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FIN 644 Lecture 2

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FIN 644 Investments

(Fall 2024)
Lecture 2
Readings: Chapter 4 & 5

Prepared by Changjie Hu

9/10/2024
Recap
▪ What is investment?
▪ Current commitment of money/resources in the expectation of future benefits

▪ What is the main difference between financial & real assets?


▪ Allocation/claims of income vs. productive capacity

▪ Financial markets are traditionally segmented into:


▪ Money Market: E.g., T-bill, CD, commercial papers, bankers’ acceptance, money market fund
▪ Capital Market: E.g., bonds, equity, futures, options

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Investment Companies
▪ Do investors usually trade securities by themselves?
▪ More commonly, they direct funds to investment companies to trade on their behalf.

▪ What are investment companies?


▪ They are financial intermediaries that pool and invest the funds of individual investors
▪ Perform several important functions:
1. Record keeping and administration (e.g., performance analysis and tracking)
2. Diversification and divisibility (e.g., holding fractions of stocks)
3. Professional management (e.g., hiring securities analysts and portfolio managers)
4. Lower transaction costs (e.g., economies of scale on fixed trading costs)

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Investment Companies
▪ After pooling assets, they need to divide claims to these assets.
▪ Investors buy shares and ownership is proportional to shares purchased.
▪ What should be the value of each share?
▪ Net asset value (NAV):

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Investment Companies
▪ After pooling assets, they need to divide claims to these assets.
▪ Investors buy shares and ownership is proportional to shares purchased.
▪ What should be the value of each share?
▪ Net asset value (NAV):
▪ Example: Consider a mutual fund that manages a portfolio of securities worth $120M.
Suppose the fund owes $4M to its investment advisers and another $1M for rent, wages
due, and miscellaneous expenses. The fund has 5M shares outstanding.

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Types of Investment Companies
▪ Investment companies can be classified as:
1. Unit Investment Trust
▪ Sponsor (brokerage firms) buys a portfolio of securities that are deposited into a trust
▪ Sells shares, or "units" in the trust called redeemable trust certificates
▪ Little active management and portfolio composition is fixed
▪ Tend to invest in relatively uniform type of assets
▪ Sponsor sell shares at a premium to the cost of assets as a profit

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Types of Investment Companies
▪ Investment companies can be classified as:
2. Managed Investment Companies
▪ Can be the organizer and manager of a fund for itself or others for a fee
▪ There are two types of funds:
1. Open-end funds:

▪ Typically known as the “mutual fund”

▪ issues or redeems its own shares at net asset value (NAV)

2. Closed-end funds:

▪ Issue shares only once. (one-time sale at the IPO)

▪ Unable to redeem shares at their NAV, must sell shares to other investors

▪ Shares traded on exchange (through brokers) at market prices (may be different from NAV)

▪ Do you think the share typically trade above or below its NAV?

▪ A puzzle that most closed-end funds trade at a discount!

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Types of Investment Companies
▪ Investment companies can be classified as:
2. Managed Investment Companies

▪ https://www.cefconnect.com/closed-end-funds-daily-pricing

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Types of Investment Companies
▪ Investment companies can be classified as:
2. Managed Investment Companies
▪ Exchange-traded Funds (ETFs)
▪ Similar to open-end mutual funds but do NOT redeem/buy directly from the sponsor

▪ ETF shares are traded intra-day through a broker whereas mutual fund once a day at NAV based
on market close price.

▪ ETF started out exclusively as an index tracker (i.e., indexed ETFs) until about 2008

▪ Now we have many actively managed ETF with unique strategies.

Source: https://www.fool.ca/

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Types of Investment Companies
▪ Other Investment Organizations:
1. Commingled Funds
▪ Partnerships of investors that pool funds (e.g., trusts or retirement/pension funds)
▪ Managed by investment companies (e.g., insurance firm/bank) for a fee

▪ Much larger than individual investors but still not efficient to be managed separately

2. Real Estate Investment Trusts (REITs)


▪ Similar to closed-end fund and two main types:
1. Equity Trusts: invest in real estate directly (e.g., buildings/apartment/offices)

2. Mortgage trusts: Invest in loans backed by real estate (E.g., mortgages/MBS)

▪ REITs are typically highly levered with a debt ratio of 70%

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Types of Investment Companies
▪ Other Investment Organizations:
3. Hedge Funds
▪ Similar to mutual fund by pooling investors’ assets by a fund manager
▪ Usually opened to wealthy/institutional investors only

▪ Typically structured as private partnerships and subject to minimal regulations


▪ Allowing the use of more exotic strategies including leverage, short sales, derivatives unlike mutual
funds.

▪ Contain redemption constraints such as lockups, a side pocket and a gate. Why?
▪ Allowing longer term investment without worrying about redemption => higher expected return

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Types of Investment Companies
▪ Other Investment Organizations:
3. Hedge Funds (Optional Reading Ch 26)
Style Strategy
Equity market Commonly uses long/short hedges. Typically controls for industry, sector, size, and other exposures and
neutral establishes market-neutral positions designed to exploit some market inefficiency. Typically deploys leverage to
amplify inefficiencies.
Long/short equity Equity-oriented positions on either side of the market (i.e., long or short), depending on outlook. Not meant
hedge to be market neutral; low beta may be incidental. May establish a concentrated focus regionally (example, U.S.
or Europe) or on a specific sector (example, tech or health care stocks). Derivatives may be used to hedge
positions.
Dedicated short Net short position, usually in equities, as opposed to pure short exposure. In recent years, the number of true
bias dedicated short bias managers has dwindled.
Event driven Attempts to profit from events such as mergers & acquisitions (risk-arbitrage event driven), regulatory changes,
restructurings, bankrupitcies, and reorganizations (distressed event driven), or other litigation. Can invest across
asset classes and events (multi-strategy event driven).
Fixed-Income Attempts to profit from price anomalies in related interest rate securities. Includes interest rate swap arbitrage,
arbitrage U.S. versus non-U.S. government bond arbitrage, yield-curve arbitrage, and mortgage-backed arbitrage.
Convertible Hedged investing in convertible securities, typically long convertible bonds and short corresponding stock,
arbitrage particularly when there is a price discrepancy in the conversion ratio.

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Types of Investment Companies
▪ Other Investment Organizations:
3. Hedge Funds (Optional Reading Ch 26)

Style Strategy
Global macro Involves long and short positions in capital or derivative markets across the world. Portfolio
positions reflect views on broad market conditions and major economic trends.
Emerging Goal is to exploit market inefficiencies in emerging markets. Typically, long only because short-
markets selling is not feasible in many developing markets. Can be invested across asset classes (and
currency).
Managed futures Use financial, currency, or commodity futures. May make use of technical trading rules or a less
structured judgmental approach.
Multistrategy Opportunistic choice of strategy depending on outlook.
Fund of Funds Fund allocates its-cash-to several other-hedge-funds-to be managed.

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Mutual Funds
▪ Mutual funds are essentially open-end funds classified by investment policy:
1. Money Market Funds
▪ Invest in money market securities (e.g., T-bills, Commercial Paper, CD) with average maturity
slightly more than 1 month
▪ Further classified as prime vs. government

2. Equity Funds
▪ Invest primarily in stocks (sometimes also fixed-income and others)
▪ Holds some money-market instrument to maintain liquidity for redemption
▪ Can be classified as income funds or growth funds
▪ Essentially stocks with higher dividend vs. higher capital gain potential

3. Sector Funds
▪ Focusing on a particular industry (e.g., biotech, utilities, energy, telecom)

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Mutual Funds
▪ Mutual funds are essentially open-end funds classified by investment policy:
4. Bond Funds
▪ Specialize in fixed-income sector
▪ Specialization include different maturities and credit risk, corporate vs. government, MBS etc.

5. International Funds
▪ International focus with securities in different part of the world (e.g., emerging market funds)

6. Balanced Funds
▪ Designed as an “appropriate” investment portfolio for individuals
▪ Good mix of equities and fixed-income
▪ Life-cycle funds target different age groups vs. target-date funds decrease risks gradually

7. Asset Allocation and Flexible Funds


▪ Flexible strategies to adjust timing and exposure to different asset classes or sectors

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Mutual Funds
▪ Mutual funds are essentially open-end funds classified by investment policy:
8. Index Funds
▪ Passively managed
▪ Tries to match the performance
of a broad market index (e.g., SP500)
▪ Why will you invest in an index fund?
▪ A low-cost way to achieve
diversification and market exposure

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Mutual Funds
▪ Mutual funds are essentially open-end funds classified by investment policy:
▪ From CIFC:

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Mutual Funds – Fee Structures
▪ What are the costs of a mutual fund?
1. Operating Expenses
▪ Including administrative expenses, advisory fees paid to manager typically
expressed as a % of total assets under management (AUM)
▪ E.g., typically, 0.25% to 1.5%, avg in 2020 is 1.16% for US equity funds

2. Front-End Load
▪ A commission or sales charge when first purchase and paid to the broker
▪ Typically, will not < 6% and might decrease when the investment is larger
▪ E.g., a $1000 payment = $940 invested in the fund if 6% load

▪ There exist no-load funds

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Mutual Funds – Fee Structures
▪ What are the costs of a mutual fund?
3. Back-End Load
▪ Redemption/exit fee when sell the shares
▪ Also known as contingent deferred sales loads
▪ Typically decreases (e.g. , 1% annually) as your fund remains with the fund

4. Others
▪ 12b-1 Charges (distribution costs approved by SEC)
▪ Trailer/trailing fees in Canada (similar to 12b-1)

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Mutual Funds – Fee Structures
▪ Example: BNY Mellon High Yield Fund in 2021
▪ Class I shares are sold only to institutional investors and carry lower fees.

▪ Which will you invest? A or C?


▪ Hard to tell. It typically depends on your investment horizon!
▪ Longer term may prefer lower back-end load and 12b-1 fees.

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Mutual Funds – Returns
▪ Fees can have significant impact on ending value of your investment. Suppose you
have $10,000 invested in:
1. Fund A: operating expense of 0.25%, no load, no 12-b1 charges
2. Fund B: management expenses of 0.75%, no load, 0.5% in 12-b1 charges
3. Fund C: management expenses of 0.80%, front-load 6%, no 12-b1 charges

▪ Can you tell which is active which is passive?


▪ A looks like a passive fund and B & C active

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Mutual Funds – Returns
▪ How do we calculate the return of mutual funds per se?

▪ Example: A fund has an initial NAV of $20 at the start of the month, makes
income distributions of $0.15 and capital gain distributions of $0.05, and ends the
month with NAV of $20.10. What is the monthly rate of return?

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Mutual Funds – Historical Performance
▪ How did the mutual fund industry perform in the past?
▪ We need to have a proper benchmark because different funds have different risks!
▪ E.g., mutual funds tracking SP500 should use SP500 as a benchmark
▪ Suppose we use Wilshire 5000 index as the benchmark for equity fund managers: Who wins?

The average annual return


for index is 12.49% which
is 0.96% higher than an
average equity fund!

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Exchange-Traded Funds (ETF)
▪ ETFs before 2008 are only allowed to track index passively and SEC approved
active management only after then
▪ Many ETFs are known as “smart beta” funds with strategic exposure to different risk factors such
as industry, asset classes, value, growth, dividend yield, or volatility

▪ Advantages and disadvantages of ETF vs. mutual funds?


▪ Intra-day continuous trading vs. buy/sell once a day at NAV
▪ More tax burden for mutual fund due to selling of actual securities for redemption
▪ ETF has typically lower marketing and management fees
▪ ETFs’ price can deviate from NAV when markets are stressed

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Exchange-Traded Funds (ETF)
▪ In 2021:

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Resources – ETF and Mutual Funds
▪ www.morningstar.com
▪ finance.yahoo.com/funds
▪ https://www.wsj.com/market-data/mutualfunds-etfs
▪ www.ici.org

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Measuring Returns
▪ Suppose we have a zero-coupon bond that pays $100 at maturity (t = T), how to
express the return, r(T), in terms of its initial price, P(T)?

▪ More generally, with income:

▪ Note that income will be expressed as FV if it is interim (i.e., including reinvestment).

▪ r(T) is the return over the entire holding period

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APR vs. EAR
▪ Suppose there are 3 ZCB with par $100 and prices as follow:
▪ What is the holding period return?

▪ Note:
▪ EAR is the actual return gained per year

▪ APR is the simple sum of periodic rates or a “quoted” rate

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APR vs. EAR
▪ Recall from FIN610: or

▪ Suppose APR is 5.8%, with is the corresponding EAR?

▪ Will the EAR becomes infinitely large when compounding period n → ∞ ?

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Continuously Compounding
▪ What if it is continuously compound (i.e., when n → ∞)?

▪ So, a 5.8% APR(rcc) corresponds to EAR = e(0.058) – 1 = 5.9715%

▪ How do you find the rcc (APR) from EAR?

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Continuously Compounding
▪ Suppose A bank offers two alternative interest schedules for savings account of
$100,000 locked in for 3 years, which will you choose:
▪ A) a monthly rate of 1%
▪ B) an annually, continuously compounded rate of 12%

▪ Both have APR = 12%. We need to compare their EAR!

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Interest Rate and Inflation
▪ Can you recall some of the factors that will impact level of interest rates?
1) The supply of funds from savers (primarily households)
2) The demand for funds from businesses to finance investments
3) The government's net demand for funds (i.e., fiscal/monetary policy)
4) Above participants’ expected rate of inflation (e.g., Fisher’s effect)
▪ Recall from FIN 610 - Fisher equation:

▪ A common approximation is:

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Interest Rate and Inflation
▪ The Fisher equation predicts that rnominal should track iexpected

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Expected Return & Standard Deviation
▪ Why is equity investment considered risky?
▪ Uncertainty in future cash flows and therefore uncertainty in HPR
▪ How to calculate the HPR for stocks?

▪ Example: Suppose you bought a share at the beginning of the year for $100. The end-
of-year price per share is $110 and cash dividends over the year amount to $4. What is
the HPR?

▪ Note that:
▪ Dividend yield = $4/$100 = 4%
▪ Capital gain = $110/$100 = 10%

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Expected Return & Standard Deviation
▪ However, we don’t know for sure what is the ending price of stocks
▪ We might need to find expected return based on scenario analysis

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Expected Return & Standard Deviation
▪ What about expected variance?
▪ Recall from FIN 610 again:

▪ From the previous example:

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Reward vs. Risk
▪ How would you evaluate the performance of mutual funds?
▪ Looking at returns or risks? Or both?

▪ One of the most common measures is the Sharpe ratio:

▪ Interpretation of Sharpe ratio:


▪ What is the excess return (above risk-free rate) that is earned by exposing to 1 unit of standard
deviation risk.
▪ Note that return is now standardized by per unit risk and hence can be compared across funds of
varying risks level!

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Normal Distribution
▪ What do the monthly returns of a broad market index like SP500 look like?

▪ Looks like a bell curve


shape!

▪ Most return outcomes


concentrated in the middle
and less frequently on both
tails

▪ Do you think the returns


resemble a normal
distribution?

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Normal Distribution
▪ Recall normal distribution from FIN 610 or your statistics class:

▪ If returns follow normal distribution, what does it mean to have an expected return of 10% and
standard deviation of 20%?

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Normal Distribution - Excel
▪ Suppose the monthly rate of return on the S&P 500 is approximately normally
distributed with a mean of 1% and standard deviation of 6%.
▪ What is the probability that its return in any month will be negative?
1. We can use NORM.DIST (cutoff, mean, standard deviation, cumulative) function in Excel:
▪ =NORM.DIST(0, 1, 6, TRUE) = 0.4338 = 43.38%

-11% -5% 1% 6% 11%

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Normal Distribution - Excel
▪ Suppose the monthly rate of return on the S&P 500 is approximately normally
distributed with a mean of 1% and standard deviation of 6%.
▪ What is the probability that its return in any month will be negative?
2. We can also use NORM.S.DIST(z,cumulative) function in Excel:
▪ z = how many standard deviation is the cutoff (0% ret) below mean = - 1%/6% = - 1/6 SD
▪ =NORM.S.DIST(-1/6, TRUE) = 43.38%

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Normality of Returns
▪ In reality, assumption of returns being normal can be dangerous.
▪ There could be potential deviations:
1. Skewness (measure of asymmetry)

▪ Positively (right) skewed:


▪ fatter right tail
▪ More frequent extreme good
outcome

▪ Negatively (left) skewed:


▪ fatter left tail
▪ More frequent extreme bad
outcome

▪ What is the skewness of stock


returns?
▪ Negatively skewed!

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Normality of Returns
▪ In reality, assumption of returns being normal can be dangerous.
▪ There could be potential deviations:
2. Excess Kurtosis (measure of fat tails)

▪ A standard normal distribution has a


kurtosis of 3
1) Kurtosis < 0
▪ Leptokurtic with “thinner”
tails
2) Kurtosis > 0
▪ Platykurtic with “fatter”
tails

▪ What is the kurtosis of stock returns?


▪ Platykurtic – more extreme
events than implied by a normal
distribution!

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Tail Risks
▪ One common way to measure tail (downside) risk is Value at Risk (VaR)
▪ Practitioners often assume returns to be normally distributed
▪ A 1% VaR means the loss on the 1st percentile of the return distribution

▪ Suppose the expected return is 10% and SD is 15% => 1% VaR = 10% - 2.33(15%) = -24.75%
▪ There is 99% chance that the loss in the next period will not be worse than -24.75%

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Tail Risks
▪ An alternative measure is known as conditional VaR or expected shortfall
▪ The average of all losses which are greater or equal than VaR
▪ Intuitively, what is the average loss if the return does happen to be worse than VaR

▪ What is a weakness of Sharpe ratio?


▪ It does not differentiate between “good” standard deviation from “bad”
▪ Sortino ratio only considers the “bad” standard deviation (i.e., lower partial standard
deviation)
𝑅𝑖𝑠𝑘 𝑃𝑟𝑒𝑚𝑖𝑢𝑚
▪ Sortino Ratio =
𝐷𝑜𝑤𝑛𝑠𝑖𝑑𝑒 𝐷𝑒𝑣𝑖𝑎𝑡𝑖𝑜𝑛

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Historical Returns
▪ Investors often analyze historical returns. How do we find expected return based
on historical data?

▪ Note that there is no probability involved as we treat each historical observation as an


equally likely scenario

▪ How do we find the variance/standard deviation based on historical data?

▪ Excel: VAR.P( ) or STDEV.P( ) ▪ Adjusted for degrees of freedom considering


estimation error from sample

▪ Excel: VAR.S( ) or STDEV.S( )

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Historical Returns
▪ Recall from FIN610:

▪ Suppose a particular investment had annual returns of 10%, 12%, 3% and -9% over the
past 4 years. What is the geometric average return and the arithmetic average
return?

▪ Answer:

▪ Geometric average return = (1.1 x 1.12 x 1.03 x 0.91)1/4 – 1 = 3.66%

▪ Arithmetic average return = (0.1 + 0.12 + 0.03 – 0.09)/4 = 4%

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Historical Returns
▪ Recall from FIN610:
▪ Suppose investing $1 in a large-company stock portfolio from 1926 to 2020 (95 years)
will end up with a portfolio value of $10,944.66

▪ What is the geometric mean return?


▪ Geometric return = [(1+R1) x (1+R2) x ... (1+RT)]1/T – 1
= $10,944.66 1/95 – 1
= 10.3%

▪ What is the approximate arithmetic mean return when the σ is 19.7%?


▪ Arithmetic return ≈ Geometric return + 0.5(Variance)
≈ 0.103+ 0.5 (0.197)2
≈ 12.24%

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Historical Returns

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Historical Returns

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Historical Returns

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Historical Returns

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Historical Returns

▪ Which country will you invest in?

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Historical Returns

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▪ End of Lecture 2
▪ Readings: Chapters 4 & 5
▪ E-mail: chu@niagara.edu

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