Financial Management

Mihail Busu, PhD

mihail.busu@fabiz.ase.ro
Course Outline
1. Financial Markets
2. Dividend Valuation Models
3. Financial Valuation of Bonds
4. Portfolio Management
5. Efficient Portfolios
1. Financial Markets

Mihail Busu, PhD

mihail.busu@fabiz.ase.ro
The movement of funds in the economy
 Indirect finance/ Direct finance
The financial market is the mechanism by which financial assets
are issued and introduced into the economic circuit.

Monetary
Market
Financial
securities market
Capital Market

Financial Market
Long-term credit
market
Banking Market
Short-term
credit market
 Financial Securities Market
 The market in which financial assets are bought and resold,
without changing their nature.
 In its simplest form, it is a mechanism of connection between
 the holders of surplus funds (investors) and
 users of funds (issuers of financial securities) and can take two
distinct forms: the money market and the capital market.

Monetary
Financial Market
Securities
Market
Capital Market
 MONETARY MARKET
 It includes the relationships that are formed in the field of
attracting and placing short-term funds, usually up to
one year.
 Money market operations can take the following forms:

The traditional form of attracting

deposits and lending - as is the case
with the interbank market
Form of operations with financial
assets on short maturities (treasury
bills, certificates of deposit, credit
securities, etc.)
 Entities acting on the money market
PARTICIPANTS MAIN ROLE
Central Bank What is central Bank?

State Treasury What is State Treasury?

Commercial Bank What is a Commercial Bank?

Companies What are companies ?

Investment Company What is an investment company?

Financing Companies What are financing companies?
Insurance Companies What is an insurance company?

Pension Funds What are pension funds ?

Individuals Who are individuals ?

Funds of monetary What are funds of monetary markets ?

markets
 Entities acting on the money market
PARTICIPANTS MAIN ROLE
Central Bank Sell and buy treasury certificates in order to influence the monetary mass of
the economy
State Treasury Issues treasury certificates to the population, repurchases them at maturity
and converts treasury certificates into deposit certificates.
Commercial Bank Trade government securities, treasury bills, certificates of deposit in their own
name and for clients, grant and receive short and very short term loans and
loans.
Companies Trade various short-term financial securities as part of their treasury
management.
Investment Company Trade financial instruments on behalf of their clients.
Financing Companies Lending funds to individuals.
Insurance Companies It assures its liquidity needs in order to meet the unexpected demands.

Pension Funds Placing funds in money market instruments (together with investments in
equities and bonds).
Individuals Occasionally buy money market instruments and money market fund units.

Funds of monetary It facilitates the participation of small investors in the money market by
markets aggregating their funds and placing them in large value instruments.
 The Capital Market

• Represents the set of relationships and mechanisms through

which the transfer of funds is made
• from those with a capital surplus - investors
• to those in need of capital, with the help of specific instruments (the securities
issued) and through specific operators (the companies).
• Unlike the money market, the capital market is specialized in
carrying out transactions with financial assets with medium and
long term maturities.
 From the point of view of the production and marketing of
financial securities, the capital market comprises two segments:

Primary Secondary
market market
•What is •What is
primary secondary
Market? market?
 From the point of view of the production and marketing of
financial securities, the capital market comprises two segments:

Primary market Secondary market

• the market through • the market on which

which new issues of the instruments
financial instruments already in circulation
are traded for the first are traded.
time. • provides liquidity for
investors who want to
change their portfolios
before the maturity
date.
According to the object of the transaction:

The
The stock
options
market
market

The market
The bond
for forward
market
contracts
 According to the model of formation of the price of financial
securities the capital market is structured in:

The auction Negotiation

market market
•What is •What is
auction negotiation
market? market?
 According to the model of formation of the price of financial
securities the capital market is structured in:

The auction market Negotiation market

• The market where the trading is • the market in which buyers and
conducted by a third party sellers negotiate with each other
depending on the price overlap the price and volume of real estate
with the orders received to buy or either directly or through
sell a certain security. intermediaries.
• Buyers and sellers do not trade • If the transaction is done through
directly and generally do not know an intermediary, the identity of
the identity of the other party. one party may or may not be
• The market is impersonal and known to the other party.
organized, operating according to • Negotiation generates time to
well-established trading rules. identify buyers and sellers and to
review the price or volume to be
traded.
Depending on the time of completion of transactions are different

The futures
Spot market
market
•What is spot •What is future
market? market?
Depending on the time of completion of transactions are different

Spot market The futures market

• the cash market is the • The market where the

one on which the completion of the
securities are traded for transactions regarding the
immediate delivery and delivery of the securities to
payment. the new buyer and the
• "Immediate" is defined payment is made at a
by the respective future date.
market and varies from
one day to one week
depending on the
regulations in force.
The instruments present on the capital
market

• Real
Assets
• Financial

• Primary
Financial • Derivatives
securities • Synthetics
The instruments present on the capital
market

• Real: goods that generate income in the future in the form of

profits, rent, etc.
• Financial: banking (results from operations specific to banks and
similar institutions) or non-banking (results from investment
Assets operations and which are materialized in: capital assets - results
from long-term investments and which give the right to obtain
future income - as well as monetary assets - results from short-
term investments and negotiable on the money market.

• Primary: shares or bonds.

Financial • Derivatives: forward contracts or options.
• Synthetics: the combination of futures contracts for sale and
securities purchase, put and call options, as well as combinations between
different types of futures and options.
 Stock market
Stock Market

1. What is a stock (share)?

2. Rights/obligations?
 Shares are securities that certify a right of ownership over a part
of the share capital of the issuing company. In addition to the
ownership right over a part of the issuing company, the shares confer
other rights, of which the most important are:
 the right to receive each year a share of the company's profit (in the
form of dividends) corresponding to the number of shares held and the
amount allocated by the company management for the payment of
dividends. Due to the fact that this dividend may vary (or may even be
zero), the shares are also called variable income securities;
 the right to information on the economic-financial evolution of the
company;
 the right to participate in the important decisions regarding the activity
of the company, as well as the management of the company, by
attending the General Meetings of the Shareholders (GMS), respectively
by the possibility of choosing and being elected on the board of directors
of the company;
 ownership of a part of the assets of the company, in case of its
liquidation (cessation of operation), etc.
According to the presentation form there are:

Nominative
Bearer shares
shares
•What are •What are
nominative bearer
shares? shares?
 According to the presentation form there are:

Nominative shares Bearer shares

• They are personalized by • They are the actions whose

mentioning the name of their movement is absolutely free, their
owner who have a restrictive possessor benefiting from all the
circulation, in the sense that they rights and obligations arising from
can only be alienated by their possession.
transcribing the transaction in the • The securities are called to the
register of the issuing company. bearer when the issuing company
• The nominative shares have does not know their owner.
registered names, in which case • These securities can be traded
the shares are registered without deadline and without
simultaneously in the company formalities.
register and in the account of the • The movements of the securities
financial intermediary chosen by are materialized in simple
their owner to whom the accounting records between
purchase and sale orders are intermediaries (the one of the
transmitted; buyer and the one of the seller).
 According to the rights they generate, shares can be:

Simple (ordinary) The privileged Preferential

shares shares shares

• What are • What are • What are

simple privileged preferenti
shares? shares? al shares?
 According to the rights they generate, shares can be:

Simple (ordinary) The privileged Preferential

shares shares shares
• The only permitted • It confers on the • Do not give the
in Romania. shareholders the shareholder the
• These give the right to a fixed
right to vote in
holder the right to dividend,
regardless of the the general
vote, at annual
dividends - the size of the profit meeting, but
size of which is realized by the have priority in
directly company. the collection of
proportional to the pre-determined
ratio between the dividends either
value of the shares in absolute
and the profit
distributed to the
value or relative
shareholders value.
Stock valuation problems

𝐷1 𝐷2 𝐷3 𝐷𝑛 + 𝐹𝑉
𝑉= + 2
+ 3
+⋯+
1+𝑖 1+𝑖 1+𝑖 1+𝑖 𝑛
Example
1. A stock has brought, for 3 years, the annual dividends of 6 lei, 8 lei and 10 lei
and is sold at 3 years from the date of purchase at the price of 120 lei. Determine
the price for which the stock was bought, if the annual percentage rate was
constant 6%.
Example
1. A stock has brought, for 3 years, the annual dividends of 6 lei, 8 lei and 10 lei
and is sold at 3 years from the date of purchase at the price of 120 lei. Determine
the price for which the stock was bought, if the annual percentage rate was
constant 6%.

6 8 10 120
PV    
1  0.06 1  0.06 2 1  0.06 3 1  0.06 3

6 8 130
PV     121.93
1.06 1.06 2 1.06 3
Thank you for your attention!
Financial Management

Mihail Busu, PhD

mihail.busu@fabiz.ase.ro
Course Outline
1. Financial Markets
2. Dividend Valuation Models
3. Financial valuation of bonds
4. Portfolio Management
5. Efficient Portfolios
2. Dividend Valuation Models

Mihail Busu, PhD

mihail.busu@fabiz.ase.ro
 Dividend valuation models

The Zero-Growth Model

The Constant-Growth Model

The Multiple-Growth Model

 Geometric series

1. Arithmetic series

1 2  3  ...  n  ?
2. Geometric series (finite) a > 0.

1  a  a 2  a3  ...  a n  ?
3. Geometric series (infinite) and a < 1

1  a  a 2  a3  ...  a n  ?
 Geometric sequences

1. Arithmetic series

n(n  1)
1  2  3  ...  n 
2
2. Geometric series (finite)

an 1 1  an
1  a  a  a  ...  a 
2 3 n

a 1 1  a
3. Geometric series (infinite) and a < 1

1  an 1
1  a  a  a  ...  a  lim
2 3 n

n  1  a 1 a
 Geometric series

n 
1 1
1.  ? 2.  ?
t 1 (1  k ) t 1 (1  k )
t t

n
(1  g )t 
(1  g )t
3.  ? 4.  ?
t 1 (1  k ) t 1 (1  k )
t t
 Geometric series

2 n
n
1 1  1   1 
1.      ...   
t 1 (1  k ) 1 k 1 k  1 k 
t

1 1
1 1
1 k  1  k  1  1 
n n
1 1
      1  
1 k 1 1 1 k k k  1  k  
n

(1  k ) (1  k )


1 1  1  1
2.   lim  1  
n  k   k
t 1 (1  k )   
t n
 1 k 
 Geometric series

n
(1  g )t
3.  ?
t 1 (1  k )
t


(1  g )t
4.  ?
t 1 (1  k )
t
 Geometric series

1 g  1 g  1 g 
t
 1 g 
n 2 n

3.      ...   
t 1 (1  k ) t
1  k  1  k   1  k 
 1 g   1 g 
n n

1  1 
1 g 
1 k  1  g  1  k 
   
1 k 1 1 g 1 k kg
1 k (1  k )

1 g   1 g  
n

  1    
k  g   1  k  
 Geometric series


1 1 g  1 g  
n

4.   lim  1     ,g  k
t 1 (1  k )
n  k  g
  1  k  
t

1 g 1 g
 1  0  
kg kg
 Geometric series

1 g 
t
T 
1
5.   ?
t 1 (1  k ) t T 1 (1  k )
t t
 Geometric series

1 g 
t
T 
1
5.    VT  VT 1
t 1 (1  k ) t T 1 (1  k )
t t

1  
T
1
VT     1 
1

t 1 (1  k ) k  1  k T 
t


1 g   1 g 
T 1 T 2
t

 1 g 
VT 1        ...
t T 1 (1  k ) t
 1  k   1  k 
 Geometric series

1 g   1 g 
T 1
  1  g 1  1  g 2 
t

VT 1     1       ...
t T 1 (1  k )  1 k    1  k   1  k 
t

  1  g n 
T 1  1   
 1 g    1 k  
   lim
 1  k  n   1 g 
 1 1 k 
 

 
1 g 
T 1 T 1
 1 g   1  1
     
 1 k   1 1 g 1  k   k  g 
T

 1 k 
 Expected dividends in the future
 are calculated by updating the cash flows, representing the
future fruition of the investment through dividends.

 V - the value of the share;

 Di - dividends at time i, evaluated as expected cash flows in the future;
 k - the profitability required by the shareholders;
 i - 1, 2, ...

 If the issuing company is experiencing regular development, it is

assumed that the dividends increase each year with an average
rate g.
 The Zero-Growth Model
In this case, the dividends are constant from year to year.
(D0 = D1 = D2 =…)
So the dividend growth rate will be g = 0 and we will have Dt = Dt-1
The value of an stock will be:

Using the properties of infinite series of numbers, since k > 0, we obtain:

Substituting in the original formula, it results:

To find out the profitability required by the shareholders (k *), the value of the
share with the stock exchange is replaced in the above relation.
 The Constant-Growth Model
The issuing company is experiencing a regular development and it is assumed
that the dividends increase each year with an average rate g. Thus, the
dividends will have the following evolution:
D0 – last year's dividend (last paid dividend)
D1 = D0 (1+g)
D2 = Di (1+g) = D0 (1+g)2
.........................................
Dt = Dt-1 (1+g) = D0 (1+g)t

The present value of the share is:

k – the profitability required by the shareholders.

Since D0 is constant, the value of the share is:
 The Constant-Growth Model
Since k> g and using the properties of infinite series of numbers in mathematics,
equality is:

 Substituting in the initial relationship, it results:

Which could be written as: , because D1 = D0 (1+g)

The rate of return required by the shareholders is :

k* - the profitability required by the shareholders;

D1 – dividend at the end of the first year;
P – stock exchange rate;
g – the dividend growth rate.
 The Constant Growth Model
 In this case, the present value of an stock or its rate (C) is equal to:

 D1 - the dividends to be distributed in the following year (t = 1);

 k - the rate of return required by the shareholders;
 g - the increase of the dividend in year t compared to the previous year.
 The profitability claimed by the shareholders is given by the relationship:

 D1 / C expresses the dividend yield of the stock.

 The Multiple-Growth Model
 This model implies finding a moment in the future after which the dividends
will increase with a constant average rate g. If we note this future moment
with T, then the dividends D1, D2, .... DT will be provided separately by the
investor. Thereafter, dividends that are considered to grow at a constant rate
g will be forecast as follows:
DT+1 = DT (1+g)
DT+2 = DT+1 (1+g) = DT(1+g)2
DT+3 = DT+2 (1+g) = DT(1+g)3
................................................
 In order to find out the present value of the share, the dividends are
updated differently, dividing them into two groups:
 In the first situation, the dividends received up to the time T are included.
This value is denoted by VT.
 The Multiple-Growth Model
 In the second situation, the dividends distributed after the moment T. are
updated. Also, it is considered that the investor is not at the moment t = 0,
but at the moment t = T (1). At this time (t = T) the dividends are updated
according to the constant growth model, and this obtained value will be
updated at the time t = 0 (2).

 Equating the two values VT and VT+1, the present value of the share will be:
 The Multiple-Growth Model

 To determine the rate of return required by the shareholders, the

relationship is used :

where:
P – stock exchange rate;
k* - the rate of return required by the shareholders.

 From this relationship, the rate of return required by the shareholders

cannot be deduced mathematically. However, it can be expressed by the
method of tests, by which its value can be approximated.
Practical applications
 Practice problems
1. A stock has brought, for 4 years, the annual dividends of 6
lei, 8 lei, 9 lei and 10 lei and is sold at 4 years from the date of
purchase at the price of 360 lei. Determine the price for which
the stock was bought, if the annual percentage rate was
constant, 6%.
2. A stock has brought, for 10 years, constant annual dividends
of 12 lei and is sold after 10 years with 1000 lei. Determine the
price for which the stock was bought, if the annual percentage
rate was constant, 5%.
 Practice problems
6 8 9 10  360
4. PV    
1  0.06 1  0.06  1  0.06  1  0.06 3
2 3

12 12 12 12  1000
5. PV     ... 
1  0.05 1  0.05  1  0.05 
2 3
1  0.05
10

 12 
 1  1.0611  1000
5. PV  12   1 
 1.05
10
 1 12
 1.06 
 Practice problems
6. A stock has brought, for 22 years, constant annual
dividends of 8 USD and is sold after 22 years with 1000
USD. Determine the price for which the stock was bought, if
the annual percentage rate was constant 3.2%.
7. A stock was bought for 2226 euro and sold for 2424 lei
after 9 years. Find the constant dividend, given that the
interest rate during the whole period was constant 2.6%.
Thank you for your attention!
3. BONDS

Mihail Bușu, PhD

mihail.busu@fabiz.ase.ro
 Long-term
maturity

Bonds –
funds borrowed by an
organization at a certain interest
that is paid periodically, having a
fixed repayment date.
Negotiable –
the secondary
market
Advantages of bond issuance
Provides funding for organizations that
cannot be listed at Stock Exchange

Cheaper coupon issues

Fixed annual cost

Interest paid on the bond is deducted from

gross profit (dividends from net profit)
 Structure of bonds
Nominal
Coupon Maturity
(Face) values

the amount of the periodic income the period of time

money that the received by the the loan is granted
issuer of the bond bond holder and the interest
(the debtor) will pay (interest on the coupons are paid
at maturity. bond investment)
The market value
varies depending
on the interest
rate
Vi - the value of the loan; c - coupon rate
N - number of bonds issued. VN - the nominal value
 TYPES OF BONDS
Standard (classic) bonds
• Fixed coupon, paid annually, maturity and fixed maturity value, amount paid on investor issue = face
value
Bonds with variable coupon
• with floating rate - adjusted based on a reference interest rate
• Indexed - Revenue varies by indicator (retail price index or stock index)
Zero coupon bond
• do not involve interest payments for the period of their existence and are issued at a significant discount.
eliminates the risk of reinvesting interest income
Bonds with options
• LOBO: the coupon rate established periodically by the investor; the issuer has the possibility to accept it
or redeem the bond before maturity
• BOLO: the coupon rate established by the issuer, the investor has the possibility to accept it, or to ask the
issuer to redeem the bond before maturity.
International Bonds
• sunt are issued in the currency of another country by an entity from a foreign country
• Counterparty risk
• Exchange rate risk

Dual currency bond, Bond with annuities, Bond with participation

CLAUSES ASSOCIATED WITH BONDS

The redemption
Redemption
clause at the
clause at the
initiative of the
issuer's initiative
bond holder

Convertibility
clause
 An investor holds a bond (VN = 1000 EUR) that has the associated
convertibility clause, and the conversion rate is 1 bond at 10
shares. The bond price is currently 873 EUR.

The exercise of the convertibility clause is performed by the investor if the share price is
higher than, Bond ’s price  # Bonds 873 1
  87.3 EUR
Conversion rate 10

that is, the shares are worth more than the bond. We note that convertible bonds
behave like option contracts.

What happens if the share price is 65?

But 122?

In what situation is the conversion

clause appropriate?
 Credit risk
of the
issuer

BOND VALUE
 The price of bonds
Percentage of face value
if the face value is 1000 RON and the price is 87.25%, the price in
monetary units is

the present value of all future cash flows

 Necessary:
 estimating the future cash flows according to the loan repayment
method;
 determining the interest rate used for the discount.

dbonds with risk  d no risk asset  risk premium

 The price of the
bonds depends on
the redemption
methods.
 Bonds that are refunded at maturity
 Classical bonds
d - interest rate;
VN - the nominal value;
CFt - total clash flow
C - coupon;
n – maturity.
 If the coupons are constant(C1= C2=...=Cn), we get:

A bond has the nominal value VN = 1000 RON, the coupon

rate (c) is 10%, the maturity (n) is 5 years, and the interest
rate (d) is 8%.

What would be the price of the bond?

 Bonds that are refunded at maturity
 Bonds with zero coupon

For periods longer than one year, the price will be:

 Bonds with constant growth coupon

Deduction of the price of a single coupon bond
Interest Coupon Reinvested amount
 Bonds that are refunded at maturity
 Treasury Inflation Protected Securities (TIPS) index value is
adjusted to inflation rate

An investor purchases 10 TIPS bonds with the following characteristics: VN

1000 EUR, c = 5% (coupons are paid annually), maturity 4 years, the bond is
repaid at maturity, and the nominal value is adjusted taking into account the
inflation rate from one year to another.
Knowing that the interest rate is 7%, and the expected inflation rate is: 5%,
for the next 4 years, to determine the price of a TIPS bond!

The future cash flows must be calculated, taking into account the
inflation rate! See the table above!
Bond return (yield)

Nominal return

Current return

Maturity return

Realized return
 Nominal return
Or the coupon rate represents the percentage gain the investor makes by
buying a bond taking into account the interest coupon and the face value:

Current return
the income brought by bonds as a percentage against its price without
taking into account future income or future capital losses

It shows what the investor is earning at a given moment in relation to the

market value of the bond
 Maturity return
 The discount rate that equals the present value of all cash flows with
the current market price of the bond.
 A measure of the average return to be earned by an investor from a
bond he holds until maturity.

If the market price of a bond is present

1134.2 GBP and has the following characteristics:
the face value is 1000 GBP,
the coupon rate is 10%,
maturity 10 years, and the repayment method is at maturity.

How much is the yield at maturity?

 Realized return
is determined by taking into account: the present price (P) of the bond and
the amount held by the investor at maturity, i.e. the value of reinvested
coupons, to which is added the last cash flow generated by the bond (VF),
as in the relation:

VF - The amount the investor holds at maturity

An investor buys a bond having the following characteristics:

the nominal value 1000 RON, the coupon rate 6%, and the
coupon is paid annually, the market price of the bond is
currently 829,7287 RON, the maturity of 15 years. Knowing
the estimated reinvestment rate of the coupon is 5%, to
determine the realized yield of the bond.
The relationship between price and return
The company "Helveta" has issued a bond having the characteristics:
nominal value 1500 EUR, coupon rate 10%, (coupon is paid annually),
maturity 9 years, the repayment being made at maturity. Interest rate is
12%.

Another company BSB issues a bond with a coupon rate of 12%, a

maturity of 9 years, and the same characteristics as those of the bond
issued by Helveta.

What will investors prefer?

The relationship between price and return
The company "Helveta" has issued an obligation having the
characteristics: nominal value 1500 EUR, coupon rate 10%, (coupon is
paid annually), maturity 9 years, the repayment being made at maturity.

Over a year the company BSB issues a bond with a coupon rate of 12%, a
maturity of 9 years, and the same characteristics as those of the bond
issued by Helveta.

What will investors prefer? Interest rate is 12%

If we determine the value of the two bonds 9 years before maturity, we

obtain:

CONCLUSION: there is an inverse relationship between the price of the bond and the
interest rate (the yield of the bond).
The relationship between price and return

Suppose an investor holds a classic bond with the following

characteristics: face value 1000 EUR, coupon rate 10%, coupon is paid
annually, maturity 20 years, and interest rate: 8%; 10% and 12%.
What will be the price of the bond?
The relationship between price and return

Suppose an investor holds a classic bond with the following

characteristics: face value 1000 EUR, coupon rate 10%, coupon is paid
annually, maturity 20 years, and interest rate: 8%; 10% and 12%.
What will be the price of the bond?

CONCLUSION: Between the price of the bond and the interest rate (the yield of
the bond) there is a convex relation.
The relationship between price and return

Be a classic bond with the nominal value 1000 RON, coupon rate
a). 7% and b). 12%, interest rate 10%, and maturity 5, 2, 1 years.
Determine its price.
The relationship between price and return

Be a classic bond with the nominal value 1000 RON, coupon rate
a). 7% and b). 12%, interest rate 10%, and maturity 5, 2, 1 years.
Determine its price.

Case a.

Case b.
 Moody's rating and Standard & Poor's rating scale
Moody’s S&P The payment capacity of the issuer

Aaa AAA The best payment capacity. (Australia, Canada, Denmark, Finland, Germany, Luxembourg,
Netherlands, Norway)
Aa AA Bonds whose issuer has a very good payment capacity. Together with the AAA or Aaa
securities, they are the high-grade bond class.

A A The issuer has a very good payment capacity, the bonds are susceptible to changes in the
economic conditions.

Baa BBB Coupon payment capacity and the appropriate face value, but certain economic changes
result in lower payment capacity, being considered bonds with medium credit risk.

Ba BB Bonds that have a speculative degree in accordance with the contractual provisions for
the reimbursement of coupons and the nominal value. The bonds with the lowest degree
B B of speculation are Ba and BB. The bonds with the highest degree of speculation are CC
and Ca. The activity of the issuers of these bonds is exposed to numerous uncertainties,
Caa CCC so the credit risk is high. Some titles may default.

Ca CC

C C It is the rating given to issuers who have not paid any interest coupons.

D D Bonds default.
Q/A
 Portfolio Management

1 and 2- Stock Portfolio

Statistics review

 Let X be a discrete random variable

x x2 ... xn 
X : 1 
 p1 p2 ... pn 

 Xi – possible values of X
 pi – probabilities: P(X=xi)=pi

n
E ( X )   pi  xi
 Expected value of X: i 1
2
n
 n 
 Standard deviation: V ( X )  E( X )  E( X ) 2 2
  pi  x    pi  xi 
2
i
i 1  i 1 
 ( x)  V ( X )

2
Statistics Review

 Example 1: throwing a dice

1 2 ... 6 
X : 1 1 1

 ... 
6 6 6

 Expected value:
 E(X)=?

 Standard deviation:
 σ(X ) =?

3
Statistics Review

 Example 1: throwing a dice

1 2 ... 6 
X : 1 1 1

 ... 
6 6 6

 Expected value:
1 1 1 42
E ( X )  1  2   ...6    3,5
 6 6 6 12

1 1 1 91
E ( X 2 )  12   22   ...62    15,17
6 6 6 6

 Standard deviation:
V ( X )  E ( X 2 )  E ( X ) 2  15.17  (3.5) 2  3.45

 ( X )  V ( X )  3.45  1.86

4
Statistics review

 Properties
 If X, Y and Z are three r.v., s.t. Z= aX+bY, then
E ( Z )  a  E ( X )  b  E (Y )

 2 ( Z )  a 2   2 ( X )  b 2   2 (Y )  2ab   ( X )   (Y )

 Example
 Let X cu E(X) = 12 and V(X)=4;
 Let Y cu E(Y) = 14 and V(Y)=9;
 Compute E(Z) and V(Z), where Z = 2X+3Y

5
1-stock portfolio

The return on the portfolio is represented by the random variable R.

4
R   ri x i
i 1

The portfolio return under any scenario j is given by:

4
R j   rij x i
i 1

(Note that we are using r as a percent and R as thousands of dollars.)

6
Return

Using the same procedure, it can be shown that for this

particular allocation of assets, the seven scenarios would
have returns as follows:

Scenario Return
1 500
2 -900
3 -2,300
4 -2,200
5 -538
6 5,670
7 11,878

7
Return

Therefore, the expected return on this particular

allocation of assets is calculated as follows:
7
mR  Rj Pj
j 1

 R1 P1  R2 P2  R3 P3  R4 P4  R5 P5  R6 P6  R7 P7
 (500 )(0.05 )  ( 900 )(0.1 )  ( 2300)(0.2 )  ( 2200)(0.3 )  ( 538)(0.2 )  (5670)(0.1 )  (11878)(0.05 )
 (25)  ( 90 )  ( 460)  ( 660)  ( 108)  (567 )  (594)
 132

8
Return of a stock
We consider a market stock (i). The return of stock (i), in the time range from t = 0 to t = 1, is
denoted by ( Ri ) and has the following distribution:

 0, 2 0,3 0, 2 0, 2 0,1 
Ri :  
1, 4 1,5 1,5 1, 4 1, 4  .

The return of the stock is:

9
Return of a stock
We consider a market stock (i). The return of stock (i), in the time range from t = 0 to t = 1, is
denoted by ( Ri ) and has the following distribution:

 0, 2 0,3 0, 2 0, 2 0,1 
Ri :  
1, 4 1,5 1,5 1, 4 1, 4  .

The return of the stock is:

Return of the stock:

n
E ( Ri )   pk  Ri k , where
pk Rk
şi were previously defined.
k 1

Thus, we get:

E ( Ri )  0, 2 1, 4  0,3 1,5  0, 2 1,5  0, 2 1, 4  0,11, 4

E ( Ri )  1, 45

10
Risk of the stock
We consider a stock ( Ri ) in the 5 possible future states:

 0, 2 0,3 0, 2 0, 2 0,1 
Ri :  
1, 4 1,5 1,5 1, 4 1, 4 

Compute the risk of the stock.

11
Risk of the stock
n
E ( Ri 2 )   pk  R 2 k
k 1

E ( Ri 2 )  0, 2 1, 42  0,3 1,52  0, 2 1,52  0, 2 1, 4 2  0,1 1, 4 2

E ( Ri 2 )  1,5562

The variance is:

 i2  var( Ri )  E ( Ri2 )  E ( Ri ) 2

 1,5562  1, 452

 2, 22  1, 452

 2,105  2.1025

 0, 0025

The risk is:  i  0,0025  0,05  5%

12
Example 2
 Compute the risk and return of the following
stock:

13
Example 2
 Compute the risk and return of the following
stock:

E ( R)  0, 2 1,80  0, 4 1, 60  0,11, 70  0, 2 1, 75  0, 05 1,82  0, 05 1,88

E ( R)  1, 705
E ( R2 )  0, 2 1,802  0, 4 1,602  0,11,702  0, 2 1,752  0,05 1,822  0, 05 1,882

E ( R 2 )  2,92

 p 2  E ( R 2 )  [ E ( R)]2  2,92  1, 7052  0.0088

14
2-stock Portfolio
 We have a 2-stock portfolio (w ,w ), where
1 2

w + w =1
1 2

 Each stock has a return and a risk:

 S : E(R ) and 21
1 1

 S : E(R ) and 22

2 2

 What are the risk and return of the portfolio?

15
Some Intuition:
 Risk of a single asset is the variance (SD =
1 ) of its return

 Risk of a portfolio of shares depends

crucially on (correlation) between the assets.

16
Statistics: Some Definitions
 Expected Return of Portfolio
 E(RP) = w1E(R1)+ w2 E(R2)

 Variance of Portfolio
 2P = w21 21+ w22 22 + 2 w1 w2 12
 2P = w21 21+ w22 22 + 2 w1 w2(  1 2)

 Also, ‘weights’ are: w1 + w2 = 1.

 Note 12 =  1 2 - from statistics

17
 Example 3
Consider a 2 stocks, R1 şi R2 with returns E ( R1 )  22% , E ( R2 )  24% and risks
 1  8% şi  2  9% . Consider a portfolio with weights 40% of R1 and 60% from
R2 with 3 cases:

a) 12  1

b) 12  0

c) 12  0,8

where 12 is the correlation coefficient between the two stocks.

Compute the return and the risk of the portfolio.

18
Solution

cov( R1 , R2 )  12  1   2

 E ( Rp )  0, 4  E ( R1 )  0,6  E ( R2 )
 2
 Rp  (0, 4)   1  (0,6)   1  2(0, 4)(0,6) 12 1 2
2 2 2 2

 E ( Rp )  0, 4  0, 22  0,6  0, 24
 2
 Rp  (0, 4)  (0,08)  (0,6)  (0.09)  2(0, 4)(0,6) 12 (0,08)(0,09)
2 2 2 2

 E ( Rp )  0, 232
 2
 Rp  0.001024  0,002916  0,003456  12

 E ( Rp )  0, 232
 2
 Rp  0.00394  0,003456  12

Now we replace 12 with the values given.

19
 Example 4
We consider a portfolio consisting of two shares R1 and R2. R1 has the return
E ( R1 )  20% and the
  8% , and R it has the return E ( R2 )  30% and the risk  2  9% . We consider a portfolio
risk 1 2
w  (w1 , w 2 ) , where w and w represents the portfolio weights of each share:
1 2
w1  40%, w 2  60% and 12  1 . Compute the return of the portfolio.

20
Example 4
We consider a portfolio consisting of two shares R1 and R2. R1 has the return
E ( R1 )  20% and the
  8% , and R it has the return E ( R2 )  30% and the risk  2  9% . We consider a portfolio
risk 1 2
w  (w1 , w 2 ) , where w and w represents the portfolio weights of each share:
1 2
w1  40%, w 2  60% and 12  1 . Compute the return of the portfolio.

We denote with R p the portfolio obtained from the two actions. This portfolio consists of w1 of
the first stock and w2 the second. Then:

R p  x1  R1  x2  R2

For this portfolio we will compute the return:

E ( R p )  x1  E ( R1 )  x2  E ( R2 )

By plugging in the numbers, we get:

E ( R p )  x1  0, 20  x2  0,30

E ( R p )  0, 4  0, 2  0, 6  0,3

E ( Rp )  0, 26

21
Example 5
We consider a portfolio consisting of two shares R1 and R2. R1 has the return
E ( R1 )  20% and the
  8% , and R it has the return E ( R2 )  30% and the risk  2  9% . We consider a portfolio
risk 1 2
w  (w1 , w 2 ) , where w and w represents the portfolio weights of each share:
1 2
w1  40%, w 2  60% and 12  1 . Compute the risk of the portfolio.

22
Example 5
We consider a portfolio consisting of two shares R1 and R2. R1 has the return
E ( R1 )  20% and the
  8% , and R it has the return E ( R2 )  30% and the risk  2  9% . We consider a portfolio
risk 1 2
w  (w1 , w 2 ) , where w and w represents the portfolio weights of each share:
1 2
w1  40%, w 2  60% and 12  1 . Compute the risk of the portfolio.

 2 R  ( x1 )2  12  ( x2 )2  12  2( x1 )( x2 ) 121 2

p

 2 R  (0, 4)2  (0,08)2  (0,6)2  (0,09)2  2(0, 4)(0,6) 12 (0,08)(0,09)

p

 2 R  0.001024  0,002916  0,003456  12

p

 2 R  0.00394  0,003456  (1)

p

 2 R  0, 000484
p

23
Problems
1. We consider that 2 assets are listed on the market with returns E ( R1 )  E ( R2 )  0,1 and risks
1  0,15,  2  0, 25 . The two assets evolve independently in the market, ie the correlation
coefficient between the two assets is 12  0 . Find the risk and return of the portfolio.

2. We consider that 2 assets are listed on the market with returns E ( R1 )  0.12, E ( R2 )  0,16 and
risks 1  0,03,  2  0,04 . The two assets evolve independently in the market, ie the correlation
coefficient between the two assets is 12  0.5 . Find the risk and return of the portfolio.

24
 Portfolio Theory

3- Stock Portfolio
2-stock Portfolio
 We have a 2-stock portfolio (w ,w ), where
1 2

w + w =1
1 2

 Each stock has a return and a risk:

 S : E(R ) and 21
1 1

 S : E(R ) and 22

2 2

 What are the risk and return of the portfolio?

26
Some Intuition:
 Risk of a single asset is the variance (SD =
1 ) of its return

 Risk of a portfolio of shares depends

crucially on covariance (correlation) between
the returns.

27
Statistics: Some Definitions
 Expected Return of Portfolio
 E(RP) = w1E(R1)+ w2 E(R2)

 Variance of Portfolio
 2P = w21 21+ w22 22 + 2 w1 w2 C Cov12
 2P = w21 21+ w22 22 + 2 w1 w2(  1 2)

 Also, ‘proportions’ are: w1 + w2 = 1.

 Note Cov12 =  1 2 - from statistics

28
3-stock Portfolio
 We have a 3-stock portfolio (w ,w ,w ),
1 2 3

where w + w +w =1 1 2 3

 Each stock has a return and a risk:

 S : E(R ) and 21
1 1

 S : E(R ) and 22

2 2

 S : E(R ) and 23

3 3

 What are the risk and return of the portfolio?

29
Statistics: Some Definitions
 Expected Return of Portfolio
 E(RP) = w1E(R1)+ w2 E(R2) +w3 E(R3)
 Variance of Portfolio
 2P = w21 21+ w22 22 + w23 23 + 2 w1 w2( 12 1 2)
+ 2 w1 w3( 13 1 3)+ 2 w2 w3( 23 2 3)

 Also, ‘weights’ are: w1 + w2 +w3 = 1.

 Risk is: P.

30
N- stock portfolio

 Assume we have a n-stock portfolio

 Each stock has the return and

risk , while the covariances
are
 The return vector is:

31
 The variance-covariance matrix is:

 The the risc and the return of the

portfolio is:

 Where is the return and the risk of the portfolio.

32
The portfolio-solution is:

The sensitivity of the portfolio is:

The volatility of the portfolio is:

33
Example
 We will consider a 3-stock portfolio with the
given risks and returns:
𝐸(𝑅1 ) = 14%, 𝐸(𝑅2 ) = 16%, 𝐸(𝑅3 ) = 20%
𝜎1 = 10%, 𝜎2 = 15%, 𝜎3 = 30%
 The correlation coefficients are:
𝜌12 = 0.25, 𝜌13 = 0, 𝜌23 = −0.5

 What are the return and the risk of the

portfolio? Weights are: 40%, 30% and 30%

34
Example
 The covariance coefficients are:

 The variance-covariance matrix is:

35
Example
 We will consider the following weights:
𝑥1 = 40%, 𝑥2 = 30%, 𝑥3 = 30%

 So, the portfolio is:

 Now we will compute the risk of the portfolio:

36
 The risk of the portfolio is:

 The return of the portfolio:

 The portfolio has: 16.2%return and 9.26% risk

37
 We are able to compute sensitivity and
volatility coefficients:

 Hence, the sensitivity coefficients are:

 The volatility coefficients:

38
Problem 1
 We will consider a 3-stock portfolio with the
given risks and returns:
𝐸(𝑅1 ) = 18%, 𝐸(𝑅2 ) = 14%, 𝐸(𝑅3 ) = 12%
𝜎1 = 5%, 𝜎2 = 4%, 𝜎3 = 3%
 The correlation coefficients are:
𝜌12 = 0.15, 𝜌13 = −0.25, 𝜌23 = +0.75

 What are the return and the risk of the portfolio?

 Compute the volatility and the sensitivity
coefficients.

39
Problem 2
 We will consider a 3-stock portfolio with the
given risks and returns:
𝐸(𝑅1 ) = 24%, 𝐸(𝑅2 ) = 18%, 𝐸(𝑅3 ) = 22%
𝜎1 = 6%, 𝜎2 = 5%, 𝜎3 = 4%
 The correlation coefficients are:
𝜌12 = 0, 𝜌13 = 0.35, 𝜌23 = −0.15
 What are the return and the risk of the portfolio?
 Compute the volatility and the sensitivity of the
coefficients

40
Problem 3
 We will consider a 3-stock portfolio with the
given risks and returns:
𝐸(𝑅1 ) = 15%, 𝐸(𝑅1 ) = 13%, 𝐸(𝑅1 ) = 10%
𝜎1 = 2%, 𝜎2 = 3%, 𝜎3 = 4%
 The correlation coefficients are:
𝜌12 = −0.5, 𝜌13 = −1, 𝜌23 = 0.5
 What are the return and the risk of the portfolio?
 Compute the volatility and the sensitivity of the
coefficients

41
Q/A

42
Financial Management

Lecture V
 Schedule: Saturday 12.12
• Saturday (10.00-14.30)
• Keynote Speakers:
• 10.00 - Tuba Bastan – Finance Manager, South East Europe, P&G
• 11.30 -Daniel Dumitrescu – Manager at Renault, Zentiva/ Sanofi (Academica
Medical, Simtel Team)
• 13.00 - Victor Chirila – Account Manager XTB Brokerage House (Trading and
Financial Risk)
• 14.00 – Final remarks
 Portfolio Risk
• A portfolio is a grouping of financial assets such as
• stocks, bonds, commodities, currencies and cash equivalents,
• Mutual funds, exchange-traded and closed funds.
• A portfolio could also consist of non-publicly tradable
securities, like real estate, art, and private investments.
• Money market accounts make full use of this concept to
function properly.
 3 stock- Portfolio Risk
• We have a 2-stock portfolio (w1,w2), where w 1+ w2 +w3 =1
• Each stock has a return and a risk:
• S1: E(R1) – expected return and s21 -risk
• S2: E(R2) –expected return and s22 –risk
• S3: E(R3) –expected return and s23-risk

• What are the risk and return of the portfolio?

 3 stock- Portfolio Risk
• Expected Return of Portfolio
• E(RP) = w1E(R1)+ w2 E(R 2)+ w3 E(R 3)

• Variance of Portfolio
• s2P = w21 s21+ w22 s22 + w22 s23 +2 w1 w2 s12 +2 w2 w3 s23 +2 w1 w3 s13
• s2P = w21 s21+ w22 s22 + w23 s23 +2 w1 w2( 12 s1 s2) +2 w2 w3( 23 s2 s3)
+2 w1 w3( 13 s1 s3)

Also, the weights are: w1 + w2 +w3 = 1.

• Note s12 = 12 s1 s2;
 3 stock- Portfolio Risk - solution
• The return of the portfolio is:

• The return of the portfolio is:

• The portfolio has: 16.2%return and 9.26% risk

Currency Exchange Rates
FX – Foreign Exchange Rate
- the price of one currency in terms of another
Example
• If the Australian dollar (AUD) is trading at 0.60 U.S.
dollars ($0.60), each AUD will buy 60 U.S. cents.
• Market convention would be to quote this relationship
as:
AUD:USD = 0.60
 FX quotations are sometimes described as direct or indirect.
However, this distinction depends on the home currency of the
user.
 Direct quote for currency A is value of one unit of currency A
in units of currency B (counter-currency).
 AUD:USD = 0.60
 Indirect quote for currency A is amount of currency A for one
unit of currency B.
 The quoted rate would simply be the reciprocal of the above rate:
 USD:AUD = 1 I 0.60 = 1.67
 FX Appreciation and Depreciation
• The appreciation and depreciation of a currency's value affects
the supply and demand for the currency.
• For example, suppose that the dollar-Swiss franc exchange rate
increases from USD:CHF = 1.7799 to 1.8100. Has the franc
appreciated or depreciated?
• The Swiss franc has depreciated relative to the dollar-it now
takes more Swiss francs (1.81) to buy a dollar.
• An increase in the numerical value of this exchange rate means
that the USD has appreciated, and that the CHF has depreciated.
Example: Exchange rate appreciation
and depreciation
• If the AUD:USD moves from 0.60 to 0.70, has the AUD depreciated
or appreciated?
Example: Exchange rate appreciation
and depreciation
• If the AUD:USD moves from 0.60 to 0.70, has the AUD depreciated
or appreciated?
Answer:
• The quote represents the USD price of one AUD, so the AUD has
appreciated.
• Previously, each AUD would only cost 60 cents, whereas now each
AUD costs 70 cents.
• The U.S. dollar has depreciated in value. It used to buy 1.67 AUD
but only buys 1.43 AUD today.
FX Market Participants
• The primary participants are large commercial banks.
• Other participants include:
• Foreign exchange brokers
• Major multinational corporate customers
• Central banks.
• This is the wholesale market for foreign exchange.
• The interbank market is segmented into three segments:
• (1) the spot market
• (2) the forward market
• (3) the currency swap market.
FX Market Participants (2)
• A significant proportion of interbank market trades are organized
by foreign exchange brokers who match buyers and sellers for a
small commission (e.g., 1/32 of 1%).
• Foreign-exchange brokers provide:
• information, participant anonymity, and reduce time and effort
• The typical small client gets foreign exchange from a local bank.
• The local bank in turn gets the exchange from its major
correspondent bank.
Spread and percentage spread
• Banks and other dealers generally do not charge commissions on
foreign currency transactions.
• Instead, they make their profit from the bid-ask spread.
• The bid price is always listed first.
• It is the price the dealer will pay to buy the currency.
• The ask price is always listed second.
• It is the price at which the dealer will sell the currency.

Example: EUR: RON = 4.7300 – 4.7420

Spread = 0.0120
Spread and percentage spread -
example
• In the previous example, bid rate and an ask rate as follows:
• AUD:USD = 0.6000-0.6015
• The spread is 0.0015 USD.
• The size of the spread is often expressed as a percentage of either
the bid, midpoint, or the ask rate.
• For the above quote, we get a percentage spread as a percentage
of the ask as:
• Spread = (0.6015-0.6000)/ 0.6015 = 0.0025 or 0.25%
FX cross rate
• The cross rate is the exchange rate between two currencies
implied by their exchange rates with a common third currency.
• Cross rates are necessary when there is no active FX market in the
currency pair.
• The rate must be computed from the exchange rates between
each of these two currencies and a third currency, usually the
USD or EUR.
• Example: EUR:USD and USD:RON are given and we need EUR:RON
FX cross rate - example
• Let's return to our previous quotation for the Australian dollar and
the U.S. dollar (AUD:USD = 0.60).
• Let's assume that we also have the following quotation for
Mexican pesos: USD:MXN = 10.70.
• What is the cross rate between Australian dollars and pesos
(AUD:MXN)?
FX cross rate - example
• Let's return to our previous quotation for the Australian dollar and
the U.S. dollar (AUD:USD = 0.60).
• Let's assume that we also have the following quotation for
Mexican pesos: USD:MXN = 10.70.
• What is the cross rate between Australian dollars and pesos
(AUD:MXN)?

• Answer: MXN:AUD = (USD:AUD) x (MXN:USD) =0.60 x 10.70 = 6.42

Example: cross rate calculation
• The spot exchange rate between the Swiss franc (CHF) and the
USD is USD:CHF = 1.7799, and the spot exchange rate between the
New Zealand dollar (NZD) and the U.S. dollar is USD:NZD = 2.2529.
Calculate the NZD:CHF spot rate.
Example: cross rate calculation
• The spot exchange rate between the Swiss franc (CHF) and the
USD is USD:CHF = 1.7799, and the spot exchange rate between the
New Zealand dollar (NZD) and the U.S. dollar is USD:NZD = 2.2529.
Calculate the NZD:CHF spot rate.

• The NZD:CHF cross rate is:

• 1.7799 (CHF:USD) / 2.2529(NZD:USD) =0.79005 (CHF:NZD)
Cross rates with bid-ask spreads
• Bid-ask spreads complicate the calculation of cross rates
considerably.
• The most intuitive way to think about the calculations is to think of
the process as a triangle.
• The bottom side of the triangle is missing: the only way to make
the trade is up one side to the USD and down the other to the
desired currency.
 Cross rates with bid-ask spreads
Here are the steps, depending upon
your trading objective:
• Sell AUD and buy MXN:
• Sell AUD and buy USD, then sell USD and buy MXN.

• Thus you will have effectively sold AUD and

bought MXN.
• This results in the cross rate bid because you are selling the
base currency in the AUD:MXN pair.

• Sell MXN and buy AUD:

• Sell MXN and buy USD, then sell USD and buy AUD.
• Thus you will have effectively sold MXN and
bought AUD.
• This results in the cross rate ask because you are
buying the base currency in the AUD:MXN pair.
 Example
• AUD:USD 0.6000-0.6015 and
USD:MXN 10.700- 10.720

 Obtaining the cross rate bid:

 Sell AUD at the bid of 0.60 (receive USD) and
 Sell USD at the bid of 10.70 (receive MXN).
 Resulting bid rate:
 AUD:MXN = 0.6000 X 10.700 = 6.4200

 Obtaining the cross rate ask:

 Sell MXN at the ask of 10.720 (receive USD) and
 purchase AUD at the ask of0.6015.

 Resulting ask rate:

 AUD:MXN = 0.6015 X 10.720 = 6.4481
 Example
• AUD:USD = 0.6000-0.6015
USD:MXN = 10.700- 10.720

 Thus, our cross rates are:

 bid = 6.4200 MXN per AUD
 and
 ask= 6.4481 MXN per AUD
Triangular arbitrage
• For a triangular arbitrage, there
are three pairs of currencies with
bid and ask quotes.
• You construct a triangle such that
each node in the triangle will
represent one currency.
• For arbitrage, you go through the
triangle clockwise (and
counterclockwise) until you reach
your starting point.
Triangular arbitrage - example
• Suppose that you were on vacation in Mexico, and a local bank
offered a rate of AUD:MXN 6.3000 - 6.3025. Further assume that
the exchange rate quotations between these two currencies and
the USD are those in the previous example. Would a triangular
arbitrage be profitable under these circumstances?

• Quotations:
• AUD:USD = 0.6000 - 0.6015
• USD:MXN = 10.700- 10.720
Triangular arbitrage - example
• The following steps will illustrate the process, assuming that you
start with an arbitrary amount of MXN - we will assume 1 million
pesos.
• Step 1: Buy AUD with MXN at the ask from the Mexican bank.
• 1 mil. /6.3025 = AUD 158,667.
• Step 2: Sell AUD for USD at the bid. 158,667 x 0.6000 = USD
95,200.
• Step 3: Sell USD for MXN at the bid. 95,200 x 10.700 = MXN
1,018,643.
• Result: You have made an arbitrage profit of MXN 18,643.
Spot market vs Forward market
• Forward FX markets are for an exchange of currencies that will
occur in the future. Both parties to the transaction agree to
exchange one currency for another at a specific future date at a
price that is fixed today.
• Forward contracts are typically for transactions 30, 60, 90, or 180
days into the future, although the contracts can be written for any
period.
• There is no option involved in the contract; both parties to a
forward currency contract are obligated to execute the specified
transaction in the future.
Forward FX transactions - example
• A U.S. firm is obligated to make a future payment of CHF 100,000
in 60 days. To manage its exchange rate risk, the firm contracts to
buy the Swiss francs 60 days in the future at USD:CHF = 1.7530.
The current exchange rate is 1.7799.
• a) How much would the U.S. firm gain or lose on its commitment if, at
the time of payment, the exchange rate fell to 1.6556 Swiss francs to
the dollar?
• b) How much would the U.S. firm gain or lose on its commitment if,
a.t the time of payment, the exchange rate rose to 1.8250 Swiss francs
to the dollar?
 Forward FX transactions - answer
• a) Without the forward contract, the cost to the firm would have been
• CHF 100,000 I 1.6556 = USD 60,401.
• With the contract, the cost to the firm is
• CHF 100,000 /1.7530 = USD 57,045.
• The firm has saved itself $3,356.
• b) Without the forward contract, the cost to the firm would have been
• CHF 100,000 /1.8250 = USD 54,795.
• With the contract, the cost to the firm is
• CHF 100,000 /1.7530 = USD 57,045. The contract has cost the firm $2,250.
• Note that in both cases, the cost with the forward contract in place was
the same ($57,045). Foreign exchange risk is eliminated.
 Forward FX transactions II
• Consider a 6-month (180-day) forward exchange rate quote from a U.S.
currency dealer of GBP:USD = 1.6384-1.6407.
• This means that the dealer will commit today to buy pounds for 1.6384
dollars in six months, or sell pounds in six months for 1.6407 dollars.
• In this example, the spread is 0.0023. We can also express this as a
percentage of the ask rate.
• For the above quote, we get a percentage spread as:
• Spread = (1.6407-1.6384)/1.6407 = 0.0014 or 0.14%
 Forward discount and premium
• A currency is quoted at a forward premium relative to a second currency if the
forward price (in units of the second currency) is greater than the spot price.
• A currency is quoted at a forward discount relative to a second currency if the
forward price (in units of the second currency) is less than the spot price.
• If investors must pay less (more) in their domestic currency per unit of a foreign
currency in the future, the foreign currency is at a forward discount (premium).
• The forward premium or discount is frequently stated as an annualized
percentage.
• Given spot and forward exchange rates, the annualized forward premium
(discount) can he calculated using the following formula:
 Example I: Annualized forward rate
premium and discount
• Assume the 90-day
• forward rate for the NZD:USD = 0.4439, and
• spot rate is NZD: USD = 0.4315.
• Determine if the NZD is trading at a forward premium or discount to the USD.
• Calculate the annualized premium or discount and determine whether the NZD
is strong or weak.
 Example I: Annualized forward rate
premium and discount
• Assume the 90-day forward rate for the NZD:USD = 0.4439, and the spot rate is
NZD: USD = 0.4315. Determine if the NZD is trading at a forward premium or
discount to the USD. Calculate the annualized premium or discount and
determine whether the NZD is strong or weak.
Answer
• Since it takes more U.S. dollars to buy the NZD in the forward market relative to
the spot, the NZD is trading at a forward premium versus the dollar.
• Annualized forward premium = [(0.4439-0.4315)/0.4315] x (360/90) = 0.1149
or 11.49%
• The NZD is selling at a forward premium to the USD, so the NZD is considered
strong and is expected to appreciate.
 Example II: Calculating the forward
premium/discount
• Given the following quotes in yen per U.S. dollar, calculate the forward
premium/ discount on the U.S. dollar relative to the Japanese yen and indicate
whether the U.S. dollar is strong or weak:
• Spot rate: 125.00
• 90-day forward rate: 126.25
 Example II: Calculating the forward
premium/discount
• Given the following quotes in yen per U.S. dollar, calculate the forward
premium/ discount on the U.S. dollar relative to the Japanese yen and indicate
whether the U.S. dollar is strong or weak:
• Spot rate: 125.00
• 90-day forward rate: 126.25
• Answer
• forward premium on $= [(126.25-125.00)/125.00] x (360/90) = 0.04 or 4%.

• The USD is selling at a forward premium, so it is considered strong.

 Interest rate parity
• Interest rate parity holds when any forward premium or discount just offsets
differences in interest rates so that an investor will earn the same return
investing in either currency.
• If euro interest rates are higher than dollar interest rates, a depreciation of the
euro relative to the dollar will just offset the higher euro interest when interest
rate parity holds.
• Formally, interest rate parity requires that:

• where forward (F) and spot (S) are quoted in terms of B:A (direct quote to
Country A investor) and R is the nominal risk-free rate in each country.
 Interest rate parity
• Alternatively we can state interest rate parity as:

• which states that the (discounted) interest rate difference between the
countries is equal to the forward discount or premium.
• Again, the currency with the higher (lower) nominal interest rate will be selling
at a forward discount (premium) relative to the ocher when interest rare parity
holds.
 Example: Forward premiums or
discounts from interest rate parity
• Assume the annualized U.S. dollar interest rate is 9%, and the annualized euro
interest rate is 12% when the spot exchange rate is $1.30 per euro. Calculate the
expected exchange rate for a 4-month forward contract and the expected
appreciation or depreciation of the USD in four months.
• First, we must get the 4-month interest rates from the annual rates by multiplying by
4/12. Our 4-month rates are 9%(4/12) = 3% in USD and 12%(4/12) = 4% in EUR.
• Since the U.S. dollar rate is less, the dollar will appreciate and the euro will depreciate
according to interest rate parity.
• The euro should depreciate to (1.03/1.04) x 1.30 = $1.2875 per euro.
• The expected depreciation in the euro is (0.03- 0.04)/1.04 = -0.009615 or 0.9615%.
• To check for consistency, we have
• (F- S)/S= (1.2875- 1.30) /1.30 = -0.009615, a 0.9615% depreciation of the euro.
 Covered interest arbitrage
• Forward contracts are not always available for every currency
pair, and when they are not, interest rate parity is simply a
theoretical relationship. It may or may not hold.
• When currencies are freely traded and forward contracts are
available in the marketplace, interest rate parity must hold.
• If it does not hold, arbitrage trading will take place until interest
rate parity holds with respect to the forward exchange rate.
• Such arbitrage is referred to as covered interest arbitrage.
 Example: covered interest arbitrage
• The U.S. dollar interest rate is 8%, and the euro interest rate is 6%. The spot
exchange rate is $1.30 per euro, and the forward rate is $1.35 per euro.
Determine whether a profitable arbitrage exists and illustrate such an arbitrage if
it does.
• First, we note that the forward value of the euro is “too high“. Interest rate parity
would require a forward rate of:
• $1.30(1.08/1.06) = $1.3245.
• The forward value of $1.35 is higher than what implied by interest rate parity,
and we should hold euros rather than hold dollars for a profitable arbitrage.
• The dollar is depreciating more than would be implied by interest rate parity.
 Example: covered interest arbitrage
• The steps in the covered interest arbitrage are:
• Initially:
• Step 1: Borrow $1,000 at 8% and purchase 1,000 /1.30 = 769.23 euros.
• Step 2: Invest the euros at 6%.
• Step 3: Sell the expected proceeds at the end of one year
• 769.23 (1.06) = 815.38 euros, forward 1 year at $1.35 each.
• After one year:
• Step 1: Sell the 815.38 euros under the terms of the forward contract at $1.35 to get
$1,100.76.
• Step 2: Repay the $1,000 at 8% loan, which is $1,080.
• Step 3: Keep the difference of $20.76 as an arbitrage profit.
 Conclusions
• The spot rate is the exchange rate for immediate transactions,
while the forward exchange rate is for transactions at a specific
future date.
• A currency selling at a forward premium is considered "strong"
relative to the second currency and is expected to appreciate.
• A currency selling at a forward discount is considered "weak" and is
expected to depreciate.
 Key concepts
• Direct foreign exchange quotations are in domestic currency per
unit (or 100 units) of foreign currency, and indirect quotations are
in the foreign currency per unit of the domestic currency.
• The difference between the bid and ask prices for foreign currency
is the spread, often expressed as a percentage of the ask price.
• The exchange rates of two currencies with a third can be used to
obtain a cross rate (of exchange) between the two currencies.
• Forward foreign exchange rates are for currency to be exchanged
at a future date, while spot rates are for immediate delivery.
 Key concepts
• Forward foreign exchange rates have a bid-ask spread calculated as
for spot rates. These spreads tend to increase with the length of the
contract and exchange rate volatility.
• The forward contract price is said to be at a forward premium
(discount) for a currency if the forward value of that currency is
higher (lower) than the spot value.
• A currency selling at a forward premium is considered "strong"
relative to the second currency, while a currency selling at a
forward discount is considered "weak."
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