ASSET PRICING
Pre-Master Finance
2021-2022
,Table of Contents
Cycle 1 ......................................................................................................................................... 2
Chapter 1) The Corporation and Financial Markets............................................................................ 2
Chapter 2) Introduction to Financial Statement Analysis ................................................................... 8
Chapter 3) Financial Decision Making and the Law of One Price ..................................................... 18
Cycle 2 ....................................................................................................................................... 24
Chapter 4) The Time Value of Money ............................................................................................... 24
Chapter 5) Interest Rates .................................................................................................................. 28
Chapter 6) Valuing Bonds (6.1-6.2) ................................................................................................... 32
Cycle 3 ....................................................................................................................................... 36
Chapter 6) Valuing Bonds (6.3-6.5) ................................................................................................... 36
Chapter 9) Valuing Stocks ................................................................................................................. 39
Cycle 4 ....................................................................................................................................... 48
Chapter 10) Capital Markets and the Pricing of Risk ........................................................................ 48
Chapter 11) Optimal Portfolio Choice and the Capital Asset Pricing Model .................................... 53
Cycle 5 ....................................................................................................................................... 61
Chapter 12) Estimating the Cost of Capital ....................................................................................... 61
Chapter 13) Investor Behaviour and Capital Market Efficiency ........................................................ 67
Cycle 6 ....................................................................................................................................... 76
Chapter 20) Financial Options........................................................................................................... 76
Chapter 21) Option Valuation (21.1-21.4) ........................................................................................ 82
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,Cycle 1
Chapter 1) The Corporation and Financial Markets
1.1. The Four Types of Firms
Sole proprietorships
A sole proprietorship is a business owned and run by one person. Sole proprietorships are usually very
small with few, if any, employees. They do not account for much sales revenue in the economy, but
are the most common type of firm in the world. Key characteristics:
1. Sole proprietorships are straightforward to set up. Consequently, many new businesses
use this organizational form.
2. There is no separation between the firm and the owner – the firm can only have one
owner. If there are other investors, they cannot hold an ownership stake in the firm.
3. The owner has unlimited personal liability for any of the firm’s debts → when the firm
defaults on any debt payment, the lender can (and will) require the owner to repay the
loan from personal assets. An owner who cannot afford to repay the loan must declare
personal bankruptcy.
4. The life of a sole proprietorship is limited to the life of the owner. It is also difficult to
transfer ownership of a sole proprietorship.
The disadvantages of a sole proprietorship often outweigh the advantages. As soon as the firm reaches
the point at which it can borrow without the owner agreeing to be personally liable, the owners
typically convert the business into a form that limits the owner’s liability.
Partnerships
A partnership is identical to a sole proprietorship except it has more than one owner. Key features:
1. All partners are liable for the firm’s debt. That is, a lender can require any partner to repay
all the firm’s outstanding debts.
2. The partnership ends on the death or withdrawal of any single partner, although partners
can avoid liquidation if the partnership agreement provides for alternatives such as a
buyout of a deceased or withdrawn partner.
▪ Some old and established businesses remain partnerships or sole proprietorships.
Often the basis for these businesses is the owners’ personal reputations. For such
enterprises, the partners’ personal liability increases the confidence of the firm’s
clients that the partners will strive to maintain their reputation.
A limited partnership is a partnership with two kinds of owners, general partners and limited partners.
• General partners have the same rights and privileges as partners in a (general) partnership – they
are personally liable for the firm’s debt obligations.
• Limited partners have limited liability – their liability is limited to their investment. Their private
property cannot be seized to pay off the firm’s debts.
Limited liability company (LLC)
A limited liability company (LLC) is a limited partnership without a general partner. That is, all owners
have limited liability, but unlike limited partners, they can also run the business.
Corporation
A corporation is a legally defined, artificial being (a judicial person or legal entity) separate from its
owners. Therefore, it has many of the legal powers that people have. Because a corporation is a legal
entity separate and distinct from its owners, it is solely responsible for its own obligations → the
owners of a corporation (or its employees, customers, etc.) are not liable for any obligations the
corporation enters into.
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,• Corporations must be legally formed, which means that the state in which it is incorporated must
formally give its consent to the incorporation by chartering it.
• Because most corporations have many owners (there is no limit), each owner owns only a small
fraction of the corporation.
o The entire ownership stake of a corporation is divided into shares known as stock.
o The collection of all the outstanding shares of a corporation is known as the equity of the
corporation.
o An owner of a share or stock in the corporation is known as a shareholder, stockholder,
or equity holder and is entitled to dividend payments, that is, payments made at the
discretion of the corporation to its equity holders → distribution of the company’s profits
to its shareholders.
• There is no limitation on who can own the stock of the corporation. Everyone can own a stock,
and there is no need to have any special expertise or qualification.
Tax implications for corporate entities
Because a corporation is a separate legal entity, a corporation’s profits are subject to taxation separate
from its owners’ tax obligations → in effect, shareholders pay taxes twice.
• Double taxation: first, the corporation pays tax on its profits, and then when the remaining profits
are distributed to the shareholders, the shareholders pay their own personal income tax on this
income.
• S Corporations are corporations that elect subchapter S tax treatment (an exemption from double
taxation). Under these tax regulations, the firm’s profits (and losses) are not subject to corporate
taxes, but instead are allocated directly to shareholders based on their ownership share. The
shareholders must include these profits as income on their individual tax returns (even if no
money is distributed to them).
o Strict limitations from the government on the qualifications for subchapter S tax
treatment → often only citizens of US (in this case) can be shareholders.
• Most large corporations are “C corporations”, which are corporations subject to corporate taxes.
1.2. Ownership Versus Control of Corporations
In a corporation, direct control and ownership are often separate → owners of a corporation have no
direct control of the firm, because there are (sometimes) many owners, each of whom can freely trade
his or her stock.
The Corporate Management Team
Rather than the owners, the board of directors and chief executive officer possess direct control of the
corporation:
• The shareholders of a corporation exercise their control by electing a board of directors: a group
of people who have the ultimate decision-making authority in the corporation.
o In most corporations, investors with the most shares have the most influence → every
share gives shareholder one vote.
o The board of directors makes rules on how the corporation should be run (including how
the top managers in the corporation are compensated), sets policy, and monitors the
performance of the company. The board of directors delegates most decisions that
involve day-to-day running of the corporation to its management.
• The chief executive officer (CEO) is charged with running the corporation by instituting the rules
and policies set by the board of directors.
o The separation of powers within corporations between the board of directors and the CEO
is not always distinct → sometimes the CEO is chairman of the board.
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, o The most senior financial manager is the chief financial officer (CFO), who reports directly
to the CEO.
The Financial Manager
Within the corporation, financial managers are responsible for three main tasks:
• Making investment decisions: the financial manager must weigh the costs and benefits of all
investments and projects and decide which of them qualify as good uses of the money
stockholders have invested in the firm.
• Making financing decisions: large investments may require the corporation to raise additional
money. The financial manager must decide whether to raise more money from new and existing
owners by selling more shares of stock (equity) or to borrow the money (debt).
• Managing the firm’s cash flows: the financial manager must ensure that the firm has enough cash
on hand to meet its day-to-day obligations.
o A company typically burns through a significant amount of cash developing a new product
before its sales generate income. The financial manager’s job is to make sure that access
to cash does not hinder the firm’s success.
The Goal of the Firm
In theory the goal of the firm should be determined by the firm’s owners. In organizational form with
multiple owners this is not possible. However, the shareholders will agree that the management
should make decisions that increase the value of their shares.
The Firm and Society
Decisions that increase the value of the firm’s equity are often beneficial for society as a whole →
good products come from it and as long as nobody else is made worse off by the decisions of a
corporation, increasing the value of equity is good for society.
The problem occurs when increasing the value of equity comes at the expense of others, e.g.,
pollution; use of the products may harm the environment.
Appropriate public policy and regulation is required to assure that corporate interests and societal
interests remain aligned.
Ethics and incentives within corporations
• Agency problem: when managers, despite being hired as the agents of shareholders, put their
own self-interest ahead of the interests of shareholders.
o Managers face the ethical dilemma of whether to adhere to their responsibility to put the
interests of shareholders first, or to do what is in their own personal best interest.
o A corporation should minimize the number of decisions managers must make for which
their own self-interest substantially differs from the interest of the shareholders.
▪ Shareholders often tie the compensation of top managers to the corporation’s
profits or perhaps to its stock price. The limitation, however, is that by tying
compensation too closely to performance, the shareholders might be asking
managers to take on more risk than they are comfortable taking. They might not
make the decisions shareholders want them to.
o Some actions, like donations, are costly and reduce shareholder wealth. While some
shareholders might support such policies because they feel that they reflect their own
moral and ethical priorities, it is unlikely that all shareholders will feel this way, leading to
potential conflicts of interests among shareholders.
▪ In some cases the firm can return the cash to shareholders who can then
determine how much money to give/spend on their own.
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, ▪ In other cases, to maximize shareholder welfare, it is appropriate for the firm’s
managers to weigh conflicting shareholder preferences in their decision making.
• The CEO’s performance: another way shareholders can encourage managers to work in the
interest of shareholders is to discipline them if they don’t → shareholders could pressure the
board to oust the CEO.
o In reality, a shareholder uprising rarely happens. Instead, dissatisfied investors often
choose to sell their shares.
▪ If enough shareholders are dissatisfied, the only way to entice investors to buy (or
hold on to) the shares is to offer them a low price.
▪ Similarly, investors who see a well-managed corporation will want to purchase
shares, which drives the stock price up.
▪ The stock price of the corporation is a barometer for corporate leaders that
continuously gives them feedback on their shareholders’ opinion of their
performance.
o In a hostile takeover, an individual or organization (also known as corporate raider) can
purchase a large fraction of the stock and acquire enough votes to replace the board of
directors and the CEO.
▪ With a new superior management team, the stock is a much more attractive
investment, which would likely result in a price rise and a profit for the corporate
raider and the other shareholders.
• Corporate bankruptcy: When a corporation borrows money, the holders of the firm’s debt also
become investors in the corporation. While the debt holders do not normally exercise control over
the firm, if the corporation fails to repay its debts, the debt holders are entitled to seize the assets
of the corporation in compensation for the default. To prevent such a seizure, the firm may
attempt to renegotiate with the debt holders, or file for bankruptcy protection in a federal court.
Ultimately, however, if the firm is unable to repay or renegotiate with the debt holders, the control
of the corporation’s assets will be transferred to them.
o Thus, when a firm fails to repay its debts, the end result is a change in ownership of the
firm, with control passing from equity holders to debt holders.
o Important: bankruptcy need not result in a liquidation of the firm, which involves shutting
down the business and selling off its assets. → even if control of the firm passes to the
debt holders, it is in the debt holders’ interest to run the firm in the most profitable way
possible. Doing so often means keeping the business operating.
A useful way to understand corporations is to think of there being two sets of investors with claims to
its cash flows – debt holders and equity holders:
➢ As long as the corporation can satisfy the claims of the debt holders, ownership remains in the
hands of the equity holders.
➢ If the corporation fails to satisfy debt holders’ claims, debt holders may take control of the firm.
Thus, a corporate bankruptcy is best thought of as a change in ownership of the corporation.
1.3. The Stock Market
The value of shareholders’ investment in the firm is determined by the price of a share of the
corporation’s stock. Because private companies have limited set of shareholders and their shares are
not regularly traded, the value of their shares can be difficult to determine. But many corporations
are public companies, whose shares trade on organized markets called a stock market (or stock
exchange).
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,Stock markets provide liquidity and determine a market price for the company’s shares. An investment
is said to be liquid if it is possible to sell it quickly and easily for a price very close to the price at which
you could contemporaneously buy it.
Primary and Secondary Stock Markets
• When a corporation itself issues new shares of stock and sells them to investors, it does so on the
primary market.
• After this initial transaction between the corporation and investors, the shares continue to trade
in a secondary market between investors without the involvement of the corporation.
o Because firms only occasionally issue new shares, secondary market trading accounts for
the vast majority of trading in the stock market.
Traditional Trading Venues
• Historically, a firm would choose one stock exchange on which to list its stock, and almost all trade
in the stock would occur on that exchange.
o Market makers (were also known as specialists) matched buyers and sellers. They posted
two prices for every stock in which they made a market:
▪ bid price: the price at which they were willing to buy the stock
▪ ask price: the price at which they were willing to sell the stock
The market maker would honour the posted prices (up to a limited number of shares) and
make the trade with a customer even when they did not have another customer willing
to take the other side of the trade → hence, market makers provided liquidity by ensuring
that market participants always had somebody to trade with.
• In other markets, trades could also be completed over the phone or on a computer network.
o These stocks had multiple market makers who competed with one another.
• Market makers make money because ask prices are higher than bid prices → this difference is
called the bid-ask spread.
• The bid-ask spread is a transaction cost investors pay in order to trade → compensation market
makers earn for providing a liquid market.
New Competition and Market Changes
• With the change in market structure (competition form new, fully electronic exchanges and
alternative changing systems), the role of an official market maker has largely disappeared.
• Because all transactions occur electronically with computers matching buy and sell orders, anyone
can make a market in a stock by posting a limit order – an order to buy or sell a set amount at a
fixed price. The limit sell order with the lowest price is the ask price. The limit buy order with the
highest price is the bid price.
o Limit order book is the collection of all limit orders → exchanges make their limit order
books public so that investors can see the best bid and ask prices when deciding where to
trade.
o Traders who post limit orders provide the market with liquidity.
• On the other hand, traders who place market orders – orders that trade immediately at the best
outstanding limit order – are said to be “takers” of liquidity.
o Providers of liquidity earn the bid-ask spread, but in so doing they risk the possibility of
their orders becoming stale: when news about a stock arrives that causes the price of that
stock to move, smart traders will quickly take advantage of the existing limit orders by
executing trade at the old prices. To protect themselves against this possibility, liquidity
providers need to constantly monitor the market, cancelling old orders and posting new
orders when appropriate.
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,• High frequency traders (HFTs) are a class of traders who, with the aid of computers, will place,
update, cancel, and execute trades many times per second in response to new information as well
as other orders, profiting both by providing liquidity and by taking advantage of stale limit orders.
Dark Pools
• When trading on an exchange, investors are guaranteed the opportunity to trade immediately at
the current bid or ask price, and transactions are visible to all traders when they occur.
• In contrast, alternative trading systems called dark pools do not make their limit order books
visible → these dark pools offer investors the ability to trade at a better price (e.g., the average of
the bid and ask, thus saving the bid-ask spread), with the tradeoff being that the order might not
be filled if an excess of either buy or sell orders is received.
o Trading on a dark pool is therefore attractive to traders who do not want to reveal their
demand and who are willing to sacrifice the guarantee of immediacy for a potentially
better price.
1.4. Fintech: Finance and Technology
The relation between financial innovation and technical innovation has become known as Fintech.
Telecommunications
• Because the same financial securities are often traded on markets that are physically far apart,
finance professionals have always been amongst the first adopters of improved communication
technologies.
• Once the telegram was introduced, prices of the same security trading in markets at different
physical locations became significantly closer to each other.
• Today, some traders use microwave technology to transmit information and orders at the highest
possible speeds.
Security and Verification
• Finance has spurred significant innovation in security and verification technology → derived from
a need to verify transactions across distance: technology that allowed banks to transmit signatures
over telegraph lines, thereby greatly shortening the time needed to verify transactions at a
distance.
• Blockchain technology allows a transaction to be recorded in a publicly verifiable way without the
need for a trusted third party to certify the authenticity of the transaction → by enabling a public
ledger of transactions, blockchain technology allows for the digital transfer of assets without the
backing of a government or a central clearinghouse.
o Cryptocurrency is a currency whose creation and ownership is determined via a public
blockchain.
Automation of Banking Services
• The automatic teller machine (ATM) was one of the earliest instances of automated customer
service in any industry. Today, automated customer service is routine in banking.
• Recently, smartphone apps have made it easy for individuals to pay for goods and transfer money
to others almost instantly. In the developing world, this innovation grants access to the modern
financial system via cellular phones to millions of people who would otherwise not have access.
• Investment advising is another traditional banking service that may potentially be disrupted by
the recent growth in robo-advisors, computer programs that are intended to replace the work of
financial advisors by providing detailed and customized investment recommendations.
Big Data and Machine Learning
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,• Investors have access to an unprecedented array of financial data at very low cost. These data not
only give individual investors an unprecedented window into the companies they invest in, it also
allows both firms and policy makers to make more informed decisions.
• Another important use of data and technology in finance is in predicting price changes in the
market. However, as computer algorithms compete with each other to better predict price moves,
and as traders adjust their strategies to make them less predictable, future price moves become
harder to forecast and so a technological arms race has ensued.
• The availability of data has enabled companies throughout the economy to better target their
products to consumers, and financial services companies are no exception.
o Potential concern → customers that are found to be higher risk based on the machine
learning algorithms may now pay more for the service or not be offered the service at all.
Competition
• Technological advances, and the internet in particular, have opened the way for non-finance
organizations to provide financial services.
o E.g., Apple, PayPal, and Google provide payment services that traditionally have been
provided by banks.
• Numerous start-ups are entering the market to provide new and improved financial services to
customers, businesses, and banks themselves. This intense competition will likely spur further
innovation.
• Any technology that confers a competitive advantage has the potential to provide large profits to
early adopters. Beyond that, the provision of financial services can create substantial value to end
users and the broader economy.
Chapter 2) Introduction to Financial Statement Analysis
2.1. Firms’ Disclosure of Financial Information
Financial statements are accounting reports with past performance information that a firm issues
periodically – usually quarterly (10-Q) and annually (10-K). They must also send an annual report with
their financial statements to their shareholders each year.
Financial statements are important tools through which investors, financial analysts, and other
interested outside parties (such as creditors) obtain information about a corporation. Also useful for
managers within the firm as a source of information for corporate financial decisions.
Preparation of Financial Statements
• Generally Accepted Accounting Principles (GAAP) provide a common set of rules and a standard
format for public companies to use when they prepare their reports. This standardization makes
reports understandable and accurate and it is easier to compare financial results of different firms.
• Investors also need some assurance that the financial statements are prepared accurately. Hence,
corporations are required to hire a neutral third party (auditor) to check the annual financial
statements, to ensure that the annual financial statements are reliable and prepared according to
GAAP.
Types of Financial Statements
Every public company is required to produce four financial statements: the balance sheet, the income
sheet, the statement of cash flows, and the statement of stockholders’ equity. These financial
statements provide investors and creditors with an overview of the firm’s financial performance.
Private companies often prepare financial statements as well, but they usually do not have to disclose
these reports to the public. Hence, there are not required to.
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, 2.2. The Balance Sheet
The balance sheet (or statement of financial position) lists the firm’s assets and liabilities, providing
a snapshot of the firm’s financial position at a given point in time.
• A balance sheet is divided into two parts → assets on the left, liabilities on the right.
o The assets list the cash, inventory, property, plant, and equipment, and other investments
the company has made.
o The liabilities show the firm’s obligations to creditors.
▪ Shown with the liabilities on the right side of the balance sheet is the stockholders’
equity. The stockholders’ equity is the difference between the firm’s assets and
liabilities and is used as an accounting measure of the firm’s net worth.
• The assets on the left side show how the firm uses its capital (its investments), and the right side
summarizes the sources of capital, or how a firm raises the money it needs.
• Because of the way stockholders’ equity is calculated, the left and right sides must balance:
o The Balance Sheet Identity: Assets = Liabilities + Stockholders’ Equity.
Assets
• Current assets are either cash or assets that could be converted into cash within one year. This
category includes the following:
1. Cash and other marketable securities, which are short-term, low-risk investments that
can be easily sold and converted to cash (such as money market investments like
government debt that matures within a year)
2. Accounts receivable, which are amounts owned to the firm by customers who have
purchased goods or services on credit
3. Inventories, which are composed of raw materials as well as work-in-progress and
finished goods
4. Other current assets, which is a catch-all category that includes items such as prepaid
expenses (such as rent or insurance paid in advance).
• Long-term assets
o Net property, plant, and equipment: includes assets such as real estate or machinery that
produce tangible benefits for more than one year.
▪ Because equipment tends to wear out or become obsolete over time, a
corporation will reduce the value recorded (depreciation) for this equipment each
year by deducting a depreciation expense.
▪ An asset’s accumulated depreciation is the total amount deducted over its life.
The firm reduces the value of fixed assets (other than land) over time according
to a depreciation schedule that depends on the asset’s life span.
• Depreciation is not an actual cash expense that the firm pays; it is a way
of recognizing that buildings and equipment wear out and thus become
less valuable the older they get.
▪ The book value of an asset, which is the value shown in the firm’s financial
statement, is equal to its acquisition cost less accumulated depreciation. Net
property, plant, and equipment shows the book value of these assets.
o When a firm acquires another company, it will acquire a set of tangible assets (such as
inventory or property, plant, and equipment) that will then be included on its balance
sheet.
▪ In many cases, however, the firm may pay more for the company than the total
book value of the assets it acquires. In this case, the difference between the price
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