Financial

Financial Economics (ECO-605) VU
Lesson 01
INTRODUCTION TO FINANCIAL ECONOMICS
TOPIC 001: INTRODUCTION

Financial economics is a branch of economics that analyzes the use and distribution of
resources in markets. Financial decisions must often take into account future events, whether
those be related to individual stocks, portfolios, or the market as a whole. Making financial
decisions is not always a straightforward process. Time, risk (uncertainty), opportunity costs, and
information can create incentives or disincentives. Financial economics employs economic theory
to evaluate how certain things impact decision making, providing investors with the instruments
to make the right calls.
Financial economics usually involves the creation of sophisticated models to test the variables
affecting a particular decision. Often, these models assume that individuals or institutions making
decisions act rationally, though this is not necessarily the case. The irrational behavior of parties
has to be taken into account in financial economics as a potential risk factor. This branch of
economics builds heavily on microeconomics and basic accounting concepts. It is a quantitative
discipline that uses econometrics as well as other mathematical tools.
TOPIC 002: FINANCE AND FINANCIAL SYSTEM

Finance is a term for matters regarding the management, creation, and study of money and
investments. It involves the use of credit and debt, securities, and investment to finance current
projects using future income flows. Because of this temporal aspect, finance is closely linked to
the time value of money, interest rates, and other related topics.
 It is the study of how people allocate scarce resources over time.
 Allocation of financial decisions are different from other resource allocation decisions
Financial decisions:
1. Spread out over time and
2. Usually not known with certainty in advance by either the decision makers or anybody
else.
A financial system is a set of institutions, such as banks, insurance companies, and stock
exchanges that permit the exchange of funds. Financial systems exist on firm, regional, and global
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©Copyright Virtual University of Pakistan 1
levels. Borrowers, lenders, and investors exchange current funds to finance projects, either for
consumption or productive investments, and to pursue a return on their financial assets. The
financial system also includes sets of rules and practices that borrowers and lenders use to decide
which projects get financed, who finances projects, and terms of financial deals.
 The set of markets and other institutions used for financial contracting and the exchange
of assets and risks.
 It includes stocks, bonds and other financial instruments; financial intermediaries such as
banks and insurance companies; and regulatory bodies
Multiple components make up the financial system at different levels. The firm's financial system
is the set of implemented procedures that track the financial activities of the company. Within a
firm, the financial system encompasses all aspects of finances, including accounting measures,
revenue and expense schedules, wages, and balance sheet verification.
On a regional scale, the financial system is the system that enables lenders and borrowers to
exchange funds. Regional financial systems include banks and other institutions, such as
securities exchanges and financial clearinghouses.
The global financial system is basically a broader regional system that encompasses all
financial institutions, borrowers, and lenders within the global economy. In a global view, financial
systems include the International Monetary Fund, central banks, government treasuries and
monetary authorities, the World Bank, and major private international banks.
TOPIC 003: WHY STUDY FINANCIAL ECONOMICS?

The study of financial economics helps students understand these forces and provides the tools
to assess their impacts. It provides a framework for analyzing how individuals or families,
businesses, and governments make decisions as they face trade-offs.
• To manage your personal resources.
• To deal with the world of business.
• To pursue interesting and rewarding career opportunities.
• To make informed public choices as a citizen.
• To expand your mind.
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TOPIC 004: FINANCIAL DECISIONS

Households and firms have to make financial decisions. The financial decisions of households
include:
Consumption and saving decisions: How much of the current wealth should they spend on
consumption and how much of their current income should they save for the future?
Investment decision: How should they invest the money they have saved?
Financing decision: When and how should households use other people’s money to implement
their consumption and investment plans?
Risk-management decision: How and on what terms should households seek to reduce the
financial uncertainties they face or when should they increase their risks?
There are four main financial decisions- Capital Budgeting or long-term Investment decision
(Application of funds), Capital Structure or Financing decision (Procurement of funds), Dividend
decision (Distribution of funds) and Working Capital Management Decision in order to accomplish
goal of the firm viz., to maximize shareholder’s (owner’s) wealth.
TOPIC 005: MANAGEMENT AND OWNERSHIP OF A BUSINESS

A sole proprietorship is a business owned by only one person.
Advantages include: complete control for the owner, easy and inexpensive to form, and owner
gets to keep all of the profits.
Disadvantages include: unlimited liability for the owner, complete responsibility for talent and
financing, and business dissolves if the owner dies.
A general partnership is a business owned jointly by two or more people.

Advantages include: more resources and talents come with an increase in partners, and the
business can continue even after the death of a partner.
Disadvantages include: partnership disputes, unlimited liability, and shared profits.
A limited partnership has a single general partner who runs the business and is responsible for
its liabilities, plus any number of limited partners who have limited involvement in the business
and whose losses are limited to the amount of their investment.
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A corporation is a legal entity that’s separate from the parties who own it, the shareholders who
invest by buying shares of stock. Corporations are governed by a Board of Directors, elected by
the shareholders.
Advantages include: limited liability, easier access to financing, and unlimited life for the
corporation.
Disadvantages include: the agency problem, double taxation, and incorporation expenses and
regulations.
A limited liability company (LLC) is similar to a C-corporation, but it has fewer rules and
restrictions than a C-corporation. For example, an LLC can have any number of members.
A cooperative is a business owned and controlled by those who use its services. Individuals and
firms who belong to the cooperative join together to market products, purchase supplies, and
provide services for its members.
A not-for-profit corporation is an organization formed to serve some public purpose rather than
for financial gain. It enjoys favorable tax treatment.
A merger occurs when two companies combine to form a new company.
An acquisition is the purchase of one company by another with no new company being formed.
A hostile takeover occurs when a company is purchased even though the company’s
management and Board of Directors do not want to be acquired.
• Ability to run the business
• For the efficient scale of a business resources are to be pooled
• Diversification of risk is needed to overcome uncertainty
• Saving in the cost of gathering information
• The “learning curve” or “going concern” effect
• Primary goal of a corporate management
• Maximize shareholder wealth
• Maximize shareholder wealth
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Lesson 02
FINANCIAL MARKETS AND INSTITUTIONS
TOPIC 006: FINANCIAL MARKETS AND INSTITUTIONS

• Financial system encompasses the markets, intermediaries, service firms and other
institutions used to carry out the financial decisions of households, business firms, and
governments.
Basic Functions – Financial System

• Transferring resources across time and space
• Managing risk
• Clearing and settling payments to facilitate trade
• Pooling resources and subdividing shares
• Providing information
• Dealing with incentive problems
Financial markets refer broadly to any marketplace where the trading of securities occurs,
including the stock market, bond market, forex market, and derivatives market, among others.
Financial markets are vital to the smooth operation of capitalist economies.
Financial markets play a vital role in facilitating the smooth operation of capitalist economies by
allocating resources and creating liquidity for businesses and entrepreneurs. The markets make
it easy for buyers and sellers to trade their financial holdings. Financial markets create securities
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products that provide a return for those who have excess funds (Investors/lenders) and make
these funds available to those who need additional money (borrowers).
The stock market is just one type of financial market. Financial markets are made by buying and
selling numerous types of financial instruments including equities, bonds, currencies, and
derivatives. Financial markets rely heavily on informational transparency to ensure that the
markets set prices that are efficient and appropriate. The market prices of securities may not be
indicative of their intrinsic value because of macroeconomic forces like taxes.
Some financial markets are small with little activity, and others, like the New York Stock
Exchange (NYSE), trade trillions of dollars of securities daily. The equities (stock) market is a
financial market that enables investors to buy and sell shares of publicly traded companies. The
primary stock market is where new issues of stocks, called initial public offerings (IPOs), are sold.
Any subsequent trading of stocks occurs in the secondary market, where investors buy and sell
securities that they already own.
TOPIC 007: FINANCIAL INNOVATION AND THE INVISIBLE HAND

Financial innovation is the process of creating new financial products, services, or processes.
Financial innovation has come via advances in financial instruments, technology, and payment
systems. Digital technology has helped to transform the financial services industry, changing how
we save, borrow, invest, and pay for goods.
While large banks continue to invest in mobile banking, FinTech companies, like Stripe, help small
businesses conduct online payments, and investment broker Robinhood seeks to democratize
investing and finance. These innovations have increased the number of financial providers
available to consumers, borrowers, and businesses.
The invisible hand is a metaphor for the unseen forces that move the free market economy.
Through individual self-interest and freedom of production and consumption, the best interest of
society, as a whole, are fulfilled. The constant interplay of individual pressures on market supply
and demand causes the natural movement of prices and the flow of trade. The term "invisible
hand" first appeared in Adam Smith's famous work, The Wealth of Nations, to describe how free
markets can incentivize individuals, acting in their own self-interest, to produce what is societally
necessary.
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TOPIC 008: TYPES OF FINANCIAL MARKETS
Stock Markets
Perhaps the most ubiquitous of financial markets are stock markets. These are venues where
companies list their shares and they are bought and sold by traders and investors. Stock markets,
or equities markets, are used by companies to raise capital via an initial public offering (IPO), with
shares subsequently traded among various buyers and sellers in what is known as a secondary
market.
Stocks may be traded on listed exchanges, such as the New York Stock Exchange (NYSE) or
Nasdaq, or else over-the-counter (OTC). Most trading in stocks is done via regulated exchanges,
and these play an important role in the economy as both a gauge of the overall health of the
economy as well as providing capital gains and dividend income to investors, including those with
retirement accounts such as IRAs and 401(k) plans.
Typical participants in a stock market include (both retail and institutional) investors and traders,
as well as market makers (MMs) and specialists who maintain liquidity and provide two-sided
markets. Brokers are third parties that facilitate trades between buyers and sellers but who do not
take an actual position in a stock.
Over-the-Counter Markets
An over-the-counter (OTC) market is a decentralized market—meaning it does not have physical
locations, and trading is conducted electronically—in which market participants trade securities
directly between two parties without a broker. While OTC markets may handle trading in certain
stocks (e.g., smaller or riskier companies that do not meet the listing criteria of exchanges), most
stock trading is done via exchanges. Certain derivatives markets, however, are exclusively OTC,
and so they make up an important segment of the financial markets. Broadly speaking, OTC
markets and the transactions that occur on them are far less regulated, less liquid, and more
opaque.
Bond Markets
A bond is a security in which an investor loans money for a defined period at a pre-established
interest rate. You may think of a bond as an agreement between the lender and borrower that
contains the details of the loan and its payments. Bonds are issued by corporations as well as by
municipalities, states, and sovereign governments to finance projects and operations. The bond
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market sells securities such as notes and bills issued by the United States Treasury, for example.
The bond market also is called the debt, credit, or fixed-income market.
Money Markets
Typically the money markets trade in products with highly liquid short-term maturities (of less than
one year) and are characterized by a high degree of safety and a relatively low return in interest.
At the wholesale level, the money markets involve large-volume trades between institutions and
traders. At the retail level, they include money market mutual funds bought by individual investors
and money market accounts opened by bank customers. Individuals may also invest in the money
markets by buying short-term certificates of deposit (CDs), municipal notes, or U.S. Treasury bills,
among other examples.
Derivatives Markets
A derivative is a contract between two or more parties whose value is based on an agreed-upon
underlying financial asset (like a security) or set of assets (like an index). Derivatives are
secondary securities whose value is solely derived from the value of the primary security that they
are linked to. In and of itself a derivative is worthless. Rather than trading stocks directly, a
derivatives market trades in futures and options contracts, and other advanced financial products,
that derive their value from underlying instruments like bonds, commodities, currencies, interest
rates, market indexes, and stocks.
Futures markets
Futures markets are where futures contracts are listed and traded. Unlike forwards, which trade
OTC, futures markets utilize standardized contract specifications, are well-regulated, and utilize
clearinghouses to settle and confirm trades. Options markets, such as the Chicago Board Options
Exchange (CBOE), similarly list and regulate options contracts. Both futures and options
exchanges may list contracts on various asset classes, such as equities, fixed-income securities,
commodities, and so on.
Forex Market
The forex (foreign exchange) market is the market in which participants can buy, sell, hedge, and
speculate on the exchange rates between currency pairs. The forex market is the most liquid
market in the world, as cash is the most liquid of assets. The currency market handles more than
$6.6 trillion in daily transactions, which is more than the futures and equity markets combined.
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As with the OTC markets, the forex market is also decentralized and consists of a global network
of computers and brokers from around the world. The forex market is made up of banks,
commercial companies, central banks, investment management firms, hedge funds, and retail
forex brokers and investors.
Commodities Markets
Commodities markets are venues where producers and consumers meet to exchange physical
commodities such as agricultural products (e.g., corn, livestock, soybeans), energy products (oil,
gas, carbon credits), precious metals (gold, silver, platinum), or "soft" commodities (such as
cotton, coffee, and sugar). These are known as spot commodity markets, where physical goods
are exchanged for money.
The bulk of trading in these commodities, however, takes place on derivatives markets that utilize
spot commodities as the underlying assets. Forwards, futures, and options on commodities are
exchanged both OTC and on listed exchanges around the world such as the Chicago Mercantile
Exchange (CME) and the Intercontinental Exchange (ICE).
Cryptocurrency Markets
The past several years have seen the introduction and rise of cryptocurrencies such as Bitcoin
and Ethereum, decentralized digital assets that are based on blockchain technology. Today,
thousands of cryptocurrency tokens are available and trade globally across a patchwork of
independent online crypto exchanges. These exchanges host digital wallets for traders to swap
one cryptocurrency for another, or for fiat monies such as dollars or euros.
Because the majority of crypto exchanges are centralized platforms, users are susceptible to
hacks or fraud. Decentralized exchanges are also available that operate without any central
authority. These exchanges allow direct peer-to-peer (P2P) trading of digital currencies without
the need for an actual exchange authority to facilitate the transactions. Futures and options
trading are also available on major cryptocurrencies.
TOPIC 009: FINANCIAL MARKET RATES

The interest rate is the amount a lender charges a borrower and is a percentage of the principal—
the amount loaned. The interest rate on a loan is typically noted on an annual basis known as the
annual percentage rate (APR). An interest rate can also apply to the amount earned at a bank or
credit union from a savings account or certificate of deposit (CD). Annual percentage yield (APY)
refers to the interest earned on these deposit accounts.
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Interest is essentially a charge to the borrower for the use of an asset. Assets borrowed can
include cash, consumer goods, vehicles, and property. Because of this, an interest rate can be
thought of as the "cost of money" - higher interest rates make borrowing the same amount of
money more expensive.
Interest rates thus apply to most lending or borrowing transactions. Individuals borrow money to
purchase homes, fund projects, launch or fund businesses, or pay for college tuition. Businesses
take out loans to fund capital projects and expand their operations by purchasing fixed and long-
term assets such as land, buildings, and machinery. Borrowed money is repaid either in a lump
sum by a pre-determined date or in periodic installments.
For loans, the interest rate is applied to the principal, which is the amount of the loan. The interest
rate is the cost of debt for the borrower and the rate of return for the lender. The money to be
repaid is usually more than the borrowed amount since lenders require compensation for the loss
of use of the money during the loan period. The lender could have invested the funds during that
period instead of providing a loan, which would have generated income from the asset. The
difference between the total repayment sum and the original loan is the interest charged.
When the borrower is considered to be low risk by the lender, the borrower will usually be charged
a lower interest rate. If the borrower is considered high risk, the interest rate that they are charged
will be higher, which results in a higher cost loan.
Simple Interest Rate

If you take out a $300,000 loan from the bank and the loan agreement stipulates that the interest
rate on the loan is 4% simple interest, this means that you will have to pay the bank the original
loan amount of $300,000 + (4% x $300,000) = $300,000 + $12,000 = $312,000.
The example above was calculated based on the annual simple interest formula, which is:
Simple interest = Principal X interest rate X time
The individual that took out a loan will have to pay $12,000 in interest at the end of the year,
assuming it was only a one-year lending agreement. If the term of the loan was a 30-year
mortgage, the interest payment will be:
Simple interest = $300,000 X 4% X 30 = $360,000
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A simple interest rate of 4% annually translates into an annual interest payment of $12,000.
After 30 years, the borrower would have made $12,000 x 30 years = $360,000 in interest
payments, which explains how banks make their money.
Compound Interest Rate

Some lenders prefer the compound interest method, which means that the borrower pays even
more in interest. Compound interest, also called interest on interest, is applied both to the
principal and also to the accumulated interest made during previous periods. The bank assumes
that at the end of the first year the borrower owes the principal plus interest for that year. The
bank also assumes that at the end of the second year, the borrower owes the principal plus the
interest for the first year plus the interest on interest for the first year.
The interest owed when compounding is higher than the interest owed using the simple
interest method. The interest is charged monthly on the principal including accrued interest from
the previous months. For shorter time frames, the calculation of interest will be similar for both
methods. As the lending time increases, however, the disparity between the two types of interest
calculations grows.
Using the example above, at the end of 30 years, the total owed in interest is almost $700,000
on a $300,000 loan with a 4% interest rate.
The following formula can be used to calculate compound interest:

Compound interest = p X [(1 + interest rate)n − 1]
Where:
p = Principal
n = Number of compounding periods
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Lesson 03
INTEREST RATES AND RATES OF RETURN
TOPIC 010: RATES OF RETURN ON RISKY ASSETS

A Rate of Return (RoR) is the net gain or loss of an investment over a specified time period,
expressed as a percentage of the investment’s initial cost.
A rate of return (RoR) can be applied to any investment vehicle, from real estate to bonds, stocks,
and fine art. The RoR works with any asset provided the asset is purchased at one point in time
and produces cash flow at some point in the future. Investments are assessed based, in part, on
past rates of return, which can be compared against assets of the same type to determine which
investments are the most attractive. Many investors like to pick a required rate of return before
making an investment choice.
The Formula for Rate of Return (RoR)

The formula to calculate the rate of return (RoR) is:
Rate of return = [Initial value (Current value−Initial value) ]×100
This simple rate of return is sometimes called the basic growth rate, or alternatively, return on
investment (ROI). If you also consider the effect of the time value of money and inflation, the real
rate of return can also be defined as the net amount of discounted cash flows (DCF) received on
an investment after adjusting for inflation.
Rate of Return (RoR) on Stocks and Bonds

The rate of return calculations for stocks and bonds is slightly different. Assume an investor buys
a stock for $60 a share, owns the stock for five years, and earns a total amount of $10 in dividends.
If the investor sells the stock for $80, his per-share gain is $80 - $60 = $20. In addition, he has
earned $10 in dividend income for a total gain of $20 + $10 = $30. The rate of return for the stock
is thus a $30 gain per share, divided by the $60 cost per share, or 50%.
On the other hand, consider an investor that pays $1,000 for a $1,000 par value 5% coupon bond.
The investment earns $50 in interest income per year. If the investor sells the bond for $1,100 in
premium value and earns $100 in total interest, the investor’s rate of return is the $100 gain on
the sale, plus $100 interest income divided by the $1,000 initial cost, or 20%.
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Real Rate of Return (RoR) vs. Nominal Rate of Return (RoR)
The simple rate of return is considered a nominal rate of return since it does not account for the
effect of inflation over time. Inflation reduces the purchasing power of money, and so $335,000
six years from now is not the same as $335,000 today.
Discounting is one way to account for the time value of money. Once the effect of inflation is taken
into account, we call that the real rate of return (or the inflation-adjusted rate of return).
Real Rate of Return (RoR) vs. Compound Annual Growth Rate (CAGR)
A closely related concept to the simple rate of return is the compound annual growth rate (CAGR).
The CAGR is the mean annual rate of return of an investment over a specified period of time
longer than one year, which means the calculation must factor in growth over multiple periods.
To calculate compound annual growth rate, we divide the value of an investment at the end of the
period in question by its value at the beginning of that period; raise the result to the power of one
divided by the number of holding periods, such as years; and subtract one from the subsequent
result.
Internal Rate of Return (IRR) and Discounted Cash Flow (DCF)

The next step in understanding RoR over time is to account for the time value of money (TVM),
which the CAGR ignores. Discounted cash flows take the earnings of an investment and discount
each of the cash flows based on a discount rate. The discount rate represents a minimum rate of
return acceptable to the investor, or an assumed rate of inflation. In addition to investors,
businesses use discounted cash flows to assess the profitability of their investments.
Assume, for example, a company is considering the purchase of a new piece of equipment for
$10,000, and the firm uses a discount rate of 5%. After a $10,000 cash outflow, the equipment is
used in the operations of the business and increases cash inflows by $2,000 a year for five years.
The business applies present value table factors to the $10,000 outflow and to the $2,000 inflow
each year for five years.
The $2,000 inflow in year five would be discounted using the discount rate at 5% for five years. If
the sum of all the adjusted cash inflows and outflows is greater than zero, the investment is
profitable. A positive net cash inflow also means that the rate of return is higher than the 5%
discount rate.
The rate of return using discounted cash flows is also known as the internal rate of return (IRR).
The internal rate of return is a discount rate that makes the net present value (NPV) of all cash
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flows from a particular project or investment equal to zero. IRR calculations rely on the same
formula as NPV does and utilizes the time value of money (using interest rates).
When calculating the rate of return, you are determining the percentage change from the
beginning of the period until the end.
Example
𝐂𝐚𝐬𝐡 𝐃𝐢𝐯𝐢𝐝𝐞𝐧𝐝 𝐄𝐧𝐝𝐢𝐧𝐠 𝐏𝐫𝐢𝐜𝐞 𝐨𝐟 𝐚 𝐒𝐡𝐚𝐫𝐞−𝐁𝐞𝐠𝐢𝐧𝐧𝐢𝐧𝐠 𝐏𝐫𝐢𝐜𝐞
• r = 𝐁𝐞𝐠𝐢𝐧𝐧𝐢𝐧𝐠 𝐏𝐫𝐢𝐜𝐞 + 𝐁𝐞𝐠𝐢𝐧𝐧𝐢𝐧𝐠 𝐏𝐫𝐢𝐜𝐞
• r = Dividend Income Component + Price Change Component

Suppose you buy a stock for Rs 100 and hold it for a year. At the end of the year, the stock pays
a cash dividend of Rs 5 per share and the price per share is Rs 105 just after the dividend is paid.
The one year rate of return, r, is
r = 5% + 5% = 10%
• Suppose you invest in a stock costing Rs. 50. It pays a cash dividend during the year of
Rs. 1 and you expect that it’s price will be Rs. 60 at year’s end. What is your expected rate
of return?
• If the stock’s price is actually $40 at year’s end, what is your realized rate of return?
TOPIC 011: MARKET INDEXES AND MARKET INDEXING

A market index is a hypothetical portfolio of investment holdings that represents a segment of the
financial market. The calculation of the index value comes from the prices of the underlying
holdings. Some indexes have values based on market-cap weighting, revenue-weighting, float-
weighting, and fundamental-weighting. Weighting is a method of adjusting the individual impact
of items in an index.
Investors follow different market indexes to gauge market movements. The three most popular
stock indexes for tracking the performance of the U.S. market are the Dow Jones Industrial
Average (DJIA), S&P 500 Index, and Nasdaq Composite Index. In the bond market, Bloomberg
is a leading provider of market indexes with the Bloomberg U.S. Aggregate Bond Index serving
as one of the most popular proxies for U.S. bonds. Investors cannot invest directly in an index, so
these portfolios are used broadly as benchmarks or for developing index funds.
Some of the market’s leading indexes include:

1. S&P 500
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2. Dow Jones Industrial Average
3. Nasdaq Composite
4. S&P 100
5. Russell 1000
6. S&P MidCap 400
7. Russell Midcap
8. Russell 2000
9. S&P 600
10. U.S. Aggregate Bond Market
11. Global Aggregate Bond Market
Investors often choose to use index investing over individual stock holdings in a diversified
portfolio. Investing in a portfolio of index funds can be a good way to optimize returns while
balancing risk. For example, investors seeking to build a balanced portfolio of U.S. stocks and
bonds could choose to invest 50% of their funds in an S&P 500 ETF and 50% in a U.S. Aggregate
Bond Index ETF.
Investors may also choose to use market index funds to invest in emerging growth sectors. Some
popular emerging growth indexes and corresponding exchange-traded funds (ETFs) include the
following:
 The iShares Global Clean Energy ETF (ICLN), which tracks the S&P Global Clean Energy
Index
 The Reality Shares Nasdaq NexGen Economy ETF (BLCN), which tracks the Reality
Shares Nasdaq Blockchain Economy Index
 The First Trust Nasdaq Artificial Intelligence and Robotics ETF (ROBT), which tracks the
Nasdaq CTA Artificial Intelligence and Robotics Index
What Are the Major Stock Indexes?

In the United States, the three leading stock indexes are the Dow Jones Industrial Average, the
S&P 500, and the Nasdaq Composite. For international markets, the Financial Times Stock
Exchange 100 Index and the Nikkei 225 Index are popular proxies for the British and Japanese
stock markets, respectively.
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Why Are Indexes Useful to Investors?
Indexes provide investors with a simplified snapshot of a large market sector, without having to
examine every single asset in that index. For example, it would be impractical for an ordinary
investor to study hundreds of different stock prices in order to understand the changing fortunes
of different technology companies. However, a sector-wide index like the NASDAQ-100
Technology Sector Index can show the average trend for the sector.
Indexing
Indexing, broadly, refers to the use of some benchmark indicator or measure as a reference or
yardstick. In finance and economics, indexing is used as a statistical measure for tracking
economic data such as inflation, unemployment, gross domestic product (GDP) growth,
productivity, and market returns.
• Indexing is an investment strategy that seeks to match the investment returns of a
specified stock market index.
• In the investment market, indexes exist to represent specific market segments.
• Costs involved must be considered in addition to Average Return Per Anum
• Costs to be considered
• Fund’s expense ratio (e.g. advisory fee, distribution charges, operating expenses)
• Portfolio and transaction costs (brokerage and other trading costs)
Passive Investing
1. Indexing is Passive investing technique,
2. Passive investing broadly refers to a buy-and-hold portfolio strategy for long-term
investment horizons, with minimal trading in the market.
Active Investing
• Active investing refers to activities entered into by investors or fund managers seeking to
rearrange a portfolio of securities. Active investors constantly seek alpha, which is the
difference between a return on any actively managed portfolio compared to an index,
benchmark, or similar passive investing strategy. It involves on-going buying and selling.
TOPIC 012: INFLATION AND REAL INTEREST RATES

• Nominal interest rate on a bond is a promised amount of money you receive per unit you
lend.
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• Real rate of return is defined as the nominal interest rate you earn corrected for the change
in the purchasing power of money.
• Consumer Price Index (CPI)
• CPI measures average change in prices over time that consumers pay for a basket of
goods and services
• In Pakistan, prices of 487 items are accounted for on monthly basis for the calculation of
CPI.
Nominal Interest Rate −Rate of Inflation
• Real Rate= 1+Rate of Inflation
• Example: Suppose nominal rate of return is 8% and inflation is 5%. What will be the real
rate of return?
0.08 −0.05 0.03
• Real Rate= 1+0.05
= 1.05 =0.02857=2.857%
Interest rates represent the cost of borrowing and the return on savings and investing. They're
expressed as a percentage of the total amount of a loan or investment. They can be the total
return lenders receive when they offer loans or the return people earn when they save and invest.
Interest rates can be expressed in nominal or real terms. A nominal interest rate equals the real
interest rate plus a projected rate of inflation. A real interest rate reflects the true cost of funds to
the borrower and the real yield to the lender or to an investor.
The nominal interest rate is the rate that is advertised by banks, debt issuers, and investment
firms for loans and various investments. It is the stated interest rate paid or earned to the lender
or by investor. So, if as a borrower, you get a loan of $100 at a rate of 6%, you can expect to pay
$6 in interest. The rate has been marked up to take account of inflation.
Nominal Interest Rate = Real Interest Rate + Projected Rate of Inflation

Short-term nominal interest rates are set by central banks. These rates are the basis for other
interest rates that are charged by banks and other institutions on, e.g., loans to consumers and
credit card balances. Central banks may decide to keep nominal rates at low levels in order to
spur economic activity.
Low nominal rates encourage consumers to take on more debt and increase their spending. This
was the case following the Great Recession when the U.S. Federal Reserve dropped the federal
funds rate to a range of 0% to 0.25%. The rate remained in this range between December 2008
and December 2015.
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EXCERCISE
• Suppose the risk-free nominal interest rate on a one-year Treasury bill is 6% per yearand
the expected rate of inflation is 3% per year. What is the expected real rate of return on
the T-bill? Why is the T-bill risky in real terms? (=0.03/1.03=0.02913)
TOPIC 013: INTEREST RATE EQUALIZATION

• Competition in financial markets ensures that interest rates on equivalent assets are the
same.
• If there are entities that have the ability to borrow and lend on the same terms (maturity
and default risk) at different interest rates, then there will be interest-rate arbitrage.
TOPIC 014: THE FUNDAMENTAL DETERMINANTS OF RATES OF RETURN
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Productivity of capital goods
• Capital goods are goods produced in the economy that can be used in the production of
other goods.
• e.g. mines, roads, canals, dams, factories, machinery, inventories, patents, formulas,
brand-name recognition.
• Capital’s productivity is represented by rate of return on capital.
• The return on capital is the source of dividends and interest paid to the holders of the
stocks or other financial instruments holders.
• The expected return on capital varies over time and space.
• Space: technology, availability of other factors of production.
• The higher the expected rate of return on capital, the higher the level of interest rates in
the economy.
Uncertainty about the productivity

• The uncertainties of weather affect agricultural output;
• Dry mines and wells e.g. KEKRA 1 in Pakistan costed Rs. 14 billion
• Machine breakdown
• Change in consumer preference/taste
• Development of substitute
• The greater the degree of uncertainty about the productivity of capital goods, the higher
the risk premium on equity securities.
Time preferences of people

• The preferences of people for consumption now and consumption in the future.
• The greater the preference of people for current consumption over future consumption,
the higher the interest rate will be.
Risk Aversion
• The greater the degree of risk aversion of the population, the higher the risk premium
required, and the lower will be the risk-free rate of interest.
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Lesson 04
FINANCIAL INTERMEDIARIES
TOPIC 015: FINANCIAL INTERMEDIARIES

A financial intermediary is an entity that acts as the middleman between two parties in a financial
transaction, such as a commercial bank, investment bank, mutual fund, or pension fund. Financial
intermediaries offer a number of benefits to the average consumer, including safety, liquidity, and
economies of scale involved in banking and asset management. Although in certain areas, such
as investing, advances in technology threaten to eliminate the financial intermediary,
disintermediation is much less of a threat in other areas of finance, including banking and
insurance.
• Banks
• Other Depository Saving Institutions
• Insurance Companies
• Pension and Retirement Funds
• Mutual Funds
• Investment Banks
• Venture Capital Firms
• Asset Management Firms
• Information Services
TOPIC 016: FINANCIAL INTERMEDIARIES IN PAKISTAN

Financial sector of Pakistan constitute banks, Development Finance Institutions (DFIs),
Microfinance Banks (MFBs), Non-banking Finance Companies (NBFCs), insurance
companies, Modarabas and other financial intermediaries. Latest asset structure of the
financial sector is given below.
Regulatory
Institution Licensed under
Body
Banks SBP Section 27 of BCO, 1962
of which: Islamic Banking Institutions SBP Section 27 of BCO, 1962
Microfinance Institutions
Microfinance Banks SBP
Ordinance 2001
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Foreign Exchange Regulation

Exchange Companies SBP
Act, 1947
DFIs SBP
Nonbank financial institutions: SECP
Investment companies SECP Companies Ordinance, 1984
Asset Management Companies SECP Companies Ordinance, 1984
Mutual Funds and Plans SECP Companies Ordinance, 1984
Pension Funds SECP Companies Ordinance, 1984
Discretionary & Non-Discretionary
SECP Companies Ordinance, 1984
Portfolios
Real Estate Investment Trust SECP Companies Ordinance, 1984
Leasing Companies SECP Companies Ordinance, 1984
Modarabas SECP Companies Ordinance, 1984
Insurance companies SECP Companies Ordinance, 1984
Financial sector of Pakistan predominantly comprises of banks, as they hold the largest
share of financial assets as a percentage of GDP.
State Bank of Pakistan (SBP) regulates Banks, DFIs, Exchange Companies and MFBs, while
Securities and Exchange Commission of Pakistan (SECP) regulate NBFCs, Insurance
Companies and Modaraba Companies.
Discount House
• A discount house is a firm that buys, sells, discounts, and negotiates bills of exchange
or promissory notes.
• This is generally performed on a large scale with transactions that also include
government bonds and Treasury bills.
• NBP Capital Discount Ltd.
Venture Capital Company

• Government, semi-government, or private firm that provides startup or growth equity
capital and/or loan capital to promising ventures for returns that are higher than
market interest rates.
• AKD Venture Limited
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• AMZ Ventures Limited
• Pakistan Private Equity Management Limited
• TRG Pakistan Limited
Reinsurance Company (01)

• Reinsurance is an insurance that an insurance company purchases from another
insurance company to insulate itself (at least in part) from the risk of a major claims
event. Insurance companies that accept reinsurance refer to the business as
'assumed reinsurance'.
• Pakistan Reinsurance Company Limited is a public sector company under the
administrative control of the Ministry of Commerce.
TOPIC 017: YIELD CURVE

A yield curve is a line that plots yields (interest rates) of bonds having equal credit quality but
differing maturity dates. The slope of the yield curve gives an idea of future interest rate changes
and economic activity. There are three main shapes of yield curve shapes: normal (upward
sloping curve), inverted (downward sloping curve), and flat.
A yield curve is used as a benchmark for other debt in the market, such as mortgage rates or
bank lending rates, and it is used to predict changes in economic output and growth. The most
frequently reported yield curve compares the three-month, two-year, five-year, 10-year, and 30-
year U.S. Treasury debt. Yield curve rates are usually available at the Treasury's interest rate
websites by 6:00 p.m. ET each trading day.
A normal yield curve is one in which longer maturity bonds have a higher yield compared to
shorter-term bonds due to the risks associated with time. An inverted yield curve is one in which
the shorter-term yields are higher than the longer-term yields, which can be a sign of an upcoming
recession. In a flat or humped yield curve, the shorter- and longer-term yields are very close to
each other, which is also a predictor of an economic transition.
Types of Yield Curves

A normal or up-sloped yield curve indicates yields on longer-term bonds may continue to rise,
responding to periods of economic expansion. A normal yield curve thus starts with low yields
for shorter-maturity bonds and then increases for bonds with longer maturity, sloping upwards.
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This is the most common type of yield curve as longer-maturity bonds usually have a higher yield
to maturity than shorter-term bonds.
For example, assume a two-year bond offers a yield of 1%, a five-year bond offers a yield of
1.8%, a 10-year bond offers a yield of 2.5%, a 15-year bond offers a yield of 3.0%, and a 20-
year bond offers a yield of 3.5%. When these points are connected on a graph, they exhibit a
shape of a normal yield curve.
A normal yield curve implies stable economic conditions and should prevail throughout a
normal economic cycle. A steep yield curve implies strong economic growth in the future—
conditions that are often accompanied by higher inflation, which can result in higher interest
rates.
Inverted Yield Curve

An inverted yield curve instead slopes downward and means that short-term interest rates exceed
long-term rates. Such a yield curve corresponds to periods of economic recession, where
investors expect yields on longer-maturity bonds to become even lower in the future. Moreover,
in an economic downturn, investors seeking safe investments tend to purchase these longer-
dated bonds over short-dated bonds, bidding up the price of longer bonds driving down their yield.
• An inverted or down-sloped yield curve suggests yields on longer-term bonds may

continue to fall, corresponding to periods of economic recession. When investors expect
longer-maturity bond yields to become even lower in the future, many would purchase
longer-maturity bonds to lock in yields before they decrease further.
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• The increasing onset of demand for longer-maturity bonds and the lack of demand for
shorter-term securities lead to higher prices but lower yields on longer-maturity bonds,
and lower prices but higher yields on shorter-term securities, further inverting a down-
sloped yield curve.
Flat Yield Curve

A flat yield curve is defined by similar yields across all maturities. A few intermediate maturities
may have slightly higher yields, which causes a slight hump to appear along the flat curve. These
humps are usually for the mid-term maturities, six months to two years.
As the word flat suggests, there is little difference in yield to maturity among shorter and longer-
term bonds. A two-year bond could offer a yield of 6%, a five-year bond 6.1%, a 10-year bond
6%, and a 20-year bond 6.05%.
Such a flat or humped yield curve implies an uncertain economic situation. It may come at the
end of a high economic growth period that is leading to inflation and fears of a slowdown. It might
appear at times when the central bank is expected to increase interest rates. In times of high
uncertainty, investors demand similar yields across all maturities.
• A flat yield curve may arise from the normal or inverted yield curve, depending on
changing economic conditions. When the economy is transitioning from expansion to
slower development and even recession, yields on longer-maturity bonds tend to fall and
yields on shorter-term securities likely rise, inverting a normal yield curve into a flat yield
curve.
• When the economy is transitioning from recession to recovery and potential expansion,
yields on longer-maturity bonds are set to rise and yields on shorter-maturity securities
are sure to fall, tilting an inverted yield curve toward a flat yield curve.
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TOPIC 018: ANOMALY IN THE BOND MARKET AND THE RECESSION
• Asset prices depend on the people’s expectation about future.

• Sometimes, there is an anomaly when long-term bonds a a lower yield than their short-
term cousins.
• All (except one) economic recessions of the past half century have been preceded by
inverted yield curve.
• In early 2006, 10-year treasury bonds yield was only 0.4% more than bonds maturing in 3
months.
Reasons
• Expectations
• An inverted yield curve indicates that the market believes the Fed will lower rates in the
future. If the Fed lowers interest rates, there is a chance that the economy is not growing
very quickly. This may lead to recession.
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Yield Comparisons
Yields
Treasury 5-year 4.94
10-year 5.05
5-year AAA Bank &Finance 5.58
10-year AAA Bank &Finance 5.91
Source: Bloomberg.com. May 26, 2006.
TOPIC 019: GERMANY’S INFLATION LINKED BONDS

The S&P Germany Sovereign Inflation-Linked Bond Index is a comprehensive, market value
weighted index designed to track the performance of EUR-denominated inflation-linked securities
publicly issued by the German government for the domestic market.
• Inflation can be a bondholder’s worst enemy unless the return is inflation-protected.

• In the 1920s, the Reichsbank – Germany’s central bank started printing too much money.
• This led to inflation.
• In 1922, it was 1,024%
• In 1923, it was 105,700,000,000%
• In 1923, one US dollar was worth about 4.2 billion Reichsmarks
• German bonds issued during WWI became nearly worthless.
• In early 2006, Germany reintroduced inflation-linked bonds.
• As long as inflation remains low, this is one of the cheapest ways for a government to
borrow.
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Lesson 05
FINANCIAL REGULATIONS
TOPIC 020: FINANCIAL INFRASTRUCTURE AND REGULATION
Financial infrastructure is a set of institutions, which provides an enabling environment for the
effective operation of financial intermediaries. In broad terms, the financial infrastructure
encompasses the existing legal and regulatory framework that plays a vital role in determining
the structure, growth and the health of financial sector. A safe and efficient financial infrastructure
fosters financial stability and is imperative for the successful operation of modern integrated
financial markets. On the other hand, a weak financial infrastructure can result in major disruptions
to the smooth operation of financial markets, directly exposing market participants to greater
financial risk.
• Laws are made to outlaw frauds and to reinforce contracts.

• The laws governing financial system vary from country to country.
• The financial infrastructure consists of the legal and accounting procedures, the
organization of trading and clearing facilities, and the regulatory structures that govern the
relations among the users of the financial system.
• The financial structure consists of legal and accounting procedures.
• Some regulatory tasks are performed by private sector organizations and some are
performed by governmental organizations.
Rules for Trading

• These rules are usually established by organized exchanges and then sometimes given
the sanction of law.
• Purpose is standardization.
• It helps in keeping minimum costs.
Accounting Systems
• The discipline that studies reporting of financial information is called accounting.
• Ancient Babylon (around 2000 B.C.)
• Double entry bookkeeping (Italy)
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TOPIC 021: REGULATION BY GOVERNMENT
Government regulation affects the financial services industry in many ways, but the specific
impact depends on the nature of the regulation. Increased regulation typically means a higher
workload for people in financial services, because it takes time and effort to adapt business
practices that follow the new regulations correctly.
While the increased time and workload resulting from government regulation can be detrimental
to individual financial or credit services companies in the short term, government regulations can
also benefit the financial services industry as a whole in the long term. The Sarbanes-Oxley
Act was passed by Congress in 2002 in response to multiple financial scandals involving large
conglomerates such as Enron and WorldCom.
The act held senior management of companies accountable for the accuracy of their financial
statements, while also requiring that internal controls be established at these companies to
prevent future fraud and abuse. Implementing these regulations was expensive, but the act gave
more protection to people investing in financial services, which can increase investor confidence
and improve overall corporate investment.
• Governmental and Quasi-Governmental Organizations
– Central Banks
– They promote public policy objectives by influencing key policy variables such
as money supply, bank rate
– Price stability
Special-Purpose Intermediaries
 This group of organizations includes entities that are set up to encourage specific
economic activities by making financing more readily available or by guaranteeing debt
instruments of various sorts.
 e.g.
 First Securitization Trust
TOPIC 022: REGIONAL AND WORLD ORGANIZATIONS

• Bank for International Settlements (BIS) in Basel, Switzerland, whose objective is to
promote uniformity of banking regulations.
• International Monetary Fund (IMF) and
• International Bank for Reconstruction and Development (World Bank)
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International Monetary Fund (IMF)
• The IMF monitors economic and financial conditions in member countries
• provides technical assistance
• establishes rules for international trade and finance
• provides technical assistance
• establishes rules for international trade and finance
• provides a forum for international consultation, and
• most important, provides resources that permit lengthening the time necessary for
individual members to correct imbalances in their payments to other countries.
World Bank
• It finances investment projects in developing countries.
• It raises funds primarily by selling bonds in developed countries and then make loans for
projects that must meet certain criteria designed to encourage economic development.
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Lesson 06
FINANCIAL STATEMENTS
TOPIC 023: FUNCTIONS OF FINANCIAL STATEMENTS

Financial statements are written records that convey the business activities and the financial
performance of a company. Financial statements are often audited by government agencies,
accountants, firms, etc. to ensure accuracy and for tax, financing, or investing purposes. For-profit
primary financial statements include the balance sheet, income statement, statement of cash flow,
and statement of changes in equity. Non-profit entities use a similar but different set of financial
statements.
Investors and financial analysts rely on financial data to analyze the performance of a company
and make predictions about the future direction of the company's stock price. One of the most
important resources of reliable and audited financial data is the annual report, which contains the
firm's financial statements.
The financial statements are used by investors, market analysts, and creditors to evaluate a
company's financial health and earnings potential. The three major financial statement reports
are the balance sheet, income statement, and statement of cash flows.
• They provide information to the owners and creditors of the firm about the company’s
current status and past financial performance.
• Financial statements provides a convenient way for owners and creditors to set
performance targets and to impose restrictions on the managers of the firm.
• Financial statements provide convenient templates for financial planning.
TOPIC 024: FINANCIAL STATEMENTS- BALANCE SHEET

• A firm’s balance sheet shows its assets (what it owns) and its liabilities (what it owes) at a
point in time. The difference between assets and liabilities is the firm’s net worth (owner’s
equity).
• For a corporation, net worth is called stockholder’s equity.
• The values of assets, liabilities and net worth carried on a company’s published balance
sheet are measured at historical acquisition costs in accordance with Generally Accepted
Accounting Principles (GAAP).
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Financial Statements- Balance Sheet – Sample
The balance sheet provides an overview of a company's assets, liabilities, and shareholders'
equity as a snapshot in time. The date at the top of the balance sheet tells you when the snapshot
was taken, which is generally the end of the reporting period. Below is a breakdown of the items
in a balance sheet.
Assets
Cash and cash equivalents are liquid assets, which may include Treasury bills and certificates of
deposit.
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Accounts receivables are the amount of money owed to the company by its customers for the
sale of its product and service.
Inventory is the goods a company on hand it intends to sell as a course of business. Inventory
may include finished goods, work in progress that are not yet finished, or raw materials on hand
that have yet to be worked.
Prepaid expenses are costs that have been paid in advance of when they are due. These
expenses are recorded as an asset because the value of them has not yet been recognized;
should the benefit not be recognized; the company would theoretically be due a refund.
Property, plant, and equipment are capital assets owned by a company for its long-term benefit.
This includes buildings used for manufacturing for heavy machinery used for processing raw
materials.
Investments are assets held for speculative future growth. These aren't used in operations; they
are simply held for capital appreciation.
Trademarks, patents, goodwill, and other intangible assets cannot physically be touched but have
future economic (and often long-term benefits) for the company.
Liabilities
Accounts payable are the bills due as part of the normal course of operations of a business. This
includes the utility bills, rent invoices, and obligations to buy raw materials.
Wages payable are payments due to staff for time worked.
Notes payable are recorded debt instruments that record official debt agreements including the
payment schedule and amount.
Dividends payable are dividends that have been declared to be awarded to shareholders but have
not yet been paid.
Long-term debt can include a variety of obligations including sinking bond funds, mortgages, or
other loans that are due in their entirety in longer than one year. Note that the short-term portion
of this debt is recorded as a current liability.
Shareholders' Equity
Shareholders' equity is a company's total assets minus its total liabilities. Shareholders' equity
(also known as stockholders' equity) represents the amount of money that would be returned to
shareholders if all of the assets were liquidated and all of the company's debt was paid off.
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Retained earnings are part of shareholders' equity and are the amount of net earnings that were
not paid to shareholders as dividends.
QUESTION
• What difference would it have made to the end-of-year balance sheet if Company XYZ
had issued an additional $50 million in long term debt during the year and added that
amount to its holdings in cash and marketable securities?
TOPIC 025: FINANCIAL STATEMENTS - INCOME STATEMENT

 The income statement summarizes the profitability of the firm over a period of time, in this
case a year. The income statement is also known as the statement of earnings or the
statement of profit and loss.
Unlike the balance sheet, the income statement covers a range of time, which is a year for annual
financial statements and a quarter for quarterly financial statements. The income statement
provides an overview of revenues, expenses, net income, and earnings per share.
Income Statement- Key Points

– Revenue
– Expenses
– Gains
– Losses
– It does not cover receipts
(money received by the business)
or the cash payments/disbursements
(money paid by the business).
• It starts with sales => net income => and the earnings per share (EPS).
• The process how the net revenue realized by the company gets transformed into
net earnings (profit or loss).
Revenue
Operating revenue is the revenue earned by selling a company's products or services. The
operating revenue for an auto manufacturer would be realized through the production and sale of
autos. Operating revenue is generated from the core business activities of a company.
Non-operating revenue is the income earned from non-core business activities. These revenues
fall outside the primary function of the business. Some non-operating revenue examples include:
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Interest earned on cash in the bank
Operating Revenue
• Revenue realized through primary activities
Non-Operating Revenue
Revenues realized through secondary, non-core business activities
• The net money made from other activities, e.g. sale of long-term assets.
• These include the net income realized from one-time non-business activities, like a
company selling its old transportation van, unused land, or a subsidiary company.
Rental income from a property

Income from strategic partnerships like royalty payment receipts
Income from an advertisement display located on the company's property
Other income is the revenue earned from other activities. Other income could include gains from
the sale of long-term assets such as land, vehicles, or a subsidiary.
Expenses
Primary expenses are incurred during the process of earning revenue from the primary activity
of the business. Expenses include the cost of goods sold (COGS), selling, general and
administrative expenses (SG&A), depreciation or amortization, and research and development
(R&D).
Typical expenses include employee wages, sales commissions, and utilities such as electricity
and transportation.
Expenses that are linked to secondary activities include interest paid on loans or debt. Losses
from the sale of an asset are also recorded as expenses.
Primary Activity Expenses

All expenses incurred for earning the normal operating revenue linked to the primary activity of
the business.
1. The cost of goods sold (COGS)
2. General, selling and administrative expenses (GS&A)
3. Depreciation and
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4. R&D expenses
• Taxes
• Dividends
Secondary Activity Expenses

• All expenses linked to non-core business activities, like interest paid on loan money.
Losses as Expenses
• All expenses that go towards a loss-making sale of long-term assets, one-time or any
other unusual costs, or expenses towards lawsuits.
Gains/Other Income
• The net money made from other activities, e.g. sale of long-term assets.
• These include the net income realized from one-time non-business activities, like a
company selling its old transportation van, unused land, or a subsidiary company.
TOPIC 026: STRUCTURE OF INCOME STATEMENT

The main purpose of the income statement is to convey details of profitability and the financial
results of business activities; however, it can be very effective in showing whether sales or
revenue is increasing when compared over multiple periods.
Investors can also see how well a company's management is controlling expenses to determine
whether a company's efforts in reducing the cost of sales might boost profits over time.
• Net Income = (Revenue + Gains) – (Expenses + Losses)
• Example of Company XYZ’s Income Statement
Expenses
1. Cost of Goods Sold $110 million
(production+materials+labor)
Gross Margin =
2. General, administrative, and selling (GS&Aa) expense.
Operating income = gross margin-GS&A
GS&A expenses in 2001 – 30 million
Operating income = 60 million
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Income Statement - Sample
TOPIC 027: CASH FLOW STATEMENT

 It provides aggregate data regarding all cash inflows a company receives from its ongoing
operations and external investment sources. It also includes all cash outflows that pay for
business activities and investments during a given period.
Two main aspects

• It focuses attention on what is happening to the firm’s cash position over time.
• Financial distress is a condition in which a company or individual cannot generate revenue
or income because it is unable to meet or cannot pay its financial obligations. It is not
influenced by accrual accounting decisions
The Cash Flow Statement (CFS) measures how well a company generates cash to pay its debt
obligations, fund its operating expenses, and fund investments. The cash flow statement
complements the balance sheet and income statement.
• The income statement is based on accrual accounting methods hence not every revenue
is an inflow of cash and not every expense is an outflow.
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• Net income depends on judgments e.g.
– how to value inventory
– how to depreciate tangible assets
– how to amortize its intangible assets
Major Components
1. Cash flow from Operating Activities
2. Cash Flow from Investment Activities
3. Cash Flow from Financing Activities
 The cash flow statement includes cash made by the business through operations,
investment, and financing—the sum of which is called net cash flow.
 The first section of the cash flow statement is cash flow from operations, which
includes transactions from all operational business activities.
 Cash flow from investment is the second section of the cash flow statement, and is the
result of investment gains and losses. For example, cash spent on property, plant, and
equipment.
 Cash flow from financing is the final section, which provides an overview of cash used
from debt and equity.
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Cash Flow Statement - Example
TOPIC 028: NOTES TO FINANCIAL STATEMENTS

• Accrual Accounting Methods records revenues and expenses when they are incurred,
regardless of when cash is exchanged.
• The term "accrual" refers to any individual entry recording revenue or expense in the
absence of a cash transaction.
• An explanation of accounting methods used e.g. for depreciation straight line or
accelerated depreciation charges; for inventory costing method LIFO or FIFO.
• Details regarding which specific accounting standards are used.
• Greater detail regarding certain assets or liabilities e.g. the conditions and expiration dates
for long- and short-term debt, lease etc.
• information regarding the equity structure of the firm e.g. conditions attached to ownership
of shares
• documentation of changes in operations e.g. acquisitions and divestitures
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• off-balance sheet items
e.g. forward contracts, swaps, options for risk management.
•
The CFS allows investors to understand how a company's operations are running, where its
money is coming from, and how money is being spent. The CFS also provides insight as to
whether a company is on a solid financial footing.
There is no formula, per se, for calculating a cash flow statement. Instead, it contains three
sections that report cash flow for the various activities for which a company uses its cash. Those
three components of the CFS are listed below.
Operating Activities
The operating activities on the CFS include any sources and uses of cash from running the
business and selling its products or services. Cash from operations includes any changes made
in cash accounts receivable, depreciation, inventory, and accounts payable. These transactions
also include wages, income tax payments, interest payments, rent, and cash receipts from the
sale of a product or service.
Investing Activities
Investing activities include any sources and uses of cash from a company's investments in the
long-term future of the company. A purchase or sale of an asset, loans made to vendors or
received from customers, or any payments related to a merger or acquisition is included in this
category.
Also, purchases of fixed assets such as property, plant, and equipment (PPE) are included in this
section. In short, changes in equipment, assets, or investments relate to cash from investing.
Financing Activities
Cash from financing activities includes the sources of cash from investors or banks, as well as
the uses of cash paid to shareholders. Financing activities include debt issuance, equity issuance,
stock repurchases, loans, dividends paid, and repayments of debt.
The cash flow statement reconciles the income statement with the balance sheet in three major
business activities.
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Limitations of Financial Statements
Although financial statements provide a wealth of information on a company, they do have
limitations.
The statements are open to interpretation, and as a result, investors often draw vastly different
conclusions about a company's financial performance.
For example, some investors might want stock repurchases while other investors might prefer to
see that money invested in long-term assets. A company's debt level might be fine for one investor
while another might have concerns about the level of debt for the company.
When analyzing financial statements, it's important to compare multiple periods to determine if
there are any trends as well as compare the company's results to its peers in the same industry.
Last, financial statements are only as reliable as the information being fed into the reports. Too
often, it has been documented that fraudulent financial activity or poor control oversight have led
to misstated financial statements intended to mislead users. Even when analyzing audited
financial statements, there is a level of trust that users must place into the validity of the report
and the figures being shown.
What Are the Main Types of Financial Statements?

The three main types of financial statements are the balance sheet, the income statement, and
the cash flow statement. These three statements together show the assets and liabilities of a
business, its revenues and costs, as well as its cash flows from operating, investing, and financing
activities.
What Are the Main Items Shown in Financial Statements?

Depending on the corporation, the line items in a financial statement will differ; however, the most
common line items are revenues, costs of goods sold, taxes, cash, marketable securities,
inventory, short-term debt, long-term debt, accounts receivable, accounts payable, and cash flows
from investing, operating, and financing activities.
What Are the Benefits of Financial Statements?

Financial statements show how a business operates. It provides insight into how much and how
a business generates revenues, what the cost of doing business is, how efficiently it manages its
cash, and what its assets and liabilities are. Financial statements provide all the detail on how
well or poorly a company manages itself.
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How Do You Read Financial Statements?
Financial statements are read in several different ways. First, financial statements can be
compared to prior periods to better understand changes over time. For example, comparative
income statements report what a company's income was last year and what a company's income
is this year. Noting the year-over-year change informs users of the financial statements of a
company's health.
Financial statements are also read by comparing the results to competitors or other industry
participants. By comparing financial statements to other companies, analysts can get a better
sense on which companies are performing the best and which are lagging the rest of the industry.
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Lesson 07
MARKET VALUES AND BOOK VALUES
TOPIC 029: MARKET VALUES VERSUS BOOK VALUES

• The book value means the value of a business according to its books (accounts) that is
reflected through its financial statement.
• Formula:
Book value of a company
= Total assets – Total liabilities
Determining the book value of a company is more difficult than finding its market value, but it can
also be far more rewarding. Many famous investors, including billionaire Warren Buffett, built their
fortunes in part by buying stocks with market valuations below their book valuations. The market
value depends on what people are willing to pay for a company's stock. The book value is similar
to a firm's net asset value, which jumps around much less than stock prices. Learning how to use
the book value formula gives investors a more stable path to achieving their financial goals.
Book value is the net value of a firm's assets found on its balance sheet, and it is roughly equal
to the total amount all shareholders would get if they liquidated the company. Market value is the
company's worth based on the total value of its outstanding shares in the market, which is its
market capitalization.
Market value tends to be greater than a company's book value since market value captures
profitability, intangibles, and future growth prospects.
Book value per share is a way to measure the net asset value investors get when they buy a
share.
The price-to-book (P/B) ratio is a popular way to compare book and market values, and a lower
ratio may indicate a better deal.
The book value literally means the value of a business according to its books or accounts, as
reflected on its financial statements. Theoretically, it is what investors would get if they sold all
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the company's assets and paid all its debts and obligations. Therefore, book value is roughly
equal to the amount stockholders would receive if they decided to liquidate the company.
Book Value Formula

Mathematically, book value is the difference between a company's total assets and total liabilities.
Book value of a company=Total assets−Total liabilities
Example
Suppose that XYZ Company has total assets of $100 million and total liabilities of $80 million.
Then, the book valuation of the company is $20 million. If the company sold its assets and paid
its liabilities, the net worth of the business would be $20 million.
Total assets cover all types of financial assets, including cash, short-term investments, and
accounts receivable. Physical assets, such as inventory, property, plant, and equipment, are also
part of total assets. Intangible assets, including brand names and intellectual property, can be
part of total assets if they appear on financial statements. Total liabilities include items like debt
obligations, accounts payable, and deferred taxes.
Book Value Per Share (BVPS)

• It is total dollar amount of shareholders’ equity account of the firm’s official balance sheet
divided by the number of shares of common stock outstanding.
• It can be used to make a per share comparison.
• Outstanding shares refer to a company's stock currently held by all its shareholders,
including share blocks held by institutional investors and restricted shares.
When we divide book value by the number of outstanding shares, we get the book value per share
(BVPS). It allows us to make per-share comparisons. Outstanding shares consist of all the
company's stock currently held by all its shareholders. That includes share blocks held by
institutional investors and restricted shares.
Market Value
The market value represents the value of a company according to the stock market. It is the price
an asset would get in the marketplace. In the context of companies, market value is equal
to market capitalization. It is a dollar amount computed based on the current market price of the
company's shares.
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Market Value Formula
Market value—also known as market cap—is calculated by multiplying a company's outstanding
shares by its current market price.
If XYZ Company trades at $25 per share and has 1 million shares outstanding, its market value
is $25 million. Financial analysts, reporters, and investors usually mean market value when they
mention a company's value.
• It represents the value of a company according to the stock market.
• It is the price an asset would get in the marketplace
• In the context of companies, it represents the market capitalization
• It is the aggregate market value of a company represented as a dollar amount.
• Since it represents the “market” value of a company, it is computed based on the current
market price (CMP) of its shares.
As the market price of shares changes throughout the day, the market cap of a company does so
as well. On the other hand, the number of shares outstanding almost always remains the same.
That number is constant unless a company pursues specific corporate actions. Therefore, market
value changes nearly always occur because of per-share price changes.
Market Value Examples

Returning to the examples from before, Microsoft had 7.57 billion shares outstanding at the end
of its fiscal year on June 30, 2020.1 On that day, the company's stock closed at $203.51 per
share.3 The resulting market cap was about $1,540.6 billion (7.57 billion * $203.51). This market
value is over 13 times the value of the company on the books.
Similarly, Walmart had 2.87 billion shares outstanding.4 Its closing price was $114.49 per share
at the end of Walmart's fiscal year on January 31, 2020.5 Therefore, the firm's market value was
roughly $328.59 billion (2.87 billion * $114.49). That is more than four times Walmart's book
valuation of $74.67 billion that we calculated earlier.
It is quite common to see the book value and market value differ significantly. The difference is
due to several factors, including the company's operating model, its sector of the market, and the
company's specific attributes. The nature of a company's assets and liabilities also factor into
valuations.
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TOPIC 030: LIMITATIONS OF BOOK VALUE AND MARKET VALUE
One of the major issues with book value is that companies report the figure quarterly or annually.
It is only after the reporting that an investor would know how it has changed over the months.
Book valuation is an accounting concept, so it is subject to adjustments. Some of these
adjustments, such as depreciation, may not be easy to understand and assess. If the company
has been depreciating its assets, investors might need several years of financial statements to
understand its impact. Additionally, depreciation-linked rules and accounting practices can create
other issues.
For instance, a company may have to report an overly high value for some of its equipment. That
could happen if it always uses straight-line depreciation as a matter of policy.
Book value does not always include the full impact of claims on assets and the costs of selling
them. Book valuation might be too high if the company is a bankruptcy candidate and has liens
against its assets. What is more, assets will not fetch their full values if creditors sell them in a
depressed market at fire-sale prices.
The increased importance of intangibles and difficulty assigning values for them raises questions
about book value. As technology advances, factors like intellectual property play larger parts in
determining profitability. Ultimately, accountants must come up with a way of consistently valuing
intangibles to keep book value up to date.
Market Value Limitations

While market cap represents the market perception of a company's valuation, it may not
necessarily represent the real picture. It is common to see even large-cap stocks moving 3 to 5
percent up or down during a day's session. Stocks often become overbought or oversold on a
short-term basis, according to technical analysis.
Long-term investors also need to be wary of the occasional manias and panics that impact market
values. Market values shot high above book valuations and common sense during the 1920s and
the dotcom bubble. Market values for many companies actually fell below their book valuations
following the stock market crash of 1929 and during the inflation of the 1970s. Relying solely on
market value may not be the best method to assess a stock’s potential.
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TOPIC 031: COMPARING BOOK AND MARKET VALUE
• Most investors and traders use both values
Scenario 1: Book value greater than market value
It usually indicates that the market has momentarily lost confidence in the company. It may be
due to:
1. Problems with the business,
2. Loss of important business-related lawsuits, or
3. Chances of financial anomalies.
Value investors often prefer such companies hoping that the market perception turns out to be
incorrect in the future.
However, there is no guarantee that the price will rise in the future.
Scenario 2: A market value greater than book value

• The stock market is assigning a higher value to the company due to the potential of it and
its assets' earnings power.
• It indicates that investors believe the company has excellent future prospects for growth,
expansion, and increased profits that will eventually raise the book value of the company.
Scenario 3: Book value equals market value

The market sees no compelling reason to believe the company's assets are better or worse than
what is stated on the balance sheet.
The examples given above should make it clear that book and market values are very different.
Many investors and traders use both book and market values to make decisions. There are three
different scenarios possible when comparing the book valuation to the market value of a company.
Book Value Greater Than Market Value

• Consistently, profitable companies typically have market values greater than book values.
• Most of the companies in the top indexes meet this criterion, e.g. Microsoft and Walmart.
• Growth investors may find such companies promising. However, it may also indicate
overvalued or overbought stocks trading at a high price.
It is unusual for a company to trade at a market value that is lower than its book valuation. When
that happens, it usually indicates that the market has momentarily lost confidence in the company.
It may be due to business problems, loss of critical lawsuits, or other random events. In other
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words, the market doesn't believe that the company is worth the value on its books.
Mismanagement or economic conditions might put the firm's future profits and cash flows in
question.
Value investors actively seek out companies with their market values below their book valuations.
They see it as a sign of undervaluation and hope market perceptions turn out to be incorrect. In
this scenario, the market is giving investors an opportunity to buy a company for less than its
stated net worth. However, there is no guarantee that the price will rise in the future.
Market Value Greater Than Book Value

The market value of a company will usually exceed its book valuation. The stock market assigns
a higher value to most companies because they have more earnings power than their assets. It
indicates that investors believe the company has excellent future prospects for growth, expansion,
and increased profits. They may also think the company's value is higher than what the current
book valuation calculation shows.
Profitable companies typically have market values greater than book values. Most of the
companies in the top indexes meet this standard, as seen from the examples of Microsoft and
Walmart mentioned above. Growth investors may find such companies promising. However, it
may also indicate overvalued or overbought stocks trading at high prices.
Book Value Equals Market Value

Sometimes, book valuation and market value are nearly equal to each other. In those cases, the
market sees no reason to value a company differently from its assets.
TOPIC 032: PRICE-TO-BOOK (P/B) RATIO

The price per share divided by the book value per share.
• If a company has a P/B of 1, it means that the book value and market value are equal.
• If the market price drops and the P/B ratio becomes less than 1, it means the market value
is less than the book value (undervalued).
• If the market price zooms higher and creates a P/B ratio greater than 1, it means market
value now exceeds book value (overvalued).
• Since prices change every second, it is possible to track and spot stocks which move from
a P/B ratio of less than one to more than one and time the trades to maximize the profits.
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The price-to-book (P/B) ratio is a popular way to compare market value and book value. It is equal
to the price per share divided by the book value per share.
For example, a company has a P/B of one when the book valuation and market valuation are
equal. The next day, the market price drops, so the P/B ratio becomes less than one. That means
the market valuation is less than the book valuation, so the market might undervalue the stock.
The following day, the market price zooms higher and creates a P/B ratio greater than one. That
tells us the market valuation now exceeds book valuation, indicating potential overvaluation.
However, the P/B ratio is only one of several ways investors use book value.
• Both book value and market value offer meaningful insights to a company's valuation
• Comparing the two can help investors determine whether a stock is overvalued or
undervalued given its assets, liabilities, and its ability to generate income.
• An investor must determine when the book value or market value should be used and
when it should be discounted or disregarded in favor of other meaningful parameters
when analyzing a company.
TOPIC 033: ACCOUNTING VERSUS ECONOMIC MEASURES OF INCOME

Accounting income or loss recognizes realized gains and losses, and does not recognize
unrealized gains and losses. Economic income or loss recognizes all gains and losses, whether
realized or unrealized.
Income/Earnings/Profit - Definition
According to John R. Hicks, income is the amount that you could spend during the period while
maintaining the wealth with which you started the period.
The accounting definition ignores unrealized gains or losses in the market values of assets and
liabilities.
Accounting Profit
It is the net income for a company.
It's the profit after various costs and expenses are subtracted from total revenue or total sales
as stipulated by generally accepted accounting principles (GAAP).
• It is the amount of money left over after deducting the explicit costs of running the
business.
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• Explicit costs are merely the specific amounts that a company pays for those costs in
that period – for example, wages.
• Typically, accounting profit or net income is reported on a quarterly and annual basis
and is used to measure the financial performance of a company.
Accounting Profit - Costs

• Labor costs, such as wages
• Inventory needed for production
• Raw materials
• Transportation costs
• Sales and marketing costs
• Production costs and overhead
Economic Profit
• Similar to accounting profit in that it deducts explicit costs from revenue. However,
economic profit also includes the opportunity costs for taking one action versus another in
the period.
• Economic profit is determined by economic principles, not by accounting principles.
Economic Profit - Costs

• Economic profit also uses implicit costs, which are typically the costs of a
company's resources.
• Examples of implicit costs include:
a. Company-owned buildings
b. Plant and equipment
c. Self-employment resources
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Lesson 08
RETURN ON ASSETS AND RETURN ON EQUITY
TOPIC 034: FINANCIAL RATIOS
• Financial ratios are powerful tools to help summarize financial statements and the health
of a company or enterprise.
• Total Shareholder Return (TSR)
Ratio analysis is a quantitative method of gaining insight into a company's liquidity, operational
efficiency, and profitability by studying its financial statements such as the balance sheet and
income statement. Ratio analysis is a cornerstone of fundamental equity analysis.
Total Shareholder Return (TSR)

• Total Shareholder Return (TSR) factors in capital gains and dividends when measuring
the total return generated by a stock to an investor.
• TSR is the internal rate of return (IRR) of all cash flows to an investor during the holding
period of an investment.
• It is the total amount returned to investors.
Total shareholder return is the financial gain that results from a change in the stock's price plus
any dividends paid by the company during the measured interval divided by the initial purchase
price of the stock.
TSR = { (current price - purchase price) + dividends } ÷ purchase price
Example
Assume that an investor bought 100 shares at $20 and still owns the stock. Company paid out
$4.50 in dividends since the investor bought the stock and the current price is $24.
• TSR = { (current price - purchase price) + dividends } ÷ purchase price
• TSR = { ($24 - $20) + $4.50 } ÷ $20 = 0.425 * 100 = 42.5%
Key Points
• There are two basic ways that an Investor makes money in stocks - capital gains and
current income (dividends).
• Total Shareholder Return factors in capital gains and dividends when measuring the
total return generated by a stock to an investor.
• TSR represents an easily understood figure of the overall financial benefits generated for
stockholders.
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Classification of Financial Ratios
TOPIC 035: RETURN ON EQUITY (ROE)

• It is a measure of financial performance calculated by dividing net
income by shareholders' equity.
• Shareholders' equity is equal to a company’s assets minus its debt, ROE could be thought
of as the return on net assets.
• ROE is considered a measure of how effectively management is using a company’s assets
to create profits.
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Formula:
Net Income
ROE = Average Shareholders' Equity
• Net Income is the amount of income, net of expense, and taxes that a company generates
for a given period.
• Average Shareholders' Equity is calculated by adding equity at the beginning of the period.
The beginning and end of the period should coincide with that which the net income is
earned.
• Net income over the last full fiscal year, or trailing 12 months, is found on the income
statement—a sum of financial activity over that period.
• Shareholders' equity comes from the balance sheet—a running balance of a company’s
entire history of changes in assets and liabilities.
Example
𝐍𝐞𝐭 𝐈𝐧𝐜𝐨𝐦𝐞
ROE =
𝐒𝐡𝐚𝐫𝐞𝐡𝐨𝐥𝐝𝐞𝐫𝐬 ′ 𝐄𝐪𝐮𝐢𝐭𝐲
$𝟐𝟑.𝟒
ROE = = 0.078 = 7.8%
$𝟑𝟎𝟎
Rule of thumb
• Relatively high or low ROE ratios will vary significantly from one industry group or sector
to another.
• When used to evaluate one company to another similar company the comparison will be
more meaningful.
• A common shortcut for investors to consider a return on equity near the long-term average
of the S&P 500 (14%) as an acceptable ratio and anything less than 10% as poor.
Return on equity (ROE) is a measure of financial performance calculated by dividing net income
by shareholders' equity. Because shareholders' equity is equal to a company’s assets minus its
debt, ROE is considered the return on net assets.
ROE is considered a gauge of a corporation's profitability and how efficient it is in generating
profits. The higher the ROE, the more efficient a company's management is at generating income
and growth from its equity financing.
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ROE is expressed as a percentage and can be calculated for any company if net income and
equity are both positive numbers. Net income is calculated before dividends paid to common
shareholders and after dividends to preferred shareholders and interest to lenders.
Return on Equity=Average Shareholders/Equity Net Income

Net income is the amount of income, net expenses, and taxes that a company generates for a
given period. Average shareholders' equity is calculated by adding equity at the beginning of the
period. The beginning and end of the period should coincide with the period during which the net
income is earned.
Net income over the last full fiscal year, or trailing 12 months, is found on the income statement—
a sum of financial activity over that period. Shareholders' equity comes from the balance sheet—
a running balance of a company’s entire history of changes in assets and liabilities.
It is considered best practice to calculate ROE based on average equity over a period because
of the mismatch between the income statement and the balance sheet.
TOPIC 036: PROFITABILITY RATIOS

• Profitability ratios are a class of financial metrics that are used to assess a business's
ability to generate earnings relative to its revenue, operating costs, balance sheet assets,
and shareholders' equity over time, using data from a specific point in time.
Return on Sales (ROS)
• Return on sales (ROS) is a ratio used to evaluate a company's operational efficiency.
• This measure provides insight into how much profit is being produced per dollar of sales.
• An increasing ROS indicates that a company is growing more efficiently, while a
decreasing ROS could signal impending financial troubles.
• ROS is very closely related to a firm's operating profit margin.
Formula
𝐎𝐩𝐞𝐫𝐚𝐭𝐢𝐧𝐠 𝐏𝐫𝐨𝐟𝐢𝐭
ROS =
𝐍𝐞𝐭 𝐒𝐚𝐥𝐞𝐬
Where:
• Operating Profit is calculated as earnings before income and taxes, or EBIT.
• Net sales is the sum of a company's gross sales minus its returns, allowances, and
discounts.
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• Investors, creditors, and other debt holders rely on this efficiency ratio because it
accurately communicates the percentage of operating cash a company makes on its
revenue and provides insight into potential dividends, reinvestment potential, and the
company's ability to repay debt.
• ROS is used to compare current period calculations with calculations from previous
periods. This allows a company to conduct trend analyses and compare internal efficiency
performance over time. It is also useful to compare one company's ROS percentage with
that of a competing company, regardless of scale.
Example
• ROS is larger if a company's management successfully cuts costs while increasing
revenue.
• For example, the company with $50,000 in sales and $30,000 in costs has an operating
profit of $20,000 and a ROS of 40% ($20,000 / $50,000).
• If the company's management team wants to increase efficiency, it can focus on
increasing sales while incrementally increasing expenses, or it can focus on decreasing
expenses while maintaining or increasing revenue.
These ratios convey how well a company can generate profits from its operations. Profit margin,
return on assets, return on equity, return on capital employed, and gross margin ratios are all
examples of profitability ratios.
For most profitability ratios, having a higher value relative to a competitor's ratio or relative to the
same ratio from a previous period indicates that the company is doing well. Profitability ratios are
most useful when compared to similar companies, the company's own history, or average ratios
for the company's industry.
Gross profit margin is one of the most widely used profitability or margin ratios. Gross profit is the
difference between revenue and the costs of production—called cost of goods sold (COGS).
Some industries experience seasonality in their operations. For example, retailers typically
experience significantly higher revenues and earnings during the year-end holiday season. Thus,
it would not be useful to compare a retailer's fourth-quarter gross profit margin with its first-quarter
gross profit margin because they are not directly comparable. Comparing a retailer's fourth-
quarter profit margin with its fourth-quarter profit margin from the previous year would be far more
informative.
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Examples of Profitability Ratios
Profitability ratios are one of the most popular metrics used in financial analysis, and they
generally fall into two categories—margin ratios and return ratios.
Margin ratios give insight, from several different angles, on a company's ability to turn sales into
a profit. Return ratios offer several different ways to examine how well a company generates a
return for its shareholders.
Some common examples of profitability ratios are the various measures of profit margin, return
on assets (ROA), and return on equity (ROE). Others include return on invested capital (ROIC)
and return on capital employed (ROCE).
Profit Margin
Different profit margins are used to measure a company's profitability at various cost levels of
inquiry, including gross margin, operating margin, pretax margin, and net profit margin. The
margins shrink as layers of additional costs are taken into consideration—such as the COGS,
operating expenses, and taxes.
Gross margin measures how much a company makes after accounting for COGS. Operating
margin is the percentage of sales left after covering COGS and operating expenses. The pretax
margin shows a company's profitability after further accounting for non-operating expenses. The
net profit margin is a company's ability to generate earnings after all expenses and taxes.
TOPIC 037: RETURN ON ASSETS (ROA)

• Return on assets (ROA) is an indicator of how profitable a company is relative to its total
assets.
• ROA gives a manager, investor, or analyst an idea as to how efficient a company's
management is at using its assets to generate earnings.
• Return on assets is displayed as a percentage.
• It is calculated by dividing a company’s net income by total assets.
Net Income
• ROA = Total Asset
• Higher ROA indicates more asset efficiency
Example
• Suppose Sam and Fran start shawarma stands. Sam spends $1,500 on the stand and
Fran spends $150000 on his unit. Suppose Sam had earned $150 and Fran had earned
$1,200. Sam’s ROA =$150/1500 = 10%
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• Fran’s ROA = $1200/$15000 = 8%
• Fran’s business is more valuable but Sam has an efficient one.
Example of How to Use Return on Assets—ROA

• ROA is most useful for comparing companies in the same industry, as different industries
use assets differently.
• For example, the ROA for service-oriented firms, such as banks, will be significantly higher
than the ROA for capital intensive companies, such as construction or utility companies.
Example
• Let's evaluate the return on assets (ROA) for three companies in the retail industry:
• Macy's (M)
• Kohl’s (KSS)
• Dillard's (DDS)
• The data in the table is for the trailing twelve months as of Feb. 13, 2019.
Data
Company Net Income Total Assets ROA
Macy's $1.7 billion $20.4 billion 8.3%
Kohl's $996 million $14.1 billion 7.1%
Dillard's $243 million $3.9 billion 6.2%
Explanation
• The data shows that every dollar that Macy's has invested in assets generates 8.3 cents
of net income.
• Macy's is better at converting its investment into profits, compared with Kohl’s and
Dillard’s.
• One of management's most important jobs is to make wise choices in allocating its
resources.
• It appears Macy’s management is more adept than its two peers.
Profitability is assessed relative to costs and expenses and analyzed in comparison to assets to
see how effective a company is deploying assets to generate sales and profits. The use of the
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term "return" in the ROA measure customarily refers to net profit or net income—the value of
earnings from sales after all costs, expenses, and taxes. ROA is net income divided by total
assets.
The more assets a company has amassed, the more sales and potential profits the company may
generate. As economies of scale help lower costs and improve margins, returns may grow at a
faster rate than assets, ultimately increasing ROA.
TOPIC 038: COMPARISON BETWEEN ROA AND ROE

Return on equity (ROE) and return on assets (ROA) are two key measures to determine how
efficient a company is at generating profits. The main differentiator between the two is that ROA
takes into account leverage/debt, while ROE does not. ROE can be calculated by multiplying ROA
by the equity multiplier.
• Both ROA and return on equity (ROE) are measures of how a company utilizes its
resources.
– ROA =
𝐓𝐨𝐭𝐚𝐥 𝐀𝐬𝐬𝐞𝐭
– ROE =𝐒𝐡𝐚𝐫𝐞𝐡𝐨𝐥𝐝𝐞𝐫𝐬′ 𝐄𝐪𝐮𝐢𝐭𝐲
• Essentially, ROE only measures the return on a company’s equity, leaving out the
liabilities.
• Thus, ROA accounts for a company’s debt and ROE does not.
• The more leverage and debt a company takes on, the higher ROE will be relative to ROA.
• The biggest issue with return on assets (ROA) is that it can't be used across industries.
• That’s because companies in one industry—such as the technology industry—and
another industry like oil drillers will have different asset bases.
• The St. Louis Federal Reserve provides data on US bank ROAs, which have generally
hovered around or just above 1% since 1984, the year collection started.
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Lesson 09
ASSET TURNOVER RATIOS
TOPIC 039: ASSET TURNOVER RATIO
• It measures the value of a company's sales or revenues relative to the value of its assets.
• This ratio can be used as an indicator of the efficiency with which a company is using its
assets to generate revenue.
• The higher the asset turnover ratio, the more efficient a company.
• If a company has a low asset turnover ratio, it indicates it is not efficiently using its assets
to generate sales.
The asset turnover ratio measures the efficiency of a company's assets in generating revenue or
sales. It compares the dollar amount of sales (revenues) to its total assets as an annualized
percentage. Thus, to calculate the asset turnover ratio, divide net sales or revenue by the average
total assets.
Receivable turnover ratio

• The accounts receivable turnover ratio is an accounting measure used to quantify a
company's effectiveness in collecting its receivables or money owed by clients.
• The ratio shows how well a company uses and manages the credit it extends to customers
and how quickly that short-term debt is collected or is paid.
• The receivables turnover ratio is also called the accounts receivable turnover ratio.
Receivable turnover ratio – Formula

𝐍𝐞𝐭 𝐂𝐫𝐞𝐝𝐢𝐭 𝐒𝐚𝐥𝐞𝐬
= 𝐀𝐯𝐞𝐫𝐚𝐠𝐞 𝐀𝐜𝐜𝐨𝐮𝐧𝐭𝐬 𝐑𝐞𝐜𝐞𝐢𝐯𝐚𝐛𝐥𝐞
• Add the value of accounts receivable at the beginning of the desired period to the value
at the end of the period and divide the sum by two to get the value for the denominator in
the formula.
• Divide the value of net credit sales for the period by the average accounts
receivable during the same period.
• Net credit sales are the revenue generated from sales that were done on credit minus any
returns from customers.
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𝐍𝐞𝐭 𝐂𝐫𝐞𝐝𝐢𝐭 𝐒𝐚𝐥𝐞𝐬
= 𝐀𝐯𝐞𝐫𝐚𝐠𝐞 𝐀𝐜𝐜𝐨𝐮𝐧𝐭𝐬 𝐑𝐞𝐜𝐞𝐢𝐯𝐚𝐛𝐥𝐞

$𝟐𝟎𝟎
= ($𝟓𝟎+$𝟔𝟎)/𝟐 = 3.6 times
Balance sheet discussed earlier shows Accounts Receivable for 2000 and 2001 as $50 and $60
respectively.
Receivables Turnover Ratio Inferences

• Companies that maintain accounts receivables are indirectly extending interest-free loans
to their clients since accounts receivable is money owed without interest.
• If a company generates a sale to a client, it could extend terms of 30 or 60 days, meaning
the client has 30 to 60 days to pay for the product.
• The receivables turnover ratio measures the efficiency with which a company collects on
their receivables or the credit it had extended to its customers.
• The ratio also measures how many times a company's receivables are converted to cash
in a period. The receivables turnover ratio could be calculated on an annual, quarterly, or
monthly basis.
TOPIC 040: INVENTORY TURNOVER RATIO

Inventory turnover is a financial ratio showing how many times a company turned over its
inventory relative to its cost of goods sold (COGS) in a given period. A company can then divide
the days in the period, typically a fiscal year, by the inventory turnover ratio to calculate how many
days it takes to sell its inventory, on average.
The inventory turnover ratio can help businesses make better decisions on pricing, manufacturing,
marketing, and purchasing. It is one of the efficiency ratios measuring how effectively a company
uses its assets.
• Inventory is the account of all the goods a company has in its stock, including raw
materials, work-in-progress materials, and finished goods that will ultimately be sold.
• It is a ratio showing how many times a company has sold and replaced inventory during a
given period.
• A company can then divide the days in the period by the inventory turnover formula to
calculate the days it takes to sell the inventory on hand.
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• Calculating inventory turnover can help businesses make better decisions on pricing,
manufacturing, marketing and purchasing new inventory.
Inventory turnover ratio

𝐒𝐚𝐥𝐞𝐬
= 𝐀𝐯𝐞𝐫𝐚𝐠𝐞 𝐈𝐧𝐯𝐞𝐧𝐭𝐨𝐫𝐲
where: Average Inventory

=(BI−Ending Inventory)÷2
BI=Beginning Inventory
Days Sales of Inventory (DSI) or Days Inventory

• Days Sales of Inventory (DSI) measures how many days it takes for inventory to turn into
sales.
• It is calculated by taking the inverse of the inventory turnover ratio multiplied by 365.
• This puts the figure into a daily context, as follows:
(Average Inventory ÷ Cost of Goods Sold) x 365
Days Sales of Inventory (DSI)

• A lower DSI is ideal since it would translate to fewer days needed to turn inventory into
cash. However, DSI values can vary between industries.
• For example, companies that sell groceries, like Kroger supermarkets (KR), have lower
days inventory than companies that sell automobiles, like General Motors Co. (GM).
TOPIC 041: INVENTORY TURNOVER RATIO-CALCULATION

• Companies calculate inventory turnover by:
– Calculating the average inventory, which is done by dividing the sum of beginning
inventory and ending inventory by two
– Dividing sales by average inventory
Inventory Turnover Ratio
𝐂𝐨𝐬𝐭 𝐨𝐟 𝐆𝐨𝐨𝐝𝐬 𝐒𝐨𝐥𝐝
=
𝐀𝐯𝐞𝐫𝐚𝐠𝐞 𝐈𝐧𝐯𝐞𝐧𝐭𝐨𝐫𝐲
$ 𝟏𝟏𝟎
= ($𝟏𝟓𝟎+$𝟏𝟖𝟎)/𝟐 = 𝟎. 𝟕 𝐭𝐢𝐦𝐞𝐬
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Example of Calculating Inventory Turnover
• For the fiscal year ending January 2018, Wal-Mart Stores (WMT) reported annual sales
of $500.34 billion, year-end inventory of $43.78 billion, and an annual cost of goods
sold (or cost of sales) of $373.40 billion.
• Walmart's inventory turnover for the year equals:
• $373.40 billion ÷ $43.78 billion = 8.53
Days Sales of Inventory (DSI) or Days Inventory

• Its days inventory equal:
• (1 ÷ 8.53) x 365 = 42 days
• This indicates that Walmart sells its entire inventory within a 42-day period, which is quite
impressive for such a large, global retailer.
• The inventory turnover ratio is an effective measure of how well a company is turning its
inventory into sales.
• The ratio also shows how well management is managing the costs associated with
inventory and whether they're buying too much inventory or too little.
• It also shows how well the company sells its goods. If sales are down or the economy is
under-performing, it may show up as a lower inventory turnover ratio.
• Usually, a higher inventory turnover ratio is preferred, as it indicates that more sales are
being generated given a certain amount of inventory.
• Sometimes a very high inventory ratio could result in lost sales, as there is not enough
inventory to meet demand. It is always important to compare the inventory turnover ratio
to the industry benchmark to assess if a company is successfully managing its inventory.
Inventory Turnover Formula and Calculation

Inventory Turnover = COGS/Average Value of Inventory
Where COGS=Cost of goods sold
Average value of inventory is used to offset seasonality effects. It is calculated by adding the value
of inventory at the end of a period to the value of inventory at the end of the prior period and
dividing the sum by 2.
Cost of goods sold (COGS) is also known as cost of sales. Analysts use COGS instead of sales
in the formula for inventory turnover because inventory is typically valued at cost, whereas the
sales figure includes the company’s markup. Some companies may use sales instead of COGS
in the calculation, which would tend to inflate the resulting ratio.
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TOPIC 042: ASSET TURNOVER RATIO - FORMULA
• Asset turnover is the ratio of total sales or revenue to average assets.
• This metric helps investors understand how effectively companies are using their assets
to generate sales.
• Investors use the asset turnover ratio to compare similar companies in the same sector or
group.
• It is a tool to see which firms are making the most use of their assets and to identify
weaknesses in firms.
The asset turnover ratio measures the value of a company's sales or revenues relative to the
value of its assets. The asset turnover ratio can be used as an indicator of the efficiency with
which a company is using its assets to generate revenue.
The higher the asset turnover ratio, the more efficient a company is at generating revenue from
its assets. Conversely, if a company has a low asset turnover ratio, it indicates it is not efficiently
using its assets to generate sales.
Asset Turnover Ratio Formula:
• The asset turnover ratio is calculated on an annual basis.

• The total assets number used in the denominator can be calculated by taking the average
of assets on the balance sheet at the beginning of the year and at the year's end.
• The higher the asset turnover ratio, the better the company is performing, since higher
ratios imply that the company is generating more revenue per dollar of assets.
• The asset turnover ratio tends to be higher for companies in certain sectors than in others.
• Retail and consumer staples, for example, have relatively small asset bases but have high
sales volume – thus, they have the highest average asset turnover ratio. Conversely, firms
in sectors such as utilities and real estate have large asset bases and low asset turnover.
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• Since this ratio can vary widely from one industry to the next, comparing the asset turnover
ratios of a retail company and a telecommunications company would not be very
productive.
• Comparisons are only meaningful when they are made for different companies within the
same sector.
TOPIC 043: ASSET TURNOVER RATIO – EXAMPLE
• Let's calculate the asset turnover ratio for four companies in the retail and
telecommunication-utilities sectors –
– Walmart Inc. (NYSE: WMT),
– Target Corporation (NYSE: TGT)
– AT&T Inc. (NYSE: T), and
– Verizon Communications Inc. (NYSE: VZ)
for the fiscal year ended 2016.
• AT&T and Verizon have asset turnover ratios of less than one, which is typical for firms in
the telecommunications-utilities sector.
• Since these companies have large asset bases, it is expected that they would slowly turn
over their assets through sales.
• Clearly, it would not make sense to compare the asset turnover ratios for Walmart and
AT&T, since they operate in very different industries.
• But comparing the asset turnover ratios for AT&T and Verizon may provide a better
estimate of which company is using assets more efficiently.
• For example, from the table, Verizon turns over its assets at a faster rate than AT&T.
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• For every dollar in assets, Walmart generated $2.30 in sales, while Target generated
$1.79.
• Target's turnover may indicate that the retail company was experiencing sluggish sales or
holding obsolete inventory. Furthermore, its low turnover may also mean that the company
has lax collection methods. The firm's collection period may be too long, leading to
higher accounts receivable. Target could also not be using its assets efficiently.
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Lesson 10
FINANCIAL LEVERAGE RATIOS AND LIQUIDITY RATIOS
TOPIC 044: FINANCIAL LEVERAGE RATIOS

A leverage ratio is any one of several financial measurements that look at how much capital
comes in the form of debt (loans) or assesses the ability of a company to meet its financial
obligations. The leverage ratio category is important because companies rely on a mixture of
equity and debt to finance their operations, and knowing the amount of debt held by a company
is useful in evaluating whether it can pay off its debts as they come due.
• These ratios highlight the capital structure of the firm, and the extent to which it is burdened
with debt.
• Types of financial leverage ratios
– Debt ratio
– Times interest earned
– Debt to Equity Ratio
Debt Ratio
• It measures the capital structure
• It is a financial ratio that measures the extent of a company’s leverage.
• It is expressed as a decimal or percentage.
• It can be interpreted as the proportion of a company’s assets that are financed by debt.
Formula
Total Debt
• Debt ratio=Total Assets
A ratio greater than 1 shows that a considerable portion of debt is funded by assets OR the
company has more liabilities than assets.
A high ratio also indicates that a company may be putting itself at a risk of default on its loans if
interest rates were to rise suddenly.
• A ratio below 1 translates to the fact that a greater portion of a company's assets is funded
by equity.
• The debt ratio is also referred to as the debt-to-assets ratio.
Too much debt can be dangerous for a company and its investors. However, if a company's
operations can generate a higher rate of return than the interest rate on its loans, then the debt
may help to fuel growth. Uncontrolled debt levels can lead to credit downgrades or worse. On the
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other hand, too few debts can also raise questions. A reluctance or inability to borrow may be a
sign that operating margins are tight.
There are several different ratios that may be categorized as a leverage ratio, but the main factors
considered are debt, equity, assets, and interest expenses.
A leverage ratio may also be used to measure a company's mix of operating expenses to get an
idea of how changes in output will affect operating income. Fixed and variable costs are the two
types of operating costs; depending on the company and the industry, the mix will differ.
Finally, the consumer leverage ratio refers to the level of consumer debt compared to disposable
income and is used in economic analysis and by policymakers.
TOPIC 045: FINANCIAL LEVERAGE RATIO-TIMES INTEREST EARNED (TIE)

• It indicates the ability of the firm to cover its interest payments.
• It is a measure of a company's ability to meet its debt obligations based on its current
income.
• The formula for a company's TIE number is earnings before interest and taxes (EBIT)
divided by the total interest payable on bonds and other debt.
EBIT
• TIE =
Interest Expense
• The result is a number that shows how many times a company could cover its interest
charges with its pretax earnings.
• It is also referred to as the interest coverage ratio.
A better TIE number means a company has enough cash after paying its debts for investment.
The TIE ratio is an indication of a company's relative freedom from the constraints of debt.
Generating enough cash flow to continue to invest in the business is better than having enough
money to stave off bankruptcy.
Example
• Assume, that XYZ Company has $10 million in 4% debt outstanding and $10 million in
common stock. The company needs to borrow more loan. The cost of capital for issuing
more debt is an annual interest rate of 6%. The company's shareholders expect an annual
dividend payment of 8% plus growth in the stock price of XYZ.
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• The business decides to issue $10 million in additional debt. Its total annual interest
expense will be: (4% X $10 million) + (6% X $10 million), or $1 million annually. The
company's EBIT is $3 million.
• This means that the TIE ratio for XYZ Company is 3, or three times the annual interest
expense.
The times interest earned (TIE) ratio is a measure of a company's ability to meet its debt
obligations based on its current income. The formula for a company's TIE number is earnings
before interest and taxes (EBIT) divided by the total interest payable on bonds and other debt.
The result is a number that shows how many times a company could cover its interest charges
with its pretax earnings.
TIE is also referred to as the interest coverage ratio.
Obviously, no company needs to cover its debts several times over in order to survive. However,
the TIE ratio is an indication of a company's relative freedom from the constraints of debt.
Generating enough cash flow to continue to invest in the business is better than merely having
enough money to stave off bankruptcy.
A company's capitalization is the amount of money it has raised by issuing stock or debt, and
those choices impact its TIE ratio. Businesses consider the cost of capital for stock and debt and
use that cost to make decisions.
Assume, for example, that XYZ Company has $10 million in 4% debt outstanding and $10 million
in common stock. The company needs to raise more capital to purchase equipment. The cost of
capital for issuing more debt is an annual interest rate of 6%. The company's shareholders expect
an annual dividend payment of 8% plus growth in the stock price of XYZ.
The business decides to issue $10 million in additional debt. Its total annual interest expense will
be: (4% X $10 million) + (6% X $10 million), or $1 million annually. The company's EBIT is $3
million.
This means that the TIE ratio for XYZ Company is 3, or three times the annual interest expense.
TOPIC 046: FINANCIAL LEVERAGE RATIO-DEBT TO EQUITY RATIO

• D/E Ratio
Total Liabilities
=Total Shareholders′ Equity
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• For example, TKMaxx has $15.53 billion in debt and $4.32 billion in equity (FY 2019).
• The company's D/E ratio is thus:
$15.53 billion
= = 3.59
$4.32 billion
• TKMaxx's liabilities are 359% of shareholders' equity which is very high for a retail
company.
• A high debt/equity ratio generally indicates that a company has been aggressive in
financing its growth with debt.
• This can result in volatile earnings as a result of the additional interest expense.
• If the company's interest expense grows too high, it may increase the company's chances
of a default or bankruptcy.
• Typically, a D/E ratio greater than 2.0 indicates a risky scenario for an investor; however,
this yardstick can vary by industry.
• Businesses that require large capital expenditures (CapEx), such as utility and
manufacturing companies, may need to secure more loans than other companies.
• It is a good idea to measure a firm's leverage ratios against past performance and with
companies operating in the same industry to better understand the data.
TOPIC 047: LIQUIDITY RATIOS

Liquidity ratios are an important class of financial metrics used to determine a debtor's ability to
pay off current debt obligations without raising external capital. Liquidity ratios measure a
company's ability to pay debt obligations and its margin of safety through the calculation of metrics
including the current ratio, quick ratio, and operating cash flow ratio.
• Liquidity Ratios include:
– Current ratio
– Quick ratio/acid test
Liquidity is the ability to convert assets into cash quickly and cheaply. Liquidity ratios are most
useful when they are used in comparative form. This analysis may be internal or external.
• Internal analysis regarding liquidity ratios involves using multiple accounting periods using
the same accounting methods.
• Such comparison helps to track changes in the business.
• A higher liquidity ratio indicates that the company is more liquid and has better coverage
of outstanding debts.
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• External analysis involves comparing the liquidity ratios of one company to another or an
entire industry.
• This information is useful to compare the company's strategic positioning in relation to its
competitors when establishing benchmark goals.
For example, internal analysis regarding liquidity ratios involves using multiple accounting periods
that are reported using the same accounting methods. Comparing previous periods to current
operations allows analysts to track changes in the business. In general, a higher liquidity ratio
shows a company is more liquid and has better coverage of outstanding debts.
Limitation
• Liquidity ratio analysis may not be as effective when looking across industries as various
businesses require different financing structures.
• Liquidity ratio analysis is less effective for comparing businesses of different sizes in
different geographical locations.
TOPIC 048: CURRENT RATIO AND QUICK RATIO

• The current ratio measures a company's ability to pay off its current liabilities (payable
within one year) with its current assets such as cash, accounts receivable and inventories.
The higher the ratio, the better the company's liquidity position.
Current Assets
• Current Ratio =Current Liabilities
• The quick ratio measures a company's ability to meet its short-term obligations with its
most liquid assets and therefore excludes inventories from its current assets.
• It is also known as the "acid-test ratio.”
• Quick Ratio
C+MS+AR
=
Current Liabilities
C = Cash and cash equivalents

MS = Marketable securities
AR = Accounts Receivable
CL = Current liabilities
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Example
• Consider two hypothetical companies—ABC Inc. and XYZ Co.—with the following assets
and liabilities on their balance sheets (figures in millions of dollars). We assume that both
companies operate in the same manufacturing sector.
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Balance Sheet (in millions of

ABC Inc. XYZ Co.
dollars)
Cash $5 $1
Marketable Securities $5 $2
Accounts Receivable $10 $2
Inventories $10 $5
Current Assets (a) $30 $10
Plant and Equipment (b) $25 $65
Intangible Assets (c) $20 $0
Total Assets (a + b + c) $75 $75
Current Liabilities* (d) $10 $25
Long-Term Debt (e) $50 $10
Total Liabilities (d + e) $60 $35
Shareholders' Equity $15 $40
Calculations - ABC Inc.
Current Assets
• Current ratio =Current Liabilities
=$30 / $10 = 3.0

C+MS+AR
• Quick ratio =Current Liabilities
= ($30 – $10) / $10 = 2.0

• Debt to equity = $50 / $15 = 3.33
• Debt to assets = $50 / $75 = 0.67
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Calculations - XYZ Co.
• Current ratio = $10 / $25 = 0.40
• Quick ratio = ($10 – $5) / $25 = 0.20
• Debt to equity = $10 / $40 = 0.25
• Debt to assets = $10 / $75 = 0.13
Conclusions
• ABC Inc. has a high degree of liquidity. Based on its current ratio, it has $3 of current
assets for every dollar of current liabilities.
• Its quick ratio points to adequate liquidity even after excluding inventories, with $2 in
assets that can be converted rapidly to cash for every dollar of current liabilities.
• XYZ Company's current ratio of 0.4 indicates an inadequate degree of liquidity with only
40 cents of current assets available to cover every $1 of current liabilities.
• The quick ratio suggests an even more dire liquidity position, with only 20 cents of liquid
assets for every $1 of current liabilities.
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Lesson 11
MARKET VALUE RATIOS
TOPIC 049: MARKET VALUE RATIOS

Market value ratios are used to evaluate the current share price of a publicly-held company's
stock. These ratios are employed by current and potential investors to determine whether a
company's shares are over-priced or under-priced.
• Market Value ratios measure the relationship between accounting representation of the
firm and the market value of the firm.
• Two commonly used market value ratios include:
– Price to earning ratio
– Market Price to book ratio
Price-to-Earnings Ratio – P/E Ratio

• The price-to-earnings ratio (P/E ratio) is the ratio for valuing a company that measures its
current share price relative to its per-share earnings (EPS). The price-to-earnings ratio is
also sometimes known as the price multiple or the earnings multiple.
• P/E ratios are used by investors and analysts to determine the relative value of a
company's shares in an apples-to-apples comparison. It can also be used to compare a
company against its own historical record or to compare aggregate markets against one
another or over time.
Formula
• P/E Ratio
Market Value Per Share
= Earnings per share
• To determine the P/E value, one simply must divide the current stock price by the earnings
per share (EPS)
• Sometimes, analysts investigate long term valuation trends and consider the P/E 10 or
P/E 30 measures, which average the past 10 or past 30 years of earnings, respectively.
• These measures help to gauge the overall value of a stock index, such as the S&P 500
since these longer term measures can compensate for changes in the business cycle.
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TOPIC 050: MARKET PRICE TO BOOK RATIO
 Companies use the price-to-book ratio (P/B ratio) to compare a firm's market capitalization
to its book value. It's calculated by dividing the company's stock price per share by its
book value per share (BVPS). The price-to-book ratio is often used by value investors
looking for stocks that are underpriced by the market.
 An asset's book value is equal to its carrying value on the balance sheet, and companies
calculate it by netting the asset against its accumulated depreciation.
 Book value is also the net asset value of a company calculated as total assets
minus intangible assets (patents, goodwill) and liabilities.
 For the initial outlay of an investment, book value may be net or gross of expenses, such
as trading costs, sales taxes, and service charges.
 Some people may know this ratio by its less common name, price-equity ratio.
Formula
 Price Equity Ratio
Market Price Per Share
 = Book value per share
In this equation, book value per share is calculated as follows: (total assets - total liabilities) /
number of shares outstanding). Market value per share is obtained by simply looking at the share
price quote in the market.
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TOPIC 051: THE RELATIONS AMONG RATIOS
• ROA is a product of two Ratios
• These include:
– Return on Sales (ROS)
– Asset Turnover Ratio (ATO)
EBIT SALES
ROA = SALES X ASSETS
• Firms in different sectors with different ROS and ATO can have same ROA
• For example:
• A supermarket chain can have a low profit margin but high turnover ratio, but a high-priced
jewelry store can have a high profit margin but low turnover ratio.
• Return on Sales (ROS) is the indicator of operational efficiency.
• Asset Turnover ratio (ATO) also indicates how efficiently the company is deploying its
assets to produce revenue.
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TOPIC 052: THE EFFECTS OF FINANCIAL LEVERAGE
• Financial Leverage means the use of borrowed money.

• The shareholders of a firm use financial leverage to boost their ROE.
• This increases the financial and operating risks.
• Financial leverage has value due to the interest tax shield.
• The use of financial leverage also has value when the assets that are purchased with the
debt capital earn more than the cost of the debt that was used to finance them.
TOPIC 053: RELATIONSHIP OF ROE, ROA AND LEVERAGE
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• This equation implies that if a firm’s ROA exceeds interest rate that it pays, then ROE will
exceed (1-Tax Rate) times ROA plus debt/equity ratio times the difference between ROA
and interest rate.
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Lesson 12
THE FINANCIAL PLANNING PROCESS
TOPIC 054: THE FINANCIAL PLANNING PROCESS

Financial Planning is the process of estimating the capital required and determining its
competition. It is the process of framing financial policies in relation to procurement, investment
and administration of funds of an enterprise.
TOPIC 055: FIRM’S SUSTAINABLE GROWTH RATE

The sustainable growth rate (SGR) is the maximum rate of growth that a company or social
enterprise can sustain without having to finance growth with additional equity or debt. In other
words, it is the rate at which the company can grow while using its own internal revenue without
borrowing from outside sources. The SGR involves maximizing sales and revenue growth without
increasing financial leverage. Achieving the SGR can help a company prevent being over-
leveraged and avoid financial distress.
First, obtain or calculate the return on equity (ROE) of the company. ROE measures the
profitability of a company by comparing net income to the company's shareholders' equity.
Then, subtract the company's dividend payout ratio from 1. The dividend payout ratio is the
percentage of earnings per share paid to shareholders as dividends. Finally, multiply the
difference by the ROE of the company.
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TOPIC 056: WORKING CAPITAL MANAGEMENT

Working capital management is a business strategy designed to ensure that a company operates
efficiently by monitoring and using its current assets and liabilities to their most effective use. The
efficiency of working capital management can be quantified using ratio analysis. The primary
purpose of working capital management is to enable the company to maintain sufficient cash flow
to meet its short-term operating costs and short-term debt obligations. A company's working
capital is made up of its current assets minus its current liabilities.
Current assets include anything that can be easily converted into cash within 12 months. These
are the company's highly liquid assets. Some current assets include cash, accounts receivable,
inventory, and short-term investments. Current liabilities are any obligations due within the
following 12 months. These include accruals for operating expenses and current portions of long-
term debt payments.
TOPIC 057: CASH CONVERSION CYCLE (CCC)

The cash conversion cycle (CCC) is a metric that expresses the time (measured in days) that it
takes for a company to convert its investments in inventory and other resources into cash flows
from sales. Also called the net operating cycle or simply cash cycle, CCC attempts to measure
how long each net input dollar is tied up in the production and sales process before it gets
converted into cash received.
This metric takes into account how much time the company needs to sell its inventory, how much
time it takes to collect receivables, and how much time it has to pay its bills.
The CCC is one of several quantitative measures that help evaluate the efficiency of a company’s
operations and management. A trend of decreasing or steady CCC values over multiple periods
is a good sign, while rising ones should lead to more investigation and analysis based on other
factors. One should bear in mind that CCC applies only to select sectors dependent on inventory
management and related operations.
Since CCC involves calculating the net aggregate time involved across the above three stages of
the cash conversion life cycle, the mathematical formula for CCC is represented as:
CCC = DIO + DSO – DPO
Where: DIO = Days of inventory outstanding (also known as days sales of inventory)
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DSO = Days sales outstanding
DPO = Days payables outstanding
DIO and DSO are associated with the company’s cash inflows, while DPO is linked to cash
outflow. Hence, DPO is the only negative figure in the calculation. Another way to look at the
formula construction is that DIO and DSO are linked to inventory and accounts receivable,
respectively, which are considered as short-term assets and are taken as positive. DPO is linked
to accounts payable, which is a liability and thus taken as negative.
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Lesson 13
INTEREST RATES AND YIELD TO MATURITY
TOPIC 058: INTEREST RATES

The interest rate is the amount a lender charges a borrower and is a percentage of the principal—
the amount loaned. The interest rate on a loan is typically noted on an annual basis known as the
annual percentage rate (APR).
An interest rate can also apply to the amount earned at a bank or credit union from a savings
account or certificate of deposit (CD). Annual percentage yield (APY) refers to the interest earned
on these deposit accounts.
Different debt instruments have very different streams of cash payments (known as cash flows)
to the holder, with very different timing. Thus we first need to understand how we can compare
the value of one kind of debt instrument with the value of another before we see how interest
rates are measured. To do this, we make use of the concept of present value.
Four Types of Credit Instruments

1. Simple loan
2. Fixed-payment loan
3. Coupon bond
4. Discount (zero coupon) bond
Present Value
The concept of present value (or present discounted value) is based on the commonsense notion
that a dollar paid to you one year from now is less valuable than a dollar paid to you today. This
notion is true because you can deposit a dollar today in a savings account that earns interest and
have more than a dollar in one year. Economists use a more formal definition, as explained in this
section.
Let’s look at the simplest kind of debt instrument, which we will call a simple loan. In this loan, the
lender provides the borrower with an amount of funds (called the principal) that must be repaid to
the lender at the maturity date, along with an additional payment for the interest. For example, if
you made your friend, Jane, a simple loan of $100 for one year, you would require her to repay
the principal of $100 in one year’s time, along with an additional payment for interest—say, $10.
In the case of a simple loan like this one, the interest payment divided by the amount of the loan
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is a natural and sensible way to measure the interest rate. This measure of the so-called simple
interest rate, i, is:
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Simple Loan
Concept of Present Value
Simple loan of $1 at 10% interest
Years
1 2 3 n
$1.10 $1.21 $1.33 $1X(1+i)n
Present Value of Future $1

1
=(1+i)n
Interest Rate/Yield to Maturity

Yield to maturity = interest rate that equates today’s value with present value of all future
payments
1. Simple Loan (i = 10%)
$100 = $110/(1 + i)
$110 −$100 $10
i= $100
= $100 =0.10 or 10%
Fixed Payment Loan

Fully Amortized Loan
The lender provides the borrower with an amount of funds, which must be repaid by making the
same payment every period.
For example: A person borrowed $1000, a fixed-payment loan might require you to pay $126
every year for 25 years. For example, auto and home loans.
$126 $126 $126
$1000 = (1+i) + (1+i)2+…+ (1+i)25
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(i = 12%)
FP FP FP
• LV = + +…+
(1+i) (1+i) (1+i)
• LV = Loan value
• FP=Fixed yearly cash flow payment
• n=number of years after maturity
TOPIC 059: YIELD TO MATURITY – COUPON BOND

• A coupon bond, also referred to as a bearer bond or bond coupon, is a debt obligation
with coupons attached that represent semiannual interest payments.
• Bondholders receive these coupons during the period between the issuance of the bond
and the maturity of the bond.
Strategy
• Equate today’s value of the bond with its present value.
• Present value of the bond is calculated as the sum of the present values of all the coupon
payments plus the present value of the final payment of the face value of the bond.
• Example: Pakistan Investment Bond
Example
If the face value (FV) of a bond is Rs 1000 with 10 years to maturity and yearly coupon payments
of Rs 100 (a 10% coupon rate). Find the present value?
100 100 100 1000
P=(1+i) + (1+i)2+… + (1+i)10 + (1+i)10
Generally, it can be stated as:

C C C F
P=(1+i) + (1+i)2+…+ (1+i)10+ (1+i)10
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Relationship between Price and Yield to Maturity
Yields to Maturity on a 10 % Coupon Rate Bond Maturing in 10

years (Face Value = Rs 1000)
Price of Bond Yield to Maturity %
1200 7.13
1100 8.48
1000 10.00
900 11.75
800 13.81
1. When yield equals coupon rate, bond is at par.

2. Price and yield are negatively related.
3. Yield is greater than coupon rate when bond price is below par value.
Perpetuity
• A perpetual bond, also known as a "consol bond" or "prep," is a fixed income security with
no maturity date. This type of bond is often considered a type of equity, rather than debt.
One major drawback to these types of bonds is that they are not redeemable.
C
• Price of perpetuity = Pc=
iC
• Where Pc = price of the perpetuity (consol)

• C = yearly payment
• ic = yield to maturity of the perpetuity
Perpetuity – Example
What is the yield to maturity on a bond that has a price of Rs 2,000 and pays Rs 100 annually
forever?
C C
Pc= => iC =
iC Pc
Where C = yearly payment = Rs100

Pc = price of perpetuity = Rs 2000
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100
Thus iC = = 5%
2000
TOPIC 060: YIELD TO MATURITY- DISCOUNT BOND

• A discount bond is a bond that is issued for less than its par—or face—value.
• Discount bonds may also be a bond currently trading for less than its face value in the
secondary market.
• A bond is considered a deep-discount bond if it is sold at a significantly lower price than
par value, usually at 20% or more.
F−P
• Yield to maturity = i = P
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• F = Face value of the discount bond
• P = Current price of the discount bond
Discount Bond – Example

• Suppose a discount bond (a government issued T-bill), which pays a face value of Rs
1000 in one year’s time. If the current purchase price of this bill is Rs 900. Equating this
price to the present value of the Rs 1000 received in one year.
F−P
• Yield to maturity = i = P
1000−900
• i= =0.111 = 11.1%
900
Current bond prices and interest rates are negatively related – When the interest rate rises, the
price of the bond falls, and vice versa.
Real and Nominal Interest Rates

• Real Interest Rate
The interest rate that is adjusted by subtracting expected changes in the price level (inflation) so
that it can represent the true cost of borrowing.
• Nominal Interest Rate
The interest rate before adjusting it for inflation. Nominal can also refer to the advertised or stated
interest rate on a loan.
Real Interest Rates

• Ex ante real interest rate is adjusted for expected changes in price level.
• It is considered as an indicator of “real” interest rate.
• The interest rate that is adjusted for actual changes in the price level is called the
ex post real interest rate.
Fisher Equation
• Developed by Irving Fisher.
• The nominal interest rate i equals the real interest rate ir
Plus the expected rate of inflation πe .
i = ir + πe
Rearranging terms, we find the real interest rate:
ir = i - πe
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• When the real interest rate is low, there are greater incentives to borrow and fewer
incentives to lend.
• It is important to consider the real interest rate for correct decision making.
The yield-to-maturity calculation for a discount bond is similar to that for a simple loan. Let’s
consider a discount bond such as a one-year U.S. Treasury bill that pays a face value of $1,000
in one year’s time but today has a price of $900. As we just saw in the preceding application, the
yield to maturity for a one-year discount bond equals the increase in price over the year, $1,000
– $900, divided by the initial price, $900. Hence, more generally, for any one-year discount bond,
the yield to maturity can be written as:
F−P
i=
P
Where,
F = face value of the discount bond
P = current price of the discount bond
In other words, the yield to maturity equals the increase in price over the year F – P divided by
the initial price P. In normal circumstances, investors earn positive returns from holding these
securities and so they sell at a discount, meaning that the current price of the bond is below the
face value. Therefore, F – P should be positive, and the yield to maturity should be positive as
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well. However, this is not always the case, as extraordinary events in Japan and elsewhere have
indicated.
An important feature of this equation is that it indicates that, for a discount bond, the yield to
maturity is negatively related to the current bond price. This is the same conclusion that we
reached for a coupon bond. The above equation shows that a rise in the bond price—say, from
$900 to $950—means that the bond will have a smaller increase in its price at maturity and so
the yield to maturity will fall, from 11.1% to 5.3% in our example. Similarly, a fall in the yield to
maturity means that the current price of the discount bond has risen.
Summary
The concept of present value tells you that a dollar in the future is not as valuable to you as a
dollar today because you can earn interest on a dollar you have today. Specifically, a dollar
received n years from now is worth only $1/(1 + i)n today. The present value of a set of future cash
flow payments on a debt instrument equals the sum of the present values of each of the future
payments. The yield to maturity for an instrument is the interest rate that equates the present
value of the future payments on that instrument to its value today. Because the procedure for
calculating the yield to maturity is based on sound economic principles, the yield to maturity is the
measure that economists think most accurately describes the interest rate.
Our calculations of the yield to maturity for a variety of bonds reveal the important fact that current
bond prices and interest rates are negatively related: When the interest rate rises, the price of the
bond falls, and vice versa.
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Example
TOPIC 061: INTEREST RATES and Returns

• A return, also known as a financial return, in its simplest terms, is the money made or lost
on an investment over some period.
• Interest rate is different from rate of return.
• A coupon bond with Rs 1000-face-value was issued with a coupon rate of 10%.
• It is bought for Rs 1000, held for one year, and then sold for Rs 1200.
• The owner gets two payments
• i. yearly coupon payment of Rs 100
• ii. change in its value
(Rs 1200-Rs 1000)
• Rate of Return
100+200 300
= 1000
= 1000
= 0.30 or 30%
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Hence, the return on a bond will not necessarily equal the interest rate on that bond.
The distinction between interest rate and return can be important.
Many people think that the interest rate on a bond tells them all they need to know about how well
off they are as a result of owning it. If Irving the Investor thinks he is well off when he owns a long-
term bond yielding a 10% interest rate, and the interest rate then rises to 20%, he will have a rude
awakening: As we will shortly see, if he has to sell the bond, Irving will lose his shirt! How well a
person does financially by holding a bond or any other security over a particular time period is
accurately measured by the security’s return, or, in more precise terminology, the rate of return.
For any security, the rate of return is defined as the amount of each payment to the owner plus
the change in the security’s value, expressed as a fraction of its purchase price.
TOPIC 062: RATE OF RETURN - FORMULA
To make this definition clearer, let us see what the return would look like for a $1,000-face-value
coupon bond with a coupon rate of 10% that is bought for $1,000, held for one year, and then
sold for $1,200. The payments to the owner are the yearly coupon payments of $100, and the
change in the bond’s value is $1,200 - $1,000 = $200.
Adding these values together and expressing them as a fraction of the purchase price of $1,000
gives us the one-year holding-period return for this bond:
You may have noticed something quite surprising about the return that we just calculated: It
equals 30%, yet as Table 1 indicates, initially the yield to maturity was only 10%. This discrepancy
demonstrates that the return on a bond will not necessarily equal the yield to maturity on that
bond. We now see that the distinction between interest rate and return can be important, although
for many securities the two may be closely related.
More generally, the return on a bond held from time t to time t + 1 can be written as:
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Where,
g is the rate of capital gain.
The above equation can be written as:
R=ic +g
Which shows that the return on a bond is the current yield ic plus the rate of capital gain g. The
formula shows that even for a bond for which the current yield ic is an accurate measure of the
yield to maturity, the return can differ substantially from the interest rate. Returns will differ
substantially from the interest rate if the price of the bond experiences sizable fluctuations that
produce substantial capital gains or losses.
The return on a bond held from time t to time t+1

C+Pt+1 −Pt
R= Pt
R = return from holding the bond from time t to time t+1

C = Coupon payment
Pt+1 = price of the bond at time t+1
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Pt = price of the bond at time t
C Pt+1 −Pt
• R= +
Pt Pt
C
• Let ic = Pt
= current yield
Pt+1 −Pt
• g= Pt
= capital gain
• R = ic + g
TOPIC 063: INTEREST RATES, RETURNS AND YEARS TO MATURITY
The finding that the prices of longer-maturity bonds respond more dramatically to changes in
interest rates helps explain an important fact about the behavior of bond markets:
Prices and returns for long-term bonds are more volatile than those for shorter-term bonds. Price
changes of +20% and -20% within a year, with corresponding variations in returns, are common
for bonds that are more than 20 years away from maturity. We now see that changes in interest
rates make investments in long-term bonds quite risky. Indeed, the risk level associated with an
asset’s return that results from interest-rate changes is so important that it has been given a
special name, interest rate risk.
Although long-term debt instruments have substantial interest-rate risk, short-term

debt instruments do not. Indeed, bonds with a maturity term that is as short as the
holding period have no interest-rate risk. We see this for the coupon bond at the bottom of the
table given below, which has no uncertainty about the rate of return because it equals
the yield to maturity, which is known at the time the bond is purchased.
The key to
understanding why there is no interest-rate risk for any bond whose time to maturity
matches the holding period is to recognize that (in this case) the price at the end of the
holding period is already fixed at the face value. A change in interest rates can then
have no effect on the price at the end of the holding period for these bonds, and the
return will therefore be equal to the yield to maturity, which is known at the time the
bond is purchased.
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Table 1: One-year Returns on Different-Maturity 10%-Coupon-Rate Bonds when interest
rates rise from 10% to 20%
One-Year Returns - Different-Maturity 10%-Coupon-Rate Bonds-

Interest Rates Rise from 10% to 20%;
*Col (4) values are calculated using formula for Price of Coupon bond.
• In the previous table, we have assumed that the interest rate has increased from 10% to
20%
• Increase in interest rates => a fall in bond prices
• It results in capital losses on bonds whose terms to maturity are longer.
• The more distant a bond’s maturity date, => the greater is the price change associated
with an interest rate change.
• Even if there is a substantial initial interest rate, its return can turn out to be negative if
interest rates rise.
TOPIC 064: INTEREST RATE RISK

Interest rate risk is the potential for investment losses that can be triggered by a move upward in
the prevailing rates for new debt instruments. If interest rates rise, for instance, the value of a
bond or other fixed-income investment in the secondary market will decline. The change in a
bond's price given a change in interest rates is known as its duration.
Interest rate risk can be reduced by buying bonds with different durations, or by hedging fixed-
income investments with interest rate swaps, options, or other interest rate derivatives.
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Interest rate changes can affect many investments, but it impacts the value of bonds and other
fixed-income securities most directly. Bondholders, therefore, carefully monitor interest rates and
make decisions based on how interest rates are perceived to change over time.
• Prices and returns for long-term bonds are more volatile than those for shorter-term
bonds.
• Price changes of +20% and -20% within a year, with corresponding variations in returns,
are common for bonds that are more than 20 years away from maturity.
• The risk level associated with an asset’s return that results from interest-rate changes is
called interest rate risk.
• Long-term debt instruments have substantial interest-rate risk.
• Short-term debt instruments do not have any interest-rate risk.
• Bonds with a maturity term that is as short as the holding period have no interest-rate risk.
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Lesson 14
DEMAND AND SUPPLY ANALYSIS OF BOND MARKET
TOPIC 065: DETERMINANTS OF ASSET DEMAND

Whether to buy and hold an asset?
OR
Whether to buy one asset rather than another?
1. Wealth, the total resources owned by the individual, including all assets
Holding everything else constant, an increase in wealth raises the quantity demanded of an asset
2. Expected return (the return expected over the next period) on one asset relative to alternative
assets. An increase in an asset’s expected return relative to that of an alternative asset, holding
everything else unchanged, raises the quantity demanded of the asset
3. Risk (the degree of uncertainty associated with the return) on one asset relative to alternative
assets. Holding everything else constant, if an asset’s risk rises relative to that of alternative
assets, its quantity demanded will fall.
4. Liquidity (the ease and speed with which an asset can be turned into cash) relative to
alternative assets. The more liquid an asset is relative to alternative assets, holding everything
else unchanged, the more desirable it is and the greater the quantity demanded will be.
For the demand of an asset, an individual must consider the following factors:
1. Wealth, the total resources owned by the individual, including all assets
2. Expected return (the return expected over the next period) on one asset relative to
alternative assets
3. Risk (the degree of uncertainty associated with the return) on one asset relative to
alternative assets
4. Liquidity (the ease and speed with which an asset can be turned into cash) relative to
alternative assets
Wealth
When we find that our wealth has increased, we have more resources available with which to
purchase assets, and so, not surprisingly, the quantity of assets we demand increases. Therefore,
the effect of changes in wealth on the quantity demanded of an asset can be summarized as
follows: Holding everything else constant, an increase in wealth raises the quantity demanded of
an asset.
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Expected Returns
The return on an asset (such as a bond) measures how much we gain from holding that asset.
When we make a decision to buy an asset, we are influenced by what we expect the return on
that asset to be. If an ExxonMobil bond, for example, has a return of 15% half the time and 5%
the other half, its expected return (which you can think of as the average return) is 10% (= 0.5 *
15% + 0.5 * 5%).
If the expected return on the ExxonMobil bond rises relative to expected returns on alternative
assets, then, holding everything else constant, it becomes more desirable to purchase the
ExxonMobil bond, and the quantity demanded increases. This can occur in either of two ways:
(1) when the expected return on the ExxonMobil bond rises while the return on an alternative
asset—say, stock in Facebook—remains unchanged or (2) when the return on the alternative
asset, the Facebook stock, falls while the return on the ExxonMobil bond remains unchanged. To
summarize, an increase in an asset’s expected return relative to that of an alternative asset,
holding everything else unchanged, raises the quantity demanded of the asset.
Risk
The degree of risk or uncertainty of an asset’s returns also affects demand for the asset. Consider
two assets, stock in Fly-by-Night Airlines and stock in Feet-on-the-Ground Bus Company.
Suppose that Fly-by-Night stock has a return of 15% half the time and 5% the other half, making
its expected return 10%, while Feet-on-the-Ground stock has a fixed return of 10%. Fly-by-Night
stock has uncertainty associated with its returns and so has greater risk than Feet-on-the-Ground
stock, whose return is a sure thing.
A risk-averse person prefers stock in Feet-on-the-Ground (the sure thing) to Fly-by Night stock
(the riskier asset), even though the stocks have the same expected return, 10%. By contrast, a
person who prefers risk is a risk preferrer or risk lover. Most people are risk-averse, especially in
their financial decisions: Everything else being equal, they prefer to hold the less risky asset.
Hence, holding everything else constant, if an asset’s risk rises relative to that of alternative
assets, its quantity demanded will fall.
Liquidity
Another factor that affects the demand for an asset is how quickly it can be converted into cash
at low costs—its liquidity. An asset is liquid if the market in which it is traded has depth and
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breadth, that is, if the market has many buyers and sellers. A house is not a very liquid asset
because it may be hard to find a buyer quickly; if a house must be sold to pay off bills, it might
have to be sold for a much lower price.
And the transaction costs associated with selling a house (broker’s commissions, lawyer’s fees,
and so on) are substantial. A U.S. Treasury bill, by contrast, is a highly liquid asset. It can be sold
in a well-organized market with many buyers, and so it can be sold quickly at low cost. The more
liquid an asset is relative to alternative assets, holding everything else unchanged, the more
desirable it is and the greater the quantity demanded will be.
TOPIC 066: THEORY OF PORTFOLIO CHOICE

It states that, holding all other factors constant:
1. The quantity demanded of an asset is positively related to wealth.
2. The quantity demanded of an asset is positively related to its expected return relative to
alternative assets.
3. The quantity demanded of an asset is negatively related to the risk of its returns relative
to alternative assets.
4. The quantity demanded of an asset is positively related to its liquidity relative to alternative
assets.
All the determining factors we have just discussed can be assembled into the theory of portfolio
choice, which tells us how much of an asset people will want to hold in their portfolios. It states
that, holding all other factors constant:
1. The quantity demanded of an asset is positively related to wealth.

2. The quantity demanded of an asset is positively related to its expected return relative to
alternative assets.
3. The quantity demanded of an asset is negatively related to the risk of its returns relative to
alternative assets.
4. The quantity demanded of an asset is positively related to its liquidity relative to alternative
assets.
These results are summarized in the table presented below:
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TOPIC 067: DEMAND IN THE BOND MARKET

• How are the prices of bonds determined?
• A bond is a fixed income instrument that represents a loan made by an investor to a
borrower (corporate or governmental)
• A bond demand curve shows the relationship between the quantity demanded and the
price when all other economic variables are held constant.
• Hence
F−P
• i = Re = P
• where i = interest rate = yield to maturity

• Re = expected return
• F = face value of the discount bond
• P = initial purchase price of the discount bond
Example:
• If the bond sells for $950, the interest rate and expected return are
1000−950
• i = Re = 950
= 0.053 = 5.3%
The analysis of interest-rate determination looks at supply and demand in the bond market so
that we can better understand how the prices of bonds are determined. Each bond price is
associated with a particular level of the interest rate. Specifically, the negative relationship
between bond prices and interest rates means that when a bond’s price rises, its interest rate
falls, and vice versa.
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The first step in our analysis is to obtain a bond demand curve, which shows the relationship
between the quantity demanded and the price when all other economic variables are held
constant (that is, values of other variables are taken as given). The assumption that all other
economic variables are held constant is called ceteris paribus, which means “other things being
equal” in Latin.
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will be greater than at point B. Similarly, at the even lower prices of $800 (interest rate = 25%)
and $750 (interest rate = 33.3%), the quantity of bonds demanded will be even higher (points D
and E). The curve Bd, which connects these points, is the demand curve for bonds. It has the
usual downward slope, indicating that at lower prices of the bond (everything else being equal),
the quantity demanded is higher.
TOPIC 068: SUPPLY IN THE BOND MARKET

• A supply curve shows the relationship between the quantity supplied and the price when
all other economic variables are held constant.
• It is a positively sloping curve.
• If the interest rate low, it is less costly to borrow by issuing bonds.
• Firms will be willing to borrow more through bond issues, and the quantity of bonds
supplied is at the higher level
• If the interest rate is high, it is expensive to borrow by issuing bonds.
• Firms will be willing to borrow more through bond issues, and the quantity of bonds
supplied is at the higher level
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• The relationship between interest rate and bond price is inverse.
An important assumption behind the demand curve for bonds in Figure 1 is that all other economic
variables besides the bond’s price and interest rate are held constant. We use the same
assumption in deriving a supply curve, which shows the relationship between the quantity
supplied and the price when all other economic variables are held constant.
In Figure 1, when the price of the bonds is $750 (interest rate = 33.3%), point F shows that the
quantity of bonds supplied is $100 billion for the example we are considering. If the price is $800,
the interest rate is the lower rate of 25%. Because at this interest rate it is now less costly to
borrow by issuing bonds, firms will be willing to borrow more through bond issues, and the quantity
of bonds supplied is at the higher level of $200 billion (point G).
An even higher price of $850, corresponding to a lower interest rate of 17.6%, results in a larger
quantity of bonds supplied of $300 billion (point C). Higher prices of $900 and $950 result in even
lower interest rates and even greater quantities of bonds supplied (points H and I). The Bs curve,
which connects these points, is the supply curve for bonds. It has the usual upward slope found
in supply curves, indicating that as the price increases (everything else being equal), the quantity
supplied increases.
TOPIC 069: EQUILIBRIUM IN THE BOND MARKET

• Market equilibrium occurs when the amount that people are willing to buy (demand) equals
the amount that people are willing to sell (supply) at a given price.
• In the bond market, this is achieved when the quantity of bonds demanded equals the
quantity of bonds supplied:
Bd = Bs
• The asset market approach for understanding behavior in financial markets emphasizes
stocks of assets, rather than flows, in determining asset prices.
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Figure 1
In economics, market equilibrium occurs when the amount that people are willing to buy (demand)
equals the amount that people are willing to sell (supply) at a given price. In the bond market, this
is achieved when the quantity of bonds demanded equals the quantity of bonds supplied:
Bd = Bs
In Figure 1 (in Topic 10), equilibrium occurs at point C, where the demand and supply curves
intersect at a bond price of $850 (interest rate of 17.6%) and a quantity of bonds of $300 billion.
The price of P* = 850, where the quantity demanded equals the quantity supplied, is called the
equilibrium or market-clearing price. Similarly, the interest rate of i* = 17.6% that corresponds to
this price is called the equilibrium or market-clearing interest rate.
The concepts of market equilibrium and equilibrium price or interest rate are useful because the
market tends to head toward them. We can see this in Figure 1 by first looking at what happens
when we have a bond price that is above the equilibrium price. When the price of bonds is set too
high, at, say, $950, the quantity of bonds supplied at point I is greater than the quantity of bonds
demanded at point A. A situation like this, in which the quantity of bonds supplied exceeds the
quantity of bonds demanded, is called a condition of excess supply. Because people (borrowers)
want to sell more bonds than others (lender-savers) want to buy, the price of the bonds will fall,
as shown by the downward arrow in the figure at the bond price of $950.
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As long as the bond price remains above the equilibrium price, an excess supply of bonds will
continue to be available, and the price of bonds will continue to fall. This decline will stop only
when the price has reached the equilibrium price of $850, the price at which the excess supply of
bonds has been eliminated.
Now let’s look at what happens when the price of bonds is below the equilibrium price. If the price
of the bonds is set too low, at, say, $750, the quantity demanded at point E is greater than the
quantity supplied at point F. This is called a condition of excess demand. People (lender-savers)
now want to buy more bonds than others (borrowers) are willing to sell, so the price of bonds will
be driven up, as illustrated by the upward arrow in the figure at the bond price of $750. Only when
the excess demand for bonds is eliminated by the bond price rising to the equilibrium level of $850
is there no further tendency for the price to rise.
We can see that the concept of equilibrium price is a useful one because it indicates where the
market will settle. Because each price on the vertical axis of Figure 1 corresponds to a particular
value of the interest rate, the same diagram also shows that the interest rate will head toward the
equilibrium interest rate of 17.6%. When the interest rate is below the equilibrium interest rate, as
it is when it is at 5.3%, the price of the bond is above the equilibrium price, and an excess supply
of bonds results. The price of the bond then falls, leading to a rise in the interest rate toward the
equilibrium level. Similarly, when the interest rate is above the equilibrium level, as it is when it is
at 33.3%, an excess demand for bonds occurs, and the bond price rises, driving the interest rate
back down to the equilibrium level of 17.6%.
TOPIC 070: SHIFTS IN THE DEMAND FOR BONDS

Factors that can cause shift in the demand curve:
1. Wealth
2. Expected returns on bonds relative to alternative assets
3. Risk of bonds relative to alternative assets
4. Liquidity of bonds relative to alternative assets
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Figure 1 is a conventional supply and demand diagram with price on the vertical axis and quantity
on the horizontal axis. Because the interest rate that corresponds to each bond price is also
marked on the vertical axis, this diagram allows us to read the equilibrium interest rate, giving us
a model that describes the determination of interest rates. It is important to recognize that a supply
and demand diagram like Figure 1 can be drawn for any type of bond because the interest rate
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and price of a bond are always negatively related for all kinds of bonds, whether a discount bond
or a coupon bond.
An important feature of the analysis here is that supply and demand are always described in terms
of stocks (amounts at a given point in time) of assets, not in terms of flows. The asset market
approach for understanding behavior in financial markets—which emphasizes stocks of assets,
rather than flows, in determining asset prices—is the dominant methodology used by economists,
because correctly conducting analyses in terms of flows is very tricky, especially when we
encounter inflation.
The theory of portfolio choice, provides a framework for deciding which factors will cause the
demand curve for bonds to shift. These factors include changes in the following four parameters:
1. Wealth
2. Expected returns on bonds relative to alternative assets
3. Risk of bonds relative to alternative assets
4. Liquidity of bonds relative to alternative assets
To see how a change in each of these factors (holding all other factors constant) can shift the
demand curve, let’s look at some examples. (As a study aid, Table 2 summarizes the effects of
changes in these factors on the bond demand curve.)
Wealth When the economy is growing rapidly in a business cycle expansion and wealth is
increasing, the quantity of bonds demanded at each bond price (or interest rate) increases, as
shown in Figure 2. To see how this works, consider point B on the initial demand curve for bonds,
Bd 1. With higher wealth, the quantity of bonds demanded at the same price must rise, to point
B′. Similarly, for point D, the higher wealth causes the quantity demanded at the same bond price
to rise to point D′. Continuing with this reasoning for every point on the initial demand curve Bd 1,
we can see that the demand curve shifts to the right from Bd 1 to Bd 2, as indicated by the arrows.
We can conclude that in a business cycle expansion with growing income and wealth, the demand
for bonds rises and the demand curve for bonds shifts to the right. Applying the same reasoning,
in a recession, when income and wealth are falling, the demand for bonds falls, and the demand
curve shifts to the left. Another factor that affects wealth is the public’s propensity to save. If
households save more, wealth increases and, as we have seen, the demand for bonds rises and
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the demand curve for bonds shifts to the right. Conversely, if people save less, wealth and the
demand for bonds fall, and the demand curve shifts to the left.
Expected Returns For a one-year discount bond and a one-year holding period, the expected
return and the interest rate are identical, so nothing other than today’s interest rate affects the
expected return. For bonds with maturities of greater than one year, the expected return may
differ from the interest rate. A rise in the interest rate on a long-term bond from 10% to 20% would
lead to a sharp decline in price and a very large negative return. Hence, if people began to think
that interest rates would be higher next year than they had originally anticipated, the expected
return today on long-term bonds would fall, and the quantity demanded would fall at each interest
rate. Higher expected future interest rates lower the expected return for long-term bonds,
decrease the demand, and shift the demand curve to the left.
By contrast, an expectation of lower future interest rates would mean that long-term bond prices
would be expected to rise more than originally anticipated, and the resulting higher expected
return today would raise the quantity demanded at each bond price and interest rate. Lower
expected future interest rates increase the demand for long-term bonds and shift the demand
curve to the right (as in Figure 2).
Changes in expected returns on other assets can also shift the demand curve for bonds. If people
suddenly become more optimistic about the stock market and begin to expect higher stock prices
in the future, both expected capital gains and expected returns on stocks will rise. With the
expected return on bonds held constant, the expected return on bonds today relative to stocks
will fall, lowering the demand for bonds and shifting the demand curve to the left. An increase in
expected return on alternative assets lowers the demand for bonds and shifts the demand curve
to the left.
A change in expected inflation is likely to alter expected returns on physical assets (also called
real assets), such as automobiles and houses, which affect the demand for bonds. An increase
in expected inflation from, say, 5% to 10% will lead to higher prices on cars and houses in the
future and hence higher nominal capital gains. The resulting rise in the expected returns today on
these real assets will lead to a fall in the expected return on bonds relative to the expected return
on real assets today and thus cause the demand for bonds to fall. Alternatively, we can think of
the rise in expected inflation as lowering the real interest rate on bonds, and thus the resulting
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decline in the relative expected return on bonds will cause the demand for bonds to fall. An
increase in the expected rate of inflation lowers the expected return on bonds, causing their
demand to decline and the demand curve to shift to the left.
Risk If prices in the bond market become more volatile, the risk associated with bonds increases,
and bonds become a less attractive asset. An increase in the riskiness of bonds causes the
demand for bonds to fall and the demand curve to shift to the left. Conversely, an increase in the
volatility of prices in another asset market, such as the stock market, would make bonds more
attractive. An increase in the riskiness of alternative assets causes the demand for bonds to rise
and the demand curve to shift to the right (as in Figure 2).
Liquidity If more people started trading in the bond market, and as a result it became easier to
sell bonds quickly, the increase in their liquidity would cause the quantity of bonds demanded at
each interest rate to rise. Increased liquidity of bonds results in an increased demand for bonds,
and the demand curve shifts to the right (see Figure 2). Similarly, increased liquidity of alternative
assets lowers the demand for bonds and shifts the demand curve to the left. The reduction of
brokerage commissions for trading common stocks that occurred when the fixed-rate commission
structure was abolished in 1975, for example, increased the liquidity of stocks relative to bonds,
and the resulting lower demand for bonds shifted the demand curve to the left.
Figure 2
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TOPIC 071: SHIFTS IN THE SUPPLY OF BONDS
Certain factors can cause the supply curve for bonds to shift. Among these factors are:
1. Expected profitability of investment opportunities
2. Expected inflation
3. Government budget deficits
We will look at how the supply curve shifts when each of these factors changes (all others
remaining constant). (As a study aid, Table 3 summarizes the effects of changes in these factors
on the bond supply curve.) bonds, and the resulting lower demand for bonds shifted the demand
curve to the left.
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Figure 3
Expected Profitability of Investment Opportunities When opportunities for profitable plant and
equipment investments are plentiful, firms are more willing to borrow to finance these investments.
When the economy is growing rapidly, as in a business cycle expansion, investment opportunities
that are expected to be profitable abound, and the quantity of bonds supplied at any given bond
price increases (for example, from G to G′ or H to H′ in Figure 3). Therefore, in a business cycle
expansion, the supply of bonds increases and the supply curve shifts to the right.
Likewise, in a recession, when far fewer profitable investment opportunities are expected,
the supply of bonds falls and the supply curve shifts to the left.
Expected Inflation The real cost of borrowing is most accurately measured by the real interest
rate, which equals the (nominal) interest rate minus the expected inflation rate. For a given interest
rate (and bond price), when expected inflation increases, the real cost of borrowing falls; hence,
the quantity of bonds supplied increases at any given bond price. An increase in expected
inflation causes the supply of bonds to increase and the supply curve to shift to the right
(see Figure 3), and a decrease in expected inflation causes the supply of bonds to decrease
and the supply curve to shift to the left.
Government Budget Deficits The activities of the government can influence the supply of bonds
in several ways. The U.S. Treasury issues bonds to finance government deficits, caused by gaps
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between the government’s expenditures and its revenues. When these deficits are large, the
Treasury sells more bonds, and the quantity of bonds supplied at each bond price increases.
Higher government deficits increase the supply of bonds and shift the supply curve to the
right (see Figure 3). On the other hand, government surpluses, as occurred in the late
1990s, decrease the supply of bonds and shift the supply curve to the left.
State and local governments and other government agencies also issue bonds to finance their
expenditures, and this can affect the supply of bonds as well. The conduct of monetary policy
involves the purchase and sale of bonds, which in turn influences the supply of bonds. We now
can use our knowledge of how supply and demand curves shift to analyze how the equilibrium
interest rate can change. The best way to do this is to pursue several applications that are
particularly relevant to our understanding of how monetary policy affects interest rates. In studying
these applications, keep two things in mind:
1. When we examine the effect of a variable change, remember we are assuming that all
other variables are unchanged; that is, we are making use of the ceteris paribus
assumption.
2. Remember that the interest rate is negatively related to the bond price, so when the
equilibrium bond price rises, the equilibrium interest rate falls. Conversely, if the
equilibrium bond price moves downward, the equilibrium interest rate rises.
TOPIC 072: FISHER EFFECT

 If expected inflation rises, the expected return on bonds relative to real assets falls for any
given bond price and interest rate.
 The demand for bonds falls, and the demand curve shifts to the left.
 The rise in expected inflation also shifts the supply curve. At any given bond price and
interest rate, the real cost of borrowing declines, causing the quantity of bonds supplied
to increase and the supply curve to shift to the right.
 When the demand and supply curves shift in response to the rise in expected inflation, the
equilibrium moves from point 1 to point 2.
 The equilibrium bond price falls, and, because the bond price is negatively related to the
interest rate, this means that the equilibrium interest rate rises.
 When expected inflation rises, interest rates will rise.
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The Fisher Effect is an economic theory created by economist Irving Fisher that describes the
relationship between inflation and both real and nominal interest rates. The Fisher Effect states
that the real interest rate equals the nominal interest rate minus the expected inflation rate.
Therefore, real interest rates fall as inflation increases, unless nominal rates increase at the same
rate as inflation.
Fisher's equation reflects that the real interest rate can be taken by subtracting the expected
inflation rate from the nominal interest rate. In this equation, all the provided rates are
compounded.
The Fisher Effect can be seen each time you go to the bank; the interest rate an investor has on
a savings account is really the nominal interest rate. For example, if the nominal interest rate on
a savings account is 4% and the expected rate of inflation is 3%, then the money in the savings
account is really growing at 1%. The smaller the real interest rate, the longer it will take for savings
deposits to grow substantially when observed from a purchasing power perspective.
Suppose that expected inflation is initially 5% and the initial supply and demand curves
Bs 1 and Bd 1 intersect at point 1, where the equilibrium bond price is P1. If expected inflation
rises to 10%, the expected return on bonds relative to real assets falls for any given
bond price and interest rate. As a result, the demand for bonds falls, and the demand
curve shifts to the left from Bd 1 to Bd 2. The rise in expected inflation also shifts the supply
curve. At any given bond price and interest rate, the real cost of borrowing declines,
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causing the quantity of bonds supplied to increase and the supply curve to shift to the
right, from Bs1 to Bs2.
When the demand and supply curves shift in response to the rise in expected inflation, the
equilibrium moves from point 1 to point 2, at the intersection of Bd 2 and Bs 2.
The equilibrium bond price falls from P1 to P2 and, because the bond price is negatively
related to the interest rate, this means that the equilibrium interest rate rises. Note that
Figure 4 has been drawn so that the equilibrium quantity of bonds remains the same at
both point 1 and point 2. However, depending on the size of the shifts in the supply and
demand curves, the equilibrium quantity of bonds can either rise or fall when expected
inflation rises.
Our supply and demand analysis has led us to an important observation: When
expected inflation rises, interest rates will rise. This result has been named the Fisher
effect, after Irving Fisher, the economist who first pointed out the relationship of
expected inflation to interest rates.
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Lesson 15
RISK STRUCTURE OF INTEREST RATES
TOPIC 073: RISK STRUCTURE OF INTEREST RATES
Bonds with the same maturity have different interest rates due to:
– Default risk
– Liquidity
– Tax considerations
– Term to maturity
Default risk: probability that the issuer of the bond is unable or unwilling to make interest payments
or pay off the face value
– Treasury bonds are considered default free (government can raise taxes).
– Risk premium: the spread between the interest rates on bonds with default risk
and the interest rates on (same maturity) Treasury bonds.
Response to an Increase in Default Risk on Corporate Bonds
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Interest rate behavior for bonds of the same maturity shows two important features: Interest rates
on different categories of bonds, although they generally move together, differ from one another
in any given year, and the spread (or difference) between the interest rates varies over time. The
interest rates on municipal bonds, for example, were higher than those on U.S. government
(Treasury) bonds in the late 1930s but lower thereafter. In addition, the spread between the
interest rates on Baa corporate bonds (riskier than Aaa corporate bonds) and U.S. government
bonds was very large during the Great Depression years from 1930 to 1933, was smaller during
the 1940s–1960s, and then widened again afterward, particularly during the global financial crisis
from 2007 to 2009. Which factors are responsible for these phenomena?
TOPIC 074: DEFAULT RISK AND RATING AGENCIES

Bond Ratings
• A bond rating is a way to measure the creditworthiness of a bond, which corresponds to
the cost of borrowing for an issuer.
• These ratings assign a letter grade to bonds that indicates their credit quality.
• Private independent rating services such as Standard & Poor's, Moody’s Investors
Service, and Fitch Ratings Inc. evaluate a bond issuer's financial strength, or its ability to
pay a bond's principal and interest, in a timely fashion.
Default Risk
One attribute of a bond that influences its interest rate is its risk of default. Default occurs when
the issuer of the bond is unable or unwilling to make interest payments when promised or pay off
the face value when the bond matures.
Corporations suffering big losses, such as the major airline companies like United, Delta, US
Airways, and Northwest in the mid-2000s, and then American Airlines in 2011, might be more
likely to suspend interest payments on their bonds. The default risk on their bonds
would therefore be quite high. By contrast, U.S. Treasury bonds have usually been
considered to have no default risk because the federal government can always increase
taxes or print money to pay off its obligations. Bonds like these with no default risk are
called default-free bonds.
(However, during the budget negotiations in Congress in

2013, which led to a government shutdown, the Republicans threatened to let Treasury bonds
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default, and this threat had an adverse impact on the bond market.) The
spread between interest rates on bonds with default risk and interest rates on default free bonds,
both of the same maturity, is called the risk premium. The risk premium
indicates how much additional interest people must earn to be willing to hold the risky
bond. Our supply and demand analysis of the bond market in Chapter 5 can be used
to explain why a bond with default risk always has a positive risk premium, and why a
higher default risk means a larger risk premium.
To examine the effect of default risk on interest rates, let’s look at the supply and
demand diagrams for the default-free (U.S. Treasury) and corporate long-term bond
markets in Figure 2. To make the diagrams somewhat easier to read, let’s assume that
initially corporate bonds have the same default risk as U.S. Treasury bonds. In this
case, these two bonds have the same attributes (identical risk and maturity); their equilibrium
prices and interest rates will initially be equal (Pc 1 = PT 1 and ic 1 = iT 1), and
the risk premium on corporate bonds (ic 1 - iT 1) will be zero.
If the possibility of a default increases because a corporation begins to suffer large

losses, the default risk on corporate bonds will increase and the expected return on these
bonds will decrease. In addition, the corporate bond’s return will be more uncertain. The
theory of portfolio choice predicts that because the expected return on the corporate bond
falls relative to the expected return on the default-free Treasury bond while its relative
riskiness rises, the corporate bond is less desirable (holding everything else equal), and
demand for it will fall. Another way of thinking about this is that if you were an investor,
you would want to hold (demand) a smaller amount of corporate bonds.
The demand curve for corporate bonds in panel (a) of Figure 2 then shifts to the left, from Dc 1 to
Dc 2. At the same time, the expected return on default-free Treasury bonds increases relative to
the expected return on corporate bonds, while their relative riskiness declines.
The Treasury bonds thus become more desirable, and demand rises, as shown in panel
(b) by the rightward shift in the demand curve for these bonds from DT 1 to DT 2.
As we can see in Figure 2, the equilibrium price for corporate bonds falls from Pc 1 to
Pc 2, and since the bond price is negatively correlated to the interest rate, the equilibrium
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interest rate on corporate bonds rises to ic 2. At the same time, however, the equilibrium
price for the Treasury bonds rises from PT 1 to PT 2 and the equilibrium interest rate falls to iT 2.
The spread between the interest rates on corporate and default-free bonds—that is, the risk
premium on corporate bonds—has risen from zero to ic 2 - iT 2.
We can now conclude that a bond with default risk will always have a positive risk premium, and
an increase in its default risk will raise the risk premium. Because default risk is so important to
the size of the risk premium, purchasers of bonds need to know whether a corporation is likely to
default on its bonds. This information is provided by credit-rating agencies, investment advisory
firms that rate the quality of corporate and municipal bonds in terms of their probability of default.
TOPIC 075: RATING AGENCIES – EXAMPLE

The term credit rating refers to a quantified assessment of a borrower's creditworthiness in
general terms or with respect to a particular debt or financial obligation. A credit rating can be
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assigned to any entity that seeks to borrow money—an individual, a corporation, a state or
provincial authority, or a sovereign government.
Individual credit scores are calculated by credit bureaus such as Experian, Equifax, and
TransUnion on a three-digit numerical scale using a form of Fair Isaac Corporation (FICO) credit
scoring. Credit ratings for companies and governments are calculated by a credit rating agency
such as S&P Global, Moody’s, or Fitch Ratings. These rating agencies are paid by the entity
seeking a credit rating for itself or one of its debt issues.
Examples
Fitch Ratings
John Knowles Fitch founded the Fitch Publishing Company in 1913, providing financial statistics
for use in the investment industry via "The Fitch Stock and Bond Manual" and "The Fitch Bond
Book." In 1924, Fitch developed and introduced the AAA through D rating system that has become
the basis for ratings throughout the industry.
In the late 1990s, with plans to become a full-service global rating agency, Fitch Ratings merged
with IBCA of London, a subsidiary of Fimalac, S.A., a French holding company. Fitch also
acquired market competitors Thomson BankWatch and Duff & Phelps Credit Rating Co.
Beginning in 2004, Fitch started to develop operating subsidiaries specializing in enterprise risk
management, data services, and finance-industry training with the acquisition of a Canadian
company, Algorithmics, and the creation of Fitch Solutions and Fitch Learning.
Moody’s Investors Service

John Moody and Company first published Moody’s Manual of Industrial and Miscellaneous
Securities in 1900. The manual published basic statistics and general information about stocks
and bonds of various industries.
From 1903 until the stock market crash of 1907, Moody’s Manual was a national publication. In
1909, Moody began publishing Moody’s Analyses of Railroad Investments, which added
analytical information about the value of securities.
Expanding this idea led to the 1914 creation of Moody’s Investors Service, which in the following
10 years would provide ratings for nearly all of the government bond markets at the time. By the
1970s, Moody’s began rating commercial paper and bank deposits, becoming the full-scale rating
agency that it is today.
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TOPIC 076: RISK STRUCTURE OF INTEREST RATES – LIQUIDITY

Liquidity
Another attribute of a bond that influences its interest rate is its liquidity. A liquid asset is one that
can be quickly and cheaply converted into cash if the need arises. The more liquid an asset is,
the more desirable it is (holding everything else constant). U.S.
Treasury bonds are the most liquid of all long-term bonds; because they are so widely traded,
they are the easiest to sell quickly, and the cost of selling them is low. Corporate bonds are not
as liquid because fewer bonds for any one corporation are traded; thus it can be costly to sell
these bonds in an emergency because it might be hard to find buyers quickly.
• Liquidity: the relative ease with which an asset can be converted into cash
• The more liquid an asset is, the more desirable it is (holding everything else constant).
• Treasury bonds are the most liquid of all long-term bonds; because they are so widely
traded, they are the easiest to sell quickly, and the cost of selling them is low.
• Corporate bonds are not as liquid because fewer bonds for any one corporation are
traded; it can be costly to sell these bonds in an emergency because it might be hard to
find buyers quickly.
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• The lower liquidity of corporate bonds relative to Treasury bonds increases the spread
between the interest rates on these two bonds.
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Lesson 16
RISK STRUCTURE OF INTEREST RATES (CONTINUED)
TOPIC 077: RISK STRUCTURE OF INTEREST RATES - TAX

Income Tax Considerations
The risk structure of interest rates (the relationships among interest rates on bonds with the same
maturity) is explained by three factors: default risk, liquidity, and the income tax treatment of a
bond’s interest payments. As a bond’s default risk increases, the risk premium on that bond (the
spread between its interest rate and the interest rate on a default-free Treasury bond) rises. The
greater liquidity of Treasury bonds also explains why their interest rates are lower than those on
less liquid bonds. If a bond has a favorable tax treatment, as do municipal bonds, whose interest
payments are exempt from federal income taxes, its interest rate will be lower.
– Interest payments on some government bonds are exempt from income taxes.
Example:
Suppose income tax is 40%.
For every extra 100 rupees of income you earn, you have to pay 40 rupees to the government. If
you own a Rs 1,000-face-value Treasury bond that sells for Rs 1,000 and has a coupon payment
of Rs 100, you get to keep only Rs 60 of the payment after taxes. Although the bond has a 10%
interest rate, you actually earn only 6.0% after taxes.
Summary
• Interest Rates will be LOWER if:
– default risk is low
– Liquidity is high, and
– the income tax is exempted or very low
TOPIC 078: RISK STRUCTURE OF INTEREST RATES- TERM TO MATURITY

We have seen how risk, liquidity, and tax considerations (collectively embedded in the
risk structure) can influence interest rates. Another factor that influences the interest
rate on a bond is its term to maturity: Bonds with identical risk, liquidity, and tax characteristics
may have different interest rates because their times remaining to maturity
are different. A plot of the yields on bonds with differing terms to maturity but the same
risk, liquidity, and tax considerations is called a yield curve, and it describes the term
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structure of interest rates for particular types of bonds, such as government bonds. The
Following the Financial News box shows a yield curve for Treasury securities.
 Bonds with identical risk, liquidity, and tax characteristics may have different interest rates
because their times remaining to maturity are different.
 A plot of the yields on bonds with differing terms to maturity but the same risk, liquidity,
and tax considerations is called a yield curve.
 The three key types of yield curves include normal, inverted and flat. Upward sloping (also
known as normal yield curves) is where longer-term bonds have higher yields than short-
term ones.
 While normal curves point to economic expansion, downward sloping (inverted) curves
point to economic recession.
TOPIC 079: FACTS ABOUT THE YIELD CURVES

Yield curves can be classified as upward-sloping, flat, or downward-sloping (the last sort is often
referred to as an inverted yield curve). When yield curves slope upward, which is the most
common case, long-term interest rates are above short-term interest rates; when yield curves are
flat, short- and long-term interest rates are the same; and when yield curves are inverted, long-
term interest rates are below short-term interest rates.
Yield curves can also have more complicated shapes in which they first slope up and then down,
or vice versa. Why does the yield curve usually slope upward, but sometimes take on other
shapes?
In addition to explaining why yield curves take on different shapes at different times, a good theory
of the term structure of interest rates must explain the following three important empirical facts:
1. Interest rates on bonds of different maturities move together over time.
2. When short-term interest rates are low, yield curves are more likely to have an upward slope;
when short-term interest rates are high, yield curves are more likely to slope downward and be
inverted.
3. Yield curves almost always slope upward.
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1. Interest rates on bonds of different maturities move together over time

2. When short-term interest rates are low, yield curves are more likely to have an upward
slope; when short-term rates are high, yield curves are more likely to slope downward and
be inverted
3. Yield curves almost always slope upward
Movements over Time of Interest Rates on U.S. Government Bonds with Different
Maturities
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Theories that explain Yield Curve Patterns
Three theories explain the term structure of interest rates—that is, the relationships among
interest rates on bonds of different maturities reflected in yield curve patterns
(1) The expectations theory
(2) The segmented markets theory
(3) The liquidity premium theory
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LESSON 17
VARIOUS THEORIES OF TERM STRUCTURE OF INTEREST RATES
TOPIC 080: THE EXPECTATIONS THEORY

• The interest rate on a long-term bond will equal an average of the short-term interest rates
that people expect to occur over the life of the long-term bond.
• Buyers of bonds do not prefer bonds of one maturity over another.
• People will not hold any quantity of a bond if its expected return is less than that of another
bond with a different maturity
• Bond holders consider bonds with different maturities to be perfect substitutes
• Let the current rate on one-year bond be 6%.
• You expect the interest rate on a one-year bond to be 8% next year.
• Then the expected return for buying two one-year bonds averages (6% + 8%)/2 = 7%.
• The interest rate on a two-year bond must be 7% for you to be willing to purchase it.
• Explains why the term structure of interest rates changes at different times
• Explains why interest rates on bonds with different maturities move together over time
(fact 1)
• Explains why yield curves tend to slope up when short-term rates are low and slope down
when short-term rates are high (fact 2)
• Cannot explain why yield curves usually slope upward (fact 3)
The expectations theory of the term structure states the following commonsense proposition: The
interest rate on a long-term bond will equal the average of the short-term interest rates that people
expect to occur over the life of the long-term bond. For example, if people expect that short-term
interest rates will be 10%, on average, over the coming five years, the expectations theory predicts
that the interest rate on bonds with five years to maturity will be 10%, too.
If short-term interest rates are expected to rise even higher after this five-year period, so that the
average short-term interest rate over the coming 20 years is 11%, then the interest rate on 20-
year bonds will equal 11% and will be higher than the interest rate on five-year bonds. Thus the
expectations theory predicts that interest rates on bonds of different maturities differ because
short-term interest rates are expected to have different values at future dates.
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The key assumption behind this theory is that buyers of bonds do not prefer bonds of one maturity
over another, so they will not hold any quantity of a bond if its expected return is less than that of
another bond with a different maturity. Bonds that have this characteristic are said to be perfect
substitutes. In practice, this means that if bonds with different maturities are perfect substitutes,
then the expected returns on those bonds must be equal.
To see how the assumption that bonds with different maturities are perfect substitutes leads to
the expectations theory, let us consider the following two investment strategies:
1. Purchase a one-year bond, and when it matures in one year, purchase another one year bond.
2. Purchase a two-year bond and hold it until maturity.
Because both strategies must have the same expected return, the interest rate on the two-year
bond must equal the average of the two one-year interest rates. For example, let us say that the
current interest rate on the one-year bond is 9%, and you expect the interest rate on the one-year
bond next year to be 11%. If you pursue the first strategy of buying the two one-year bonds, the
expected return over the two years will average out to be (9% + 11%)>2 = 10% per year. You will
be willing to hold both the one and two-year bonds only if the expected return per year on the two-
year bond equals this return. Therefore, the interest rate on the two-year bond must equal 10%,
the average interest rate on the two one-year bonds.
TOPIC 081: SEGMENTED MARKETS THEORY

• This theory sees markets for different-maturity bonds as completely separate and
segmented.
• The interest rate on a bond of a particular maturity is then determined by the supply of and
demand for that bond.
• The interest rate on a bond of a particular maturity is not affected by expected returns on
other bonds with other maturities.
• The key assumption of the segmented markets theory is that bonds of different maturities
are not substitutes at all.
• The expected return from holding a bond of one maturity has no effect on the demand for
a bond of another maturity.
• This theory is the opposite extreme of the expectations theory, which assumes that bonds
of different maturities are perfect substitutes.
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• For example, if you are putting away funds for your young child to go to college in the
future, your desired holding period will be much longer, and you will want to hold longer-
term bonds.
• The risk-averse investors have short desired holding periods and generally prefer bonds
with shorter maturities that have less interest-rate risk.
• The segmented markets theory can explain fact 3, which states that yield curves typically
slope upward.
• The demand for long-term bonds is typically relatively lower than that for short-term bonds,
long-term bonds will have lower prices and higher interest rates, and hence the yield curve
will typically slope upward.
As the name suggests, the segmented markets theory of the term structure sees markets for
different-maturity bonds as completely separate and segmented. The interest rate on a bond of a
particular maturity is then determined by the supply of and demand for that bond and is not
affected by expected returns on other bonds with other maturities.
The key assumption of the segmented markets theory is that bonds of different maturities are not
substitutes at all, and so the expected return from holding a bond of one maturity has no effect on
the demand for a bond of another maturity. This theory of the term structure is the opposite
extreme of the expectations theory, which assumes that bonds of different maturities are perfect
substitutes.
TOPIC 082: LIQUIDITY PREMIUM THEORY

The liquidity premium theory of the term structure states that the interest rate on
a long-term bond will equal an average of short-term interest rates expected to occur
over the life of the long-term bond plus a liquidity premium (also referred to as a term
premium) that responds to supply and demand conditions for that bond.
The liquidity premium theory’s key assumption is that bonds of different maturities
are substitutes, which means that the expected return on one bond does influence the
expected return on a bond of a different maturity.
However, the theory allows investors

to prefer one bond maturity over another. In other words, bonds of different maturities are
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assumed to be substitutes, but not perfect substitutes. Investors tend to prefer
shorter-term bonds because these bonds bear less interest-rate risk.
For this reason, investors must be offered a positive liquidity premium to induce them to hold long-
term bonds. Thus the expectations theory is modified by adding a positive liquidity
premium to the equation that describes the relationship between long- and short-term
interest rates. The liquidity premium theory is written as
where:
nt is the liquidity (term) premium for the n-period bond at time t, which is always positive and rises
with the term to maturity of the bond, n.
• The liquidity premium theory of the term structure states that the interest rate on a long-
term bond will equal an average of short-term interest rates expected to occur over the life
of the long-term bond plus a liquidity premium (also referred to as a term premium) that
responds to supply and demand conditions for that bond.
Key Assumption:
• Bonds of different maturities are substitutes, which means that the expected return on one
bond does influence the expected return on a bond of a different maturity.
• However, the theory allows investors to prefer one bond maturity over another.
• Bonds of different maturities are assumed to be substitutes, but not perfect substitutes.
• Investors tend to prefer shorter-term bonds because these bonds bear less interest-rate
risk.
• Investors must be offered a positive liquidity premium to induce them to hold longer-term
bonds. Thus the expectations theory is modified by adding a positive liquidity premium to
the equation that describes the relationship between long- and short-term interest rates.
TOPIC 083: PREFERRED HABITAT THEORY

• Investors have a preference for bonds of one maturity over another.
• They will be willing to buy bonds of different maturities only if they earn a somewhat higher
expected return.
• Investors are likely to prefer short-term bonds over longer-term bonds.
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It assumes that investors have a preference for bonds of one maturity over bonds of another—a
particular bond maturity (“preferred habitat”) in which they prefer to invest. Because they prefer
bonds of one maturity over bonds of another, they are willing to buy bonds that do not have the
preferred maturity (habitat) only if those bonds earn a somewhat higher expected return. Because
risk averse investors are likely to prefer the habitat of short-term bonds over that of longer-term
bonds, they are willing to hold long-term bonds only if they have higher expected returns. This
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reasoning leads to the same Equation 3 implied by the liquidity premium theory, with a term
premium that typically rises with maturity.
The relationship between the expectations theory and the liquidity premium and preferred habitat
theories is shown in Figure 5. There we see that because the liquidity premium is always positive
and typically grows as the term to maturity increases, the yield curve implied by the liquidity
premium theory is always above the yield curve implied by the expectations theory and generally
has a steeper slope.
(For simplicity, we are assuming that the expectations theory yield curve is flat.) A simple
numerical example, similar to the one we used for the expectations hypothesis, further clarifies
the liquidity premium and preferred habitat theories given in Equation 3. Again suppose that the
one-year interest rates over the next five years are expected to be 5%, 6%, 7%, 8%, and 9%,
while investors’ preferences for holding short-term bonds means that the liquidity premiums for
one- to five-year bonds are 0%, 0.25%, 0.5%, 0.75%, and 1.0%, respectively.
TOPIC 084: INTERPRETING YIELD CURVES, 1980–2017

Figure 7 illustrates several yield curves for U.S. government bonds, for selected dates from 1981
to 2017. What do these yield curves tell us about the public’s expectations of future movements
of short-term interest rates?
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• Figure shown on the next slide illustrates several yield curves for U.S. government bonds,
for selected dates from 1981 to 2017.
• What do these yield curves tell us about the public’s expectations of future movements of
short-term interest rates?
The steep inverted yield curve that occurred on January 15, 1981 indicated that short-term interest
rates were expected to decline sharply in the future. In order for longer-term interest rates, along
with their positive liquidity premiums, to be well below short-term interest rates, short-term interest
rates must be expected to decline so sharply that their average would be far below the current
short-term rate. Indeed, the public’s expectations of sharply lower short-term interest rates evident
in the yield curve were realized soon after January 15; by March, three-month Treasury bill rates
had declined from the 16% level to 13%.
The steep, upward-sloping yield curves that occurred on March 28, 1985, and July 24, 2017,
indicated that short-term interest rates were expected to climb in the future. Long-term interest
rates are higher than short-term interest rates when short-term interest rates are expected to rise
because their average plus the liquidity premium will be higher than the current short-term rate.
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The moderately upward-sloping yield curves on May 16, 1980, and March 3, 1997, indicated that
short-term interest rates were expected neither to rise nor to fall in the near future. In this case,
their average remains the same as the current short-term rate, and the positive liquidity premium
for longer-term bonds explains the moderate upward slope of the yield curve. The flat yield curve
of February 6, 2006, indicated that short-term interest rates were expected to fall slightly.
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LESSON 18
VARIOUS THEORIES OF TERM STRUCTURE OF INTEREST RATES (CONTINUED)
TOPIC 085: COMMON STOCK

• Common stock is the principal way that listed companies raise equity capital.
• Common stock holders have an ownership interest in the enterprise in the form of a bundle
of rights.
• The right to vote at the AGM. The right to be the residual claimant of all cash flows into
the company. The right to sell stock.
• Dividends are paid quarterly or six monthly.
• Stockholders may receive dividends from the net earnings of the corporation.
• Dividends are payments made periodically, usually every quarter, to stockholders.
• The board of directors of the firm sets the level of the dividend, usually based on the
recommendation of management.
• The term "common stock" indicates that the investors in the company do not own any
particular assets, but that instead all of the assets are the shared, or common, property
of all investors. ... When the liquidation happens through bankruptcy, the common
stock investors typically receive nothing.
Common stock is the principal medium through which corporations raise equity capital.
Stockholders—those who hold stock in a corporation—own an interest in the corporation equal to
the percentage of outstanding shares they own. This ownership interest gives them a bundle of
rights. The most important are the right to vote and to be a residual claimant of all funds flowing
into the firm (known as cash flows), meaning that the stockholder receives whatever remains after
all other claims against the firm’s assets have been satisfied. Stockholders may receive dividends
from the net earnings of the corporation. Dividends are payments made periodically, usually every
quarter, to stockholders. The board of directors of the firm sets the level of the dividend, usually
based on the recommendation of management. In addition, the stockholder has the right to sell
the stock.
One basic principle of finance is that the value of any investment is calculated by computing the
present value of all cash flows the investment will generate over its life. For example, a
commercial building will sell for a price that reflects the net cash flows (rents minus expenses) it
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is projected to have over its useful life. Similarly, we value common stock as the value in today’s
dollars of all future cash flows. The cash flows that a stockholder might earn from stock are
dividends, the sales price, or both.
To develop the theory of stock valuation, we begin with the simplest possible scenario: You buy
the stock, hold it for one period to get a dividend, then sell the stock. We call this the one-period
valuation model.
TOPIC 86: COMPUTING THE PRICE OF A COMMON STOCK

• The value of any investment is calculated by computing the present value of all cash flows
the investment will generate over its life.
• We value common stock as the value in today’s dollars of all future cash flows.
• The cash flows that a stockholder might earn from stock are dividends, the sales price, or
both.
• To answer this question, you need to determine:
• Whether the current price accurately reflects the analyst’s forecast.
• To value the stock today, you need to find the present discounted value of the expected
cash flows (future payments)
• The discount factor used to discount the cash flows is the required return on investments
in equity rather than the interest rate.
• The cash flows consist of one dividend payment plus a final sales price.
Suppose that you have some extra money to invest for one year. After a year, you will
need to sell your investment to pay tuition. After watching CNBC or Nightly Business
Report on TV, you decide that you want to buy Intel Corp. stock. You call your broker
and find that Intel is currently selling for $50 per share and pays $0.16 per year in dividends. The
analyst on CNBC predicts that the stock will be selling for $60 in one year.
Should you buy this stock?
To answer this question, you need to determine whether the current price accurately reflects the
analyst’s forecast. To value the stock today, you need to find the present discounted value of the
expected cash flows (future payments) using the formula given below. In this equation, the
discount factor used to discount the cash flows is the required return on investments in equity
rather than the interest rate. The cash flows consist of one dividend payment plus a final sales
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price. When these cash flows are discounted back to the present, the following equation computes
the current price of the stock:
TOPIC 087: THE ONE-PERIOD VALUATION MODEL – EXAMPLE

The One-Period Valuation Model
• Suppose that you have some extra money to invest for one year. You decided that you
want to buy Lucky Cement stock.
• You call your broker and find that Lucky Cement share is currently selling for Rs. 50 per
share and pays Rs. 0.16 per year in dividends. The analyst predicts that the stock will be
selling for Rs. 60 in one year. Should you buy this stock?
• Suppose the expected return on investment is 12% (k = 0.12).
• Dividend is Rs. 0.16 per year (D= 0.16)
• The forecasted share price after the end of one year is Rs. 60 (𝑷𝟏 = Rs. 60).
𝟎.𝟏𝟔 𝑹𝒔. 𝟔𝟎
• 𝑷𝟎 = 𝟏+𝟎.𝟏𝟐 + 𝟏+𝟎.𝟏𝟐
•
• = Rs. 0.14 +Rs 53.57
• = Rs. 53.71
Example
• Market price < Present Value
• Be aware that the stock may be selling for less than Rs. 53.71, because other investors
have placed a greater risk on the cash flows or estimated the cash flows to be less than
you did.
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TOPIC 088: THE GENERALIZED DIVIDEND VALUATION MODEL

• The value of a stock today is the present value of all future cash flows.
• The only cash flows that an investor will receive are dividends and a final sales price when
the stock is ultimately sold in period n.
• The important information is knowing Pn.
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TOPIC 089: THE THEORY OF RATIONAL EXPECTATIONS
The analysis of stock price evaluation we outlined in the previous section depends on people’s
expectations—especially expectations of cash flows. Indeed, it is difficult to think of any sector of
the economy in which expectations are not crucial; this is why it is important to examine how
expectations are formed. We do so by outlining the theory of rational expectations, currently the
most widely used theory to describe the formation of business and consumer expectations.
In the 1950s and 1960s, economists regularly viewed expectations as formed from past
experience only. Expectations of inflation, for example, were typically viewed as being an average
of past inflation rates. This view of expectation formation, called adaptive expectations, suggests
that changes in expectations will occur slowly over time, as data for a variable evolve. So, if
inflation had formerly been steady at a 5% rate, expectations of future inflation would be 5%, too.
If inflation rose to a steady rate of 10%, expectations of future inflation would rise toward 10%,
but slowly: In the first year, expected inflation might rise only to 6%; in the second year, to 7%;
and so on.
The adaptive expectations hypothesis has been faulted on the grounds that people use more
information than just past data on a single variable to form their expectations of that variable.
Their expectations of inflation will almost surely be affected by their predictions of future monetary
policy, as well as by current and past monetary policy.
In addition, people often change their expectations quickly in the light of new information. To
address these objections to the validity of adaptive expectations, John Muth developed an
alternative theory of expectations, called rational expectations, which can be stated as follows:
Expectations will be identical to optimal forecasts (the best guess of the future) using all available
information.
What exactly does this mean? To explain it more clearly, let’s use the theory of rational
expectations to examine how expectations are formed in a situation that most of us will encounter
at some point in our lifetime: our drive to work. Suppose that if Joe Commuter travels when it is
not rush hour, his trip takes an average of 30 minutes. Sometimes his trip takes 35 minutes; other
times, 25 minutes; but the average, non rush-hour driving time is 30 minutes. If, however, Joe
leaves for work during the rush hour, it takes him, on average, an additional 10 minutes to get to
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work. Given that he leaves for work during the rush hour, the best guess of his driving time—the
optimal forecast—is 40 minutes.
If the only information available to Joe before he leaves for work related to his driving time is that
he is leaving during the rush hour, what does rational expectations theory allow you to predict
about Joe’s expectations of his driving time? Since the best guess of his driving time, using all
available information, is 40 minutes, Joe’s expectation should be the same. Clearly, an
expectation of 35 minutes would not be rational, because it is not equal to the optimal forecast,
or the best guess of the driving time.
Rational Expectations
• In the 1950s and 1960s, economists regularly viewed expectations as formed from past
experience only.
• Stock price valuation depends on expectations
• But how are expectations formed?
• One model of expectations formation is the theory of rational expectations.
• John Muth ‘Expectations will be identical to optimal forecasts (the best guess of the future)
using all available information’
Adaptive Expectations
• Expectations of inflation, for example, were typically viewed as being an average of past
inflation rates. This view of expectation formation, called adaptive expectations, suggests
that changes in expectations will occur slowly over time, as data for a variable evolve.
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LESSON 19
EFFICIENT MARKET HYPOTHESIS
TOPIC 090: EFFICIENT MARKET HYPOTHESIS
• It is an application of rational expectations to the pricing of stocks and other securities.
• It was developed from economist Eugene Fama's Ph.D. dissertation in the 1960s.
• It is based on the assumption that prices of securities in financial markets fully reflect all
available information.
• Return can be calculated using formula:
𝑃𝑡+1 − 𝑃𝑡 +𝐶
R=
𝑃𝑡
• R = rate of return on the security held from time t to time t + 1
• Pt + 1 = price of the security at time t + 1 (the end of the holding period)
• Pt = price of the security at time t (the beginning of the holding period)
• C = cash payment (coupon or dividend payments) made in the period t to t + 1
• Expected Return can be calculated using:
𝑒
𝑃𝑡+1 − 𝑃𝑡 +𝐶
• 𝑅𝑒 =
𝑃𝑡
• 𝑅 𝑒 = expected rate of return on the security held from time t to time t + 1

𝑒
• 𝑃𝑡+1 = expected price of the security at time t + 1 (the end of the holding period)
• The efficient market hypothesis views expectations of future prices as equal to optimal
forecasts using all currently available information.
• Simply, we can put it as:
𝑅𝑒 = 𝑅∗
• Equilibrium condition
𝑅𝑒 = 𝑅∗ = 𝑅 𝑜𝑓
While monetary economists were developing the theory of rational expectations, financial
economists were developing a parallel theory of expectations formation for financial markets. It
led them to the same conclusion as that of the rational expectations theorists: Expectations in
financial markets are equal to optimal forecasts using all available information. Although financial
economists, such as Eugene Fama, later a winner of the Nobel Prize in economics, gave their
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theory another name, calling it the efficient market hypothesis, in fact their theory is just an
application of rational expectations to the pricing of stocks and other securities.
The efficient market hypothesis is based on the assumption that prices of securities in financial
markets fully reflect all available information. The rate of return from holding a security equals the
sum of the capital gain on the security (the change in the price), plus any cash payments, divided
by the initial purchase price of the security.
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TOPIC 091: RATIONALE BEHIND EFFICIENT MARKET HYPOTHESIS

• Suppose the normal return on ABC common stock is 10% at an annual rate, and its current
𝑜𝑓 𝑜𝑓
price Pt is lower than the optimal forecast of tomorrow’s price 𝑃𝑡+1, or Pt = 10% and 𝑃𝑡+1 =
50%.
• i.e. 𝑅 ∗ < 𝑅 𝑜𝑓
• Investors will buy more ABC common stocks; Pt will increase relative to its expected future
of
price Pt+1 , => Rof will fall
• When the current price has risen sufficiently so that Rof = R*, the efficient market condition
is satisfied, the buying of ABC stock will stop, and the unexploited profit opportunity will
disappear.
• A security for which the optimal forecast of the return is -5% and the equilibrium return is
10% (R∗ > Rof ) would be a poor investment.
• Investors will sell the security; its price will fall until Rof rises to the level of R* and the
efficient market condition is satisfied.
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Hence, in an efficient market, all unexploited profit opportunities will be eliminated.
To see why the efficient market hypothesis makes sense, we make use of the concept
of arbitrage, in which market participants (arbitrageurs) eliminate unexploited profit
opportunities, that is, returns on a security that are larger than what is justified by the
characteristics of that security. Arbitrage is of two types: pure arbitrage, in which the
elimination of unexploited profit opportunities involves no risk, and the type of arbitrage we discuss
here, in which the arbitrageur takes on some risk when eliminating
the unexploited profit opportunities.
To see how arbitrage leads to the efficient market hypothesis given a security’s risk
characteristics, let’s look at an example. Suppose the
normal return on ExxonMobil common stock is 10% at an annual rate, and its current
price Pt is lower than the optimal forecast of tomorrow’s price Po t f+ 1, so that the optimal
forecast of the return at an annual rate is 50%, which is greater than the equilibrium
return of 10%.
We are now able to predict that, on average, ExxonMobil’s return will

be abnormally high, so there is an unexploited profit opportunity. Knowing that, on
average, you can earn an abnormally high rate of return on ExxonMobil stock (because
Rof 7 R*), you will buy more, which will in turn drive up the stock’s current price Pt
relative to its expected future price Po t f+ 1, thereby lowering Rof. When the current price
has risen sufficiently so that Rof equals R* and the efficient market condition (Equation
10) is satisfied, the buying of ExxonMobil stock will stop, and the unexploited profit
opportunity will disappear.
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TOPIC 092: RANDOM-WALK BEHAVIOR OF STOCK PRICES

• Random Walk describes the movements of a variable whose future values cannot be
predicted (are random) because, given today’s value, the value of the variable is just as
likely to fall as it is to rise.
• Implication of the EMH is that stock prices should approximately follow a random walk.
• Future changes in stock prices should, for all practical purposes, be unpredictable.
Example – Pakistan Stock Exchange

1. Pakistan’s equity market expanded at a compound annual growth rate of more than 11%
(in terms of US$) since 1992.
2. The KSE 100 increased 3904 points or 8.92% since the beginning of 2021.
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Source: https://tradingeconomics.com/pakistan/stock-market
The term random walk describes the movements of a variable whose future values
cannot be predicted (are random) because, given today’s value, the value of the variable
is just as likely to fall as it is to rise. An important implication of the efficient market
hypothesis is that stock prices should approximately follow a random walk; that is
future changes in stock prices should, for all practical purposes, be unpredictable.
The random-walk implication of the efficient market hypothesis is the one most commonly
mentioned in the press because it is the most readily comprehensible to the public. In fact, when
people mention the “random-walk theory of stock prices,” they are in
reality referring to the efficient market hypothesis.
The case for random-walk stock prices can be demonstrated. Suppose people
could predict that the price of Happy Feet Corporation (HFC) stock would rise 1% in
the coming week. The predicted rate of capital gains and rate of return on HFC stock
would then exceed 50% at an annual rate. Since this is very likely to be far higher than
the equilibrium rate of return on HFC stock (Rof > R*), the efficient market hypothesis
indicates that people would immediately buy this stock and bid up its current price.
The action would stop only when the predictable change in the price dropped to near
zero, so that Rof = R*.
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Similarly, if people could predict that the price of HFC stock would fall by 1%, the
predicted rate of return would be negative (Rof < R*), and people would immediately
sell the stock. The current price would fall until the predictable change in the price rose
back to near zero, where the efficient market condition again would hold.
The efficient
market hypothesis suggests that the predictable change in stock prices will be near zero, leading
to the conclusion that stock prices will generally follow a random walk.6
As the Global Box “Should Foreign Exchange Rates Follow a Random Walk?” indicates,
the efficient market hypothesis suggests that foreign exchange rates should also follow
a random walk.
TOPIC 093: FORMS OF EFFICIENT MARKET HYPOTHESIS (EMH)

There are three tenets to the efficient market hypothesis:
• The weak
• The semi-strong
• The strong
Weak Form Efficiency

• Current stock prices reflect all available information.
• Past performance is irrelevant to what the future holds for the stock.
• Therefore, it assumes that technical analysis can't be used to achieve returns.
Semi-Strong Form Efficiency

• The stock prices are factored into all information that is publicly available.
• No investor can earn excess returns from trading rules based on any publicly available
information.
• Therefore, investors can't use fundamental analysis to beat the market and make
significant gains.
• Market reaction to new publicly available information is instantaneous and unbiased.
• No over- or under-reaction.
• Hence, ffundamental analysis based on publicly available information shouldn’t result in
abnormal returns.
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Strong Form Efficiency

• No investor can earn excess returns using any information – public or private.
• Even private information! – Insider trading is ineffective
• The market is perfect, and making excessive profits from the market is next to impossible.
Though the efficient market hypothesis (EMH), as a whole, theorizes that the market is generally
efficient, the theory is offered in three different versions: weak; semi-strong; and strong. The
basic efficient market hypothesis posits that the market cannot be beaten because it incorporates
all important determining information into current share prices. Therefore, stocks trade at the
fairest value, meaning that they can't be purchased undervalued or sold overvalued. The theory
determines that the only opportunity investors have to gain higher returns on their investments
is through purely speculative investments that pose a substantial risk.
Weak Form
The three versions of the efficient market hypothesis are varying degrees of the same basic
theory. The weak form suggests that today’s stock prices reflect all the data of past prices and
that no form of technical analysis can be effectively utilized to aid investors in making trading
decisions.
Advocates for the weak form efficiency theory believe that if the fundamental analysis is used,
undervalued and overvalued stocks can be determined, and investors can research
companies' financial statements to increase their chances of making higher-than-market-
average profits.
Semi-Strong Form
The semi-strong form efficiency theory follows the belief that because all information that is
public is used in the calculation of a stock's current price, investors cannot utilize either technical
or fundamental analysis to gain higher returns in the market.
Those who subscribe to this version of the theory believe that only information that is not readily
available to the public can help investors boost their returns to a performance level above that
of the general market.
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Strong Form
The strong form version of the efficient market hypothesis states that all information—both the
information available to the public and any information not publicly known—is completely
accounted for in current stock prices, and there is no type of information that can give an investor
an advantage on the market.
Advocates for this degree of the theory suggest that investors cannot make returns on
investments that exceed normal market returns, regardless of information retrieved or research
conducted.
TOPIC 094: EVIDENCE IN FAVOR OF EFFICIENT MARKET HYPOTHESIS

• Empirical studies confirm that stock pickers or mutual fund managers cannot outperform
the market over a long period of time.
• The EMH states that stock prices reflect all available information so that earnings
announcements that are already known will not affect stock prices when the
announcements are made.
• Only ‘new’ news causes stock prices to change.
• Future changes in stock prices should follow a random walk (future changes in prices are
unpredictable).
If you follow the stock market, you might have noticed a puzzling phenomenon:
When good news about a corporation, such as a particularly favorable earnings
report, is announced, the price of the corporation’s stock frequently does not rise. The efficient
market hypothesis explains this phenomenon.
Because changes in stock prices are unpredictable, when information is announced

that has already been expected by the market, stock prices will remain unchanged. The
announcement does not contain any new information that would lead to a change in
stock prices. If this were not the case, and the announcement led to a change in stock
prices, it would mean that the change was predictable.
Because such a scenario is ruled

out in an efficient market, stock prices will respond to announcements only when the
information being announced is new and unexpected. If the news is expected, no stock
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price response will occur. This is exactly what the evidence shows: Stock prices do
reflect publicly available information.
Sometimes an individual stock price declines when good news is announced.

Although this seems somewhat peculiar, it is completely consistent with the workings
of an efficient market. Suppose that although the announced news is good, it is not as
good as expected. HFC’s earnings may have risen by 15%, but if the market expected
earnings to rise by 20%, the new information is actually unfavorable, and the stock
price declines.
TOPIC 095: EVIDENCE AGAINST EFFICIENT MARKET HYPOTHESIS

• Size effect – Studies show that small firms earn abnormal returns over long periods.
• January effect – studies have confirmed an abnormal price rise from December to
January.
• Market overreaction – over/under shooting following ‘new’ news.
• Excessive volatility – fluctuations in stock prices are greater than the fluctuations in the
fundamentals.
• Mean reversion – low returns stock tend to be followed by high returns and vice versa.
Stocks that have done poorly in the past tend to do better in the future. But the evidence
on this is controversial.
• Lag in effect of ‘new’ news – stock prices do not always react to news instantly.
• They show some evidence of autocorrelation.
• If capital markets are informationally efficient, why people take different views about the
same future?
On October 19, 1987, dubbed “Black Monday,” the Dow Jones Industrial Average
declined by more than 20%, the largest one-day decline in U.S. history. The collapse
of the high-tech companies’ share prices from their peaks in March 2000 caused the
heavily tech-laden NASDAQ index to fall from about 5,000 in March 2000 to about
1,500 in 2001 and 2002, a decline of well over 60%. These stock market crashes
caused many economists to question the validity of the efficient market hypothesis.
These economists do not believe that a rational marketplace could have produced
such a massive swing in share prices.
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To what degree should these stock market
crashes make us doubt the validity of the efficient market hypothesis? Nothing in efficient markets
theory rules out large changes in stock prices. A
large change in stock prices can result from new information that produces a dramatic
decline in optimal forecasts of the future valuation of firms. However, economists are
hard pressed to find fundamental changes in the economy that would have caused the
Black Monday and tech crashes. One lesson from these crashes is that factors other than
market fundamentals probably have an effect on asset prices. There are good reasons to believe
that impediments to the proper
functioning of financial markets do exist.
Hence these crashes have convinced many

economists that the stronger version of market efficiency, which states that asset prices
reflect the true fundamental (intrinsic) value of securities, is incorrect. These economists attribute
a large role in determination of stock and other asset prices to market
psychology and to the institutional structure of the marketplace.
However, nothing in
this view contradicts the basic reasoning behind rational expectations or the efficient
market hypothesis—that market participants eliminate unexploited profit opportunities. Even
though stock market prices may not always solely reflect market fundamentals, as long as market
crashes are unpredictable, the basic premises of efficient markets
theory hold.
However, other economists believe that market crashes and bubbles suggest that
unexploited profit opportunities may exist and that the efficient market hypothesis
might be fundamentally flawed. The controversy over the efficient market hypothesis
continues.
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LESSON 20
ASYMMETRIC INFORMATION AND THE LEMONS PROBLEM
TOPIC 096: BEHAVIORAL FINANCE
 Doubts about the efficiency of financial markets, triggered by the stock market crash
of 1987, led economists such as Nobel Prize winner Robert Shiller to develop a new
field of study called behavioral finance.
 It applies concepts from other social sciences,
such as anthropology, sociology, and particularly psychology, to explain the behavior
of securities prices.
 One of the arguments of EMH is that unexploited profit is eliminated by knowledgeable
investors. For this to happen they must engage in short selling.
 Short selling – borrowing the stock from brokers and then sell it in the market with the aim
of making a profit by buying the stock back at a lower price.
 Psychologists suggest that people are subject to ‘loss aversion’. They are unhappy from
losses than happy with equivalent gains. Because the potential losses can be huge from
short selling in reality short selling occurs only in special circumstances.
 Psychologists also find that people tend to be overconfident in their own judgements.
 They trade on their beliefs rather than on pure facts.
 Overconfidence and social contagion (fad) explain the creation of speculative bubbles.
As we have seen, the efficient market hypothesis assumes that unexploited profit
opportunities are eliminated by “smart money” market participants. But can smart
money dominate ordinary investors so that financial markets are efficient? Specifically,
the efficient market hypothesis suggests that smart money participants will sell when a
stock price goes up irrationally, with the result that the stock price falls back down to
a level that is justified by fundamentals. For this to occur, smart money investors must
be able to engage in short sales; that is, they must borrow stock from brokers and then
sell it in the market, with the aim of earning a profit by buying the stock back again
(“covering the short”) after it has fallen in price.
Work by psychologists, however, suggests that people are subject to loss aversion:
They are unhappy when they suffer

losses than they are happy when they achieve gains. Short sales can result in losses far
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in excess of an investor’s initial investment if the stock price climbs sharply higher than
the price at which the short sale is made (and losses might be unlimited if the stock
price climbs to astronomical heights).
Loss aversion can thus explain an important phenomenon: Very little short selling actually takes
place. Short selling may also be constrained by rules restricting it,
because it seems unsavory for someone to make money from another person’s misfortune.
The existence of so little short selling can explain why stock prices are sometimes
overvalued. That is, the lack of enough short selling means that smart money does not
drive stock prices back down to their fundamental value.
Psychologists have also found that people tend to be overconfident in their own
judgments. As a result, investors tend to believe that they are smarter than other investors.
Because investors are willing to assume that the market typically doesn’t get it right,
they trade on their beliefs rather than on pure facts. This theory may explain why securities
markets have such a large trading volume—something that the efficient market
hypothesis does not predict.
Overconfidence and social contagion (fads) provide an explanation for stock market bubbles.
When stock prices go up, investors attribute their profits to their intelligence and talk up the stock
market. This word-of-mouth enthusiasm and glowing
media reports then can produce an environment in which even more investors think
stock prices will rise in the future. The result is a positive feedback loop in which prices
continue to rise, producing a speculative bubble, which finally crashes when prices get
too far out of line with fundamentals.10
The field of behavioral finance is a young one, but it holds out hope that we
might be able to explain some features of securities markets’ behavior that are not well
explained by the efficient market hypothesis.
TOPIC 097: BASIC FACTS ABOUT FINANCIAL STRUCTURE

• It includes banks, insurance companies, mutual funds, stock and bond markets, and so
on—all of which are regulated by government.
• The financial system channels trillions of dollars per year from savers to people with
productive investment opportunities.
• There are EIGHT basic facts of a financial structure.
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• Stocks are not the most important source of external financing for businesses.
• Issuing marketable debt and equity securities is not the primary way in which businesses
finance their operations.
• Indirect finance, is many times more important than direct finance.
• Financial intermediaries, particularly banks, are the most important source of external
funds used to finance businesses.
• The financial system is among the most heavily regulated sectors of the economy.
• Only large, well-established corporations have easy access to securities markets to
finance their activities
• Collateral is a prevalent feature of debt contracts for both households and businesses.
• Collateral is property that is pledged to a lender to guarantee payment in the event that
the borrower is unable to make debt payments.
• Collateralized debt (secured debt) is the predominant form of household debt and is widely
used in business borrowing as well.
• Debt contracts typically are extremely complicated legal documents that place substantial
restrictions on the behavior of the borrower.
The financial system is complex in structure and function throughout the world. It
includes many different types of institutions: banks, insurance companies, mutual
funds, stock and bond markets, and so on—all of which are regulated by government.
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The financial system channels trillions of dollars per year from savers to people with
productive investment opportunities. If we take a close look at financial structure all
over the world, we find eight basic facts, some of which are quite surprising, that we
must explain if we are to understand how the financial system works.
The bar chart in Figure 1 shows how American businesses financed their activities using external
funds (those obtained from outside the business itself) in the period
1970–2000 and compares U.S. data with data for Germany, Japan, and Canada. The
conclusions drawn from this period still hold true today. The Bank Loans category is
made up primarily of loans from depository institutions; Nonbank Loans are primarily
loans by other financial intermediaries; the Bonds category includes marketable debt
securities, such as corporate bonds and commercial paper; and Stock consists of new
issues of equity (stock market shares).
Now let’s explore the eight facts.
1. Stocks are not the most important source of external financing for businesses.
Because so much attention in the media is focused on the stock market, many people have the
impression that stocks are the most important source of financing for American corporations.
However, as we can see from the bar chart in Figure 1, the stock market accounted for only a
small fraction of the external financing of American businesses
in the 1970–2000 period: 11%. Similarly, low figures apply for the other countries
presented in Figure 1. Why is the stock market less important than other sources of
financing in the United States and other countries?
2. Issuing marketable debt and equity securities is not the primary way in which
businesses finance their operations. Figure 1 shows that bonds are a far more important
source of financing in the United States than stocks are (32% versus 11%). However, stocks and
bonds combined (43%), which make up the total share of marketable
securities, still supply less than one-half of the external funds needed by U.S. corporations to
finance their activities. The fact that issuing marketable securities is not the
most important source of financing is true elsewhere in the world as well. Indeed, as we
see in Figure 1, other countries have a much smaller share of external financing supplied by
marketable securities than does the United States. Why don’t businesses use
marketable securities more extensively to finance their activities?
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3. Indirect finance, which involves the activities of financial intermediaries,

is many times more important than direct finance, in which businesses raise funds
directly from lenders in financial markets. Direct finance involves the sale to households of
marketable securities, such as stocks and bonds. The 43% share of stocks and
bonds used as a source of external financing for American businesses actually greatly
overstates the importance of direct finance in our financial system. Since 1970, less than
5% of newly issued corporate bonds and commercial paper, and less than one-third of
new issues of stocks, have been sold directly to American households. The rest of these
securities have been bought primarily by financial intermediaries such as insurance
companies, pension funds, and mutual funds. These figures indicate that direct finance is
used in less than 10% of the external funding of American business. Because in most
countries marketable securities are an even less important source of finance than in
the United States, direct finance is also far less important than indirect finance in the
rest of the world. Why are financial intermediaries and indirect finance so important
in financial markets? In recent years, however, indirect finance has been declining in
importance. Why is this happening?
4. Financial intermediaries, particularly banks, are the most important source

of external funds used to finance businesses. As we can see in Figure 1, the primary
source of external funds for businesses throughout the world is loans made by banks
and other nonbank financial intermediaries, such as insurance companies, pension
funds, and finance companies (56% in the United States, but more than 70% in
Germany, Japan, and Canada). In other industrialized countries, bank loans are
the largest category of sources of external finance (more than 70% in Germany and
Japan, and more than 50% in Canada). Thus the data suggest that banks in these
countries have the most important role in financing business activities. In developing countries,
banks play an even more important role in the financial system than
they do in industrialized countries. What makes banks so important to the workings
of the financial system? Although banks remain important, their contributions to
external funds for businesses have been declining in recent years. What is driving
this decline?
5. The financial system is among the most heavily regulated sectors of the economy. The
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financial system is heavily regulated in the United States and in all other
developed countries. Governments regulate financial markets primarily to promote the
provision of information and to ensure the soundness (stability) of the financial system.
Why are financial markets so extensively regulated throughout the world?
6. Only large, well-established corporations have easy access to securities markets to

finance their activities. Individuals and smaller businesses that are not well
established are less likely to raise funds by issuing marketable securities. Instead, they
most often obtain their financing from banks. Why do only large, well-known corporations find it
easier to raise funds in securities markets?
7. Collateral is a prevalent feature of debt contracts for both households and

businesses. Collateral is property that is pledged to a lender to guarantee payment in
the event that the borrower is unable to make debt payments. Collateralized debt (also
known as secured debt to contrast it with unsecured debt, such as credit card debt,
which is not collateralized) is the predominant form of household debt and is widely
used in business borrowing as well. The majority of household debt in the United
States consists of collateralized loans: Your automobile is collateral for your auto loan,
and your house is collateral for your mortgage. Commercial and farm mortgages, for
which property is pledged as collateral, make up one-quarter of borrowing by nonfinancial
businesses; corporate bonds and other bank loans also often involve pledges of
collateral. Why is collateral such an important feature of debt contracts?
8. Debt contracts typically are extremely complicated legal documents that place
substantial restrictions on the behavior of the borrower. Many students think of a
debt contract as a simple IOU that can be written on a single piece of paper. The reality of debt
contracts is far different, however. In all countries, bond or loan contracts
typically are long legal documents with provisions (called restrictive covenants) that
restrict and specify certain activities that the borrower can engage in. Restrictive covenants are
not just a feature of debt contracts for businesses; for example, personal
automobile loan and home mortgage contracts include covenants that require the borrower to
maintain sufficient insurance on the automobile or house purchased with the
loan. Why are debt contracts so complex and restrictive?
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TOPIC 098: TRANSACTION COSTS
• Transaction costs are expenses incurred when buying or selling a good or service.
• Transaction costs are the payments that banks and brokers receive from buyers and
sellers for their roles.
• Transaction costs are one of the key determinants of net returns.
• Different asset classes have different ranges of transaction costs; investors should select
assets with costs that are at the low end of the range for their types.
Say you have $5,000 that you would like to invest, and you are thinking about investing
in the stock market. Because you have only $5,000, you can buy only a small number
of shares. Even if you use online trading, your purchase is so small that the brokerage
commission for buying the stock you pick will be a large percentage of the purchase
price of the shares. If, instead, you decide to buy a bond, the problem becomes even
worse; the smallest denomination offered on some bonds that you might want to buy
is as large as $10,000, and you do not have that much money to invest. You are disappointed
and realize that you will not be able to use financial markets to earn a return on
your hard-earned savings. You can take some consolation, however, in the fact that you
are not alone in being stymied by high transaction costs. This is a fact of life for many of
us:
About one-half of American households own any securities.

You also face another problem related to transaction costs. Because you have only a
small amount of funds available, you can make only a restricted number of investments, because
a large number of small transactions would result in very high transaction costs.
That is, you have to put all your eggs in one basket, and your inability to diversify will
subject you to a lot of risk.
TOPIC 099: FINANCIAL INTERMEDIARIES AND TRANSACTION COSTS

 Economies of Scale
 One solution to the problem of high transaction costs is to bundle the funds of many
investors together so that they can take advantage of economies of scale, the reduction
in transaction costs per dollar of investment as the size (scale) of transactions increases.
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 Expertise
 Financial intermediaries are also better able to develop expertise, e. g. in computer
technology. Low transaction costs enable financial intermediaries to provide their
customers with liquidity services. For example, money market mutual funds pay
shareholders relatively high interest rates.
Financial intermediaries, an important part of the financial structure, have evolved to reduce
transaction costs and allow small savers and borrowers to benefit from the existence of financial
markets.
Economies of Scale One solution to the problem of high transaction costs is to bundle the funds
of many investors together so that they can take advantage of economies of scale, the reduction
in transaction costs per dollar of investment as the size (scale) of transactions increases. Bundling
investors’ funds together reduces transaction costs for each individual investor. Economies of
scale exist because the total cost of carrying out a transaction in financial markets increases only
a little as the size of the transaction grows. For example, the cost of arranging a purchase of
10,000 shares of stock is not much greater than the cost of arranging a purchase of
50 shares of stock.
The presence of economies of scale in financial markets helps explain the development of
financial intermediaries and why financial intermediaries have become such an important part of
our financial structure. The clearest example of a financial intermediary that arose because of
economies of scale is a mutual fund. A mutual fund is a financial intermediary that sells shares to
individuals and then invests the proceeds in bonds or stocks. Because it buys large blocks of
stocks or bonds, a mutual fund can take advantage of lower transaction costs. These cost savings
are then passed on to individual investors after the mutual fund has taken its cut in the form of
management fees for administering their accounts.
An additional benefit for individual investors is that a mutual fund is large enough to purchase a
widely diversified portfolio of securities.
The increased diversification for individual investors reduces their risk, making them better off.
Economies of scale are also important in lowering the costs of resources that financial institutions
need to accomplish their tasks, such as computer technology. Once a large mutual fund has
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invested a lot of money in setting up a telecommunications system, for example, the system can
be used for a huge number of transactions at a low cost per transaction.
Expertise Financial intermediaries are also better able to develop expertise that can be used to
lower transaction costs. Their expertise in computer technology, for example, enables them to
offer their customers convenient services such as check-writing privileges on their accounts and
toll-free numbers that customers can call for information on how well their investments are doing.
Low transaction costs enable financial intermediaries to provide their customers with liquidity
services, which are services that make it easier for customers to conduct transactions. Money
market mutual funds, for example, not only pay shareholders relatively high interest rates but also
allow them to write checks for convenient bill paying.
TOPIC 100: ASYMMETRIC INFORMATION
Asymmetric Information
 A situation that arises when one party’s insufficient knowledge about the other party
involved in a transaction makes it impossible for the first party to make accurate decisions
when conducting the transaction—is an important aspect of financial markets.
Adverse Selection
 It occurs before a transaction takes place. The parties who are most likely to produce an
undesirable outcome are also the ones most likely to want to engage in the transaction.
For example, big risk takers or outright crooks are often the most eager to take out a loan
because they know they are unlikely to pay it back.
Moral Hazard
 It arises after the transaction occurs. The lender runs the risk that the borrower will engage
in activities that are undesirable from the lender’s point of view, because such activities
make it less likely that the loan will be paid back.
Moral Hazard – Example

 Once borrowers have obtained a loan, they may take on big risks (which have possible
high returns but also run a greater risk of default) because they are playing with someone
else’s money.
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 Moral hazard lowers the probability that the loan will be repaid, lenders may decide that
they would rather not make a loan.
The presence of transaction costs in financial markets partly explains why financial
intermediaries and indirect finance play such an important role in financial markets
(fact 3). To understand financial structure more fully, however, we turn to the role of
information in financial markets.
Asymmetric information—a situation that arises when one party’s insufficient knowledge about
the other party involved in a transaction makes it impossible for the first
party to make accurate decisions when conducting the transaction—is an important
aspect of financial markets. For example, managers of a corporation know whether they
are honest and usually have better information about how well their business is doing
than stockholders do.
Adverse selection is an asymmetric information problem that occurs before a transaction occurs:
Potential bad credit risks are the ones who most actively seek out loans.
Thus the parties who are most likely to produce an undesirable outcome are also the
ones most likely to want to engage in the transaction. For example, big risk takers or
outright crooks are often the most eager to take out a loan because they know they
are unlikely to pay it back. Because adverse selection increases the chances that a loan
might be made to a bad credit risk, lenders might decide not to make any loans, even
though good credit risks can be found in the marketplace.
Moral hazard arises after the transaction occurs: The lender runs the risk that the
borrower will engage in activities that are undesirable from the lender’s point of view,
because such activities make it less likely that the loan will be paid back. For example,
once borrowers have obtained a loan, they may take on big risks (which have possible
high returns but also run a greater risk of default) because they are playing with someone else’s
money. Because moral hazard lowers the probability that the loan will be
repaid, lenders may decide that they would rather not make a loan.
The analysis of how asymmetric information problems affect economic behavior
is called agency theory.
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TOPIC 101: THE LEMONS PROBLEM
• Nobel Prize winner George Akerlof.
• It is called the “lemons problem” because it resembles the problem created by “lemons,”
that is, bad cars, in the used-car market.
• What is the Lemons Problem?
• The lemons problem refers to issues that arise regarding the value of an investment or
product due to asymmetric information possessed by the buyer and the seller.
• If investors can’t distinguish between good and bad securities, they are only willing to pay
only average of good and bad securities’ values.
• Result: Good securities are undervalued and firms won’t issue them; bad securities
overvalued, so too many issued.
• Few bonds are likely to sell in this market, so it will not be a good source of financing.
• Investors won’t want to buy bad securities, so market won’t function well.
• Less asymmetric information for well known firms, so smaller lemons problem.
A particular aspect of the way the adverse selection problem interferes with the efficient
functioning of a market was outlined in a famous article by Nobel Prize winner George
Akerlof. It is called the “lemons problem” because it resembles the problem created by
“lemons,” that is, bad cars, in the used-car market. Potential buyers of used cars are frequently
unable to assess the quality of a car; that is, they can’t tell whether a particular used car is one
that will run well or a lemon that will continually give them grief.
The price that a buyer pays must therefore reflect the average quality of the cars in the
market, somewhere between the low value of a lemon and the high value of a good car.
The owner of a used car, by contrast, is more likely to know whether the car is a
peach or a lemon. If the car is a lemon, the owner is more than happy to sell it at the price
the buyer is willing to pay, which, being somewhere between the value of a lemon and
that of a good car, is greater than the lemon’s value.
However, if the car is a peach, that is,

a good car, the owner knows that the car is undervalued at the price the buyer is willing
to pay, and so the owner may not want to sell it. As a result of this adverse selection problem,
fewer good used cars will come to the market. Because the average quality of a used
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car available in the market will be low, and because very few people want to buy a lemon,
there will be few sales. The used-car market will function poorly, if at all.
Lemons in the Stock and Bond Markets

A similar lemons problem arises in securities markets—that is, the debt (bond) and equity
(stock) markets. Suppose that our friend Irving the Investor, a potential buyer of securities such
as common stock, can’t distinguish between good firms with high expected
profits and low risk and bad firms with low expected profits and high risk. In this situation, Irving
will be willing to pay only a price that reflects the average quality of firms
issuing securities—a price that lies between the value of securities from bad firms and
the value of those from good firms. If the owners or managers of a good firm have better
information than Irving and know that they have a good firm, then they know that their
securities are undervalued and will not want to sell them to Irving at the price he is willing to pay.
The only firms willing to sell Irving securities will be bad firms (because his
price is higher than the securities are worth). Our friend Irving is not stupid; he does not
want to hold securities in bad firms, and hence he will decide not to purchase securities
in the market. In an outcome similar to that in the used-car market, this securities market
will not work very well because few firms will sell securities in it to raise capital.
The analysis is similar if Irving considers purchasing a corporate debt instrument in

the bond market rather than an equity share. Irving will buy a bond only if its interest rate
is high enough to compensate him for the average default risk of the good and bad firms
trying to sell the debt. The knowledgeable owners of a good firm realize that they will be
paying a higher interest rate than they should, so they are unlikely to want to borrow in this
market.
Only the bad firms will be willing to borrow, and because investors like Irving are
not eager to buy bonds issued by bad firms, they will probably not buy any bonds at all.
Few bonds are likely to sell in this market, so it will not be a good source of financing.
The analysis we have just conducted explains fact 2—why marketable securities
are not the primary source of financing for businesses in any country in the world. It
also partly explains fact 1—why stocks are not the most important source of financing
for American businesses. The presence of the lemons problem keeps securities markets
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such as the stock and bond markets from being effective in channeling funds from savers to
borrowers.
TOPIC 102: TOOLS TO HELP SOLVE ADVERSE SELECTION (LEMONS) PROBLEM

 If purchasers of securities can distinguish good firms from bad, they will pay the full value
of securities issued by good firms, and good firms will sell their securities in the market.
 The securities market will then be able to move funds to the good firms that have the most
productive investment opportunities.
 Private Production and Sale of Information
 Reduce asymmetric information by furnishing the people supplying funds with more details
about the individuals or firms seeking to finance their investment activities.
 Private companies that collect and produce information distinguishing good firms from bad
firms and then sell it to the saver-lenders.
 Examples:
 Standard and Poor’s, Moody’s, and Value Line gather information on firms’ balance sheet
positions and investment activities, publish these data, and sell them to subscribers
(individuals, libraries, and financial intermediaries involved in purchasing securities).
In the absence of asymmetric information, the lemons problem goes away. If buyers
know as much about the quality of used cars as sellers, so that all involved can tell a
good car from a bad one, buyers will be willing to pay full value for good used cars. Because the
owners of good used cars can now get a fair price, they will be willing to
sell them in the market. The market will have many transactions and will perform its
intended job of channeling good cars to people who want them.
Similarly, if purchasers of securities can distinguish good firms from bad, they will
pay the full value of securities issued by good firms, and good firms will sell their securities in the
market. The securities market will then be able to move funds to the good
firms that have the most productive investment opportunities.
Private Production and Sale of Information

The solution to the adverse selection problem in financial markets is to reduce asymmetric
information by furnishing the
people supplying funds with more details about the individuals or firms seeking to finance
their investment activities. One way for saver-lenders to get this information is through
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private companies that collect and produce information distinguishing good firms from
bad firms and then sell it to the saver-lenders. In the United States, companies such as
Standard and Poor’s, Moody’s, and Value Line gather information on firms’ balance sheet
positions and investment activities, publish these data, and sell them to subscribers (individuals,
libraries, and financial intermediaries involved in purchasing securities).
TOPIC 103: FREE RIDER PROBLEM

 The free-rider problem occurs when people who do not pay for information take advantage
of the information that other people have paid for.
 The free-rider problem suggests that the private sale of information is only a partial solution
to the lemons problem.
 Suppose you have just purchased information that tells you which firms are good and
which are bad.
 You believe that this purchase is worthwhile because you can make up the cost of
acquiring this information, by purchasing the securities of good firms that are undervalued.
 When a (free-riding) investor sees you buying certain securities, he buys right along with
you, even though he has not paid for any information.
 If many other investors act as he did, the increased demand for the undervalued good
securities causes their low price to be bid up immediately to reflect the securities’ true
value.
 Due to free rider problem adverse selection (the lemons problem) will still interfere with
the efficient functioning of securities markets.
The system of private production and sale of information does not completely solve
the adverse selection problem in securities markets, however, because of the free-rider
problem. The free-rider problem occurs when people who do not pay for information
take advantage of the information that other people have paid for. The free-rider problem suggests
that the private sale of information is only a partial solution to the lemons problem. To see why,
suppose you have just purchased information that tells you
which firms are good and which are bad.
You believe that this purchase is worthwhile

because you can make up the cost of acquiring this information, and then some, by
purchasing the securities of good firms that are undervalued. However, when our savvy
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(free-riding) investor Irving sees you buying certain securities, he buys right along with
you, even though he has not paid for any information. If many other investors act as
Irving does, the increased demand for the undervalued good securities causes their
low price to be bid up immediately to reflect the securities’ true value. Because of all
these free riders, you can no longer buy the securities for less than their true value.
Now, because you will not gain any profit from purchasing the information, you realize
that you never should have paid for the information in the first place. If other investors come to
the same realization, private firms and individuals may not be able to sell
enough of this information to make it worth their while to gather and produce it.
The weakened ability of private firms to profit from selling information will mean that less
information is produced in the marketplace, so adverse selection (the lemons problem)
will still interfere with the efficient functioning of securities markets.
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LESSON 21
ADVERSE SELECTION AND MORAL HAZARD
TOPIC 104: GOVERNMENT REGULATION TO INCREASE INFORMATION

• The government could, for instance, produce information to help investors distinguish
good from bad firms and provide it to the public free of charge.
• This solution, however, would involve the government releasing negative information
about firms, a practice that might be politically difficult.
• A second possibility (and one followed by Pakistan, and most governments throughout the
world) is for the government to regulate securities markets in a way that encourages firms
to reveal honest information about themselves so that investors can determine how good
or bad the firms are.
• Securities Exchange Commission of Pakistan (SECP)
• Government regulation lessens the adverse selection problem, it does not eliminate it
entirely
• A lot more is involved in knowing the quality of a firm than statistics alone can provide.
• Bad firms have an incentive to make themselves look like good firms because this enables
them to fetch a higher price for their securities.
• Bad firms will slant the information they are required to transmit to the public, thus making
it harder for investors to sort out the good firms from the bad.
The free-rider problem prevents the private market from producing enough information to
eliminate all the asymmetric information that leads to adverse selection. Could financial markets
benefit from government intervention? The government could, for instance, produce information
to help investors distinguish good from bad firms and provide it to the public
free of charge. This solution, however, would involve the government releasing negative
information about firms, a practice that might be politically difficult.
A second
possibility (and one followed by the United States and most governments throughout
the world) is for the government to regulate securities markets in a way that encourages firms to
reveal honest information about themselves so that investors can determine how good or bad the
firms are. In the United States, the Securities and Exchange Commission (SEC) is the
government agency that requires firms selling their securities
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to undergo independent audits, in which accounting firms certify that the firm is adhering to
standard accounting principles and disclosing accurate information about sales,
assets, and earnings. Similar regulations are found in other countries. However, disclosure
requirements do not always work well, as the collapse of Enron and accounting
scandals at other corporations, such as WorldCom and Parmalat (an Italian company),
suggest (see the FYI box, “The Enron Implosion”).
The asymmetric information problem of adverse selection in financial markets

helps explain why financial markets are among the most heavily regulated sectors of
the economy (fact 5). Government regulation aimed at increasing the information available to
investors is necessary to reduce the adverse selection problem, which interferes
with the efficient functioning of securities (stock and bond) markets.
Although government regulation lessens the adverse selection problem, it does not
eliminate it entirely. Even when firms provide information to the public about their
sales, assets, or earnings, they still have more information than investors: A lot more
is involved in knowing the quality of a firm than statistics alone can provide. Furthermore, bad
firms have an incentive to make themselves look like good firms because this
enables them to fetch a higher price for their securities. Bad firms will slant the information they
are required to transmit to the public, thus making it harder for investors
to sort out the good firms from the bad.
TOPIC 105: TOOLS TO REDUCE ADVERSE SELECTION-FINANCIAL INTERMEDIATION

 A financial intermediary, e.g. a bank, becomes an expert in producing information about
firms.
 It can sort out good credit risks from bad ones.
 It then can acquire funds from depositors and lend them to the good firms.
Role of Financial Intermediaries

 The bank is able to lend mostly to good firms, it is able to earn a higher return on its loans
than the interest it has to pay to its depositors.
 A bank can avoid the free-rider problem by primarily making private loans, rather than by
purchasing securities that are traded in the open market.
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So far we have seen that private production of information and government regulation to
encourage provision of information lessen, but do not eliminate, the adverse selection problem in
financial markets. How, then, can the financial structure help promote the flow of funds to people
with productive investment opportunities when asymmetric information exists? A clue is provided
by the structure of the used-car market. An important feature of the used-car market is that most
used cars are not sold directly by one individual to another. An individual who considers buying a
used car might pay for privately produced information by subscribing to a magazine like Consumer
Reports to find out if a particular make of car has a good repair record.
Nevertheless, reading Consumer Reports does not solve the adverse selection problem, because
even if a particular make of car has a good reputation, the specific car someone is trying to sell
could be a lemon. The prospective buyer might also bring the used car to a
mechanic for a once-over. But what if the prospective buyer doesn’t know a mechanic
who can be trusted or the mechanic charges a high fee to evaluate the car?
Because these roadblocks make it hard for individuals to acquire enough information about used
cars, most used cars are not sold directly by one individual to another.
Instead, they are sold by an intermediary, a used-car dealer who purchases used cars
from individuals and resells them to other individuals.
Used-car dealers produce information in the market by becoming experts in determining whether
a car is a peach or
a lemon. Once a dealer knows that a car is good, the dealer can sell it with some form
of a guarantee: either an explicit guarantee such as a warranty or an implicit guarantee
in which the dealer stands by its reputation for honesty. People are more likely to purchase a used
car because of a dealer guarantee, and the dealer is able to sell the used car
at a higher price than he or she paid for it. Thus the dealer profits from the production
of information about automobile quality. If dealers purchase and then resell cars on
which they have produced information, they avoid the problem of other people freeriding on the
information they produced.
Just as used-car dealers help solve adverse selection problems in the automobile market,
financial intermediaries play a similar role in financial markets. A financial
intermediary, such as a bank, becomes an expert in producing information about firms
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so that it can sort out good credit risks from bad ones. It then can acquire funds from
depositors and lend them to the good firms. Because the bank is able to lend mostly to
good firms, it is able to earn a higher return on its loans than the interest it has to pay to
its depositors. The resulting profit that the bank earns gives it the incentive to engage in this
information production activity.
An important element of the bank’s ability to profit from the information it produces is that it avoids
the free-rider problem by primarily making private loans, rather
than by purchasing securities that are traded in the open market. Because a private loan
is not traded, other investors cannot watch what the bank is doing and bid down the
loan’s interest rate to the point that the bank receives no compensation for the information it has
produced.
The bank’s role as an intermediary that holds mostly nontraded

loans is the key to its success in reducing asymmetric information in financial markets.
Our analysis of adverse selection indicates that financial intermediaries in general—
and banks in particular, because they hold a large fraction of nontraded loans—should
play a greater role in moving funds to corporations than securities markets do. Our
analysis thus explains facts 3 and 4: why indirect finance is so much more important
than direct finance and why banks are the most important source of external funds for financing
businesses.
Our analysis also explains the greater importance of banks, as opposed to securities
markets, in the financial systems of developing countries. As we have seen, better information
about the quality of firms lessens asymmetric information problems, making it
easier for firms to issue securities. Information about private firms is harder to collect in developing
countries than in industrialized countries; therefore, the smaller role played
by securities markets leads to a greater role for financial intermediaries such as banks.
As a corollary to our analysis, as information about firms becomes easier to acquire, the
role of banks should decline. A major development in the past 30 years in the United
States has been huge improvements in information technology. Thus our analysis suggests that
the lending role of financial institutions such as banks in the United States
should have declined, and this is exactly what has occurred.
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Our analysis of adverse selection also explains fact 6, which questions why large
firms are more likely to obtain funds from securities markets, a direct route, rather
than from banks and financial intermediaries, an indirect route. The better known a
corporation is, the more information about its activities is available in the marketplace.
Thus it is easier for investors to evaluate the quality of the corporation and determine
whether it is a good firm or a bad one. Because investors have fewer worries about
adverse selection when dealing with well-known corporations, they are more willing to
invest directly in their securities. Thus, in accordance with adverse selection, a pecking
order for firms that can issue securities should exist. Hence we have an explanation for
fact 6: The larger and more established a corporation is, the more likely it will be to
issue securities to raise funds.
TOPIC 106: ADVERSE SELECTION, COLLATERAL AND NET WORTH

• Adverse selection interferes with the functioning of financial markets if a lender suffers a
loss when a borrower is unable to make loan payments and defaults on the loan.
• Collateral (property promised to the lender if the borrower defaults), reduces the
consequences of adverse selection because it reduces the lender’s losses in the event of
a default.
• Lenders are more willing to make loans secured by collateral, and borrowers are willing to
supply collateral because the reduced risk for the lender makes it more likely that the loan
will be made, perhaps even at a better loan rate.
• The presence of adverse selection in credit markets thus explains why collateral is an
important feature of debt contracts.
Adverse selection interferes with the functioning of

financial markets only if a lender suffers a loss when a borrower is unable to make loan
payments and thereby defaults on the loan. Collateral, property promised to the lender if
the borrower defaults, reduces the consequences of adverse selection because it reduces
the lender’s losses in the event of a default. If a borrower defaults on a loan, the lender
can sell the collateral and use the proceeds to make up for the losses on the loan. For
example, if you fail to make your mortgage payments, the lender can take the title to
your house, auction it off, and use the receipts to pay off the loan.
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TOPIC 107: ADVERSE SELECTION AND NET WORTH
• Net worth (also called equity capital), is the difference between a firm’s assets (what it
owns or is owed) and its liabilities (what it owes), can perform a similar role to that of
collateral.
• If a firm has a high net worth, then even if it engages in investments that lead to negative
profits and so defaults on its debt payments.
• The lender can take title to the firm’s net worth, sell it off, and use the proceeds to recoup
some of the losses from the loan.
• In addition, the more net worth a firm has in the first place, the less likely it is to default,
because the firm has a cushion of assets that it can use to pay off its loans.
• Hence, when firms seeking credit have high net worth, the consequences of adverse
selection are less important and lenders are more willing to make loans.
• This concept lies behind the often-heard lament, “Only the people who don’t need money
can borrow it!”
Lenders are thus more willing to make loans secured by collateral, and borrowers are willing to
supply collateral because the reduced risk for the lender makes it more likely that the loan will
be made, perhaps even at a better loan rate. The presence of adverse selection in credit
markets thus explains why collateral is an important feature of debt contracts (fact 7).
Net worth (also called equity capital), the difference between a firm’s assets
(what it owns or is owed) and its liabilities (what it owes), can perform a similar role to
that of collateral. If a firm has a high net worth, then even if it engages in investments
that lead to negative profits and so defaults on its debt payments, the lender can take
title to the firm’s net worth, sell it off, and use the proceeds to recoup some of the losses
from the loan.
In addition, the more net worth a firm has in the first place, the less
likely it is to default, because the firm has a cushion of assets that it can use to pay off
its loans. Hence, when firms seeking credit have high net worth, the consequences of
adverse selection are less important and lenders are more willing to make loans. This
concept lies behind the often-heard lament, “Only the people who don’t need money
can borrow it!
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TOPIC 108: MORAL HAZARD AND THE CHOICE BETWEEN DEBT AND EQUITY
• Equity contracts, such as common stock, are claims to a share in the profits and assets of
a business.
• Equity contracts are subject to a particular type of moral hazard called the principal–agent
problem.
• Managers own only a small fraction of the firm they work for, the stockholders who own
most of the firm’s equity (called the principals) are not the same people as the managers
of the firm.
• The managers are the agents of the owners. This separation of ownership and control
involves moral hazard.
• The managers in control (the agents) may act in their own interest rather than in the
interest of the stockholder-owners (the principals) because the managers have less
incentive to maximize profits than the stockholder-owners do.
Moral hazard is the asymmetric information problem that occurs after a financial transaction takes
place, when the seller of a security may have incentives to hide information
and engage in activities that are undesirable for the purchaser of the security. Moral
hazard has important consequences for whether a firm finds it easier to raise funds with
debt than with equity contracts.
Moral Hazard in Equity Contracts: The Principal–Agent Problem

Equity contracts, such as common stock, are claims to a share in the profits and assets
of a business. Equity contracts are subject to a particular type of moral hazard called
the principal–agent problem. When managers own only a small fraction of the firm
they work for, the stockholders who own most of the firm’s equity (called the principals) are not
the same people as the managers of the firm. Thus the managers are the
agents of the owners. This separation of ownership and control involves moral hazard,
in that the managers in control (the agents) may act in their own interest rather than in
the interest of the stockholder-owners (the principals) because the managers have less
incentive to maximize profits than the stockholder-owners do.
To understand the principal–agent problem more fully, suppose that your friend
Steve asks you to become a silent partner in his ice-cream store. The store setup
requires an initial investment of $10,000, and Steve has only $1,000. So you purchase
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an equity stake (stock shares) for $9,000, which entitles you to 90% of the ownership
of the firm, while Steve owns only 10%. If Steve works hard to make tasty ice cream,
keeps the store clean, smiles at all the customers, and hustles to wait on tables quickly,
after all expenses (including Steve’s salary) have been paid, the store will make $50,000
in profits per year, of which Steve will receive 10% ($5,000) and you will receive 90%
($45,000).
But if Steve doesn’t provide quick and friendly service to his customers, uses the
$50,000 in income to buy artwork for his office, and even sneaks off to the beach
while he should be at the store, the store will not earn any profit. Steve can earn the
additional $5,000 (his 10% share of the profits) over his salary only if he works hard
and forgoes unproductive investments (such as art for his office). Steve might decide
that the extra $5,000 just isn’t enough to make him expend the effort to be a good
manager. If Steve feels this way, he does not have enough incentive to be a good
manager and will end up with a beautiful office, a good tan, and a store that doesn’t
show any profits. Because the store won’t show any profits, Steve’s decision not to act
in your interest will cost you $45,000 (your 90% of the profits had he chosen to be a
good manager instead).
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LESSON 22
THE PRINCIPAL-AGENT PROBLEM
TOPIC 109: THE PRINCIPAL–AGENT PROBLEM – EXAMPLE

• Suppose that your friend Steve asks you to become a silent partner in his ice-cream store.
• The store setup requires an initial investment of $10,000, and Steve has only $1,000.
• You purchase an equity stake (stock shares) for $9,000, which entitles you to 90% of the
ownership of the firm, while Steve owns only 10%.
• Suppose Steve:
• works hard to make tasty ice cream,
• keeps the store clean,
• smiles at all the customers, and hustles to wait on tables quickly
• After all expenses (including Steve’s salary) have been paid, the store will make $50,000
in profits per year, of which
• Steve will receive 10% ($5,000) and you will receive 90% ($45,000).
The moral hazard arising from the principal–agent problem might be even worse if
Steve is not totally honest. Because his ice-cream store is a cash business, Steve has the
incentive to pocket $50,000 in cash and tell you that the profits were zero. He now gets
a return of $50,000, and you get nothing.
Further proof that the principal–agent problem created by equity contracts can
be severe is provided by past scandals involving corporations such as Enron and Tyco
International, in which managers were found to have diverted corporate funds for their
own personal use. In addition to pursuing personal benefits, managers might also pursue
corporate strategies (such as the acquisition of other firms) that enhance their personal power but
do not increase the corporation’s profitability.
The principal–agent problem would not arise if the owners of a firm had complete information
about what the managers were up to and could prevent wasteful
expenditures or fraud. The principal–agent problem, which is an example of moral
hazard, arises only because a manager, such as Steve, has more information about his
activities than the stockholder does—that is, information is asymmetric. The principal–
agent problem also would not occur if Steve alone owned the store, and ownership and
control were not separate. If this were the case, Steve’s hard work and avoidance of
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unproductive investments would yield him a profit (and extra income) of $50,000, an
amount that would make it worth his while to be a good manager.
TOPIC 110: TOOLS TO HELP SOLVE THE PRINCIPAL–AGENT PROBLEM

Production of Information: Monitoring
• The principal–agent problem arises because managers have more information about their
activities and actual profits than stockholders do.
• One way for stockholders to reduce this moral hazard problem is to engage in information
production.
• Monitoring the firm’s activities by auditing the firm frequently and checking on what the
management is doing.
• Monitoring process can be expensive (time and money).
Costly state verification

• It makes the equity contract less desirable and explains in part why equity is not a more
important element in our financial structure.
One way for stockholders to reduce this moral

hazard problem is for them to engage in a particular type of information production:
monitoring the firm’s activities by auditing the firm frequently and checking on what
the management is doing. The problem is that the monitoring process can be expensive in terms
of time and money, as reflected in the name economists give it: costly
state verification. Costly state verification makes the equity contract less desirable and
explains in part why equity is not a more important element in our financial structure.
As with adverse selection, the free-rider problem decreases the amount of private
information production that would reduce the moral hazard (principal–agent) problem.
In this example, the free-rider problem decreases monitoring. If you know that
other stockholders are paying to monitor the activities of the company you hold shares
in, you can take a free ride on their activities. Then you can use the money you save
by not engaging in monitoring to vacation on a Caribbean island. If you can do this,
though, so can other stockholders. Perhaps all the stockholders will go to the islands,
and no one will spend any resources on monitoring the firm. The moral hazard problem for shares
of common stock will then be severe, making it hard for firms to issue
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them to raise capital (providing an additional explanation for fact 1).
TOPIC 111: PRINCIPAL–AGENT PROBLEM: GOVERNMENT REGULATION

• Governments everywhere have laws to force firms to adhere to standard accounting
principles that make profit verification easier.
• Examples
– International financial reporting standards (IFRS)
– The Accounting and Auditing Organization for Islamic Financial Institutions
standards (AAOIFI)
Accounting Standards
 International financial reporting standards (IFRS) is a set of accounting rules and

standards that determine how accounting events should be reported in your business's
financial statements.
 The Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI)
maintains and promotes Shari'ah standards for Islamic financial institutions and the overall
industry.
 The Government also pass laws to impose stiff criminal penalties on people who commit
the fraud of hiding and stealing profits.
 These measures can be only partly effective.
As with adverse selection, the government has an incentive to try to reduce the moral hazard
problem created by asymmetric information, which provides another reason why the financial
system is so heavily regulated (fact 5). Governments everywhere have laws to force firms to
adhere to standard accounting principles that make profit verification easier. They also pass
laws to impose stiff criminal penalties on people who commit the fraud of hiding and
stealing profits. However, these measures can be only partly effective. Catching this kind of fraud
is not easy; fraudulent managers have the incentive to make it very hard
for government agencies to find or prove fraud.
TOPIC 112: PRINCIPAL–AGENT PROBLEM: FINANCIAL INTERMEDIATION

• Financial intermediaries have the ability to avoid the free-rider problem in the face of moral
hazard
• One financial intermediary that helps reduce the moral hazard arising from the principal–
agent problem is the venture capital firm.
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Venture Capital Firm
 Venture capital firms pool the resources of their partners and use the funds to help budding
entrepreneurs start new businesses.
• In exchange for supplying the venture capital, the firm receives an equity share in the new
business.
• Verification of earnings and profits is so important in eliminating moral hazard
• Venture capital firms usually insist on having several of their own people participate as
members of the managing body— the board of directors—of the new business so that
they can keep a close watch on the new firm’s activities.
• When a venture capital firm supplies start-up funds, the equity in the new firm is private—
that is, not marketable to anyone except the venture capital firm.
• Other investors are unable to take a free ride on the venture capital firm’s verification
activities.
• As a result of this arrangement, the venture capital firm is able to garner the full benefits
of its verification activities and is given the appropriate incentives to reduce the moral
hazard problem.
• Venture capital firms have been important in the development of the high-tech sector in
the United States, which has resulted in job creation, economic growth, and increased
international competitiveness.
Financial intermediaries have the ability to avoid the

free-rider problem in the face of moral hazard, and this is another reason why indirect
finance is so important (fact 3). One financial intermediary that helps reduce the moral
hazard arising from the principal–agent problem is the venture capital firm. Venture
capital firms pool the resources of their partners and use the funds to help budding
entrepreneurs start new businesses. In exchange for supplying the venture capital, the
firm receives an equity share in the new business.
Because verification of earnings and

profits is so important in eliminating moral hazard, venture capital firms usually insist
on having several of their own people participate as members of the managing body—
the board of directors—of the new business so that they can keep a close watch on the
new firm’s activities. When a venture capital firm supplies start-up funds, the equity
in the new firm is private—that is, not marketable to anyone except the venture capital
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firm.3 Thus other investors are unable to take a free ride on the venture capital firm’s
verification activities. As a result of this arrangement, the venture capital firm is able to
garner the full benefits of its verification activities and is given the appropriate incentives to reduce
the moral hazard problem. Venture capital firms have been important in
the development of the high-tech sector in the United States, which has resulted in job
creation, economic growth, and increased international competitiveness.
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Lesson 23
RISK MANAGEMENT AND ECONOMIC DECISIONS
TOPIC 113: PRINCIPLES OF RISK MANAGEMENT

Risk implies future uncertainty about deviation from expected earnings or expected outcome. Risk
measures the uncertainty that an investor is willing to take to realize a gain from an
investment. We will explain how risk affects financial decision making. We will also explain the
conceptual framework for the management of risk. In these topics, we also explain how the
financial system facilitates the efficient allocation of risk bearing.
Three analytical pillars of finance
• The time value of money
• Valuation, and
• Risk Management
Uncertainty and Risk
• Uncertainty exists whenever one does not know for sure what will happen in the future
• Risk (in financial terms) is the chance that an outcome or investment's actual gains will
differ from an expected outcome or return.
• Risk includes the possibility of losing some or all of an original investment.
• Every risky situation is uncertain but there can be uncertainty without risk
Example
• Risk and uncertainty in a dinner party and a one-dish party
• In case of Dinner Party, there is uncertainty (less or more people might come) and risk
(food shortage or surplus).
• In case of One-Dish Party, there is uncertainty (less or more people might come) but no
risk of shortage or surplus of food.
TOPIC 114: RISK MANAGEMENT

• In the financial world, risk management is the process of identification, analysis, and
acceptance or mitigation of uncertainty in investment decisions.
• Risk management occurs when an investor or fund manager analyzes and attempts to
quantify the potential for losses in an investment, such as a moral hazard, and then takes
the appropriate action (or inaction) given the fund's investment objectives and risk
tolerance.
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• The appropriateness of a risk-management decision should be judged in the light of the
information available at the time the decision is made.
• Risk is inseparable from return in the investment world.
• A variety of ways exist to ascertain risk.
• One of the most common is standard deviation, a statistical measure of dispersion around
a central tendency.
It is possible and prudent to manage investing risks by understanding the basics of risk and how
it is measured. Learning the risks that can apply to different scenarios and some of the ways to
manage them holistically will help all types of investors and business managers to avoid
unnecessary and costly losses.
In the financial world, risk management is the process of identification, analysis, and acceptance
or mitigation of uncertainty in investment decisions. Essentially, risk management occurs when
an investor or fund manager analyzes and attempts to quantify the potential for losses in an
investment, such as a moral hazard, and then takes the appropriate action (or inaction) given the
fund's investment objectives and risk tolerance.
Risk is inseparable from return. Every investment involves some degree of risk, which is
considered close to zero in the case of a U.S. T-bill or very high for something such as emerging-
market equities or real estate in highly inflationary markets. Risk is quantifiable both in absolute
and in relative terms. A solid understanding of risk in its different forms can help investors to better
understand the opportunities, trade-offs, and costs involved with different investment approaches.
Risk management occurs everywhere in the realm of finance. It occurs when an investor
buys U.S. Treasury bonds over corporate bonds, when a fund manager hedges his currency
exposure with currency derivatives, and when a bank performs a credit check on an individual
before issuing a personal line of credit. Stockbrokers use financial instruments
like options and futures, and money managers use strategies like portfolio diversification, asset
allocation and position sizing to mitigate or effectively manage risk.
Inadequate risk management can result in severe consequences for companies, individuals, and
the economy. For example, the subprime mortgage meltdown in 2007 that helped trigger the
Great Recession stemmed from bad risk-management decisions, such as lenders who extended
mortgages to individuals with poor credit; investment firms who bought, packaged, and resold
these mortgages; and funds that invested excessively in the repackaged, but still risky, mortgage-
backed securities (MBSs).
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TOPIC 115: RISK EXPOSURE
• Risk exposure is the measure of potential future loss resulting from a specific activity or
event.
• An analysis of the risk exposure for a business often ranks risks according to their
probability of occurring multiplied by the potential loss if they do.
• The riskiness of an asset or a transaction cannot be assessed in isolation or in the
abstract.
• The purchase of sale of a particular asset may add to your risk exposure; in another, the
same transaction may be risk reducing.
Speculators and Hedgers
• Speculators are the investors who take positions that increase their exposure to certain
risks in the hope of increasing their wealth.
• Hedgers take positions to reduce their exposures.
• The same person can be a speculator on some exposures and a hedger on others.
Risk exposure in any business or an investment is the measurement of potential future loss due
to a specific event or business activity and is calculated as the probability of the event multiplied
by the expected loss due to the risk impact.
What is a Speculator?
A speculator utilizes strategies and typically a shorter time frame in an attempt to outperform
traditional longer-term investors. Speculators take on risk, especially with respect to anticipating
future price movements, in the hope of making gains that are large enough to offset the risk.
Speculators that take on excessive risk typically don't last long. Speculators exert control over
long-term risks by employing various strategies such as position sizing, stop loss orders, and
monitoring the statistics of their trading performance. Speculators are typically sophisticated risk-
taking individuals with expertise in the markets in which they are trading.
Hedgers are primary participants in the futures markets. A hedger is any individual or firm that
buys or sells the actual physical commodity. Many hedgers are producers, wholesalers, retailers
or manufacturers and they are affected by changes in commodity prices, exchange rates, and
interest rates.
TOPIC 116: RISK AND ECONOMIC DECISIONS
• Financial decisions expose us to various risk exposures
• Saving, Investment and financing decisions are significantly influenced by the presence
of risk, and therefore, are risk-management decisions.
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• The ultimate function of a financial system is to help Implement optimal consumption and
resource allocation of households.
• Economic organizations such as firms and governments exist primarily to facilitate the
achievement of that ultimate function.
• To have a better understanding of how risk influences economic decisions, it is important
to explain it in terms of:
1. Households
2. Firms, and
3. Government.
Some financial decisions, such as how much insurance to buy against risk exposures, relate
exclusively to the management of risk. But many general resource allocation decisions, are also
significantly influenced by the presence of risk and therefore, are partly risk-management
decisions.
For example, some households saving is motivated by the desire for the increased security that
comes from owning assets that can cover unanticipated expenses in the future. Economists call
this precautionary saving.
TOPIC 117: RISKS FACING HOUSEHOLDS
Five major categories of risk exposures for households:
1. Sickness, disability, and death
2. Unemployment risk
3. Consumer-durable asset risk in case of fire, theft, technological change
4. Liability risk
• The risk that others will have a financial claim against you because they suffer a loss for
which you can be held responsible.
• For example, you cause a car accident and are required to pay for the injury and damage
caused.
5. Financial-asset risk
• The risk arising from holding different kinds of financial assets such as equities or fixed-
income securities denominated in one or more currencies.
• The underlying sources of financial-asset risk are the uncertainties faced by the firms,
governments, or other economic organizations that have issued these securities.
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There can be many types of risks which households face but there are five major categories of
risk that the households face the most.
Sickness, disability, and death: Unexpected sickness or accidental injuries can impose large costs
on people because of the need for treatment and care and because of the loss of income caused
by the inability to work.
Unemployment risk: This is the risk of losing one’s job.
Consumer-durable asset risk: This is the risk of loss arising from ownership of a house, car, etc.
Losses can occur due to hazards such as fire or theft, etc.
Liability risk: This is the risk that others will have a financial claim against you because they suffer
a loss for which you can be held responsible. For example, you cause a car accident through
reckless driving and are required to cover the cost to others of personal injury and property
damage.
Financial-asset risk: This is the risk arising from holding different kinds of financial assets such as
equities or fixed-income securities denominated in one or more currencies. The underlying
sources of financial-asset risk are the uncertainties face by the firms, governments, or their
economic organizations that have issued these securities.
The risks faced by households influence virtually all of their economic decisions.
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Lesson 24
RISKS FACING FIRMS AND ROLE OF GOVERNMENT
TOPIC 118: RISKS FACING FIRMS

• Running a business comes with many types of risk.
• Some of these potential hazards can destroy a business, while others can cause serious
damage that is costly and time-consuming to repair.
• Despite the risks implicit in doing business, CEOs and risk management officers can
anticipate and prepare, regardless of the size of their business.
Types of Risks facing Firms
1. Physical Risks
2. Location Risks
3. Human Risks
4. Technology Risks
5. Strategy Risks
Some of the major categories of risk, firms are exposed to include:

Production risk: this is the risk that machines will break down, that deliveries of raw materials will
not arrive on time, that workers will not show up for work, or that a new technology will make the
firm’s existing equipment obsolete.
Price risk of outputs: This is the risk that the demand for the baked goods produced by the bakery
will unpredictably change because of an unanticipated shift in consumer preferences (e.g., celery
becomes a popular substitute for bread at restaurants and therefore, the market price of baked
goods might fall.
Price risk of inputs: This is the risk that the prices of some of the inputs of the bakery will change
unpredictably. Flour can become more expensive, or wage rates rise. If the bakery borrows
money to finance its operations at a floating interest rate, it is exposed to risk that interest rates
might rise.
TOPIC 119: PHYSICAL AND LOCATION RISKS FACING FIRMS

Building risks are the most common type of physical risk. Think fires or explosions.
• Fire alarms
• Emergency numbers
• Emergency exits
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Physical Risks
Hazardous material risk is present where spills or accidents are possible. The risk from hazardous
materials can include:
 Acid
 Gas
 Toxic fumes
 Toxic dust or filings
 Poisonous liquids or waste
Location Risks
• Among the location hazards facing a business are nearby fires, storm damage, floods,
hurricanes or tornados, earthquakes, and other natural disasters.
Building risks are the most common type of physical risk. Think fires or explosions. To manage
building risk, and the risk to employees, it is important that organizations do the following:
Make sure all employees know the exact street address of the building to give to a 911 operator
in case of emergency.
Make sure all employees know the location of all exits.
Install fire alarms and smoke detectors.
Install a sprinkler system to provide additional protection to the physical plant, equipment,
documents and, of course, personnel.
Inform all employees that in the event of emergency their personal safety takes priority over
everything else. Employees should be instructed to leave the building and abandon all work-
associated documents, equipment and/or products.
Fire department hazardous material units are prepared to handle these types of disasters. People
who work with these materials, however, should be properly equipped and trained to handle them
safely.
Organizations should create a plan to handle the immediate effects of these risks. Government
agencies and local fire departments provide information to prevent these accidents. Such
agencies can also provide advice on how to control them and minimize their damage if they occur.
Among the location hazards facing a business are nearby fires, storm damage, floods, hurricanes
or tornados, earthquakes, and other natural disasters. Employees should be familiar with the
streets leading in and out of the neighborhood on all sides of the place of business. Individuals
should keep sufficient fuel in their vehicles to drive out of and away from the area. Liability or
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property and casualty insurance are often used to transfer the financial burden of location risks to
a third-party or a business insurance company.
There are other business risks associated with location that are not directly related to hazards,
such as city planning. For example, a gas station exists on a major road, and as a result of its
location, it receives plenty of business. City planning can eventually restructure the area around
the gas station. The city may close the road the gas station is on, build other infrastructure that
would make the gas station inaccessible, or overall just not take the gas station into consideration
with any redevelopment. This would leave the gas station with no traffic to serve.
TOPIC 120: HUMAN AND TECHNOLOGY RISKS FACING FIRMS

Human Risks
• Illness or injury
• Alcohol and drug abuse are major risks to personnel in the workforce. Employees
suffering from alcohol or drug abuse should be urged to seek treatment, counseling, and
rehabilitation if necessary.
• Embezzlement, theft and fraud
• A system of double-signature requirements for checks, invoices,
and payables verification can help prevent embezzlement and fraud. Stringent
accounting procedures may discover embezzlement or fraud. A thorough background
check before hiring personnel can uncover previous offenses in an applicant's past
Technology Risks
• A power outage is perhaps the most common technology risk. Auxiliary gas-driven power
generators are a reliable back-up system to provide electricity for lighting and other
functions.
• Computers may be kept up and running with high-performance back-up batteries.
• Establish offline and online data back-up systems to protect critical documents.
• Telephone and communications failure are relatively uncommon, risk managers may
consider providing emergency-use company cell phones to personnel whose use of the
phone or internet is critical to their business.
Alcohol and drug abuse are major risks to personnel in the workforce. Employees suffering from
alcohol or drug abuse should be urged to seek treatment, counseling, and rehabilitation if
necessary. Some insurance policies may provide partial coverage for the cost of treatment.
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Protection against embezzlement, theft and fraud may be difficult, but these are common crimes
in the workplace. A system of double-signature requirements for checks, invoices,
and payables verification can help prevent embezzlement and fraud. Stringent accounting
procedures may discover embezzlement or fraud. A thorough background check before hiring
personnel can uncover previous offenses in an applicant's past. While this may not be grounds
for refusing to hire an applicant, it would help HR to avoid placing a new hire in a critical position
where the employee is open to temptation.
Illness or injury among the workforce is a potential problem. To prevent loss of productivity, assign
and train backup personnel to handle the work of critical employees when they are absent due to
a health-related concern.
Technology Risks
A power outage is perhaps the most common technology risk. Auxiliary gas-driven power
generators are a reliable back-up system to provide electricity for lighting and other functions.
Manufacturing plants use several large auxiliary generators to keep a factory operational until
utility power is restored.
Computers may be kept up and running with high-performance back-up batteries. Power surges
may occur during a lightning storm (or randomly), so organizations should furnish critical business
systems with surge-protection devices to avoid the loss of documents and the destruction of
equipment.
Cloud storage is another source of risks nowadays. The process involves backing up data with
Amazon Web Services, for example, using Azure, IBM, and Oracle, for instance. This is a huge
undertaking that should be considered given the reliance on cloud-based data to run most
businesses now. It is important to establish both offline and online data backup systems to protect
critical documents.
Although telephone and communications failure are relatively uncommon, risk managers may
consider providing emergency-use company cell phones to personnel whose use of the phone or
internet is critical to their business.
TOPIC 121: STRATEGIC RISKS FACING FIRMS

• Strategic risks are those that arise from the fundamental decisions that directors take
concerning an organization’s objectives.
• Essentially, strategic risks are the risks of failing to achieve these business objectives.
Strategic Risks – Types
1. Strategic Business risks
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2. Strategic Non-Business risks
Strategic Business Risks
Risks that derive from the decisions that the board takes about the products or services that the
organization supplies. They include risks associated with developing and marketing those
products or services, economic risks affecting product sales and costs, and risks arising from
changes in the technological environment which impact on sales and production.
Strategic Non-Business Risks
• Risks that do not derive from the products or services supplied, e.g. risks associated with
the long-term sources of finance used.
• Competitor actions will affect risk levels in product markets, and technological
developments may mean that production processes, or products, quickly become out-of-
date.
Strategy risks are not altogether undesirable. Financial institutions such as banks or credit
unions take on strategy risk when lending to consumers, while pharmaceutical companies are
exposed to strategy risk through research and development for a new drug. Each of these
strategy-related risks is inherent in an organization's business objectives. When structured
efficiently, the acceptance of strategy risks can create highly profitable operations.
Companies exposed to substantial strategy risk can mitigate the potential for negative
consequences by creating and maintaining infrastructures that support high-risk projects. A
system established to control the financial hardship that occurs when a risky venture fails often
includes diversification of current projects, healthy cash flow, or the ability to finance new projects
in an affordable way, and a comprehensive process to review and analyze potential ventures
based on future return on investment.
TOPIC 122: ROLE OF GOVERNMENT IN RISK MANAGEMENT

• Governments at all levels play an important role in managing risks by:
– Preventing them or
– Redistributing them.
• Governments provide relief in case of natural disasters and various human-caused
hazards, e.g. war, pollution
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TOPIC 123: THE RISK-MANAGEMENT PROCESS

• The risk-management process can be broken into five steps:
1. Risk identification
2. Risk assessment
3. Selection of risk-management techniques
4. Implementation
5. Review
Risk Identification
• The process of figuring out what the most important risk exposures are for the unit of
analysis, i.e. a household, a firm, or some other entity.
• Sometimes the households or firms are completely unaware of the possible risks they
are exposed to.
• Effective risk identification requires that one take the perspective of the entity as a whole
and consider the totality of uncertainties affecting it.
• For example, future prices of raw material, stocks, foreign-exchange rate, price risks,
quantity risks
• Maintain a checklist of the entity’s potential exposures and the relations among them.
• Detailed knowledge about the economics of the industry in which the firm competes, the
technology of the firm, and its sources of supply.
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Lesson 25
RISK ASSESSMENT
TOPIC 124: RISK ASSESSMENT

• The quantification of the costs associated with the risks that have been identified in the
first step of risk-management.
• For better assessment of risk, actuaries are employed.
• Actuaries are professionals specially trained in mathematics and statistics to gather and
analyze data and estimate the probabilities of illness, accidents and other such risks.
• In case of financial-asse risks, households and firms often seek expert advice in
assessing their exposures and
• In quantifying the trade-offs between the risks and rewards of investing in various
categories of assets, such as stocks and bonds, they typically turn to professional
investment advisors, mutual funds, or other financial intermediaries an service firms that
help them make those assessments.
Clearly, she needs information, and information may be costly to gather. One of the main
functions of insurance companies is to provide this kind of information. They employ actuaries,
who are professional specially trained in mathematics and statistics, to gather and analyze data
and estimate the probabilities of illness, accidents, and other such risks.\In the realm of final-
asset risks, households and firms often need expert advice in assessing their exposures and in
quantifying the trade-offs between the risks and rewards of investing in various categories of
assets, such as stocks and bonds. They typically turn to professional investment advisors, mutual
funds, or other financial intermediaries and service firms that help them make those
assessments.
TOPIC 125: RISK MANAGEMENT TECHNIQUES

There are FOUR basic techniques available for reducing risk:
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1. Risk avoidance
2. Loss prevention and control
3. Risk retention
4. Risk transfer
Risk avoidance
• A conscious decision of not to be exposed to a particular risk.
• People may decide to avoid the risks of going into certain professions and firms may avoid
certain lines of business because they are considered too risky.
• It is not always feasible to avoid risk, e. g. in case of illness.
Loss prevention and control
• Actions taken to reduce the likelihood or the severity of losses.
• Such actions can be taken prior to, concurrent with, or after a loss occurs
Risk Retention
• Absorbing the risk and covering losses out of one’s own resources.
• This sometimes happens by default.
• For example, when may decide to bear all expenses if gets ill instead of buying insurance.
Risk transfer
• Transferring the risk to others.
• It can be done by:
– Selling the risky asset to somebody else
– Buying insurance.
TOPIC 126: THE THREE DIMENSIONS OF RISK TRANSFER

The three dimensions of risk transfer include hedging, insuring and diversifying. Each of these
dimensions are discussed in the subsequent topics in detail.
• Financial system plays the greatest role in transferring risk
• Risk transfer has three dimensions
– Hedging
– Insuring
– Diversifying
Hedging
• Hedging is a strategy that tries to limit risks in financial assets.

• One is said to hedge a risk when the action taken to reduce one’s exposure to a loss also
causes one to give up the possibility of gain.
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• Example: Farmers sell their crop before harvest to hedge against price fluctuations.
Insuring
• Insuring means paying premium.
• Example: Car insurance by paying premium of Rs 30000 per month for two years
Suppose car price is 20 lacs.
Difference between Insuring and Hedging
• There is a fundamental difference between insuring and hedging.
• When you hedge, you eliminate the risk of loss by giving up the potential for gain.
• When you insure, you pay a premium to eliminate the risk of loss and retain the
potential for gain.
Diversifying
• It means holding similar amounts of many risky assets instead of concentrating all your
investment in only one.
• It limits your exposure to the risk of any single asset.
TOPIC 127: RISK TRANSFER AND ECONOMIC EFFICIENCY

• Institutional arrangements for the transfer of risk contribute to economic efficiency in two
fundamental ways:
– They reallocate existing risks to those most willing to bear them
– They cause a reallocation of resources to production and consumption according
to the new distribution of risk bearing.
Efficient Bearing of Existing Risks
 Suppose there are two investors; a widow and a graduating student. Each has Rs
100,000 to invest. The widow is a more conservative investor, and the graduating student
is aggressive.
 The widow has all her wealth in the form of shares left by her husband. The college
student has all her wealth in the form of bank certificate of deposit (CD).
 Both will be better off if they could swap their assets.
Institutional arrangements for the transfer of risk contribute to economic efficiency in two
fundamental ways:
1. They reallocate existing risks to those most willing to bear them, and
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2. They cause a reallocation of resources to production and consumption in accordance with
the new distribution of risk bearing.
Efficient Bearing of Existing Risks
It means that a conservative investor or a risk avertor investor sells his risky investments to those
who are risk lovers and buys financial investors that are considered to be less risky.
Risk and Resource Allocation
• The ability to reallocate risks facilitate the undertakings of valuable projects that might not
otherwise be undertaken because they are too risky.
• The ability to pool and share risks can lead to an increase in innovations and the
development of new products.
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Risk and Resource Allocation
TOPIC 128: INSTITUTIONS FOR RISK MANAGEMENT

• Over the centuries, various economic organizations and contractual arrangements have
evolved to facilitate a more efficient allocation of risk bearing both by expanding the scope
of diversification and by permitting greater specialization in the management of risk.
• Examples
• Insurance companies
• Futures markets
Debt and equity securities are designed to differ in the risks of the business they carry.
• New discoveries in telecommunications, information processing, and finance theory have
significantly lowered the cost of achieving greater global diversification and specialization
in the bearing of risks.
• However, increased volatility of exchange rates, interest rates, and commodity prices
have increased the demand for ways to manage risk.
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Lesson 26
PROBABILITY DISTRIBUTION OF RETURNS
TOPIC 129: PROBABILITY DISTRIBUTION OF RETURNS

• A probability distribution is a statistical function that describes all the possible values and
likelihoods that a random variable can take within a given range.
• It’s shape depends on the distribution's mean (average), standard deviation, skewness,
and kurtosis.
• Investors use probability distributions to anticipate returns on assets such as stocks over
time and to hedge their risk.
Probability Distribution – Example
• Suppose there is stock called GENCO
Probability Distribution of Rate of Return on Genco
State of the Rate of Return Probability

Economy on Genco
Strong 30% 0.20
Normal 10% 0.60
Weak -10% 0.20
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Probability Distribution
0.7
0.6
0.5
0.4
Probability
0.3
0.2
0.1
0
-10% 10% 30%
Returns
TOPIC 130: EXPECTED RATE OF RETURN

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The Total Rate of Return
= Dividend Income Component +Price Change Component
𝐶𝑎𝑠ℎ 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑃1 −𝑃0
= 𝑃0
+ 𝑃0
• Suppose you expect the dividend component to be 3%, and the price-change component
to be 7%. The Expected Rate of Return
• = r = 3% +7% = 10%
• The expected rate of return (the mean) is defined as the sum over all possible outcomes
of each possible rate of return multiplied by the respective probability of its happening.
• E(r) = P1r1+P2r2+…+ Pnrn
• E(r) = ∑𝑛𝑖=1 𝑃𝑖 𝑟𝑖
Expected Rate of Return – Example
Using the above data, the expected rate of return is calculated as:
E(r) = 0.2X30%+0.60X10%+0.2X(- 10%)
= 0.1 or 10%
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Where E(r) is the expected rate of return, Pi is the probability of event I, and i=1, 2, 3, …., n. r i is
the return of an outcome i.
TOPIC 131: EXPECTED RATE OF RETURN – MICROSOFT EXCEL
• Enter the data for returns and their probabilities of occurrence

• Calculate (return X probability)
• Find the sum
• The value of sum is the expected rate of return
TOPIC 132: VOLATILITY

• It is related to the range of possible rates of return from holding the stock and to their
likelihood of occurring.
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• If the range of possible outcomes is wide, and the probabilities of returns at the extremes
is high, the stock’s volatility will be higher.
Standard Deviation as a Measure of Risk
• Standard deviation is a measure of the risk that an investment will fluctuate from its
expected return.
• The smaller an investment's standard deviation, the less volatile it is, thus less risky the
investment is.
The volatility of a stock’s return was shown to depend on the range of possible outcomes and on
the probabilities of extreme values occurring. We use standard deviation to measure the volatility
of a stock’s probability distribution of returns. The formula used to measure standard deviation is
𝜎 = √∑ 𝑃𝑖 (𝑟𝑖 − 𝐸(𝑟))2
𝑖=1
TOPIC 133: CALCULATION OF EXPECTED RETURN AND STANDARD DEVIATION OF

EXPECTED RATE OF RETURN
Suppose Risco and Genco are two stocks with the following details:
Probability Distribution of the Two Stocks
Economy Rate of Return on Rate of Return on Probability

Risco Genco
Weak -30% -10% 0.2
Strong 10% 10% 0.6
Normal 50% 30% 0.2
The standard deviation for Risco stock is:

• 𝜎 = √[(0.2) (0.5 − 0.1)2 + (0.6) (0.1 − 0.1)2 + (0.2) (-0.3 − 0.1)2 ]
= 25.30%
The standard deviation for Genco stock is:
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• 𝜎 = √[(0.2) (-0.1 − 0.1)2 + (0.6) (0.1 − 0.1)2 + (0.2) (0.3 − 0.1)2]

= 12.65%
Let us take an investment A, which has a 20% probability of giving a 15% return on investment,
a 50% probability of generating a 10% return, and a 30% probability of resulting in a 5% loss. This
is an example of calculating a discrete probability distribution for potential returns.
The expected return on investment A would then be calculated as follows:
Expected Return of A = 0.2(15%) + 0.5(10%) + 0.3(-5%)
(That is, a 20%, or .2, probability times a 15%, or .15, return; plus a 50%, or .5, probability times
a 10%, or .1, return; plus a 30%, or .3, probability of a return of negative 5%, or -.5)
= 3% + 5% – 1.5%
= 6.5%
Therefore, the probable long-term average return for Investment A is 6.5%.
Calculating Expected Return of a Portfolio
Calculating expected return is not limited to calculations for a single investment. It can also be
calculated for a portfolio. The expected return for an investment portfolio is the weighted average
of the expected return of each of its components. Components are weighted by the percentage
of the portfolio’s total value that each accounts for. Examining the weighted average of portfolio
assets can also help investors assess the diversification of their investment portfolio.
To illustrate the expected return for an investment portfolio, let’s assume the portfolio is comprised
of investments in three assets – X, Y, and Z. $2,000 is invested in X, $5,000 invested in Y, and
$3,000 is invested in Z. Assume that the expected returns for X, Y, and Z have been calculated
and found to be 15%, 10%, and 20%, respectively. Based on the respective investments in each
component asset, the portfolio’s expected return can be calculated as follows:
Expected Return of Portfolio = 0.2(15%) + 0.5(10%) + 0.3(20%)
= 3% + 5% + 6%
= 14%
Thus, the expected return of the portfolio is 14%.
Standard Deviation of the Expected Return of A = √𝟎. 𝟐𝟐 (𝟏𝟓%) + 𝟎. 𝟓𝟐 (𝟏𝟎%) + 𝟎. 𝟑𝟐 (−𝟓%)
=0.1628
I have used the data followed for calculation of expected rate of return.
Standard deviation is unit free measure.
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Lesson 27
HEDGING RISK USING FORWARD AND FUTURES CONTRACTS
TOPIC 134: USING FORWARD AND FUTURES CONTRACTS TO HEDGE RISK

Three ways of transferring risk
• Hedging
• Insuring
• Diversifying
Hedging
• Hedging is a risk management strategy employed to offset losses in investments by
taking an opposite position in a related asset.
• The reduction in risk provided by hedging also typically results in a reduction in potential
profits.
 Hedging is a risk management strategy employed to offset losses in investments by
taking an opposite position in a related asset.
 The reduction in risk provided by hedging also typically results in a reduction in potential
profits.
 Hedging requires one to pay money for the protection it provides, known as the premium.
 Hedging strategies typically involve derivatives, such as options and futures contracts.
Hedging techniques generally involve the use of financial instruments known as derivatives. Two
of the most common derivatives are options and futures. With derivatives, you can develop
trading strategies where a loss in one investment is offset by a gain in a derivative.
Forward Contract
• Hedging strategies typically involve derivatives, such as options and futures contracts.
• Anytime two parties agree to exchange some item in the future at a prearranged price they
are entering into a forward contract.
Main Features of Forward Contracts
1. Two parties agree to exchange some item in the future at a price specified now – the
forward price.
2. The price for immediate delivery of the item is called the spot price.
3. No money is paid in the present by either party to the other.
4. The face value of the contract is the quantity of the item specified in the contract times the
forward price
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5. The party who agrees to buy the specified item is said to take a long position, and the
party who agrees to sell the item is said to take a short position.
Futures Contract
• It is a standardized forward contract that is traded on some organized exchange.
• The exchange interposes itself between the buyer and the seller, so that each has a
separate contract with the exchange.
• Standardization: the terms of futures contract are the same for all contracts
Forward and futures contracts are derivatives arrangements that involve two parties who agree
to buy or sell a specific asset at a set price by a certain date in the future. Buyers and sellers can
mitigate the risks associated with price movements down the road by locking in the purchase/sale
price in advance.
A forward contract is an arrangement that is made over-the-counter (OTC) and settles just once
at the end of the contract. Both parties involved in the agreement negotiate the exact terms of the
contract. It is privately negotiated and comes with a degree of default risk since the counterparty is
responsible for remitting payment.
Futures contracts, on the other hand, are standardized contracts that trade on stock exchanges.
As such, they are settled on a daily basis. These arrangements come with fixed maturity
dates and uniform terms. There is very little risk with futures, as they guarantee payment on the
agreed-upon date.
Futures are derivative financial contracts that obligate parties to buy or sell an asset at a
predetermined future date and price. The buyer must purchase or the seller must sell the
underlying asset at the set price, regardless of the current market price at the expiration date.
Underlying assets include physical commodities and financial instruments. Futures
contracts detail the quantity of the underlying asset and are standardized to facilitate trading on
a futures exchange. Futures can be used for hedging or trade speculation.
TOPIC 135: FORWARD CONTRACT – EXAMPLE

• A forward contract can often reduce the risks faced by both the buyer and the seller.
• Suppose a farmer has planted his fields with wheat.
• It is now a month before harvest time.
• Farmer wants to eliminate risk due to uncertainty about its future price.
• Suppose, there is a baker, who also want to minimize risk
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• Risk is due to uncertainty about the future price of wheat.
• He has a large investment in the bakery.
• The farmer and the baker agree to a certain forward price that the baker will pay the
farmer at the time of delivery.
• They sign a contract that the farmer will deliver a specified quantity of wheat to the baker
at the forward price regardless of what the spot price turns out to be at the delivery date.
• Suppose the size of the farmer’s crop is 400,000 kg (10,000 maunds)
• The forward price for delivery a month from now is Rs. 2000 per 40 kg.
• After a month, the farmer will deliver 400,000 kg wheat and will get Rs. 20 million in
return.
• With this agreement, both parties eliminate the risk associated with the uncertainty about
the spot price of wheat at the delivery date.
• They both are hedging their exposures.
Consider the following example of a forward contract. Assume that an agricultural producer has
two million bushels of corn to sell six months from now and is concerned about a potential decline
in the price of corn. It thus enters into a forward contract with its financial institution to sell two
million bushels of corn at a price of $4.30 per bushel in six months, with settlement on a cash
basis.
In six months, the spot price of corn has three possibilities:
1. It is exactly $4.30 per bushel. In this case, no monies are owed by the producer or
financial institution to each other and the contract is closed.
2. It is higher than the contract price, say $5 per bushel. The producer owes the
institution $1.4 million, or the difference between the current spot price and the contracted
rate of $4.30.
3. It is lower than the contract price, say $3.50 per bushel. The financial institution will
pay the producer $1.6 million, or the difference between the contracted rate of $4.30 and
the current spot price.
TOPIC 136: HEDGING PRICE RISK WITH FUTURES CONTRACTS

Example:
• The size of the farmer’s crop is 400,000 kg (10,000 maunds)
• To hedge his exposure to the price risk, he takes a short position in a one-month futures
contract for his total crop at a futures price of Rs. 2000 per 40 kg.
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• After a month, the farmer will deliver 400,000 kg wheat and will get Rs. 20 million in
return.
Farmer’s Transaction Spot Price of Wheat on Delivery Date
Rs. 1500 per maund Rs. 2000 per maund
Proceeds from sale of wheat to Rs. 15 million Rs. 20 million

distributor
Cash flow from the futures contract Rs. 5 million paid to farmer 0
Total Receipts Rs. 20 million Rs. 20 million
Baker’s Transaction Spot Price of Wheat on Delivery Date
Rs. 1500 per maund Rs. 2000 per maund
Cost of wheat bought from supplier Rs. 15 million Rs. 20 million
Cash flow from the futures contract Rs. 5 million paid by baker 0
Total Outlays Rs. 20 million Rs. 20 million
Futures can be used to hedge the price movement of the underlying asset. Here, the goal is to
prevent losses from potentially unfavorable price changes rather than to speculate. Many
companies that enter hedges are using—or in many cases producing—the underlying asset.
For example, corn farmers can use futures to lock in a specific price for selling their corn crop. By
doing so, they reduce their risk and guarantee they will receive the fixed price. If the price of corn
decreased, the farmer would have a gain on the hedge to offset losses from selling the corn at
the market. With such a gain and loss offsetting each other, the hedging effectively locks in an
acceptable market price.
• The farmer is able to eliminate the price risk he faces from owning the wheat by taking a
short position in a futures contract, effectively selling the wheat for future delivery at the
futures price.
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• The baker too is able to eliminate risk by taking long position in the futures market for
wheat.
TOPIC 137: HEDGING FOREIGN-EXCHANGE RISK WITH SWAP CONTRACTS

Hedging Foreign-Exchange Risk with Swap Contracts
• Hedging can be done by using swap contracts
• A swap contract consists of two parties exchanging (or “swapping”) a series of cash flows
at specified intervals over a specified period of time.
Swap Contracts
• The swap payments are based on an agreed principal amount (the notional amount).
• There is no immediate payment of money.
• A swap contract could call for the exchange of anything.
Swap Contracts –Types
• Two most common and most basic types of swaps:
– interest rate swaps
– currency swaps
Swaps Market
• Swaps are not exchange-traded instruments.
• They are customized contracts that are traded in the over-the-counter (OTC) market
between private parties.
• Firms and financial institutions dominate the swaps market, with few (if any) individuals
ever participating.
Swaps Market- Risk
• Swaps occur on the OTC market, hence there is always the risk of
a counterparty defaulting on the swap.
Currency risk is the financial risk that arises from potential changes in the exchange rate of one
currency in relation to another. And it's not just those trading in the foreign exchange markets
that are affected. Adverse currency movements can often crush the returns of a portfolio with
heavy international exposure, or diminish the returns of an otherwise prosperous international
business venture. Companies that conduct business across borders are exposed to currency
risk when income earned abroad is converted into the money of the domestic country, and when
payables are converted from the domestic currency to the foreign currency.
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The currency swap market is one way to hedge that risk. Currency swaps not only hedge against
risk exposure associated with exchange rate fluctuations, but they also ensure receipt of foreign
monies and achieve better lending rates.
A currency swap is a financial instrument that involves the exchange of interest in one currency
for the same in another currency.
Currency swaps comprise two notional principals that are exchanged at the beginning and end of
the agreement. These notional principals are predetermined dollar amounts, or principal, on which
the exchanged interest payments are based. However, this principal is never actually repaid: It's
strictly "notional" (which means theoretical). It's only used as a basis on which to calculate the
interest rate payments, which do change hands.
TOPIC 138: HEDGING FOREX RISK WITH SWAP CONTRACTS-EXAMPLE

• Suppose you have computer software business in US, and a German company wants to
acquire the right to produce and market your software in Pakistan.
• The German company agrees to pay you € 100,000 each year for the next 10 years for
these rights.
• If you want to hedge the risk of fluctuations in the dollar value of your expected stream of
revenues, you can enter a CURRENCY SWAP now to exchange your future stream of
euros for a future stream of dollars at a set of forward exchange rates specified now.
• Suppose the dollar/euro exchange rate is currently $1.30 per euro and this exchange rate
also applies to all forward contracts covering the next 10 years. Notional amount in your
swap is € 100,000 per year.
• By entering in the swap contract, you lock in a dollar revenue of $130,000 per year.
• Each year on the settlement date you will receive (or pay) an amount of cash equal to €
100,000 times the difference between the forward rate and the actual spot rate at that
time.
Items traded through Swap Agreements
• The international swap market began in the early 1980s.
• In addition to currency and interest-rate swaps, many other items, i.e. returns on different
stock indexes, bushels of wheat and barrels of oil are also exchanged through swap
agreements.
A U.S. company (Party A) is looking to open up a €3 million plant in Germany, where its borrowing
costs are higher in Europe than at home. Assuming a 0.6 euro/USD exchange rate, the company
can borrow €3 million at 8% in Europe or $5 million at 7% in the U.S. The company borrows the
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$5 million at 7% and then enters into a swap to convert the dollar loan into euros. Party B, the
counterparty of the swap may likely be a German company that requires $5 million in U.S. funds.
Likewise, the German company will be able to attain a cheaper borrowing rate domestically than
abroad—let's say that the Germans can borrow at 6% within from banks within the country's
borders.
Now, let's take a look at the physical payments made using this swap agreement. At the outset
of the contract, the German company gives the U.S. Company the €3 million needed to fund the
project, and in exchange for the €3 million, the U.S. Company provides the German counterparty
with $5 million.
Subsequently, every six months for the next three years (the length of the contract), the two
parties will swap payments. The German firm pays the U.S. company the sum that's the result of
$5 million (the notional amount paid by the U.S. company to the German firm at initiation),
multiplied by 7% (the agreed-upon fixed rate), over a period expressed as .5 (180 days ÷ 360
days). This payment would amount to $175,000 ($5 million x 7% x .5). The U.S. company pays
the Germans the result of €3 million (the notional amount paid by the Germans to the U.S.
company at initiation), multiplied by 6% (the agreed-upon fixed rate), and .5 (180 days ÷ 360
days). This payment would amount to €90,000 (€3 million x 6% x .5).
The two parties would exchange these fixed two amounts every six months. Three years after
initiation of the contract, the two parties would exchange the notional principals. Accordingly, the
U.S. company would "pay" the German company €3 million and the German company would
"pay" the U.S. company $5 million.
TOPIC 139: HEDGING SHORTFALL RISK BY MATCHING ASSETS TO LIABILITIES

• Insurance companies and other financial intermediaries that sell insured savings plans
and other insurance contracts need to assure their customers that the product they are
buying is free of DEFAULT RISK.
• One way to assure customers about the risk of contract default is for insurance
companies to hedge their liabilities in the financial markets by investing in assets that
match the characteristics of their liabilities.
Example:
• Suppose that an insurance company sells a customer a guaranteed investment contract
that promises to pay $1,000 five years from now for a one-time premium today of $783.53.
(@ 5% p.a.).
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• The insurance company can hedge this customer liability by buying a default-free zero
coupon bond with a face value of $1,000 issued by the government.
• The insurance company will be matching assets to liabilities
• The insurance company will buy the government bond for less that $783.53
Insurance companies and other financial intermediaries that sell insured savings plans and other
insurance contracts need to assure their customers that the product they are buying is free of
default risk. One way to assure customers about the risk of contract default is for insurance
companies to hedge their liabilities in the financial markets by investing in assets that match the
characteristics of their liabilities.
TOPIC 140: MINIMIZING THE COST OF HEDGING

• There may be multiple ways for hedging risk.
• A rational manager will choose the one that costs the least.
• You also have to consider the transaction costs (broker fees, the amount of effort and
time involved, etc.)
• Another important point to be considered is the desired level of reduction of risk.
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If there are two or more ways to hedge against risk, the investor will analyze the cost of hedging
and choose the method that has less cost.
This can be explained with the help of the example presented below.
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Lesson 28
INSURANCE VERSUS HEDGING AND THE DIVERSIFICATION PRINCIPLE
TOPIC 141: INSURING VERSUS HEDGING

• There is fundamental difference between insuring and hedging.
• When you hedge, you eliminate the risk of loss by giving up the potential for gain.
• When you insure, you pay a premium to eliminate the risk of loss and retain the potential
for gain.
Example
• You are planning a trip from Lahore to London a year from now.
• You make your flight reservations now; you can buy the ticket now or close to the day of
your travel. If you decide to lock in the price today, you have hedges against the risk of
loss.
• It costs you nothing to do so, but you have given up the possibility of paying less than the
amount you have paid for the ticket.
• Alternatively, the airline may offer you that if you pay $20 now, you will have to pay $1000
whenever you buy the ticket.
• This is an example of buying insurance.
Insurance and hedging both reduce your exposure to financial risk, but they do so in different
ways. Insurance typically involves paying someone else to bear risk, while hedging involves
making an investment that offsets risk.
Insurance Shifts Risk
Buying an insurance policy that protects your home against fire does not guarantee that your
home won't burn down. Having auto insurance doesn't mean you won't crash your car, and life
insurance won't keep you from dying. What insurance does is shift potential financial losses from
you to someone else. If your house burns down or your car gets totaled, you don't have to pay to
replace it because the insurance company does.
Hedging Offsets Risk
Hedging reduces uncertainty, which is really just another word for risk. For a simple example, say
you do a lot of business with Europe, and you've discover that you lose money if the exchange
rate rises above $1.50 per euro. So you buy a series of options contracts that give you the right
to buy euros for, say, $1.40 per euro. Those options offset your risk from rising exchange rates.
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If the rate never rises about $1.40, then you just let the options expire. But if the rate tops $1.40,
then you've locked in an exchange rate that offsets the increase and protects your profit. The
options, therefore, are hedges.
TOPIC 142: BASIC FEATURES OF INSURANCE CONTRACTS
• Four important features of insurance contracts include:

1. Exclusions
2. Caps
3. Deductibles, and
4. Copayments
Exclusions
• Exclusions are losses that might seem to meet the conditions for coverage under the
insurance contracts but are specifically excluded.
• For example, in case of life insurance, case of suicide will be excluded.
Caps
• Caps are limits placed on compensation for particular losses covered under an
insurance contract.
• For example, if a health insurance policy is capped at Rs. 5 lacs, it means the insurance
company will pay no more than this amount for the treatment of an illness.
Deductibles
• A deductible is an amount of money that the insured party must pay out of his or her own
resources before receiving any compensation from the insurer.
• For example, if your car insurance policy has a Rs. 1000 deductible for damage due to
accidents, you must pay the first Rs. 1000 in repair costs and the insurer will only pay for
the amount in excess of Rs. 1000.
Copayments
• A copayment feature means that the insured party must cover a fraction of the loss. For
example, an insurance policy might stipulate that the copayment is 20% of any loss,
and the insurance company pays the other 80%.
• Copayments are similar to deductibles. The difference is in the way the paying part is
computed.
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Why Deductibles and Copayments are Imposed?
• To create incentives for the insured party to control losses.
• Example:
– In case of health insurance, the insured pays part of the doctor’s fee
Insurance policies can contain both deductibles and copayments.
The FOUR important features of insurance contracts are EXCLUSIONS AND CAPS,
DEDUCTIBLES, AND COPAYMENTS.
EXCLUSIONS AND CAPS

Exclusions are losses that might seem to meet the conditions for coverage under the insurance
contracts but are specifically excluded.
Caps are limits placed on compensation for particular losses covered under an insurance
contract. For example, for a damaged car insurance company pays only up to 2 lacs for the repair.
Deductibles
An insurance deductible is a specific amount you must spend before your insurance policy pays
for some or all of your claims.
Insurance companies use deductibles to ensure policyholders have skin in the game and will
share the cost of any claims.
Deductibles cushion against financial stress caused by catastrophic loss or an accumulation of
small losses all at once for an insurer.
In addition to premiums, individuals must meet health insurance deductibles and may also be
required for other costs like copays and coinsurance, depending on their plans.
The general rule is that policies with higher premiums come with lower deductibles while those
with lower premiums tend to have higher deductibles.
Copayment or simply a copay

A copay is a fixed out-of-pocket amount paid by an insured for covered services. It is a standard
part of many health insurance plans. Insurance providers often charge co-pays for services such
as doctor visits or prescription drugs.
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Copays are a specified dollar amount rather than a percentage of the bill, and they usually paid
at the time of service. Not all medical services ask you for a copay. For example, some insurance
companies do not require a copay for annual physicals.
TOPIC 143: FINANCIAL GUARANTEES
• Financial guarantees are insurance against credit risk, which is the risk that the other
party to a contract into which you have entered will default.
• A loan guarantee is a contract that obliges the guarantor to make the promised payment
on a loan if the borrower fails to do so.
Example
• Banks and other issuers of credit cards guarantee to merchants that they will stand
behind all customer purchases made their credit cards.
• Credit card issuers provide merchants with insurance against credit risk.
Financial Guarantors
• Banks, insurance companies and governments offer guarantees on a broad spectrum of
financial instruments ranging from credit cards to interest-rate and currency swaps.
A financial guarantee is an agreement that guarantees a debt will be repaid to a lender by another
party if the borrower defaults. Essentially, a third party acting as a guarantor promises to assume
responsibility for a debt should the borrower be unable to keep up on its payments to the creditor.
Guarantees can also come in the form of a security deposit or collateral. The types vary, ranging
from corporate guarantees to personal ones.
Some financial agreements may require the use of a financial guarantee before they can be
executed. In many cases, a guarantee is a legal contract that promises repayment of a debt to a
lender. This agreement takes place when a guarantor agrees to take on the financial responsibility
if the original debtor defaults on their financial obligation or goes insolvent. All three parties must
sign the agreement in order for it to go into effect.
Guarantees may take on the form of a security deposit. Common in the banking and lending
industries, this is a form of collateral provided by the debtor that can be liquidated if the debtor
defaults.
For instance, a secured credit card requires the borrower—usually someone with no credit
history—to put down a cash deposit for the amount of the credit line.
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Financial guarantees act just like insurance and are very important in the financial industry. They
allow certain financial transactions, especially those that wouldn't normally take place, to go
through, permitting, for instance, high-risk borrowers to take out loans and other forms of credit.
In short, they mitigate the risk associated with lending to high-risk borrowers and extending credit
during times of financial uncertainty.
TOPIC 144: CAPS AND FLOORS ON INTEREST RATES
Caps on Interest Rates

• A cap is a limit on the interest rates a variable-rate credit product can charge.
• The cap limits the interest levels that borrowers have to pay in rising rate environments.
• Adjustable-rate mortgages (ARMs) typically have a rate cap to limit how much interest
homebuyers pay for a home loan.
Variable-Rate Capped Products

• Products with a capped interest rate have a variable rate structure that includes an
indexed rate and a spread.
• An indexed rate is based on the lowest rate creditors are willing to offer.
• The spread or margin is based on a borrower’s credit profile and determined by the
underwriter.
Who is an Underwriter?
• An underwriter is any party that evaluates and assumes another party's risk for a fee,
which often takes the form of a commission, premium, spread, or interest.
• Agents and brokers represent both consumers and insurance companies, while
underwriters work for insurance companies.
Advantage of Putting a Cap on Interest Rate

• If a product has a capped rate, then the interest rate will rise with increases in the indexed
rate until it reaches a specified cap.
• The cap is advantageous for borrowers because it limits the level of interest, they have
to pay in a rising rate environment.
Floors on Interest Rates

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• A floor sets a base level of interest that a borrower must pay and also sets a base level
of interest that a lender or investor can expect to earn.
• A floor benefits the lender or credit investor in a falling rate environment. Limiting the
interest base level, however, requires a borrower to pay a specified floor interest rate
even when the current market rate is lower.
Caps and Floors on Interest Rates

• Variable interest rate products can have both a cap and a floor, which sets a base level
of interest that a lender or investor can expect to earn.
An interest rate cap is a type of interest rate derivative in which the buyer receives payments at
the end of each period in which the interest rate exceeds the agreed strike price. An example of
a cap would be an agreement to receive a payment for each month the LIBOR rate exceeds 2.5%.
Similarly an interest rate floor is a derivative contract in which the buyer receives payments at the
end of each period in which the interest rate is below the agreed strike price.
Caps and floors can be used to hedge against interest rate fluctuations. For example, a borrower
who is paying the LIBOR rate on a loan can protect himself against a rise in rates by buying a cap
at 2.5%. If the interest rate exceeds 2.5% in a given period the payment received from the
derivative can be used to help make the interest payment for that period, thus the interest
payments are effectively "capped" at 2.5% from the borrowers' point of view.
TOPIC 145: OPTIONS AS INSURANCE

• The term option refers to a financial instrument that is based on the value of underlying
securities such as stocks.
• An options contract offers the buyer the opportunity to buy or sell—depending on the type
of contract they hold—the underlying asset.
Futures and Options

• Unlike futures, the holder is not required to buy or sell the asset if they decide against it.
• Options are versatile financial products. These contracts involve a buyer and seller,
where the buyer pays a premium for the rights granted by the contract.
Call and Put Options
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• Call options allow the holder to buy the asset at a stated price within a specific timeframe.
• Put options, on the other hand, allow the holder to sell the asset at a stated price within
a specific timeframe.
• Each call option has a bullish buyer and a bearish seller while put options have a bearish
buyer and a bullish seller.
• The fixed price specified in an option contract is called the option’s strike price or exercise
price.
• The date after which an option can no longer be exercised is called its expiration date or
maturity date.
• If an option can be exercised on the expiration date only, it is called a European-type
option.
• If it can be exercised at any time up to and including the expiration date it is called an
American-type option.
Options started as insurance policies for either long or short stock. A put option gives the buyer
the right to sell a set stock at a set price on or before a set date. This means that no matter how
low a stock goes, the investor has the right to sell the stock for the agreed upon price.
Why would an investor purchase insurance on the stock instead of using the stop-loss? The
answer to that question will be specific to each investor, but things like tax considerations when
selling, dividend payments, or belief in the company through a rough patch are all very valid
reasons that an investor might buy insurance on the stock.
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Lesson 29
THE DIVERSIFICATION PRINCIPLE
TOPIC 146: THE DIVERSIFICATION PRINCIPLE

• Diversifying means splitting an investment among many risky assets instead of
concentrating it all in only one.
• The diversification principle states that by diversifying across risky assets people can
sometimes achieve a reduction in their overall risk exposure with no reduction in their
expected return.
Diversification with Uncorrelated Risks

• Suppose you are planning to invest $100,000 in a medicine business.
• Assume there is a 0.5 probability of success for each medicine and 0.5 probability of
failure.
• If the medicine gets successful, you will get $400,000. If it fails, you will get nothing.
Probability Distribution for Investment in a Single Medicine
Outcome Probability (Pi) Payoff (XI) Rate of Return) rj
Medicine fails 0.5 0 -100%
Medicines 0.5 $400,000 300%

succeeds
• The cost of developing a medicine is $100,000. The rate of return is the payoff minus the
cost divided by the cost.
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Diversification with Two Drugs
Outcome Probability (Pi) Payoff (Xi) Rate of Return (rj)
No drugs succeed 0.25 0 -100%
One drug succeeds 0.5 $200,0000 100%
Both drugs succeed 0.25 $400,000 300%
• The cost of developing a medicine is $100,000. The rate of return is the payoff minus the
cost divided by the cost.
Advantages of Diversification
• Thus, by diversifying and holding a portfolio of two drugs you reduce the probability of
losing your entire investment to only one-half of what it would be without diversification.
• The probability of winding up with $400,000 has fallen from 0.5 to 0.25.
If one were to poll investors and investment professionals to determine their ideal investment
outcome, the vast majority would no doubt agree: It's a double-digit total return in all economic
environments, each and every year.
Naturally, they would also agree that the worst-case scenario is an overall decrease in asset
value. But despite this knowledge, very few achieve this desired outcome; and many, indeed,
encounter the worst-case scenario—losses. The reasons for this are diverse: misallocation of
assets, pseudo-diversification, hidden correlation, weighting imbalance, false returns, and
underlying devaluation.
The solution, however, could be simpler than you would expect. In this article, we will show how
to achieve true diversification through asset class selection, rather than stock picking and market
timing.
Many investors do not truly understand effective diversification, often believing they are fully
diversified after spreading their investment across large-, mid- or small-cap stocks; energy,
financial, health care or technology stocks; or even investing in emerging markets. In reality,
however, they have merely invested in multiple sectors of the equities asset class and are prone
to the rise and fall within that market.
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TOPIC 147: THE DIVERSIFICATION PRINCIPLE- PROBABILITY DISTRIBUTION
For diversification, the probabilities of all the possible outcomes are considered in the form of a
probability distribution (discussed earlier). Expected rate of returns and standard deviations are
estimated to decide how diversification will be done.
• The formula for the expected payoff is:
• E(X) = ∑𝑛𝑖=1 𝑃𝑖 𝑋𝑖
• Expected Payoff – One drug  E(X) = 0.5 (0)+0.5(400,000) = $200,000
• Standard Deviation:
• 𝜎 = √0.5(0 − 200,000)2 + 0.5(400,000 − 200,000)2
• = $200,000
• Expected Payoff – Two drugs 
• E(X) = 0.25 (0) + 0.5(200,000)+0.25(400,000) = $200,000
• Standard Deviation:
• 𝜎=
√0.25(0 − 200,000)2 + 0.5(200, 000 − 200,000)2 + 0.25(400,000−200,000)2
• = $141,421
Advantage of Diversification
 When we diversify between two uncorrelated drugs the expected payoff remains
$200,000, but the standard deviation of the rate of return falls from $200, 000 to
$141,421.
 If the number of drugs in the portfolio increases further:
 The expected payoff stays the same, but
 The standard deviation declines in proportion to the square root of the number of drugs:
 𝜎𝑝𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜 = $200,000/√𝑁
TOPIC 148: NON-DIVERSIFIABLE RISK

• Many important risks are positively correlated with each other because they get affected
by the same underlying economic factors.
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Diversifiable and Non-diversifiable Risks
• The part of portfolio volatility that can be eliminated by adding more stocks is the
diversifiable risk, and
• The part that remains no matter how many stocks are added is the non-diversifiable risk.
What accounts for Non-diversifiable Risk?

• If an event occurs that affects many firms, such as an unanticipated downturn in general
economic conditions, then many stocks will be affected.
• The risk of loss arising from such events is called market risk.
Firm-Specific Risk
• Random events that affect the prospects of only one firm, such as a lawsuit, a strike or a
new product failure, give rise to random losses that are uncorrelated across stocks and
can, be diversified away.
• Such risk is called firm-specific risk.
International Diversification
• By combining stocks of firms located in different countries it is possible to reduce the risk
of one’s stock portfolio, but there is a limit to this risk reduction.
• International diversification can improve the prospects for risk reduction for people around
the world, a significant amount of risk remains for even the best-diversified global stock
portfolio.
Non-diversifiable risk can be referred to a risk which is common to a whole class of assets or
liabilities. The investment value might decline over a specific period of time only due to economic
changes or other events which affect large sections of the market. However, diversification and
asset allocation can provide protection against non-diversifiable risk as different sections of the
market have a tendency to underperform at different times. Non-diversifiable risk can also be
referred as market risk or systematic risk.
Putting it simple, risk of an investment asset (real estate, bond, stock/share, etc.) which cannot
be mitigated or eliminated by adding that asset to a diversified investment portfolio can be
delineated as non-diversifiable risks. Moreover, this is the risk you are exposed to in an individual
investment. This risk type is involved in almost every investment, i.e. uncertainty of market moving
up or down and the particular movement of the investment.
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Understanding non-diversifiable risk
Being unavoidable and non-compensating for exposure to such risks, non-diversifiable risk can
be taken as the significant section of an asset’s risk attributable to market factors affecting all
firms. The main reasons for this risk type include inflation, war, political events, and international
incidents. Moreover, it cannot be purged through diversification.
Factors responsible for non-diversifiable risk

Non-diversifiable risk is an outcome of factors influencing the complete market like changes in
investment policy, foreign investment policy, alterations in taxation clauses, altering of socio-
economic parameters, global security threats and measures, etc. the non-diversifiable risk is not
under the investors’ control and is also difficult to be mitigated to a large extent.
However, non-diversifiable risks are identified through the analysis and estimation of the statistical
relationships between the different asset portfolios of the company through different techniques,
including principal components analysis. There is no specific method that can be used to handle
the non-diversifiable risk. This is due to their impact which is reflected on the entire market.
TOPIC 149: DIVERSIFICATION AND THE COST OF INSURANCE

• The cost of insuring a diversified portfolio of risks against a loss is almost always less
than the cost of insuring against each risk separately.
Example
• Suppose you are investing $100,000 in drug stocks.
• If you invest $50,000 in each of the two drug’s stocks you will have to pay separately for
insurance.
• But for the portfolio as a whole, you will have to pay for one insurance.
• The more diversified are the risks in a portfolio of a given size, the less it will cost to insure
the portfolio’s total value against a loss.
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Lesson 30
THE PROCESS OF PERSONAL PORTFOLIO SELECTION
TOPIC 150: THE PROCESS OF PERSONAL PORTFOLIO SELECTION

• The process of Portfolio Selection describes how people should invest their wealth.
• A person’s wealth includes all of his or her assets (stocks, bonds, shares, houses,
pension benefits, insurance policies, etc.)
• There is no single portfolio selection strategy that is best for all people.
• It is a process of trading off risk and expected return to find the best portfolio of assets
and liabilities.
• There are however some principles that are to be followed for portfolio selection
• For example, the principle of diversification.
Determinants of Personal Portfolio Selection

• The Life Cycle
• Time Horizons
• Risk Tolerance
• The Role of Professional Asset Managers
A portfolio is a collection of financial investments like stocks, bonds, commodities, cash, and cash
equivalents, including closed-end funds and exchange traded funds (ETFs). People generally
believe that stocks, bonds, and cash comprise the core of a portfolio. Though this is often the
case, it does not need to be the rule. A portfolio may contain a wide range of assets including real
estate, art, and private investments.
You may choose to hold and manage your portfolio yourself, or you may allow a money manager,
financial advisor, or another finance professional to manage your portfolio.
One of the key concepts in portfolio management is the wisdom of diversification—which simply
means not putting all of your eggs in one basket. Diversification tries to reduce risk by allocating
investments among various financial instruments, industries, and other categories. It aims to
maximize returns by investing in different areas that would each react differently to the same
event. There are many ways to diversify.
How you choose to do it is up to you. Your position in the life cycle, time horizon, yYour goals for
the future, your appetite for risk, and your personality are all factors in deciding how to build your
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portfolio. It may also get affected by the type of adice you will get from your professional asset
manager.
Regardless of your portfolio's asset mix, all portfolios should contain some degree of
diversification, and reflect the investor's tolerance for risk, return objectives, time horizon, and
other pertinent constraints, including tax position, liquidity needs, legal situations, and unique
circumstances.
TOPIC 151: PERSONAL PORTFOLIO SELECTION – LIFE CYCLE
• In portfolio selection the best strategy depends on an individual’s personal circumstances
(age, family status, occupation, income, wealth, etc.)
• For a young couple recently starting a family it may be optimal to buy a house and take
out a mortgage loan.
• For an older couple about to retire, it may be optimal to sell their house and invest the
proceeds in some asset that will provide a steady stream of income for as long as they
live.
• People of the same age, with the same income and wealth, may have different
perspectives on buying a house or buying insurance.
• The same is true of investing in stocks, bonds, and other securities.
• There is no single portfolio that is best for all people.
TOPIC 152: PERSONAL PORTFOLIO SELECTION – TIME HORIZONS

Time Horizon
• In formulating a plan for portfolio selection you begin by determining your goals and time
horizon.
• The planning horizon is the total length of time for which one plans.
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• The longest time horizon would typically correspond to the retirement goal and would be
the balance of one’s lifetime.
• Thus for a 25 year old who expects to live to the age of 85, the planning horizon will be
60 years.
• There are shorter planning horizons also.
• For example, if you have a ten years old child and you plan to pay for his education when
he reaches age 22, the planning horizon for this goal is 12 years.
Decision Horizon
• The decision horizon is the length of time between decisions to revise the portfolio.
• The length of the decision horizon is controlled by the individual within certain limits.
• Some people review their portfolios at regular intervals, e.g. once in a month, etc. or once
a year
Strategy
• Portfolio decisions you make today are influenced by what you think might happen
tomorrow. A plan that takes account of future decisions in making current decisions is
called a strategy.
Investors should consider how long they have to invest when building a portfolio. In general,
investors should be moving toward a conservative asset allocation as their goal date approaches,
to protect the portfolio's earnings up to that point.
For example, a conservative investor might favor a portfolio with large-cap value stocks, broad-
based market index funds, investment-grade bonds, and a position in liquid, high-grade cash
equivalents.
TOPIC 153: PERSONAL PORTFOLIO SELECTION – RISK TOLERANCE

Risk Tolerance
• Risk tolerance is a measure of how much of a loss an investor is willing to endure within
their portfolio.
• A person's age, investment goals, income, and comfort level all play into determining
their risk tolerance.
• It looks at how much market risk—stock volatility, stock market swings, economic or
political events, regulatory, or interest rate changes—an investor can tolerate,
considering that all of these factors might cause their portfolio to slide.
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Risk tolerance assessments
• Risk tolerance assessments for investors are done through risk-related surveys or
questionnaires.
• As an investor, you may also want to review historical worst-case returns for
different asset classes to get an idea of how much money you would feel comfortable
losing if your investments have a bad year or bad series of years.
Factors affecting Risk Tolerance

These include:
• the time horizon you have to invest,
• your future earning capacity, and
• the presence of other assets such as a home, pension, Social Security, or an inheritance.
Levels of Risk Tolerance

• An aggressive investor, or someone with higher risk tolerance, is willing to risk more
money for the possibility of better returns than a conservative investor, who has lower
tolerance.
• A person with moderate risk tolerance sits in the balance between an aggressive and
conservative investor.
Risk tolerance is the degree of risk that an investor is willing to endure given the volatility in the
value of an investment. An important component in investing, risk tolerance often determines the
type and amount of investments that an individual chooses.
Greater risk tolerance is often synonymous with investment in stocks, equity funds, and
exchange-traded funds (ETFs), while lower risk tolerance is often associated with the purchase
of bonds, bond funds, and income funds.
TOPIC 154: PORTFOLIO SELECTION – ROLE OF PROFESSIONAL ASSET MANAGERS

• Most people have neither the knowledge nor the time to carry out portfolio optimization.
• They hire an investment advisor to do it for them or they buy finished product from a
financial intermediary.
Finished Products
• Finished products include:
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– Various investment accounts and mutual funds offered by banks, securities firms,
investment companies, and insurance companies.
How Financial Institutions develop Products?
• Financial intermediaries decide what asset choices to offer to households.
• The selection is done by examining the quantitative trade-off between risk and expected
return.
Objective of Professional Asset Managers
• To find the portfolio that offers investors the highest expected rate of return for any
degree of risk they are willing to tolerate.
An asset manager manages assets on behalf of someone else, making important investment
decisions that will help the client's portfolio grow. An asset manager also ensures the client's
investment doesn't depreciate and that exposure to risk is mitigated. Doing this means watching
the market, keeping up to date with research and trends, and staying current with political,
financial, and economic news. The advice of the asset manager plays an important role and can
shape the portfolio selection process to a great extent.
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Lesson 31
PORTFOLIO OPTIMIZATION
TOPIC 155: PORTFOLIO OPTIMIZATION

• It is done in two steps:
– 1. Find the combination of risky assets, and
– 2. mix this optimal risky-asset portfolio and a riskless asset.
The single risky-asset portfolio is composed of many risky assets chosen in an optimal way.
• A riskless asset is defined as a security that offers a perfectly predictable rate of return
in terms of account selected for the analysis and the investor’s decision horizon.
• When no specific investor is identified, the riskless asset refers to an asset that offers a
predictable rate of return over the trading horizon (i.e., the shortest possible decision
horizon).
Example
• If Pakistani Rupee is taken as a unit of account and trading horizon is a day, the riskless
rate is the interest rate on Treasury bill maturing the next day.
Optimization is the process of making a trading system more effective by adjusting the variables
used for technical analysis. A trading system can be optimized by reducing certain transaction
costs or risks, or by targeting assets with greater expected returns. The single risky-asset portfolio
is composed of many risky assets chosen in an optimal way.
Portfolio optimization is often done as a two-step process:
1. Find the optimal combination of risky assets, and
2. Mix this optimal risky-asset portfolio with the riskless asset
A riskless asset is defined as a security that offers a perfectly predictable rate of return in terms
of account selected for the analysis and the investor’s decision horizon.
When no specific investor is identified, the riskless asset refers to an asset that offers a predictable
rate of return over the trading horizon (i.e., the shortest possible decision horizon).
If Pakistani Rupee is taken as a unit of account and trading horizon is a day, the riskless rate is
the interest rate on Treasury bill maturing the next day.
TOPIC 156: FRAMEWORK USED BY PROFESSIONAL PORTFOLIO MANAGERS

• The framework used by professional portfolio managers for examining the quantitative
trade-off between risk and expected return.
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Combining the Riskless Asset and a Single Risky Asset
• Suppose you have Rs. 100,000 to invest. You are choosing between a riskless asset with
an interest rate of 0.06 per year and a risky asset with an expected rate of return of 0.14
per year and a standard deviation of 0.2. How much of your Rs 100,000 should you invest
in the risky asset?
How Portfolio Composition is Determined?

• The portfolio composition for any point lying on the trade-off line in the figure shown
above, are based on the points listed in the table discussed earlier.
Portfolio management is the art and science of selecting and overseeing a group of investments
that meet the long-term financial objectives and risk tolerance of a client, a company, or an
institution.
Some individuals do their own investment portfolio management. That requires a basic
understanding of the key elements of portfolio building and maintenance that make for success,
including asset allocation, diversification, and rebalancing. Most people have neither the
knowledge nor the time to carry out portfolio optimization.
They hire an investment advisor to do it for them or they buy finished product from a financial
intermediary. Finished products include:
Various investment accounts and mutual funds offered by banks, securities firms, investment
companies, and insurance companies.
The objective of the professional asset manager is to find the portfolio that offers investors the
highest expected rate of return for any degree of risk they are willing to tolerate.
The Professional Portfolio Managers use risk-reward tradeoff to decide between (among) various
investment options.
1. The risk-return tradeoff is an investment principle that indicates that the higher the risk,
the higher the potential reward.
2. To calculate an appropriate risk-return tradeoff, investors must consider many factors,
including overall risk tolerance, the potential to replace lost funds and more.
3. Investors consider the risk-return tradeoff on individual investments and across portfolios
when making investment decisions.
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When an investor considers high-risk-high-return investments, the investor can apply the risk-
return tradeoff to the vehicle on a singular basis as well as within the context of the portfolio as a
whole. Examples of high-risk-high return investments include options, penny stocks and
leveraged exchange-traded funds (ETFs). Generally speaking, a diversified portfolio reduces the
risks presented by individual investment positions. For example, a penny stock position may have
a high risk on a singular basis, but if it is the only position of its kind in a larger portfolio, the risk
incurred by holding the stock is minimal.
Risk-Return Tradeoff at the Portfolio Level
That said, the risk-return tradeoff also exists at the portfolio level. For example, a portfolio
composed of all equities presents both higher risk and higher potential returns. Within an all-equity
portfolio, risk and reward can be increased by concentrating investments in specific sectors or by
taking on single positions that represent a large percentage of holdings. For investors, assessing
the cumulative risk-return tradeoff of all positions can provide insight on whether a portfolio
assumes enough risk to achieve long-term return objectives or if the risk levels are too high with
the existing mix of holdings.
The Professional Portfolio Managers use quantitative analysis of risk and reward tradeoff to do
the portfolio management.
Suppose you have Rs. 100,000 to invest. You are choosing between a riskless asset with an
interest rate of 0.06 per year and a risky asset with an expected rate of return of 0.14 per year
and a standard deviation of 0.2. How much of your Rs 100,000 should you invest in the risky
asset?
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Portfolio Proportion Proportion Invested Expected Standard

(1) Invested in the in Riskless Asset Rate of Deviation
Risky Asset (3) Return E(r) σ
(2) (4) (5)
F 0 100% 0.06 0.00
G 25% 75% 0.08 0.05
H 50% 50% 0.10 0.10
I 75% 25% 0.12 0.15
J 100% 0% 0.14 0.20
The Risk-Reward Trade-Off Line (Capital Allocation Line)

The portfolio composition for any point lying on the trade-off line in the figure shown above, not
only the points listed in the table discussed earlier.
TOPIC 157: FORMULA FOR THE TRADE-OFF LINE

Step 1: Relate the portfolio’s expected return to the proportion invested in the risky asset.
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E(r) = w E(𝒓_𝒔) +(1-w)𝒓_𝒇
= 𝒓_𝒇+ w [E(𝒓_𝒔) - 𝒓_𝒇]
The Risk-Reward Trade-Off Line
Example: Suppose w denote the proportion of the PKR 100,000 investment to be allocated to
the risky asset. Then, (1-w) will be invested in riskless asset.
Substituting 0.06 for 𝒓_𝒇 𝐚𝐧𝐝 𝟎.𝟏𝟒 𝐟𝐨𝐫 (𝒓_𝒔)
The Expected Rate of Return E(r) will be: E(r) = 0.06+w(0.14-0.06) = 0.06 + 0.08 w
Interpretation
The portfolio is expected to earn a risk premium which depends on:
1. The risk premium on the risky asset E(𝒓_𝒔) - 𝒓_𝒇, which is 0.14-0.06=0.08 in the above example
2. The proportion of the portfolio invested in the risky asset i.e. w
TOPIC 158: PORTFOLIO COMPOSITION AND AN EXPECTED RATE OF RETURN

To find portfolio composition corresponding to an expected rate of return we use the following
formula:
E(r) = 𝒓_𝒇+ w [E(𝒓_𝒔) - 𝒓_𝒇]
Suppose, a person wants to know the portfolio composition corresponding to an expected rate of
return of 0.09, risk premium is 0.08 and risk free interest is 0.06. Substituting these values in the
formula discussed above, we get:
0.09 = 0.06 +0.08w
w = (𝟎.𝟎𝟗 −𝟎.𝟎𝟔)/(𝟎.𝟎𝟖) = 0.375
Thus, the portfolio mix is 37.5% risky asset and 62.5% riskless asset.
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TOPIC 159: PORTFOLIO COMPOSITION AND STANDARD DEVIATION

After determining the portfolio composition, Professional Portfolio Managers relate the portfolio
standard deviation to the proportion invested in the risky asset.
If 𝝈_𝒔 is the standard deviation of the risky asset, the portfolio’s standard deviation is:
𝝈=𝝈_𝒔 𝒘
Example: Using the data given in the example discussed earlier

w = 0.375
𝝈_𝒔=𝟎.𝟐
𝝈=𝝈_𝒔 𝒘
= 0.2X0.375 = 0.075
Thus, the portfolio standard deviation is 0.075.
Relate the portfolio expected rate of return to its standard deviation.

Rearranging 𝝈=𝝈_𝒔 𝒘 for w,
w = 𝝈/𝝈_𝒔
Substituting value of w in:
E(r) = w E(𝒓_𝒔) +(1-w)𝒓_𝒇
= 𝒓_𝒇+ w [E(𝒓_𝒔) - 𝒓_𝒇], we get
E(r) = 𝒓_𝒇 +(E( 𝒓_𝒔 ) − 𝒓_𝒇)/𝝈_𝒔 𝝈
The Sharpe (Reward-to-Volatility) Measure

E(r) = 𝒓_𝒇 +(E( 𝒓_𝒔 ) − 𝒓_𝒇)/𝝈_𝒔 𝝈
S = Sharpe Ratio
"E(" 𝒓_𝒔 ") − " 𝒓_𝒇 = Portfolio Risk Premium
𝝈_𝒔 = Standard deviation of Portfolio Excess Return
Example: Suppose 𝒓_𝒇= 0.06; 𝝈_𝒔=𝟎.𝟐;

E(𝒓_𝒔) - 𝒓_𝒇=0.14-0.06=0.08
"E(r) =" 𝒓_𝒇 +("E(" 𝒓_𝒔 ") − " 𝒓_𝒇)/𝝈_𝒔 𝝈
=0.06+ "0.08" /(𝟎.𝟐) 𝝈 =0.06+0.4 𝝈
The slope of the trade-off line measures the extra expected return the market offers for each unit
of extra risk an investor is willing to bear.
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TOPIC 160: ACHIEVING A TARGET EXPECTED RETURN

Find the portfolio corresponding to an expected rate of return of 0.11 per year. What is its standard
deviation?
Expected Rate of Return = 0.11
Substituting the given values in the equation

E(r) = w E(𝒓_𝒔) +(1-w)𝒓_𝒇
= 𝒓_𝒇+ w [E(𝒓_𝒔) - 𝒓_𝒇]
and solving for w
0.11 = 0.06+0.08w
w = (𝟎.𝟏𝟏−𝟎.𝟎𝟔)/(𝟎.𝟎𝟖) = 0.625
Thus, the portfolio mix is 62.5% risky asset and 37.5% riskless asset.
To find standard deviation, we substitute w= 0.625 in
𝝈=𝝈_𝒔 𝒘 = 0.2X0.625=0.125
Thus, the portfolio standard deviation is 0.125.
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Lesson 32
PORTFOLIO EFFICIENCY
TOPIC 161: PORTFOLIO EFFICIENCY

 An efficient portfolio is defined as the portfolio that offers the investor the highest possible
expected rate of return at a specified level of risk. Investors must examine their own risk-
return preferences to determine where they should invest in the efficient frontier.
Efficient Frontier
• The line that connects all these efficient portfolios is known as the efficient frontier.
• The efficient frontier represents those portfolios that have the maximum rate of return for
every given level of risk.
• The last thing investors want is a portfolio with a low expected return and a high level of
risk.
Modern Portfolio Theory (MPT)

• Investors must examine their own risk-return preferences to determine where they should
invest in the efficient frontier.
• This concept was first formulated by Harry Markowitz in 1952. This concept is called the
modern portfolio theory (MPT).
Overall Portfolio’s Risk and Return

• According to MPT, an investment's risk and return characteristics should not be viewed
alone. Instead, they should be evaluated by how the investment affects the overall
portfolio's risk and return.
Inefficient Portfolio (1/2)

• An inefficient portfolio exposes an investor to a higher degree of risk than necessary to
achieve a target return.
• For example, a portfolio of high-yield bonds expected to provide only the risk-free rate of
return would be said to be inefficient.
• An investor could achieve the same return by purchasing Treasury bills, which are
considered among the safest investments in the world (rather than high-yield bonds, which
are, by definition, rated as risky investments).
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Portfolio efficiency is achieved by applying Modern Portfolio Theory (MPT). This concept was first
formulated by Harry Markowitz in 1952. According to MPT, an investment's risk and return
characteristics should not be viewed alone. Instead, they should be evaluated by how the
investment affects the overall portfolio's risk and return.
An inefficient portfolio exposes an investor to a higher degree of risk than necessary to achieve a
target return.
For example, a portfolio of high-yield bonds expected to provide only the risk-free rate of return
would be said to be inefficient.
An investor could achieve the same return by purchasing Treasury bills, which are considered
among the safest investments in the world (rather than high-yield bonds, which are, by definition,
rated as risky investments).
TOPIC 162: EFFICIENT FRONTIER

• The efficient frontier theory was introduced by Nobel Laureate Harry Markowitz in 1952
and is a cornerstone of modern portfolio theory (MPT). The efficient frontier rates
portfolios (investments) on a scale of return (y-axis) versus risk (x-axis).
• The compound annual growth rate (CAGR) of an investment is commonly used as the
return component while standard deviation (annualized) depicts the risk metric.
• The efficient frontier graphically represents portfolios that maximize returns for the risk
assumed. Returns are dependent on the investment combinations that make up the
portfolio.
• The less synchronized the securities (lower covariance), the lower the standard deviation.
If this mix of optimizing the return versus risk paradigm is successful, then that portfolio
should line up along the efficient frontier line.
The line that connects all these efficient portfolios is known as the efficient frontier.
The efficient frontier represents those portfolios that have the maximum rate of return for every
given level of risk.
The last thing investors want is a portfolio with a low expected return and a high level of risk.
The efficient frontier theory was introduced by Nobel Laureate Harry Markowitz in 1952 and is a
cornerstone of modern portfolio theory (MPT). The efficient frontier rates portfolios (investments)
on a scale of return (y-axis) versus risk (x-axis). The compound annual growth rate (CAGR) of an
investment is commonly used as the return component while standard deviation (annualized)
depicts the risk metric.
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The efficient frontier graphically represents portfolios that maximize returns for the risk assumed.
Returns are dependent on the investment combinations that make up the portfolio.
The less synchronized the securities (lower covariance), the lower the standard deviation. If this
mix of optimizing the return versus risk paradigm is successful, then that portfolio should line up
along the efficient frontier line.
The ultimate capital allocation line (CAL) tangent to the optimal risky portfolio is termed the capital
market line (CML), which offers the highest possible expected return for any given level of risk,
and the lowest possible risk for any given level of expected return.
• The ultimate capital allocation line (CAL) tangent to the optimal risky portfolio is termed
the capital market line (CML), which offers the highest possible expected return for any
given level of risk, and the lowest possible risk for any given level of expected return.
TOPIC 163: EFFICIENT DIVERSIFICATION WITH MANY RISKY ASSETS

 Portfolio risk depends on the correlation between the returns of the assets in the portfolio
 Covariance and the correlation coefficient provide a measure of the returns on two assets
to vary.
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Two Asset Portfolio Return
 Portfolios of Two Risky Assets
Expected Rate of Return of the Portfolio
E(r) = w E(r1) + (1-w) E(r2)
Efficient Diversification with Many Risky Assets

Variance = 𝝈^𝟐
= 𝒘^𝟐 𝝈_𝟏^𝟐+〖(𝟏−𝒘)〗^𝟐 𝝈_𝟐^𝟐+𝟐𝒘(𝟏−𝒘)𝝆_(𝟏,𝟐) 𝝈_𝟏 𝝈_𝟐
Covariance = 𝝆_(𝟏,𝟐) 𝝈_𝟏 𝝈_𝟐

𝝆_(𝟏,𝟐) = (𝑪𝒐𝒗 (𝒓_𝟏,𝒓_(𝟐 ))" " )/(𝝈_𝟏 𝝈_𝟐 )
If Asset 2 is risk free 𝝈_𝟐=0
Correlation Coefficients: Possible Values

𝝆 is correlation coefficient.
Range of values for 𝝆_(𝟏,𝟐)
-1.0 < 𝝆_(𝟏,𝟐) < 1.0
If 𝝆_(𝟏,𝟐) = 1.0, the securities would be perfectly positively correlated
If 𝝆_(𝟏,𝟐) = - 1.0, the securities would be perfectly negatively correlated
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Risk Reward Tradeoff between two risky assets
Risk Reward Tradeoff Curves: Risky Assets

Minimum -Variance Portfolio
Risky Asset 1 =36%
Risky Asset 2 = 64%
Expected Return = 10.15%
Standard Deviation = 12%
Correlation Coefficient = 0.00
TOPIC 164: OPTIMAL COMBINATION OF RISKY ASSETS

 The optimal combinations result in lowest level of risk for a given return
 The optimal trade-off is described as the efficient frontier.
 For Graphical Analysis, the optimal combination is obtained by drawing a tangent on the
efficiency frontier.
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 The point corresponding to the point of tangency is the risky portfolio, indication the
optimal combination of risky assets.
 Optimal = Most efficient portfolios
Graphical Illustration
The point corresponding to the point of tangency is the risky portfolio, indication the optimal
combination of risky assets.
Optimal = Most efficient portfolios
Formula for Efficient Combination
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Where w1 and w2 are the proportions of the risky assets.
Selection of the Preferred Portfolio

• Any point between F and T
• Depending on:
• Planning Horizon
• Life Cycle
• Risk Tolerance
Expected Rate of Return of the Portfolio

• To calculate a portfolio's expected return, an investor needs to calculate the expected
return of each of its holdings, as well as the overall weight of each holding.
• The basic expected return formula involves multiplying each asset's weight in the portfolio
by its expected return, then adding all those figures together.
Problem with Expected Return

• The expected return is usually based on historical data and is therefore not guaranteed.
• Since the market is volatile and unpredictable, calculating the expected return of a security
is more guesswork than definite. So it could cause inaccuracy in the resultant expected
return of the overall portfolio.
• Expected returns do not paint a complete picture, so making investment decisions based
on them alone can be dangerous.
Standard Deviation of the Rate of Return of the Portfolio

• It is calculated to judge the realized performance of a portfolio manager.
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• In a large fund with multiple managers with different styles of investing, a CEO or head
portfolio manager might calculate the risk of continuing to employ a portfolio manager who
deviates too far from the mean in a negative direction.
• This can go the other way as well, and a portfolio manager who outperforms their
colleagues and the market can often expect a hefty bonus for their performance.
TOPIC 165: SELECTION OF THE PREFERRED PORTFOLIO

Optimal Combination of Risky Assets
• The optimal risky portfolio is found at the point where the CAL is tangent to the efficient
frontier. This asset weight combination gives the best risk-to-reward ratio, as it has the
highest slope for CAL.
• w1 and w2 are the proportions of the risky assets.
Selection of the Preferred Portfolio

• Any point between F and T
• Depending on:
• Planning Horizon
• Life Cycle
• Risk Tolerance
• To find the optimal combination of risky assets, we do not need to know about investor’s
wealth or preferences.
• The composition of this portfolio depends on the expected rate of returns and standard
deviations of Risky Assets 1 and 2 and the correlation between them.
Preferred Portfolio will be a portfolio shown by any point between F and T. Depending on:
 Planning Horizon
 Life Cycle
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 Risk Tolerance
To calculate a portfolio's expected return, an investor needs to calculate the expected return of
each of its holdings, as well as the overall weight of each holding.
The basic expected return formula involves multiplying each asset's weight in the portfolio by its
expected return, then adding all those figures together.
Expected returns do not paint a complete picture, so making investment decisions based on them
alone can be dangerous.
It is calculated to judge the realized performance of a portfolio manager.
In a large fund with multiple managers with different styles of investing, a CEO or head portfolio
manager might calculate the risk of continuing to employ a portfolio manager who deviates too
far from the mean in a negative direction.
Standard Deviation of the Rate of Return of the Portfolio

It is calculated to judge the realized performance of a portfolio manager.
In a large fund with multiple managers with different styles of investing, a CEO or head portfolio
manager might calculate the risk of continuing to employ a portfolio manager who deviates too
far from the mean in a negative direction.
This can go the other way as well, and a portfolio manager who outperforms their colleagues and
the market can often expect a hefty bonus for their performance.
The optimal risky portfolio is found at the point where the CAL is tangent to the efficient frontier.
This asset weight combination gives the best risk-to-reward ratio, as it has the highest slope for
CAL.
To find the optimal combination of risky assets, we do not need to know about investor’s wealth
or preferences.
The composition of this portfolio depends on the expected rate of returns and standard deviations
of Risky Assets 1 and 2 and the correlation between them.
TOPIC 166: PORTFOLIOS OF MANY RISKY ASSETS

 When there are many risky assets, we use two-step method of portfolio construction.
 First, we consider portfolios constructed from the risky assets only
 Second, we find the tangency portfolio of risky assets to combine with the riskless asset
Point of Tangency and CAL
 The straight line connecting the riskless asset and the tangency point representing the
optimal combination of risky assets is the best risk-reward trade-off line achievable.
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 People have thousands of assets to choose from but they make their choices from a list
of a few final products offered by financial intermediaries such as bank accounts, stock
and bond mutual funds, and real estate.
 Intermediaries make use of the latest advances in financial technology but the basic mean-
variance approach is still the dominant method.
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Lesson 33
CAPITAL ASSET PRICING MODEL (CAPM)
TOPIC 167: CAPITAL ASSET PRICING MODEL (CAPM)

• The Capital Asset Pricing Model is an equilibrium theory that is based on the theory of
portfolio selection.
• It was developed in 1964 by William F. Sharpe.
• The Capital Asset Pricing Model (CAPM) describes the relationship between systematic
risk and expected return for assets, particularly stocks. CAPM is widely used throughout
finance for pricing risky securities and generating expected returns for assets given the
risk of those assets and cost of capital.
Assumptions
1. Investors are rational, mean-variance optimizers.
2. Investors use identical input lists, referred to as homogeneous expectations.
3. All assets are publicly traded (short positions are allowed) and investors can borrow or
lend at a common risk-free rate.
Market Portfolio
• A portfolio that holds all assets in proportion to their observed market values is called the
market portfolio.
Example
• Suppose there are only three assets:
• GM stocks; Toyota stocks and the risk-free asset.
• Total market values of each at current prices are $66 billion of GM, $22 billion of Toyota,
and $12 billion of the risk-free asset.
• Total market value of all assets is $100 billion.
• The CAPM says that in equilibrium any investor’s relative holdings of risky assets will be
the same as in the market portfolio.
• In our example, all investors will hold GM and Toyota stock in the proportion of 3 to 1
(i.e., 66/22).
The Capital Asset Pricing Model is an equilibrium theory that is based on the theory of portfolio
selection. It was developed in 1964 by William F. Sharpe. The Capital Asset Pricing Model
(CAPM) describes the relationship between systematic risk, or the general perils of investing, and
expected return for assets, particularly stocks.
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It is a finance model that establishes a linear relationship between the required return on an
investment and risk. The model is based on the relationship between an asset's beta, the risk-
free rate (typically the Treasury bill rate), and the equity risk premium, or the expected return on
the market minus the risk-free rate.
CAPM evolved as a way to measure this systematic risk. It is widely used throughout finance for
pricing risky securities and generating expected returns for assets, given the risk of those assets
and cost of capital.
Assumptions
Investors are rational, mean-variance optimizers.
Investors use identical input lists, referred to as homogeneous expectations.
All assets are publicly traded (short positions are allowed) and investors can borrow or lend at a
common risk-free rate.
The formula for calculating the expected return of an asset, given its risk, is as follows:
ERi=Rf+βi(ERm−Rf)
where:ERi=expected return of investmentRf=risk-free rate
βi=beta of the investment
(ERm−Rf)=market risk premium
Investors expect to be compensated for risk and the time value of money. The risk-free rate in
the CAPM formula accounts for the time value of money. The other components of the CAPM
formula account for the investor taking on additional risk.
The goal of the CAPM formula is to evaluate whether a stock is fairly valued when its risk and
the time value of money are compared with its expected return. In other words, by knowing the
individual parts of the CAPM, it is possible to gauge whether the current price of a stock is
consistent with its likely return.
A portfolio that holds all assets in proportion to their observed market values is called the market
portfolio.
Example: Suppose there are only three assets:
GM stocks; Toyota stocks and the risk-free asset.
Total market values of each at current prices are $66 billion of GM, $22 billion of Toyota, and
$12 billion of the risk-free asset.
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Total market value of all assets is $100 billion.
The CAPM says that in equilibrium any investor’s relative holdings of risky assets will be the
same as in the market portfolio.
In our example, all investors will hold GM and Toyota stock in the proportion of 3 to 1 (i.e., 66/22).
TOPIC 168: CAPITAL MARKET LINE (CML)

 The capital market line (CML) represents portfolios that optimally combine risk and return.
 CML is a special case of the capital allocation line (CAL) where the risk portfolio is the
market portfolio. Thus, the slope of the CML is the Sharpe ratio of the market portfolio.
 The intercept point of CML and efficient frontier would result in the most efficient portfolio
called the tangency portfolio.
 As a generalization, buy assets if Sharpe ratio is above CML and sell if Sharpe ratio is
below CML.
CAPM and CML
 The CAPM says that in equilibrium, the CML represents the best risk-reward combinations
available to all investors.
CML’s formula
 Slope of CML is the risk premium on the market portfolio divided by its standard deviation.
Capital Market Line
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TOPIC 169: DETERMINANTS OF THE RISK PREMIUM ON THE MARKET PORTFOLIO
The size of the risk premium of the market portfolio depends on:
 the aggregate risk aversion of investors and
 the volatility of the market return
 To be induced to accept the risk of the market portfolio, investors must be offered an
expected rate of return that exceeds the risk-free rate of return.
 The greater the average degree of risk aversion, the higher the risk premium needed.
Equilibrium Risk Premium
 In the CAPM, the equilibrium risk premium on the market portfolio is equal to the variance
of the market portfolio times a weighted average of the degree of risk aversion of the
holders of wealth (A);
Risk Premium on Market Portfolio

 A = index of the degree of risk aversion in the economy
Example
Suppose the standard deviation of the market portfolio is 0.2, and the average degree of risk
aversion is 2. The risk premium on the market portfolio will be:
= 0.08
TOPIC 170: ACTIVE AND PASSIVE INVESTING
• Active investing requires a hands-on approach, typically by a portfolio manager or other
so-called active participant.
• Passive investing involves less buying and selling and often results in investors buying
index funds or other mutual funds.
Active Investing
• The goal of active money management is to beat the stock market’s average returns and
take full advantage of short-term price fluctuations.
• It involves a much deeper analysis and the expertise to know when to pivot into or out of
a particular stock, bond, or any asset.
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• A portfolio manager usually oversees a team of analysts who look
at qualitative and quantitative factors, then gaze into their crystal balls to try to determine
where and when that price will change.
Active investing, as its name implies, takes a hands-on approach and requires that someone act
in the role of a portfolio manager. The goal of active money management is to beat the stock
market’s average returns and take full advantage of short-term price fluctuations. It involves a
much deeper analysis and the expertise to know when to pivot into or out of a particular stock,
bond, or any asset. A portfolio manager usually oversees a team of analysts who look at
qualitative and quantitative factors, then gaze into their crystal balls to try to determine where and
when that price will change.
Active investing requires confidence that whoever is managing the portfolio will know exactly the
right time to buy or sell. Successful active investment management requires being right more
often than wrong.
Passive Investing
If you are a passive investor, you invest for the long haul. Passive investors limit the amount of
buying and selling within their portfolios, making this a very cost-effective way to invest. The
strategy requires a buy-and-hold mentality. That means resisting the temptation to react or
anticipate the stock market’s every next move.
The prime example of a passive approach is to buy an index fund that follows one of the major
indices like the S&P 500 or Dow Jones Industrial Average (DJIA). Whenever these indices switch
up their constituents, the index funds that follow them automatically switch up their holdings by
selling the stock that’s leaving and buying the stock that’s becoming part of the index. This is why
it is such a big deal when a company becomes big enough to be included in one of the major
indices: It guarantees that the stock will become a core holding in thousands of major funds.
• Although both styles of investing are beneficial, passive investments have garnered more
investment flows than active investments.
• Historically, passive investments have earned more money than active investments.
• Active investing has become more popular than it has in several years, particularly during
market upheavals.
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TOPIC 171: BETA AND RISK PREMIUMS ON INDIVIDUAL SECURITIES
 The risk of security A is larger than the risk of security B, if in equilibrium the expected
return on A exceeds the expected return on B.
 In other words, along CML, among optimal (efficient) portfolios, the larger the standard
deviation of its return, the larger the equilibrium expected return E(r), and therefore, the
larger the risk.
 The risk of an efficient portfolio is measured by 𝝈
The measure of a security’s risk is its beta, which is defined as:
𝜷_𝒋=𝝈_𝒋𝑴/(𝝈_𝑴^𝟐 )
Where
𝝈_𝒋M denotes the covariance between the return on security j and the return on the market
portfolio.
Equilibrium
According to CAPM, in equilibrium, the risk premium on any asset is equal to its beta times the
risk premium on the market portfolio, i.e.
E(𝒓_𝒋) −𝒓_𝒇 = 𝜷_𝒋 [𝑬(𝒓_𝑴 )− 𝒓_𝒇 ]
TOPIC 172: SECURITY MARKET LINE

• The security market line is an investment evaluation tool derived from the CAPM—a
model that describes risk-return relationship for securities
• It is based on the assumption that investors need to be compensated for both the
• time value of money (TVM) and
• The corresponding level of risk associated with any investment, referred to as the risk
premium.
Security Market Line – Equation
• E(𝑟𝑗 ) − 𝑟𝑓 = 𝛽𝑗 [𝐸(𝑟𝑀 ) − 𝑟𝑓 ]
• Slope of SML is the risk premium.
• If any security is not on SML, e.g. it is at J, its expected return is “too low” to support
equilibrium.
• The existence of such situation contradicts CAPM and implies that the market is not in
equilibrium.
The security market line (SML) is a line drawn on a chart that serves as a graphical representation
of the capital asset pricing model (CAPM)—which shows different levels of systematic, or market
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risk, of various marketable securities, plotted against the expected return of the entire market at
any given time.
Also known as the "characteristic line," the SML is a visualization of the CAPM, where the x-axis
of the chart represents risk (in terms of beta), and the y-axis of the chart represents expected
return. The market risk premium of a given security is determined by where it is plotted on the
chart relative to the SML.
The security market line is an investment evaluation tool derived from the CAPM—a model that
describes risk-return relationship for securities—and is based on the assumption that investors
need to be compensated for both the time value of money (TVM) and the corresponding level of
risk associated with any investment, referred to as the risk premium.
If any security is not on SML, e.g. it is at J, its expected return is “too low” to support equilibrium.
The existence of such situation contradicts CAPM and implies that the market is not in equilibrium.
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Lesson 34
USING THE CAPM IN PORTFOLIO SELECTION
TOPIC 173: USING THE CAPM IN PORTFOLIO SELECTION

 The CAPM implies that the market portfolio of risky assets is an efficient portfolio.
 It means that an investor follows a passive portfolio selection strategy of combining a
market index fund and the risk-free asset.
Passive Portfolio Strategy
 Diversify your holdings of risky assets in the proportions of the market portfolio, and
 Mix this portfolio with the risk-free asset to achieve a desired risk-reward combination.
Example
 Suppose you have $1 million to invest.
 You want to invest in three asset classes, i.e. stocks, bonds and the risk-free asset.
 The net relative supply of first two is 60% and 40%.
 The composition of the portfolio will follow this ratio.
Process
 The investors will compare the rate of return earned on the managed portfolio to the rate
of return attainable by simply mixing the market portfolio and risk free asset in proportions
that would have produced the same volatility
 The volatility of the managed portfolio will be computed for the same period. Then the
average rate of return will be estimated and compared with the managed portfolio’s
average rate of return. Managed portfolio is the benchmark portfolio.
 Then the average rate of return will be estimated and compared with the managed
portfolio’s average rate of return.
 Managed portfolio is the benchmark portfolio.
TOPIC 174: INDEXING IN FINANCIAL MARKETS

• An index is a method to track the performance of a group of assets in a standardized
way.
• Indexes typically measure the performance of a basket of securities intended to replicate
a certain area of the market. These could be a broad-based index that captures the entire
market, such as the Standard & Poor's 500 Index or KSE100 Index.
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• Indexes can also be more specialized, such as indexes that track a particular industry or
segment.
• Index providers have numerous methodologies for constructing investment market
indexes.
• Index fund management, aims to duplicate the return of a particular market index or
benchmark.
• Managers buy the same stocks that are listed on the index, using the same weighting
that they represent in the index.
• CAPM contributed to the rise in the use of indexing–assembling a portfolio of shares to
mimic a particular market or asset class–by risk-averse investors.
• This is largely due to CAPM's message that it is only possible to earn higher returns than
those of the market as a whole by taking on higher risk (beta).
• If a fund manager is underperforming the S&P 500 over the long term, for example, it will
be hard to entice investors into the fund.
What is alpha?
• Alpha is a measure of the active return on an investment, the performance of that
investment compared with a suitable market index.
Indexing, broadly, refers to the use of some benchmark indicator or measure as a reference or
yard stick. In finance and economics, indexing is used as a statistical measure for tracking
economic data such as inflation, unemployment, gross domestic product (GDP) growth,
productivity, and market returns.
Indexing may also refer to passive investment strategies that replicate benchmark indexes. Index
investing has become increasingly popular over the past decades.
Indexes typically measure the performance of a basket of securities intended to replicate a certain
area of the market. These could be a broad-based index that captures the entire market, such as
the Standard & Poor's 500 Index or KSE100 Index.
Indexes can also be more specialized, such as indexes that track a particular industry or segment.
Index providers have numerous methodologies for constructing investment market indexes. Index
fund management, aims to duplicate the return of a particular market index or
benchmark. Managers buy the same stocks that are listed on the index, using the same weighting
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that they represent in the index. CAPM contributed to the rise in the use of indexing–assembling
a portfolio of shares to mimic a particular market or asset class–by risk-averse investors.
This is largely due to CAPM's message that it is only possible to earn higher returns than those
of the market as a whole by taking on higher risk (beta).
If a fund manager is underperforming the S&P 500 over the long term, for example, it will be hard
to entice investors into the fund.
TOPIC 175: ALPHA FUND AND THE SECURITY MARKET LINE
Alpha is a measure of the active return on an investment, the performance of that investment
compared with a suitable market index. The capital market line (CML) shows the rates of return
for a specific portfolio. The security market line (SML) represents the market’s risk and return at
a given time, and shows the expected returns of individual assets. The measure of risk in the CML
is the standard deviation of returns (total risk), the risk measure in the SML is systematic risk or
beta.
CML’s equation
SML’s equation
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Capital Market Line
Security Market Line

Alpha is used to determine by how much the realized return of the portfolio varies from the
required return, as determined by the CAPM.
𝜶=𝑹−〖[𝒓_𝒇+𝜷〗_𝒋 [𝑬(𝒓_𝑴 )− 𝒓_𝒇 ]
R=realized return of portfolio

𝑬(𝒓_𝑴 ) = Expected Market Return
Alpha Fund and the Security Market Line

Point alpha represents the alpha fund. In the figure above, alpha lies above SML. Alpha Fund’s
alpha is measured as the vertical distance between alpha and SML.
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• The capital market line (CML) shows the rates of return for a specific portfolio
• The security market line (SML) represents the market’s risk and return at a given time,
and shows the expected returns of individual assets.
• The measure of risk in the CML is the standard deviation of returns (total risk), the risk
measure in the SML is systematic risk or beta.
TOPIC 176: VALUATION AND REGULATING RATES OF RETURN

Risk premiums derived from the CAPM are used to:
1. Portfolio Selection
2. Discounted Cash Flow (DCF) Valuation Models
3. Capital Budgeting decisions of firms.
4. Establish ‘fair’ rates of return on invested capital in regulated firms
Discounted Cash Flow (DCF) Valuation Models

The price of a share is sometimes viewed as the present value of all expected future dividends
discounted at the market capitalization rate
𝑫𝟏 𝟏 𝑫 𝑫𝟏
𝑷𝟎 = (𝟏+𝒌)+ (𝟏+𝒌) 𝟐 + (𝟏+𝒌)𝟑 + ⋯
𝑫
=∑∞ 𝒕
𝒕=𝟏 (𝟏+𝒌)𝒕
• 𝐷𝑡 = the expected dividend per share in period t

• k = the risk-adjusted discount rate (expected rate of return)
Analysts use CAPM to calculate the value of k.
TOPIC 177: COST OF CAPITAL

• The firm’s cost of capital is a weighted average of its cost of equity capital and debt.
• Practitioners use a CAPM based method to estimate the cost of equity capital.
Example
• Suppose you want to compute your firm’s cost of equity capital.
• You compute the beta of your company’s stock and find it to be 1.1.
• The current risk free rate is 0.06 per year
• You assume that the market premium is 0.08 per year.
• The equilibrium expected rate of return on the stock of your company will be:
• E(r)= 𝑟𝑓 + 𝛽 [𝐸(𝑟𝑀 ) − 𝑟𝑓 ]
• = 0.06 +1.1 (0.08)
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• = 0.148
• Thus, 14.8% per year is the cost of equity capital.
Cost of capital is a company's calculation of the minimum return that would be necessary in order
to justify undertaking a capital budgeting project, such as building a new factory.
The term cost of capital is used by analysts and investors, but it is always an evaluation of whether
a projected decision can be justified by its cost. Investors may also use the term to refer to an
evaluation of an investment's potential return in relation to its cost and its risks.
Many companies use a combination of debt and equity to finance business expansion. For such
companies, the overall cost of capital is derived from the weighted average cost of all capital
sources. This is known as the weighted average cost of capital (WACC).
The concept of the cost of capital is key information used to determine a project's hurdle rate. A
company embarking on a major project must know how much money the project will have to
generate in order to offset the cost of undertaking it and then continue to generate profits for the
company.
Cost of capital, from the perspective of an investor, is an assessment of the return that can be
expected from the acquisition of stock shares or any other investment. This is an estimate and
might include best- and worst-case scenarios. An investor might look at the volatility (beta) of a
company's financial results to determine whether a stock's cost is justified by its potential return.
The concept of the cost of capital is key information used to determine a project's hurdle rate. A
company embarking on a major project must know how much money the project will have to
generate in order to offset the cost of undertaking it and then continue to generate profits for the
company.
Practitioners use a CAPM based method to estimate the cost of equity capital.
Example
Suppose you want to compute your firm’s cost of equity capital. You compute the beta of your
company’s stock and find it to be 1.1. The current risk free rate is 0.06 per year. You assume that
the market premium is 0.08 per year.
The equilibrium expected rate of return on the stock of your company will be:
E(r)= 𝒓_𝒇 + 𝜷 [𝑬(𝒓_𝑴 )− 𝒓_𝒇]
= 0.06 +1.1 (0.08)
= 0.148
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Thus, 14.8% per year is the cost of equity capital.
TOPIC 178: REGULATION AND COST-PLUS PRICING

 Regulators may use the CAPM to establish a “fair” rate of return on invested capital for
public utilities and other firms subject to price regulations.
Example
 A commission regulating an electric power company may have to establish a price that
the company is allowed to charge its customers for electricity.
 The commission will do so by computing the cost of producing the electricity, including an
allowance for the cost of capital.
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Lesson 35
MODIFICATIONS AND ALTERNATIVES TO THE CAPM
TOPIC 179: MODIFICATIONS AND ALTERNATIVES TO THE CAPM

 Recent research on asset pricing indicated that the original simple version of the CAPM
needs to be modified.
 It was suggested that the market portfolio used in CAPM were incomplete and inadequate
representations of the true market portfolio.
 Market imperfections such as borrowing costs and constraints, shortsale restrictions and
costs, different tax treatments for various assets and the non-tradability of important
assets like human capital are not contemplated in CAPM.
 CAPM must consider more realistic and complicated factors that effect the optimal
portfolio selection process.
 Two famous alternatives to CAPM are:
1. The multifactor Intertemporal Capital Asset Pricing Model (ICAPM).
2. Arbitrage Pricing Theory (APT)
TOPIC 180: FORWARD AND FUTURES MARKETS

 A forward market is an over-the-counter marketplace that sets the price of a financial
instrument or asset for future delivery.
 Forward markets are used for trading a range of instruments, but the term is primarily used
with reference to the foreign exchange market.
 It can also apply to markets for securities and interest rates as well as commodities.
 A forward market leads to the creation of forward contracts.
Forward and Futures Markets

• While forward contracts like futures contracts may be used for both hedging and
speculation, but they are different.
• Forward contracts can be customized to fit a customer's requirements, while futures
contracts have standardized features in terms of their contract size and maturity.
• Forwards are executed between banks or between a bank and a customer
• Futures are done on an exchange, which is a party to the transaction. The flexibility of
forwards contributes to their attractiveness in the foreign exchange market.
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Forward Markets – Pricing
• Prices in the forward market are interest-rate based.
• In the foreign exchange market, the forward price is derived from the interest rate
differential between the two currencies
• In interest rate forwards, the price is based on the yield curve to maturity.
How A Forward Market Works

A forward market leads to the creation of forward contracts. While forward contracts—like futures
contracts—may be used for both hedging and speculation, there are some notable differences
between the two. Forward contracts can be customized to fit a customer's requirements, while
futures contracts have standardized features in terms of their contract size and maturity.
Forwards are executed between banks or between a bank and a customer; futures are done on
an exchange, which is a party to the transaction. The flexibility of forwards contributes to their
attractiveness in the foreign exchange market.
Pricing
Prices in the forward market are interest-rate based. In the foreign exchange market, the forward
price is derived from the interest rate differential between the two currencies, which is applied
over the period from the transaction date to the settlement date of the contract. In interest rate
forwards, the price is based on the yield curve to maturity.
Foreign Exchange Forwards

Interbank forward foreign exchange markets are priced and executed as swaps. This means that
currency A is purchased vs. currency B for delivery on the spot date at the spot rate in the market
at the time the transaction is executed. At maturity, currency A is sold vs. currency B at the original
spot rate plus or minus the forward points; this price is set when the swap is initiated.
The interbank market usually trades for straight dates, such as a week or a month from the spot
date. Three- and six-month maturities are among the most common, while the market is less liquid
beyond 12 months. Amounts are commonly $25 million or more and can range into the billions.
Customers, both corporations and financial institutions such as hedge funds and mutual funds,
can execute forwards with a bank counter-party either as a swap or an outright transaction. In an
outright forward, currency A is bought vs. currency B for delivery on the maturity date, which can
be any business day beyond the spot date. The price is again the spot rate plus or minus the
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forward points, but no money changes hands until the maturity date. Outright forwards are often
for odd dates and amounts; they can be for any size.
A futures market is an auction market in which participants buy and sell commodity and futures
contracts for delivery on a specified future date. Futures are exchange-traded derivatives
contracts that lock in future delivery of a commodity or security at a price set today.
Examples of futures markets are the New York Mercantile Exchange (NYMEX), the Chicago
Mercantile Exchange (CME), the Chicago Board of Trade (CBoT), the Cboe Options Exchange
(Cboe), and the Minneapolis Grain Exchange.
Originally, such trading was carried on through open outcry and the use of hand signals in trading
pits, located in financial hubs such as New York, Chicago, and London. Throughout the 21st
century, like most other markets, futures exchanges have become mostly electronic.
In order to understand fully what a futures market is, it’s important to understand the basics of
futures contracts, the assets traded in these markets.
Futures contracts are made in an attempt by producers and suppliers of commodities to avoid
market volatility. These producers and suppliers negotiate contracts with an investor who agrees
to take on both the risk and reward of a volatile market.
Futures markets or futures exchanges are where these financial products are bought and sold for
delivery at some agreed-upon date in the future with a price fixed at the time of the deal. Futures
markets are for more than simply agricultural contracts, and now involve the buying, selling and
hedging of financial products and future values of interest rates.
Futures contracts can be made or "created" as long as open interest is increased, unlike other
securities that are issued. The size of futures markets (which usually increase when the stock
market outlook is uncertain) is larger than that of commodity markets and is a key part of the
financial system.
Large futures markets run their own clearinghouses, where they can both make revenue from the
trading itself and from the processing of trades after the fact. Some of the biggest futures markets
that operate their own clearinghouses include the Chicago Mercantile Exchange, the ICE, and
Eurex. Other markets like Cboe have outside clearinghouses (Options Clearing Corporation)
settle trades.
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Most all futures markets are registered with the Commodity Futures Trading Commission (CFTC),
the main U.S. body in charge of regulation of futures markets. Exchanges are usually regulated
by the nation’s regulatory body in the country in which they are based.
Example
If a coffee farm sells green coffee beans at $4 per pound to a roaster, and the roaster sells that
roasted pound at $10 per pound and both are making a profit at that price, they’ll want to keep
those costs at a fixed rate. The investor agrees that if the price for coffee goes below a set rate,
the investor agrees to pay the difference to the coffee farmer.
If the price of coffee goes higher than a certain price, the investor gets to keep profits. For the
roaster, if the price of green coffee goes above an agreed rate, the investor pays the difference
and the roaster gets the coffee at a predictable rate. If the price of green coffee is lower than an
agreed-upon rate, the roaster pays the same price and the investor gets the profit.
TOPIC 181: DISTINCTIONS BETWEEN FORWARD AND FUTURE CONTRACTS

1. Two parties agree to exchange some item in the future at a delivery price specified now.
2. The forward price is defined as the delivery price that makes the current market value of
the contract zero.
3. No money is paid in the present by either party to the other.
4. The face value of the contract is the quantity of the item specified in the contract times
the forward price.
5. The party who agrees to buy the specified item is said to take a long position, and the
party who agrees to sell the item is said to take a short position.
Who benefits from a forward contract?
• If the spot price on the contract maturity date is higher than the forward price, the party
who is long makes money.
• If the spot price on the contract maturity date is lower than the forward price, the party
who is short makes money.
• By contrast, futures contracts are standardized contracts that are traded on exchanges.
The exchange specifies the exact commodity, the contract size, and where and when
delivery will be made.
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Distinctions between Forward and Future Contracts
Futures Forwards
Traded on Exchange Privately negotiated
Standardized, having an exchange-specified contract Customized

unit, expiration, tick size, and notional value
Actively traded Non-transferrable
No counterparty risk, since payment is guaranteed by the Credit default risk, since it is privately negotiated, an
exchange clearing house dependent on the counterparty for payment
Regulated Not regulated
Forward and futures contracts are derivatives arrangements that involve two parties who agree
to buy or sell a specific asset at a set price by a certain date in the future. Buyers and sellers can
mitigate the risks associated with price movements down the road by locking in the purchase/sale
price in advance.
A forward contract is an arrangement that is made over-the-counter (OTC) and settles just once
at the end of the contract. Both parties involved in the agreement negotiate the exact terms of the
contract. It is privately negotiated and comes with a degree of default risk since the counterparty
is responsible for remitting payment.
Futures contracts, on the other hand, are standardized contracts that trade on stock exchanges.
As such, they are settled on a daily basis. These arrangements come with fixed maturity dates
and uniform terms. There is very little risk with futures, as they guarantee payment on the agreed-
upon date.
The forward contract is a privately-negotiated agreement between a buyer and seller to trade an
asset at a future date at a specified price. As such, they don't trade on an exchange. Because of
the nature of the contract, forward contracts have more flexible terms and conditions, including
the number of units of the underlying asset and what exactly will be delivered, among other
factors. Forwards have one settlement date: the end of the contract.
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Many hedgers use forward contracts to cut down on the volatility of an asset's price. Since the
terms are set when it is executed, a forward contract is not subject to price fluctuations. That
means if two parties agree to the sale of 1,000 ears of corn at $1 each (for a total of $1,000), the
terms cannot change even if the price of corn goes down to 50 cents per ear. It also ensures that
delivery of the asset or cash settlement (if specified) will take place.
Because of the nature of these contracts, forwards are not readily available to retail investors.
The market for them is often hard to predict. That's because the agreements and their details are
generally kept between the buyer and seller, and are not made public. Since they are private
agreements, there is a high degree of counterparty risk, which means there may be a chance that
one party will default.
Like forwards, futures contracts involve the agreement to buy and sell an asset at a specific price
at a future date. The futures contract, however, has some differences from the forward contract.
These contracts are marked-to-market (MTM) daily, which means that daily changes are settled
day by day until the end of the contract. The futures market is highly liquid, giving investors the
ability to enter and exit whenever they choose to do so.
These contracts are frequently used by speculators, who bet on the direction in which an asset's
price will move, they are usually closed out prior to maturity and delivery usually never happens.
In this case, a cash settlement usually takes place.
Because they are traded on an exchange, they have clearing houses that guarantee the
transactions. This drastically lowers the probability of default to almost never. Contracts are
available on stock exchange indexes, commodities, and currencies. The most popular assets for
futures contracts include crops like wheat and corn, and oil and gas.
Key Differences
One of the things that set forward contracts from futures contracts is how they're regulated.
Forward contracts aren't regulated at all while futures are overseen by a central government body.
The agency that provides oversight and regulation of futures contracts is the Commodity Futures
Trading Commission (CFTC). The CFTC was established in 1974 to regulate the derivatives
market, to ensure the markets run efficiently, and to protect the interests of investors by preventing
fraud and manipulation.
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Guarantees for each contract are also provided by different parties. Since forwards are privately
negotiated, they provide the guarantee to settle the contract. Futures, on the other hand, have an
institutional guarantee provided by the clearinghouses that back them. Unlike forwards, where
there is no guarantee until the contract settles, futures require a deposit or margin. This acts as
collateral to cover the risk of default.
TOPIC 182: THE ECONOMIC FUNCTIONS OF FUTURE MARKETS

 To facilitate the reallocation of exposure to commodity price risk among market
participants.
 To provide information to the producers, distributors, and consumers of commodities who
must decide how much wheat to sell (consume) and how much to store for the future.
Example
Suppose that it is one month before the next harvest. A wheat distributor is left with one ton of
wheat in storage. The spot price of wheat is $2 per bushel. The futures price for delivery a month
from now is F.
The distributor can hedge its exposure to price change by either

1. Selling the wheat in the spot market for $2 per bushel and delivering it immediately, or
2. Selling short a futures contract at a price of F and delivering the wheat a month from now.
Suppose the distributor’s cost of physically storing the wheat is 10 cents per bushel per month.
The distributor will store the wheat only if F > $2.10. If the storage cost is 15 cents, the distributor
will sell the wheat immediately if F= $2.10.
Hence, distributor will choose to carry wheat for the next month only if
𝑪_𝒋<𝑭−𝑺
𝑪_𝒋 is cost of carry for distributor j
Spot price
F – S => Spread
TOPIC 183: THE ROLE OF SPECULATORS

 Speculators are risk-takers who bet on the short- and mid-term future direction of
movements in an asset without having any other stake in that asset.
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 Speculators provide the markets with liquidity, aid in price discovery, and take on risk that
other market participants wish to unload.
 In commodities markets, speculators also keep markets efficient and stave off shortages
of goods by bidding them up when prices fall and financing the middlemen who link supply
chains.
 A speculator should thus not be confused with the middleman or broker.
 Speculators often get a bad rep, especially when headlines report a crash in stocks, a
spike in oil prices, or a currency's value is shattered in short order. This is because the
media often confounds speculation with manipulation.
 Manipulation is fraudulent and unethical, many times leading to extensive economic
damage; whereas speculation, while risky for the speculator, performs several important
functions that keep our markets and economy healthy.
 Speculation in the commodities markets keeps not only financial markets, but also our
supermarket shelves and food supply chains running smoothly.
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Lesson 36
COMMODITY SPOT AND FUTURES PRICES
TOPIC 184: RELATION BETWEEN COMMODITY SPOT AND FUTURES PRICES
• The futures price of a commodity is set in advance between producer and buyer.
• The spot price is the commodity's value when it is ready for delivery.
• The difference in the two values is where arbitrage traders make their money.
Formula
• The futures price cannot exceed the spot price by more than the cost of carry:
• F-S≤ C
• The cost of carry can vary over time and across market participants.
Futures Prices Converge upon Spot Prices
• It's a fairly safe bet that the price of a future will inch toward its spot price as the delivery
month of a futures contract approaches, and it could even match the price. This is a very
strong trend that occurs regardless of the contract's underlying asset.
• The convergence depends on:

• Arbitrage interest and
• The law of supply and demand.
The spot price is the current price in the marketplace at which a given asset—such as a security,
commodity, or currency—can be bought or sold for immediate delivery. While spot prices are
specific to both time and place, in a global economy the spot price of most securities or
commodities tends to be fairly uniform worldwide when accounting for exchange rates. In contrast
to the spot price, a futures price is an agreed upon price for future delivery of the asset.
Spot prices are most frequently referenced in relation to the price of commodity futures contracts,
such as contracts for oil, wheat, or gold. This is because stocks always trade at spot. You buy or
sell a stock at the quoted price, and then exchange the stock for cash.
A futures contract price is commonly determined using the spot price of a commodity, expected
changes in supply and demand, the risk-free rate of return for the holder of the commodity, and
the costs of transportation or storage in relation to the maturity date of the contract. Futures
contracts with longer times to maturity normally entail greater storage costs than contracts with
nearby expiration dates.
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Spot prices are in constant flux. While the spot price of a security, commodity, or currency is
important in terms of immediate buy-and-sell transactions, it perhaps has more importance in
regard to the large derivatives markets. Options, futures contracts, and other derivatives allow
buyers and sellers of securities or commodities to lock in a specific price for a future time when
they want to deliver or take possession of the underlying asset. Through derivatives, buyers and
sellers can partially mitigate the risk posed by constantly fluctuating spot prices.
The Relationship Between Spot Prices and Futures Prices

The difference between spot prices and futures contract prices can be significant. Futures prices
can be in contango or backwardation. Contango is when futures prices fall to meet the lower spot
price. Backwardation is when futures prices rise to meet the higher spot price. Backwardation
tends to favor net long positions since futures prices will rise to meet the spot price as the contract
get closer to expiry. Contango favors short positions, as the futures lose value as the contract
approaches expiry and converges with the lower spot price.
Futures markets can move from contango to backwardation, or vice versa, and may stay in either
state for brief or extended periods of time. Looking at both spot prices and futures prices is
beneficial to futures traders.
Example
An asset can have different spot and futures prices. For example, gold may have a spot price of
$1,000 while its futures price may be $1,300. Similarly, the price for securities may trade in
different ranges in the stock market and the futures market. For example, Apple Inc. (AAPL) may
trade at $200 in the stock market but the strike price on its options may be $150 in the futures
market, reflecting pessimistic trader perceptions of its future.
TOPIC 185: EXTRACTING INFORMATION FROM COMMODITY FUTURES PRICES

Sometimes the future prices can provide information about investor expectations of spot prices in
the future.
Information?
There can be two possibilities:
Case 1. No wheat is in storage
Case 2. Wheat is in storage
Case 1. No wheat is in storage
There is stock out.
F-S < C
___________________________________________________________________________________
It will be a strict inequality.
The forward price will provide information about the expected future spot price that is not
extractable from the current spot price.
Case 2. Wheat is in storage
No further inference about the future expected spot price is possible beyond that extractable from
the current spot price.
F-S = C
It will be an equality.
The forward price is completely specified by knowing the cost of carry and the spot price.
TOPIC 186: FORWARD-SPOT PRICE PARITY FOR GOLD

Suppose you are planning to invest in an ounce of gold for the next year.
You can do it in two ways:
Buy gold at the current spot price, S
Put it in storage
At the end of year 1, sell it at a price of S1.
In this case, your rate of return will be:
𝒓_𝒈=(𝑺_𝟏−𝑺)/𝑺 - b
b = storage cost
Example
Suppose the spot price of gold is $300 and storage costs are 2% per year, your rate of return is:
𝒓_𝒈=(𝑺_𝟏−𝟑𝟎𝟎)/𝟑𝟎𝟎 - 0.02
Another way is to take the same $300 and invest in synthetic gold (by paying the spot price).
At the same time by taking a long position in a gold forward contract with a delivery date of after
a year at a forward price of F.
The rate of return for synthetic gold is:
Suppose the risk free return r is 8%, return on synthetic gold will be:
___________________________________________________________________________________
By the Law of One Price, these two equivalent investments must offer the same return.
Hence by equating the two equations, we get:
(𝑺_𝟏−𝑭)/𝑺 +r =(𝑺_𝟏−𝑺)/𝑺 – b
Solving it for F, we get:
F=(1+r+b)S
Hence, the forward price for delivery of gold in one year should be:
F =(1+r+b)S = (1+0.08+0.02)X300
= 1.10X300=$330
TOPIC 187: THE IMPLIED COST OF CARRY

 Cost of carry refers to costs associated with the carrying value of an investment.
 It includes financial costs, such as the interest costs on bonds, interest on loans used to
make an investment, and any storage costs involved in holding a physical asset.
The Implied Cost of Carry
Implied Cost of Carry = F –S
Carrying Cost can be calculated by using the following formula:
F = S(1+r+s)
(𝑭−𝑺)/𝑺 = r+s
Implied Cost of Storing:
s = (𝑭−𝑺)/𝑺 – r
Example
Suppose the spot price of gold is $300 per ounce, the one-year forward price is $330, and the
risk-free interest rate is 8%.
Implied Cost of Carry:
F-S = $300 - $330 = $30 per ounce
year, your rate of return is:
Implied Storage Cost:
s=((𝑭−𝑺))/𝑺 - r = 0.10-0.08=0.02
or 2% per year
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Lesson 37
FINANCIAL FUTURES AND FORWARD PRICE
TOPIC 188: FINANCIAL FUTURES

 Futures are derivative financial contracts obligating the buyer to purchase an asset or the
seller to sell an asset at a predetermined future date and set price.
 A futures contract allows an investor to speculate on the direction of a security, commodity,
or financial instrument.
 Futures are used to hedge the price movement of the underlying asset to help prevent
losses from unfavorable price changes.
Types of Futures
• Commodity futures such as crude oil, natural gas, corn, and wheat
• Stock index futures such as the PSX 100 Index
• Currency futures including those for the dollar and the British pound
• Precious metal futures for gold and silver
The concept of futures trading can seem fairly simple when we are explaining physical
commodities such as agricultural products, metals or crude oil. But things start to get more
complex when we enter the intangible world of financial futures.
This is where we get into the business of financial instruments – trading numbers and figures,
calculations and data, percentages and indexes. The products may seem abstract, but they are
integral to the world’s economies because they enable governments, businesses and financial
institutions to manage the costs of doing business.
Three types of financial futures markets
1. THE FOREIGN CURRENCY MARKET
If you buy products or services in other countries, you must manage the risk of fluctuations in
foreign exchange rates.
2. THE INTEREST RATE MARKET
If you lend or borrow money, you must manage the risk of shifting interest rates to ensure a steady
level of access to your capital.
3. THE EQUITY INDEX MARKET
If you invest in stocks, you may want to manage the risk of price changes reflected in underlying
equity indexes such as the S&P 500 and the Dow Jones Industrial Average.
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TOPIC 189: FINANCIAL FUTURES – EXAMPLE

 A trader wants to speculate on the price of crude oil by entering into a futures contract in
May with the expectation that the price will be higher by year-end.
 The December crude oil futures contract is trading at $50 and the trader locks in the
contract.
Example
 The investor now has a position worth $50,000 of crude oil (1,000 x $50 = $50,000).
 The trader will only need to pay a fraction of that amount up-front—the initial margin that
they deposit with the broker.
 From May to December, the price of oil fluctuates as does the value of the futures contract.
If oil's price gets too volatile, the broker may ask for additional funds to be deposited into
the margin account—a maintenance margin.
Example
 Suppose in December, the price of crude oil has risen to $65, and the trader sells the
original contract to exit the position.
 The net difference is cash-settled, and they earn $15,000, less any fees and commissions
from the broker ($65 - $50 = $15 x 1000 = $15,000).
 However, if the price oil had fallen to $40 instead, the investor would have lost $10,000
($40 - $50 = negative $10 x 1000 = negative $10,000).
TOPIC 190: IMPLIED RISKLESS RATE

 In practice, the risk-free rate of return does not truly exist, as every investment carries at
least a small amount of risk. To calculate the real risk-free rate, subtract the inflation rate
from the yield of the Treasury bond matching your investment duration.
 The interest rate on a three-month Treasury bill (T-bill) is often used as the risk-free rate
for investors.
 The three-month Treasury bill is a useful proxy because the market considers there to be
virtually no chance of the government defaulting on its obligations.
 The large size and deep liquidity of the market contribute to the perception of safety.
However, a foreign investor whose assets are not denominated in PKR incurs currency
risk when investing in Treasury bills. The risk can be hedged via currency forwards and
options but affects the rate of return.
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TOPIC 191: FORWARD PRICE AND FUTURE SPOT PRICE

• If a stock that pays no dividend and offers a positive risk premium to investors, forward
price is not a forecast of the expected future spot price.
• Suppose that the risk premium on S&P stock is 7% and the riskless interest rate is 8%.
The expected rate of return on S&P is 15 %.
• If the current spot price is $100 per share, the expected spot price one year from now will
be $115.
• In the absence of any dividends, the ending spot price must be 15% higher than the
beginning spot price.
Important Point
• The forward-spot price parity relation says that the forward price of the S&P for delivery
in one year must be $108.
• It means only risk premium is to be taken.
The precise meanings of the terms "forward rate" and "spot rate" are somewhat different in
different markets. In general, a spot rate refers to the current price or bond yield, while a forward
rate refers to the price or yield for the same product or instrument at some point in the future.
In commodities futures markets, a spot rate is the price for a commodity being traded immediately,
or "on the spot". A forward rate is the settlement price of a transaction that will not take place until
a predetermined date.
In bond markets, the forward rate refers to the effective yield on a bond, commonly U.S. Treasury
bills, and is calculated based on the relationship between interest rates and maturities.
If a stock that pays no dividend and offers a positive risk premium to investors, forward price is
not a forecast of the expected future spot price.
Suppose that the risk premium on S&P stock is 7% and the riskless interest rate is 8%. The
expected rate of return on S&P is 15 %.
If the current spot price is $100 per share, the expected spot price one year from now will be
$115.
___________________________________________________________________________________
In the absence of any dividends, the ending spot price must be 15% higher than the beginning
spot price.
Example
The forward-spot price parity relation says that the forward price of the S&P for delivery in one
year must be $108.
It means only risk premium is to be taken.
TOPIC 192: FORWARD-SPOT PRICE-PARITY RELATION WITH CASH PAYOUTS

Suppose everyone expects the stock to pay a cash dividend of D per share at the end of the year.
Price of Stock= S = (𝑫+𝑭)/((𝟏+𝒓))
F= S(1+r) – D
F = S + rS – D
F>S if D <rS
TOPIC 193: IMPLIED DIVIDENDS

Implied Dividend can be calculated using:
Example
Suppose S=$100; r =0.08; F=$103
Putting these values in the above mentioned formula, we get:
= 100(1.08) -103
= $5
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Lesson 38
FOREIGN-EXCHANGE PARITY RELATION
TOPIC 194: FOREIGN-EXCHANGE PARITY RELATION

 Foreign-Exchange Parity is also known as Interest Rate Parity (IRP).
 Interest rate parity (IRP) is a theory according to which the interest rate differential
between two countries is equal to the differential between the forward exchange rate and
the spot exchange rate.
 Parity is used by forex traders to find arbitrage opportunities.
Interest Rate Parity is:
Where:
F=Forward Price
S = Spot Price
𝒊𝒄 = interest rate in country c
𝒊𝒃 = interest rate in country b
 The difference between the forward rate and spot rate is known as swap points.
 If this difference (forward rate minus spot rate) is positive, it is known as a forward
premium;
 A negative difference is termed a forward discount.
 A currency with lower interest rates will trade at a forward premium in relation to a
currency with a higher interest rate. For example, the U.S. dollar typically trades at a
forward premium against the Canadian dollar. Conversely, the Canadian dollar trades at
a forward discount versus the U.S. dollar.
TOPIC 195: THE ROLE OF EXPECTATIONS IN DETERMINING EXCHANGE RATES

 Expectations Hypothesis states that the forward price of a currency is equal to its
expected future spot price.
 If 𝑺𝟏 denotes the spot dollar price of the pound one year from now and (𝑺𝟏) is the
expected future spot price, then
𝑭=𝑬(𝑺𝟏)
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TOPIC 196: PRICING OF SWAP CONTRACTS
Derivatives contracts can be divided into two general families:
1. Contingent claims (e.g., options)

2. Forward claims, which include exchange-traded futures, forward contracts, and swaps
A swap is an agreement between two parties to exchange sequences of cash flows for a set
period of time. Usually, at the time the contract is initiated, at least one of these series of cash
flows is determined by a random or uncertain variable, such as an interest rate, foreign exchange
rate, equity price, or commodity price.
Swap Contracts
• Swaps are derivative instruments that represent an agreement between two parties to
exchange a series of cash flows over a specific period of time. Swaps offer great flexibility
in designing and structuring contracts based on mutual agreement.
Pricing of Swap Contracts

• Consider a yen-dollar swap.
• Suppose the contract is of two years, with a notional principal of 100 million yens.
• Suppose that the one-year forward price of the yen is $0.01 and two year forward price is
$0.0104.
• In the first year it is $1 million and in the second it is $1.04 million.
• But the currency swap calls for a single swap exchange rate to apply in both years.
• To calculate this, we use the following formula
• Suppose riskless dollar interest rate is 8% per year. Let F be the swap rate.
• F will be calculated using:
• $1 m/1.08+$1.04m/(1.08)^2 = 100,000,000 F(1/1.08+1/1.082 )
$1 m/1.08+$1.04m/(1.08)^2
• F=100,000,000 (1/1.08+1/1.082 )
• = $0.010192307 per yen

•
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Conceptually, one may view a swap as either a portfolio of forward contracts or as a long position
in one bond coupled with a short position in another bond. This article will discuss the two most
common and most basic types of swaps: interest rate and currency swaps.
Consider a yen-dollar swap.
TOPIC 197: FOREIGN EXCHANGE MARKET

 The foreign exchange market (also known as forex, FX, or the currencies market) is an
over-the-counter (OTC) global marketplace that determines the exchange rate for
currencies around the world. Participants in these markets can buy, sell, exchange, and
speculate on the relative exchange rates of various currency pairs.
 Foreign exchange markets are made up of banks, forex dealers, commercial companies,
central banks, investment management firms, hedge funds, retail forex dealers, and
investors.
 An exchange rate is the price of one currency in terms of another.

 There are two kinds of exchange rate transactions:
 -Spot transactions, involve the immediate exchange of bank deposits.
 -Forward transactions, involve the exchange of bank deposits at some specified future
date.
The foreign exchange market—also called forex, FX, or currency market—was one of the original
financial markets formed to bring structure to the burgeoning global economy. In terms of trading
volume, it is, by far, the largest financial market in the world. Aside from providing a venue for the
buying, selling, exchanging, and speculation of currencies, the forex market also enables currency
conversion for international trade settlements and investments.
Currencies are always traded in pairs, so the "value" of one of the currencies in that pair is relative
to the value of the other. This determines how much of country A's currency country B can buy,
and vice versa. Establishing this relationship (price) for the global markets is the main function of
the foreign exchange market. This also greatly enhances liquidity in all other financial markets,
which is key to overall stability.
___________________________________________________________________________________
The value of a country's currency depends on whether it is a "free float" or "fixed float." Free-
floating currencies are those whose relative value is determined by free-market forces, such as
supply-demand relationships.
A fixed float is where a country's governing body sets its currency's relative value to other
currencies, often by pegging it to some standard. Free-floating currencies include the U.S. dollar,
Japanese yen, and British pound, while examples of fixed floating currencies include the
Panamanian Balboa and the Saudi Riyal.
One of the most unique features of the forex market is that it is comprised of a global network of
financial centers that transact 24 hours a day, closing only on the weekends. As one major forex
hub closes, another hub in a different part of the world remains open for business. This increases
the liquidity available in currency markets, which adds to its appeal as the largest asset class
available to investors.
The most liquid trading pairs are, in descending order of liquidity:

 EUR/USD
 USD/JPY
 GBP/USD
There are three main forex markets: the spot forex market, the forward forex market, and the
futures forex market.
Spot Forex Market: The spot market is the immediate exchange of currencies at the current
exchange. On the spot. This makes up a large portion of the total forex market and involves
buyers and sellers from across the entire spectrum of the financial sector, as well as those
individuals exchanging currencies.
Forward Forex Market: The forward market involves an agreement between the buyer and seller
to exchange currencies at an agreed-upon price at a set date in the future. No exchange of actual
currencies takes place, just the value. The forward market is often used for hedging.
Futures Forex Market: The futures market is similar to the forward market, in that there is an
agreed price at an agreed date. The primary difference is that the futures market is regulated and
happens on an exchange. This removes the risk found in other markets. Futures are also used
for hedging.
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TOPIC 198: IMPORTANCE OF FOREIGN EXCHANGE
 The exchange rate plays an important role in a country's trade performance. Whether
determined by exogenous shocks or by policy, the relative valuations of currencies and
their volatility often have important repercussions on international trade, the balance of
payments and overall economic performance.
When a currency increases in value, it experiences appreciation; when it falls in value and is worth
fewer U.S. dollars, it undergoes depreciation.
At the beginning of 1999, for example, the euro was valued at 1.18 dollars; on Jun 19, 2017, it
was valued at 1.12 dollars.
The euro depreciated by 6%
(1.12 - 1.18)/1.18= -0.06 = -6%
Appreciation
Equivalently, we could say that the U.S. dollar, which went from a value of 0.85 euro per dollar at
the beginning of 1999 to a value of 0.89 euro per dollar on June 19, 2017, appreciated by 6%:
(0.89 - 0.85)/0.85 = 0.06 = 6%.
Foreign Exchange
 When a country’s currency appreciates, the country’s goods abroad become more
expensive, and foreign goods in that country become cheaper (holding domestic prices
constant in both countries).
 Conversely, when a country’s currency depreciates, its goods abroad become cheaper,
and foreign goods in that country become more expensive.
TOPIC 199: HOW IS FOREIGN EXCHANGE TRADED?

 The foreign exchange market is where currencies are traded. Currencies are important
because they allow us to purchase goods and services locally and across borders.
International currencies need to be exchanged to conduct foreign trade, business, travel,
etc.
Where is Forex Traded?
 Forex is traded primarily via three venues: spot markets, forwards markets, and futures
markets. The spot market is the largest of all three markets because it is the “underlying”
asset on which forwards and futures markets are based.
How to trade FOREX?
___________________________________________________________________________________
 The first step to forex trading is to educate yourself about the market’s operations and
terminology.
 Next, develop a trading strategy based on your finances and risk tolerance.
 Finally, open a brokerage account.
 It can be done online.
TOPIC 200: EXCHANGE RATES IN THE LONG RUN - LAW OF ONE PRICE
 The exchange rate is determined in the long run by prices, which are determined by the
relative supply of money across countries and the relative real demand of money across
countries.
Law of One Price
 The law of one price is an economic concept that states that the price of an identical asset
or commodity will have the same price globally, regardless of location, when certain
factors are considered.
The law of one price takes into account a frictionless market, where there are no transaction costs,
transportation costs, or legal restrictions, the currency exchange rates are the same, and that
there is no price manipulation by buyers or sellers. The law of one price exists because differences
between asset prices in different locations would eventually be eliminated due to the arbitrage
opportunity.
The arbitrage opportunity would be achieved whereby a trader would purchase the asset in the
market it is available at a lower price and then sell it in the market where it is available at a higher
price. Over time, market equilibrium forces would align the prices of the asset.
The law of one price is the foundation of purchasing power parity. Purchasing power parity states
that the value of two currencies is equal when a basket of identical goods is priced the same in
both countries. It ensures that buyers have the same purchasing power across global markets.
In reality, purchasing power parity is difficult to achieve, due to various costs in trading and the
inability to access markets for some individuals.
The formula for purchasing power parity is useful in that it can be applied to compare prices across
markets that trade in different currencies. As exchange rates can shift frequently, the formula can
be recalculated on a regular basis to identify mispricings across various international markets.
___________________________________________________________________________________
Example of the Law of One Price
If the price of any economic good or security is inconsistent in two different free markets after
considering the effects of currency exchange rates, then to earn a profit, an arbitrageur will
purchase the asset in the cheaper market and sell it in the market where prices are higher. When
the law of one price holds, arbitrage profits such as these will persist until the price converges
across markets.
For example, if a particular security is available for $10 in Market A but is selling for the equivalent
of $20 in Market B, investors could purchase the security in Market A and immediately sell it for
$20 in Market B, netting a profit of $10 without any true risk or shifting of the markets.
As securities from Market A are sold on Market B, prices on both markets should change in
accordance with the changes in supply and demand, all else equal. Increased demand for these
securities in Market A, where it is relatively cheaper, should lead to an increase in its price there.
Conversely, increased supply in Market B, where the security is being sold for a profit by the
arbitrageur, should lead to a decrease in its price there. Over time, this would lead to a balancing
of the price of the security in the two markets, returning it to the state suggested by the law of one
price.
Violations of the Law of One Price

In the real world, the assumptions built into the law of one price frequently do not hold, and
persistent differentials in prices for many kinds of goods and assets can be readily observed.
1. Transportation Cost
When dealing in commodities, or any physical good, the cost to transport them must be included,
resulting in different prices when commodities from two different locations are examined.
2. Transaction Cost
These are the payments that banks and brokers receive for their roles.
In case of buying and selling real estate, transaction costs include the agent's commission and
closing costs, such as title search fees, appraisal fees, and government fees. It also include the
time and labor associated with transporting goods across long distances.
3. Legal Restrictions
___________________________________________________________________________________
Legal barriers to trade, such as tariffs, capital controls, or in the case of wages, immigration
restrictions, can lead to persistent price differentials rather than one price. These will have a
similar effect to transportation and transaction costs, and might even be thought of as a type of
transaction cost.
4. Market Structure
The number of buyers and sellers (and the ability of buyers and sellers to enter the market) can
vary between markets, market concentration and ability of buyers and sellers to set prices can
vary as well.
• A seller who enjoys a high degree of market power due to natural economies of scale in
a given market might act like a monopoly price setter and charge a higher price. This can
lead to different prices for the same good in different markets.
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Lesson 39
THEORY OF PURCHASING POWER PARITY
TOPIC 201: THEORY OF PURCHASING POWER PARITY

• PPP is an economic theory that compares different countries' currencies through a
"basket of goods" approach.
• According to this concept, two currencies are in equilibrium—known as the currencies
being at par—when a basket of goods is priced the same in both countries, taking into
account the exchange rates.
Formula
• Relative version of Purchasing Power Parity
𝑃
• S =𝑃1
2
• S = Exchange rate of currency 1 to currency 2

• 𝑃1 =Cost of good X in Currency 1
• 𝑃2 = Cost of good X in Currency 2
Example
• Suppose it costs $10 to buy a shirt in the U.S., and it costs €8.00 to buy an identical shirt
in Germany. To make a comparison, we must first convert the €8.00 into U.S. dollars.
• If the exchange rate was such that the shirt in Germany costs $15.00, the PPP would,
therefore, be 15/10, or 1.5.
• In other words, for every $1.00 spent on the shirt in the U.S., it takes $1.50 to obtain the
same shirt in Germany buying it with the euro.
One popular macroeconomic analysis metric to compare economic productivity and standards of
living between countries is purchasing power parity (PPP). PPP is an economic theory that
compares different countries' currencies through a "basket of goods" approach.
According to this concept, two currencies are in equilibrium—known as the currencies being at
par—when a basket of goods is priced the same in both countries, taking into account the
exchange rates.
Relative version of Purchasing Power Parity
S =𝑷𝟏/𝑷𝟐
S = Exchange rate of currency 1 to currency 2
𝑷𝟏=Cost of good X in Currency 1
___________________________________________________________________________________
𝑷𝟐= Cost of good X in Currency 2
Drawbacks of Purchasing Power Parity

Since 1986, The Economist has playfully tracked the price of McDonald's Corp.’s (MCD) Big Mac
hamburger across many countries. Their study results in the famed "Big Mac Index". In
"Burgernomics"—a prominent 2003 paper that explores the Big Mac Index and PPP—authors
Michael R. Pakko and Patricia S. Pollard cited the following factors to explain why the purchasing
power parity theory is not a good reflection of reality.
Transport Costs
Goods that are unavailable locally must be imported, resulting in transport costs. These costs
include not only fuel but import duties as well. Imported goods will consequently sell at a relatively
higher price than do identical locally sourced goods.
Tax Differences
Government sales taxes such as the value-added tax (VAT) can spike prices in one country,
relative to another.
Government Intervention
Tariffs can dramatically augment the price of imported goods, where the same products in other
countries will be comparatively cheaper.
Non-Traded Services
The Big Mac's price factors input costs that are not traded. These factors include such items as
insurance, utility costs, and labor costs. Therefore, those expenses are unlikely to be at parity
internationally.
Market Competition
Goods might be deliberately priced higher in a country. In some cases, higher prices are because
a company may have a competitive advantage over other sellers. The company may have a
monopoly or be part of a cartel of companies that manipulate prices, keeping them artificially high.
The Bottom Line
___________________________________________________________________________________
While it's not a perfect measurement metric, purchase power parity does allow for the possibility
of comparing pricing between countries that have differing currencies.
TOPIC 202: FACTORS THAT AFFECT EXCHANGE RATES IN THE LONG RUN
1. Relative Price Levels

If the demand for a domestic good relative to a foreign good increases, the domestic currency will
appreciate and vice versa.
2. Trade Barriers
 Tariffs, quotas and other restrictions.
 Increasing trade barriers causes a country’s currency to appreciate in the long run.
3. Preferences for Domestic versus Imported Goods
 Increased demand for a country’s exports causes its currency to appreciate in the long
run.
 Pakistan imports in July 2021: $5,601 million
 Pakistan exports in Aug 2021: $2,248 million
4. Productivity
In the long run, as a country becomes more productive relative to other countries, its currency
appreciates.
TOPIC 203: EXCHANGE RATES IN THE SHORT RUN

 Traders and institutions buy and sell currencies 24 hours a day during the week. For a
trade to occur, one currency must be exchanged for another. To buy British Pounds
(GBP), another currency must be used to buy it. Whatever currency is used will create a
currency pair.
 If U.S. dollars (USD) are used to buy GBP, the exchange rate is for the GBP/USD pair.
 If the USD/CAD currency pair is 1.33, that means it costs 1.33 Canadian dollars for 1 U.S.
dollar.
 In USD/CAD, the first currency listed (USD) always stands for one unit of that currency.
Equilibrium in Foreign Exchange Market

Factors that Shift the Demand Curve for Domestic Assets
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Factors that Shift the Demand Curve for Domestic Assets (continued)
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TOPIC 204: PAKISTAN'S EXCHANGE RATE

The broad-based up surge in global commodity prices, COVID-19 vaccine imports, and demand-
side pressures, all contributed to the rising imports. While the PKR exchange rate acted as a
shock absorber and depreciated, in response to external payments pressure. Amidst the
challenging present global environment, Pakistan’s external account also came under strain
during Jul-Mar FY2022 and the trade deficit widened substantially over last year. On one hand,
export receipts and workers’ remittances both reached record-high levels during the nine-month
period. On the other hand, however, the import payments also registered a sizable, broad-based
increase. As a result, the current account deficit widened considerably over last year. These
payment pressures manifested on the interbank PKR-USD exchange rate, which depreciated
14.1 percent during Jul-Mar FY2022. The SBP’s FX reserves also came under pressure from Q2
onwards, dropping US$ 5.9 billion during Jul-Mar FY2022 to US$ 11.4 billion by end March 2022.
SBP has announced to embark on the market based flexible exchange rate regime from May
2019. This has helped SBP not only to build foreign exchange reserves from US$ 7.3 billion in
June 2019 to US$16.4 billion at end March 2022 but also to reduce size of its forward swap book
from US$ 8.0 billion in June 2019 to US$ 4.4 billion at end January 2022.
Despite the uncertainties of the COVID-19, market-based exchange rate regime helped the
external sector to record marked improvement during FY2021.The current account deficit fell to
US$1.9 billion (0.6 percent of the GDP) in FY21 from US$4.4 billion (1.7 percent of GDP) in FY20.
This is the lowest deficit in 10 years with all-time high exports (US$25.6 billion) and workers
remittances (US$29.4 billion). With the sharp rise in global commodity prices amid supply chain
disruptions, however, current account deficit widened to US$12.1 billion during Jul-Feb FY2022.
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Exchange rate is continuing to play its role of shock absorber and as of 28th March 2022 is
depreciated by around 13.5 percent since end June 2021. This depreciation together with other
policy actions are expected to contain the current account deficit in the rest of FY2022 and
FY2023. Despite adverse terms of trade shock, current account deficit (CAD) narrowed sharply
to US$0.5 billion in February 2022, almost one fifth of US$ 2.5 billion in January 2022. This is a
broad-based improvement as indicated by reduction of deficits in balances of goods and services,
primary income and increase in secondary income.
To analyze the fluctuations in the Pakistan US Dollar Exchange Rate in the past three years see
the following trend diagram.
TOPIC 205: BEHAVIORAL FINANCE

 Behavioral finance, a subfield of behavioral economics, proposes that psychological
influences and biases affect the financial behaviors of investors and financial practitioners.
 Moreover, influences and biases can be the source for the explanation of all types of
market anomalies and specifically market anomalies in the stock market, such as severe
rises or falls in stock price. As behavioral finance is such an integral part of investing, the
Securities and Exchange Commission has staff specifically focused on behavioral finance.
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Behavioral finance can be analyzed from a variety of perspectives. Stock market returns are one
area of finance where psychological behaviors are often assumed to influence market outcomes
and returns but there are also many different angles for observation. The purpose of the
classification of behavioral finance is to help understand why people make certain financial
choices and how those choices can affect markets.
Within behavioral finance, it is assumed that financial participants are not perfectly rational and
self-controlled but rather psychologically influential with somewhat normal and self-controlling
tendencies. Financial decision-making often relies on the investor's mental and physical health.
As an investor's overall health improves or worsens, their mental state often changes. This
impacts their decision-making and rationality towards all real-world problems, including those
specific to finance.
One of the key aspects of behavioral finance studies is the influence of biases. Biases can occur
for a variety of reasons. Biases can usually be classified into one of five key concepts.
Understanding and classifying different types of behavioral finance biases can be very important
when narrowing in on the study or analysis of industry or sector outcomes and results.
TOPIC 206: OVERCONFIDENCE AND INVESTMENT

Overconfidence has two components:
1. overconfidence in the quality of your information,
2. and your ability to act on said information at the right time for maximum gain.
 Studies show that overconfident traders trade more frequently and fail to appropriately
diversify their portfolios.
 One study analyzed trades from 10,000 clients at a large discount brokerage firm. The
study sought to ascertain if frequent trading led to higher returns.
 The study found that the purchased stocks underperformed the sold stocks by 5% over
one year and 8.6% over two years. In other words, the more active the retail investor, the
less money they make.
How to avoid this bias?

• Trade less and invest more.
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• Understand that by entering into trading activities you're trading against computers,
institutional investors, and others around the world with better data and more experience
than you.
• By increasing your time frame, mirroring indexes, and taking advantage of dividends, you
will likely build wealth over time. Resist the urge to believe that your information and
intuition are better than others in the market.
After backing out tax-loss trades and others to meet liquidity needs, the study found that the
purchased stocks underperformed the sold stocks by 5% over one year and 8.6% over two years.
In other words, the more active the retail investor, the less money they make.
This study was replicated several times in multiple markets and the results were always the same.
The authors concluded that traders are, "basically paying fees to lose money."
How to Avoid This Bias
Trade less and invest more. Understand that by entering into trading activities you're trading
against computers, institutional investors, and others around the world with better data and more
experience than you. The odds are overwhelmingly in their favor. By increasing your time frame,
mirroring indexes, and taking advantage of dividends, you will likely build wealth over time. Resist
the urge to believe that your information and intuition are better than others in the market.
TOPIC 207: LOSS AVERSION

• Loss aversion refers to a phenomenon where a real or potential loss is perceived by
individuals as psychologically or emotionally more severe than an equivalent gain.
• For instance, the pain of losing $100 is often far greater than the joy gained in finding the
same amount.
• This overwhelming fear of loss can cause investors to behave irrationally and make bad
decisions, such as holding onto a stock for too long or too little time.
• Investors can avoid psychological traps by adopting a strategic asset allocation strategy,
thinking rationally, and not letting emotion get the better of them.
Loss aversion occurs when investors place a greater weighting on the concern for losses than
the pleasure from market gains. In other words, they're far more likely to try to assign a higher
priority to avoiding losses than making investment gains.
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As a result, some investors might want a higher payout to compensate for losses. If the high
payout isn't likely, they might try to avoid losses altogether even if the investment's risk is
acceptable from a rational standpoint.
Applying loss aversion to investing, the so-called disposition effect occurs when investors sell
their winners and hang onto their losers. Investors' thinking is that they want to realize gains
quickly. However, when an investment is losing money, they'll hold onto it because they want to
get back to even or their initial price. Investors tend to admit they are correct about an investment
quickly (when there's a gain).
However, investors are reluctant to admit when they made an investment mistake (when there's
a loss). The flaw in disposition bias is that the performance of the investment is often tied to the
entry price for the investor. In other words, investors gauge the performance of their investment
based on their individual entry price disregarding fundamentals or attributes of the investment that
may have changed.
TOPIC 208: INERTIA

• Inertia is the endurance of a stable state associated with inaction and the concept of
status quo bias (Madrian & Shea 2001). Behavioral nudges can either work with people’s
decision inertia (e.g. by setting defaults) or against it (e.g. by giving warnings)(Jung,
2019).
• In social psychology, the term inertia is sometimes also used in relation to a persistence
in (or commitments to) attitudes and relationships.
In behavioral economics, inertia is the endurance of a stable state associated with inaction and
the concept of status quo bias (Madrian & Shea 2001). Behavioral nudges can either work with
people’s decision inertia (e.g. by setting defaults) or against it (e.g. by giving warnings)(Jung,
2019). In social psychology, the term inertia is sometimes also used in relation to a persistence
in (or commitments to) attitudes and relationships.
TOPIC 209: FRAMING

• Framing bias occurs when people make a decision based on the way the information is
presented, as opposed to just on the facts themselves. The same facts presented in two
different ways can lead to people making different judgments or decisions.
• For example, an equity research report may come with a lot of opinion and bias included
in the research.
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• Try to remove any editorial/judgmental comments and look at only the key numbers and
underlying assumptions driving the valuation. Then arrive at your own conclusions, rather
than being swayed by how the information is presented to you.
Choices can be presented in a way that highlights the positive or negative aspects of the same
decision, leading to changes in their relative attractiveness. This technique was part of Tversky
and Kahneman’s development of prospect theory, which framed gambles in terms of losses or
gains (Kahneman & Tversky, 1979). Different types of framing approaches have been identified,
including risky choice framing (e.g. the risk of losing 10 out of 100 lives vs the opportunity to save
90 out of 100 lives), attribute framing (e.g. beef that is 95% lean vs 5% fat), and goal framing (e.g.
motivating people by offering a $5 reward vs imposing a $5 penalty) (Levin et al., 1998).
The concept of framing also has a long history in political communication, where it refers to the
informational emphasis a communicator chooses to place in a particular message. In this domain,
research has considered how framing affects public opinions of political candidates, policies, or
broader issues (Busby et al., 2018).
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Lesson 40
MODERN AND BEHAVIORAL PORTFOLIO THEORIES
TOPIC 210: MODERN AND BEHAVIORAL PORTFOLIO THEORIES

• Modern portfolio theory (MPT) was developed by Harry Markowitz
• It identifies how a rational actor would construct a diversified portfolio across several
asset classes in order to maximize expected return for a given level of risk preference.
• The resulting theory constructed an "efficient frontier," or the best possible portfolio mix
for any risk tolerance.
• Modern portfolio theory then uses this theoretical limit to identify optimal portfolios
through a process of mean-variance optimization (MVO).
• It means that emotion and psychology play a role when investors make decisions,
sometimes causing them to behave in unpredictable or irrational ways.
• Behavioral economists Shefrin and Statman developed the behavioral portfolio theory
based on mental accounts.
• They view behavioral portfolios as being formed of a layered pyramid, with each layer a
separate mental account.
• The base layers represent assets designed to provide ‘protection from poverty,’ which
results in conservative investments designed to avoid loss.
• Higher layers represent ‘hopes for riches’ and are invested in risky assets in the hope of
high returns.
• An individual investor can simultaneously display risk-averse and risk-tolerant behavior,

depending on which mental account they are thinking about.
• This model can help explain why individuals can buy at the same time both ‘insurance’
and ‘lottery tickets’ such as a handful of small-cap stocks.
• The theory also suggests that investors treat each layer in isolation and don’t consider
the relationship between the layers.
Modern portfolio theory (MPT) and behavioral finance represent differing schools of thought that
attempt to explain investor behavior. Perhaps the easiest way to think about their arguments and
positions is to think of modern portfolio theory as how the financial markets would work in the
ideal world, and to think of behavioral finance as how financial markets work in the real world.
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Having a solid understanding of both theory and reality can help you make better investment
decisions.
Modern Portfolio Theory

Modern portfolio theory is the basis for much of the conventional wisdom that underpins
investment decision making. Many core points of modern portfolio theory were captured in the
1950s and1960s by the efficient market hypothesis put forth by Eugene Fama of the University of
Chicago.
According to Fama’s theory, financial markets are efficient, investors make rational decisions,
market participants are sophisticated, informed and act only on available information. Since
everyone has the same access to that information, all securities are appropriately priced at any
given time. If markets are efficient and current, it means that prices always reflect all information,
so there's no way you'll ever be able to buy a stock at a bargain price.
Other snippets of conventional wisdom include the theory that the stock market will return an
average of 8% per year (which will result in the value of an investment portfolio doubling every
nine years), and that the ultimate goal of investing is to beat a static benchmark index. In theory,
it all sounds good. The reality can be a bit different.
Modern portfolio theory (MPT) was developed by Harry Markowitz during the same period to
identify how a rational actor would construct a diversified portfolio across several asset classes in
order to maximize expected return for a given level of risk preference. The resulting theory
constructed an "efficient frontier," or the best possible portfolio mix for any risk tolerance. Modern
portfolio theory then uses this theoretical limit to identify optimal portfolios through a process of
mean-variance optimization (MVO).
Behavioral Finance
Despite the nice, neat theories, stocks often trade at unjustified prices, investors make irrational
decisions, and you would be hard-pressed to find anyone who owns the much-touted “average”
portfolio generating an 8% return every year like clockwork.
So what does all of this mean to you? It means that emotion and psychology play a role when
investors make decisions, sometimes causing them to behave in unpredictable or irrational ways.
This is not to say that theories have no value, as their concepts do work—sometimes.
Perhaps the best way to consider the differences between theoretical and behavioral finance is
to view the theory as a framework from which to develop an understanding of the topics at hand,
and to view the behavioral aspects as a reminder that theories don’t always work out as expected.
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Accordingly, having a good background in both perspectives can help you make better decisions.
Comparing and contrasting some of the major topics will help set the stage.
Education can be put to work on behalf of your portfolio in a logical way, yet with your eyes wide
open to the degree of illogical factors that influence not only investors' actions, but security prices
as well. By paying attention, learning the theories, understanding the realities and applying the
lessons, you can make the most of the bodies of knowledge that surround both traditional financial
theory and behavioral finance.
TOPIC 211: MANAGING DIVERSIFICATION

1. Naïve diversification
Evidence suggests that investors use ‘naïve’ rules of thumb for portfolio construction in the
absence of better information.
One such rule has been dubbed the ‘1/n’ approach, where investors allocate equally to the range
of available asset classes or funds (‘n’ stands for the number of options available).
This approach ignores the specific risk-return characteristics of the investments and the
relationships between them.
2. Investing in the familiar

Investors have been documented to prefer investing in familiar assets. Investors associate
familiarity with low risk. This manifests itself in home bias – high portfolio weights in assets from
an investor’s own country.
Institutional and individual investors around the globe tend to bias portfolios towards familiar local
markets and away from international markets. In these cases, the danger is one of inadequate
diversification.
TOPIC 212: USING OR MISUSING INFORMATION

Researchers have documented a number of biases in the way in which we filter and use
information when making decisions.
Anchoring
Decisions can be ‘anchored’ by the way information is presented.
Example: A salesman can offer a very high price to start negotiations that is objectively well above
fair value. Yet, because the high price is an anchor, the final selling price will also tend to be
higher than if the salesman had offered a fair or low price to start.
Availability bias
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Some evidence suggests that recently observed or experienced events strongly influence
decisions. Psychologists refer to this as the ‘availability bias.’
Researchers found that investors are more likely to be fearful of a stock market crash when one
has occurred in the recent past.
Representativeness Bias
It reflects the case where decisions are made based on a situation’s superficial characteristics
rather than a detailed evaluation of reality. It means that decisions are based on stereotypes.
Example: Investors assume that shares in a high-profile, well-managed company will
automatically be a good investment.
TOPIC 213: GROUP BEHAVIOR

A group situation may counteract a particular bias or it may strengthen it.
Equally, the group situation could create new biases.
We typically use groups to make decisions in order to benefit from the range of knowledge and
experience in a group.
A desire for social acceptance may encourage individuals with conflicting views to fall into line.
Or, those with opposing views may start to doubt their own convictions.
Evidence suggests that crowds – groups of unrelated individuals – are often able to identify correct
answers to problems.
The research suggests the majority opinion of the audience is correct over 90% of the time.
TOPIC 214: MANAGING THE BIASES

We are unlikely to find a ‘cure’ for the biases, but if we are aware of them and their effect, we can
possibly avoid the major pitfalls.
Audit trails
A clear understanding of why particular investment decisions have been taken can help mitigate
the effects of behavioral biases.
As markets move and emotions take hold, this record can help prevent making snap judgments.
Framing
Framing is also a valuable adviser tool. Portfolio discussions should always be framed in terms
of long-term goals and the client’s total wealth picture.
Feedback
More generally, investors may be able to use feedback to mitigate behavioral biases.
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Careful consideration of the outcomes of past decisions should help individuals learn to control
and work around unhelpful decision-making biases.
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Lesson 41
THE EXPECTED UTILITY MODEL
TOPIC 215: THE EXPECTED UTILITY MODEL

• Expected utility model was developed by John von Neuman and Oskar Morgenstern to
explain rational behaviour when people face uncertainty.
• It shows that when a consumer is faced with a choice of items or outcomes subject to
various levels of chance, the optimal decision will be the one that maximizes the expected
value of the utility (i.e., satisfaction) derived from the choice made.
• Expected value is the sum of the products of the various utilities and their associated
probabilities.
• The consumer is expected to be able to rank the items or outcomes in terms of
preference, but the expected value will be conditioned by their probability of occurrence.
• The von Neumann-Morgenstern utility function can be used to explain risk-averse, risk-
neutral, and risk-loving behavior.
"Expected utility" is an economic term summarizing the utility that an entity or aggregate economy
is expected to reach under any number of circumstances. The expected utility is calculated by
taking the weighted average of all possible outcomes under certain circumstances. With the
weights being assigned by the likelihood or probability, any particular event will occur.
The expected utility of an entity is derived from the expected utility hypothesis. This hypothesis
states that under uncertainty, the weighted average of all possible levels of utility will best
represent the utility at any given point in time. Expected utility model was developed by John von
Neuman and Oskar Morgenstern to explain rational behavior when people face uncertainty.
Expected utility theory is used as a tool for analyzing situations in which individuals must make a
decision without knowing the outcomes that may result from that decision, i.e., decision making
under uncertainty. These individuals will choose the action that will result in the highest expected
utility, which is the sum of the products of probability and utility over all possible outcomes. The
decision made will also depend on the agent’s risk aversion and the utility of other agents.
This theory also notes that the utility of money does not necessarily equate to the total value of
money. This theory helps explain why people may take out insurance policies to cover themselves
for various risks. The expected value from paying for insurance would be to lose out monetarily.
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The possibility of large-scale losses could lead to a serious decline in utility because of the
diminishing marginal utility of wealth.
Decisions involving expected utility are decisions involving uncertain outcomes. An individual
calculates the probability of expected outcomes in such events and weighs them against the
expected utility before making a decision.
For example, purchasing a lottery ticket represents two possible outcomes for the buyer. They
could end up losing the amount they invested in buying the ticket, or they could end up making a
smart profit by winning either a portion of the entire lottery. Assigning probability values to the
costs involved (in this case, the nominal purchase price of a lottery ticket), it is not difficult to see
that the expected utility to be gained from purchasing a lottery ticket is greater than not buying it.
Expected utility is also used to evaluate situations without immediate payback, such as
purchasing insurance. When one weighs the expected utility to be gained from making payments
in an insurance product (possible tax breaks and guaranteed income at the end of a
predetermined period) versus the expected utility of retaining the investment amount and
spending it on other opportunities and products, insurance seems like a better option. Expected
value is the sum of the products of the various utilities and their associated probabilities.
The consumer is expected to be able to rank the items or outcomes in terms of preference, but
the expected value will be conditioned by their probability of occurrence.
The von Neumann-Morgenstern utility function can be used to explain risk-averse, risk-neutral,
and risk-loving behavior.
TOPIC 216: THE NO-ARBITRAGE PRICING PRINCIPLE

 The idea behind a no-arbitrage condition is that if there is a mispriced security in the
market, investors can always construct a portfolio with factor sensitivities similar to those
of mispriced securities and exploit the arbitrage opportunity.
 As all investors would sell an overvalued and buy an undervalued portfolio, this would
drive away any arbitrage profit.
TOPIC 217: ARBITRAGE PRICING MODEL

• Arbitrage pricing model is an alternative model to the capital asset pricing model
• It explains asset or portfolio returns with systematic factors and asset/portfolio
sensitivities to such factors.
• It was developed by economist Stephen Ross in the 1970s.
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• The theory estimates the expected returns of well-diversified portfolios with the
underlying assumption that portfolios are well-diversified and any discrepancy from the
equilibrium price in the market would be instantaneously driven away by investors.
• APT is a multi-factor technical model based on the relationship between a financial
asset's expected return and its risk. The model is designed to capture the sensitivity of
the asset's returns to changes in certain macroeconomic variables. Investors and
financial analysts can use these results to help price securities.
• These macroeconomic variables include:

 Inflation
 Industrial production
 Risk premiums
 The shape of the term structure of interest rates
How Options Work?

• An option is a contract giving the buyer the right—but not the obligation—to buy (in the
case of a call) or sell (in the case of a put) the underlying asset at a specific price on or
before a certain date.
• People use options for income, to speculate, and to hedge risk.
• An option to buy the specified item at a fixed price is a call
• An option to sell is a put.
• The fixed price specified in an option contract is called the option’s strike price or exercise
price.
• The date after which an option can no longer be exercised is called its expiration date or
maturity date.
• Exchange-traded options have standard terms defined by the options exchange.
• Options not traded on an exchange are called over-the-counter options.
• An option is identified by its strike price and its expiration date.
Index Options
• Index options are options contracts that utilize a benchmark index, or a futures contract
based on that index, as its underlying instrument.
• Index options are typically European style and settle in cash for the value of the index at
expiration.
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• Like all options, index options will give the buyer the right, but not the obligation, to either
go long (for a call) or short (for a put) the value of the index at a pre-specified strike price.
Example
• Suppose the S&P 500 is at 4,500 points. Jane decides to sell a call option to Tim with a
strike price of 4,500. Tim pays a premium of $10. Just as a stock option typically covers
100 shares of a stock, index options typically use a multiplier of 100. So, in this case, Tim
will pay $1,000 in total.
• $10 * 100 = $1,000
• If the S&P 500 gains value, Tim’s call option will increase in price.
• If it falls, the call option will fall in price. For instance, if it rises to 4,525, Tim could exercise
the option to get a payment of $2,500.
• (4,525 - 4,500) * 100 = $2,500
Arbitrage pricing theory (APT) is an alternative to the capital asset pricing model (CAPM) for
explaining returns of assets or portfolios. It was developed by economist Stephen Ross in the
1970s. Over the years, arbitrage pricing theory has grown in popularity for its relatively simpler
assumptions. However, arbitrage pricing theory is a lot more difficult to apply in practice because
it requires a lot of data and complex statistical analysis.
APT is a multi-factor technical model based on the relationship between a financial asset's
expected return and its risk. The model is designed to capture the sensitivity of the asset's returns
to changes in certain macroeconomic variables. Investors and financial analysts can use these
results to help price securities.
Inherent to the arbitrage pricing theory is the belief that mispriced securities can represent short-
term, risk-free profit opportunities. APT differs from the more conventional CAPM, which uses
only a single factor. Like CAPM, however, the APT assumes that a factor model can effectively
describe the correlation between risk and return.
Underlying Assumptions of APT
Unlike the capital asset pricing model, arbitrage pricing theory does not assume that investors
hold efficient portfolios.
The theory does, however, follow three underlying assumptions:
Asset returns are explained by systematic factors.
Investors can build a portfolio of assets where specific risk is eliminated through diversification.
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No arbitrage opportunity exists among well-diversified portfolios. If any arbitrage opportunities do
exist, they will be exploited away by investors. (This is how the theory got its name.)
However, according to the research of Stephen Ross and Richard Roll, the most important factors
are the following:
1. Change in inflation
2. Change in the level of industrial production
3. Shifts in risk premiums
4. Change in the shape of the term structure of interest rates
TOPIC 218: FINANCIAL STRUCTURE OF A FIRM

 Financial structure refers to the mix of debt and equity that a company uses to finance its
operations. It can also be known as capital structure.
 This composition directly affects the risk and value of the associated business. The
financial managers of the business have the responsibility of deciding the best mixture of
debt and equity for optimizing the financial structure.
In general, the financial structure of a company can also be referred to as the capital structure. In
some cases, evaluating the financial structure may also include the decision between managing
a private or public business and the capital opportunities that come with each.
Companies have several choices when it comes to setting up the business structure of their
business. Companies can be either private or public. In each case, the framework for managing
the capital structure is primarily the same but the financing options differ greatly.
Debt capital is received from credit investors and paid back over time with some form of interest.
Equity capital is raised from shareholders giving them ownership in the business for their
investment and a return on their equity that can come in the form of market value gains or
distributions. Each business has a different mix of debt and equity depending on its needs,
expenses, and investor demand.
Private versus Public

 Private and public companies have the same framework for developing their structure but
several differences that distinguish the two.
Both types of companies can issue equity. Private equity is created and offered using the same
concepts as public equity but private equity is only available to select investors rather than the
public market on a stock exchange. As such the equity fundraising process is much different than
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a formal initial public offering (IPO). Private companies can also go through multiple rounds of
equity financing over time which affects their market valuation. Companies that mature and
choose to issue shares in the public market do so through the support of an investment bank that
helps them to pre-market the offering and value the initial shares. All shareholders are converted
to public shareholders after an IPO and the market capitalization of the company is then valued
based on shares outstanding times market price.
Debt capital follows similar processes in the credit market with private debt primarily only offered
to select investors. In general, public companies are more closely followed by rating agencies
with public ratings helping to classify debt investments for investors and the market at large. The
debt obligations of a company take priority over equity for both private and public companies.
Even though this helps debt to come with lower risks, private market companies can still usually
expect to pay higher levels of interest because their businesses and cash flows are less
established which increases risk.
Debt versus Equity

In building the financial structure of a company, financial managers can choose between either
debt or equity. Investor demand for both classes of capital can heavily influence a company’s
financial structure. Ultimately, financial management seeks to finance the company at the lowest
rate possible, reducing its capital obligations and allowing for greater capital investment in the
business.
Overall, financial managers consider and evaluate the capital structure by seeking to optimize the
weighted average cost of capital (WACC). WACC is a calculation that derives the average
percentage of payout required by the company to its investors for all of its capital. A simplified
determination of WACC is calculated by using a weighted average methodology that combines
the payout rates of all of the company’s debt and equity capital.
TOPIC 219: INTERNAL AND EXTERNAL SOURCES OF FINANCE

Internal Sources of Finance
 Internal sources of finance alludes to the sources of business finance that are generated
within the business, from the existing assets or activities.
 Internal Sources of Finance include Sale of Stock, Sale of Fixed Assets, Retained
Earnings and Debt Collection.
External Sources of Finance
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 External sources of finance implies the arrangement of capital or funds from sources
outside the business. External Sources of finance include Financial Institutions, Loan from
banks, Preference Shares, Debenture, Public Deposits, Lease financing, Commercial
paper, Trade Credit.
 Financial Institutions, Loan from banks, Preference Shares, Debenture, Public Deposits,
Lease financing, Commercial paper, Trade Credit.
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Lesson 42
EQUITY & DEBT FINANCING AND CAPITAL STRUCTURE
TOPIC 220: EQUITY FINANCING

• Equity financing is used when companies, often start-ups, have a short-term need for
cash.
• It is typical for companies to use equity financing several times during the process of
reaching maturity.
• There are two methods of equity financing: the private placement of stock with investors
and public stock offerings.
• National and local governments keep a close watch on equity financing to ensure that
everything done follows regulations.
Equity financing is the process of raising capital through the sale of shares. Companies raise
money because they might have a short-term need to pay bills or need funds for a long-term
project that promotes growth. By selling shares, a business effectively sells ownership in its
company in return for cash.
Equity financing comes from a variety of sources. For example, an entrepreneur's friends and
family, professional investors, or an initial public offering (IPO) may provide needed capital.
An IPO is a process that private companies undergo to offer shares of their business to the public
in a new stock issuance. Public share issuance allows a company to raise capital from public
investors. Industry giants, such as Google and Meta (formerly Facebook), raised billions in capital
through IPOs.
While the term equity financing refers to the financing of public companies listed on an exchange,
the term also applies to private company financing.
Equity financing involves the sale of common stock and the sale of other equity or quasi-equity
instruments such as preferred stock, convertible preferred stock, and equity units that include
common shares and warrants.
A startup that grows into a successful company will have several rounds of equity financing as it
evolves. Since a startup typically attracts different types of investors at various stages of its
evolution, it may use different equity instruments for its financing needs.
For example, angel investors and venture capitalists—generally the first investors in a startup—
favor convertible preferred shares rather than common stock in exchange for funding new
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companies because the former have more significant upside potential and some downside
protection.
Once a company has grown large enough to consider going public, it may consider selling
common stock to institutional and retail investors.
Later, if the company needs additional capital, it may choose secondary equity financing options,
such as a rights offering or an offering of equity units that includes warrants as a sweetener.
TOPIC 221: DEBT FINANCING

• There are distinct advantages to both types of financing.
• Most companies use a combination of equity and debt financing.
Forms of Debt Financing
1. Corporate bond/Debt Securities

• A corporate bond is a type of debt security that is issued by a firm and sold to investors.
The company gets the capital it needs and in return the investor is paid a pre-established
number of interest payments at either a fixed or variable interest rate.
2. Secured Debt
Secured debt is debt backed or secured by collateral to reduce the risk associated with lending.
If the borrower on a loan defaults on repayment, the bank seizes the collateral, sells it, and uses
the proceeds to pay back the debt.
3. Long-term leases
A long-term lease is simply a lease in which the agreement term is ten years or longer.
4. Pension Liabilities
Pension Liabilities means any current or future obligations, liabilities, etc. in relation to pension
plans, retiree medical, and any other long-term pension, welfare, or benefit plans.
Debt financing occurs when a firm raises money for working capital or capital expenditures by
selling debt instruments to individuals and/or institutional investors. In return for lending the
money, the individuals or institutions become creditors and receive a promise that the principal
and interest on the debt will be repaid. The other way to raise capital in debt markets is to issue
shares of stock in a public offering; this is called equity financing.
___________________________________________________________________________________
When a company needs money, there are three ways to obtain financing: sell equity, take on
debt, or use some hybrid of the two. Equity represents an ownership stake in the company. It
gives the shareholder a claim on future earnings, but it does not need to be paid back. If the
company goes bankrupt, equity holders are the last in line to receive money.
A company can choose debt financing, which entails selling fixed income products, such as
bonds, bills, or notes, to investors to obtain the capital needed to grow and expand its operations.
When a company issues a bond, the investors that purchase the bond are lenders who are either
retail or institutional investors that provide the company with debt financing. The amount of the
investment loan—also known as the principal—must be paid back at some agreed date in the
future. If the company goes bankrupt, lenders have a higher claim on any liquidated assets than
shareholders.
TOPIC 222: CAPITAL STRUCTURE AND FACTORS CAUSING FRICTION

Factors that cause friction include:
1. Income Tax
2. Transaction Costs of Issuing debt or equity securities
3. Conflicts among the stakeholders
TOPIC 223: CREATING VALUE THROUGH FINANCING DECISIONS

By its choice of capital structure the firm can:
 Reduce its cost and circumvent regulations
 Reduce conflict of interest
 Provide stakeholders with financial assets, e.g. financial instruments
TOPIC 224: CAPITAL STRUCTURE AND REDUCING COSTS

 Taxes and Subsidies
 Costs of Financial Distress
 Financial distress is a condition in which a company cannot generate revenue or income
because it is unable to meet or cannot pay its financial obligations.
 This is generally due to high fixed expenses (like overhead or salaries), illiquid assets, or
revenues sensitive to economic downturns.
 Distress cost refers to the greater expense that a firm in financial distress incurs beyond
the cost of doing business.
___________________________________________________________________________________
 Distress costs can be tangible, such as having to pay higher interest rates or more money
to suppliers upfront.
 Distress costs can also be intangible, such as a loss of employee morale and productivity.
TOPIC 225: TYPES OF CAPITALIZATION STRUCTURES

 A company's debt-to-equity ratio is a measure of risk for investors.
 Companies that use more debt than equity to finance their assets and fund operating
activities have a high leverage ratio and an aggressive capital structure.
 A company that pays for assets with more equity than debt has a low leverage ratio and
a conservative capital structure. That said, a high leverage ratio and an aggressive capital
structure can also lead to higher growth rates, whereas a conservative capital structure
can lead to lower growth rates.
Optimal Capital Structure

 It is the goal of company management to find the ideal mix of debt and equity, also referred
to as the optimal capital structure, to finance operations.
 Analysts use the D/E ratio to compare capital structure. It is calculated by dividing total
liabilities by total equity.
 Savvy companies have learned to incorporate both debt and equity into their corporate
strategies. At times, however, companies may rely too heavily on external funding and
debt in particular. Investors can monitor a firm's capital structure by tracking the D/E ratio
and comparing it against the company's industry peers.
___________________________________________________________________________________
Lesson 43
FINANCING DECISIONS AND FINANCIAL METHODS
TOPIC 226: FINANCING DECISIONS

To explain how financial decisions are carried out, we take five examples and explain why and
which financial decision is suggested for each of them.
1. Orr Oil Company needs $10 million to finance the test drilling of land it owns already.
2. Gormeh Foods operates as a chain of food stores. It is owned by 5 sisters. Each owns
1/5th of the outstanding stock.
3. Bombay Textile Company manufactures cotton clothes and exports about half of it to
clothing companies in Singapore.
4. Holey wants to buy Burger Queen’s franchise. He has $50,000 but is in need of another
$50,000 to buy the franchise.
5. Lee production is a small movie production company. The 10 owners want to double the
number of movies they produce in a year and want $10 million from outside investors.
TOPIC 227: FIVE FINANCING METHODS

1. Loans from Friends and Relatives
Appropriate when a firm is starting as a small enterprise. Future prospects are very uncertain.
2. Lease Arrangement
___________________________________________________________________________________
Lessor provides real assets and gets regular payments in return
3. Common Stock
A corporation goes public and issues common stock. Common stock represents shares of
ownership in a corporation and the type of stock in which most people invest.
4. Debt with Warrants
Warrants are call options giving their owners the right to buy shares of the issuing company’s
stock at a fixed price. Warrants are attached to a debt issue when the company envisions a need
for raising new equity sometime before the debt has to be repaid.
5. Factoring Receivables
When a company factors its receivables, it sells its accounts receivables (t a discount) to a factor,
which is a firm that specializes in investing in receivables. Factoring is raising cash by selling a
company asset rather than by borrowing or issuing new equity.
TOPIC 228: HOW TO EVALUATE LEVERED INVESTMENTS?

Levered Investments are evaluated using the following techniques:
1. Adjusted Present Value (APV)
2. Flows to Equity (FTE)
3. Weighted Average Cost of Capital (WACC)
Adjusted Present Value (APV)

 APV is the NPV of a project or company if financed solely by equity plus the present value
of financing benefits.
 It is best used for leverage transactions, such as leveraged buyouts, but is more of an
academic calculation.
The formula for APV is
Adjusted Present Value = Unlevered Firm Value + Net effect of debt
Example
Assume a multi-year projection calculation finds that the present value of Company ABC’s free
cash flow (FCF) plus terminal value is $100,000. The tax rate for the company is 30% and the
interest rate is 7%. Its $50,000 debt load has an interest tax shield of $15,000, or ($50,000 * 30%
* 7%) / 7%. Thus, the adjusted present value is $115,000, or $100,000 + $15,000.
___________________________________________________________________________________
TOPIC 229: FLOWS TO EQUITY (FTE)
The FTE approach requires that the cash flows from the project to the equity holders of the
levered firm be discounted at the cost of equity capital. There are three steps to the FTE
approach:
1.Calculating the levered cash flow

2.Calculating the discount rate for levered equity
3. NPV analysis
1. Calculating the levered cash flow (LCF)
The levered cash flow is the cash flows of the project after cash costs, cash paid on
interest, and cash paid in taxes.
rB = the interest rate

B = the amount of the project financed by debt
TC = the tax rate
LCF = Levered cash flow
UCF =Unlevered cash flow
2. Calculating the discount rate for levered equity
The discount rate for levered equity is simply the rate of expected return that can be
observed by the stock's price in the market.
rs = the levered rate of return
ro = the unlevered rate of return
B/S = the debt to equity ratio
Tc= Tax rate
3. NPV analysis
To find the present value of the cash flows to equity, we simply discount the levered cash
flows by the expected return of the levered equity. To find net present value, the present
value of the initial cash outflows are subtracted.
___________________________________________________________________________________
TOPIC 230: WEIGHTED AVERAGE COST OF CAPITAL (WACC)

• The weighted average cost of capital (WACC) represents a firm's average cost of capital
from all sources, including common stock, preferred stock, bonds, and other forms of
debt.
• The weighted average cost of capital is a common way to determine required rate of
return.
• It expresses, in a single number, the return that both bondholders and shareholders
demand in order to provide the company with capital. A firm’s WACC is likely to be higher
if its stock is relatively volatile or if its debt is seen as risky because investors will demand
greater returns.
Weighted average cost of capital (WACC) represents a firm’s average after-tax cost of capital
from all sources, including common stock, preferred stock, bonds, and other forms of debt. WACC
is the average rate that a company expects to pay to finance its assets.
WACC is a common way to determine required rate of return (RRR) because it expresses, in a
single number, the return that both bondholders and shareholders demand to provide the
company with capital. A firm’s WACC is likely to be higher if its stock is relatively volatile or if its
debt is seen as risky because investors will require greater returns.
WACC Formula and Calculation

𝑬 𝑫
WACC =( 𝑽 X 𝑹𝑬 ) + (𝑽 𝑿 𝑹𝒅 𝑿 (1-𝑻𝒄 )
Where:
E=Market value of the firm’s equity
D=Market value of the firm’s debt
V=E+D
Re=Cost of equity
Rd=Cost of debt
Tc=Corporate tax rate
___________________________________________________________________________________
𝑬 𝑫
WACC =( 𝑽 X 𝑹𝑬 ) + (𝑽 𝑿 𝑹𝒅 𝑿 (1-𝑻𝒄 )
Where
𝐸
( 𝑉 X 𝑅𝐸 ) = weighted value of equity capital
𝐷
(𝑉 𝑋 𝑅𝑑 𝑋 (1-𝑇𝑐 ) = weighted value of debt capital
Example
• Suppose that a company obtained $1,000,000 in debt financing and $4,000,000 in equity
financing by selling common shares. Proportion of equity based financing E/V would
equal 0.8 ($4,000,000 ÷ $5,000,000 of total capital) and D/V would equal 0.2 ($1,000,000
÷ $5,000,000 of total capital).
___________________________________________________________________________________
Lesson 44
HOW OPTIONS WORK?
TOPIC 231: HOW OPTIONS WORK?

 An option is a contract giving the buyer the right—but not the obligation—to buy (in the
case of a call) or sell (in the case of a put) the underlying asset at a specific price on or
before a certain date.
 People use options for income, to speculate, and to hedge risk. An option to buy the
specified item at a fixed price is a call. An option to sell is a put.
 An option to buy the specified item at a fixed price is a call.
 An option to sell is a put.
 The fixed price specified in an option contract is called the option’s strike price or exercise
price.
 The date after which an option can no longer be exercised is called its expiration date or
maturity date.
 Exchange-traded options have standard terms defined by the options exchange.
 Options not traded on an exchange are called over-the-counter options.
 An option is identified by its strike price and its expiration date.
The fixed price specified in an option contract is called the option’s strike price or exercise price.
The date after which an option can no longer be exercised is called its expiration date or maturity
date. Exchange-traded options have standard terms defined by the options exchange.
Options not traded on an exchange are called over-the-counter options.
An option is identified by its strike price and its expiration date.
TOPIC 232: INDEX OPTIONS

 Index options are options contracts that utilize a benchmark index, or a futures contract
based on that index, as its underlying instrument.
 Index options are typically European style and settle in cash for the value of the index at
expiration.
 Like all options, index options will give the buyer the right, but not the obligation, to either
go long (for a call) or short (for a put) the value of the index at a pre-specified strike price.
___________________________________________________________________________________
Example
 Suppose the S&P 500 is at 4,500 points. Jane decides to sell a call option to Tim with a
strike price of 4,500. Tim pays a premium of $10. Just as a stock option typically covers
100 shares of a stock, index options typically use a multiplier of 100. So, in this case, Tim
will pay $1,000 in total.
 If the S&P 500 gains value, Tim’s call option will increase in price.
$10 * 100 = $1,000
If it falls, the call option will fall in price. For instance, if it rises to 4,525, Tim could exercise the
option to get a payment of $2,500.
(4,525 - 4,500) * 100 = $2,500
 When Tim chooses to exercise his option, Jane and Tim will exchange money to settle the
contract. However, if exercising the option would cause Tim to lose money, he’d likely
simply let it expire, and no additional money would change hands. In this case, Jane profits
from the premium Tim paid.
TOPIC 233: INVESTING WITH OPTIONS

Buying a Call
 Carla and Rick are bullish on GE and would like to buy the March call options.
___________________________________________________________________________________
With GE trading at $27.20, Carla thinks it can trade up to $28 by March; in terms of downside
risk, she thinks the stock could decline to $26. She, therefore, opts for the March $25 call (which
is in-the-money) and pays $2.26 for it. The $2.26 is referred to as the premium or the cost of the
option. As shown in Table 1, this call has an intrinsic value of $2.20 (i.e., the stock price of
$27.20 less the strike price of $25) and the time value of $0.06 (i.e., the call price of $2.26 less
intrinsic value of $2.20).
TOPIC 234: PUT OPTIONS PAYOFF DIAGRAM

 A put payoff diagram is a way of visualizing the value of a put option at expiration based
on the value of the underlying stock.
TOPIC 235: PUT-CALL PARITY

 It shows the relationship that has to exist between European put and call options that have
the same underlying asset, expiration, and strike prices.
 This concept says the price of a call option implies a certain fair price for the corresponding
put option with the same strike price and expiration and vice versa.
 Put-call parity does not apply to American options because you can exercise them before
the expiry date.
 If the put-call parity is violated, then arbitrage opportunities arise.
 You can determine the put-call party by using the formula C + PV(x) = P + S.
 Put-call party by using the formula C + PV(x) = P + S.
 C = price of the European call option
 PV(x) = the present value of the strike price (x), discounted from the value on the expiration
date at the risk-free rate
 P = Price of the European put
___________________________________________________________________________________
 S = Spot price or the current market value of the underlying asset
TOPIC 236: SHORT SELLING

• Short selling occurs when an investor borrows a security and sells it on the open market,
planning to buy it back later for less money.
• Short-sellers bet on, and profit from, a drop in a security's price. This can be contrasted
with long investors who want the price to go up.
• Short selling has a high risk/reward ratio: It can offer big profits, but losses can mount
quickly and infinitely due to margin calls.
Short selling is an investment or trading strategy that speculates on the decline in a stock or other
security’s price. It is an advanced strategy that should only be undertaken by experienced traders
and investors.
Traders may use short selling as speculation, and investors or portfolio managers may use it as
a hedge against the downside risk of a long position in the same security or a related one.
Speculation carries the possibility of substantial risk and is an advanced trading method. Hedging
is a more common transaction involving placing an offsetting position to reduce risk exposure.
In short selling, a position is opened by borrowing shares of a stock or other asset that the investor
believes will decrease in value. The investor then sells these borrowed shares to buyers willing
to pay the market price. Before the borrowed shares must be returned, the trader is betting that
the price will continue to decline and they can purchase the shares at a lower cost. The risk of
loss on a short sale is theoretically unlimited since the price of any asset can climb to infinity.
With short selling, a seller opens a short position by borrowing shares, usually from a broker-
dealer, hoping to buy them back for a profit if the price declines. Shares must be borrowed
because you cannot sell shares that do not exist. To close a short position, a trader buys the
shares back on the market—hopefully at a price less than at which they borrowed the asset—and
returns them to the lender or broker. Traders must account for any interest charged by the broker
or commissions charged on trades.
To open a short position, a trader must have a margin account and will usually have to pay interest
on the value of the borrowed shares while the position is open. Also, the Financial Industry
Regulatory Authority (FINRA), which enforces the rules and regulations governing registered
brokers and broker-dealer firms in the United States, the New York Stock Exchange (NYSE), and
___________________________________________________________________________________
the Federal Reserve have set minimum values for the amount that the margin account must
maintain—known as the maintenance margin.
If an investor’s account value falls below the maintenance margin, more funds are required, or
the position might be sold by the broker.
The process of locating shares that can be borrowed and returning them at the end of the trade
is handled behind the scenes by the broker. Opening and closing the trade can be made through
the regular trading platforms with most brokers. However, each broker will have qualifications that
the trading account must meet before they allow margin trading.
Example
 Imagine a trader who believes that XYZ stock—currently trading at $50—will decline in
price in the next three months.
 They borrow 100 shares and sell them to another investor. The trader is now “short” 100
shares since they sold something that they did not own but had borrowed.
 The short sale was only made possible by borrowing the shares, which may not always
be available if the stock is already heavily shorted by other traders.
 A week later, the company whose shares were shorted reports dismal financial results for
the quarter, and the stock falls to $40.
 The trader decides to close the short position and buys 100 shares for $40 on the open
market to replace the borrowed shares. The trader’s profit on the short sale, excluding
commissions and interest on the margin account, is $1,000: ($50 - $40 = $10 x 100 shares
= $1,000).
TOPIC 237: VOLATILITY AND OPTION PRICES

 Option pricing, the amount per share at which an option is traded, is affected by a number
of factors including volatility.
 Implied volatility is the real-time estimation of an asset’s price as it trades.
 Implied volatility tends to increase when options markets experience a downtrend.
 Implied volatility falls when the options market shows an upward trend.
 Larger implied volatility means higher option prices
 Another form of volatility that affects options is historic volatility, also known as statistical
volatility.
 This measures the speed at which underlying asset prices change over a given time
period.
___________________________________________________________________________________
TOPIC 238: THE BLACK-SCHOLES MODEL

• The Black-Scholes model, aka the Black-Scholes-Merton (BSM) model, is a differential
equation widely used to price options contracts.
• The Black-Scholes model requires five input variables: the strike price of an option, the
current stock price, the time to expiration, the risk-free rate, and the volatility.
• The Black-Scholes model makes certain assumptions that can lead to prices that deviate
from the real-world results.
• The standard BSM model is only used to price European options, as it does not take into
account that American options could be exercised before the expiration date.
The Black-Scholes model, also known as the Black-Scholes-Merton (BSM) model, is one of the
most important concepts in modern financial theory. This mathematical equation estimates the
theoretical value of derivatives based on other investment instruments, taking into account the
impact of time and other risk factors. Developed in 1973, it is still regarded as one of the best
ways for pricing an options contract.
Developed in 1973 by Fischer Black, Robert Merton, and Myron Scholes, the Black-Scholes
model was the first widely used mathematical method to calculate the theoretical value of an
option contract, using current stock prices, expected dividends, the option's strike price, expected
interest rates, time to expiration, and expected volatility.
The initial equation was introduced in Black and Scholes' 1973 paper, "The Pricing of Options
and Corporate Liabilities," published in the Journal of Political Economy.
Robert C. Merton helped edit that paper. Later that year, he published his own article, "Theory of
Rational Option Pricing," in The Bell Journal of Economics and Management Science, expanding
the mathematical understanding and applications of the model, and coining the term "Black–
Scholes theory of options pricing."
In 1997, Scholes and Merton were awarded the Nobel Memorial Prize in Economic Sciences for
their work in finding "a new method to determine the value of derivatives." Black had passed away
two years earlier, and so could not be a recipient, as Nobel Prizes are not given posthumously;
however, the Nobel committee acknowledged his role in the Black-Scholes model.
Black-Scholes posits that instruments, such as stock shares or futures contracts, will have a
lognormal distribution of prices following a random walk with constant drift and volatility. Using
this assumption and factoring in other important variables, the equation derives the price of a
European-style call option.
___________________________________________________________________________________
The Black-Scholes equation requires five variables. These inputs are volatility, the price of the
underlying asset, the strike price of the option, the time until expiration of the option, and the risk-
free interest rate. With these variables, it is theoretically possible for options sellers to set rational
prices for the options that they are selling.
Furthermore, the model predicts that the price of heavily traded assets follows a geometric
Brownian motion with constant drift and volatility. When applied to a stock option, the model
incorporates the constant price variation of the stock, the time value of money, the option's strike
price, and the time to the option's expiry.
Black-Scholes Assumptions
The Black-Scholes model makes certain assumptions:
1. No dividends are paid out during the life of the option.
2. Markets are random (i.e., market movements cannot be predicted).
3. There are no transaction costs in buying the option.
4. The risk-free rate and volatility of the underlying asset are known and constant.
5. The returns of the underlying asset are normally distributed.
6. The option is European and can only be exercised at expiration.
While the original Black-Scholes model didn't consider the effects of dividends paid during the life
of the option, the model is frequently adapted to account for dividends by determining the ex-
dividend date value of the underlying stock. The model is also modified by many option-selling
market makers to account for the effect of options that can be exercised before expiration.
___________________________________________________________________________________
Formula
C = Call option price

S=Current stock price
K = Strike price
r = risk-free interest rate
t = time to maturity
N = normal distribution
The Black-Scholes call option formula is calculated by multiplying the stock price by the
cumulative standard normal probability distribution function. Thereafter, the net present value
(NPV) of the strike price multiplied by the cumulative standard normal distribution is subtracted
from the resulting value of the previous calculation.
___________________________________________________________________________________

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Financial Economics (ECO-605) VU

TOPIC 001: INTRODUCTION

TOPIC 002: FINANCE AND FINANCIAL SYSTEM

TOPIC 003: WHY STUDY FINANCIAL ECONOMICS?

TOPIC 004: FINANCIAL DECISIONS

TOPIC 005: MANAGEMENT AND OWNERSHIP OF A BUSINESS

A general partnership is a business owned jointly by two or more people.

A merger occurs when two companies combine to form a new company.

TOPIC 006: FINANCIAL MARKETS AND INSTITUTIONS

Basic Functions – Financial System

TOPIC 007: FINANCIAL INNOVATION AND THE INVISIBLE HAND

TOPIC 009: FINANCIAL MARKET RATES

Simple Interest Rate

Compound Interest Rate

The following formula can be used to calculate compound interest:

TOPIC 010: RATES OF RETURN ON RISKY ASSETS

The Formula for Rate of Return (RoR)

Rate of Return (RoR) on Stocks and Bonds

Internal Rate of Return (IRR) and Discounted Cash Flow (DCF)

• r = Dividend Income Component + Price Change Component

TOPIC 011: MARKET INDEXES AND MARKET INDEXING

Some of the market’s leading indexes include:

What Are the Major Stock Indexes?

TOPIC 012: INFLATION AND REAL INTEREST RATES

Nominal Interest Rate = Real Interest Rate + Projected Rate of Inflation

TOPIC 013: INTEREST RATE EQUALIZATION

TOPIC 014: THE FUNDAMENTAL DETERMINANTS OF RATES OF RETURN

Uncertainty about the productivity

Time preferences of people

TOPIC 015: FINANCIAL INTERMEDIARIES

TOPIC 016: FINANCIAL INTERMEDIARIES IN PAKISTAN

Foreign Exchange Regulation

Venture Capital Company

Reinsurance Company (01)

TOPIC 017: YIELD CURVE

Types of Yield Curves

Inverted Yield Curve

• An inverted or down-sloped yield curve suggests yields on longer-term bonds may

Flat Yield Curve

• Asset prices depend on the people’s expectation about future.

Treasury 5-year 4.94

5-year AAA Bank &Finance 5.58

10-year AAA Bank &Finance 5.91

Source: Bloomberg.com. May 26, 2006.

TOPIC 019: GERMANY’S INFLATION LINKED BONDS

• Inflation can be a bondholder’s worst enemy unless the return is inflation-protected.

• Laws are made to outlaw frauds and to reinforce contracts.

Rules for Trading

TOPIC 022: REGIONAL AND WORLD ORGANIZATIONS

TOPIC 023: FUNCTIONS OF FINANCIAL STATEMENTS

TOPIC 024: FINANCIAL STATEMENTS- BALANCE SHEET

Financial Statements- Balance Sheet – Sample

TOPIC 025: FINANCIAL STATEMENTS - INCOME STATEMENT

Income Statement- Key Points

Rental income from a property

Primary Activity Expenses

Secondary Activity Expenses

TOPIC 026: STRUCTURE OF INCOME STATEMENT

TOPIC 027: CASH FLOW STATEMENT

Two main aspects