also very expensive. The commissions to the sellers and underwriters and other expenses may amount to as much as 10% of the size of the issue.

1.5.2

Secondary Market

Once the securities have been issued, investors who bought the securities may want to sell them and others may want to buy them. These trades occur in the secondary market. The New York Stock Exchange (NYSE) is a major secondary market. Other secondary markets include the American Stock Exchange (AMEX or ASE) and many regional exchanges located in various parts of the country.2 The trading in these stock exchanges takes place through face-to-face contact between the brokers who act as agents for the investors. The brokers make oers for the securities by shouting and using hand signals, much like in an auction. This trading method is known as the open outcry system. With the advances in

Sometimes, in popular nancial reporting, the term secondary markets is used for smaller exchanges such as American Stock Exchange or the over-the-counter markets only. That use of the term is technically imprecise.

2

Securities Markets

11

computers and communications, the over-the-counter (OTC) has become a very prominent secondary market. The OTC market is a network of communications between the securities dealers. The securities that are traded over-the-counter are listed on the NASDAQ (National Association of Securities Dealers Automated Quotation) system. The communication network makes the most recent prices available on computer terminals and trades are completed through communication lines without the two parties ever meeting each other. There are organized exchanges for other securities and nancial contracts also. Bonds are traded in a separate area in the New York and other stock exchanges. Option contracts are traded in Chicago Board Options Exchange (CBOE), American Stock Exchange, and regional exchanges. Futures contracts are traded in Chicago Board of Trade (CBT), New York Futures Exchange (NYFE), New York Mercantile Exchange, etc. There are organized exchanges for trading securities in other countries as well. Some of the worlds largest stock exchanges are located in Tokyo, London, Toronto, Milan, Paris, Amsterdam, Stockholm, Brussels, Frankfurt, Montreal, Hong Kong, Singapore, and Sydney. The New York Stock Exchange, founded in 1792, is the largest stock exchange in the United States. It is located in a large building at 18 Broad Street. The stocks are traded on a oor about the size of a football eld which is divided into several chambers. There are several booths, known as trading posts, on the trading oor, each trading a few securities. There are electronic bulletin boards and TV monitors throughout the exchange oor that constantly display security prices and news from around the world. Along the boundary of the trading areas, there are oces for the brokers. These oces are managed by clerical sta and runners who convey orders received on the phone to the brokers. During the trading hours, the exchange oor appears to be a crowded mad house with paper all over the place and people screaming and gesturing endlessly with their hands. Trading in the exchange is done by the members, who have to buy seats in the exchange. At present there are 1,366 seats in the NYSE. Fifty eight non-seat owning members have access to the exchange by paying an annual fee. The seats are owned by individuals and companies, and are traded in the open market. The price of a big board seat during 1994 uctuated between $760,000 and $830,000. Members of the exchange can be classied as follows: Traders buy and sell on their personal account. Commission brokers execute orders for their customers. Floor brokers engage in miscellaneous trading. One of their functions is to trade for a commission broker who may be temporarily busy. Specialists are traders who specialize in trading some particular securities. They manage the trading posts and facilitate in trading among brokers and dealers by keeping track of their orders and matching the buy and sell orders as feasible. Specialists also have the responsibility of being the market makers. In other words, they have an

Securities Markets

12

obligation to keep the market going by buying and selling shares as needed. For example, if many investors want to sell their shares of IBM during an afternoon, the market will shut down if there are no buyers. The IBM specialist has the responsibility to buy the shares in this situation. Similarly, if there is a sudden demand for the shares of IBM, the specialist has to sell the shares. For such contingencies, the specialist must carry a large inventory of shares. However, only 17.3% of the trades in 1994 involved specialists. In rest of the cases, brokers traded among themselves. The NYSE is open for trading between 9:30 am and 4:00 pm. Two after-hours sessions (known as crossing sessions I and II) allow trading between 4:15 pm and 5:00 pm, and 4:00 pm and 5:15 pm, respectively, at that days closing prices. The average daily trading volume (number of shares traded) during 1994 was 291.4 million shares. The annual trading volume was 73.4 billion shares, accounting for $2.45 trillion in value. The rate at which the shares change hands on the NYSE works out to over 10,000 shares per second. Clearly, face to face trading among brokers and dealers would not be able to accomplish this rate. A computerized order matching system known as SuperDot3 was responsible for 44.4 billion, or 60.5% of all shares traded in 1994. For a stock to be traded on the NYSE, it has to be listed on the exchange. Firms have to meet strict requirements and pay a fee to be listed and traded on the NYSE. These requirements are designed to make sure that only the nationally prominent securities are traded in the NYSE. Despite the strict listing requirements, corporations like their stock to be listed on the big boarda nickname for the NYSEbecause it gives them visibility and prominence which is useful when issuing new securities. At the end of 1994, the NYSE had 2,570 rms listed which made up 3,060 stock issues, with over 142 billion shares having a total market value of $4.45 trillion. The price of an average share in the NYSE in 1994 was $31.26.

1.6

Investors who want to buy and sell securities have to contact a brokerage house, open an investment account, and be assigned an account executive (AE). There are two kind of brokerage houses: discount and full service. Discount brokerage houses just trade for their customers while full service brokerage houses provide recommendations and advice as well. Some well known brokerage houses are Merrill Lynch, Dean Witter, and Charles Schwab. To buy or sell some securities, the investor places an order with the account executive. The order can be a day order or a good till cancelled order. Day orders must be executed during the specied day, while good till cancelled orders are valid from the time the order is placed till the order is lled or cancelled. With respect to price, there are three kinds of orders:

3

Securities Markets

13

Market order is an order to buy or sell securities at the best price available. A market order is placed when an investor wants to leave the judgement about the price to the broker. Limit order is an order to buy at a specied price (called the limit price) or less, or sell at a specied price or more. Limit orders are placed to make sure that securities are bought at a low enough price or sold at a high enough price. Stop loss order is an order to sell if the price falls to a particular level (stop level) or to buy if the price rises to a particular level. Stop loss orders are placed when an investor wants to cut losses. The order is transmitted to the exchange oor oce of the commission broker associated with the brokerage house. The order is taken by the runner to the commission broker. The commission broker goes to the booth where the security is traded. There may be other brokers at the booth waiting to buy or sell. The specialist who deals in the stock quotes two prices: a price at which he will sell the sharesthe ask priceand another at which he will buy the sharesthe bid price. As you may expect, the ask price is higher than the bid price. The dierence is known as the bid-ask spread and provides a commission to the specialist. If the bid and ask prices4 on the stock of XYZ are 24 1/4 and 24 1/2 then an investors buy order for the shares will be executed at 24 1/2 and sell order at 24 1/4. The order may be executed at an intermediate price, say 24 3/8, if there are two brokers: one who wants to sell and another who wants to buy, and they decide to bypass the specialist. Upon completion of the trade, the broker noties the account executive through the runner who in turn noties the investor that the order has been executed. The investor usually makes the payment (for a buy transaction) or receives the payment (for a sell transaction) within three business days of the transaction. In addition to the security price, the investor has to pay commissions and trading costs. These transaction costs are always incurred by the investor whether he is buying or selling the securities. The amount of transaction costs depends on the kind of account, the brokerage house, the size of the order, etc. The transaction costs are not xed and dierent brokerage houses may charge dierent amounts for the same transaction. The commissions are higher if an investor wants to trade in odd lots (not multiples of 100 shares). A good estimate for transaction costs for a round lot (multiples of 100 shares) is 2% of the security price. For example, if the shares were purchased for $100 each, the investor will have to pay approximately $102. If they were sold for $100 the investor will get approximately $98. A popular term used in the market is round trip transaction costs. Round trip refers to buying and then selling a security. If an investor paid $30 in commissions when buying the securities and $35 while selling them then the round trip transaction cost is $65.

4 The securities are traded at price intervals of 1/8, 1/16, or 1/32 depending on the exchange and the type of security. 1/8, 1/16, or 1/32 is known as a tick. A tick is the smallest price movement allowed by the exchange. A proposal for making the smallest price movement a penny is being studied by the SEC.

Securities Markets

14

1.7

Suppose the common stock of ABC is selling at $10 today. Based on your information you expect the price to go up to $15 in 6 months. To make a prot one must buy low and sell high. So, you may buy 100 shares of ABC for a total of $1,000 today. This is a positive investment of $1,000 in ABC on your part. You will be 100 shares long on ABC, i.e., you will own the shares of ABC. In six months, when the price does go up to $15, you may sell the shares and make a prot of $500 on your investment. Of course, you will have a loss if the price goes down. When you go long, your dollar loss is limited to the amount you invested because the market price of a common stock can never be negative. However, there is no limit to your prots because the stock price can keep rising without any limit. Another stock, XYZ, is also selling at $10 today. Based on your information about this stock, you expect the price to go down to $5 in 6 months. Since the stock price is high, you should sell the shares now and buy them when the price is low. If you do not own any shares to sell, you may borrow 100 shares from a friend, sell them, and pocket the proceeds ($1,000). This represents a negative investment of $1,000 because money has come into your pocket, not gone out. You will be 100 shares short in XYZ. You do not own the shares but you owe them; they are a liability. Six months later, when the price does go down to $5, you may buy 100 shares of XYZ in the market (for $500), return them to your friend and keep $500 as your prot. When you go short, there is a limit on your dollar gain because the lowest the price can go is zero, but there is no limit on your losses because the price can keep going up without any limit. Short selling is risky not only because of unlimited losses but also because for each short seller, there are two investorsthe lender and the buyerwho have a positive outlook about the stock. The lender must feel optimistic about the stock otherwise he would have sold the shares himself. The buyer must also feel positively about the shares otherwise he would not buy them. Therefore, one must be very sure of ones information before short selling. Going short is not as simple as described above. Even your best friends may not trust you so much as to lend you the shares without any guarantee. In actual investing situations, you borrow the shares from your broker. The broker requires you to maintain a collateral for the market value of the borrowed shares ($1,000 in the example above) till the shares are returned. The deposit must always be equal to the market value of the securities. Therefore, if the share price in the example above were to go up to $13 in a week, you will have to add $300 to the deposit. On the other hand, if it were to go down to $7, you could withdraw $300 from the account. The collateral is maintained in an interest free account with the broker. Therefore, the investor does not receive any interest on these funds. The investor may substitute the collateral cash by other securities whose market values equal the required collateral. The short seller is required to pay dividends to the lender if the stock pays a dividend. Let us understand the reason for this by following the mechanism of short selling carefully using Figure 1.2. When you short sell 100 shares of XYZ, your broker borrows them on your behalf

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

15

1. Shares

Lender

Short Seller .

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

2. Shares . 3. Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

. . . . . . .

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Buyer

4. Cash

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

4. Shares

Lender

Short Seller .

.. . . . . .. . . . . . . . .. . . . . . . . . . . .

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

3. Shares 2. Cash

Seller

1. Cash

from another investors account, say Ms. L. You sell the shares to Mr. B. Now, suppose the stock declares the dividend. Since Mr. B owns the shares, he will get the dividends directly from the corporation. Ms. L, on the other hand, has only lent the shares.5 She still owns them. Therefore, she expects the dividends that the stock paid. Since you borrowed the shares, you are expected to pay those dividends. Trading restrictions do not allow short selling if the last movement in the security price has been downward. This is called the up-tick rule and is designed to keep the market free of any psychological pressures. Regulators believe that if the market is on a downward trend due to selling, short selling could put additional articial downward pressure on the prices. A large amount of short selling in the market indicates that investors are bearish about the market, i.e., they expect the prices to go down. Does this mean that other investors should also sell? Maybe. However, remember that the shares that have been sold short will be bought back. This assures a demand for the shares in the future. Therefore, some investors should be willing to buy the shares and sell them later when short sellers go to the market to buy the shares back to replace them. However, short sellers may not need to buy back all the shares if they are shorting against the box, i.e., short selling the shares they already own. Shorting against the box is used by investors because it allows them to lock in the prots they have made (see problems 1.8 and 1.15). In that case, only those shares that have not been shorted against the box will need to be replaced. This information is conveyed by short interest. Short interest is the net short position of an investor. For example, if

5

As a matter of fact, she may not even know that her shares have been lent.

Securities Markets

16

I sell 300 shares of XYZ short while I am long 200 shares of XYZ, my net short position or short interest is only 100 shares of XYZ because, to replace the borrowed shares, I will need to buy only 100 shares of XYZ, not 300 shares. The Wall Street Journal publishes a short interest report every month around the end of the third week. It contains a lot of useful information about short selling and short interest trends in the market. An important lesson from the idea of short selling is that you never have to stay out of the market. If you nd a security that is a good buy, i.e., you expect its price to go up, you should go long on it. If you nd a security that is not a good buy, i.e., you expect its price to go down, you should not ignore that security. If you hold that security, sell it. If you do not own that security, you may make a prot by selling it short.

1.8

When you open an investment account with a brokerage house, you can make it either a cash account or a margin account. In a cash account all the transactions are nanced by 100% of your funds. You do not borrow any money from the broker. A margin account allows you to take loans from the brokerage house to nance your investments. When you purchase securities using a cash account, you may take possession of the securities, i.e., take them home, or you may leave them with the broker. Securities left with the broker are said to be held in street name. When the securities are held in street name, your account statement reects the fact that you own the securities. This arrangement is preferred by the brokerage houses because selling and buying transactions are quite easy to performthey become mere book-keeping exercises. The arrangement is also preferred by the investors because they do not have to guard the securities from theft and accidents. In a margin account the securities must be kept in the street name because they are used as collateral against the loan made by the brokerage house. The broker, however, does not advance full value of the securities as a loan. The investor has to put up some cash to make the purchase. This cash is required to cover the losses that may result from adverse price movements. The size of the loan that an investor is allowed in a margin account is governed by many factors. The two important ones are the risk of the investment and the status of the investor and the account. Accounts are allowed bigger loans if the investment is less risky. Also, the amount of loan that an account may be forwarded depends on the investors other asset holdings and reputation. The interest rate on the margin loans are quite low because these loans are secured by marketable securities. The Federal Reserve Bank and the securities exchanges provide guidelines which are followed by the brokerage houses in maintaining the margin accounts. The brokerage houses usually impose stricter requirements. The guidelines are dened in terms of the margin ratio or simply the margin. The margin ratio measures the amount of equity in the account as

Securities Markets a fraction of the market value of securities: Margin = Equity . Market Value of Securities

17

(1.3)

The higher the margin, the higher the equity and the less the debt in the account. A 100% margin account is fully equity nancedit is a cash accountwhile a 40% margin account is nanced by 40% equity and 60% loan. Each account has two margin requirements: initial margin and maintenance margin. When the account is opened, the margin in the account must at least be equal to the initial margin specied for that account. Once the account is well established and in good standing, the margin may drop, but it should not go below the maintenance level. Initial and maintenance margins specify the minimum equity that the investor must have in the account. The margin in an account uctuates with the market price of the securities held in the account. If the margin falls below the maintenance level, the investor receives a margin call from the brokerage house to bring the account up to the initial margin. If the investor does not respond to the margin call, the brokerage house may sell some of the securities to make the account current. If the margin in the account is above the maintenance level, the investor can use the excess equity to make more investments or even withdraw cash from the account. In the following subsections we will look at some common calculations in margin accounts.

1.8.1

Long Position

Let us take the example of Mr. Garner, who has a margin account with Lean Hitter. The initial and maintenance margin requirements for his account are 60% and 25%. Mr. Garner wants to buy 100 shares of QVC. The shares are priced at $31 each. Since the initial margin requirement is 60%, Mr. Garner must have equity worth at least 0.6 $3,100 = $1,860. He may take a loan for the remaining amount.6 Let us say Mr. Garner takes the maximum loan permitted to him. The balance sheet of Mr. Garners account after the transaction is:

Assets ($) Mkt. Val. of QVC 3,100 3,100 Liabilities and Equity ($) Loan Equity Total 1,240 1,860 3,100

Total

An investor is not required to borrow anything from the broker. He may choose to borrow all or part of what he can. In our examples we will assume that investors borrow as much as they can.

6

Securities Markets

$

18

Let us say that the market price goes up to $40. The account position is:

Assets ($) Mkt. Val. of QVC 4,000 4,000 Liabilities and Equity ($) Loan Equity Total 1,240 2,760 4,000

Total

Note that the equity value increased as the market value of shares went up while the loan amount did not change. The margin ratio now is 2,760/4,000 = 69%. Mr. Garner is not required to maintain such a high margin. He can reduce his margin either by selling some shares and withdrawing the cash resulting from this transaction, or by making additional investment. Let us examine each of these alternatives. (a) If Mr. Garner decides to sell some shares and withdraw the proceeds, he has to be careful that margin does not fall below the maintenance level of 25%. Let us say Mr. Garner wants to sell enough shares to bring the margin down to 40%, keeping some cushion for himself. We want to nd out how many shares he can sell. If the number of shares he can sell is n then the remaining shares is (100 n). The equity is $40(100 n) 1,240. The position of the account is:

Assets ($) Mkt. Val. of QVC 40(100 n) 40(100 n) Liabilities and Equity ($) Loan Equity Total 1,240 40(100 n) 1,240 40(100 n)

Total

The margin ratio that Mr. Garner wants to keep gives us: 0.40 = 40(100 n) 1,240 . 40(100 n)

Solving this equation gives n = 48.33. To keep the margin above 0.40, he should sell 48 shares and withdraw the resulting $1,920,7 leaving behind 52 shares with a total value of $2,080. The value of equity becomes $840. The balance is:

Assets ($) Mkt. Val. of QVC 2,080 2,080 Liabilities and Equity ($) Loan Equity Total 1,240 840 2,080

Total

7 We are not rounding to the nearest integer here. Even if n were 48.7, we will sell 48 shares because selling 49 shares will bring the margin below the target.

Securities Markets

19

Rather than withdrawing the cash from the account, Mr. Garner may use it to reduce the loan in the account. (b) Suppose Mr. Garner decides to buy shares of another stock, TBC, selling for $20 each. The cash needed for this purchase will be loaned by the broker. We want to nd out how many shares Mr. Garner can buy. Let us denote the number of shares by n. Again, let us assume that Mr. Garner does not want the margin to fall below 40%. The balance sheet is now made up of $4,000 + $20n in market value of shares, $1,240 + $20n in loan, and $2,760 in equity. From the margin requirement we get: 2,760 0.40 = , 4,000 + 20n which results in n = 145. Mr. Garner can buy 145 shares of TBC. The balance sheet now is:

Assets ($) Mkt. Val. of QVC Mkt. Val. of TBC Total 4,000 2,900 6,900 Liabilities and Equity ($) Loan Equity Total 4,140 2,760 6,900

&

The previous set of examples assumed that the share price went up from the initial price of $31. What happens if the price goes down? Let us calculate the price P at which Mr. Garner will receive a margin call. The market value of shares at that price will be 100P which will make the equity equal to 100P 1,240. The margin call will go out when the margin ratio falls to 0.25. Therefore, 0.25 = 100P 1,240 , 100P

which gives us P = 16.53. Let us say that the price actually falls to $15 before Mr. Garner can respond. At this price the balance sheet looks like:

Assets ($) Mkt. Val. of QVC 1,500 1,500 Liabilities and Equity ($) Loan Equity Total 1,240 260 1,500

Total

To increase the margin to the initial level, Mr. Garner may either increase equity by adding cash or reduce the market value of shares by selling some shares and leaving the cash in the account. Let us examine these choices.

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(a) If he adds cash, on the assets side we will have a new entry for cash and there will be an increase in equity. A simple calculation will show that the required amount of cash is $640. The balance sheet of the restored account is:

Assets ($) Mkt. Val. of QVC Cash Total 1,500 640 2,140 Liabilities and Equity ($) Loan Equity Total 1,240 900 2,140

(b) He may sell some shares and create cash in the account. In fact, if Mr. Garner does not respond in a reasonable amount of time (usually 5 business days), the broker will do it for him. You can check that the required number of shares to be sold is 72. The balance sheet after selling the shares is:

Assets ($) Mkt. Val. of QVC Cash Total 420 1,080 1,500 Liabilities and Equity ($) Loan Equity Total 1,240 260 1,500

1.8.2

Short Position

Let us take the case of Ms. Stanford. Her account with Lean Hitter has an initial margin of 50% and a maintenance margin of 40%. Ms. Stanford begins by short selling 100 shares of QVC at $31 each. This generates $3,100 which is deposited with the broker. To protect himself against price increases, the broker asks Ms. Stanford to deposit cash. To understand the need for this cash, imagine what will happen if there were no cash in the account and the share price went up to $32. The broker will have to contact Ms. Stanford for an additional $100. If he cannot nd Ms. Stanford, he will have to absorb the loss.8 The initial margin requirement is 50% so Ms. Stanford must put in $1,550. The balance sheet of the account is:

Assets ($) Cash Deposit Total 1,550 3,100 4,650 Liabilities and Equity ($) Mkt. Val. of QVC Equity Total 3,100 1,550 4,650

Note that the market value of the securities is a liability because the securities are a loan and have to be returned.

8 To return the securities, the broker will have to buy them back for $3,200 and there are only $3,100 in the account.

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Suppose the price goes up to $33bad news for Ms. Stanford. This will require a total deposit of $3,300 with the broker. The additional amount required will be taken out of the cash and added to the collateral deposit. The account position will be:

Assets ($) Cash Deposit Total 1,350 3,300 4,650 Liabilities and Equity ($) Mkt. Val. of QVC Equity Total 3,300 1,350 4,650

The margin on the account now is 40.9% which is slightly above the maintenance margin of 40%. You can check to see that Ms. Stanford will get a margin call at the price of $33.21.

1.8.3

Mixed Position

Let us consider the account of Mr. and Mrs. Murphy. The initial and maintenance margins for their account are 70% and 40%, respectively. The Murphys began by buying 2,500 shares of XLC at $40. The balance sheet at that point was:

Assets ($) Mkt. Val. of XLC 100,000 100,000 Liabilities and Equity ($) Loan Equity Total 30,000 70,000 100,000

Total

Once their account was in good standing, they went short 500 shares of PCM selling at $80. The account balance sheet was:

Assets ($) Mkt. Val. of XLC Deposit 100,000 40,000 140,000 Liabilities and Equity ($) Mkt. Val. of PCM Loan Equity Total 40,000 30,000 70,000 140,000

Total

This is where the account stands now. The margin ratio is: Margin = 70, 000 Equity = = 50% Market Value of Securities 100, 000 + 40, 000

which is above the maintenance margin. Note that the two market values are added even though one is on the asset side and the other is on the liabilities side.

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The broker will make additional loans to the account as long as the margin stays above the maintenance level of 40%. Suppose the share price of PCM becomes $86, the additional deposit of $3,000 will be loaned by the broker and the account position will be:

Assets ($) Mkt. Val. of XLC Deposit 100,000 43,000 143,000 Liabilities and Equity ($) Mkt. Val. of PCM Loan Equity Total 43,000 33,000 67,000 143,000

Total

The margin in the account will be 46.8%, which is above the maintenance margin. Now, if the market price of XLC drops to $32, the account balance sheet will be:

Assets ($) Mkt. Val. of XLC Deposit 80,000 43,000 123,000 Liabilities and Equity ($) Mkt. Val. of PCM Loan Equity Total 43,000 33,000 47,000 123,000

Total

The margin now is 38% which is below the maintenance level. The margin call will go out to the Murphys. They may restore their account by either adding cash, or selling some shares of XLC, or buying some shares of PCM. If they choose to add cash, they will have to add $39,100. The balance sheet, after adding cash, will be:

Assets ($) Mkt. Val. of XLC Deposit Cash Total 80,000 43,000 39,100 152,100 Liabilities and Equity ($) Mkt. Val. of PCM Loan Equity Total 43,000 33,000 86,100 152,100

1.8.4

Account Closing

An investor may close the whole account or some of the positions in the account at any time by selling the long securities, and buying back the short securities and returning them. The proceeds from selling the long holdings will create cash. The cash needed to close the short position will come from the collateral deposit. Neither of these actions will aect the equity position. The investor may reduce the equity by taking out cash from the account or completely close the account by reducing the equity to zero.

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In our discussion of margin accounts, we did not consider the eect of interest and commissions on the transactions. In reality these costs are incorporated as they are incurred. For example, if an investor buys 100 shares at the price of $31 per share and the transaction costs are $100 for this round lot, the investor will have to pay $3,200 to purchase $3,100 worth of shares. Similar costs will be incurred at the time of selling. Interest on loan outstanding will be deducted from the equity periodically (monthly or quarterly). While doing the exercises, you may let such costs accrue and assume they are paid in the end while closing the account.

1.9

Investment Information

All investment decisions depend on information. Without proper information and the ability to interpret and use it, investors will not be able to make proper decisions. The most popular sources of investment information are nancial and business publications such as The Wall Street Journal, Financial Times, Barrons, Business Week, Forbes, Money Magazine, and Fortune. Several TV programs are also good sources of information. Nightly Business Report and Wall Street Week on PBS, and various business related programs on CNN are some of them. CNBC is a cable channel dedicated to nancial programming. TV news services such as CNN Headline News and CNBC display a ticker tape at the bottom of the screen during the trading hours. This ticker tape shows the trades as they happen. The company names in these trades are indicated using special symbols known as ticker symbols. You can nd the list of ticker symbols in The Wall Street Journal stock tables. The ticker tape shows the most recent trade and the price at which the trade took place. For example, IBM 3s58 on the tape means that 300 shares of IBM were traded at $58 per share. If you really get serious about investing, you may want to subscribe to a computerized news services such as Dow Jones News Retrieval (DJNR). DJNR lets you access the breaking business and political stories from around the world. You may also be connected to a broker through your computer and a modem, and be able to place your order instantly after reading a news item from DJNR. Like any specialized subject, investment markets have their own jargon. To a novice the nancial news may sound like a foreign language. You will have to follow these news sources for a few weeks before you become comfortable with the terminology. You should make it a habit to watch at least one hour of nancial news a week. Also, go through the Money & Investing section of The Wall Street Journal at least once a week. Probably the single most popular investment term is Dow Jones Industrial Average (DJIA). The DJIA is an index of the prices in the stock market. The index is created by summing the prices of 30 carefully selected stocks of industrial companies in the NYSE and dividing the sum by a constant. DJIA is intended to be a measure of the prices of the stocks in the market. There are other broader indices, e.g., the Standard and Poors 500 (S&P 500), and the NYSE and NASDAQ composites. While following these indices you should

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keep in mind that it is the relative change in the index value, and not the index value itself, that is important. For example, the news that Dow closed at at 3,721.50 today is not of much use without knowing that yesterday it was 3,710. Over the period of one day the index value increased by 11.50. This represents an increase of 0.31% in one day. The change in the index is useful to the investors in assessing the change in the value of their own investment portfolios. For example, if you hold a portfolio of securities which are very much like those included in the DJIA then by knowing that the DJIA went up by 0.31%, you know that your portfolio value also went up by about 0.31%. Other economic data items to watch for are the number of issues traded, share volume, odd lot trading, short interest, etc. Most of this information is contained in the Money & Investing section of The Wall Street Journal. General information about the economy as a whole e.g., interest rates, money supply, GNP, and dollar exchange rates are also important because they have a bearing on the value of the securities.

1.10

Market Regulation

Securities markets are mostly self regulated. Self regulation works quite eciently most of the time. Nevertheless, sometimes special events require intervention of outside agencies. An important external agency that watches over the securities issue and trading is the Securities and Exchange Commission (SEC). The SEC sets the reporting requirements for corporations and brokerage houses. It also keeps a watch on the trading to make sure that there are no irregularities or fraud. Some areas of trading fraud being examined by the securities regulators are insider trading and market manipulation. An insider trade is a trade driven by information that should be available to corporate insiders only. Market manipulation refers to xing the market price by a brokerage house or by an institutional investor using false information or tricks such as block trades. Insider trading and market manipulation are considered damaging to the market because they deter other investors from the market, and if investors stay away from the market, it may be dicult for corporations to raise capital, which in turn hurts the economy as a whole.

1.11

Conclusion

A wide range of information about the securities markets was presented in this Chapter. This Chapter was intended to only introduce the basics of the securities markets. You should consult the additional readings listed below for detailed information. The investment environment is changing constantly and therefore the best source of information is current literature and news. Therefore, you should make it a practice to read and watch business news regularly. You may also want to call up some brokerage houses and ask for free literature on various investment alternatives.

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Additional Reading

Educational Service Bureau. The Dow Jones Averages: A Non-Professionals Guide. Dow Jones & Co. Inc., 1986. A good description of the Dow Jones Averages. Sonny Kleineld. The Traders. New York: Holt, Rinehart and Winston, 1983. An entertaining look at the lives of the traders in various securities markets. Matthew Lesko. The Investors Information Sourcebook. New York: Harper Row, 1987. A good desktop reference for where to nd investment related information. New York Stock Exchange. Fact Book. Detailed information about the NYSE. New York Stock Exchange. Margin Trading Guide. Good practical information about margin trading. U. S. Securities and Exchange Commission. The SEC: Organization and Functions. The Investments Reader, Jay Wilbanks (ed.), Homewood, Ill: Richard D. Irwin, 1989. pp. 1139. A summary of what the SEC is all about. Richard Saul Wurman, Alan Siegel, and Kenneth Morris. The Wall Street Journal Guide to Understanding Money & Markets. New York: Access Press, 1989. An excellent reference for the general information on the securities. Kenneth M. Morris and Alan M. Siegel. The Wall Street Journal Guide to Understanding Personal Finance. New York: Lightbulb Press, 1992. An excellent reference for personal nance and information on the securities.

Exercises

1.1 Return On January 1, 1990 Rebecca Wong bought a commercial paper issued by GMAC for $98,000. Three months later the commercial paper matured and she received a check for $100,000 from GMAC. What was the rate of return on Rebeccas investment? Return On March 15, 1988, John bought 100 shares of Federal Express at 24 1/2. John sold the shares a year later for 27 3/4. There were no other payments or costs involved. What was the rate of return on Johns investment? 1.3 Round and Odd Lots Mr. Williams owns 375 shares of D/A Devices, Inc. The bid and ask prices for the stock are $2.75 and $3.00. The commission charges on a round lot are $12. On odd lot trades the commission is $0.15 per share. How much money will Mr. Williams receive if he were to sell all his shares? Transaction Costs and Return Alvin Lee got a tip from his brother Ric that the stock of Ten Years After (TYA) should be in big demand soon because of their new product called A Space In Time. Alvin immediately called his account executive, Leo Lyons, and issued a market order to buy 200 shares of TYA. The oor broker for Leos company lled the order when the bid and ask prices for TYA were 13 1/8 and 13 1/4. One month later, when the price had indeed climbed, Alvin called his AE again and issued a market order to sell the shares. The shares were sold when the bid and ask prices were 15 1/2 and 15 7/8. The commission charges for the transactions were 2% of the value of the transaction. 1.4 1.2

Securities Markets

(a) What was the initial outow from Alvins pocket for the shares? (b) What was the inow to Alvin from the shares? (c) What was the rate of return?

26

Round Trip Transaction Cost Alice Jenkins placed an order to buy 100 shares of Kodak. The order was executed when the bid and ask prices were 47 1/4 and 47 1/2. How much money did she send in for this transaction? Assume that there were no commission expenses. Two weeks later, Alice realized that she should not have made this investment. She called her AE and asked him to sell the shares. The shares were sold when the bid and ask prices were exactly the same as when the shares were bought, i.e., 47 1/4 and 47 1/2. How much money did she receive from this transaction? What was the round trip transaction cost? Who received the money paid by Alice? What would the round trip cost have been if the brokerage commissions were 2% of the trading value? 1.6 Long and Short

1.5

(a) You bought 100 shares of AT&T on January 1, 1991 at $30 per share. What is the maximum prot you can make? What is your maximum possible loss? What are the corresponding maximum and minimum returns? (b) Your friend went short 100 shares of AT&T on January 1, 1991 at $30 per share. What is the maximum prot she can make? What is her maximum possible loss? What are the corresponding maximum and minimum returns? 1.7 Short Interest What are the short interests in the following cases?

(a) Ramone Fernandes is long 500 shares of IBM. (b) Sheila Stewart is long 300 shares of Kodak and short 200 shares of Kodak. (c) Andrew Johnson is long 200 shares of AT&T and short 200 shares of AT&T. (d) Brenda Myers is long 200 shares of Sears and short 500 shares of Sears. (e) Glen Watkins is short 300 shares of McDonalds. (f) Susan Love is long 200 shares of IBM and short 500 shares of McDonalds. 1.8 Shorting Against the Box Gorba the Zeek bought 500 shares of Purex, Inc. at $19 on March 15, 1988. On August 30, the price had gone to $35. While Gorba was pleased with the performance of his investments, he was worried that his prots would vanish if the price took a downswing. For tax reasons Gorba did not want to sell his shares in 1988. So, he borrowed 500 shares from a friend and sold them short. He closed all his positions on January 1, 1989 when the price was $50. What was Gorbas prot from the investment? What would Gorbas prot had been if the price on January 1 were $15? 1.9 Margin Accounts Ms. Millers brokerage account requires a 60% initial margin and 40% maintenance margin. Ms. Millers rst transaction was to purchase 500 shares of a stock at $40 using full initial margin. (a) What were the initial equity and loan balances in her account? (b) At what stock price will she receive a margin call?

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(c) Today the stock price fell to $20. How much cash will Ms. Miller be asked to add to her account to bring the account to the initial margin level? (d) The account executive (AE) tried to get hold of Ms. Miller. Ms. Miller, however, was not available. How many shares must the AE sell to restore the account to the initial margin level? 1.10 Margin Accounts Jack Bruce has a margin account with the brokerage rm of Smith & Wesson. The initial and maintenance margins on his account are 60% and 40%, respectively. The interest rate on margin loans is 11% per year. On October 11, 1988, Jack purchased 500 shares of Toledo Bakeries at $18. He took the maximum loan possible to make his purchase. The stock did not pay dividends during the year and today (October 11, 1989) Jack is selling his shares for $20 each. (a) Show the position of Jacks account after the initial transaction on October 11, 1988, and today before the sale of the shares. (b) Calculate the return on Jacks investment during the year. (c) Jack was lucky that the stock price went up. If the price had started going down, Jack would have received a margin call sooner or later. Determine the stock price at which Jack would have received the margin call. 1.11 Margin Accounts Kate Bush opened a new investment account at Yoshida and Barenbom. Her account executive, Kenji Yoshida, explained that she had a margin account with initial margin of 75% and maintenance margin of 50%. Margin loans will be made to Kate at 9.2% per year. Kate started by asking Kenji to buy 100 shares of CMA for her at market using full margin. CMA is traded on the OTC. Kenji executed the trade when the bid and ask prices for the stock were 23 1/4 and 24 1/2, respectively. Yoshida and Barenbom charge a 3% commission for the OTC transactions. (a) How much money did Kate have to pay upon completion of the transaction? (b) A year later, Kate issued a sell order which was executed when the bid and ask prices were 27 and 27 1/2. How much money did Kate receive? (c) What was the rate of return on Kates investment? 1.12 Margin Accounts Dr. Hannibal Lecter opened an account with the brokerage company of Duran, Duran, Duran, and Duran. The initial and maintenance margin on his account are 75% and 40%, respectively. The opening transaction of Dr. Lecter was to purchase 500 shares of Classic Automobiles. The transaction was executed when the bid and the ask prices of the stock were 12 1/8 and 12 3/8, respectively. Dr. Lecter paid 90% of the value of the shares and borrowed the rest at 8% per year. He wrote a separate check to cover the commission expenses. (a) What was the position of Dr. Lecters account after the opening transaction? (b) At what stock price will Dr. Lecter receive a margin call? (c) Six months after the initial transaction, the bid and ask prices for the stock were 14 1/4 and 14 3/8. What was the margin of Dr. Lecters account?

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1.13 Short Selling and Margin Freddie, on a tip from his acquaintance Bertie, sold short 100 shares of Diet Purina at $12. Initial margin requirement on Freddies account is 70%. (a) What did the balance sheet of the account look like after this initial transaction? (b) The maintenance margin on Freddies account is 40%. At what price will Freddie get a margin call? (c) What are the two choices available to Freddie to make his account current if he gets the margin call? (d) Show the account positions after these choices have been executed. 1.14 Long, Short, and Margin On January 1, 1991, Earl Conway opened a margin account with a discount broker with initial and maintenance margins of 60% and 35%. (a) On January 1, he purchased 200 shares of AT&T at $30. How much cash did he send in if he took the maximum loan possible? What was the position of his account after this transaction? (b) On February 1, the price of AT&T was $32. Earl placed an order to short sell 100 shares of IBM selling at $104 per share. His account was considered to be in good standing on February 1. Calculate the margin in his account after the short sale is completed. Did he have to send any cash for this transaction? If yes, how much? What was be the position of the account after adding the cash? (c) On April 1, the price of AT&T was $34 and IBM was selling at $101. What was the margin in the account? (d) If Earl decided to liquidate his investments on April 1, what steps would he have taken? What would be the net proceeds to Earl assuming that there were no transaction costs or interest? What would be the net proceeds if the transaction costs were 1.5% of the trade value and the interest rate on the margin loan was 2.1% per quarter? 1.15 Shorting Against the Box and Margin On August 1, 1987 Ms. Agatha Forsythe bought 1,000 shares of UBM for $21.50 per share. Ms. Forsythe used her initial margin of 50% to purchase these securities. The broker provides loans at a simple interest of 1% per month. The interest is not payable till the account is closed. The broker does not charge any commission. Show the status of her account after this purchase. By October 1, 1987 things had vastly improved for Ms. Forsythe because the price of UBM had climbed to $45.75. What did the account look like on October 1, 1987? During late evening of October 1, 1987 Ms. Forsythe received a phone call from a close friend who predicted that a major stock market crash was imminent. Convinced after a long talk, Ms. Forsythe decided to sell her securities and get out of the market. What would be the prot to Ms. Forsythe at this point if she closed her account? When she told her broker about closing the account, the broker almost chuckled, No way, Agatha, the market is much too strong to go down during the next year or two. I am a professional, you should listen to me. Crash. Huh! Ms. Forsythe, however, had more faith in her friend. She insisted,What if the market does go down and I lose all my prots? I want to sell my shares now. But, the broker said, if you sell your shares now you will have to pay taxes on your gains in 1988. If you wait till January 1, you will defer your taxes till 1989. This made sense to Ms. Forsythe. After all, why pay taxes now if they could be delayed. She asked the broker if he knew of a way by which she could lock in her prots but not have to pay taxes till later. The broker suggested to Ms. Forsythe to short sell 1,000 shares of UBMnot the ones that she owned but a dierent 1,000 shares that she would borrow from the broker. How much cash did Ms. Forsythe have to add to her account to accomplish this transaction to stay above maintenance margin of 25%?

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Verify the brokers claim by looking ahead to January 1, 1988. Create the statement of Ms. Forsythes account rst assuming that the price of UBM went up to $50 and then assuming that it went down to $20. Calculate the prots on January 1, 1988 under each scenario. Summarize your ndings about shorting against the box by comparing the numbers for January 1, 1988 with the corresponding numbers from October 1, 1987.

Return and risk are the basis of all investment decisions. In this chapter you will learn how to dene and measure return and risk. You will also learn about investors attitudes towards risk and the resulting relationship between return and risk.

2.1

Return

Returnrate of return on investment to be precisearises from the prot on an investment. Return is also known as interest rate and yield. Suppose you bought 100 shares of DEC at $55 for a total of $5,500, and sold them a year later at $62 for a total of $6,200. You made a prot of $7 per share, or a total of $700. For analysis and decision making we would like to be able to compare alternative investments. It may not be possible to compare alternative investments using prots because prots depend on the amount invested: the higher the investment, the higher the prot. To get around this problem, prots are divided by the amount invested to calculate return. Return is comparable across securities regardless of the amount invested. The return on your investment in DEC, for example, was 700/5,500 = 0.127 or 12.7 percent. The same answer is obtained if we use per share values rather than total values: 7/55 = 0.127. In most of the illustrations and exercises, we will use per share values rather than total values. Let us take another example. Suppose you bought 200 shares of IBM at $107. Three months later, you received a dividend of $1 per share and then you sold the shares at $110. Your prot was: $1 (from dividend) + $3 (from change in price) = $4. The return on your investment, therefore, was 4/107 = 0.037 or 3.7%. Suppose we want to compare returns from investments in DEC and IBM. The return on DEC was 12.7% while that on IBM was 3.7%. It seems, therefore, that DEC was a better investment. However, by comparing the DEC return of 12.7% with the IBM return of 3.7%, we are essentially comparing apples and oranges. The two returns were earned over dierent periods: DECs return was earned over a year while IBMs over only three months. We 30

31

made the mistake of comparing the returns earned over dierent periods because we did not include the time unit when stating the returns. The proper way to state the returns would be 12.7% per year for DEC and 3.7% per quarter for IBM. Now, we would be less likely to make the mistake of comparing 12.7% with 3.7%. If we do want to compare them, we will have to convert them to identical time units. We will see how to do that in the next section. Let us take one nal example. Suppose you bought 100 shares of General Motors at $47, held them for three months, received a dividend of $0.40 per share, and sold them at $45.50. The return on your investment was 1.10/47 = 0.023 or 2.3% per quarter. This example shows that it is possible for return to be negative. The return can take values between 100% and +. The return cannot be less than 100% because the maximum you can lose is your initial investment. There is no limit to how high your prots can go because the stock price can keep rising without limit. These observations about maximum and minimum returns assume positive initial investment, i.e., a long position. With short selling, the highest possible return is +100% while the lowest possible return is . Let us write the denition of return in algebraic notation. Suppose a person invests w0 in some securities and the value of the securities some time later becomes w1 , then the rate of return r can be calculated as: w1 w0 r= . (2.1) w0 The numerator in equation (2.1), w1 w0 , represents prots from the investment. The prot may come from one of the two sources: Capital gain: It results from an increase in the value of the securities. A negative capital gain is a capital loss. Income: Commonly known examples of income are dividends and interest. Separating the prot into capital gain and income components, we can write equation (2.1) as: r = or, r = p1 p0 + d p0 p1 p 0 d + , p0 p0 (2.2a) (2.2b)

where p0 is the initial purchase price, p1 is the nal selling price, and d is the income. The rst part of the right hand side in equation (2.2b) is the return from the price change alone. It is also known as capital gains yield. The second part is the return from the income. It is known as current yield in the case of bonds and dividend yield in the case of stocks. A high dividend yield is important to those investors who seek regular income from their investments. Those investors who seek growth of their capital look for investments with low dividend yields.

32

In these equations, we ignored the taxes and transaction costs incurred by the investor. This is customary in the investment literature. The reason is that dierent investors have dierent taxes and transaction costs. Ignoring taxes and transaction costs puts all securities on a common footing and often provides a meaningful basis for comparison across securities. To determine the return from an investment in a real life situation, one should use the actual cashows which take taxes and transaction costs into account. The equations and the examples given above are necessarily simplistic. They involve only two transactions: the initial investment (cash outow) and the nal redemption (the cash inow). We also assume that the income from the investment is received at the same time as the investment is redeemed. The situation described by the examples above is known as a single period situation. Most real life situations are multiperiod because they involve multiple cash ows. For example, you may buy some shares, receive quarterly dividends for several years and then sell them. We will see how to calculate the rate of return in such situations in Chapter 4. Rate of return can be viewed as growth rate also. For example, if you invest $100, and earn a return of 10% in a year, your prot will be $10, and the total value of your investment will be $110. Going from $100 to $110, your money will grow by 10% during the year, which is the same as the rate of return.

2.2

As we saw in section 2.1, to compare returns between two securities, we have to make sure that they are expressed in the same time unit. Therefore, we need to know how to convert returns from one time unit to another. Before going to the topic of conversion of units of return, read a short story:

A lady left her house at 4:00 and was pulled over by a cop at 4:15 for driving too fast. When the cop told her that she was going at 90 miles per hour, the lady lost her temper. She said, It cant be. I have been driving for only 15 minutes. How do you know I would have done 90 miles in the hour? But Maam, you were doing 90 when I caught you. said the cop, Here is your ticket. Have a nice day.

The moral of the story is that you dont have to be driving an hour for your speed to be measured at the hourly rate. The cops radar gun probably clocked the lady at 0.025 miles per second. The rest was easy. The radar gun just converted the speed from per second to per hour by multiplying 0.025 by 3600 because there are 3600 seconds in an hour. Actually, the conversion was necessary only because the cop would have looked pretty silly telling the lady that she was going 0.025 miles per second. The conversion of units of returns is necessary for similar reasons. It is customary to express the returns on an annual basis. However, you dont have to invest for a year for your return to be measured on an annual basis. Returns may be converted from one time unit

Return and Risk Table 2.1: Compounded growth of $1.00 at 3.7% per quarter for four quarters.

Quarter 1 2 3 4 Beginning Balance 1.000 1.037 1.075 1.115 Prot 1.000 0.037 = 0.037 1.037 0.037 = 0.038 1.075 0.037 = 0.040 1.115 0.037 = 0.041 Ending Balance 1.000 + 0.037 = 1.037 1.037 + 0.038 = 1.075 1.075 + 0.040 = 1.115 1.115 + 0.041 = 1.156

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to another quite easily. The assumption in such conversions is that the rate at which return was earned in a period will continue through other periods.1 Let us take the IBM example from section 2.1. The quarterly return there was 3.7%. What would be the corresponding annual return? Since there are 4 quarters in a year, based on the speeding example, you may be tempted to say 3.7% 4 = 14.8%. This is quick and easy but not correct. Conversion of units become a little complicated when we are dealing with percentages because the same percentage is being applied to dierent amounts in dierent intervals. Let us see this by following the progress of a dollar invested at the beginning of the rst quarter. Since the dollar earned a return of 3.7%, the prot at the end of the quarter would be 0.037 $1.00 = $0.037, making the accumulated sum to be $1.037. In the second quarter, 3.7% would be earned again (this is the assumption behind the conversion of units), but this return would now be earned on the amount at the beginning of the quarter, i.e., $1.037. The prot during the second quarter, therefore, would be 0.037 $1.037 = $0.038. The extra 1/10 of a cent comes from the interest earned during the second quarter on the interest from the rst quarter. This process of earning interest on interest is known as compounding. The compounding process for all four quarters is shown in Table 2.1. The Table shows that continuing at the rate of return IBM earned during the rst quarter, a dollar would have grown to $1.156 at the end of the year. The prot on a dollar, therefore, would have been $0.156. Therefore, the annual return on IBM was 15.6%. The conversion process can be summarized using the following formula: (1 + rq )4 = (1 + ra ), (2.3)

where rq is the quarterly rate of return and ra is the annual rate of return. In using this formula, the rate of returns should be expressed as fractions rather than percentages. To use the formula for the IBM example, we substitute rq = 0.037 and calculate ra as: ra = (1 + 0.037)4 1 = 1.156 1 = 0.156. So the annual rate is 15.6%, which is the same as the result of the long calculation.

1

The same kind of assumption was made by the radar gun in the speeding example.

34

Let us explore equation (2.3) a little bit. It gives the relationship between a quarterly rate and an annual rate. So, this equation can be used to convert from an annual rate to a quarterly rate also. For example, take the case of DEC in section 2.1. The annual return there was 12.7%. To express this rate on a quarterly basis, use equation (2.3), substitute ra = 0.127 and solve for rq : rq = (1 + 0.127)(1/4) 1 = 0.03034. The quarterly rate, therefore, is 3.034%. Equations similar to (2.3) can be written for other time units. The general form of those equations can be understood by carefully examining equation (2.3). In equation (2.3), to relate quarterly rate rq to the annual rate ra , we raise (1 + rq ) to power 4 because there are 4 quarters in one year. Using this logic, while relating a monthly rate rm and an annual rate ra , we would raise (1 + rm ) to the power 12 because there are 12 months in one year. So we can write: (1 + rm )12 = (1 + ra ). (2.4) Similarly, we can write some other relationships as: (1 + rs )2 (1 + rq )2 (1 + rm )3 (1 + rm )6 (1 + rd )365 = = = = = (1 + ra ), (1 + rs ), (1 + rq ), (1 + rs ), (1 + ra ) (2.5a) (2.5b) (2.5c) (2.5d) (2.5e)

where rs is the semiannual rate and rd is the daily rate. Using these formulae, you can convert a rate given in any time unit into another. More importantly, you should see the general pattern of these relationships so that you can write the formula for conversion from any unit to another.

2.2.1

Rates of return or interest rates are often stated as follows: 12% per year compounded quarterly. This statement is just another way of saying that the rate of return is 3% per quarter. 3% per quarter is the subperiod rate. Similarly, 15% per year compounded monthly means that the subperiod rate is 15/12 or 1.25% per month. The full period (annual) rates can be calculated using equations (2.3) and (2.4). The 12% in 12% per year compounded quarterly and 15% in 15% per year compounded monthly are known as stated rates that are being compounded during subperiods. The corresponding numbers used in and calculated using equations (2.3) and (2.4), respectively, are known as the eective rates. For example, for the stated rate of 12% per year compounded quarterly, the eective rates are 3% per

35

quarter and (1 + 0.03)4 1 = 0.1255 or 12.55% per year. Investment alternatives should be compared using eective rates because thats what they are actually earning. A special situation encountered in investments is of continuous compounding. In continuous compounding, the interest rate is compounded every instant. Let us examine the continuous compounding situation by comparing 12% per year compounded monthly with 12% per year compounded continuously. In the rst case, there are 12 subperiods while in the second case there are m subperiods where m is a very large number (tending to innity). The subperiod rate in the rst case is 0.12/12 while in the second case it is 0.12/m. Now, to nd the eective annual rate, for the rst case we will write: 1+ 0.12 12

12

= (1 + ra ),

because there are 12 subperiods (months) in a full period (year). Upon solving, we get ra = 0.1268 or 12.68% per year. Therefore, a stated rate of 12% per year compounded monthly is equal to an eective annual rate of 12.68%. We can write a similar equation for the continuous compounding case:

m

lim

1+

0.12 m

= (1 + ra ).

The lim is the notation for the fact that m is a very large number (tending to innity). m Mathematically, the left hand side of the equation evaluates to e0.12 where e denotes the exponential function. So we can write: e0.12 = (1 + ra ). Upon calculation, ra turns out to be 0.1275 or 12.75% per year. For the same stated rate, the eective annual rate with continuous compounding is a little bit higher than with monthly compounding because with continuous compounding, interest is earning interest continuously while with monthly compounding it sits idle for a month between earning interest. In general, the more frequent the compounding, the higher the eective rate. The continuous compounding formula can be written in general notation as follows: (1 + re ) = er , (2.6)

where re denotes the eective rate and r denotes the stated rate that is being compounded continuously. The time units of r and re are identical. For example, for the stated rate of 3% per quarter compounded continuously, the eective rate is e0.03 1 = 0.03045 or 3.045% per quarter.

36

2.3

In Chapter 1, we saw that investors can borrow money (from the broker or other sources) for investments. Here we examine the impact of borrowing on the return on investors equity. Suppose you buy shares of XYZ selling at $10 in two dierent ways: 1. You buy 100 shares using your own personal funds. This investment, therefore, is nanced entirely by your equity, and is an unleveraged investment. 2. You buy another 100 shares for which you put $600 of your own money and borrow the remaining $400 at the interest rate of 10% per year. By borrowing money you are leveraging this investment. To see the eect of leverage, we will calculate the return on your equity in both the investments for various stock prices a year from now. To keep things simple, we will assume that the stock does not pay any dividends. Let us rst assume that the stock price goes up to $12 in one year. The value of the shares is $1,200. Since the stock price has gone up by 20%, the return on assets (shares) is 20% per year. Your unleveraged investment realizes a 20% per year return on equity because you realize a prot of $200 on your equity of $1,000. The net prot in the leveraged account after paying interest on the loan is $200 0.10 $400 = $160.2 This prot, however, is on your investment of $600. Therefore, the return on equity is 160/600 = 26.67% per year. Let us assume that the stock price goes up to only $10.50. The return on stock and the unleveraged investment is 5% per year. The net prot on your $600 investment in the leveraged account is $50 $40 = $10 making your return on equity equal to 1.67% per year. Finally, let us assume that the stock price goes down to $9.00. This results in a rate of return of 10% on the stock and your equity in the unleveraged account. In the leveraged account, your net loss is $140, leaving you with a return on equity of 23.33% per year. Table 2.2 summarizes our results. ROA in the Table refers to the return on assets (shares), and ROE is the return on equity (the personal investment capital). The relationship between ROE and ROA can be expressed algebraically through the following equation: D ROE = ROA + (ROA i), (2.7) E

2 Another way to calculate the net gain is as follows: Sell the shares for $1, 200, use $440 to pay back the principal and interest on loan, and be left with $760. Since the initial investment was $600, you have a net gain of $160.

Return and Risk Table 2.2: The eect of leverage on return on equity (ROE).

ROE ROA 20% 5% 10% Unleveraged 20% 5% 10% Leveraged 26.67% 1.67% 23.33%

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where D is the debt to equity ratio used to purchase the securities, and i is the interest rate E on the debt. To verify the equation, let us apply it to our second scenario. ROA = 0.05, D = 400/600 = 0.67, i = 0.10. So, E ROE = 0.05 + 0.67(0.05 0.10) = 0.0167 = 1.67%. The numbers in the Table show that the rate of return on an unleveraged investment is equal to the rate of return on the security. Equation (2.7) also supports this observation because D is zero for an unleveraged investment makes ROE equal to ROA. E This relationship between the return on equity, leverage, and the return on assets leads to the following conclusion: If the rate of return on the security is higher than the interest rate on the loan then leveraging leads to a higher rate of return. Conversely, if the rate of return on the security is lower than the interest rate on the loan then leveraging leads to a lower rate of return. Leveraging, therefore, is useful if an investor believes that the securities are going to provide a rate of return higher than the rate of interest on the loan. Speculators borrow money for investment purposes because they believe that their securities will provide a higher rate of return than the interest rate on loan.

2.4

Our discussion so far has involved situations where we examine the return after the outcome of investment has been realized. The investment returns, therefore, have been known. Now we will discuss the situation where we have to make a decision about investment whose outcome will be realized in the future. The cash ows and the return on the investment, therefore, are not known with certainty. At best, we may assign probabilities to the various possible values of cash ows and returns. Suppose you buy 100 shares of IBM at $102. You may visualize the situation one year later as follows: There is a good chance (50%) that the dividends and the selling price of each share will be worth $110; there is some chance (30%) that it will be worth $105; and there is a small chance (20%) that it will be worth $100. We

38

can convert the various future prices to returns using equation (2.2) on page 31. For the ending value of $110, the return will be 7.84%; for the ending value of $105, the return will be 2.94%; and for the ending value of $100, the return will be 1.96%. The information about the possible values and associated probabilities is known as a probability distribution. The variable described by the probability distribution is known as a random variable. Security prices and returns are random variables. In the IBM example, the probability distribution was discrete because there were only a nite number of possible values. In reality, the future stock price can be anywhere between 0 and +, and the return, therefore, can be anywhere between 100% and +. Describing the probability distribution for a variable that can take innitely many values requires a continuous probability distribution. In continuous probability distributions, probabilities are assigned to ranges of values rather than individual values. Here is an example of continuous probability distribution: There is a 40% chance that the return on the common stock of Sears will be 10% or more, a 30% chance that it will be between 0% and 10%, and a 30% chance that it will be less than 0%. You may divide the range of possible values (100% to +) into many more intervals. Security prices and returns are continuous random variables.3 The prices and returns are not independent. They are related by equation (2.2) shown on page 31. Therefore, once we know about one of these variables, we can determine the other variable easily.

2.5

Since security returns are random variables, we cannot know with certainty what the actual return will be. The uncertainty about return introduces risk in our decision making process. Investors view risk as the probability that the actual return will be less than some specied amount. Some people may regard risk as the probability of losing money, i.e., earning a return of 0% or less. Others may regard risk as the probability of earning a return less than what the local bank is oering. Mathematically, we can write the denition of risk as: Risk = Prob (r < r ), (2.8)

where Prob() denotes the probability of the condition described within the parentheses, and r is the cuto return established by the investor to measure risk. All investment decision making situations involve risk because the actual outcome of investment cannot be known with certainty. The decision, therefore, should take risk into account. One way to take risk into account would be to incorporate the entire probability distribution into decision making. That, however, would be an impossible task because returns have a continuous distribution, and therefore, involve innitely many values.

3 We are ignoring the fact that because of the trading regulations, the stock prices move in ticks and therefore cannot take values that fall between the ticks. For example, the stock price can either be 100 1/8 or 100 1/4 but not anywhere between these two values.

Return and Risk Figure 2.1: Stock returns have a normal distribution.

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AT&T

IBM

. . . . . . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Kodak

Sears

A result from statistical decision theory comes to our rescue. The theory shows that the decisions made using the expected value and standard deviation of the probability distribution will be identical to the ones made using the entire probability distribution if the probability distribution is normal. The reason behind this result is that the normal distribution is described fully by the expected value and standard deviation. Therefore, if returns have a normal distribution, we can make decisions using just two key characteristics of the distribution: the expected value and the standard deviation. Strictly speaking, security returns cannot have a normal distribution because the stock returns can take values between 100% and + while the normal distribution runs between and +. However, it is possible that the stock returns approximate the normal distribution so closely that we may treat them as if they have a normal distribution. Figure 2.1 shows the frequency distribution of returns on four stocks superimposed on the theoretical normal distribution. The frequency distributions were calculated from monthly returns for the stocks for 360 months between January 1965 and December 1994. Visually, the frequency distributions seem to approximate the normal distribution. A careful scientic test would be based on the 2 goodness of t test. Results from such statistical tests suggest that security returns do indeed approximate a normal distribution. Therefore we will use expected return and standard deviation of returns for decision making. The expected return is a measure of the return investors may expect from an investment. The actual return will surely deviate from the expected return. The deviation is measured using standard deviation. Under the assumption of normal distribution, standard deviation of returns is a measure of risk because the higher the standard deviation, the higher the probability that the return will be away from the expected value, and therefore, the higher

Return and Risk Figure 2.2: Standard deviation of returns is a measure of risk.

= 10% . . . . . = 20%

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0% 10% A

0% 10% B

the probability that it will be less than the cuto point as described in equation (2.8). Let us take an example. Suppose the expected return and standard deviation of return for stock A are 10% per year and 10% per year. Suppose you dene risk as being the probability that the return will be less than 0% per year. This can be determined by calculating the z score and using the normal distribution table printed at the end of the notes. The z score is (0 10)/10 = 1. Using the normal distribution table, we see that the probability is 0.1587. Stock B also has an expected return of 10% but a standard deviation ( ) of 20%. The z score for getting a return less than 0% from this stock is (0 10)/20 = 0.5. The probability of getting a return less than 0%, therefore, is 0.3085. The probabilities are illustrated graphically in Figure 2.2. Note that the stock with a higher standard deviation also has a higher probability of getting a low return. Therefore, the stock with higher standard deviation is riskier.

2.6

We may estimate the expected return and standard deviation of return for a security using a sample of historical data if the returns uctuate randomly without any growth or systematic pattern. Figure 2.3 shows monthly returns on the common stocks of AT&T, IBM, Kodak, and Sears during the ve year period (60 months) of January 1990 to December 1994. You can see that there is no systematic growth or cyclical pattern in these returns. Similar behavior is seen in the rates of returns on most investments during most periods. Therefore, it is reasonable to use past returns as a sample for the future behavior of returns. Suppose today is December 30, 1994 and we want to estimate the expected return and standard deviation of returns for January 1995 for the common stock of AT&T. We need to collect historical data for estimation. Since we are interested in obtaining estimates for the monthly return, we have to collect monthly data. We have to decide how many observations to collect and for what period. Having too few observations would make our estimates unreliable and collecting too many observations would be time consuming and may bias the

41

Figure 2.3: Monthly returns on four stocks (January 1990 to December 1994).

AT&T 0.20 0.15 0.10 0.05 0.00 0.05 0.10 0.15

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IBM 0.20 0.15 0.10 0.05 0.00 0.05 0.10 0.15 0.20 0.25 0.30

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Kodak 0.25 0.20 0.15 0.10 0.05 0.00 0.05 0.10 0.15

. . . . . . . . . . . . . . . . . . .. . . . . .. . . . . . .. . . . . . . .. . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . .. .. . . . . . . . . . . . . . . . . . . . . . . .. .. . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . .. . . . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . .. . . .. . .. . . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . .. .. .. . .. .. . . . . . . . . . . .. . . . . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . .. . . . . . .. . .. . . . . . . . . . . . . . .. . . . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. .. . .. .. . . . . . . . . .. . . . . .. .. . . . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . .. . . . . . . . . . . . .. . . .. . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . .

Sears 0.25 0.20 0.15 0.10 0.05 0.00 0.05 0.10 0.15 0.20

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t 1 2 3 4 5 . . . 57 58 59 60 60 Month 01/90 02/90 03/90 04/90 05/90 . . . 09/94 10/94 11/94 12/94 r 0.1429 0.0192 0.0650 0.0446 0.0748 . . . 0.0054 0.0185 0.1068 0.0295 0.3507 r2 0.020420 0.000369 0.004225 0.001989 0.005595 . . . 0.000029 0.000342 0.011406 0.000870 0.200888

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estimates because the estimates will be based on data from too far back. For our example, we will use 60 monthly returns, from January 1990 to December 1994. Each of these returns was calculated using equation (2.2) on page 31. For example, if the prices at the beginning and the end of a month are $10 and $10.25, and the dividend for that month is $0.15, then the return for that month is (10.25 10 + 0.15)/10 = 0.04. Table 2.3 shows the returns and some other information needed for calculations.4 The bottom row in the Table shows the summary statistics needed for calculations.5 The number under the rst column shows the number of observations while the other numbers are the sum of numbers in that column. The expected return for the stock, denoted by , is estimated by the average return: . (2.9) T The expected return on the stock of AT&T during January 1995, therefore is: 0.3507 = = 0.0058 = 0.58%. 60 The standard deviation of returns, denoted by , is estimated by the sample standard deviation from the historical data: =

4 5

( r) r2 T . T 1

(2.10)

Full data is shown in a table at the end of the notes. Table 2.3 only shows the rst few digits of the numbers. The calculations were performed using full accuracy.

43

Note that we use T 1 in the denominator realizing that we are estimating the standard deviation using a sample.6 The standard deviation for AT&T returns is calculated as: = 0.200888 59

(0.3507)2 60

= 0.0581 = 5.81%.

The expected return and standard deviation for security returns using historical data are only as reliable as the data itself. Often, you may have additional information about the future that is not contained in the historical data. In such situations, you should adjust the statistical estimates accordingly. For example, if you believe that the future returns of AT&T will be higher than the last ve years because of the recent acquisitions, you should adjust the historical estimate of expected return up by a suitable amount. In these notes, to eliminate the subjectivity, we will rely primarily on the historical data. Statistical calculations can be done easily using spreadsheet programs because they have built-in functions for the number of observations, average, and standard deviation for the values in a spreadsheet range. For example, in Microsoft Excel, count(a1:a60) calculates the number of observations in the spreadsheet range a1:a60. Similarly, average(a1:a60), and stdev(a1:a60) give the average, and standard deviations of the values in the range a1:a60.

2.6.1

The expected return and standard deviation for security returns may be used to answer some important questions related to investments. Let us do some calculations for AT&T using the results from above. Let us say we want to nd out the range of possible values for the return on AT&T during January 1995. This information will be useful in determining the highest and the lowest possible returns from the stock. This range is the condence interval. Suppose we want to nd out the 95% condence interval. Since we have a large number of observations, we can use the critical z value of 1.96 for this purpose. The 95% condence interval is [ z, + z ] or [0.0058 1.96(0.0581), 0.0058 + 1.96(0.0581)] or [0.1079, 0.1196]. This calculation shows that there is a 95% probability that the actual return for AT&T during January 1995 will be between 0.1079 and 0.1196. Another quantity we may be interested in is the probability that the return will be in some range. For example, let us calculate the probability of losing money on AT&T, i.e., its return being less than 0. The z score for this probability is (0 0.0058)/0.0581 = 0.10. From the normal distribution table we nd that the probability of a z score less than 0.10 is 0.4602. Therefore, there is a 46.02% probability that the return on AT&T during January 1995 will

6 You may be accustomed to denoting the sample standard deviation with an s rather than a . Since we never need the population standard deviation in this course, we will use as the symbol for standard deviation, even if it is a sample estimate.

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be less than 0. Let us now calculate the probability that the return will be between 5% and 10%. The z scores corresponding to these values are (0.05 0.0058)/0.0581 = 0.76 and (0.10 0.0058)/0.0581 = 1.62. Using the normal distribution table we nd the probability that the return will be between 5% and 10% is 0.1710. So there is a 17.10% chance that the return on AT&T during January 1995 will be between 5% and 10%. We can also convert our statistical estimates for returns into estimates for prices. To keep things simple, we will assume that the stock will not pay any dividend during January 1995. The relationship between the future price, current price, and return can then be written by manipulating equation (2.2) on page 31 as: p1 = p0 (1 + r ). (2.11)

The closing price of AT&T on December 30, 1994 was $50.250. The expected price at the end of January 1995 can be calculated using equation (2.11). For the calculation, r is 0.0058 and p0 is 50.250, so that p1 = 50.250(1 + 0.0058) = 50.544. So the price of AT&T at the end of January is expected to be $50.544. Now, let us calculate the 95% condence interval for the stock price at the end of January. Since the lowest and highest returns for this interval are 0.1079 and 0.1196 as calculated above, the corresponding prices using equation (2.11) are 50.250(1 0.1079) = 44.826 and 50.250(1 + 0.1196) = 56.261, respectively. So there is a 95% chance that the price of AT&T at the end of January 1995 will be between $44.826 and $56.261. As a nal illustration, let us estimate the probability that the price will be greater than $60. For the price to be greater than $60, the return will have to be greater than (60 50.250)/50.250 = 0.1940. The probability of return being greater than 0.1940 can be calculated easily. First we calculate the z score as (0.1940 0.0058)/0.0581 = 3.24. Now we look up the normal distribution table and nd that the probability is 0.9994 or 99.94% that the price will be more than $60. Note that in all calculations involving prices, we do not apply normal distribution to prices directly. We convert price information to returns and then apply normal distribution to returns. This is because prices do not have a normal distribution but returns do.

2.7

Sources of Risk

Risk in an investment may arise from several sources. Some of these are macroeconomic and aect most of the securities. Examples of macroeconomic factors are GNP, unemployment, oil prices, and currency exchange rates. If you watch business news regularly, you will see frequent mention of security prices reacting to these macroeconomic variables. Other factors are industry, rm, or security specic. For example, a new breakthrough in chip manufacturing technology will aect the securities of computer industry, or a strike by the labor union in a company will eect only that company.

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The sources of risks from an investors point of view are grouped into three categories described below: 1. The most important source of risk is the uncertainty about the prots. When you buy shares of common stock, there is uncertainty about the dividends and for how much the shares may be sold later. Bonds are somewhat dierent in the sense that their issuers promise a xed interest amount periodically. Also, if the investor holds the bond till the date of maturity, the issuer promises to pay the face value of the bond. Notice that the key word is promise. Occasionally an issuer is not able to keep its promise, i.e., it is unable to pay the promised interest or the face value. In that situation the bond is said to be in default. The issuer has to declare bankruptcy and go through a tedious legal process. The investor may get some amount back from the bankrupt borrower but the amount that will be received is uncertain. Securities issued by the U.S. Treasury do not have the risk of default because they are backed by the U.S. Government and the Government can always print more money! 2. The second source of riskthe marketability riskis the uncertainty about being able to sell the security on a short notice. Only securities issued by obscure corporations have signicant marketability risk. 3. The third source of risk is the interest rate risk. This form of risk arises from the probability that the interest rates in the economy may change after you have made an investment, and this may cause the value of your investment to deteriorate. For example, suppose you bought a 10 year bond last year when it was yielding 12% per year. Since you bought the bond, the interest rates have gone up so that other similar bonds are yielding 15% per year. Your bond now has a lower value in the market and, therefore, if you decide to sell it you will get less money for it than you would have if the rates had not gone up. Even the securities issued by the Treasury have this kind of risk. 4. The fourth source of risk is the reinvestment risk. The source of this risk is the same as the interest rate risk, i.e., uctuations in the interest rates. However, it arises only in income (dividends or coupon interest) providing securities. The risk arises because the income provided by the security may have to be reinvested at a lower rate if the interest rates decline between the initial investment and when the income is received. 5. Another source of risk for all securities is unexpected ination. Since money loses purchasing power because of ination, a higher than expected ination would cause the real return on an investment to be lower than what one may have expected.

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . 3 2 1 . . . .. . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . .

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U3 U2 U1

U >U >U

2.8

Risk Aversion

An investors preference for a security depends on both expected return and risk. Borrowing the terminology from economics, we can denote this dependence through a utility function. We can say an investors utility depends on expected return and risk. Equation (2.12) illustrates the dependence of utility on expected return and risk. Utility = U (, ). (2.12)

Other things being the same, investors prefer higher expected return over lower expected return, and lower risk over higher risk. Since risk is an integral part of all investments, investors do have to take some risk. Being risk averse, investors will take additional risk only if it is accompanied by additional reward in form of a higher expected return. This characteristic of investors to demand a higher expected return from a risky investment is known as risk aversion. As an example, consider two investments: A and B. Both A and B have expected returns of 10% per year. However, their risks, as measured by the standard deviation, are 20% and 25%, respectively. Although B has a potential for higher returns, risk averse investors will not choose it because it also has a potential for much bigger losses. To risk averse individuals, avoiding a loss of $1 has more utility than receiving a gain of $1. They will accept B only if it has a higher expected return. The amount of extra expected returnpremiumthat B should oer for it to be acceptable will be dierent for dierent investors. Those investors who demand a higher premium are more risk averse than those who demand a lower premium. Suppose an investor will be equally interested in A and B if B oers an expected return of 12%a premium of 2%then that investor is said to be indierent between A and B. The investors indierence between the two investments implies that the utilities to the investor from these two alternatives are equal. We can, at least theoretically, determine all combinations of risk and expected return among which the investor is indierent. The

Return and Risk Figure 2.5: Indierence curves for dierent investors.

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3 . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . .. . . . . . . . . . . . . 2 .. . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. .. .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 . . . . .. .. .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

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I3 I2 I1

B B B

curve obtained by plotting the indierence points on a graph is known as an indierence curve. Figure 2.4 shows indierence curves for an investor. Dierent indierence curves for an individual correspond to dierent levels of utility, with higher indierence curves corresponding to higher levels of utility. Points on a higher indierence curve, therefore, are preferred over those on a lower indierence curve. To understand this, compare investment alternative A with C. Since C has a higher expected return than A for the same amount of risk as A, C is preferred over A. The slope of the indierence curve represents the acceptable risk-return trade-o. Dierent investors have dierent indierence curves. Furthermore, an investor may have dierent risk-return trade-os at dierent times depending on factors such as the level of risk taken, the investors wealth, and investors age. Figure 2.5 shows the indierence curves for three investors, I1 , I2 , and I3 . The utilities to all three investors from investment A are equal. However, as they are oered opportunities of more risk, they desire dierent amounts of expected returns to accept the additional risk. I1 is most easily satised investor and I3 requires the highest premium. Such dierences in investors risk preferences are described using degree of risk aversion and risk tolerance. I1 has the lowest degree of risk aversion while I3 has the highest degree of risk aversion. I1 , therefore, is less risk averse than I2 who is less risk averse than I3 . We can also state the dierences in risk attitudes by saying that I1 is more risk tolerant than I2 who is more risk tolerant than I3 . The indierence curves for risk averse investors slope up as shown in Figures 2.4 and 2.5. If the indierence curve for an investor is at, that investor is risk neutral. A risk neutral investor ignores risk and bases his decisions on expected return only. He prefers an investment with a higher expected return over one with a lower expected return. If the indierence curve for an investor is sloping downwards, that investor is risk loving. A risk loving investor likes risk so much that he is willing to accept a lower expected return from a

48

riskier investment. Risk neutral and risk loving behaviors may be exhibited in some special circumstances, such as gambling where other factors such as excitement and thrill also aect the choice among the alternatives. In rational investment decision making, investors are risk averse. Therefore, throughout these notes, we will assume that investors are risk averse.

2.8.1

Investors Objective

Since the utility from investment depends both on the expected return and risk, investors take both of these into account in deciding among the available securities. As we saw above, investors want to earn the highest expected return for a given level of risk and take the lowest possible risk for a desired level of expected return. This objective can be restated by saying that investors want to maximize their utility. In other words, they want to be on as high an indierence curve as possible. Since utility functions are hard to observe and measure, we may state the objective of an investor to be maximization of expected return for a desired risk. Alternatively, we can state it to be the minimization of risk for a desired expected return. Both these specications will put the investor on the highest indierence curve possible. These alternative specications of investors objectives are easier to operationalize because both risk and expected return are quantiable and measurable. Table 2.4: Statistics for 4 securities.

Security A B C D 0.10 0.15 0.10 0.15 0.20 0.20 0.30 0.30

2.8.2

Let assume that there are four alternative securities: A, B, C, and D. The expected return and standard deviations for these securities are shown in Table 2.4. Figure 2.6 shows these securities graphically. Between securities A and B, all risk averse investors will choose B because B has a higher expected return for the same amount of risk as A. This fact is stated by saying that B dominates A. For the same reason D dominates C. Between A and C, all investors will choose A because A has a lower risk for the same amount of expected return. Therefore, A dominates C. For the same reason B dominates D. Between B and C, all investors will choose B because B has a higher expected return and a lower risk. Therefore, B dominates C. Between A and D, there is no such obvious relationship. D has a higher risk but it also oers a higher expected return.

B A D C

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Therefore, whether an investor will prefer A or D will depend on the investors risk aversion and utility function. An investor may be indierent between A and D. A more risk averse investor will prefer A over D, and a less risk averse investor will prefer D over A. Understanding dominance relationships will make it easy to identify the preferred alternative when there are many alternatives from which to choose.

2.8.3

The conclusion from our discussion of risk aversion is that investors expect a higher return from a riskier security. If a risky security does not oer a high enough return, investors will not want to buy it. This lack of demand will bring down the market price of the security. As the price comes down, the security becomes a better bargain, and its return goes up. This process will continue until the return expected from the security is commensurate with its risk. Of course, dierent investors have dierent degrees of risk aversion. Therefore, they will desire dierent amounts of expected returns for the same risk. In spite of these dierences, if investors indeed are risk averse then we should observe securities with higher risk to have higher average returns. Figure 2.7 shows the standard deviations and averages of monthly returns for 60 stocks (indicated by s), the Treasury bills (indicated by ), and the S&P 500 index (indicated by ) for the period January 1965 to December 1994. The best t line is also drawn in the Figure. The best t line shows that the relationship between risk and average return is indeed positive. Therefore, we can conclude that higher risk securities do indeed provide higher average returns. The slope of the line in Figure 2.7 measures the extra return than an investor gets for taking an extra unit of risk. In other words, it is a measure of the risk premium that the securities market is oering for bearing the risk. The intercept, since it corresponds to zero risk, can be viewed as the return for bearing no risk at all, or simply the risk-free rate. The relationship between the average return and risk may be written as: Average return = Risk-free rate + Risk Premium per unit of risk. (2.13)

From Figure 2.7, we see that the standard deviation of the Treasury bills is negligible compared to that of the stocks. Frequently in our discussion in this course we will refer to

Return and Risk Figure 2.7: Risk-return relationship for 60 stocks, Treasury bills and S&P 500.

0.03

50

0.02 0.01

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0.00 0.00

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an idealized investment called risk-free security. Statistically, the returns on a risk-free security remain constant over time and therefore the standard deviation of its returns is zero. While there are no securities that are truly risk-free, Treasury bills come very close to it. Therefore, we will assume that the Treasury bill is a risk-free security and the average return on the Treasury bill is the risk-free rate.

2.9

In our discussion of risk and return, we learned that riskier securities have higher average return. Risk, however, is only one of the many factors that aect the interest rates. In this section we examine other major factors that determine the rates of return. Since all the rates in the economy are connected, a change in one interest rate is transmitted to other rates. For example, if the banks start oering a higher rate on savings, stocks have to oer a higher return also otherwise many risk-averse investors will withdraw their money from stocks and deposit it with the banks. Therefore, a knowledge of the factors that aect the key interest rates will be useful in understanding their eects on the rates of return. During this discussion, it may be helpful to keep an alternative interpretation of interest rates. Since investors like more money rather than less, they are inconvenienced when they have to give up some of their money for some time. Therefore, they demand a compensation for this inconvenience which is what we call interest rate or rate of return. The factors we will discuss below are various forms of inconvenience.

Return and Risk Figure 2.8: Monthly T bill returns and expected ination.

0.80

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12/90

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Date

2.9.1

Basic Rate

Basic rate refers to the rate of interest we would charge for lending and borrowing money in absence of all other factors. The basic rate depends on the demand and supply of money. If everyone has a lot of money then the basic rate will be low. Conversely, if there is a great demand for funds then the rate will be high. It is impossible for us to observe the basic rate because the observed rates are contaminated by other factors. Conceptually, however, the basic rate is very important because the observed rates are built on this rate.

2.9.2

Expected Ination

Investments provide cashows in the future. Since ination reduces the purchasing power of the cashows, investors demand higher rates when they expect the ination to be higher. The expected rate of ination aects all the interest rates in the economy. The easiest way to observe the eect of ination on interest rates is through the time series of an interest rate in the economy. The solid line in Figure 2.8 shows monthly returns on the Treasury bills from January 1990 to December 1994 and the dashed line shows the expected ination rates, estimated as the twelve month moving average of actual ination. The Treasury bill returns seem to be highly correlated with the expected ination rates.

7.25%

Yesterday

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1 week ago

3 mos.

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5 7 10

30

2.9.3

Time to Maturity

Another important factor in determining interest rates across securities is how long the money will be tied-up in the investment, i.e., when the security will mature. The behavior of interest rates with respect to the time to maturity is known as the term structure of interest rates. We observe the dependence of interest rates on the time to maturity in the car loans. A two year loan may have an annual rate of 4.8% while a ve year loan may cost 10.2% per year. The term structure of interest rates in the securities markets can be observed in the Treasury Yield Curve which is printed in the Credit Markets section of The Wall Street Journal every day. Figure 2.9 shows the Treasury Yield Curve as it appeared in The Wall Street Journal of Tuesday, August 8, 1995. There are three lines in the yield curve. The solid line is for August 7, 1995, the long dashes are for a week before, and the short dashes are for 4 weeks before. The yield curve shows that if you had invested in a Treasury security maturing in six months, you would have got an interest rate of about 5.64% per year. A three month Treasury security would have paid about 5.54% per year. Treasury securities maturing in thirty years were yielding about 6.91% per year. There are several theories that try to explain the term structure of interest rates. The three major ones are: The liquidity preference hypothesis is based on the intuition that long term in-

53

vestments cause higher inconvenience to the investors than the short term investments. Therefore, long term investments should have higher rates of return than the short term investments. The expectations hypothesis is based on the premise that the long term rates are actually composed of several short term rates. For example, if the one year rate currently is 10% and investors expect the one year rate next year to be 11%, then the annual interest rate on a two year loan would be somewhere between 10% and 11%. The shape of the term structure, therefore, would depend on what investors expect the short term rates to be in the future. The market segmentation hypothesis states that the markets for short and long term capitals are segmented. In other words, long term borrowers would borrow from those who want to lend for the long term, and short term borrowers would borrow from short term lenders. The rates in the long and short term markets, therefore, would move independent of each other.

2.9.4

Taxes

An important factor that results in dierent securities having dierent returns is how the cashows from these securities are taxed. Almost all the income from most common investments such as stocks and bonds is taxed fully. However, income from some securities issued by state and municipal governments is exempt from federal and/or state taxes. Dierences in tax status may cause securities to oer dierent returns. Consider two securities A and B which are identical in every respect but their tax status. Income from security A is taxed as regular income while that from security B is exempt from federal taxes. Clearly, if these two securities oer the same returns, all tax-paying investors will buy security B because they are concerned with the after-tax cashows rather than pretax. For security A to have a demand in the market, it has to oer a higher rate of return than security B so that the after-tax return from the securities are equal. This equalization will take place due to demand and supply adjustments in the market. If the two securities were oering equal rates of return, nobody would want to buy security A. As a result the demand for security A will fall which would result in a lower price for A. As the price of the security goes down its return goes up. The return on A will go up till the after-tax return on A equals the after-tax return on B. If an investors marginal tax rate is and the investor earns a return r on a security then the investor will have to pay r in taxes. Therefore, the after-tax return from securities will be r r or r (1 ). This calculation is based on the assumption that all investment income (whether income or capital gains) is taxed at the same marginal tax rate. The formula will be a little bit complicated if dierent forms of incomes are taxed dierently.

54

2.10

Conclusion

In this chapter, you learned about risk and return. Other factors that aect returns and interest rates were also discussed. You learned how to measure risk and return in an uncertain situation. Having completed Chapters 1 and 2, you have the background needed for investment analysis. We will now begin applying these fundamentals.

Exercises

2.1 Return Ken purchased 500 shares of Amax Corporation on January 1, 1987 at $30. On March 31, he received a dividend of $0.30 per share. Immediately thereafter he sold the shares for $31.25 each. What was his quarterly rate of return? What was the annualized rate of return? 2.2 Dividend Yield Sylvia Potter bought 100 shares of IBM at $98 per share. IBM has a policy of paying a dividend of $1.10 every quarter. What will be the dividend yield to Sylvia if IBM continues with its policy? 2.3 Conversion of Units

(a) Convert 1% per month to an annual rate. (b) Convert 12% per year to a monthly rate. (c) Convert 0.03% per day to a semiannual rate. (d) Convert 2.4

1/2%

Conversion of Units The return on a security was 1% per month. Convert this rate to a quarterly rate. Now convert the quarterly rate to the annual rate. Finally, convert the 1% per month directly to an annual rate. 2.5 Comparison of Returns During the last quarter, I earned 4% on my investment. The return on my friends investment was 16.3% during the last one year. Whose investment earned a higher return? 2.6 Compounding and Eective Rates Three local banks are oering the following rates on deposits: 7% per year compounded quarterly; 6.9% per year compounded monthly; and 6.8% per year compounded continuously. Where would you put your money? 2.7 Compounding and Eective Rates

(a) Impala Bank is advertising that their 3 year CD (Certicate of Deposit) has an annual rate of 10% and an annual yield of 10.47%. How often is the interest being compounded in this CD? (b) The 3 year CD at Cadillac Bank is also oering a rate of 10% per year but the yield on the Cadillac CD is advertised to be 10.52% per year. What is the compounding period at Cadillac?

2.8

55

Compounded Returns Richard Fish explained to his friend,I started out in the stock market in 1987. With my luck, things had to go wrong. My portfolio suered a loss of 15% during that year. I stuck it out though, and fortunately 1988 proved to be helpful. The portfolio went up, would you believe it, by exactly 15%. So now I am back where I started. Show that Mr. Fishs statement is incorrect, i.e., he is not back where he started. Is he worse o or better o? Would things have been dierent if the rst year he had faced a gain of 15% and the following year a loss of 15%? 2.9 Compounding Peter Fox, the friendly banker, told a client,Lets see now. You deposited $100 three years back. The rst year your deposit earned 5%, the second year it earned 4%, and the third year it earned 6%. That comes to a total of 15%. Here are your $115. Explain to the client how Mr. Fox is outfoxing him. How much money should the client get? 2.10 Leverage Derive equation 2.7by going through the steps in section 2.3 using symbols rather than the numbers. 2.11 Statistical Analysis Twenty weekly returns for common stocks of Huge, Inc. (H) and the Micro, Inc. (M) are given below: t 1 2 3 4 5 6 7 8 9 10 rH 0.01 0.02 0.01 0.02 0.05 0.07 0.02 0.01 0.02 0.02 rM 0.01 0.02 0.01 0.02 0.02 0.01 0.01 0.02 0.01 0.03 t 11 12 13 14 15 16 17 18 19 20 rH 0.03 0.01 0.03 0.02 0.01 0.01 0.01 0.03 0.02 0.02 rM 0.03 0.07 0.09 0.03 0.20 0.02 0.05 0.01 0.05 0.03

(a) Calculate the expected returns and standard deviations of returns for these stocks. (b) Calculate the 90% condence interval for returns on these stocks. (c) What are the probabilities of losing money on these stocks? (d) What is the probability that you will make more than 3% on Huge? (e) What is the probability that you will at least double your money in Micro? 2.12 Statistical Calculations The following table provides prices for a stock. Calculate the expected return and standard deviation of returns. t p 0 10 1 11 2 12 3 14 4 15 5 14 6 13 7 14 8 14 9 14 10 15

2.13 Security Statistics Closing prices for the past 11 weeks for the common stocks of ABC and XYZ are given below: Week 0 1 2 3 4 5 6 7 8 9 10

56

ABC 39.50 40.00 41.00 41.50 41.00 41.50 42.00 41.50 42.00 41.00 41.00 XYZ 10.75 11.00 10.50 11.25 11.75 11.50 11.75 12.00 11.75 12.00 12.50 Neither stock has paid any dividends during the past 10 weeks and is not expected to pay any during the next week. (a) Using the prices, calculate the weekly returns. (b) Calculate the expected returns and standard deviations of returns. (c) Is there a dominant choice between these stocks? Which stock would you choose? Why? (d) Calculate the 95% condence intervals for the returns of both stocks. (e) What is the expected value of next weeks price for XYZ? What are the highest and lowest prices you expect XYZ to take with 95% condence? (f) What is the probability that the price of ABC will at least double during the week? 2.14 Statistical Analysis Lou Graham is trying to calculate the statistics for the stock of Window Works. Lou has collected 48 months of returns information for the stock. His calculations provided him with the following results: r = 0.58, r2 = 0.063. (a) Calculate the expected return and the standard deviations of the returns for the stock. (b) Calculate the 95% condence range for the return. (c) What is the probability of losing money on the stock? 2.15 Risk, Return, and Wealth Monthly returns (in %) for the stocks A and B during 1989 are shown below: t rA rB 1 1 7 2 3 3 3 2 5 4 4 5 5 3 6 6 4 4 7 5 5 8 2 6 9 2 8 10 4 7 11 2 5 12 6 7

(a) Calculate the average return and standard deviation of returns for the stocks. Does one stock dominate the other? (b) What would $100 invested at the beginning of the year grow to in each of the stocks? Compare the results from this part with those from part (a). 2.16 Returns and Prices The expected return and standard deviation of XYZ for next month are 3% and 4%, respectively. What are the highest and the lowest returns with 95% level of condence? If the price of XYZ today is $12 what are the future prices corresponding to the highest, expected, and lowest returns?

57

2.17 Risk Premium The risk-free rate is 6% per year. The average return from security A is 8% per year. You believe that security B is twice as risky as A. What should be the average return from security B? 2.18 Eect of Ination Mr. Johnson is expecting 13% from his investments during the next year. The ination during the next year will be 5%. What is the real rate of return expected by Mr. Johnson? 2.19 Term Premium You can lend money for one year at the rate of 12% per year. You believe that one year from now, a similar loan will be made at 14% per year. Someone wants to borrow from you for two years. What annual rate should you charge this person so that whether you lend for one year now and then for another year, or for two years right now, your total return is the same? 2.20 Tax Premium The interest income from New York Thruway bonds will be free of all taxes for you. On the other hand, you will have to pay 28% taxes on interest income from the U.S. Treasury bonds. You believe that the Thruway bonds are identical to the Treasury bonds in all other respects. The U.S. Treasury bonds are yielding 9% per year. What should the minimum yield on the Thruway bonds be for you to invest in them rather than the Treasury bonds?

In Chapter 2, you learned that risk is measured by the standard deviation of returns. You also learned that the objective of every investor is to maximize the utility from investments. Furthermore, since utility is a function of expected return and risk, the objective may be stated as the maximization of expected return for a desired level of risk, or the minimization of risk for a desired level of expected return. This chapter shows how investors should go about nding investment opportunities that satisfy their objectives. You will learn that investors can improve the expected return to risk trade-o by dividing their capital among securities to form portfolios. In a portfolio, losses on some securities are oset by the gains on others. Therefore, portfolios allow investors to diversify away some of the risk of the securities without sacricing the expected return. The intuition underlying portfolios is contained in the old saying: Dont put all your eggs in one basket. Here we go a step beyond and answer some other important questions: How many and what securities to include in the portfolio? How to divide the money among the securities? and What eect do our choices have on the portfolio?

3.1

Portfolios

In spite of the availability of thousands of securities it may not be possible for investors to nd securities that meet their specication. To see why, examine Figure 2.7 on page 50. It shows the risk and return for several securities. You can see that investors who want to take little risk can do so by investing in Treasury bills. Investors who want to take more risk will have to choose from the stocks which are all clustered together. Therefore, those investors who want to take medium risk, will not be able to do so. Since Figure 2.7 does not show all the securities available, there is a chance that some securities not shown there may meet their specications. However, the cost of searching for the security may be signicant, and there is no guarantee that they will be successful. Portfolios allow investors to design investments using available securities to suit their 58

Portfolio Analysis

59

requirements. For example, investors looking for medium risk may invest a part of their money in the Treasury bills and the rest in a stock in such a way that the risk of the combined investment is to their taste. Any number of securities may be combined to form portfolios which then become viable investment alternatives. Portfolios, therefore, provide a wider choice of investment opportunities to investors which allows them to make better decisions. Portfolios are formed by dividing money among securities. I may form a portfolio by investing $20,000 in common stocks of AT&T, IBM, Kodak, and Sears as: $4,000 in AT&T, $5,000 in IBM, $6,000 in Kodak, and the remaining $5,000 in Sears. I am investing 20% of the money in AT&T, 25% in IBM, 30% in Kodak, and 25% in Sears. The biggest component of my portfolio is Kodak. Therefore, movements in the return of Kodak have the greatest inuence on the portfolio return. In other words, Kodak exerts the most weight on the portfolio. For this reason, the fractional amounts invested in individual securities are called portfolio weights. We will use symbol x to denote a portfolio weight. xi will denote the portfolio weight for security i. We will identify the composition of a portfolio by the notation {x1 , x2 , x3 , . . . , xn }. For example, the portfolio described above can be represented as {0.20, 0.25, 0.30, 0.25}. Since all the money invested in the portfolio must be divided among the individual securities, the portfolio weights must add up to 100% or 1. For the portfolio in this example: xAT&T + xIBM + xKodak + xSears = 0.20 + 0.25 + 0.30 + 0.25 = 1. In general, for a portfolio of n securities, this condition can be stated as: xi = x1 + x2 + + xn = 1 (3.1)

Equation (3.1) is the only condition on the portfolio weights. Therefore, using two or more securities, one can form innitely many dierent portfolios. Furthermore, portfolio weights may be positive, zero, or negative. Therefore, {0, 0.20, 0.40, 0.40}, {0, 0, 0, 1}, and {0.30, 0.10, 0.40, 0.40} are all valid portfolios of AT&T, IBM, Kodak, and Sears. In the rst portfolio, there is zero investment in AT&T. In the second portfolio, there are zero investments in AT&T, IBM, and Kodak, and all the money is invested in Sears. While this is not a good use of a portfolio, such a notation is used to indicate investment in an individual security when comparing individual securities with portfolios. Before we discuss the third portfolio, let us examine an important simplifying assumption that we make throughout this chapter. We assume that there are no margin or short selling constraints. Therefore, an investor can borrow or short sell as much as he wants. The assumption underlying this assumption is that the lender has full faith that the borrowed cash or securities will be returned. While this assumption may contradict1 our discussion of

1 Actually, it doesnt necessarily contradict the short selling and margin rules. Recall that the investor may meet the short selling collateral requirement through other securities. Therefore, the proceeds from short selling can be used to purchase other securities and those securities can be kept as collateral as long as the margin does not drop below the maintenance level.

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short selling and margin in Chapter 1, it makes the calculations and algebra of our analysis much simpler without taking away any insight. Now let us examine the third portfolio. This portfolio invests 10% in security 2 (IBM). Negative investment indicates short selling. 10% means that shares of IBM worth 10% of the value of the portfolio are sold short. Since the total value of the portfolio is $20,000, $2, 000 worth of shares of IBM are being sold short. The money generated from short selling is invested in other securities. The total investment in the remaining three securities, therefore, is $22,000. New portfolios can also be formed by combining a security with an existing portfolio. For example, you may form a portfolio by dividing your money between the risk-free security and a portfolio of risky securities. Suppose you want to invest 20% of your money in the risk-free security and 80% in a portfolio of AT&T, IBM, Kodak, and Sears with the composition {0.20, 0.25, 0.30, 0.25}. The composition of your overall portfolio made up of a risk-free security and the portfolio of stocks as {0.20, 0.80}. Alternatively, you can utilize the information about the composition of the portfolio of stocks and express the portfolio composition by specifying the exact investments in the risk-free security, AT&T, IBM, Kodak, and Sears. Since 20% of 80% of your money, i.e., 16% is in AT&T, 25% of 80%, i.e., 20% is in IBM, etc., the portfolio composition would be {0.20, 0.16, 0.20, 0.24, 0.20}. Similarly, new portfolios may be formed by combining existing portfolios.

3.2

Portfolio Returns

Portfolio prots and returns are derived from the prots and returns on the securities in the portfolio. Let us follow the example of the portfolio of AT&T, IBM, Kodak, and Sears with the composition {0.20, 0.25, 0.30, 0.25}. Since $20,000 is invested in the portfolio, $4,000 is invested in AT&T, $5,000 in IBM, $6,000 in Kodak, and $5,000 in Sears. In January 1990, the returns on these securities were 14.29%, 4.78%, 7.29%, and 4.59%, respectively. We want to nd out the return on the portfolio. Knowing the returns on the securities and the amounts invested, we can determine the prots from the securities. For example, the prot from AT&T was $4,000(0.1429) = $571.60. Similarly, the prots from IBM, Kodak, and Sears were $239.00, $437.40, and $229.50. The total prot therefore was $571.60 + $239.00 $437.40 + $229.50 = $540.50. The return on the portfolio, therefore, was $540.50/$20,000 = 0.0270 or 2.70%. Our calculation for portfolio return can be described by the following steps:

Return = = Prot Investment $4,000(0.1429) + $5,000(0.0478) + $6,000(0.0729) + $5,000(0.0459) , $20,000

Portfolio Analysis

= = $4,000 $20,000 (0.1429) + $5,000 $20,000 (0.0478) + $6,000 $20,000 (0.0729) + $5,000 $20,000

61

(0.0459),

The portfolio return, therefore, can be calculated by summing the product of the portfolio weights and the security returns. For a portfolio of n securities, we can write: rp = xi ri = x1 r1 + x2 r2 + + xn rn , (3.2)

where rp denotes the return on the portfolio. This equation shows that the portfolio return is a weighted sum of the security returns.

3.3

Diversication

In section 3.1, we saw that portfolios allow investors to create more investment alternatives. In addition to the expanded choice, portfolios reduce risk without a corresponding reduction in expected return. This phenomenon is called diversication. To understand diversication, examine Figure 3.1 which shows returns on two stocks Dot Inc. and Dash Inc. by dotted and dashed lines, respectively. The solid line shows the returns on a portfolio that invests equal amounts in both the stocks. The data for this Figure is shown in Table 3.1. At t = 1, the return on Dot was 0.0099 while the return on Dash was 0.0272. The return on the portfolio, therefore, was 0.5(0.0099) + 0.5(0.0272) = 0.0086. Going from t = 1 to t = 2, the return on Dot went down but the return on Dash went up by a larger amount. The net eect was an increase in return on the portfolio. This trend of opposite movements in stocks and a relatively small movement in the portfolio continues up to t = 9. From t = 9 to t = 15 the stocks move up and down together causing the portfolio to show Figure 3.1: Returns on two securities and their equally weighted portfolio.

.. . . . . . . . .

10 t

11

12

13

14

15

16

17

18

19

20

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Table 3.1: Return on two securities and their equally weighted portfolio.

t 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 Dot Inc. 0.0099 0.0087 0.0163 0.0012 0.0158 0.0048 0.0478 0.0024 0.0313 0.0440 0.0357 0.0101 0.0025 0.0387 0.0282 0.0065 0.0153 0.0009 0.0005 0.0110 0.0100 0.0200 Dash Inc. 0.0272 0.0190 0.0528 0.0283 0.0038 0.0202 0.0058 0.0101 0.0105 0.0120 0.0430 0.0245 0.0117 0.0234 0.0076 0.0283 0.0207 0.0076 0.0007 0.0038 0.0100 0.0200 Portfolio 0.0086 0.0051 0.0183 0.0147 0.0098 0.0125 0.0210 0.0062 0.0104 0.0280 0.0394 0.0173 0.0071 0.0311 0.0103 0.0109 0.0027 0.0034 0.0001 0.0074 0.0100 0.0131

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63

signicant movement. From t = 15 to t = 20 the stocks do not move together and we see that the movements in the portfolio are relatively small. The overall eect on the portfolio return and risk is summarized in the last two rows of Table 3.1. Both securities have average returns and standard deviations of 0.01 and 0.02, respectively. The portfolio also has an average return of 0.01, but its standard deviation is 0.0131. The portfolio risk is lower than that of the individual stocks without any decline in the average return. This happened because the stock returns did not go up and down together uniformly. The reduction in risk of a portfolio without a corresponding reduction in the expected return because of the diverse movements of the securities in the portfolio is known as diversication. As the description above suggests, the variability of the portfolio returns depends on the degree of comovement among the returns on the stocks in the portfolio. There is no reduction in risk if the returns move in unison, i.e., they have a correlation of +1. Diverse movement in the returns, suggested by the correlation being less than +1, would lead to the reduction of risk due to diversication. Therefore, the lower the correlation among the security returns, the better the prospect for diversication.

3.3.1

Correlation

Correlation between the returns of a pair of securities can be calculated using historical data. Table 3.2 shows the monthly returns on the stocks of AT&T and IBM for 60 months and additional information needed to calculate the correlation.2 AT&T is indexed as 1 and IBM is indexed as 2 in the Table and our calculations. The rst step in calculating correlation is the calculation of covariance. Covariance between the returns on securities 1 and 2, denoted by 12 , is calculated using the following equation: ( r1 )( r2 ) r1 r2 T 12 = . (3.3) T 1 The covariance between the returns of AT&T and IBM, therefore, is: 12 =

.1368) 0.004070 (0.3507)(0 60 = 0.000055. 59

The covariance can take values between and +. A positive value of covariance indicates that the returns move together and a negative value means that they move in opposite directions. The strength of the comovement, however, cannot be determined by the magnitude of the covariance because the covariance may be high simply because the returns have high variance. Correlation between securities 1 and 2 is denoted by 12 and is calculated as: 12 . (3.4) 12 = 1 2

2

t 1 2 3 4 5 . . . 57 58 59 60 60 Month 01/90 02/90 03/90 04/90 05/90 . . . 09/94 10/94 11/94 12/94 r1 0.1429 0.0192 0.0650 0.0446 0.0748 . . . 0.0054 0.0185 0.1068 0.0295 0.3507 r2 0.0478 0.0660 0.0217 0.0271 0.1130 . . . 0.0164 0.0700 0.0470 0.0389 0.1368

2 r1 2 r2

64

r1 r2 0.006831 0.001267 0.001411 0.001209 0.008452 . . . 0.000089 0.001295 0.005020 0.001148 0.004070

0.020420 0.000369 0.004225 0.001989 0.005595 . . . 0.000029 0.000342 0.011406 0.000870 0.200888

0.002285 0.004356 0.000471 0.000734 0.012769 . . . 0.000269 0.004900 0.002209 0.001513 0.358326

Before we can calculate the correlation, we need to calculate the standard deviations:

2 r1 T1 T 1 ( r )2

1 = =

0.200888 59

(

(0.3507)2 60

= 0.0581,

2 = =

2 r2 T2 T 1

r )2

0.358326 59

(0.1368)2 60

= 0.0779.

The correlation between the returns of AT&T and IBM, therefore, is: 12 = 0.000055 = 0.0123. (0.0581)(0.0779)

The correlation can take values between 1 and +1. Like the covariance, a negative correlation indicates that the returns move opposite to each other and a positive correlation means that they move together. Moreover, the magnitude of correlation is an indicator of the strength of comovement. For example, a correlation of 0.8 is stronger than that of 0.5.

Portfolio Analysis Table 3.3: Frequency distribution of correlations among stock returns.

Range 1.00 < 0.10 0.10 < +0.00 +0.00 < +0.10 +0.10 < +0.20 +0.20 < +0.30 +0.30 < +0.40 +0.40 < +0.50 +0.50 < +0.60 +0.60 < +0.70 +0.70 < +0.80 +0.80 < +0.90 +0.90 +1.00 1.00 +1.00 Frequency 0 5 33 103 499 685 345 81 14 5 0 0 1770 % 0.000 0.282 1.864 5.819 28.192 38.701 19.492 4.576 0.791 0.282 0.000 0.000 100.000

65

Using Microsoft Excel, correlation between two ranges can be calculated using the correl function. For example, correl(a1:a60,b1:b60) calculates the correlation between the values in ranges a1:a60 and b1:b60. There is also a covar function in Microsoft Excel but it is not suitable for our purposes as it uses T in the denominator rather than T 1 (see equation (3.3)). The sample estimate of population covariance can be calculated either by adjusting the denominator as covar(a1:a60,b1:b60)*count(a1:a60)/(count(a1:a60)-1) or by using equation (3.4), i.e., correl(a1:a60,b1:b60)*stdev(a1:a60)*stdev(b1:b60). Examine Table 3.3 to get a feel for the magnitude of correlations among the securities in the market. The sample consists of monthly returns on 60 major stocks between January 1965 and December 1994. The average correlation is 0.3347. Note that there are very few negative correlations and very few correlations higher than 0.5.

3.3.2

Diversication Eciency

In the absence of diversication, the risk of a portfolio should equal the weighted sum of the risks of the securities in the portfolio just as the expected return of the portfolio equals the weighted sum of the expected return of the securities. Therefore, the eect of diversication may be measured by comparing the risk of the portfolio and the weighted average of the risk of the securities. The weighted average of the standard deviation of Dot and Dash from the example above is 0.5(0.02) + 0.5(0.02) = 0.02. The standard deviation of the portfolio is 0.0131. Since the portfolio standard deviation is less than the weighted

Portfolio Analysis

66

average of the standard deviation of the securities, diversication has indeed been achieved. Mathematically, the following condition describes diversication for a portfolio of n securities: p < xi i = x1 1 + x2 2 + + xn n , (3.5)

where p is the portfolio standard deviation.3 The greater the dierence between the portfolio standard deviation and the weighted average of the standard deviations of the securities, the better the diversication. The ratio created by dividing this dierence by the weighted average of standard deviation of securities tells us the fraction of the risk that has been diversied away. In absence of diversication, {0.5, 0.5} portfolio of Dot and Dash would have had a standard deviation of 0.02. The portfolio, due to diversication, has a standard deviation of 0.0131. Therefore, (0.02 0.0131)/0.02 = 0.345 or 34.5% of the risk has been diversied away. In general, we can dene a diversication eciency coecient as: = xi i p . xi i (3.6)

3.4

In this section we will examine the mechanics of optimal portfolio selection. This process can be divided into several steps: Optimal portfolio selection begins with a clear statement of the risk-return objective. This may be specied by describing the investors indierence curves, or by stating a desired level of risk or expected return. The portfolio selection process will then be directed to nding the best portfolio with respect to the specied criterion. For example, if an investor wants the portfolio to earn 14% during the coming year, the portfolio designers job is to nd a portfolio that has the least amount of risk for the specied expected return. Next, the securities to be included in the portfolio are selected. This involves considerations of investors preferences and diversication. If an investor is forming the portfolio for capital gains and does not need regular income, low dividend paying stocks are the proper choice. The opposite is true if the investor wants regular income. The investor may have other personal preferences which may determine the choice of securities to be included. For example, an investor may want to invest only in the stocks of the companies headquartered in his city, or may want to avoid the companies that have had a poor pollution record. Security selection should be done keeping such preferences in mind. Diversication considerations suggest that the correlation among the securities should be low. This can be achieved by making sure that the securities are from the dierent industries or geographical regions.

3 This condition for diversication holds only for positively weighted portfolios, i.e., when all xs are positive.

Portfolio Analysis

67

Once the securities have been selected, historical price and dividend information is collected for the securities. This data is used to calculate the returns, which are used to estimate the statistics for the security returns. The periodicity of the data should conform to the investors horizon. For example, if the portfolio will be held for a month, and then updated, the data collection should be done so that monthly returns may be calculated. Similarly, if the investor will not revise the portfolio for a year, annual data should be used. At this point, several dierent portfolios are formed. The expected return and risk for these portfolios are calculated. Finally, the optimal portfolio to suit the investors objective is identied. To illustrate these steps, suppose that today is December 30, 1994 and we have been asked to design a portfolio for Ms. Catherine Smith. After consulting with Ms. Smith, we have decided to invest in the common stocks of AT&T, IBM, and Kodak. Ms. Smith will hold her portfolio for one month and then revise it. Ms. Smith wants us to form the best possible portfolio that has an expected return of 1.4% during January 1995. In the following sections we will see the calculations needed for designing the portfolio for Ms. Smith.

3.5

To calculate portfolio statistics, we will use monthly returns on the stocks for the previous ve years: January 1990 to December 1994. We will index the stocks of AT&T, IBM, and Kodak as 1, 2, and 3 in our calculations. We will show full calculation details for the portfolio {0.2, 0.5, 0.3}, i.e., x1 = 0.2, x2 = 0.5, x3 = 0.3. 20% of the money of this portfolio is invested in AT&T, 50% in IBM, and 30% in Kodak. Portfolio statistics are calculated using the portfolio weights and the statistics for the securities, The rst step, therefore, is to calculate the statistics for the securities. Table 3.4 shows the details for calculating the security statistics. The statistics are calculated using procedures described earlier in the notes. The results from the calculations are summarized in Table 3.5. The rst column of Table 3.5 identies the security, the second column shows the expected return, the third and the fourth columns show the standard deviation and the variance, respectively. The next three columns show the covariances. The row and the column numbers identify the securities whose covariance is expressed in a particular location. For example, covariance between security 1 and 2, 12 is 0.000055 and covariance between security 3 and 2, 32 is 0.001343. Note that the covariance 2 of a security with itself is the variance of the security. For example, 11 = 0.003370 = 1 . Also note that the covariance between two securities is independent of the order in which the securities are used. For example, 12 = 21 = 0.000055. The last three columns show the correlations. Note that the correlation of a security with itself is 1.00. Also note that as

68

t Month 1 2 3 4 5 . . . 57 58 59 60 60 01/90 02/90 03/90 04/90 05/90 . . . 09/94 10/94 11/94 12/94

r1

r2

2 r1

2 r2

2 r3

r1 r2

r1 r3

r2 r3

0.1429 0.0478 0.0192 0.0660 0.0650 0.0217 0.0446 0.0271 0.0748 0.1130 . . . . . . 0.0054 0.0164 0.0185 0.0700 0.1068 0.0470 0.0295 0.0389 0.3507 0.1368

0.005314 0.006831 0.010417 0.003485 0.000000 0.001267 0.000002 0.000007 0.001592 0.001411 0.002594 0.000866 0.003306 0.001209 0.002565 0.001558 0.011025 0.008452 0.007854 0.011865 . . . . . . . . . . . . 0.001616 0.000089 0.000217 0.000659 0.004900 0.001295 0.001295 0.004900 0.002144 0.005020 0.004945 0.002176 0.002450 0.001148 0.001460 0.001926 0.004070 0.041879 0.080848

in the case of covariance, the correlation between two securities is independent of the order. For example, 12 = 21 = 0.0123. Statistical estimates of expected return, standard deviations, variances, covariances and correlations calculated above are based entirely upon historical data during the past ve years and do not reect other information that may be pertinent to the future behavior of the stock return. A portfolio manager or an analyst may have additional insight or information that may have a bearing on the expected return and other statistics of the securities. The analyst should incorporate this insight by adjusting the statistics accordingly. For example, the historical estimate of expected return of IBM is 0.0023. However, based on other available information, I feel that a better estimate of the expected return of IBM is 0.0135. So, before Table 3.5: Statistics for the securities based on historical data.

Stock 1 2 3

Covariance 2 0.000055 0.006068 0.001343 3 0.000640 0.001343 0.004243 1 1.0000 0.0123 0.1692

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69

using the statistics for portfolio calculations, I will adjust the expected return of IBM from 0.0023 to 0.0135. Similarly, I may choose to adjust other statistics. In making these changes, I have to be cautious that the changes I make are statistically consistent. One can avoid the inconsistencies by following the steps listed below: 1. Change historical estimates of expected returns to those expected based on the additional information. 2. Change historical estimates of standard deviations to those expected based on the additional information. 3. Change historical estimates of correlations to those based on the additional information.

2 4. Calculate variances as squared standard deviations, for example Var 2 = 2 .

5. Calculate covariances as the product of correlation and the standard deviations, for example Cov 12 = 12 1 2 . The adjusted statistics for the securities are shown in Table 3.6. In the portfolio calculations that follow, we will use the numbers in this table. Table 3.6: Statistics for the securities adjusted based on additional information.

Stock 1 2 3

Covariance 2 0.000824 0.006068 0.001166 3 0.000640 0.001166 0.004238 1 1.0000 0.1820 0.1692

Now that we have the security statistics, we are ready to calculate the portfolio statistics. The expected return for a portfolio is calculated by using a variation of equation (3.2). To calculate the portfolio expected return we substitute for r in that equation. The formula for expected return on a portfolio of n securities is: p = For our portfolio we get: p = 0.20(0.0095) + 0.50(0.0135) + 0.30(0.0118) = 0.0122 = 1.22%. xi i = x1 1 + x2 2 + + xn n . (3.7)

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70

Now we come to calculating the standard deviation of the portfolio returns. We rst calculate the variance of the portfolio returns and then the standard deviation by taking the square root of the variance. The variance of returns for a portfolio of n securities is calculated as:

2 p n

=

i=1

2 x2 i i

n1

+

i=1 j =i+1

2xi xj i j ij .

(3.8)

From equation (3.4), we know that i j ij = ij . Therefore, equation (3.8) can also be written as

2 p = n 2 x2 i i + n1 n

2xi xj ij .

i=1 j =i+1

(3.9)

i=1

Equations (3.8) and (3.9) may appear complicated but they are relatively simple once you understand the underlying pattern. The right hand sides of these equations consist of two set of terms. The rst set has the products of the squares of portfolio weights and standard 2 2 2 deviations, e.g., x2 1 1 , x2 2 . If there are n securities in the portfolio then there will be n such terms. The second set has the cross-product terms: 1 with 2, 1 with 3, 1 with 4, . . ., 1 with n, 2 with 3, 2 with 4, . . ., 2 with n, and so on. For a portfolio of n securities, there will be n(n 1)/2 such terms. In equation (3.8), the cross-product terms consist of 2 times the product of the portfolio weights, the standard deviations, and the correlation, e.g., 2x1 x2 1 2 12 , 2x1 x3 1 3 13 . In equation (3.9), the cross-product terms are 2 times the product of the portfolio weights and the covariance, e.g., 2x1 x2 12 , 2x1 x3 13 . Whether to use equation (3.8) or (3.9) depends on what information is available. If correlations and standard deviations are known then equation (3.8) should be used. If covariances are known then equation (3.9) should be used. If all the statistics are known, then either equation can be used. However, in general, equation (3.9) is easier to use. Let us rst apply equation (3.8) to our portfolio:

2 2 2 2 2 2 p = x2 1 1 + x2 2 + x3 3 + 2x1 x2 1 2 12 + 2x1 x3 1 3 13 + 2x2 x3 2 3 23 ,

= (0.20)2 (0.0581)2 + (0.50)2 (0.0779)2 + (0.30)2 (0.0651)2 +2(0.20)(0.50)(0.0581)(0.0779)(0.1820) +2(0.20)(0.30)(0.0581)(0.0651)(0.1692) +2(0.50)(0.30)(0.0779)(0.0651)(0.2300) = 0.002625, so that, p = 0.0512 = 5.12%. Let us now apply equation (3.9). While applying this equation, let us also use variance ( 2 ) directly from Table 3.6.

2 2 2 2 2 2 p = x2 1 1 + x2 2 + x3 3 + 2x1 x2 12 + 2x1 x3 13 + 2x2 x3 23 ,

Portfolio Analysis = (0.20)2 (0.003376) + (0.50)2(0.006068) + (0.30)2 (0.004238) +2(0.20)(0.50)(0.000824) +2(0.20)(0.30)(0.000640) +2(0.50)(0.30)(0.001166) = 0.002625, so that, p = 0.0512 = 5.12%,

71

3.6

To identify the optimal portfolio, we calculate the expected returns and standard deviations of several portfolios. The more portfolios we use, the better the chance of identifying the truly optimal portfolio. Table 3.7 shows the expected returns and standard deviations for the three securitiesAT&T (A), IBM (I), and Kodak (K)and 20 possible portfolios of these securities. Notice that portfolio 1 is the same portfolio for which we saw detailed calculations in the previous section. Figure 3.2 shows the three securities and the twenty portfolios graphically. The optimal portfolios have the highest expected return for a specied risk, or the lowest risk for a specied expected return. Such portfolios are known as ecient portfolios. Ecient portfolios lie on the upper edge of the scatter diagram in Figure 3.2. Figure 3.3 shows that all possible portfolio combinations are enveloped within a shaped curve. This curve, known as the mean-standard deviation frontier, describes the riskreturn trade-os available to the investors. The upper half of this frontier is known as ecient frontier because it consists of the ecient portfolios. Investors should choose portfolios that lie on the ecient frontier. Picking a portfolio within the ecient frontier is suboptimal because these portfolios are dominated by the portfolios on the ecient frontier. Picking a portfolio above the ecient frontier would be better but there are no portfolio combinations available outside the ecient frontier. The particular ecient portfolio an investor should pick can be determined using his indierence curve. Figure 3.4 shows this process. Less risk averse investors should pick high-risk ecient portfolios while investors with high risk aversion should pick ecient portfolios with low risk and low expected return. The optimal portfolio selection can be simplied if the investor species the amount of risk or expected return. Recall that Ms. Smith wants her portfolio to have expected return of 1.4% during the month. Therefore, as shown in Figure 3.5 the optimal portfolio can be identied by drawing a horizontal line from 1.4% expected return and identifying the point at the intersection of this line and the ecient frontier. This portfolio has a standard deviation of 0.0774. The composition of this portfolio, after some trial-and-error, turns out to be {0.3504, 0.8201, 0.5303}. Therefore, if Ms. Smith has $100,000 to invest, $35,039 should be invested in AT&T, $82,006 in IBM, and $53,033 in Kodak.

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72

# A I K 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 x1 1.00 0.00 0.00 0.20 0.40 0.00 1.20 0.70 0.33 0.80 0.30 0.80 0.70 0.20 0.60 0.20 0.90 0.30 0.30 0.50 0.70 0.80 0.60 x2 0.00 1.00 0.00 0.50 0.30 0.50 0.00 0.70 0.33 0.40 0.20 0.60 0.60 0.50 0.60 0.75 0.50 0.60 0.25 0.20 0.10 0.25 0.70 x3 0.00 0.00 1.00 0.30 1.10 0.50 0.20 0.40 0.33 0.20 0.90 0.40 0.30 0.70 0.20 0.05 0.40 0.70 1.05 0.30 0.40 0.05 0.30 p 0.0095 0.0135 0.0118 0.0122 0.0132 0.0126 0.0090 0.0114 0.0115 0.0106 0.0108 0.0110 0.0112 0.0131 0.0114 0.0126 0.0106 0.0135 0.0129 0.0110 0.0100 0.0104 0.0116 p 0.0581 0.0779 0.0651 0.0512 0.0789 0.0562 0.0687 0.0714 0.0454 0.0586 0.0617 0.0696 0.0650 0.0648 0.0611 0.0625 0.0689 0.0706 0.0738 0.0443 0.0504 0.0529 0.0674

Portfolio Analysis

73

0.015

15 11 3 13 12 19 7 A 4 8 K 20 10 9 14 5 16 I

0.012 0.009

6 17

18

0.006 0.04

0.05

0.06

0.07

0.08

0.09

0.10

0.015 ........ .................. . . . . .. .. ... . . . . . . . . . . . . . . . . . . . . . .... ... ... ... ... .... ... ... Ecient Frontier ... ... ... . . . . . . . . . . . . . . . . ... 15 ... .. I ... . .... ... .. . .. 2 ... .... .. 11 .. . . . . . . . . . . 16 . . . .. .. .. . . . . . . 3 . . 13 . . . . . . . . . .. . .. . .. .. . . 1 . ... . . . .. . . . . K 20 . . ... . . 6 12 .. 5 10 . . . . 17 9 .

18 19 7 8 14 A

0.012 0.009

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

0.006 0.04

0.05

0.06

0.07

0.08

0.09

0.10

Portfolio Analysis

74

0.015

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. .. .... . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . .. . . . . . . . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

15

11

0.012 0.009

13

16

6 17

12

K 20

10

18

19

9 14

0.006 0.04

0.05

0.06

0.07

0.08

0.09

0.10

0.015

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. .. .... . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

15

11

13

16

0.012 0.009

6 17

12

K 20

10

18

19

9 14

0.006 0.04

0.05

0.06

0.07

0.08

0.09

0.10

Portfolio Analysis

75

3.7

So far we have assumed that investors invest only in risky securities. In reality, they invest some money in risk-free or near risk-free securities and some in risky securities. Common examples of near risk-free securities are bank accounts and certicates of deposit (CDs). In our analysis, we will use the term risk-free security to mean an investment that has a zero standard deviation. You may recall from Chapter 2 that Treasury bills come very close to being risk-free. Therefore, we will use the average return on the Treasury bills as the risk-free rate. With the availability of a risk-free security, the allocation of wealth among securities will proceed in two steps. Investors will rst choose a portfolio of risky securities and then divide the capital between the risk-free investment and the portfolio of risky securities. They can control the amount of risk they take by putting more or less money in the risk-free security. Consider an investor who wants to divide his money between a risk-free security and a portfolio of risky securities. Suppose, the expected return and standard deviation of the risky portfolio are and . Let us denote the return on the risk-free security by rf . If the investor puts x fraction of his money in the risky portfolio and (1 x) in the risk-free security, the expected return and risk of his overall portfolio, using two security case of equations (3.7) and (3.8), would be given by: p = (1 x)rf + x, p = (1 x)2 (0)2 + x2 2 + 2(1 x)(x)(0)( )(0) = x. (3.10) (3.11)

Several portfolios can be created using dierent values of x, and p and p can be calculated for these portfolios to determine the relationship between the expected return and standard deviation. This risk-return trade-o relationship can also be estimated algebraically by eliminating x between the two equations to get: p = rf + rf p . (3.12)

Therefore, the risk-return trade-o for portfolios of a risk-free security and a portfolio of risky securities is a straight line. Figure 3.6 shows the risk-return trade-o of portfolios made up of a risk-free security with expected return of 0.39% or 0.0039 per month4 and the stock of AT&T which has expected return of 0.0095 and standard deviation of 0.0581. Portfolio {0, 1} is invested entirely in the risk-free security and portfolio {1, 0} is invested entirely in AT&T. The portfolio denoted by {1.5, 0.5} is created by short selling the risk-free security. Short selling a risk-free security is the same as borrowing at the risk-free rate. Therefore,

0.0039 is the average monthly Treasury bill return during January 1990 to December 1994. We could have adjusted this historical estimate of expected risk-free rate based on more recent information.

4

Portfolio Analysis Figure 3.6: Risk-return trade-o for portfolios of a risk-free security and AT&T.

0.02

76

0.01

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . . . .. . . . . . .

{1.5, 0.5}

{1, 0}

portfolio {1.5, 0.5} is created by borrowing money and investing it in the stock of AT&T. In other words, this portfolio is a leveraged investment in AT&T. Note that the leveraged investment has a higher risk than the stock of AT&T itself. The extra risk is due to nancial risk from leveraging. From section 3.6, you know that in the absence of a risk-free security, investors choose portfolios that lie on the ecient frontier. Dierent investors choose dierent portfolios to suit their risk preference or specications. With the availability of a risk-free security, they will combine their choice of ecient portfolios with the risk-free security. The resulting tradeo lines for some choices of ecient portfolios are shown in Figure 3.7. Compare Figure 3.7 with Figures 3.33.5 carefully. Figure 3.7 is drawn from the same data as Figures 3.23.5. In Figure 3.7, the ecient frontier has been enlarged and shifted to allow us to see more details. Also, individual securities and portfolios have been omitted to enhance clarity. To get the highest expected return for a desired level of risk, investors will want to be on the highest sloping line. This line is created by drawing a tangent from the risk-free rate on to the ecient frontier of risky securities. The portfolios on this line are created by dividing money between the risk-free security and the portfolio that lies at the tangency point. The portfolio of risky securities that lies at the tangency point is known as the tangency portfolio. The solid straight line in Figure 3.7 is the tangency line and the point identied by T is the tangency point. All investors, regardless of their risk preferences, should invest in the combinations of the risk-free security and the tangency portfolio. Combinations of risk-free security and the tangency portfolio oer better risk-return trade-o than the portfolios of risky securities alone or the combinations of risk-free security with any other portfolio. Therefore, with the availability of a risk-free security, all investors should invest in the same portfolio of risky securities, unlike the case involving risky securities only where dierent investors invest in

Portfolio Analysis Figure 3.7: Optimal portfolio selection with risky and risk-free securities.

0.020 P3 . . ..... ... . . . . . .. ..... ...... . . . . . . . . ...... . . . 0.015 ...... . . . P1 P2 .. . . . . . . . ... . . . . . . . . . . . . . . . . . . . ... . ..... . . .................................................... . . . . ..................................... ... . ... .. . . . . . . . .. . . . . . . . .. . . . . . T . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ... . . . . . . . . . . . . . . .. .. . . ....... . . ....................... . . ...... . . . . . . . . . . . . . . . . . . . . . 0.010 . . . . . . . . . ... . . . . . . . . . . .. . . . ... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ....... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ... . . . ... . . . . . . ....... . . . . . . . . . . . . ... . . . ... . . . . .. . .. . . . . . . . . 0.005 . ..... . . .. . . ... . . . ... . . .. . .

77

0.000 0.00

0.02

0.04

0.06

0.08

dierent portfolios of risky securities to meet their risk specication. They should control the risk of their overall portfolio by dividing their capital suitably between the risk-free security and the tangency portfolio. Those who want to take less risk should invest more money in the risk-free security and those who want to take more risk should invest more money in the portfolio of risky securities. In addition to oering better risk-return trade-os, combining the risk-free security with the tangency portfolio has one more advantage. With the risky securities only, there is a minimum risk that the investors must take. For example, you can see from Figure 3.7 that if an investor wants to form a portfolio with the standard deviation of 0.02, he cannot do so with the risky securities only because there are no portfolio combinations that have such low risk. However, it is possible to create a portfolio of this or any level of risk by combining the risk-free security with the tangency portfolio. The equation of the tangency line joining the risk-free rate and the tangency portfolio

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78

is same as (3.12) with the substitution of the tangency portfolio statistics T and T for and : T rf p = rf + p . (3.13) T The statistics of the tangency portfolio can be determined by graphical analysis and its composition by trial-and-error.5 From Figure 3.7, the expected return and standard deviation can be approximated to be T = 0.0116 and T = 0.0460. The composition of the tangency portfolio, by trial-and-error, can be estimated to be {0.3055, 0.3185, 0.3760}. Therefore, the tangency portfolio is created by investing 30.55% of the portfolio in AT&T, 31.85% in IBM, and 37.60 in Kodak. The equation of our tangency line, therefore, is: p = 0.0039 + 0.0116 0.0039 p . 0.0460

This equation can be used to determine the relationship between expected return and risk of ones investment. Recall that Ms. Smith wants an expected return of 1.4% or 0.014 during the month. Therefore, the risk that she has to bear can be calculated as: 0.014 = 0.0039 + 0.0116 0.0039 p , 0.0460

which gives us p = 0.0600. From section 3.6, we know that to earn 1.4% expected return without using the risk-free rate, Ms. Smith had to take a risk of = 0.0774. With the risk-free security, for the risk of = 0.0774, her expected return from a portfolio created by combining the risk-free security and the tangency portfolio would be: p = 0.0039 + 0.0116 0.0039 0.0774 = 0.0169. 0.0460

Combining the tangency portfolio with the risk-free rate, therefore, results in a better portfolio than the portfolios created using risky securities only. The optimal portfolios without and with the use of the risk-free security are indicated by P1 , P2 , P3 in Figure 3.7. One thing we dont know yet is how Ms. Smith should divide her money between the risk-free security and the tangency portfolio so that she earns an expected return of 1.4% per month. Since her portfolio is composed of a risk-free security and a risky portfolio, equations (3.10) and (3.11) can be applied. We can determine the proper amounts to be invested in the risk-free security and the tangency portfolio using either of these equations. Let us use equation (3.11): p = xT 0.0600 = x(0.0460), so that x = 1.3037. Therefore, 130.37% of her money should be invested in the tangency portfolio and the remaining 30.37% should be invested in risk-free securities. The 130.37%

5 There are mathematical techniques and computer programs which can identify the tangency point directly. Optimizers built in spreadsheet programs such as Microsoft Excel can also be used for this purpose.

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79

of the money to be invested in the tangency portfolio should be divided among the stocks of AT&T, IBM, and Kodak as {0.3055, 0.3185, 0.3760}. Therefore, 30.55% of 130.37% or 39.83% should be invested in AT&T, etc. The overall portfolio made up of risk-free security, AT&T, IBM, and Kodak is {0.3037, 0.3983, 0.4152, 0.4901}. If Ms. Smith has $100,000 to invest, $30,366 should be invested in the risk-free security (Treasury bills), $39,830 in stock of AT&T, $41,524 in IBM, and $49,012 in Kodak.

3.7.1

Depending on whether we are dealing with the situation with or without the risk-free security, the terms ecient portfolios and ecient frontiers have dierent interpretations. The basic denitions of these terms do not change. The term ecient is always used to refer to the minimum risk for a desired level of expected return, or maximum expected return for a specied level of risk. However, where the ecient portfolios and frontiers lie changes depending on whether a risk-free security is included or not. In situations involving risky securities only, the ecient frontier is the upper half of the shaped curve and the ecient portfolios lie on this frontier. When dealing with the case of risk-free and risky securities, the ecient portfolios lie on the tangency line and the tangency line is the ecient frontier.

3.7.2

Constrained Portfolios

The portfolios used in the process described above did not have any constraints on the portfolio weights except that they have to add up to 1. Therefore, in some portfolios, some weights were negative, implying short selling. Some investors may not want to engage in short selling because they perceive short selling to be inherently very risky, or because the cost of short selling is too high for them. Other investors may want the investment in every security in the portfolio to be above some minimum level because they do not want to buy just a few shares in form of odd lots which, as we saw in Chapter 1, have additional transaction costs. Portfolio selection process under such constraints will proceed in the same manner as described above except that when considering alternative portfolios, the portfolio weights would be chosen to satisfy the constraints. For example, if our investor did not want to sell short, portfolios 2, 4, 5, 7, 8, 9, 10, 11, 12, 14, 15, 16, 18, 19, and 20 in Table 3.7 should be substituted by positively weighted portfolios, i.e., portfolios with positive weights only. Such constraints on the portfolio selection process will diminish the optimality of the portfolios. Graphically, the mean standard deviation frontier for a constrained portfolio selection process will shrink as shown in Figure 3.8. As a result, the slope of the tangency line will decrease. The magnitude of the eect will depend on the kind of constraints and the securities used to form the portfolios. Therefore, investors should carefully consider whether constraints on short selling are worth the loss of eciency of the portfolios.

. . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . Constrained . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . .

80

Unconstrained

3.7.3

Portfolio Revision

The portfolio design process creates a portfolio that would be optimal forever only if the economic and investment conditions do not change once the portfolio has been designed. Since we live in a dynamic world, a portfolio that is ecient today is very likely to become inecient soon. For this reason, it is important to revise a portfolio. Portfolio revision may be compared with engine tune up for a car. How often a portfolio should be revised is a function of the magnitude of change in the economic and investment conditions. A highly volatile market warrants frequent examination and revision of the portfolio. For an investor, the benets of portfolio revision must be compared with its cost to decide whether a portfolio should be revised. The benet of portfolio revision comes from the improved risk-return trade-o and the resulting improvement in expected value of the prots. The cost arises from the transaction costs of buying and selling the securities to adjust the portfolio. For example, if revising a portfolio worth $100,000 would result in an improvement of 0.5% in the monthly expected return, then the expected value of the benet is $100,000 0.005 = $500. The revision will require a change in portfolio weights, i.e., selling some securities and using the proceeds to buy others. Suppose the commissions for these transactions are $300 then the portfolio revision is worthwhile. This example assumes that an expected value of $500 is worth more than a sure cost of $300. This may not be the case for all investors. The important point here is that portfolio maintenance is an important activity. Portfolios must be evaluated frequently to determine if they could benet from a revision.

3.8

Analysis of Diversication

Now that we know how to calculate the expected return and risk of portfolios, and identify the optimal portfolio for an investor using a chosen set of securities, we will examine the

Portfolio Analysis Table 3.8: Statistics for portfolios of AT&T (1) and IBM (2) using 12 = 0.0123.

# 1 2 3 4 5 6 7 8 9 10 11 x1 0.50 0.30 0.10 0.10 0.30 0.50 0.70 0.90 1.10 1.30 1.50 x2 1.50 1.30 1.10 0.90 0.70 0.50 0.30 0.10 0.10 0.30 0.50 p 0.0155 0.0147 0.0139 0.0131 0.0123 0.0115 0.0107 0.0099 0.0091 0.0083 0.0075 p 0.1152 0.0996 0.0848 0.0714 0.0602 0.0527 0.0505 0.0543 0.0630 0.0749 0.0888

81

eect of two important portfolio design choices on the diversication characteristics of the portfolio. The two design elements are the correlation among the securities in the portfolio and the number of securities in the portfolio.

3.8.1

To study the eect of correlation between the securities on the diversication characteristics of the portfolio, we will concentrate on the simplest portfoliosthose consisting of only two securities. Let us take AT&T and IBM as our sample securities. The relevant statistics for the securities are shown in Table 3.6 on page 69. The portfolio statistics can be calculated using the two security case of equations (3.7) and (3.8): p = x1 1 + x2 2 , p =

2 2 2 x2 1 1 + x2 2 + 2x1 x2 1 2 12 .

(3.14) (3.15)

Table 3.8 shows the statistics for several portfolios of these two securities. Figure 3.9 shows the portfolio statistics graphically. The points in Figure 3.9 join to form a smooth curve called a risk-return trade-o curve. This curve has the same kind of shape as the mean-standard deviation frontier. The exact shape of the risk-return trade-o curve depends on the security statistics, including the correlation. Our interest is in studying the eect of correlation. We would like to know what the portfolio statistics would be if the correlation were something else. Since the correlation can be between 1 and +1, we calculate the statistics for the portfolios of

Portfolio Analysis Figure 3.9: Statistics for portfolios of AT&T (1) and IBM (2) using 12 = 0.0123.

0.020

82

0.015 0.010

. . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. ... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ...... . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

{0.5, 1.5}

{0.0, 1.0}

{0.5, 0.5}

{1.0, 0.0}

{1.5, 0.5}

0.005

0.06

0.08

0.10

0.12

these two securities assuming dierent values for the correlation and keeping other statistics xed. From equation (3.14) you can see that for a particular portfolio, the expected return will not change when we change the correlation because the portfolio expected return does not depend on the correlation. Table 3.9 shows the result of our calculations for 5 dierent values of correlation: 1.0, 0.5, 0.0, 0.5, and 1.0. The expected return on the portfolio is shown only once because, as we saw above, it is the same for a portfolio regardless of the correlation. Figure 3.10 shows the risk and return statistics for the portfolios graphically. Note that the risk-return trade-os are straight lines when the securities are perfectly positively or negatively correlated. In other cases, the trade-o is a curved line. Table 3.9 and Figure 3.10 show that the standard deviation of a portfolio changes as the correlation changes. The standard deviations of positively weighted portfolios go down as correlation goes down. The opposite eect is seen in portfolios where one or the other portfolio weight is negative. Since most investors hold positively weighted portfolios, to minimize the risk, the securities in the portfolio should have as low correlations among their returns as possible. With perfectly positive correlation, when one security performs above average so does the other, when one results in a less than expected return so does the other. Therefore, there is no diversication eect with perfectly positive correlation. We can check this by examining the standard deviation for a portfolio under 12 = 1.0 in Table 3.9. The standard deviation of the portfolio {0.5, 0.5} is 0.0680. The weighted average of the standard deviation of securities is 0.5 0.0581 + 0.5 0.0779 = 0.0680. Since the portfolio risk is equal to the weighted average of the security risks, there is no diversication. Diversication is exhibited in the

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portfolio when correlation is less than +1.0. The portfolio risk declines and diversication eciency increases as correlation decreases. As Figure 3.10 shows, the extreme case of perfectly negative correlation allows us to eliminate all the risk if the portfolio is chosen carefully. A portfolio that allows the risk to be eliminated completely is known as a hedge portfolio. The hedge portfolio is shown by a in Figure 3.10. The composition of this portfolio can be determined by setting the correlation equal to 1 and standard deviation of the portfolio equal to zero in equation (3.15), and solving for the unknown portfolio weights: p =

2 2 2 x2 1 1 + x2 2 + 2x1 x2 1 2 (1) = 0.

2 2 2 x2 1 1 + (1 x1 ) 2 2x1 (1 x1 )1 2 = 0,

which can be factored and written as: x1 1 (1 x1 )2 so that, x1 1 (1 x1 )2 = 0. Table 3.9: Statistics for portfolios of AT&T (1) and IBM (2) using 12 = 1.0, 0.5, 0.0, 0.5, and 1.0.

p # 1 2 3 4 5 6 7 8 9 10 11 x1 0.50 0.30 0.10 0.10 0.30 0.50 0.70 0.90 1.10 1.30 1.50 x2 1.50 1.30 1.10 0.90 0.70 0.50 0.30 0.10 0.10 0.30 0.50 p 0.0155 0.0147 0.0139 0.0131 0.0123 0.0115 0.0107 0.0099 0.0091 0.0083 0.0075 12 = 1.0 0.0878 0.0838 0.0799 0.0759 0.0720 0.0680 0.0640 0.0601 0.0561 0.0522 0.0482 12 = 0.5 0.1054 0.0938 0.0829 0.0732 0.0650 0.0591 0.0561 0.0566 0.0604 0.0670 0.0756 12 = 0.0 0.1204 0.1028 0.0859 0.0704 0.0572 0.0486 0.0469 0.0529 0.0644 0.0791 0.0955 12 = 0.5 0.1338 0.1110 0.0887 0.0674 0.0482 0.0351 0.0354 0.0489 0.0681 0.0895 0.1118 12 = 1.0 0.1459 0.1187 0.0915 0.0643 0.0371 0.0099 0.0173 0.0445 0.0717 0.0989 0.1261

2

= 0,

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Figure 3.10: Statistics for portfolios of AT&T (1) and IBM (2) using 12 = 1.0, 0.5, 0.0, 0.5, and 1.0.

0.02 12 = 1.0 0.5 0.0 0.5 1.0

0.01

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . .. .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . .. . . .. . . . . . . .. . . . . . . . . . . . . . . . . . .. . . .. . . . . . . ..... . . . . . .. . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

0.00

0.05

0.10

0.15

Now we can solve for x1 and then for x2 = 1 x1 to get: x1 = 2 1 + 2 and x2 = 1 x1 = 1 . 1 + 2 (3.16)

For the numbers in our example, x1 = 0.0779 = 0.5728 0.0581 + 0.0779 and x2 = 1 0.5728 = 0.4272.

The expected return and standard deviation of this portfolio are: p = 0.5728(0.0095) + 0.4272(0.0135) = 0.0112 p = (0.5728)2(0.0581)2 + (0.4272)2(0.0779)2 +2(0.5728)(0.4272)(0.0581)(0.0779)(1.0) = 0.00 Hedge portfolios can also be formed when correlation between the securities is 1.0. You can see this by extending the line for = 1.0 in Figure 3.10. It will intersect the y axis at some point. That point is also a hedge portfolio. In reality, hedge portfolios cannot be formed using stocks only because there are no stocks with perfect positive or negative correlations. Under some conditions, stocks and options

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85

on the stocks have perfect correlations. Therefore, options and stocks may be combined to form hedge portfolios. The expected return on a real hedge portfolio must be equal to riskfree rate. If the expected return on the hedge portfolio were to be more than the risk-free security, everybody will invest in the hedge portfolio instead of the risk-free security. This will increase the demand for the hedge portfolio and decrease the demand for the risk-free security. The result will be that the return on the hedge portfolio will come down and that on the risk-free security will go up till the two are equal. The opposite will happen if the expected return on the hedge portfolio were to be less than the risk-free rate.

3.8.2

To examine the eect of the number of securities in the portfolio on diversication, imagine that we have thousands of securities that have identical expected returns () and risks ( ). The correlation between every pair of securities is . Now we take n of these securities and 1 form a portfolio by investing equal fractions in each of these n securities, i.e., n . Because of the equal investment policy, the portfolio has the same expected return as any one security: p = 1 1 1 1 + ++ = n = n n n n (3.17)

Therefore, we can draw inferences about the diversication eect by focusing on the standard deviations of the portfolios. To study the eect of the number of securities on portfolio risk, we increase the number of securities in the portfolio, n, as 1, 2, 3, . . ., etc. The standard deviations of the portfolio of n securities is calculated using equation (3.8) to be: p = n 1 n

2

2 +

1 n(n 1) 2 2 n

2 .

(3.18)

Figure 3.11 shows a plot between the standard deviation of the portfolio and the number of securities in the portfolio assuming = 1 and = 0.2. As you can see, the standard deviation declines as the number of securities is increased. Therefore, portfolios of more securities have less risk without any decline in expected return. The drop in standard deviation is quite rapid in the beginning. The portfolio of two securities has a standard deviation of only 75% of a single security. The portfolio of three securities has a standard deviation of only 68%. In other words, 32% of the security risk gets diversied when one forms a portfolio of three securities. A portfolio of about 20 securities leads to a high level of diversication. After 20 securities the reduction in risk becomes very small so that there is not much diversication benet by including more securities in the portfolio. Figure 3.12 shows the eect of the number of securities on the ecient frontier. Notice that the eect of the number of securities on the ecient frontier is similar to that of imposing constraints. This is not surprising. Using fewer securities to form portfolios is indeed a form of constraint.

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86

Figure 3.11: The eect of the number of securities on the portfolio risk.

1.0

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

0.8 0.6

0.4 0 10 20 n 30 40 50

Figure 3.12: The eect of the number of securities on the ecient frontier.

. . . . . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . .. . . . . . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. .. . . . . . . . . . . . . . . . . . . . . . . .. .. . . . . . . . . . . . .

Large n

Small n

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87

Our observations are based on some very specic assumptions about securities and portfolio formation methods. We assumed that all securities have equal expected returns and standard deviations, that the correlations between all pairs of securities are equal, and that portfolios are equally weighted. In real investment situations, security statistics are not alike, and investors form portfolios by investing dierent amounts in dierent securities. However, similar results are obtained in those situations also. These results suggest that investors should hold as many securities as available. We do not observe this in reality because investors also consider the transaction costs which have been ignored in our presentation. Beyond a certain point the transaction costs of creating and maintaining a portfolio of many securities outweigh the benets of diversication. Typically, 15 to 20 securities are considered ideal for individual investors.

3.9

Mutual Funds

We know that portfolios are desirable because of their diversication eect. Portfolio formation and management, however, is a time consuming activity and requires special skills. In addition, portfolio formation is not feasible for small, individual investors because most of the benets of diversication are lost due to the transaction costs incurred during portfolio formation and revision. The costs are lower if the transactions are done on a large scale. The need for professional skills to design and manage a large diversied portfolio, and the economies of scales associated with large portfolios led to the development of mutual funds. Mutual funds are portfolios created and managed by nancial companies such as Fidelity Investments, Merrill Lynch, Vanguard, and Dean Witter. Individuals buy shares of mutual funds. Mutual fund managers use the money collected from the investors to buy securities that make up the portfolio. In this sense a mutual fund can be viewed as a cooperative. Today, mutual funds are almost as important a part of the investments market as common stocks. The process of optimal portfolio selection by the fund managers is not revealed. However, we can guess that they combine the securities to form ecient portfolios. Investors get to enjoy the benets of diversication without having to be directly involved in the process of selecting and maintaining a portfolio of a large number of securities. The main advantage of mutual funds, however, comes from the reduced transaction costs because of the buying power of the funds. Mutual funds can be formed using a variety of securities. A broad classication of mutual funds is in terms of the time to maturity of the securities in the funds. Money market mutual funds, usually referred to as money market funds, consist of short term, money market securities such as Treasury bills, commercial paper, and repurchase agreements. Mutual funds consisting of capital market instruments such as stocks, bonds, and precious metals are usually referred to simply as mutual funds. Money market funds have very little risk and, therefore, yield relatively low interest rates. However, they are highly liquid and can

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88

be converted into cash on a short notice without any penalty. Capital market mutual funds have relatively higher risks and therefore are expected to yield higher rates. However, they require a commitment of capital for some minimum time and may impose penalties for early withdrawal of money. Investors can specialize by choosing a special kind of mutual fund to meet their investment needs. For example, there are growth oriented funds and high yield funds; there are funds that consist of long term bonds; funds that invest in stocks of energy sector companies; funds made up of municipal securities; funds that invest in foreign securities; etc. Sector funds invest in a sector of the economy and therefore allow investors to exploit their intuition about a particular group of securities. For example, if you believe that the health care business will make big strides during the next few years but you are not sure which companies will be most successful, you may buy shares in a health care mutual fund. The choice of funds available to the investors has become so wide that it takes almost as much eort to decide among the mutual funds as among individual stocks and bonds. Usually, a mutual fund company manages several dierent funds. For example, in The Wall Street Journal of August 8, 1995, there were over 100 funds listed for Merrill Lynch and over 150 for Fidelity. Fund managers charge fees for managing the portfolios. The fees are collected either directly from the investor in the form of commissions at the time of buying or selling mutual fund shares, or in the form of deductions from the portfolio earnings, or both. Funds that charge commissions are called load funds. The commission charged is called front end load if the commission is charged at the time of purchase of shares and back end load if it is charged at the time of selling the shares. Funds that do not charge any such commissions are known as no-load funds. Mutual funds can be open end or closed end. Open end funds do not have any limit on the number of shares that can be issued. These funds issue shares on demand and use the proceeds from issuing shares for buying additional securities that make up the fund portfolio. Closed end funds, on the other hand, have a xed number of sharesalmost like corporations. The shares of closed end funds are traded in the stock exchanges. An investor can buy shares in a closed fund only if some other investor is willing to sell them. The market price of the shares of closed end mutual funds, therefore, depends on the demand and supply of the shares. As a result, the market price of closed end shares is not necessarily equal to the value of the underlying assetsthe net asset value. In fact, most often the market price of closed end funds is below their net asset values, i.e., the closed end fund shares sell at a discount to their net asset values. Open end funds are not traded in the stock markets. The value of an open end mutual fund is given by its Net Asset Value (NAV). The net asset value, as the name implies, refers to the net value of the assets of the mutual fund on a per share basis. Therefore, it is like the price of a common stock of a corporation. Table 3.10 provides an excerpt from the mutual fund quotations from The Wall Street Journal of August 8, 1995. The rst column in the mutual fund quotation gives the name of the fund group (in bold print) and the funds. The next column gives the funds stated objective. A table in The

89

Inv. Obj. Janus Fund: Balanced S&B Enterprise MID Fund CAP Twen CAP Japan Fd ITL John Hancock: CA TE MCA Grwth p GRO NYTE p DNY

NAV Chg. +0.04 +0.17 +0.09 +0.05 0.02 0.03 +0.09 0.02

Total Return YTD 4 wks 1 yr R +15.9 +12.4 +21.3 +27.2 13.1 +9.5 +24.4 +8.9 +1.0 +2.1 +1.2 1.0 +1.2 1.8 +3.9 1.5 +16.2 +22.7 +21.3 +28.3 20.7 +6.9 +31.5 +6.0 B D D B E A A B

Wall Street Journal describes all the objectives. For example, S&B refers to stock and bond balanced funds, SML refers to small company growth funds, etc. The next column provides the Net Asset Value of the fund on a per share basis. For example, if you own 100 shares of Janus Twenty fund (Twen), the total value of your investment is $28.89 100 = $2,889. If you want to get out of the mutual fund you will receive a total of $2,889. The next column shows the oer price, which is what you have to pay to buy the shares in the company. For the Janus group of funds and the Japan fund, the entry in this column is NL which stands for no load. For these funds, the share price is the same whether you want to buy or sell. For John Hancock funds, however, the oer price is higher than the net asset value. You have to pay $20.80 to buy a share of their growth fund whose net asset value is $19.76. The dierence, $1.04 or 5% of the oer price is the load for this fund. The next column gives the change in NAV since the previous trading day. The next three columns provide some performance results for the funds. Columns titled YTD, 4 wk, and 1 yr give returns on the fund year-to-date, for the last four weeks, and for the last one year in percent. The year-to-date return on Janus Twenty fund is +27.2%. The last column gives a ranking of the fund based on the performance of the fund over the last one year among funds of similar objectives. The top 20% funds get ranking of A while the bottom 20% get ranked E. Since Janus Twenty Funds rank is B, it was between 60th to 80th percentile among all the funds with stated objectives of CAP (capital appreciation). The entries in the last three columns of the mutual fund table change from Monday through Friday. On Mondays, the mutual fund table provides information about the funds

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90

expenses. Specicaly, funds maximum initial charge (load) and expense ratio are listed. Expense ratio is the ratio of funds operating expenses to its assets. No performance based fund ranks are provided on Mondays. On Tuesday through Friday, the table lists returns for 4 weeks/1 year, 13 weeks/3 years, 26 weeks/4 years, and 39 weeks/5 years. On these four days, the Journal also provides fund rankings based on 1, 3, 4, and 5 years of returns, respectively. Since periods of dierent lengths are used to arrive at performance ranks on dierent days, the fund ranks may change from day to day.

3.10

As we saw above, with the availability of a risk-free and several risky securities, investors should diversify by dividing their money between the risk-free security and the tangency portfolio of risky securities. For maximum diversication, the tangency portfolio should consist of as many securities as possible. The transaction costs, however, keep investors from diversifying across all securities in the market. If there were a market where there were no taxes, transaction costs, or costs of acquiring and interpreting information, then all investors would diversify to the limit by buying as many securities as there are in the market. A market without any taxes, transactions, and information costs is known as a perfect market. Being a theoretical construct, a perfect market is not very useful from an immediate practical perspective. However, implications of analysis in a perfect market provide insight and models about the securities which are useful in real markets also. As mentioned above, in a perfect market, investors include all available securities to form portfolios because there are no transaction costs. The tangency portfolio, therefore, includes all the securities in the market. The tangency portfolio in a perfect market setting is known as the market portfolio. The tangency line in a perfect market is known as the capital market line. The composition of market portfolio may be determined using the method described in section 3.7. However, applying the principles of market equilibrium, it can be shown that the market portfolio is value weighted. In other words, the weights of the securities in the market portfolio are proportional to their market values. As an example, suppose that there are only 5 risky securities in the economy: A, B, C, D, and E, with total market values of $20, $15, $20, $35, and $10 (in millions), respectively. Since the market value of all securities = 20 + 15 + 20 + 35 + 10 = 100, the composition of the market portfolio 20 15 20 35 10 is xA = 100 = 0.20, xB = 100 = 0.15, xC = 100 = 0.20, xD = 100 = 0.35, and xE = 100 = 0.10. If our real economy were a perfect market, the market portfolio would be made up of all the securities available, including stocks, bonds, options, futures, and real estate. Obviously, this portfolio will consist of hundreds of thousands of securities. For application of the models derived in a perfect market setting, stock indexes such as S&P 500 or NYSE composite are used as proxies for the market portfolio. S&P 500 is a value weighted portfolio of 500 major stocks traded on the NYSE. The NYSE composite is a value weighted portfolio of all stocks traded on the NYSE.

t 1 2 3 4 5 . . . 57 58 59 60 60 Month 01/90 02/90 03/90 04/90 05/90 . . . 09/94 10/94 11/94 12/94 ri 0.1429 0.0192 0.0650 0.0446 0.0748 . . . 0.0054 0.0185 0.1068 0.0295 0.3507 rm 0.0671 0.0129 0.0263 0.0247 0.0975 . . . 0.0241 0.0229 0.0367 0.0146 0.4560 ri rm 0.009589 0.000248 0.001709 0.001102 0.007293 . . . 0.000130 0.000424 0.003920 0.000431 0.069631

2 rm

91

0.004502 0.000166 0.000692 0.000610 0.009506 . . . 0.000581 0.000524 0.001347 0.000213 0.080374

3.11

When viewing a security as a part of the market portfolio, its total risk may be divided into two components. Of the total risk only a small portion remains undiversied in the market portfolio. This portion is known as undiversiable, systematic, or market related. The portion that gets diversied away is known as diversiable, unsystematic, or unique risk. The systematic risk is measured by . The of security i is calculated as: i = im 2 m (3.19)

where im is the covariance between the returns of the investment and the market portfolio, 2 and m is the variance of returns on the market portfolio. Since im = im i m , equation (3.19) can also be written as: i i = im (3.20) m Table 3.11 shows the details for calculating the for the stock of AT&T using S&P 500 as the proxy for the market portfolio. Monthly data from January 1990 to December 1994 is used for the calculations. First we calculate the covariance between the stock and the market returns, and the variance of the market returns, and then the : im = ri rm T 1

ri T rm

Portfolio Analysis

2 m 2 rm Tm 0.080374 = = T 1 59 im 0.001135 = 0.8707 = = 2 m 0.001304 ( r )2 (0.4560)2 60

92 = 0.001304

The value of can be between and +. The risk-free security has a of 0 and the market portfolio has a of 1. From regression theory, we know that the formula for i in equation (3.19) is same as the formula for the slope coecient in a simple linear regression with rm being the independent variable and ri being the dependent variable. The regression equation is shown below: ri = ai + i rm . (3.21)

Therefore, you could save time by feeding the data for ri and rm to a computer program (such as the regression procedure in Microsoft Excel) and asking it to run the regression. The output from the computer program will provide as the slope coecient. Equation (3.21) is known as the market model. The regression output also gives us some statistics. The most useful among these are R2 and the standard error of beta. The R2 is a measure of the goodness of t of the regression equation. Using the standard error, we can conduct a test for the signicance of . The t statistic for this test is calculated by dividing the by the standard error. Sometimes, the market model is written in terms of the excess returnsreturns in excess of the risk-free rateas: ri rf = i + i (rm rf ). (3.22) This form of the market model is preferred over equation (3.21) if one wants to eliminate the eect of the economywide changes in the level of interest rates. The total returns may change from one period to another because of the changes in the interest rates across all securities in the economy. The movements in excess returns is only due to the riskiness of the securities. The in equation (3.22) is exactly equal to the in equation (3.21) if the risk-free rate rf is constant over time. Even if we use the monthly Treasury bill returns as risk-free rates, which are not constant but have a very little variance, the obtained using equation (3.22) is almost the same as the one obtained using equation (3.21). The market model provides us an alternative interpretation of . can be seen as the sensitivity of a securitys returns to that of the market. Suppose the of a security is 1.5. Then, if the return on the market goes up by 1%, the return on the security would go up by 1.5%. Based on this interpretation, systematic risks and s can be calculated for portfolios also. The of a portfolio measures the sensitivity of portfolio returns to those of the market. The relationship between the returns of the security and the market is shown graphically by the characteristic line. A characteristic line is the best t regression line between

r rf 0.20

93

0.15

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0.10

0.15

r r

0.20

the excess returns of a stock and that of the market. Figure 3.13 shows the data and the characteristic line for AT&T. The slope of the characteristic line is the of the security. Securities with s higher than 1 are known as aggressive and those with s lower than 1 are known as conservative . Figure 3.14 shows the characteristic lines for IBM (solid line), Kodak (dashed line), and Sears (dotted line). The s for IBM, Kodak, and Sears, are 0.5699, 0.5854, and 1.0308, respectively. Several investment information services provide s for individual stocks. These services dier from each other in their calculation methodology and, therefore, do not always give the same for a particular stock. The methodologies dier on parameters such as periodicity (daily, weekly, monthly, or annual) for the returns, the number of observations, and the proxy for the market portfolio. Also, these services apply adjustments to after it is calculated. Therefore, you should be very careful in using the s provided by the information services. You must ascertain that the calculation method used by the service is suitable for your application.

3.12

In perfect markets, investors hold risky securities through the market portfolio. Therefore, the only risk that matters is the systematic risk measured by . The Capital Asset Pricing

Portfolio Analysis Figure 3.14: Characteristic line for IBM, Kodak, and Sears.

r rf 0.20

. . . .

94

0.15

. . . . . . . . . .. . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . .. . . . . . . . . .. . . . .. . . . . . . . .. . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ... . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . m f . . . . . . . . . . . . . . . .. . . . . . . . . . .. . .. . . . . .. .. . . .. . . .. . . . . . . . . . . . . . . .. . . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

0.10

0.05

0.05

0.15

r r

0.10

0.20

Model (CAPM) shows that since investors need to bear only the systematic risk, the expected return from a security should be related to its systematic risk only. The relationship between a securitys expected return and its systematic risk is given by the security market line (SML): ki = rf + i (m rf ), (3.23) where ki is the rate of return investors should expect from a security, rf is the rate of return on the risk-free security, and m is the expected return on the market portfolio. Note that on the right hand side i is the only variable that depends on the security. rf and m are constant across securities. Let us use equation (3.23) to calculate the rate of return investors should expect from AT&T during January 1995. The of AT&T is 0.8707. Expected returns on the risk-free security (rf ) and the market portfolio (m ) during January 1995 are 0.0039 per month and 0.0076, respectively.6 Therefore, the expected return from AT&T should be: k = 0.0039 + 0.8707(0.0076 0.0039) = 0.0071. In equilibrium, the price of a security equals its value, and its expected return equals its equilibrium expected return k given by the security market line. If a securitys price is not

6 These estimates are strictly based on the historical data and may be updated to incorporate additional information as we did for the statistics for the stocks.

Portfolio Analysis Figure 3.15: Security market line for 60 stocks, Treasury bills and S&P 500.

0.03

95

0.02 0.01

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ..

equal to its value, and therefore, its expected return is not equal to the equilibrium expected return, the security is said to be mispriced. There will be an excess demand or supply for a mispriced security which will cause the price of the security to change till equilibrium is established. For example, if we believe that AT&Ts returns will continue to behave the same way as they did during the previous 60 months, the expected return from AT&T is 0.0058 (see Table 3.5). Since the expected return from the AT&T (0.0058) is less than what should be expected from it based on its risk (0.0071), AT&T is overpriced. An overpriced or overvalued security is priced above its proper value so that its expected return is lower than what should be expected based on its risk. Because an overpriced security is selling above its value, there would be little demand for it, which would cause its price to go down and the expected return to come up to the level that should be expected from it based on its risk. Once this state is reached, the security is in equilibrium. If AT&Ts expected return had been higher than the proper expected return, the security would have been underpriced or undervalued, which would have caused everyone to want to buy the security. This would create an excess demand for the security, which in turn would bring the prices up and expected return down until the expected return equals the proper expected return. Disturbances in the form of new information arrive in the market continuously. As a result, the markets are never in a state of equilibriumeven when they are closed. The equilibrium rate ki given by the CAPM, therefore, will not exactly equal the expected return, . However, if the model is a realistic description of the market, the answers given by the

1.4 1.2 1.0 0.8 0.6 0.4 0.2 0.0

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

96

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CAPM should, on an average, agree with the actual observations. Therefore, we should observe an increasing linear relationship between and . Figure 3.15 shows the s and average monthly returns s for 60 stocks (indicated by s), the Treasury bills (indicated by ) and the S&P 500 index (indicated by ) for the period January 1965 to December 1994. The relationship between the expected return and is indeed increasing and linear.

3.12.1

Now we have three measures of risk: total risk (measured by ), systematic risk (measured by ), and the residual unsystematic risk. The total risk refers to the variability of returns and is the risk that is faced by the investor. The return that the investor can expect, however, is related to the systematic risk. In other words, the investor is rewarded for bearing only the systematic portion of the risk. There is a direct, linear relationship between the systematic risk and the expected return, and is given by the security market line, equation (3.23). There is no reward for bearing the unsystematic risk. Therefore, all risk-averse investors should try to reduce the unsystematic risk as much as possible. The less the unsystematic risk in a portfolio, the more ecient the portfolio. To understand this issue better, study Figure 3.16. The total height of the bar represents the total risk, the lower (shaded) portion of the bar denotes the systematic risk and the upper (unshaded) portion denotes the unsystematic risk. Suppose an investor is faced with a choice of investing in either security A or B. Both the securities have identical total risks. Therefore,

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the amount of uncertainty about returns with both the securities are equal. However, B has more systematic risk than A. This means that the expected return on B is higher than that on A. A risk-averse investor should, therefore, pick B over A. Similarly, a risk-averse investor should pick security C over A because both C and A oer equal expected returns (they have equal systematic risks) but with A the investor will have to face a greater uncertainty of returns. Similarly, between B and D, B dominates D. We cannot make any clear comparisons between A and D, B and C, and C and D.

3.12.2

The CAPM and the associated security market line give us the proper or equilibrium expected rate of return from an investment. The equilibrium expected rate of return of a security may be compared with its expected return to check if the security is in equilibrium. The direction of departure from the equilibrium may be used to determine if the security is overpriced or underpriced. For example, in our sample calculations we found that the proper expected rate of return (as per the CAPM) for AT&T was 0.0071 per month. The expected return based on the historical performance of the stock was 0.0058 per month. Since the return we expect from the stock (based on the historical data) is less than what should be expected (based on the risk of the stock), AT&T is overpriced and is not a good buy. Another use of the CAPM is in setting the rate of returns that regulated public utilities are allowed to earn on their investments. Analysts calculate the of the stock of a utility company and then calculate the proper expected return to the stockholders based on this . The prices that the company can charge their customers for the services or goods are set such that the rate of return to the stockholders of the company equals the rate expected based on their risks. The equilibrium expected rate of return given by the security market line is the return one should expect from a security based on its risk. This is the discount rate that is needed for valuation of securities as we will see in Chapter 4. Therefore, CAPM nds application in valuation of securities also.

3.12.3

Over time many problems have been found with the CAPM. The main problem is the proper identication of market portfolio. Theoretically, the market portfolio is a value weighted portfolio of all the investment opportunities in the economy. Such a portfolio would be impossible to create, even mathematically, because of its size. The users of the CAPM have to rely on proxies for the market portfolio. The usefulness of the CAPM, therefore, depends on how good a proxy we have for the market portfolio. Dierent people use dierent proxies and come up with dierent answers for the same problem. Secondly, the portfolio theory on which the CAPM is based requires that investors invest in risky securities through the market portfolio. In other words, one should not invest in a

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security such as IBM by itself. One should form a portfolio of all securities in the market and this portfolio should include IBM. In the real world we do not see investors holding such diversied portfolios. At most, they hold portfolios of 20 or 30 securities. These theoretical problems diminish our condence in the CAPM. The CAPM has also had some other problems. According to the CAPM, the only security characteristic that is relevant in determining its expected return is its systematic risk . Therefore, the average returns of securities should not be related to any other characteristic of the securities. During the last 15 years, several violations to this rule have been documented. For example, it has been shown that the average returns on the small rms are higher than those on large rms of equal systematic risk. Similar behavior has been shown with respect to other security characteristics. It has also been shown that the observed returns during January are higher than those expected by the CAPM, and during the other months they are lower than those expected by the CAPM. Despite these problems the CAPM continues to be used because of its simplicity. Also, not too many better alternatives to the CAPM have been proposed. Since a poor model is better than no model at all, people have learned to use the answers given by the CAPM with caution and adjust them to include other factors. During the last 15 years, a new model called the Arbitrage Pricing Model has been proposed as a replacement for the CAPM. This model, however, is mathematically much more complicated than the CAPM and is still being tested to see if it is an improvement over the CAPM.

3.13

Conclusion

In this chapter, the process of designing an ecient portfolio for an investor was described. The eects of the portfolio design parameters on the portfolio characteristics were also studied. Finally, the portfolio selection was extended to the ideal setting of perfect markets which gave us the security market line.

Exercises

Portfolio of Portfolios Henry decided to diversify by investing his money in two dierent portfolios of the stocks of Alpha, Beta, Gamma, and Delta. The compositions of the two portfolios are {0.2, 0.4, 0.3, 0.1} and {0.1, 0.2, 0.5, 0.2}. What is the composition of Henrys overall portfolio if he invests 30% in the rst portfolio and 70% in the second? Security and Portfolio Statistics The following table gives the annual returns on the common stocks of two companies, S1 and S2 , for the past ten years: 3.2 3.1

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t 1 2 3 4 5

t 6 7 8 9 10

(a) Compute the means, variances, standard deviations, covariance, and correlation for the returns on these two securities. Present the information in form similar to Table 3.5. (b) Calculate expected returns and standard deviations for the following ve portfolios of these securities: {0.2, 1.2}, {0.2, 0.8}, {0.6, 0.4}, {0.3, 0.7}, {0.5, 0.5}. 3.3 Optimal Portfolio Selection Mr. I. N. Vestor believes in diversication through portfolio formation. Therefore, rather than putting all his money in one stock, he has invested equally among the common stocks of Attractive (A), Beautiful (B), and Cute (C). To verify whether an equally weighted portfolio is indeed a good choice, you collect information for the three stocks and come up with the following table: Covariance Security A B C 0.13 0.14 0.18 A 0.05 0.02 0.00 B 0.02 0.08 0.03 C 0.00 0.03 0.11

Calculate the expected return and standard deviation for the portfolio that Mr. Vestor is currently holding. Now calculate these quantities for a portfolio with the composition of (0.40, 0.25, 0.35). What message do you have for Mr. Vestor? 3.4 Portfolio Calculations Bob Kong told his investment advisor Larry that he does not mind taking risks as long as he is rewarded properly. Bob would be satised getting a long run average return of 14% per year as long as during any year the return does not fall below 8%. Larry is pretty shrewd in these matters. Using a reasonable assumption about the distribution of returns, he estimated the expected return and the standard deviation of the investment portfolio that Bob would be satised with. (You need to do the same!) Now, Larry selected three of his favorite securities and did a whole lot of calculations for these securities and summarized the information about these securities as follows: Correlation Security A B C 0.12 0.16 0.14 0.18 0.26 0.25 A 1.00 0.04 0.05 B 0.04 1.00 0.10 C 0.05 0.10 1.00

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Larry realized that he will have to try out some portfolios and then see if he can meet or beat Bobs requirements. He decided to calculate the expected return and the standard deviations of the following 5 portfolios: Portfolio 1 2 3 4 5 xA 0.3 0.2 0.2 0.1 0.5 xB 0.3 0.4 0.6 0.8 0.3 xC 0.4 0.4 0.6 0.1 0.2

xA , xB and xC are the fractions of Bobs money that would be invested in these securities. Calculate the expected return and the standard deviation of return for these portfolios. Which of these portfolios should Larry pick for Bob? Why? 3.5 Portfolios Involving a Risk-free Security The return on the risk-free security is 6% per year. The expected return on a risky security is 13% per year and the standard deviation of its returns is 4% per year. Calculate the expected return and standard deviation of several portfolios of these securities and plot the risk-return tradeo line. 3.6 Portfolio Calculations Liz Floyd wants to pick an investment strategy that would yield an expected return of 15% during the next year on her $250, 000. She knows that a local bank is oering 9% on a one year CD. For her investment in the market, Liz decided to pick three blue chip stocks: ALM, BPI, and CRN. Using monthly data, she calculated the statistics for these stocks and modied them to get the annualized expectations for the next year as follows: Correlation Security ALM BPI CRN 0.16 0.20 0.10 0.08 0.10 0.06 ALM 1.00 0.00 0.00 BPI 0.00 1.00 0.02 CRN 0.00 0.02 1.00

Now, you take over Lizs job. The next task is to form portfolios using these stocks and plot the ecient frontier. Calculate the expected return and standard deviations for the following six portfolios (Liz does not want to short sell any stocks): Portfolio 1 2 3 4 5 6 xA 1.0 0.0 0.0 0.1 0.2 0.4 xB 0.0 1.0 0.0 0.2 0.7 0.4 xC 0.0 0.0 1.0 0.7 0.1 0.2

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Plot the results and approximately generate the ecient frontier. Using the CD as the risk-free security, plot the tangency line. Roughly approximate the tangency portfolio. What are the expected return and standard deviation of the tangency portfolio? How should Liz divide her money between the CD and the tangency portfolio to achieve her goal of 15% per year? What will be the standard deviation of her overall investment? What are the lowest and the highest returns she can get? 3.7 Portfolio Analysis Consider the following statistics for the annual returns of three securities: Covariances Security A B C 0.15 0.19 0.13 A 0.32 B 0.08 0.38 C 0.27 0.16 0.26

Create a portfolio of securities B and C that has the same expected return as A. Does this portfolio dominate security A? 3.8 Portfolio Calculations The expected returns and the covariances for three securities are given below: Covariances Security A B C 0.15 0.12 0.17 A 0.0484 0.0330 0.0260 B 0.0330 0.0625 0.0380 C 0.0260 0.0380 0.0906

(a) Mr. Thomas believes that an equally weighted portfolio provides as good a diversication as there is. So he decided to invest in a portfolio constructed as {0.33, 0.33, 0.34}. Calculate the expected return and standard deviation of his portfolio. (b) Ms. Walker decided to invest in a portfolio constructed as {0.50, 0.15, 0.35}. Calculate the expected return and standard deviation of her portfolio. (c) Between Mr. Thomas and Ms. Walker, who has the better portfolio? Why? 3.9 Tangency Line Suppose the risk-free rate is 7% and the tangency portfolio has an expected return of 17% and a standard deviation of 21.4%. (a) Calculate the expected return and risk for an investor who invests 75% in the tangency portfolio and 25% in the risk-free security. (b) An investor wants to earn an expected return of 15%. How much should she invest in the risk-free security and how much in the tangency portfolio? What will be the risk faced by this investor? 3.10 Hedge Portfolios Derive the portfolio weights for a hedge portfolio of two securities with perfectly positive correlation following the steps in section 3.8.1.

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3.11 Hedge Portfolios Consider two securities S1 and S2 . Their annualized expected returns are 10% and 12%, and standard deviations of their returns are 18% and 20%. The correlation between returns of the two securities is 1. What portfolio weights would lead to a perfect hedge portfolio made using S1 and S2 ? What will be the portfolio composition if the correlation were +1? 3.12 Rate of Return on a Mutual Fund Three years back I purchased 98 shares of Dean Witters USGvt fund for $10.27 each. The NAV of these shares today is 9.54. Because of reinvestment I own 130 shares today. What is the annualized rate of return on my investment during these three years? 3.13 Risk-free and Market Betas Show that the of market is 1 and that of the risk-free rate is 0. 3.14 CAPM Calculations The annual standard deviation of returns on the stock of Canon, Inc. is 0.30, while that on the market portfolio is 0.22. The correlation between the returns of Canon and the market portfolio is 0.49. Calculate the for the Canon stock. The risk-free rate during the next year is expected to be 0.07. The expected return on the market portfolio is 0.12. What is the proper expected return on the stock of Canon? 3.15 and CAPM Consider the following table of information. The numbers in the last row are the column sums. Month 1 2 3 4 5 6 7 8 9 10 11 12 rS&P 0.015 0.025 0.037 0.045 0.050 0.030 0.035 0.040 0.010 0.050 0.035 0.045 0.337 rMBI 0.045 0.035 0.040 0.040 0.050 0.040 0.065 0.035 0.010 0.070 0.040 0.050 0.420

2 rS&P 2 rMBI

rS&P rMBI 0.000675 0.000875 0.001480 0.001800 0.002500 0.001200 0.002275 0.001400 0.000100 0.003500 0.001400 0.002250 0.019455

0.000225 0.000625 0.001369 0.002025 0.002500 0.000900 0.001225 0.001600 0.000100 0.002500 0.001225 0.002025 0.016319

0.002025 0.001225 0.001600 0.001600 0.002500 0.001600 0.004225 0.001225 0.000100 0.004900 0.001600 0.002500 0.025100

(a) Calculate the of the stock of MBI using S&P as a proxy for the market portfolio. (b) The risk-free rate is estimated to be 7% per year. Use the historical mean return on S&P as an estimate of the expected return for the market. Calculate the proper expected return for the stock of MBI. (c) Use the historical mean return on MBI as an estimate of its expected return. Is the stock of MBI priced correctly? Should you buy the stock or sell the stock?

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3.16 CAPM and Equilibrium The of the common stock of Elwin Motors is 1.7. It is expected that the return on the risk-free security and the market for the coming year will be 8% and 14%, respectively. Analysts also expect that the price of the common stock of Elwin Motors one year from now will be $18. Elwin has a policy of paying annual dividends. Its next dividend will be one year from now and is expected to equal $2 per share. (a) Calculate the proper expected return for Elwin. (b) Calculate the proper price for the common stock of Elwin. (c) The common stock of Elwin is currently priced at $16.25. Is the stock overpriced or underpriced? Should you buy it or sell it? (d) What will be the expected return if you were to buy the common stock of Elwin today at the prevailing market price, hold it for one year, receive the dividend and then sell it? Is this return higher than the proper return or lower than the proper return? Should you buy the stock or sell it? (e) What will be the eect of investors action (buying/selling) on the market price and on the expected return from the stock? When will they stop buying/selling? (f) Repeat parts (c), (d), and (e) assuming that the market price of Elwin today is $17.50. 3.17 of a Portfolio The of a portfolio is equal to the weighted sum of the s of the securities that make up the portfolio, just like the expected return. Securities A and B have s of 0.7 and 1.5 respectively. How should an investor distribute his capital between the two securities to make a portfolio that has a of 1? 3.18 The Various Expected Returns Consider the following information for the common stock of DRAM Corporation. The average monthly return during the past 3 years has been 1.1%. The current price of the stock is $15.00. An investor expects that next month the stock will pay a dividend of $0.15 and after that it may be sold for $15.10. The for the stock is 1.2. Based on this and the expected returns on the market and the risk-free security, the discount rate for the security is calculated to be 1.15% per month. Interpret the expected returns provided by these three items of information. How do they dier from each other?

According to the portfolio theory, investors should diversify by dividing their money among several securities to form portfolios. Nevertheless, many investors buy and sell individual securities because they believe they can spot good investment opportunities. The mechanics of identifying the securities that should be bought or sold is described in this chapter. In a well functioning competitive nancial market, it should not be possible for an investor to identify superior investments consistently. This argument leads to the Ecient Market Hypothesis which is also discussed in this chapter. Finally, we discuss the method for evaluating the performance of investments.

4.1

Valuation

Valuation is central to the security selection process. If we can determine the value of a security, then the selection decision can be made by comparing the value of the security with its market price. If a securitys price is less than its value, the security is underpriced and it should be bought. Conversely, if the price is more than the value, the security is overpriced and it should be sold. A securitys value is equal to the present value of the expected cashows from the security. This valuation system seems to ignore other tangible or intangible benets from the security. However, that is not the case. Non-cash benets may be taken into account by imputing cash equivalence to them using opportunity cost methods. In our discussion, we will assume that all benets have been converted to cash values. The expected cashows from a security can be estimated by a careful study of the security and the issuer. The theory of present value is related to the principles of utility. A cashow to be received today has a higher utility than the same cashow to be received later because we prefer an earlier consumption over a later consumption. Therefore, a cashow to be received later 104

105

has the same utility as some smaller amount to be received today. This smaller amount, whose utility is the same as that of the future cashow, is the present value of the future cashow. For example, if I am indierent between receiving $80 now and receiving $100 a year later, then $80 is the present value of $100 to be received a year later. Present value is the discounted value of a cashow to be received in the future. The factor by which a cashow is multiplied to get its present value is known as the discount factor. The one year discount factor in my case is 0.8 because $80 = $100 0.8. To nd out the present value of $100 to be received two years from now, we have to discount it twice: once from year 2 to year 1 and then from year 1 to today. Assuming the same discount factor for both the years, the present value is 100 0.8 0.8 = 100 0.82 = $64. Therefore, a two year discount factor is the square of the one year discount factor. Once we know the one year discount factor, we can calculate the present value of any cashow to be received any time assuming that the same discount factor holds for every year. For example, the present value of $600 to be received 4 years from now is $600 0.8 0.8 0.8 0.8 = 600 0.84 = $245.76. Similarly, the present value of $800 to be received 3.5 years from now is $800 0.83.5 = $366.36. Discount factors can be used to calculate not only the present value of a cashow, but its value at any other time. For example, the value one year from now of $400 to be received 4 years from now is $400 0.83 = $204.80. This process of converting the value of a cashow from a time to an earlier time, or taking it back in time, is known as discounting. The value calculated using discounting is known as discounted value. If the cashow is discounted all the way to the present, the discounted value is known as present value. The discount factor is often expressed in terms of a discount rate. The discount factor for t years is related to the discount rate as: discount factor = 1 . (1 + discount rate)t (4.1)

The units of discount rate are % per year, the same as the units of interest rate or the rate of return. Using equation (4.1), we nd that a one year discount factor of 0.8 is equivalent to a discount rate of 0.25 or 25%. The name discount rate arises from the fact that it is the rate at which a dollar loses value due to the delayed consumption. If a dollar loses value at the rate of 25% per year, then $100 to be received next year have the same value as $80 today. Discount rate not only has the same units as the rate of return but it also has the same interpretation. Both discount rate and rate of return are measures of compensation for delayed consumption. Therefore, for calculation purposes, it is easier to think of the discount rate as an interest rate or a rate of return. With this interpretation, the present value may be viewed as an amount that would grow at the discount rate to become the future cashow. Discount rates, like interest rates, are aected by several factors in the economy. For example, expectations of a higher ination will make the discount rates higher. Similarly, in a risky situation, the increased risk of the cashows would make the discount rates higher. Since dierent securities have dierent risk, the discount rates applicable to the cashows

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of dierent securities are dierent. The discount rate for a security is the expected return based on its risk. In Chapter 3, we saw that the capital asset pricing model (CAPM) gives us the discount rate. There are two caveats that one should be aware of in using the CAPM to calculate discount rates for valuation. First, CAPM is a single period model. Therefore, results obtained using CAPM are valid for single period situations only. Most valuation applications, however, are multiperiod. Therefore, the discount rate obtained from CAPM may not be suitable for these applications. Second, from our discussion of term structure of interest rates, we know that rates for dierent maturities may be dierent. Therefore, cashows at dierent times should be discounted at dierent rates. By using the same discount factor for dierent years, we are discounting the cashows in dierent years at the same rate and therefore we are assuming that the term structure is at, which is rarely true. The errors caused by the problems mentioned above, however, are not too severe. Furthermore, there are no well accepted alternatives to CAPM for determining the discount rates. Therefore, we will use CAPM to determine the discount rates keeping the limitations in mind.

4.2

PV = c df k t = c c 1 = , t (1 + k ) (1 + k )t (4.2)

The present value, PV , of a cashow c to be received t periods from now is calculated as:

where df k t is the discount factor for t periods at the discount rate of k per period. The present value calculation discounts (brings back) a cashow by t periods as shown in the time line below:

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . .

... t1 t 0 1 2 3 Note that the discount factor for t periods is related to the discount rate k as: 1 . df k t = (1 + k )t

PV = c df k t

(4.3)

Present value of several cashows is calculated by adding the present values of the individual cashows. Therefore, if cashows c1 , c2 , c3 , . . ., are expected from a security at times t1 , t2 , t3 , . . ., as shown below: c1 t1 c2 t2 c3 ... t3

Security Selection and Performance Evaluation then the present value is calculated as: PV = =

k k k cj df k tj = c1 df t1 + c2 df t2 + c3 df t3 + , cj c1 c2 c3 = + + + . t t t j 1 2 (1 + k ) (1 + k ) (1 + k ) (1 + k )t3

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(4.4a) (4.4b)

One precaution that should be exercised in using the present value equations is that the times t1 , t2 , t3 , . . ., should be expressed in the same unit as the discount rate k . For example, if a problem involves cashows of $0.40 every quarter for 3 quarters as shown below: 0.40 0 1 0.40 2 0.40 3

and the discount rate is 11% per year, then the following calculation is incorrect: PV = 0.40 0.40 0.40 + + = 0.98 2 (1 + 0.11) (1 + 0.11) (1 + 0.11)3

because the times of cashow are being measured in quarters (1, 2, 3) while the discount rate is expressed on an annual basis. The time units may be made consistent in one of the two ways: Convert the discount rate into the time unit of the cashows. Continuing with the example, rst convert the 11% per year to a quarterly rate as: (1+0.11)1/4 1 = 0.0264. Now do the PV calculation as: PV = 0.40 0.40 0.40 + + = 1.14. 2 (1 + 0.0264) (1 + 0.0264) (1 + 0.0264)3

Convert the unit on the time line by measuring the distances on the time line in the same units as the discount rate. With this conversion, the cash ows in our example are 1/4, 1/2, and 3/4 years from the present as shown in the time line below: 0.40 0 1/4 0.40 1/2 0.40 3/4

Now the PV can be calculated as: PV = 0.40 0.40 0.40 + + = 1.14. (1 + 0.11)1/4 (1 + 0.11)1/2 (1 + 0.11)3/4

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One should also be careful with subperiod compounding in present value applications. In PV calculations, eective rates should be used rather than stated rates. Suppose we want to nd the present value of $100 to be received 1 year from now using a discount rate of 8% per year compounded quarterly. As you know from Chapter 2, the eective rate for this problem is 2% per quarter or (1 + 0.02)4 1 = 0.08243 or 8.243% per year. The present value may now be calculated either as 100/(1.02)4 = 92.38 or as 100/(1.08243) = 92.38. The rst approach uses the eective quarterly rate while the second approach uses the eective annual rate. A similar approach with suitable modication may be used with continuous compounding. Recall that the relationship between the continuously compounded rate r and the corresponding eective rate re is given by (1 + re ) = er . Therefore, if the discount rate is k per period compounded continuously, we may replace (1 + k ) by ek in the present value calculations. Suppose we want to nd the present value of $500 to be received 3 years from now and the discount rate is 12% per year compounded continuously. Without continuous compounding, we would calculate the PV as 500/(1 + 0.12)3 . To take into account the continuous compounding, the (1 + 0.12) should be replaced by e0.12 to get 500/(e0.12 )3 = 500/e3(0.12) = 500/e0.36 = 348.84.

4.2.1

Special Cases

Equations (4.4a) and (4.4b) on page 107 are the most general ways of calculating present values. The equations, however, can be tedious and time consuming if there are many cashows. There are some special cases in which the equations may be simplied and compacted. First, we may have a situation involving a nite number, n, of equal cashows occurring at times 1, 2, . . ., n 1, n. This cashow situation is known as an annuity. The cashows for an annuity are shown below: c 1 c ... 2 c n1 c n

This equation can be compacted by summing up the terms to get: PV = c 1 1 1 , k (1 + k )n (4.5a) (4.5b)

= c af k n,

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where the quantity that is being multiplied by c is known as the annuity factor. The annuity factor af k n , when multiplied with a cash amount c gives the present value of n cashows of c each at times 1, 2, . . ., n. Note that the annuity factor is dened as: af k n = 1 1 1 . k (1 + k )n (4.6)

Another special situation is when an annuity goes on forever rather than terminating after n cashows. In that case it is called a perpetuity. The cashows for a perpetuity are shown below: c c c 1 2 3 ...

The present value of a perpetuity is calculated by taking the limit of equation (4.5a) with n to get: 1 c PV = c = . (4.7) k k Finally, there is the growing perpetuity, where the cashows not only go on forever but they also grow at a constant rate as shown below: c 1 c(1 + g ) 2 c(1 + g )2 3 ...

Note that the growing perpetuity formula is valid only if the cashow growth rate g is constant and less than the discount rate k . If the cashows grow at a higher rate than the discount rate then equation (4.8) cannot be used. The present value of a growing perpetuity with a growth rate higher than the discount rate is innity. Note that the simple perpetuity is a special case of the growing perpetuity with g = 0.

4.2.2

Some Hints

You should be careful while using the annuity and perpetuity (simple and growing) shortcut formulae. These formulae actually give us the discounted value of the cashows at a time point that is one period before the rst cashow in the annuity or the perpetuity. If the annuity or perpetuity begins at a time point that is one period from the present then the formulae will give us the present value. If the annuity or perpetuity is delayed, i.e., begins at

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a later time point, then the formulae will not give us the present value. If the rst cashow is at time t then the formulae give us the discounted value at time t 1. To nd the present value, we will have to discount this value further by using appropriate discount factor. As an example, let us nd the present value of the following cashows at the discount rate of 10% per period: 10 0 1 2 3 10 4 10 5 10 6

The rst step is to recognize that this is a delayed annuity with 4 cashows beginning at .10 t = 3. Applying the formula, 10af 0 4 , therefore, will give us the value at time t = 2 because the rst cashows is at t = 3. To nd the present value, i.e., the value at t = 0, we will discount this value by two periods and get

.10 0.10 PV = 10af 0 = 26.20. 4 df 2

An alternative way to calculate the present value of these cashows is to view them as the dierence between two annuities: one going from t = 1 to t = 6 and the other going from t = 1 to t = 2 as shown below:

10 0 10 0 1 10 2 10 3 1 10 4 2 10 5 3 10 6 0 1 2 3 4 5 6 10 4 10 5 10 10 = 6 10

.10 .10 PV = 10af 0 10af 0 = 26.20. 6 2

Another situation you may encounter is where the rst payment of annuity or a perpetuity begins at a partial period from the present. For example, consider the following cashows:

30 1/31/91 3/31/91 30 6/30/91 30 9/30/91 30 12/31/91 1,420 3/31/92

Suppose the discount rate is 3% per quarter. The cashows can be broken down to an annuity of four cashows of $30 each and a single cashow of $1,420. The payments, however, do not begin one period (quarter) from the present. They begin 2/3 quarters from the present. To nd the present value of the cashows, therefore, we proceed in two steps. First, we nd the discounted value of all the cashows on 3/31/91 and then discount it to 1/31/91:

.03 .03 0.03 PV = [30 + 30af 0 + 1,420df 0 3 4 ]df 2/3 = 1,349.65.

Security Selection and Performance Evaluation The PV calculation for this example can also be done as:

.03 0.03 0.03 0.03 0.03 PV = 30df 0 2/3 + 30df 5/3 + 30df 8/3 + 30df 11/3 + 1,420df 14/3 = 1,349.65.

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As we saw in the examples above, there may be many ways of calculating the present value of a given set of cashows. Depending on your preferences and insight about the present value calculation process, you may use any of the alternatives.

4.3

Return

In Chapter 2, we saw how to calculate the rate of return on an investment in a single period setting. The cashows for a one period investment requiring an initial outlay of p0 and resulting income of d and nal cash inow of p1 are shown in the time line below: p0 0 d + p1 1

We will follow the convention of denoting the cash outows with a negative sign on the time line. From Chapter 2 we know that the return in this situation is calculated as: r= p1 p0 + d . p0

Cross multiplying and simplifying this equation we get: d + p1 . 1+r The right hand side of this equation is the expression for present value of the future cashows with the discount rate k replaced by the rate of return r and the left hand side is the initial cash outow. This provides us a valuable insight. The rate of return on an investment can be calculated by setting up the following equation: p0 = Initial cash outow = PV of future cashows, and using symbol r rather than k for the discount rate.1 The value of r obtained by solving the equation is the rate of return from the investment. This calculation procedure is known as calculating the internal rate of return. This insight helps us calculate returns for situations that involve multiple cashows at dierent times. The time line below shows a general multiperiod situation: c0 0

1

c1 t1

c2 t2

c3 ... t3

Security Selection and Performance Evaluation To calculate the rate of return, we solve the following equation for the unknown r : c0 = c1 c2 c3 + + + . t t 1 2 (1 + r ) (1 + r ) (1 + r )t3

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Calculating return requires some mathematical and algebraic skills. The calculations, inevitably require using present value concepts. Using annuity and perpetuity shortcuts can also make the calculations easier. Returns may be calculated in many dierent situations. Sometimes we want to calculate the rate of return for shares we bought in the past and are going to sell now. In that case all the cash ows on the time line would be actual, realized cashows. Often, we want to estimate the rate of return we can expect from a security if it is purchased today. In that case the cashows on the time line will be based on our expectations. Once the realized or the expected cashows have been determined and put on the time line, the process for calculating the rate of return is the same. Follow these basic steps to calculate the rate of return: Identify the cashows. Put the cashows on a time line diagram. Write the equation to calculate the internal rate of return. Calculate the internal rate of return. Present the answer in proper units. These steps are illustrated using examples below: Example 1 : Lisa Robinson bought 100 shares of Magnet, Inc. on January 15, 1989 for $12 per share. On March 15, 1989 she received a dividend of $0.10 per share. On June 15, Lisa got another dividend of $0.08 per share. On July 15, Lisa sold the shares for $13 per share. The cashows on a per share basis are shown in the time line diagram below: 12.00 0.00 0.10 0.00 0.00 0.08 13.00 1/15 2/15 3/15 4/15 5/15 6/15 7/15

The following equation can now be written for the monthly rate r : 12.00 = 0.10 0.08 13.00 + + . 2 5 (1 + r ) (1 + r ) (1 + r )6

This equation can be solved using trial-and-error method. In trial-and-error method, we try a value of the unknown (r ) and see if the two sides of the equation match. We try new values of r till the two sides of the equation are reasonably close. While

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there are no simple rules of thumb about the initial guess in a trial-and-error process, a proper value can be determined by examining the time unit of the rate. For example, a 10% value would make sense with annual rate but not with a monthly rate. While trying new guesses, keep in mind that the present value and the discount rate have inverse relationships. Therefore, if you want to reduce the present value, try a higher value for the discount rate, and vice versa. The following table shows the result from trial-and-error for Lisa Robinsons cashows: r 0.010 0.015 0.017 r rhs 12.42073 12.06038 11.91967 12

From the trial-and-error table we see that the answer lies between 0.015 and 0.017. We could try to get a more accurate answer by trying many other values. However, a good approximation may be obtained using linear interpolation. Linear interpolation uses two values from the trial and error process that are close enough to the nal answer, and nds a value that is a very good approximation to the nal answer in most situations. There are many ways to set up linear interpolation. One way is shown below: r = 0.015 + 0.017 0.015 (12 12.06038) = 0.01586. 11.91967 12.06038

The rate of return earned by Lisa Robinson, therefore, was 1.586% per month or (1 + 0.01586)12 1 = 0.2078 or 20.78% per year. Example 2 : James Henry is buying a savings bond for $300. The bond will not make any interim payments but on maturity in 15 years, it will pay $1000. The annual interest rate that will be earned by James can be calculated by solving the following equation: 300 = 1000 (1 + r )15

1/15

1 = 0.0836.

Therefore, the rate of return is 8.36% per year. Example 3 : I am planning to buy 100 shares of IBM selling at $100. I expect IBM to pay dividends of $1.10 every quarter, the rst payment coming exactly one quarter from

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today. I also expect that I will be able to sell the shares for $115 in two years. The following time line shows the cashows from my investment: 100 0 1.10 1 1.10 2 1.10 3 1.10 4 1.10 5 1.10 6 1.10 7 1.10+115 8

Note that the last cashow consists of the nal dividend of $1.10 and the expected selling price of $115. The following equation can be written for calculating the quarterly rate of return r : r 100 = 1.10af r 8 + 115df 8 . This equation cannot be solved for r using algebraic methods. Therefore, we have to use trial-and-error and interpolation. The trial-and-error process is shown below: r 0.030 0.025 r af r 8 7.0197 7.1701 df r 8 0.7894 0.8207 rhs 98.50372 102.27301 100

Now we can apply the interpolation: r = 0.025 + 0.030 0.025 (100 102.27301) = 0.028. 98.50372 102.27301

Therefore, my expected return from IBM is 2.8% per quarter or (1+0.028)4 1 = 0.1168 or 11.68% per year. Example 4 : Fred Hitchcock is investing $300 in a security. He does not expect any income from the security for 2 years. After that he expects the security to provide cashows every six months. The rst cashow is expected to be $20 and the cashows are expected to increase by 2% every six months. Freds cashows in six month time units are shown below: 300 ... 0 1 4 5 6 7 20 20(1.02) 20(1.02)2 ...

Realizing that the cashows represent a delayed growing perpetuity, the following equation can be used to solve for the semiannual rate of return: 300 = 20 1 . (r 0.02) (1 + r )4

Security Selection and Performance Evaluation Figure 4.1: Security selection using returns.

Underpriced

. . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

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rf

SML

Correctly Priced

Overpriced

The equation can be solved using trial-and-error and interpolation: r 0.050 0.070 0.072 r r = 0.070 + rhs 548.4683 305.1581 291.2376 300

0.072 0.070 (300 305.1581) = 0.071. 291.2376 305.1581 The semiannual expected rate of return from Freds investment is 7.1%. The annual rate is (1 + 0.071)2 1 = 0.1470 or 14.7% per year.

4.3.1

In section 4.1, we saw that a security can be selected by determining whether it is underpriced or overpriced. This criterion is essentially the Net Present Value (NPV) method you learned in your basic nance course because it relies on the dierence in the current cash outow and the present value of future cashows. Security selection can also be done by comparing a securitys expected return with the rate of return that should be expected based on its risk, i.e., its discount rate. A security whose expected return is higher than its discount rate should be bought. This security is underpriced. Conversely, if a securitys expected return is less than its discount rate, the security is overpriced and should be sold. The expected rate of return for a correctly priced security is equal to its discount rate. Figure 4.1 shows underpriced, correctly priced, and overpriced securities with respect to the security market line (SML).

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Return is used as a primary decision making variable in investments. We saw above that return is the same as the internal rate of return (IRR). From your course in basic nance you may remember that the criterion for selecting a project should be its net present value (NPV) rather than the IRR because the IRR has some shortcomings and problems. Nevertheless, decisions using IRR provide the same answers as those using NPV as long as the following conditions hold: One can invest as much in a security as one wants. Mathematically, the rate of return can be determined uniquely and is not imaginary. These conditions hold for most investors and for most securities in the market. Therefore, both NPV and IRR are appropriate for investment decision making. Both methods provide the same nal recommendation about whether to buy or sell a security. Let us take an example. The shares of BT&T are selling for $36. I expect BT&T to pay regular quarterly dividends of $0.43 per share for one year. I believe that after receiving the fourth dividend one year from now, I can sell the shares for $38 per share. The cashows are shown in the time line below: 36 0.43 1 0.43 2 0.43 3 0.43+38 4

The of BT&T is 0.92. The risk-free rate during the coming year is expected to be 7% per year and the expected return on the market for the next year is 13.5%. I want to determine whether to buy the stock of BT&T. The discount rate for BT&T is calculated using the security market line as rf + (m rf ) = 0.07 + 0.92(0.135 0.07) = 0.1298 or 12.98% per year. Since the dividends are on a quarterly basis, we will need the quarterly discount rate. The quarterly discount rate is (1 + 0.1298)1/4 1 = 0.0310 or 3.10% per quarter. Let us rst use the NPV approach. We calculate the PV of the future cashows as:

.031 .031 PV = 0.43af 0 + 38df 0 = 35.23. 4 4

Since the PV of future cashows is less than the current price of BT&T, the stock is overpriced and, therefore, I shouldnt buy it. Now let us use the IRR approach. We set up the following equation to calculate the quarterly rate of return r : r 36 = 0.43af r 4 + 38df 4 ,

Security Selection and Performance Evaluation and solve for r using trial-and-error and interpolation: r 0.030 0.025 0.026 r r = 0.026 + af r 4 3.7171 3.7620 3.7529 df r 4 0.8885 0.9059 0.9024 rhs 35.36086 36.04377 35.90587 36

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0.025 0.026 (36 35.90587) = 0.0253. 36.04377 35.90587 So if I invest in BT&T, I will earn a quarterly rate of return of 2.53%. Since, based on the risk of BT&T, I should earn 3.10% per quarter, the stock is overpriced and I should not buy it. Note that both the NPV and the IRR methods are based on the same data and result in the same nal conclusion. Mathematically, the NPV approach is a little easier. However, in practice, people feel more comfortable dealing with the rates of returns than net present values. Therefore, the IRR approach is also used quite often. A third alternative that we did not show here is based on estimating the quarterly expected rate of return from BT&T using historical data. Once the expected return is known, it is compared with the discount rate in the same way as the IRR to draw conclusions about buying or selling the security.

4.4

Market Eciency

The last few sections showed how one should value securities to decide whether to buy or sell them. The objective of picking securities is to be able to earn a higher rate of return on investment than appropriate for the amount of risk taken. The popular name for earning a higher rate of return than justied by the amount of risk is beating the market. For example, if the discount rate of a stock is 12% per year and you can buy it at a time when the stocks price is temporarily down so that you expect to make 15% per year, you are earning 3% more than what you should be for the amount of risk you are taking. This dierence between the actual return earned and the proper return on an investment is known as abnormal return. Abnormal returns can be made only if securities are mispriced, i.e., their prices do not equal their values. If a market is in equilibrium, then there would be no abnormal returns to be made because the securities would be priced correctly, i.e., the security prices would be equal to their values and their expected returns would be equal to the proper expected returns. A market where securities are priced correctly, at all times, is called an ecient market. In an ecient market, security prices reect all relevant information and therefore investors cannot make abnormal returns using their information. In popular terms, investors cannot

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beat an ecient market. The rate of return investors earn in an ecient market is consistent with the amount of risk they take. An ecient market is a theoretical construct because real securities markets are never in equilibrium because of a constant inux of information and other disturbances. It is possible that securities are mispriced while the market is adjusting. In a competitive market, such mispricings should not last long. If a security is underpriced, investors should want to buy it. This demand pressure should increase the security price and bring it close to equilibrium. The equilibrium in securities markets is of stable kind because the forces created by the disturbances act in such a way as to restore the equilibrium. In real securities markets market eciency is a matter of degree. The longer it takes for market prices to adjust to new information, the less ecient the market. A competitive market should be ecient without external pressure or control. The reason is that no single investor has a monopoly on information. Information is available to all investors (maybe at a cost) and new information arrives randomly, and there is no privileged investor or group of investors who get the information rst every time. In a competitive market, where all participants are trading to maximize their utilities, any discrepancy in prices will be eliminated quickly. This will ensure that the security prices reect proper value most of the time. Market eciency can be understood by comparing a competitive market with a busy parking lot. A mispriced security is like an open parking space. A busy parking lot would be inecient if an open parking space remains unclaimed for a long time. The reason there are no open spaces in a busy parking lot is that there are people who are always searching for the open parking spaces. The moment they see one, they ll it. Similarly, in real securities markets, there are people who are always looking for mispriced securities to make extra prots. Therefore, as soon as a security becomes mispriced, these investors trade the security and this trading brings the security back to equilibrium. These investors who are looking for mispriced securities are speculators and arbitragers. While speculators and arbitragers have earned a bad name in the recent years, they serve a very useful purpose by keeping the markets ecient. They keep the market prices in line with the values. Market eciency, therefore, is an outcome of competition among investors. It is not a natural law that must be followed by all markets. An ecient market is important for an economy. Only in an ecient market can the public invest without fear of being cheated out of their fair returns. If it is possible for some investors to make abnormal returns then other investors would shy away from the market. This will ultimately hurt the economic growth. Markets can be made more ecient by increasing competition among investors.

4.4.1

To test how ecient the securities markets are, an ecient market hypothesis (EMH) is derived using the theoretical construct of ecient market. The ecient market hypothesis

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states that the security prices reect the relevant information and therefore, one cannot make abnormal returns using information. The ecient market hypothesis is like a null hypothesis in statistical hypothesis testing. To test the eciency of a market, statistical data is used to see if the market prices violate the ecient market hypothesis. If the null hypothesis cannot be rejected, one concludes that the market is ecient. The tests of ecient market hypothesis usually involve comparing the returns earned by using a trading rule with that of a simple buy and hold strategy. For example, if I believe that I can beat the market by using the trading rule of buying stocks on the second Monday of every month and selling them on the fourth Wednesday, then the results of that strategy would be compared with a simple strategy of buying shares and holding them. The comparison would be made for a few stocks for a few months to draw conclusions. Since there are dierent kinds of information, we may be willing to accept the EMH with respect to some kind of information more willingly than with respect to others. The ecient market hypothesis, therefore, is stated in three dierent forms with respect to three dierent denitions of information. Successive forms of EMH become stricter and include the previous form of the hypothesis. The three forms of EMH are described below: The Weak Form EMH states that the markets are ecient with respect to the past prices. In other words, all trends and cycles evident in past prices have already been incorporated in the current prices. Therefore, trading rules based on price patterns would not allow one to make abnormal returns. This form of the ecient market hypothesis is dicult for technical analysts or chartists to accept. Technical analysts examine the charts of past security prices, sometimes using sophisticated statistical techniques (moving averages, ltering, and lagged behaviors), to predict the future price movements. The weak form EMH says that such techniques would not enable the chartists to make higher returns than those justied by the amount of risk taken. The Semi-strong Form EMH states that the markets are ecient with respect to all publicly available information including the past prices. Publicly available information consists of news items, statements by the CEOs and other company ocials, reports released by security analysts, etc. This form of market eciency is dicult for fundamental analysts to accept. Fundamental analysts study corporate nancial statements and make projections about the future based on their analysis and the currently prevailing conditions. The semi-strong form of EMH implies that fundamental analysts would not be able to make any higher returns than justied by the amount of risk of the investment. The Strong Form EMH states that the markets are ecient with respect to all information whether publicly available or not. The strong form hypothesis, therefore, also includes private, inside information.

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4.4.2

Thousands of studies have been conducted to test the eciency of the securities markets. The evidence is mixed and depends on the form of the EMH. Most of the studies have been done by academics and conclude that the markets are ecient. Some practitioners disagree with the conclusions of these studies. They claim that the studies are too academic and ignore real elements of securities trading. They believe that it is possible to have a system that allows one to earn abnormal returns. Of course, if one has such a system, one wouldnt share it with others. Therefore, they claim that if the markets were inecient, we wouldnt nd out about it. The evidence regarding the three forms of the EMH is summarized below. There is substantial empirical evidence that supports the weak form eciency of the securities markets. Statistical tests show that stock prices and returns move randomly and do not have discernible pattern. The fact that there are no systematic patterns in price or returns can be judged by examining the time series of prices or returns. Theorists say that such a pattern cannot exist because the existence of such a pattern would be self destructive. For example, suppose a price pattern exists that predicts that the price of a stock will double in three months. The moment investors can infer this, they will start buying the stock. This will create excess demand for the shares and will bring up the price instantly, rather than in three months. Trading by investors, therefore, will destroy the pattern. In spite of the strong evidence for the weak form eciency of the securities markets, technical analysts, however, continue to believe in and trade using historical price trends. The risk-return approach taken by an ecient market believer should not be confused with the approach taken by the chartists. Both groups examine past data to derive expectations about the future behavior. A chartist attempts to pinpoint the direction in which the security price, and therefore, the return will move. The pattern of past price movements is crucial to this decision making. The ecient market believer uses the past data to estimate the expected return and risk using statistical principles. The pattern of past movements is not important to the ecient market believer. The evidence on the semi-strong form eciency of securities markets is mixed. Market eciency, in the context of semi-strong EMH is dened in terms of the speed with which the market adjusts to new information. The evidence from studies shows that depending on the reliability of information and its source, market prices adjust to new information in a matter of minutes or may take a few days. Furthermore, the market does not wait for information to be revealed fully or for an event to take place. The market reacts to the news gradually as it unfolds. For example, the market price of a companys stock jumps as soon as investors nd out that the company may receive a merger oer from a bidder. Similarly, stock prices change as companies le new patents or make signicant progress in research and development, rather than changing when the products based on the research are released. There has not been much empirical testing of strong form eciency of the markets because of the unavailability of data. The consensus, however, is that the markets are not ecient

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with respect to the private, inside information. However, there are laws designed to inhibit insider trading and keep the market ecient. As mentioned above, ecient market studies usually compare the prots from a trading strategy with that of a buy and hold strategy. The conclusions drawn by the studies are based on the assumption of no transaction costs. Inclusion of transaction costs makes the evidence even strongly in favor of the eciency of markets because trading rules require frequent buying and selling of securities which adds signicant transaction costs while buying and holding requires only two transactions and has much lower transaction costs. In real trading, the comparison of buy and hold prots with the prots from trading strategies should also take information costs into account. Information which is utilized to make trading rules may have a substantial cost and it may lower the net prots from trading strategies signicantly. Information costs may include the cost of educating oneself, the cost of analyzing information, and the cost of specialized sources of information such as investment newsletters. A nal consideration which is important in the strong form eciency of the market is the potential penalty of insider trading. While the prots from the insider trading may be substantial, the penalties, if caught, are also large. The expected value of the prots net of penalties, therefore, may not be more than the prots from a buy and hold strategy. Based on the evidence of the studies of market eciency and inclusion of the costs of information, trading, and penalties of insider trading, we can conclude that the securities markets are very close to being ecient. There may be small pockets of ineciencies while the market is adjusting to new information. Therefore, the usefulness of security selection methods depends not only on the accuracy of information but also on the quickness with which the investor can decide and trade based on the information.

4.4.3

Based on the conclusion that the securities markets are ecient, one may argue that security or portfolio selection is a futile exercise. However, this is not the case. Investors can still benet by analyzing information and selecting securities and portfolios for the reasons listed below: The securities markets reward investors for taking risk. The return on the average stock in the market, for example, is about 12% per year. In the long run, higher risks lead to higher average rewards. Taking risk in the stock market is not like taking risk in a gambling casino. The average return to the gamblers in a casino is negative by design, because the person running the casino has to make money. The average return to the players in a friendly game of poker is zero: some players lose and others win. In the stock market, however, it is possible for everyone to win. The more risk one takes, the higher the expected rewards. The proper way to approach the investment decision

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making is to choose a level of risk and select securities or ecient portfolios that have the desired level of risk. The securities markets are not absolutely ecient. The market does take some time to react and adjust to new information. The rst few investors who trade based on an information are more likely to earn higher returns than others. The abnormal returns earned by these investors may be viewed as the compensation for conveying the news to the market. If an investor believes that a security is mispriced, he may tell the market about this mispricing verbally. Verbal signals, however, are not believable because talk is cheap. Therefore, the investor trades based on his information. The trading, being a costly activity, sends out a more believable signal while earning a higher return. There are also risks in being a leader. If the information that led an investor to believe that a security is mispriced is incorrect, it could result in losses to the investor.2 There can be only one market price while dierent investors may assign dierent values to a security depending on their information, taxes, and transaction costs. The market price is an average or consensus price for a security. It is possible that a security, because of its special features is more desirable to a particular investor than others. For example, the stock of a relatively unknown company will be viewed as risky by the average investor and therefore will be priced low. However, an investor who lives in the town where the company is located may have more information about this company and nd its stock to be a bargain.

4.5

Performance Evaluation

Often, we need to evaluate the performance of investments. We may need to evaluate the performance of our own investments or to check the claim of superior performance by others. Performance evaluation is very important in the mutual fund industry because the salaries of mutual fund managers are tied to the performance of their portfolios. Performance measurement is also used to verify the claims of protable trading rules by investors. It would be incorrect to use the return on investment to judge performance because returns could be high or low for reasons beyond the control of the investor. For example, the interest rates in the economy in general could be high because of inationary expectations, or the market as a whole could move up because of good news about the budget decit. These economy-wide movements will aect the investment returns also. Movements related to the economy as a whole, however, do not reect the ability of the investor. Furthermore, a high return may be the result of high risk associated with the investment rather than the ability of the investment manager.

2 Even if the information is correct in an absolute sense, there could be harmful consequences if the market does not believe the information and therefore the price does not react the way the investor had expected it. For the price to change in a desired direction, other investors have to believe the information also.

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Two measures of performanceSharpe and Treynor ratiosassess the performance of an investment by determining the rate of return earned per unit of risk. The ratios are calculated as the excess return, the rate of return on investment minus the risk-free rate of return, divided by the measure of risk. The ratios dier in how they dene risk. The Sharpe Ratio uses the standard deviation of returns as the measure of risk while the Treynor Ratio uses the beta as a measure of the risk. Mathematically the two ratios for an investment i are: Sharpe Ratio = SRi = Treynor Ratio = TRi f r i r i f r i r = i (4.9) (4.10)

where r and r f are the average rates of return on the investment portfolio and the riskfree security, respectively. is the standard deviation of the portfolio returns and is its systematic risk. The risk-free rate is subtracted from the portfolio return because the riskfree rate can be earned without taking any risk. Subtracting the risk-free rate also adjusts for the inuences of some economywide factors such as the ination. Since these ratios measure return earned by a portfolio per unit of risk, a higher value of the ratio indicates superior performance. In popular press, claims of superior performance are made by comparing the returns earned by an investment with that of a market index such as the S&P 500. This comparison is inappropriate if the risk of the investment is not equal to that of the S&P 500, because we know that investments with dierent risks are expected to earn dierent returns. Therefore, an investment may have earned a high average return by taking a high risk. To measure performance, we need to control the eects of market-wide factors and risk. This is done by taking the dierence between the return on an investment and the return that should be expected based on the risk and the economic conditions. The expected return based on the risk and economic conditions can be calculated using the CAPM. Suppose we want to measure the performance of an investment that earned ri during a period. The risk of the investment was i and the average returns on the risk-free security and the market were rf and rm . According to the CAPM, the return on the security should have been3 rf + i (rm rf ). The securitys performance may be measured by abnormal return (ari ) calculated by subtracting the expected return from the actual return: ari = ri [rf + i (rm rf )] (4.11)

All the returns on the right hand side of this equation are the actual, realized returns. To measure the performance over several periods, we may calculate average abnormal return,

Since one observation is used to calculate the expected returns, the expected return is equal to the observation itself.

3

Security Selection and Performance Evaluation Table 4.1: Performance evaluation for Janus Fund.

MM/YY 1 2 3 4 5 . . . 57 58 59 60 60 01/90 02/90 03/90 04/90 05/90 . . . 09/94 10/94 11/94 12/94 ri 0.0790 0.0020 0.0430 0.0160 0.1270 . . . 0.0310 0.0250 0.0260 0.0030 0.5540 rm 0.0671 0.0129 0.0263 0.0247 0.0975 . . . 0.0241 0.0229 0.0367 0.0146 0.4560 rf 0.0057 0.0057 0.0064 0.0069 0.0068 . . . 0.0037 0.0038 0.0037 0.0044 0.2318 ri rm 0.005301 0.000026 0.001131 0.000395 0.012382 . . . 0.000747 0.000572 0.000954 0.000044 0.080448

2 rm

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0.004502 0.000166 0.000692 0.000610 0.009506 . . . 0.000581 0.000524 0.001347 0.000213 0.080374

a r . Using r i , r f and r m to denote the average returns,4 we can write the average abnormal return. This measure of performance is also known as alpha or Jensen alpha (JA). JAi = ar i = r i [ rf + i ( rm r f )] (4.12)

This measure of performance is also known as alpha or Jensen alpha. Let us take Janus Fund as an example. Table 4.1 shows monthly returns for the fund, the S&P 500 index, and the Treasury bills from January 1990 to December 1994. The bottom row shows the statistics needed for calculations. Using Table 4.1, we can calculate the following statistics: r i = r m = r f = im =

2 m

0.5540 ri = = 0.0092, T 60 rm 0.4560 = = 0.0076, T 60 rf 0.2318 = = 0.0039, T 60 ri rm .4560) 0.080448 (0.5540)(0 ri rm T 60 = = 0.001292, T 1 59

2 rm Tm T 1 ( r )2

0.080374 = 59

(0.4560)2 60

= 0.001304,

4 We are not using here because is used for expected value. We use r to denote simple historical average.

2 ri Ti 0.090940 = T 1 59 0.001292 = 0.9913. = 0.001304 ( r )2 (0.5540)2 60

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i = i = im 2 m

= 0.0381,

The can also be calculated by running the market model regression equation (3.21) on page 92 with ri being the dependent variable and rm being the independent variable. Now the performance measures for Janus Fund for the 60 months during January 1990 to December 1994 are calculated as: SRi = TRi = JAi = = = f r i r 0.0092 0.0039 = 0.1408 = i 0.0381 r i r 0.0092 0.0039 f = 0.0054 = i 0.9913 r i [ rf + i ( rm r f )] 0.0092 [0.0039 + (0.9913)(0.0076 0.0039)] 0.0017

Since the Jensen alpha for the Janus Fund is positive, the fund exhibited superior performance during the period. To draw meaningful conclusions from Sharpe and Treynor ratios, we should compare these ratios for the fund with similar ratios for the benchmark S&P 500 index. The Sharpe and Treynor ratios for the S&P 500 are: SRm = TRm f r m r 0.0076 0.0039 = 0.1035 = m 0.0361 f r m r 0.0076 0.0039 = 0.0037 = = m 1

Since the Sharpe and Treynor ratios for the Janus fund are greater than those for the S&P 500, the fund was a superior performer during the ve year period. Recall that the market model regression to estimate can be run using the excess returns also as shown in equation (3.22) on page 92. Table 4.2 shows the data for statistical calculations using excess returns. The returns shown here are all in excess of the risk-free rate. For example, the excess return for the fund (ri ) in January 1990 is calculated as 0.0790 0.0057 = 0.0847. The covariance, variance, and are now calculated using excess returns as: im =

m i f (ri rf )(rm rf ) T T 1 (0.3222)(0.2242) 0.077574 60 = = 0.001294, 59

(r r )

(r rf )

Security Selection and Performance Evaluation Table 4.2: Performance evaluation for Janus Fund using excess returns.

MM/YY 1 2 3 4 5 . . . 57 58 59 60 60 01/90 02/90 03/90 04/90 05/90 . . . 09/94 10/94 11/94 12/94 ri rf 0.0847 0.0037 0.0366 0.0229 0.1202 . . . 0.0347 0.0212 0.0297 0.0014 0.3222 rm rf 0.0728 0.0072 0.0199 0.0316 0.0907 . . . 0.0278 0.0191 0.0404 0.0102 0.2242 (ri rf )(rm rf ) 0.006166 0.000027 0.000728 0.000724 0.010902 . . . 0.000965 0.000405 0.001200 0.000014 0.077574 (rm rf )2 0.005300 0.000052 0.000396 0.000999 0.008226 . . . 0.000773 0.000365 0.001632 0.000104 0.077993

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2 m

(r r ))2

The , once again, can also be calculated by running the market model regression with (ri rf ) being the dependent variable and (rm rf ) being the independent variable. The average abnormal return is now calculated as: ar i = r i [ rf + (i )( rm r f )] = 0.0092 [0.0039 + 0.9898(0.0037 0.0039)] = 0.0017 The average abnormal return is almost the same as the one calculated using the full returns . The excess returns calculations are preferred because they take into account the reality of the changing Treasury bill rates while the full return calculation ignores that variability. Furthermore, the average abnormal performance calculated using the excess returns is exactly equal to the intercept in the excess return market model regression. Therefore, the excess return market model regression gives us the , as well as the average abnormal return, eliminating the need for extra calculations.

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4.5.1

Claims of superior performance are frequently made by nancial companies to attract investors to buy shares in their funds. The fund managers claim that they beat the market in the past using their timing and selectivity skills. Timing refers to the ability to predict which way the market as a whole will go. Selectivity refers to the ability to predict which securities will be superior performers. Such claims, however, are always presented with the caveat that the historical performance is not necessarily a guarantee of future performance. Studies done by nance academics nd little evidence for superior performance by mutual funds or their managers on an average. Most studies nd that the timing ability of the fund managers are particularly suspect. There are, however, periods during which a fund or a group of funds may perform well. For example, Fidelitys Magellan Fund produced excellent results during the 1980s. The conclusion most performance measurement studies draw from long term studies is that the returns an investor earns by investing in mutual funds are in line with or less than what the investor should have earned based on the risk taken. Even if some mutual fund managers have superior skills, they charge fees commensurate with their skills, so that the benets of their skills accrue to them and not to the investors. Investors, therefore, should invest in mutual funds for reasons of diversication, and not necessarily for superior performance.

4.6

Conclusion

The procedure for selecting securities using the principles of present value was described in this chapter. Due to the eciency of the competitive securities markets, the practical usefulness of such selection rules depends on the nature of information used to arrive at the security values and the speed with which the decisions are made and implemented. Finally, we studied the procedures for measuring the performance of investments.

Exercises

4.1 Present Value Calculations Calculate the present value for the following cashows. Assume that the discount rate for all these cases is 10% per period. 10 10 10 10 a. 0 b. 0 1 2 3 4 5 1 2 10 3 10 4 10 5 10

10 c. 0 d. 0 e. 0 f. 0 g. 0 h. 0 4.2 1 2 3 4 5 1 2 3 10 4 10.50 5 11.025 ... 1 10 2 10.50 3 11.025 4 11.576 5 12.155 ... 1 2 3 4 10 5 10 ... 1 10 2 10 3 10 4 10 5 10 ... 1 10 2 10 3 4 10 5 10 10 10 10 10

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Present Value (a) Calculate the present value of the following cashows. The discount rate is 9% per period. 30 0 1 33 2 36.3 3 37.03 4 37.77 5 38.52 ... 6

(b) Calculate the present value of the following cashows. The discount rate is 11.5% per period. 300 0 4.3 1 300 2 300 3 4 300 5 315 6 330.75 7 347.29 8 364.65 9 382.82 ... 10

Annuity Formula An annuity can be viewed as a dierence between two perpetuities. Use this principle to derive the formula for valuing an annuity. Use a similar idea to derive the formula for a growing annuity. 4.4 Rate of Return Calculations Calculate the rates of returns for the cashows in exercise 4.1 assuming that the initial investment in each case is $30. 4.5 Rule of 72 In popular nancial press you often read about the rule of 72. The rule is that the number of years it takes for your money to double can be approximated by dividing 72 by the interest rate. For example, at

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8% per year it will take about 9 years for your money to double. Test the rule of 72 for 4%, 6%, . . ., 16%, 18%. 4.6 Continuous Compounding A Treasury bill is selling for $9,823. On maturity, in 2 months, the buyer will receive $10,000. What is the continuously compounded annual rate for this Treasury bill? 4.7 Present Value and IRR On January 1, 1988 I purchased 100 shares of a common stock at $45. I received per share dividends of $0.30, $0.30, $0.35, and $0.30 on March 31, June 30, September 30, and December 31 of 1988. I sold the shares on December 31, 1988 for $44 each. (a) Show these cashows on a time line. (b) Calculate the PV of the cash inows assuming that the discount rate is 14% per year. (c) Calculate the quarterly rate of return on this stock. What is the annualized rate of return? 4.8 Rate of Return Calculate the rate of return implied by the following cashows: 200 1/1/89 4.9 30 12/31/89 30 12/31/90 30 12/31/91 30 12/31/92 280 12/31/93

Rate of Return Thelma Houston bought 100 shares of a preferred stock on January 1, 1987 for $30 each. The stock paid dividends of $0.60 per share every quarter with the following exception: dividends were skipped during quarter 2 of 1988 but Thelma received $1.25 in quarter 3 of 1988$0.60 regular dividend and $0.65 for the skipped dividend. Thelma sold the shares on January 1, 1989 for $32 each. (a) Show the cashows for this investment on a time line. (b) Calculate the quarterly rate of return earned by Thelma on her investment. Compound this return to obtain the annualized rate. (c) The discount rate for the stock is 9% per year. Was this a good investment for Thelma? 4.10 Return on Investment The market price of UP Systems on January 1, 1987 was $32 per share. The stock paid regular quarterly dividends of 0.30 per share in 1987, 0.35 per share in 1988, and 0.40 per share in 1989. The price on December 31, 1989 (after the dividend payment) was $31 per share. What was the annual rate of return on the stock of UP Systems? 4.11 Expected Rate of Return Ms. Bonnie Raitt is considering purchasing shares of Moon Macrosystems. Moon is currently selling for $12 per share. Ms. Raitt expects to receive quarterly cash dividends of $0.20 per share, the rst one coming exactly one quarter from now. She believes that she will be able to sell the stock for $14 per share two years from now. (a) Show the cashows on a time line. (b) What is the expected rate of return based on Ms. Raitts information? (c) Ms. Raitt believes that the discount rate for the stock is 14% per year. Is this a good investment for Ms. Raitt?

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4.12 Expected Rate of Return After considerable research, Julia Child has gured out that due to a gimmick employed by the master chef, the dividends from Grandmas Kitchen will grow at 15% per year during the next three years. After that, the growth rate will be 5% per year for two years, and will nally settle down to constant dividends after that. The dividends this year were $0.50 per share. (a) Show the dividends expected by Julia Child on a time line. (b) Calculate the rate of return from investing in the stock, if the current price is $9.75. (c) Ms. Child has also estimated that a return of 16% per year would be the proper compensation for the risk in this stock. What should Ms. Childs decision be regarding the common stock of Grandmas Kitchen? 4.13 Security Valuation Ziggy is considering investing in common stock of Murphy. The correlation between the returns on the common stock of Murphy and the market is 0.80. The annualized standard deviation for Murphy and the market are 0.24 and 0.16. The annualized returns on the risk free securities and the S&P 500 are expected to be 8% and 14% during the next two years. Ziggy expects Murphy to pay quarterly dividends of $0.40 per share for the next 8 quarters. The current market price of the stock is $10.50 and Ziggy believes that two years later the price will be $15. What should be Ziggys strategy regarding this common stock? 4.14 Security Selection Mary Ross feels that the price of Orpheus will jump to $12 next month because of a takeover bid from Nimbus. The current price of Orpheus is $10.20. Orpheus is a growing company and pays no cash dividends. To analyze the stock, Mary collected monthly prices for 5 years for Orpheus and the S&P 500. She converted these prices into monthly returns. From the market model regression she found the of Orpheus to be 1.08. Mary expects the risk-free rate to be at 8% per year during the next month. She expects that the market will go up by 1.2% during the next month. Should Mary buy shares of Orpheus or sell them? Analyze the problem using both the present value and the internal rate of return methods. 4.15 Security Selection The common stock of DeBondt Corporation paid a dividend of $0.20 per share this quarter. The dividends are expected to grow at the rate of 1.5% every quarter, forever. The returns on the Treasury bills and the market are expected to be 7.8% per year and 13.5% per year. The of the stock of DeBondt Corporation is 1.2. The market price of the stock of DeBondt Corporation is 10 7/8. What should you do about the stock if you believe that your expectations about the stock and the economy are correct? 4.16 Security Selection Carol Carney expects that there will be signicant changes in the national energy policy during this decade. Therefore, she is interested in the common stock of Surya, an emerging rm specializing in solar energy. The stock of Surya is selling at $8. Carol has done a fair amount of research on the stock and expects that the stock will not be in a position to pay any dividends for the next 4 years. After that, the stock should pay quarterly dividends of $0.50 per share for 3 years. After 3 years of constant dividend, the dividends should grow at the rate of 1% per quarter forever. (a) Show the cashows expected by Carol on a time line. (b) Calculate the quarterly rate of return Carol expects from the stock. (c) Carol believes that Surya is twice as risky as the average stock in the market. The average stock in the market is oering a rate of return of 12% per year. The risk-free rate is 7% per year. What is the annual rate of return that Carol should expect from the stock of Surya?

(d) Should Carol invest in the stock of Surya? 4.17 Market Eciency Discuss the following statements:

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(a) The high volatility in the market prices these days is clear evidence that the markets are not ecient. (b) Why invest in the stock market? The market is ecient and therefore you cant make any money anyway. 4.18 Performance Evaluation Refer to exercise 4.14. Suppose Mary bought 100 shares at $10 per share. A month has passed and the expectations of Mary did come true to some extentshe sold the stock for $11.60 per share. What is her realized return? During the month, the market returned 2.6% and the risk-free rate averaged at 9% per year. Calculate the proper expected return on Orpheus based on the market conditions. Calculate the abnormal return. Was it a good investment for Mary Ross? 4.19 Performance Evaluation The Jupiter Fund has a of 1.5. Analysts are predicting that over the next year the risk-free rate will be 8% and the market will go up by 18%. What rate of return can the shareholders in Jupiter Fund expect? At the end of the year the following results were actually observed: rf = 0.07, rm = 0.20, rJ = 0.25, where f, m and J denote the risk-free security, the market, and Jupiter, respectively. Portfolio managers at Jupiter were ecstatic and claiming that they not only beat the market but also came out ahead of their own expectations. Are their celebrations justied? 4.20 Performance Evaluation The document accompanying the account statement to the shareholders of the Alliance Fund stated: During the past 3 months your fund showed excellent performanceit provided an annualized return of 12%. In comparison the annualized return on the S&P 500 during this period was 10%. Comment on this statement. 4.21 Performance Measurement During the last ve years, the growth fund managed by E. John had an average return of 17.2% per year while the growth fund managed by S. Denny had an average return of 18.9% per year. The s of the two funds are 1.3 and 1.5 while the standard deviations of their returns are 28% and 26%. The average return on the S&P 500 during this period was 14.5% per year while the risk-free rate was 8.2% per year. (a) Calculate the abnormal returns for the funds managed by E. John and S. Denny. (b) Briey discuss the relative performance of the two funds. Which one would you invest in? Why? 4.22 Performance Measurement The 1990 New Account Kit for Fidelity Magellan Fund gave the following table:

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Year Ended 3/31 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989

Magellan Fund Total Return 20.37% 100.13 .68 87.70 8.77 21.01 56.59 24.26 9.64 22.26

S&P Total Return 5.91% 39.73 13.08 44.04 8.60 18.67 37.42 26.14 8.43 18.13

The average risk-free rate during the period of 1980 to 1989 was 6.2% per year. (a) Calculate the average and the standard deviation of returns on the fund and the S&P, and the for the fund. (b) The managers at Fidelity are quite proud of the performance of their fund because, on an average, it has done better than the S&P. Do you agree with their argument? (c) Calculate a proper measure of performance of Fidelity. 4.23 Performance Measurement The Marginal Fund has shown an average return of 12.6% per year during the previous 10 years. The S&P 500 on the other hand, has had an average annual return of 14.2%. The risk-free rate during these ten years has averaged to 7.4% per year. The standard deviation of the returns on the Fund and the S&P 500 are 0.33 and 0.42, respectively. The Marginal Fund has a correlation of 0.60 with the S&P 500 index. Has the Marginal Fund exhibited superior performance during the previous 10 years? 4.24 Performance Measurement Venus Group of Funds, in a recent advertisement, claimed that their growth fund was the fund of the 80s. They claimed that in seven of the ten years, the fund kept pace with or outperformed the S&P 500. As an evidence, they provided the following table that shows the total annual returns on the fund and the S&P 500 for each of the ten years. Year Fund S&P 500 80 7 6 81 40 40 82 4 13 83 60 44 84 12 9 85 10 18 86 61 37 87 33 26 88 25 8 89 35 18

The advertisement also mentioned that the annualized rate of return on the Treasury bills during this period was 8.2% per year. (a) Discuss the claim made in the advertisement. (b) Calculate a measure of performance of the fund in the CAPM framework.

Common stock is the most popular security. To many people, investing in securities is synonymous with buying and selling stocks. In the same spirit, the well-being of the economy is usually judged by looking at indices such as the Dow Jones Industrial Average and the S&P 500 index, which are made up of stocks. This Chapter describes the characteristics of common stock and sources of specic information needed for valuing them.

5.1

Stockholder Rights

Shares of common stock are issued by corporations to nance real investment projects. Purchasing shares of common stock gives an investor partial ownership in the company. Let us consider the ABC company. The market value of the assets of ABC is $150 million and the market value of its debt is $50 million.1 Therefore, the market value of equity is $100 million. If the company has 1 million shares outstanding then the market price of each share is $100. If you own 1,000 shares of this company, you own one thousandth (1,000/1,000,000) of the company. The total value of your investment is 1,000 $100 = $100,000 Ownership in the company gives you certain rights: Voting rights: As an owner of the company you have a say in how the company is run. Investors exercise this right by voting for the board of directors who then oversee the operations of the company. Some matters may be so important that they should not be decided by the board of directors only. In such matters, stockholders are asked to cast their votes directly. Stockholders are allowed one vote for every share they own. The more shares an investor owns, the more inuence the investor can have on the decisions. Companies hold annual meetings to elect the board of directors and discuss

Market value of assets refers to the value for which the assets may be sold. Market values are not easily determinable. Corporate balance sheets show book values which are based on historical costs and are often used as a basis for comparison.

1

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other important matters. Stockholders are invited to attend these meetings. Most investors, however, send in proxy votes by mail rather than bearing the expense of attending the annual meeting. Preemptive rights: Companies may give their shareholders rights to purchase any new shares to be issued by the company before they are sold in the open market. This right is valuable because it can be used by investors to maintain their fractional ownership in the company. To continue with the example used above, if ABC decides to issue 100,000 new shares, the preemptive right would allow you to buy 100 shares of this new issue to enable you to maintain your share of ownership of the company at onethousandth (1,100/1,100,000). Preemptive rights are transferable and can be traded in the market. In the recent years, the number of companies issuing preemptive rights has been on decline. Value rights: As an owner of the company, an investor also has the right to the rm value and any earnings resulting from it. For example, if in a particular year ABC has net earnings of $10,000,000 (after interest and taxes), you are entitled to $10,000 of the rms earnings. Similarly, if the rm dissolves (or is bought out), you have a right to 1,000th of the net proceeds (after paying the claims of the creditors). Corporations pass some of their earnings to investors in form of cash dividends and retain the rest for reinvestment. To most investors, the value rights are the only ones that matter.

5.2

Shares of common stock are issued by corporations in the primary market and are traded in the secondary market to provide liquidity to the investors. The number of shares outstanding may be changed by the company through many dierent means: New issue: If a corporation needs capital it may issue new shares. Firms like to issue shares when the share price is relatively high. At a high share price the company has to issue fewer shares to raise the desired capital. This causes less dilution to the ownership of the original stockholders. Usually, new shares are issued at a price below the market price of the existing shares. The discount is expected to ensure a brisk sale of the shares. Issue of shares by a new company is known as an initial public oering (IPO). IPOs are very risky because of the lack of information about the issuer. It is not uncommon for the price of shares issued by a new rm to double or half within weeks of the IPO. Share repurchase: If a company has excess funds, it may purchase its own stock in the market. Usually, shares are repurchased when the share price is relatively low. Besides being a good investment, repurchasing shares has a benecial side eectit raises the

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demand for shares which, in turn, raises the market price of shares and provides a price support. Investors feel more condent about a company if the company is willing to buy its own shares. Stock splits and stock dividends: A stock split is an exchange of a smaller number of high priced shares for a larger number of low priced shares. Stocks are split because many companies believe that investors prefer shares in the $10$50 price range. At a high price, say $100, a round lot of shares may be too expensive for small investors. Therefore, if the price goes too much above $50 the company may split the stock. A 2-for-1 stock split is an exchange of 2 new shares for 1 old share. If one million shares were outstanding before the split at the price of $100 each then there will be two million shares after the split at the market price of $50 each. Other than the ability to attract investors who may otherwise shy away from the stock, stock split does not have a real advantage. In fact, it ends up costing the company and the stockholders quite a bit to recall old shares and print and issue new ones.2 A stock dividend is an issue of new shares directly to the existing stockholders. Stock dividends are issued when a company is short of cash. Let us suppose the ABC company does not have enough cash to pay dividends this year because all the cash is needed for reinvestment. The company, in this situation may declare a 10% stock dividend. This will cause the number of shares to go up by 10% to 1,000,000 (1 + 0.10) = 1,100,000 and the share price to go down to $100/(1 + 0.10) = $90.91. You will receive 100 shares (10% of 1,000) in the mail. Now you will own 1,100 shares but the price of each share will be $90.91. The total value of your investment will be 1,100 $90.91 = $100,000, same as before the stock dividend. On the whole, stock dividend is an expensive activity because, new shares have to be printed and mailed to the investors. Therefore, it is not clear as to why investors like to receive stock dividend and why companies like to pay them. Even though they are motivated by dierent reasons, stock splits and stock dividends result in an increase in the number of shares outstanding and a corresponding decrease in the share price but do not cause any change in the market value of equity. A 2-for-1 stock split has the same eect as a 100% stock dividend: both double the number of shares and half the price. Stock are usually split in proportions such as 3-for-1, 3-for-2, or 4-for-3. Stock dividends are usually paid in fractions such as 2%, 5%, or 10%. Sometimes rms split their stock in reverse, e.g., 1-for-2. In a reverse stock split the rm is issuing one new share for two old shares. This has the eect of increasing the share price. Stock may be split in reverse if the company wants to increase the share price. A higher share price may be desirable because extremely low priced stocks are perceived to be very risky by some investors because a small drop in price means a big loss on investment. Also, per share transaction costs may be relatively high for small

Printing new shares of stock is also harmful to the environment because of the paper and chemicals used in the process.

2

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priced stocks because some brokerage houses charge a xed minimum commission for a trade.

5.3

Cash Dividends

Cash dividends are the payments made by the company to the stockholders. Dividends are an extremely important part of stock investments. Common stocks have value only because of the expectation of dividends. An investor is able to sell the shares only because the investor buying them would receive the dividends, or would sell them to someone else who would receive the dividends. This, however, does not mean that a common stock must pay dividends regularly. Dividends are discretionary payments. A corporation may pay dividends if it has excess cash and may not pay dividends if it does not have excess cash. This suggests that the dividends may uctuate depending on the cash position of the company. However, we dont nd this behavior in reality. Most rms have well dened policies about dividends. They pay xed dividends on a regular basis. The reason for xed dividends is that investors do not like the uncertainty of uctuating dividends. They react negatively to any unexpected decline in dividends. Companies, therefore, keep dividends steady and change them only under extreme situations. Sometimes, companies even raise money by borrowing or issuing shares to pay dividends. Companies do not increase the regular dividends even if they have excess cash during a period, if they are unsure of the their ability to maintain the increased dividend. A corporation which has excess cash usually declares an extra dividend or irregular dividend, clearly indicating a bonus situation. A companys dividend policy, i.e., how much dividends to pay, is related to some extent with its growth level. A growing company needs most of its earnings for reinvestment purposes. Retained earnings are used to acquire assets or invested in research and development which may lead to increased earnings and dividends in the future. Mature companies do not need as much of their earnings and are therefore more likely to pay most of it out as dividends. Two important ratios involving dividends are the payout ratio and the plowback ratio. The payout ratio measures the fraction of earnings that is paid out as dividends and the plowback ratio is the fraction that is retained and reinvested. Usually, growth rms have low payout ratios while mature rms have high payout ratios. There are many well known rms such as Digital Equipment Corporation and Federal Express which do not pay regular dividends. Some dividend related information appears in The Wall Street Journal under the title corporate dividend news. This information is divided into two parts. In the rst part we see the information about dividends declared during the previous trading day. In Table 5.1, we see an excerpt from this part of the corporate dividend news of August 8, 1995. We see that American Eagle Corp announced on August 7 that it will pay a regular,

Common Stocks Table 5.1: Corporate Dividend News. Dividends Reported August 7

Company Period Amt. .47 1/2 .03 .11 .30 .23 .05 .21 Payable date Record date

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regular AlaPwr pf7.60% 2nd . . . Q American Eagle Grp . . . Q Beckman Instrments . . . Q General Motors . . . . . . . . Q General Motors clH . . . . Q Metro Finl Corp . . . . . . . Q Weyco Group . . . . . . . . . . Q 10 195 102095 83195 9 995 9 995 82295 10 195 9 5 10 6 811 817 817 810 9 1

funds - reits - investment cos - lps EatonVance Divers . . . . Q LordAbbot BdDeb . . . . . M Source Capital . . . . . . . . . Q .55 .073 .90 92995 81595 91595 915 8 7 825

quarterly dividend to the investors who are registered as stockholders in the company records on 106. The dividend checks will be mailed out on 102095. Most corporations pay dividends on a quarterly basis. Others pay monthly, semiannual or annual dividends. The report also shows stock dividends. Money Store declared a stock split of three-for-two which has the same eect as a 50% stock dividend. Entries under the heading funds - reits investment cos - lps show dividends declared by mutual funds, real estate investment trusts, investment companies, and limited partnerships. Not shown in Table 5.1 are some other special cases such as irregular, extra, increased, reduced, foreign, initial, special, and deferred dividends. Information about these cases is presented in the same format as shown in Table 5.1. From Table 5.1, we see that the important dates connected with dividend payments are declaration date, record date, and payable date. For investors there is a date that is even more important than these dates. This date is known as the ex-dividend date. Let us understand the importance of this date using the General Motors case. The record date for the dividend is 817. Therefore, an investor who is a registered owner on August 17 is

Common Stocks Table 5.2: Corporate Dividend News. Stocks Ex-Dividend August 9

Company AIM Strategic Inco Amer Home Prod AmerWaterWrks5%pf AmerWaterWks5%pref Applied Pwr clA Amount .05 .75 .31 1/4 .31 1/4 .03 Company MCN Corp MGIC Invest Micron Technol new Monsanto Co Muni Inco Opp Tr Amount .22 1/4 .04 .05 .69 .05 1/4

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entitled to receive the dividend. An investor who buys the shares on August 17, however, may not become a registered stockholder on that very day because it takes time for the information to be received by the corporation and recorded. Without proper control this could become a problem. Investors buying the shares would not know if they are going to get the dividend or not. The time lag for the information to be recorded is usually 4 or 5 days. The stock exchange in which the shares are traded, therefore, sets the ex-dividend date for a stock 4 or 5 days before the record date. This way, all investors know that if they buy shares of a stock before the ex-dividend date, they will get the dividend. If they buy the shares on or after the ex-dividend date, they will get the stock ex-dividend, i.e., without the dividend. All four dates associated with a dividend are shown in sequence in the time line below:

Declaration date Ex-Dividend date Record date Payable date

The second part of the corporate dividends news contains the ex-dividend information as shown in Table 5.2. Table 5.2 informs the investors that if they buy shares of these stocks on or after August 9 they will not be entitled to the dividends. For investments calculations, the relevant date with respect to dividends is the ex-dividend date, even though the dividend is received a few days after (due to mailing delay) the payable date. On the ex-dividend date, the stock price drops due to the exclusion of dividends from the shares. If there were no taxes or transaction costs, the price drop would equal the dividend amount. For example, if the closing price on the trading day before the stock goes ex-dividend is $10 and the dividend amount is $1, then on the ex-dividend day, the price will drop to $9. Investors who buy the shares on the day before the ex-dividend date buy it cum-dividend for $10 and will receive the $1 dividend. Investors who buy the shares ex-dividend, pay only $9 and will not receive the dividend. With dierential taxes, transaction costs of dividends versus capital gains, and the fact that stock prices move in ticks (1/8th of a dollar) rather

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than pennies, the drop in stock price may not be equal to the dividend amount. Because of dierent taxes and transaction costs paid by dierent investors, some may prefer to buy the shares cum-dividend at a high price and receive the dividend, while others may prefer to buy the shares ex-dividend at a lower price and forgo the dividends. Some investors, because of their tax status, prefer dividends so much that they buy the shares just before they go ex-dividend and sell them immediately after the shares go ex-dividend. In this way, they trade the drop in stock price for the dividends. This process of buying shares just to receive a dividend is known as dividend capture.

5.4

Common stock price and trading volume quotations are listed in various tables in The Wall Street Journal . Tables entitled new york stock exchange composite transactions, american stock exchange composite transactions, and nasdaq national market issues provide complete information on major stocks.3 Two other tablesnasdaq bid and asked quotations and additional nasdaq quotesprovide bid and asked prices for other stocks traded over-the-counter. Table 5.3 shows a few quotations from the new york stock exchange composite transactions from The Wall Street Journal of August 8, 1995. These quotations are for the transactions on August 7, 1995. To identify the columns during our discussion below, the columns have been numbered. Column (1) is used for special symbols. and indicate that the stock price reached a new high or low during the trading day. An s indicates that the stock went through a split during the past twelve months. An x means that the stock was traded ex-dividend. An n is used to denote a newly issued stock. There are various other symbols and notations which are not shown here. For details you should consult the explanatory notes associated with the table. Columns (2) and (3) are used for the lowest and the highest prices of the stock during the past 52 weeks. Columns (4) and (5) give the name of the stock and its trading symbol. Column (6) gives the total dividends paid by the stock during the past year. Column (7) gives the dividend yield of the stock. The dividend yield is calculated by dividing the dividend paid during the year (column (6)) by the closing price for the day (column (12)). The dividend yield is an estimate of the rate of return to the investor from the dividends alone. Therefore it is a measure of the current income potential of the stock. We can check this calculation for AmBrand. The closing price is listed as 41 and during the year the company paid $2.00 per share in dividends. Assuming that the next years dividends will equal this years the dividend yield is calculated as 2.00/41 = 0.04878 or 4.9% per year.

3 nasdaq stands for National Automated Security Dealers Association Quotation and refers to the overthe-counter market.

Common Stocks Table 5.3: New York Stock Exchange Composite Transactions.

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52 Weeks Hi Lo Stock (1) (2) (3) (4) AT&T Cp AmBrand BrownFer Chilgener Compaq India GrFd MexicoFd SmithCorona WellsF WellsF pfC WellsF pfD 55 7/8 47 1/4 42 1/8 32 7/8 40 5/8 25 5/8 34 7/8 19 1/4 52 7/8 30 3/8 25 1/8 17 36 10 1/8 1/2 4 7/8 187 3/8 140 3/4 26 3/4 24 1/4 26 5/8 24 1/8

Sym (5) T AMB BFI CHR CPQ IGF MXF SCO WFC

Div (6) 1.32 2.00 .68 .99e .92e .22e 4.60 2.25 2.22e

Yld Vol % PE 100s (7) (8) 2.6 4.9 2.0 3.4 ... 5.0 1.2 ... 2.5 8.7 8.5 (9)

Hi (10)

16 18443 52 51 3/8 51 5/8 1/8 12 2799 42 3/8 40 1/8 41 + 3/4 1 7 18 36778 34 /2 33 33 /8 5/8 ... 455 29 3/8 29 29 3/8 15 13835 50 3/4 49 3/8 49 5/8 1 1 1 1 / / / ... 180 18 2 18 4 18 4 1/8 . . . 2565 19 1/4 18 7/8 19 1/8 + 3/8 5/8 1/2 5/8 + 1/8 ... 745 11 657 181 7/8 180 3/8 181 5/8 +1 7/8 ... 413 26 1/8 26 26 1/8 1 / ... 46 26 8 26 26 1/4

Column (8) gives the price earnings (PE) ratio for the stock. It is calculated by dividing the closing price by the earnings per share. The PE ratio measures the price per dollar of the current earnings of the company. A high PE ratio means that investors are paying a high price for the companys current earnings. Therefore, they must expect companys future earnings to be high. Therefore, a high PE ratio is believed to be an indicator of the companys growth potential. Many investment advisors, therefore, recommend stocks based on the PE ratios. The PE ratio for AmBrand is 12 and the closing price is $41. Therefore, the earnings per share for AmBrand were $41/12 = $3.42. Since we know that the company paid $2.00 in dividends, the dividend payout ratio for AmBrand is 2.00/3.42 = 0.58 or 58%. In other words, this year AmBrand paid out 58% of its earnings in dividends and reinvested the remaining 42%. Column (9) gives the number of shares traded in 100s. For example, 2799 100 = 279,900 shares of AmBrand were traded. Columns (10), (11) and (12) give the highest, the lowest, and the closing (last) prices for the day. Column (13) gives the net change in the closing prices since the previous trading day. A negative net change indicates that the price went down while a positive number indicates that the price went up. For example, the previous days closing price for BrownFer was 33 7/8 + 5/8 = 34 1/2. Some other things are also worth noticing about Table 5.3. Compaq does not pay regular dividend. Therefore, the dividend amount and the

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As mentioned in Chapter 3, closed end mutual funds are traded on the exchanges. The two examples shown in the Table are India GrFd and MexicoFd which are closed end funds that invest in India and Mexico, respectively. A company may have more than one of its issues (securities) being traded on the exchange. For example, there are three issues being traded for Wells Fargo (WellsF): A common stock and 2 preferred stocks. Other stock quotation tables contain similar information. nasdaq bid and asked quotations contain the bid and asked prices and the share volume and additional nasdaq quotes contain only the bid and ask prices.

5.5

The value of a share of common stock is the present value of the cashows from the stock. This fact is denoted by the following equation: PV = dt t t=1 (1 + k )

T

(5.1)

where dt is the expected dividend per share t periods from now and k is the discount rate. Usually, a stock has an innite time horizon i.e., T . Assuming an innite horizon for the common stock, equation (5.1) can be simplied to provide compact valuation equations. We will consider two special cases in the following subsections.

5.5.1

Mature Firm

A mature rm pays out all its earnings as dividends. Therefore, it experiences no growth and the dividends remain unchanged over time. If this situation continues forever, the dividends from this stock of a mature rm result in a perpetuity. The present value formula then gives us: d e PV = = , (5.2) k k where e is the earnings per share of the company.

5.5.2

Growth Firm

Consider a stock that starts out paying only a part of its earnings as dividends and retains the rest for reinvestment. If the company has a policy of maintaining a xed payout ratio,

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the dividends will grow at a uniform rate g (because of reinvestment). If the growth rate g is less than k the present value can be written as: PV = d kg (5.3)

where d is the dividend expected one period from now. The growth in dividends arises from reinvestment. In fact, the growth rate is equal to the product of the plowback ratio and the rate of return on the reinvestment. If the payout ratio is , so that the plowback ratio is (1 ), and the rate of return on rms reinvestment is i, the growth rate is given by: g = (1 )i (5.4)

The eect of the reinvestment policy of the company on the value is usually expressed by the following equation: e P V = + PVGO (5.5) k The rst term on the right hand side is the value that the stock would have if the rm were paying out all the earnings as dividends and not reinvesting anything. The second term, PVGO, is the additional value from reinvestment and is known as the present value of growth opportunities. As you may expect intuitively, PVGO is positive only if the rm is reinvesting in those opportunities that provide better returns than the usual operations of the company, i.e., are positive NPV projects. To use the growing perpetuity formula given in equation (5.3), one needs to know the growth rate in dividends. The growth rate may be estimated using the historical growth rate. The growth rate in the formula is the compound growth, rather than simple. Therefore, if a dividend d grows at a uniform rate of g per year, in n years, it will become d(1 + g )n . Therefore, if the dividends on two dates n periods apart are known to be d0 and dn then the growth rate can g can be determined as: dn = d0 (1 + g )

n

g=

dn d0

(1/n)

1.

(5.6)

As an example, suppose the quarterly dividend for a company in Quarter 1, 1985 was $0.30 per share and in Quarter 4, 1988 it was $0.48. Then the quarterly dividend growth rate can be estimated as: 0.48 (1/15) g= 1 = 0.03183 0.30 or 3.18% per quarter. Note that it takes 15 quarters of growth to go from Quarter 1, 1985 to Quarter 4, 1988, which is why we use 15 in the example above. To determine if the growth rate was constant through this period, one should calculate the growth rate for every quarter, e.g., Quarter 1, 1985 to Quarter 2, 1985, Quarter 2, 1985 to Quarter 3, 1985, and so

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on. Each of these growth rates should be close to the 3.18% for the constant growth model to be reliable. A double check may be done for the growth rate calculation using the earnings. If there is a constant growth, then the earnings should grow at the same rate as the dividends. In fact, because of the companies policy about not changing dividends frequently, it is possible that the dividends change in steps rather than continuously while the earnings change from quarter to quarter. In these situations, the growth rate estimated using earnings is more reliable than the one estimated using dividends.

5.5.3

Usually, the valuation process does not lead to simplied equations such as (5.2) and (5.3) because, while the stock may have an innite horizon, investors do not. In other words, investors buy shares, hold them for some time and sell them. In that case one has to use a variation of equation (5.1). Suppose the investor will hold the shares for T periods and sell them at a price of pT then the following equation can be written: PV = dt pT + t (1 + k )T t=1 (1 + k )

T

(5.7)

5.6

To make an investment decision about a stock, an investor has to know the current price, the discount rate, the future dividends and prices. The market price is the easiest information to obtain. It is readily available from The Wall Street Journal or other publications. More current prices can be obtained from other information sources. The discount rate can be estimated using CAPM provided the investor knows the stocks and has estimates of the expected returns on the market and the risk-free rate. Estimates of future dividends and prices are the most dicult data items to obtain. Historical information is the starting point in this exercise. Historical data about the company may be obtained from sources such as Moodys Manuals , Standard and Poors Stock Guides , and Value Line Investment Surveys . The estimates obtained using historical data should be adjusted to reect the changes expected in the future. Publications such as Standard and Poors Outlook and Value Line Investment Surveys provide such analysis as well.

5.7

A reasonable estimate of future stock prices can be obtained if one has reliable information about the economic variables aecting the stock prices and one knows the relationship between these variables and the stock prices. The stock price, in equilibrium, is equal to the

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The numerator, dividends, depend on the rms earnings while the denominator contains the discount rate, which depends on the interest rates in the economy (the risk-free rate and the market rate) and the stocks risk . Economic variables aect stock prices by aecting the dividends, the interest rates and the risk of the company. Therefore, if one can estimate the eect of an economic factor on these variables, the eect on the stock price can be estimated easily. Here are some examples: Ination: Expectation of ination increases the rates in the economy. Therefore, the discount rate goes up as higher ination is expected. This has a negative eect on the price. A higher ination rate, however, also increases a rms revenues and costs which may have a net eect of an increase in the rms earnings (assuming the demand is unchanged). In popular press, common stock is viewed as an ination hedge because the dividends go up with ination so that the real dollar value of dividends is unaected by ination. Increased dividends have a positive eect on the stock price. The net eect of increases in discount rate and dividends on stock prices, in general, is uncertain and depends on the sensitivity of the rms to ination. One can determine the eect of ination on a particular company by doing some simple calculations using the formula above. Taxes: Increased taxes require investors to demand higher returns on their investments and therefore the discount rate goes up. At the same time earnings decline due to a bigger tax burden so that the dividends decline. The net eect on the stock price is negative. Macroeconomic conditions: Macroeconomic conditions aect stock prices through their eect on interest rates and corporate earning power. Poor economic conditions lead to lower earnings. However, the interest rates also decline with poor economic conditions. The net eect on stocks is therefore indeterminable in general but it can be determined for a particular stock using information about that company.

5.8

Conclusion

In this chapter you learned about the characteristics of common stocks and how to interpret the information about the common stocks. This information is used in determining values of the stocks and making investment decisions.

Exercises

Common Stocks

5.1 5.2 Stock Splits and Stock Dividends What stock dividend is equivalent to a stock split of 5-for-3? 7-for-5?

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Dividend Preference On February 15, 1989 ABC Corporation declared a dividend of $1 per share with the record date of March 18, 1989. The ex-dividend date was set to be March 13, 1989. The common stock of ABC closed at $12 on March 12, 1989. On March 13, 1989 the stock opened at $11.20a $0.80 drop to reect the loss of dividend. Consider three investors: An individual who pays 28% taxes on capital gains and dividends. An American corporation that pays 34% taxes on capital gains and 8% on dividends. A Japanese corporation that pays 30% taxes on capital gains and no taxes on dividends. Imagine that each of these groups bought 100 shares of ABC on January 2, 1989 for $10 per share. Calculate the net after-tax prot to these investors if they sold the shares on the evening of March 12. Calculate the net after-tax prot if they sold the shares on the morning of March 13. Which timing is preferred for which investor? 5.3 Common Stock Valuation On January 1, 1988 the common stock of Khilona Inc. was listed as: 52 Weeks Hi Lo

Stock Khilona

Sym KHL

Div 2.55

Yld % 6.07

PE 7

Vol 100s 20

Hi 42

Lo 42

Close 42

41 7/8

40 3/8

(a) Explain each entry in the listing. Do any calculations necessary to conrm the dividend yield. (b) What was the dividend payout ratio for Khilona during the year? Would you classify Khilona as a mature or a growth rm? (c) Khilona pays dividends quarterly. Based on your private information you expect the next four dividends per share to be $0.60, $0.60, $0.80, and $0.60, respectively; and you expect to be able to sell the common stock of Khilona for $46 on January 1, 1989. You want to determine whether, based on your information, the common stock of Khilona is overor underpriced. You do some research and collect the following information: the expected rate of return on the S&P 500 over the next year is 12%, the risk-free rate over the next year would be 7%, the standard deviation of the annual returns on the S&P 500 is 14%. The standard deviation of returns on the common stock of Khilona is 22%, and the correlation between the returns on Khilona and the S&P 500 is 0.80. Calculate the for the common stock of Khilona; and then calculate the discount ratethe expected rate of return expected based on the risk. Using this information calculate the proper price (the present value) of the common stock of Khilona. Should you buy the stock? 5.4 Common Stock Valuation The listing for the common stock of Jumbo Peanuts, Inc. reads as follows: 52 Weeks Hi Lo 30 18 Yld % 12.3 Vol 100s 20 Net Chg +1

Sym JP

Div 2.70

PE 6

Hi 23

Lo 21

Close 22

Curio Month 0 1 2 3 4 5 6 7 8 9 10 11 12 Price 20.40 20.00 19.50 18.50 19.00 19.60 18.90 19.10 19.00 18.50 18.70 19.00 19.20 Dividend 0.60 0.00 0.00 0.60 0.00 0.00 0.60 0.00 0.00 0.60 0.00 0.00 0.60 S&P 500 230 235 237 235 239 242 245 243 246 249 255 258 262 Month 13 14 15 16 17 18 19 20 21 22 23 24 Price 21.50 22.00 21.00 19.00 18.00 17.00 17.50 18.00 18.00 18.50 19.00 19.20 Curio Dividend 0.00 0.00 0.60 0.00 0.00 0.60 0.00 0.00 0.60 0.00 0.00 0.60 S&P 500 264 267 264 270 265 278 282 282 287 290 292 293

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(a) Explain all the entries in the listing. (b) What were the earnings per share for this company during the last year? What is this companys dividend payout ratio? Is this company growing? (c) Suppose the of the stock is 1.4, the expected return on the market portfolio is 12.55% per year, and the risk-free rate is 6.14% per year. What is the discount rate for the common stock of Jumbo Peanuts? (d) Assume that the company has a policy of paying dividends quarterly. The last quarterly dividend was $0.70 per share, and the next dividend is expected one quarter from now. Suppose the market expects this company (and therefore its earnings and dividends) to grow at a constant rate forever. What is the value of the growth rate expected by the market? 5.5 Valuation of Common Stock Table 5.4 shows the closing prices for the past 25 months and the dividends for the common stock of Curio Inc. and the levels of the S&P 500: (a) Calculate the for the common stock of Curio Inc. How much return do you expect the market to provide during the next month? The monthly risk-free rate is 0.6%. What is the proper rate of return that you expect from Curio based on its risk? (b) Your private and reliable information sources lead you to expect that the closing price of Curios common stock next month would be $20.00. What is the expected rate of return based on your information? (c) What would be your trading strategy based on your analysis and information?

Common Stocks

5.6

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Price Earning Ratios Show that under the assumptions of uniform growth of future dividends and earnings, the price earnings ratio can be written as: (1 + g ) p = e kg where p is the current price, e is the current earning per share, is the dividend payout ratio, k is the discount rate, and g is the rate of growth in the dividends. What kind of stocks would have a high PE ratio? 5.7 Price Earnings Ratio The WSJ of June 5, 1990 reported the PE ratio for American Express company to be 52. The annual dividends paid by the company were listed to be 0.92 and the closing price was listed to be 31 5/8. (a) What were the earnings per share for American Express during the past year? (b) What is the dividend payout ratio for American Express company? (c) The for American Express company is 1.2. The long term expectation of the risk-free rate is 6.5% per year and that of the market is 13% per year. Estimate the discount rate for the American Express. (d) Assuming that the market believes that American Express is a steady growth company, estimate the appropriate value of the rate of growth in dividends that would justify such as high PE ratio for American Express? 5.8 PVGO The next years earnings per share for nIce Cream, Incorporated is expected to be $1.20. The discount rate applicable to the common stock is 10% per year. Calculate the PVGO for nIce Cream if its current stock price is $14. 5.9 PVGO Show that the present value of growth opportunities (PVGO) is given by: P V GO = e(i k ) (1 ) k k (1 )i

where = payout ratio. k = discount rate for the rm. i = rate of return on the plowed back reinvestment. e = earnings per share for the rm one period from now. As a special case note that PVGO=0 if i = k . 5.10 Valuing a Growth Stock The discount rate for the common stock of BULL Corporation is estimated to be 15% per year. The BULL Corporation paid $0.79 per share in dividends this year, $0.70 last year, 0.62 the year before that, and $0.55 the year before that. An analyst classies BULL as a growth company. Determine the value of the common stock of BULL. 5.11 Delayed Growth Imagine that today is January 1, 1990. The earnings per share for Pixel Technologies in the last quarter of 1989 were $0.75 but the company paid no dividends, and is not expected to pay any dividends till the rst quarter of 1995. The analysts expect that because of reinvestment the earnings per share will grow at the rate of 2% per quarter till then. It is expected that in the rst quarter of 1995 the company will adopt

Common Stocks

148

a policy of paying 60% of its earnings as dividends. Because of this change in policy the rate of growth in earnings is expected to decline to 1.4% per quarter. The long term return on the market is expected to be 12.5% per year while the risk-free rate is expected to average 6.5% per year. Finally, the of the common stock of Pixel is 1.4. Calculate the proper price of the common stock of Pixel Technologies. 5.12 Information and Price Reaction The return on S&P 500 is expected to be 13% per year with the standard deviation of 20%. The risk-free rate is expected to be 6% per year. The common stock of Merit Company has a standard deviation of 25%, and a 0.20 correlation with the S&P 500. (a) What is the proper expected return from the common stock of Merit Company? (b) Merit Company is a mature company with 100% dividend payout. The market price of the stock is currently $20. What annual dividend does the market expect from Merit? (c) The IRS announces a small change in the corporate tax laws, which would allow Merit to pay less in taxes and therefore, increase its annual dividends by $0.07 per share. What eect will this announcement have on the price of Merits stock?

Bonds and preferred stocks are xed income securities because they promise to pay xed sums of money to the security holder. By buying these securities investors lend money to the issuer. For tax purposes, the income from the bonds is treated as interest while that from the preferred stock is treated as a dividend. This feature makes preferred stocks very attractive for corporate investors because 80% of the dividend income is tax-free for them. The eective tax rate on dividend income for corporations with marginal tax rate of 34%, therefore, is only 0.20 0.34 = 0.068 or 6.8%. While both bonds and preferred stocks are xed income securities they have many differences. A major dierence between bonds and preferred stocks is that bonds must pay interest regularly without skipping a single payment. Skipping even one interest payment would put the bond into default. Preferred stocks are not that restrictive. A company may skip a dividend on a preferred stock. Most preferred stocks, however, have cumulative dividends which means that the skipped dividend is accumulated and must be paid laterusually before any dividends are paid to the common stockholders. Another dierence between bonds and preferred stock is that bonds have a nite life and the principal amount (the face value) must be paid back at maturity while preferred stocks usually do not have a stipulated time for retiring. This dierence, however, should not be of major consequence because there are active secondary markets for both bonds and preferred stocks. Preferred stocks are traded in the stock markets along with common stocks while the bonds are traded in separate bond markets.

6.1

A bond buyer becomes entitled to regular (usually semiannual) payments called the coupon payments. The amount of coupon payment is determined by the coupon rate.1 If a bond of XYZ corporation has a coupon rate of 12% then the annual coupon amount would be 12%

1

149

150

of the face value of the bond.2 The coupon payments are usually made in two semiannual installments. For example, if the XYZ bond mentioned above has a face value of $1,000, it will make coupon payments of $60 every six months. The face or par value of the bond is promised to be paid at the maturity of the bond. Bonds usually have face values of $1,000 or $10,000. The maturity date for a bond is set at the time the bond is issued. It ranges from 3 months to 30 years. The information about the coupon rate, the face value, and the maturity date is sucient for determining the promised cashows from the bond.3 For example, if the XYZ bond mentioned above is maturing on December 31, 1996 and an investor buys the bond on July 1, 1994, the investor is promised the following cashows: $60 7/1/94 12/31/94 $60 6/30/95 $60 12/31/95 $60 6/30/96 $1,060 12/31/96

Note that at the time of maturity (December 31, 1996), the investor is promised the face value and the coupon amount for the last six month period. To decide whether the bond is a good investment, the investor will have to use the principles developed in Chapter 4, i.e., compare the bonds present value with its market price, or compare its rate of return with the discount rate. The rate of return oered by a bond is known as its yield. You may calculate the yield to maturity for a bond by assuming that the bond will be held till maturity, or you may calculate a holding period yield or holding period return by assuming that the bond will be sold before its maturity. To do the holding period computation you will have to estimate the price at which you can sell the bond at the end of the holding period. Let us say that the market price of the bond described above is $956.70. To nd the yield to maturity, we solve for the semiannual yield to maturity r using the following equation:

r 956.70 = 60af r 5 + 1000df 5 .

This equation can be solved for r using the trial-and-error and interpolation techniques. On doing the calculations we get r = 0.0706, or 7.06% per half year which is compounded to give the annual yield of (1 + 0.0706)2 1 = 0.1461 or 14.61%. Similar calculations can be done for any desired holding period. To make an investment decision, this yield should be compared with the discount rate. Alternatively, we could have used the discount rate to calculate the present value and compared the present value with the price. The price of the bond is what the market is willing to pay for the bond. Therefore, the price of the bond is the markets estimate of the bonds value. The rate of return calculated

2 Some bonds do not pay xed coupon amounts. The coupon payments on these bonds are variable and are tied to the conditions of the economy in a predetermined manner. Usually, if the interest rates in the economy are higher, these bonds pay a higher coupon amount and vice versa. 3 Similarly, the dividend rate, the face value, and the retirement date, if any, are sucient for determining the cashows promised by a preferred stock.

Market Price < the face value = the face value > the face value Market Terminology Below par or at a discount At par Above par or at a premium Yield to Maturity > the coupon rate = the coupon rate < the coupon rate

151

using the price, therefore, is an estimate of the markets expectations of the return from the bond based on its risk; i.e., the markets estimate of the discount rate. An investor buys or sells a security because his estimate diers from that of the market. The bond valuation equation shows an important relationship between the prices and yields. The pricethe number on the left hand sidehas an inverse relationship with the yield. As the yield goes up, bond price goes down and vice versa. Since all the interest rates in the economy are connected (through the risk-free and the market rates), an announcement of a reduction in the basic rates (federal funds rate, prime rate, etc.) causes bond prices to go up. Movements in interest rates are often measured in basis points. A basis point is 1/100 of 1 percent. Therefore, if the yield on a bond changes from 7.25% to 7.27%, it moves up 2 basis points. There is a special terminology for bond prices in the market. The bond is said to be selling at par if the market price of the bond is equal to its face value. It can be shown that if a bond is selling at par then its yield to maturity is equal to the coupon rate (see exercise 6.2). For example, if the XYZ bond mentioned above were selling for $1,000, its semiannual yield to maturity would be 6%. If the bond is selling at a price below its face value, it is selling below par or at a discount. If a bond is selling at a price above its face value, it is selling above par or at a premium. Realizing that the price and the yield to maturity are inversely related we can summarize our information in Table 6.1

6.2

Bond Features

The valuation process presented above applies to all the securities once the cashows promised or expectedare known. One must understand other features of the bondstheir issuers, risks, tax implications etc.before making a decision because these factors aect the cashows and risk of the bond. Here we discuss some important features and terminology of the bonds. Most of this discussion is pertinent to the preferred stocks also. A bond may have a call feature which gives the issuer a right to recall (buy back) the bond during a specied period by paying the bondholders a pre-agreed price. This gives the issuer an opportunity to reissue the debt at a lower interest rate if the rates in the market go down. Since this feature does not favor the investors, a callable bond sells for a lower price

152

than a similar non-callable bond. Some bonds have a put feature which gives the bondholder (the investor) a right to sell the bond to the issuer at a pre-specied price. The put feature is useful for those bonds that do not have an active secondary market because it ensures that the investor can sell the bond. Bonds with put features have a lower yield than those without the put features. Some bonds have a convertibility feature. This feature gives the investor a right to exchange the bond for a pre-specied number of shares of the issuer. This pre-specied number is known as the conversion ratio. Convertibility gives the investor an option to take part in the prots of the company if the company does well. Convertible bonds sell at a price higher than the corresponding non-convertible bonds. Let us take an example. Suppose ABC has two bonds outstanding. The bonds dier in only one way: one bond is convertible with a conversion ratio of 40 while the other one is non-convertible. The convertible bond is at least as good as the non-convertible bond because it gives all the rights that the non-convertible bond gives. Therefore, if the non-convertible bond is selling for $980 then the convertible bond must also sell for at least $980. Now suppose that the share price of ABC is $26. The convertible bond can be exchanged for shares with a total value of 40 $26 = $1,040. Therefore, the convertible bond is worth at least $1,040. We say at least because there is time remaining before the maturity of the bond and in that time the share price may go up further. A bond may have a sinking fund provision to pay back the face value. The sinking fund is usually a bank or an investment account in which the company deposits regular sums which will grow to the total amount to be paid at the time of maturity. Bonds with sinking funds are considered safer and sell at a price higher then the corresponding bonds without the sinking fund. An investor should also be aware of the security and the seniority level of the bond. Some bonds are secured by a particular piece of property or asset. These are known as secured or mortgage bonds and are considered safer and therefore carry a premium over unsecured bonds. Most corporate bonds are unsecured and are called debentures. There may be a seniority structure among bonds. In case of bankruptcy, junior bonds receive payments only if something is left over after paying the senior bonds.

6.3

While xed income securities promise payments to the investors, they are not free of risk. Their risks, however, are substantially less than those of the common stocks. The three main components of the risks of xed income securities are the interest rate risk, marketability risk, and default risk. Interest rate risk refers to the risk that uctuating interest rates pose to the bondholder. Suppose you purchase a bond which is priced to yield 14% per year. A month later, the rates in the market change so that bonds of similar risk are yielding 15%. This change in interest

153

rates is a loss to you because comparable bonds in the market are yielding higher than your bond. If you decide to sell the bond you will get a lower price than what you paid. The interest rate risk exists even if the bond makes all the payments as promised. Appendix 6A provides a detailed discussion of this issue. Marketability risk refers to the risk of not being able to sell the bond. Even if there is a market maker (a specialist) for the bond, if the bond is traded infrequently the investor will have to pay a higher commission to sell the bond. Bonds of relatively unknown issuers have a higher marketability risk. Default risk refers to the chance that the company may not keep its promise of making the payment. Usually, companies default on their payments because of cashow troubles. One can ascertain the ability of a company to make the payments by examining its nancial statements. Historically, less than 1% of the bonds issued have defaulted. Junk bond is the term for a bond that has a very high risk of default. These bonds, therefore, oer relatively high yields. Bonds are rated for their safety from default risk by Standard and Poors and Moodys. Standard and Poors rates bonds by symbols such as AAA, AA, A, BBB, BB, B, CCC, CC, C, D. AAA is the highest rating and indicates that the bond has very low chances of default. D is the lowest rating and suggests that the bond is already in default. Moodys, similarly, rates bonds as Aaa, Aa, A, Baa, Ba, B, Caa, Ca, or C.

6.4

Bond Issuers

Bonds are issued by several dierent agencies, e.g., the U.S. Treasury and government agencies, municipalities, corporations, and nancial institutions. Bonds backed by the U.S. government do not have any default or marketability risk. They do have the risk of interest rate uctuation. Municipal and corporate bonds suer from all three sources of risk. Municipal and government bonds are classied as revenue bonds or general obligation bonds depending on the purpose for which they are issued and how they are backed. General obligation bonds are backed by all the assets of the issuer while the revenue bonds are backed only by the income from the particular project nanced. Holders of revenue bonds may not receive a payment if there are insucient funds from the project. The New York State Thruway was nanced using revenue bonds. The Treasury issues three kinds of bonds: short term bonds known as Treasury bills or just T bills, medium term bonds known as Treasury notes, and long term bonds known as Treasury bonds. Corporations also issue short term bonds known as commercial paper, medium term bonds known as notes, and long term bonds. Short term bondsTreasury bills and commercial paperare zero coupon bonds, i.e., they do not pay any coupon interest before maturity. They are sold on a discount basis. For example, an investor may buy a T-bill for $9,920 and on maturity receive $10,000. Treasury bills usually have maturity periods of 3 months, 6 months, or 1 year.

154

The taxability of interest income depends on the investor and the issuer. Interest from corporate bonds is taxed both at the state and the federal level. Interest from municipal bonds is exempt from federal taxes. It is also exempt from state taxes if the investor resides in the same state as the issuer. Interest from the U.S. Treasury securities is exempt from state taxes. The tax eects should be incorporated into the calculations before deciding to invest in bonds. Let us take the example of an investor living in New York State. This investor may be deciding between the Treasury bonds and the bonds of a local municipality. Let us assume that the bonds have identical risks and investor falls in the 28% federal income tax bracket. Suppose the municipal bond is oering a yield of 7% and the Treasury bond is oering a yield of 9.5%. It would be incorrect to compare the two bonds using their stated pre-tax yields. The municipal bond will oer 7% on the after-tax basis because its income is exempt from all taxes. The Treasury bond, on the other hand, will oer 0.095(1 0.28) = 6.84%.4 The municipal bond is the better choice because it oers a higher after-tax yield. For the Treasury bond to be as good as the municipal bond, it has to oer a higher yield. This yield is called the fully taxable equivalent yield of the bond. It can be calculated as: fully taxable equivalent yield = tax-exempt yield , 1 exempt tax rate (6.1)

where exempt tax rate is the amount of taxes that the bond is exempt from. For example, our municipal bond is exempt from 28% taxes and therefore its fully taxable equivalent yield is 9.72%. In other words, a Treasury bond that is oering a pre-tax yield of 9.72% will oer the same after-tax yield as the municipal bond.

6.5

Corporate and municipal bonds are issued in the primary market with the help of investment bankers. Treasury securities (bills, notes, and bonds) are issued in weekly auctions and investors can bid on them directly or through dealers. There are secondary markets for most bonds. Information about the transactions in the secondary markets is available in the bond tables in The Wall Street Journal. The Wall Street Journal reports information for the corporate bonds on the New York Exchange, the municipal bonds, the Treasury bonds, notes, and bills. Each table has its own unique features, so you have to be careful in interpreting the numbers. It is very important to read and understand the footnotes associated with the tables. The following subsections present brief discussions of the numbers in the major bond tables from The Wall Street Journal of Tuesday, August 8, 1995. The tables reect the trading for August 7, 1995. A comment that applies to all coupon bonds is that the listed price is not the actual price at which the bond is traded. The actual price is the listed price

4 This is only an approximate calculation. To take the eect of taxes into account you should calculate the yield to maturity using the after-tax cashows. See exercises 6.4 and 6.7 for more realistic examples.

Cur Yld Vol 8.6 cv 7.2 cv ... 9.7 7.4 10 31 37 40 69 95 39 Net Chg. ... + + + +

1/2 1/4

155

Bonds AMR 9s16 AMR 6 1/824 ATT 7 1/206 AlskAr 6 7/814 AlldC zr2000 Chryslr 10.4s99 IBM 7 1/213

Close 105 1/8 102 1/2 103 7/8 84 1/2 71 107 1/4 101 3/4

...

1/2 1/4 3/4

plus the accrued interest since the last coupon payment. For example, if the listed price is $900, the annual coupon rate is 14% payable in two installments each year, the face value is $1,000, and it has been 40 days since the last coupon payment then the actual transaction price is $900 + (40/182) $70 = $915.38. In this calculation we have assumed that the coupon payment is made every 182 days (6 months).

6.5.1

Corporate Bonds

We begin by looking at the corporate bonds listed in the table entitled new york exchange bonds. A few entries from this table are reproduced in Table 6.2. The rst column shows the name of the issuer, the annual coupon rate, and the year of maturity. For example, the issuer of the rst bond shown in Table 6.2 is AMR, the bond has a coupon rate of 9% per year, and it matures in 2016.5 The Chrysler 10.4s99 bond has a coupon rate of 10.4% per year and matures in 1999. Notice that there are two bonds for the issuer AMR. In fact, if you look at the full tables, you will nd that there are many issuers with more than one bond. The second column gives the current yield of the bond. The current yield is a measure of current income from the bond. Consider an investor who buys the bond today, holds it for one year, and then sells it. During the year the investor will receive the coupon payments. The current yield measures this coupon income as a percentage of the current price of the bond. For AlskAr 6 7/814, the current yield column shows cv. cv is a symbol for convertible bond. The current yield for these bonds can be calculated easily. Peeking ahead, we can see

To the best of my knowledge, the s has no special signicance. Some people say that it is put in there to separate the maturity year from the coupon rate and others say that the s makes it easy to read the bond name, for example AMR 9s16 would be read as AMR nines sixteen.

5

Maturity Mo/Yr Ask Yld. 2.68 5.34 5.06 6.49 6.63 6.88 6.89

156

Rate

Bid Asked Chg. 99:31 101:00 101:17 104:31 105.03 146:16 109:07 100:01 101:02 101:21 105:01 105.07 146:18 109:09 ... ... ... + 3 + 5 + 7 + 5

4 5/8 Aug 95n 9 1/2 Nov 95n 11 1/2 Nov 95 1 7 /4 May 04n 7 5/8 Feb 0207 11 1/4 Feb 15 5 7 /8 Feb 25

that the listed price of AlskAr 6 7/814 is 84 1/2 or 84.5% of the face value. We know that the bondholder will receive 6 7/8% or 6.875% of face value in coupon, therefore, the current yield is 6.875/83 or 8.1%. For AMR 9s16, the current yield is calculated as 9/105.125 = 0.0856 or 8.6%. AlldC zr2000 is a zero coupon bond maturing in 2000. The current yield for this bond is zero. The third column gives the trading volume for the bond in terms of the number of bonds traded. For example, 10 bonds of AMR 9s16 were traded. Often, there is no trading for a bond during a session. The information for that bond is not printed in the bond tables. Therefore, it is possible that you may not see every bond listed every day. The last two columns give the price of the bond when the trading closed in the market and the change in the price since the previous day. For example, the closing price of ATT 7 1/206 was 103 7/8 (103.875% of face value) which was down 1/4 from the previous day. The price of Chryslr 10.4s99 went up by 1/4 and the price of IBM 7 1/213 went up by 3/4 since the previous trading day. Note that the face value is not mentioned anywhere in the table. The numberscoupon rate, current yield, priceare given as a percentage of the face value. The face value is not very crucial because it is only a scaling factor.

6.5.2

Treasury Securities

The information for Treasury securities is grouped into three parts. Treasury bonds and notes are presented in the rst part. Table 6.3 shows the information about some Treasury bonds and notes. The only dierence between the two is the number of original years to maturity. Many of the explanations given above for the corporate bonds hold true for the Treasury bonds and notes too.

Bid Bid Asked Chg. Yld. 82:05 82:04 15:31 16:05 82:08 82:07 16:03 16:09 + + + + 1 2 1 1 6.08 6.09 7.22 7.17

157

Mat.

Type

The rst column of Table 6.3 gives the coupon rate and the next column species the maturity date. The symbols following the date specify the special features of the bond, if any. For example n means that it is a note. p means that it is a note and non-resident aliens are exempt from withholding taxes on interest income. k means that non-resident aliens are exempt from withholding taxes on interest income. If there is no symbol then it is an ordinary bond. There are other symbols that the table in the Journal explains. The next two columns give the last bid and the asked (ask) price quoted by the bond dealer. The number after the colon in the prices represents 32nd s. For example, 100:02 stands for 100 2/32. The next column gives the change in bid price in 32nd s since the previous trading day. The last column is the approximate annualized yield to maturity based on the ask price. The second part of the Treasury securities table contains information about Treasury Strips. Treasury Strips are long term zero coupon bonds created by nancial companies by stripping individual coupons and face value and selling them in the market. For example, Merrill Lynch may buy 1000 Treasury bonds maturing in 10 years and sell claims to individual coupons and face values to separate investors. This creates long term zero coupon Treasury bonds which are not otherwise available. Table 6.4 shows information for Treasury Strips. The rst column shows the maturity date in month and year. For example, the last strip shown in Table 6.4 matures in May 2021. The next column shows the type of strip. ci indicates that it is a stripped coupon interest, np indicates that it is a stripped principal from a note, and bp indicates a stripped principal from a bond. The next two columns give the bid and the asked prices in the same format as the Treasury bonds. The next column shows the change in the bid price. The last column shows the annualized yield to maturity based on Bid price. The last part of the Treasury securities table contains information about Treasury bills. Treasury bills are important for our analysis because they are the closest substitute for the risk-free security. Information for Treasury bills in Table 6.5. The rst column in Table 6.5 shows the maturity date. The next column gives the days to

Days to Mat. Bid Asked 5.40 5.33 5.38 5.36 5.37 5.33 Ask Chg. Yld. +0.11 0.01 0.01 ... 0.01 0.01 5.48 5.45 5.54 5.55 5.60 5.64

158

Maturity

Aug 10 95 1 5.50 Sep 14 95 36 5.37 Nov 02 95 85 5.40 Dec 07 95 120 5.38 Feb 08 96 183 5.39 Jul 25 96 351 5.35

maturity.6 The next two columns give the annualized discounts for the T bill. The discount here refers to the annualized discount on the price compared to the face value. For example, if a $100 face value T bill that will mature in 3 months is selling for $98, its discount is 2% for three months and the annualized discount is 8% because there are 4 quarters per year. Quoting discounts rather than the price is a unique feature of Treasury bills. Keep in mind that the higher the discount the lower the price. As the numbers in Table 6.5 show, the ask discount is lower than the bid discount because the ask price is higher than the bid price. Before any calculations can be done with a Treasury bill information, we have to convert the discount to price. The annualized discount d is related to the price p as: 100 p 360 d= , 100 n where n is the days to maturity. This formula always uses 360 for the number of days in the year, regardless of the actual number of days in the year. The formula can be simplied for p as: 100nd p = 100 . 360 To use the formula, let us take the T-bill maturing on Sep 14, 1995. There are 36 days to maturity for this T bill. Therefore the ask price can be calculated as: 100 36 0.0533 p = 100 = 99.4670. 360 This means that it will cost $99.4670 to buy the Treasury bill which will pay $100 in 36 days. The 36-day rate of return, therefore can be calculated as: 100 99.4670 = 0.0053586 .0.0054 99.4670

6 The days to maturity may dier from the calendar days because of the procedure followed in settlement of Treasury bills.

Fixed Income Securities which can be converted into the annual ratewithout compoundingas: (0.0054) 365 = 0.0545 36 or 5.45% per year.

159

This is the number given in the last column of the table. As we saw, this calculation is based on simple interest and ignores compounding. A more realistic calculation should consider the eect of compounding. The compounded annual rate can be calculated as: (1 + 0.0053586)365/36 1 = 0.0556797 or 5.57% per year.

Often, we are interested in nding out what stated annual rate, when compounded continuously, will give us the return oered by a T bill. If the rate is r per year compounded continuously, then the present value of $100 to be received n days from now must equal the price of the T bill, so that: 100 p = r(n/365) e from which we get the return as: r= 365 100 ln n p

Applying this equation to the T bill in our example, we get r= 365 36 ln 100 = 0.0541848, 99.4670

or 5.42% per year. The eective annual rate because of the continuous compounding eect can be calculated as: re = e0.0541848 1 = 0.0556797 or 5.57% per year. Note that this is the same rate we got above by using compounding the 36-day rate. This shows that the eective annual rate is the same regardless of how we view it.

6.6

Bond Portfolios

Many retirement and pension funds invest in portfolios made up of bonds because of their low risk. These bond portfolios can be analyzed in the same manner as the portfolios of stocks. However, the biggest component of risk of bond portfolios arises from the interest rate sensitivity of bonds. Dierent bonds have dierent sensitivities to interest rate uctuations depending on their coupon rate and years to maturity. For example, low coupon bonds are more sensitive to interest rate changes than high coupon bonds and long term bonds are more sensitive than short term bonds. To understand the interest rate sensitivity, consider three Treasury bonds.

Fixed Income Securities Bond 1 has a semiannual coupon rate of 6% and matures in 2.5 years. Bond 2 has a semiannual coupon rate of 6% and matures in 6 years. Bond 3 has a semiannual coupon rate of 12% and matures in 6 years.

160

At a particular moment, the semiannual yield to maturities on these bonds are equal to 4%. Therefore, the bonds are priced at 108.9036, 118.7701, and 175.0805, respectively. We would like to know the impact of change in interest rates on the prices of these bonds. Suppose the interest rates go up so that the semiannual yield on these bonds become 5%. As the rates go up, the prices come down but dierent bonds respond dierently. The new bond prices become 104.3294, 108.8632, and 162.0427. The relative price changes in the bonds are 4.2%, 8.3%, and 7.4%, respectively. At the same coupon rate, the long term bond (bond 2) is more sensitive than the short term bond (bond 1). For the same time to maturity, the low coupon bond (bond 2) is more sensitive than the high coupon bond (bond 3). There is a pattern to sensitivity. Those bonds from whom more income is to be received earlier (either because of high coupon or shorter maturity) are less sensitive to interest rates than the bonds from whom less income is to be received earlier. The exposure of an investors capital to interest rate risk can be controlled by combining bonds of various maturities and coupon rates. The process of combining dierent bonds to form a portfolio so that it would have as little interest rate risk as possible is known as immunization. See Appendix 6A for more details.

6.7

Conclusion

This chapter described the characteristics of many dierent kind of bonds. We also saw some sources of bond information and how to interpret the information properly.

Exercises

Bond Valuation A bond issued by AT&T with face value of $1,000 was selling for $910 on July 1, 1991. The bond has a coupon rate of 5 5/8 and it matures on December 31, 1995. Calculate the yield to maturity of the bond. Would you buy this bond if the rate you expect from the bond based on its risk is 9.2% per year? 6.2 Yield of a Bond Selling at Par On January 1, 1990, a 7% coupon bond maturing on December 31, 1995 was listed at 100. Calculate the yield to maturity for the bond. 6.3 Convertible Bonds ABC9s92 is a convertible bond with a conversion ratio of 50 and ABC8s91 is a debenture without the convertibility feature. On January 1, 1991, ABC8s91 was priced at $920 and shares of ABC were selling at $18. Investors believe that all bonds of ABC are equally risky. What must be the minimum price of ABC9s92? 6.1

6.4

161

Pre-tax and After-tax Yields It is commonly believed that the after-tax yield from a bond can be calculated as pre-tax yield (1 tax-rate). Let us see how good this formula is. Consider a bond with semiannual coupon rate of 5% and maturing in 5 years. The bond is priced at $920. Calculate the pre-tax yield to maturity of this bond. Consider an investor who pays taxes at the rate of 28% on both the interest income and the capital gains. Calculate the after-tax yield to maturity for this investor by using the after-tax cashows. Does your answer agree with the intuition mentioned above? 6.5 Basic Bond Calculations Imagine that today is January 1, 1990. The listed price for Ace9s06 is $985. The bond pays coupon interests on June 30 and December 31, and will mature on December 31. The bond is callable in 1997 for $1075. (a) Is the bond selling above, at, or below par? What do you expect the bonds yield to maturity to be in relation to the coupon rate? (b) Calculate the current yield for the bond. Explain the information conveyed by this number. (c) Calculate the yield to maturity for the bond. Explain the meaning of this number. (d) Calculate the yield to call for the bond, assuming that the bond will be called on December 31, 1997, after the payment of coupon interest. Explain the meaning of this number. 6.6 Bond Pricing Here is a conversation between two graduates of a reputed business school employed by a Wall Street rm. The conversation was recorded on May 12, 1988. Read it carefully: Steve: Hi Laura! How are things going? Laura: (in a tired voice) Oh, I dont know. I am stumped by this new assignment my boss gave me. Steve: Whats the problem? Laura: I have to gure the proper price of this new bond to be issued on July 1. All I know is that the bond has a coupon rate of 9% and it will mature in 1999. Steve: Thats a start. Do you know the discount rate for the bond? Laura: (frustrated) Thats the problem. I did do some research but all I could learn was that the risk of this bond would be equivalent to that of an existing bond... here it is... CRX8.25s1995. Steve: Do you know the market price of this CRX bond? Laura: Yes. I just looked it up. It is $952.50. Steve: (with a smile) Then you have your problem solved. Laura: (in disbelief) What do you mean? Tell me. Steve: Can you calculate the yield to maturity for CRX? Laura: Sure. I do remember how to do that. Steve: Now, do you remember that the yield to maturity is the markets estimate of the discount rate of a bond? Laura: Yes. But how will that help? I only know the discount rate for CRX, not for my bond.

162

Steve: Remember what Prof. Shukla told us about the discount rate? The discount rate is the rate of return required based on the risk. Laura: And if two bonds are equivalent in risk they will have equal discount rates! Steve you are a genius. I owe you a lunch for this. Now be a dear and let me nish this job. Steve: See you later, Laura. Good luck. (With a foreign accent) Dont forget the time lines. Laura: (smiles) Bye, Steve. Following this conversation, calculate the price of the bond that Laura has to evaluate. Show all your steps clearly. 6.7 Bond Yields Using Real Data The bond of Dow Chemical is listed on the New York Exchange. The bond has a coupon rate of 8 5/8 and it matures on December 31, 2008. The bond splits the coupon payments into two partsone is paid on June 30 and the other on December 31 of the year. The closing price of the bond on February 9, 1988 was $940. The bond can be purchased for the listed price plus the accrued interest, if any, since the last coupon payment (this is true for all bonds). (a) On a time line show the cashows that would arise from this bond. Clearly identify them as inows or outows. Assume that there are no transactions costs or taxes. Calculate the annualized yield to maturity on the bond. (b) Now assume that the purchaser would have to pay transaction costs of 3% of the price paid. Also, the investor will pay taxes at the rate of 28% on the coupon income and the capital gains. Show the cashows and calculate the annualized yield to maturity. (c) The previous two calculations assume that the promised coupon and principal will be paid and on time. In real life there is always the chance that the bond may default on its payments. To keep things simple but still give some avor of real life let us assume that the investor expects that the rm will not default during the coupon payments. The investor believes that there is an 80% chance that the principal (face value) will be paid as promised but there is a 20% chance that the rm will go into default and the investor will only get $850. The resulting capital loss would be tax-deductible. Show the cashows now with other assumptions as in part b and calculate the annualized yield to maturity. 6.8 Treasury Note Review the following entry for a U. S. Treasury Note from The Wall Street Journal of May 4, 1988: Maturity Ask Rate Mo/Yr Bid Asked Chg. Yld. 13 7/8 Jun 92n 105:13 105:17 2 8.85 (a) Explain the entries for the note. (b) Calculate the yield to maturity for the note. 6.9 Comparing Bond Investments A 15-year, Treasury strip is selling for 26:02 while a 15-year, 12% coupon Treasury bond is selling for 123:14. Which bond is oering a higher annual rate of return? Compare the risks of these two bond investments.

163

6.10 Treasury Bill Calculate the bid and ask prices of the Treasury bill shown below. Show the calculations to determine the ask yield shown. What is its eective annual yield using ask price? What is the continuously compounded rate for this Treasury bill using the ask price? Days to Ask Maturity Mat. Bid Asked Chg. Yld. Sep 05 91 77 5.58 5.56 +0.01 5.71 6.11 Yield of a Bond Portfolio Consider two bonds: Bond A matures in 3 years from now, has a semiannual coupon rate of 8% and is priced at $1,050. Bond B matures in 2 years from now, has a semiannual coupon rate of 6% and is priced at $940. (a) Calculate the semiannual yields to maturity for the bonds. (b) Consider an investor who buys two A bonds and 3 B bonds. What is his total dollar investment? What fractions of his money are invested in A and B? What is the weighted average yield of his bond portfolio? (c) Calculate the yield to maturity of his total bond investment. 6.12 Interest Rate Sensitivity

(a) A 5% coupon Treasury bond maturing in 8 years is priced at 978. What is its yield to maturity? (b) What would be the price of the bond if the interest rates were to go up so that the bonds yield to maturity were to go up by 1%? What is the sensitivity of the bond price to interest rate?

6A.1 Introduction

The common and probably the biggest single inuence on stock investments is the market. If the market as a whole goes up, most stocks will go up with the market. If the market goes down, the stocks will go down with it. For bonds, the common inuencing factor is the interest rate. Changes in interest rates aect the bond investments severely. Therefore, bond investors, especially institutions such as pension and endowment funds, spend considerable eort to minimize the eects of interest rate uctuations on their investments. Rates of return realized by bond investors are aected by changes in interest rates in two ways: The price of the bond moves inversely with interest rates. Therefore, if the interest rates were to go up after an investor bought a bond, the bond price would decline causing the realized rate of return to come down. Of course, if the rates were to come down, the bond price would go up with the associated benecial eect. Let us call this component of interest rates eect on bond return the price eect. An investor who holds the bond until maturity does not face the price eect because upon maturity, he is promised the face amount by the issuer regardless of the prevailing interest rates. The coupon income has to be reinvested at the prevailing interest rates. If the rates go up after an investor bought a bond, the coupon income will be reinvested at the higher rates, causing the overall rate of return on the bond to go up. The opposite will be true if the rates were to come down. Let us call this component of interest rates eect on bond return the reinvestment eect. The price and reinvestment eects work in opposite directions. An increase in interest rate causes a detrimental price eect but benecial reinvestment eect. In this note, we will examine the combined eect of these two components of the interest rate changes on bond returns. 164

165

Throughout this note, we will use an 18% coupon bond maturing in 6 years as an example. The bond has a face value of $1,000 and is priced at $1,098.00. It pays coupon semiannually and the next coupon is due in six months. The bond cashows are shown below: 1,098.00 0 $90 1 $90 ... 2 11 12 It can be veried that the yield to maturity on the bond is 7.718% per six-month period or 16.033% per year. The realized rate of return may not be 7.718% per six-month period depending on the holding period and interest rates changes. $90 $1,090

6A.2

Let us consider two investors: Larry and Sandy. Larry will buy the bond and hold it for ve years, i.e., 10 six-month periods. Sandy will buy the bond and hold it for three years, i.e., 6 six-month periods. Let us calculate realized rates of return for these investors. The investors do not have any need for the coupon income so the coupon amounts will be reinvested at the prevailing interest rates. To simplify calculations, let us assume that the coupons will be reinvested in pure discount instruments whose maturity will coincide with the end of the investors holding period. For example, the rst coupon will be invested for 9 periods by Larry and 5 periods by Sandy.

6A.2.1

Let us rst consider the scenario where the interest rate environment does not change for the next 5 years. Therefore, the rate of return on investments with the same level of risk as the initial bond investment will remain 7.718% per six-month period. Five years from now, when Larry has to liquidate his investment, he will receive some money from his coupon reinvestments and some from the sale of the bond. The amount from the coupon reinvestments will be: 90(1 + 0.07718)9 + 90(1 + 0.07718)8 + + 90(1 + 0.07718)1 + 90 = $1,286.49 Note that in this calculation, the rst coupon is invested for 9 six-month periods, second for eight six-month periods, etc. The price of the bond will be the present value of the remaining cashows and will be calculated as: 90 1,090 + = $1,022.94 1 (1 + 0.07718) (1 + 0.07718)2

Interest Rate Risk and Duration The total value, therefore, would be: 90(1 + 0.07718)9 + 90(1 + 0.07718)8 + + 90(1 + 0.07718)1 + 90 90 1,090 + + 1 (1 + 0.07718) (1 + 0.07718)2 = $1,286.49 + $1,022.94 = $2,309.43

166

Considering that Larry invested $1,098.00 today and will receive $2,309.43 ten six-month periods from today, his rate of return can be calculated as: 1,098.00(1 + r )

10

= 2,309.43

r=

2,309.43 1,098.00

1 10

1 = 0.07718 = 7.718%

This makes sense. When Larry made his investment, he was going to earn 7.718% per sixmonth period from his investment, and over the 10 six-month periods that he was invested in the bond, the rates didnt change causing him to really earn 7.718% per period. A similar calculation for Sandy shows that three years from now, when she decides to liquidate, she will receive: 90(1 + 0.07718)5 + 90(1 + 0.07718)4 + + 90(1 + 0.07718)1 + 90 + 90 1,090 90 ++ + 1 5 (1 + 0.07718) (1 + 0.07718) (1 + 0.07718)6 = $655.56 + $1,059.75 = $1,715.32 which results in a realized rate of return calculated as: 1,098.00(1 + r )6 = 1,715.32 r= 1,715.32 1,098.00

1 6

1 = 0.07718 = 7.718%

For the same reason as for Larry, the realized rate of return on Sandys investment is 7.718% per six-month period.

6A.2.2

Now let us consider a case where the interest rates do not stay xed over the life of the investment. To keep things tractable, we will consider one shock to the interest rates, i.e., the interest rates change once after the initial investment and then remain at that level for the rest of the life of the bond. First let us consider the case of an interest rate increase. Suppose the rates go up by 0.01% per six-month period. So the coupon reinvestments will be made at 7.728% per sixmonth period and the bond will be priced using the interest rate of 7.728% per six-month

Interest Rate Risk and Duration period. The cashow to Larry at time point 10 would be: 90(1 + 0.07728)9 + 90(1 + 0.07728)8 + + 90(1 + 0.07728)1 + 90 90 1,090 + + 1 (1 + 0.07728) (1 + 0.07728)2 = $1,287.10 + $1,022.76 = $2,309.86

167

The component of cashow from coupon reinvestments went up with the increased interest rate but the bond price component went down. The net eect is an increased cashow. The rate of return to Larry is calculated as: 1,098.00(1 + r )

10

= 2,309.86

r=

2,309.86 1,098.00

1 10

1 = 0.0772 = 7.720%

Similar calculations for Sandy show that her cashow would be: 90(1 + 0.07728)5 + 90(1 + 0.07728)4 + + 90(1 + 0.07728)1 + 90 + 90 90 1,090 ++ + 1 5 (1 + 0.07728) (1 + 0.07728) (1 + 0.07728)6 = $655.73 + $1,059.27 = $1,715.00 For Sandy, just as for Larry, the coupon income went up and the bond price went down. However, the combined eect is that unlike for Larry, the total cashow to her went down. Her rate of return would be: 1,098.00(1 + r ) = 1,715.00

6

r=

1,715.00 1,098.00

1 6

1 = 0.07715 = 7.715%

6A.2.3

Next let us consider the scenario where the interest rates are shocked downwards by 0.01% from 7.718% per six-month period to 7.708% per six-month period. The cashow and return to Larry would be: 90(1 + 0.07708)9 + 90(1 + 0.07708)8 + + 90(1 + 0.07708)1 + 90 90 1,090 + + (1 + 0.07708)1 (1 + 0.07708)2 = $1,285.88 + $1,023.12 = $2,309.00 1,098.00(1 + r )

10

= 2,309.00

r=

2,309.00 1,098.00

1 10

1 = 0.07716 = 7.716%

Interest Rate Risk and Duration The cashows and return to Sandy would be: 90(1 + 0.07708)5 + 90(1 + 0.07708)4 + + 90(1 + 0.07708)1 + 90 + 90 90 1,090 ++ + 1 5 (1 + 0.07708) (1 + 0.07708) (1 + 0.07708)6 = $655.40 + $1,060.24 = $1,715.63 1,098.00(1 + r ) = 1,715.63

6

168

r=

1,715.63 1,098.00

1 6

1 = 0.07722 = 7.722%

6A.2.4

Summary

Larry: 10 period horizon Interest Rate 7.708% 7.718% 7.728% Value of Coupons 1,285.88 1,286.49 1,287.10 Bond Price 1,023.12 1,022.94 1,022.76 Total Cashow 2,309.00 2,309.43 2,309.86 Rate of Return 7.716% 7.718% 7.720% Sandy: 6 period horizon Value of Coupons 655.40 655.56 655.73 Bond Price 1,060.24 1,059.75 1,059.27 Total Cashow 1,715.63 1,715.32 1,715.00 Rate of Return 7.722% 7.718% 7.715%

The table shows that when the interest rate goes down to 7.708% per six-month period the coupon value declines and the bond price goes up, and the opposite happens when the interest rate goes up to 7.728% per six-month period. The total value and rate of return for Larry and Sandy depend on what happens to interest rates. If the rates go up, Larry is better o because the total cash ow to him increases but Sandy is worse o. If the returns go down, Larry is worse o but Sandy is better o. The only dierence between these two investors is their investment horizon. Larry is investing for 10 six-month periods while Sandy is investing for 6 six-month periods. It seems natural, therefore, to expect that for an intermediate holding period, the value and returns wouldnt be aected by the change in interest rate, i.e., the investor will have the same cashow and rate of return, regardless of whether the interest rate goes up or down. This special holding period, called duration, is 8 six-month periods for our bond.

6A.3

Duration

Bond portfolio managers are always looking for ways to minimize the sensitivity of their portfolio to interest rate shocks. One may think that the risk associated with interest rate changes can be minimized or even eliminated by holding the bond to maturity or for a very short while. Both the answers are incorrect. The correct holding period lies somewhere inbetween.

169

The duration is that holding period for which the terminal value and therefore realized rate of return from a bond holding will not be aected by small changes in interest rates.1 The terminal value (TV ) from a bond for D holding periods can be written as:

n

TV =

t=1

CF t (1 + k )(Dt)

where CF t is the cashow from the bond at the end of period t and k is the appropriate discount rate. We are trying to nd a value of D such that TV is unaected by changes in the discount rate k . Using basic calculus, we nd that: D=

n CF t t=1 t (1+k )t n CF t t=1 (1+k )t

The numerator in the expression for duration (D ) is the sum of discounted values of the cashows weighted by the times of the cashows. The denominator is the sum of the discounted values of the cashows, which is the price of the bond itself. For our bond, the duration is: D = = 1

CF t Bond Price (1+k )t (1+0.90 + 2 (1+0.90 07718) 07718)2 CF t t (1+ k )t

CF t t (1+ k )t

+ + 12

1,090 (1+0.07718)12

1,098.00

= 8.00

6A.3.1

Sensitivity of Duration

The duration is sensitive to interest rate and time changes. Let us consider the example of our bond: Suppose the bonds yield to maturity were 7.5% per six-month period, rather than 7.718% per six-month period. Then the bond price would be $1,116.03 and its duration would be 7.88 years. This means that unlike the bond maturity, the bonds duration is not xed. It changes with the interest rate. Therefore, the bond duration needs to be evaluated constantly and bond holding period needs to be adjusted in response to interest rate changes. Suppose today is Jan 1, 1995. With maturity and duration of 12 and 8 six-month periods, respectively, our bond matures on Dec 31, 2000, and its duration ends on Dec 31, 1998, respectively. Therefore, based on todays conditions, if the bond is held until Dec 31, 1998, small changes in interest rates will not aect the realized rate of return. Now consider our bond six months later. Suppose the interest rates have not changed, so the yield to maturity is still 7.718%. The bond price would be $1,092.75 and its duration would be 7.58 periods. Therefore, the passage of one six-month period reduced the bonds duration by only 0.42

1

It is impossible to nd a holding period for which the terminal value will not be aected by big changes.

170

six-month periods. The bonds maturity would still be Dec 31, 2000 but its duration ends in March 1999. In general, as time expires, bonds duration changes such that the end of duration becomes closer to the end of bonds life. Therefore, the bond duration and holding period strategy needs to be adjusted with passage of time as well.

6A.3.2

A zero coupon bond makes just one cashow upon maturity. Therefore, its duration coincides with the end of the life of the bond. D=

CF t t (1+ k )t CF t (1+k )t

CF T T (1+ k )T CF T (1+k )T

=T

6A.4

Applications of Duration

Consider a pension fund manager who knows that on December 31, 1999 he will have to pay out $3 million in pension checks. Therefore, he would like to invest in relatively safe securities, maybe in bonds issued by the Treasury, in such a way that the proceeds from the bond portfolio on December 31, 1999 should be exactly $3 million. Suppose today is January 1, 1995. The bond manager is looking at a ve year investment horizon. One may think that a strategy would be to buy ve year notes and bonds, i.e., bonds maturing on December 31, 1999. That however will not immunize the bond portfolio from the eects of interest rate changes. The face value is guaranteed but the coupon reinvestments are not. As an alternative, one may, therefore, suggest zero coupon bonds. That would be ideal but zero coupon bonds are not always available for desired maturity and amounts. The most practical solution for the manager is to invest in bonds with duration of 5 years. The problem here is that there may not be enough bonds of managers choice with 5 year duration either. However, a property of duration helps the manager. The duration of a portfolio of bonds is the weighted average of durations of the bonds, i.e.,: Dp = xi Di

where xi is the weight of bond i in the portfolio and Di is the duration of bond i. For example, suppose the manager has two bonds available, one with the duration of 3 years and another one with the duration of 8 years. The manager can create a portfolio with the duration of 5 years by investing 60% in bond 1 and 40% in bond 2, because 0.6 3 + 0.4 8 = 5. Of course, the manager will need to continuously monitor the bond portfolios duration to correct for the passage of time and changes in interest rates. Most bond portfolios consist of dozens or even hundreds of bonds making this problem much more complicated. Therefore, bond portfolio managers utilize computers for this application.

Chapter 7 Options

Options have existed for centuries but they have become a very popular part of investments only since 1973 due to a signicant progress in their systematic trading. Options allow investors to trade risk. Therefore, they allow some investors to hedge and others to bear the risk inherent in securities. Options are created when two investors enter a contract involving a security. Through the contract, the risk of the security is transferred from one investor to the other. In this chapter, we will study the characteristics and uses of stock options,1 and techniques for determining their values.

7.1

Terminology

An option contract gives the option buyer a right which may be exercised at his will and the option seller will have to comply. The seller is said to have written the option and is known as the option writer. The buyer holds the option after purchasing it and is known as the option holder. Sometimes, the terminology of long and short is used with options to indicate the transactions of buying and selling. The option buyer goes long on the option and the option writer goes short. The option writer charges a price for the option which is known as the option price or the option premium. There are two kind of options: calls and puts. A call option involves a right to buy and a put option involves a right to sell. Options can be of American or European type.2 An American type call option gives the option buyer a right to buy a specied number of shares of a certain stock at a specied price by (on or before) a specied date. An American type put option gives the buyer a right to sell a specied number of shares of a certain stock

The term stock option should not be confused with the stock options given by companies to their employees as part of wages. While those stock options are similar to the stock options discussed in this chapter, they are not publicly traded. 2 The names American and European do not mean that options traded in America are American type and options traded in Europe are European type.

1

171

Options

172

at a specied price by (on or before) a specied date. European type call and put options involve the rights to buy or sell only on the maturity date, not before the maturity date. An option is described completely by the following characteristics: The underlying stock and the number of shares: Options are traded primarily on active stocks such as IBM, AT&T, Kodak, and Digital Equipment. An option is written on 100 shares (a round lot) of stock. The specied date by or on which the option may be exercised: The options are usually written for maturities ranging from 3 months to 9 months.3 They mature on the Saturday following the third Friday in the month of maturity. The last trading day for an option, therefore, is the third Friday of the month. The specied price at which the stock may be bought or sold: This price is known as the strike price or the exercise price. The type of option: An option can either be a call or a put. Many more call options are traded in the market than put options. Unless specied otherwise, options are of the American type. For example, IBM Jan 80 call is the full description of an option. It is an American type call option on the common stock of IBM. The option may be exercised anytime up to the Saturday following the third Friday in January to purchase 100 shares of IBM for $80 each. A special feature of options is that the option holder is not obligated to exercise the option. The option holder will exercise the option only if exercising it will benet him. Since a call option allows the option holder to buy shares at the strike price, he will exercise it only if the stock price is more than the strike price. For example, if you own IBM Jan 80 call option and the market price of IBM stock is 85, you may want to exercise the option to buy the shares for $80. On the other hand, if the stock price is $75, you will not exercise the option because by exercising the option you will be paying $80 for shares that are available in the market for only $75. Because of this contingent relationship between the exercise of the option and the price of the stock, options are known as contingent claim securities. Many other securities are either directly or indirectly contingent claim. For example, convertible bonds are contingent claim because the bondholder will convert the bond to shares only if the share price is high enough. With a good imagination one may view many other nancial contracts as options also. For example, an automobile collision insurance can be treated as an option which gives the insured a right to recover the losses from the insurer if the car is wrecked. Option contracts are adjusted for stock splits and stock dividends. For example, if the IBM stock has a 2-for-1 split then the option mentioned above will be adjusted to allow the option holder to buy 100 2 = 200 new shares at the strike price of $80/2 = $40 each.

3

Options

173

Options, however, are not protected from the change in price due to cash dividends. For example, if the price of IBM stock is $81 and you own IBM Jan 80 call, your option is valuable because it can be exercised for a net prot of $1. If IBM pays a dividend of $2.00, the stock price will drop by about the value of the dividend, which may render your option worthless. Options are transferable, i.e., an option holder may sell the option to someone else. Options are bought and sold in the secondary markets. The biggest options market is the Chicago Board Options Exchange (CBOE). American Stock Exchange, Philadelphia Stock Exchange, and New York Stock Exchange are the other major markets for options. Trading of options is managed by the exchanges and an organization called the Options Clearing Corporation (OCC). The OCC decides which options may be created and traded. It also acts as an intermediary and guarantor for option buyers and sellers. Suppose investor A wants to sell an option contract and investor B wants to buy it. Once the investors have identied each other, they contact the OCC. The OCC enters into opposite contracts with the investors to complete the trade. It buys the option from A and sells an identical option to B. Since, the option buyers and sellers actually trade with the OCC, the OCC takes the responsibility of meeting the obligation implied in the option. When an option is exercised by an option holder, the OCC makes the required payment to the option holder and in turn asks the option writer to make the payment to the OCC.4 The option contracts are settled in cash, rather than in terms of stock. For example, if you own an IBM Oct 90 call option and you choose to exercise it today when IBMs stock price is 108 3/4, rather than you having to buy the stock for $90 and then selling it for 108 3/4 to realize a payo of $18.75, the option writer pays you $18.75 in cash. This is also convenient for the option writer because if there were no cash settlement, the option writer may have to buy the share in the market and the hand it over to you. Cash settlement avoids the transaction costs of buying and selling the shares. At any time there may be several dierent options for the common stock of a company. These options dier from each other by the strike price or maturity. The strike prices are set at intervals of $2.50, $5, or $10. For example, there may be call options on IBM maturing in various months with several dierent strike prices. Each combination of strike price and maturity month is a dierent option. The listed options quotations in The Wall Street Journal lists the prices of options. Even though the option contracts are issued for 100 shares, the listed prices are on a per share basis. We will also follow this system, i.e., assume that the options are on one share rather than 100. Table 7.1 shows the extract from The Wall Street Journal of August 8, 1995 for the options of IBM. These prices reect the trading completed on August 7, 1995. The rst column in Table 7.1 shows the name of the underlying stock and its closing

The OCC does not necessarily seek out the writer of the original option to settle the contract. It essentially uses a random selection method to pick one of the many investors who are short on the particular option.

4

Options

174

Call Vol. Last 54 39 3/4 54 30 1/8 37 31 1 186 25 /2 ... ... 2605 18 3/4 2790 19 3/4 108 20 1/2 7 22 1/8 203 13 3/4 24 16 1/8 1028 9 1106 10 1/2 230 11 5/8 533 14 1/4 571 4 1/2 104 6 1/2 220 8 1/8 2187 1 9/16 844 3 3/4 318 5 1/4 619 8 1/8 7/16 310 173 1 7/8 142 3 3/8 84 6 1/8 1/16 62 153 1 15 65 1 /16 111 4 1/2 Put Vol. Last 1/16 54 1/4 74 ... ... 3/8 194 79 1 1 /16 320 1/4 153 9/16 94 35 1 3/8 1/16 50 36 1 1 / 949 4 86 1 1/8 252 1 7/8 444 3 1/2 7/8 1097 208 2 3/8 73 3 1/2 645 2 3/4 26 4 1/2 50 5 3/8 11 7 1/2 80 6 5/8 ... ... 10 8 5/8 ... ... ... ... ... ... ... ... ... ...

Option/Strike IBM 70 3 / 108 4 80 108 3/4 80 3 / 85 108 4 108 3/4 85 3 90 108 /4 3 / 108 4 90 108 3/4 90 3 / 108 4 90 108 3/4 95 3 108 /4 95 3 / 100 108 4 108 3/4 100 3 108 /4 100 108 3/4 100 3 108 /4 105 3 / 108 4 105 108 3/4 105 3 108 /4 110 3 / 108 4 110 108 3/4 110 3 / 108 4 110 108 3/4 115 3 108 /4 115 3 / 115 108 4 108 3/4 115 3 / 120 108 4 120 108 3/4 3 120 108 /4 3 / 120 108 4

Exp. Oct Oct Jan Oct Jan Aug Sep Oct Jan Aug Oct Aug Sep Oct Jan Aug Sep Oct Aug Sep Oct Jan Aug Sep Oct Jan Aug Sep Oct Jan

Options

175

stock price. For example, IBM stock closed at 108 3/4. The second column shows the strike price. The third column shows the maturity month. The next four columns show the trading volumes and closing prices for the call and put options corresponding to the combination of strike price and maturity. For example, the IBM Jan 90 call option closed at 22 1/8 per share. Since the option contract is written on a round lot of 100 shares, the cost of an option on 100 shares is $2,212.50. The IBM Oct 115 call is priced at 3 3/8 and the IBM Aug 95 put is priced at 1/16. 220 contracts of IBM Oct 105 call were traded during the day while 645 contracts of IBM Aug 110 put were traded.

7.2

As mentioned above, options allow an investor to transfer risk to another investor. Let us understand this using examples. Suppose today is August 7, 1995 and you know that you will buy 100 shares of IBM in the middle of October. You can see from Table 7.1 that the price of IBM is 108 3/4. You believe that IBM is a good deal at this price. However, you would not want to pay more than $110 for the stock in October. To hedge against the risk of the price going above $110, you may buy an IBM Oct 110 call option. It will cost you 5 1/4 per share, but that is the price you are paying for the insurance. Once you have the option, you can buy the shares for $110, regardless of how high the market price becomes. Therefore, if the price in October is $120, you can use your option to buy the stock for $110. However, if the price in June is $100, you will not exercise your option because you can buy the stock for less in the market. You buy this option because you expect the price to go above $110. The person who sells you the call option believes that the probability of the price of IBM going above $110 by October is very small, and he is willing to take that chance. Now let us take an example involving a put option. Suppose today is August 7, 1995 and you own 100 shares of IBM. You want to hold these shares because you believe that IBM stock is a good long term investment. However, you want to insure against the loss if the stock price goes below $100 in the short run. You may buy IBM Oct 100 put option for $1 7/8 per share. Purchasing this option gives you a right to sell your shares at $100 anytime between now and the option maturity date in October. If the price of IBM stock goes below $100, say to $90, you can recover your losses by exercising your put and selling the shares at $100. On the other hand if the price does not go below $100, you will let your option expire. The option premium is like an insurance premium. If there is no casualty, the premium goes unused. However, if there is a casualty, the option is used to recover some of the losses. The strategy described here is known as a protective put.

7.3

Since options involve stocks as the underlying asset, they allow for an indirect investment in stocks. To compare an investment in options with an investment in stocks, let us consider

Options Table 7.2: Payos and Returns on Stock and Option Investments.

Capital=$10,875 Share price=$108.75 Number of shares purchased=100 Payo ($) Stock Price ($) 90 95 100 105 110 115 120 125 130 135 140 Stock 9,000 9,500 10,000 10,500 11,000 11,500 12,000 12,500 13,000 13,500 14,000 Option 0.00 0.00 0.00 0.00 0.00 0.00 0.00 12,083.33 24,166.67 36,250.00 48,333.33 Option exercise price=$120 Option price=$4.50 Number of options purchased=2,416.67 Prot ($) Stock 1,875.00 1,375.00 875.00 375.00 125.00 625.00 1,125.00 1,625.00 2,125.00 2,625.00 3,125.00 Option 10,875.00 10,875.00 10,875.00 10,875.00 10,875.00 10,875.00 10,875.00 1,208.33 13,291.67 25,375.00 37,458.33 Return (%) Stock 17.24 12.64 8.05 3.45 1.15 5.75 10.34 14.94 19.54 24.14 28.74

176

Option 100.00 100.00 100.00 100.00 100.00 100.00 100.00 11.11 122.22 233.33 344.44

an example using the data from Table 7.1. On August 7, 1995, John and Mary both had $10,875 to invest. John bought shares of IBM using his money. Since the share price was $108.75, he bought 100 shares. Mary, instead, bought IBM Jan 120 call options. Since an option on one share was priced at $4 1/2, she bought options on about 2,416.67 shares.5 Let us see how their investments fare on September 10, 1995. Suppose the price of IBM stock on that day is $110. John sells his shares to receive a payo of $110 per share, and a prot of $110 $108.75 = $1.25 per share. This results in a total prot of $125 and a return of 1.15%. Marys call options give her a right to buy the shares for $120. Since the market price of the shares is $110, she will not exercise her options. The value of her options, therefore, is zero. She has lost all her money and has earned a return of 100%. We can do similar calculations assuming other values for the stock price. Suppose the stock price is $130. John receives a prot of $130 $108.75 = $21.25 per share, or a total prot of $2,125. Marys call options are valuable now. She exercises them to buy shares of IBM for $120 and sells them in the market for $130. This gives her a payo of $10 per share. Her total payo is $10 2,416.67 = $24,166.67. Her prot, therefore, is $24,166.67 $10,875 = $13,291.67. Table 7.2 shows the results from several such calculations. Figures 7.1 and 7.2 plot the payos and returns against the stock price. As you can see,

I am using fractional number of option contracts only to make the investments in stock and option equal to each other.

5

Options

177

50 . ... ... . . . .. Option . .... 40 . . . .. .. .. . . . . ... 30 ... . . . .. .. ... . . . .. Stock 20 .. ... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10 ................................... .. ... .. . . . .. .. .. . ............................................ ........................................... ........................................ 0 .................. 90 100 110 120 130 140 Stock Price

Payo ($000)

400 . . . .. . .. . . . . . . . .. . .. . . . . . .. . .. .. . . 200 . . . . ... . .. . . . . . . . .. . 100 .. . . . Stock . . . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .................................... . . . 0 .................................................................................................................................................................................................. . . . ... . .. . . . . . . . .. . ........................................... ........................................... ................................ 100 ........................... 90 100 110 120 130 140 300

Option

Return (%)

Stock Price

Options

178

the payo from the options is zero (a 100% return) if the stock price is less than or equal to the exercise price. If the stock price is above the exercise price, the options provide positive payos. Once the stock price is above the exercise price, the prot from an option increases by $1 for every $1 that the stock price goes up. As a result, the return on the options goes up much faster than the return on the stock because the same prot is realized on a much lower investment with the options than with the stock. This example shows that options are a very risky but potentially very rewarding investments. The risk and high potential reward from options arises from their ability to magnify the gain or loss on stocks. This characteristic is just like that of a leveraged investment. Therefore, options are also known as leveraged securities. In our example, using the same amount of money ($10,875), John controlled 100 shares of IBM while Mary controlled 2,416.67 shares. To control 2,416.67 shares, John would have had to take out a loan, i.e., leverage his investment. Marys leverage was automatically built into the options.

7.4

Option Strategies

As we saw in section 7.3, changes in the price of an option are directly associated with the changes in the price of the underlying stock. Therefore, options can be used to capture the movements in the stock price. For example, if an investor believes that the price of IBM shares will go above $110 by September, he should buy IBM Sep 110 call. An investor who believes that the price of IBM shares will not go above $110 should sell the option. Similarly, if an investor believes that the price of IBM will go below $90 by September, he should buy IBM Sep 90 put. Another investor who believes that the price will not go below $90 should sell the option. Selling a call should not be confused with buying a put. While both these positions indicate that the investor is not too enthusiastic about the stock, the extent of the lack of enthusiasm is dierent. An investor should sell a call if he believes that the stock price will not go above the exercise price. This means that the investor is not bullish on the stock. The investor does not necessarily have to believe that the price will go down. If the investor believes that the price will go down, i.e., he is bearish on the stock, he should buy a put option. Similar relationship exists between a long position on a call and a short position on a put. The following table shows these relationships: Long Call Put Bullish Bearish Short Not Bullish Not Bearish

Buying and selling options by themselves is a very risky activity. An investor buying a call option is speculating on the movement of the stock price. As we saw in the previous section, this can result in signicantly higher prots than investing in the stock itself, but

Options

179

it can also result in a loss of all the investment capital. Options are often combined with the shares of the underlying stock, or other options for specic strategic reasons. Protective put, described in section 7.2, is one such strategy. In a strategy called covered call writing, an investor writes a call option on the stock he owns. Writing the option generates cash for the option writer because the option buyer pays him the premium. If the stock price goes up, the option buyer will exercise the option, and the option writer will have to sell the shares at the exercise price. However, if the market price of shares does not go above the exercise price, the call option will not be exercised and the option writer will keep the premium.

7.5

Option Valuation

Like common stocks and bonds, the value of an option depends on the cashows from the option. Suppose you own the IBM Sep 105 call option. If you were to exercise this option today (August 7, 1995) you will force the option writer to sell the shares of IBM to you for $105 each. It will, therefore, cost you $105, but the shares that you receive can be sold in the market for $108 3/4 or $108.75. This transaction would give you a payo of $108.75 $105 = $3.75 per share. The option, therefore, is worth at least $3.75 to you. If someone wants to buy the option from you, you should charge at least $3.75. At least because there is one more month before the option matures and during this time the stock price may go up, increasing the payo from the option. The option price, therefore, should be at least $3.75. The extra amount you charge would depend on your expectation about the stock price of IBM going up. From Table 7.1, we see that the market price of this option is $6.50. The $6.50 price can be divided into two parts: $3.75, the amount one would make by exercising the option today, and $2.75, the premium for the probability that the stock price may go up in the one month before the option expires. The rst part is known as the intrinsic value of the call option and the second part is known as the time value. Let us consider IBM Oct 110 call option. If you exercise it now, you will face a loss of $1.25. Since the exercise is optional, you will not exercise the option. The intrinsic value of this option, therefore, is zero today. This option has only time value because of the possibility that the stock price may go up before the option expires. The time value of this option makes up the entire price of $5.25. The intrinsic value of an option, therefore, is the payo from exercising the option if it is prudent to exercise the option; otherwise the intrinsic value of the option is zero. Let us use Ps to denote the stock price and E to denote the exercise price. The intrinsic value of the call option is given by Ps E , if the option should be exercised. Otherwise, the intrinsic value is zero. The option will not be exercised if the payo from exercising the option will be negative. This condition will be true if the stock price is less than the exercise price, making Ps E negative. Therefore, the intrinsic value is Ps E , if Ps E is positive, and it is zero if Ps E is negative. This leads to the following relationship for the price of

Options a call option, Pc : Price of a call option = Intrinsic Value + Time value, Pc = Max[0, Ps E ] + Time value

180

(7.1)

Max[0, Ps E ] denotes maximum of the two values: 0 and Ps E . Note that by taking the maximum of 0 and Ps E , we pick 0 if Ps E is negative. Similar arguments can be made for a put option. The intrinsic value of a put option results from the potential of buying a share in the market at a low price and then selling it at a higher price by exercising the option. The corresponding equation for the price of a put option, Pp , is: Pp = Max[0, E Ps ] + Time value. (7.2) Options that would result in a positive payo if exercised, and therefore have positive intrinsic values, are said to be in the money. All call options with Ps > E are in the money while all put options with Ps < E are in the money. Those options for which the payo would be exactly zero if exercised, are known as on the money. All on the money options have Ps = E . Options that would result in a negative payo if exercised (and therefore would not be exercised), are known as out of the money options. Call options with Ps < E and put options with Ps > E are out of the money. An option which would provide a large positive payo, if exercised, is known as deep in the money. Similarly, an option that would result in a large negative payo, if exercised, is known as deep out of the money. The in, on, and out of the money options can be identied using the following block structure: Call Ps > E Ps = E Ps < E In the money On the money Out of the money Put Out of the money On the money In the money

The relationships between the market price of an option and the characteristics of the option and the underlying stock are described below: An increase in the stock price has a positive eect on the value of the call option.6 If the price of IBM were $115 rather than $108.75, all call options would be worth more because of the increased intrinsic value. The intrinsic value of the IBM Sep 110 call, for example, would be $115 $110 = $5. The eect of an increase in the stock price on put options is opposite to that of the call option. An increase in the stock price makes a put option less valuable.

The relationship is not necessarily one-for-one because of the time value. The movement is closer to one-for-one for in the money options.

6

Options

181

An increase in the exercise price has a negative impact on the call option and a positive impact on the put option. This eect can be understood by nding the intrinsic values of options for dierent strike prices while keeping other things the same. The option quotations in Table 7.1 also veries this eect. The prices of IBM call options maturing in January with exercise prices of 80, 90, 100, 110, 115, and 120 are 31, 22 1/8, 14 1/4, 8 1/8, 6 1/8, and 4 1/2, respectively, and the prices of IBM put options maturing in January with exercise prices of 90, 100, and 110 are 1 3/8, 3 1/2, and 7 1/2, respectively. We see that the prices of call options decrease and those of the put options increase as the exercise prices increases. An increase in the time to maturity has a positive impact on the values of both the call and the put options. The more the time to maturity the higher the chances that the stock price will go up (for call option) or go down (for put option) and make the options more valuable. Again, the option quotations in Table 7.1 conrm this behavior. For the same strike price, the January options are more valuable than the October options which are more valuable than the September options. The volatility of the stock price movement has a positive eect on the values of the call and put options. The reason is that the higher the volatility the higher the chances that the price will go up or down and cross the exercise price. Therefore, other things being the same, a higher volatility stock has a higher value. Cash dividends have a negative impact on the value of a call option and a positive eect on the value of a put option. The price of a dividend paying stock drops by about the dividend amount on the ex-dividend day. The drop in stock price makes the call option worth less and put option worth more as we saw above. One factor that does not seem obvious but has an eect on values of options is the risk-free rate. The risk-free rate enters the picture to ensure that the rate of return one earns on an option investment should be in line with other investments. The risk-free rate has a positive eect on the value of a call option and a negative eect on the value of a put option. We can summarize these relationships as follows: Pc = f (Ps [+], E [], T [+], [+], d[], rf [+]) Pp = f (Ps [], E [+], T [+], [+], d[+], rf []) where Pc Pp Ps E T = = = = = the value of a call option the value of a put option, current stock price, the exercise price, time to maturity, (7.3) (7.4)

Options d rf [+] [] = = = = = standard deviation (volatility) of stock returns, dividend yield of the stock, the risk-free rate, the relationship is positive, the relationship is negative.

182

7.5.1

American options can be exercised before their maturity while European options cannot. This exibility of American options makes them at least as valuable as the corresponding European options. The dierence in the value of the American and European options diminishes as the time to maturity decreases. Even though an American option may be exercised before maturity, under some conditions it may be optimal not to exercise an American option before maturity. It may be more benecial to sell the option to someone else rather than exercise. The decision to exercise the option depends on the comparison of the market price of the option and the payo from the option if exercised. Let us examine an American call option. If the option is exercised, the payo will be the intrinsic value, Ps E (assuming that Ps > E so that it makes sense to exercise the option). The market value of the option, however, is Ps E + time value. The option is worth more than its payo if exercised. Therefore, the option holder can sell it in the market to get a higher value than the payo from exercising it. Let us verify this using the IBM Sep 105 call option. If the option holder exercises the option, he would force the option writer to sell shares of IBM for $105 each. These shares have a market value of $108.75. Exercising the option will result in a payo of $3.75 to the option holder. On the other hand, the option holder will receive $6.50 if he sells the option in the market. Therefore, the option holder will sell the option rather than exercise it. The option price is higher than its intrinsic value because of the time value. As the option approaches expiration, its time value declines and ultimately becomes zero on the expiration date. On the expiration date, therefore, the option would be exercised. This analysis, however, is valid only for an option written on a stock that will not pay any dividends before the maturity. If the stock has an ex-dividend day before maturity, the stock price will drop on the ex-dividend day making the option worth less, maybe even worthless. Therefore, it may be prudent to exercise the option before the stock goes ex-dividend. In summary, an American type call option on a stock that would not pay any dividends before the maturity of the option will not be exercised before the day of the maturity and therefore may be treated as a European option. The case of American put options is dierent. It may be rational to exercised them early, regardless of whether the underlying stock will go ex-dividend or not. Consider the extreme case when the price of the underlying stock becomes zero. The put option, at this point will have no time value because the stock price can only go up which will hurt the value of the

Options

183

put option. Furthermore, any movement in the stock price will also hurt the intrinsic value of the put. Therefore, the holder of the put option will be better o exercising the option. In general, this result will hold if the stock price falls to a low enough level.

7.5.2

Payo Diagrams

As we saw above, the value of an option is a function of the cashows or the payos from the options. The payo, however, depends on the stock price. A payo diagram describes the cashow as a function of the stock price. We have already seen examples of payo diagrams in Figure 7.1. The payo diagrams are quite useful in analysis and valuation. While the payo diagrams can be drawn for any day, we will draw them for the day the option matures. On the maturity date, the options have no time value. Therefore, the payos and the market prices of options are equal to their intrinsic values. While payo diagrams are useful in the context of options, they can be drawn for any security. Let us start by looking at the payo diagram for a share of common stock. This payo diagram is shown in Figure 7.3a. The payo from the common stock would come from selling the share. The higher the stock price, the higher the payo would be. For each dollar change in the stock price, there is a dollar change in the payo. The slope of the payo line, therefore, is 45 degrees. Figure 7.3a shows the payo to an investor who is long on a share. For an investor who is short a share, the payo line would be sloping downward from the origin. We will denote a long stock position as +s and a short stock position as s. Figure 7.3b shows the payo from a risk-free asset. The payo on a risk-free asset is independent of the stock price. Figure 7.3b shows the payo to an investor who is long on the risk-free asset. The payo for the investor short on the risk-free asset would be negative and therefore the payo diagram would be a mirror image (with the mirror placed along the x-axis). Figure 7.3c shows the payo to a call option holder, i.e., an investor who is long on a call option. We denote this position as +c. The payo is zero till the stock price reaches the exercise price E . This is because the option holder would not exercise the option unless the stock price is above the exercise price. Beyond the exercise price, the payo on the option changes one-to-one with the price of the stock. This means that as long as the stock price is above the exercise price, the gain on a call option is just like it would be from buying the stock itself. This feature of options make them a substitute for common stock for many investors. Figure 7.3d shows the payo to a call writer, i.e., an investor who is short on the call option. This investment position is denoted by c. If the call holder decides to exercise the option, the writer has to go along with the wish of the option holder. Every dollar gained by the option holder comes from the pocket of the option writer. For this reason, the payo diagram for a call option writer is a mirror image of that of the call option holder. Consider the IBM Sep 105 call option. The stock price is $108.75. If the option holder decides to exercise the option, the following transactions will take place: The option writer will buy the

Options

184

a. +s . .... ... . . . . .. ... .. .. . . . .. ... ... . . . E . . .... ... . . . . .. ... .. .. . . . .. . .. . E b. +f c. +c d. c

E ......................................................................... E

..................................... .. .. .. ... E .. . .. .. . .. .. .. . .. .. . .. .. . .. ..

e. +p

f. p

g. s + p

. . . . . . .. . . . . .. . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . .. . . . . . . .. . . . .. . . . . . . . . . . . . . . .............................. . . . . . . . . . . E . . . . . . .. . .. . .. . . . . . . .. . . .. . . . . . . . . . .. . .. . . . . . .. . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

h. c + p

.. E . . .. .. . .. .. . .. .. . .. .. .. . .. .. . .. .. . .. . .................................... E

. . . . . .. . . . . . . E . . . . . . . . . .. . . . . . . . . . . . . . . . . . .. . . . . . . . . . . .. . . . .. . . . . . . . .. . .. . . . . . . . . . . . . .. . . . . . . . . . .. . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . .. . .. . .. . .. . .. . .. . .. . .. . .. . . .

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185

shares in the market for $108.75 and sell them to option holder for $105 realizing a negative payo of $3.75 per share. The option holder will buy the shares for $105 and sell them in the market for $108.75 making a positive payo of $3.75 per share. Figures 7.3e and 7.3f show payo diagrams to a put holder (+p) and a put writer (p). They can be understood in the same manner as the diagrams for the call options. Investors often hold options in conjunction with other securities. Payo diagrams for these joint positions can be drawn by combining the individual payo diagrams. Figures 7.3g and 7.3h are two examples. The dashed lines in these diagrams show the payo for the components while the solid line shows the payo on the portfolio. Figure 7.3g shows the payo on a portfolio which is long on stock (+s) and long on put (+p). This strategy is called protective put. Notice that because of this strategy, the payo has no upper limit but the payo will not be less than the exercise price of the option. Figure 7.3h shows the payo on a portfolio which is long on a call (+c) and long on a put (+p). This strategy is known as a straddle. With a straddle the investor realizes a payo regardless of whether the stock price goes up or goes down. The payo diagrams only show the cashow. They do not show the prots or losses. The prot/loss diagram can be constructed by appropriately taking into account the cashow at the time the option contract was made. For example, the person who went long on a call option, paid a price to buy the option. To draw the prot/loss diagram we should subtract this price from the payo diagram for the call option, thus shifting the entire payo diagram down. The option writer, on the other hand, received the price and therefore the payo diagram for the option writer would get shifted up.

7.5.3

Put-Call Parity

Call and put options on the same stock with the same exercise price and same maturity date have many features in common. Therefore, it seems natural to expect that their prices should be related in some way. They indeed are. To see the relationship, let us consider a portfolio that is composed as follows: it is long on stock (+s), long on a European put (+p), and short on a European call (c). The put and call options are on the stock in the portfolio and they have the same exercise price and maturity date. Now let us consider the payo on this portfolio on the day of the maturity of the options. The stock price on the maturity date will either be above the exercise price, equal to the exercise price, or below the exercise price. Below we discuss the payos on the portfolio in these situations: Ps > E : The payo from the stock will be Ps . Since Ps > E , the put will not be exercised so that the payo from the put will be 0. Since Ps > E , the call will be exercised, and since the portfolio is short a call, the payo on the portfolio will be (Ps E ). The payo on the portfolio will be Ps + 0 (Ps E ) or E . Ps = E : The payo from the stock will be Ps . Since Ps = E , the put will not be exercised so that the payo from the put will be 0. Since Ps = E , the call will also not be exercised,

.. . .. . .. . .. . .. . . . . .. . .. . .. . .. . . .. .. . .. .. . .. . . . .. .. . .. .. . .. . . . .. . .. . . .. . . . . . .. . . . . . . . .. . . . .. . . .. . . . . . .. . . . . . . . . . . . . .. . . .. . . . . . . .. . . . . . . . . . . . . . .. . . .. . . .. . . . .. . . . . . . .. . . . . . . . . . . . . . . . .. . . . . . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

186

E .........................................................................................................................

so that the payo from the call will be 0. The payo on the portfolio will be Ps + 0 0 or Ps which is equal to E . Ps < E : The payo from the stock will be Ps . Since Ps < E , the put will be exercised, and since the portfolio is long on a put, the payo will be E Ps . Since Ps < E , the call will not be exercised so that the payo from the call will be 0. The payo on the portfolio will be Ps + (E Ps ) + 0 or E . This means that the payo from the portfolio is guaranteed to be equal to the exercise price E regardless of the value of the stock price. The payo diagram shown in Figure 7.4 also conrms this. A xed payo makes the portfolio perfectly risk-free. The cost of the portfolio, therefore, should be E/(1 + rf )T , where rf is the risk-free rate and T is the time to option maturity. If the risk-free rate is being compounded continuously, then the value should be Eerf T . This gives us the following equation: Ps + Pp Pc = or E (1 + rf )T (7.5a) (7.5b)

Ps + Pp Pc = Eerf T

The relationship described by this equation is called put-call parity. This equation holds only for the European options. Since most option valuation formulae are derived for call

Options

187

options, this equation can be used to value a put option by rst valuing the corresponding call option and then using the equation to nd the price of the put option. The put-call parity can also be used to identify arbitrage opportunities. An arbitrage opportunity exists if it is possible to create a portfolio that costs nothing, has no risk, and results in a positive payo. Arbitrage opportunities arise because of the temporary mispricing of securities. The put-call parity describes the relationship between the proper prices of the put and call options, the stock, and the risk-free security. If the put-call parity is violated, one of the securities is mispriced and an arbitrage opportunity exists.7 Let us consider an example. The market price of stock of ABC is $20. The call and put options on the stock with exercise price of $25 are selling for $0.75 and $5.50, respectively. The options mature in exactly 6 months. A Treasury bill is oering a semiannual yield of 4%. To check if the put-call parity is violated, calculate the left hand side of the equation: it is 20 + 5.50 0.75 = 24.75. The right hand side of the equation is 25/(1.04)1 = 24.04. The two sides are not equal to each other. This indicates that an arbitrage opportunity exists. To identify the arbitrage opportunity, imagine s + p c to be one portfolio and the Treasury bill to be another. Both the portfolios are perfectly risk free and yield E on maturity. Since the two are not priced equally, one should sell the higher priced portfolio, buy the lower priced portfolio, and pocket the dierence. On the maturity date, the payo on the portfolio bought will pay for the portfolio sold. Therefore, we should go short on the portfolio s + p c, i.e., we should sell a share of stock, sell the put, and buy the call. This would result in a cashow of 20 + 5.50 0.75 = 24.75. Use $24.04 of this amount to buy a Treasury bill with face value of $25 and pocket the dierence of $0.71. Six months later we redeem the Treasury bill and get $25 and use these $25 to settle the claims resulting from the portfolio we sold.8 If the put-call parity were violated in the other direction we would sell the Treasury bill and buy the stock, put, call portfolio.

7.5.4

The valuation of puts and calls is done using the ideas of hedging. As we did for the put-call parity, options are combined with other securities to form a risk-free hedge and the valuation of the risk-free hedge leads to the valuation of the option. In this section we will see how to value a European call option in a very specialized situation. A similar formulation can also be used to value a European put option. The binomial formulation assumes that at the time the option matures, the underlying stock can have one of the two possible prices. Obviously,

We do not know which security is mispriced. All we know is that one of the securities is mispriced relative to the others. 8 Dont worry about there not being a Treasury bill with face value of $25. We are considering the transaction for 1 share. You can do this transaction for 400 shares. This would result in everything getting scaled by 400 and you can buy one $10,000 face value Treasury bill. The prot in this case would be 400 0.71 or $284.00.

7

188

Ps

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

uPs

mPc

lPs

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

mPcu

Ps mPc

mPcl

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

uPs mPcu

lPs mPcl

this is nowhere near the reality but later this formulation can be generalized to let the stock take many dierent values (even innitely many). Consider a stock which is currently priced at Ps . T periods from now, the stock can take two values: an upper value (uPs ) and a lower value (lPs ). The upper and lower values are relative to each other, not relative to the current stock price.9 As a numerical example let us follow the stock of LMN which is currently priced at $102 and the price 6 months from now can either be $110 or $105. The values of u and l, therefore, are 1.078 and 1.029, respectively. Now consider a call option which has the exercise price of E . For the numerical example, take the exercise price to be $105. The payos on the option at the time of maturity are denoted by Pcu and Pcl corresponding to the two stock prices. The option has no time value on the day of its maturity, therefore, the option value consists of the intrinsic value only. Using our notation Pcu = Max[0, uPs E ] and Pcl = Max[0, lPs E ]. For the numerical example Pcu = 5 and Pcl = 0. Now consider a portfolio that is created by buying 1 share of stock and selling m calls, i.e., selling m calls for each share bought. The payo on this portfolio will be either uPs mPcu or lPs mPcl depending on the stock price. These payos are shown in Figure 7.5. The objective is to make the portfolio risk-free. To be risk-free, the portfolio should provide the same payo regardless of the stock price. The only variable in our portfolio is m, the number of calls per share of stock. So, we want to nd out a value of m which would result in the same payo regardless of which of the two prices the stock takes. In other words, we want to choose a value of m such that, uPs mPcu = lPs mPcl , which gives us: m=

9

(7.6)

If the price can take two dierent values, one has to be lower than the other.

Options

189

For the numerical example, we get m = (110 105)/(5 0) = 1, i.e., if we sell one call option for each share we purchase, the payo on our portfolio will be the same regardless of which of the two prices the stock takes. Let us calculate the value of this payo. If the price becomes uPs then the payo will be uPs mPcu = (110) (1)(5) = 105. If the price becomes lPs then the payo will lPs mPcl = (105) (1)(0) = 105. The payo on the portfolio is the same regardless of the price of the stock. The cost of such a portfolio today should be such that the rate of return on the portfolio is equal to the risk-free rate. Since the cost of the portfolio today is Ps mPc , the present value of the payo discounted using the risk-free rate should be equal to Ps mPc . This is shown in the equations below: Ps mPc = or Ps mPc = uPs mPcu (1 + rf )T lPs mPcl (1 + rf )T (7.7a) (7.7b)

where rf is the risk-free rate and T is the time to maturity.10 Either of these two equations can now be used to solve for the proper price of the call option, Pc , because all the other parameters are known. For our numerical example let us assume that the call option expires in six months and the six monthly risk-free rate is 4% or 0.04. Therefore, T =1 and rf = 0.04. You should check that both the equations above give Pc = 1.038. Therefore, the price of the call option should be $1.038 today. The equations above can be modied to express the price of the call option explicitly in terms of the known quantities. For that, we substitute for m from equation (7.6) in either equation in (7.7) and simplify to get: Pc = Pcu (1 + rf )T l u (1 + rf )T + Pcl ul ul (1 + rf )T (7.8)

7.5.5

The formula for pricing call options developed by Fischer Black and Myron Scholes does not impose the constraint of the stock price being able to take only two prices in the future. It assumes that the stock price can take innitely many values. The formula, however, is valid only for a European type call option or an American type call option on a stock that will not pay any dividends before the option expires. Similar formulae, however, are available for valuing American type call options on dividend paying stocks as well. The Black-Scholes valuation equation for a European call option is given by the following equation: P c = P s N (d 1 )

10

E N (d 2 ) (1 + rf )T

(7.9)

Options where Pc Ps E rf T N ( ) = = = = = = the value of the call option, current stock price, the exercise price, the risk-free rate, the time to maturity of option, the area under the normal curve from , d1 = d2

s ln( P ) + rf T 1 E + T 2 T Ps ln( E ) + rf T 1 T = 2 T

190

(7.10a) (7.10b)

where = the standard deviation of the stock returns. In the equation above (1+1 is replaced by erf T if the risk-free rate is compounded rf )T continuously. The standard deviation of the stock returns is the most dicult quantity to estimate in the above formula. Two commonly used approaches to estimating it are historical standard deviation (hsd) and implied standard deviation (isd). In the historical method, one uses past stock returns to estimate the standard deviation. This estimate may be adjusted to incorporate additional information. In the implied standard deviation method, one applies the Black-Scholes formula to a call option whose market price is known to estimate the standard deviation of stock returns. This estimate of the standard deviation is then used for the other options on the stock. Sometimes, more than one call option is used to calculate the standard deviations, and the standard deviations are then averaged to arrive at the implied standard deviation. Let us consider an example using the numbers we used in the binomial formulation. Ps = 102, E = 105, T = 1, rf = 0.04. The standard deviation of stock returns can be estimated using the historical data. Here, let us come up with a rough estimate of the standard deviation using some statistical principles. Since the highest and the lowest prices for the stock are 110 and 105, the highest and the lowest six-monthly returns for the stock are (110 102)/102 = 0.0784313 and (105 102)/102 = 0.0294117. From the normal distribution tables we know that 95% of the observed values lie within 2 standard deviations of the mean, which means that the distance between the highest and the lowest values is approximately 4 standard deviations. Assuming that the returns are distributed normally, we get 4 = 0.0784313 0.0294117 or = 0.012254. Now we apply these numbers to the Black-Scholes formula. We get d1 = 0.90 and d2 = 0.89 so that from the normal distribution table, N (d1 ) = 0.8172 and N (d2 ) = 0.8140. Using these numbers in the Black-Scholes formula we get Pc = 1.24. The answer given by Black-Scholes formula is dierent than the one given by the binomial formulation because of the obvious dierences between the two methods and because of our assumptions.

Options

191

The price of the put options can be estimated using the put-call parity once the price of a call option with the same parameters is known.

7.6

Conclusion

We studied some basic characteristics of options in this chapter. We also studied how to value call options. Options are extremely important in todays investment world and deserve a much more detailed study than presented in this chapter. You should consult one of the many books devoted entirely to options for further details.

Exercises

7.1 OptionsTerminology and Strategy The option quotes shown in Table 7.3 are taken from The Wall Street Journal of May 4, 1988.

(a) Pick four options of your choice: one in the money call, one out of the money call, one in the money put, and one out of the money put. For each option determine the payo to an option holder if the option holder decides to close the position at the listed prices. Also determine the time value for each option. (b) By taking suitable examples show what eects the time to maturity and the exercise price have on the price of a call option. (c) An investor is long on a June 110 call and long on a June 100 put. Show the payo diagram to the investor from this portfolio on the date of maturity of these options. Option Pricing On April 19, the price of the common stock of Pzer was 58 1/4. On the same day, the Pzer May 55 call option was trading at 3 7/8. What are the two components that make up the price of the option. What do you think the price of the option would be if the stock price were $60? What do you think the price of the option would be if it were expiring on April 20? 7.3 Payo Diagrams Consider the option quotes for Digital Equipment given in exercise Draw the payo diagram for an investor who is long on 1 Dig Eq May 100 call, long on 1 Dig Eq May 120 call, short on 2 Dig Eq May 110 calls. Note: This combination is known as the buttery spread. 7.4 Put-call Parity The price of XYZ Sep 40 call option is $6.75. The risk free rate is 0.08 per year and there are 6 months to expiration. Calculate the price of XYZ Sep 40 put assuming that the put-call parity holds and the current stock price of XYZ is $45. 7.5 Binomial Option Pricing The common stock of DMB Corporation is priced at $40. A year from now the stock price may be either $48 or $34. Calculate the price of a put option with exercise price of $45 if the risk-free rate is 6% per year. Black-Scholes Formula Given Ps = 30, E = 20, T = 0.25 years, rf = 0.08 per year compounded continuously, = 0.10, calculate the price of the call option, Pc , using Black-Scholes formula. 7.6 7.2

Options

192

Option/Strike Dig Eq 95 5 / 106 8 95 106 5/8 95 5 / 106 8 100 106 5/8 100 5 106 /8 100 5 / 106 8 105 105 106 5/8 5 106 /8 105 106 5/8 110 5 106 /8 110 5 / 106 8 110 115 106 5/8 5 106 /8 115 5 / 115 106 8 120 106 5/8 5 / 120 106 8 120 106 5/8 5 125 106 /8 5 / 125 106 8 130 106 5/8 5 / 106 8 140

Exp. May Jun Sep May Jun Sep May Jun Sep May Jun Sep May Jun Sep May Jun Sep May Sep Sep Sep

Call Vol. Last 28 11 7/8 ... ... 106 13 1/2 12 7 3/8 205 9 1/2 134 12 7/8 87 3 5/8 139 6 3 432 7 /4 232 1 3/8 157 3 3/8 387 5 7/16 815 467 1 3/4 832 3 1/8 1/8 216 7/8 378 87 1 7/8 1/16 82 25 1 1/8 3/4 46 1/4 25

Put Vol. Last 3/16 2 13/16 12 20 1 1/8 5/8 18 25 1 3/4 45 2 9/16 71 2 43 3 1/4 84 4 3/4 22 4 1/2 132 5 7/8 ... ... 122 8 1/4 ... ... 57 10 ... ... ... ... ... ... ... ... ... ... 221 23 3/4 ... ...

Appendix 7A Futures

Let us understand futures contracts through a simple example. Suppose you own Breakfeast Inc., a company that produces breakfast foods. Suppose today is April 1, 1989 and you are planning for the coming six months. You realize that you will need 60,000 bushels of corn 5 months later, in September 1989. The prevailing cash price of corn is $2.58 per bushel. Of course, you do not know what price the corn will sell for in September. This uncertainty is going to aect all your planning. Suppose, I approach you with the following proposition: we enter a contract for 60,000 bushels of corn at the price of $2.63 per bushel; I will deliver the corn to you in September at this contract price. This contract is benecial for you because it reduces your uncertainty. You know exactly what your expense for corn will be in September. In addition, you also pass on any risk of an unexpected price increase to me. Of course, your decision will seem incorrect if the price of corn goes down by September. Nevertheless, the biggest benet to you is the removal of uncertainty. The contract described above is known as a forward contract. When such forward contracts are traded under strict regulations regarding the size of the contract, the quality of the commodity, the delivery dates and arrangements, etc, they are known as futures contract. For example, corn futures are traded in contract sizes of 5,000 bushels and the delivery dates are limited to March, May, July, September, and December. Futures traders may be classied as hedgers and speculators. Hedgers trade in futures to hedge from the risk. In the example above, you were the hedger. Similarly, if a farmer enters into a contract to deliver the corn, he would be hedging because he would be locking in a price for his product. Speculators assume the risk that the hedgers do not want to take. In the example above I was the speculator. On the day of the delivery I would buy the corn at the prevailing market price and deliver it to you. The dierence between the prevailing market price and our contract price would determine my prot or loss. The example should not be taken to mean that the a futures contract always involves a hedger and a speculator. It may be also be between two hedgers or two speculators. One important point about modern futures trading is that most futures contracts do not result in an actual delivery. Traders buy a futures contract, hold it for a while, and then 193

Futures

194

sell the contract or take an opposing position canceling their original position. They make prots because of the movement in the futures contract price. Consider our example above. Suppose after we entered the contract the cash price of corn falls so that the contract price for September corn futures falls to $2.60 per bushel. This drop reects a prot of $0.03 per bushel to me because I could buy a futures contract from someone else who would deliver the corn to me for $2.60 per bushel and I will deliver it to you for $2.63, our agreed price. I can take advantage of this situation by buying the September futures contract for the same quantity as I am supposed to deliver, thus zeroing my net position. Alternatively, I could sell our futures contract to another futures trader who would pay me the dierence $0.03 per bushel. Futures contracts can be compared with options contracts. The main dierence between a futures contract and an options contract is that in a futures contract the parties involved are obliged to make a trade on the date of the expiration of contract regardless of the market price. The exercise of an option, on the other hand, depends on the person who bought the option: the buyer would exercise the option only if the market price of the share is higher is than the exercise price for a call option or is lower than the exercise price for a put option. Futures and options contract have become an extremely important part of the investment world today. New contracts are being designed almost every day. The range of contracts traded currently include, options on futures, options and futures on market indices, etc. A serious investor cannot aord to ignore these new developments.

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. .. . . . . . . . . .. . .... .. . . . . . . . . . . .. .... .. . .. . . . . . .... ...... . . . .. . . . . .. . . ........ . . . . . . . . . . . .......... . . . . . . . . . . .......... . . . . . . . . . . . . . . . .......... . . . . . . . . . . . . . . . . . . .......... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ... .. . . . . . . . . . . . . . . . . . . . . . . . . . . . .

0 z 0.0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1.0 1.1 1.2 1.3 1.4 1.5 1.6 1.7 1.8 1.9 2.0 2.1 2.2 2.3 2.4 2.5 2.6 2.7 2.8 2.9 3.0 0.00 0.0000 0.0398 0.0793 0.1179 0.1554 0.1915 0.2257 0.2580 0.2881 0.3159 0.3413 0.3643 0.3849 0.4032 0.4192 0.4332 0.4452 0.4554 0.4641 0.4713 0.4772 0.4821 0.4861 0.4893 0.4918 0.4938 0.4953 0.4965 0.4974 0.4981 0.4987

Entries in the table give the area under the normal distribution curve from z = 0. For example, the area between z = 0 and z = 2.24 is 0.4875. Other areas can be determined by using the fact that the normal distribution is symmetric about z = 0.

0.01 0.0040 0.0438 0.0832 0.1217 0.1591 0.1950 0.2291 0.2611 0.2910 0.3186 0.3438 0.3665 0.3869 0.4049 0.4207 0.4345 0.4463 0.4564 0.4649 0.4719 0.4778 0.4826 0.4864 0.4896 0.4920 0.4940 0.4955 0.4966 0.4975 0.4982 0.4987

0.02 0.0080 0.0478 0.0871 0.1255 0.1628 0.1985 0.2324 0.2642 0.2939 0.3212 0.3461 0.3686 0.3888 0.4066 0.4222 0.4357 0.4474 0.4573 0.4656 0.4726 0.4783 0.4830 0.4868 0.4898 0.4922 0.4941 0.4956 0.4967 0.4976 0.4982 0.4987

0.03 0.0120 0.0517 0.0910 0.1293 0.1664 0.2019 0.2357 0.2673 0.2967 0.3238 0.3485 0.3708 0.3907 0.4082 0.4236 0.4370 0.4484 0.4582 0.4664 0.4732 0.4788 0.4834 0.4871 0.4901 0.4925 0.4943 0.4957 0.4968 0.4977 0.4983 0.4988

0.04 0.0160 0.0557 0.0948 0.1331 0.1700 0.2054 0.2389 0.2703 0.2995 0.3264 0.3508 0.3729 0.3925 0.4099 0.4251 0.4382 0.4495 0.4591 0.4671 0.4738 0.4793 0.4838 0.4875 0.4904 0.4927 0.4945 0.4959 0.4969 0.4977 0.4984 0.4988

0.05 0.0199 0.0596 0.0987 0.1368 0.1736 0.2088 0.2422 0.2734 0.3023 0.3289 0.3531 0.3749 0.3944 0.4115 0.4265 0.4394 0.4505 0.4599 0.4678 0.4744 0.4798 0.4842 0.4878 0.4906 0.4929 0.4946 0.4960 0.4970 0.4978 0.4984 0.4989

0.06 0.0239 0.0636 0.1026 0.1406 0.1772 0.2123 0.2454 0.2764 0.3051 0.3315 0.3554 0.3770 0.3962 0.4131 0.4279 0.4406 0.4515 0.4608 0.4686 0.4750 0.4803 0.4846 0.4881 0.4909 0.4931 0.4948 0.4961 0.4971 0.4979 0.4985 0.4989

0.07 0.0279 0.0675 0.1064 0.1443 0.1808 0.2157 0.2486 0.2794 0.3078 0.3340 0.3577 0.3790 0.3980 0.4147 0.4292 0.4418 0.4525 0.4616 0.4693 0.4756 0.4808 0.4850 0.4884 0.4911 0.4932 0.4949 0.4962 0.4972 0.4979 0.4985 0.4989

0.08 0.0319 0.0714 0.1103 0.1480 0.1844 0.2190 0.2517 0.2823 0.3106 0.3365 0.3599 0.3810 0.3997 0.4162 0.4306 0.4429 0.4535 0.4625 0.4699 0.4761 0.4812 0.4854 0.4887 0.4913 0.4934 0.4951 0.4963 0.4973 0.4980 0.4986 0.4990

0.09 0.0359 0.0753 0.1141 0.1517 0.1879 0.2224 0.2549 0.2852 0.3133 0.3389 0.3621 0.3830 0.4015 0.4177 0.4319 0.4441 0.4545 0.4633 0.4706 0.4767 0.4817 0.4857 0.4890 0.4916 0.4936 0.4952 0.4964 0.4974 0.4981 0.4986 0.4990

195

196

Data

Many examples in Chapters 2, 3 and 4 use monthly returns from January 1990 to December 1994 on the stocks of AT&T, Kodak, IBM and Sears, S&P 500, Treasury bills and Janus Fund. This data is presented below in its entirety. The data is available from me in a spreadsheet form if you are interested.

Month 01/90 02/90 03/90 04/90 05/90 06/90 07/90 08/90 09/90 10/90 11/90 12/90 01/91 02/91 03/91 04/91 05/91 06/91 07/91 08/91 09/91 10/91 11/91 12/91 01/92 02/92 03/92 04/92 05/92 06/92 AT&T 0.1429 0.0192 0.0650 0.0446 0.0748 0.1001 0.0390 0.1250 0.0362 0.1012 0.0551 0.0520 0.0830 0.0230 0.0365 0.0912 0.0067 0.0394 0.0425 0.0219 0.0301 0.0367 0.0643 0.0848 0.0479 0.0034 0.1065 0.0613 0.0173 0.0198 IBM 0.0478 0.0660 0.0217 0.0271 0.1130 0.0208 0.0511 0.0757 0.0442 0.0094 0.0904 0.0055 0.1217 0.0254 0.1155 0.0955 0.0424 0.0848 0.0425 0.0317 0.0697 0.0519 0.0468 0.0378 0.0112 0.0217 0.0388 0.0868 0.0129 0.0785 Kodak 0.0729 0.0001 0.0399 0.0575 0.1050 0.0062 0.0586 0.0691 0.0435 0.0325 0.0784 0.0177 0.0240 0.0379 0.0029 0.0458 0.0305 0.0855 0.0581 0.0639 0.0116 0.0587 0.0445 0.0349 0.0466 0.1067 0.0896 0.0246 0.0190 0.0063 Sears 0.0459 0.0410 0.0427 0.0955 0.0353 0.0069 0.0788 0.1150 0.1325 0.0296 0.0820 0.0287 0.1330 0.0993 0.1245 0.0679 0.1011 0.0677 0.0825 0.0242 0.0723 0.0260 0.0434 0.0707 0.0825 0.0702 0.0346 0.0279 0.0113 0.0888 S&P 500 0.0671 0.0129 0.0263 0.0247 0.0975 0.0070 0.0032 0.0903 0.0492 0.0037 0.0644 0.0274 0.0442 0.0716 0.0238 0.0028 0.0428 0.0457 0.0468 0.0235 0.0164 0.0134 0.0404 0.1143 0.0186 0.0128 0.0196 0.0291 0.0054 0.0145 T Bills 0.0057 0.0057 0.0064 0.0069 0.0068 0.0063 0.0068 0.0066 0.0060 0.0068 0.0057 0.0060 0.0052 0.0048 0.0044 0.0053 0.0047 0.0042 0.0049 0.0046 0.0046 0.0042 0.0039 0.0038 0.0034 0.0028 0.0034 0.0032 0.0028 0.0032 Janus 0.0790 0.0020 0.0430 0.0160 0.1270 0.0140 0.0250 0.1010 0.0170 0.0010 0.0420 0.0210 0.0620 0.0660 0.0520 0.0010 0.0250 0.0390 0.0700 0.0410 0.0100 0.0260 0.0350 0.1180 0.0140 0.0170 0.0300 0.0080 0.0140 0.0180

197

Data

198

Month 07/92 08/92 09/92 10/92 11/92 12/92 01/93 02/93 03/93 04/93 05/93 06/93 07/93 08/93 09/93 10/93 11/93 12/93 01/94 02/94 03/94 04/94 05/94 06/94 07/94 08/94 09/94 10/94 11/94 12/94

AT&T 0.0203 0.0370 0.0403 0.0000 0.0802 0.0890 0.0368 0.0567 0.0215 0.0154 0.1007 0.0298 0.0060 0.0079 0.0584 0.0234 0.0500 0.0331 0.0810 0.0749 0.0177 0.0000 0.0659 0.0015 0.0046 0.0000 0.0054 0.0185 0.1068 0.0295

IBM 0.0319 0.0732 0.0678 0.1718 0.0393 0.2619 0.0223 0.0669 0.0644 0.0442 0.0970 0.0640 0.0987 0.0340 0.0820 0.0952 0.1771 0.0487 0.0000 0.0597 0.0331 0.0526 0.1004 0.0675 0.0532 0.1115 0.0164 0.0700 0.0470 0.0389

Kodak 0.0841 0.0285 0.0056 0.0815 0.0368 0.0328 0.2315 0.0858 0.0117 0.1014 0.0716 0.0338 0.0725 0.1468 0.0266 0.0589 0.0240 0.0760 0.0227 0.0160 0.0320 0.0648 0.1392 0.0267 0.0052 0.0368 0.0402 0.0700 0.0463 0.0495

Sears 0.0063 0.0500 0.0783 0.0615 0.0418 0.0520 0.0797 0.0843 0.0355 0.0434 0.0458 0.0115 0.2200 0.0955 0.0115 0.0650 0.0453 0.0276 0.0378 0.1615 0.0548 0.0899 0.0856 0.0519 0.0156 0.0112 0.0132 0.0312 0.0373 0.0265

S&P 500 0.0403 0.0202 0.0115 0.0036 0.0337 0.0131 0.0073 0.0135 0.0215 0.0245 0.0270 0.0033 0.0047 0.0381 0.0074 0.0203 0.0094 0.0123 0.0335 0.0270 0.0435 0.0130 0.0163 0.0247 0.0331 0.0407 0.0241 0.0229 0.0367 0.0146

T Bills 0.0031 0.0026 0.0026 0.0023 0.0023 0.0028 0.0023 0.0022 0.0025 0.0024 0.0022 0.0025 0.0024 0.0025 0.0026 0.0022 0.0025 0.0023 0.0025 0.0021 0.0027 0.0027 0.0032 0.0031 0.0028 0.0037 0.0037 0.0038 0.0037 0.0044

Janus 0.0150 0.0240 0.0140 0.0330 0.0420 0.0110 0.0100 0.0160 0.0260 0.0300 0.0160 0.0130 0.0010 0.0260 0.0060 0.0260 0.0140 0.0100 0.0300 0.0210 0.0340 0.0120 0.0050 0.0280 0.0280 0.0300 0.0310 0.0250 0.0260 0.0030

Index

abnormal return, 117 account executive, 12 aggressive securities, 93 annuity, 108 annuity factor, 109 arbitrage opportunities, 187 ask price, 13 bankruptcy, 45 basis points, 151 beating the market, 117 best eorts, 10 beta (beta), 91 beta services, 93 bid price, 13 bid-ask spread, 13 big board, 12 block trade, 7 Bonds, 149 bonds, 3 brokerage house, 12 buy and hold, 119 call feature, 151 call option, 171 callable bond, 151 Capital gain, 31 capital gains yield, 31 capital market, 4 capital market line, 90 capital market securities, 4 CAPM, 94 cash account, 16 CBOE, 173 199 characteristic line, 92 Chicago Board Options Exchange, 173 Closed end funds, 88 Commercial paper, 3 Commission brokers, 11 compounding, 33 condence interval, 43 conservative securities, 93 contingent claim securities, 172 continuous compounding, 35 continuous probability distribution, 38 conversion ratio, 152 Convertible bonds, 152 Correlation, 63 coupon rate, 149 covariance, 63 covered call, 179 cumulative dividends, 149 current yield, 31, 155 day order, 12 debentures, 152 declaration date, 137 default, 45 Default risk, 153 degree of risk aversion, 47 direct investment, 5 discount rate, 106 discounted value, 105 discounting, 105 Diversication, 61 diversication and correlation, 63, 81 Diversication Eciency, 65 dividend, 4, 136

Index dividend capture, 139 dividend rate, 149 dividend yield, 31, 139 DJIA, 23 Dominance, 48 Dow Jones Industrial Average, 23 Dow Jones News Retrieval, 23 duration, 168 eective rates, 34 ecient frontier, 71 ecient market, 117 Ecient market hypothesis, 118 semi-strong form, 119 strong form, 119 weak form, 119 ecient portfolios, 71 equilibrium, 6 ex-dividend date, 137 exercise price, 172 expectations hypothesis, 53 extra dividend, 136 face value, 4, 150 nancial instruments, 3 nancial investment, 2 Financial markets, 2 rm commitment, 8 xed income securities, 4, 149 Floor brokers, 11 forward contract, 193 fully taxable equivalent yield, 154 futures, 5, 193 futures contract, 5, 193 General obligation bonds, 153 good till cancelled order, 12 growing perpetuity, 109 hedge portfolio, 83 Hedging, 8 holding period return, 150 holding period yield, 150 immunization, 160 in the money, 180 Income, 31 indierence curve, 47 indirect investment, 5 initial margin, 17 initial public oering, 134 insider trading, 24, 121 Institutional investors, 7 interest rate, 30 Interest rate risk, 152 interest rate risk, 45 internal rate of return, 111 intrinsic value, 179 investment, 2 investment bankers, 8 investment banking rms, 8 investment objective, 48 irregular dividend, 136 Junk bond, 153 leveraged securities, 178 leveraging, 36 Limit order, 13 limited liability, 4 Liquidity motivated investors, 7 liquidity preference hypothesis, 52 load funds, 88 maintenance margin, 17 margin account, 16 margin call, 17 margin ratio, 16 market makers, 11 market manipulation, 24 market model, 92 Market order, 13 market portfolio, 90 market segmentation hypothesis, 53

200

Index Marketability risk, 153 marketability risk, 45 marketable security, 2 mean-standard deviation frontier, 71 members, 11 Microsoft Excel, 43, 65 mispriced, 95 mispriced security, 95, 117, 118 money market, 3 money market funds, 5, 87 municipal bonds, 154 Mutual Funds, 87 mutual funds, 4 NASDAQ, 11 Need for liquidity, 7 Net Asset Value, 88 New issue, 134 New York Stock Exchange, 10 no-load funds, 88 NPV and IRR, 116 NYSE, 10 OCC, 173 on the money, 180 Open end funds, 88 open outcry system, 10 option contract, 5 option premium, 171 option writer, 171 Options, 5, 171 Options Clearing Corporation, 173 out of the money, 180 over-the-counter, 11 overpriced, 95 payable date, 137 payout ratio, 136 PE ratio, 140, 147 perfect market, 90 perpetuity, 109 plowback ratio, 136 portfolio, 58 portfolio weights, 59 portfolios, 4 positively weighted portfolios, 79 Preemptive rights, 134 preferred stocks, 4, 149 present value, 105 primary market, 8 Privately placed securities, 2 prospectus, 10 protective put, 175, 185 put option, 171 random variable, 38 Real investments, 2 record date, 137 reinvestment risk, 45 residual income security, 4 Retained earnings, 4 revenue bonds, 153 reverse stock split, 135 risk, 38 risk loving, 47 risk neutral, 47 risk premium, 49 risk tolerance, 47 risk-free security, 50 risk-return trade-o, 81 risk-return trade-os, 71 Round trip, 13

201

seats, 11 SEC, 8 Sector funds, 88 secured, 152 Securities, 3 Securities and Exchange Commission, 24 security, 2 security market line, 94 selectivity, 127 Share repurchase, 134

Index Short interest, 15 short interest report, 16 shorting against the box, 15 single period, 32 sinking fund, 152 Specialists, 11 Speculation, 7 stated rates, 34 stock dividends, 135 Stock splits, 135 Stop loss order, 13 straddle, 185 street name, 16 strike price, 172 supply and demand, 6 systematic risk, 91 tangency line, 77 tangency portfolio, 76 term structure of interest rates, 52 tick, 13 ticker tape, 1, 23 time value, 179 timing, 127 Traders, 11 trading rule, 119 transaction costs, 13 Treasury bills, 3, 157 Treasury bond, 156 Treasury note, 156 Treasury Strips, 157 Treasury Yield Curve, 52 trial-and-error method, 112 underpriced, 95 underwriters, 8 unexpected ination, 45 up-tick rule, 15 utility, 2 utility maximization, 48 Value rights, 134 value weighted, 90 variance of the portfolio returns, 70 Voting rights, 133 yield, 30 yield to maturity, 150 zero coupon bonds, 153

202

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