Modelling in Finance

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1 BFC3540: Modelling in Finance LO Learning Objective Contents Topic 1: Dividend Discount Model (DDM)... 4 LO1: Understand how dividends relate to stock value... 4 LO2: Fundamental Principles for Generated Cash Flows used for Shares... 4 LO3: Understand how to price a share using dividend model... 5 LO4: Understand 3 Dividend models (capital gains, infinite, constant)... 5 LO5: Understand why the dividend models don t work well in practice... 6 LO6: Understand poor performance of DDM motivates use of ratio analysis... 6 Topic 2: The Statistical Properties of Portfolios... 6 Single-Asset Portfolio... 6 LO1: Understand stock returns are distributed randomly (implies non-predictability)... 6 LO2: Know how to measure/calculate the dispersion of stock returns (mean, stdev.)... 6 LO3: How dispersion effects the time series of stock returns & relationship to risk... 7 Two-Asset Portfolio... 7 LO1: How the combination of two assets can reduce variability in portfolio... 7 LO2: Understand that covariance is the statistical measure describing co-movement... 7 LO3: Understand that covariance is positive when stocks move together (& vice versa)... 7 Multi-Asset Portfolio... 7 LO1: Portfolio formula should be a summation of all covariance... 7 LO2: Understand the covariance between an asset and itself is the variance... 7 LO3: Express the covariance as a matrix... 8 LO4: Diagonals of covariance matrix are variance terms... 8 LO5: Covariance matrix is dominated by off-diagonal covariance terms... 8 LO6: Covariance terms can be positive or negative (variance terms are JUST positive)... 8 Topic 3: The Variance Covariance Matrix... 9 LO1: Understand equivalence between excess matrix & covariance matrix... 9 LO2: Calculate covar matrix in Excel (excess matrix/transpose function)... 9 LO3: Calculate the covar matrix in VBA

2 Topic 4: Share Ratios LO1: Accounting data can be transformed into financial ratios LO2: Financial ratios can be useful for aiding investment decisions LO3: How to calculate financial ratios and interpret them LO4: Create a holistic analysis of a company from its financial ratios LO5: Problems associated with financial ratio analysis Topic 5: The Capital Market Line LO1: How CML is derived from matrix return and variance formula LO2: Calculating CML in excel LO3: What CML tells us about investing LO4: How to apply the CML to investment decisions Topic 6: Estimating the Beta and the Security Market Line LO1: How to calculate Beta (β) LO2: Beta (β) of a portfolio is the weighted sum of individual Beta s (β) LO3: How linear regression relates to Beta (β) LO4: Determining SML on Excel Topic 7: No Short Sales LO1: The definition of short sales LO2: Evaluate what problems short sales cause for the CML LO3: Why short sales must be constrained in practice LO4: Calculate efficient frontier in Excel (Goal Seek, short sale constraints) LO5: Difference short sale constraints make to efficient frontier Topic 8: Futures and Options Futures LO1: What are forwards and futures? LO2: Why do futures markets exist? LO3: How does the All Ordinaries Share Price Index (AO SPI) work? LO4: How is the future related to the underlying security? LO5: How is hedging achieved with the AO SPI future? Options LO1: Definition of Put and Call options

3 LO2: Put-Call parity LO3: LONG call pay-off at expiry LO4: SHORT call pay-off at expiry LO5: American vs European options LO6: How to value European options prior to expiry LO7: Sensitivity analysis Topic 10: Binomial Option Pricing Single-Period Model Multi-Period Model Excel Binomial Option Pricing VBA

4 Topic 1: Dividend Discount Model (DDM) LO1: Understand how dividends relate to stock value Stock: Residual claim of firm s earnings (common stock holder) Receive whatever is left Cumulative preferred stock o If dividends skipped, must pay THESE before common dividends Common stock holders o Have the weakest legal claim of firms assets 1. Mortgage bond holders 2. Subordinated debenture holders 3. Callable preferred shareholders 4. Cumulative preferred shareholders 5. Common shareholders o (debt > equity in terms of claim/strength) o Common is riskier than preferred due to no guarantee of dividends Preferred stock, requires the following: o A return the market requires (k) o The par value for the preferred (P) o The dividend rate/amount of the preferred If preferred stock is redeemable at the option of the issuer o Callable preferred option to buy o Put preferred option to sell Dividend: Payment made to common stock holders of earnings Discretionary (management) LO2: Fundamental Principles for Generated Cash Flows used for Shares Stock Valuation Model 1. PV & FV of money A stock pays dividends PV = D (1k) n Provides dollar value for stock Excel formula = NPV(interest, Dividend payments 2. Preferred Stock Valuation Perpetuity o Bond that makes fixed interest payments forever (never returns principal) P = D k 3. Common Stock Valuation The Dividend Valuation Model o Share price = present value o Assumes company pays all profits as dividends 4

5 if D = 0 P = 0 o PV = D t (1k) t a.k.a Intrinsic value o Dividend model does not ignore capital gains o The inclusion of capital gains does not contradict the dividend model The Constant Growth Model o Stock with infinite number of dividends o o P = D 1 = D 0(1g) kg kg Assumptions: Constant growth rate (g) Grow forever (infinite) g < k LO3: Understand how to price a share using dividend model Share price = present value o Common Stock Valuation The Dividend Valuation Model LO4: Understand 3 Dividend models (capital gains, infinite, constant) Capital Gains: Profits generated by share price of an asset o Buy low, sell high! Capital gains > dividends investor s interest mainly in capital gains Dividend model does not ignore capital gains The inclusion of capital gains does not contradict the dividend model SELL intrinsic < market value BUY Intrinsic > market value Infinite Dividends: Perpetuity o Bond that makes fixed interest payments forever (never returns principal) o However dividend would change overtime P = D k Constant growth model: Stock with infinite number of dividends P = D kg Assumptions: o Constant growth rate (g) o Grow forever (infinite) o g < k 5

Key Concepts. Some Features of Common Stock Common Stock Valuation How stock prices are quoted Preferred Stock

Key Concepts. Some Features of Common Stock Common Stock Valuation How stock prices are quoted Preferred Stock 1 Key Concepts Some Features of Common Stock Common Stock Valuation How stock prices are quoted Preferred Stock 2 1 I. Common Stock 3 1. Basic Features of Common Stock Forms the major part of corporate