Stock Markets, Investments

Size: px

Start display at page:

Download "Stock Markets, Investments"

Jane Crawford
6 years ago
Views:

1 Stock Markets, Investments and Corporate Behavior A Conceptual Framework of Understanding

2 This page intentionally left blank

3 Stock Markets, Investments and Corporate Behavior A Conceptual Framework of Understanding Michael Dempsey RMIT University, Melbourne, Australia ICP Imperial College Press

4 Published by Imperial College Press 57 Shelton Street Covent Garden London WC2H 9HE Distributed by World Scientific Publishing Co. Pte. Ltd. 5 Toh Tuck Link, Singapore USA office: 27 Warren Street, Suite , Hackensack, NJ UK office: 57 Shelton Street, Covent Garden, London WC2H 9HE Library of Congress Cataloging-in-Publication Data Dempsey, Michael (Michael J.) Stock markets, investments and corporate behavior : a conceptual framework of understanding / by Michael Dempsey. pages cm Includes bibliographical references and index. ISBN (alk. paper) 1. Corporations--Finance--Mathematical models. 2. Capital assets pricing model. 3. Stocks-- Prices. 4. Corporations--Valuation. 5. Capital market. I. Title. HG4012.D '2--dc British Library Cataloguing-in-Publication Data A catalogue record for this book is available from the British Library. Copyright 2016 by Imperial College Press All rights reserved. This book, or parts thereof, may not be reproduced in any form or by any means, electronic or mechanical, including photocopying, recording or any information storage and retrieval system now known or to be invented, without written permission from the Publisher. For photocopying of material in this volume, please pay a copying fee through the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, USA. In this case permission to photocopy is not required from the publisher. In-house Editors: Catharina Weijman/Dipasri Sardar Typeset by Stallion Press enquiries@stallionpress.com Printed in Singapore

5 The text is dedicated to Mary, Frank and children and their loved ones, the great Hugh Williams, who dictated the destiny of more than one of us, Tony Naughton, whom I remember with great affection, and the girls in Bangkok. All of them have been good to me. By three methods we may learn wisdom: First, by reflection, which is noblest; Second, by imitation, which is easiest; and third by experience, which is the bitterest. Confucius All I ask is the chance to prove that money can t make me happy. Spike Milligan Mathematical finance can take us only so far. The rest is economics and management There are many patterns in finance, but few immutable rules. And the Sun comes up tomorrow It just doesn t know she s gone Gram Parsons for Yokie

6 This page intentionally left blank

A Short Bio for the Author (Official Version) RMIT official photo: Spot the rather forced smile aimed at showing how enthusiastic I am at my work, how happy I am to be at RMIT, and how I will say

7 A Short Bio for the Author (Official Version) RMIT official photo: Spot the rather forced smile aimed at showing how enthusiastic I am at my work, how happy I am to be at RMIT, and how I will say almost anything if it might give me a salary increase at my next performance meeting. Michael Dempsey joined RMIT University as Professor and Head of the Finance Discipline in early Prior to this, he was an Associate Professor at Monash University, before which he was an Associate Professor with Griffith University, having previously been at Leeds University, UK. He also has many years experience working for the petroleum exploration industry, in the Middle East, Egypt, Aberdeen and London. His teaching expertise includes corporate and investment finance, international finance, derivatives and financial engineering. He is an active researcher and research supervisor across financial markets, in which he has published over fifty articles that have appeared in leading international journals, including Journal of Banking and Finance (2), Financial Analysts Journal (2), European Financial Management (1), Abacus (3), Journal of Investment Management (2), Australian Journal of Management (2), Journal of Business Finance and Accounting (3), Accounting and Business Research (3), Critical Perspectives on Accounting (3), Journal of Asset Management (1), and Accounting and Finance (1). He has a first degree in Mathematics and a PhD in Astrophysics, as well as an MBA and Masters degrees in Theoretical physics and Petroleum engineering. vii

8 This page intentionally left blank

9 ix Unofficial Bio Mike Dempsey has failed in many aspects of life. He has failed to learn a second language despite (numerous) attempts, to ski with anything approaching style, or to hang-glide a significant distance cross-country. He is also been mostly unsuccessful in his stock trading strategies (the reader of the text should bear this in mind ). Nevertheless, his poker-playing skills are improving significantly. He is currently working at RMIT University in Melbourne, Australia under the delusion that the royalties from the present text along with movie rights will make him immensely rich and famous. Unofficial photo: of myself (third from left) at one of our academic soirées in my Melbourne flat. Where were you Riley and Larry? Yes, that s Jimi Hendrix almost falling over in the background. I tell my nieces that they must listen to Jimi at least once a month in their formative years. And lots of Van Morrison. (And early Bob Dylan.) Comment or suggestions on the text are welcomed at: Michael.Dempsey@rmit.edu.au Cover design concept: Michael Dempsey; above photo by John Vaz. The bull and bear on the front cover are in front of the Frankfurt Stock Exchange. Or, place it back on the shelf if you are one of those people who reads books at bookstores (go on, buy it!).

10 This page intentionally left blank

11 Prologue First there was barter Then we had money Then we had financial markets These changed everything... It is an interesting story. It is not just the story of financial markets and large firms, but also the story of how finance academics have developed their understanding of financial markets and such firms over time. Financial markets function to gather from millions upon millions of individuals, their financial savings each insignificant individually that are in excess of their immediate needs, so that investments of billions of dollars can be invested in large firms which attain such finance by either borrowing (debt finance) or issuing stocks or shares as certificates of ownership of the firm (equity finance). Without access to such financing arrangements, large firms would not exist. And without such firms, we would be without the capacity to develop modern civilization; from the technologies of electronics and airplanes, urban infrastructure and highways, to the mass, and therefore affordable, production of our housing, pharmaceuticals, cars, agriculture, and so on. In addition to this, we would be without services such as banking and financing arrangements for smaller firms, and our insurance and pension arrangements. In short, the history of the landscape of modern civilization is inseparable from the history of financial markets and their provisions for large firms. The human brain that developed the aerodynamics of the boomerang many thousands of years ago would one day develop the capacity to send a spacecraft around the moon and have it return. But ingenuity without the means of production afforded by large firms financed by capital markets, can take us only so far. The aboriginals of Australia did not see the need to xi

12 xii Prologue develop large firms with capital markets. Whereas other societies did. That was the difference. Finance academics have attempted to understand financial markets and large firms as they might understand the laws that govern physics. In their models, financial capital, like rainwater seeking the steepest downhill path as it flows, is forever looking for the highest return. In the models, the market s required rate of return on the investment of financial capital identifies the firm s cost of financial capital. It follows that the activities of large firms and financial markets must be understood in terms of each other. The criterion for the firm s activities is that they provide a rate of financial return that at least meets shareholders required rate of return. Unfortunately, there is a problem with these models. Stated simply, it is that finance is not physics. Markets and firms do not operate as the outcome of mathematical models applied mechanically. Rather, they must be understood as the outcome of real people in organizations, who are called on to make decisions against an uncertain future. For this reason, the present text begins by deconstructing the traditional foundations of financial theory, before reshaping a quantitative model of markets in the context of the mathematics of growth combined with market psychology, which leads us to an assessment of the decision-making processes of firms in response. The present text represents an invitation to share an intellectual journey that, hopefully, will appeal to anyone with an interest in the interplay between stock markets, investments and corporate activity and who is not altogether allergic to mathematics, provided it remains intuitive, not overly demanding, and, most definitely, elegant as well as to academics with openness to new ideas. And it should be of interest to anyone who has been subject to the models and theories of standard finance theory, and who is prepared to have those models and theories dismantled and ultimately contradicted.

13 Contents A Short Bio for the Author (Official Version) Unofficial Bio Prologue Chapter 1. Introduction: Stock Markets, Investments and Corporate Financial Decision Making 1 Part A Foundations of Stock Pricing: A Critical Assessment 9 Chapter 2. The Capital Asset Pricing Model Introduction Background to the CAPM A Test for the CAPM The Black Model A Test of the Irrelevancy of Beta Time for Reflection: What Have We Learned? 27 Chapter 3. The Fama and French Three-Factor Model Introduction The Fama and French Three-Factor Model Critique of the Fama and French Three-Factor Model Time for Reflection: What Have We Learned? 36 vii ix xi xiii

14 xiv Contents Chapter 4. Beyond the Fama and French Three-Factor Model Introduction Asset Pricing Research Asset Pricing and Data Mining Implications of Abandoning the CAPM Time for Reflection: What Have We Learned? 45 PartB Foundations of Corporate Financial Activity: A Critical Assessment Chapter 5. The Modigliani and Miller Propositions and the Foundations of Corporate Finance Introduction Corporate Financial Management prior to MM Corporate Finance and the Paradigm of the MM Propositions A Critique of the MM Propositions Recent Developments in Corporate Finance Time for Reflection: What Have We Learned? 69 47

15 Contents xv Part C Stock Markets and Investment Choices: Growth, Asset Pricing and Portfolio Construction 71 Chapter 6. Mathematics of Growth Introduction The Important Power Laws Discrete Returns, Compounding, and Discounting Continuously Compounding Growth Rates Application of Logarithms The Normal Distribution The Normal Distribution and Asset Pricing Rates of Change between Variables and their Implied Direct Relation: The Calculus The Calculus of the Normal Probability Function Portfolio Formation: Expected Returns, Standard Deviations (Variance), Covariance, Beta, and Correlation Coefficients Expected return Variance and standard deviation Covariance Variance of portfolio returns An example with normal distribution tables Beta Correlation The Central Limit Theorem The Binomial Representation of Normally Distributed Exponential Growth Rates Time to Reflect: What Have We Learned? 121 Chapter 7. The Statistical Growth of Asset Portfolios Introduction Normally Distributed Growth Rates as a Foundation for Asset Price Formation The Mathematics of Normally Distributed Growth Rates 126

16 xvi Contents 7.4. The Outcome of Normally Distributed Growth Rates Normally Distributed Growth Rates and the Small Firm Size Effect in the FF-3F Model Time for Reflection: What Have We Learned? 130 Chapter 8. The Fundamentals of Growth, Asset Pricing, and Portfolio Allocation Introduction Portfolio Formation with One Risky Asset and One Risk-Free Asset The Log-Wealth Utility Function Optimal Portfolio Selection Portfolio Allocation and the Market Risk Premium The Case for Stable Dividends Time for Reflection: What Have We Learned? 153 Chapter 9. A Model of Asset Pricing and Portfolio Allocation Introduction A Generalized Utility Function Portfolio Optimization The CAPM Repeated Investment Periods A Worked Example Investors Risk Aversion and Required Equity Return The CML The CAPM and Roll s Critique Can We Retain Log-Wealth Utility? Generalization of the Equations of Portfolio Choice Time to Reflect: What Have We Learned? 172 Chapter 10. Stock Mispricing Introduction The Model Mispricing and Portfolio Valuation 178

17 Contents xvii The Model for Mispricing and Portfolio Valuation Equal Weighting of Assets Exploiting Mispricing by Avoidance of Capital Weighting Fundamental Indexation and the FF-3F Model: Models of Risk Assimilation or Stock Mispricing? Time for Reflection: What Have We Learned? 190 Chapter 11. Practitioner Client Portfolios, the Risk Premium, and Time Diversification Introduction The Mutual Fund Separation Theorem Consumption-Based Models Time Diversification Time to Reflect: What Have We Learned? 202 Chapter 12. Option Pricing: The Black Scholes Model Introduction The Principle of Risk Neutrality Derivation of the Black Scholes Formula The Probability That the Call is in the Money The Probability-Weighted Summation Over All In-the-money Outcome Prices A Closed Expression for the Price of a Call Option Options on the Index with Dividends Testing the Black Scholes Model Time for Reflection: What Have We Learned? 219 Part D Corporate Financial Decision Making 221 Chapter 13. Valuation of the Firm s Cash Flows Introduction Complicating Issues in Discounting Towards Coherence in Discounting 227

18 xviii Contents A Discount Model for Cash Flows Subject to Taxes (Proposition 1) The Cost of Equity and Leverage (Proposition 2) The Market Valuation of the Firm s Component Cash Flows Free Cash Flow (FCF) Cash Flow to Equity and to Debt (CFD) Capital Cash Flow The Discounting Methods Choice of Discount Method Consistency of the CAPM with the Principle of Additivity of Investors Risk-Return Exposures (as Proposition 2, Eq. (13.6)) In-consistency of the FF-3F Model with the Principle of Additivity of Investors Risk-Return Exposures as MM s proposition 2 (and Proposition 2, Eq. (13.6)) The Capitalization Factors, q E and q D Valuation of Imputation Tax Credits Time for Reflection: What Have We Learned? 250 Chapter 14. Corporate Finance in a Strategic/ Behavioral Context Introduction Corporate Finance and the Management Literature Towards a Corporate Management Context for Corporate Finance Time for Reflection: What Have We Learned? 259 Chapter 15. Ethics Introduction The Nature of Ethics The Institutionalization of Ethics Corporate Ethics Ethics and the Individual Time for Reflection: What Have We Learned? 271

19 Contents xix Final Chapter 273 Chapter 16. Academic Finance: Responsible Enquiry or Stamp Collecting? Summary of the Text Finance Theory as Performative Academic Finance: Responsible Enquiry or Stamp Collecting? 282 References 285 Index 305

Mathematical Modeling and Methods of Option Pricing

Mathematical Modeling and Methods of Option Pricing This page is intentionally left blank Mathematical Modeling and Methods of Option Pricing Lishang Jiang Tongji University, China Translated by Canguo