Lecture 8: Historical Returns in Investments PDF

Lecture 8 The study of historical returns is important process in investments as they provide perspective and forecasting purposes ○ Overall risk vs return profile of an investment ○ How an investment might react to some news in the future ○ Current retur...

Lecture 8 The study of historical returns is important process in investments as they provide perspective and forecasting purposes ○ Overall risk vs return profile of an investment ○ How an investment might react to some news in the future ○ Current returns vs where they will go in future – reversion to the mean Reversion to the mean ex: Current 2-year returns for Stock A: 20%, Long term return: 5%. Eventually the current return of 20% will return back to the 5% mean return. Same thing would happen if the current return was -20% instead of 20%. They will revert back to the mean ○ Used in valuation models Several firms have developed aggregate measures, indexes, of the stock market to help measure the historical returns an investment in common stocks would have provided ○ Index examples: Dow Jones, S&P 500 Indexes that have been developed differ in the stocks that are included in them and how each stock is weighted Total Market Value of Shares = Shares outstanding * Stock Price Class example: 3 stocks make up an index of stocks, Stocks X, Y and Z How should these three securities be weighted to determine the average price and return from the Initial Price to the New Price? Price weighted: Average price = simple average of the prices Value weighted: Average Price = Total Market Value of All Shares / Total # of shares Geometric weighted: Average Price = Multiply prices and take the nth root of the product  Different methods of calculating averages can produce different measures of stock performance. There isn’t one right answer. Price weighted average is dominated by the higher priced stocks Value weighted average is dominated by the stocks with the highest value (total market value of shares) ○ Value weighted average is the most common type of index Geometric weighted average treats stocks equally so all stocks, regardless of share volumes or price have an equal impact on the index price Base years and co,position of the index are important when looking at stock returns Dow Jones Industrial Average ○ Includes 30 large blue-chip corporations Computed since 1896 Price-Weighted Index ○ S&P 500 Broad based index of 500 firms Market-Value-Weighted Index Investors can base their portfolios on an index ○ Buy an index mutual fund ○ Buy exchange-traded-funds (ETFs) Even though different indexes have different portfolios, they tend to vary together, meaning they have a high correlation Vix Index- measure of the investor’s sentiment ○ Aka a “fear index. It rises during periods of volatility. It is inversely related with how well the stock market performs  Class example: ○ Average annual return = (70 - 26.5 + 20) / 3 = 21.17% Implies earned 21.17% each year = 20 * (1.2117)3 = 35.58 = $15.58 gain Thats not what happened. Stock only went from $20 to $30 Gain only equals $10 (30-20) → simple average bias returns upwards Solution = use geometric returns = “true annualized return” To do this, add 1 to each return, multiply them, and then compute the nth root, then subtract 1. This is much closer to the actually answer than the simple average When computing stock returns need to consider ○ Change in price from purchase price ○ Income (dividends) ○ Time - how long you owned it Holding period returns (HPR)- The percentage earned on an investment ○ Ex: Buy stock at $40, collect $2.00 dividends, sell stock for $50 HPR = (P + D - P0)/P0 > (50 + 2 - 40)/40 = 30% ○ Since HPR does not consider the length of time, If time > 1 year, HPR overstates the true annual return. A simple average of HPR also overstates true annual return Dollar Weighted Rate of Return aka Internal Rate of Return (IRR)- The percentage earned on an investment during a period of time  ○ ○ Use “Rate” function on excel to calculate ○ If there are dividends, ○ Use “rate” function on excel and put dividends under payment Time Weighted Rate of Return - The percentage earned on an investment during a period of time but ignroes the dollars amount invested ○ Alternative to Dollar Weighted; not always equal but can be ○ Most commonly used method to calculate returns ○ Step 1: Get HPRs, Step 2: Geometric Average Ex: You purchase a stock for $100 that pays an annual dividend of $5.50. At the end of first year the stock is at $130. At the end of the second year, you sell your shares for $140 Two 1-year holding periods: Year one: ($130 + $5.50 -100)/$100 = 35.5% Year two: ($140 + $5.50-130)/$130 = 11.9% Time weighted Rate of Return = Geometric Average [(1 + 35.5%)(1 + 11.9%)]^½ - 1 = 1.231 -1 = 23.1% = True annualized return Studies of annual stock returns have found investor have earned an annual return of approximately 10% Two simple strategies = goal is to reduce average cost basis of the stock owned ○ Dollar Cost Averaging- the purchase of securities at different intervals to reduce the impact of price fluctuations Make the same $ amount purchase each time. More shares purchased when shares fall means that if the stock subsequently rises, you will earn more proits on the lower-priced shares and thus will increase the return on the entire position ○ Averaging Down- periodic purchase of same amount of shares or the same $ amount, but only when price falls Both premises above are based on the premise that the stock price will rise again Lecture 9  Theory = stock and bond markets are driven by rational individuals making investment decisions designed to maximize returns for the risk taken ○ Reality is more complicated. Human emotions such as hope, fear, and greed affect investing Behavior finance applies psychological principles to finance and studies how human behavior affects financial decisions ○ Once the individual is aware that emotions may lead to poor investment decisions, it may be possible to overcome these emotions or at least reduce their impact Technical Analysis attempts to remove the impacts of emotions from the investment process ○ Uses historical price and volume data to forecast the direction of stock prices ○ This technique is deployed by accumulating and summarizing data in a variety of figures and charts to focus on the trend in a stock’s price or a particular price pattern to determine if the pattern has changed. ○ Once a technical indicator generates a buy or sell signal, the investor executes the appropriate trade Traditional financial theory is built upon the belief that investors are rational and that irrational behavior does not affect investment decisions. Behavioral finance suggests that human traits are not always rational, and that irrational behavior does affect investment decisions ○ For example, failing to close losing positions or increasing risk exposure in an effort to recoup losses may be driven by irrational behavior. Such bad investment decisions lead to lower returns Anchoring effect- A cognitive bias where a specific piece of information is relied upon to make a decision ○ An important part of anchoring bias is the tendency for the first piece of information to be used as the ‘anchor’. This ‘anchor’ is the reference point for future decisions, expectations, or judgments ○ Anchoring occurs to reduce the amount of cognitive load placed on our brains ○ Idea here for stocks is that the current stock price will impact investors’ ○ valuation of the stock. That is, when evaluating the true value of a company, a low current stock price leads to lower valuations, while high stock prices lead to the opposite Herding- Following the herd, lacking independent thinking ○ Herding refers to acting based on what the crowd is doing (rather than acting based on relevant circumstances)  ○ For example, if an investor sees that lots of people are selling a certain stock, the investor might sell that stock, even if that’s not a good long term-decision ○ FOMO can create stock prices to deviate from fundamental value Forecasting errors- Too much weight is placed on recent experiences (turkey example a while ago in class) Overconfidence- Investors overestimate their abilities and the precision of their forecasts Sample Size Neglect and Representativeness- Investors are too quick to infer a pattern or trend from a small sample Disposition effect- The tendency of investors to hold on to losing investments ○ Losses create feelings of regret Technical analysis attempts to exploit recurring and “predictable” patterns/trends in stock prices to find shifts in supply and demand to ○ Protect you from large losses → decrease in demand drops prices ○ Be invested as stocks rise → increase in demand raises prices ○ Trend is your friend. If you can identify a trend in the market, get on with it Dow Theory- Emphasizes movements in the industrial and transportation from Dow Jones (DJ) averages ○ Built on the idea that measures of stock prices tend to move together Movement in one average confirmed by movement in the other average indicates a trend If the DJ Industrial is rising, then so should the DJ Transportation – suggest a strong bull market If one is declining, then the other should be declining – suggests a strong bear market If both are moving in same direction, say rising, and one changes and starts declining → suggests the other will start to fall as well = signal to sell stocks Investment Advisory Opinions- Assumes investor advisory opinions are wrong ○ Requires taking a contrary view of advisory opinions (Contrarian) ○ Example: majority of financial analysts become bearish and forecast that stocks are overvalued and thus will decline. They say you should sell. A contrarian would buy Advance/Declines - Market “Breadth” indicator- cumulative series based on the cumulative net difference between the number of stocks that rose in price relative to the number that declined  ○ Moving average- an average computed over time in which the most recent observation is added and the most distant observation is deleted before the average is computed - smooths out daily price data to observe trends ○ When the daily stock price crosses the moving average line from above, you sell When the daily stock price crosses the moving average line from below, you buy ○ When the 50 day moving average crosses the 200 day moving average from below, it is a golden cross. It is a strong buy signal The golden cross works sometimes, but sometimes it does not work  ○ When the 50 day moving average crosses the 200 day moving average from above, it is a death cross. It is a strong sell signal The death cross has happened in almsot every economic crisis, however it has also happened when there was no crisis and everything was fine At first glance, technical analysis seems so appealing, however, you must realize that the efficient market hypothesis suggests that technical analysis will not lead to superior investment results ○ Nevertheless, you should be aware of it. By knowing the rules, you may avoid buying or selling when technical analysts are perhaps artificially driving up or down the price Most empirical results do not support technical analysis Lecture 10 The bond market is the biggest investment market in the world at $141 Trillion, bigger than the equity market at $115 Trillion When a company needs capital, they can sell equity/ownership shares, but the most common option is for them to borrow money or use debt. With the borrowing comes a contract, which can be turned into a bond A bond is a loan in security form The bond market is also referred to as the fixed-income market Retirees who desire a relatively stable income stream often hold fixed-income securities In a general sense:  ○ If a corporation issues a bond, they are an issuer, which means that they are the borrower They are securities commonly issued by a corporation or government with a stated interest rate and fixed dates when interest and principal must be paid Principal- the borrowed amount of money Bonds are not like stocks ○ Bond cash flows and the timing of those cash flows are usually known upfront, with stocks cash flows are unknown ○ Bondholders have a promise of repayment from the issuer but hold no ownership privileges. Bonds are a contractual obligation to borrow money The investor lendor loans the principal amount to the corporation Bond investors are basically entitled to 2 distinct types of cash flows ○ The periodic payment of coupon (interest income over the life of the bond) ○ The recovery of principal or “par value” or “face value” at the end of the bond’s term Typically, 1 bond = $1000 = Principal = Face value / par value ○ Annual payments of 10% of the principal= the coupon = $100. This coupon is fixed, meaning it is required that it be paid ○ Maturity date = 3 years which means the money will be payed back in 3 years ○ Year 0, investor pays $1000, year 1 investor gets $100, year 2 investor gets $100, year 3 investor gets another $100 plus the principal which was $1000. Jargon definitions from slides Bond- A long-term liability with a specified amount of interest and specified maturity date  Principal- The amount borrowed and owed back; the face value or par value of a debt. Usually $1,000 Maturity Date- The time at which a debt issue becomes due and the principal or face value must be repaid Interest- Payment for the use of borrowed money Coupon Rate- The specified interest rate or amount of interest paid by a bond ○ Expressed as an annual percentage of the bond's face value ○ Example: A bond with a 5% coupon will pay $50 per $1000 of the bond's face value, per year Current Yield (CY)- Annual income / the current price of the security Yield to Maturity (YTM)- The approximate average rate of return (aka “Yield”) earned on a bond from the time it is acquired until the maturity date. NOT the same as the Coupon Rate Yield Curve (YC)- The relationship between time to maturity and yields (rates of return) for debt in a given risk class ○ Generally, the longer the term to maturity, the higher will be the yield (interest rate) will be ○ The YC reflects expectations about future changes in interest rates and the economic conditions ○ Normal Yield Curve- upward or positively-sloped, long term yields are higher than short-term yields ○ Inverted (abnomal) Yield Curve- downward-sloping, long term yields are lower than short term yields The Bond Indenture-Contract between the company and the bondholders /lenders. Includes: ○ The basic terms of the bonds How long are they borrowing for and for how much ○ The total amount of bonds issued ○ A description of property used as collateral, if applicable ○ Details of protective covenants or loan restrictions Limits on paying dividends, Limits on issuing additional debt Restrictions on merging or significantly changing the nature of the business without the prior consent of the creditors If a borrower fails to meet any of the terms of the bond indenture (e.g., fails to make the coupon payment or repay the principal), they are said to be in default ○ Certain rights will kick in for the lender where they can take the company to court and force them into bankruptcy  The trustee- An appointee, usually a commercial bank, responsible for upholding the terms of the bond’s indenture. They protect the interest of the bondholders ○ Morgan Stanley, JP Morgan, etc. ○ Takes remedial action if the borrower defaults on the terms of the loan ○ Receive the funds from the borrower to pay the interest and principal owed to the bondholder ○ Also acts a “transfer agent” by registering the bonds in the name of the new owner when a bond changes ownership They keep track of ownership if the bond gets traded Most bonds are known as “registered bonds”, in that ownership is registered with the trustee that distributes interest payments and principal repayments Other type = Bearer Bonds- A bond with coupons attached or a bond whose possession denotes ownership – significant risk 4 main sources of Risk for a bond investor: ○ Default Risk ○ Interest rate risk (fluctuations in interest rates) ○ Reinvestment Rate Risk ○ Inflation (purchasing power risk) Default Risk- failure of the borrowing firm to meet the terms of the debt's indenture; more commonly, not paying the interest and principal owed to the bond investor as they come due. Also known as “Credit Risk”. When an issuer defaults investors do not receive their expected yield/return! ○ Factors that affect default risk include financial performance of the company and provisions in the bond contract/indenture (secured (collatoral) vs. unsecured; senior vs. subordinated; maturity) ○ Firms that have higher likelihood to default will be required to pay a higher coupon and their bonds will have a higher yield (or required rate of return) than firms with more financially sound profile Higher risk → Higher required return Rating agencies come up with grades for corporations that say how likely a company is to default ○ Moody’s Investor Service, Standard & Poor’s, Fitch, etc. Rating Categories via a Credit Ratings System ○ Investment grade - Better, less likely to default Baa and above = less likely to default ○ Below Investment Grade aka Junk or High Yield Anything under Baa  The Default Risk “Spread” = the difference in yields between bonds of different ratings. For instance, High Yield and Investment Grade Bonds and Government Bonds ○ It’s the extra compensation a bond investor requires to take on more default risk ○ Expressed in BASIS POINTS (.01 percent). For example, the spread between AAA bonds and CCC bonds is 3.75% (7.40 – 3.65), or 375 basis points Spreads change as economic conditions and/or the financial health of a company changes the likelihood of default. The more likely a firm will default, the higher or wider the spread will be Financial ratios ○ Debt ratio ○ Coverage ratios, such as interest coverage ratio or EBITDA coverage ratio ○ Profitability ratios ○ Current ratios Bond Ratings Median Ratios ○  Interest Rate Risk- Yields or Interest rates (the costs to borrow money) fluctuate as conditions change within the economy and as the supply and demand for borrowing changes. Since most bonds coupon payments are fixed at the outset, their value will rise or fall depending on the move in interest rates ○ The cost to borrow someones money will change ○ EXAMPLE- If a bond is issued with an 8% coupon when required rates of return for investors are 8%, the bond will trade at its face value. However, if rates then rise to 12%, no one will purchase the 8% coupon bond for its face value. The bond price must fall until its expected return = the 12%. If interest rates rise, the price of existing debt must fall so that its fixed interest payments relative to its price become competitive with the higher rates. If interest rates decline, the opposite is true There is an inverse relationship between bond prices and interest rates. As interest rates go up, bond prices go down. The possibility of rising interest rates is a major source of risk to investors in ALL fixed income assets ○ If interest rates go up, you are going to have to sell/trade your bond at a lower price because the fixed rate you are at is not worth it anymore Reinvestment rate risk- Risk that the cash flows you receive from a bond (coupon payments and return of principal) are reinvested at a lower rate in future ○ Ex: you won $5 million, invest all, live off interest. Option A: Buy 1-year bond, coupon = 10%. x $5mil = $500k. At end of year, have $5.5 million ($5 m + $500,000 interest) If Interest rates drop to 4% & you reinvest in another 1-year bond ○ You earn only $200,000 (4% x $500k) in interest that next year Option B: Buy 10-year bond, Coupon= 10% At end of year, Interest rates drop to 4%, do not lose interest Inflation risk- Inflation reduces the purchasing power of interest and principal payments. Time value of money ○ Ex: You invest $1,000 in a bond that matures in 1 year and pays a 5% coupon rate. At the end of the year, you will receive $1,050—your original $1,000 plus $50 of interest Now suppose that the inflation rate during the year is 10% and that it affects all items equally. If gas had cost $2 per gallon at the beginning of the year, it would cost $2.20 at the end of the year. Therefore, your $1,000 would have bought $1,000/$2 = 500 gallons at the beginning of the year but only 1,050/$2.20 = 477 gallons at the end. Bonds may be purchased in much the same way as stocks  ○ Purchase through a brokerage firm with cash or on margin (mostly OTC) ○ Same types of orders as stocks (market, limit etc.) ○ Can also by mutual funds and ETFs made up of just bonds! Market Price- The currently quoted bond price. There will be a price that the buyer can purchase at – “Ask Price”, and usually a price at which they can sell at – “Bid Price” Par Value- The stated value of a bond-typically $1,000, also known as face value. Bonds are usually issued and mature at par (i.e.: at maturity the bond holder receives $1,000) Bonds earn interest every day, but the borrowing entity only distributes the coupon payments only once or twice a year (typically) ○ Thus, when a bond is purchased, the buyer owes the previous owner accrued interest for days the previous owner held the bond Accrued interest- interest that has been earned but not paid ○ The accrued interest is added to the purchase price the buyer must pay to the seller Bonds come in a variety of forms w/ numerous different terms → too many to go into all the details. Two types of bonds are: ○ Corporate bonds Secured- the borrower pledges a specific asset as collateral. In case of default, the creditor/lender may seize this collateral (through a court proceeding) Unsecured- Bonds that are not collateralized by specific assets are unsecured. If the borrower were to default, there would be no specific assets the creditors could seize to satisfy their claims on the borrower. Supported solely by the general capacity of the firm to service its debt (i.e., pay the interest and repay the principal) from operating income (EBIT) Convertible- a hybrid type security where investors own a bond (unsecured) but have the option to convert it into a certain amount of shares of common stock ○ Government bonds Federal Government- The federal government has the constitutional right to tax and to create money. Thus, there should be no question of the ability of the federal government to pay interest and retire the principal. In theory, there is no default risk but they are not riskless. Still has interest rate risk, inflation risk, and risk and reinvestment rate risk State and local governments (municiple bonds)- State and local governments issue debt to finance capital expenditures, such as  schools or roads. The government then retires the debt as the facilities are used. The funds used to retire the debt may be raised through taxes (e.g., property taxes) or through revenues generated by the facilities themselves A bond issued by a state or one of its political subdivisions whose interest is not taxed by the federal government (tax exempt) Common features of corporate bonds: (can also apply to other types of bonds ○ Variable Interest Rate (Floating Rate)- A bond with a coupon rate that adjusts with changes in short- term interest rates. This alleviates interest rate risk (e.g., higher interest rates driving down the bond’s market value) Limits interest rate risk ○ Zero Coupons- A bond on which interest accrues and is only paid at maturity; initially sold at a discount. NO intermediate coupon payments ○ Sinking Funds- A series of periodic payments to retire a bond issue. Helps alleviate the risk of default of the “balloon” payment of principal (e.g., gradually put aside money and avoid a large lump-sum payment at maturity) ○ Callable bonds- Bonds with a call feature give the borrower/issuer the right to payback/retire a debt issue prior to maturity. Why would a borrower want this option? If interest rates go down, a call feature gives the borrower a chance to payoff their higher coupon debt by issuing new lower coupon debt, thereby saving interest costs. This is known as a refunding or refinancing Call features can benefit borrowers but can be harmful to investors who are paid back and now must reinvest their money at a lower interest rate To compensate borrowers, there may be a call penalty which is a lump sum payment that the borrower pays the investor U.S Treasury security types: ○ Bills- matures in one year or less, issued at a discount to face value; considered the safest of all investments. Minimum denominations of $100 ○ Notes- matures between 2-10 years, issued as a coupon security ○ Bonds- maturities longer than 10 years, issued as a coupon security ○ Treasury inflation protection securities (TIPS)- principal is indexed to measure of inflation called the CPI (consumer price index). Helps alleviate inflation (purchasing power) risk. As inflation rates go up, interest payments and the face value of the bonds increase  Investors who invest in municipal bonds are willing to accept lower returns because the after-tax return is equivalent to higher yields on taxable corporate bonds ○ Ex: Investor is in the 28 percent tax bracket and can purchase a tax-exempt municipal bond that yields 4.5%. What yield would a taxable corporate bond have to offer to be equivalent to the yield on the municipal bond? ic (1 -.028) =.045 → /.72 = 6.25% There are many types of municipal bonds. The two major types are: ○ General Obligation- A bond whose interest does not depend on the revenue of a specific project; government bonds supported by the full faith and credit of the issuer (i.e., authority to tax) ○ Revenue Bond- A bond whose interest is paid only if the debtor earns sufficient revenue → Revenue bonds are supported by a specific revenue source, such as income from a toll road or public power utilities Municipal Bonds face the same types of risks as Corporate bonds ○ Default risk (cities can default, although it is rare) ○ Interest rate risk, inflation risk, and reinvestment rate risk Lecture 11 Comparable bonds are priced so their yields are the same. What is important is how much you earn and not how much you pay The price of any bond (for a given risk class) is primarily related (1) the interest paid by the bond, (2) the interest rate that investors may earn on comparable, competitive bonds, and (3) the maturity date Bonds are priced just like stocks (or most other assets in finance!); using a Discounted Cash Flow (DCF) approach ○ Take future cash flows and discount them back to the present using the appropriate discount rate or required rate of return on comparably risky investments (Time Value of Money!) Simple example = perpetual bonds, those that do not have a maturity (never pay back the borrowed amount) but just makes a periodic coupon payment ○ A perpetual bond has a face value of $1000 and pays an 8% coupon payment each year. We determine comparable risk securities offer a 10% return  Value: P = PMT/i = $1k x.08 /.1 = $800 ^ If market interest rates of comparable investments were to increase to 20%, the value of this perpetual stream of interest payments would decline; if market interest rates were to fall to 4%, the value of the bond would rise ○ As interest rates go up, the value of the bond goes down, and vice versa Suppose you are offered two different perpetual bond issues to choose from: ○ Bond 1 = 10% coupon, $1,000 Face Value = $100 per year payment; → ask price = $1,000 ○ Bond 2 = 12% coupon, $1,000 Face Value - $120 per year payment; → ask price = $1,000 Bond 2 is more attractive since it pays more per year. The seller of bond 1 can make the bond more attractive by lowering the ask price. If the seller were to ask only $833 for Bond 1 that pays $100 annually, the buyer should be indifferent as to which to purchase since both bonds would offer a yield of 12%. In valuing a bond, you are dealing with a stream of coupon/interest payments PLUS a large single cash flow at the end (the recovery of the Face Value at maturity) Bond Price/Value = Present Value of Coupons + Present Value of Par Value Bond Valuation Ex: $1,000 Face Value Bond with 10% Annual Coupon Payments and it matures in 3-years. Required return/discount rate = 10% PV =?, FV = 1000, PMT = 100, N = 3, i = 10% In excel: =-PV(i, n, pmt, fv)  If the above bond was worth less than 1k, it would sell at a discount in order to be competitive with other bonds If the above bond was worth more than 1k, it would sell for a premium since it offers more than other bonds Although the Coupons on a bond are stated as an annual interest rate, most bonds pay their coupons TWICE per year (semiannually) ○ A $100 annual coupon might pay $50 twice a year ○ To calculate: 1) Multiply years until maturity by 2 to get periods = 2N. 2) Divide discount rate by 2 to get periodic rate = id/2. 3) Divide annual PMT by 2 to get PMT = PMT/2 Semiannual Compounding example: Coupon rate = 14%, semiannual coupons Required rate of return= discount rate= i = 16% Maturity = 7 years Face value = $1000 Questions: How many coupon payments are there? → 14 (7 x 2) What is the semiannual coupon payment? → $70 (14%x1000/2) What is the semiannual discount rate? → 8% (16%/2) What’s the price/value of the bond? → $917.56 (=-PV(8, 14, 70, 1000) Yield is a word used frequently when discussing bonds and understanding the return that they provide Unlike the coupon interest rate on a bond, a bond’s yield varies from day to day depending on market prices ○ Yields change constantly, the coupons on fixed rate coupon bonds do not There are three types Current Yield (CY)- the annual interest payment divided by the bond’s current price. Since the price changes with changes in market interest rates, the current yield also changes over time ○ Current Yield (CY) = Annual interest payment / price of the bond ○ Ex: A 30 yr bond with a $1k face value, a 10% coupon and a current price of 1372 or 775 CY at $1372 = 100/1372 = 7.29% CY at $775 = 100/775 = 12.9% The Current Yield provides the amount of cash income that a bond will generate in a given year. However, it does not account for the price increase or decrease over a bond’s life as it approaches maturity  Current Yield can be misleading; for it fails to consider any change in the price of the bond that may occur if the bond is held to maturity ○ If a bond is bought at a discount, its value must rise as it approaches maturity ○ If a bond is bought at a premium, its price will decline as maturity approaches ○ The above 2 bullets are known as Pull to Par Yield To Maturity (YTM)- considers the current income generated by the bond as well as any change in its value when it is held to maturity. It is the approximate yield earned on a bond from the time it is acquired until the time it matures For a $1,000 Face/Par Value bond with a 10% coupon paid annually that matures in 3-years and a current price of $952 ○ CY = 100/952 = 10.5% ○ YTM= 12%. Considers both the current income and the rise in price over the 3-years from $952 to $1,000 at maturity YTM is also the rate that makes present value of all future cash flows equal to current market price ○ To calculate, use the rate function on excel =rate(n, pmt, -pv, fv) PV is negative because you are losing that money in the beginning to get a positive FV If the coupon is paid semiannually, you have to double n and halve pmt. Then you will multiply that answer by 2 If Bond is at a premium price, Coupon > Current Yield > YTM If Bond is at par, The Coupon =Current Yield = YTM If Bond is at a discount price, Coupon < Current Yield < YTM  ○ Top 2 are premiums, 3rd is par, the rest are discounts Coupon is 8% for all bonds in the image Callable bonds- Bonds with a call feature give the borrower/issuer the right to payback/retire a debt issue prior to maturity ○ Better for the borrower because it allows them to save interest expenses ○ Typically when the borrower pays the investor back early there is a call penalty Yield To Call (YTC)- the yield earned on a callable bond from the time it is acquired until the time it is called or retired by the issuing firm ○ If interest rates have fallen and a firm is expected to “call” its callable bond by repaying the borrowed amount, the yield to call may be a more accurate measure of return ○ Calculated in the same was as YTM, but the expected call date is subbed in for the maturity date, and the principal + the call penalty is subbed in for the face value/principal I buy a bond and its YTM = 8% ○ If interest rates rise, realized return will be greater than the YTM ○ If interest rates fall, realized return will be less than the YTM Lecture 12 Bond prices depend on the interest paid (coupon), the maturity date of the bond, and the yield currently earned on comparable investments As the yield currently earned on comparable investment fluctuates, so do bond prices ○ Bond prices and yields are inversely related Not all bonds have the same amount of price fluctuation as yields change The longer the maturity → the more sensitive the bond’s price to changes in market interest rates/yields  ○ If interest rates fall, the prices of both bonds will rise, but the price of the bond with the longer term will rise more on a percentage basis. ○ If interest rates rise, the prices of both bonds will fall, but the price of the bond with the longer term will fall more on a percentage basis Longer term bonds are more risky but give more reward For bonds with the same coupons the following will always hold true: The longer the maturity of the bond, the more its price changes in response to a given change in interest rates, all else equal. Why? ○ Let’s say you bought a 10-yr bond that paid a 10% coupon, or $100 a year. Now let’s say interest rates of bonds w/ comparable risk rise to 17%. You would be stuck with w/ a $100 in coupon payments for 10yrs! However, if you bought the 1-yr bond, you would only have to live w/ the $100 for one year. At the end of one year you would get your principal back ($1000) and you could reinvest it and now receive the 17% ($170) a year  If you predict interest rates are going up, you want a bond with less maturity time. If you predity interest rates are going down, you want a bond with a longer maturity time ○ If interest rates fall, the prices of both bonds will rise, but the price of the bond with the lower coupon will rise more on a percentage basis. ○ If interest rates rise, the prices of both bonds will fall, but the price of the bond with the lower coupon will fall more on a percentage basis For bonds with the same maturities the following will always holds true: The lower the coupon of the bond, the more its price changes in response to a given change in interest rates, all else equal ○ Lower coupon = more change The fact that bond prices decline when interest rates rise is known as interest rate risk ○ When interest rates rise, if you need to sell a bond prior to maturity, it will result in a capital loss! Despite a known set of cash flows and guaranteed payments, even a plain vanilla US Treasury bond can be “risky” Duration- a measure of how sensitive a bond’s price is to changes in interests rates ○ How risky is a bond in terms of price volatility ○ The larger the numerical value, the greater is the price volatility Duration is the average time it takes the bond to collect the interest and principal ○ We won’t have to compute, just need to know what it is Bonds with similar durations will experience similar percentage price moves as interest rates change  Bonds with longer (larger) durations will experience greater percentage price moves as interest rates change. Hence, they have more interest rate risk as their prices will drop more on a percentage basis when interest rates rise If you expect interest rates to rise and you want to limit price fluctuations in your bond portfolio, you should sell the bonds in your portfolio with longer durations and use the proceeds to buy bonds with shorter durations Duration may also be used to forecast a change in a bond’s price for small changes in interest rates ○ Dollar value change Example: 8% Coupon Bond with 10-years until maturity has a YTM of 8.0% and therefore a current price of $1,000. If interest rates rise to 8.25%, what’s the change in the bond’s price if the duration of the bond is 7.25 years? Change in bond’s price = -7.25 * (8.25%-8%)/(1+.08) * 1,000 = - $16.78 Duration is a forecast, actual price changes will be different than what the forecasted price change is This is because duration forecasts a straight line. Acutal price changes are convex ○ Lecture 13 Derivatives- securities that “derive” their value from the price of other securities ○ Stock options are a type of derivative Option- a contract which gives its holder the right, but not the obligation, to buy (or sell) an asset at some predetermined price within a specified time period (e.g., 1 month, 3 months, etc.) ○ It does not obligate its owner to take any action. It merely gives the owner the right to buy or sell a stock Option speak – “exercise” the right to buy or sell Option (more formal definition)- generally a type of contract between 2 parties where one party grants the other party the right to buy or sell a specific asset at a specific price within a specific time period. There are 2 types of options: ○ Call Option- An option that gives the holder the right to buy (or “call forth”) a share of stock on or before a given date at a predetermined price You are betting on the stock price to go up Holder is the owner/buyer ○ Put Option- An option that gives the holder the right to sell (or “put the stock to someone else”) a share of stock on or before a given date at a predetermined price You are betting on the stock price to go down Holder is the owner/buyer Option contracts on stocks specify 4 main items ○ The company whose shares can be bought or sold ○ The number of shares that can be bought or sold (1 contract = 100 shares, typically) ○ The purchase or sale price for those shares, known as the Exercise Price or Strike Price ○ The date when the right to buy or sell shares expires, known as the Expiration Date Will be a specific day Parties of the option contract ○ Option Buyer- The party that has the right, but not the obligation, to buy or sell the asset. The decision maker, the option buyer, must pay a price for the right to be the decision maker. This market price is known as the premium The option buyer is long of the contract ○ Option Writer (seller)- The party who has sold the right to buy or sell the asset to the option buyer. They are obligated to respond to the buyer’s decision. They receive the premium from the option buyer The option writer is short of the contract  Example of obligation – writer of a call must be prepared to sell stock to the investor who owns the call if they “exercise” the call The buyer of an option is said to be long the option, whereas the seller of an option is said to be short the option Options trade on the exchange just like stocks American option- the option can be exercised at any time prior to expiration European option- the option can only be exercised on the expiration date In the U.S., most options on stocks are American style Review of option jargon: Call: An option that gives the holder the right to buy stock at a specified price within a specified time period Put: An option that gives the holder to sell stock at a specified price within a specified time period Expiration date: The date by which the option must be exercised; or the date on or before which the option holder can buy or sell the underlying stock Exercise/Strike Price: The price at which the option holder may buy or sell the stock via exercising the option Premium: The market price of the option Option Buyer: Holds the right to buy/sell; pays the premium Option Writer: obligated to respond to buyer’s decision; receives the premium Notation ○ C = call Time subscript if necessary: C0 or Ct ○ P, P0, Pt = put ○ X = exercise price Also called strike price ○ S, S0, St = stock price ○ T = expiration date ○ ST = Stock price at expiration Although put and call options typically trade in units of 100 shares (one option = 100 shares of stock), all our examples/problems are on a per-share basis to make calculations easier  All options have a minimum value known as the Intrinsic Value or Payoff Value or Exercise Value Intrinsic value (IV)- The value of the option if exercised today ○ EX: Hold a call option that gives you right to buy a stock at $25 and the stock is trading in the market at $35 → Intrinsic Value = $35 – $25 = $10 S-X ○ EX: Hold a put option that gives you right to sell stock at $50 and the stock is trading in the market at $42→ Intrinsic Value = $50 – $42 = $8 X-S Since option holders will not exercise an option if it will produce a negative cash flow, options CANNOT have a negative intrinsic value → floor value of ZERO Intrinsic Value is not the same as the option price/premium, however, option prices must approach their intrinsic value as the option approaches expiration How to find intrinsic value in EXCEL ○ Call: max(S - X, 0) Max function will give you the highest value in the parenthesis, so either the value of the stock, or if it is negative then it will say 0 ○ Put: max(X - S, 0) Max function will give you the highest value in the parenthesis, so either the value of the stock, or if it is negative then it will say 0 Arbitrage example: ○ On the NYSE, IBM stock is worth $125. On SFX, it is worth $135. Anyone who is able to would buy the stock in the NYSE and then sell it on SFX. It is a riskless profit of $10 per stock. Eventually when enough stock is bought and sold, the prices would equalize at a value in the middle, around $130 ○ People take advantage of this quickly and it should not exist Option “Moneyness" If an option has a positive intrinsic value it is said to be “in the money” (ITM) ○ Exercising the option would produce a positive cash flow to the holder If exercising an option would cause a negative cash flow to the holder it’s known as being “Out of the Money” (OTM). Option holders will not execute out of the money options When exercising an option would produce neither a positive or negative cash flow = “At the money” (ATM). This occurs when the underlying stock price = exercise price. The “At”, In” and “Out of” the money” terminologies in the 3 bullets above only refer to the relationship between the stock’s price and the exercise/strike price.  Thus, they do not consider the cost of the option, or the premium paid to buy the option. Moneyness of an option relies on the relationship between the underlying stock price and the exercise price of the option In the money = positive cash flow if exercised ○ A call option is in the money if underlying price > exercise price ○ A put option is in the money if underlying price < exercise price Out of money = negative cash flow if exercised ○ A call option is out of the money if underlying price < exercise price ○ A put option is out of the money if underlying price > exercise price At the money = zero cash flow ○ Underlying price = exercise price ○ S< 50 is out of the money, S=50 is at the money, S>50 is in the money A call option’s Intrinsic Value (and price) rises as the price of the stock increases above the exercise/strike price of the option Prior to expiration, Intrinsic Value often does not = Market Price/Premium Time Value = Premium - Intrinsic Value Time Value- The difference between the option price and the intrinsic value. Thus, option premium/price = intrinsic value + time value ○ It is additional value above intrinsic value because the option still has remaining time until it expires and because options provide the potential for levered returns. ○ Prior to expiration, an option includes time premium; there is no time premium at expiration At expiration = IV Options offer the potential for levered returns; more time = greater the chance ○ Leverage = magnification of the potential return on an investment Buy a stock at $25, or buy a call on stock for $5 with strike price of $25  The Call Option Buyer’s maximum possible loss is the cost of the option. Theoretically the potential profit is unlimmited ○ You pay the premium to own the option, if it expires worthless, that’s the most you can lose Example: You buy a call option for $15 on Stock ABC with an exercise price of $50. The option expires in 3 months. The current price of the stock is $50. - If at expiration S < X, then option/intrinsic payoff value = 0 - Stock ABC price < 50 three months from now, you have a net loss of $15 because you are able to sell the stock for $50 which is what you bought it at, but you paid $15 for the option - -15/15 = -100% return on owning - If at expiration S > X, then the option value = S - X - Stock ABC price is trading at $70, then the option/intristic payoff value = 70 - 50 = $20. The net profit is $5 because $20 - $15 (option premium) = $5 - 5/15 = 33% return on owning Breakeven stock price- where profits begin ○ = Exercise price + premium paid ○ In the above example, breakeven stock price = 50 + 15 = $65 Percent return on owning = $profit / C Calls have limited loss and time constraint. Stocks have larger possible loss  ○ Call Option Seller – obligated to sell the stock to option buyer; receives the option premium ○ Emphasis is on the stock not rising Naked call- Sells (writes) a call option without owning the underlying stock ○ Since the writer does not own the stock, unlimited risk of loss if the price of the stock keeps rising ○ Maximum profit = the premium received for selling the call ○ Naked Call writers want the stock to stay where it is or to decline ○ Naked calls are extremely risky. Never write a naked call. The losses are theoretically unlimited, and the maximum gain is just the premium price Seller at expiration: C - IVcall A put option gives its holder the right to sell a stock at the exercise price and on or before the expiration date A put is a bet that the stock price will go down in the future Buyers exercise the option if the market price < exercise price  The owner of a put option would exercise the option to sell the underlying stock only if the stock price is less than the strike price at expiration In other words the stock price must fall to such a point that the market price is lower than the put option exercise price, otherwise it would not be economical to exercise the option The put option value at expiration will be ○ = Max (the option exercise price – Stock Price, 0) Example: You buy a put option for $8 on Stock ABC with an exercise price of $30. The option expires in 3 months. The current price of the stock is $25 - If at expiration S > X, then option intrinsic/payoff value = 0 - Stock ABC price is $40 three months from now option will expire worthless - IV = max( 30 - 40, 0) = $0 - $8 = -$8. -$8/$8 = 100% loss - If at expiration S < X, then option value = exercise price - stock price - Stock ABC price is trading at $20, then option/intrinsic value = 30-20 = $10. - IV = max(30-20, 0) = 10 - 8 = $2 profit. 2/8 = 25% gain Put Option Seller- obligated to buy the stock from the option buyer; receives the option premium Naked Put: Sells (writes) a put option ○ Maximum loss = exercise price – premium received ○ Maximum profit = the premium received for selling the put ○ Naked put writers want the stock to stay where it is or to rise  ○ Investors who purchase put options or short a stock anticipate the stock will go down Puts vs short selling ○ Put advantages = Limited loss and potential leverage on returns ○ Put disadvantage = put has a time constraint Investors can also use puts to reduce risk – Protective put ○ Protective Put combines Purchase of put Purchase of stock ○ If the stock price declines → the value of the put rises and offsets the loss on the stock Question:Diego buys a TSLA June $800 strike price Put option at $4.00 premium when TSLA’s stock price is $797. A. Is the Option in, at or out of the money? In, 800-797 = $3 B. What’s the option’s Intrinsic/Exercise/Payoff Value? $3 ^ C. What’s the option’s time value? Premium - IV = 4-3 = $1 D. What’s the most Diego can lose as the option buyer? $4 CBOE: Chicago Board Options Exchange. Thats where a lot of options are traded Open Interest: Number of contracts outstanding with a specified strike price and expiration date on a particular stock Put / Call Ratio: Ratio of puts in existence to calls; measure of sentiment ○ Essentially the # of bets that the stock will go down / # of bets that the stock will go up ○ If it =1, the sentiment is neutral, if its > 1, people are bearish, if it is < 1, people are bullish LEAPS: long term options => 1-year up; more time premium OTHER Options: on interest rates; on currency  ○ Speculate on changes in interest rates or currencies ○ Also used for risk management Stock Index Options: Put and call options based on an index of stock prices ○ Can bet on the direction of the market as a whole Buy a stock index call → long position in market → anticipate a market increase Sell a stock index call → short position in market →anticipate a market decline Buy a stock index put → anticipate a market decline Sell a stock index put → anticipate a market increase Basic option positions summary ○ Lecture 14 The “intrinsic” or “fundamental” value of an asset depends on the cash flows that can be expected from it ○ Example: the fundamental value of a stock depends on the dividend and earnings we expect from the firm → The success of the firm and its stock price is tied to its operating performance Fundamental analysis will often begin with analysis of the economy, as the global economy will have an effect on individual firm performance ○ Stock prices generally rise with earnings, and earnings are impacted by ability to grow sales and/or keep costs low Top-down approach- Calls for analysis of the economy with the goal of identifying industries and companies that will perform well in that economic environment ○ Thus, a top-down analysis of a company begins with an examination of economic prospects ○ The ability to forecast the direction of the economy or industries better than others may lead to enhanced investment performance  Top down approach focuses on the economic outlook. Based on the economic outlook, one would identify industries/sectors of the market that will do well. Then they will identify specific companies that are “the best” and invest in them ○ More common approach Bottom’s up approach- Looks for good companies that are at good prices ○ Is focused at the bottom portion of the top down approach Gross domestic product (GDP)- Measures the economy’s total production of goods and services ○ The sum of domestic spending across the different segments of the domestic economy. A “scorecard” for the size and growth of an economy GDP growing at a fast pace = expanding economy = opportunity for firms to increase sales → increase earnings → rising stock prices GDP = C + I + G + E ○ C: personal consumption Individuals spending ○ I: gross private domestic investment Businesses spending ○ G: government spending ○ E: net exports Exports - Imports US GDP is $27.36 trillion The U.S is a consumer driven economy. Consumer spending drives most (about ⅔) of the economy The second most economic driver is business spending As the economy expands, employment tends to increase. However, if the economy contracts, unemployment will increase and consumer incomes and spending will fall, and with it, GDP  Recession- a period of rising unemployment and declining national output (Declining GDP ) ○ Investors try to find out where in this graph we are, and they will adjust their portfolios accordingly to take advantage This is just a theory and you can never be 100% sure ○ They are highly correlated ○ Stock prices are a leading indicator of where the economy is headed. At the Covid point, stock prices fell months before the GDP fell ○ GDP is a lagging indicator of where stocks are heading. It is backwards looking To create the best investment opportunities, we need to know the direction of economic change before it occurs. Hence the emphasis is placed on leading indicators of economic activity  List of leading indicators ○ Average weekly hours of production workers ○ Initial Claims for unemployment insurance ○ Manufacuturers' new orders (consumer goods and materials) ○ Institute of Supply Management :Index of New Orders" ○ New orders for nondefense capital goods ○ Building permits, new private housing units ○ Stock prices ( e.g., S&P 500 stock index) ○ Yield Curve Slope (difference between 10yr Treasury bond yields and short term interest rates ○ Leading index of credit market conditions (willingness of lenders to lend) ○ Index of Consumer expectations for business conditions Consumer optimism or pessimism (Confidence and Sentiment) about the economy can translate into how the economy performs. For instance, if consumers have confidence in their future income levels, they will be more willing to spend and spend more → higher demand for businesses → more economic activity ○ If the blue line (The US LEI) crossed the red line from above, that is a recession signal. It is not always accurate however because it has signalled for a recession from 2022-2024 but we have not had one LEI- The Conference Board Leading Economic Index Inflation- The rate at which the general level of prices rise ○ Measures of inflation include Consumer Price Index (CPI), Personal Consumption Expenditures (PCE), and Producers Price Index (PPI) The first two are from a consumer’s perspective, and the third is from the producer’s perspective Deflation- the general decline in prices. Opposite of inflation Disinflation- Prices are going up still, but at a lower rate  ○ If inflation was at 7% and then went down to 2%. Prices are still going up since inflation is at 2%, but they aren’t going up as much Hyperinflation- when prices go up more than 50% Naturally, how an economy performs affects individual employment, income, and wealth and affects the cost of funds and earnings of companies. Thus, the government is concerned with ensuring the economy functions smoothly ○ With full (maximum) levels of employment, ○ With stable prices (small amounts of inflation) 2% is the target inflation rate ○ Economic growth The government can influence the economy in 2 main ways: ○ Monetary Policy ○ Fiscal Policy The Federal Reserve (“The Fed”) and Monetary Policy (more indirect intervention in the economy) The central bank of the United States (separate from the federal government = independent) Goals: maximum employment, stable prices (known as the “dual mandate”) The Fed will implement Monetary policy to attempt to acheive its goals Monetary Policy- the manipulation of the “money supply” to impact economic activity ○ Money supply generally refers to the amount currency and other liquid investments outstanding in an economy -→ the amount available for lending or “loanable funds” Monetary policy works mostly through its impact on the cost to borrow (interest rates) ○ Lower interest rates, encouraging business investment and consumer spending. Higher interest rates = opposite impact The Fed has monetary policy “tools” to influence the money supply and the cost of borrowing (interest rates) across the economy, thereby influencing employment, inflation and economic activity. This is known as “conducting monetary policy” A main goal is to influence the cost to borrowing by setting a target for the Federal Funds Rate ○ Federal Funds Rate- the rate banks charge to borrow money for eachother The base rate in the economy. Almost all other rates are based off of this rate ○ Banks that need funds can borrow from banks that have excess funds.  ○ The transfer of funds from one bank’s reserve account to another bank’s reserve account is termed a federal funds transaction, and the agreed interest rate in this transaction is the federal funds rate (FFR). Changes in the federal funds rate tend to cause changes in other short-term interest rates, which ultimately affect the cost of borrowing for businesses and consumers, the total amount of money and credit in the economy, and employment and inflation Policy implementation tools influence our spending decisions by making the borrowing rate (federal funds rate) higher or lower ○ Interest on Excess Reserves ○ The overnight Reverse Repurchase Agreement Facility ○ The Discount Rate ○ Open Market Operations ○ Moral Suasion, aka “jawboning” Headline: The economy weakens → FED “EASES” Financial Conditions ○ Employment falls below maximum employment. ○ The inflation rate is steady around or slightly below 2 percent but is showing signs of decreasing  ○ Headline: Inflation is rising → FED “TIGHTENS” Financial Conditions ○ Inflation has been above the Fed’s 2 percent target for considerable time. ○ And inflation is increasing, and the unemployment rate is very low. ○ ○ Fiscal Policy (more direct intervention in the economy) Fiscal policy refers to the taxation, expenditures and debt management actions by the government. ○ Fiscal policy often results in direct intervention in the economy while monetary policy works through changes in interest rates and the supply of credit Increases in government spending directly inflate the demand for goods and services Decreases in tax rates can immediately put more income into the hands of consumers and result in an increase in consumption Despite its direct and immediate impact, agreeing on and implementing fiscal policy typically must go through a time consuming and cumbersome political process One way to summarize the net impact of government fiscal policy is to look at the government’s budget deficit or surplus ○ Deficit: Government expenditures > revenues; stimulative if it is not accompanied by higher interest rates ○ Surplus: Government revenues > expenditures To run a deficit the government must borrow by selling more Treasury securities; this can increase interest rates and offset some of the stimulative impact of government spending To finance a deficit and avoid higher interest rates, the Fed can “monetize” the debt → directly finance the federal government’s deficit by purchasing the Treasury securities ○ Monetize the debt- The government just prints more money to cover their debt. This often leads to high bouts of inflation over time ○ By doing so, the money supply increases and interest rates decrease, easing financial conditions. This debt monetization is now known as “quantitative easing” The economy is complex → forecasting the direction of the economy and fine-tuning it through monetary and fiscal polices aimed at low unemployment and low inflation is difficult Investment professional incorporate an economic forecast into their investment process, and that forecast can have a major impact on how one allocates their investment dollars. A common focus is where we are “in the cycle” ○ Headed toward recession? Headed toward expansion? In the middle? Headed toward a recession → choose “defensive” stocks and allocate more to bonds (interest rates go up)  Low beta stocks, bonds, etc Headed toward an expansion → choose more “cyclical” stocks and allocate less to bonds (interest rates go down) High beta stocks Lecture 14 Other Idea: Corporations should be accountable for the issues they may cause society and the economy. ○ Investors can influence outcomes by choosing investments that align with their values or those issues that matter most to them ○ Good corporate performance on value-based initiatives can translate into better financial performance and future competitive advantages Socially responsible investing (SRI) and Environment, social, and corporate governance (ESG) investing, and impact investing assets grew from $3 trillion in 2010 to $12 trillion in 2018 to $17.1 trillion by the start of 2020 SRI- entails screening investments to exclude businesses that conflict with the investor's values ○ Example of SRI exclusions = tobacco and fossil fuel producers ○ Divest from the “sin” stocks ○ Goal: If enough people do this, you cause economic harm to induce change in the company ○ Identifies bad companies ESG- Focuses on companies making an active effort to either limit their negative societal impact or deliver benefits to society (or both) ○ An example of an ESG investment might be buying stock in a technology company that converts one of its data centers to use renewable energy, resulting in cost benefits as well as a positive effect on the environment ○ Identifies good companies Impact investing- characterized by a direct connection between values-based priorities and the use of investor’s capital ○ More direct than the other 2 strategies ○ These funds not only report on financial performance, but they also try to generate and quantify a positive societal impact — for instance, number of schools built, measures of economic activity in a low-income community, or reduction of carbon footprint by X units ○ Impact investors are often able to deploy funds in service of causes that are not directly addressed by the public financial markets, such as community development and poverty alleviation  A “public benefit corporation” is a for-profit corporation that is intended to produce a public benefit or public benefits and to operate in a responsible and sustainable manner ○ AKA “B-Corp” ○ To that end, a public benefit corporation shall be managed in a manner that balances the stockholders’ pecuniary interests, the best interests of those materially affected by the corporation’s conduct, and the public benefit or public benefits identified in its certificate of incorporation Public Benefit- A positive effect (or reduction of negative effects) including, but not limited to, effects of an artistic, charitable, cultural, economic, educational, environmental, literary, medical, religious, scientific or technological nature ○ Public Benefit Corporations are required to promote at least one specific public benefit. ○ PBC management should regularly refer back to the company’s identified public benefit purpose and assess how the company is pursuing mission. Lecture 15 Investing needs a financial objective. Those can include: ○ Funds to meet emergencies ○ Funds to finance an education ○ Funds to make a large purchase (home, that party yacht you always wanted) ○ Funds for retirement After determining the resources to invest and the financial objectives, the next step is to construct a portfolio designed to meet the objectives ○ To transfer purchasing power from the present to the future and meet the objectives a portfolio needs to generate returns from Income, such as interest or dividends or Capital gains (price appreciation) Portfolio construction should consider taxes and the risks involved and one’s willingness to bear it ○ Willingness to bear risk may be based on personality, lifestyle, or age Unsystematic risk can be diversified away in a portfolio When you lose money in the market, it takes a greater percentage return to gain the money back than the money you lost (EX Q1 in the final review) ○ If the market declines 30% on day 1 and rises 30% on day 2, overall the market is down from day 0 The process of constructing a portfolio through asset selection and allocation can reduce asset specific risk  ○ Asset Allocation: Process of allocating investor funds among a broad set of asset classes to meet their objectives. Has a significant impact on portfolio returns Often expressed as percentages or range: What proportion of the portfolio should be invested in various classes of assets? Final Review Q: The S&P500 declined 38.49% during 2008. What percentage increase is necessary to recoup the 38.48=9% loss? ○ A: Lets say we started witb $100. $100 - $38.49 = $61.51. → 38.29/61.51 = 62.58% return to recover that loss Anchoring- A cognitive bias where a specific piece of information is relied upon to make a decision Herding- Following the herd, lacking independent thinking Disposition- The tendency of investors to hold on to losing investments ○ Losses create feelings of regret Overconfidence- Investors overestimate their abilities and the precision of their forecasts For a value weighted index, those stocks that have the highest market capitalization (price x shares outstanding) have the most impact in determining the performance of an index For price weighted, the highest price stock has the biggest impact in determining the performance of an index Bond prices and interest rates have an inverse relationship Issuers have the right to call bonds, not investors If someone offered to sell you a bond at a price of 99.00, that means 99% of the bond’s face value ○ If the bond had a face value of $1000, you would have to outlay 1000 x 99% = $990 The longer the maturity (greater duration) or the lower the coupon will yield to a greater percentage change ○ A shorter maturity (less duration) or a greater coupon will yield a lower percentage change “At the money” put option means that the potential profit would increase if the stock goes down If someone writes (sells) an “at the money” call option and they have no other position in the stock, their potential loss is unlimited ○ Naked call  If someone writes (sells) an “at the money” call option and they have no other position in the stock, their potential profit is limited to the premium paid for the option ○ When someone writes an option, the most they can make is the premium One disadvantage (versus just purchasing the stock) of buying a 1-week call option on a stock in anticipation of an increase in the stock's price is the short life of the option. For the strategy to generate a profit, the stock's price must rise during the lifetime of the option. In general, the more time to expiration, the greater the time value of an option. Time value represents the amount of time the option position has to become profitable due to a favorable move in the underlying price. A stock is in the money if positive value is exercised, and it is out of the money if it has negative value exercised ○ If you have a call option on the stock, you want it to go up ○ If you have a put option on the stock, you want it to go down If an option writer's losses increase, that implies the option buyer's gains increase An option will not trade below it’s intrinsic value The most an option buyer can lose is the premium they paid for the option