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Artificial Intelligence(AI) for Investments

Lesson 1: Goals of a firm


Introduction
In this lesson we will cover the following topics:

• Different forms of corporations

• Goals of a firm and the role of management

• Introduction to Firm value and Opportunity Cost of Capital

• Investment and Financing Decisions

• Agency Problems and Corporate Governance

• Summary and Concluding remarks


Organization of a Corporation

• Organization as a legal entity

• Proprietorship and Partnerships

• Private and Public (listed) Companies

• Unlimited vs Limited liability of stockholders


Introduction to Firm value and Opportunity
Cost of Capital
• Maximization of firm value – appropriate target?

• What about maximization of profit or cash flows

• Short-term myopic objectives vs. long term value creation

• Role of financial markets

• Opportunity cost of capital


Investment and Financing decisions

• Two key decisions affect firm value: Investment decisions and Financial decisions

• Investment decisions: investing in real assets, plant and machinery, R&D, etc.

• Risk-return profile of the investment and opportunity cost of capital

• Financing decisions: Issue of debt and equity securities to raise finances

• Availability of liquid and efficient markets


Investment and Financing decisions
Agency Problems and Corporate Governance
• Managers are the agents of the shareholders as principals

• Are their interest aligned with each other?

• Will managers always act in the best interest of owners: Not always

• Classical principal and agent problem: how to mitigate?

• Goods systems of corporate governance ensure that the interest and objectives of managers are well

aligned to those of owners

• These include: Institution of board of governors, compensation management, market discipline.


Summary and Concluding remarks

• Two important financial decisions: investment decision and financing decision

• Value maximization as the ultimate objective of managers

• Trade-off faced by financial managers and opportunity cost of capital

• Separation of ownership and control

• Principal agent problem

• Good systems of corporate governance


Thanks!
Artificial Intelligence (AI) for Investments
Lesson 2: Cash Flow Discounting
Introduction
In this lesson we will cover the following topics:

• Time value of money and cash flow discounting

• Discount rates and opportunity cost of capital

• Present value of annuities and perpetuities

• Valuation of growing annuities and perpetuities

• Impact of compounding frequency on present value computation

• Summary and concluding remarks


Time value of money

• Receive $100 today or one year later

• What would be that additional amount for which you would agree to delay your consumption of

this $100 by a year

• This is called time-value of money

• A dollar worth today is more than the dollar worth tomorrow: but how much more
Time value of money
• An investment of $100 into fixed deposit at 7% interest will grow to become $107 in one year and

$114.49 in two years

• In second year, you earn interest on principal as well as on the interest earned in second year:

power of compounding

• Similarly $100, invested for 20 years at 10% will grow to become 100 ∗ 1.1020 = $672.75
Time value of money
Assume an interest rate of r and
a period of t. The future value of
$100 invested today, will be:
100 ∗ 1 + 𝑟 𝑡

20 years, $100 invested at 10%


interest. It will grow to become
100 ∗ 1.1020 = $672.75

At 5% the money will grow to


become 100 ∗ 1.0520 = $265.33
Time value of money
• $100 invested for two years at 7% will grow to a future value of 100 ∗ 1.072 = $114.49

• So, if appropriate interest is 7%, then the present value of $114.49 to be received two years from

now is $100 today!

114.49
• This can be simply computed as follows: Present Value (PV)= =$100
1.072

𝐶𝑡
• Therefore the formula of present value can also be written simply as follows: 𝑃𝑉 = .
1+𝑟 𝑡
Time value of money
A payment worth $100
to be received in 20 years at
an interest rate of 5% has a PV
100
of 1.0520 = $37.69

If the interest rate increases to


100
10%, the PV falls to 1.1020 =
$14.86. A decline of more than
50%.
Time value of money
• A simple project: purchase of office space a cost of $370000

• Your advisor tells you that it is a sure thing with $42000 expected by the end of the year

• What is the appropriate opportunity cost: prevailing risk-free rate of r=5%

420000
• The present value of this investment can be computed as 𝑃𝑉 = = $400000
1.05

• Net-present value of this investment (NPV)=PV-investment=400000-370000=$30000


Time value of money
• This NPV formula can be easily represented as 𝑁𝑃𝑉 =

𝐶1
𝐶0 +
1+𝑟

• Accept the project if NPV>0 and reject the project if

NPV is less than 0

• It is useful to perform the analysis through time-lines,

as shown in the diagram here


Time value of money
• Let us now introduce risk

• In our previous office space example, now consider that you are not so certain about the revenues

• You consider it to be a risky venture and a 12% interest rate to be an appropriate opportunity cost

420000
• The new NPV computation: 𝑁𝑃𝑉 = 𝑃𝑉 − 370000 = − 370000 = 5000
1.12

• NPV of the project has come down as it has become riskier for you

• The present value of the office space has two aspects (1) The timelines of the cash flows; and (2) The risk of the

cash flow
Time value of money
• There is another decision rule for evaluating such projects: Rate of return rule

𝐏𝐫𝐨𝐟𝐢𝐭 𝟒𝟐𝟎𝟎𝟎𝟎−𝟑𝟕𝟎𝟎𝟎𝟎
• 𝐑𝐞𝐭𝐮𝐫𝐧 = 𝐈𝐧𝐯𝐞𝐬𝐭𝐦𝐞𝐧𝐭 = = 𝟏𝟑. 𝟓%
𝟑𝟕𝟎𝟎𝟎𝟎

• Opportunity cost of capital> Project return then accept the project and vice-versa

• So now we have two rules for making investment decisions:

• Net-present value rule (NPV) rule: Accept the investments that have positive NPVs

• Rate of return rule: Accept the investments that have rate of returns higher than their opportunity cost of

capital.
Computing NPVs with multiple cash flows

• Present values can be simply added up

• Suppose that a cash flow stream spread over ‘t’ years is provided as follows, 𝐶𝑖 , 𝑓𝑜𝑟 𝑖 = 1 𝑡𝑜 𝑇. Also assume

a discount rate ‘r’

𝐶 𝐶2 𝐶T 𝐶𝑡
• 1
𝑃𝑉 = 1+𝑟 + + ⋯+ = σ𝑇𝑡=1
1+𝑟 2 1+𝑟 𝑇 1+𝑟 𝑡

𝐶𝑡
• 𝑁𝑃𝑉 = 𝐶0 + 𝑃𝑉 = 𝐶0 + σ𝑇𝑡=1 1+𝑟 𝑡
Computing NPVs with multiple cash flows

• You are planning to rent out your recently purchased

office premises for $20000 a year for two years

(acquired at a cost of $370000)

• Also at the end of second year you plan to sell the

premise and receive an expected cash flow of

$400000 at the end of the year

• The appropriate discount rate is 12%. The timelines

for these cash flows are shown in the Figure here


Computing NPVs with multiple cash flows

• You expect to earn $20000 in the first year and

$420000 at the end of the second year. The present

value of these cash flows can be computed as per

the following scheme.

20000 420000
• 𝑃𝑉 = + = 17900 + 334800 = 352700
1.12 1.122

• The NPV of this investment is = 352700 − 370000 =

− 17300.
Valuing perpetuities and annuities
• A perpetuity is a security that pays periodic cash flows over infinite time intervals

• Consider a perpetuity with annual cash flows amounting to ‘C’ and an appropriate discounting rate of r

𝐶
• The present value of this perpetuity is provided here: 𝑃𝑉 = 𝑟

• Consider a simple example as follows. You are a billionaire and would like to fund the education at your alma-

mater with $1 Mn each year in perpetuity, starting with next year. If the interest rate is 10%, you would need to

1
provide the following amount: 0.1 = $10𝑀𝑛

• In case you want this perpetuity to start right now immediately. Then you would need to shell-out an additional

$1Mn, i.e., $11 Mn total.


Valuing perpetuities and annuities
• Annuity has a finite life of a specified number of

years

• The annuity computation formula can be derived

with the help of perpetuity formula as shown in the

diagram here

• Similarly, we can value an annuity that pays C amount at the end of year for each of the t years, starting from the

𝐶 1
year end. This will be : 𝑟 [1 − ]
1+𝑟 𝑡
Valuing perpetuities and annuities
• Consider an example of an annuity that pays $5000

a year, paid at the end of year, for each of the next

five years

• If the appropriate discount rate is 7%, what is the

present value of this annuity.

5000 1
• 𝑃𝑉 = 1 − 1.075 = $20501
0.07
Valuing perpetuities and annuities
• Often these cash flows do not remain constant and exhibit a certain growth rate.

𝐶
• If a perpetuity is growing at a rate of ‘g’ the simple formula for this perpetuity becomes: ; where r>g
𝑟−𝑔

• A $1Mn perpetuity, starting from the year end, that grows at an interest of 4%. If the appropriate discount rate is 10%,

1
the present value of this perpetuity will be = $16.67 𝑀𝑛
0.10−0.04

𝐶 1+𝑔 𝑡
• The simple formula for annuities (C) growing at a rate ‘g’ for ‘t’ years is provided below: 𝑃𝑉 = 𝑟−𝑔
[1 − 1+𝑟 𝑡
]

• Consider a 3-year $5000 annuity with 10% discount rate and a growth rate of 6%

5000 1.063
• Then its PV would be 𝑃𝑉 = 1− = $13146
0.10−0.06 1.103
A short lesson on compounding
• Sometimes cash flows are not received annually but at higher frequencies, e.g., quarterly, weekly, monthly

• If you get an interest of 10% per annum on $100. You will get an interest amount of $10

• However, if a 5% interest is paid at 6-monthly intervals you get an overall amount of 1.05*105= $110.25 by the

end of this year

• Therefore, 10% interest compounded semi-annually results in an effective interest of 1.052 − 1 = 10.25%

𝑟 𝑚
• The compounding frequency increases to m periods, the resulting formula becomes: 1 + 𝑚

• if m-> ∞, then the resulting formula becomes 𝑒 𝑟 , where is e=2.718


Summary and Concluding remarks
• Cash flows are discounted for two simple reasons

• (1) Dollar is worth more today than a dollar tomorrow

• (2) A safe dollar is worth more than a risky dollar

• Managers can maximize the firm-value by accepting projects with positive net present values (NPVs)

1 𝐶 𝐶2
• 𝑁𝑃𝑉 = 𝐶0 + 1+𝑟 + …..
1+𝑟 2

• 𝐶0 here is the initial investment, which is expected to be negative, that is outflow of cash. Discount rate ‘r’ is

obtained by examining the prevailing interest rates in financial markets, on the instruments with the same risk
Thanks!
Artificial Intelligence (AI) for Investments
Lesson 3: Making investment decisions
Introduction
In this lesson we will cover the following topics:

• Review of NPV basics

• Alternatives to NPV rule – Payback period method

• Alternatives to NPV rule – Internal rate of return (IRR) method

• Pitfalls of IRR

• Capital investments with limited resources

• Summary and concluding remarks


Review of NPV basics
• Consider yourself in a position of a CFO where you are analyzing $1 million investment in a new

venture called project P

• That the current market value of your firm is $10 million, which includes $1 million cash that you plan

to invest min project P

• You find the NPV of this project by discounting the cash flows, adding them up to compute there PV,

and subtracting the initial investment of $1 million

• It is easy to understand if PV>9 this project has a positive NPV


Review of NPV basics
Review of NPV basics
• NPV rule recognizes that a dollar today is worth more than a dollar tomorrow

• Any decision rule that is affected by managers’ tastes, choice of accounting method, profitability of

existing business, or that of other projects will lead to an inefficient decision

• NPV(A+B) =NPV(A)+NPV(B)

• Book incomes are not necessarily the same as cash flows

• Profitability measures such as book rate of returns, heavily depend on the classification of various

items as capital investment and their rate of depreciation


Alternatives to NPV rule – Payback period
method
• A project’s payback period is simply found by estimating the years it takes for the project cash flows to

meet the initial investment

• A washing machine is costing $800. You spend $300 a year on washing your clothes. As a thumb

rule, if this machine is purchased, it will recover its expenses in 3 years

• The payback rule states that a project should be accepted if its payback period is less than some cut-

off period

• Consider a simple example here


Project C0 C1 C2 C3 Payback Period (years) NPV at 10%
A -2,000 500 500 5,000 3 +2,624
B -2,000 500 1,800 0 2 -58
C -2,000 1,800 500 0 2 +50
Alternatives to NPV rule – Discounted Payback
period method
• An improved version of payback period is to employ discounted cash flows

• This discounted payback rule examines that how many years it takes for the discounted cash flows to

recover the initial investment, i.e., become NPV positive

• Let us examine our previous example, with the help of discounted cash flows

Discounted Payback
Project C0 C1 C2 C3 Period NPV at 10%
(years)
500 500 5,000
A -2,000 = 455 = 413 = 3757 3 +2,624
1.1 1.12 1.13
500 1,800
B -2,000 = 455 = 1488 - - -58
1.1 1.12

1,800 500
C -2,000 = 1636 = 413 - 2 +50
1.1 1.12
Alternatives to NPV rule – Internal rate of return
(IRR) method
• IRR rule comes from the simple return measure

Profit Payoff Payoff


• Project return = Investment = Investment − 1; or −Investment + 1+Project Return = 0

• IRR is the return or discount rate at which NPV=0

C
1 C2 CT
• NPV = C0 + (1+IRR) + 1+IRR 2
+ ⋯+ 1+IRR T
=0

𝑪𝟎 𝑪𝟏 𝑪𝟐
-4000 +2000 +4000
2000 4000
• 𝑁𝑃𝑉 = −4000 + 1+𝐼𝑅𝑅 + = 0 ; solving for this, we get IRR= 28.08%
1+𝐼𝑅𝑅 2
Alternatives to NPV rule – Internal rate of return
(IRR) method
• If the opportunity cost of capital is less than the 28.08%

IRR, then the project has a positive NPV

• If opportunity cost of capital is greater than the IRR, the

project has a negative NPV

• Please note that IRR is a profitability measure and

depends solely on the timing of the project cash flows

• The opportunity cost of capital is the standard of

profitability to judge the worth (or NPV) of the project


Pitfalls of IRR
• Pitfall 1: Problem of Lending vs borrowing

• Consider the project cash flows from projects A and B as shown here

Projects 𝐂𝟎 𝐂𝟏 IRR NPV at 10%


A -1000 +1500 50% +364
B 1000 -1500 50% -364

• Both of these projects will give you the same IRR

• In project A, we are paying out $1000 initally, and getting $1500 later - Case of lending

• While in case of B, we are initially getting $1000 and paying back $1500 later- Case of borrowing

• When you lend money, you want a higher return and when you borrow money money you want a
lower return
Pitfalls of IRR
• Pitfall 2: Multiple rates of return

• Consider another project that involves an initial investment of $3 Billion and then produce a cash flow $1

Billion per year, for next nine years

• At the end of the project, the company will incur $6.5 billion of cleanup costs

𝑪𝟎 𝑪𝟏 𝑪𝟐 𝑪𝟑 𝑪𝟒

-3 1 1 1 1

𝑪𝟓 𝑪𝟔 𝑪𝟕 𝑪𝟖 𝑪𝟗

1 1 1 1 1
Pitfalls of IRR
• Pitfall 3: Mutually exclusive projects

• Firms often have to choose from mutually exclusive projects, since it may not be feasible to take all of

them

• In the project cash flows shown here, it seems IRR and NPV are contradicting each other

Projects 𝐂𝟎 𝐂𝟏 IRR (%) NPV at 10%


D -10000 +20000 100 8182
E 20000 +35000 75 11818

• In such cases, IRR can still be salvaged by examining incremental cash flows as shown here

Projects 𝑪𝟎 𝑪𝟏 IRR (%) NPV at 10%


E-D -10000 +15000 50 3636
IRR in Conclusion
• Many things can go wrong with IRR, but it is still a very useful benchmark

• To see its utility, have a look at the project cash flows, NPV, and IRR estimates for two projects X and Y

as shown here ($, thousands)

Projects 𝐂𝟎 𝐂𝟏 𝐂𝟐 𝐂𝟑 NPV at 8% IRR (%)


X -9.0 2.9 4.0 5.4 1.4 15.58
Y -9000 2560 3540 4530 1.4 8.01

• Both of these projects offer the same positive NPV of $1400

• As rational individuals you would select X over Y (Why?)

• The higher IRR associated with X (15.58%) reflects the low risk and efforts involved as compared with Y
Capital investments with limited resources
• Capital is a scarce resource, thus it is not possible to select all the positive NPV

projects

• Thus, firms would like to select those projects that offer highest NPV per dollar of

investment

NPV
• Profitability index (PI) =
Initial Investment
Cash Flows ($ Mn)
Project C0 C1 C2 NPV at 10% PI
A -10 +30 +5 21 2.1
B -5 +5 +20 16 3.2
C -5 +5 +15 12 2.4
Capital investments with limited resources
• Let us add another project D, which needs $40 Mn investment in second year

Project C0 C1 C2 NPV at 10% PI


A -10 +30 +5 21 2.1
B -5 +5 +20 16 3.2
C -5 +5 +15 12 2.4
D 0 -40 +60 13 0.4

• The firm can only raise $10 Mn in the second year: additional constraint of capital rationing

• The simple way of ranking projects as per PI may not work here

• This particular problem is rather simple, as A and D combined offer a higher NPV than B and C
combined

• However, more complex problems are solved with linear programming (LP) techniques
Summary and concluding remarks
• In addition to NPV, other rules are also employed to examine alternate investments

• These include book rate of return, payback period, and IRR method

• Book rate of return is simply computed as book income divided by book value of investment

• Payback method examines the project cash flows against a certain specific cut-off period

• Only those projects with payback period is less than cut-off period, are considered

• Lastly, IRR is the discount rate at which the firm NPV is zero

• As per the IRR rule, firms should accept those projects that have an IRR greater than opportunity cost of

capital
Thanks!
Artificial Intelligence (AI) for Investments
Lesson 4: Valuation of fixed income securities
Introduction
In this lesson we will cover the following topics:

• Introduction to fixed income securities (FIS)

• Valuation of FIS through DCF methods

• Theories of term structure of interest rates

• Concept of yield to maturity

• Duration of an FIS and interest rate risk

• Summary and concluding remarks


Simple valuation of fixed income securities (FIS)
• If you own a fixed income security like a bond you are entitled to fixed set of payoffs called interest or coupons; and at maturity you get the

face value or the principal

• Consider a simple bond that pays 8.5% interest. If you have invested $100, you will get $8.50 annually, if the coupons are annual, and at

maturity you will also get the principal amount, i.e., total $108.5. Also assume a 3% discount rate

• The PV of this bond can be easily computed as provided here

8.50 8.50 8.50 108.50


• 𝑃𝑉 = + + + = $120.44 ; or in the manner provided below
1.03 1.032 1.033 1.034

• PV (Bond)=PV (annuity of bond coupon payments)+PV(Principal payment)

8.5 1 100
• PV (Bond)= ∗ 1− + = 31.59 + 88.85 = $120.44
0.03 1.034 1.034
Simple valuation of fixed income securities (FIS)
• Another very important concept for FIS is yield-to-maturity (YTM)

• In the previous example, if the bond under discussion, has a present value of $120.44 then what

is the current interest rate or yield of this bond to the buyer

• This YTM can be easily computed as with expression shown here

8.50 8.50 8.50 108.50


• 120.44 = + + +
1+𝑦𝑡𝑚 1+𝑦𝑡𝑚 2 1+𝑦𝑡𝑚 3 1+𝑦𝑡𝑚 4

• In this case, the answer is ytm=3%, since we assumed the discount rate of 3% at the beginning
Simple valuation of fixed income securities (FIS)
• Consider the example of a simple bond with the following cash-flow profile

T=6m T=12m T=18m T=24m T=30m T=36m


24.375 24.375 24.375 24.375 24.375 1024.375
• If the bond is currently trading at $1107.95, then the current ytm of the bond can be simply computed
from this equation provided here

• Coupons amounting to $24.375 are paid semi-annually and at the end of the period, a principal
payment of $1000 is paid at the end of 3-years

24.375 24.375 24.375 24.375 24.375 1024.375


• 𝑃𝑉 = 𝑦𝑡𝑚 + 𝑦𝑡𝑚 2 + 𝑦𝑡𝑚 3 + 𝑦𝑡𝑚 4 + 𝑦𝑡𝑚 5 + 𝑦𝑡𝑚 6
; here ytm/2=0.6003%; ytm=1.2006%
1+ 1+ 1+ 1+ 1+ 1+
2 2 2 2 2 2

• The effective annual yield (EAF) would be (1.6003)^2-1=1.2042%


Bond prices and interest rates
• Bond prices change with interest rates

• In the previous example, where the semi-annual yield was 0.6003%, assume investors start

demanding a semi-annual yield of 4%, that is annual percentage quoted rate of 8%

• The price of this bond will fall to reflect this change in yield, as per the computation shown here

24.375 24.375 24.375 24.375 24.375 1024.375


• 𝑃𝑉 = 1.04
+ 1.04 2
+ 1.04 3
+ 1.04 4
+ 1.04 5
+ 1.04 6
= $918.09
Bond prices and interest rates
Duration of a bond
• We saw that changes in interest rates have greater impact on the prices of long-term bonds that short-

term bonds

• Separate Trading of Registered Interest and Principal Securities (STRIPS) are special instruments,

created by stripping the cash flows from treasury instruments and government securities

• These are often called as zero-coupon bonds, and have the maturity same as duration
Duration of a bond
• Consider three bonds, one strip and two coupon paying bonds with cash flow profile as provided here
Price (%) Cash payments %
Bond Feb. 2015 Aug. 2015 Feb. 2016. . . . . . Aug. 2016 Feb. 2021
Strip for Feb. 2015 88.74 0 0... ...0 100.00
Feb. 2015 (4% p.a.) 111.26 2.00 2.00 . . . . . . 2.00 102.00
Feb. 2015 (11.25% p.a.) 152.05 5.625 5.625 . . . . . . 5.625 105.625

• All of these bonds have a ytm of 2%

• The two coupon paying bonds offer a considerable proportion of their cash flows earlier than maturity.

Thus it is very easy to observe that the strip has the longest duration

• Bond with 11.25% coupon (i.e., 5.625% semi-annual coupon) offers a larger proportion of cash flows

earlier than maturity, as compared to the bond with lower coupon of 4% (i.e., 2% semi-annual coupon)
Duration of a bond
• However, we need a more concrete measure of duration

• The duration measure also indicates the sensitivity of a fixed income security to interest rate changes

• The simple measure of duration is computed as a weighted average of times, with weights being the

present value of cash flows received at these times

• Consider a bond with a maturity of T years. The corresponding cash flows in each of these years

being 𝐶1 , 𝐶2 … . 𝐶𝑇 being received at the end of year 1, 2, 3,…,T

𝑃𝑉 𝐶1 𝑃𝑉 𝐶2 𝑃𝑉 𝐶3 𝑃𝑉 𝐶𝑇
• 𝐷𝑢𝑟𝑎𝑡𝑖𝑜𝑛 = 1 ∗ 𝑃𝑉
+2∗ 𝑃𝑉
+3∗ 𝑃𝑉
+ ⋯+ 𝑇 ∗ 𝑃𝑉
Duration of a bond
• Let us understand this through one example

• Consider a fixed income security with coupons of $8.5 paid at the end of each year and a final

principal payment in the final year, that is fourth year

• Also assume the appropriate interest rate of 3%


Year (t) 1 2 3 4
Cash payment (C t) 8.5 8.5 8.5 108.5 PV
PV(Ct) at 3% 8.25 8.01 7.78 96.4 120.44
Fraction of total value [PV(Ct)/PV] 0.069 0.067 0.065 0.8 Total=Duration
Year x Fraction of total value [t x PV(Ct)/PV] 0.069 0.134 0.195 3.2 3.6 years

𝐷𝑢𝑟𝑎𝑡𝑖𝑜𝑛
• 𝑀𝑜𝑑𝑖𝑓𝑖𝑒𝑑 𝐷𝑢𝑟𝑎𝑡𝑖𝑜𝑛 =
1+𝑦𝑖𝑒𝑙𝑑
Duration of a bond
• This modified duration measures the percentage change in price a one percentage change in yield (or
interest rates)

• For our bond of duration 3.6 years. This measure works out to 3.6/1.03= 3.49%

• Now consider a scenario where interest rates rise by 0.5% and fall by the same amount

Year (t) 1 2 3 4 PV Change (%)


Cash payment (C t) 8.5 8.5 8.5 108.5
PV(Ct) at 3% 8.25 8.01 7.78 96.4 120.44
PV(Ct) at 3.5% 8.21 7.93 7.67 94.55 118.37 -1.72%
PV(Ct) at 2.5% 8.29 8.09 7.89 98.30 122.57 1.77%

• The total magnitude of change works out to 1.72%+1.77%= 3.49%

• This is the same amount as our modified duration measure


Term structure of interest rates
• Interest rates vary over different tenors, and short-term interest rates are different from long-term

interest rates

• This variation in interest rates over short-term and long-term and across periods, is often referred to

as term structure of interest rates


Term structure of interest rates
• Consider a term structure of interest rates 𝑟1 , 𝑟2 , 𝑟3 , … 𝑟𝑡 for time periods 1, 2, 3,…,t

1
• A simple cash-inflow of $1 in the first year will have a value of 𝑃𝑉 = 1+𝑟 . Here 𝑟1 , would be called the one-
1

year spot rate

1
• Similarly, a loan that pays $1 at the end of two years, will have a present value of 𝑃𝑉 = 1+𝑟2 2

• For simple illustration purposes assume that 𝑟1 = 3% and 𝑟2 = 4%. A security that offers only these two cash
1 1
flows will have a present value of 𝑃𝑉 = 1.03 + = 1.895
1.04 2

1 1
• P𝑉 = + = 1.895
1+𝑦𝑡𝑚 1+𝑦𝑡𝑚 2

• Solving for this equation, we get ytm= 3.67%


Term structure of interest rates
• In a well-functioning liquid and efficient markets, all safe (that is risk-free cash flows) must be discounted at
the same risk-free spot: Law of one price
1 2 3 4 Bond Price (PV) Ytm
Spot rates 3.50% 4% 4.20% 4.40%
Discount factor 0.97 0.92 0.88 0.84

A 8% coupon-2year 80 1080
PV 77.29 998.52 - - 1,075.82 3.98%

B 11%-coupon-3year 110 110 1110


PV 106.28 101.70 981.11 - 1,189.10 4.16%

C 6% coupon-4year 60 60 60 1060
PV 57.97 55.47 53.03 892.29 1,058.76 4.37%

D STRIP 1000
841.78 841.78 4.40%
Term structure of interest rates
• A 10-year strip with face-value of $1000 at then end of maturity is selling at $714.18

1
• 𝐹0 = = 0.71418; solving for this, 𝑟10 = 3.42%
1+𝑟10 10

• Expectations theory of term structure: Term-structure of interest rates reflect the expectation of interest
rates in future

• Assume that the spot rate for year 1, 𝑟1 is 5% and spot rate for year 2, 𝑟2 is 7%

• If you invest $100 for one year, you get $5 for interest. If you invest it for two years, you get 100 ∗ 1.072 , that
is, $114.49 after two years

1.072
• The extra return that you earn in second year can be computed as noted here. -1=9.0%
1.05

• This means that if you invest for two years, you will get 5% in year 1 and 9% in year 2
Term structure of interest rates
• If you expect that bond prices in the year 2 will yield more, then you would prefer to invest at 1-year spot and

then invest in second year at prevailing rate

• In equilibrium, long term spot rates are a combination of short-term spot and a series of forward rates

• Forward rates are future rates booked (contracted) today. For example, rate of interest for period T=1 to T=2

booked at T=0; or interest rate for T=2 to T=4 booked at T=0

• Liquidity preference theory suggests that investors prefer to invest in short-term as they fear the additional

volatility, risk, and uncertainty associated with the long-term instruments


Summary and concluding remarks
• Fixed income securities like bonds are simply long-term loans

• These instruments include regular interest (or coupon) payments and at the maturity you get back the face-

value (or principal)

• These instruments can be easily valued through discounting cash flow valuation method

• Also, it is appropriate to discount each of these cash flows with its on spot rate corresponding to the duration

of the cash flows

• The spot rate is observed on the term structure of interest rates. The term structure of interest rates is

computed using the STRIPs


Summary and concluding remarks
• Once the present value of a bond is computed, using bond cash flows, one can also calculate the ytm of the

bond

• Duration reflects the average time associated with cash-flows of a fixed income security

• The expectations theory of interest rates suggests that rising interest rates reflect the future expectations of

investors

• The theory of liquidity preference suggests that investors prefer to hold short-term instruments as compared

to long-term instruments
Thanks!
Artificial Intelligence (AI) for Investments
Lesson 5: Valuation of common stocks
Introduction
In this lesson we will cover the following topics:

• Introduction to common stocks and trading operations

• Fundamental principles of stock valuation

• Single-period and multi-period DCF approaches to stock valuation

• Valuation of common stock for growth and income stocks

• Dividend discount model and cost of equity

• Summary and concluding remarks


Trading of securities on exchanges
• Market microstructure and trading operations

• Primary and secondary markets

• Trading in modern financial markets: electronic communication networks and limit order books

• Role of designated market makers in quote driven markets


Market value of common stocks
Fundamental valuation of stocks-I
• The comparable valuation method provides estimates of value that are more aligned to the current

market expectations

• Fundamental valuation methods provide estimates, independent of market valuation, and depend on

the assumptions

• What are these factors that affect stock prices?

• PV of Stock = PV of expected future dividend income

𝐷𝐼𝑉1 +𝑃1 −𝑃0


• Expected Returns= 𝑟 =
𝑃0
Fundamental valuation of stocks-I
• Consider a company ABC with the current price 𝑃0 = $100; dividend 𝐷𝐼𝑉1 = $5, and an expected price
of $110 at the end of the year. Then the expected returns by shareholders would be computed as
shown here

𝐷𝐼𝑉1 +𝑃1 −𝑃0 5+110−100


• 𝑟= = = 15%
𝑃0 100

• Assume that 15% is the interest that you (or other investors) are expected from this stock and those
stocks having similar risk

𝐷𝐼𝑉1 +𝑃1 5+110


• 𝑃0 = 1+𝑟
= 1.15
= $100

𝐷𝐼𝑉1 +𝑃1
• 𝑃0 =
1+𝑟
Fundamental valuation of stocks-II
• Let us examine the price of stock next year 𝑃1 . Similar to 𝑃0 , we can also write this price 𝑃1 in terms of dividend 𝐷𝐼𝑉1 and
the discount rate r

𝐷𝐼𝑉2 +𝑃2
• 𝑃1 =
1+𝑟

• Subsequently, we can also write the current price (𝑃0 ) in terms of dividends for next two years, 𝐷𝐼𝑉1 and 𝐷𝐼𝑉2

𝐷𝐼𝑉1 𝐷𝐼𝑉2 𝑃2
• 𝑃0 = + +
1+𝑟 1+𝑟 2 1+𝑟 2

• Let us further consider the previous example of the company ABC. The investors are expecting a dividend of $5.50 in

year 2 a price of $121 at the end of year 2

5.00 5.50 121


• 𝑃0 = + + = 100
1.15 1.152 1.152

𝐃𝐈𝐕𝟏 𝐃𝐈𝐕𝟐 𝐃𝐈𝐕𝟑 𝐃𝐈𝐕𝐇 +𝐏𝐇 𝐃𝐈𝐕𝐭 𝐏𝐇


• 𝐏𝟎 = + + + ⋯+ = σ𝐇
𝐭=𝟏 +
𝟏+𝐫 𝟏+𝐫 𝟐 𝟏+𝐫 𝟑 𝟏+𝐫 𝐇 𝟏+𝐫 𝐭 𝟏+𝐫 𝐇
Fundamental valuation of stocks-II
• For company ABC, let us consider a 100-period horizon with 10% growth in

dividends and prices year-on-year

Expected Future Values Present Values


1.HorizonPeriod 2.Dividend 4.Cumulative
3.Price (Pt) 5.Future Price 6.Total
(H) (DIVt) Dividends
0 — 100 — — 100
1 5.00 110 4.35 95.65 100
2 5.50 121 8.51 91.49 100
3 6.05 133.10 12.48 87.52 100
4 6.66 146.41 16.29 83.71 100
10 11.79 259.37 35.89 64.11 100
20 30.58 672.75 58.89 41.11 100
50 533.59 11,739.09 89.17 10.83 100
100 62,639.15 1,378,061.23 98.83 1.17 100
Fundamental valuation of stocks-II

𝑫𝑰𝑽𝒕
𝑷𝟎 = σ∞
𝒕=𝟏 𝟏+𝒓 𝒕
Dividend discount model and cost of equity
capital
• Assume a constant long-term growth rate of ‘g’ in dividends and an appropriate
discount rate ‘r’

• Assuming a dividend of 𝐷𝐼𝑉1 in the first year, this perpetuity can be valued using the
𝐷𝐼𝑉1
formula shown here: 𝑃0 =
𝑟−𝑔

• If the current price (𝑃0 ) is observed, this formula can be used to estimate ‘r’ as

𝐷𝐼𝑉1
shown here: 𝑟 = +𝑔
𝑃0
Dividend discount model and cost of equity
capital
• Firm XYZ has a share price of $42.45 at the start of the period, expected dividends starting from the year
end amount to $1.68 per share, payout ratio is 60%

𝐷𝐼𝑉1 1.68
• he dividend yield for this stock can be simply computed as Dividend yield= = 42.45 = 4.0%
𝑃0

DIV
• Plowback raio = 1 − payout ratio = 1 − = 1 − .60 = 0.40
EPS

𝐷𝐼𝑉1
• Then your overall estimate of cost of equity capital: r= + 𝑔 = 4.0% + 4.0%=8.0%
𝑃0

• Such estimates are often noisy and prone to errors of estimation

• Constant growth dividend discount formula employed earlier is extremely sensitive to changes in the values
of ‘g’ and ‘r’
Dividend discount model and cost of equity
capital
• Consider the example of a firm with equity of $25, 𝐷𝐼𝑉1 = $0.5 and 𝑃0 = $50.0. The firm has an ROE of 25%

and payout ratio of 20%

• Let us first compute the cost of equity for this firm

• (1) Dividend growth rate= (1-Payout ratio)*ROE= (1-0.20)*0.25= 20%

0.5
• 𝑟 = 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑦𝑖𝑒𝑙𝑑 + 𝑔 = + 20% = 1% + 20% = 21%
50

• No firm can sustain a growth rate of 21% infinitely into future. In real life such growth rates drop gradually

over the years and attain that lower long-term growth that is sustainable
Dividend discount model and cost of equity
capital
• To simplify things here, assume that the firm ROE drops to 16% in the third year. Also that the payout ratio

increases to 50%

• So now we have new growth figure, i.e., g= 0.50*16%= 8%.

Years 1 2 3 4

Equity 10.00 10*1.20=12.00 12*1.20=14.40 14.40*1.08=15.55


Return on equity, ROE 0.25 0.25 0.16 0.16
Earnings per share, EPS 10*0.25=2.50 12*0.25=3.00 14.40*0.16=2.30 15.55*0.16=2.49
Payout ratio 0.20 0.20 0.50 0.50
Next year growth=
- (1-0.2)*0.25=0.20 (1-0.5)*0.16=0.08 (1-0.5)*0.16=0.08
(1-Payout)*ROE
Dividends per share, DIV 2.5*0.2=0.50 3*0.20=0.60 2.30*0.5=1.15 2.49*0.5=1.245
Dividend discount model and cost of equity
capital
• In order to compute the current price (𝑃0 ), one needs to use the DCF formula in two stages

• In the high-growth phase, we need to value the three dividend inflows in year 1, 2, and 3.

𝐷𝐼𝑉1 𝐷𝐼𝑉2 𝐷𝐼𝑉3


• Present value of dividends obtained in years 1, 2, and 3: + +
1+𝑟 1+𝑟 2 1+𝑟 3

𝑃3 𝐷𝐼𝑉
4 1
• Steady state growth phase with cash flows in perpetuity: = (𝑟−𝑔) ∗
1+𝑟 3 1+𝑟 3

0.50 0.60 1.15 1.245 1


• 50 = + + + (𝑟−0.08) ∗ ; current price is $50
1+𝑟 1+𝑟 2 1+𝑟 3 1+𝑟 3

• Solving for above equation, we get a value of r=9.94%


Stock price, growth, and earnings per share
• Investors often contrast growth with income stocks

• Growth stocks offer capital gains; Contrast this to income stocks that offer regular income in the form of

cash dividends

• Consider the example of a company that doesn’t grow and pay most of the earnings as dividends ($10), it is

currently valued at $100

𝐷𝐼𝑉1 10
• Expected returns = dividend yield = = = 10.0%
𝑃0 100

𝐷𝐼𝑉1
• Also, if one discounts the dividends of this company, till perpetuity (𝑃0 = 𝑟
), one should be able to obtain

the current price that is $100


Stock price, growth, and earnings per share
• Let us consider the case of a growth firm

• The firm invests most of its earnings internally, investment of $10 at the end of year t=1

• The company also expects that this investment opportunity has a return of 10%, same as market

capitalization rate

𝐷𝐼𝑉1 1
• NPV of this project= −𝐶0 + = −10 + 0.10 = 0
𝑟

• Investors were expecting a return of 10% on their investment in the firm

• Even if the firm distributed these cash flows to investors, they would’ve obtained the same 10% returns by

investing in financial market instruments


Stock price, growth, and earnings per share
• Let us consider four examples of different returns from this project

Project Increment Share


Project contribution to firm P0/EPS1
Rate of al Cash Project NPV in year 1 Price at r
value at T=0
Return Flows T=0, P0
0.05 .50 -10+0.5/0.10=- 5.00 -4.55 95.45 9.545 0.10
0.10 1.00 -10+1.0/0.10=0 0 100.00 10.000 0.10
0.15 1.50 -10+1.5/0.10= 5.00 + 4.55 104.55 10.455 0.10
0.20 2.00 -10+2.0/0.10= 10.00 + 9.09 109.09 10.909 0.10
• Please observe that in those cases where NPV is negative, the price to earnings ratio is less than 10 and
more than 10 where NPV is positive

• The value of price can be distributed in two components. First component, the capitalized value of earnings
under no-growth policy; Second component, is the present value of growth opportunities (PVGO)

𝐸𝑃𝑆1 𝐸𝑃𝑆1 𝑃𝑉𝐺𝑂


• 𝑃0 = + 𝑃𝑉𝐺𝑂 or = 𝑟(1 − )
𝑟 𝑃0 𝑃0
Stock price, growth, and earnings per share
• Consider a company COM with market capitalization rate of 15% and ROE=25%. COM has earnings of

$8.33 and a payout ratio of 0.6. The company is expected to pay a divided of $5 in the next year, and

thereafter, the dividend is expected to increase indefinitely by 10% a year

𝐷𝐼𝑉1 5
• 𝑃0 = = 15%−10% = $100
𝑟−𝑔

• The company is plowing back 40% of earnings with an ROE of 25%. Growth rate of the firm ‘g’=

0.40*25%=10%

𝐸𝑃𝑆 8.33
• Assume a no-growth policy: P ′ = = 0.15 = $55.56
𝑟

• Thus, PVGO=𝑃0 − P ′ = 100−55.56=44.44


Stock price, growth, and earnings per share
• Let us try and break-down this figure of $44.44

• The company plows back 40% of earnings. In the first year, this amount is 8.33-5=$3.33. This amount is
invested at a return of 25%, that is 3.33*25%=$0.83 earnings starting from year 2

0.83
• The present value of this investment at T=1 can be computed as shown here: −3.33 + 0.15 = $2.22

• Also, it is known to us that firm earnings are growing at 10%. Therefore, we can expect this $2.22 additional
earnings to also grow at the same rate of 10%. That means, in the second year, we will have additional
earnings of 2.22*1.10= $2.44 and 2.44*1.10=$2.69 in the third year and so on

• At 10% capitalization rate, let us compute the present value of all these incremental cash flows, starting
from year 1 at $2.22

𝟐.𝟐𝟐 𝐄𝐏𝐒𝟏
• 𝐏𝐕𝐆𝐎 = 𝟎.𝟏𝟓−𝟎.𝟏𝟎 = $𝟒𝟒. 𝟒𝟒 or 𝐏𝟎 = + 𝐏𝐕𝐆𝐎 = 𝟓𝟓. 𝟓𝟔 + 𝟒𝟒. 𝟒𝟒 = 𝟏𝟎𝟎
𝐫
A simple example of business valuation
• Let us start with some basic information and assumptions about this business

• The business has an appropriate discount rate of 10%. The business grows at a rapid pace of 20% per
annum for five years, the falls to 13% for years 6-7, and finally settles down at a 6% steady state growth
rate thereafter. Returns on asset (RoA) amount to a constant 12%. The plowback ratio is derived from the
expected growth of the business, using the formula g= RoA (or RoE)* Plowback ratio. Starting with a size of
$10Mn in the first year, the cash flows are provided here

Years 1 2 3 4 5 6 7 8 9 10
Growth (%) 20% 20% 20.0% 20.0% 20.0% 13% 13% 6% 6% 6%
Asset value ($Mn) 10.00 12.00 14.40 17.28 20.74 23.43 26.48 28.07 29.75 31.54
RoA* 12.0% 12.0% 12.0% 12.0% 12.0% 12.0% 12.0% 12.0% 12.0% 12.0%
Earnings ($Mn) 1.20 1.44 1.73 2.07 2.49 2.81 3.18 3.37 3.57 3.78
Plowback 167% 167% 167% 167% 108% 108% 50% 50% 50% 50%
Net investment ($Mn) 2.00 2.40 2.88 3.46 2.70 3.05 1.59 1.68 1.79 1.89
Free cash flows ($Mn) -0.80 -0.96 -1.15 -1.38 -0.21 -0.23 1.59 1.68 1.79 1.89
A simple example of business valuation
• There are two components to this value

𝟎.𝟖𝟎 𝟎.𝟗𝟔 𝟏.𝟏𝟓 𝟏.𝟑𝟖 𝟎.𝟐𝟏 𝟎.𝟐𝟑


• Pre-steady state growth period value: 𝐏𝐕 𝐜𝐚𝐬𝐡 𝐟𝐥𝐨𝐰𝐬 = − 𝟏.𝟏𝟎 − 𝟏.𝟏𝟎 𝟐

𝟏.𝟏𝟎 𝟑

𝟏.𝟏𝟎 𝟒

𝟏.𝟏𝟎 𝟓

𝟏.𝟏 𝟔
=-3.59

1.59 1
• Steady state growth period value or horizon value: 𝑃𝑉 𝐻𝑜𝑟𝑖𝑧𝑜𝑛 𝑣𝑎𝑙𝑢𝑒 = ∗ =22.42
(0.10−0.06) 1.1 6

• Total value= -3.59+22.42=$18.83 Mn.

• If you observe in financial markets that the average PE ratio for a mature business with similar profile is 11

1
• 𝑃𝑉 𝐻𝑜𝑟𝑖𝑧𝑜𝑛 𝑣𝑎𝑙𝑢𝑒 = 11 ∗ 3.18 ∗ =19.75
1.1 6

• If you observe that average market to book asset values for the similar mature companies is 1.4

1
• 𝑃𝑉 𝐻𝑜𝑟𝑖𝑧𝑜𝑛 𝑣𝑎𝑙𝑢𝑒 = 1.4 ∗ 26.48 ∗ =20.93
1.1 6
Summary and concluding remarks
• The value of stock is equal to the discounted dividend payments expected to be received in perpetuity

𝐷𝐼𝑉𝑡
• 𝑃𝑉 = σ∞
𝑡=1 1+𝑟 𝑡

• However, investors often do not plan to hold the stock for eternity and have finite investment horizons

• These investment horizons involve returns in the form of dividends and capital gains

𝐷𝐼𝑉1
• The value of the stocks with infinite stream of growing dividends: 𝑃0 = 𝑟−𝑔

𝐸𝑃𝑆1
• Price in terms of capitalized value of earnings and PVGO and 𝑃0 = + 𝑃𝑉𝐺𝑂
𝑟
Thanks!
INDIAN INSTITUTE OF TECHNOLOGY KANPUR

Artificial Intelligence (AI) for Investments


INDIAN INSTITUTE OF TECHNOLOGY KANPUR

Lesson 6 : Introduction to Risk and


Return
Introduction
In this lesson, we will cover the following topics:
• Basics of risk-return framework
• Measures of risk
• Diversification of risk
• Computing portfolio risk
• Impact of individual securities on portfolio risk
• Summary and concluding remarks
Basics of Risk-Return Framework
• Consider three instruments: T-Bills, government bonds, and common
stock.
• T-Bills are short maturity instrument with almost no risk of default.
• Bond is a rather long-term instrument and fluctuates with the interest
rates.
• Common stocks are infinite maturity instruments.
Basics of Risk-Return Framework
T-Bill Returns=4% Bond Returns =5.5% Common Stock Returns =11.1%
Basics of Risk-Return Framework
• Notice the difference between the returns on T-Bills and common stocks is
11.1 - 4 = 7.1 percent.
• This additional return can also be called the risk-premium received by
investors.
• If on a given year T-Bill rate was 0.2 percent, and you are asked to estimate
the expected return on common stocks. A reasonable estimate would be
obtained by adding this to 7.1 percent to obtain the total return of 7.30
percent.
• However, this assumes that there is a stable risk premium on the common
stock portfolio, that is, future risk premium can be measured by the average
past risk premium.
• But (a) Economic and financial conditions change over time; (b) Risk
perceptions change; (c) Investors' risk tolerance and return expectations also
change over time.
Basics of Risk-Return Framework
• Consider a stock with $12 dividend expected by the end of the year
• Investors are expecting a 10% return on this stock
𝐷𝐼𝑉1 12
• P𝑉 = = = $400; Dividend yield = 12/400 = 3%
𝑟−𝑔 0.10−0.07

• If dividend yield changes to 2%, and investors demand an expected return = 2% + 7% = 9%


12
• 𝑃𝑉 = = $600
0.09−0.07

• Expected returns on the stock reflect the dividend yields and the growth rate of dividends:
𝐷𝐼𝑉
𝑟 = 1+𝑔
𝑃0

• Risk-premium= 𝑟 − 𝑟𝑓 ; this risk premium can change overtime


• Often dividend yield is a good indicator of risk-premium
Measures of Risk
• A very prominent statistical measure of risk is variance (or standard deviation)
• 𝑉𝑎𝑟𝑖𝑎𝑛𝑐𝑒 𝑟𝑡 = 𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑟𝑡 − 𝑟ҧ 2

• Where 𝑟𝑡 is the actual return and 𝑟ҧ is the expected returns


• 𝑆𝑡𝑎𝑛𝑑𝑎𝑟𝑑 𝑑𝑒𝑣𝑖𝑎𝑡𝑖𝑜𝑛 𝑆𝐷 = 𝑉𝑎𝑟𝑖𝑎𝑛𝑐𝑒 (𝑟𝑡 )
• Standard deviation is often denoted by the symbol 𝜎 and variance by 𝜎 2
Measures of Risk
• Let us understand this concept with a small coin toss game
• The following probabilities are observed
➢ (a) H + H: Gain 40%; (b) H + T: Gain 10%;
➢ (c) T + H: Gain 10%; (d) T + T: Lose 20%
• Thus, there is a 25% chance that your return will be 40%, 50% chance that
your return will be 10%, and 25% chance that you will lose 20%
• Expected return : 𝑟=0.25*40%
ҧ + 0.5*10% + 0.25*(-20%) = 10%.
Measures of Risk
• Now let us compute the variance and standard deviation of these returns.
Returns (%) Mean Deviation 𝐫𝐭 − 𝐫)ҧ Mean Square Deviation Probability Probability Squared Deviation
𝐫𝐭 − 𝐫ҧ 𝟐
40 30 900 0.25 225
10 0 0 0.50 0
-20 -30 900 0.25 225
Total 450

• Variance = 225 + 225 = 450 and Standard Deviation (𝜎) = 450 = 21%
• An event is considered risky if there are many possibilities of outcomes associated
with it.
• As these possibilities increase, that is, the spread of possible outcomes increases, the
event is said to have become riskier.
• Standard deviation or variance is a summary measure of these possibilities, that is
spread in the possible outcome.
Measures of Risk
• The risk of an asset can be completely expressed, by writing all the possible outcomes
and the possible payoffs associated with each of the outcomes.
• If the outcome was certain, that is, it had no risk, then the standard deviation would
have been zero
• One of the challenges in performing such computations is the estimation of probability
associated with each outcome
• One way to go about this is to observe past variability
• For example, consider the historical volatilities of three different kinds of securities.
Portfolio Standard Deviation (𝛔) Variance (𝛔𝟐 )
Treasury Bills 2.8 7.7
Government Bonds 8.3 69.3
Common Stocks 20.2 406.4

• It appears that T-Bills are the least variable and common stocks are the most variable
Diversification of Risk
• One can compute the measure of variability for individual securities as well as a
portfolio of securities.
• The standard deviation of selected U.S. Common stocks (2004-08) such as
Amazon (50.9%), Ford (47.2%), Newmont (36.1%), Dell (30.9%), and
Starbucks (30.3%) was much less than the standard deviation of a market
portfolio, that is, 13% during this period.
• It is well known that individual stocks are more volatile than the market indices.
• The variability of market doesn’t reflect or is the same as the variability of
individual stock components.
• The simple answer to this question is that diversification reduces variability.
Diversification of Risk
Diversification of Risk
SD of Dell and Starbucks is approximately 30%

SD of portfolio = 20%
Diversification of Risk
Computing Portfolio Risk
• We now know that diversification reduces the risk of a portfolio
• Consider a portfolio comprising two stocks, A (60%) and B (40%)
• A has expected returns of 3.1%, and B has expected returns of 9.5%
• 𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑝𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜 𝑟𝑒𝑡𝑢𝑟𝑛 = 0.6 ∗ 3.1 + 0.40 ∗ 9.5 = 5.7%
• Standard deviation of A is observed as 15.8% for A and 23.7% for B
• Therefore, the standard deviation of this portfolio: 0.6*15.8% + 0.4*23.7% =
19.0%?
• This would be incorrect
Computing Portfolio Risk
𝑃𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜 𝑉𝑎𝑟𝑖𝑎𝑛𝑐𝑒 = 𝑥12 𝜎12 + 𝑥22 𝜎22 + 2(𝑥1 𝑥2 𝜌12 𝜎1 𝜎2 )
𝐶𝑜𝑣𝑎𝑟𝑖𝑎𝑛𝑐𝑒 𝜎12 = 𝜌12 𝜎1 𝜎2

Correlation coefficient (𝝆𝟏𝟐 )


= 𝜌12 𝜎1 𝜎2
Computing Portfolio Risk
• Let us fill the above box with some numbers; assume a correlation coefficient of 1
Stock A Stock B
Stock A 𝑥12 𝜎12 = 0.62 ∗ 15.82 𝑥1 𝑥2 𝜎1 𝜎2 = 0.6 ∗ 0.4 ∗ 1 ∗ 15.8 ∗ 23.7
Stock B 𝑥1 𝑥2 𝜎1 𝜎2 = 0.6 ∗ 0.4 ∗ 1 ∗ 15.8 ∗ 23.7 𝑥22 𝜎22 = 0.42 ∗ 23.72

• Portfolio variance = 0.62 ∗ 15.82 + 2 ∗ 0.6 ∗ 0.4 ∗ 1 ∗ 15.8 ∗ 23.7 + 0.42 ∗ 23.72 = 359.5
• The standard deviation is 359.5 = 19%
• Let us now assume a correlation coefficient of 𝜌12 = 0.18
• Portfolio variance= 0.62 ∗ 15.82 + 2 ∗ 0.6 ∗ 0.4 ∗ 0.18 ∗ 15.8 ∗ 23.7 + 0.42 ∗ 23.72 = 212.1
• The standard deviation is 212.1 = 14.6%
Computing Portfolio Risk
• Let us consider a very hypothetical case of extreme negative correlation
𝜌12 = −1
• Portfolio variance = 0.62 ∗ 15.82 + 2 ∗ 0.6 ∗ 0.4 ∗ (−1) ∗ 15.8 ∗ 23.7 + 0.42 ∗
23.72 = 0!
• However, perfect negative correlations do not exist in real markets.
Computing Portfolio Risk
• Variances in diagonal boxes (𝑥 2 𝜎 2 )
• Covariance terms in off-diagonal
(𝑥𝑖 𝑥𝑗 𝜎𝑖𝑗 )
• Let us consider a case of N securities
and equal investment in all the
1
securities ( )
𝑁
• Portfolio variance can be computed in
the form of two components. That is,
variance component and covariance
component
Computing Portfolio Risk
• There will be N variance terms; then portfolio variance can be simply written
1
as 𝑁 ∗ 2 ∗ (𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑣𝑎𝑟𝑖𝑎𝑛𝑐𝑒)
𝑁
1
• Remember 𝑤1 ∗ 𝑤2 ∗ 𝜎 2 . 𝐻𝑒𝑟𝑒
𝑤1 = 𝑤2 = ; 𝑎𝑛𝑑
𝜎 = 𝑎𝑣𝑒𝑟𝑎𝑔𝑒 𝑣𝑎𝑟𝑖𝑎𝑛𝑐𝑒 =
𝑁
𝜎𝐴𝑣𝑔
• Also, 𝑁 2 − 𝑁 covariance terms where average covariance term =𝜎𝐶𝑜𝑣−𝐴𝑣𝑔
1
• The sum of covariance terms is 𝑁2 −𝑁 ∗ ∗ 𝜎𝐶𝑜𝑣−𝐴𝑣𝑔
𝑁2
1 1
• 𝑃𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜 𝑉𝑎𝑟𝑖𝑎𝑛𝑐𝑒 = 𝑁 ∗ ∗ 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑉𝑎𝑟𝑖𝑛𝑎𝑐𝑒 + 𝑁 2 − 𝑁 ∗ ∗
𝑁2 𝑁2
(𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐶𝑜𝑣𝑎𝑟𝑖𝑎𝑛𝑐𝑒)
• As the number of securities, N, in the portfolio increase, the specific-risk term,
1
𝑁 ∗ 2 ∗ 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑉𝑎𝑟𝑖𝑛𝑎𝑐𝑒 , approaches to a value of zero
𝑁
Computing Portfolio Risk
• Thus, the overall portfolio variance approaches the average covariance term
• This is also often referred to as portfolio diversification
• Thus, if these securities have very low correlation, then one can obtain a
portfolio with very low risk
• That is, just by increasing the number of securities in a portfolio, one can
eliminate the idiosyncratic (specific or diversifiable risk)
• The remaining risk is often called market risk or non-diversifiable risk
• That is why, this market risk (or average covariance or non-diversifiable risk) is
what constitutes the bedrock of risk, that is risk that is there after eliminating
all the specific risk
Impact of Individual Securities on Portfolio Risk
• Investors usually add many securities in their portfolio to diversify the stock-
specific idiosyncratic risk
• It is not the risk of a security held individually but in a portfolio that is important
• To measure the impact of a security to the risk of portfolio, one needs to
measure the market risk component of the security
• The market risk of a security is measured through its beta
• Stocks with beta of more than 1.0 tend to amplify the movements of market
• Stocks with beta between 0 to 1.0 tend to move in the same direction as
market, but are considered less sensitive
• The market portfolio has a beta of 1.0 and reflects the average movement of all
the stocks in the market
Impact of Individual Securities on Portfolio Risk
• Consider a stock A with beta of 1.41 over a
given time-horizon
• This means that, on average, when market
rises by 1%, stock A will rise by 1.41%
• The stock would also have some stock-
specific risk

• When a stock is added to a well-diversified portfolio, the movements on


account of idiosyncratic factors are expected to cancel each other out
• Therefore, for this portfolio what matters is only these systematic market
related effects
Impact of Individual Securities on Portfolio Risk
• Stocks like Stock A with high beta will have
steep straight curve
• Stocks with small beta (e.g., beta = 0.3), the
straight-line plot will be less steep
• A stock with high beta may also have less
idiosyncratic risk and a stock with low beta may
also have high idiosyncratic risk
• For example, a stock of gold-mining firm may have low beta and a very high
idiosyncratic stock specific risk
• When added to a well-diversified portfolio, the idiosyncratic risk of this gold-firm
will not matter
Impact of Individual Securities on Portfolio Risk
• So, let us now answer this question how
security betas affect the portfolio risk
• Market risk accounts for most of the risk of a
well-diversified portfolio
• Beta of an individual security measures its
sensitivity to market movements

• Examine the figure shown here: the standard deviation (total risk) of the
portfolio depends on the number of securities in the portfolio
• As the number of securities increase in the portfolio, more diversification is
achieved
Impact of Individual Securities on Portfolio Risk
• With addition of more and more securities, the
specific risk declines until all the stock specific
risk is eliminated and only market risk remains
• Market risk depends on the average beta of
the securities, that is, the portfolio beta
• If one selects a fairly large number of securities
from a market, you diversify all the
idiosyncratic risk
• Thus, you get the market portfolio with beta = 1.0
• If the market portfolio has a standard deviation of 20%, then this portfolio is
expected to have a standard deviation of close to 20%
Impact of Individual Securities on Portfolio Risk
Impact of Individual Securities on Portfolio Risk
• Beta of a stock ‘i' can be computed using the following formula. 𝛽𝑖 = 𝜎𝑖𝑚 /𝜎𝑚
2.

Here 𝜎𝑖𝑚 is the covariance between the stock returns and market returns. 𝜎𝑚 2

is the variance of the returns on the market.


1 2 3 4 5 6 7
Market Return Deviation in Market Squared Market Deviation in Deviation Product
Month Stock A
(%) Returns Deviation Stock A Returns (3*6)
1 -8 -10 100 -11 -13 130
2 4 2 4 8 6 12
3 12 10 100 19 17 170
4 -6 -8 64 -13 -15 120
5 2 0 0 3 1 0
6 8 6 36 6 4 24
Avg.= 2 Sum=304 Avg.= 2 Sum=456
304
Variance= σ2𝑚 = = 50.67
6
456
Co-variance=σ𝑖𝑚 = = 76
6
σ𝑖𝑚 76
Beta= 𝛽𝑖 = = = 1.5
σ2𝑚 50.67
Impact of Individual Securities on Portfolio Risk
• Can we say that a diversified firm is more attractive to investors than an
undiversified firm
• If diversification is a good objective for a firm to pursue then each new project’s
contribution to the firm’s diversification should also add value to the firm.
• This seems to be not consistent with what we have studied about present values
• Investors can diversify for themselves more easily than firms.
• If investors can diversify on their own, they would not be paying anything extra to
a firm for this diversification.
• The present value of any number of assets is equal to the present value of their
parts. That is, PV (ABC) = PV(A) + PV(B) + PV(C): Value Additivity
Summary and Concluding Remarks
• Returns to investor vary depending upon the risk borne by them.
• Very safe instruments such as treasury securities provide the lowest returns.
• Equity securities are considered more riskier asset class and offer higher
expected returns.
• Accordingly, the discount rates applied to a safe project versus risky project
will also differ.
• Risk of a security means that there are many possible return outcomes for
that security…
• The total risk of a stock has two components: stock-specific risk and
systematic (or market) risk.
Summary and Concluding Remarks
• Investors eliminate a sizable portion of their specific (or diversifiable) risk,
simply by adding more securities to their portfolio.
• A well diversified portfolio is only exposed to market risk.
• A security’s contribution to a well diversified portfolio measured as the
sensitivity of the security to market movements, that is, beta (β).
• A stock with high beta is more sensitive to market movements and vice-versa.
• Investors can diversify on their personal account; they do not want firms to
pursue the diversification objective.
Thanks!
Artificial Intelligence (AI) for Investments
INDIAN INSTITUTE OF TECHNOLOGY KANPUR

Lesson 7: Portfolio Theory and Asset


Pricing Model
Introduction
In this lesson we will cover the following topics:
• Investment performance and return distribution
• Combining stocks with portfolios
• Introduction to CAPM
• Validity of CAPM
• Alternative theories of asset pricing
• Summary and concluding remarks
INDIAN INSTITUTE OF TECHNOLOGY KANPUR

Investment Performance and Return


Distribution
Investment Performance and Return Distribution

Brealey, Myers and Allen; Principles of Corporate Finance. 10th, 11th, or 12th editions. Chapter 8
Investment Performance and Return Distribution

• Compare investments A and B. These


investments offer an expected returns of 10%.
But A has much wider spread of possible
outcomes (SD of A is 15% and that of B is
7.5%).
• Compare investments B and C. Both of them
have the same standard deviation. However,
the expected returns from B (10%) and C
(20%) are different.

Brealey, Myers and Allen; Principles of Corporate Finance. 10th, 11th, or 12th editions. Chapter 8
INDIAN INSTITUTE OF TECHNOLOGY KANPUR

Combining Stocks with Portfolios:


Part 1
Combining Stocks with Portfolios
• Consider a scenario where you are examining stocks A and B as potential
investments.
• Stock A offers 3.1% expected returns and Stock B offers 9.5% expected
returns.
• Stock A has a standard deviation of 15.8% and stock B has a standard
deviation of 23.7%.
• You can invest in a combination of these stocks.
• If you invest 60% in stock A and 40% in stock B then the expected return
from this portfolio, is 0.60*3.1% + 0.40*9.5% = 5.66%.
• The same can not be said about the risk of the portfolio.
Combining Stocks with Portfolios
• The risk of a portfolio, that is standard deviation (SD), is less than
the simple weighted average of individual stock SDs.
• Variance = x12 σ12 + x22 σ22 + 2 ∗ x1 x2 σ1 σ2 = 0.602 ∗ 15.82 + 0.42 ∗
23.72 + 2 ∗ 0.60 ∗ 0.40 ∗ 0.18 ∗ 15.8 ∗ 23.7 = 212.1;
Standard Deviation = Sqrt 212.1 = 14.6%
• The lower amount of SD reflects the diversification aspect,
assuming a correlation of 0.18.
Combining Stocks with Portfolios
• The blue curve line shows all the possible
expected risk and return combinations of
these two stocks that one can achieve.
• A risk averse investor would hold A:B (50:50
or 60:40)
• A less risk-averse investor would invest most
of their wealth in B.

• The brown line connecting A and B represents all portfolio combinations with
correlation 𝜌 = 1.0
• With 𝜌 = −1.0 (red line), the stocks would move in exact opposite manner.
Brealey, Myers and Allen; Principles of Corporate Finance. 10th, 11th, or 12th editions. Chapter 8
Combining Stocks with Portfolios
• In practice, you invest in many
socks, by examining their historical
risk-return related properties.
• For example, consider a portfolio of
ten securities plotted here using risk-
return data.
• The shaded green region shows the
possible combinations of expected
return and standard deviation by
investing in a mixture of these
stocks.
Brealey, Myers and Allen; Principles of Corporate Finance. 10th, 11th, or 12th editions. Chapter 8
Combining Stocks with Portfolios
• Where would you want to be in that
shaded region?
• You would want to go up, that is,
increase the expected returns. You
would also want to go left, that is, to
reduce risk.
• As you move up and left, you end up at
the solid dark brown line.
• The portfolio on this solid dark outer surface is often referred to as an efficient
portfolio.

Brealey, Myers and Allen; Principles of Corporate Finance. 10th, 11th, or 12th editions. Chapter 8
Combining Stocks with Portfolios
• For a given level of risk, these
portfolios offer the highest return.
And for a given level of return, these
portfolios offer the lowest amount of
risk.
• Three such portfolios (A, B, and C)
are shown in the figure here.

• You want to deploy the investor’s funds to generate maximum expected


returns for a given level of risk.
• This solution to this problem requires quadratic programming (QP).
Brealey, Myers and Allen; Principles of Corporate Finance. 10th, 11th, or 12th editions. Chapter 8
INDIAN INSTITUTE OF TECHNOLOGY KANPUR

Combining Stocks with Portfolios:


Part 2
Combining Stocks with Portfolios
• Now we introduce the possibility of
lending and borrowing at a risk-free
rate of interest (rf).
• Is this possibility a practical scenario?
• A combination of rf and any efficient
portfolio (e.g., S) can offer various risk-
return possibilities on the line rf-S.
• Investing in rf and S leads a portfolio on the line segment between rf and S.
• Borrowing at rf and investing the entire amount in S leads a position on rf-S
towards the right of S.

Brealey, Myers and Allen; Principles of Corporate Finance. 10th, 11th, or 12th editions. Chapter 8
Combining Stocks with Portfolios
• Suppose that portfolio S has an expected return of 15% and a standard deviation of
16%.
• For risk-free instrument rf = 5% and risk = 0.
• If you decide to invest 50% in S and 50% in rf, the expected return and risk as
computed here.
1 1
• 𝑟 = ∗ 𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝑆 + ∗ 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑅𝑎𝑡𝑒 𝑜𝑛 𝑅𝑖𝑠𝑘 − 𝑓𝑟𝑒𝑒 = 10%
2 2
• The formula for computation of risk: 𝑆𝐷 = 𝑥12 𝜎12 + 𝑥22 𝜎22 + 2𝑥1 𝑥2 𝜌12 𝜎1 𝜎2 [Here,
𝜎2 = 0]
1
• 𝜎 = ∗ 𝑆𝐷 𝑜𝑓 𝑆 = 0.5*15% = 8%
2
Combining Stocks with Portfolios
• Consider another scenario where you borrow at the risk-free rate
an amount equal to 100% of your initial wealth.
• You invest your initial 100% wealth along with these borrowings in
Portfolio S. That is double the amount of your initial wealth.
• Expected returns: 𝑟 = 2 ∗ 𝑒𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑟𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝑆 − ሺ1 ∗
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒ሻ = 25%
• Risk 𝜎 = 2 ∗ 𝑆𝐷 𝑜𝑓 𝑆 = 32%
Combining Stocks with Portfolios
• On the efficient region, you can always
find a portfolio S that is the best efficient
portfolio.
• How to find this portfolio?
• The steepest line (from rf) on the curve
representing efficient portfolios: tangent
line
• This tangent line has the highest ratio of risk-premium to standard deviation: Sharpe
Ratio
𝑅𝑖𝑠𝑘−𝑃𝑟𝑒𝑚𝑖𝑢𝑚 𝑟−𝑟𝑓
• 𝑆ℎ𝑎𝑟𝑝𝑒 𝑟𝑎𝑡𝑖𝑜 = =
𝑆𝑡𝑎𝑛𝑑𝑎𝑟𝑑 𝐷𝑒𝑣𝑖𝑎𝑡𝑖𝑜 𝜎

Brealey, Myers and Allen; Principles of Corporate Finance. 10th, 11th, or 12th editions. Chapter 8
Combining Stocks with Portfolios
• In a competitive market, it is
extremely difficult to find
undervalued securities.
• Professional investors often
investment in benchmark
indices (e.g., S&P 500).
• This is often referred to as the
passive strategy of investment.

Brealey, Myers and Allen; Principles of Corporate Finance. 10th, 11th, or 12th editions. Chapter 8
INDIAN INSTITUTE OF TECHNOLOGY KANPUR

Introduction to CAPM
Introduction to CAPM
• We have previously examined the returns on different instruments.
• T-Bills have a beta = 0, and the market portfolio has a beta = 1.
• Difference between market risk (rm) and risk-free rate (rf) is often
referred to as market risk premium.
• Using these benchmarks, we can determine the risk-premium for
instruments for which beta is neither 0 nor 1.
Introduction to CAPM
• In 1960s, three economists, Sharpe,
Lintner, and Treynor came-up with
this model called Capital Asset
Pricing Model (CAPM) that provides
an extremely simple and easy to use
solution for the asset pricing
problem.
• In a competitive economy, the risk-
premium is directly proportional to
beta.

Brealey, Myers and Allen; Principles of Corporate Finance. 10th, 11th, or 12th editions. Chapter 8
Introduction to CAPM
• The risk-premium on an investment with beta of 0.5 should be half of that available
on the market.
• The expected risk-premium on an investment with beta of 2 is twice the risk-premium
expected on the market.
• The resulting relationship is shown here: 𝑟 − 𝑟𝑓 = 𝛽 ∗ ሺ𝑟𝑚 − 𝑟𝑓 ሻ
• Consider two stocks with beta of 0.30 (Stock A) and 2.16 (Stock B). You also
observe that the market is offering a current risk-premium of 7% ሺ𝑟𝑚 − 𝑟𝑓 ሻ and the
current treasury bill rate is 0.2%.
• 𝑟𝐴 = 𝑟𝑓 + 𝛽 ∗ 𝑟𝑚 − 𝑟𝑓 = 0.20% + 0.30 ∗ 7% = 2.30%
• 𝑟𝐵 = 𝑟𝑓 + 𝛽 ∗ 𝑟𝑚 − 𝑟𝑓 = 0.20% + 2.16 ∗ 7% = 15.32%
Introduction to CAPM
• CAPM can also be employed to estimate discount rates for risky projects and
companies.
• To estimate discount rates, different risk factors, appropriate benchmark for risk-free
rates needs to be estimated.
• The following principles are sacrosanct:
• Investors like higher expected returns and low risk.
• If the investors can lend and borrow at risk-free rate of interest, then one portfolio
is better than all the other portfolios.
• This best efficient portfolio depends on (a) expected returns, (b) standard
deviation, and (c) correlations across securities.
• In a well-diversified portfolio, only systematic risk matters.
Introduction to CAPM
• If stocks A and B (overvalued)
do not fall on this line, then you
will not buy them.
• Given the less demand and
excess supply, the prices of A
and B will fall until the expected
returns lie on SML.
• The same logic applies to
undervalued stocks as well.
Brealey, Myers and Allen; Principles of Corporate Finance. 10th, 11th, or 12th editions. Chapter 8
Introduction to CAPM
• Investors can hold a combination of
market portfolio M and risk-free rate
rf, to obtain an expected return 𝑅ത =
𝑟𝑓 + 𝛽 𝑟𝑚 − 𝑟𝑓
• In well-functioning liquid and efficient
markets, nobody will hold a stock
that offers anything less.
• Equilibrium is obtained from the arbitrage mechanism, which drives prices
towards efficient values, that is, towards this SML.

Brealey, Myers and Allen; Principles of Corporate Finance. 10th, 11th, or 12th editions. Chapter 8
INDIAN INSTITUTE OF TECHNOLOGY KANPUR

Validity of CAPM
Validity of CAPM
• Any economic model aims to provide a simple view of actual and real-world
scenarios.
• There is a trade-off that the real thing may be far-away from the model if the
model is too simple.
• Otherwise, the complexity has to be increased to make it closer to the real
thing.
• Investors are rational, risk-averse individuals that require extra-return for
taking on additional risk.
• Investors do not worry about those risks that can be diversified.
• The power of CAPM lies in its extreme simplicity, and it also has some pitfalls.
Validity of CAPM
• Ten investors portfolio returns are
plotted.
• Investor 1 has a portfolio of mostly
small stocks and Investor 10 has a
portfolio of large-cap stocks.
• One can obtain by combining
Investor 1 (long) and investor (10) to
generate a zero-risk portfolio that
offers excess abnormal returns.

Brealey, Myers and Allen; Principles of Corporate Finance. 10th, 11th, or 12th editions. Chapter 8
Validity of CAPM
• The red line shows the cumulative
difference between small and large cam
firms.
• The green line shows the cumulative
difference between high book to value
(Value stocks) minus low book to value
stocks (Growth stocks).
• The figure does not fit well with CAPM
postulations: that is beta is the only
factor causing returns to differ across
instruments.

Brealey, Myers and Allen; Principles of Corporate Finance. 10th, 11th, or 12th editions. Chapter 8
Validity of CAPM
• Value stocks are underpriced cheap stocks. They may be
underpriced at current P/E ratios for different reasons.
• Growth stocks are not cheap stocks at current P/E levels.
• The returns on value stocks minus growth stocks, on average, are
often positive, and significant over long-term.
• This does not fit well with CAPM.
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Alternative Theories of Asset Pricing


Alternative Theories of Asset Pricing
• CAPM considers investors are rational risk-averse investors that only
consider expected return, risk, and correlation structure as relevant
factors.
• However, investors often behave in irrational manner.
• Arbitrage Pricing Theory (APT) incorporates broad macroeconomic
factors in asset pricing.
• It does not require efficient portfolios.
• 𝑅𝑒𝑡𝑢𝑟𝑛 = 𝑎 + 𝑏1 𝑟𝑓𝑎𝑐𝑡𝑜𝑟1 + 𝑏2 𝑟𝑓𝑎𝑐𝑡𝑜𝑟2 + 𝑏3 𝑟𝑓𝑎𝑐𝑡𝑜𝑟3 + ⋯ +
𝑛𝑜𝑖𝑠𝑒 𝑡𝑒𝑟𝑚
Alternative Theories of Asset Pricing
• The APT theory does not provide any information on what these
factors may be
• One set of risks, that are on account of these APT factors can not
be eliminated with diversification
• PT theory suggests that expected risk premium on a stock should
depend on the risk-premium associated with each of these factors
and the stock’s sensitivity (𝑏1 , 𝑏2 , 𝑏3 . . ሻ
• 𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑟𝑖𝑠𝑘 − 𝑝𝑟𝑒𝑚𝑖𝑢𝑚 = 𝑟 − 𝑟𝑓 = 𝑏1 𝑟𝑓𝑎𝑐𝑡𝑜𝑟1 − 𝑟𝑓 + 𝑏2 ൫𝑟𝑓𝑎𝑐𝑡𝑜𝑟2 −
𝑟𝑓 ൯ + ⋯ 𝑏𝑛 𝑟𝑓𝑎𝑐𝑡𝑜𝑟𝑛 − 𝑟𝑓
Alternative Theories of Asset Pricing
• As per APT, a well diversified portfolio that is not sensitive to any
risk factor must be priced to offer a return that is same as risk-free
rate.
• A portfolio’s expected return is directly proportional to its
sensitivity to these risk factors.
• A stock’s contribution to a portfolio depends upon its sensitivity to
the broad macroeconomic influences, often referred to as factors
in APT parlance.
• CAPM and APT give similar results if the factors considered in APT
have sensitivity to market portfolio.
Alternative Theories of Asset Pricing
• In CAPM, market portfolio plays a very important role as it is
supposed to capture all the relevant influences.
• Identifying this portfolio is difficult, however, APT does not require
identification of this market portfolio.
• APT can be tested only with a small number of risky assets.
• APT does not tell any information about these factors.
• Fama-French three-factor model is a very prominent example of
APT.
• r − rf = bmarket rmarket + bsize ሺrsize ሻ + bbtm ሺrbtm ሻ
INDIAN INSTITUTE OF TECHNOLOGY KANPUR

Summary and Concluding Remarks


Summary and Concluding Remarks
• Investors try to increase the expected returns and reduce the risk on their
portfolios.
• A portfolio that gives the highest expected return for a given standard
deviation, or the lowest standard deviation for a given expected return, is
known as an efficient portfolio.
• The best efficient portfolio (tangent) has the highest risk-premium to standard
deviation, i.e., Sharpe ratio.
• As per CAPM, the expected return and risk-premium are defined by the
following model:
R ̅ =rf+β(rm-rf )
• A stock’s marginal contribution to portfolio risk is measured by its sensitivity to
changes in the value of the portfolio.
Summary and Concluding Remarks
• The capital asset pricing theory is the best-known model of risk
and return
• However, other risk factors appear to explain the returns as well
• APT offers an alternative theory of risk and return, i.e., expected
risk premium depends on the exposure of a portfolio to various
macroeconomic systematic factors
• One example of APT is Fama-French three factor model which
considers: (a) Market, (b) Size, (c) Book-to-market (BTM).
Thanks!
INDIAN INSTITUTE OF TECHNOLOGY KANPUR

Artificial Intelligence (AI) for Investments


Lesson 8: Cost of Capital
Introduction

In this lesson we will cover the following topics:


• Introduction Company and Project Cost of Capital
• Computing Company Cost of Capital
• Estimating the components of WACC
• Analyzing Project Risk
• Certainty Equivalents
• Summary and concluding remarks
Company and Project Cost of Capital
Company and Project Cost of Capital
• Company cost of capital is defined as the expected return on a portfolio of all
the company’s existing securities
• It is the opportunity cost of capital for investment in the firm’s assets

• If the firm has no debt outstanding, then the company cost of capital is
just the expected rate of return on the firm’s stock

• The company cost of capital is not the correct discount rate if the new
projects are more or less risky than the firm’s existing business

• 𝐹𝑖𝑟𝑚 𝑉𝑎𝑙𝑢𝑒 = 𝑃𝑉 𝐴𝐵 = 𝑃𝑉 𝐴 + 𝑃𝑉 𝐵

• The two discount rates will, in general, be different


Company and Project Cost of Capital
• If the present value of an asset depended on the identity of the company that
bought it, present values would not add up
• Consider a portfolio of $1 million invested in firm A and $1 million invested
in firm B

• If the firm considers investing in a third project C, it should also value C as


if C were a mini-firm

• The opportunity cost of capital depends on the use to which that capital is
put

• A new division with different risk profile, considerable uncertainty and


customer demand that is yet to be established, should of course have
different cost of capital
Company and Project Cost of Capital
• Suppose we measure the risk of each project by its beta
• Then a firm should accept any project lying above the upward-sloping
security market line that links expected return to risk

• If the project is high-risk, the firm needs a higher prospective return than if
the project is low-risk

• That is different from the company cost of capital rule, which accepts any
project regardless of its risk as long as it offers a higher return than the
company’s cost of capital
Company and Project Cost of Capital

Brealey, Myers and Allen; Principles of Corporate Finance. 10th, 11th, or 12th editions. Chapter 9
Company and Project Cost of Capital
• The true cost of capital depends on project risk, not on the company
undertaking the project
• Why is so much time spent estimating the company cost of capital?

• First, many (maybe most) projects can be treated as average risk

• Second, the company cost of capital is a useful starting point for setting
discount rates for unusually risky or safe projects

• It is easier to add to, or subtract from, the company cost of capital


Company and Project Cost of Capital
• Businesspeople have good intuition about relative risks
• They set a companywide cost of capital as a benchmark

• Many large companies use the company cost of capital not just as a
benchmark, but also as an all-purpose discount rate for every project
proposal

• Measuring differences in risk is difficult to do objectively

• Top management may demand extra- conservative cash-flow forecasts


from extra-risky projects

• Top management may demand extra- conservative cash-flow forecasts


from extra-risky projects
Computing Company Cost of Capital
Computing Company Cost of Capital
• Company cost of capital is the expected return on a portfolio of all the
company’s existing securities
• The portfolio of company security usually includes debt as well as equity

• Thus the cost of capital is estimated as a blend of the cost of debt

• The values of debt and equity add up to overall firm value


Computing Company Cost of Capital
• The company cost of capital is not equal to the cost of debt or to the cost of
equity but is a blend of the two
• Suppose you purchased a portfolio consisting of 100% of the firm’s debt
and 100% of its equity

• The expected rate of return on your hypothetical portfolio is the company


cost of capital

• The expected rate of return is just a weighted average of the cost of debt
(𝑟𝐷 = 7.5%) and the cost of equity (𝑟𝐸 = 15%)
• The weights are the relative market values of the firm’s debt and equity,
that is, D / V = 30% and E / V = 70%
Computing Company Cost of Capital
• The company cost of capital is not equal to the cost of debt or to the cost of
equity but is a blend of the two
• The marginal corporate tax rate 𝑇𝐶 = 35%
𝐷 𝐸
• WACC or Company cost of capital= 𝑟𝐷 ∗ 1 − 𝑇𝑐 ∗ + 𝑟𝐸 ∗ =
𝑉 𝑉
7.5% ∗ 1 − 0.35 ∗ 0.30 + 15 ∗ 0.70 = 12.00%
• This blended measure of the company cost of capital is called the
weighted-average cost of capital or WACC
Estimating the components of WACC
Estimating the components of WACC
• To calculate the weighted-average cost of capital, you need an estimate of
the cost of equity
• We will use the capital asset pricing model (CAPM) to estimate the cost of
equity

• CAPM: 𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑅𝑒𝑡𝑢𝑟𝑛𝑠 = 𝑟𝑓 + 𝛽(𝑟𝑚 − 𝑟𝑓 )

• In principle we are interested in the future beta of the company’s stock

• We will estimate beta using historical security price data


Estimating the components of WACC
• In the scatter diagram shown here, each dot represents the
return on a security and return on market
• The slope of fitted line is called beta

• The R-square measure tells the proportion of total


variance that can be explained by market variance

• It appears that 29.7% of the variance was was explained


by the market

• The 95% confidence interval estimate of beta is 2.16

Brealey, Myers and Allen; Principles of Corporate Finance. 10th, 11th, or 12th editions. Chapter 9
Estimating the components of WACC
• In the scatter diagram shown here, each dot represents the
return on a security and return on market
• Standard error of the estimated beta is computed to show
the extent of possible mismeasurement

• Standard error of beta estimate is 0.436

• The 95% confidence interval estimate 2.16 plus or minus


2*0.436

• That is, you have 95% chance of being right in saying that
beta can fall in this interval

Brealey, Myers and Allen; Principles of Corporate Finance. 10th, 11th, or 12th editions. Chapter 9
Estimating the components of WACC
• How to estimate the risk-free rate of interest (𝑟𝑓 )
• Should we use short-term treasury bill rate, daily over night rate, monthly
rate, one year interest rate or long-term interest rates

• CAPM is a short-term model

• It works period by period and calls for a short-term interest rate

• Could a .2% three-month risk-free rate give the right discount rate for
cash flows 10 or 20 years in the future?
Estimating the components of WACC
• How to estimate the risk-free rate of interest (𝑟𝑓 )
• Financial managers can simply use a long-term risk-free rate in the CAPM
formula

• Or, they can compute the term premia (for investing in long-term
government bonds – T-Bills) =1.5%

• The difference in current Govt. bond yields (e.g., 3.3%) and this term
premia reflects that short-term T-Bill rates= 3.3%-1.5%=1.8%

• If the market risk-premium in 7%, beta is 1.16, then the cost of equity can
be computed as follows. 𝐶𝑜𝑠𝑡 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦 = 𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑅𝑒𝑡𝑢𝑟𝑛𝑠 = 𝑟𝑓 +
𝛽 𝑟𝑚 − 𝑟𝑓 = 1.8 + 1.16 ∗ 7.0 = 9.9%
Estimating the components of WACC
• Estimating cost of equity and WACC
• If the market risk-premium in 7%, beta is 1.16, then the cost of equity can
be computed as follows. 𝐶𝑜𝑠𝑡 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦 = 𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑅𝑒𝑡𝑢𝑟𝑛𝑠 = 𝑟𝑓 +
𝛽 𝑟𝑚 − 𝑟𝑓 = 1.8 + 1.16 ∗ 7.0 = 9.9%

• Let us calculate the WACC for a firm with cost of Debt of about 7.8%,
corporate tax-rate of 35%, and debt ratio (D/V) of 31.5%.
𝐷 𝐸
• 𝐴𝑓𝑡𝑒𝑟 𝑇𝑎𝑥 𝑊𝐴𝐶𝐶 = 1 − 𝑇𝐶 ∗ 𝑟𝐷 ∗ + 𝑟𝐸 ∗ = 1 − 0.35 ∗ 7.8 ∗ 0.315 +
𝑉 𝑉
9.9 ∗ 0.685 = 8.4%
Estimating the components of WACC
• The cost of debt is always less than the cost of equity
• The WACC formula blends the two costs: Debt and Equity

• As the debt ratio D/V increases, the cost of the remaining equity also
increases

• This offsets offsetting the apparent advantage of more cheap debt

• Debt does have a tax advantage, however, because interest is a tax-


deductible expense
Estimating the components of WACC
• The after-tax WACC depends on the average risk of the company’s assets,
but it also depends on taxes and financing
• It’s easier to think about project risk if you measure it directly

• As the debt ratio D/V increases, the cost of the remaining equity also
increases

• We calculate the asset beta as a blend of the separate betas of debt ( 𝛽𝐷 )


and equity (𝛽𝐸 )

• For example, let us consider a security with 𝛽𝐸 =1.16 and 𝛽𝐷 = 0.3. The
weights are the fractions of debt and equity financing, D/V= .315 and E/V
=.685
Estimating the components of WACC
• The after-tax WACC depends on the average risk of the company’s assets,
but it also depends on taxes and financing
• For example, let us consider a security with 𝛽𝐸 =1.16 and 𝛽𝐷 = 0.3. The
weights are the fractions of debt and equity financing, D/V= .315 and E/V
=.685
𝐷 𝐸
• Asset beta= 𝛽𝐴 = 𝛽𝐷 ∗ + 𝛽𝐸 ∗ = 0.3 ∗ 0.315 + 1.16 ∗ 0.685 = 0.89
𝑉 𝑉

• Calculating an asset beta is similar to calculating a weighted-average cost


of capital

• This asset beta is an estimate of the average risk of the firm’s business
Analyzing Project Risk
Analyzing Project Risk
• Suppose that a coal-mining corporation wants to assess the risk of investing
in commercial real estate
• The asset beta for coal mining is not helpful

• You need to know the beta of real estate

• A company that wants to set a cost of capital for one particular line of
business typically looks for pure plays in that line of business

• Pure-play companies are public firms that specialize in one activity


Analyzing Project Risk
• Schlumberger wants to set a cost of capital for its new Oil exploration
venture
• It could estimate the average asset beta or cost of capital for Oil and Gas
firms that have not diversified into multiple business lines (e.g., Reliance)

• They should not consider Reliance group as it would have multiple


companies in different groups

• ONGC would be a pure-play and suitable for estimating the cost of capital

• Many times good comparable pure plays are not available, then we go for
asset betas
Analyzing Project Risk
• What determines asset betas?
• Cyclicality: What is the strength of the relationship between the firm’s
earnings and aggregate market earnings

• We can measure this either by the earnings beta or by the cash-flow beta

• Cyclical firms—firms whose revenues and earnings are strongly


dependent on the state of the business cycle—tend to be high-beta firms

• Cyclical businesses include airlines, luxury resorts and restaurants,


construction, and steel
Analyzing Project Risk
• What determines asset betas?
• Operating Leverage: A production facility with high fixed costs, relative to
variable costs, is said to have high operating leverage

• High operating leverage means a high asset beta

• Cash flow = revenue - fixed cost - variable cost

• Fixed costs are cash outflows that occur regardless of whether the asset
is active or idle

• PV(asset)= PV(revenue)- PV(fixed cost) – PV(variable cost)


Analyzing Project Risk
• What determines asset betas?
• Operating Leverage: PV(revenue) = PV(fixed cost)+ PV(variable
cost)+PV(Asset)
𝑃𝑉 𝑓𝑖𝑥𝑒𝑑𝑐𝑜𝑠𝑡 𝑃𝑉 𝑣𝑎𝑟𝑖𝑎𝑏𝑙𝑒𝑐𝑜𝑠𝑡
• 𝛽𝑟𝑒𝑣𝑒𝑛𝑢𝑒 = 𝛽𝑓𝑖𝑥𝑒𝑑𝑐𝑜𝑠𝑡 ∗ + 𝛽𝑣𝑎𝑟𝑖𝑎𝑏𝑙𝑒𝑐𝑜𝑠𝑡 ∗ +
𝑃𝑉 𝑅𝑒𝑣𝑒𝑛𝑢𝑒 𝑃𝑉 𝑅𝑒𝑣𝑒𝑛𝑢𝑒
𝑃𝑉 𝑣𝑎𝑟𝑖𝑎𝑏𝑙𝑒
𝛽𝑎𝑠𝑠𝑒𝑡 ∗
𝑃𝑉 𝑅𝑒𝑣𝑒𝑛𝑢𝑒

𝑃𝑉 𝑟𝑒𝑣𝑒𝑛𝑢𝑒 −𝑃𝑉 𝑣𝑎𝑟𝑖𝑎𝑏𝑙𝑒𝑐𝑜𝑠𝑡


• 𝛽𝑎𝑠𝑠𝑒𝑡 = 𝛽𝑟𝑒𝑣𝑒𝑛𝑢𝑒 ∗ = 𝛽𝑟𝑒𝑣𝑒𝑛𝑢𝑒 [1 +
𝑃𝑉 𝐴𝑠𝑠𝑒𝑡
𝑃𝑉 𝑓𝑖𝑥𝑒𝑑𝑐𝑜𝑠𝑡
]
𝑃𝑉 𝐴𝑠𝑠𝑒𝑡

• Given the cyclicality of revenues (𝛽𝑟𝑒𝑣𝑒𝑛𝑢𝑒 ), the asset beta (𝛽𝑎𝑠𝑠𝑒𝑡 ) is


proportional to the ratio of the present value of fixed costs to the present
value of the project
Analyzing Project Risk
• What determines asset betas?
• Don’t Be Fooled by Diversifiable Risk

• In everyday usage, “risk” simply means “bad outcome”

• People think of the risks of a project as a list of things that can go wrong

• Risks such as a pharma-company finding side-effects of a new drug are


diversifiable risks

• Thus, these hazards should not affect the discount rates


Analyzing Project Risk
• Sometimes financial managers increase discount rates in an attempt to offset
these risks
• Consider a project Z that produces just one cash flow, forecasted at $1
million at year 1
𝐶1 100000
• 𝑃𝑉 = = = 909,100
1+𝑟 1.1

• Company discovers a small hazard, which may cause a small chance that
project will have zero cash flow

• The appropriate way to deal with this situation is to prepare unbiased cash
flow forecasts that give due weight to all possible outcomes
Analyzing Project Risk
• Managers making unbiased forecasts are correct on average
• Sometimes their forecasts will turn out high, other times low, but their errors will
average out over many projects

• The appropriate way to deal with this situation is to prepare unbiased cash flow
forecasts that give due weight to all possible outcomes

• . If you forecast a cash flow of $1 million for projects like Z, you will overestimate
the average cash flow
Possible Probability- Unbiased
Probability
Cash Flow Weighted Forecast
1.2 0.25 0.3
1 0.5 0.5 $1 million
0.8 0.25 0.2
Analyzing Project Risk
• Managers making unbiased forecasts are correct on average
• If technological uncertainty introduces a 10% chance of a zero cash flow, the
unbiased forecast could drop
Possible Probability- Unbiased
Probability
Cash Flow Weighted Forecast
1.2 0.25 0.27
1 0.45 0.45 $0.90 million
0.8 0.225 0.18
0.0 0.10 0.00

0.90
• Thus, the new present value computation would be: 𝑃𝑉 = = $0.818 million
1.1
Analyzing Project Risk
• Managers often work out a range of possible outcomes for major projects,
sometimes with explicit probabilities attached
• The manager can still consider the good and bad outcomes as well as the
most likely one

• When the bad outcomes outweigh the good, the cash-flow forecast should
be reduced until balance is regained

• Step 1, then, is to do your best to make unbiased forecasts of a project’s


cash flows

• Step 2 is to consider whether diversified investors would regard the


project as more or less risky than the average project
Certainty Equivalents
Certainty Equivalents
• Discount rates are not constant and constantly change over the project life
as the project risk changes
• You are considering construction of an office building that you plan to sell
after one year for $420,000

• That cash flow is uncertain with the same risk as the market, so β=1

• Given 𝑟𝑓 =5% and 𝑟𝑚 − 𝑟𝑓 = 7%, you compute the present value as:
420,000/1.12 = $375,000

• What is that certain payoff you are willing to accept to sell the project in
future
𝐶𝑒𝑟𝑡𝑎𝑖𝑛 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤
• 𝑃𝑉 = = 375000, Certain cash flow= $393,750
1.05
Certainty Equivalents
• Discount rates are not constant and constantly change over the project life
as the project risk changes
• Thus, a certain cash flow of $393,750 has exactly the same present value
as an expected but uncertain cash flow of $420,000

• To compensate for both the delayed payoff and the uncertainty in real
estate prices, you need a return of 420,000 - 375,000 = $45,000

• One part of this difference compensates for the time value of money

• The other part ($420,000 -393,750 = $26,250) is a markdown or haircut


to compensate for the risk attached to the forecasted cash flow of
$420,000.
Certainty Equivalents
• How to value risky project cash flows
• Method 1: Discount the risky cash flow at a risk-adjusted discount rate r
that is greater than 𝑟𝑓

• Method 2: Find the certainty-equivalent cash flow and discount at the risk-
free interest rate 𝑟𝑓

• What is the smallest certain payoff for which I would exchange the risky
cash flow, this is called certainty equivalent (CEQ)
Certainty Equivalents
• Thus, We now have two identical expressions for the PV of a cash flow
𝐶1 𝐶𝐸𝑄
• At period 1, 𝑃𝑉 = =
1+𝑟 1+𝑟𝑓
𝐶𝑡 𝐶𝐸𝑄
• For cash flows two, three, or t years away, 𝑃𝑉 = = 𝑡
1+𝑟 𝑡 1+𝑟𝑓

Brealey, Myers and Allen; Principles of Corporate Finance. 10th, 11th, or 12th editions. Chapter 9
Certainty Equivalents
• Consider two simple projects
• Project A is expected to produce a cash flow of $100 million for each of
three years. The risk-free interest rate is 6%, the market risk premium is
8%, and project A’s beta is .75

• Cost of capital for A as per CAPM: = 𝑟𝑓 + 𝛽 𝑟𝑚 − 𝑟𝑓 = 6 + 8 ∗ 0.75 =


12%
Year Cash Flow PV at 12%
1 100 89.3
2 100 79.7
71.2
3 100
Total PV 240.2
Certainty Equivalents
• Consider two simple projects
• Project B is a safe project and the cash flows can be discounted at risk-
free rate

• The discounted cash flows are shown here


Year Cash Flow PV at 6%
1 94.6 89.3
2 89.6 79.7
71.2
3 84.8
Total PV 240.2
Certainty Equivalents
• Risk-free cash flow vs. certainty equivalents
• In year 1 project A has a risky cash flow of 100. This has the same PV as
the safe cash flow of 94.6 from project B

• In year 2 project A has a risky cash flow of 100, and B has a safe cash
flow of 89.6

Forecasted Certainty- Deduction


Year
Cash Flow Equivalent for Risk

1 100 94.6 5.4


2 100 89.6 10.4
3 100 84.8 15.2
Summary and Concluding remarks
Summary and Concluding remarks
• If the project has the same risk as the average company risk, then company
cost of capital is good benchmark to discount project cash flows
• Company cost of capital is measured with after-tax weighted-average cost of
capital (after-tax WACC)
• When the project risk is considerably different from average company risk,
then asset betas are often employed t estimate the project risk
• Overtime as the project risk changes, discount rates also change
• In such scenarios, we may use certainty equivalents (CEQ) to discount at
risk-free rate to value the project
Thanks!
Artificial Intelligence (AI) for Investments
INDIAN INSTITUTE OF TECHNOLOGY KANPUR

Lesson 9: Theory of Efficient Capital


Markets
Introduction

In this lesson, we will cover the following topics:


• NPV computation for financing decision
• Differences between investment and financing decisions
• What is an efficient market
• Theory of market efficiency
• The evidence against market efficiency
• Investor psychology and behavioral finance
• Key implications of market efficiency
• Summary and concluding remarks
INDIAN INSTITUTE OF TECHNOLOGY KANPUR

NPV Computation for Financing


Decision
Net Present Value (NPV) : Computation for
Financing Decision
• It is helpful to separate investment and financing decisions
• There are certain similarities between these decisions
• The decisions to purchase a machine tool and to sell a bond each involves
the valuation of a risky asset
• In both cases, we end up computing the net present value
• As part of its policy of encouraging small businesses, the government
offers to lend your firm $100,000 for 10 years at 3%. This means that the
firm is liable for interest payments of $3,000 in each of the years, 1 through
10 years, and responsible for repaying the $100,000 in the final year
NPV Computation for Financing Decision

• Should you accept this offer?


• We can compute the NPV of the loan agreement in the usual
way
• NPV = amount borrowed − present value of interest payments
− present value of loan repayment
3000 100000
• NPV= + 100,000 − 10
σ𝑡=1 −
1+𝑟 𝑡 1+𝑟 10
• The only missing variable is r, the opportunity cost of capital
• You need that to value the liability created by the loan
NPV Computation for Financing Decision

• The government’s loan to you is a financial asset


• We can compute the NPV of the loan agreement in the usual way
• A piece of paper representing your promise to pay $3,000 per year
plus the final repayment of $100,000
• It would sell for the present value of those cash flows discounted at r
• The only missing variable is r, the opportunity cost of capital
• What interest rate would my firm need to pay to borrow money
directly from the capital markets rather than from the government?
NPV Computation for Financing Decision

• Suppose that this rate is 10%


3000 100000
• NPV = +100,000 − 10
σ𝑡=1 −
1.10 𝑡 1.10 10

• NPV = +100,000 − 56,988 = +$43,012


• NPV calculations tell you just how much that opportunity is
worth ($43,012)
• You don’t need any arithmetic to tell you that borrowing at 3%
is a good deal when the fair rate is 10%
INDIAN INSTITUTE OF TECHNOLOGY KANPUR

Differences Between Investment and


Financing Decisions
Differences Between Investment and Financing Decisions

• Investment decisions and financing decisions differ from each


other in contrasting ways
• Financing decisions do not have the same degree of finality as
investment decisions
• It’s harder to make money through smart financing strategies
• Financial markets are more competitive than product markets
• It is more difficult to find positive-NPV financing strategies than
positive-NPV investment strategies
Differences Between Investment and Financing Decisions

• Capital investment decisions do not face competitive markets


• Markets for financing are highly competitive
• Numerous smart investors supply financing
• Money flows across different financial markets in a
seamless manner
• Thus, it is expected that financing instruments would be
fairly priced
INDIAN INSTITUTE OF TECHNOLOGY KANPUR

What Is an Efficient Market


What Is an Efficient Market

• Security prices seem to follow a random walk


• A process is a random walk process if the successive changes
are independent
• Consider a simple example of a coin-toss game
• If it comes up heads, you win 3% of your investment; if it is
tails, you lose 2.5%
• The odds each week are the same, regardless of the value at
the start of the week or of the pattern of heads and tails in the
previous weeks
What Is an Efficient Market

• As per the random walk model, the price changes are


independent of one another
• One can compute correlation coefficients between price
changes at each of the successive days
• If prices persist, then one can expect to find some correlation
across price changes
• No correlation if there is purely a random walk-in price changes
What Is an Efficient Market

• Consider the following four correlation examples

• For example, the correlation between successive price changes in Microsoft was -0.019
• For Philips, this correlation was also negative at - 0.030
• However, for BP and Sony, the correlations were positive at +0.004 and +0.026
Brealey, Myers and Allen; Principles of Corporate Finance. 10th, 11th, or 12th editions. Chapter 13
What Is an Efficient Market

• The Fig. shown here provides an example of


such a predictable cycle
• An upswing in Microsoft’s stock price
started last month when the price was
$20, and it is expected to carry the price
to $40 next month
• Since Microsoft stock is a bargain at $30,
investors will rush to buy
• As soon as a cycle becomes apparent to
investors, they immediately eliminate it by
their trading
Brealey, Myers and Allen; Principles of Corporate Finance. 10th, 11th, or 12th editions. Chapter 13
INDIAN INSTITUTE OF TECHNOLOGY KANPUR

Theory of Market Efficiency


Theory of Market Efficiency

• Prices in competitive markets must follow a random walk


• If past price changes could be used to predict future price
changes, investors could make easy profits
• All the information in past prices will be reflected in today’s
stock price, not tomorrow’s
• No one earns consistently superior returns in competitive
markets
• Thus, collecting more information may not help
Theory of Market Efficiency

• Economists define three levels of market efficiency


• Weak market efficiency: prices reflect the information contained in
the record of past prices
• Semi-strong form of efficiency: prices reflect all the public
information
• Strong form of efficiency: prices reflect all the available information,
including historical prices, public information, and private
information
• In a strong form efficient market, investment managers cannot
consistently beat the market
Theory of Market Efficiency

• How to test different forms of efficiencies


• Weak market efficiency: researchers examine the profitability of
various technical trading rules employing historical price information
• Semi-strong form of efficiency: researchers examine how fast public
information (such as dividend announcements) is incorporate into
prices
• To analyze the semi-strong form of the efficient-market hypothesis,
researchers measure how rapidly security prices respond to
different items of news, such as earnings or dividend
announcements, news of a takeover, or macroeconomic information
Theory of Market Efficiency

• Consider an example of news that a company


being a target of acquisition coming into public
• The graph shows the abnormal returns on the
firms that are target take-overs
• The prices of the target stocks jump up on the
announcement day, but from then on, there are
no unusual price movements
• The announcement of the takeover attempt
seems to be fully reflected in the stock price on
the announcement day

Brealey, Myers and Allen; Principles of Corporate Finance. 10th, 11th, or 12th editions. Chapter 13
Theory of Market Efficiency

• The graph shows the abnormal returns on the


firms that are target takeovers
• The acquiring firms usually must pay a
substantial takeover premium to get the deal
done
• Stock prices drift up before date zero, as
investors gradually realize that a takeover may
be coming
• Within the day, the new stock prices reflect (at
least on average) the magnitude of the
takeover premium
Brealey, Myers and Allen; Principles of Corporate Finance. 10th, 11th, or 12th editions. Chapter 13
Theory of Market Efficiency

• Strong form of efficiency: tests of the strong form of the hypothesis have
examined the recommendations of professional security analysts
• Researchers examine whether mutual funds and pension funds can
outperform the market
• Evidence suggests that professionally managed funds fail to recoup the costs
of management
• It appears that in some years they do well and not so well in others
• It would be difficult to believe that some managers possess superior abilities
to others
Theory of Market Efficiency

• The evidence of efficient markets has convinced many professional and


individual investors to give up the pursuit of superior performance
• The implication is less focus on active management as more and more people
follow passive investment strategies by investing in market indices over
long horizons
• However, if everybody invests in index funds, then nobody will collect new
information
• An efficient market needs some smart investors who gather information and
attempt to profit from it
• There must be some profits available to allow the costs of information to
be recouped
INDIAN INSTITUTE OF TECHNOLOGY KANPUR

The Evidence Against Market Efficiency


The Evidence Against Market Efficiency

• Research suggests that there are indeed anomalies that can be exploited and
contradict the notion of market efficiency
• What exactly is an anomaly?
• In an efficient market, it is not possible to find expected returns greater
(or less) than the risk-adjusted opportunity cost of capital
𝐶𝑡
• 𝑃 = σ∞
𝑡=1 ; future cash flows (Ct) and the opportunity cost of capital
1+𝑟 𝑡
(r)
• If price equals fundamental value, the expected rate of return is the
opportunity cost of capital, no more and no less
The Evidence Against Market Efficiency

• The principle tells us that you can’t identify a superior return unless you know what
the normal expected return is
• We need an asset pricing model to determine the relationship between the risk
and expected returns
• The most used asset pricing model is the CAPM
• Several CAPM violations have been found in the literature
• This includes the abnormally high returns on the stocks of small firms vis-à-vis
large firms
• Investors may demand higher returns for bearing the risk associated with small
stocks
The Evidence Against Market Efficiency

• If these anomalies offer easy pickings, you expect to find a number of


investors eager to take advantage of them
• However, this seems to be surprisingly difficult for investors to get rich by
picking these
• Some of the calendar anomalies include day of the week effect
• Long-term investors are usually less concerned with these short-term
mispricing
• They are more interested in long-lasting inefficiencies such as the
earnings announcement puzzle and new issue puzzle
The Evidence Against Market Efficiency

• Another interesting phenomenon is bubbles and market efficiency


• Bubbles: prices can no longer be justified with fundamentals
• Valuation of stocks from scratch through methods such as dividend
growth model is extremely difficult
• Easier to estimate tomorrow's price relative to today’s price
• When investors lose confidence in prices, prices become inefficient and
volatile
• Most of the tests of market efficiency are concerned with relative prices
and focus on whether there are easy profits to be made
The Evidence Against Market Efficiency

• It may be impossible to prove that market levels are, or are not,


consistent with fundamentals
• Now and again investors seem to be caught up in a speculative
frenzy, and asset prices are inflated much beyond
fundamentals
• Bubbles can result when prices rise rapidly, and more and
more investors join the game on the assumption that prices will
continue to rise
• Lots of money is lost when these bubbles burst
INDIAN INSTITUTE OF TECHNOLOGY KANPUR

Investor Psychology and Behavioral


Finance
Investor Psychology and Behavioral Finance

• Often, prices depart from fundamental values


• This may be so because people are not rational all the times
• This manifests in their attitude toward risk: people are particularly loath to
incur losses
• Prospect theory: investors are more averse to losing than their affinity
toward gain
• Beliefs about probabilities: investors often make errors in assessing the
probability of uncertain events
• They place higher weights on more recent events
Investor Psychology and Behavioral Finance

• Also, investors are slow in updating their beliefs in the presence of new
evidence
• Most investors are systematically biased due to overconfidence and consider
themselves better-than-average stock pickers
• Such biases help in anomalies and bubbles
• Limits to arbitrage: these are limits to which smart investors can carry out
arbitrage and drive prices toward efficient values
• Arbitrage is an investment strategy aimed to generate guaranteed superior
returns without any risk
• However, these are not as risk-free as the theory might suggest
Investor Psychology and Behavioral Finance

• For example, trading costs can be significant, and some trades are difficult to
execute
• To sell a stock short, you borrow shares from another investor’s portfolio, sell
them, and then wait hopefully until the price falls and you can repurchase the
stock back for less than you sold it for
• If you’re wrong and the stock price increases, then sooner or later, you will be
forced to repurchase the stock at a higher price (therefore at a loss) to return
the borrowed shares to the lender
• In addition, there are costs and fees to be paid, and in some cases, you will
not be able to find shares to borrow
INDIAN INSTITUTE OF TECHNOLOGY KANPUR

Key Implications of Market Efficiency


Key Implications of Market Efficiency

• The efficient-market hypothesis emphasizes that arbitrage will rapidly


eliminate any profit opportunities and drive market prices back to fair value
• Lesson 1: Markets Have No Memory: the weak form of the efficient-
market hypothesis states that the sequence of past price changes
contains no information about future changes
• Lesson 2: Trust Market Prices: in an efficient market, you can trust prices,
for they impound all available information about the value of each security
• Lesson 3: Read the Entrails: if the market is efficient, prices impound all
available information; and therefore, can tell us a lot about future
worldview of that stock
Key Implications of Market Efficiency

• The efficient-market hypothesis emphasizes that arbitrage will rapidly


eliminate any profit opportunities and drive market prices back to fair value
• Lesson 4: There Are No Financial Illusions: investors are only concerned
with the firm’s cash flows and the portion of those cash flows to which
they are entitled
• Lesson 5: The Do-It-Yourself Alternative: in an efficient market, investors
will not pay others for what they can do equally well themselves
• Lesson 6: Seen One Stock, Seen Them All: investors don’t buy a stock for
its unique qualities; they buy it because it offers the prospect of a fair
return for its risk. This means that stocks are like perfect substitutes for
each other
Key Implications of Market Efficiency

• The efficient-market hypothesis emphasizes that arbitrage will rapidly


eliminate any profit opportunities and drive market prices back to fair value
• Lesson 1: Markets Have No Memory
• Lesson 2: Trust Market Prices
• Lesson 3: Read the Entrails
• Lesson 4: There Are No Financial Illusions
• Lesson 5: The Do-It-Yourself Alternative
• Lesson 6: Seen One Stock, Seen Them All
INDIAN INSTITUTE OF TECHNOLOGY KANPUR

Summary and Concluding remarks


Summary and Concluding remarks

• Competition between investors will tend to produce an efficient market


• In such a market, prices will rapidly impound any new information, and it will
be difficult to make consistently superior returns
• The efficient-market hypothesis comes in three different flavors: weak form,
semi-strong form, and strong form
• Limits to arbitrage can explain why asset prices may get out of line with
fundamental values
• Limits to arbitrage can explain why asset prices may get out of line with
fundamental values
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