Table of Contents
Lecture 1: An Overview of Financial Markets......................................................................2
Introduction.....................................................................................................................................2
Corporation on Financial Markets................................................................................................2
Risk and Return of Stocks and Indexes.........................................................................................3
Other Financial Assets....................................................................................................................5
Lecture 2: Assessing Assets Risk/Return & Portfolio Theory.................................................7
Small Variation................................................................................................................................7
Asset’s Characteristics....................................................................................................................7
Portfolio Theory............................................................................................................................10
The Efficient Frontier (EF)...........................................................................................................12
The Sharpe Ratio...........................................................................................................................13
Lecture 3: EMH, CAPM, and Behavioral Finance...............................................................15
The Efficient Market Hypothesis.................................................................................................15
The Capital Asset Pricing Model..................................................................................................16
Behavioral Finance and Technical Analysis................................................................................17
Lecture 4: Equity Valuation Models.......................................................................................19
Balance Sheet Models....................................................................................................................19
Dividend Discount Models (DDM)...............................................................................................19
Price/Earnings Ratios....................................................................................................................21
Free Cash Flow Models.................................................................................................................21
Lecture 5: Fixed-Income Securities.......................................................................................23
Basics of bond valuation................................................................................................................23
Term structure of interest rates...................................................................................................23
Default Risk...................................................................................................................................25
Other bond features......................................................................................................................25
Lecture 6: Derivatives – Options Valuation...........................................................................27
Forwards, futures and swaps........................................................................................................27
Option contracts............................................................................................................................28
Option payoffs...............................................................................................................................28
The Put-Call Parity Relationship.................................................................................................30
Options valuation..........................................................................................................................32
Black-Scholes option valuation.....................................................................................................34
,Lecture 1: An Overview of Financial Markets
Introduction
This lecture focuses on:
What is a corporation and its connection to the financial markets?
The existing difference between real and financial assets.
What is the risk/return trade-off?
The concept of efficiency on financial markets.
Which are the major categories of financial assets?
Corporation on Financial Markets
Main characteristics of a corporation with respect to all the existing models of firms:
- It is a legal entity separate from its owners
- The best feature of a corporation is that it is solely responsible for its obligations,
meaning that its owners are not liable for any liability the corporation enters into
- The ownership is divided among the fixed amount of stocks issued, and due to that,
the owner of a share is known as a: shareholder, stockholder, or equity holder.
- The sum of all the shares outstanding is called Equity (E)
- There is no limit to the number of shareholders, and thus the amount of funds a
company can raise by selling shares
- The shareholders are entitled to dividend payments and have voting rights
- The corporations can be private and public
- The shareholders are subject to the so-called double taxation issue
Focus on Public Corporations, because the stocks of these firms are the only ones that trade
on the Financial Market.
Graphical overview of a corporation
Firm’s capital can be decomposed in Debt and Equity. Thus, firms can raise money issuing
debt and new shares. The proportions of debt and equity constitute the firm’s Capital
Structure. Most of the firms decide to finance them by equity alone, or by a combination of
equity and debt.
Concerning the equity, previously, we have assumed that there exists only one type of
share: ordinary shares. In practice, firms can issue at least two kinds of shares:
1. Ordinary shares: represent the basic voting shares of a corporation. Holders of these
type of shares are typically entitled to one vote per share and do not have
predetermined dividend amounts
, 2. Preferred shares: a class of ownership in a corporation that has a higher claim on its
assets and earnings than common stock. Preferred shares generally have:
- Dividend that must be paid out before dividends to common shareholders
- The shares usually do not carry voting rights
For both private and public company, the equity is divided in a given amount of share. The
difference is that for the private company the shares are traded privately, while for public
company the shares are traded on stock markets. The main aim of financial markets is to:
Allow for the separation of Ownership and Management -> agency problems
Transfer money across individuals and time
Provides liquidity to shareholders
Allocation of risk (by creating a portfolio of assets)
They are divided in Primary and Secondary market
In a corporation, ownership and direct control are typically separated. Specifically,
shareholders, who own the company, can indirectly control the firm by electing the Board of
Directors. The Board of Directors is elected by a voting procedure in which each share
counts for one vote.
Board of Directors: the ultimate decision-making authority and et-up the main strategy
followed by the firm.
Chief Executive Officer (CEO): the one entitled to run day-to-day the firm.
Chief Financial Officer (CFO): the one entitled to take investment decisions, take financing
decision, and managing the cash for the treasury.
The main aim of shareholders is to maximize the value of their shares, but they do not run
directly the firm. Sometimes this can lead to agency problems. We have agency problems
when the managers work for their self-interests). The shareholders have three possible tools
to enforce that the managers work to maximize the value of the shares rather than their
own wealth. They can:
1. Limit the managers’ compensations.
2. Tie the management’s compensation to firm performance.
3. Replace the CEO by through a so-called hostile takeover.
The hostile takeover allows us to formally introduce the concept of the stock market.
Risk and Return of Stocks and Indexes
From the investor perspective, buying the stocks of a corporation is equivalent to investing.
The investment can be of two types: Real and Financial. An investment in stocks can then
be seen as a Financial Investment. The following differences between the two investment
types exist:
Real Assets
Have productive capacity (not covered in the course)
Examples: land, buildings, machines, intellectual property (not covered in the
course)
Financial Assets
They are claims on real assets (not covered in the course)
They do not contribute directly to productive capacity (not covered in the course)
, Fixed income security promises a fixed stream of income determined by a
specified formula
Equity: represents ownership share in a corporation
Derivative: provides payoffs that are determined by the fluctuation of the related
currency
Investment in currency: the payoffs are determined by the fluctuation of the
related currency
Commodity futures: the payoffs are determined by the fluctuation of the
commodity’s prices
If you buy a stock of a generic firm and keep it for one year, then the price of such stock
according will be equal to:
D 1 + P1
P0=
1+r
Where P0 and P1 are the prices of the stock when you buy it and sell it respectively, D1 is the
dividend paid by the firm after the first year and r, from the firm perspective, is the equity
cost of capital. From the investor perspective instead, it represents the expected return on
its shares.
There are at least two good reasons to use the return series of financial securities instead of
price series:
1. Investors are concerned about the return of his assets.
2. Given their properties, return series can be handled easily concerning price series.
It is possible to verify how risky an asset is by using the return series of assets.
The return can be decomposed into two parts. Starting from the previous central equation
and solving for r, we can write down:
Where written like this, r is called Total Net Return. The total return decomposes profits of
the shareholders in two parts: the first one indicates how much of these profits come from
dividends, while the second part suggests how much comes from selling the stock on
financial markets.
Computing a return timeseries
On the right the relation between Risk and Return is
exhibited. Note that to higher risk (σ) is associated with a
higher average return (r).
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