Applied Finance Lectures 1. What is finance? 2. The diffusion of the discounted cash flow method 3. Markowitz and the birth of modern portfolio theory 4. CAPM: the relationship between expected returns and risk 5. The Efficient Market Hypothesis: do stock prices move randomly? 6. Modigliani-Miller: does financing matter? 7. Black – Merton – Scholes: how to value options 8. Beyond Black-Merton-Scholes: state prices, stochastic discount factors
What is Finance? Companies Investors Equity Capital expenditures Debt Portfolio management Dividends Operating cash flow Interests
Time Uncertainty Asset pricing models Discounted cash flow method Capital Asset Pricing Model Markowitz Sharpe Lintner Option Pricing Models Black Scholes Cox Ross Rubinstein State Prices Arrow-Debreu Stochastic discount factors
Outline 1. What is finance? 2. The diffusion of the discounted cash flow method 3. Markowitz and the birth of modern portfolio theory 4. CAPM: the relationship between expected returns and risk 5. The Efficient Market Hypothesis: do stock prices move randomly? 6. Modigliani-Miller: does financing matter? 7. Black – Merton – Scholes: how to value options 8. Beyond Black-Merton-Scholes: state prices, stochastic discount factors
Discounted cash flow method PV = C1 v1 + C2 v2 + …+Cn vn Cash flows Required rates of return
Penetration rate of discount cash flow Callahan, C. and S. Haka, A Model and Test of Interfirm Innovation Diffusion: the Case of Discounted Cash Flow Techniques, Manuscript January 2002
Outline 1. What is finance? 2. The diffusion of the discounted cash flow method 3. Markowitz and the birth of modern portfolio theory 4. CAPM: the relationship between expected returns and risk 5. The Efficient Market Hypothesis: do stock prices move randomly? 6. Modigliani-Miller: does financing matter? 7. Black – Merton – Scholes: how to value options 8. Beyond Black-Merton-Scholes: state prices, stochastic discount factors
Markowitz (1952) Portfolio selection Return of portfolio: normal distribution Characteristics of a portfolio: Expected return Risk: Variance/Standard deviation
Calculation of optimal portfolio
Markowitz: the birth of modern portfolio theory
Outline 1. What is finance? 2. The diffusion of the discounted cash flow method 3. Markowitz and the birth of modern portfolio theory 4. CAPM: the relationship between expected returns and risk 5. The Efficient Market Hypothesis: do stock prices move randomly? 6. Modigliani-Miller: does financing matter? 7. Black – Merton – Scholes: how to value options
Capital Asset Pricing Model
Capital Asset Pricing Model Expected return rM r Risk free interest rate β 1 Beta
Net Present Value Calculation with CAPM
Outline 1. What is finance? 2. The diffusion of the discounted cash flow method 3. Markowitz and the birth of modern portfolio theory 4. CAPM: the relationship between expected returns and risk 5. The Efficient Market Hypothesis: do stock prices move randomly? 6. Modigliani-Miller: does financing matter? 7. Black – Merton – Scholes: how to value options 8. Beyond Black-Merton-Scholes: state prices, stochastic discount factors
Jensen 1968 - Distribution of “t” values for excess return 115 mutual funds 1955-1964 Not significantly different from 0
US Equity Mutual Funds 1982-1991 (Malkiel, Journal of Finance June 1995) Average Annual Return Capital appreciation funds 16.32% Growth funds 15.81% Small company growth funds 13.46% Growth and income funds 15.97% Equity income funds 15.66% S&P 500 Index 17.52% Average deviation from benchmark -3.20% (risk adjusted)
The Efficient Market Hypothesis S&P 500 2000-2004
The Efficient Market Hypothesis S&P 500 2000-2004
The Random Walk Model
Outline 1. What is finance? 2. The diffusion of the discounted cash flow method 3. Markowitz and the birth of modern portfolio theory 4. CAPM: the relationship between expected returns and risk 5. The Efficient Market Hypothesis: do stock prices move randomly? 6. Modigliani-Miller: does financing matter? 7. Black – Merton – Scholes: how to value options 8. Beyond Black-Merton-Scholes: state prices, stochastic discount factors
Does the capital structure matters? Modigliani Miller 1958: NO, under some conditions Debt Equity
Trade-off theory Market value PV(Costs of financial distress) PV(Tax Shield) Value of all-equity firm Debt ratio
Outline 1. What is finance? 2. The diffusion of the discounted cash flow method 3. Markowitz and the birth of modern portfolio theory 4. CAPM: the relationship between expected returns and risk 5. The Efficient Market Hypothesis: do stock prices move randomly? 6. Modigliani-Miller: does financing matter? 7. Black – Merton – Scholes: how to value options 8. Beyond Black-Merton-Scholes: state prices, stochastic discount factors
Options Right to: Buy (CALL) Sell (PUT) an asset at a fixed price (EXERCICE PRICE / STRIKING PRICE) up to or at a future date (MATURITY) at a future date (EUROPEAN OPTION) up to a future date (AMERICAN OPTION)
Buy 1 Fortis share
Buying a put Stock + Put Stock Put
Buying a call Bond + Call Bond Call
f=(#shares)(Stockprice)+Bond How to value an option Standard present value calculation fails Value of option = f(Stock price, Time) Required rate of return = f(Stock price, Time) Black Merton Scholes Combine stock and option to create a riskless position Law of one price (no arbitrage) f=(#shares)(Stockprice)+Bond
The fundamental partial differential equation Assume we are in a risk neutral world Expected change of the value of derivative security Change of the value with respect to time Change of the value with respect to the price of the underlying asset Change of the value with respect to volatility
And now, the Black Scholes formulas Closed form solutions for European options on non dividend paying stocks assuming: Constant volatility Constant risk-free interest rate Call option: Put option: N(x) = cumulative probability distribution function for a standardized normal variable
Binomial option pricing model Risk neutral probability Stock price Su Option fu Stock price S Stock price Sd Option fd Time interval Δt Risk free interest rate
Outline 1. What is finance? 2. The diffusion of the discounted cash flow method 3. Markowitz and the birth of modern portfolio theory 4. CAPM: the relationship between expected returns and risk 5. The Efficient Market Hypothesis: do stock prices move randomly? 6. Modigliani-Miller: does financing matter? 7. Black – Merton – Scholes: how to value options 8. Beyond Black-Merton-Scholes: state prices, stochastic discount factors
State prices Law of one price (no free lunches) Current price State Up Down Stock S Su Sd Risk free bond 1 1+rΔt Law of one price (no free lunches) Price of a digital option
Stochastic discount factors Valuing a derivative: Expectation operator Stochastic discount factor Random payoff of derivative
Growth of derivative industry
Explosion of the market for options