Lecture notes Principles of Asset Trading
Lecture 1 (9-9-2020): 1, 2.1 and 2.2
Tangible assets = can be touched; intangible assets = cannot be touched.
Book is a bit broader than this course, covers the basics very well.
Corporation = shareholders (want to increase value) + management board (manage company) and
supervisory board (protects stakeholders); management board + supervisory board come up with
proposal, shareholders vote for or against proposal.
Financial manager = connects the market to what the company develops/produces by selling it; the
money then flows back into the financial market through dividends (to stockholders) or coupons (to
bondholders); the company gets money from the market through selling stocks or bonds.
Buybacks = when a company buys their own outstanding shares.
Bond: coupon payments + nominal value = cash flow streams; when the coupon percentage becomes
lower that the interest rate (interest rate goes up) the price (for trading) of the bond will
decrease; when the coupon percentage is higher than the interest rate, the price you pay for the
bond is higher than the face value.
Dividends on stocks are uncertain, but coupons on bonds are certain.
Deterministic cash flows = amount is known in advance.
Stochastic cash flows = amount is unknown, and time of cash flow is unknown (stochastic point in
time); for example: cash flow from car insurance after an accident.
Hedging = ensuring the exposure you have on something, protecting it.
Money right now it better than money later (because of inflation).
Present value = the value of a cash flow later in time as if you have it right now; PV = cashflow / (risk
free) interest rate (1.05 = 5% interest rate); the interest rate of a similar project with the same risk is
used in the formula.
Net present value = present value of a project - initial investment; when NPV > 0, the project creates
value.
Future value = opposite of present value: the value of money right now as if you have it in a point in
time in the future.
Opportunity costs of capital = the average return offered in the market for an investment with the
same risk profile; is a percentage.
Rate of return (RoR) = (earnings of an investment - initial investment) / initial investment; also a
percentage.
Internal rate of return = the rate of return scaled to an annual value; for when the investment has a
number of different cash flows on different points in time.
You determine if you should invest in a project by:
1. NPV rule: NPV should be positive
2. Rate of return rule: rate of return should be higher than opportunity costs of capital
Whether a person wants to invest in a certain project also depends on the type of person: is he a
consumer (wants to spend their money now) or a saver (wants to increase their savings)?
1
,The x-axis is the saver, and the y-axis is the consumer. The €370.000 is what they both have in their
savings account. With the risk-free interest rate this will be €385.000 in a year if they leave it in the
bank. When the person uses their savings to invest in the project, they will have €420.000 in a year
good investment for saver. Because the project has a risk-free return, they can take also out a
loan right now for €400.000 good investment for consumer.
This shows that the NPV rule is a general rule, for a person that wants to save or consume. This is
only true if the capital market is efficient: (almost) the same (interest) rates for saving and borrowing
money.
The goal of the board of the company = create stakeholder value (American approach: create
shareholders value). Creating stakeholder value is done by creating profit through investing or paying
out dividends. The stakeholders are also the employees so this could be by buying a new office for
the employees etc.
Lecture 2 (16-9-2020): 2.3 and 3.1
What discount rate should be used with the PV formula. The discount rate increases when risk of the
project increases.
The average rate of return that exists for the same type of project (same risk) in de market should be
used as the interest rate for the PV formula (= opportunity costs of capital).
The interest rate that exists on a loan from a bank has nothing to do with this, they compile this rate
on the risk that you can’t pay the loan back (more risk = higher rate).
The PV formula for a perpetuity is based on what money you need to have in the bank to come up
with the yearly amount to pay to the person that has the perpetuity: P=A/r.
When the perpetuity doesn’t start next year, but n years from now, you discount the first payment to
one year from now, so it is the same as a normal annuity (see summary for formula).
The formulas for the perpetuities above can be combined to make the formula for an annuity
(payment that starts next year and ends at year n).
2
,Amortization = calculating what amount you accumulate every year from the interest rate of a bank
(A from P). Or what you need to accumulate to pay a certain perpetuity.
Different types of mortgage: amortization, aflossingsvrij, linear, savings (tax opportunity) doesn’t
exist anymore.
Simple interest = every year you get a percentage of interest on the initial amount: A n = (1+nr)A0.
Compounded interest = every year you get a percentage of interest on the amount on your bank
account which accumulates interest payments of past years (interest on interest): A n = A0(1+r)n. The
amount you can receive from compounded interest gets higher when
the times the interest is paid out gets more (every day or every
second), it converges to the limit here.
Exposure = long: make money when stock goes up; short: lose money
when stock goes up. Exposure mean being exposed to the movements of particular stocks or the
market.
Hedging = decreasing risk with having a certain exposure: limits exposure.
Effective return = for example your bank pays 5% interest in a year, but they pay is quarterly, so the
effective return is 5,09%. It is the actual return you get.
Nominal return = the yearly 5% interest is the nominal return, so the yearly return.
Bonds = loans issued by corporations or by the government that can be traded. PV of a bond is the
PV of every coupon payment plus the PV of the final nominal payment added together. If the coupon
(for example 5%) is the same as the current market rate (discount rate), then the price of the bond is
the same as the nominal value. If the coupon is higher than the current market rate, the price of the
bond is higher than the face value. So when the current market rate goes down, the price of the
bond will go up.
Calculation PV bond with 5% coupon, €100 face value and 4% current market interest:
PVcoupons = €26,21 and PVnominal = €79,03, so the PVbond = 26,21 + 79,03 = €105,24
You could also calculate the interest of the market when you know the PV of the bond and the
coupon. We call this the yield to maturity (= what you will earn from a bond if you keep it until
maturity). The yield to maturity thus says something about the current market interest. YTM is
calculated with the following formula:
3
, The solution to this equation should be solved in excel, because the polynomial has a too high
degree.
US government bonds pay twice a year a coupon: 5% US bond = 2.5% payment first half year and
2.5% payment second half year, every year. EU bonds pay once a year.
Bills = short-term bonds, < 1 year, no coupon payments
Bonds = 1 – 10 year bonds, there are coupon payments
Notes = > 10 year bonds, there are coupon payments
Bonds that are issued nowadays usually have a coupon of around 1 – 2%. Bonds that are issues a long
time ago will have higher coupons, because the market conditions were better at that time.
The yields that are calculated for bonds, that will expire soon, give an estimation of the short-term
interest rate of the market (slightly negative, close to 0 in the US right now).
Asked yields are calculated using the ask price, not the same as the normal YTM.
Bonds that will mature soon are usually traded between big companies for access liquidity that they
don’t want to put in a bank because it has more risk. Thus, they invest it for 2 weeks or less until they
pay salaries. Used as checking accounts.
Bloomberg terminal = news service for financial instruments and data with details and also a real
time feed of the news.
Accrued interest = the coupons that have already been paid to the owner of the bond after it being
issues. When the bond is sold to a new owner, the old owner has to pay for the payments they
already received.
Lecture 3 (23-9-2020): 3.2 – 3.5, 4.1 and 4.2
Yield curve of a bond shows the sensitivity to changes in yield (volatility) and coupon percentage. The
graph shows the price of the bond against the yield of the market.
The coupon of the bond is around the same value of the interest rate of the market / yield. So bonds
that have a high coupon were probably issued a while ago, since the market rate is 0% nowadays.
Duration = the average time to maturity of the bond; bond with coupons: 0 < D < T, bond without
coupons: D = T. The higher the coupon payments are, the higher the weight of these payments are
against the final payment higher average maturity and thus higher sensitivity to changes in yield.
Smaller coupons D is closer to T (time to maturity). Duration is the same as the delta for options
(delta shows the sensitivity of the option price to a change in the underlying stock).
When finding the duration for different bonds, you find that:
Volatility is also called modified duration.
To calculate the change in price ∆ P of a bond by a change in yield in the market ∆ y we use the
following formula (see assignment 1):
4
