Athens University of Economics and Business Principles of Finance with Excel

Yiannis Dendramis gpd@aueb.gr

Part I Time Value of money 1. Future value

The future value tells you the value in the future of money deposited in a bank account today and left in the account to draw interest. The future value uses the concept of compound interest. That is, you earn interest on interest. The value of x deposited today in an account paying r% annually and left in the account for n years is its future value

Figure 1 In the spreadsheet above you can see the FV of 100 for 2 interest rates: 6% and 8%. Notice that interest is earned at the end of the year, so at time 0, we just have our initial investment. Consider the case that you intend to make 4 annual deposits of 100, with the first deposit made at time 0 (today). The next spreadsheet answers the question of how much you will have accumulated at the end of period 3.

Figure 2 Figure 2 analyses in a step by step manner how money accumulates in a typical savings plan. The excel function FV simplifies all these calculations. It computes the future value of any series of constant payments. It requires as inputs the Rate of interest, the number of periods Nper, the annual payment Pmt and the Type which tells excel whether payments are made at the beginning of the period (type=1) or at the end of the period (type=0). To see the difference, see the calculations in the next figure.

Figure 3 Here, each deposit is in the account one year less and earns one years less interest.

2. Present value
The present value is the value today of a payment that will be made in the future. The present value of x to be received in n years when the interest rate is r% is

The interest r is also called the discount rate.

Figure 4 Figure 4 presents a simple example. If you anticipate getting 100 in 3 years and the bank pays 6% interest on savings accounts, the future payment worths 83.96 today. That is, if you put 83.96 today in a bank account, in 3 years you would have 100. We next discuss the PV of an annuity1. The PV of an annuity tells you the value today of all the future payments on the annuity.

Figure 5 The PV of an annuity that gives you 100 at the end of each year, for the next 3 years is 267.30. You can calculate this in two ways: find the present value of each value and then sum the individual discounted values, or use the excels function PV. This, calculates the PV of an annuity and it looks like the FV preciously discussed. Again, the type denotes whether the payments are made at the beginning or the end of the year (default=0).

Annuity is a series of equal periodic payments

3. Net present value The NPV of a series of future cash flows is their present value minus the initial investment required to obtain the future cash flows. It is the increase in wealth which you get if you make the investment.

Figure 6 Figure 6 presents an example. We pay 800 today to get the series of future cash flows F63:F65. So, the increase in wealth that we obtain from this investment is 258.8. 4. Internal rate of return The IIR of a series of cash flows is the discount rate the sets the net present value of the cash flows equal to zero. We can calculate this in two ways: using the NPV excel function, or using the IRR excel function. Figure 7 presents an example. If the initial investment is 800 and the future cash flows are in cells E74:E76, the IRR of this project is 2.8%. In cells E79:E85 of figure 7 we also calculate the NPV for various discount rates. As you can see, somewhere between 2% and 3% the NPV becomes zero. This means that if a bank gives you an r>2.8% you prefer the bank account than this investment plan, and if the bank gives you an r<2.8% you consider this project plan as a good investment opportunity.

Figure 7

Figure 8

Part II Portfolio management 1. The problem

Markowitz reduced the optimization problem to that of finding mean-variance efficient portfolios, with efficient points having the highest expected return for a given level of risk (variance or std deviation of portfolio returns). Given a set of N risky assets and a set of weights that describe how

the portfolio investment is split, the general formulas for expected return and variance are:

Or in matrix format:

Where

is the Nx1 vector of weights,

is the Nx1 vector of expected returns,

is

the variance covariance matrix (symmetric and positive semidefinite).

Then the single investor faces the problem:

s.t.

, where is an Nx1 vector of ones.

The solution to the above problem expected return . We say that such that

is the minimum variance portfolio with

is mean variance efficient if there exists no other

If there are no short selling constraints

the unique solution can be obtained

by minimizing the Lagrangian of the problem. Otherwise we can use excel build in functions to numerically optimize with respect to the portfolio weights.

2. Excel implementation Excel has several individual functions for quickly summarizing the features of a dataset. These include AVERAGE(array) which returns the mean, STDEV(array) for the standard deviation, MAX(array) and MIN(array), COVAR(array1,array2) & CORREL(array1,array2) for the correlation/covariance between two arrays. The next figure illustrates basic calculations for three asset classes (Bond, Stock, Exchange rate).

Figure 1 A covariance matrix is a symmetric matrix whose element in the position is

the covariance between the th and th elements of a random vector. There are two alternatives to calculate the covariance matrix in excel. The first alternative uses the COVAR(array) excel function to calculate the matrix (see J52:J54 cells in figure 1). Another way to calculate the covariance matrix is to use the excel Data Analysis ToolPak. This is a Microsoft Office Excel add-in program which must be activated before you use it2. To calculate the variance covariance matrix go to Tools -> Data analysis and choose the choice Covariance. element of the covariance

To activate it go to tools->Add-Ins->Analysis Toolpak

Figure 2 Then choose the Input Range (the returns in our case), the Grouped By set it to Rows if your dataset is in row vectors, check the Labels in first row if the Input Range contains labels of the data in the first row and finally choose the Output Options, that is, the area that excel displays the output.

Figure 3 As we have already seen in section one, the portfolio is characterized by the weight vector . Assume that the percentage composition of our portfolio is : 20% stocks,

40% bond, 40% exchange rate. The daily return of our portfolio is the weighted sum of the individual securities. To compute the portfolio return and variance one can use the excel functions: AVERAGE, VAR, STDEV. Notice the C78 cell in figure 4. This displays the portfolio return formula. The $ sign before and after each portfolio weight ($B$76, $C$76, and $D$76) tell Excel that in pasting the formula, it should not

modify the cell reference relative to the cell where the formula is being pasted. The $B$76 ($C$76, and $D$76) is called an absolute cell reference, which is not modified when formulas are copied and pasted.

Figure 4

Figure 5 We should emphasize that the portfolio variance and return could also be computed using the analytic formulas (). An interesting result from our calculations is that our portfolio has lower risk than any individual asset. This can be seen intuitively because different types of assets often change in value in opposite ways. For example, as prices in the stock market are negatively correlated with prices in the bond market, a collection of both types of assets can have lower overall risk. This is why we want the Diversification of the portfolio. 3. Using the Excel Solver Given the same asset data set (Bond, Stock, Exchange rate), suppose that we want to construct an efficient portfolio producing target return 7%. The problem is to find

the split across assets that achieve the target return whilst minimizing the variance return. This is a standard optimization problem amenable to excels solver, which contains a range of iterative methods for optimization. The solver requires changing cells, a target cell for minimization and the specification of constraints. To calculate the objective function we need the excel functions TRANSPOSE and MMULT. The Transpose function returns a transposed range of cells. For example, a vertical range of cells is returned if a horizontal range of cells is entered as a parameter. TRANSPOSE must be entered as an array formula (use brackets {} or CTRL+SHIFT+ENTER) in a specified range.

Figure 6 The changing cells for optimization are cells C141:C137. The target cell to be minimized is the portfolio variance, C155. There are two explicit constraints, namely the expected return (C146) must equal the target level (C158), and the weights must sum to 1 (C159).

Figure 7 The next figure plots the frontier portfolio.

Figure 8 Notice that there are no constraints on the weights assigned to individual assets, that is, short selling is possible. We next extend our analysis to include a riskless asset. That is, an assets with zero variance. Now, the investor faces the problem:

s.t. Again
is the target level and

is the risk free rate. Notice that the constraint

is

no longer there. To see why this constraint is no longer needed, note that the optimization is written only in terms of the N risky assets, so once the weights are chosen, we can always choose the weight of the riskless asset to be . The excel file is modified as follows:

Figure 9 Now, the efficient frontier is linear in volatility: