Principles of Finance CONTENTS
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1 Principles of Finance CONENS Value of Bonds and Equiy... 3 Feaures of bonds... 3 Characerisics... 3 Socks and he sock marke... 4 Definiions:... 4 Valuing equiies... 4 Ne reurn... 4 idend discoun model... 4 DDM wih growh... 4 Gordon Growh model... 4 Capializaion rae... 5 Perpeuiy... 5 Reurn measuremens... 5 Re-invesmens... 5 Risk and Reurn... 6 Definiion of reurns... 6 Properies of reurns... 6 Measuring risk... 6 Porfolio variance... 7 Porfolio heory and CAPM... 7 Markowiz Porfolio heory... 7 Efficiency fronier... 8 Asse pricing... 9 he Capial Asse Pricing Model (CAPM)... 9 Alernaive asse pricing mehods... Marke Efficiency... Efficien Marke Hypohesis... Abnormal reurn... Weak Form Efficiency... Semi-Srong Form Efficiency... Srong Form Efficiency... 3 PE raios... 3 Empirical findings... 3
2 Behavioural elemens... 3 Anomalies... 4 Valuing Governmen Bonds... 4 Bond pricing... 4 erm srucure... 4 Yield curve... 4 Gils... 5 Duraion... 6 Properies of duraion... 7 Spo/forward raes... 7 Deerminans of he erm srucure... 8 Unbiased Expecaions heory... 8 Liquidiy Premium heory... 8 Marke Segmenaion Hypohesis... 8 Pu and Call Opions... 8 Derivaives... 8 erminology:... 8 Valuing opions... 9 Pu call pariy... 0 Opion sraegies... Sraddle... Bull call spread... Opion pricing relaionships... Opion pricing heory... 3 Valuing opions... 3 Replicaing sraegy... 3 Risk-neural Probabiliies... 4 Muli-binomial models... 5 Black-Scholes Formula... 5 Valuing pu opions... 6 Opion prices wih zero dividends... 6 Opion prices wih dividends... 6 Forwards and Fuures... 6 Forwards... 6 Fuures... 7 Pricing fuures... 7
3 Sock index fuures pricing:... 8 Commodiies pricing... 8 Foreign exchange fuures... 9 Key feaures of forwards and fuures... 9 Hedging wih sock index fuures... 9 Choosing a hedge raio: Formula Presen values and discoun raes Valuing Equiies Reinvesmens... 3 Presen Value of Growh Opporuniy... 3 VALUE OF BONDS AND EQUIY Feaures of bonds Bonds are a ype of deb issued by a borrower o raise funds, issued by governmens and companies. Borrower pays a fixed amoun of ineres periodically o he lender, hen pays a fixed amoun of principle a he dae of mauriy. Bonds are differen o loans! Bonds are radable, whereas loans are no o Loans are beween he bank and cusomers o Banks can parcel up loans (securiizaion) o allow for hem o be raded Conrary o equiy, bond holders do no own a company, hey lend o a company o Bu ownership righs can rever o bondholders in he even of insolvency or violaion of covenans o Bonds & loans usually have limied erm (fixed mauriy) while shareholding in a company is indefinie. Characerisics Inrinsic feaure Coupon paymen (applies o face value) Mauriy/Redempion dae o Dae a which issuer of he bond buys back he bond back from he holder Face/nominal/par value (differen from marke value) o he amoun on which ineres is calculaed (normally 000) ype of ownership o Bearer o Regisered 3
4 PV = Where R is he required rae of reurn, or YM If he marke yield increases (BoE raises base rae): C ( + R) + C ( + R) + C C ( + R) 3 ( + R) n Coupon says he same ineres rae is fixed Price falls YM increases Socks and he sock marke Definiions Common Sock: Securiy represening ownership of a corporaion Secondary Marke: A marke (ofen a sock exchange) in which previously issued securiies are raded beween he invesors Valuing equiies Ne reurn r (P ) P 0 Gross (holding period) reurn is + r Broken down ino dividend yield and capial appreciaion Since reurns are expeced and no cerain, he equaion should be expressed differenly: E0[ P ] Er P 0 idend discoun model ( ( P... ( Share value equals he presen value of all expeced fuure dividends. DDM wih growh ( ( g)0 ( g) 0 ( g) 0... ( ( Assumes ha dividends grow a a consan rae Gordon Growh model 0 ( g) r - g r g 4
5 Same as he perpeuiy wih growh formula, excep wih dividends Capializaion rae he capializaion rae is an esimae of he firm s cos of capial, and can be used o value similar firm s equiy. Perpeuiy EPS Perpeuiy P 0 or r r Use if he company is forecased o have no growh, and plan o hold he sock indefiniely Reurn measuremens idend Yield EPS Reurn on Equiy (ROE) Book Equiy Per Share Ne profi EPS = Equiy shares ousanding Re-invesmens g reurn on equiy plowback raio Payou Raio: Fracion of earnings paid ou as dividends Plowback (Reenion) Raio: Fracion of earnings reained by he firm idend Growh = ROE plowback raio Presen Value of Growh Opporuniy (PVGO) PVGO is he ne presen value of he invesmens he firm is expeced o make in he fuure PVGO = Difference in value of company wihou and wih growh 5
6 RISK AND REURN Definiion of reurns Reurn R from holding an asse X over he period - o d ( p p R p Where: ) d p ) ( p p p R = ne reurn during period (or Holding Period Yield, HPY): +R = gross reurn during period (or Holding Period Reurn, HPR) p = he marke price of securiy a he end of period d = he dividend paymens made a end of period ime period may be days, monhs, or years Reurns may be random If reurns are monhly, o achieve yearly reurns compound up: R A = (+R m ) - Where R m is he nominal yearly reurn o achieve quarerly reurns from annual: R Q = (+R A ) /4 Properies of reurns Arihmeic Mean AMi R AM is he beer indicaion of wha an invesor will achieve in any paricular year because i makes allowances for inernal volailiy. Geomeric Mean / GM i ( ) GM is beer R esimae of rue long-run reurn ha an invesor would acually achieve, as i does no incorporae inernal volailiy. Measuring risk Variance: Var i p ( R ER ) Sandard deviaion: i SDi Var i Covariance: ij p ( R i, ER )( R i j, ER ) j 6
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