Summary

Financial markets and instruments

Default waterfall

 Senior debt
 Junior bond
 Preferred shares
 Common shares
Debt

 Short term debt: less than 1 year

 Long term debt: more than 2 years
Money market (short term debt)

 T-bills – Issued by Gov

o No coupons
o Yield based on diff b/w purchase price and value at maturity
 Commercial paper – Issued by large corporations
 Banker’s acceptance – for small corporation who cannot issuer their own
commercial paper, they start a line of credit at Canadian banks. Note that Banker
acceptance use bank’s credit rating
 Repo
 Interbank lending
Long term debt

 Some gov bond are inflation protected

o Canada: real return bond (RRB)
o US: Treasury Inflation protected Securities (TIPS)
 Provincial bond
 NHA MBS
 Corporate bond
 Equities
o Common stock
 Residual claim and limited liability
o Income trust
 Income trust hold some underlying assets which generate income.
Most income is then distributed to the holders of the income trust
units
 Current popular type is REIT (Real estate Investment Trust) –
allow investors access to real-estate income that they would
otherwise be excluded from
o Preferred shares
o American depository receipts
 Certificates represents shares of foreign corporations
 Made it easier for US investors to trade shares of foreign
corporations
Derivatives
  Warrants: similar to call options but are issued by the firm whose shares are
involved rather than exchanges (as options)
 Swaps: trade a set of liabilities b/w 2 parties

Securities trading
How to trade

 Exchange
 Over the counter
 Some securities can only be traded by certain type of investor
Private and public firms
Underwriters perform a number of important jobs:

 Advising the firm on the number and price of new shares.

 Advising the firm on the preparation of the prospectus. •
 Marketing the securities to potential investors on road shows

 IPO: is conducted by one or more ibs called the underwriter.

 Firm commitment (bought deal): the underwriter buys the shares from the
company directly at a pre-agreed price. Then sell to the market
 Best efforts: underwriter agrees to get the best price available from investors
 Alternatives to IPO
o Remaining private
o Direct listing: allow initial investors to sell their shares on exchange
Trading process

 Market types
o Over the counter
o Exchanged traded
o ECN (Electronic Communications Network) OR AST (Alternative Trading
System) – an electronic venue on which securities are traded but listing
service not avlb.
 Order types
o Limit order book
 Orders to buy referred to as bids – highest bid is bid price
 Orders to sell referred to as asks – lowest ask is ask price
 Bid-ask spread is the difference
o Market order – immediately buy or sell
o Dark orders: similar to limit orders but other traders cannot view them in
the order book – used to hide trading intention
o Pegged orders – price change as market condition changes
o Stop-loss order – placed after trader buys, auto close the deal if lost too
much
o Intermarket sweep order: divide large order to small ones and send to diff
markets at the same time
o Margined trades
  Margin ratio: % of the trade which the investor must own in equity
– typically 30%
 Settlements
o The process where 2 parties actually exchange the securities and cash
involved in the trade
o T+2 – affects shareholder votes and dividend payment
o Bilateral vs. centrally cleared
 Bilateral – each trader settles trades with all traders
 Centrally cleared – each trader settles with single counterparty
o Transaction costs
 Price impact – when a investor trades a large # of shares, price
move against them

Mutual Funds, ETFs and Hedge funds

Investment companies

 Benefit for investors

o Lower transaction cost
o Record keeping and admin
o Diversification and asset divisibility
o Professional management
 Closed vs. Open
o Open ended fund: allow investors to create new shares or redeem old
shares directly from the fund itself
o Closed ended fund: don’t allow investors to create or redeem shares
Major types of funds

 Index trackers
o Used to track a pre-defined index
o Usually passively managed
 Active funds – alter securities holding in order to achieve an object other than
tracking index
 Inverse fund (bear funds)
o Offer return which are opposite to those of the performance of some other
assets
 Leveraged fund (bull fund)
o Offer return which multiply the performance of other assets
 Mutual funds
o Problems: high fee, traded at the end of the day only, may not beat index
 ETFs
o Can be traded at any time during the day; less fee
 Hedge funds
o Characteristic
 Few disclosure standards
 Only accredited investors can invest
 Have min AMT of 1M
 Have a locked-up period, during which investors cannot withdrew
fund
 o Types
 Statistical arbitrage funds – exploit price abnormalities b/w assets
 Event driven funds – attempt to profit from M&A/default
 Litigation funds – profit form successfully funding lawsuits
 Catastrophe-oriented funds – sell bonds to insures which cover
catastrophic losses
o Fee
 2-20 structure – 2% management fee + 20% incentive fee for
gains above performance benchmark

Lecture 8: Optimal Risky Portfolio

Risk

 Diversifiable risk (non-symmetric risk): can be reduced/eliminated by holding

additional type of securities
 Non-diversifiable risk (symmetric risk): cannot be eliminated by holding add.
Securities

Lecture 10: APT & Factor Model

APT is used to price well diversified portfolios, while Factor model can model a single
stock

 Difference: all points (portfolio) APT models are on a regression line, while factor
model has residuals (error term) – firm specific risks

Lecture 11: Performance Measure

Investor mistakes

 Hesitate to sell
 Stick to current portfolio
Performance measure

 Arithmetic avg of holding period return

 Time weighted avg / geometric avg

 Dollar weighted avg / IRR

o When portfolio size change
Risk adjusted return

 Sharpe ratio
 M square – allow us to compare the return on our portfolio to the potential return
of a market portfolio
 
 The Treynor Ratio – used when comparing a portfolios performance to its
expected performance under CAPM

o
 Jensen’s Alpha – actual return of a portfolio vs. return it should have under CAPM

o
 Information ratio – adjust Jensen’s Alpha for the risk taken
o We have adjusted systematic risk using alpha, only need non-systematic
risk (tracking error)


 Segma (ep) is the sd of CAPM residual
 Other alpha values – when operating under Fama-French 3 factor models or
Carhart 4 factor models

Timing the market

Lecture 12: The Efficient Markets Hypothesis

Efficient market hypothesis

 Basic idea: price should reflect the fundamental value of the assets
 Stock price in the future can be viewed as random
o Still reflect fundamentals
o Do reflect today’s fundamentals
o Any predictable future info in the price
o Any unpredictable future info at random
 Why market efficient – competition and arbitrage
 Form
o Weak: stock prices reflect all avlb info that can be derived by examining
trading data
 i.e. technical indicators, moving average – which relies on past
price and volume
 Contradict example: momentum effect
 o Semi-strong: stock price reflects all avlb public info
 i.e. earning reports, FS, analyst report, macro news
 Contradict examples: prevalence of fundamental analysis
o Strong: reflects all avlb info including public and insider info
o Application:
 Technical analysis – rejection of EMH
 Fundamental analysis – rejection of strong / semi-strong EMH
 Active managed fund can be seen as a rejection of EMH
 Tech indicator based – reject entirely
 Fundamental analysis based – reject semi-strong and
strong
 Measuring efficiency – cumulative abnormal returns (CAR)
o Abnormal return: different b/w actual return of the stock and expected
return of the stock
 Abnormal return = return – E[return]
o Cumulative AR


o CAR measures the unexplained changes in stokc price before or after
event takes place
o If |CAR| large => info leak
o Rejection of strong form EMH – as

Lecture 13: Bhavioural Finance and Technical Analysis

Why price may not reflect all avlb info – investors not fully rational
Behavioural finance

 Relies on 2 fundamental differences

o Investors not fully rational – push price away from fundamental value
o Limited arbitrage opportunity – prevent correction
 Key diffb/w conventional financial theories and behavioral finance: market
efficient / inefficient
Type of behavioral finance errors

 Information processing error

o Definition: investor do not accurately estimate true prob of events, price
or return
o Forecasting error / memory bias: weight recent experience heavier
o Overconfidence bias: overestimate precision of their forecast, believe
extreme unlikely
o Conservation bias: conservative updating forecast/beliefs
o Representative bias: treat single events as representative of broader trend
 Behavioral biases
o Definition: do not make correct decision even of they have correct
estimate
o Framing: affect by how choice are framed (5$ for bag vs. 5$ free bring bag)
 o Anchoring: anchor beliefs on single info. (view but in price as base)
o Mental accounting: separate info rather than whole (view wining/losing
stocks differently)
o Regret avoidance: avoid decision they may regret
 Affect error
o Definition: attach emotional or moral weights to their decision
o Loss aversion: view losses inherently bad and gains inherently good
(more negatively impacted by loss)
o Prospect theory: risk averse w.r.t. gains and loss averse w.r.t. losses.
Unwilling to accept fair gamble for gains but willing to accept unfair
gambles for losses

Limit to arbitrage

 Example: limits to arbitrage premium/discount paid on closed-end mutual fund

o In theory: price move towards NAV, but many have persistent
premium/discount over long time
o Why hard to arbitrage:
 Underlying basked may change frequently/difficult to recreate
 Fund price may not trend toward NAV quickly
 Cost to maintain a short position may exceed profit
Technical analysis

 Tech analysis can attempt to use the slow movement of price to profit off others
Trends and corrections

 Trends (momentum)
 Moving avg
 Volatility bands: create ranges around the moving avg which depend on the
stock’s volatility
 Relative strength indicators: how security performed lately compared to full
market
 Breadth indicator: measure how many stocks moving in a given direction
 Sentiment identification: how optimistic market participants are
o Trin statistic: relative trading volume of stocks which gain vs. lose

o
o Pull/call ratio
 Usually around 65%
 Higher -> bearing; lower -> bullish
Lecture 14: Bond Pricing
Bond indenture: actual contract agreed to by the bond issuer. Contains any covenants that
form part of the bond, indentures include set of restrictions on firm.
Covenant – protect lenders from a borrower who takes deliberately risky action
  Sinking funds – firm must purchase certain column of its own debt to reduce risk
 Subordination of future debt – debt drop in value is senior than existing debt –
restrict ability to issue new debt
 Dividend restriction – put limit on frims dividend
 Collateral

Types of bonds

 International – raise money in other jurisdictions

o Issue in foreign curr – protect investors from EX rate risk
 Different names: Yankees (USA), Maples (Canada), Samurai Bonds
(Japan), Bulldog Bonds (UK).
o In domestic curr but sell in other country
 Referred to Eurobonds
 Eurodollar (issued in USA), Eurocanadians (issued in CAD)
 Special bond types
o Callable – corp can buy back after period of time
 YTC (yield to call)
o Convertible – covert to equity at a certain ratio
o Extendable/retracable – can extend/decrease maturity
o Floating rate – adjust based one external factor (t-bill yield)
 cZero-oupon bond constructed from coupon bond is call strip

Bond pricing

 Accrued interest


 Dirty price:


o If coupon paid more frequently e.g. semi-annual
 y/2, c/2, 2T
 Clean price = dirty price – accrued interest
Bond safety

 Coverage ratio – future cash flow issues

 Leverage (D/E)
 Liquidity ratio – curr asset/curr liab i.e. current ratio and quick ratio
 Profitability ratio – rate of return compared to assets or equity
 Cash flow to debt ratio
 Altman’s Z score
 o
o --vulnerable to default--1.23---somewhat risky---2.90-----safe---------
Lecture 15: Bond term structure
Yield curve

 On the run
o Taking on the run coupon bond near pay values
 Pure yield – want bond to have cash flows at the exact period of time
o Taking gov treasuries, zero-c bonds and strips with diff maturities and
imputing a curve
Rates

 (yi) Spot rate – YTM of zero-coupon bond – time 0 to time t

 (ri) Short rate – yield b/w 2 specific point of time – time t to time 1
 Forward rate – with uncertainty
o Diff b/w forward rate and expectation of short rate is liquidity premium
o Expectation hypothesis
 Yield curve
o Liquidity preference theory
 YTM depends on expectation of future I and shape of liquidity
premium
Lecture 16: Bond Duration and Convexity
Duration – relatively maturity of bond’s CF, rather than FV -> avg timing of all bond’s CF

 Macaulay Duration: weights the rime of maturity of a bond by the relative,

discounted CF in each period of time


 Modified duration


  Duration of perp with yield = y is (1+y)/y
Convexity

 Measure: change in slope of pricing curve


 High convexity – when rate fall, price raise more; when rate rise, price fall less
Passive bond management

 Index funds – hold a representative sampling of bonds which match the

maturities, coupons and issuers of the entire index.
 Duration immunization – match interest rate exposure of assets and liability
o Steps:
o Find duration of liability
o Calculate duration of asset
o Calculate necessary asset mix s.t. asset match liab
o Fund the obligation
 CF matching
Active management

 Common strategies
o Substitution swap: 2 bond with identical char but one with higher yield,
sell low buy high
o Intermarket spread swap: when investor identifies rate misalignment
b/w 2
o Rate anticipation swap: when anticipate rate change (i.e. when rate cut,
sell short buy long)
o Pure yield swap- when yield curve steep, sell short buy long
o Tax swap
Lecture 17: Equity valuation with macro and industry analysis
Indicator

 Leading – move before econ activity become to change

o Employment
o New orders
o Financial indicator (yield curve)
o Consumer expectation
 Lagging
o Duration of unemployment
o Ratio of inventories to sales
o Labour cost / output
o Loan outstanding
Industry analysis
  Curr stat of business cycle
o Business cycle: trough-expansion-peak-recession
o Sensitivity to business cycle – how strongly an industry follows the trend
of business cycle

o
 Curr industry life cycle
o Start up stage – fast growing, new ideas, high risk
o Consolidation state – stable growth high risk fall, small->large
o Maturity state – predictable, profits stabilize, start pay dividend & repur
shares, slow growth
o Relative decline
 State of competition
o Vertical integration: single firm control many aspects of supply chain
o Reduce need to negotiate with supplier
o Complex
 Composition of industry mean
o Industry composition: competitive environment within industry
o Competitive structure
 Monopoly: single large
 Oligopoly: several large
 Competition: many firm

Lecture 18: Equity valuation models

Valuation

 Book value
 Dividend discount model
o Gordon growth model


o Discounting and earning retention
 Plowback ratio (b) = (earning – D) / earning
 Assume g= ROE * b


 PVGO is the PV of growth oppor
o Multi-stage growth
 Rate change after yeras


 Price-earning
o Leading P/E ratio = P0/E1 where E1 is the expected upcoming earning
 o Trailing P/E ratio = P0/E0
o Modify dividend growth model with earning retention

o
o Earning model and dividends

o
 DCF
o FCF for the first t period
o
o Calculate terminal value
o Ke

Lecture 19: equity valuation and financial statement analysis

Ratio analysis

 Profitability ratio – efficiency generating revenue using asset

o ROA = EBIT/Total Asset
o ROC (return on capital)
 o
o EVA (economic value added)
 EVA = (ROC-WACC) * total capital
o ROE = Net income / Shareholder’s Equity

o
o ROE decomposition

o
 Turnover and asset utilization ratios

o
 Liquidity ratios

o
 Market price ratio

o
Comparability
  2 firms compare
 Compare with industry avg

Lecture 20 Options and futures

Basic of options

 Premium (market price): price that option itself traded for

 Strike price (exercise price): option allow holder to sell/buy for
 In the money: profit immediately
 Out of the money: not profit immediately
 At the money: same price
 Option trading
o Canada: Montreal exchange
o USL Chicago Board Options Exchange (CBOE) and the International
Securities Exchange (ISE).
 Options clearing
o If exercise, write face loss, need margin
o Cleated at
 Canada: Canadian Derivatives Clearing Corporation (CDCC).
 USA: Options Clearing Corporation (OCC).
Basic options strategies

 Goal
o Hedging cash pos
o Eliminating up/down risk
o Profiting from volatility
Basic of futures

 Definition: contract for delivery of some asset at a given point in future

 Diff from option: must buy/sell
 Future price: Futures contracts transact at the future price, which is the amount
that the buyer will pay the seller at expiry.
 Open interest: active contracts in a given future that haven’t expired
 Profit:
o Long: sport price at maturity (actual price) – future price (in contract)
o Short: the opposite (Po-Ft)
 Futures trading
o Clearinghouse and CCP