FIN 435 - Exam 1 Slides
FIN 435 - Exam 1 Slides
FIN 435 - Exam 1 Slides
Exam 1 content
Financial assets
– Claims on real assets.
– Examples: stocks, bonds, etc.
Real asset
– This Rothko painting was
sold for $186 million in an
auction to a Russian billionaire.
Is cash a real asset or a financial asset?
Why?
A financial asset.
Because its value is based on what it represents.
The paper it is printed on has very little inherent value by itself.
Net wealth of the economy
Financial assets of the holders (e.g., households) represent
financial liabilities of the issuers (e.g., businesses) and hence,
cancel out each other at the aggregate national level, leaving only
real assets as the net wealth of the economy.
Marketable securities
– Financial assets that are easily and cheaply tradable in
organized markets.
Marketable securities
Money market Capital market Indirect
securities securities Derivatives investments
Negotiable
certificates Treasury Notes Swaps
Repurchase
agreement Corporate Bonds
Underlying investment decisions: the
tradeoff between expected return and risk
– Expected return is not usually the same as realized return
Risk: the possibility that the realized
return will be different than the expected
return
– Investor risk tolerance affects expected return
The tradeoff between expected return and
risk
– Investors manage risk at a cost - lower expected returns (ER)
– Any level of expected return and risk can be attained
Stocks
ER Bonds
Risk-free Rate
Risk
The investment decision process:
– Asset allocation
– Choice among broad asset classes (stocks, bonds, real
estate, commodities and so on).
– Security selection
– Choice of which securities to hold within asset class.
– Conducted to value securities and determine investment
attractiveness.
Uncertainty in returns
Problem #1
Assume that when you are 25 years old you plan to aggressively
save for your retirement by contributing $5,000 a year to a tax-
sheltered account.
You decide to see for yourself the various results that could occur
by doing some calculations.
Problem #1
C = $5,000
6% 7% 10%
20 years
30 years
40 years
Problem #1 (solution)
C = $5,000
6% 7% 10%
20 years
183,928 204,977 286,375
30 years
395,291 472,304 822,470
40 years
773,810 998,176 2,212,963
Chapter 2
Topics
a) Calculate the final value of the index if the initial index value is
100 points.
Value-weighted average
– Initial value of all stocks
= ($25 * 20 million) + ($100 * 1 million) = $600 million
– Final value of all stocks
= ($30 * 20 million) + ($90 * 1 million) = $690 million
Website
DSE market cap (2005 – 2018, in billions USD)
51
42
40
29
13
2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018
The Chittagong Stock Exchange
– Trading started in 1995
– Automated trading started in 1998
– Online (internet) trading started in 2004
The market crash of 1996
– The DSE index gained 140% between 1991 and 1995
– In 1996, the index rose by 337% (DSE) and 258% (CSE)
respectively
– New records almost every day in September, October and early
November
– Market was overheated
The market crash of 1996
– The DSE index reached 3,627 points, up from around 1,000
points in June
– dropped by 233 points on November 6, 1996
– The DSE index (DGEN) dropped to 957 points by April 1997
DGEN – 1990 - 2011
8,250
7,250
6,250
5,250
4,250
3,250
2,250
1,250
250
9 9 0 99 0 99 1 99 2 9 9 3 99 4 9 95 9 95 9 96 9 97 9 9 8 99 9 0 0 0 00 0 0 0 1 00 2 0 0 3 00 4 0 0 5 0 05 0 06 0 07 0 0 8 0 09 0 1 0 01 0 0 1 1
1 1 1 1 1 1 1 1 1 1 1 1 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2
Series1
The market crash of 2011
– Number of BO account holders in Dec. 2009 = 1.25 million
Stock Bangladesh
Chapter 3
Topics
What would happen if the price were to fall below BDT 40/share?
Buying on margin
What would happen if the price were to fall below BDT 40/share?
Buying on margin
Answer
c) -10.00%
d) -50.00%
Why investors buy on margin
Change in stock price Rate of return
+20.00% +30.00%
0.00% - 10.00%
-20.00% - 50.00%
Maintenance margin
Account margin
= Equity/Value
= (100P – 4,000)/ (100P)
Maintenance margin
Account margin = Equity/Value = (100P – 4,000)/ (100P)
P = BDT 57.14
Maintenance margin
Account margin
= Equity/Value
= (200P – 3,000)/ (200P)
Maintenance margin
Account margin = Equity/Value = (200P – 3,000)/ (200P)
P = BDT 20.00
Short sale
– In a long sale, an investor would buy a share and then sell it.
– In a short sale, first the investor sells the share and then he
buys it.
– A short sale allows the investor to profit from a decline in a
security’s price. An investor borrows a share from a broker and
sells it; later, the short-seller must purchase a share of the same
stock in order to replace the share that was borrowed.
Short sale
– The short seller must replace the share he borrowed, and also
pay any dividends paid during the short sale.
– Short sellers are required to post collateral (cash or securities)
with the broker to cover losses should the stock price rise.
Short sale
Equity
=A–L
= 150,000 – 1,000P
Maintenance margin
Account margin = (150,000 – 1,000P)/ (1,000P)
P = BDT 115.38
Chapter 5
The Fisher Equation
R = r + E(i)
where
R = nominal interest rate
r = real interest rate
E(i) = expected rate of inflation
Problem #1
Suppose the real interest rate is 3% per year and the expected
inflation rate is 8%. Using the Fisher Equation, what is the
nominal interest rate?
R = r + E(i)
R = 3% + 8%
R = 11%
Real and nominal
interest rates
where
r = real interest rate
R = nominal interest rate
E(i) = expected rate of inflation
Real and nominal
interest rates
Solution
Suppose the nominal interest rate on a 1-year CD is 8% and you
expect inflation to be 5% over the coming year. What is the real
interest rate?
r = (R – i) / (1 + i)
r = (8% – 5%) / (1 + 5%)
r = 2.86%
Return
Calculate HPR
Calculate HPR
Excellent = 31.00%
Good = 14.00%
Poor = – 6.75%
Crash = – 52.00%
Return
Expected return
E (r ) p( s)r ( s)
s
where
p(s) = probability of a state
r(s) = return if a state occurs
s = state
Return
Calculate E(r)
Solution
State Prob. of State r in State
1 .1 -.05
2 .2 .05
3 .4 .15
4 .2 .25
5 .1 .35
Variance
p ( s ) r ( s ) E (r )
2 2
Risk premium
The risk premium of an asset is the excess return you would receive
by investing in the asset over and above what you would have
received if you had invested in a risk-free asset.
Solution
If a portfolio had a return of 15%, the risk free asset return was
3%, and the standard deviation of the portfolio's excess returns
was 34%, what would be the risk premium?
Risk premium
----------------------------
Sharpe ratio =
SD of excess return
Sharpe ratio
Solution
If a portfolio had a return of 8%, the risk free asset return was
3%, and the standard deviation of the portfolio's excess returns
was 20%, what is the Sharpe ratio?
Risk premium
Sharpe ratio = ----------------------------
SD of excess return
Risk premium
Sharpe ratio = ----------------------------
SD of excess return