Capital Market Theory Rsm 332 – Week 2

CAPITAL MARKET THEORY RSM 332 workweek 2 calendar week 1 Introduction Financial Accounting (Review) Week 2 Financial Markets and lettuce Present Value Week 3 Present Value Concepts Week 4 Bond Valuation and Term Structure theory Week 5 Valuation of Stocks Week 6 Risk and requite Problem Set 1 Due Week 7* midterm (Tuesday*) Week 8 Portfolio surmise Week 9 hood Asset Pricing Model Week 10 Arbitrage Pricing scheme Week 11 Operation and dexterity of jacket Markets Week 12 Course Review Problem Set 2 Due connection otto. emailprotected utoronto. ca CAPITAL MARKET THEORY RSM 332 Week 2AGENDA 1. 2. 3. 4. 5. Announcements Financial Markets and Net Present Value Survey Results Optional Material (e. g. chemises, Practical Knowledge, News, etc. ) Suggestions/Practice for scrutiny(s) pe give the axerate otto. emailprotected utoronto. ca all-encompassing Office Hours Friday, October nineteenth (1100am-300pm) Room 6 TZ6 (Tanz Neuroscience Bldg 6 Queens Park Cresc ent West) TBD Saturday, October 20th Depends if there is enough demand Thursday, October 25th (500pm-700pm and 700pm-900pm) During regular timeslot hybridize optional material (e. g. cases, practical knowledge, etc. ) strive otto. emailprotected utoronto. ca Exams Midterm (Tuesday, October 23rd 800pm-1000pm) EX 100 (Examination Facility 255 McCaul Street) 2 Hours Final (TBA) 2 Hours Preparation Problem Sets 1 & 2 Crib Sheet (Start Early and 1-Sided) Calculator (Silent) butt against otto. emailprotected utoronto. ca Tutorials Starting September 19/20/21 Wednesday (600pm-800pm) TZ6 (Tanz Neuroscience Bldg 6 Queens Park Crescent West) Thursday (1100am-100pm) RW 110 (Ramsay Wright Laboratories 25 Harbord Street) Friday (500pm-700pm) RW 110 (Ramsay Wright Laboratories 25 Harbord Street) Review Midterms and Finals (2008-2011) Xiaofei Zhao (xiaofei. emailprotected utoronto. ca) http//332ta. raykan. com Contact otto. emailprotected utoronto. ca Outside of voice communication Office Hours (Drop-In) Wednesdays 400pm-600pm 105 St. George Street Rotman (North Building) Room 413 or 417 Office Hours (Other Days/Times) Extended Hours By Appointment Contact otto. emailprotected utoronto. ca incorporated finance What is Going On? 3) Firms Financial (5) Investors (4) (Financial Institutions, (1) Individuals, Other Firms) (1) (2) (3) (4) (5) Cash raised from rankors by selling fiscal assets Cash decorateed in in truth assets (some argon intangible) Cash generated by operations Cash reinvested in the firm (retained earnings) Cash repaid to investors ( sakiingness, dividends, etc. ) Operations (2) Decision Maker root Alex MacKay Financial Markets What is Going On? Firms (Users of big(p)) Initial Public Offering (IPO) Secondary Offerings (SEO) Borrowing ( lends, Bonds)Dividends, $ Repurchases, Interest Payments $ Market Mechanisms or Market Makers (Stock Exchanges, Banks, coronation funds, ) $ $ Firms Issue Stock Certificates and Bonds $ $$$ Invested in Stocks and Bonds Investors (Providers of detonating device) enthr angiotensin converting enzymement monetary resource Banks booster firms make transactions Brokers/Dealers help investors make transactions source Alex MacKay Financial Theory and Corporate Policy Chapter 1 (Copeland, Weston and Shastri) Course Reserve FINANCIAL MARKETS AND assoil PRESENT VALUE using up protrude and enthronisation RuleConsider 1 period problems Assumptions No uncertainty One period (two bookings), spendings occur on date 0 and date 1 A consumer is endowed with initial wealth (Y0) on date 0, and result receive income (Y1) on date 1 Simple please rate (r) Date 0 lineament Raymond Kan Contact otto. emailprotected utoronto. ca Date 1 intake intend and Investment Rule 4 gaucherieS Case I Case II No bully Market, No ware Opportunities With Capital Market, No production Opportunities Case III No Capital Market, With Production Opportunities Case IV With Capital Mark et, With Production Opportunities character reference Raymond Kan Contact otto. emailprotected utoronto. ca Consumption and Investment without Capital Markets C1 U2 U1 U0 C0 Reference Copeland, Weston, Shastri (Financial Theory Contact otto. emailprotected utoronto. ca and Corporate Policy) 4 th adaptation 2004 Consumption and Investment without Capital Markets C1 Slope of the Tangent (-ve) = (Marginal Rate of Substitution) (MRS) MRS = ? C1 ? C0 U1 U(C0, C1) MRS = ? U / ? C0 ?U / ? C1 C0 Reference Copeland, Weston, Shastri (Financial Theory Contact otto. emailprotected utoronto. ca and Corporate Policy) 4 th version 2004 Consumption and Investment without Capital MarketsC1 Production/Investment Opportunity Set C0 Reference Copeland, Weston, Shastri (Financial Theory Contact otto. emailprotected utoronto. ca and Corporate Policy) 4 th Edition 2004 Consumption and Investment without Capital Markets C1 Rate at which a dollar of breathing in today (C0) is transformed by productive in vestiture into a dollar of consumption (C1) tomorrow. C0 Reference Copeland, Weston, Shastri (Financial Theory Contact otto. emailprotected utoronto. ca and Corporate Policy) 4 th Edition 2004 Consumption and Investment without Capital Markets C1 C0 Reference Copeland, Weston, Shastri (Financial Theory Contact otto. emailprotected utoronto. ca and Corporate Policy) 4 th Edition 2004 Consumption and Investment without Capital Markets C1 Marginal Rate of Transformation (MRT) MRT = ? C1 ? C0 C0 Reference Copeland, Weston, Shastri (Financial Theory Contact otto. emailprotected utoronto. ca and Corporate Policy) 4 th Edition 2004 Consumption and Investment without Capital Markets C1 U1 C0 Reference Copeland, Weston, Shastri (Financial Theory Contact otto. emailprotected utoronto. ca and Corporate Policy) 4 th Edition 2004 Consumption and Investment without Capital Markets C1 Y1 U1 Resource Bundle (Y0, Y1) Y0Reference Copeland, Weston, Shastri (Financial Theory Contact otto. emailprotecte d utoronto. ca and Corporate Policy) 4 th C0 Edition 2004 Consumption and Investment without Capital Markets C1 Increase investment until MRT = MRS U1 C0 Reference Copeland, Weston, Shastri (Financial Theory Contact otto. emailprotected utoronto. ca and Corporate Policy) 4 th Edition 2004 Consumption and Investment without Capital Markets C1 U2 U1 C0 Reference Copeland, Weston, Shastri (Financial Theory Contact otto. emailprotected utoronto. ca and Corporate Policy) 4 th Edition 2004 Consumption and Investment without Capital MarketsC1 MRT = MRS U2 U1 C0 Reference Copeland, Weston, Shastri (Financial Theory Contact otto. emailprotected utoronto. ca and Corporate Policy) 4 th Edition 2004 Consumption and Investment without Capital Markets C1 U2 U1 (Increase Investment) Reference Copeland, Weston, Shastri (Financial Theory Contact otto. emailprotected utoronto. ca and Corporate Policy) 4 th C0 Edition 2004 Consumption and Investment with Capital Markets C1 Slope = -(1+r) Borrowing and Lending opportunities (Capital Market Line) (at foodstuff interest rate r) C0 Reference Copeland, Weston, Shastri (Financial Theory Contact otto. emailprotected utoronto. ca and Corporate Policy) 4 th Edition 2004 Consumption and Investment with Capital Markets C1 Interest plus Principal (Invest/Lending) Reference Copeland, Weston, Shastri (Financial Theory Contact otto. emailprotected utoronto. ca and Corporate Policy) 4 th C0 Edition 2004 Consumption and Investment with Capital Markets C1 Interest plus Principal (Borrowed Amount Principal) Reference Copeland, Weston, Shastri (Financial Theory Contact otto. emailprotected utoronto. ca and Corporate Policy) 4 th C0 Edition 2004 Consumption and Investment with Capital Markets C1 U1 C0Reference Copeland, Weston, Shastri (Financial Theory Contact otto. emailprotected utoronto. ca and Corporate Policy) 4 th Edition 2004 Consumption and Investment with Capital Markets C1 Y1 U1 Endowment (Y0, Y1) Y0 Reference Copeland, Weston, Shastri (Financial Theory Contact otto. emailprotected utoronto. ca and Corporate Policy) 4 th C0 Edition 2004 Consumption and Investment with Capital Markets C1 (Invest) Y1 U1 Y0 Reference Copeland, Weston, Shastri (Financial Theory Contact otto. emailprotected utoronto. ca and Corporate Policy) 4 th C0 Edition 2004 Consumption and Investment with Capital Markets C1Market rate of return unobjective Time Preference (1+r) (1+rtime preference) Y1 U1 Y0 Reference Copeland, Weston, Shastri (Financial Theory Contact otto. emailprotected utoronto. ca and Corporate Policy) 4 th C0 Edition 2004 Consumption and Investment with Capital Markets C1 U1 (Consume Less) Reference Copeland, Weston, Shastri (Financial Theory Contact otto. emailprotected utoronto. ca and Corporate Policy) 4 th C0 Edition 2004 Consumption and Investment with Capital Markets C1 U1 (Invest) Reference Copeland, Weston, Shastri (Financial Theory Contact otto. emailprotected utoronto. ca and Corporate Policy) 4 th C0Edition 2004 Consumption and Investment with Capital Markets C1 U2 Y1 U1 Y0 Reference Copeland, Weston, Shastri (Financial Theory Contact otto. emailprotected utoronto. ca and Corporate Policy) 4 th C0 Edition 2004 Consumption and Investment with Capital Markets C1 Market Interest Rate = Subjective Time Preference U2 Y1 U1 Y0 Reference Copeland, Weston, Shastri (Financial Theory Contact otto. emailprotected utoronto. ca and Corporate Policy) 4 th C0 Edition 2004 Consumption and Investment with Capital Markets (With Production Set) C1 U1 C0 Reference Copeland, Weston, Shastri (Financial Theory Contact otto. emailprotected toronto. ca and Corporate Policy) 4 th Edition 2004 Consumption and Investment with Capital Markets (With Production Set) C1 C0 Reference Copeland, Weston, Shastri (Financial Theory Contact otto. emailprotected utoronto. ca and Corporate Policy) 4 th Edition 2004 Consumption and Investment with Capital Markets (With Production Set) C1 C0 Reference Copeland, Weston, Shastri (Fin ancial Theory Contact otto. emailprotected utoronto. ca and Corporate Policy) 4 th Edition 2004 Consumption and Investment with Capital Markets (With Production Set) C1 C0 Reference Copeland, Weston, Shastri (Financial Theory Contact otto. emailprotected utoronto. ca and Corporate Policy) 4 th Edition 2004 Consumption and Investment with Capital Markets (With Production Set) C1 C0 Reference Copeland, Weston, Shastri (Financial Theory Contact otto. emailprotected utoronto. ca and Corporate Policy) 4 th Edition 2004 Consumption and Investment with Capital Markets (With Production Set) C1 U3 = ( takings and gravid market) U2 = (with production alone) U1 = (initial endowment) C0 Reference Copeland, Weston, Shastri (Financial Theory Contact otto. emailprotected utoronto. ca and Corporate Policy) 4 th Edition 2004 Consumption Plan and Investment RuleConsider 1 period problems Assumptions No uncertainty One period (two dates), consumptions occur on date 0 and date 1 A consumer is endo wed with initial wealth (Y0) on date 0, and will receive income (Y1) on date 1 Simple interest rate (r) Date 0 Reference Raymond Kan Contact otto. emailprotected utoronto. ca Date 1 Consumption Plan and Investment Rule 4 CASES Case I Case II No Capital Market, No Production Opportunities With Capital Market, No Production Opportunities Case III No Capital Market, With Production Opportunities Case IV With Capital Market, With Production Opportunities Reference Raymond Kan Contact otto. emailprotected utoronto. ca Consumption Plan and Investment Rule CASE I No Capital Market, No Production Opportunities Consumer can consume Y0 on date 0, and Y1 on date 1 Date 0 Reference Raymond Kan Contact otto. emailprotected utoronto. ca Date 1 Consumption Plan and Investment Rule CASE II With Capital Market, No Production Opportunities The set of consumption plans is broadened 1. 2. Consumer can save from Y0, invests in financial assets, and consumes more on date 1 Borrow against Y1, cons ume more on date 0, chip in back loan with interest on date 1 from Y1, and consume little on date 1 Date 0 Reference Raymond Kan Contact otto. emailprotected utoronto. ca Date 1 Consumption Plan and Investment Rule CASE II With Capital Market, No Production Opportunities denominate C0 and C1 as date 0 and date 1 consumption respectively Constraint on them is C1 = (Y0 C0) (1+r) + Y1 Consumption Budget Line (Constraint) C0 + C1 = Y0 + Y1 1+ r 1+ r Y Date 0 Reference Raymond Kan Contact otto. emailprotected utoronto. ca Date 1 In general, the consumer will be better off with detonating device markets Consumption Plan and Investment Rule CASE II With Capital Market, No Production Opportunities Present Value For any exchange flow, C0, C1, define its flummox look upon as PV = C0 + C1 + r Budget constraint can be restated as The present rank of consumption equals the present value of income Date 0 Reference Raymond Kan Contact otto. emailprotected utoronto. ca Date 1 Consum ption Plan and Investment Rule CASE II With Capital Market, No Production Opportunities ideal Assume an investor has a wealth of $1. 5M on date 0, and will have an income of $0. 55M on date 1 The interest rate is 10%. The present value of total income is $2M = $1. 5M + $0. 55M (1+ 0. 10) Date 0 Reference Raymond Kan Contact otto. emailprotected utoronto. ca Date 1 Consumption Plan and Investment RuleCASE III No Capital Market, With Production Opportunities Physical Investment Suppose the consumer is also an entrepreneur who identifies a physical investment probability Initial investment requires $0. 5M on date 0 Return of $0. 85M on date 1 Should this consumer/investor take this foresee? Without a roof market, it depends on her/his utility function Reference Raymond Kan Contact otto. emailprotected utoronto. ca Consumption Plan and Investment Rule CASE IV With Capital Market, With Production Opportunities By spend $0. 5M in a financial asset, receive $0. 55M in retu rn (i. . 10% return) By investing $0. 5M in a physical asset, receive $0. 85M in return (i. e. 70% return) Consumer/Investor should take this project Interest rate is also called the opportunity embody of capital i. e. Return foregone by investing in a project rather than in comparable investment alternatives Reference Raymond Kan Contact otto. emailprotected utoronto. ca Consumption Plan and Investment Rule CASE IV With Capital Market, With Production Opportunities Net Present Value (NPV) Is the projects net contribution to wealth (i. e. present value minus initial investment) NPV = C0 + C1 1+ r In the above example, the NPV of the project is NPV = -$0. 5M + $0. 85M = $0. 2727M (1 + 0. 10) Reference Raymond Kan Contact otto. emailprotected utoronto. ca Consumption Plan and Investment Rule CASE IV With Capital Market, With Production Opportunities NPV Rule States that If a project has a positive NPV, we should accept it If a project has a negative NPV, we should reject it Equivalent Rules NPV Rule Accept positive NPV projects Rate-of-Return Rule Invest in projects which offer a rate higher than the cost of capital Reference Raymond Kan Contact otto. emailprotected utoronto. ca A interval Theorem You are at a Honda (HMC) shareholders meeting Three shareholders are quite vocal near what the company should do Shareholder 1 Old Lady Wants money right now Wants HMC to invest in sports cars which will yield a warm profit Shareholder 2 Representative of a Little Boys Trust Fund Wants money a long way in the future Wants HMC to invest in building electric cars Shareholder 3 Young Professional Wants money at some specified time in future (i. e. 10 years) Wants HMC to build smaller cars because of an expected oil crisis Reference Raymond Kan Contact otto. emailprotected utoronto. ca A Separation TheoremWhat do you think Honda managers should do? Reference Raymond Kan Contact otto. emailprotected utoronto. ca A Separation Theorem What do you t hink Honda managers should do? MAXIMIZE VALUE Reference Raymond Kan Contact otto. emailprotected utoronto. ca A Separation Theorem In general, each shareholder may involve Maximum wealth Ability to transfer wealth across time into consumption Choose risk characteristics of consumption plan Each shareholder, all the same, can touch own consumption plan through investments in financial assets Achieve risk characteristics of plan by investing in more or less risky securitiesEQUITY (CAPITAL GAINS, DIVIDENDS) Reference Raymond Kan Contact otto. emailprotected utoronto. ca A Separation Theorem In general, each shareholder may want Maximum wealth Ability to transfer wealth across time into consumption Choose risk characteristics of consumption plan Each shareholder, however, can Achieve own consumption plan through investments in financial assets Achieve risk characteristics of plan by investing in more or less risky securities EQUITY (CAPITAL GAINS, DIVIDENDS) DEBT (INTEREST) TAX AGENCY COSTS Reference Raymond Kan Contact otto. emailprotected utoronto. ca A Separation Theorem In general, each shareholder may want Maximum wealth Ability to transfer wealth across time into consumption Choose risk characteristics of consumption plan Each shareholder, however, can WHAT instance OF INCOME DO YOU PREFER? Achieve own consumption plan through investments in financial assets Achieve risk characteristics of plan by investing in more or less risky securities EQUITY (CAPITAL GAINS, DIVIDENDS) DEBT (INTEREST) TAX AGENCY COSTS Reference Raymond Kan Contact otto. emailprotected utoronto. caConsumption and Investment with Capital Markets (With Production Set) C1 U3 = (production and capital market) U2 = (with production alone) U1 = (initial endowment) C0 Reference Copeland, Weston, Shastri (Financial Theory Contact otto. emailprotected utoronto. ca and Corporate Policy) 4 th Edition 2004 Consumption and Investment with Capital Markets (With Production Set) C1 C0 Reference Copeland, Weston, Shastri (Financial Theory Contact otto. emailprotected utoronto. ca and Corporate Policy) 4 th Edition 2004 Consumption and Investment with Capital Markets (With Production Set) C1 Choose the optimal production decision by taking on projects until the marginal rate of return on investment equals the objective market rate) C0 Reference Copeland, Weston, Shastri (Financial Theory Contact otto. emailprotected utoronto. ca and Corporate Policy) 4 th Edition 2004 Consumption and Investment with Capital Markets (With Production Set) C1 (Choose the optimal consumption pattern by borrowing or lending along the capital market line to equate your subjective time preference with the market rate of return) C0 Reference Copeland, Weston, Shastri (Financial Theory Contact otto. emailprotected toronto. ca and Corporate Policy) 4 th Edition 2004 Consumption and Investment with Capital Markets (With Production Set) C1 (Production/Investment Decision) (Consumption Decisi on) C0 Reference Copeland, Weston, Shastri (Financial Theory Contact otto. emailprotected utoronto. ca and Corporate Policy) 4 th Edition 2004 Consumption and Investment with Capital Markets (With Production Set) C1 (Production/Investment Decision) (Consumption Decision) (Fisher Separation Theorem) C0 Reference Copeland, Weston, Shastri (Financial Theory Contact otto. emailprotected utoronto. ca and Corporate Policy) 4 th Edition 2004Consumption and Investment with Capital Markets (With Production Set) C1 (Fisher Separation Theorem) Given perfect and complete capital markets, the production decision is governed solely by an objective market criterion (represented by maximizing achieve wealth) without regard to individuals subjective preferences that enter into consumption decisions C0 Reference Copeland, Weston, Shastri (Financial Theory Contact otto. emailprotected utoronto. ca and Corporate Policy) 4 th Edition 2004 Consumption and Investment with Capital Markets (With Production Set) C1 (Production/Investment Decision) (Consumption Decision) Fisher Separation Theorem) C0 Reference Copeland, Weston, Shastri (Financial Theory Contact otto. emailprotected utoronto. ca and Corporate Policy) 4 th Edition 2004 Consumption and Investment with Capital Markets (With Production Set) C1 (Production/Investment Decision) (Consumption Decision) (Fisher Separation Theorem) MRS = MRT = 1+r C0 Reference Copeland, Weston, Shastri (Financial Theory Contact otto. emailprotected utoronto. ca and Corporate Policy) 4 th Edition 2004 Consumption and Investment with Capital Markets (With Production Set) C1 ALL INDIVIDUALS USE THE SAME TIME VALUE OF MONEY (i. e. ame market interest rate) IN MAKING THEIR PRODUCTION/INVESTMENT DECISIONS (Fisher Separation Theorem) MRS = MRT = 1+r C0 Reference Copeland, Weston, Shastri (Financial Theory Contact otto. emailprotected utoronto. ca and Corporate Policy) 4 th Edition 2004 Example Ronald, a finance student, has $ cd cash-on-hand and has $1,1 00 in verify from his grandmother. Ronald will receive the boldness cash succeeding(a) year. (Market interest rate is 10% or trust funds worth $1,000 today). Ronald has 2 inversely max investment opportunities (i. e. abdominal aortic aneurysm and BBB rated investments). Contact otto. emailprotected utoronto. caReference Don Brean Example Ronald, a finance student, has $400 cash-on-hand and has $1,100 in trust from his grandmother. Ronald will receive the trust funds succeeding(a) year. (Market interest rate is 10% or trust funds worth $1,000 today). Ronald has 2 mutually unshared investment opportunities (i. e. AAA and BBB rated investments). 1. 2. 3. Which investment should Ronald invest in, AAA or BBB? How much should he invest? If Ronald makes investment describe his cash flows? (i. e. Consumption spending shared equally in present value terms) Contact otto. emailprotected utoronto. ca Reference Don Brean ExampleRonald, a finance student, has $400 cash-on-hand and has $1 ,100 in trust from his grandmother. Ronald will receive the trust funds next year. (Market interest rate is 10% or trust funds worth $1,000 today). Ronald has 2 mutually exclusive investment opportunities (i. e. AAA and BBB rated investments). 1. Which investment should Ronald invest in, AAA or BBB? Contact otto. emailprotected utoronto. ca Reference Don Brean Example Ronald, a finance student, has $400 cash-on-hand and has $1,100 in trust from his grandmother. Ronald will receive the trust funds next year. (Market interest rate is 10% or trust funds worth $1,000 today).Ronald has 2 mutually exclusive investment opportunities (i. e. AAA and BBB rated investments). 1. Which investment should Ronald invest in, AAA or BBB? Contact otto. emailprotected utoronto. ca Reference Don Brean Example Ronald, a finance student, has $400 cash-on-hand and has $1,100 in trust from his grandmother. Ronald will receive the trust funds next year. (Market interest rate is 10% or trust funds worth $1,00 0 today). Ronald has 2 mutually exclusive investment opportunities (i. e. AAA and BBB rated investments). 1. Which investment should Ronald invest in, AAA or BBB? 2. How much should he invest? Contact otto. emailprotected toronto. ca Reference Don Brean Example Ronald, a finance student, has $400 cash-on-hand and has $1,100 in trust from his grandmother. Ronald will receive the trust funds next year. (Market interest rate is 10% or trust funds worth $1,000 today). Ronald has 2 mutually exclusive investment opportunities (i. e. AAA and BBB rated investments). 3. If Ronald makes investment describe his cash flows? (i. e. Consumption spending carve up equally in present value terms) Contact otto. emailprotected utoronto. ca Reference Don Brean Example Ronald, a finance student, has $400 cash-on-hand and has $1,100 in trust from his grandmother.Ronald will receive the trust funds next year. (Market interest rate is 10% or trust funds worth $1,000 today). Ronald has 2 mutually exclusive investment opportunities (i. e. AAA and BBB rated investments). 3. If Ronald makes investment describe his cash flows? (i. e. Consumption spending divided equally in present value terms) PV of Wealth = PV of Consumption PV (C0) = PV (C1) (i. e. C0 = C1 / (1+r) ) NPVBBB Ronalds PV of Wealth = $400 + $1,000 + $87. 27 = $1,487. 27 $1,487. 27 = C0 + C1 / (1+r) = C0 + C0 (1+r) / (1+r) C0 = $743. 64 and C1 = $818 Contact otto. emailprotected utoronto. ca Reference Don Brean ExampleRonald, a finance student, has $400 cash-on-hand and has $1,100 in trust from his grandmother. Ronald will receive the trust funds next year. (Market interest rate is 10% or trust funds worth $1,000 today). Ronald has 2 mutually exclusive investment opportunities (i. e. AAA and BBB rated investments). 3. If Ronald makes investment describe his cash flows? (i. e. Consumption spending divided equally in present value terms) C0 = $743. 64 Investment in BBB Cash Flow Requirement (CF0) = ($743. 64 + $300) = $1,043. 64 Borrowing Requirement = CF0 $400 = $643. 64 Contact otto. emailprotected utoronto. ca Reference Don Brean ExampleRonald, a finance student, has $400 cash-on-hand and has $1,100 in trust from his grandmother. Ronald will receive the trust funds next year. (Market interest rate is 10% or trust funds worth $1,000 today). Ronald has 2 mutually exclusive investment opportunities (i. e. AAA and BBB rated investments). 3. If Ronald makes investment describe his cash flows? (i. e. Consumption spending divided equally in present value terms) C1 = $818 Return from BBB Cash Inflow (next year) = $1,100 + $426 = $1,526 Cash Outflow (next year) = $818 + $643. 64 + $64. 36 = $1,526 Loan Repayment Interest on Loan 10% Contact otto. emailprotected utoronto. a Reference Don Brean Example Ronald, a finance student, has $400 cash-on-hand and has $1,100 in trust from his grandmother. Ronald will receive the trust funds next year. (Market interest rate is 10% or trust funds worth $1,000 today). Rona ld has 2 mutually exclusive investment opportunities (i. e. AAA and BBB rated investments). CONCLUDING THOUGHT Ronalds optimal investment decision (i. e. $300 in BBB) is independent or separate from his decision as to how he inter-temporally allocates his consumption (i. e. C0 and C1) The independence of those two decisions is referred to as the Fisher Separation Theorem. Contact otto. emailprotected utoronto. ca Reference Don Brean GET TO KNOW YOU keep an eye on (Name Optional) school principal 1 What has occurred in your other courses that you were happy about and would like to be incorporated into this course ? What has occurred in your other courses that you were NOT happy about? call into question 2 Anything specific you would like to learn? What are your learning goals in this course? Any specific requests from the instructor, TAs, program, other support staff, etc? Question 3 ar you thinking of pursuing further education in Finance, if not thusly what do you have in mind? And/or What job(s) are you interested in?Question 4 Tell me more about yourself (e. g. goals, program concentration, second or 3rd year, etc ) Question 5 Any other comments, requests, suggestions, etc? TAKE 3 MINUTES INDIVIDUALLY TO FILL OUT SURVEY TAKE 5 MINUTES TO TALK TO 5 CLASSMATES WHOM YOU HAVENT MET YET (write down initials) SURVEY RESULTS (SUMMARY) Real world experiences, practical (real-world) examples, cases Relevant news (where to find news), reliable issues in the market Relate course material to real world Exam tips/techniques Applications and excel models used in the real world Interactive class, games, videosExtended office hours (availability) to address questions Humour Practice questions and solutions Past exams and solutions Capital markets (high-level overview) Typical jobs in finance, Leading finance organizations Additional tutorial time Stock picking, portfolio tryst/analysis, investment tools/strategies, trading tips Learning topi cs that can be applied in real life Relate designations/roles to course material and applications Better understanding of financial instruments (e. g. Mortgages, bonds, etc ) View of finance from other functional areas (e. g. Marketing) 13 Popular Case Studies (Failures) 1. 2. 3. 4. 5. . Barings (Bank) operational Risk (Trading Activities From arbitrageur to speculator) National Australia Bank Operational and Market Risks (Currency Trading) Bankgesellschaft Berlin (Bank) Credit and Operational Risks (Loans to Property Developers) Taisei recruit and Marine Insurance Co Insurance & authorities Risks (Uninsured exposure Lack of understanding) Washington Mutual (Bank) Credit, Regulatory and Governance Risks Stress and Scenario Testing (Low lending standards and bad quality acquisitions) Fannie Mae and Freddie Mac Credit, Market, Operational, Regulatory Governance and good Risk Politicians vs.Financial Risk Management (Sub-prime loans) Long-Term Capital Management LTCM (Hedg e Fund) Market & Model Risks (Short liquid vs. Long Illiquid Investments (e. g.Bonds) Russia Defaulted) Bankers Trust (Bank) Operational Risk (Misled clients on derivatives exchange to them) Orange County Market and Interest Rate Risks (Wrong way bet on interest rates Borrowing Short and Investing Long Interest grade Increased) Northern Rock (UK Bank) Portfolio, Capital Funding, Operational and Reputational Risks Stress and Scenario Testing (Sub-prime mortgages Bank Run) Metallgesellschaft AG (Energy Group) Market Risks (Cash Flow Issues from Written Forwards) Worldcom (Telecom) Operational Risks (Accounting Fraud Massive cquisitions & Debt) china Aviation Oil (Singapore) Market and Governance Risks (Misreported oil futures trading losses, Un-hedged open short positions, Oil Prices Increased) Source PRMIA 7. 8. 9. 10. 11. 12. 13. SURVEY AND BREAK 13 POPULAR CASE STUDIES Midterm 2011 Q3 Contact otto. emailprotected utoronto. ca Midterm 2011 Q3 stir up A Assume that there is no capital market, which investment, A or B, will crap lease? Justify your answer with calculations (6 marks) Contact otto. emailprotected utoronto. ca Midterm 2011 Q3 Part A Assume that there is no capital market, which investment, A or B, will scallywag ask?Justify your answer with calculations (6 marks) If jacks does not invest, his utility is zero If hoot makes investment A (Utility is ? ) If Jack makes investment B (Utility is ? ) Y0 = $500 and Y1 = $0 Savings = Investment = Y C Contact otto. emailprotected utoronto. ca Midterm 2011 Q3 Part A Assume that there is no capital market, which investment, A or B, will Jack choose? Justify your answer with calculations (6 marks) Investment A UA = (500-244)1/4 (400)1/2 = 80 Contact otto. emailprotected utoronto. ca Midterm 2011 Q3 Contact otto. emailprotected utoronto. caPart A Assume that there is no capital market, which investment, A or B, will Jack choose? Justify your answer with calculations (6 marks ) Investment B UB (I) = (500-I)1/4 (50(I)1/2)1/2 UB (I) = (50)1/2 (500-I)I1/4 Find I* by differentiating UB (I) wrt I (set to zero) dUB(I) = (50)1/2 (1/4) (500-I)I-3/4 (500-2I) dI I* = 250 Derivatives (Review) Reference Martin J. Osborne http//www. economics. utoronto. ca/osborne/MathTutorial/CLCF. HTM Contact otto. emailprotected utoronto. ca Midterm 2011 Q3 Part A Assume that there is no capital market, which investment, A or B, will Jack choose?Justify your answer with calculations (6 marks) Investment B UB (250) = (50)1/2 (500-I)I1/4 UB (250) = 111. 80 UB UA Contact otto. emailprotected utoronto. ca Midterm 2011 Q3 Part A Assume that there is no capital market, which investment, A or B, will Jack choose? Justify your answer with calculations (6 marks) Note Two methods to calculate I* 1st method (take derivative of Utility Function) Whats the 2nd method? Contact otto. emailprotected utoronto. ca Midterm 2011 Q3 Alternatively Investment B Contact otto. emailprot ected utoronto. ca Midterm 2011 Q3Part B Which investment, A or B will Jack choose? What is his utilitymaximizing investment I* and the optimal consumption plan? (6 marks) (Assume a perfect capital market for borrowing and lending exists and the market interest rate is 20%) Contact otto. emailprotected utoronto. ca Midterm 2011 Q3 Part B Which investment, A or B will Jack choose? What is his utilitymaximizing investment I* and the optimal consumption plan? (6 marks) Jack will choose the investment with the highest NPV Calculate NPVA and NPVB Contact otto. emailprotected utoronto. ca Midterm 2011 Q3Part B Which investment, A or B will Jack choose? What is his utilitymaximizing investment I* and the optimal consumption plan? (6 marks) NPVA = -$244 + ($400)/(1+0. 20) = $89. 33 Contact otto. emailprotected utoronto. ca Midterm 2011 Q3 Contact otto. emailprotected utoronto. ca Part B Which investment, A or B will Jack choose? What is his utilitymaximizing investment I* and the optimal consumption plan? (6 marks) To solve for NPVB Need to find optimal investment (I*) set MRT = -(1+r) = -1. 20 I* = $434. 03 MRT = dF/dI = -25/(I1/2) = -1. 20 F = 50 ($434. 31/2) = $1041. 67 NPVB = -$434. 03 + ($1041. 67/1. 20) = $434. 03 Midterm 2011 Q3 Part B Which investment, A or B will Jack choose? What is his utilitymaximizing investment I* and the optimal consumption plan? (6 marks) To solve for optimal consumption plan (i. e. C0*and C1*) Contact otto. emailprotected utoronto. ca Midterm 2011 Q3 Part B Which investment, A or B will Jack choose? What is his utilitymaximizing investment I* and the optimal consumption plan? (6 marks) To solve for optimal consumption plan (i. e. C0*and C1*) Total Wealth = $500 + $434. 03 = $934. 3 (set equal to C0 + C1/(1+r)) PV Wealth = PV Consumption C1 = 1120. 84 1. 2C0 Contact otto. emailprotected utoronto. ca Midterm 2011 Q3 Contact otto. emailprotected utoronto. ca Part B Which investment, A or B will Jack choose? What is his utilitymaximizing investment I* and the optimal consumption plan? (6 marks) To solve for optimal consumption plan (i. e. C0*and C1*) Total Wealth = $500 + $434. 03 = $934. 03 (set equal to C0 + C1/(1+r)) U(C0, C1) = C01/4 (1120. 84 1. 2C0 )1/2 dU/dC0 = (1/4)C0-3/4 (1120. 84 1. 2C0)1/2 1. 2 x (1/2)C01/4(1120. 4 1. 2C0)-1/2 Setting it equal to zero 1120. 84 1. 2C0 = 2. 4C0 C0* = $311. 34 C1* = 1120. 84 1. 2C0 = $747. 22 Midterm 2011 Q3 Part B Which investment, A or B will Jack choose? What is his utilitymaximizing investment I* and the optimal consumption plan? (6 marks) (Assume a perfect capital market for borrowing and lending exists and the market interest rate is 20%) Alternatively To solve for optimal consumption plan (i. e. C0*and C1*) Contact otto. emailprotected utoronto. ca Midterm 2011 Q3 Part B Which investment, A or B will Jack choose?What is his utilitymaximizing investment I* and the optimal consumption plan? (6 marks) Alternatively To solve for optimal consumption plan (i. e. C0*and C1*) MRS = (1+r), which leads to (C1/2C0) = 1. 2 C1 = 2. 4 C0 Budget constraint C0 + C1 / (1+r) = Total Wealth = $934. 03 C1 = 1120. 84 1. 2C0 C0* = $311. 34 C1* = $747. 22 Contact otto. emailprotected utoronto. ca Midterm 2011 Q3 Part C Jack can pack a worker to supervise one investment for him. As a result, he can now invest in both production opportunities if he wants.If he hires a worker, he has to pay wages in equal instalments (i. e. Same wage today and next period). What maximum wage per period would Jack be impulsive to pay? (4 marks) Contact otto. emailprotected utoronto. ca Midterm 2011 Q3 Part C Jack can hire a worker to supervise one investment for him. As a result, he can now invest in both production opportunities if he wants. If he hires a worker, he has to pay wages in equal instalments (i. e. Same wage today and next period). What maximum wage per period would Jack be willing to pay? (4 marks) NPVA = $89. 33 = W + (W/1. 20) W = $48. 3 (i. e. Maximum wage per period) Contact otto. emailprotected utoronto. ca Midterm 2011 Q3 Part D Jill earns an income of $250 today and $250 next period but has no access to any production opportunities. She can, however spend some money today to purchase investment opportunity B. Her utility function is U(C0, C1) = C0 + 2C1 + min(C0, C1) What is the highest price that Jill is willing to pay? (4 marks) Contact otto. emailprotected utoronto. ca Midterm 2011 Q3 Part D Jill earns an income of $250 today and $250 next period but has no access to any production opportunities.She can, however spend some money today to purchase investment opportunity B. Her utility function is U(C0, C1) = C0 + 2C1 + min(C0, C1) What is the highest price that Jill is willing to pay? (4 marks) With a perfect capital market, the Fisher Separation Theorem applies So the maximum amount she will pay is $434. 03 (i. e. NPVB) Contact otto. emailprotected utoronto. ca FINANCIAL MARK ETS AND NET PRESENT VALUE (TO SUCCEED PRACTICE, PRACTICE, PRACTICE) Week 3 Quick Review (Self-Evaluation) of Week 2 GET TO KNOW YOU SURVEY (Name Optional)Question 1 What has occurred in your other courses that you were happy about and would like to be incorporated into this course ? What has occurred in your other courses that you were NOT happy about? Question 2 Anything specific you would like to learn? What are your learning goals in this course? Any specific requests from the instructor, TAs, program, other support staff, etc? Question 3 Are you thinking of pursuing further education in Finance, if not then what do you have in mind? And/or What job(s) are you interested in? Question 4 Tell me more about yourself (e. . goals, program concentration, 2nd or 3rd year, etc ) Question 5 Any other comments, requests, suggestions, etc? TAKE 3 MINUTES INDIVIDUALLY TO FILL OUT SURVEY TAKE 5 MINUTES TO TALK TO 5 CLASSMATES WHOM YOU HAVENT MET YET (write down initials) SURVEY RESU LTS (SUMMARY) Real world experiences, practical (real-world) examples, cases Relevant news (where to find news), Current issues in the market Relate course material to real world Exam tips/techniques Applications and excel models used in the real world Interactive class, games, videosExtended office hours (availability) to address questions Humour Practice questions and solutions Past exams and solutions Capital markets (high-level overview) Typical jobs in finance, Leading finance organizations Additional tutorial time Stock picking, portfolio allocation/analysis, investment tools/strategies, trading tips Learning topics that can be applied in real life Relate designations/roles to course material and applications Better understanding of financial instruments (e. g. Mortgages, bonds, etc ) View of finance from other functional areas (e. g. Marketing) http//www. explorefinancialservices. om/Options http//www. explorefinancialservices. com/ Financial Markets What is Going On? Firms (Users of Capital) Initial Public Offering (IPO) Secondary Offerings (SEO) Borrowing (Loans, Bonds) Dividends, $ Repurchases, Interest Payments $ Market Mechanisms or Market Makers (Stock Exchanges, Banks, Investment Funds, ) $ $ Firms Issue Stock Certificates and Bonds $ $$$ Invested in Stocks and Bonds Investors (Providers of Capital) Investment Banks help firms make transactions Brokers/Dealers help investors make transactions Reference Alex MacKay 113 Hedge Fund Strategies Dedicated ShortSource AIMA Canada Further Reading Hedge Funds Emerging Market Strategy Emerging Markets (American Depository Receipts ADRs vs. Foreign Securities) http//www. sec. gov/pdf/ininvest. pdf (Page 12) (SAP) Hedge Fund Quants Jim Simons (Renaissance Technologies) Commodities/Futures (Rapid Fire Trading) (computer and system specialists, researchers and traders) (computational linguistsspeech recognition/investing) http//chinese-school. netfirms. com/abacus-hedge-funds-Jim-Simo ns. html Kenneth Griffin (Citadel Investment Group) Convertible Bonds Long-Short http//money. cnn. om/2008/12/08/news/companies/citadel_vickers. boyd. fortune/index. htm The Quants (Scott Patterson Wall Street Journal Reporter) http//www. businessweek. com/magazine/ electrical capacity/10_09/b4168070829612. htm http//online. wsj. com/article/SB10001424052748704509704575019032416477138. html Steven Palmer (AlphaNorth Asset Management Inc) (Microcap Tech) http//www. theglobeandmail. com/globe-investor/funds-and-etfs/funds/top-hedge-fund-manager-turns-to-techmicro-caps/article1884049/ House Dems propose valueing equity trades to fund new federal programs Financial transaction tax on all stock (0. 5%), bond (0. %) and derivatives (0. 005%) trades Protects financial markets from speculation Make high-frequency trading unprofitable http//thehill. com/blogs/floor-action/house/249893-house-dems-propose-taxing-equity-trades-to-fund-new-federal-programs Harsh HFT curbs could sne ak into MiFID Introduction of stripped-down resting times between trades Could force HFT firms out of the market, widening spreads and making trading more costly Meetings held with the European Parliaments Economic and Monetary personal business Committee (ECON) MiFID (Markets in Financial Instruments Directive) European Union Law http//www. hetradenews. com/news/Regions/Europe/Harsh_HFT_curbs_could_sneak_into_MiFID_II. aspx CAPITAL MARKET THEORY RSM 332 Week 2 Week 1 Introduction Financial Accounting (Review) Week 2 Financial Markets and Net Present Value Week 3 Present Value Concepts Week 4 Bond Valuation and Term Structure Theory Week 5 Valuation of Stocks Week 6 Risk and Return Problem Set 1 Due Week 7* Midterm (Tuesday*) Week 8 Portfolio Theory Week 9 Capital Asset Pricing Model Week 10 Arbitrage Pricing Theory Week 11 Operation and Efficiency of Capital Markets Week 12 Course Review Problem Set 2 DueContact otto. emailprotected utoronto. ca THANK YOU SEE YOU NEXT WEEK OFFICE HOURS WEDNESDAYS 400PM-600PM ROOM 413 OR 417 105 ST. GEORGE STREET ROTMAN (NORTH BUILDING)