Investments Fall 2010 This document will be continuously updated throughout the semester. This version: June 29, 2010. Please check for new updates frequently. Classes Mon+Wed 11:00 12:20 Room TBA All materials may be downloaded from the class page in the FEUNL web portal. Instructors Professor Pedro Santa Clara email: psc@fe.unl.pt web: http://docentes.fe.unl.pt/~psc phone: 21 382 27 06 room: 343 office hours: TBA T.A. Carolina Almeida email: a.carolina.almeida@gmail.com room: 127 office hours: TBA Pedro Santa Clara holds the Millennium Chair in Finance at Universidade Nova de Lisboa since 2007. He is a member of the school s board. He was Professor of Finance at UCLA s Anderson School of Management from 1996 to 2009. He received a Ph.D. degree in Management from INSEAD, France. He is a research associate of the National Bureau of Economic Research and has served as associate editor of the Journal of Financial and Quantitative Analysis, Journal of Business and Economic Statistics, and Management Science. Pedro Santa Clara s research interests are focused on theoretical models of asset pricing and the development of econometric methods to estimate them. His current work focuses on quantitative portfolio management, option pricing, risk management, currency and fixed income markets, and financial econometrics. His contributions, including the string model of the term structure of interest rates, the MIDAS model of conditional volatility, and optimal investment choice by parameterizing portfolio policies, have gained wide acceptance by academics and finance professionals. His research has been published in the Journal of Finance, the Review of Financial Studies, the Journal of Financial Economics, and other leading journals in Economics and Finance.
Pedro Santa Clara is a partner of Atrium Investimentos, an asset management firm. He has consulted extensively with investment banks and hedge funds on pricing derivatives, risk management, and developing investment strategies. Course Description This course is designed to provide students with a strong foundation for all of the fundamental concepts in investments. Broad topics include discounting and present values, bond and stock valuation, risk and return, constructing optimal portfolios, asset pricing models, and an introduction to options and futures markets. We will seek a balance between the theoretical paradigms, the empirical findings, and their applicability to the real world. Emphasis will be on principles and problem solving. Lectures and exams will concentrate on both quantitative and conceptual foundations. Prerequisites The class assumes familiarity with economics, basic statistical concepts (including means, variances, covariances and linear regression), basic calculus (derivatives) and a standard spreadsheet package such as Excel. Workload You are required to read the assigned material before each lecture. Good class participation consists of asking informed questions or making informed comments, as well as answering well the questions asked in class. There will be problem sets assigned every week. These assignments will be posted online (using Moodle) and will be available up to Sunday at midnight. The assignments will include questions about the material covered during the previous week as well as questions related to the assigned readings for the coming week. These problem sets are to be done individually. I will trust you to work on them on your own. Any irregularity will be investigated and, if there is evidence of wrongdoing, will be referred to the school administration. There will be four case assignments for this course. A written analysis of each case is due for each group. The maximum number of pages (excluding tables ) of the written report is four. The handout should be synthetic but specify clearly all the computations performed, present the results in wellformatted tables and graphs, and interpret and discuss the findings. Please do not hand in data listings or raw software output. Presentation will factor in the grading. You may work in groups of no more than 4 members on your write up. You should drop your work in a box available at the front desk (security) before class on the due date. The final exam will cover lectures, readings assigned in the textbook, additional readings, and materials distributed during class time. The exam will be closed book. No notes, cheat sheets or other study aids may be used. You may, however, use a calculator in the exams. Re grade requests for exams must be submitted in writing within one week of the return of your exam. You must submit your entire exam along with an explanation of the grading issue.
Students are required to read the Financial Times on a daily basis. The problem sets and the exams will contain questions related to recent financial news. Students should pick a pet stock to follow on a daily basis. Choose a large company in Europe or the US and use Bloomberg or some internet site to follow the stock s performance and the news that come out about that company. You will be asked questions about your stock. Grading The final grade will be a weighted average of the grades in the assignments: Problem sets 20% Cases 20% Exams 60% Class participation rounding the final grade To obtain a passing grade in the course, the students must have a grade in the final exam of at least 10. Students will have to deliver all the problem sets and cases to be able to complete the course. Materials The textbook is: Bodie, Kane, and Marcus, Investments, Eighth Edition (henceforth BKM). There will be documents posted for download on the class web page. You should become acquainted with the use of the Bloomberg terminals available in the school and participate in the training sessions. Bloomberg is the main tool used in financial institutions worldwide.
Entertaining books related to the subject of this course: Michael Lewis, Liar's Poker: Rising Through the Wreckage on Wall Street. Nassim Taleb, Fooled by Randomness. Roger Lowenstein, When Genius Failed: The Rise and Fall of Long Term Capital Management. Peter L. Bernstein, Against the Gods: The Remarkable Story of Risk. Peter L. Bernstein, Capital Ideas. Burton G. Malkiel, A Random Walk Down Wall Street. Resources on the web that you may find interesting and useful: http://www.marketwatch.com/ for market news http://www.bloomberg.com/ for market news and data http://www.finviz.com/news.ashx for market news and opinion http://www.frontlinethoughts.com/subscribe.asp a free weekly newsletter on investment topics http://finance.yahoo.com/ lots of free data http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html some academic data http://www.ssrn.com/fen/index.html a repository of academic working papers http://www.afajof.org/ site of the American Finance Association and the Journal of Finance http://rfs.oxfordjournals.org/ site of the Review of Financial Studies http://jfe.rochester.edu/ site of the Journal of Financia Economics http://www.cob.ohio state.edu/fin/journal/jofsites.htm this is a list of many finance related sites http://www.nber.org/ one of the top research institutions, check the asset pricing program The Nova Investment Club (http://www.nova investmentclub.com/) has many interesting initiatives in the area of finance.
Syllabus Class 1 Introduction to the Course and Overview of Financial Markets Required reading: BKM 1 4, Statistics Review lecture note, Moodle user guide Class 2 Returns and Present Values Required reading: lecture notes Class 3 Fixed Income I Required reading: BKM 14, 15, 16, lecture notes Optional reading: R. Roll, U.S. Treasury Inflation Indexed Bonds Class 4 Class 5 Fixed Income II Risk and Return Required reading: BKM 5, lecture notes Optional reading: Dimson, Marsh, Staunton, Global Evidence on the Equity Risk Premium, Business Week, The Long and Short of Short Selling Class 6 Portfolio Management I Case 1 due Required reading: BKM 6 7, lecture notes Optional reading: The Regents of the University of California, Asset Allocation Plan Class 7 Portfolio Management II Required reading: BKM 8, lecture notes Class 8 New Developments in Portfolio Management Required reading: BKM 8, lecture notes Class 9 The CAPM I Case 2 due Required reading: BKM 9, 13.1, 13.5, lecture notes Class 10 The CAPM II Required reading: lecture notes
Optional readings: JPMorgan, Estimating the U.S. Cost of Equity, How to Calculate Betas, McKinsey Staff Paper, Regression Analysis Class 11 Class 12 Class 13 Multi Factor Asset Pricing Models Midterm Exam Market Efficiency Required reading: BKM 12, 13.3, lecture notes Optional readings: B. Malkiel and A. Shleifer, Are Markets Efficient?, G. Schwert, Anomalies and Market Efficiency, R. Thaler, The End of Behavioral Finance Class 14 Anomalies Case 3 due Class 15 Equity Valuation I Required reading: BKM 18, lecture notes Optional readings: Equity research report Class 16 Class 17 Equity Valuation II Nova Equity Research Case 4 due Class 18 Options I Required reading: BKM 20, 21.1 21.3, lecture notes Class 19 Options II Required reading: BKM 21.4 21.6, lecture notes Class 20 Options III Required reading: BKM 22, lecture notes Optional readings: Structured notes Class 21 Options IV Case 5 due Class 22 Forwards and Futures
Cases Instructions for Case 1 Fixed Income Suppose that you were hired by PIMCO, a leading global investment management firm with more than 800 billion dollars in assets under management as of June 30, 2008. PIMCO s major shifts in portfolio strategy are based on long term trends, and therefore forecasting interest rates is of major importance. For that purpose, you are asked to study how well forward rates forecast future spot rates. The spreadsheet USZeroCouponInterestRates.xls contains yields with maturities between 1 and 5 years observed on the last day of the year between 1952 and 2005. Instructions for Case 2 Asset Allocation This homework will help you plan your retirement...; ) Similar problems are frequently solved by pension plans, banks, and insurance companies. (Actually, these institutions typically hire expensive consultants to recommend an asset allocation ) The spreadsheet StocksBondsCash.xls contains annual returns for the stock market, the (long term) T bond, and the one month T bill from 1928 to 2008. Take the stock market and the long bond to be the only risky assets available and the T bill to be the risk free asset. (In real life you would also want to consider international stock markets and alternative investments.) For the following, use data up to the end of 1999. Compute descriptive statistics for the returns of the two risky assets. Compute an optimal portfolio of the three assets. Carefully describe and justify your approach. Discuss how you handle potential problems such as estimation error. Compute descriptive statistics for the returns of the portfolio. How did your portfolio perform since 2000? Show relevant statistics. What implications does the expected return on the stock market have for the number of years you need to work and how much you need to save per year? Try to quantify your answer. Explain the assumptions you need to make. (Isn t the market premium a really important number?)
Instructions for Case 3 Dimensional Fund Advisors As background to this case, read the material in DFA's website. The objective of this case is to analyze DFA's investment strategy and at the same time review the empirical evidence for (and against) the CAPM. In particular, we want to examine two famous anomalies : small cap stocks and value stocks have historically outperformed other stocks (even after adjusting for risk). DFA was set up to provide investment vehicles to exploit these anomalies. In the beginning of the 1980 s, they created a small cap fund, and in the beginning of the 1990 s, they created a value fund. To help you with the analysis, the spreadsheet DFAdata.xls contains the risk free rate (RF), monthly returns for the stock market (MKT), returns to three portfolios formed according to the firms' market capitalization (ME), and returns to three portfolios formed according to the firms' ratio of book value of equity to market value of equity (BTM) which is a measure of value or growth. Technical Note: There is a LINEST function in Excel which performs regression analysis. When using regression often, it is easier to use a function than the data analysis tool pack. LINEST is an array function, so to use it properly look up arrays in Excel help, or ask a classmate. Put yourself in the place of David Booth and Rex Sinquefield in 1981 and study the attractiveness of small cap stocks. You may want to run regressions of excess returns of the size based portfolios on the excess return of the market. For each portfolio, you will obtain an alpha and a beta. What do you find? As a fund manager, what opportunities do you see? Technical Note: These are rebalanced portfolios, their composition changes every year to maintain stable characteristics. It is therefore appropriate to run time series regressions of the portfolio excess returns on the market s excess return without concern that the beta of those regressions might change over time. Repeat the analysis for BTM decile portfolios in 1990. What do you find? What, do you think, has been the performance of the funds created by DFA since their inception? Use the portfolio data you have as a proxy for the DFA funds. Are the returns to small caps and high book to market firms a good deal (the result of market mispricing possibly due to irrational investors), compensation for risk (in the sense of the CAPM or the APT), or a statistical fluke (resulting from a short sample or the use of incorrect statistical methods)? What is DFA s view and what is your view?
Instructions for Case 4 Equity Valuation Read Valuing Intel Corporation, Inc. Construct three discounted cash flow (DCF) valuation models as follows. Build a DCF valuation model to match Intel s stock at the moment before the September 21, 2000 news release. You may want to base your model on revenues projected according to analyst expected growth rates. After reading the announcement, what information would you change in your model? What, according to your model would be the new stock price? Actually, Intel s stock price fell to about $43.50 in the days following the announcement. Adjust the cash flow forecasts in your model to match this new stock price. Do the required adjustments seem reasonable in the face of the actual news? Please explain why. Based on your studies and personal experience in the financial markets, why do you think Intel dropped so much? What does this imply about market efficiency and anomalies? Can you think of a trading strategy that might exploit situations such as Intel s? What percentage of your own wealth would you commit to it? To construct your DCF model: Build an income statement forecast of expected revenues for the future 10 years. You might use either a single, constant growth rate for all years or employ sequential growth rates in forming these assumptions. You may want to use a few stock analyst reports published prior to September 21, 2000 to help you in your forecasts. Make assumptions for future below line items (costs & taxes). The percent of sales method works well. Construct cashflow forecasts and estimate the terminal value of the company (in year 10). Download historical stock market prices in order to compute Intel s cost of capital via the CAPM. You can easily get these data in spreadsheet format from Yahoo! Finance. Interest rates are also available at the site. Use your own estimate of the market premium. Given forecasted cashflows and the discount rate, you are ready to value the stock. Intel s website, http://www.intel.com/intel/finance/financials.htm, contains a treasure trove of official statements and financial documents. You can find there the full September 21, 2000 press release, as well as the company's annual reports. For those who are still insatiably curious, Uncle Sam keeps all of Intel s public filings at http://www.sec.gov/edgar.shtml.
Instructions for Case 5 Option Pricing Go to the Chicago Board of Options Exchange site, type in the ticker symbol for a stock you like and download the corresponding option prices. Pick one contract that has more than a month to expiration. It can be a call or put, with any strike price, but make sure that there have been transactions on the option on that day. Next, download a time series of prices for the underlying stock. You may use Yahoo! Finance as a source of stock price data. You will also need current interest rate data. Use the stock price data to estimate the stock's volatility. Price the option using the binomial or the Black Scholes model. Compare the price you computed for the option with its actual market price. Compare the implied volatility of the option with the volatility you estimated.