ECN241 Asset Pricing - Week 1 Lecture Slides PDF

ECN241 Asset Pricing ECN 241 Asset Pricing* Lecture 1 *Some slides contain material from Bodie, Kane & Marcus (2021). Investments, 12th Edition. McGraw-Hill....

ECN241 Asset Pricing ECN 241 Asset Pricing* Lecture 1 *Some slides contain material from Bodie, Kane & Marcus (2021). Investments, 12th Edition. McGraw-Hill. 1  ECN241 Asset Pricing About the module ECN241 replaces ECN226 “Capital Markets 1” The aim of this course is twofold: to provide training in the theory of investment and capital markets and introduce you to the main concepts in this area. to introduce you to coding in Python: weekly IT classes with Xiaoyu and Teng. We will study: the pricing of the main securities in capital markets. the most fundamental asset pricing models (CAPM, APT). optimal portfolio choice and market efficiency. Introduction 2  ECN241 Asset Pricing About the organiser Jan Toczynski Email: [email protected] Office: GC510, School of Economics and Finance Office hours: Tuesdays, 13-15 pm. Teaching Assistants: Xiaoyu Zheng: [email protected] (office hours: Thursday 9-11 am) Teng Jiao: [email protected] (office hours: Wednesday 3-5 pm) Introduction 3  ECN241 Asset Pricing Assessment Midterm exam (20%) – during lecture 6, 1 hour on 01.11.2024. Individual project (30%) – a coding exercise on portfolio analysis. Final exam (50%) – mainly on the “theory” part of the class, but with simple Python/programming questions. Introduction 4  ECN241 Asset Pricing Real vs. Financial Assets Real Assets Financial Assets They are used to produce goods and Do not contribute directly to productive services. capacity. Tangible and non-tangible; Claims on future economic outputs; Real estate vs. patents. ⇒Holding a firm’s equity confers Examples: real estate, natural ownership of part of the company resources, land, machines, patents, and entitles the owner to part of the factories, intellectual property, human income generated using real assets capital/talent. Examples: stocks, bonds, deposits. Distinguish between different types of financial assets 5  ECN241 Asset Pricing Real vs. Financial Assets Real assets generate net income for the economy. Financial assets define the allocation of income or wealth among investors. Household wealth: Real Assets + Financial Assets Financial Assets are Liabilities for the issuers of the securities. ⇒ A deposit in a bank is an asset for the holder, while it is a liability for the bank which owes you the amount of your deposit. ⇒ A bond is an asset for its owner and a liability for the issuer. This means that, at the aggregate level, financial assets and liabilities cancel each other out, leaving only real assets as the net wealth of the economy. Distinguish between different types of financial assets 6  ECN241 Asset Pricing Types of Financial Assets 1) Fixed Income or Debt Securities 2) Equity 3) Derivatives Distinguish between different types of financial assets 7  ECN241 Asset Pricing 1) Fixed Income or Debt Securities Fixed-income or Debt securities represent the debt of the issuer to the investor. Fixed stream of income or determined by a formula: ⇒ U.S. government bonds (T-bills). ⇒ floating rate: interest payable at a margin over a benchmark (SONIA, BOE base rate). Investment performance of debt securities is closely tied to the financial condition of the issuer. Money Market vs. Capital Markets Short term debt instruments (1 year). Note: we also classify equities as Capital Markets instruments! Distinguish between different types of financial assets 8  ECN241 Asset Pricing Money Market Instruments Maturity < 1 year. These instruments are used for managing liquidity and funding short-term needs. Highly marketable debt securities (so tend to be more liquid) and generally safer investments. Money Market Instrument 2023 Q4: Outstanding (billions of $) Treasury Bills 4,241 Commercial Paper 969 Federal Funds and Security Repos 968.7 Source: the Federal Reserve Economic Data (FRED) provided by the St. Louis Federal Reserve Distinguish between different types of financial assets 9  ECN241 Asset Pricing Capital Market Instruments The capital market instruments serve to raise long-term capital, finance company growth and large-scale investments. Debt and equity instruments have wider price fluctuations than money market debt instruments, so they are relatively riskier. Capital Market Instrument 2023 Q4: Outstanding (billions of $) Corporate Equities 77,571 Total Residential Mortgages 16,170 Corporate and Foreign Bonds 15,597 Total Consumer Credit 5,024 Source: the Federal Reserve Economic Data (FRED) provided by the St. Louis Federal Reserve Distinguish between different types of financial assets 10  ECN241 Asset Pricing 2) Equity Represents an ownership share in the corporation. Receive dividends (not promised any) and have prorated ownership in the real assets of the firm. Residual claimant. An investment in equity is tied directly to the success of the firm and its real assets. Distinguish between different types of financial assets 11  ECN241 Asset Pricing How big is the equity market? Source: sifma Global Equity Markets Primer Distinguish between different types of financial assets 12  ECN241 Asset Pricing 3) Derivative securities What is a Derivative? A financial instrument whose value depends on another asset (the underlying asset), such as stocks, interest rates, exchange rates, or commodities. Key Features: Payoff: Dependent on the value of the underlying asset/variable. Contracts: Legal agreements to buy/sell the underlying asset at a future date, or to capitalize on changes in its price. Purpose: Used to hedge risk or for speculation. Examples of Derivative Contracts: Futures: Agreement to buy/sell an asset at a future date at a specified price. Options, Swaps, Forwards Distinguish between different types of financial assets 13  ECN241 Asset Pricing 3) Derivative example: futures The Problem: A wheat farmer worries that wheat prices might fall by harvest time. The Solution: The farmer uses a futures contract to lock in a selling price for the wheat today. How It Works: Today: Farmer agrees to sell wheat at $100 per ton in 6 months, regardless of the market price. What Happens Later? If prices drop to $80/ton: The farmer still sells at $100/ton—avoiding losses. If prices rise to $120/ton: The farmer sells at $100/ton—missing extra profit but staying safe from risk. Key Takeaway: Hedging protects against price drops, offering certainty and stability. Distinguish between different types of financial assets 14  ECN241 Asset Pricing 3) Derivatives markets Often traded OTC (Over-the-counter) but standardized contracts are also exchange- traded. Over $700 trillion! Distinguish between different types of financial assets 15  ECN241 Asset Pricing Financial markets Broadly, any marketplace where financial assets are traded. Some assets exchange-traded, some OTC-traded. Financial Instrument Main Mode(s) of Trading - Exchanges Equities - Electronic Trading Systems - Over-the-Counter (OTC) Fixed Income Securities - Dealer Markets - Exchanges (less common) - Exchanges Derivatives - Over-the-Counter (OTC) The term is often used in an abstract sense, referring to “all financial markets” at once. Distinguish between different types of financial assets 16  ECN241 Asset Pricing Functions of financial markets 1. Informational – prices reflect “consensus” assessment/expectations of projects’ value. Markets help channel resources to uses that seem most promising. 2. Intertemporal consumption shifting – financial assets allow to “move” resources across time. For example, young people save to spend after they retire. 3. Allocation of risk – financial assets allow to re-allocate risk across the economy. 4. Separation of ownership and management – one can own a company without being directly involved in its management. can create agency problems due to asymmetric information, where the managers may have more information about the company's operations and may not always act in the best interest of the shareholders. Functions of financial assets 17  ECN241 Asset Pricing The Investment process We will learn how to analyze investments in financial markets. A portfolio is a collection of investment assets, which can be rebalanced after it is established. Two types of decisions when constructing portfolios: Asset Allocation: Choice among broad asset classes ⇒ e.g., stocks, derivatives, real estate etc. Security selection: choice of which securities to include within each broad asset class ⇒e.g., Include stock A or B? The investment process 18  ECN241 Asset Pricing The Investment process Top-down portfolio construction: Broad asset allocation followed by a determination of particular securities to be held in each asset class. Bottom-up approach: Investment based on attractively priced securities without as much concern for asset allocation. The investment process 19  ECN241 Asset Pricing Risk-Return profile of asset classes The decision to allocate your investments to the capital markets (stocks or bonds) or to the Treasury money market bills will determine the resulting risk-return portfolio. Average returns: UK risk categories 1900-2000 Mean returns % St. Dev. % Equities 7.6% 20% Bonds 4.3% 14.5% Treasury Bills 2.3% 1.2% Inflation 6.6% 6.9% Source: Dimson, E., Marsh, P. & Staunton, M., 2002. Triumph of the Optimists: 101 Years of Global Investment Returns. Princeton, NJ, and Oxford: Princeton University Press. The investment process 20  ECN241 Asset Pricing Markets are competitive Investors invest for anticipated future returns. but at the same time, they would prefer low risk. Would you prefer a certain 5% return or a “maybe” 5% return? Markets are highly competitive. sophisticated investors scour the markets for bargains. If the price of a stock is low relative to its perceived riskiness, investors would keep buying it, driving the price up. Proposition: in competitive markets, there should be no “free lunches”. ⇒ [Implication 1] risk-return trade-off. If you want higher returns, you might need to accept higher risk. Competitive markets 21  ECN241 Asset Pricing Efficient Markets Hypothesis If there are no free lunches, then the markets should quickly price in any new information about a security and correct any mispricing. ⇒ [Implication 2] Efficient markets. “A market in which prices fully reflect available information is called efficient.” (Fama, 1970). In Efficient Markets: New information -> price quickly adjusts; no mispriced securities. No mispriced securities -> you cannot systematically “beat the market”. But someone must buy/sell first for the price to adjust… Active trading is needed to correct mispricing and “implement” market efficiency. Competitive markets 22  ECN241 Asset Pricing Efficient Markets Hypothesis Market is efficient with respect to “some information set” - it is impossible to make economic profits based on this information set (after the prices adjust). The classic taxonomy of information sets distinguishes: Weak-form Efficiency: ⇒The information set includes only historical information Semi strong-Form Efficiency: ⇒All publicly available information Strong-form Efficiency: ⇒All information known to any market participant (including private information). Competitive markets 23  ECN241 Asset Pricing Active and Passive Investment Strategies Active and passive investment strategies 24  ECN241 Asset Pricing Passive Investment Strategy Passive investment is based on the premise that securities are fairly priced (i.e., the market is efficient), thus avoiding the costs involved in undertaking security analysis. The simplest case of the passive investment is the index fund which is designed to perfectly replicate a well-identified index of common stocks (S&P 500 or the UK FTSE100). Trade-off between accurately duplicating the index (tracking error) and the transaction costs. Active and passive investment strategies 25  ECN241 Asset Pricing Passive Investment Strategy Construction of portfolios tailor-made to meet specific risk-return patterns (small stock index funds, low P/E ratio funds, etc.) For example: Investors in high tax brackets would tilt their portfolios towards stocks that yield capital gains and not dividends (when the former are taxed less). Generally, older investors are more risk averse than younger investors. Active and passive investment strategies 26  ECN241 Asset Pricing Passive Investment Strategy An assumption of strong form efficiency, where all information is available to all, suggests that passive portfolio management is the only feasible option. The benefits of such a strategy include:- minimisation of transaction costs- minimisation of management fees- free rider benefit. The disadvantages include:- performance dictated by index - lack of control. Active and passive investment strategies 27  ECN241 Asset Pricing Active Investment Strategy Active investors employ sophisticated techniques to achieve excess returns and outsmart other investors. A popular classification of active investors is: 1.Market timers: they change the beta of the portfolio based on their forecasts. 2.Security selectors: they make a positive bet for undervalued securities and the opposite. 3.Sector selectors: try to identify sector and/or industry is undervalued/overvalued. Active and passive investment strategies 28  ECN241 Asset Pricing Active Investment Strategy The predictive content of forecasts used in active management must be sufficiently large to overcome: Higher management fees of active relative to passive investment strategies. Higher transaction costs. A significant proportion of active investors in a given market will underperform in the long run, irrespective of the level of market efficiency. This is because active management is a zero-sum game. Active and passive investment strategies 29  ECN241 Asset Pricing Active Investors and Market Efficiency Even if we accept that markets are almost efficient, there is a role for active investors. Market efficiency prevails when some investors are willing to depart from a passive strategy, and correct, in an unbiased and timely manner, any mispricing (note the symbiotic relationship between active investors and market efficiency!). What would happen if all investors in the market followed a passive strategy? Mispricing would not be corrected, markets would not be efficient! Active and passive investment strategies 30  ECN241 Asset Pricing Time Value of Money Investing money in a particular project → generate cash inflows in the future, greater than the amount invested. Must consider also: 1. The time value of money: $100 now is not the same as $100 50 years ago. 2. The investors opportunity cost: the sacrifice of the return available on the best forgone alternative (e.g., putting the money in a term deposit). Investments must generate at least enough cash for all investors to obtain their required returns. Time value of money 31  ECN241 Asset Pricing Time Value of Money Compensation is required to induce people to make a consumption sacrifice (investing and getting money later rather than using it now). Compensation will be required for at least three things: 1. Impatience to consume - Pure rate of interest: rate of exchange between certain future consumption and certain current consumption. 2. Inflation. 3. Risk. Time value of money 32  ECN241 Asset Pricing Time Value of Money Investor A is considering a one-year investment. Risk-free rate: A return of 2 percent is required for the pure rate of interest; Inflation 3 per cent over the year; To compensate the investor for impatience to consume and inflation the investment needs to generate a return of 5.06 percent, that is: (1 + 0.02) (1 + 0.03) – 1 = 0.0506 5.06% is called the (nominal) risk-free rate (RFR) – this assumes that there is no risk. If the investment is risky, the investor will require additional compensation: risk premium. Required return = RFR + Risk premium Time value of money 33  ECN241 Asset Pricing Opportunity Cost of Capital The required rate of return represents the Opportunity Cost of Capital (OCC). The OCC is the return investors expect from the next best alternative investment with a similar risk profile. Represents the minimum return required to justify investing in a particular asset. Risk-Free Rate is the rate investors expect from a risk-free asset. Relation to Risk-Free Rate: The nominal risk-free rate serves as the baseline for OCC. For risky investments, OCC includes the risk-free rate plus an additional risk premium to compensate for taking on extra risk. Time value of money 34  ECN241 Asset Pricing Present Value – Example 1 Test Plc is considering investing in Machine “A”, which will result in the following cost reductions over time. The minimum required return by this company is 12%. To compare money today with money that will be received in the future, the future money needs to be discounted by the time value of money. => Express them in today’s terms (in a common currency) Time value of money 35  ECN241 Asset Pricing Present Value – Example 1 Test Plc is considering investing in Machine “A”, which will result in the following cost reductions over time. The minimum required return by this company is 12%. £3,571 today is equivalent to £4,000 next year. In total, future cash flows are worth £20,479 now, assuming a 12% required return. 12% is called the discount rate. We say that a cash flow is “discounted” to the present value. 1/(1+discount rate)^n represents the exchange rate of future and Time value of money present cash flows. 36  ECN241 Asset Pricing Present Value – Example 2 Your portfolio manager has the following deal for you. Buy land for £400,000 and sell in a year for £450,000. If the risk-free rate of return is 10%, should you invest? Time value of money 37  ECN241 Asset Pricing Present Value – Example 2 1) If you did not invest and put the same £400,000 in the bank, you would have £400,000 × (1 +0.10) = £440,000 available next year. £440,000 < £450,000 so you would invest. 2) You can make this conclusion by calculating the present value (PV) of £450,000 as: 450,000 PV = 1 = 409,091 > 400,000 (1+0.1) which is larger than the value of the investment. 3) What if the sell price is uncertain? Assume an additional 5% to account for risk, then: Discount rate 450,000 PV = 1 = 391,304 < 400,000 represents the (1+0.1+0.05) OCC, here with now, the investment is not beneficial. a risk premium Time value of money 38  ECN241 Asset Pricing Net Present Value (NPV) Definition: Net Present Value (NPV) is the present value of future cash flows discounted at a rate reflecting the opportunity cost of capital, summing them over the life of the project and deducting the initial (and any other future) outlays. The NPV formula is: 𝑛 𝐶𝐹𝑡 𝑁𝑃𝑉 = ෍ (1 + 𝑖)𝑡 𝑡=0 If NPV≥0, then Accept the project. => the project’s rate of return is higher than the opportunity cost of capital. If NPV the project’s rate of return is lower than the opportunity cost of capital. Time value of money 39  ECN241 Asset Pricing Net Present Value (NPV) Consider a project with the following cash flows. If the discount rate is 10%, what is the NPV of the project? Time value of money 40  ECN241 Asset Pricing Net Present Value (NPV) NPV > 0, we accept the project as it has a higher present value than the alternative. Time value of money 41  ECN241 Asset Pricing Annuities – application of discounting techniques Sometimes you can simplify the discounting… An annuity is an asset that pays a series of identical payments made over a period of years (e.g., a house mortgage) Method 1: 𝐴 𝐴 𝐴 𝐴 𝑃𝑉 = + 2 + 3 +⋯+ 𝑛 , (1 + 𝑖) (1 + 𝑖) (1 + 𝑖) 1+𝑖 where A = the periodic receipt and n is the number of year Method 2: 𝐴 1 This formula will save 𝑃𝑉 = (1 − ) us some work next 𝑖 1+𝑖 𝑛 week! Annuities 42  ECN241 Asset Pricing Annuities – application of discounting techniques You have won the lottery, and you can choose to receive £100,000 immediately, or £19,000 for 10 years, starting from next year. The interest rate is 12%. The present value of an annuity of 19,000 for 10 years at a 12% interest rate is: 19,000 1 𝑃𝑉 = 1− 10 = 107,354 0.12 1 + 0.12 The annuity is better than receiving the full amount of £100,000 immediately. Annuities 43  ECN241 Asset Pricing Compound Interest Compound Interest rate: if r is an interest rate compounded annually and we deposit/invest D for n years, then at the end of the investment period we will have: 𝐹 = 𝐷 ∗ (1 + 𝑟)𝑛. Calculate a project’s annualized rate of return. Starting from the compound interest rate formula 𝐷 ∗ (1 + 𝑟)𝑛 , we solve for r as follows: 𝑛 𝐹 𝑟= −1 𝐷 ⇒Example: 1) Deposit £8,000 today and receive £10,000 in 5 years. 2) the interest rates on deposits elsewhere compounded annually is 6% per annum, is this a good deal? 5 10,000 The rate of return on product 1) is r = − 1 = 4.6%. Not a good deal! 8,000 Compound interest 44  ECN241 Asset Pricing Compound Interest How many years will it take until you double your initial investment given an interest rate? Starting from the compound interest rate formula 𝐹 = 𝐷 ∗ (1 + 𝑟)𝑛 , we solve for n as follows: 𝐹 log( ) n= 𝐷 log(1 + 𝑟) How long will it take to double your initial investment if your financial advisor promises a return of 10% per annum? 2 log( ) n= 1 = 7.27 𝑦𝑒𝑎𝑟𝑠 log(1 + 0.1) Compound interest 45  ECN241 Asset Pricing Compounding frequency Compounding may occur more frequently than just once a year. If that is the case compounding an investment m-times a year provides end-of-year wealth of: 𝑟 𝑚 𝐹 = 𝐷 ∗ (1 + ) 𝑚 Example: What will your end-of-year wealth be if you deposit £1,000 in a bank that compounds interest monthly and the nominal return per year is 24%? Monthly: 1,000 x (1+[0.24/12])^12 = £1,268.24 Compound interest 46  ECN241 Asset Pricing Introduction to Python What is Python? High-level, general-purpose programming language. Known for its readability and simplicity. Very popular in the industry, especially for data science and machine-learning applications. Very common in the finance industry! Source: https://x.com/Python_Dv/status/1753828947232448832 Python - Introduction 47  ECN241 Asset Pricing Why learn Python? Highly useful in the industry. Easy syntax: (relatively) close to plain English, beginner-friendly. Extensive libraries for: We will focus on these in Web development (Django, Flask). our class Data science (Pandas, NumPy) Machine Learning (TensorFlow, Scikit-learn) Automation (Selenium, Requests) Python - Introduction 48  ECN241 Asset Pricing We will be learning how to write this… Python code example Python - Introduction 49  ECN241 Asset Pricing How will we learn Python? I will briefly discuss the key concepts during the lectures – we assume no prior exposure to programming. TAs will expand on this in the IT tutorial classes. You will be given (optional) Python exercises to work on at home. Feedback: The Python part is new to this course – we appreciate your feedback (too slow, too fast?). Let me know if you have any issues with the Programming part. Learning programming might be daunting and slow at the beginning, but this is the part of the class that will be most useful for you in the long term. Python - Introduction 50  ECN241 Asset Pricing Python – getting started You will be provided with a Python installation in the IT room. In principle, this is all you need to succeed in the class. To practice at home: You can install Python yourself. Download and install Anaconda: https://docs.anaconda.com/anaconda/install/windows/ this will automatically install a version of Python. Alternatively: Python from python.org. Ask the TAs if you have any problems with it! PyCharm (IDE) is a Python editor (a text tool where we write code). Anaconda is a programming distribution platform – it simplifies editor/package management (e.g., you can access other Python editors through Anaconda without the need to install them separately). Python - Introduction 51  ECN241 Asset Pricing Python – online compilers You can use online web-based compilers to play around with simple code (highly recommended). 1.https://www.programiz.com/python-programming/online- compiler/ (easy to use, no registration) 2.https://replit.com/ (requires registration) 3.https://colab.research.google.com/ (no registration, uses ipython) If you use these, only use the FREE versions, no need to pay for anything. Python - Introduction 52  ECN241 Asset Pricing Variables and variable assignment Variables “store” data in Python (a number, a text, a table…) How do I create a variable? E.g., type “ x = 5 “. This is called an assignment. A variable can be thought of as a box in the computer’s memory that holds a “pointer” to an object/value. x 5 If you refer to X in the code, the code will retrieve whatever the pointer points to. If you write: x=5 The variable now points to another value. We overwrote x = 10 the pointer with another assignment. If you type x now, x it points to 10; 5 is forgotten. Assignments such as y = x set y to point to the same 5 thing as x, not to x. So, if you overwrite x, y stays the same. 10 Python - Introduction 53  ECN241 Asset Pricing Variables and Data Types Basic data types: int: Integers, e.g., x = 5 float: Floating-point numbers, e.g., y = 3.14 str: Strings, e.g., name = "Alice“ print() function is used to bool: Boolean, e.g., is_active = True output data to the console. type() function returns the type of a given object or value. Python - Introduction 54  ECN241 Asset Pricing Basic Operations with Variables Simple arithmetic operations: Addition (+) Subtraction (-) Multiplication (*) Division (/): Returns a float. Floor Division (//): Returns an integer (rounded down). Modulus (%): Returns the remainder of a division. String Operations: Concatenation (+): Joins two strings. Repetition (*): Repeats the string a specified number of times. Different operations/functions will require different data Be careful: Mixing incompatible types (e.g., string and types. Always be mindful of data types. Here, it is easy to integer) leads to errors. spot problems, but in more advanced applications, this might become a real headache! Python - Introduction 55  ECN241 Asset Pricing Basic Operations with Variables Logical operations: “and” / ”&” “or” / ”|” There is a subtle difference between the two approaches. No need to “not” / “!=“ worry about it now! Change data type: str() – change to string. E.g., 3 the number becomes “3” the text. int() – change to integer. float() – change to float. Python - Introduction 56  ECN241 Asset Pricing Next time… We learn about bonds and how to price them. For-loops and lists to automatize cash flow discounting. Go through your problem sets! Python - Introduction 57  ECN241 Asset Pricing Conditions and if statements Logical conditions: Equals == Greater, Smaller, >, < Greater or equal, Smaller or equal >=, 5) this evaluates as boolean “True”. Common usage: in conditional “if” statements. if (condition): do something elif (condition): do something else else: do something else Python - Introduction 58