Investments Fin 201a Syllabus (subject to change) Fall 2016 Prof. Anna Scherbina Brandeis International Business School Teaching Assistants: Yiyang Guo Ming Shen Anqi Wang Yixin Zhang ascherbina@brandeis.edu youngguo@brandeis.edu mshen@brandeis.edu aqwang@brandeis.edu yxzhang@brandeis.edu Course Description This course aims at developing key concepts in investment theory from the perspective of a portfolio manager rather than an individual investor. The goal of this class is to provide you with a structure for thinking about investment theory and show you how to address investment problems in a systematic manner. Course Materials Textbook: Investments by Bodie, Kane and Macrus, 10 th edition Prerequisites and Co-requisites: ECON 210f (may be taken concurrently). The course may not be taken for credit by students who have previously taken ECON 171a. Learning Goals: Understand the fundamental principles of investment in financial markets o how investors make investment decisions o what determines returns and asset valuations Increase understanding of current events in financial markets Class Participation Class participation is a very important part of the learning process in this course. A major part of your final grade (30%) will be based on an assessment of the quality of your 1
contributions to class discussions. If you have a compelling reason for missing a class, you should inform me in advance (email is best). Missing classes will affect your grade; missing any without reasonable cause is likely to do so significantly (see participation grading scheme below). If you absolutely need to miss a class, please let me know ahead of time. Homework There will be several homework assignments. Basic knowledge of all course material covered in prior classes will be tested. Midterm There will be one in-class midterm. It will cover all topics presented up to that point. Final The final exam will cover all topics presented in the course. Office Hours Office hours will be held of Fridays, 2 pm to 3 pm or by appointment. Evaluation Final grades will be computed according to the following formula: Individual participation 30% Homework 15% Midterm Exam 20% Final Exam 35% TOPICS COVERED: The course will cover the following topics: Risk and return; diversification Capital Asset Pricing Model Performance evaluation; active investment management Stock valuation; valuation multiples Multifactor models Market efficiency; stock return anomalies; behavioral finance Short selling Asset bubbles International capital markets; market segmentation Bonds Options 2
LIST OF CASES: In this course, we will analyze the following cases: Partners Healthcare Hurricane Risk Massachusetts General Hospital and the Enbrel Royalty Carol Brewer s Investments Eskimo Pie Corporation (Abridged) Health Development Corp. Dimensional Fund Advisers (DFA) AQR s Momentum Funds Quadriserv and the Short Selling Market Recorded Future: Searching the Web for Alpha Please use this link to download these cases and case supplements from Harvard Business Publishing: http://cb.hbsp.harvard.edu/cbmp/access/51582585 CASE QUESTIONS: Partners Healthcare (HBS Case number 206-005) 1. Based on what we have done so far in class, must it be that the required return (discount rate) of any asset be related to its risk? Could it be that some assets with high standard deviations of return rationally have low expected returns? 2. Suppose that there are two assets: A and P. Assume that asset P has a standard deviation of returns of 20% per annum. You invest faction x or your wealth in asset A and (1-x) in asset P. Suppose that x is in the rage 0-3%. a. How does the risk of the portfolio change with x if asset A is riskless? b. How does the risk of the portfolio change with x if asset A is risky, with a standard deviation of 50% p.a., but with a zero correlation with asset P? c. How does the risk of the portfolio change if, instead of zero, asset A has a correlation of 0.6 with asset P? d. How does the risk of the portfolio change if asset A is perfectly correlated with asset P and has a standard deviation of 30%? Do the same for x in the range of 3%-50%. For small x, why are the answers similar for (a) and (b), and also (c) and (d), but not for large x? Hurricane Risk (HBS Case number 9-207-075) 1. What is the P&C business model? Why do insurance companies exist? How do they make money? 2. Is purchasing insurance an investment? As a policy holder, what is the expected return from investing in insurance? 3
3. What would be your personal required rate of return? 4. What should Joe Martinez do? 5. What should Suzanne Feller do? Massachusetts General Hospital and the Enbrel Royalty (HBS Case number 9-206- 075) 1. Why does MGH want to sell Enbrel royalties? Why would anyone want to buy them? 2. Is the issue of being undevirsified unique to MGH? 3. If the best offer is $400 mil., should MGH accept it? a. Forecast the cash flows b. What s the right discount rate to use? Case: Carol Brewer s Investments (HBS Case number 9-204-017) 1. How did Marshfield perform? Did its investments out-perform or underperform the market? 2. Suppose Marshfield charges a fee of 1% and a passive index fund would charge a fee of 0.15%. Is that difference in fees significant? 3. Define the following terms: return, mean return, return variance, standard deviation of returns, covariance of returns, correlation of returns, regression analysis, beta, R-squared. 4. Using the data in Exhibit 4 of the case: a. Compute mean returns and return standard deviations for Marshfield, the S&P 500 index, and the Russell 3000 Value index. b. Compute the covariance and correlation between Marshfield and the S&P 500. c. Create an xy graph with Marshfield s Equities returns on the y- axis, and the S&P 500 returns on the x-axis. Plot the regression line (Select Chart, Add trendline, Options and click Display equation on chart as well as Display R-squared value on chart ). d. Create a column of annual returns for a portfolio that each year was invested 50% in the S&P 500 index and 50% in U.S. treasury bills, beginning in 1990. Plot these returns vs. the S&P 500 index return on the same chart as in question 4c. 5. What does this analysis tell us about Marshfield s performance? 6. Does it make sense for Carol Brewer to have reduced her allocation target for equities below 100%? 7. How have U.S. stocks performed relative to U.S. bonds over the long term? How risky are stocks versus bonds? 8. Compute mean returns and return standard deviations for each of the asset categories in U.S. Annual Returns tab of the Capital Market Returns Data spreadsheet. 9. Compute the covariance and correlation between U.S. stocks and U.S. treasury bonds. 4
10. Create a column of annual returns for a portfolio that each year was invested 75% in U.S. stocks and 25% in U.S. treasury bonds. Calculate the mean and standard deviation of returns for this portfolio. Do the same for other stock/bond combinations, e.g. 50%/50% stocks/bonds, 25%/75% stocks/bonds, etc.. Can you explain how the mean return of the portfolio changes as the percentages in stocks and treasury bonds vary? Can you explain how the standard deviation of the portfolio changes as the percentages in stocks and treasury bonds vary? Eskimo Pie Corporation (Abridged) (HBS Case number 9-202-037) 1. What is your estimate of the per share value of Eskimo Pie using the discounted cash flow approach? Hints: a. Begin by estimating the cash flows anticipated in 1992. You should build your cash flows off the updated forecasts on page 5 of the case instead of using the information in Exhibit 6. b. The working capital listed in the balance sheet data portion of Exhibit 1 equals current assets less current liabilities, and therefore includes a substantial amount of cash. Because the business involves so little manufacturing or retailing, it is reasonable to assume that working capital (A/R plus Inventory less A/P) is negligible. c. You can also reasonably assume that capital expenditures equal depreciation. d. Choose your comparable companies from Exhibit 8, and follow the procedure we used in Ameritrade to estimate the cost of capital for Eskimo Pie. e. Use your cash flow estimate for 1992 along with your estimate of a growth rate and cost of capital in a growing perpetuity formula to estimate the discounted cash flow value of Eskimo Pie. 2. How does the value you estimated using the discounted cash flow approach compare to the market value of the comparable companies? Hints: a. Use multiples of sales and cash flows b. Consider multiples implicit in Nestle s offer for Eskimo Pie 3. Why would Nestle want to acquire Eskimo Pie? Is Eskimo Pie worth more to Nestle than it worth as a stand-alone company? 4. As an advisor to Reynolds, would you recommend the sale to Nestle or the proposed initial public offering? Case: Health Development Corporation (HBS Case number 9-200-049) Case Questions: 1. Did the purchase of the Lexington Club real estate increase the pre-tax value of HDC? 2. Why does the Lexington Club real estate purchase reduce the office prices? Does it make sense? 5
3. How would you structure the deal? Case: Dimensional Fund Advisors (DFA) (HBS Case number 212-068) Case Questions: 1. Are DFA investment management practices consistent with market efficiency? 2. What are the Fama-French (FF) findings? How do Fama and French explain the size and book to market effects in stock prices? Looking forward, should you expect small stocks to outperform large stocks? Value stocks to outperform growth stocks? Do FF findings hold in other financial markets beyond the US? What are the alternative explanations for the size and value effects? 3. Visit http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html Download returns on 25 size and book to market portfolios and then replicate the table in the class notes (the one in the value anomaly section) based on: a. the sample period starting from 1/70 b. the 1/1/90-31/12/00 period c. the period starting from 1/1/2001. Describe the size and book-to-market effects in all these periods. Case: AQR s Momentum Funds (A) (HBS Case number 9-211-025) 1. Should AQR launch its momentum funds? 2. Do you believe the Fama-French momentum factor will have returns over the next decade that are significantly greater than zero, significantly less than zero, or approximately zero? Use the historical data to do your analysis and come to class prepared to defend your conclusion. 3. What are the appropriate benchmarks for AQR s momentum funds? Will the net performance of the funds exceed those benchmarks? Why or why not? 4. Does momentum make an attractive product for retail mutual fund investors? 5. If AQR launches its momentum funds, how should the firm weigh maximizing returns vs. minimizing tracking errors? How should it manage the portfolio? Case: Quadriserv and the Short Selling Market (HBS Case number 212-021) Case Questions: 1. Can Quadriserv win? What does winning mean in this case? 2. Should Quadriserv focus solely on being a data provider? Solely on being an exchange? What are the risks of both? Can they do both at once? What would be the potential conflicts? Are they likely large or small? 3. What are the arguments for the short selling market remaining as it is? Who are making these arguments? How do these arguments weigh against Quadriserv s goals? 4. Are the concessions asked for by the industry in this exchange reasonable? How will they affect the success or failure of AQS? 5. Does Quadriserv help reduce short sale constraints? If so, how? 6. Why is there such large variation in loan fees for the same stock, same broker, on the same day? 6
7. One interesting observation is that short interest seems reasonably low at only 1%-5%. Does this mean that only 1%-5% of information investors have to incorporate into prices is negative? In other words, does this imply that negative information is so efficiently priced into stocks that only 1-5% of the time do short sellers need to bet on stocks being overvalued? Case: Recorded Future: Searching the Web for Alpha (HBS Case number 212-057) Case Questions: 1. Why would both the CIA and Google invest in Recorded Future? Would you invest in Recorded Future? 2. What features of Recorded Futures approach are most appealing to the financial services industry? 3. What type of clients should Recorded Future target? 4. How should they structure their product offerings? 5. What do you think of Recorded Future s news momentum and sentiment measures? What do you think of the insider trading strategy that LXE Capital is thinking about employing? 6. How would you use Recorded Future s data to design your own trading strategy? What features of their data would you like to exploit? Method of Instruction: Instruction will be done on the basis of a combination of lectures, discussions, and problem solving. This course is fast paced, reasonably technical in nature, and it requires each student to do considerable out-of-class work. There is assigned homework required for nearly every class session. Problem solving is very important in this course and I encourage participation from all my students in this activity throughout the term. Answers to most assigned questions will be provided to students. You should read the assigned book chapters prior to coming to class. The material will mean a great deal more to you, and you will understand and retain much more of it, especially when you review the class notes and problems prior to an exam. Class Format. Classes will be a mixture of lectures introducing new material and case discussions Academic Honesty. You are expected to be honest in all of your academic work. Please consult Brandeis University Rights and Responsibilities for all policies and procedures related to academic integrity. Students may be required to submit work to TurnItIn.com software to verify originality. Allegations of alleged academic dishonesty will be forwarded to the Director of Academic Integrity. Sanctions for academic dishonesty can include failing grades and/or suspension from the university. Citation and research assistance can be found at LTS - Library guides. For any work involving historical cases, under no circumstance may you search the internet (or turn to any other outside source) for any information regarding these cases without my permission. Failure to comply with this directive is cheating. 7
Special Accommodation. If you are a student with a documented disability on record at Brandeis and wish to have a reasonable accommodation made for you in this class, please see me immediately. Please keep in mind that reasonable accommodations are not provided retroactively. Use of Laptop Computers and Cell Phones in Class: Cell phones and PDA.s (i.e., Blackberrys, iphones, etc.) must be turned off during lectures. Laptops may be used only to take notes. Laptop computers and cellphones may not be used during exams. 8