Book

Investments
Ravi Shukla
Finance Department
School of Management
Syracuse University
1995,
c Ravi Shukla.
Typeset in LATEX 2ε .
Contents
Preface ii
Introduction 1
1 Securities Markets 3
1.1 The Securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
1.1.1 Money Market Securities . . . . . . . . . . . . . . . . . . . . . . . . . 3
1.1.2 Capital Market Securities . . . . . . . . . . . . . . . . . . . . . . . . 4
1.1.3 Mutual Funds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
1.1.4 Options and Futures . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
1.2 Security Prices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
1.3 Investment Profits and Returns . . . . . . . . . . . . . . . . . . . . . . . . . 6
1.4 Investors and their Motives . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
1.5 The Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
1.5.1 Primary Market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
1.5.2 Secondary Market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
1.6 The Trading Process . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
1.7 Long and Short Positions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
1.8 Cash and Margin Accounts . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16
1.8.1 Long Position . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17
1.8.2 Short Position . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20
1.8.3 Mixed Position . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21
1.8.4 Account Closing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22
1.9 Investment Information . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23
1.10 Market Regulation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24
1.11 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24
2 Return and Risk 30

2.1 Return . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30
2.2 Conversion of Units of Return . . . . . . . . . . . . . . . . . . . . . . . . . . 32
2.2.1 Subperiod and Continuous Compounding . . . . . . . . . . . . . . . . 34
i
Contents ii
2.3 Leverage and Return . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36

2.4 Return as a Random Variable . . . . . . . . . . . . . . . . . . . . . . . . . . 37
2.5 Investment Decision Making under Risk . . . . . . . . . . . . . . . . . . . . 38
2.6 Estimating Return Statistics . . . . . . . . . . . . . . . . . . . . . . . . . . . 40
2.6.1 Using the Statistics . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43
2.7 Sources of Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44
2.8 Risk Aversion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 46
2.8.1 Investor’s Objective . . . . . . . . . . . . . . . . . . . . . . . . . . . . 48
2.8.2 Risk Aversion and Dominance . . . . . . . . . . . . . . . . . . . . . . 48
2.8.3 Risk and Return: Historical Evidence . . . . . . . . . . . . . . . . . . 49
2.9 Other Determinants of Rates of Return . . . . . . . . . . . . . . . . . . . . . 50
2.9.1 Basic Rate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 51
2.9.2 Expected Inflation . . . . . . . . . . . . . . . . . . . . . . . . . . . . 51
2.9.3 Time to Maturity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 52
2.9.4 Taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 53
2.10 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 54
3 Portfolio Analysis 58
3.1 Portfolios . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 58
3.2 Portfolio Returns . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60
3.3 Diversification . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 61
3.3.1 Correlation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 63
3.3.2 Diversification Efficiency . . . . . . . . . . . . . . . . . . . . . . . . . 65
3.4 An Overview of the Portfolio Selection Process . . . . . . . . . . . . . . . . . 66
3.5 Calculating Portfolio Statistics . . . . . . . . . . . . . . . . . . . . . . . . . . 67
3.6 Identifying the Optimal Portfolio . . . . . . . . . . . . . . . . . . . . . . . . 71
3.7 Optimal Portfolio with Risky and Risk-free Securities . . . . . . . . . . . . . 75
3.7.1 Efficient Frontier and Tangency Line . . . . . . . . . . . . . . . . . . 79
3.7.2 Constrained Portfolios . . . . . . . . . . . . . . . . . . . . . . . . . . 79
3.7.3 Portfolio Revision . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 80
3.8 Analysis of Diversification . . . . . . . . . . . . . . . . . . . . . . . . . . . . 80
3.8.1 The Effect of Correlation . . . . . . . . . . . . . . . . . . . . . . . . . 81
3.8.2 The Effect of the Number of Securities . . . . . . . . . . . . . . . . . 85
3.9 Mutual Funds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 87
3.10 Portfolio Selection in a Perfect Market . . . . . . . . . . . . . . . . . . . . . 90
3.11 Systematic and Unsystematic Risks . . . . . . . . . . . . . . . . . . . . . . . 91
3.12 Capital Asset Pricing Model . . . . . . . . . . . . . . . . . . . . . . . . . . . 93
3.12.1 CAPM and Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 96
3.12.2 Using the CAPM . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 97
3.12.3 Problems with the CAPM . . . . . . . . . . . . . . . . . . . . . . . . 97
3.13 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 98
Contents iii
4 Security Selection and Performance Evaluation 104

4.1 Valuation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 104
4.2 Calculating Present Values . . . . . . . . . . . . . . . . . . . . . . . . . . . . 106
4.2.1 Special Cases . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 108
4.2.2 Some Hints . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 109
4.3 Return . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 111
4.3.1 Security Selection using Rates of Return . . . . . . . . . . . . . . . . 115
4.4 Market Efficiency . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 117
4.4.1 Efficient Market Hypothesis . . . . . . . . . . . . . . . . . . . . . . . 118
4.4.2 Are Securities Markets Efficient? . . . . . . . . . . . . . . . . . . . . 120
4.4.3 Investing in an Efficient Securities Market . . . . . . . . . . . . . . . 121
4.5 Performance Evaluation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 122
4.5.1 Do Mutual Funds Exhibit Superior Performance? . . . . . . . . . . . 127
4.6 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 127
5 Common Stocks 133

5.1 Stockholder Rights . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 133
5.2 Issue and Repurchase of Shares . . . . . . . . . . . . . . . . . . . . . . . . . 134
5.3 Cash Dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 136
5.4 Reading Stock Quotations . . . . . . . . . . . . . . . . . . . . . . . . . . . . 139
5.5 Common Stock Valuation . . . . . . . . . . . . . . . . . . . . . . . . . . . . 141
5.5.1 Mature Firm . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 141
5.5.2 Growth Firm . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 141
5.5.3 Finite Holding Period . . . . . . . . . . . . . . . . . . . . . . . . . . . 143
5.6 Obtaining Information for Valuation Decisions . . . . . . . . . . . . . . . . . 143
5.7 Factors Affecting Stock Prices . . . . . . . . . . . . . . . . . . . . . . . . . . 143
5.8 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 144
6 Fixed Income Securities 149

6.1 Basic Terminology and Valuation . . . . . . . . . . . . . . . . . . . . . . . . 149
6.2 Bond Features . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 151
6.3 Risks of Fixed Income Securities . . . . . . . . . . . . . . . . . . . . . . . . . 152
6.4 Bond Issuers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 153
6.5 Reading Bond Tables . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 154
6.5.1 Corporate Bonds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 155
6.5.2 Treasury Securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . 156
6.6 Bond Portfolios . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 159
6.7 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 160
Contents iv
6AInterest Rate Risk and Duration 164

6A.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 164
6A.2 Interest Rate Changes and Realized Return . . . . . . . . . . . . . . . . . . 165
6A.2.1 Case 1: Interest Rates Remain Unchanged . . . . . . . . . . . . . . . 165
6A.2.2 Case 2: Interest Rates Go Up . . . . . . . . . . . . . . . . . . . . . . 166
6A.2.3 Case 3: Interest Rates Go Down . . . . . . . . . . . . . . . . . . . . . 167
6A.2.4 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 168
6A.3 Duration . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 168
6A.3.1 Sensitivity of Duration . . . . . . . . . . . . . . . . . . . . . . . . . . 169
6A.3.2 Duration for a Zero Coupon Bond . . . . . . . . . . . . . . . . . . . . 170
6A.4 Applications of Duration . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 170
7 Options 171
7.1 Terminology . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 171
7.2 Option as Risk Transferring Contracts . . . . . . . . . . . . . . . . . . . . . 175
7.3 Option vs. Stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 175
7.4 Option Strategies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 178
7.5 Option Valuation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 179
7.5.1 American Options vs. European Options . . . . . . . . . . . . . . . . 182
7.5.2 Payoff Diagrams . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 183
7.5.3 Put-Call Parity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 185
7.5.4 Call Valuation—Binomial Formulation . . . . . . . . . . . . . . . . . 187
7.5.5 Call Valuation—Black-Scholes Formulation . . . . . . . . . . . . . . . 189
7.6 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 191
7AFutures 193
Normal Distribution Table 195
Data 197
Preface
These notes are intended to be used in a one semester course in investments. The students
are expected to have knowledge of algebra, statistics, and basic finance.
The objective of these notes is to present a concise introduction to the fundamentals
of investments. The notes take a risk-return valuation approach in an efficient markets
framework and do not delve into technical and fundamental analyses. To keep the notes
to reasonable length so that they can be covered in a one semester course, some secondary
topics have been presented briefly or omitted entirely. Also, many ideas have been brought
out only through the end-of-the-chapter exercises. It is extremely important for students to
try out these exercises for a better understanding of the subject.
I would like to express my gratitude to my teachers: Professors Donald Bosshardt, Sris
Chatterjee, Robert Hagerman, Philip Perry, and Charles Trzcinka, who taught me finance
and encouraged me to learn more about this exciting field of study. I would also like to
acknowledge the influence of seminal textbooks in finance and investments by authors such
as Brealey and Myers, Copeland and Weston, Sharpe, and Francis, that may be evident in
my presentation.
I have used these notes as a basis for my lectures during the past few semesters at SUNY
Brockport and Syracuse University. Feedback from students has significantly improved the
quality of these notes. I am obliged to James Cordeiro, Roberta Klein, Joan Norton and
Mike Tomas who read the notes patiently and provided detailed comments.
August 16, 1995 Ravi Shukla
v
Preface vi
Introduction
Welcome to the exciting world of investments. When you think of investment, you probably
imagine men and women in dark pinstripe suits, talking about millions of dollars as if it were
pocket change; or maybe you think of the traders in stock or futures exchanges (as seen in
movies such as Wall Street, Trading Places, Blue Steel, etc.); or maybe you think of the ticker
tape running at the bottom of the screen in CNN Headline News with those seemingly endless
symbols and numbers. Those are the glamorous, the chaotic, and the mysterious sides of
investments. In this course, we will take some of the mystery out of the world of investments.
When you finish this course, you may not become a smooth talking investment banker or a
frenzied trader, but you will have an understanding of the investment fundamentals that are
used by the investment bankers and traders. You will learn the language of investments and
the process of investment analysis and decision making. You may apply this knowledge to
your personal investments or become an investment professional and manage other people’s
money.
This course is about stocks, bonds, mutual funds, options, and futures. More importantly,
it is about risk and reward; about portfolios and diversification; about value and price. These
are the fundamental tools of investment decision making. Once you know these fundamentals,
you will have the background to make proper investment decisions. I have no doubt that
sooner or later you will be faced with an investment decision making situation, if you haven’t
done so already. Someday, you may want to set some money aside either with a definite
motive of using it as a down payment for a house or a car, or with a general motive of having
it for emergencies. You will examine alternative places to put this money: a savings account,
a money market mutual fund, a stock mutual fund, or maybe stock or bond of your favorite
company. To make an intelligent decision you should be able to evaluate these alternatives.
This course gives you the background to make that evaluation.
Let us begin by defining investment. When we make an investment, we are using the
money that could otherwise have been consumed. We could have used it to buy groceries, buy
a car, take a vacation, or build a house. By making the investment, we are sacrificing these
pleasures. There ought to be some reward for this sacrifice. The reward is that we expect to
get back more than what we put in. We can then consume the amount that we get back. In
economic terms, when we invest, we trade current consumption for future consumption. For
an investment to be acceptable, the trade-off should be favorable, i.e., we must expect that
1
Introduction 2
the pleasure derived from the future consumption will be more than the pleasure foregone.
Since the economic term for pleasure is utility, we can define investment as the act of
giving up current consumption and using it so that the resulting future consumption may
provide an improvement in utility. For an investment to be acceptable it is not enough that
the amount received in the future be more than what we invested. It should be more by
such an amount that it compensates for the inconvenience caused by the postponement of
consumption.
Investments are classified into two categories: real and financial. Real investments are
made in tangible assets. If you invest $100,000 in a factory or a restaurant, you are making
a real investment. Real investments are made by people who have technical knowledge or
insight that can lead to a valuable product or service. Often, these people do not have enough
capital to make the investment and therefore they look elsewhere for financial support.
Financial investors invest in the companies formed for the sake of real investment, and thus,
support real investment activity in the economy.
Financial markets bring the real and financial investors together. When you make a
financial investment, you receive a piece of paper known as a security that outlines the
terms and conditions of the investment. This course deals with financial investments and
therefore concentrates on securities such as stocks and bonds. Securities may be marketable
or privately placed. A marketable security is one that can be bought and sold in an open
market. Most corporations and governments issue marketable securities. Privately placed
securities are issued by companies to family, friends, relatives and acquaintances, and are not
traded publicly. Our focus will be on the marketable securities issued by the governments
(federal, state, and local) and corporations.
These notes are organized as follows: Chapter 1 describes the different kind of securities,
how the securities are issued and traded, and where one can get information about the
securities. Chapter 2 explores the concepts of return and risk. Chapter 3 shows how investors
can reduce risk by investing in portfolios of several securities. Chapter 4 discusses the process
of security selection and performance evaluation. Chapters 5, 6, and 7 are devoted to the
individual securities: stocks, bonds, and options and futures, respectively.
Chapter 1
Securities Markets
In this Chapter you will learn about the different kind of securities, how the securities are
issued and traded in the market, how investors buy and sell securities, and where one can get
investment information. The description focuses on the important aspects of these topics.
For detailed information you should consult the additional readings listed at the end of the
Chapter.
1.1 The Securities

Securities, also called financial instruments, are the medium of financial investments.
Common stock, preferred stock, bonds, mutual funds, and options and futures contracts are
examples of securities. Common and preferred stock, and bonds are issued by corporations
or governments to raise capital. Mutual funds are created by financial companies using
existing securities. Options and futures contracts are created by the investors and involve
other securities. Brief descriptions of these securities are provided later in this section.
1.1.1 Money Market Securities

Short term securities issued by corporations and governments to borrow money are known
as money market securities and are traded in the money market. Securities are classified
as short term if they have a life of one year or less, i.e., all the obligations associated with
the security are paid off within a year. Commercial paper (issued by corporations) and
Treasury bills (issued by the U.S. Treasury for the federal government) are examples of
short term securities. Money market securities do not pay any interim interest. They are
sold at a discount, the discount being the interest. Consider an investor who buys GMAC
commercial paper for $98,000. On maturity, three months later, GMAC pays back $100,000
to the investor. The $2,000 difference is the interest amount.
3
Securities Markets 4
1.1.2 Capital Market Securities

Long term securities issued by corporations and governments are known as capital market
securities and are traded in the capital market. Bonds, preferred stocks, and common
stocks are capital market securities.
Bonds and preferred stocks are debt securities.1 By buying these securities, investors
lend money to the issuer. In return, the issuer promises to pay interest periodically till the
maturity date and to pay the face value on the maturity date. The interest and face value
payments to be made by the issuer are usually fixed and known at the time the security
is issued. For this reason, bonds and preferred stock are also known as fixed income
securities.
Common stocks are issued by corporations. By buying shares of common stock, investors
become part owners of the issuing corporation. Common stockholders are entitled to certain
ownership privileges, most important of which is a claim to the corporation’s assets and
earnings net of the payments to the bondholders and other lenders. Since common stock-
holders receive what is left over after paying the bondholders and lenders, common stock is
also known as a residual income security. Even though common stock gives the investor
the privileges of ownership, the liability from the ownership is limited to the amount invested
in the common stock. For example, if you bought 100 shares of Kodak at $50, and Kodak
were to go bankrupt (because of a lawsuit, for example), the maximum you could lose is
the $5,000 you already invested. For this reason, common stock is known to have a limited
liability.
Corporations pass their earnings to the common stockholders in form of dividend pay-
ments. A corporation, however, is not obligated to pay dividends. It may retain the earnings
for reinvestment purposes. Retained earnings increase the value of the corporation’s assets
and therefore the market price of the stock.
Common stock is the most popular form of investment among individuals. Therefore,
majority of the financial news is concentrated on common stock. Keeping with this spirit,
common stock will be used to illustrate the concepts in Chapters 1 through 4 of these notes,
although many of the concepts apply to other securities also.
1.1.3 Mutual Funds

Investors like to diversify by distributing their money over several different securities so that
the losses on some securities may be compensated by the gains on the others. Forming such
portfolios, however, is time consuming and expensive for individual investors. Financial
companies such as Fidelity Investments and Vanguard create and manage portfolios known
as mutual funds. Investors buy shares in these mutual funds and receive the benefits of
1
While preferred stock is treated in the same manner as common stock for accounting purposes, it shares
more investment characteristics with bonds than with common stocks. Therefore, it is treated as a bond
here.
diversification. Mutual fund companies aggregate the shareholders wealth and invest it
in securities. Investing in mutual funds is considered an indirect investment because
individuals are investing in funds which in turn are investing in securities. If individual
investors buy securities directly, it is known as a direct investment.
There are many kind of mutual funds: funds that invest in stocks, funds that invest
in short term bonds (money market funds), funds that invest in municipal bonds, etc.
Investors can choose the funds that meet their objectives and preferences. Mutual funds
have become immensely popular during the last twenty years. The number of mutual funds
available has grown from 477 in 1977 to 5,375 at the end of 1994. The total assets invested in
mutual funds amount to $2,164.5 billion. About 31% of the US households invest in mutual
funds.
1.1.4 Options and Futures

Options and futures are contracts between investors. An option or a futures contract is
created if there are two investors who want to enter the contract: one wants to buy it and
the other wants to sell it.
A futures contract involves the sale of an asset on a future date at a price agreed upon
now. For example, we may enter a futures contract which states that you will sell me 5,000
bushels of corn 3 months from now at $2.40 per bushel. Why would we enter this contract?
Suppose the current price of corn is $2.36 per bushel. I know that I will need 5,000 bushels
of corn three months later but I don’t want to face the risk of the price going up too much.
You, on the other hand, are willing to take that risk. So you offer to sell me the corn for
$2.40. Three months later, if the corn price goes up to $2.50, I will save $0.10 per bushel. If
the price goes down to $2.30, you will make $0.10 per bushel.
An option contract involves one person giving the other a right for a transaction in
the future. For example, we may enter the following option contract. For a small fee (say
$1) that I pay you now, you give me the right to buy from you a share of Kodak for $45
any time during the next 2 months. Why would we enter this contract? I may do it because
I believe that the price of Kodak will go up during the next two months and will be more
than $45. You may enter the contract because you believe that the share price will not go
above $45. If the price goes above $45, I will exercise the right you gave me and buy a share
of Kodak for $45 while it is worth a lot more. On the other hand, if the price does not go
above $45, I will not exercise the right you gave me and you will make $1.
Options and futures allow security risk to be transferred from one person to another. In
the corn futures example, I transferred the risk of corn price going up to you for a small fee
($0.04 per bushel). Similarly, in the Kodak option example, I transferred the risk of share
price going up to you for $1. In popular literature, options and futures are viewed as risky
investments and investing in these securities is considered similar to gambling. However,
judicious use of options and futures with other securities such as stocks and bonds can be
extremely useful to investors.
1.2 Security Prices

Security prices are determined by the process of supply and demand. Under ideal con-
ditions, the market price of a security should be equal to the intrinsic value of the security.
The intrinsic value of a security comes from the cashflows expected from the security in the
future. Investors estimate the value of a security using the information available to them.
Since investors differ from each other in information, age, attitudes, tax brackets, and needs,
they arrive at different estimates for the same security. These differential estimates create
supply and demand for securities.
If the market price is below the estimated value, investors want to buy the security, and if
the price is above the estimated value, they want to sell it. The market price of the security
responds to demand and supply: it goes up if the demand exceeds supply, and it goes down
if the supply exceeds demand. The condition when supply equals demand, i.e., the market
clears, is known as equilibrium. The securities markets are very dynamic. New information
and interpretations arrive in the market constantly which causes the demand and supply to
fluctuate continuously. As a result, market equilibrium does not last very long. The market
moves from one equilibrium to another. For our discussion we will often freeze the market
at a particular point. Otherwise, by the time we finish our discussion the market would be
at a different point!
1.3 Investment Profits and Returns

Buying and selling securities creates profits or losses for investors. If an investor buys a
security at a low price and sells at a high price, he makes a profit. On the other hand, if
he buys high and sells low, he realizes a negative profit, i.e., a loss. Any cash distributions
(dividends or interest) that the investor receives from the security add to the profits. To
be able to compare the profits from one security with another, the profits are scaled by
dividing by the investment amount. The resulting number is known as the rate of return on
investment, or simply return. Other things being the same, investments with higher returns
are more desirable.
Suppose you bought 100 shares of a stock at $60 a share, held them for one year, received
a dividend of $2 per share, and sold the shares at $70 a share after receiving the dividend,
then your profit per share was ($70 − $60) + $2 = $12. The profit of $12 was made up of
two parts: a capital gain of ($70 − $60) = $10 from the increase in price and an income
of $2 in form of the dividend. Since you made $12 on your investment of $60, your return
was 12/60 = 0.20 or 20%. It is important to associate a time unit with the rate of return.
Since you made this profit over a one year period, your return was 20% per year.
To generalize the above example, suppose at the beginning of a period, you make an
investment of w0 and at the end of the period the securities are worth w1 , then the profit
from the investment is w1 − w0 and the return r is:

w1 − w0
r= (1.1)
w0
For a security, let us express the initial price by p0 , the final price by p1 , and the interest or
dividend by d, then the total profit is p1 − p0 + d and the return is:
p1 − p0 + d
r= (1.2)
p0
1.4 Investors and their Motives

The investment marketplace is filled with many different kind of investors:
• Individual investors like you and me who mostly use investments as a vehicle for
savings. About 51 million Americans owned shares in 1994, either directly or indirectly
through mutual funds, etc.
• Corporations who purchase securities when they have excess funds. Sometimes they
may do it to gain ownership and control of other companies.
• Institutional investors such as insurance companies, pension funds, college endow-
ment funds, and mutual funds whose professional function is to invest.
Individual investors usually make relatively small trades. For example, an individual
investor may buy 100 shares of AT&T, or sell 200 shares of Kodak. Institutional investors
deal with large amounts of money and therefore often trade shares in large quantities. If a
trade involves 10,000 shares or more, it is known as a block trade. Block trades usually
cause the market prices to fluctuate significantly. In this way, institutional investors exercise
great influence on the market. In 1994, 55.5% of the shares traded in the New York Stock
Exchange were through block trades. Block trades, however, accounted for only 5.8% of all
trades conducted on the NYSE. 78.8% of the trades involved 2,000 or fewer shares.
Different investors have different motives for trading in securities. The motives can be
classified as follows:
• Need for liquidity: Liquidity motivated investors buy securities when they have
excess funds and sell them when they need funds. Most trades by individual investors
are liquidity motivated.
• Speculation: An investor who speculates is betting on the movement of the price of
a security. Speculators believe that they can predict the movement of security prices.
Therefore, they invest in specific securities at specific times. If you were to buy 100
shares of Microsoft Corporation because of a hot tip, you would be speculating. While
liquidity motivated investors use their own money, speculators may even borrow money
for investment.
• Hedging: An investment that is made to reduce risk is called hedging. Hedging is

similar to buying insurance to protect against loss. Options and futures contracts are
used for hedging purposes. Options, for example, allow investors to recover some or
all the losses from unfavorable price movements.
1.5 The Markets

Investors buy and sell securities in securities markets. The securities markets can be classified
as primary and secondary.
1.5.1 Primary Market

Corporations and governments that need capital sell securities in the primary market. Rather
than being an actual place, primary market refers to the process through which securities are
exchanged for money between investors and the issuer. The process of issuing securities is
managed by investment banking firms. Merrill Lynch, Salomon Brothers, Smith Barney, and
CS First Boston are some of the well known investment banking firms. Investment banking
firms advise the issuing corporations on the following matters related to the security issue:
• The kind of security to issue: “Stock or bond?” “Common or preferred stock?” “Serial
or term bonds?”
• The proper time to issue the securities: “Should we issue the securities now or will the
market respond better in three months?”
• The price at which to sell the securities: “The market price of the existing common
stock is $8.50. Should we try to sell the issue at $8.00? Will a discount of $0.50
guarantee the sale of all the shares the corporation wants to sell?”
• Fulfilling the legal requirements: Designing the prospectus. Filing necessary papers
with the Securities and Exchange Commission (SEC). Making necessary announce-
ments.
• Actual selling of the securities: In addition to the basic salesmanship, the investment
bankers may also act as risk takers or underwriters for the issue. The two major
types of agreements between the issuing corporation and the investment banking firms
for selling the securities are firm commitment and best efforts.
◦ Under a firm commitment agreement, the corporation sells the securities to

investment banker(s) at a price below the issue price. The difference being the
commission. For example, if the offering price is $8.00 a share, the corporation
Figure 1.1: A security offerings announcement.
This announcement is not an offer of securities for sale or a solicitation of an offer to buy securities.
June 17, 1991
1,650,000 Shares
Ecogen Inc.
Common Stock
Price $8 per share
Copies of the prospectus may be obtained from such of the undersigned (who are
among the underwriters named in the prospectus) as may legally
offer these securities under applicable securities laws.
Dillon, Read & Co. Inc.

Prudential Securities Incorporated
Piper, Jaffray & Hopwood

Incorporated
Bear, Stearns & Co. Inc. The First Boston Corporation Alex. Brown & Sons
Incorporated
Donaldson, Lufkin & Jenrette Hambrecht & Quist Kidder, Peabody & Co.
Securities Corporation Incorporated Incorporated
Lazard Frères & Co. Merrill Lynch & Co. Montgomery Securities
PaineWebber Incorporated Robertson, Stephens & Company
Smith Barney, Harris Upham & Co. Wertheim Schroder & Co.
Incorporated Incorporated
Deutsche Bank Capital Advest. Inc. Arnhold and S. Bleichroeder, Inc.

Corporation
Interstate/Johnson Lane Janney Montgomery Scott Inc.

Corporation
Jessup, Josephthal & Co., Inc Ladenburg, Thalmann & Co. Inc.
Legg Mason Wood Walker Neuberger & Berman Raymond James & Associates, Inc.
Incorporated
Wheat First Butcher & Singer W. H. Newbold’s Son & Co., Inc.
Capital Markets
Nordberg Capital Inc. Pennsylvania Merchant Group Ltd
Source: The Wall Street Journal, June 17, 1991.

may sell the securities to the investment banker for $7.25 a share. Thus, if one
million shares are to be issued, the potential income to the investment bankers
is $0.75 million. Of course, the realized income will depend on how many shares
are sold. The issuing corporation is not concerned with the number of shares sold
because it will get the money from the investment bankers. Firm commitment is
the common method of issue for large corporations.
◦ In the best efforts arrangement, investment banking firms do not take any risk.
Their commission is either fixed regardless of how many shares are sold, or is
a combination of a fixed fee plus a commission on each share sold. Any unsold
shares are returned to the issuing corporation. Best efforts arrangements are used
for smaller, lesser known firms.
Investors are informed about security issues through announcements in The Wall Street
Journal and other business publications. An announcement that appeared in the Journal on
June 17, 1991 is shown in Figure 1.1. Note that the advertisement refers to a prospectus.
The prospectus outlines the history of the company, its current financial situation, and its
plans. If investors find the prospectus appealing, they may purchase the shares from the
investment bankers. Usually, many investment bankers are involved in selling the securities
even though they do not act as advisors. In the announcement in Figure 1.1, Dillon, Read &
Co. Inc., Prudential Securities Incorporated, and Piper, Jaffray & Hopwood, Incorporated
are the primary investment bankers, i.e., they advised Ecogen Inc. throughout the issue. The
remaining investment bankers only acted as sellers.
The securities issue process is a very time consuming activity. From start to finish, it
may take as long as four to six months. It is also very expensive. The commissions to the
sellers and underwriters and other expenses may amount to as much as 10% of the size of
the issue.
1.5.2 Secondary Market

Once the securities have been issued, investors who bought the securities may want to sell
them and others may want to buy them. These trades occur in the secondary market. The
New York Stock Exchange (NYSE) is a major secondary market. Other secondary mar-
kets include the American Stock Exchange (AMEX or ASE) and many regional exchanges
located in various parts of the country.2 The trading in these stock exchanges takes place
through face-to-face contact between the brokers who act as agents for the investors. The
brokers make offers for the securities by shouting and using hand signals, much like in an
auction. This trading method is known as the open outcry system. With the advances in
2
Sometimes, in popular financial reporting, the term secondary markets is used for smaller exchanges
such as American Stock Exchange or the over-the-counter markets only. That use of the term is technically
imprecise.
computers and communications, the over-the-counter (OTC) has become a very prominent
secondary market. The OTC market is a network of communications between the securities
dealers. The securities that are traded over-the-counter are listed on the NASDAQ (National
Association of Securities Dealers Automated Quotation) system. The communication net-
work makes the most recent prices available on computer terminals and trades are completed
through communication lines without the two parties ever meeting each other.
There are organized exchanges for other securities and financial contracts also. Bonds
are traded in a separate area in the New York and other stock exchanges. Option contracts
are traded in Chicago Board Options Exchange (CBOE), American Stock Exchange, and
regional exchanges. Futures contracts are traded in Chicago Board of Trade (CBT), New
York Futures Exchange (NYFE), New York Mercantile Exchange, etc. There are organized
exchanges for trading securities in other countries as well. Some of the world’s largest stock
exchanges are located in Tokyo, London, Toronto, Milan, Paris, Amsterdam, Stockholm,
Brussels, Frankfurt, Montreal, Hong Kong, Singapore, and Sydney.
The New York Stock Exchange, founded in 1792, is the largest stock exchange in the
United States. It is located in a large building at 18 Broad Street. The stocks are traded on
a floor about the size of a football field which is divided into several chambers. There are
several booths, known as trading posts, on the trading floor, each trading a few securities.
There are electronic bulletin boards and TV monitors throughout the exchange floor that
constantly display security prices and news from around the world. Along the boundary of
the trading areas, there are offices for the brokers. These offices are managed by clerical staff
and runners who convey orders received on the phone to the brokers. During the trading
hours, the exchange floor appears to be a crowded mad house with paper all over the place
and people screaming and gesturing endlessly with their hands.
Trading in the exchange is done by the members, who have to buy seats in the exchange.
At present there are 1,366 seats in the NYSE. Fifty eight non-seat owning members have
access to the exchange by paying an annual fee. The seats are owned by individuals and
companies, and are traded in the open market. The price of a big board seat during 1994
fluctuated between $760,000 and $830,000. Members of the exchange can be classified as
follows:
• Traders buy and sell on their personal account.
• Commission brokers execute orders for their customers.
• Floor brokers engage in miscellaneous trading. One of their functions is to trade for
a commission broker who may be temporarily busy.
• Specialists are traders who specialize in trading some particular securities. They
manage the trading posts and facilitate in trading among brokers and dealers by keeping
track of their orders and matching the buy and sell orders as feasible. Specialists also
have the responsibility of being the market makers. In other words, they have an
obligation to keep the market going by buying and selling shares as needed. For
example, if many investors want to sell their shares of IBM during an afternoon, the
market will shut down if there are no buyers. The IBM specialist has the responsibility
to buy the shares in this situation. Similarly, if there is a sudden demand for the shares
of IBM, the specialist has to sell the shares. For such contingencies, the specialist must
carry a large inventory of shares. However, only 17.3% of the trades in 1994 involved
specialists. In rest of the cases, brokers traded among themselves.
The NYSE is open for trading between 9:30 am and 4:00 pm. Two after-hours sessions
(known as crossing sessions I and II) allow trading between 4:15 pm and 5:00 pm, and
4:00 pm and 5:15 pm, respectively, at that day’s closing prices. The average daily trading
volume (number of shares traded) during 1994 was 291.4 million shares. The annual trading
volume was 73.4 billion shares, accounting for $2.45 trillion in value. The rate at which the
shares change hands on the NYSE works out to over 10,000 shares per second. Clearly, face
to face trading among brokers and dealers would not be able to accomplish this rate. A
computerized order matching system known as SuperDot3 was responsible for 44.4 billion,
or 60.5% of all shares traded in 1994.
For a stock to be traded on the NYSE, it has to be listed on the exchange. Firms have
to meet strict requirements and pay a fee to be listed and traded on the NYSE. These
requirements are designed to make sure that only the nationally prominent securities are
traded in the NYSE. Despite the strict listing requirements, corporations like their stock to
be listed on the big board—a nickname for the NYSE—because it gives them visibility and
prominence which is useful when issuing new securities. At the end of 1994, the NYSE had
2,570 firms listed which made up 3,060 stock issues, with over 142 billion shares having a
total market value of $4.45 trillion. The price of an average share in the NYSE in 1994 was
$31.26.
1.6 The Trading Process

Investors who want to buy and sell securities have to contact a brokerage house, open an
investment account, and be assigned an account executive (AE). There are two kind of
brokerage houses: discount and full service. Discount brokerage houses just trade for their
customers while full service brokerage houses provide recommendations and advice as well.
Some well known brokerage houses are Merrill Lynch, Dean Witter, and Charles Schwab.
To buy or sell some securities, the investor places an order with the account executive. The
order can be a day order or a good till cancelled order. Day orders must be executed
during the specified day, while good till cancelled orders are valid from the time the order
is placed till the order is filled or cancelled. With respect to price, there are three kinds of
orders:
3
The Dot stands for Designated Order Turnaround.
• Market order is an order to buy or sell securities at the best price available. A market
order is placed when an investor wants to leave the judgement about the price to the
broker.
• Limit order is an order to buy at a specified price (called the limit price) or less, or
sell at a specified price or more. Limit orders are placed to make sure that securities
are bought at a low enough price or sold at a high enough price.
• Stop loss order is an order to sell if the price falls to a particular level (stop level)
or to buy if the price rises to a particular level. Stop loss orders are placed when an
investor wants to cut losses.
The order is transmitted to the exchange floor office of the commission broker associated
with the brokerage house. The order is taken by the runner to the commission broker. The
commission broker goes to the booth where the security is traded. There may be other
brokers at the booth waiting to buy or sell. The specialist who deals in the stock quotes
two prices: a price at which he will sell the shares—the ask price—and another at which
he will buy the shares—the bid price. As you may expect, the ask price is higher than
the bid price. The difference is known as the bid-ask spread and provides a commission
to the specialist. If the bid and ask prices4 on the stock of XYZ are 24 1/4 and 24 1/2 then
an investor’s buy order for the shares will be executed at 24 1/2 and sell order at 24 1/4. The
order may be executed at an intermediate price, say 24 3/8, if there are two brokers: one who
wants to sell and another who wants to buy, and they decide to bypass the specialist. Upon
completion of the trade, the broker notifies the account executive through the runner who
in turn notifies the investor that the order has been executed. The investor usually makes
the payment (for a buy transaction) or receives the payment (for a sell transaction) within
three business days of the transaction.
In addition to the security price, the investor has to pay commissions and trading costs.
These transaction costs are always incurred by the investor whether he is buying or selling the
securities. The amount of transaction costs depends on the kind of account, the brokerage
house, the size of the order, etc. The transaction costs are not fixed and different brokerage
houses may charge different amounts for the same transaction. The commissions are higher
if an investor wants to trade in odd lots (not multiples of 100 shares). A good estimate
for transaction costs for a round lot (multiples of 100 shares) is 2% of the security price.
For example, if the shares were purchased for $100 each, the investor will have to pay
approximately $102. If they were sold for $100 the investor will get approximately $98. A
popular term used in the market is round trip transaction costs. Round trip refers to
buying and then selling a security. If an investor paid $30 in commissions when buying the
securities and $35 while selling them then the round trip transaction cost is $65.
4
The securities are traded at price intervals of 1/8, 1/16, or 1/32 depending on the exchange and the type of
security. 1/8, 1/16, or 1/32 is known as a tick. A tick is the smallest price movement allowed by the exchange.
A proposal for making the smallest price movement a penny is being studied by the SEC.
1.7 Long and Short Positions

Suppose the common stock of ABC is selling at $10 today. Based on your information you
expect the price to go up to $15 in 6 months. To make a profit one must buy low and sell
high. So, you may buy 100 shares of ABC for a total of $1,000 today. This is a positive
investment of $1,000 in ABC on your part. You will be 100 shares long on ABC, i.e., you
will own the shares of ABC. In six months, when the price does go up to $15, you may sell
the shares and make a profit of $500 on your investment. Of course, you will have a loss
if the price goes down. When you go long, your dollar loss is limited to the amount you
invested because the market price of a common stock can never be negative. However, there
is no limit to your profits because the stock price can keep rising without any limit.
Another stock, XYZ, is also selling at $10 today. Based on your information about this
stock, you expect the price to go down to $5 in 6 months. Since the stock price is high,
you should sell the shares now and buy them when the price is low. If you do not own any
shares to sell, you may borrow 100 shares from a friend, sell them, and pocket the proceeds
($1,000). This represents a negative investment of $1,000 because money has come into your
pocket, not gone out. You will be 100 shares short in XYZ. You do not own the shares but
you owe them; they are a liability. Six months later, when the price does go down to $5,
you may buy 100 shares of XYZ in the market (for $500), return them to your friend and
keep $500 as your profit. When you go short, there is a limit on your dollar gain because
the lowest the price can go is zero, but there is no limit on your losses because the price can
keep going up without any limit.
Short selling is risky not only because of unlimited losses but also because for each short
seller, there are two investors—the lender and the buyer—who have a positive outlook about
the stock. The lender must feel optimistic about the stock otherwise he would have sold the
shares himself. The buyer must also feel positively about the shares otherwise he would not
buy them. Therefore, one must be very sure of one’s information before short selling.
Going short is not as simple as described above. Even your best friends may not trust
you so much as to lend you the shares without any guarantee. In actual investing situations,
you borrow the shares from your broker. The broker requires you to maintain a collateral
for the market value of the borrowed shares ($1,000 in the example above) till the shares are
returned. The deposit must always be equal to the market value of the securities. Therefore,
if the share price in the example above were to go up to $13 in a week, you will have to add
$300 to the deposit. On the other hand, if it were to go down to $7, you could withdraw
$300 from the account. The collateral is maintained in an interest free account with the
broker. Therefore, the investor does not receive any interest on these funds. The investor
may substitute the collateral cash by other securities whose market values equal the required
collateral.
The short seller is required to pay dividends to the lender if the stock pays a dividend. Let
us understand the reason for this by following the mechanism of short selling carefully using
Figure 1.2. When you short sell 100 shares of XYZ, your broker borrows them on your behalf
Figure 1.2: Transactions in short selling.
1. Shares ....
..................................................................................
2. Shares ....
..................................................................................
.... Short ....
Buyer
Lender Seller .... 3. Cash
...............................................................................
.......
. ...
..
...
...
4. Cash ... .... ...
........
..
Deposit
Initial Transaction
4. Shares
....
..................................................................................
3. Shares
....
..................................................................................
.... Short ....
Lender Seller 2. Cash ....
...................................................................................
Seller
. ...
.........
... ... ..
....
1. Cash ..
...
..
Deposit
Final Transaction
from another investor’s account, say Ms. L. You sell the shares to Mr. B. Now, suppose the
stock declares the dividend. Since Mr. B owns the shares, he will get the dividends directly
from the corporation. Ms. L, on the other hand, has only lent the shares.5 She still owns
them. Therefore, she expects the dividends that the stock paid. Since you borrowed the
shares, you are expected to pay those dividends.
Trading restrictions do not allow short selling if the last movement in the security price
has been downward. This is called the up-tick rule and is designed to keep the market free
of any psychological pressures. Regulators believe that if the market is on a downward trend
due to selling, short selling could put additional artificial downward pressure on the prices.
A large amount of short selling in the market indicates that investors are bearish about
the market, i.e., they expect the prices to go down. Does this mean that other investors
should also sell? Maybe. However, remember that the shares that have been sold short
will be bought back. This assures a demand for the shares in the future. Therefore, some
investors should be willing to buy the shares and sell them later when short sellers go to the
market to buy the shares back to replace them. However, short sellers may not need to buy
back all the shares if they are shorting against the box, i.e., short selling the shares they
already own. Shorting against the box is used by investors because it allows them to lock in
the profits they have made (see problems 1.8 and 1.15). In that case, only those shares that
have not been shorted against the box will need to be replaced. This information is conveyed
by short interest. Short interest is the net short position of an investor. For example, if
5
As a matter of fact, she may not even know that her shares have been lent.
I sell 300 shares of XYZ short while I am long 200 shares of XYZ, my net short position or
short interest is only 100 shares of XYZ because, to replace the borrowed shares, I will need
to buy only 100 shares of XYZ, not 300 shares. The Wall Street Journal publishes a short
interest report every month around the end of the third week. It contains a lot of useful
information about short selling and short interest trends in the market.
An important lesson from the idea of short selling is that you never have to stay out of
the market. If you find a security that is a good buy, i.e., you expect its price to go up, you
should go long on it. If you find a security that is not a good buy, i.e., you expect its price
to go down, you should not ignore that security. If you hold that security, sell it. If you do
not own that security, you may make a profit by selling it short.
1.8 Cash and Margin Accounts

When you open an investment account with a brokerage house, you can make it either a cash
account or a margin account. In a cash account all the transactions are financed by 100% of
your funds. You do not borrow any money from the broker. A margin account allows you
to take loans from the brokerage house to finance your investments.
When you purchase securities using a cash account, you may take possession of the
securities, i.e., take them home, or you may leave them with the broker. Securities left with
the broker are said to be held in street name. When the securities are held in street name,
your account statement reflects the fact that you own the securities. This arrangement is
preferred by the brokerage houses because selling and buying transactions are quite easy to
perform—they become mere book-keeping exercises. The arrangement is also preferred by
the investors because they do not have to guard the securities from theft and accidents.
In a margin account the securities must be kept in the street name because they are used
as collateral against the loan made by the brokerage house. The broker, however, does not
advance full value of the securities as a loan. The investor has to put up some cash to make
the purchase. This cash is required to cover the losses that may result from adverse price
movements.
The size of the loan that an investor is allowed in a margin account is governed by many
factors. The two important ones are the risk of the investment and the status of the investor
and the account. Accounts are allowed bigger loans if the investment is less risky. Also,
the amount of loan that an account may be forwarded depends on the investor’s other asset
holdings and reputation. The interest rate on the margin loans are quite low because these
loans are secured by marketable securities.
The Federal Reserve Bank and the securities exchanges provide guidelines which are
followed by the brokerage houses in maintaining the margin accounts. The brokerage houses
usually impose stricter requirements. The guidelines are defined in terms of the margin ratio
or simply the margin. The margin ratio measures the amount of equity in the account as
a fraction of the market value of securities:

Equity
Margin = . (1.3)
Market Value of Securities
The higher the margin, the higher the equity and the less the debt in the account. A 100%
margin account is fully equity financed—it is a cash account—while a 40% margin account
is financed by 40% equity and 60% loan.
Each account has two margin requirements: initial margin and maintenance margin.
When the account is opened, the margin in the account must at least be equal to the
initial margin specified for that account. Once the account is well established and in good
standing, the margin may drop, but it should not go below the maintenance level. Initial
and maintenance margins specify the minimum equity that the investor must have in the
account.
The margin in an account fluctuates with the market price of the securities held in the
account. If the margin falls below the maintenance level, the investor receives a margin
call from the brokerage house to bring the account up to the initial margin. If the investor
does not respond to the margin call, the brokerage house may sell some of the securities to
make the account current. If the margin in the account is above the maintenance level, the
investor can use the excess equity to make more investments or even withdraw cash from the
account. In the following subsections we will look at some common calculations in margin
accounts.
1.8.1 Long Position

Let us take the example of Mr. Garner, who has a margin account with Lean Hitter. The
initial and maintenance margin requirements for his account are 60% and 25%. Mr. Garner
wants to buy 100 shares of QVC. The shares are priced at $31 each. Since the initial margin
requirement is 60%, Mr. Garner must have equity worth at least 0.6 × $3,100 = $1,860. He
may take a loan for the remaining amount.6 Let us say Mr. Garner takes the maximum loan
permitted to him. The balance sheet of Mr. Garner’s account after the transaction is:
Assets ($) Liabilities and Equity ($)
Mkt. Val. of QVC 3,100 Loan 1,240

Equity 1,860
Total 3,100 Total 3,100
Now we will examine Mr. Garner’s account under different scenarios.

6
An investor is not required to borrow anything from the broker. He may choose to borrow all or part of
what he can. In our examples we will assume that investors borrow as much as they can.
$ Let us say that the market price goes up to $40. The account position is:

Equity 2,760
Note that the equity value increased as the market value of shares went up while the
loan amount did not change. The margin ratio now is 2,760/4,000 = 69%. Mr. Garner
is not required to maintain such a high margin. He can reduce his margin either by
selling some shares and withdrawing the cash resulting from this transaction, or by
making additional investment. Let us examine each of these alternatives.
(a) If Mr. Garner decides to sell some shares and withdraw the proceeds, he has to be
careful that margin does not fall below the maintenance level of 25%. Let us say
Mr. Garner wants to sell enough shares to bring the margin down to 40%, keeping
some cushion for himself. We want to find out how many shares he can sell. If
the number of shares he can sell is n then the remaining shares is (100 − n). The
equity is $40(100 − n) − 1,240. The position of the account is:
Mkt. Val. of QVC 40(100 − n) Loan 1,240

Equity 40(100 − n) − 1,240
Total 40(100 − n) Total 40(100 − n)
The margin ratio that Mr. Garner wants to keep gives us:
40(100 − n) − 1,240
0.40 = .
40(100 − n)
Solving this equation gives n = 48.33. To keep the margin above 0.40, he should
sell 48 shares and withdraw the resulting $1,920,7 leaving behind 52 shares with
a total value of $2,080. The value of equity becomes $840. The balance is:

Equity 840
7
We are not rounding to the nearest integer here. Even if n were 48.7, we will sell 48 shares because
selling 49 shares will bring the margin below the target.
Rather than withdrawing the cash from the account, Mr. Garner may use it to
reduce the loan in the account.
(b) Suppose Mr. Garner decides to buy shares of another stock, TBC, selling for $20
each. The cash needed for this purchase will be loaned by the broker. We want
to find out how many shares Mr. Garner can buy. Let us denote the number of
shares by n. Again, let us assume that Mr. Garner does not want the margin to
fall below 40%. The balance sheet is now made up of $4,000 + $20n in market
value of shares, $1,240 + $20n in loan, and $2,760 in equity. From the margin
requirement we get:
2,760
0.40 = ,
4,000 + 20n
which results in n = 145. Mr. Garner can buy 145 shares of TBC. The balance
sheet now is:

Mkt. Val. of TBC 2,900 Equity 2,760
& The previous set of examples assumed that the share price went up from the initial
price of $31. What happens if the price goes down? Let us calculate the price P at
which Mr. Garner will receive a margin call. The market value of shares at that price
will be 100P which will make the equity equal to 100P − 1,240. The margin call will
go out when the margin ratio falls to 0.25. Therefore,
100P − 1,240
0.25 = ,
100P
which gives us P = 16.53. Let us say that the price actually falls to $15 before
Mr. Garner can respond. At this price the balance sheet looks like:

Equity 260
To increase the margin to the initial level, Mr. Garner may either increase equity by
adding cash or reduce the market value of shares by selling some shares and leaving
the cash in the account. Let us examine these choices.
(a) If he adds cash, on the assets side we will have a new entry for cash and there will
be an increase in equity. A simple calculation will show that the required amount
of cash is $640. The balance sheet of the restored account is:

Cash 640 Equity 900
(b) He may sell some shares and create cash in the account. In fact, if Mr. Garner
does not respond in a reasonable amount of time (usually 5 business days), the
broker will do it for him. You can check that the required number of shares to be
sold is 72. The balance sheet after selling the shares is:
Mkt. Val. of QVC 420 Loan 1,240

Cash 1,080 Equity 260
1.8.2 Short Position

Let us take the case of Ms. Stanford. Her account with Lean Hitter has an initial margin
of 50% and a maintenance margin of 40%. Ms. Stanford begins by short selling 100 shares
of QVC at $31 each. This generates $3,100 which is deposited with the broker. To protect
himself against price increases, the broker asks Ms. Stanford to deposit cash. To understand
the need for this cash, imagine what will happen if there were no cash in the account and the
share price went up to $32. The broker will have to contact Ms. Stanford for an additional
$100. If he cannot find Ms. Stanford, he will have to absorb the loss.8 The initial margin
requirement is 50% so Ms. Stanford must put in $1,550. The balance sheet of the account
is:
Cash 1,550 Mkt. Val. of QVC 3,100

Deposit 3,100 Equity 1,550
Note that the market value of the securities is a liability because the securities are a loan
and have to be returned.
8
To return the securities, the broker will have to buy them back for $3,200 and there are only $3,100 in
the account.
Suppose the price goes up to $33—bad news for Ms. Stanford. This will require a total
deposit of $3,300 with the broker. The additional amount required will be taken out of the
cash and added to the collateral deposit. The account position will be:
Cash 1,350 Mkt. Val. of QVC 3,300

Deposit 3,300 Equity 1,350
The margin on the account now is 40.9% which is slightly above the maintenance margin
of 40%. You can check to see that Ms. Stanford will get a margin call at the price of $33.21.
1.8.3 Mixed Position

Let us consider the account of Mr. and Mrs. Murphy. The initial and maintenance margins
for their account are 70% and 40%, respectively. The Murphys began by buying 2,500 shares
of XLC at $40. The balance sheet at that point was:
Mkt. Val. of XLC 100,000 Loan 30,000

Equity 70,000
Total 100,000 Total 100,000
Once their account was in good standing, they went short 500 shares of PCM selling at
$80. The account balance sheet was:
Mkt. Val. of XLC 100,000 Mkt. Val. of PCM 40,000

Deposit 40,000 Loan 30,000
Equity 70,000
Total 140,000 Total 140,000
This is where the account stands now. The margin ratio is:
Equity 70, 000
Margin = = = 50%
Market Value of Securities 100, 000 + 40, 000
which is above the maintenance margin. Note that the two market values are added even
though one is on the asset side and the other is on the liabilities side.
The broker will make additional loans to the account as long as the margin stays above
the maintenance level of 40%. Suppose the share price of PCM becomes $86, the additional
deposit of $3,000 will be loaned by the broker and the account position will be:

Equity 67,000
Total 143,000 Total 143,000
The margin in the account will be 46.8%, which is above the maintenance margin. Now,
if the market price of XLC drops to $32, the account balance sheet will be:

Equity 47,000
Total 123,000 Total 123,000
The margin now is 38% which is below the maintenance level. The margin call will go
out to the Murphys. They may restore their account by either adding cash, or selling some
shares of XLC, or buying some shares of PCM. If they choose to add cash, they will have to
add $39,100. The balance sheet, after adding cash, will be:

Cash 39,100 Equity 86,100
Total 152,100 Total 152,100
1.8.4 Account Closing

An investor may close the whole account or some of the positions in the account at any
time by selling the long securities, and buying back the short securities and returning them.
The proceeds from selling the long holdings will create cash. The cash needed to close the
short position will come from the collateral deposit. Neither of these actions will affect the
equity position. The investor may reduce the equity by taking out cash from the account or
completely close the account by reducing the equity to zero.
In our discussion of margin accounts, we did not consider the effect of interest and
commissions on the transactions. In reality these costs are incorporated as they are incurred.
For example, if an investor buys 100 shares at the price of $31 per share and the transaction
costs are $100 for this round lot, the investor will have to pay $3,200 to purchase $3,100
worth of shares. Similar costs will be incurred at the time of selling. Interest on loan
outstanding will be deducted from the equity periodically (monthly or quarterly). While
doing the exercises, you may let such costs accrue and assume they are paid in the end while
closing the account.
1.9 Investment Information

All investment decisions depend on information. Without proper information and the ability
to interpret and use it, investors will not be able to make proper decisions. The most popular
sources of investment information are financial and business publications such as The Wall
Street Journal, Financial Times, Barron’s, Business Week, Forbes, Money Magazine, and
Fortune. Several TV programs are also good sources of information. Nightly Business
Report and Wall Street Week on PBS, and various business related programs on CNN are
some of them. CNBC is a cable channel dedicated to financial programming. TV news
services such as CNN Headline News and CNBC display a ticker tape at the bottom of the
screen during the trading hours. This ticker tape shows the trades as they happen. The
company names in these trades are indicated using special symbols known as ticker symbols.
You can find the list of ticker symbols in The Wall Street Journal stock tables. The ticker
tape shows the most recent trade and the price at which the trade took place. For example,
IBM 3s58 on the tape means that 300 shares of IBM were traded at $58 per share.
If you really get serious about investing, you may want to subscribe to a computerized
news services such as Dow Jones News Retrieval (DJNR). DJNR lets you access the breaking
business and political stories from around the world. You may also be connected to a broker
through your computer and a modem, and be able to place your order instantly after reading
a news item from DJNR.
Like any specialized subject, investment markets have their own jargon. To a novice the
financial news may sound like a foreign language. You will have to follow these news sources
for a few weeks before you become comfortable with the terminology. You should make it a
habit to watch at least one hour of financial news a week. Also, go through the Money &
Investing section of The Wall Street Journal at least once a week.
Probably the single most popular investment term is Dow Jones Industrial Average
(DJIA). The DJIA is an index of the prices in the stock market. The index is created by
summing the prices of 30 carefully selected stocks of industrial companies in the NYSE and
dividing the sum by a constant. DJIA is intended to be a measure of the prices of the stocks
in the market. There are other broader indices, e.g., the Standard and Poor’s 500 (S&P
500), and the NYSE and NASDAQ composites. While following these indices you should
keep in mind that it is the relative change in the index value, and not the index value itself,
that is important. For example, the news that Dow closed at at 3,721.50 today is not of
much use without knowing that yesterday it was 3,710. Over the period of one day the index
value increased by 11.50. This represents an increase of 0.31% in one day. The change in the
index is useful to the investors in assessing the change in the value of their own investment
portfolios. For example, if you hold a portfolio of securities which are very much like those
included in the DJIA then by knowing that the DJIA went up by 0.31%, you know that your
portfolio value also went up by about 0.31%.
Other economic data items to watch for are the number of issues traded, share volume,
odd lot trading, short interest, etc. Most of this information is contained in the Money &
Investing section of The Wall Street Journal. General information about the economy as a
whole e.g., interest rates, money supply, GNP, and dollar exchange rates are also important
because they have a bearing on the value of the securities.
1.10 Market Regulation

Securities markets are mostly self regulated. Self regulation works quite efficiently most of
the time. Nevertheless, sometimes special events require intervention of outside agencies.
An important external agency that watches over the securities issue and trading is the
Securities and Exchange Commission (SEC). The SEC sets the reporting requirements
for corporations and brokerage houses. It also keeps a watch on the trading to make sure
that there are no irregularities or fraud. Some areas of trading fraud being examined by the
securities regulators are insider trading and market manipulation. An insider trade is
a trade driven by information that should be available to corporate insiders only. Market
manipulation refers to fixing the market price by a brokerage house or by an institutional
investor using false information or tricks such as block trades. Insider trading and market
manipulation are considered damaging to the market because they deter other investors from
the market, and if investors stay away from the market, it may be difficult for corporations
to raise capital, which in turn hurts the economy as a whole.
1.11 Conclusion
A wide range of information about the securities markets was presented in this Chapter.
This Chapter was intended to only introduce the basics of the securities markets. You
should consult the additional readings listed below for detailed information. The investment
environment is changing constantly and therefore the best source of information is current
literature and news. Therefore, you should make it a practice to read and watch business
news regularly. You may also want to call up some brokerage houses and ask for free literature
on various investment alternatives.
Additional Reading
• Educational Service Bureau. The Dow Jones Averages: A Non-Professional’s Guide. Dow Jones &
Co. Inc., 1986. A good description of the Dow Jones Averages.
• Sonny Kleinfield. The Traders. New York: Holt, Rinehart and Winston, 1983. An entertaining look
at the lives of the traders in various securities markets.
• Matthew Lesko. The Investor’s Information Sourcebook. New York: Harper Row, 1987. A good
desktop reference for where to find investment related information.
• New York Stock Exchange. Fact Book. Detailed information about the NYSE.
• New York Stock Exchange. Margin Trading Guide. Good practical information about margin trading.
• U. S. Securities and Exchange Commission. “The SEC: Organization and Functions.” The Investments
Reader, Jay Wilbanks (ed.), Homewood, Ill: Richard D. Irwin, 1989. pp. 11–39. A summary of what
the SEC is all about.
• Richard Saul Wurman, Alan Siegel, and Kenneth Morris. The Wall Street Journal Guide to Under-
standing Money & Markets. New York: Access Press, 1989. An excellent reference for the general
information on the securities.
• Kenneth M. Morris and Alan M. Siegel. The Wall Street Journal Guide to Understanding Personal Fi-
nance. New York: Lightbulb Press, 1992. An excellent reference for personal finance and information
on the securities.
Exercises
1.1 Return
On January 1, 1990 Rebecca Wong bought a commercial paper issued by GMAC for $98,000. Three
months later the commercial paper matured and she received a check for $100,000 from GMAC. What was
the rate of return on Rebecca’s investment?
1.2 Return
On March 15, 1988, John bought 100 shares of Federal Express at 24 1/2. John sold the shares a year
later for 27 3/4. There were no other payments or costs involved. What was the rate of return on John’s
investment?
1.3 Round and Odd Lots
Mr. Williams owns 375 shares of D/A Devices, Inc. The bid and ask prices for the stock are $2.75 and
$3.00. The commission charges on a round lot are $12. On odd lot trades the commission is $0.15 per share.
How much money will Mr. Williams receive if he were to sell all his shares?
1.4 Transaction Costs and Return
Alvin Lee got a tip from his brother Ric that the stock of Ten Years After (TYA) should be in big demand
soon because of their new product called A Space In Time. Alvin immediately called his account executive,
Leo Lyons, and issued a market order to buy 200 shares of TYA. The floor broker for Leo’s company filled
the order when the bid and ask prices for TYA were 13 1/8 and 13 1/4. One month later, when the price had
indeed climbed, Alvin called his AE again and issued a market order to sell the shares. The shares were sold
when the bid and ask prices were 15 1/2 and 15 7/8. The commission charges for the transactions were 2% of
the value of the transaction.
(a) What was the initial outflow from Alvin’s pocket for the shares?
(b) What was the inflow to Alvin from the shares?
(c) What was the rate of return?
1.5 Round Trip Transaction Cost

Alice Jenkins placed an order to buy 100 shares of Kodak. The order was executed when the bid and
ask prices were 47 1/4 and 47 1/2. How much money did she send in for this transaction? Assume that there
were no commission expenses.
Two weeks later, Alice realized that she should not have made this investment. She called her AE and
asked him to sell the shares. The shares were sold when the bid and ask prices were exactly the same as
when the shares were bought, i.e., 47 1/4 and 47 1/2. How much money did she receive from this transaction?
What was the round trip transaction cost? Who received the money paid by Alice?
What would the round trip cost have been if the brokerage commissions were 2% of the trading value?
1.6 Long and Short
(a) You bought 100 shares of AT&T on January 1, 1991 at $30 per share. What is the maximum profit you
can make? What is your maximum possible loss? What are the corresponding maximum and minimum
returns?
(b) Your friend went short 100 shares of AT&T on January 1, 1991 at $30 per share. What is the maximum
profit she can make? What is her maximum possible loss? What are the corresponding maximum and
minimum returns?
1.7 Short Interest

What are the short interests in the following cases?
(a) Ramone Fernandes is long 500 shares of IBM.
(b) Sheila Stewart is long 300 shares of Kodak and short 200 shares of Kodak.
(c) Andrew Johnson is long 200 shares of AT&T and short 200 shares of AT&T.
(d) Brenda Myers is long 200 shares of Sears and short 500 shares of Sears.
(e) Glen Watkins is short 300 shares of McDonald’s.
(f) Susan Love is long 200 shares of IBM and short 500 shares of McDonald’s.
1.8 Shorting Against the Box

Gorba the Zeek bought 500 shares of Purex, Inc. at $19 on March 15, 1988. On August 30, the price
had gone to $35. While Gorba was pleased with the performance of his investments, he was worried that his
profits would vanish if the price took a downswing. For tax reasons Gorba did not want to sell his shares in
1988. So, he borrowed 500 shares from a friend and sold them short. He closed all his positions on January
1, 1989 when the price was $50. What was Gorba’s profit from the investment? What would Gorba’s profit
had been if the price on January 1 were $15?
1.9 Margin Accounts
Ms. Miller’s brokerage account requires a 60% initial margin and 40% maintenance margin. Ms. Miller’s
first transaction was to purchase 500 shares of a stock at $40 using full initial margin.
(a) What were the initial equity and loan balances in her account?
(b) At what stock price will she receive a margin call?
(c) Today the stock price fell to $20. How much cash will Ms. Miller be asked to add to her account to
bring the account to the initial margin level?
(d) The account executive (AE) tried to get hold of Ms. Miller. Ms. Miller, however, was not available. How
many shares must the AE sell to restore the account to the initial margin level?
1.10 Margin Accounts

Jack Bruce has a margin account with the brokerage firm of Smith & Wesson. The initial and mainte-
nance margins on his account are 60% and 40%, respectively. The interest rate on margin loans is 11% per
year. On October 11, 1988, Jack purchased 500 shares of Toledo Bakeries at $18. He took the maximum
loan possible to make his purchase. The stock did not pay dividends during the year and today (October
11, 1989) Jack is selling his shares for $20 each.
(a) Show the position of Jack’s account after the initial transaction on October 11, 1988, and today before
the sale of the shares.
(b) Calculate the return on Jack’s investment during the year.
(c) Jack was lucky that the stock price went up. If the price had started going down, Jack would have
received a margin call sooner or later. Determine the stock price at which Jack would have received the
margin call.

Kate Bush opened a new investment account at Yoshida and Barenbom. Her account executive, Kenji
Yoshida, explained that she had a margin account with initial margin of 75% and maintenance margin of
50%. Margin loans will be made to Kate at 9.2% per year. Kate started by asking Kenji to buy 100 shares
of CMA for her at market using full margin. CMA is traded on the OTC. Kenji executed the trade when
the bid and ask prices for the stock were 23 1/4 and 24 1/2, respectively. Yoshida and Barenbom charge a 3%
commission for the OTC transactions.
(a) How much money did Kate have to pay upon completion of the transaction?
(b) A year later, Kate issued a sell order which was executed when the bid and ask prices were 27 and 27 1/2.
How much money did Kate receive?
(c) What was the rate of return on Kate’s investment?

Dr. Hannibal Lecter opened an account with the brokerage company of Duran, Duran, Duran, and
Duran. The initial and maintenance margin on his account are 75% and 40%, respectively. The opening
transaction of Dr. Lecter was to purchase 500 shares of Classic Automobiles. The transaction was executed
when the bid and the ask prices of the stock were 12 1/8 and 12 3/8, respectively. Dr. Lecter paid 90% of the
value of the shares and borrowed the rest at 8% per year. He wrote a separate check to cover the commission
expenses.
(a) What was the position of Dr. Lecter’s account after the opening transaction?
(b) At what stock price will Dr. Lecter receive a margin call?
(c) Six months after the initial transaction, the bid and ask prices for the stock were 14 1/4 and 14 3/8. What
was the margin of Dr. Lecter’s account?
1.13 Short Selling and Margin

Freddie, on a tip from his acquaintance Bertie, sold short 100 shares of Diet Purina at $12. Initial margin
requirement on Freddie’s account is 70%.
(a) What did the balance sheet of the account look like after this initial transaction?
(b) The maintenance margin on Freddie’s account is 40%. At what price will Freddie get a margin call?
(c) What are the two choices available to Freddie to make his account current if he gets the margin call?
(d) Show the account positions after these choices have been executed.
1.14 Long, Short, and Margin

On January 1, 1991, Earl Conway opened a margin account with a discount broker with initial and
maintenance margins of 60% and 35%.
(a) On January 1, he purchased 200 shares of AT&T at $30. How much cash did he send in if he took the
maximum loan possible? What was the position of his account after this transaction?
(b) On February 1, the price of AT&T was $32. Earl placed an order to short sell 100 shares of IBM selling at
$104 per share. His account was considered to be in good standing on February 1. Calculate the margin
in his account after the short sale is completed. Did he have to send any cash for this transaction? If
yes, how much? What was be the position of the account after adding the cash?
(c) On April 1, the price of AT&T was $34 and IBM was selling at $101. What was the margin in the
account?
(d) If Earl decided to liquidate his investments on April 1, what steps would he have taken? What would be
the net proceeds to Earl assuming that there were no transaction costs or interest? What would be the
net proceeds if the transaction costs were 1.5% of the trade value and the interest rate on the margin
loan was 2.1% per quarter?
1.15 Shorting Against the Box and Margin

On August 1, 1987 Ms. Agatha Forsythe bought 1,000 shares of UBM for $21.50 per share. Ms. Forsythe
used her initial margin of 50% to purchase these securities. The broker provides loans at a simple interest
of 1% per month. The interest is not payable till the account is closed. The broker does not charge any
commission. Show the status of her account after this purchase.
By October 1, 1987 things had vastly improved for Ms. Forsythe because the price of UBM had climbed
to $45.75. What did the account look like on October 1, 1987?
During late evening of October 1, 1987 Ms. Forsythe received a phone call from a close friend who
predicted that a major stock market crash was imminent. Convinced after a long talk, Ms. Forsythe decided
to sell her securities and get out of the market. What would be the profit to Ms. Forsythe at this point if
she closed her account?
When she told her broker about closing the account, the broker almost chuckled, “No way, Agatha, the
market is much too strong to go down during the next year or two. I am a professional, you should listen to
me. Crash. Huh!” Ms. Forsythe, however, had more faith in her friend. She insisted,“What if the market
does go down and I lose all my profits? I want to sell my shares now.” “But,” the broker said, “if you
sell your shares now you will have to pay taxes on your gains in 1988. If you wait till January 1, you will
defer your taxes till 1989.” This made sense to Ms. Forsythe. After all, why pay taxes now if they could be
delayed. She asked the broker if he knew of a way by which she could lock in her profits but not have to
pay taxes till later. The broker suggested to Ms. Forsythe to short sell 1,000 shares of UBM—not the ones
that she owned but a different 1,000 shares that she would borrow from the broker. How much cash did
Ms. Forsythe have to add to her account to accomplish this transaction to stay above maintenance margin
of 25%?
Verify the broker’s claim by looking ahead to January 1, 1988. Create the statement of Ms. Forsythe’s
account first assuming that the price of UBM went up to $50 and then assuming that it went down to
$20. Calculate the profits on January 1, 1988 under each scenario. Summarize your findings about shorting
against the box by comparing the numbers for January 1, 1988 with the corresponding numbers from October
1, 1987.
Chapter 2
Return and Risk
Return and risk are the basis of all investment decisions. In this chapter you will learn how
to define and measure return and risk. You will also learn about investors’ attitudes towards
risk and the resulting relationship between return and risk.
2.1 Return
Return—rate of return on investment to be precise—arises from the profit on an investment.
Return is also known as interest rate and yield. Suppose you bought 100 shares of DEC
at $55 for a total of $5,500, and sold them a year later at $62 for a total of $6,200. You made
a profit of $7 per share, or a total of $700. For analysis and decision making we would like to
be able to compare alternative investments. It may not be possible to compare alternative
investments using profits because profits depend on the amount invested: the higher the
investment, the higher the profit. To get around this problem, profits are divided by the
amount invested to calculate return. Return is comparable across securities regardless of the
amount invested. The return on your investment in DEC, for example, was 700/5,500 =
0.127 or 12.7 percent. The same answer is obtained if we use per share values rather than
total values: 7/55 = 0.127. In most of the illustrations and exercises, we will use per share
values rather than total values.
Let us take another example. Suppose you bought 200 shares of IBM at $107. Three
months later, you received a dividend of $1 per share and then you sold the shares at $110.
Your profit was: $1 (from dividend) + $3 (from change in price) = $4. The return on your
investment, therefore, was 4/107 = 0.037 or 3.7%.
Suppose we want to compare returns from investments in DEC and IBM. The return on
DEC was 12.7% while that on IBM was 3.7%. It seems, therefore, that DEC was a better
investment. However, by comparing the DEC return of 12.7% with the IBM return of 3.7%,
we are essentially comparing apples and oranges. The two returns were earned over different
periods: DEC’s return was earned over a year while IBM’s over only three months. We
30
Return and Risk 31
made the mistake of comparing the returns earned over different periods because we did not
include the time unit when stating the returns. The proper way to state the returns would
be 12.7% per year for DEC and 3.7% per quarter for IBM. Now, we would be less likely to
make the mistake of comparing 12.7% with 3.7%. If we do want to compare them, we will
have to convert them to identical time units. We will see how to do that in the next section.
Let us take one final example. Suppose you bought 100 shares of General Motors at
$47, held them for three months, received a dividend of $0.40 per share, and sold them at
$45.50. The return on your investment was −1.10/47 = −0.023 or −2.3% per quarter. This
example shows that it is possible for return to be negative. The return can take values
between −100% and +∞. The return cannot be less than −100% because the maximum
you can lose is your initial investment. There is no limit to how high your profits can go
because the stock price can keep rising without limit. These observations about maximum
and minimum returns assume positive initial investment, i.e., a long position. With short
selling, the highest possible return is +100% while the lowest possible return is −∞.
Let us write the definition of return in algebraic notation. Suppose a person invests w0
in some securities and the value of the securities some time later becomes w1 , then the rate
of return r can be calculated as:
w1 − w0
r= . (2.1)
w0
The numerator in equation (2.1), w1 − w0 , represents profits from the investment. The profit
may come from one of the two sources:
Capital gain: It results from an increase in the value of the securities. A negative capital
gain is a capital loss.
Income: Commonly known examples of income are dividends and interest.
Separating the profit into capital gain and income components, we can write equation
(2.1) as:
p1 − p0 + d
r = (2.2a)
p0
or,
p1 − p 0 d
r = + , (2.2b)
p0 p0
where p0 is the initial purchase price, p1 is the final selling price, and d is the income. The
first part of the right hand side in equation (2.2b) is the return from the price change alone.
It is also known as capital gains yield. The second part is the return from the income. It
is known as current yield in the case of bonds and dividend yield in the case of stocks.
A high dividend yield is important to those investors who seek regular income from their
investments. Those investors who seek growth of their capital look for investments with low
dividend yields.
Return and Risk 32
In these equations, we ignored the taxes and transaction costs incurred by the investor.
This is customary in the investment literature. The reason is that different investors have
different taxes and transaction costs. Ignoring taxes and transaction costs puts all securities
on a common footing and often provides a meaningful basis for comparison across securities.
To determine the return from an investment in a real life situation, one should use the actual
cashflows which take taxes and transaction costs into account.
The equations and the examples given above are necessarily simplistic. They involve only
two transactions: the initial investment (cash outflow) and the final redemption (the cash
inflow). We also assume that the income from the investment is received at the same time
as the investment is redeemed. The situation described by the examples above is known as
a single period situation. Most real life situations are multiperiod because they involve
multiple cash flows. For example, you may buy some shares, receive quarterly dividends for
several years and then sell them. We will see how to calculate the rate of return in such
situations in Chapter 4.
Rate of return can be viewed as growth rate also. For example, if you invest $100, and
earn a return of 10% in a year, your profit will be $10, and the total value of your investment
will be $110. Going from $100 to $110, your money will grow by 10% during the year, which
is the same as the rate of return.
2.2 Conversion of Units of Return

As we saw in section 2.1, to compare returns between two securities, we have to make sure
that they are expressed in the same time unit. Therefore, we need to know how to convert
returns from one time unit to another. Before going to the topic of conversion of units of
return, read a short story:
A lady left her house at 4:00 and was pulled over by a cop at 4:15 for driving too fast. When
the cop told her that she was going at 90 miles per hour, the lady lost her temper. She said,
“It can’t be. I have been driving for only 15 minutes. How do you know I would have done 90
miles in the hour?” “But Ma’am, you were doing 90 when I caught you.” said the cop, “Here
is your ticket. Have a nice day.”
The moral of the story is that you don’t have to be driving an hour for your speed to be
measured at the hourly rate. The cop’s radar gun probably clocked the lady at 0.025 miles
per second. The rest was easy. The radar gun just converted the speed from per second to
per hour by multiplying 0.025 by 3600 because there are 3600 seconds in an hour. Actually,
the conversion was necessary only because the cop would have looked pretty silly telling the
lady that she was going 0.025 miles per second.
The conversion of units of returns is necessary for similar reasons. It is customary to
express the returns on an annual basis. However, you don’t have to invest for a year for your
return to be measured on an annual basis. Returns may be converted from one time unit
Return and Risk 33
Table 2.1: Compounded growth of $1.00 at 3.7% per quarter for four quarters.
Quarter Beginning Balance Profit Ending Balance

1 1.000 1.000 × 0.037 = 0.037 1.000 + 0.037 = 1.037
2 1.037 1.037 × 0.037 = 0.038 1.037 + 0.038 = 1.075
3 1.075 1.075 × 0.037 = 0.040 1.075 + 0.040 = 1.115
4 1.115 1.115 × 0.037 = 0.041 1.115 + 0.041 = 1.156
to another quite easily. The assumption in such conversions is that the rate at which return
was earned in a period will continue through other periods.1 Let us take the IBM example
from section 2.1. The quarterly return there was 3.7%. What would be the corresponding
annual return? Since there are 4 quarters in a year, based on the speeding example, you may
be tempted to say 3.7% × 4 = 14.8%. This is quick and easy but not correct. Conversion of
units become a little complicated when we are dealing with percentages because the same
percentage is being applied to different amounts in different intervals. Let us see this by
following the progress of a dollar invested at the beginning of the first quarter.
Since the dollar earned a return of 3.7%, the profit at the end of the quarter would be
0.037 × $1.00 = $0.037, making the accumulated sum to be $1.037. In the second quarter,
3.7% would be earned again (this is the assumption behind the conversion of units), but this
return would now be earned on the amount at the beginning of the quarter, i.e., $1.037. The
profit during the second quarter, therefore, would be 0.037 × $1.037 = $0.038. The extra 1/10
of a cent comes from the interest earned during the second quarter on the interest from the
first quarter. This process of earning interest on interest is known as compounding.
The compounding process for all four quarters is shown in Table 2.1. The Table shows
that continuing at the rate of return IBM earned during the first quarter, a dollar would
have grown to $1.156 at the end of the year. The profit on a dollar, therefore, would have
been $0.156. Therefore, the annual return on IBM was 15.6%.
The conversion process can be summarized using the following formula:
(1 + rq )4 = (1 + ra ), (2.3)
where rq is the quarterly rate of return and ra is the annual rate of return. In using this
formula, the rate of returns should be expressed as fractions rather than percentages. To
use the formula for the IBM example, we substitute rq = 0.037 and calculate ra as:
ra = (1 + 0.037)4 − 1 = 1.156 − 1 = 0.156.
So the annual rate is 15.6%, which is the same as the result of the long calculation.
1
The same kind of assumption was made by the radar gun in the speeding example.
Return and Risk 34
Let us explore equation (2.3) a little bit. It gives the relationship between a quarterly
rate and an annual rate. So, this equation can be used to convert from an annual rate to a
quarterly rate also. For example, take the case of DEC in section 2.1. The annual return
there was 12.7%. To express this rate on a quarterly basis, use equation (2.3), substitute
ra = 0.127 and solve for rq :
rq = (1 + 0.127)(1/4) − 1 = 0.03034.
The quarterly rate, therefore, is 3.034%.

Equations similar to (2.3) can be written for other time units. The general form of those
equations can be understood by carefully examining equation (2.3). In equation (2.3), to
relate quarterly rate rq to the annual rate ra , we raise (1 + rq ) to power 4 because there are
4 quarters in one year. Using this logic, while relating a monthly rate rm and an annual rate
ra , we would raise (1 + rm ) to the power 12 because there are 12 months in one year. So we
can write:
(1 + rm )12 = (1 + ra ). (2.4)
Similarly, we can write some other relationships as:
(1 + rs )2 = (1 + ra ), (2.5a)
(1 + rq )2 = (1 + rs ), (2.5b)
(1 + rm )3 = (1 + rq ), (2.5c)
(1 + rm )6 = (1 + rs ), (2.5d)
(1 + rd )365 = (1 + ra ) (2.5e)
where rs is the semiannual rate and rd is the daily rate. Using these formulae, you can
convert a rate given in any time unit into another. More importantly, you should see the
general pattern of these relationships so that you can write the formula for conversion from
any unit to another.
2.2.1 Subperiod and Continuous Compounding

Rates of return or interest rates are often stated as follows: 12% per year compounded
quarterly. This statement is just another way of saying that the rate of return is 3% per
quarter. 3% per quarter is the subperiod rate. Similarly, 15% per year compounded monthly
means that the subperiod rate is 15/12 or 1.25% per month. The full period (annual) rates
can be calculated using equations (2.3) and (2.4). The 12% in 12% per year compounded
quarterly and 15% in 15% per year compounded monthly are known as stated rates that are
being compounded during subperiods. The corresponding numbers used in and calculated
using equations (2.3) and (2.4), respectively, are known as the effective rates. For example,
for the stated rate of 12% per year compounded quarterly, the effective rates are 3% per
Return and Risk 35
quarter and (1 + 0.03)4 − 1 = 0.1255 or 12.55% per year. Investment alternatives should be
compared using effective rates because that’s what they are actually earning.
A special situation encountered in investments is of continuous compounding. In
continuous compounding, the interest rate is compounded every instant. Let us examine the
continuous compounding situation by comparing 12% per year compounded monthly with
12% per year compounded continuously. In the first case, there are 12 subperiods while in
the second case there are m subperiods where m is a very large number (tending to infinity).
The subperiod rate in the first case is 0.12/12 while in the second case it is 0.12/m. Now,
to find the effective annual rate, for the first case we will write:
12
0.12
1+ = (1 + ra ),
12
because there are 12 subperiods (months) in a full period (year). Upon solving, we get
ra = 0.1268 or 12.68% per year. Therefore, a stated rate of 12% per year compounded
monthly is equal to an effective annual rate of 12.68%. We can write a similar equation for
the continuous compounding case:
m
0.12
lim 1+ = (1 + ra ).
m→∞ m
The lim is the notation for the fact that m is a very large number (tending to infinity).
m→∞
Mathematically, the left hand side of the equation evaluates to e0.12 where e denotes the
exponential function. So we can write:
e0.12 = (1 + ra ).
Upon calculation, ra turns out to be 0.1275 or 12.75% per year. For the same stated rate, the
effective annual rate with continuous compounding is a little bit higher than with monthly
compounding because with continuous compounding, interest is earning interest continuously
while with monthly compounding it sits idle for a month between earning interest. In
general, the more frequent the compounding, the higher the effective rate. The continuous
compounding formula can be written in general notation as follows:
(1 + reff ) = er , (2.6)
where reff denotes the effective rate and r denotes the stated rate that is being compounded
continuously. The time units of r and reff are identical. For example, for the stated rate of
3% per quarter compounded continuously, the effective rate is e0.03 − 1 = 0.03045 or 3.045%
per quarter.
Return and Risk 36
2.3 Leverage and Return

In Chapter 1, we saw that investors can borrow money (from the broker or other sources) for
investments. Here we examine the impact of borrowing on the return on investor’s equity.
Suppose you buy shares of XYZ selling at $10 in two different ways:
1. You buy 100 shares using your own personal funds. This investment, therefore, is
financed entirely by your equity, and is an unleveraged investment.
2. You buy another 100 shares for which you put $600 of your own money and borrow
the remaining $400 at the interest rate of 10% per year. By borrowing money you are
leveraging this investment.
To see the effect of leverage, we will calculate the return on your equity in both the
investments for various stock prices a year from now. To keep things simple, we will assume
that the stock does not pay any dividends.
• Let us first assume that the stock price goes up to $12 in one year. The value of
the shares is $1,200. Since the stock price has gone up by 20%, the return on assets
(shares) is 20% per year. Your unleveraged investment realizes a 20% per year return
on equity because you realize a profit of $200 on your equity of $1,000. The net profit
in the leveraged account after paying interest on the loan is $200 −0.10×$400 = $160.2
This profit, however, is on your investment of $600. Therefore, the return on equity is
160/600 = 26.67% per year.
• Let us assume that the stock price goes up to only $10.50. The return on stock and
the unleveraged investment is 5% per year. The net profit on your $600 investment in
the leveraged account is $50 − $40 = $10 making your return on equity equal to 1.67%
per year.
• Finally, let us assume that the stock price goes down to $9.00. This results in a rate
of return of −10% on the stock and your equity in the unleveraged account. In the
leveraged account, your net loss is −$140, leaving you with a return on equity of
−23.33% per year.
Table 2.2 summarizes our results. ROA in the Table refers to the return on assets (shares),
and ROE is the return on equity (the personal investment capital).
The relationship between ROE and ROA can be expressed algebraically through the
following equation:
D
ROE = ROA + (ROA − i), (2.7)
E
2
Another way to calculate the net gain is as follows: Sell the shares for $1, 200, use $440 to pay back the
principal and interest on loan, and be left with $760. Since the initial investment was $600, you have a net
gain of $160.
Return and Risk 37
Table 2.2: The effect of leverage on return on equity (ROE).
ROE
ROA Unleveraged Leveraged
20% 20% 26.67%

5% 5% 1.67%
−10% −10% −23.33%
where D
E
is the debt to equity ratio used to purchase the securities, and i is the interest rate
on the debt. To verify the equation, let us apply it to our second scenario. ROA = 0.05,
D
E
= 400/600 = 0.67, i = 0.10. So,
ROE = 0.05 + 0.67(0.05 − 0.10) = 0.0167 = 1.67%.
The numbers in the Table show that the rate of return on an unleveraged investment is equal
to the rate of return on the security. Equation (2.7) also supports this observation because
D
E
is zero for an unleveraged investment makes ROE equal to ROA.
This relationship between the return on equity, leverage, and the return on assets leads
to the following conclusion: If the rate of return on the security is higher than the interest
rate on the loan then leveraging leads to a higher rate of return. Conversely, if the rate of
return on the security is lower than the interest rate on the loan then leveraging leads to a
lower rate of return.
Leveraging, therefore, is useful if an investor believes that the securities are going to
provide a rate of return higher than the rate of interest on the loan. Speculators borrow
money for investment purposes because they believe that their securities will provide a higher
rate of return than the interest rate on loan.
2.4 Return as a Random Variable

Our discussion so far has involved situations where we examine the return after the outcome
of investment has been realized. The investment returns, therefore, have been known. Now
we will discuss the situation where we have to make a decision about investment whose
outcome will be realized in the future. The cash flows and the return on the investment,
therefore, are not known with certainty. At best, we may assign probabilities to the various
possible values of cash flows and returns. Suppose you buy 100 shares of IBM at $102. You
may visualize the situation one year later as follows: There is a good chance (50%) that the
dividends and the selling price of each share will be worth $110; there is some chance (30%)
that it will be worth $105; and there is a small chance (20%) that it will be worth $100. We
Return and Risk 38
can convert the various future prices to returns using equation (2.2) on page 31. For the
ending value of $110, the return will be 7.84%; for the ending value of $105, the return will
be 2.94%; and for the ending value of $100, the return will be −1.96%.
The information about the possible values and associated probabilities is known as a
probability distribution. The variable described by the probability distribution is known
as a random variable. Security prices and returns are random variables. In the IBM ex-
ample, the probability distribution was discrete because there were only a finite number of
possible values. In reality, the future stock price can be anywhere between 0 and +∞, and
the return, therefore, can be anywhere between −100% and +∞. Describing the probability
distribution for a variable that can take infinitely many values requires a continuous prob-
ability distribution. In continuous probability distributions, probabilities are assigned to
ranges of values rather than individual values. Here is an example of continuous probability
distribution: There is a 40% chance that the return on the common stock of Sears will be
10% or more, a 30% chance that it will be between 0% and 10%, and a 30% chance that
it will be less than 0%. You may divide the range of possible values (−100% to +∞) into
many more intervals.
Security prices and returns are continuous random variables.3 The prices and returns are
not independent. They are related by equation (2.2) shown on page 31. Therefore, once we
know about one of these variables, we can determine the other variable easily.
2.5 Investment Decision Making under Risk

Since security returns are random variables, we cannot know with certainty what the actual
return will be. The uncertainty about return introduces risk in our decision making process.
Investors view risk as the probability that the actual return will be less than some specified
amount. Some people may regard risk as the probability of losing money, i.e., earning a
return of 0% or less. Others may regard risk as the probability of earning a return less than
what the local bank is offering. Mathematically, we can write the definition of risk as:
Risk = Prob (r < r∗), (2.8)
where Prob(·) denotes the probability of the condition described within the parentheses, and
r∗ is the cutoff return established by the investor to measure risk.
All investment decision making situations involve risk because the actual outcome of
investment cannot be known with certainty. The decision, therefore, should take risk into
account. One way to take risk into account would be to incorporate the entire probability
distribution into decision making. That, however, would be an impossible task because
returns have a continuous distribution, and therefore, involve infinitely many values.
3
We are ignoring the fact that because of the trading regulations, the stock prices move in ticks and
therefore cannot take values that fall between the ticks. For example, the stock price can either be 100 1/8
or 100 1/4 but not anywhere between these two values.
Return and Risk 39
Figure 2.1: Stock returns have a normal distribution.
....................... .......................
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AT&T IBM
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Kodak Sears
A result from statistical decision theory comes to our rescue. The theory shows that
the decisions made using the expected value and standard deviation of the probability dis-
tribution will be identical to the ones made using the entire probability distribution if the
probability distribution is normal. The reason behind this result is that the normal distri-
bution is described fully by the expected value and standard deviation. Therefore, if returns
have a normal distribution, we can make decisions using just two key characteristics of the
distribution: the expected value and the standard deviation. Strictly speaking, security re-
turns cannot have a normal distribution because the stock returns can take values between
−100% and +∞ while the normal distribution runs between −∞ and +∞. However, it is
possible that the stock returns approximate the normal distribution so closely that we may
treat them as if they have a normal distribution. Figure 2.1 shows the frequency distribution
of returns on four stocks superimposed on the theoretical normal distribution.
The frequency distributions were calculated from monthly returns for the stocks for 360
months between January 1965 and December 1994. Visually, the frequency distributions
seem to approximate the normal distribution. A careful scientific test would be based on
the χ2 goodness of fit test. Results from such statistical tests suggest that security returns
do indeed approximate a normal distribution. Therefore we will use expected return and
standard deviation of returns for decision making.
The expected return is a measure of the return investors may expect from an investment.
The actual return will surely deviate from the expected return. The deviation is measured
using standard deviation. Under the assumption of normal distribution, standard deviation
of returns is a measure of risk because the higher the standard deviation, the higher the
probability that the return will be away from the expected value, and therefore, the higher
Return and Risk 40
Figure 2.2: Standard deviation of returns is a measure of risk.
σ=
.....
10% σ = 20% ....
.....
.. ......
..... ......
......
Prob(r < 0) = 0.1587 ......
........
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..... Prob(r < 0) = 0.3085 ........
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..................................
.................. ................ .................................... ...
0% 10% 0% 10%
A B
the probability that it will be less than the cutoff point as described in equation (2.8). Let
us take an example. Suppose the expected return and standard deviation of return for stock
A are 10% per year and 10% per year. Suppose you define risk as being the probability
that the return will be less than 0% per year. This can be determined by calculating the
z score and using the normal distribution table printed at the end of the notes. The z
score is (0 − 10)/10 = −1. Using the normal distribution table, we see that the probability
is 0.1587. Stock B also has an expected return of 10% but a standard deviation (σ) of
20%. The z score for getting a return less than 0% from this stock is (0 − 10)/20 = −0.5.
The probability of getting a return less than 0%, therefore, is 0.3085. The probabilities are
illustrated graphically in Figure 2.2.
Note that the stock with a higher standard deviation also has a higher probability of
getting a low return. Therefore, the stock with higher standard deviation is riskier.
2.6 Estimating Return Statistics

We may estimate the expected return and standard deviation of return for a security using a
sample of historical data if the returns fluctuate randomly without any growth or systematic
pattern. Figure 2.3 shows monthly returns on the common stocks of AT&T, IBM, Kodak,
and Sears during the five year period (60 months) of January 1990 to December 1994. You
can see that there is no systematic growth or cyclical pattern in these returns. Similar
behavior is seen in the rates of returns on most investments during most periods. Therefore,
it is reasonable to use past returns as a sample for the future behavior of returns.
Suppose today is December 30, 1994 and we want to estimate the expected return and
standard deviation of returns for January 1995 for the common stock of AT&T. We need to
collect historical data for estimation. Since we are interested in obtaining estimates for the
monthly return, we have to collect monthly data. We have to decide how many observations
to collect and for what period. Having too few observations would make our estimates
unreliable and collecting too many observations would be time consuming and may bias the
Return and Risk 41
Figure 2.3: Monthly returns on four stocks (January 1990 to December 1994).
AT&T IBM
0.20 0.20 ..
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Kodak Sears
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... .. .
...... ... ... ... ... ... .. .. ... .. .. ... .. ... ...... ... .. .. ...
... ...... ...... ...... ... .. ... .. ...... .. .. . .. .
−0.05 . ...... ... ... ...... ..... ... .. . .
.. ... .. .
.... .... ...... . . . ... ..
−0.10
..... .
... .. . ..... .
..... . .
..... . .
... .. .... ... . ... ...
... ..... . . .
.... ..... . . .
... ..... ... ... .. ..
... .. . .....
.. ... .. . . . .
..... .....
......
−0.10 ..... .
−0.15
.. .....
.. .
−0.15 −0.20
Return and Risk 42
Table 2.3: Calculating statistics for AT&T.
t Month r r2
1 01/90 −0.1429 0.020420

2 02/90 0.0192 0.000369
3 03/90 0.0650 0.004225
4 04/90 −0.0446 0.001989
5 05/90 0.0748 0.005595
.. .. .. ..
. . . .
57 09/94 −0.0054 0.000029
58 10/94 0.0185 0.000342
59 11/94 −0.1068 0.011406
60 12/94 0.0295 0.000870
60 0.3507 0.200888
estimates because the estimates will be based on data from too far back. For our example,
we will use 60 monthly returns, from January 1990 to December 1994. Each of these returns
was calculated using equation (2.2) on page 31. For example, if the prices at the beginning
and the end of a month are $10 and $10.25, and the dividend for that month is $0.15, then
the return for that month is (10.25 − 10 + 0.15)/10 = 0.04. Table 2.3 shows the returns and
some other information needed for calculations.4 The bottom row in the Table shows the
summary statistics needed for calculations.5 The number under the first column shows the
number of observations while the other numbers are the sum of numbers in that column.
The expected return for the stock, denoted by µ, is estimated by the average return:
P
r
µ= . (2.9)
T
The expected return on the stock of AT&T during January 1995, therefore is:
0.3507
µ= = 0.0058 = 0.58%.
60
The standard deviation of returns, denoted by σ, is estimated by the sample standard
deviation from the historical data:
v
u P 2
uP
u r 2 − ( r)
t T
σ= . (2.10)
T −1
4
Full data is shown in a table at the end of the notes.
5
Table 2.3 only shows the first few digits of the numbers. The calculations were performed using full
accuracy.
Return and Risk 43
Note that we use T − 1 in the denominator realizing that we are estimating the standard
deviation using a sample.6 The standard deviation for AT&T returns is calculated as:
v
u
u 0.200888 − (0.3507)2
t 60
σ= = 0.0581 = 5.81%.
59
The expected return and standard deviation for security returns using historical data are
only as reliable as the data itself. Often, you may have additional information about the
future that is not contained in the historical data. In such situations, you should adjust
the statistical estimates accordingly. For example, if you believe that the future returns of
AT&T will be higher than the last five years because of the recent acquisitions, you should
adjust the historical estimate of expected return up by a suitable amount. In these notes,
to eliminate the subjectivity, we will rely primarily on the historical data.
Statistical calculations can be done easily using spreadsheet programs because they have
built-in functions for the number of observations, average, and standard deviation for the
values in a spreadsheet range. For example, in Microsoft Excel, count(a1:a60) calculates
the number of observations in the spreadsheet range a1:a60. Similarly, average(a1:a60),
and stdev(a1:a60) give the average, and standard deviations of the values in the range
a1:a60.
2.6.1 Using the Statistics

The expected return and standard deviation for security returns may be used to answer some
important questions related to investments. Let us do some calculations for AT&T using
the results from above.
Let us say we want to find out the range of possible values for the return on AT&T
during January 1995. This information will be useful in determining the highest and the
lowest possible returns from the stock. This range is the confidence interval. Suppose we
want to find out the 95% confidence interval. Since we have a large number of observations,
we can use the critical z value of 1.96 for this purpose. The 95% confidence interval is
[µ − zσ, µ + zσ] or [0.0058 − 1.96(0.0581), 0.0058 + 1.96(0.0581)] or [−0.1079, 0.1196]. This
calculation shows that there is a 95% probability that the actual return for AT&T during
January 1995 will be between −0.1079 and 0.1196.
Another quantity we may be interested in is the probability that the return will be in some
range. For example, let us calculate the probability of losing money on AT&T, i.e., its return
being less than 0. The z score for this probability is (0 − 0.0058)/0.0581 = −0.10. From the
normal distribution table we find that the probability of a z score less than −0.10 is 0.4602.
Therefore, there is a 46.02% probability that the return on AT&T during January 1995 will
6
You may be accustomed to denoting the sample standard deviation with an s rather than a σ. Since
we never need the population standard deviation in this course, we will use σ as the symbol for standard
deviation, even if it is a sample estimate.
Return and Risk 44
be less than 0. Let us now calculate the probability that the return will be between 5%
and 10%. The z scores corresponding to these values are (0.05 − 0.0058)/0.0581 = 0.76 and
(0.10 − 0.0058)/0.0581 = 1.62. Using the normal distribution table we find the probability
that the return will be between 5% and 10% is 0.1710. So there is a 17.10% chance that the
return on AT&T during January 1995 will be between 5% and 10%.
We can also convert our statistical estimates for returns into estimates for prices. To keep
things simple, we will assume that the stock will not pay any dividend during January 1995.
The relationship between the future price, current price, and return can then be written by
manipulating equation (2.2) on page 31 as:
p1 = p0 (1 + r). (2.11)
The closing price of AT&T on December 30, 1994 was $50.250. The expected price at
the end of January 1995 can be calculated using equation (2.11). For the calculation, r is
0.0058 and p0 is 50.250, so that p1 = 50.250(1 + 0.0058) = 50.544. So the price of AT&T at
the end of January is expected to be $50.544.
Now, let us calculate the 95% confidence interval for the stock price at the end of January.
Since the lowest and highest returns for this interval are −0.1079 and 0.1196 as calculated
above, the corresponding prices using equation (2.11) are 50.250(1 − 0.1079) = 44.826 and
50.250(1 + 0.1196) = 56.261, respectively. So there is a 95% chance that the price of AT&T
at the end of January 1995 will be between $44.826 and $56.261.
As a final illustration, let us estimate the probability that the price will be greater
than $60. For the price to be greater than $60, the return will have to be greater than
(60 − 50.250)/50.250 = 0.1940. The probability of return being greater than 0.1940 can be
calculated easily. First we calculate the z score as (0.1940 − 0.0058)/0.0581 = 3.24. Now we
look up the normal distribution table and find that the probability is 0.9994 or 99.94% that
the price will be more than $60.
Note that in all calculations involving prices, we do not apply normal distribution to
prices directly. We convert price information to returns and then apply normal distribution
to returns. This is because prices do not have a normal distribution but returns do.
2.7 Sources of Risk

Risk in an investment may arise from several sources. Some of these are macroeconomic and
affect most of the securities. Examples of macroeconomic factors are GNP, unemployment,
oil prices, and currency exchange rates. If you watch business news regularly, you will
see frequent mention of security prices reacting to these macroeconomic variables. Other
factors are industry, firm, or security specific. For example, a new breakthrough in chip
manufacturing technology will affect the securities of computer industry, or a strike by the
labor union in a company will effect only that company.
Return and Risk 45
The sources of risks from an investor’s point of view are grouped into three categories
described below:
1. The most important source of risk is the uncertainty about the profits. When you
buy shares of common stock, there is uncertainty about the dividends and for how
much the shares may be sold later. Bonds are somewhat different in the sense that
their issuers promise a fixed interest amount periodically. Also, if the investor holds
the bond till the date of maturity, the issuer promises to pay the face value of the
bond. Notice that the key word is promise. Occasionally an issuer is not able to keep
its promise, i.e., it is unable to pay the promised interest or the face value. In that
situation the bond is said to be in default. The issuer has to declare bankruptcy
and go through a tedious legal process. The investor may get some amount back from
the bankrupt borrower but the amount that will be received is uncertain. Securities
issued by the U.S. Treasury do not have the risk of default because they are backed by
the U.S. Government and the Government can always print more money!
2. The second source of risk—the marketability risk—is the uncertainty about being
able to sell the security on a short notice. Only securities issued by obscure corporations
have significant marketability risk.
3. The third source of risk is the interest rate risk. This form of risk arises from the
probability that the interest rates in the economy may change after you have made
an investment, and this may cause the value of your investment to deteriorate. For
example, suppose you bought a 10 year bond last year when it was yielding 12% per
year. Since you bought the bond, the interest rates have gone up so that other similar
bonds are yielding 15% per year. Your bond now has a lower value in the market and,
therefore, if you decide to sell it you will get less money for it than you would have if
the rates had not gone up. Even the securities issued by the Treasury have this kind
of risk.
4. The fourth source of risk is the reinvestment risk. The source of this risk is the same
as the interest rate risk, i.e., fluctuations in the interest rates. However, it arises only
in income (dividends or coupon interest) providing securities. The risk arises because
the income provided by the security may have to be reinvested at a lower rate if the
interest rates decline between the initial investment and when the income is received.
5. Another source of risk for all securities is unexpected inflation. Since money loses
purchasing power because of inflation, a higher than expected inflation would cause
the real return on an investment to be lower than what one may have expected.
Return and Risk 46
Figure 2.4: Indifference curves for an investor.
...
...
U3
...
...
.
...
...
...
...
...
U >U >U
.
3 2 1
....
...
..
....
...
... U2
.... ....
.
. ....
....
. .
.....
..... ....
µ ......
.....
.....
.....
.....
......
.....
.....
.... .
...
U1
......
. ..
......
....... ...... .......
.
C ....... ....... .......
....... ....... .......
........
.•
.....................
........ ...
....
............
........
•
....
. . ...... ...
...
.......... .......... ...........
.......
............ .......................... ..............
.................
................
.............................. •
...................... B
A
2.8 Risk Aversion

An investor’s preference for a security depends on both expected return and risk. Borrowing
the terminology from economics, we can denote this dependence through a utility function.
We can say an investor’s utility depends on expected return and risk. Equation (2.12)
illustrates the dependence of utility on expected return and risk.
Utility = U(µ, σ). (2.12)
Other things being the same, investors prefer higher expected return over lower expected
return, and lower risk over higher risk. Since risk is an integral part of all investments,
investors do have to take some risk. Being risk averse, investors will take additional risk
only if it is accompanied by additional reward in form of a higher expected return. This
characteristic of investors to demand a higher expected return from a risky investment is
known as risk aversion. As an example, consider two investments: A and B. Both A and B
have expected returns of 10% per year. However, their risks, as measured by the standard
deviation, are 20% and 25%, respectively. Although B has a potential for higher returns,
risk averse investors will not choose it because it also has a potential for much bigger losses.
To risk averse individuals, avoiding a loss of $1 has more utility than receiving a gain of $1.
They will accept B only if it has a higher expected return. The amount of extra expected
return—premium—that B should offer for it to be acceptable will be different for different
investors. Those investors who demand a higher premium are more risk averse than those
who demand a lower premium.
Suppose an investor will be equally interested in A and B if B offers an expected return
of 12%—a premium of 2%—then that investor is said to be indifferent between A and B.
The investor’s indifference between the two investments implies that the utilities to the
investor from these two alternatives are equal. We can, at least theoretically, determine
all combinations of risk and expected return among which the investor is indifferent. The
Return and Risk 47
Figure 2.5: Indifference curves for different investors.
..
...
I3
...
...
..
..
...
...
...
.
...
.
...
...
...
...
..
... I2
... ...
•B
...
...
..
.
.
3......
..
..
....
µ .
...
....
...
.. .
......
•B
. . ....
... .....
.....
...
....
.....
.....
..... 2 ........... I1
..
...... ........ ...
......
..
. .
....
.
.......
..........
•B
.. ... .
..
.
........ ........... ......
......
...... ...... .
...... ........ ........
.........
....... ......... ..................... 1
........ ......... ...
....
............................................................
•
.. ..
.......... ..........
...............................
A
curve obtained by plotting the indifference points on a graph is known as an indifference

curve. Figure 2.4 shows indifference curves for an investor. Different indifference curves
for an individual correspond to different levels of utility, with higher indifference curves
corresponding to higher levels of utility. Points on a higher indifference curve, therefore, are
preferred over those on a lower indifference curve. To understand this, compare investment
alternative A with C. Since C has a higher expected return than A for the same amount of
risk as A, C is preferred over A.
The slope of the indifference curve represents the acceptable risk-return trade-off. Differ-
ent investors have different indifference curves. Furthermore, an investor may have different
risk-return trade-offs at different times depending on factors such as the level of risk taken,
the investor’s wealth, and investor’s age. Figure 2.5 shows the indifference curves for three
investors, I1 , I2 , and I3 . The utilities to all three investors from investment A are equal.
However, as they are offered opportunities of more risk, they desire different amounts of
expected returns to accept the additional risk. I1 is most easily satisfied investor and I3
requires the highest premium. Such differences in investors’ risk preferences are described
using degree of risk aversion and risk tolerance. I1 has the lowest degree of risk aversion
while I3 has the highest degree of risk aversion. I1 , therefore, is less risk averse than I2 who
is less risk averse than I3 . We can also state the differences in risk attitudes by saying that
I1 is more risk tolerant than I2 who is more risk tolerant than I3 .
The indifference curves for risk averse investors slope up as shown in Figures 2.4 and
2.5. If the indifference curve for an investor is flat, that investor is risk neutral. A risk
neutral investor ignores risk and bases his decisions on expected return only. He prefers
an investment with a higher expected return over one with a lower expected return. If the
indifference curve for an investor is sloping downwards, that investor is risk loving. A risk
loving investor likes risk so much that he is willing to accept a lower expected return from a
Return and Risk 48
riskier investment. Risk neutral and risk loving behaviors may be exhibited in some special
circumstances, such as gambling where other factors such as excitement and thrill also affect
the choice among the alternatives. In rational investment decision making, investors are risk
averse. Therefore, throughout these notes, we will assume that investors are risk averse.
2.8.1 Investor’s Objective

Since the utility from investment depends both on the expected return and risk, investors
take both of these into account in deciding among the available securities. As we saw above,
investors want to earn the highest expected return for a given level of risk and take the lowest
possible risk for a desired level of expected return. This objective can be restated by saying
that investors want to maximize their utility. In other words, they want to be on as high an
indifference curve as possible. Since utility functions are hard to observe and measure, we
may state the objective of an investor to be maximization of expected return for a desired
risk. Alternatively, we can state it to be the minimization of risk for a desired expected
return. Both these specifications will put the investor on the highest indifference curve
possible. These alternative specifications of investors’ objectives are easier to operationalize
because both risk and expected return are quantifiable and measurable.
Table 2.4: Statistics for 4 securities.
Security µ σ
A 0.10 0.20
B 0.15 0.20
C 0.10 0.30
D 0.15 0.30
2.8.2 Risk Aversion and Dominance

Let assume that there are four alternative securities: A, B, C, and D. The expected return
and standard deviations for these securities are shown in Table 2.4. Figure 2.6 shows these
securities graphically. Between securities A and B, all risk averse investors will choose B
because B has a higher expected return for the same amount of risk as A. This fact is
stated by saying that B dominates A. For the same reason D dominates C. Between A and
C, all investors will choose A because A has a lower risk for the same amount of expected
return. Therefore, A dominates C. For the same reason B dominates D. Between B and C, all
investors will choose B because B has a higher expected return and a lower risk. Therefore,
B dominates C. Between A and D, there is no such obvious relationship. D has a higher risk
but it also offers a higher expected return.
Return and Risk 49
Figure 2.6: Dominance relationships.
B D
µ A C
Therefore, whether an investor will prefer A or D will depend on the investor’s risk
aversion and utility function. An investor may be indifferent between A and D. A more
risk averse investor will prefer A over D, and a less risk averse investor will prefer D over A.
Understanding dominance relationships will make it easy to identify the preferred alternative
when there are many alternatives from which to choose.
2.8.3 Risk and Return: Historical Evidence

The conclusion from our discussion of risk aversion is that investors expect a higher return
from a riskier security. If a risky security does not offer a high enough return, investors will
not want to buy it. This lack of demand will bring down the market price of the security. As
the price comes down, the security becomes a better bargain, and its return goes up. This
process will continue until the return expected from the security is commensurate with its
risk. Of course, different investors have different degrees of risk aversion. Therefore, they will
desire different amounts of expected returns for the same risk. In spite of these differences,
if investors indeed are risk averse then we should observe securities with higher risk to have
higher average returns. Figure 2.7 shows the standard deviations and averages of monthly
returns for 60 stocks (indicated by ?s), the Treasury bills (indicated by •), and the S&P
500 index (indicated by ) for the period January 1965 to December 1994. The best fit line
is also drawn in the Figure. The best fit line shows that the relationship between risk and
average return is indeed positive. Therefore, we can conclude that higher risk securities do
indeed provide higher average returns.
The slope of the line in Figure 2.7 measures the extra return than an investor gets for
taking an extra unit of risk. In other words, it is a measure of the risk premium that the
securities market is offering for bearing the risk. The intercept, since it corresponds to zero
risk, can be viewed as the return for bearing no risk at all, or simply the risk-free rate. The
relationship between the average return and risk may be written as:
Average return = Risk-free rate + Risk × Premium per unit of risk. (2.13)
From Figure 2.7, we see that the standard deviation of the Treasury bills is negligible
compared to that of the stocks. Frequently in our discussion in this course we will refer to
Return and Risk 50
Figure 2.7: Risk-return relationship for 60 stocks, Treasury bills and S&P 500.
0.03
0.02 ?
?
??
µ ? ? ? ? .............
? ? ? ? ..............
..............
..............
? ??? ??? ?.........................?............................. ?
...
...
...
...
.
..
? ? .?.........?..?.................?.......?? ?
?..................... ?? ?? ?
0.01 .............. ?? ???
.
.............
..
...
...
...
...............
? ? ? ?
..............
..............
.............. ????? ?
• ? ?
?
0.00
0.00 0.05 0.10 0.15
σ
an idealized investment called risk-free security. Statistically, the returns on a risk-free

security remain constant over time and therefore the standard deviation of its returns is
zero. While there are no securities that are truly risk-free, Treasury bills come very close to
it. Therefore, we will assume that the Treasury bill is a risk-free security and the average
return on the Treasury bill is the risk-free rate.
2.9 Other Determinants of Rates of Return

In our discussion of risk and return, we learned that riskier securities have higher average
return. Risk, however, is only one of the many factors that affect the interest rates. In this
section we examine other major factors that determine the rates of return. Since all the
rates in the economy are connected, a change in one interest rate is transmitted to other
rates. For example, if the banks start offering a higher rate on savings, stocks have to offer
a higher return also otherwise many risk-averse investors will withdraw their money from
stocks and deposit it with the banks. Therefore, a knowledge of the factors that affect the
key interest rates will be useful in understanding their effects on the rates of return.
During this discussion, it may be helpful to keep an alternative interpretation of interest
rates. Since investors like more money rather than less, they are inconvenienced when they
have to give up some of their money for some time. Therefore, they demand a compensation
for this inconvenience which is what we call interest rate or rate of return. The factors we
will discuss below are various forms of inconvenience.
Return and Risk 51
Figure 2.8: Monthly T bill returns and expected inflation.
0.80
.
.......... .. .
... ... ....... ......
... .... .... .... ........
.... ... .. .. .. ..
...... ... ... ...
... . ... .. ..
.. ... ... ...
... ...... ...
... ... ... .
0.60 ....
...
... .....
..... ...
..... ..
....... ..
...
...
...
... ...
... ......
....... ........ .. ...
.. ..... .... ....
. . . .
.. ........ .... .... .........
.. .... .. ... .. ...
... . . . .
........... .... .... .........
..... ... .. ...
.. ..... ... ..
....... .. ... ..... ... ...
.. ... .. ... ..
.. .. .
... .
. ..
.
.
...... ..
0.40 .
...
...
.. .....
. ...
...
....
....
...
..
... ..... .
.....
...
.. ... .......... .......
... ....
... ... ..
.. ... .... ...
... ... .... ..
...
.. ... ... ... ....... .
. ..... ....
... ... ... ... .... .
... .... ...
..... ... .. ...
...
.. ...... ...... .. ... ..........
. ... ... .
...
. ... ....... ..... ....... ......
. ...
....
.
... .
.. .. .. ..
. ....... ....... ............. .......... ......... .... .. ........ ...
.
...... .. .. . .. .
.. .
..
... .. .. .. .... .. ............... ... ..... ..... ... .
. .
. .
.
. .......... ... .. .... .. .....
... .. ....... .....
......... ...... ... ..
...... ... ....... .. .
.. .. .. ...... ... ... .
. ...... ..
..
.
0.20 ...... .
12/90 12/91 12/92 12/93 12/94
Date
2.9.1 Basic Rate

Basic rate refers to the rate of interest we would charge for lending and borrowing money in
absence of all other factors. The basic rate depends on the demand and supply of money. If
everyone has a lot of money then the basic rate will be low. Conversely, if there is a great
demand for funds then the rate will be high. It is impossible for us to observe the basic rate
because the observed rates are contaminated by other factors. Conceptually, however, the
basic rate is very important because the observed rates are built on this rate.
2.9.2 Expected Inflation

Investments provide cashflows in the future. Since inflation reduces the purchasing power
of the cashflows, investors demand higher rates when they expect the inflation to be higher.
The expected rate of inflation affects all the interest rates in the economy. The easiest way
to observe the effect of inflation on interest rates is through the time series of an interest
rate in the economy. The solid line in Figure 2.8 shows monthly returns on the Treasury
bills from January 1990 to December 1994 and the dashed line shows the expected inflation
rates, estimated as the twelve month moving average of actual inflation. The Treasury bill
returns seem to be highly correlated with the expected inflation rates.
Return and Risk 52
Figure 2.9: Treasury Yield Curve.
7.25%
Yesterday
....
......
1 week ago ...... ....
...... ..
...... .......
6.75% ...
...
...... .....
4 weeks ago ...... ..
...... .....
...... ..
.
. ................
.
........ ..... .....
.
........... ..
...... ....... .....
.......... ...
.
........ ..
. ....
..
..... ..
6.25% ....
....... ....
....
...... ....
.
.......... ... ....
.
... .
........... . ...
............ ... ..
........ .... . ...
............... ....
..
................
. ..
. ....
.
......... ....
...... ... ... ..
5.75% ...........
...... .. ... ...
... ...
.........
...
............................................................... . . ... ...
............................... ....... ....... ... ... ...
.
... ... ... ... ... ... ... ... . ... ...
.. ... ... ... . ... ...
.. ... ... ... ...... ...
5.25%
3 6 1 2 3 5 7 10 30
mos. yr.
maturities
Source: The Wall Street Journal, August 8, 1995.
2.9.3 Time to Maturity

Another important factor in determining interest rates across securities is how long the
money will be tied-up in the investment, i.e., when the security will mature. The behavior
of interest rates with respect to the time to maturity is known as the term structure of
interest rates. We observe the dependence of interest rates on the time to maturity in the
car loans. A two year loan may have an annual rate of 4.8% while a five year loan may cost
10.2% per year.
The term structure of interest rates in the securities markets can be observed in the
Treasury Yield Curve which is printed in the Credit Markets section of The Wall Street
Journal every day. Figure 2.9 shows the Treasury Yield Curve as it appeared in The Wall
Street Journal of Tuesday, August 8, 1995. There are three lines in the yield curve. The
solid line is for August 7, 1995, the long dashes are for a week before, and the short dashes
are for 4 weeks before. The yield curve shows that if you had invested in a Treasury security
maturing in six months, you would have got an interest rate of about 5.64% per year. A
three month Treasury security would have paid about 5.54% per year. Treasury securities
maturing in thirty years were yielding about 6.91% per year.
There are several theories that try to explain the term structure of interest rates. The
three major ones are:
• The liquidity preference hypothesis is based on the intuition that long term in-
Return and Risk 53
vestments cause higher inconvenience to the investors than the short term investments.
Therefore, long term investments should have higher rates of return than the short term
investments.
• The expectations hypothesis is based on the premise that the long term rates
are actually composed of several short term rates. For example, if the one year rate
currently is 10% and investors expect the one year rate next year to be 11%, then the
annual interest rate on a two year loan would be somewhere between 10% and 11%.
The shape of the term structure, therefore, would depend on what investors expect the
short term rates to be in the future.
• The market segmentation hypothesis states that the markets for short and long
term capitals are segmented. In other words, long term borrowers would borrow from
those who want to lend for the long term, and short term borrowers would borrow from
short term lenders. The rates in the long and short term markets, therefore, would
move independent of each other.
2.9.4 Taxes
An important factor that results in different securities having different returns is how the
cashflows from these securities are taxed. Almost all the income from most common invest-
ments such as stocks and bonds is taxed fully. However, income from some securities issued
by state and municipal governments is exempt from federal and/or state taxes. Differences
in tax status may cause securities to offer different returns.
Consider two securities A and B which are identical in every respect but their tax status.
Income from security A is taxed as regular income while that from security B is exempt from
federal taxes. Clearly, if these two securities offer the same returns, all tax-paying investors
will buy security B because they are concerned with the after-tax cashflows rather than pre-
tax. For security A to have a demand in the market, it has to offer a higher rate of return
than security B so that the after-tax return from the securities are equal. This equalization
will take place due to demand and supply adjustments in the market. If the two securities
were offering equal rates of return, nobody would want to buy security A. As a result the
demand for security A will fall which would result in a lower price for A. As the price of the
security goes down its return goes up. The return on A will go up till the after-tax return
on A equals the after-tax return on B.
If an investor’s marginal tax rate is τ and the investor earns a return r on a security then
the investor will have to pay rτ in taxes. Therefore, the after-tax return from securities will
be r − rτ or r(1 − τ ). This calculation is based on the assumption that all investment income
(whether income or capital gains) is taxed at the same marginal tax rate. The formula will
be a little bit complicated if different forms of incomes are taxed differently.
Return and Risk 54
2.10 Conclusion
In this chapter, you learned about risk and return. Other factors that affect returns and
interest rates were also discussed. You learned how to measure risk and return in an un-
certain situation. Having completed Chapters 1 and 2, you have the background needed for
investment analysis. We will now begin applying these fundamentals.
Exercises
2.1 Return
Ken purchased 500 shares of Amax Corporation on January 1, 1987 at $30. On March 31, he received
a dividend of $0.30 per share. Immediately thereafter he sold the shares for $31.25 each. What was his
quarterly rate of return? What was the annualized rate of return?
2.2 Dividend Yield
Sylvia Potter bought 100 shares of IBM at $98 per share. IBM has a policy of paying a dividend of $1.10
every quarter. What will be the dividend yield to Sylvia if IBM continues with its policy?
2.3 Conversion of Units
(a) Convert 1% per month to an annual rate.

(b) Convert 12% per year to a monthly rate.
(c) Convert 0.03% per day to a semiannual rate.
(d) Convert 1/2% per week to an annual rate.
2.4 Conversion of Units

The return on a security was 1% per month. Convert this rate to a quarterly rate. Now convert the
quarterly rate to the annual rate. Finally, convert the 1% per month directly to an annual rate.
2.5 Comparison of Returns
During the last quarter, I earned 4% on my investment. The return on my friend’s investment was 16.3%
during the last one year. Whose investment earned a higher return?
2.6 Compounding and Effective Rates
Three local banks are offering the following rates on deposits: 7% per year compounded quarterly; 6.9%
per year compounded monthly; and 6.8% per year compounded continuously. Where would you put your
money?
2.7 Compounding and Effective Rates
(a) Impala Bank is advertising that their 3 year CD (Certificate of Deposit) has an annual rate of 10% and
an annual yield of 10.47%. How often is the interest being compounded in this CD?
(b) The 3 year CD at Cadillac Bank is also offering a rate of 10% per year but the yield on the Cadillac CD
is advertised to be 10.52% per year. What is the compounding period at Cadillac?
Return and Risk 55
2.8 Compounded Returns

Richard Fish explained to his friend,“I started out in the stock market in 1987. With my luck, things
had to go wrong. My portfolio suffered a loss of 15% during that year. I stuck it out though, and fortunately
1988 proved to be helpful. The portfolio went up, would you believe it, by exactly 15%. So now I am back
where I started.”
Show that Mr. Fish’s statement is incorrect, i.e., he is not back where he started. Is he worse off or
better off? Would things have been different if the first year he had faced a gain of 15% and the following
year a loss of 15%?
2.9 Compounding
Peter Fox, the friendly banker, told a client,“Let’s see now. You deposited $100 three years back. The
first year your deposit earned 5%, the second year it earned 4%, and the third year it earned 6%. That
comes to a total of 15%. Here are your $115.”
Explain to the client how Mr. Fox is outfoxing him. How much money should the client get?
2.10 Leverage
Derive equation 2.7by going through the steps in section 2.3 using symbols rather than the numbers.
2.11 Statistical Analysis
Twenty weekly returns for common stocks of Huge, Inc. (H) and the Micro, Inc. (M) are given below:
t rH rM t rH rM
1 0.01 0.01 11 0.03 0.03

2 0.02 0.02 12 0.01 0.07
3 −0.01 0.01 13 0.03 0.09
4 0.02 −0.02 14 0.02 0.03
5 0.05 0.02 15 −0.01 0.20
6 0.07 0.01 16 0.01 0.02
7 0.02 0.01 17 −0.01 0.05
8 −0.01 0.02 18 0.03 0.01
9 −0.02 0.01 19 −0.02 0.05
10 −0.02 0.03 20 0.02 0.03
(a) Calculate the expected returns and standard deviations of returns for these stocks.
(b) Calculate the 90% confidence interval for returns on these stocks.
(c) What are the probabilities of losing money on these stocks?
(d) What is the probability that you will make more than 3% on Huge?
(e) What is the probability that you will at least double your money in Micro?
2.12 Statistical Calculations

The following table provides prices for a stock. Calculate the expected return and standard deviation of
returns.
t 0 1 2 3 4 5 6 7 8 9 10
p 10 11 12 14 15 14 13 14 14 14 15
Return and Risk 56
2.13 Security Statistics

Closing prices for the past 11 weeks for the common stocks of ABC and XYZ are given below:
Week 0 1 2 3 4 5 6 7 8 9 10
ABC 39.50 40.00 41.00 41.50 41.00 41.50 42.00 41.50 42.00 41.00 41.00
XYZ 10.75 11.00 10.50 11.25 11.75 11.50 11.75 12.00 11.75 12.00 12.50
Neither stock has paid any dividends during the past 10 weeks and is not expected to pay any during
the next week.
(a) Using the prices, calculate the weekly returns.
(b) Calculate the expected returns and standard deviations of returns.
(c) Is there a dominant choice between these stocks? Which stock would you choose? Why?
(d) Calculate the 95% confidence intervals for the returns of both stocks.
(e) What is the expected value of next week’s price for XYZ? What are the highest and lowest prices you
expect XYZ to take with 95% confidence?
(f) What is the probability that the price of ABC will at least double during the week?
2.14 Statistical Analysis

Lou Graham is trying to calculate the statistics for the stock of Window Works. Lou has collected
48
P months ofPreturns information for the stock. His calculations provided him with the following results:
r = 0.58, r2 = 0.063.
(a) Calculate the expected return and the standard deviations of the returns for the stock.
(b) Calculate the 95% confidence range for the return.
(c) What is the probability of losing money on the stock?
2.15 Risk, Return, and Wealth

Monthly returns (in %) for the stocks A and B during 1989 are shown below:
t 1 2 3 4 5 6 7 8 9 10 11 12
rA 1 3 −2 4 3 −4 5 2 −2 4 −2 6
rB 7 −3 5 −5 6 4 −5 6 8 −7 −5 7
(a) Calculate the average return and standard deviation of returns for the stocks. Does one stock dominate
the other?
(b) What would $100 invested at the beginning of the year grow to in each of the stocks? Compare the
results from this part with those from part (a).
2.16 Returns and Prices

The expected return and standard deviation of XYZ for next month are 3% and 4%, respectively. What
are the highest and the lowest returns with 95% level of confidence? If the price of XYZ today is $12 what
are the future prices corresponding to the highest, expected, and lowest returns?
Return and Risk 57
2.17 Risk Premium

The risk-free rate is 6% per year. The average return from security A is 8% per year. You believe that
security B is twice as risky as A. What should be the average return from security B?
2.18 Effect of Inflation
Mr. Johnson is expecting 13% from his investments during the next year. The inflation during the next
year will be 5%. What is the real rate of return expected by Mr. Johnson?
2.19 Term Premium
You can lend money for one year at the rate of 12% per year. You believe that one year from now, a
similar loan will be made at 14% per year. Someone wants to borrow from you for two years. What annual
rate should you charge this person so that whether you lend for one year now and then for another year, or
for two years right now, your total return is the same?
2.20 Tax Premium
The interest income from New York Thruway bonds will be free of all taxes for you. On the other
hand, you will have to pay 28% taxes on interest income from the U.S. Treasury bonds. You believe that
the Thruway bonds are identical to the Treasury bonds in all other respects. The U.S. Treasury bonds are
yielding 9% per year. What should the minimum yield on the Thruway bonds be for you to invest in them
rather than the Treasury bonds?
Chapter 3
Portfolio Analysis
In Chapter 2, you learned that risk is measured by the standard deviation of returns. You
also learned that the objective of every investor is to maximize the utility from investments.
Furthermore, since utility is a function of expected return and risk, the objective may be
stated as the maximization of expected return for a desired level of risk, or the minimization
of risk for a desired level of expected return.
This chapter shows how investors should go about finding investment opportunities that
satisfy their objectives. You will learn that investors can improve the expected return to risk
trade-off by dividing their capital among securities to form portfolios. In a portfolio, losses
on some securities are offset by the gains on others. Therefore, portfolios allow investors to
diversify away some of the risk of the securities without sacrificing the expected return. The
intuition underlying portfolios is contained in the old saying: “Don’t put all your eggs in
one basket.” Here we go a step beyond and answer some other important questions: How
many and what securities to include in the portfolio? How to divide the money among the
securities? and What effect do our choices have on the portfolio?
3.1 Portfolios
In spite of the availability of thousands of securities it may not be possible for investors to
find securities that meet their specification. To see why, examine Figure 2.7 on page 50. It
shows the risk and return for several securities. You can see that investors who want to take
little risk can do so by investing in Treasury bills. Investors who want to take more risk will
have to choose from the stocks which are all clustered together. Therefore, those investors
who want to take medium risk, will not be able to do so. Since Figure 2.7 does not show
all the securities available, there is a chance that some securities not shown there may meet
their specifications. However, the cost of searching for the security may be significant, and
there is no guarantee that they will be successful.
Portfolios allow investors to design investments using available securities to suit their
58
Portfolio Analysis 59
requirements. For example, investors looking for medium risk may invest a part of their
money in the Treasury bills and the rest in a stock in such a way that the risk of the
combined investment is to their taste. Any number of securities may be combined to form
portfolios which then become viable investment alternatives. Portfolios, therefore, provide
a wider choice of investment opportunities to investors which allows them to make better
decisions.
Portfolios are formed by dividing money among securities. I may form a portfolio by
investing $20,000 in common stocks of AT&T, IBM, Kodak, and Sears as: $4,000 in AT&T,
$5,000 in IBM, $6,000 in Kodak, and the remaining $5,000 in Sears. I am investing 20% of
the money in AT&T, 25% in IBM, 30% in Kodak, and 25% in Sears. The biggest component
of my portfolio is Kodak. Therefore, movements in the return of Kodak have the greatest
influence on the portfolio return. In other words, Kodak exerts the most weight on the
portfolio. For this reason, the fractional amounts invested in individual securities are called
portfolio weights. We will use symbol x to denote a portfolio weight. xi will denote
the portfolio weight for security i. We will identify the composition of a portfolio by the
notation {x1 , x2 , x3 , . . . , xn }. For example, the portfolio described above can be represented
as {0.20, 0.25, 0.30, 0.25}.
Since all the money invested in the portfolio must be divided among the individual
securities, the portfolio weights must add up to 100% or 1. For the portfolio in this example:
xAT&T + xIBM + xKodak + xSears = 0.20 + 0.25 + 0.30 + 0.25 = 1.
In general, for a portfolio of n securities, this condition can be stated as:
X
xi = x1 + x2 + · · · + xn = 1 (3.1)
Equation (3.1) is the only condition on the portfolio weights. Therefore, using two or
more securities, one can form infinitely many different portfolios. Furthermore, portfolio
weights may be positive, zero, or negative. Therefore, {0, 0.20, 0.40, 0.40}, {0, 0, 0, 1}, and
{0.30, −0.10, 0.40, 0.40} are all valid portfolios of AT&T, IBM, Kodak, and Sears. In the
first portfolio, there is zero investment in AT&T. In the second portfolio, there are zero
investments in AT&T, IBM, and Kodak, and all the money is invested in Sears. While
this is not a good use of a portfolio, such a notation is used to indicate investment in an
individual security when comparing individual securities with portfolios.
Before we discuss the third portfolio, let us examine an important simplifying assumption
that we make throughout this chapter. We assume that there are no margin or short selling
constraints. Therefore, an investor can borrow or short sell as much as he wants. The
assumption underlying this assumption is that the lender has full faith that the borrowed
cash or securities will be returned. While this assumption may contradict1 our discussion of
1
Actually, it doesn’t necessarily contradict the short selling and margin rules. Recall that the investor
may meet the short selling collateral requirement through other securities. Therefore, the proceeds from
short selling can be used to purchase other securities and those securities can be kept as collateral as long
as the margin does not drop below the maintenance level.
short selling and margin in Chapter 1, it makes the calculations and algebra of our analysis
much simpler without taking away any insight.
Now let us examine the third portfolio. This portfolio invests −10% in security 2 (IBM).
Negative investment indicates short selling. −10% means that shares of IBM worth 10% of
the value of the portfolio are sold short. Since the total value of the portfolio is $20,000,
$2, 000 worth of shares of IBM are being sold short. The money generated from short
selling is invested in other securities. The total investment in the remaining three securities,
therefore, is $22,000.
New portfolios can also be formed by combining a security with an existing portfolio.
For example, you may form a portfolio by dividing your money between the risk-free se-
curity and a portfolio of risky securities. Suppose you want to invest 20% of your money
in the risk-free security and 80% in a portfolio of AT&T, IBM, Kodak, and Sears with the
composition {0.20, 0.25, 0.30, 0.25}. The composition of your overall portfolio made up of a
risk-free security and the portfolio of stocks as {0.20, 0.80}. Alternatively, you can utilize the
information about the composition of the portfolio of stocks and express the portfolio com-
position by specifying the exact investments in the risk-free security, AT&T, IBM, Kodak,
and Sears. Since 20% of 80% of your money, i.e., 16% is in AT&T, 25% of 80%, i.e., 20% is
in IBM, etc., the portfolio composition would be {0.20, 0.16, 0.20, 0.24, 0.20}. Similarly, new
portfolios may be formed by combining existing portfolios.
3.2 Portfolio Returns

Portfolio profits and returns are derived from the profits and returns on the securities in the
portfolio. Let us follow the example of the portfolio of AT&T, IBM, Kodak, and Sears with
the composition {0.20, 0.25, 0.30, 0.25}. Since $20,000 is invested in the portfolio, $4,000 is
invested in AT&T, $5,000 in IBM, $6,000 in Kodak, and $5,000 in Sears. In January 1990,
the returns on these securities were −14.29%, 4.78%, −7.29%, and 4.59%, respectively.
We want to find out the return on the portfolio. Knowing the returns on the securities
and the amounts invested, we can determine the profits from the securities. For example,
the profit from AT&T was $4,000(−0.1429) = −$571.60. Similarly, the profits from IBM,
Kodak, and Sears were $239.00, −$437.40, and $229.50. The total profit therefore was
−$571.60 + $239.00 − $437.40 + $229.50 = −$540.50. The return on the portfolio, therefore,
was −$540.50/$20,000 = −0.0270 or −2.70%. Our calculation for portfolio return can be
described by the following steps:
Profit
Return =
Investment
$4,000(−0.1429) + $5,000(0.0478) + $6,000(−0.0729) + $5,000(0.0459)
= ,
$20,000

$4,000 $5,000 $6,000 $5,000
= (−0.1429) + (0.0478) + (−0.0729) + (0.0459),
$20,000 $20,000 $20,000 $20,000
= 0.20(−0.1429) + 0.25(0.0478) + 0.30(−0.0729) + 0.25(0.0459) = −0.0270.
The portfolio return, therefore, can be calculated by summing the product of the portfolio
weights and the security returns. For a portfolio of n securities, we can write:
X
rp = xi ri = x1 r1 + x2 r2 + · · · + xn rn , (3.2)
where rp denotes the return on the portfolio. This equation shows that the portfolio return
is a weighted sum of the security returns.
3.3 Diversification
In section 3.1, we saw that portfolios allow investors to create more investment alternatives.
In addition to the expanded choice, portfolios reduce risk without a corresponding reduction
in expected return. This phenomenon is called diversification. To understand diversification,
examine Figure 3.1 which shows returns on two stocks Dot Inc. and Dash Inc. by dotted and
dashed lines, respectively. The solid line shows the returns on a portfolio that invests equal
amounts in both the stocks. The data for this Figure is shown in Table 3.1.
At t = 1, the return on Dot was 0.0099 while the return on Dash was −0.0272. The
return on the portfolio, therefore, was 0.5(0.0099) + 0.5(−0.0272) = −0.0086. Going from
t = 1 to t = 2, the return on Dot went down but the return on Dash went up by a larger
amount. The net effect was an increase in return on the portfolio. This trend of opposite
movements in stocks and a relatively small movement in the portfolio continues up to t = 9.
From t = 9 to t = 15 the stocks move up and down together causing the portfolio to show
Figure 3.1: Returns on two securities and their equally weighted portfolio.
..
... ..... .
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0.04% .. .. . . . ......
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1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
t
Table 3.1: Return on two securities and their equally weighted portfolio.
t Dot Inc. Dash Inc. Portfolio
1 0.0099 −0.0272 −0.0086

2 −0.0087 0.0190 0.0051
3 −0.0163 0.0528 0.0183
4 0.0012 0.0283 0.0147
5 0.0158 0.0038 0.0098
6 0.0048 0.0202 0.0125
7 0.0478 −0.0058 0.0210
8 0.0024 0.0101 0.0062
9 −0.0313 0.0105 −0.0104
10 0.0440 0.0120 0.0280
11 0.0357 0.0430 0.0394
12 0.0101 0.0245 0.0173
13 −0.0025 −0.0117 −0.0071
14 0.0387 0.0234 0.0311
15 0.0282 −0.0076 0.0103
16 −0.0065 0.0283 0.0109
17 0.0153 −0.0207 −0.0027
18 0.0009 −0.0076 −0.0034
19 −0.0005 0.0007 0.0001
20 0.0110 0.0038 0.0074
µ 0.0100 0.0100 0.0100

σ 0.0200 0.0200 0.0131
significant movement. From t = 15 to t = 20 the stocks do not move together and we see
that the movements in the portfolio are relatively small. The overall effect on the portfolio
return and risk is summarized in the last two rows of Table 3.1. Both securities have average
returns and standard deviations of 0.01 and 0.02, respectively. The portfolio also has an
average return of 0.01, but its standard deviation is 0.0131. The portfolio risk is lower than
that of the individual stocks without any decline in the average return. This happened
because the stock returns did not go up and down together uniformly. The reduction in
risk of a portfolio without a corresponding reduction in the expected return because of the
diverse movements of the securities in the portfolio is known as diversification.
As the description above suggests, the variability of the portfolio returns depends on
the degree of comovement among the returns on the stocks in the portfolio. There is no
reduction in risk if the returns move in unison, i.e., they have a correlation of +1. Diverse
movement in the returns, suggested by the correlation being less than +1, would lead to
the reduction of risk due to diversification. Therefore, the lower the correlation among the
security returns, the better the prospect for diversification.
3.3.1 Correlation
Correlation between the returns of a pair of securities can be calculated using historical data.
Table 3.2 shows the monthly returns on the stocks of AT&T and IBM for 60 months and
additional information needed to calculate the correlation.2 AT&T is indexed as 1 and IBM
is indexed as 2 in the Table and our calculations.
The first step in calculating correlation is the calculation of covariance. Covariance
between the returns on securities 1 and 2, denoted by σ12 , is calculated using the following
equation: P P
P ( r1 )( r2 )
r1 r2 − T
σ12 = . (3.3)
T −1
The covariance between the returns of AT&T and IBM, therefore, is:
0.004070 − (0.3507)(0.1368)
60
σ12 = = 0.000055.
59
The covariance can take values between −∞ and +∞. A positive value of covariance
indicates that the returns move together and a negative value means that they move in
opposite directions. The strength of the comovement, however, cannot be determined by the
magnitude of the covariance because the covariance may be high simply because the returns
have high variance.
Correlation between securities 1 and 2 is denoted by ρ12 and is calculated as:
σ12
ρ12 = . (3.4)
σ1 σ2
2
Full data is shown in a table at the end of the notes.
Table 3.2: Calculating correlation for security returns.
t Month r1 r2 r12 r22 r1 r2
1 01/90 −0.1429 0.0478 0.020420 0.002285 −0.006831

2 02/90 0.0192 0.0660 0.000369 0.004356 0.001267
3 03/90 0.0650 0.0217 0.004225 0.000471 0.001411
4 04/90 −0.0446 0.0271 0.001989 0.000734 −0.001209
5 05/90 0.0748 0.1130 0.005595 0.012769 0.008452
.. .. .. .. .. .. ..
. . . . . . .
57 09/94 −0.0054 0.0164 0.000029 0.000269 −0.000089
58 10/94 0.0185 0.0700 0.000342 0.004900 0.001295
59 11/94 −0.1068 −0.0470 0.011406 0.002209 0.005020
60 12/94 0.0295 0.0389 0.000870 0.001513 0.001148
60 0.3507 0.1368 0.200888 0.358326 0.004070
Before we can calculate the correlation, we need to calculate the standard deviations:
v P
uP
u ( r1 )2
t r1 −
2
T
σ1 =
T −1
v
u
u 0.200888 − (0.3507)2
t 60
= = 0.0581,
59
v P
uP
u r 2 − ( r2 )2
t 2 T
σ2 =
T −1
v
u
u 0.358326 − (0.1368)2
t 60
= = 0.0779.
59
The correlation between the returns of AT&T and IBM, therefore, is:
0.000055
ρ12 = = 0.0123.
(0.0581)(0.0779)
The correlation can take values between −1 and +1. Like the covariance, a negative cor-
relation indicates that the returns move opposite to each other and a positive correlation
means that they move together. Moreover, the magnitude of correlation is an indicator of
the strength of comovement. For example, a correlation of 0.8 is stronger than that of 0.5.
Table 3.3: Frequency distribution of correlations among stock returns.
Range Frequency %
−1.00 ≤ ρ < −0.10 0 0.000

−0.10 ≤ ρ < +0.00 5 0.282
+0.00 ≤ ρ < +0.10 33 1.864
+0.10 ≤ ρ < +0.20 103 5.819
+0.20 ≤ ρ < +0.30 499 28.192
+0.30 ≤ ρ < +0.40 685 38.701
+0.40 ≤ ρ < +0.50 345 19.492
+0.50 ≤ ρ < +0.60 81 4.576
+0.60 ≤ ρ < +0.70 14 0.791
+0.70 ≤ ρ < +0.80 5 0.282
+0.80 ≤ ρ < +0.90 0 0.000
+0.90 ≤ ρ ≤ +1.00 0 0.000
−1.00 ≤ ρ ≤ +1.00 1770 100.000
Using Microsoft Excel, correlation between two ranges can be calculated using the correl
function. For example, correl(a1:a60,b1:b60) calculates the correlation between the val-
ues in ranges a1:a60 and b1:b60. There is also a covar function in Microsoft Excel but it is
not suitable for our purposes as it uses T in the denominator rather than T − 1 (see equation
(3.3)). The sample estimate of population covariance can be calculated either by adjusting
the denominator as covar(a1:a60,b1:b60)*count(a1:a60)/(count(a1:a60)-1) or by us-
ing equation (3.4), i.e., correl(a1:a60,b1:b60)*stdev(a1:a60)*stdev(b1:b60).
Examine Table 3.3 to get a feel for the magnitude of correlations among the securities
in the market. The sample consists of monthly returns on 60 major stocks between January
1965 and December 1994. The average correlation is 0.3347. Note that there are very few
negative correlations and very few correlations higher than 0.5.
3.3.2 Diversification Efficiency

In the absence of diversification, the risk of a portfolio should equal the weighted sum
of the risks of the securities in the portfolio just as the expected return of the portfolio
equals the weighted sum of the expected return of the securities. Therefore, the effect of
diversification may be measured by comparing the risk of the portfolio and the weighted
average of the risk of the securities. The weighted average of the standard deviation of Dot
and Dash from the example above is 0.5(0.02) + 0.5(0.02) = 0.02. The standard deviation
of the portfolio is 0.0131. Since the portfolio standard deviation is less than the weighted
average of the standard deviation of the securities, diversification has indeed been achieved.
Mathematically, the following condition describes diversification for a portfolio of n securities:
X
σp < xi σi = x1 σ1 + x2 σ2 + · · · + xn σn , (3.5)
where σp is the portfolio standard deviation.3 The greater the difference between the portfolio
standard deviation and the weighted average of the standard deviations of the securities, the
better the diversification. The ratio created by dividing this difference by the weighted
average of standard deviation of securities tells us the fraction of the risk that has been
diversified away. In absence of diversification, {0.5, 0.5} portfolio of Dot and Dash would
have had a standard deviation of 0.02. The portfolio, due to diversification, has a standard
deviation of 0.0131. Therefore, (0.02 − 0.0131)/0.02 = 0.345 or 34.5% of the risk has been
diversified away. In general, we can define a diversification efficiency coefficient η as:
P
xi σi − σp
η= P . (3.6)
xi σi
3.4 An Overview of the Portfolio Selection Process

In this section we will examine the mechanics of optimal portfolio selection. This process
can be divided into several steps:
• Optimal portfolio selection begins with a clear statement of the risk-return objective.
This may be specified by describing the investor’s indifference curves, or by stating
a desired level of risk or expected return. The portfolio selection process will then
be directed to finding the best portfolio with respect to the specified criterion. For
example, if an investor wants the portfolio to earn 14% during the coming year, the
portfolio designer’s job is to find a portfolio that has the least amount of risk for the
specified expected return.
• Next, the securities to be included in the portfolio are selected. This involves considera-
tions of investor’s preferences and diversification. If an investor is forming the portfolio
for capital gains and does not need regular income, low dividend paying stocks are the
proper choice. The opposite is true if the investor wants regular income. The investor
may have other personal preferences which may determine the choice of securities to
be included. For example, an investor may want to invest only in the stocks of the
companies headquartered in his city, or may want to avoid the companies that have had
a poor pollution record. Security selection should be done keeping such preferences in
mind. Diversification considerations suggest that the correlation among the securities
should be low. This can be achieved by making sure that the securities are from the
different industries or geographical regions.
3
This condition for diversification holds only for positively weighted portfolios, i.e., when all x’s are
positive.
• Once the securities have been selected, historical price and dividend information is
collected for the securities. This data is used to calculate the returns, which are used
to estimate the statistics for the security returns. The periodicity of the data should
conform to the investor’s horizon. For example, if the portfolio will be held for a month,
and then updated, the data collection should be done so that monthly returns may
be calculated. Similarly, if the investor will not revise the portfolio for a year, annual
data should be used.
• At this point, several different portfolios are formed. The expected return and risk for
these portfolios are calculated.
• Finally, the optimal portfolio to suit the investor’s objective is identified.
To illustrate these steps, suppose that today is December 30, 1994 and we have been
asked to design a portfolio for Ms. Catherine Smith. After consulting with Ms. Smith, we
have decided to invest in the common stocks of AT&T, IBM, and Kodak. Ms. Smith will
hold her portfolio for one month and then revise it. Ms. Smith wants us to form the best
possible portfolio that has an expected return of 1.4% during January 1995. In the following
sections we will see the calculations needed for designing the portfolio for Ms. Smith.
3.5 Calculating Portfolio Statistics

To calculate portfolio statistics, we will use monthly returns on the stocks for the previous
five years: January 1990 to December 1994. We will index the stocks of AT&T, IBM, and
Kodak as 1, 2, and 3 in our calculations. We will show full calculation details for the portfolio
{0.2, 0.5, 0.3}, i.e., x1 = 0.2, x2 = 0.5, x3 = 0.3. 20% of the money of this portfolio is invested
in AT&T, 50% in IBM, and 30% in Kodak.
Portfolio statistics are calculated using the portfolio weights and the statistics for the
securities, The first step, therefore, is to calculate the statistics for the securities. Table 3.4
shows the details for calculating the security statistics.
The statistics are calculated using procedures described earlier in the notes. The results
from the calculations are summarized in Table 3.5. The first column of Table 3.5 identifies
the security, the second column shows the expected return, the third and the fourth columns
show the standard deviation and the variance, respectively. The next three columns show
the covariances. The row and the column numbers identify the securities whose covariance is
expressed in a particular location. For example, covariance between security 1 and 2, σ12 is
0.000055 and covariance between security 3 and 2, σ32 is 0.001343. Note that the covariance
of a security with itself is the variance of the security. For example, σ11 = 0.003370 = σ12 .
Also note that the covariance between two securities is independent of the order in which
the securities are used. For example, σ12 = σ21 = 0.000055. The last three columns show
the correlations. Note that the correlation of a security with itself is 1.00. Also note that as
Table 3.4: Calculating statistics for security returns.
t Month r1 r2 r3 r12 r22 r32 r1 r2 r1 r3 r2 r3
1 01/90 −0.1429 0.0478 −0.0729 0.020420 0.002285 0.005314 −0.006831 0.010417 −0.003485
2 02/90 0.0192 0.0660 0.0001 0.000369 0.004356 0.000000 0.001267 0.000002 0.000007
3 03/90 0.0650 0.0217 0.0399 0.004225 0.000471 0.001592 0.001411 0.002594 0.000866
4 04/90 −0.0446 0.0271 −0.0575 0.001989 0.000734 0.003306 −0.001209 0.002565 −0.001558
5 05/90 0.0748 0.1130 0.1050 0.005595 0.012769 0.011025 0.008452 0.007854 0.011865
.. .. .. .. .. .. .. .. .. .. ..
. . . . . . . . . . .
57 09/94 −0.0054 0.0164 0.0402 0.000029 0.000269 0.001616 −0.000089 −0.000217 0.000659
58 10/94 0.0185 0.0700 −0.0700 0.000342 0.004900 0.004900 0.001295 −0.001295 −0.004900
59 11/94 −0.1068 −0.0470 −0.0463 0.011406 0.002209 0.002144 0.005020 0.004945 0.002176
60 12/94 0.0295 0.0389 0.0495 0.000870 0.001513 0.002450 0.001148 0.001460 0.001926
60 0.3507 0.1368 0.7062 0.200888 0.358326 0.258621 0.004070 0.041879 0.080848
in the case of covariance, the correlation between two securities is independent of the order.
For example, ρ12 = ρ21 = 0.0123.
Statistical estimates of expected return, standard deviations, variances, covariances and
correlations calculated above are based entirely upon historical data during the past five years
and do not reflect other information that may be pertinent to the future behavior of the stock
return. A portfolio manager or an analyst may have additional insight or information that
may have a bearing on the expected return and other statistics of the securities. The analyst
should incorporate this insight by adjusting the statistics accordingly. For example, the
historical estimate of expected return of IBM is 0.0023. However, based on other available
information, I feel that a better estimate of the expected return of IBM is 0.0135. So, before
Table 3.5: Statistics for the securities based on historical data.
Covariance Correlation
Stock µ σ σ2
1 2 3 1 2 3
1 0.0058 0.0581 0.003370 0.003370 0.000055 0.000640 1.0000 0.0123 0.1692
2 0.0023 0.0779 0.006068 0.000055 0.006068 0.001343 0.0123 1.0000 0.2647
3 0.0118 0.0651 0.004243 0.000640 0.001343 0.004243 0.1692 0.2647 1.0000
using the statistics for portfolio calculations, I will adjust the expected return of IBM from
0.0023 to 0.0135. Similarly, I may choose to adjust other statistics. In making these changes,
I have to be cautious that the changes I make are statistically consistent. One can avoid the
inconsistencies by following the steps listed below:
1. Change historical estimates of expected returns to those expected based on the addi-
tional information.
2. Change historical estimates of standard deviations to those expected based on the

additional information.
3. Change historical estimates of correlations to those based on the additional information.
4. Calculate variances as squared standard deviations, for example Var 2 = σ22 .
5. Calculate covariances as the product of correlation and the standard deviations, for
example Cov 12 = ρ12 σ1 σ2 .
The adjusted statistics for the securities are shown in Table 3.6. In the portfolio calcu-
lations that follow, we will use the numbers in this table.
Table 3.6: Statistics for the securities adjusted based on additional information.
Covariance Correlation
Stock µ σ σ2
1 2 3 1 2 3
1 0.0095 0.0581 0.003376 0.003376 0.000824 0.000640 1.0000 0.1820 0.1692
2 0.0135 0.0779 0.006068 0.000824 0.006068 0.001166 0.1820 1.0000 0.2300
3 0.0118 0.0651 0.004238 0.000640 0.001166 0.004238 0.1692 0.2300 1.0000
Now that we have the security statistics, we are ready to calculate the portfolio statistics.
The expected return for a portfolio is calculated by using a variation of equation (3.2). To
calculate the portfolio expected return we substitute µ for r in that equation. The formula
for expected return on a portfolio of n securities is:
X
µp = xi µi = x1 µ1 + x2 µ2 + · · · + xn µn . (3.7)
For our portfolio we get:
µp = 0.20(0.0095) + 0.50(0.0135) + 0.30(0.0118) = 0.0122 = 1.22%.

Now we come to calculating the standard deviation of the portfolio returns. We first
calculate the variance of the portfolio returns and then the standard deviation by taking
the square root of the variance. The variance of returns for a portfolio of n securities is
calculated as:
X
n X
n−1 X
n
σp2 = x2i σi2 + 2xi xj σi σj ρij . (3.8)
i=1 i=1 j=i+1
From equation (3.4), we know that σi σj ρij = σij . Therefore, equation (3.8) can also be
written as
X
n X
n−1 X
n
σp2 = x2i σi2 + 2xi xj σij . (3.9)
i=1 i=1 j=i+1
Equations (3.8) and (3.9) may appear complicated but they are relatively simple once you
understand the underlying pattern. The right hand sides of these equations consist of two
set of terms. The first set has the products of the squares of portfolio weights and standard
deviations, e.g., x21 σ12 , x22 σ22 . If there are n securities in the portfolio then there will be n
such terms. The second set has the cross-product terms: 1 with 2, 1 with 3, 1 with 4,
. . ., 1 with n, 2 with 3, 2 with 4, . . ., 2 with n, and so on. For a portfolio of n securities,
there will be n(n − 1)/2 such terms. In equation (3.8), the cross-product terms consist of
2 times the product of the portfolio weights, the standard deviations, and the correlation,
e.g., 2x1 x2 σ1 σ2 ρ12 , 2x1 x3 σ1 σ3 ρ13 . In equation (3.9), the cross-product terms are 2 times the
product of the portfolio weights and the covariance, e.g., 2x1 x2 σ12 , 2x1 x3 σ13 .
Whether to use equation (3.8) or (3.9) depends on what information is available. If
correlations and standard deviations are known then equation (3.8) should be used. If
covariances are known then equation (3.9) should be used. If all the statistics are known,
then either equation can be used. However, in general, equation (3.9) is easier to use.
Let us first apply equation (3.8) to our portfolio:
σp2 = x21 σ12 + x22 σ22 + x23 σ32 + 2x1 x2 σ1 σ2 ρ12 + 2x1 x3 σ1 σ3 ρ13 + 2x2 x3 σ2 σ3 ρ23 ,
= (0.20)2 (0.0581)2 + (0.50)2 (0.0779)2 + (0.30)2 (0.0651)2
+2(0.20)(0.50)(0.0581)(0.0779)(0.1820)
+2(0.20)(0.30)(0.0581)(0.0651)(0.1692)
+2(0.50)(0.30)(0.0779)(0.0651)(0.2300)
= 0.002625,
so that,
σp = 0.0512 = 5.12%.
Let us now apply equation (3.9). While applying this equation, let us also use variance
(σ 2 ) directly from Table 3.6.
σp2 = x21 σ12 + x22 σ22 + x23 σ32 + 2x1 x2 σ12 + 2x1 x3 σ13 + 2x2 x3 σ23 ,
= (0.20)2 (0.003376) + (0.50)2(0.006068) + (0.30)2 (0.004238)

+2(0.20)(0.50)(0.000824)
+2(0.20)(0.30)(0.000640)
+2(0.50)(0.30)(0.001166)
= 0.002625,
so that,
σp = 0.0512 = 5.12%,
3.6 Identifying the Optimal Portfolio

To identify the optimal portfolio, we calculate the expected returns and standard deviations
of several portfolios. The more portfolios we use, the better the chance of identifying the
truly optimal portfolio. Table 3.7 shows the expected returns and standard deviations for the
three securities—AT&T (A), IBM (I), and Kodak (K)—and 20 possible portfolios of these
securities. Notice that portfolio 1 is the same portfolio for which we saw detailed calculations
in the previous section.
Figure 3.2 shows the three securities and the twenty portfolios graphically. The optimal
portfolios have the highest expected return for a specified risk, or the lowest risk for a specified
expected return. Such portfolios are known as efficient portfolios. Efficient portfolios lie
on the upper edge of the scatter diagram in Figure 3.2.
Figure 3.3 shows that all possible portfolio combinations are enveloped within a ⊂ shaped
curve. This curve, known as the mean-standard deviation frontier, describes the risk-
return trade-offs available to the investors. The upper half of this frontier is known as
efficient frontier because it consists of the efficient portfolios.
Investors should choose portfolios that lie on the efficient frontier. Picking a portfolio
within the efficient frontier is suboptimal because these portfolios are dominated by the
portfolios on the efficient frontier. Picking a portfolio above the efficient frontier would be
better but there are no portfolio combinations available outside the efficient frontier. The
particular efficient portfolio an investor should pick can be determined using his indifference
curve. Figure 3.4 shows this process. Less risk averse investors should pick high-risk efficient
portfolios while investors with high risk aversion should pick efficient portfolios with low risk
and low expected return.
The optimal portfolio selection can be simplified if the investor specifies the amount of
risk or expected return. Recall that Ms. Smith wants her portfolio to have expected return
of 1.4% during the month. Therefore, as shown in Figure 3.5 the optimal portfolio can
be identified by drawing a horizontal line from 1.4% expected return and identifying the
point at the intersection of this line and the efficient frontier. This portfolio has a standard
deviation of 0.0774. The composition of this portfolio, after some trial-and-error, turns out
to be {−0.3504, 0.8201, 0.5303}. Therefore, if Ms. Smith has $100,000 to invest, −$35,039
should be invested in AT&T, $82,006 in IBM, and $53,033 in Kodak.
Table 3.7: Portfolio statistics.
# x1 x2 x3 µp σp
A 1.00 0.00 0.00 0.0095 0.0581
I 0.00 1.00 0.00 0.0135 0.0779
K 0.00 0.00 1.00 0.0118 0.0651
1 0.20 0.50 0.30 0.0122 0.0512
2 −0.40 0.30 1.10 0.0132 0.0789
3 0.00 0.50 0.50 0.0126 0.0562
4 1.20 0.00 −0.20 0.0090 0.0687
5 0.70 0.70 −0.40 0.0114 0.0714
6 0.33 0.33 0.33 0.0115 0.0454
7 0.80 0.40 −0.20 0.0106 0.0586
8 0.30 −0.20 0.90 0.0108 0.0617
9 0.80 0.60 −0.40 0.0110 0.0696
10 0.70 0.60 −0.30 0.0112 0.0650
11 −0.20 0.50 0.70 0.0131 0.0648
12 0.60 0.60 −0.20 0.0114 0.0611
13 0.20 0.75 0.05 0.0126 0.0625
14 0.90 0.50 −0.40 0.0106 0.0689
15 −0.30 0.60 0.70 0.0135 0.0706
16 −0.30 0.25 1.05 0.0129 0.0738
17 0.50 0.20 0.30 0.0110 0.0443
18 0.70 −0.10 0.40 0.0100 0.0504
19 0.80 0.25 −0.05 0.0104 0.0529
20 0.60 0.70 −0.30 0.0116 0.0674
Figure 3.2: Portfolio statistics.
0.015
15 I
11 2
16
3 13
1
0.012 K 20
6 12 5
10
17 9
8
µ 19
7 14
18
A
0.009 4
0.006
0.04 0.05 0.06 0.07 0.08 0.09 0.10
σ
Figure 3.3: Efficient frontier.

...
0.015 ................
.
...
...
...
...
...
...................
....
..................
Efficient Frontier
.
...
...
...
...
....................
↓ ............................. 15 I
2
...
...
...
...
....... 11 16
...
...
...
....3.......
. 13
...
...........
0.012 ...
........... 1
. K 20
...
. ....6 12
10 5
...
17 .
... 9
8
µ ....
......
......
....... 19
7 14
........
........
18 .........
..........
..........
..........
A
...........
...........
...........
............
0.009 ............
............. 4
.............
.............
.............
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..............
..............
..............
..............
..............
..............
...............
...............
...............
........
0.006
0.04 0.05 0.06 0.07 0.08 0.09 0.10
σ
Figure 3.4: Optimal portfolio selection using indifference curves.
0.015 Less Risk Averse ...............

................
..................
.
. ...... ................
.......
More Risk Averse ................
..............
.......
..... ..............
.............
. ... ... ..........
. .....
...................
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...
.. .............................. ..... .............
.... ....................
15 I
...................
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..
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................................ 3 13 ...........
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.......................
0.012 •1
.....................................
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......
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.....
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.
....... ...... K 20
...... .......
....................................
6 ...
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12 5
.... 10
17...
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8
µ ....
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18 .........
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A
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0.009 ............
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..............
..............
..............
...............
...............
...............
.........
0.006
0.04 0.05 0.06 0.07 0.08 0.09 0.10
σ
Figure 3.5: Optimal portfolio selection using direct specification
0.015 ...............
................
..................
..
... ..... .............
....
................
................
....
. ....................
............. •
..............
....
.............
............ 15 I
.............
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............... 11
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3 13
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....
1
........
0.012 ......
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K 20
......
6 .
...
.
12 5
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17 ...
... 9
8
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......
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7 14
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18 .........
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A
...........
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0.009 ............
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..............
...............
...............
...............
.........
0.006
0.04 0.05 0.06 0.07 0.08 0.09 0.10
σ
3.7 Optimal Portfolio with Risky and Risk-free Secu-

rities
So far we have assumed that investors invest only in risky securities. In reality, they invest
some money in risk-free or near risk-free securities and some in risky securities. Common
examples of near risk-free securities are bank accounts and certificates of deposit (CDs). In
our analysis, we will use the term risk-free security to mean an investment that has a zero
standard deviation. You may recall from Chapter 2 that Treasury bills come very close to
being risk-free. Therefore, we will use the average return on the Treasury bills as the risk-free
rate.
With the availability of a risk-free security, the allocation of wealth among securities will
proceed in two steps. Investors will first choose a portfolio of risky securities and then divide
the capital between the risk-free investment and the portfolio of risky securities. They can
control the amount of risk they take by putting more or less money in the risk-free security.
Consider an investor who wants to divide his money between a risk-free security and a
portfolio of risky securities. Suppose, the expected return and standard deviation of the risky
portfolio are µ and σ. Let us denote the return on the risk-free security by rf . If the investor
puts x fraction of his money in the risky portfolio and (1 − x) in the risk-free security, the
expected return and risk of his overall portfolio, using two security case of equations (3.7)
and (3.8), would be given by:
µp = (1 − x)rf + xµ, (3.10)

q
σp = (1 − x)2 (0)2 + x2 σ 2 + 2(1 − x)(x)(0)(σ)(0) = xσ. (3.11)
Several portfolios can be created using different values of x, and µp and σp can be calculated
for these portfolios to determine the relationship between the expected return and standard
deviation. This risk-return trade-off relationship can also be estimated algebraically by
eliminating x between the two equations to get:
µ − rf
µ p = rf + σp . (3.12)
σ
Therefore, the risk-return trade-off for portfolios of a risk-free security and a portfolio of risky
securities is a straight line. Figure 3.6 shows the risk-return trade-off of portfolios made up
of a risk-free security with expected return of 0.39% or 0.0039 per month4 and the stock
of AT&T which has expected return of 0.0095 and standard deviation of 0.0581. Portfolio
{0, 1} is invested entirely in the risk-free security and portfolio {1, 0} is invested entirely in
AT&T. The portfolio denoted by {1.5, −0.5} is created by short selling the risk-free security.
Short selling a risk-free security is the same as borrowing at the risk-free rate. Therefore,
4
0.0039 is the average monthly Treasury bill return during January 1990 to December 1994. We could
have adjusted this historical estimate of expected risk-free rate based on more recent information.
Figure 3.6: Risk-return trade-off for portfolios of a risk-free security and AT&T.
0.02
•....
...............
...............
...............
...............
µ 0.01 •
....
...............
...............
.
...
...
...
...
.
{1.5, −0.5}
...............
...............
.
.................
{1, 0}
...
...
...
..
.....
...............
...............
...............
...............
..
...
...
...
.................
.
.........
...............
...............
•
..............
{0, 1}
0.02 0.04 0.06 0.08 0.10

σ
portfolio {1.5, −0.5} is created by borrowing money and investing it in the stock of AT&T.
In other words, this portfolio is a leveraged investment in AT&T. Note that the leveraged
investment has a higher risk than the stock of AT&T itself. The extra risk is due to financial
risk from leveraging.
From section 3.6, you know that in the absence of a risk-free security, investors choose
portfolios that lie on the efficient frontier. Different investors choose different portfolios to
suit their risk preference or specifications. With the availability of a risk-free security, they
will combine their choice of efficient portfolios with the risk-free security. The resulting trade-
off lines for some choices of efficient portfolios are shown in Figure 3.7. Compare Figure 3.7
with Figures 3.3–3.5 carefully. Figure 3.7 is drawn from the same data as Figures 3.2–3.5.
In Figure 3.7, the efficient frontier has been enlarged and shifted to allow us to see more
details. Also, individual securities and portfolios have been omitted to enhance clarity.
To get the highest expected return for a desired level of risk, investors will want to be
on the highest sloping line. This line is created by drawing a tangent from the risk-free
rate on to the efficient frontier of risky securities. The portfolios on this line are created
by dividing money between the risk-free security and the portfolio that lies at the tangency
point. The portfolio of risky securities that lies at the tangency point is known as the
tangency portfolio. The solid straight line in Figure 3.7 is the tangency line and the point
identified by T is the tangency point.
All investors, regardless of their risk preferences, should invest in the combinations of
the risk-free security and the tangency portfolio. Combinations of risk-free security and the
tangency portfolio offer better risk-return trade-off than the portfolios of risky securities
alone or the combinations of risk-free security with any other portfolio. Therefore, with the
availability of a risk-free security, all investors should invest in the same portfolio of risky
securities, unlike the case involving risky securities only where different investors invest in
Figure 3.7: Optimal portfolio selection with risky and risk-free securities.
0.020
P3 .
....
. . .. ...•..
...... . .
... . ...... . . . .
..
...... . .
.
0.015
P2 ......... . . . . P1
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......
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. . .
.. .
....... .
. .
. .
........ . . . . .
. .
.
.....
..... . . . .
.. ......... . . .
... . .
0.005 .
.
........ . .
......... .
•......
0.000
0.00 0.02 0.04 0.06 0.08
σ
different portfolios of risky securities to meet their risk specification. They should control the
risk of their overall portfolio by dividing their capital suitably between the risk-free security
and the tangency portfolio. Those who want to take less risk should invest more money in
the risk-free security and those who want to take more risk should invest more money in the
portfolio of risky securities.
In addition to offering better risk-return trade-offs, combining the risk-free security with
the tangency portfolio has one more advantage. With the risky securities only, there is a
minimum risk that the investors must take. For example, you can see from Figure 3.7 that
if an investor wants to form a portfolio with the standard deviation of 0.02, he cannot do
so with the risky securities only because there are no portfolio combinations that have such
low risk. However, it is possible to create a portfolio of this or any level of risk by combining
the risk-free security with the tangency portfolio.
The equation of the tangency line joining the risk-free rate and the tangency portfolio
is same as (3.12) with the substitution of the tangency portfolio statistics µT and σT for µ
and σ:
µ T − rf
µ p = rf + σp . (3.13)
σT
The statistics of the tangency portfolio can be determined by graphical analysis and its
composition by trial-and-error.5 From Figure 3.7, the expected return and standard deviation
can be approximated to be µT = 0.0116 and σT = 0.0460. The composition of the tangency
portfolio, by trial-and-error, can be estimated to be {0.3055, 0.3185, 0.3760}. Therefore, the
tangency portfolio is created by investing 30.55% of the portfolio in AT&T, 31.85% in IBM,
and 37.60 in Kodak. The equation of our tangency line, therefore, is:
0.0116 − 0.0039
µp = 0.0039 + σp .
0.0460
This equation can be used to determine the relationship between expected return and risk of
one’s investment. Recall that Ms. Smith wants an expected return of 1.4% or 0.014 during
the month. Therefore, the risk that she has to bear can be calculated as:
0.0116 − 0.0039
0.014 = 0.0039 + σp ,
0.0460
which gives us σp = 0.0600. From section 3.6, we know that to earn 1.4% expected return
without using the risk-free rate, Ms. Smith had to take a risk of σ = 0.0774. With the
risk-free security, for the risk of σ = 0.0774, her expected return from a portfolio created by
combining the risk-free security and the tangency portfolio would be:
0.0116 − 0.0039
µp = 0.0039 + 0.0774 = 0.0169.
0.0460
Combining the tangency portfolio with the risk-free rate, therefore, results in a better port-
folio than the portfolios created using risky securities only. The optimal portfolios without
and with the use of the risk-free security are indicated by P1 , P2 , P3 in Figure 3.7.
One thing we don’t know yet is how Ms. Smith should divide her money between the
risk-free security and the tangency portfolio so that she earns an expected return of 1.4% per
month. Since her portfolio is composed of a risk-free security and a risky portfolio, equations
(3.10) and (3.11) can be applied. We can determine the proper amounts to be invested in
the risk-free security and the tangency portfolio using either of these equations. Let us use
equation (3.11):
σp = xσT ⇒ 0.0600 = x(0.0460),
so that x = 1.3037. Therefore, 130.37% of her money should be invested in the tangency
portfolio and the remaining −30.37% should be invested in risk-free securities. The 130.37%
5
There are mathematical techniques and computer programs which can identify the tangency point di-
rectly. Optimizers built in spreadsheet programs such as Microsoft Excel can also be used for this purpose.
of the money to be invested in the tangency portfolio should be divided among the stocks
of AT&T, IBM, and Kodak as {0.3055, 0.3185, 0.3760}. Therefore, 30.55% of 130.37% or
39.83% should be invested in AT&T, etc. The overall portfolio made up of risk-free security,
AT&T, IBM, and Kodak is {−0.3037, 0.3983, 0.4152, 0.4901}. If Ms. Smith has $100,000 to
invest, −$30,366 should be invested in the risk-free security (Treasury bills), $39,830 in stock
of AT&T, $41,524 in IBM, and $49,012 in Kodak.
3.7.1 Efficient Frontier and Tangency Line

Depending on whether we are dealing with the situation with or without the risk-free security,
the terms efficient portfolios and efficient frontiers have different interpretations. The basic
definitions of these terms do not change. The term efficient is always used to refer to
the minimum risk for a desired level of expected return, or maximum expected return for
a specified level of risk. However, where the efficient portfolios and frontiers lie changes
depending on whether a risk-free security is included or not. In situations involving risky
securities only, the efficient frontier is the upper half of the ⊂ shaped curve and the efficient
portfolios lie on this frontier. When dealing with the case of risk-free and risky securities,
the efficient portfolios lie on the tangency line and the tangency line is the efficient frontier.
3.7.2 Constrained Portfolios

The portfolios used in the process described above did not have any constraints on the
portfolio weights except that they have to add up to 1. Therefore, in some portfolios, some
weights were negative, implying short selling. Some investors may not want to engage in
short selling because they perceive short selling to be inherently very risky, or because the
cost of short selling is too high for them. Other investors may want the investment in
every security in the portfolio to be above some minimum level because they do not want
to buy just a few shares in form of odd lots which, as we saw in Chapter 1, have additional
transaction costs. Portfolio selection process under such constraints will proceed in the same
manner as described above except that when considering alternative portfolios, the portfolio
weights would be chosen to satisfy the constraints. For example, if our investor did not
want to sell short, portfolios 2, 4, 5, 7, 8, 9, 10, 11, 12, 14, 15, 16, 18, 19, and 20 in Table
3.7 should be substituted by positively weighted portfolios, i.e., portfolios with positive
weights only.
Such constraints on the portfolio selection process will diminish the optimality of the
portfolios. Graphically, the mean standard deviation frontier for a constrained portfolio
selection process will shrink as shown in Figure 3.8. As a result, the slope of the tangency
line will decrease. The magnitude of the effect will depend on the kind of constraints and the
securities used to form the portfolios. Therefore, investors should carefully consider whether
constraints on short selling are worth the loss of efficiency of the portfolios.
Figure 3.8: Unconstrained and constrained efficient frontiers.
........
Unconstrained .... ........
...... ........
..... .........
......... . . ..
....... ........................... .......................
.... ..... ... .....
...... ............ ........ ............
...... ........... .....................................
...... ........... . .
........... ...................................
..
........ ................... ...
.........
.
.. .... .......
.
...... ........ ..........
..... ........ .........
............ ............ Constrained
............ ...................
...
...... . .
.....
. ...
..... ........ ......
......... ............... ....
µ ..
..
... . ....
..... .........
............ ..
.....
......... ..... ...
....
.... .....
..... ......
...... ......
....... .......
........ ........
......... .........
......... .........
......... ..........
.......... ..........
........... ......
...........
........... ......................
............ .
............ ......................
σ
............ .............
.. ..
3.7.3 Portfolio Revision

The portfolio design process creates a portfolio that would be optimal forever only if the
economic and investment conditions do not change once the portfolio has been designed.
Since we live in a dynamic world, a portfolio that is efficient today is very likely to become
inefficient soon. For this reason, it is important to revise a portfolio. Portfolio revision may be
compared with engine tune up for a car. How often a portfolio should be revised is a function
of the magnitude of change in the economic and investment conditions. A highly volatile
market warrants frequent examination and revision of the portfolio. For an investor, the
benefits of portfolio revision must be compared with its cost to decide whether a portfolio
should be revised. The benefit of portfolio revision comes from the improved risk-return
trade-off and the resulting improvement in expected value of the profits. The cost arises
from the transaction costs of buying and selling the securities to adjust the portfolio. For
example, if revising a portfolio worth $100,000 would result in an improvement of 0.5% in the
monthly expected return, then the expected value of the benefit is $100,000 × 0.005 = $500.
The revision will require a change in portfolio weights, i.e., selling some securities and using
the proceeds to buy others. Suppose the commissions for these transactions are $300 then
the portfolio revision is worthwhile. This example assumes that an expected value of $500
is worth more than a sure cost of $300. This may not be the case for all investors. The
important point here is that portfolio maintenance is an important activity. Portfolios must
be evaluated frequently to determine if they could benefit from a revision.
3.8 Analysis of Diversification

Now that we know how to calculate the expected return and risk of portfolios, and identify
the optimal portfolio for an investor using a chosen set of securities, we will examine the
Table 3.8: Statistics for portfolios of AT&T (1) and IBM (2) using ρ12 = 0.0123.
# x1 x2 µp σp
1 −0.50 1.50 0.0155 0.1152

2 −0.30 1.30 0.0147 0.0996
3 −0.10 1.10 0.0139 0.0848
4 0.10 0.90 0.0131 0.0714
5 0.30 0.70 0.0123 0.0602
6 0.50 0.50 0.0115 0.0527
7 0.70 0.30 0.0107 0.0505
8 0.90 0.10 0.0099 0.0543
9 1.10 −0.10 0.0091 0.0630
10 1.30 −0.30 0.0083 0.0749
11 1.50 −0.50 0.0075 0.0888
effect of two important portfolio design choices on the diversification characteristics of the
portfolio. The two design elements are the correlation among the securities in the portfolio
and the number of securities in the portfolio.
3.8.1 The Effect of Correlation

To study the effect of correlation between the securities on the diversification characteristics
of the portfolio, we will concentrate on the simplest portfolios—those consisting of only two
securities.
Let us take AT&T and IBM as our sample securities. The relevant statistics for the
securities are shown in Table 3.6 on page 69. The portfolio statistics can be calculated using
the two security case of equations (3.7) and (3.8):
µp = x1 µ1 + x2 µ2 , (3.14)
q
σp = x21 σ12 + x22 σ22 + 2x1 x2 σ1 σ2 ρ12 . (3.15)
Table 3.8 shows the statistics for several portfolios of these two securities. Figure 3.9
shows the portfolio statistics graphically. The points in Figure 3.9 join to form a smooth
curve called a risk-return trade-off curve. This curve has the same kind of shape as the
mean-standard deviation frontier.
The exact shape of the risk-return trade-off curve depends on the security statistics,
including the correlation. Our interest is in studying the effect of correlation. We would like
to know what the portfolio statistics would be if the correlation were something else. Since
the correlation can be between −1 and +1, we calculate the statistics for the portfolios of
Figure 3.9: Statistics for portfolios of AT&T (1) and IBM (2) using ρ12 = 0.0123.
0.020
•
............
....................
....................
{−0.5, 1.5}
0.015 ..
...
...
...
...
.
.....................
....................
.
........
.
....................
....................
...............
• ..................
.................. {0.0, 1.0}
µ ...............
........
...............
...............
............
...
•.
...........
........
{0.5, 0.5}
.....
.....
.......
.........
0.010 •
.........
..........
{1.0, 0.0}
.................
................
................
................
..................
...................
....................
•
...............
{1.5, −0.5}
0.005
0.06 0.08 0.10 0.12
σ
these two securities assuming different values for the correlation and keeping other statistics
fixed. From equation (3.14) you can see that for a particular portfolio, the expected return
will not change when we change the correlation because the portfolio expected return does
not depend on the correlation. Table 3.9 shows the result of our calculations for 5 different
values of correlation: 1.0, 0.5, 0.0, −0.5, and −1.0. The expected return on the portfolio is
shown only once because, as we saw above, it is the same for a portfolio regardless of the
correlation.
Figure 3.10 shows the risk and return statistics for the portfolios graphically. Note that
the risk-return trade-offs are straight lines when the securities are perfectly positively or
negatively correlated. In other cases, the trade-off is a curved line.
Table 3.9 and Figure 3.10 show that the standard deviation of a portfolio changes as
the correlation changes. The standard deviations of positively weighted portfolios go down
as correlation goes down. The opposite effect is seen in portfolios where one or the other
portfolio weight is negative. Since most investors hold positively weighted portfolios, to
minimize the risk, the securities in the portfolio should have as low correlations among their
returns as possible.
With perfectly positive correlation, when one security performs above average so does the
other, when one results in a less than expected return so does the other. Therefore, there is
no diversification effect with perfectly positive correlation. We can check this by examining
the standard deviation for a portfolio under ρ12 = 1.0 in Table 3.9. The standard deviation of
the portfolio {0.5, 0.5} is 0.0680. The weighted average of the standard deviation of securities
is 0.5 × 0.0581 + 0.5 × 0.0779 = 0.0680. Since the portfolio risk is equal to the weighted
average of the security risks, there is no diversification. Diversification is exhibited in the
portfolio when correlation is less than +1.0. The portfolio risk declines and diversification
efficiency increases as correlation decreases.
As Figure 3.10 shows, the extreme case of perfectly negative correlation allows us to
eliminate all the risk if the portfolio is chosen carefully. A portfolio that allows the risk to
be eliminated completely is known as a hedge portfolio. The hedge portfolio is shown
by a • in Figure 3.10. The composition of this portfolio can be determined by setting the
correlation equal to −1 and standard deviation of the portfolio equal to zero in equation
(3.15), and solving for the unknown portfolio weights:
q
σp = x21 σ12 + x22 σ22 + 2x1 x2 σ1 σ2 (−1) = 0.
Since x1 + x2 = 1, substitute x2 = 1 − x1 in the equation, and square both sides to get:
x21 σ12 + (1 − x1 )2 σ22 − 2x1 (1 − x1 )σ1 σ2 = 0,
which can be factored and written as:

2
x1 σ1 − (1 − x1 )σ2 = 0,
so that,
x1 σ1 − (1 − x1 )σ2 = 0.
Table 3.9: Statistics for portfolios of AT&T (1) and IBM (2) using ρ12 = 1.0, 0.5, 0.0, −0.5,
and −1.0.
σp
# x1 x2 µp ρ12 = 1.0 ρ12 = 0.5 ρ12 = 0.0 ρ12 = −0.5 ρ12 = −1.0
1 −0.50 1.50 0.0155 0.0878 0.1054 0.1204 0.1338 0.1459

2 −0.30 1.30 0.0147 0.0838 0.0938 0.1028 0.1110 0.1187
3 −0.10 1.10 0.0139 0.0799 0.0829 0.0859 0.0887 0.0915
4 0.10 0.90 0.0131 0.0759 0.0732 0.0704 0.0674 0.0643
5 0.30 0.70 0.0123 0.0720 0.0650 0.0572 0.0482 0.0371
6 0.50 0.50 0.0115 0.0680 0.0591 0.0486 0.0351 0.0099
7 0.70 0.30 0.0107 0.0640 0.0561 0.0469 0.0354 0.0173
8 0.90 0.10 0.0099 0.0601 0.0566 0.0529 0.0489 0.0445
9 1.10 −0.10 0.0091 0.0561 0.0604 0.0644 0.0681 0.0717
10 1.30 −0.30 0.0083 0.0522 0.0670 0.0791 0.0895 0.0989
11 1.50 −0.50 0.0075 0.0482 0.0756 0.0955 0.1118 0.1261
Figure 3.10: Statistics for portfolios of AT&T (1) and IBM (2) using ρ12 = 1.0, 0.5, 0.0,
−0.5, and −1.0.
0.02
ρ12 = 1.0 0.5 0.0 −0.5 −1.0

....
... ........... ................ . .
................... .......................
..... ........... ...............................................................................................................
........... .. ... ....
.... .......... ............... ..........................................
..
. .... ..................................................................................................................................
. ... ..... .... ......
..................................................
.......................
...........................................
........................................................ ...
...
...
.......
....... . . ........................................................................................... .......
.................... ............. ................... ........... ...
............................ .......................... .... .....
........................ ......
...
..... .....
...................... ..
.......
•
................................................
......................... .....
....
..
.
.
.....
. ....
.....
....
.....
.....
......................
..................... ....................... ..........
. ... ....
µ 0.01
................................. ...... .... .......
....................................... ... ....
...........................
. ... ..............................................
... .......................................................................................................
.... ....... . .. ...
..... ....... .............................................................................................................
..... ........ .............. . .
............... ...................................................................................
. .. .... ........
....... ............. ................. ....................
..
0.00
0.05 0.10 0.15
σ
Now we can solve for x1 and then for x2 = 1 − x1 to get:

σ2 σ1
x1 = and x2 = 1 − x1 = . (3.16)
σ1 + σ2 σ1 + σ2
For the numbers in our example,
0.0779
x1 = = 0.5728 and x2 = 1 − 0.5728 = 0.4272.
0.0581 + 0.0779
The expected return and standard deviation of this portfolio are:
µp = 0.5728(0.0095) + 0.4272(0.0135) = 0.0112

q
σp = (0.5728)2(0.0581)2 + (0.4272)2(0.0779)2
+2(0.5728)(0.4272)(0.0581)(0.0779)(−1.0) = 0.00
Hedge portfolios can also be formed when correlation between the securities is 1.0. You
can see this by extending the line for ρ = 1.0 in Figure 3.10. It will intersect the y axis at
some point. That point is also a hedge portfolio.
In reality, hedge portfolios cannot be formed using stocks only because there are no stocks
with perfect positive or negative correlations. Under some conditions, stocks and options
on the stocks have perfect correlations. Therefore, options and stocks may be combined to
form hedge portfolios. The expected return on a real hedge portfolio must be equal to risk-
free rate. If the expected return on the hedge portfolio were to be more than the risk-free
security, everybody will invest in the hedge portfolio instead of the risk-free security. This
will increase the demand for the hedge portfolio and decrease the demand for the risk-free
security. The result will be that the return on the hedge portfolio will come down and that
on the risk-free security will go up till the two are equal. The opposite will happen if the
expected return on the hedge portfolio were to be less than the risk-free rate.
3.8.2 The Effect of the Number of Securities

To examine the effect of the number of securities in the portfolio on diversification, imagine
that we have thousands of securities that have identical expected returns (µ) and risks (σ).
The correlation between every pair of securities is ρ. Now we take n of these securities and
form a portfolio by investing equal fractions in each of these n securities, i.e., n1 . Because of
the equal investment policy, the portfolio has the same expected return as any one security:

1 1 1 1
µp = µ+ µ+···+ µ = n µ = µ (3.17)
n n n n
Therefore, we can draw inferences about the diversification effect by focusing on the standard
deviations of the portfolios. To study the effect of the number of securities on portfolio risk,
we increase the number of securities in the portfolio, n, as 1, 2, 3, . . ., etc. The standard
deviations of the portfolio of n securities is calculated using equation (3.8) to be:
s
2 2
1 n(n − 1) 1
σp = n σ2 + 2 σ2ρ . (3.18)
n 2 n
Figure 3.11 shows a plot between the standard deviation of the portfolio and the number of
securities in the portfolio assuming σ = 1 and ρ = 0.2. As you can see, the standard deviation
declines as the number of securities is increased. Therefore, portfolios of more securities have
less risk without any decline in expected return. The drop in standard deviation is quite
rapid in the beginning. The portfolio of two securities has a standard deviation of only 75%
of a single security. The portfolio of three securities has a standard deviation of only 68%.
In other words, 32% of the security risk gets diversified when one forms a portfolio of three
securities. A portfolio of about 20 securities leads to a high level of diversification. After 20
securities the reduction in risk becomes very small so that there is not much diversification
benefit by including more securities in the portfolio.
Figure 3.12 shows the effect of the number of securities on the efficient frontier. Notice
that the effect of the number of securities on the efficient frontier is similar to that of imposing
constraints. This is not surprising. Using fewer securities to form portfolios is indeed a form
of constraint.
Figure 3.11: The effect of the number of securities on the portfolio risk.
1.0 ..
..
..
..
..
..
..
..
...
...
...
...
..
..
..
0.8 ..
..
...
...
..
...
σ
...
...
...
...
...
...
...
...
0.6 ...
....
.....
......
.......
.........
............
.................
............................
.......................................................
...................................................................
0.4
0 10 20 30 40 50
n
Figure 3.12: The effect of the number of securities on the efficient frontier.
.....
......
......
.......
...........
.
......
Large n .......
......
......
...... .......
........... ...... ........ .......
.
. ........ ............. ..............................
.. ..
.
....... ......... ................................
....... ......... ................
....... ......... ...............
............... ...........
.........................
. . .......
. . ............... ...........
..
........
. ........
....... ..........
....... ...............
....... ..............
...... ..................
........
............
...
... .....
........ ......
........ ....
.
Small n
µ ..
...
.. .
.......... ....... .......
...... .... ........
...... ..................
.....
.
...... ........ ...
....... ........ .. ..
....... ........ .... ...
....... ........
...
...................... ...
.
...
...
..... ..... ...
............... ... ...
............... ... ...
............. .... ....
............ .... .....
......... .....
...... .....
......
...... ......
...... ......
....... .......
....... .......
....... .......
........ ........
........ ........
........ ........
......... ........
......... .........
......... .........
......... .........
σ ........
..........
........
........
..........
........
Our observations are based on some very specific assumptions about securities and port-
folio formation methods. We assumed that all securities have equal expected returns and
standard deviations, that the correlations between all pairs of securities are equal, and that
portfolios are equally weighted. In real investment situations, security statistics are not alike,
and investors form portfolios by investing different amounts in different securities. However,
similar results are obtained in those situations also.
These results suggest that investors should hold as many securities as available. We do
not observe this in reality because investors also consider the transaction costs which have
been ignored in our presentation. Beyond a certain point the transaction costs of creating and
maintaining a portfolio of many securities outweigh the benefits of diversification. Typically,
15 to 20 securities are considered ideal for individual investors.
3.9 Mutual Funds

We know that portfolios are desirable because of their diversification effect. Portfolio forma-
tion and management, however, is a time consuming activity and requires special skills. In
addition, portfolio formation is not feasible for small, individual investors because most of
the benefits of diversification are lost due to the transaction costs incurred during portfolio
formation and revision. The costs are lower if the transactions are done on a large scale.
The need for professional skills to design and manage a large diversified portfolio, and the
economies of scales associated with large portfolios led to the development of mutual funds.
Mutual funds are portfolios created and managed by financial companies such as Fidelity
Investments, Merrill Lynch, Vanguard, and Dean Witter. Individuals buy shares of mutual
funds. Mutual fund managers use the money collected from the investors to buy securities
that make up the portfolio. In this sense a mutual fund can be viewed as a cooperative.
Today, mutual funds are almost as important a part of the investments market as common
stocks.
The process of optimal portfolio selection by the fund managers is not revealed. However,
we can guess that they combine the securities to form efficient portfolios. Investors get to
enjoy the benefits of diversification without having to be directly involved in the process of
selecting and maintaining a portfolio of a large number of securities. The main advantage
of mutual funds, however, comes from the reduced transaction costs because of the buying
power of the funds.
Mutual funds can be formed using a variety of securities. A broad classification of mutual
funds is in terms of the time to maturity of the securities in the funds. Money market mutual
funds, usually referred to as money market funds, consist of short term, money market
securities such as Treasury bills, commercial paper, and repurchase agreements. Mutual
funds consisting of capital market instruments such as stocks, bonds, and precious metals
are usually referred to simply as mutual funds. Money market funds have very little risk
and, therefore, yield relatively low interest rates. However, they are highly liquid and can
be converted into cash on a short notice without any penalty. Capital market mutual funds
have relatively higher risks and therefore are expected to yield higher rates. However, they
require a commitment of capital for some minimum time and may impose penalties for early
withdrawal of money.
Investors can specialize by choosing a special kind of mutual fund to meet their investment
needs. For example, there are growth oriented funds and high yield funds; there are funds
that consist of long term bonds; funds that invest in stocks of energy sector companies; funds
made up of municipal securities; funds that invest in foreign securities; etc. Sector funds
invest in a sector of the economy and therefore allow investors to exploit their intuition about
a particular group of securities. For example, if you believe that the health care business will
make big strides during the next few years but you are not sure which companies will be most
successful, you may buy shares in a health care mutual fund. The choice of funds available
to the investors has become so wide that it takes almost as much effort to decide among
the mutual funds as among individual stocks and bonds. Usually, a mutual fund company
manages several different funds. For example, in The Wall Street Journal of August 8, 1995,
there were over 100 funds listed for Merrill Lynch and over 150 for Fidelity.
Fund managers charge fees for managing the portfolios. The fees are collected either
directly from the investor in the form of commissions at the time of buying or selling mutual
fund shares, or in the form of deductions from the portfolio earnings, or both. Funds that
charge commissions are called load funds. The commission charged is called front end load
if the commission is charged at the time of purchase of shares and back end load if it is
charged at the time of selling the shares. Funds that do not charge any such commissions
are known as no-load funds.
Mutual funds can be open end or closed end. Open end funds do not have any limit
on the number of shares that can be issued. These funds issue shares on demand and use
the proceeds from issuing shares for buying additional securities that make up the fund
portfolio. Closed end funds, on the other hand, have a fixed number of shares—almost
like corporations. The shares of closed end funds are traded in the stock exchanges. An
investor can buy shares in a closed fund only if some other investor is willing to sell them.
The market price of the shares of closed end mutual funds, therefore, depends on the demand
and supply of the shares. As a result, the market price of closed end shares is not necessarily
equal to the value of the underlying assets—the net asset value. In fact, most often the
market price of closed end funds is below their net asset values, i.e., the closed end fund
shares sell at a discount to their net asset values.
Open end funds are not traded in the stock markets. The value of an open end mutual
fund is given by its Net Asset Value (NAV). The net asset value, as the name implies,
refers to the net value of the assets of the mutual fund on a per share basis. Therefore, it is
like the price of a common stock of a corporation. Table 3.10 provides an excerpt from the
mutual fund quotations from The Wall Street Journal of August 8, 1995.
The first column in the mutual fund quotation gives the name of the fund group (in bold
print) and the funds. The next column gives the fund’s stated objective. A table in The
Table 3.10: Mutual Fund Quotes
Inv. Offer NAV —— Total Return ——

Obj. NAV Price Chg. YTD 4 wks 1 yr R
Janus Fund:
Balanced S&B 13.35 NL +0.04 +15.9 +1.0 +16.2 B
Enterprise MID 25.84 NL +0.17 +12.4 +2.1 +22.7 D
Fund CAP 22.78 NL +0.09 +21.3 +1.2 +21.3 D
Twen CAP 28.89 NL +0.05 +27.2 −1.0 +28.3 B
Japan Fd ITL 9.02 NL −0.02 −13.1 +1.2 −20.7 E
John Hancock:
CA TE MCA 11.45 11.99 −0.03 +9.5 −1.8 +6.9 A
Grwth p GRO 19.76 20.80 +0.09 +24.4 +3.9 +31.5 A
NYTE p DNY 11.70 12.25 −0.02 +8.9 −1.5 +6.0 B
Wall Street Journal describes all the objectives. For example, S&B refers to stock and bond
balanced funds, SML refers to small company growth funds, etc. The next column provides
the Net Asset Value of the fund on a per share basis. For example, if you own 100 shares of
Janus Twenty fund (Twen), the total value of your investment is $28.89 × 100 = $2,889. If
you want to get out of the mutual fund you will receive a total of $2,889. The next column
shows the offer price, which is what you have to pay to buy the shares in the company. For
the Janus group of funds and the Japan fund, the entry in this column is NL which stands
for no load. For these funds, the share price is the same whether you want to buy or sell.
For John Hancock funds, however, the offer price is higher than the net asset value. You
have to pay $20.80 to buy a share of their growth fund whose net asset value is $19.76. The
difference, $1.04 or 5% of the offer price is the load for this fund. The next column gives the
change in NAV since the previous trading day.
The next three columns provide some performance results for the funds. Columns titled
YTD, 4 wk, and 1 yr give returns on the fund year-to-date, for the last four weeks, and for
the last one year in percent. The year-to-date return on Janus Twenty fund is +27.2%. The
last column gives a ranking of the fund based on the performance of the fund over the last
one year among funds of similar objectives. The top 20% funds get ranking of A while the
bottom 20% get ranked E. Since Janus Twenty Fund’s rank is B, it was between 60th to
80th percentile among all the funds with stated objectives of CAP (capital appreciation).
The entries in the last three columns of the mutual fund table change from Monday
through Friday. On Mondays, the mutual fund table provides information about the funds’
expenses. Specificaly, funds’ maximum initial charge (load) and expense ratio are listed.
Expense ratio is the ratio of funds’ operating expenses to its assets. No performance based
fund ranks are provided on Mondays. On Tuesday through Friday, the table lists returns
for 4 weeks/1 year, 13 weeks/3 years, 26 weeks/4 years, and 39 weeks/5 years. On these
four days, the Journal also provides fund rankings based on 1, 3, 4, and 5 years of returns,
respectively. Since periods of different lengths are used to arrive at performance ranks on
different days, the fund ranks may change from day to day.
3.10 Portfolio Selection in a Perfect Market

As we saw above, with the availability of a risk-free and several risky securities, investors
should diversify by dividing their money between the risk-free security and the tangency
portfolio of risky securities. For maximum diversification, the tangency portfolio should
consist of as many securities as possible. The transaction costs, however, keep investors
from diversifying across all securities in the market. If there were a market where there
were no taxes, transaction costs, or costs of acquiring and interpreting information, then
all investors would diversify to the limit by buying as many securities as there are in the
market. A market without any taxes, transactions, and information costs is known as a
perfect market. Being a theoretical construct, a perfect market is not very useful from
an immediate practical perspective. However, implications of analysis in a perfect market
provide insight and models about the securities which are useful in real markets also.
As mentioned above, in a perfect market, investors include all available securities to form
portfolios because there are no transaction costs. The tangency portfolio, therefore, includes
all the securities in the market. The tangency portfolio in a perfect market setting is known
as the market portfolio. The tangency line in a perfect market is known as the capital
market line. The composition of market portfolio may be determined using the method
described in section 3.7. However, applying the principles of market equilibrium, it can be
shown that the market portfolio is value weighted. In other words, the weights of the
securities in the market portfolio are proportional to their market values. As an example,
suppose that there are only 5 risky securities in the economy: A, B, C, D, and E, with total
market values of $20, $15, $20, $35, and $10 (in millions), respectively. Since the market
value of all securities = 20 + 15 + 20 + 35 + 10 = 100, the composition of the market portfolio
20 15 20 35 10
is xA = 100 = 0.20, xB = 100 = 0.15, xC = 100 = 0.20, xD = 100 = 0.35, and xE = 100 = 0.10.
If our real economy were a perfect market, the market portfolio would be made up of all
the securities available, including stocks, bonds, options, futures, and real estate. Obviously,
this portfolio will consist of hundreds of thousands of securities. For application of the models
derived in a perfect market setting, stock indexes such as S&P 500 or NYSE composite are
used as proxies for the market portfolio. S&P 500 is a value weighted portfolio of 500 major
stocks traded on the NYSE. The NYSE composite is a value weighted portfolio of all stocks
traded on the NYSE.
Table 3.11: Calculating β for AT&T.
t Month ri rm ri rm rm
2
1 01/90 −0.1429 −0.0671 0.009589 0.004502

2 02/90 0.0192 0.0129 0.000248 0.000166
3 03/90 0.0650 0.0263 0.001709 0.000692
4 04/90 −0.0446 −0.0247 0.001102 0.000610
5 05/90 0.0748 0.0975 0.007293 0.009506
.. .. .. .. .. ..
. . . . . .
57 09/94 −0.0054 −0.0241 0.000130 0.000581
58 10/94 0.0185 0.0229 0.000424 0.000524
59 11/94 −0.1068 −0.0367 0.003920 0.001347
60 12/94 0.0295 0.0146 0.000431 0.000213
60 0.3507 0.4560 0.069631 0.080374
3.11 Systematic and Unsystematic Risks

When viewing a security as a part of the market portfolio, its total risk may be divided into
two components. Of the total risk only a small portion remains undiversified in the market
portfolio. This portion is known as undiversifiable, systematic, or market related. The
portion that gets diversified away is known as diversifiable, unsystematic, or unique
risk. The systematic risk is measured by β. The β of security i is calculated as:
σim
βi = 2
(3.19)
σm
where σim is the covariance between the returns of the investment and the market portfolio,
2
and σm is the variance of returns on the market portfolio. Since σim = ρim σi σm , equation
(3.19) can also be written as:
σi
βi = ρim (3.20)
σm
Table 3.11 shows the details for calculating the β for the stock of AT&T using S&P 500
as the proxy for the market portfolio. Monthly data from January 1990 to December 1994
is used for the calculations.
First we calculate the covariance between the stock and the market returns, and the
variance of the market returns, and then the β:
P P
P ri rm
ri rm − T
0.069631 − (0.3507)(0.4560)
60
σim = = = 0.001135
T −1 59
P
P ( r )2 (0.4560)2
2
2
rm − Tm 0.080374 − 60
σm = = = 0.001304
T −1 59
σim 0.001135
βi = 2
= = 0.8707
σm 0.001304
The value of β can be between −∞ and +∞. The risk-free security has a β of 0 and the
market portfolio has a β of 1.
From regression theory, we know that the formula for βi in equation (3.19) is same as the
formula for the slope coefficient in a simple linear regression with rm being the independent
variable and ri being the dependent variable. The regression equation is shown below:
ri = ai + βi rm . (3.21)
Therefore, you could save time by feeding the data for ri and rm to a computer program
(such as the regression procedure in Microsoft Excel) and asking it to run the regression.
The output from the computer program will provide β as the slope coefficient. Equation
(3.21) is known as the market model. The regression output also gives us some statistics.
The most useful among these are R2 and the standard error of beta. The R2 is a measure
of the goodness of fit of the regression equation. Using the standard error, we can conduct
a test for the significance of β. The t statistic for this test is calculated by dividing the β by
the standard error.
Sometimes, the market model is written in terms of the excess returns—returns in excess
of the risk-free rate—as:
ri − rf = αi + βi (rm − rf ). (3.22)
This form of the market model is preferred over equation (3.21) if one wants to eliminate
the effect of the economywide changes in the level of interest rates. The total returns may
change from one period to another because of the changes in the interest rates across all
securities in the economy. The movements in excess returns is only due to the riskiness of
the securities.
The β in equation (3.22) is exactly equal to the β in equation (3.21) if the risk-free rate
rf is constant over time. Even if we use the monthly Treasury bill returns as risk-free rates,
which are not constant but have a very little variance, the β obtained using equation (3.22)
is almost the same as the one obtained using equation (3.21).
The market model provides us an alternative interpretation of β. β can be seen as the
sensitivity of a security’s returns to that of the market. Suppose the β of a security is 1.5.
Then, if the return on the market goes up by 1%, the return on the security would go up by
1.5%. Based on this interpretation, systematic risks and βs can be calculated for portfolios
also. The β of a portfolio measures the sensitivity of portfolio returns to those of the market.
The relationship between the returns of the security and the market is shown graphically
by the characteristic line. A characteristic line is the best fit regression line between
Figure 3.13: Characteristic line for AT&T.
r − rf 0.20
.....
.......
.......
......
.......
· ·
0.10 ·
.
......
.......
..
...
.......
· · · · ...
...
.
.......
...... ·
.......
....... ·
·· · ·
.......
.......
...
........
......
· · · .......
· · ·· ··
.......
.......
.......
· · · ·
.
· ...
.
......
......
.......
·· · · · ·· .......
.......
· ·· .
......
..
...
−0.15 −0.05· · · · .......

.......
0.05
.......
......
0.15
·· · · ...
...
.
· .......
.......
....... · · ·
......
· r −r m
.
...
.......
..
........
· · · f
.
.....
..
.......
......
. ·
.......
......
......
...... −0.10 ·
.
.....
.......
..
........
·
......
.......
...... ·
·
−0.20
the excess returns of a stock and that of the market. Figure 3.13 shows the data and the
characteristic line for AT&T. The slope of the characteristic line is the β of the security.
Securities with βs higher than 1 are known as aggressive and those with βs lower than 1
are known as conservative. Figure 3.14 shows the characteristic lines for IBM (solid line),
Kodak (dashed line), and Sears (dotted line). The βs for IBM, Kodak, and Sears, are 0.5699,
0.5854, and 1.0308, respectively.
Several investment information services provide βs for individual stocks. These services
differ from each other in their calculation methodology and, therefore, do not always give the
same β for a particular stock. The methodologies differ on parameters such as periodicity
(daily, weekly, monthly, or annual) for the returns, the number of observations, and the proxy
for the market portfolio. Also, these services apply adjustments to β after it is calculated.
Therefore, you should be very careful in using the βs provided by the information services.
You must ascertain that the calculation method used by the service is suitable for your
application.
3.12 Capital Asset Pricing Model

In perfect markets, investors hold risky securities through the market portfolio. Therefore,
the only risk that matters is the systematic risk measured by β. The Capital Asset Pricing
Figure 3.14: Characteristic line for IBM, Kodak, and Sears.
r − rf 0.20
.
.
.
.
.
.
.
IBM .
.
.
.
Kodak .
.
Sears
0.10 .
.
.
.......
. ...... ..
.
.
.
. ...... ..................
. ..
.. ........
. ....... .................
. .
...... ...
...
. ....... ......
.........
.
. ....... .................
. ....... ......
. .
...... ..................
. ....... ...........
.
. ....... ..........
. ...... ..............
... ...... ..................
.
...
.. ..... .
..
....... . ............
....... .............
−0.15 −0.05 .
....... ...........
..... ................... .
. 0.05 0.15
....... .......... .
....... ............. . .
....... .............
... .........................
.... ....... . .
.
.
r −r m f
.. ........................ .
.
...
. .... ... .
..................... .
......................... .
.
.. .
.
.
.
.
−0.10
.
.
.
.
.
.
.
.
−0.20
Model (CAPM) shows that since investors need to bear only the systematic risk, the expected
return from a security should be related to its systematic risk only. The relationship between
a security’s expected return and its systematic risk is given by the security market line
(SML):
ki = rf + βi (µm − rf ), (3.23)
where ki is the rate of return investors should expect from a security, rf is the rate of return
on the risk-free security, and µm is the expected return on the market portfolio. Note that
on the right hand side βi is the only variable that depends on the security. rf and µm are
constant across securities.
Let us use equation (3.23) to calculate the rate of return investors should expect from
AT&T during January 1995. The β of AT&T is 0.8707. Expected returns on the risk-free
security (rf ) and the market portfolio (µm ) during January 1995 are 0.0039 per month and
0.0076, respectively.6 Therefore, the expected return from AT&T should be:
k = 0.0039 + 0.8707(0.0076 − 0.0039) = 0.0071.
In equilibrium, the price of a security equals its value, and its expected return µ equals
its equilibrium expected return k given by the security market line. If a security’s price is not
6
These estimates are strictly based on the historical data and may be updated to incorporate additional
information as we did for the statistics for the stocks.
Figure 3.15: Security market line for 60 stocks, Treasury bills and S&P 500.
0.03
0.02 ?
?
? ?
µ ? ?? ?
? ? ?? ..................
..................
? ??? ? ? ......................................................................
?? ?...?.?....?.......................?......?....?..?... ?
......?
?
0.01 ........?
.................
.................
? ?????? ?? ?
? ?
.
...
..
? ?
..
..
?
...
.
??
..
.. .
.............
...
...
...
...
.
............
.................
?? ? ? ? ?
• ? ?
?
0.00
0.0 0.5 1.0 1.5 2.0 2.5
β
equal to its value, and therefore, its expected return is not equal to the equilibrium expected
return, the security is said to be mispriced. There will be an excess demand or supply
for a mispriced security which will cause the price of the security to change till equilibrium
is established. For example, if we believe that AT&T’s returns will continue to behave the
same way as they did during the previous 60 months, the expected return from AT&T is
0.0058 (see Table 3.5).
Since the expected return from the AT&T (0.0058) is less than what should be expected
from it based on its risk (0.0071), AT&T is overpriced. An overpriced or overvalued security
is priced above its proper value so that its expected return is lower than what should be
expected based on its risk. Because an overpriced security is selling above its value, there
would be little demand for it, which would cause its price to go down and the expected
return to come up to the level that should be expected from it based on its risk. Once this
state is reached, the security is in equilibrium.
If AT&T’s expected return had been higher than the proper expected return, the security
would have been underpriced or undervalued, which would have caused everyone to want
to buy the security. This would create an excess demand for the security, which in turn
would bring the prices up and expected return down until the expected return equals the
proper expected return.
Disturbances in the form of new information arrive in the market continuously. As
a result, the markets are never in a state of equilibrium—even when they are closed. The
equilibrium rate ki given by the CAPM, therefore, will not exactly equal the expected return,
µ. However, if the model is a realistic description of the market, the answers given by the
Figure 3.16: Total, systematic, and unsystematic risks.
1.4
1.2
1.0
0.8 . . . . . . .
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0.4 . . . . . . .
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0.2 . . . . . . .
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. . . . . . . . . . . . . . . . . . . . . . . . . . . .
0.0
A B C D
CAPM should, on an average, agree with the actual observations. Therefore, we should
observe an increasing linear relationship between µ and β. Figure 3.15 shows the βs and
average monthly returns µs for 60 stocks (indicated by ?s), the Treasury bills (indicated by
•) and the S&P 500 index (indicated by ) for the period January 1965 to December 1994.
The relationship between the expected return and β is indeed increasing and linear.
3.12.1 CAPM and Risk

Now we have three measures of risk: total risk (measured by σ), systematic risk (measured by
β), and the residual unsystematic risk. The total risk refers to the variability of returns and
is the risk that is faced by the investor. The return that the investor can expect, however, is
related to the systematic risk. In other words, the investor is rewarded for bearing only the
systematic portion of the risk. There is a direct, linear relationship between the systematic
risk and the expected return, and is given by the security market line, equation (3.23). There
is no reward for bearing the unsystematic risk. Therefore, all risk-averse investors should
try to reduce the unsystematic risk as much as possible. The less the unsystematic risk in a
portfolio, the more efficient the portfolio.
To understand this issue better, study Figure 3.16. The total height of the bar represents
the total risk, the lower (shaded) portion of the bar denotes the systematic risk and the upper
(unshaded) portion denotes the unsystematic risk. Suppose an investor is faced with a choice
of investing in either security A or B. Both the securities have identical total risks. Therefore,
the amount of uncertainty about returns with both the securities are equal. However, B has
more systematic risk than A. This means that the expected return on B is higher than that
on A. A risk-averse investor should, therefore, pick B over A. Similarly, a risk-averse investor
should pick security C over A because both C and A offer equal expected returns (they have
equal systematic risks) but with A the investor will have to face a greater uncertainty of
returns. Similarly, between B and D, B dominates D. We cannot make any clear comparisons
between A and D, B and C, and C and D.
3.12.2 Using the CAPM

The CAPM and the associated security market line give us the proper or equilibrium expected
rate of return from an investment. The equilibrium expected rate of return of a security may
be compared with its expected return to check if the security is in equilibrium. The direction
of departure from the equilibrium may be used to determine if the security is overpriced or
underpriced. For example, in our sample calculations we found that the proper expected
rate of return (as per the CAPM) for AT&T was 0.0071 per month. The expected return
based on the historical performance of the stock was 0.0058 per month. Since the return we
expect from the stock (based on the historical data) is less than what should be expected
(based on the risk of the stock), AT&T is overpriced and is not a good buy.
Another use of the CAPM is in setting the rate of returns that regulated public utilities
are allowed to earn on their investments. Analysts calculate the β of the stock of a utility
company and then calculate the proper expected return to the stockholders based on this
β. The prices that the company can charge their customers for the services or goods are
set such that the rate of return to the stockholders of the company equals the rate expected
based on their risks.
The equilibrium expected rate of return given by the security market line is the return
one should expect from a security based on its risk. This is the discount rate that is needed
for valuation of securities as we will see in Chapter 4. Therefore, CAPM finds application
in valuation of securities also.
3.12.3 Problems with the CAPM

Over time many problems have been found with the CAPM. The main problem is the proper
identification of market portfolio. Theoretically, the market portfolio is a value weighted
portfolio of all the investment opportunities in the economy. Such a portfolio would be
impossible to create, even mathematically, because of its size. The users of the CAPM have
to rely on proxies for the market portfolio. The usefulness of the CAPM, therefore, depends
on how good a proxy we have for the market portfolio. Different people use different proxies
and come up with different answers for the same problem.
Secondly, the portfolio theory on which the CAPM is based requires that investors invest
in risky securities through the market portfolio. In other words, one should not invest in a
security such as IBM by itself. One should form a portfolio of all securities in the market
and this portfolio should include IBM. In the real world we do not see investors holding such
diversified portfolios. At most, they hold portfolios of 20 or 30 securities.
These theoretical problems diminish our confidence in the CAPM. The CAPM has also
had some other problems. According to the CAPM, the only security characteristic that is
relevant in determining its expected return is its systematic risk β. Therefore, the average
returns of securities should not be related to any other characteristic of the securities. During
the last 15 years, several violations to this rule have been documented. For example, it has
been shown that the average returns on the small firms are higher than those on large firms
of equal systematic risk. Similar behavior has been shown with respect to other security
characteristics. It has also been shown that the observed returns during January are higher
than those expected by the CAPM, and during the other months they are lower than those
expected by the CAPM.
Despite these problems the CAPM continues to be used because of its simplicity. Also,
not too many better alternatives to the CAPM have been proposed. Since a poor model is
better than no model at all, people have learned to use the answers given by the CAPM with
caution and adjust them to include other factors. During the last 15 years, a new model
called the Arbitrage Pricing Model has been proposed as a replacement for the CAPM. This
model, however, is mathematically much more complicated than the CAPM and is still being
tested to see if it is an improvement over the CAPM.
3.13 Conclusion
In this chapter, the process of designing an efficient portfolio for an investor was described.
The effects of the portfolio design parameters on the portfolio characteristics were also stud-
ied. Finally, the portfolio selection was extended to the ideal setting of perfect markets which
gave us the security market line.
Exercises
3.1 Portfolio of Portfolios
Henry decided to diversify by investing his money in two different portfolios of the stocks of Alpha, Beta,
Gamma, and Delta. The compositions of the two portfolios are {0.2, 0.4, 0.3, 0.1} and {0.1, 0.2, 0.5, 0.2}.
What is the composition of Henry’s overall portfolio if he invests 30% in the first portfolio and 70% in the
second?
3.2 Security and Portfolio Statistics
The following table gives the annual returns on the common stocks of two companies, S1 and S2 , for the
past ten years:
t r1 r2 t r1 r2
1 0.15 0.12 6 0.14 0.13

2 0.19 0.08 7 0.17 0.17
3 0.12 0.10 8 0.18 0.09
4 0.14 0.14 9 0.15 0.16
5 0.15 0.16 10 0.17 0.20
(a) Compute the means, variances, standard deviations, covariance, and correlation for the returns on these
two securities. Present the information in form similar to Table 3.5.
(b) Calculate expected returns and standard deviations for the following five portfolios of these securities:
{−0.2, 1.2}, {0.2, 0.8}, {0.6, 0.4}, {0.3, 0.7}, {0.5, 0.5}.
3.3 Optimal Portfolio Selection

Mr. I. N. Vestor believes in diversification through portfolio formation. Therefore, rather than putting
all his money in one stock, he has invested equally among the common stocks of Attractive (A), Beautiful
(B), and Cute (C). To verify whether an equally weighted portfolio is indeed a good choice, you collect
information for the three stocks and come up with the following table:
Covariance
Security µ A B C
A 0.13 0.05 0.02 0.00
B 0.14 0.02 0.08 0.03
C 0.18 0.00 0.03 0.11
Calculate the expected return and standard deviation for the portfolio that Mr. Vestor is currently
holding. Now calculate these quantities for a portfolio with the composition of (0.40, 0.25, 0.35). What
message do you have for Mr. Vestor?
3.4 Portfolio Calculations
Bob Kong told his investment advisor Larry that he does not mind taking risks as long as he is rewarded
properly. Bob would be satisfied getting a long run average return of 14% per year as long as during
any year the return does not fall below 8%. Larry is pretty shrewd in these matters. Using a reasonable
assumption about the distribution of returns, he estimated the expected return and the standard deviation
of the investment portfolio that Bob would be satisfied with. (You need to do the same!)
Now, Larry selected three of his favorite securities and did a whole lot of calculations for these securities
and summarized the information about these securities as follows:
Correlation
Security µ σ A B C
A 0.12 0.18 1.00 0.04 −0.05

B 0.16 0.26 0.04 1.00 −0.10
C 0.14 0.25 −0.05 −0.10 1.00
Larry realized that he will have to try out some portfolios and then see if he can meet or beat Bob’s
requirements. He decided to calculate the expected return and the standard deviations of the following 5
portfolios:
Portfolio xA xB xC
1 0.3 0.3 0.4

2 0.2 0.4 0.4
3 −0.2 0.6 0.6
4 0.1 0.8 0.1
5 0.5 0.3 0.2
xA , xB and xC are the fractions of Bob’s money that would be invested in these securities. Calculate the
expected return and the standard deviation of return for these portfolios. Which of these portfolios should
Larry pick for Bob? Why?
3.5 Portfolios Involving a Risk-free Security
The return on the risk-free security is 6% per year. The expected return on a risky security is 13% per
year and the standard deviation of its returns is 4% per year. Calculate the expected return and standard
deviation of several portfolios of these securities and plot the risk-return tradeoff line.
Liz Floyd wants to pick an investment strategy that would yield an expected return of 15% during the
next year on her $250, 000. She knows that a local bank is offering 9% on a one year CD. For her investment
in the market, Liz decided to pick three blue chip stocks: ALM, BPI, and CRN. Using monthly data, she
calculated the statistics for these stocks and modified them to get the annualized expectations for the next
year as follows:
Correlation
Security µ σ ALM BPI CRN

ALM 0.16 0.08 1.00 0.00 0.00
BPI 0.20 0.10 0.00 1.00 0.02
CRN 0.10 0.06 0.00 0.02 1.00
Now, you take over Liz’s job. The next task is to form portfolios using these stocks and plot the efficient
frontier. Calculate the expected return and standard deviations for the following six portfolios (Liz does not
want to short sell any stocks):
Portfolio xA xB xC
1 1.0 0.0 0.0

2 0.0 1.0 0.0
3 0.0 0.0 1.0
4 0.1 0.2 0.7
5 0.2 0.7 0.1
6 0.4 0.4 0.2
Plot the results and approximately generate the efficient frontier. Using the CD as the risk-free security,
plot the tangency line. Roughly approximate the tangency portfolio. What are the expected return and
standard deviation of the tangency portfolio?
How should Liz divide her money between the CD and the tangency portfolio to achieve her goal of
15% per year? What will be the standard deviation of her overall investment? What are the lowest and the
highest returns she can get?
3.7 Portfolio Analysis
Consider the following statistics for the annual returns of three securities:
Covariances
Security µ A B C
A 0.15 0.32 0.08 0.27
B 0.19 0.38 0.16
C 0.13 0.26
Create a portfolio of securities B and C that has the same expected return as A. Does this portfolio
dominate security A?
The expected returns and the covariances for three securities are given below:
Covariances
Security µ A B C
A 0.15 0.0484 0.0330 0.0260
B 0.12 0.0330 0.0625 0.0380
C 0.17 0.0260 0.0380 0.0906
(a) Mr. Thomas believes that an equally weighted portfolio provides as good a diversification as there is. So
he decided to invest in a portfolio constructed as {0.33, 0.33, 0.34}. Calculate the expected return and
standard deviation of his portfolio.
(b) Ms. Walker decided to invest in a portfolio constructed as {0.50, 0.15, 0.35}. Calculate the expected
return and standard deviation of her portfolio.
(c) Between Mr. Thomas and Ms. Walker, who has the better portfolio? Why?
3.9 Tangency Line

Suppose the risk-free rate is 7% and the tangency portfolio has an expected return of 17% and a standard
deviation of 21.4%.
(a) Calculate the expected return and risk for an investor who invests 75% in the tangency portfolio and
25% in the risk-free security.
(b) An investor wants to earn an expected return of 15%. How much should she invest in the risk-free
security and how much in the tangency portfolio? What will be the risk faced by this investor?
3.10 Hedge Portfolios

Derive the portfolio weights for a hedge portfolio of two securities with perfectly positive correlation
following the steps in section 3.8.1.
3.11 Hedge Portfolios

Consider two securities S1 and S2 . Their annualized expected returns are 10% and 12%, and standard
deviations of their returns are 18% and 20%. The correlation between returns of the two securities is −1.
What portfolio weights would lead to a perfect hedge portfolio made using S1 and S2 ?
What will be the portfolio composition if the correlation were +1?
3.12 Rate of Return on a Mutual Fund
Three years back I purchased 98 shares of Dean Witter’s USGvt fund for $10.27 each. The NAV of these
shares today is 9.54. Because of reinvestment I own 130 shares today. What is the annualized rate of return
on my investment during these three years?
3.13 Risk-free and Market Betas
Show that the β of market is 1 and that of the risk-free rate is 0.
3.14 CAPM Calculations
The annual standard deviation of returns on the stock of Canon, Inc. is 0.30, while that on the market
portfolio is 0.22. The correlation between the returns of Canon and the market portfolio is 0.49. Calculate
the β for the Canon stock.
The risk-free rate during the next year is expected to be 0.07. The expected return on the market
portfolio is 0.12. What is the proper expected return on the stock of Canon?
3.15 β and CAPM
Consider the following table of information. The numbers in the last row are the column sums.
Month rS&P rMBI rS&P

2
rMBI
2
rS&P rMBI
1 0.015 0.045 0.000225 0.002025 0.000675

2 0.025 0.035 0.000625 0.001225 0.000875
3 0.037 0.040 0.001369 0.001600 0.001480
4 0.045 0.040 0.002025 0.001600 0.001800
5 0.050 0.050 0.002500 0.002500 0.002500
6 −0.030 −0.040 0.000900 0.001600 0.001200
7 0.035 0.065 0.001225 0.004225 0.002275
8 0.040 0.035 0.001600 0.001225 0.001400
9 −0.010 −0.010 0.000100 0.000100 0.000100
10 0.050 0.070 0.002500 0.004900 0.003500
11 0.035 0.040 0.001225 0.001600 0.001400
12 0.045 0.050 0.002025 0.002500 0.002250
0.337 0.420 0.016319 0.025100 0.019455
(a) Calculate the β of the stock of MBI using S&P as a proxy for the market portfolio.
(b) The risk-free rate is estimated to be 7% per year. Use the historical mean return on S&P as an estimate
of the expected return for the market. Calculate the proper expected return for the stock of MBI.
(c) Use the historical mean return on MBI as an estimate of its expected return. Is the stock of MBI priced
correctly? Should you buy the stock or sell the stock?
3.16 CAPM and Equilibrium

The β of the common stock of Elwin Motors is 1.7. It is expected that the return on the risk-free security
and the market for the coming year will be 8% and 14%, respectively. Analysts also expect that the price
of the common stock of Elwin Motors one year from now will be $18. Elwin has a policy of paying annual
dividends. Its next dividend will be one year from now and is expected to equal $2 per share.
(a) Calculate the proper expected return for Elwin.

(b) Calculate the proper price for the common stock of Elwin.
(c) The common stock of Elwin is currently priced at $16.25. Is the stock overpriced or underpriced? Should
you buy it or sell it?
(d) What will be the expected return if you were to buy the common stock of Elwin today at the prevailing
market price, hold it for one year, receive the dividend and then sell it? Is this return higher than the
proper return or lower than the proper return? Should you buy the stock or sell it?
(e) What will be the effect of investors’ action (buying/selling) on the market price and on the expected
return from the stock? When will they stop buying/selling?
(f) Repeat parts (c), (d), and (e) assuming that the market price of Elwin today is $17.50.
3.17 β of a Portfolio
The β of a portfolio is equal to the weighted sum of the βs of the securities that make up the portfolio,
just like the expected return. Securities A and B have βs of 0.7 and 1.5 respectively. How should an investor
distribute his capital between the two securities to make a portfolio that has a β of 1?
3.18 The Various Expected Returns
Consider the following information for the common stock of DRAM Corporation.
• The average monthly return during the past 3 years has been 1.1%.
• The current price of the stock is $15.00. An investor expects that next month the stock will pay a
dividend of $0.15 and after that it may be sold for $15.10.
• The β for the stock is 1.2. Based on this β and the expected returns on the market and the risk-free
security, the discount rate for the security is calculated to be 1.15% per month.
Interpret the expected returns provided by these three items of information. How do they differ from
each other?
Chapter 4
Security Selection and Performance

Evaluation
According to the portfolio theory, investors should diversify by dividing their money among
several securities to form portfolios. Nevertheless, many investors buy and sell individual
securities because they believe they can spot good investment opportunities. The mechanics
of identifying the securities that should be bought or sold is described in this chapter. In
a well functioning competitive financial market, it should not be possible for an investor
to identify superior investments consistently. This argument leads to the Efficient Market
Hypothesis which is also discussed in this chapter. Finally, we discuss the method for
evaluating the performance of investments.
4.1 Valuation
Valuation is central to the security selection process. If we can determine the value of a
security, then the selection decision can be made by comparing the value of the security with
its market price. If a security’s price is less than its value, the security is underpriced and it
should be bought. Conversely, if the price is more than the value, the security is overpriced
and it should be sold.
A security’s value is equal to the present value of the expected cashflows from the security.
This valuation system seems to ignore other tangible or intangible benefits from the security.
However, that is not the case. Non-cash benefits may be taken into account by imputing
cash equivalence to them using opportunity cost methods. In our discussion, we will assume
that all benefits have been converted to cash values. The expected cashflows from a security
can be estimated by a careful study of the security and the issuer.
The theory of present value is related to the principles of utility. A cashflow to be received
today has a higher utility than the same cashflow to be received later because we prefer an
earlier consumption over a later consumption. Therefore, a cashflow to be received later
104
Security Selection and Performance Evaluation 105
has the same utility as some smaller amount to be received today. This smaller amount,
whose utility is the same as that of the future cashflow, is the present value of the future
cashflow. For example, if I am indifferent between receiving $80 now and receiving $100 a
year later, then $80 is the present value of $100 to be received a year later. Present value
is the discounted value of a cashflow to be received in the future. The factor by which a
cashflow is multiplied to get its present value is known as the discount factor. The one year
discount factor in my case is 0.8 because $80 = $100 × 0.8. To find out the present value of
$100 to be received two years from now, we have to discount it twice: once from year 2 to
year 1 and then from year 1 to today. Assuming the same discount factor for both the years,
the present value is 100 × 0.8 × 0.8 = 100 × 0.82 = $64. Therefore, a two year discount factor
is the square of the one year discount factor. Once we know the one year discount factor,
we can calculate the present value of any cashflow to be received any time assuming that
the same discount factor holds for every year. For example, the present value of $600 to be
received 4 years from now is $600 × 0.8 × 0.8 × 0.8 × 0.8 = 600 × 0.84 = $245.76. Similarly,
the present value of $800 to be received 3.5 years from now is $800 × 0.83.5 = $366.36.
Discount factors can be used to calculate not only the present value of a cashflow, but its
value at any other time. For example, the value one year from now of $400 to be received 4
years from now is $400 × 0.83 = $204.80. This process of converting the value of a cashflow
from a time to an earlier time, or taking it back in time, is known as discounting. The value
calculated using discounting is known as discounted value. If the cashflow is discounted
all the way to the present, the discounted value is known as present value.
The discount factor is often expressed in terms of a discount rate. The discount factor
for t years is related to the discount rate as:
1
discount factor = . (4.1)
(1 + discount rate)t
The units of discount rate are % per year, the same as the units of interest rate or the rate
of return. Using equation (4.1), we find that a one year discount factor of 0.8 is equivalent
to a discount rate of 0.25 or 25%. The name discount rate arises from the fact that it is the
rate at which a dollar loses value due to the delayed consumption. If a dollar loses value
at the rate of 25% per year, then $100 to be received next year have the same value as $80
today.
Discount rate not only has the same units as the rate of return but it also has the
same interpretation. Both discount rate and rate of return are measures of compensation for
delayed consumption. Therefore, for calculation purposes, it is easier to think of the discount
rate as an interest rate or a rate of return. With this interpretation, the present value may
be viewed as an amount that would grow at the discount rate to become the future cashflow.
Discount rates, like interest rates, are affected by several factors in the economy. For
example, expectations of a higher inflation will make the discount rates higher. Similarly, in
a risky situation, the increased risk of the cashflows would make the discount rates higher.
Since different securities have different risk, the discount rates applicable to the cashflows
of different securities are different. The discount rate for a security is the expected return
based on its risk. In Chapter 3, we saw that the capital asset pricing model (CAPM) gives
us the discount rate.
There are two caveats that one should be aware of in using the CAPM to calculate
discount rates for valuation. First, CAPM is a single period model. Therefore, results
obtained using CAPM are valid for single period situations only. Most valuation applications,
however, are multiperiod. Therefore, the discount rate obtained from CAPM may not be
suitable for these applications. Second, from our discussion of term structure of interest
rates, we know that rates for different maturities may be different. Therefore, cashflows at
different times should be discounted at different rates. By using the same discount factor
for different years, we are discounting the cashflows in different years at the same rate and
therefore we are assuming that the term structure is flat, which is rarely true. The errors
caused by the problems mentioned above, however, are not too severe. Furthermore, there
are no well accepted alternatives to CAPM for determining the discount rates. Therefore,
we will use CAPM to determine the discount rates keeping the limitations in mind.
4.2 Calculating Present Values

The present value, PV , of a cashflow c to be received t periods from now is calculated as:
" #
1 c
PV = c · df = c · t
= , k
t (4.2)
(1 + k) (1 + k)t
where df kt is the discount factor for t periods at the discount rate of k per period. The
present value calculation discounts (brings back) a cashflow by t periods as shown in the
time line below:
.............................................................................................................................
.................................................. .............................
............................ ....................
................... ...............
............... ............
.
...
..............
. .........
.
..
....... .......
.....
.
... ....... ..
.........
..
PV = c · df kt c
...
0 1 2 3 t−1 t
Note that the discount factor for t periods is related to the discount rate k as:
1
df kt = . (4.3)
(1 + k)t
Present value of several cashflows is calculated by adding the present values of the indi-
vidual cashflows. Therefore, if cashflows c1 , c2 , c3 , . . ., are expected from a security at times
t1 , t2 , t3 , . . ., as shown below:
c1 c2 c3
...
t1 t2 t3
then the present value is calculated as:

X
PV = cj · df ktj = c1 · df kt1 + c2 · df kt2 + c3 · df kt3 + · · · , (4.4a)
X cj c1 c2 c3
= t
= t
+ t
+ + ···. (4.4b)
(1 + k) j (1 + k) 1 (1 + k) 2 (1 + k)t3
One precaution that should be exercised in using the present value equations is that the
times t1 , t2 , t3 , . . ., should be expressed in the same unit as the discount rate k. For example,
if a problem involves cashflows of $0.40 every quarter for 3 quarters as shown below:
0.40 0.40 0.40
0 1 2 3
and the discount rate is 11% per year, then the following calculation is incorrect:
0.40 0.40 0.40
PV = + 2
+ = 0.98
(1 + 0.11) (1 + 0.11) (1 + 0.11)3
because the times of cashflow are being measured in quarters (1, 2, 3) while the discount
rate is expressed on an annual basis. The time units may be made consistent in one of the
two ways:
• Convert the discount rate into the time unit of the cashflows. Continuing with the
example, first convert the 11% per year to a quarterly rate as: (1+0.11)1/4 −1 = 0.0264.
Now do the PV calculation as:
0.40 0.40 0.40
PV = + 2
+ = 1.14.
(1 + 0.0264) (1 + 0.0264) (1 + 0.0264)3
• Convert the unit on the time line by measuring the distances on the time line in the
same units as the discount rate. With this conversion, the cash flows in our example
are 1/4, 1/2, and 3/4 years from the present as shown in the time line below:
0.40 0.40 0.40
0 1/4 1/2 3/4
Now the PV can be calculated as:

0.40 0.40 0.40
PV = + + = 1.14.
(1 + 0.11)1/4 (1 + 0.11)1/2 (1 + 0.11)3/4
One should also be careful with subperiod compounding in present value applications.
In PV calculations, effective rates should be used rather than stated rates. Suppose we want
to find the present value of $100 to be received 1 year from now using a discount rate of
8% per year compounded quarterly. As you know from Chapter 2, the effective rate for this
problem is 2% per quarter or (1 + 0.02)4 − 1 = 0.08243 or 8.243% per year. The present
value may now be calculated either as 100/(1.02)4 = 92.38 or as 100/(1.08243) = 92.38. The
first approach uses the effective quarterly rate while the second approach uses the effective
annual rate.
A similar approach with suitable modification may be used with continuous compound-
ing. Recall that the relationship between the continuously compounded rate r and the
corresponding effective rate reff is given by (1 + reff ) = er . Therefore, if the discount rate
is k per period compounded continuously, we may replace (1 + k) by ek in the present
value calculations. Suppose we want to find the present value of $500 to be received 3
years from now and the discount rate is 12% per year compounded continuously. With-
out continuous compounding, we would calculate the PV as 500/(1 + 0.12)3 . To take into
account the continuous compounding, the (1 + 0.12) should be replaced by e0.12 to get
500/(e0.12 )3 = 500/e3(0.12) = 500/e0.36 = 348.84.
4.2.1 Special Cases

Equations (4.4a) and (4.4b) on page 107 are the most general ways of calculating present val-
ues. The equations, however, can be tedious and time consuming if there are many cashflows.
There are some special cases in which the equations may be simplified and compacted.
First, we may have a situation involving a finite number, n, of equal cashflows occurring
at times 1, 2, . . ., n − 1, n. This cashflow situation is known as an annuity. The cashflows
for an annuity are shown below:
c c c c
...
1 2 n−1 n
Let us apply equation (4.4b) on page 107 to this situation to get:

c c c
PV = + 2
+···+ .
(1 + k) (1 + k) (1 + k)n
This equation can be compacted by summing up the terms to get:

" #
1 1
PV = c 1− , (4.5a)
k (1 + k)n
= c · af kn , (4.5b)
where the quantity that is being multiplied by c is known as the annuity factor. The
annuity factor af kn , when multiplied with a cash amount c gives the present value of n
cashflows of c each at times 1, 2, . . ., n. Note that the annuity factor is defined as:
" #
1 1
k
af =
n 1− . (4.6)
k (1 + k)n
Another special situation is when an annuity goes on forever rather than terminating
after n cashflows. In that case it is called a perpetuity. The cashflows for a perpetuity are
shown below:
c c c
... ∞
1 2 3
The present value of a perpetuity is calculated by taking the limit of equation (4.5a) with
n → ∞ to get:
1 c
PV = c = . (4.7)
k k
Finally, there is the growing perpetuity, where the cashflows not only go on forever
but they also grow at a constant rate as shown below:
c c(1 + g) c(1 + g)2

... ∞
1 2 3
The present value of a growing perpetuity is given by:

" #
1 c1
PV = c = , if k > g. (4.8)
k−g k−g
Note that the growing perpetuity formula is valid only if the cashflow growth rate g is
constant and less than the discount rate k. If the cashflows grow at a higher rate than the
discount rate then equation (4.8) cannot be used. The present value of a growing perpetuity
with a growth rate higher than the discount rate is infinity. Note that the simple perpetuity
is a special case of the growing perpetuity with g = 0.
4.2.2 Some Hints

You should be careful while using the annuity and perpetuity (simple and growing) shortcut
formulae. These formulae actually give us the discounted value of the cashflows at a time
point that is one period before the first cashflow in the annuity or the perpetuity. If the
annuity or perpetuity begins at a time point that is one period from the present then the
formulae will give us the present value. If the annuity or perpetuity is delayed, i.e., begins at
a later time point, then the formulae will not give us the present value. If the first cashflow
is at time t then the formulae give us the discounted value at time t − 1. To find the present
value, we will have to discount this value further by using appropriate discount factor.
As an example, let us find the present value of the following cashflows at the discount
rate of 10% per period:
10 10 10 10
0 1 2 3 4 5 6
The first step is to recognize that this is a delayed annuity with 4 cashflows beginning at
t = 3. Applying the formula, 10af 0.10
4 , therefore, will give us the value at time t = 2 because
the first cashflows is at t = 3. To find the present value, i.e., the value at t = 0, we will
discount this value by two periods and get
PV = 10af 0.10 0.10
4 df 2 = 26.20.
An alternative way to calculate the present value of these cashflows is to view them as
the difference between two annuities: one going from t = 1 to t = 6 and the other going
from t = 1 to t = 2 as shown below:
10 10 10 10
=
0 1 2 3 4 5 6
10 10 10 10 10 10 10 10
−
0 1 2 3 4 5 6 0 1 2 3 4 5 6
Then we can write the present value as:
PV = 10af 0.10
6 − 10af 0.10
2 = 26.20.
Another situation you may encounter is where the first payment of annuity or a perpetuity
begins at a partial period from the present. For example, consider the following cashflows:
30 30 30 30 1,420
1/31/91 3/31/91 6/30/91 9/30/91 12/31/91 3/31/92
Suppose the discount rate is 3% per quarter. The cashflows can be broken down to an annuity
of four cashflows of $30 each and a single cashflow of $1,420. The payments, however, do
not begin one period (quarter) from the present. They begin 2/3 quarters from the present.
To find the present value of the cashflows, therefore, we proceed in two steps. First, we find
the discounted value of all the cashflows on 3/31/91 and then discount it to 1/31/91:
PV = [30 + 30af 0.03
3 + 1,420df 0.03 0.03
4 ]df 2/3 = 1,349.65.
The PV calculation for this example can also be done as:

PV = 30df 0.03 0.03 0.03 0.03 0.03
2/3 + 30df 5/3 + 30df 8/3 + 30df 11/3 + 1,420df 14/3 = 1,349.65.
As we saw in the examples above, there may be many ways of calculating the present
value of a given set of cashflows. Depending on your preferences and insight about the
present value calculation process, you may use any of the alternatives.
4.3 Return
In Chapter 2, we saw how to calculate the rate of return on an investment in a single period
setting. The cashflows for a one period investment requiring an initial outlay of p0 and
resulting income of d and final cash inflow of p1 are shown in the time line below:
−p0 d + p1
0 1
We will follow the convention of denoting the cash outflows with a negative sign on the
time line. From Chapter 2 we know that the return in this situation is calculated as:
p1 − p0 + d
r= .
p0
Cross multiplying and simplifying this equation we get:
d + p1
p0 =.
1+r
The right hand side of this equation is the expression for present value of the future cashflows
with the discount rate k replaced by the rate of return r and the left hand side is the initial
cash outflow. This provides us a valuable insight. The rate of return on an investment can
be calculated by setting up the following equation:
Initial cash outflow = PV of future cashflows,
and using symbol r rather than k for the discount rate.1 The value of r obtained by solving
the equation is the rate of return from the investment. This calculation procedure is known
as calculating the internal rate of return. This insight helps us calculate returns for
situations that involve multiple cashflows at different times. The time line below shows a
general multiperiod situation:
−c0 c1 c2 c3
...
0 t1 t2 t3
1
Alternatively, we may set: PV of inflows = PV of outflows.
To calculate the rate of return, we solve the following equation for the unknown r:
c1 c2 c3
c0 = t
+ t
+ + ···.
(1 + r) 1 (1 + r) 2 (1 + r)t3
Calculating return requires some mathematical and algebraic skills. The calculations,
inevitably require using present value concepts. Using annuity and perpetuity shortcuts can
also make the calculations easier. Returns may be calculated in many different situations.
Sometimes we want to calculate the rate of return for shares we bought in the past and are
going to sell now. In that case all the cash flows on the time line would be actual, realized
cashflows. Often, we want to estimate the rate of return we can expect from a security
if it is purchased today. In that case the cashflows on the time line will be based on our
expectations. Once the realized or the expected cashflows have been determined and put on
the time line, the process for calculating the rate of return is the same. Follow these basic
steps to calculate the rate of return:
• Identify the cashflows.
• Put the cashflows on a time line diagram.
• Write the equation to calculate the internal rate of return.
• Calculate the internal rate of return.
• Present the answer in proper units.
These steps are illustrated using examples below:
Example 1 : Lisa Robinson bought 100 shares of Magnet, Inc. on January 15, 1989 for $12
per share. On March 15, 1989 she received a dividend of $0.10 per share. On June
15, Lisa got another dividend of $0.08 per share. On July 15, Lisa sold the shares for
$13 per share. The cashflows on a per share basis are shown in the time line diagram
below:
−12.00 0.00 0.10 0.00 0.00 0.08 13.00
1/15 2/15 3/15 4/15 5/15 6/15 7/15

The following equation can now be written for the monthly rate r:
0.10 0.08 13.00
12.00 = 2
+ 5
+ .
(1 + r) (1 + r) (1 + r)6
This equation can be solved using trial-and-error method. In trial-and-error method,
we try a value of the unknown (r) and see if the two sides of the equation match.
We try new values of r till the two sides of the equation are reasonably close. While
there are no simple rules of thumb about the initial guess in a trial-and-error process,
a proper value can be determined by examining the time unit of the rate. For example,
a 10% value would make sense with annual rate but not with a monthly rate. While
trying new guesses, keep in mind that the present value and the discount rate have
inverse relationships. Therefore, if you want to reduce the present value, try a higher
value for the discount rate, and vice versa. The following table shows the result from
trial-and-error for Lisa Robinson’s cashflows:
r rhs
0.010 12.42073
0.015 12.06038
0.017 11.91967
r 12
From the trial-and-error table we see that the answer lies between 0.015 and 0.017. We
could try to get a more accurate answer by trying many other values. However, a good
approximation may be obtained using linear interpolation. Linear interpolation uses
two values from the trial and error process that are close enough to the final answer, and
finds a value that is a very good approximation to the final answer in most situations.
There are many ways to set up linear interpolation. One way is shown below:

0.017 − 0.015
r = 0.015 + (12 − 12.06038) = 0.01586.
11.91967 − 12.06038
The rate of return earned by Lisa Robinson, therefore, was 1.586% per month or
(1 + 0.01586)12 − 1 = 0.2078 or 20.78% per year.
Example 2 : James Henry is buying a savings bond for $300. The bond will not make any
interim payments but on maturity in 15 years, it will pay $1000. The annual interest
rate that will be earned by James can be calculated by solving the following equation:
1000
300 =
(1 + r)15
This equation can be solved algebraically:

1/15
1000
r= − 1 = 0.0836.
300
Therefore, the rate of return is 8.36% per year.
Example 3 : I am planning to buy 100 shares of IBM selling at $100. I expect IBM to pay
dividends of $1.10 every quarter, the first payment coming exactly one quarter from
today. I also expect that I will be able to sell the shares for $115 in two years. The
following time line shows the cashflows from my investment:
−100 1.10 1.10 1.10 1.10 1.10 1.10 1.10 1.10+115
0 1 2 3 4 5 6 7 8
Note that the last cashflow consists of the final dividend of $1.10 and the expected
selling price of $115. The following equation can be written for calculating the quarterly
rate of return r:
100 = 1.10af r8 + 115df r8 .
This equation cannot be solved for r using algebraic methods. Therefore, we have to
use trial-and-error and interpolation. The trial-and-error process is shown below:
r af r8 df r8 rhs
0.030 7.0197 0.7894 98.50372
0.025 7.1701 0.8207 102.27301
r 100
Now we can apply the interpolation:

0.030 − 0.025
r = 0.025 + (100 − 102.27301) = 0.028.
98.50372 − 102.27301
Therefore, my expected return from IBM is 2.8% per quarter or (1+0.028)4 −1 = 0.1168
or 11.68% per year.
Example 4 : Fred Hitchcock is investing $300 in a security. He does not expect any income
from the security for 2 years. After that he expects the security to provide cashflows
every six months. The first cashflow is expected to be $20 and the cashflows are
expected to increase by 2% every six months. Fred’s cashflows in six month time units
are shown below:
−300 20 20(1.02) 20(1.02)2
... ... ∞
0 1 4 5 6 7
Realizing that the cashflows represent a delayed growing perpetuity, the following
equation can be used to solve for the semiannual rate of return:
20 1
300 = .
(r − 0.02) (1 + r)4
Figure 4.1: Security selection using returns.
Underpriced ?
.......
.......
.......
.......
...
...
........
...
.......
.......
SML ? .......
.......
.......
µ & ..
........
.......
.
...
..
.......
.......
Correctly Priced
...
.........
.
...
.......
.......
.......
.......
....... ? Overpriced
rf .
...
..
..
.......
The equation can be solved using trial-and-error and interpolation:
r rhs
0.050 548.4683
0.070 305.1581
0.072 291.2376
r 300

0.072 − 0.070
r = 0.070 + (300 − 305.1581) = 0.071.
291.2376 − 305.1581
The semiannual expected rate of return from Fred’s investment is 7.1%. The annual
rate is (1 + 0.071)2 − 1 = 0.1470 or 14.7% per year.
4.3.1 Security Selection using Rates of Return

In section 4.1, we saw that a security can be selected by determining whether it is underpriced
or overpriced. This criterion is essentially the Net Present Value (NPV) method you learned
in your basic finance course because it relies on the difference in the current cash outflow
and the present value of future cashflows.
Security selection can also be done by comparing a security’s expected return with the
rate of return that should be expected based on its risk, i.e., its discount rate. A security
whose expected return is higher than its discount rate should be bought. This security is
underpriced. Conversely, if a security’s expected return is less than its discount rate, the
security is overpriced and should be sold. The expected rate of return for a correctly priced
security is equal to its discount rate. Figure 4.1 shows underpriced, correctly priced, and
overpriced securities with respect to the security market line (SML).
Return is used as a primary decision making variable in investments. We saw above that
return is the same as the internal rate of return (IRR). From your course in basic finance you
may remember that the criterion for selecting a project should be its net present value (NPV)
rather than the IRR because the IRR has some shortcomings and problems. Nevertheless,
decisions using IRR provide the same answers as those using NPV as long as the following
conditions hold:
• One can invest as much in a security as one wants.
• Mathematically, the rate of return can be determined uniquely and is not imaginary.
These conditions hold for most investors and for most securities in the market. Therefore,
both NPV and IRR are appropriate for investment decision making. Both methods provide
the same final recommendation about whether to buy or sell a security.
Let us take an example. The shares of BT&T are selling for $36. I expect BT&T to pay
regular quarterly dividends of $0.43 per share for one year. I believe that after receiving the
fourth dividend one year from now, I can sell the shares for $38 per share. The cashflows
are shown in the time line below:
−36 0.43 0.43 0.43 0.43+38
1 2 3 4
The β of BT&T is 0.92. The risk-free rate during the coming year is expected to be
7% per year and the expected return on the market for the next year is 13.5%. I want to
determine whether to buy the stock of BT&T. The discount rate for BT&T is calculated
using the security market line as rf + β(µm − rf ) = 0.07 + 0.92(0.135 − 0.07) = 0.1298 or
12.98% per year. Since the dividends are on a quarterly basis, we will need the quarterly
discount rate. The quarterly discount rate is (1 + 0.1298)1/4 − 1 = 0.0310 or 3.10% per
quarter.
Let us first use the NPV approach. We calculate the PV of the future cashflows as:
PV = 0.43af 0.031
4 + 38df 0.031
4 = 35.23.
Since the PV of future cashflows is less than the current price of BT&T, the stock is over-
priced and, therefore, I shouldn’t buy it.
Now let us use the IRR approach. We set up the following equation to calculate the
quarterly rate of return r:
36 = 0.43af r4 + 38df r4 ,
and solve for r using trial-and-error and interpolation:
r af r4 df r4 rhs
0.030 3.7171 0.8885 35.36086
0.025 3.7620 0.9059 36.04377
0.026 3.7529 0.9024 35.90587
r 36

0.025 − 0.026
r = 0.026 + (36 − 35.90587) = 0.0253.
36.04377 − 35.90587
So if I invest in BT&T, I will earn a quarterly rate of return of 2.53%. Since, based on the
risk of BT&T, I should earn 3.10% per quarter, the stock is overpriced and I should not buy
it.
Note that both the NPV and the IRR methods are based on the same data and result
in the same final conclusion. Mathematically, the NPV approach is a little easier. However,
in practice, people feel more comfortable dealing with the rates of returns than net present
values. Therefore, the IRR approach is also used quite often. A third alternative that we
did not show here is based on estimating the quarterly expected rate of return from BT&T
using historical data. Once the expected return is known, it is compared with the discount
rate in the same way as the IRR to draw conclusions about buying or selling the security.
4.4 Market Efficiency

The last few sections showed how one should value securities to decide whether to buy or
sell them. The objective of picking securities is to be able to earn a higher rate of return
on investment than appropriate for the amount of risk taken. The popular name for earning
a higher rate of return than justified by the amount of risk is beating the market. For
example, if the discount rate of a stock is 12% per year and you can buy it at a time
when the stock’s price is temporarily down so that you expect to make 15% per year, you
are earning 3% more than what you should be for the amount of risk you are taking. This
difference between the actual return earned and the proper return on an investment is known
as abnormal return. Abnormal returns can be made only if securities are mispriced, i.e.,
their prices do not equal their values.
If a market is in equilibrium, then there would be no abnormal returns to be made
because the securities would be priced correctly, i.e., the security prices would be equal to
their values and their expected returns would be equal to the proper expected returns. A
market where securities are priced correctly, at all times, is called an efficient market. In
an efficient market, security prices reflect all relevant information and therefore investors
cannot make abnormal returns using their information. In popular terms, investors cannot
beat an efficient market. The rate of return investors earn in an efficient market is consistent
with the amount of risk they take.
An efficient market is a theoretical construct because real securities markets are never in
equilibrium because of a constant influx of information and other disturbances. It is possible
that securities are mispriced while the market is adjusting. In a competitive market, such
mispricings should not last long. If a security is underpriced, investors should want to buy
it. This demand pressure should increase the security price and bring it close to equilibrium.
The equilibrium in securities markets is of stable kind because the forces created by the
disturbances act in such a way as to restore the equilibrium. In real securities markets
market efficiency is a matter of degree. The longer it takes for market prices to adjust to
new information, the less efficient the market.
A competitive market should be efficient without external pressure or control. The reason
is that no single investor has a monopoly on information. Information is available to all
investors (maybe at a cost) and new information arrives randomly, and there is no privileged
investor or group of investors who get the information first every time. In a competitive
market, where all participants are trading to maximize their utilities, any discrepancy in
prices will be eliminated quickly. This will ensure that the security prices reflect proper
value most of the time.
Market efficiency can be understood by comparing a competitive market with a busy
parking lot. A mispriced security is like an open parking space. A busy parking lot would
be inefficient if an open parking space remains unclaimed for a long time. The reason
there are no open spaces in a busy parking lot is that there are people who are always
searching for the open parking spaces. The moment they see one, they fill it. Similarly, in
real securities markets, there are people who are always looking for mispriced securities to
make extra profits. Therefore, as soon as a security becomes mispriced, these investors trade
the security and this trading brings the security back to equilibrium. These investors who
are looking for mispriced securities are speculators and arbitragers. While speculators and
arbitragers have earned a bad name in the recent years, they serve a very useful purpose by
keeping the markets efficient. They keep the market prices in line with the values. Market
efficiency, therefore, is an outcome of competition among investors. It is not a natural law
that must be followed by all markets.
An efficient market is important for an economy. Only in an efficient market can the
public invest without fear of being cheated out of their fair returns. If it is possible for some
investors to make abnormal returns then other investors would shy away from the market.
This will ultimately hurt the economic growth. Markets can be made more efficient by
increasing competition among investors.
4.4.1 Efficient Market Hypothesis

To test how efficient the securities markets are, an efficient market hypothesis (EMH) is
derived using the theoretical construct of efficient market. The efficient market hypothesis
states that the security prices reflect the relevant information and therefore, one cannot make
abnormal returns using information. The efficient market hypothesis is like a null hypothesis
in statistical hypothesis testing. To test the efficiency of a market, statistical data is used
to see if the market prices violate the efficient market hypothesis. If the null hypothesis
cannot be rejected, one concludes that the market is efficient. The tests of efficient market
hypothesis usually involve comparing the returns earned by using a trading rule with that
of a simple buy and hold strategy. For example, if I believe that I can beat the market by
using the trading rule of buying stocks on the second Monday of every month and selling
them on the fourth Wednesday, then the results of that strategy would be compared with a
simple strategy of buying shares and holding them. The comparison would be made for a
few stocks for a few months to draw conclusions.
Since there are different kinds of information, we may be willing to accept the EMH
with respect to some kind of information more willingly than with respect to others. The
efficient market hypothesis, therefore, is stated in three different forms with respect to three
different definitions of information. Successive forms of EMH become stricter and include
the previous form of the hypothesis. The three forms of EMH are described below:
The Weak Form EMH states that the markets are efficient with respect to the past prices.
In other words, all trends and cycles evident in past prices have already been incor-
porated in the current prices. Therefore, trading rules based on price patterns would
not allow one to make abnormal returns. This form of the efficient market hypothesis
is difficult for technical analysts or chartists to accept. Technical analysts examine
the charts of past security prices, sometimes using sophisticated statistical techniques
(moving averages, filtering, and lagged behaviors), to predict the future price move-
ments. The weak form EMH says that such techniques would not enable the chartists
to make higher returns than those justified by the amount of risk taken.
The Semi-strong Form EMH states that the markets are efficient with respect to all
publicly available information including the past prices. Publicly available informa-
tion consists of news items, statements by the CEO’s and other company officials,
reports released by security analysts, etc. This form of market efficiency is difficult for
fundamental analysts to accept. Fundamental analysts study corporate financial
statements and make projections about the future based on their analysis and the cur-
rently prevailing conditions. The semi-strong form of EMH implies that fundamental
analysts would not be able to make any higher returns than justified by the amount of
risk of the investment.
The Strong Form EMH states that the markets are efficient with respect to all information
whether publicly available or not. The strong form hypothesis, therefore, also includes
private, inside information.
4.4.2 Are Securities Markets Efficient?

Thousands of studies have been conducted to test the efficiency of the securities markets.
The evidence is mixed and depends on the form of the EMH. Most of the studies have been
done by academics and conclude that the markets are efficient. Some practitioners disagree
with the conclusions of these studies. They claim that the studies are too academic and
ignore real elements of securities trading. They believe that it is possible to have a system
that allows one to earn abnormal returns. Of course, if one has such a system, one wouldn’t
share it with others. Therefore, they claim that if the markets were inefficient, we wouldn’t
find out about it. The evidence regarding the three forms of the EMH is summarized below.
There is substantial empirical evidence that supports the weak form efficiency of the
securities markets. Statistical tests show that stock prices and returns move randomly and
do not have discernible pattern. The fact that there are no systematic patterns in price or
returns can be judged by examining the time series of prices or returns. Theorists say that
such a pattern cannot exist because the existence of such a pattern would be self destructive.
For example, suppose a price pattern exists that predicts that the price of a stock will double
in three months. The moment investors can infer this, they will start buying the stock. This
will create excess demand for the shares and will bring up the price instantly, rather than
in three months. Trading by investors, therefore, will destroy the pattern. In spite of the
strong evidence for the weak form efficiency of the securities markets, technical analysts,
however, continue to believe in and trade using historical price trends.
The risk-return approach taken by an efficient market believer should not be confused
with the approach taken by the chartists. Both groups examine past data to derive expecta-
tions about the future behavior. A chartist attempts to pinpoint the direction in which the
security price, and therefore, the return will move. The pattern of past price movements is
crucial to this decision making. The efficient market believer uses the past data to estimate
the expected return and risk using statistical principles. The pattern of past movements is
not important to the efficient market believer.
The evidence on the semi-strong form efficiency of securities markets is mixed. Market
efficiency, in the context of semi-strong EMH is defined in terms of the speed with which
the market adjusts to new information. The evidence from studies shows that depending
on the reliability of information and its source, market prices adjust to new information in
a matter of minutes or may take a few days. Furthermore, the market does not wait for
information to be revealed fully or for an event to take place. The market reacts to the
news gradually as it unfolds. For example, the market price of a company’s stock jumps
as soon as investors find out that the company may receive a merger offer from a bidder.
Similarly, stock prices change as companies file new patents or make significant progress in
research and development, rather than changing when the products based on the research
are released.
There has not been much empirical testing of strong form efficiency of the markets because
of the unavailability of data. The consensus, however, is that the markets are not efficient
with respect to the private, inside information. However, there are laws designed to inhibit
insider trading and keep the market efficient.
As mentioned above, efficient market studies usually compare the profits from a trading
strategy with that of a buy and hold strategy. The conclusions drawn by the studies are based
on the assumption of no transaction costs. Inclusion of transaction costs makes the evidence
even strongly in favor of the efficiency of markets because trading rules require frequent
buying and selling of securities which adds significant transaction costs while buying and
holding requires only two transactions and has much lower transaction costs.
In real trading, the comparison of buy and hold profits with the profits from trading
strategies should also take information costs into account. Information which is utilized
to make trading rules may have a substantial cost and it may lower the net profits from
trading strategies significantly. Information costs may include the cost of educating oneself,
the cost of analyzing information, and the cost of specialized sources of information such as
investment newsletters.
A final consideration which is important in the strong form efficiency of the market is
the potential penalty of insider trading. While the profits from the insider trading may be
substantial, the penalties, if caught, are also large. The expected value of the profits net of
penalties, therefore, may not be more than the profits from a buy and hold strategy.
Based on the evidence of the studies of market efficiency and inclusion of the costs of
information, trading, and penalties of insider trading, we can conclude that the securities
markets are very close to being efficient. There may be small pockets of inefficiencies while
the market is adjusting to new information. Therefore, the usefulness of security selection
methods depends not only on the accuracy of information but also on the quickness with
which the investor can decide and trade based on the information.
4.4.3 Investing in an Efficient Securities Market

Based on the conclusion that the securities markets are efficient, one may argue that security
or portfolio selection is a futile exercise. However, this is not the case. Investors can still
benefit by analyzing information and selecting securities and portfolios for the reasons listed
below:
• The securities markets reward investors for taking risk. The return on the average
stock in the market, for example, is about 12% per year. In the long run, higher risks
lead to higher average rewards. Taking risk in the stock market is not like taking risk
in a gambling casino. The average return to the gamblers in a casino is negative by
design, because the person running the casino has to make money. The average return
to the players in a friendly game of poker is zero: some players lose and others win. In
the stock market, however, it is possible for everyone to win. The more risk one takes,
the higher the expected rewards. The proper way to approach the investment decision
making is to choose a level of risk and select securities or efficient portfolios that have
the desired level of risk.
• The securities markets are not absolutely efficient. The market does take some time
to react and adjust to new information. The first few investors who trade based on an
information are more likely to earn higher returns than others. The abnormal returns
earned by these investors may be viewed as the compensation for conveying the news to
the market. If an investor believes that a security is mispriced, he may tell the market
about this mispricing verbally. Verbal signals, however, are not believable because talk
is cheap. Therefore, the investor trades based on his information. The trading, being a
costly activity, sends out a more believable signal while earning a higher return. There
are also risks in being a leader. If the information that led an investor to believe that
a security is mispriced is incorrect, it could result in losses to the investor.2
• There can be only one market price while different investors may assign different values
to a security depending on their information, taxes, and transaction costs. The market
price is an average or consensus price for a security. It is possible that a security,
because of its special features is more desirable to a particular investor than others.
For example, the stock of a relatively unknown company will be viewed as risky by the
average investor and therefore will be priced low. However, an investor who lives in the
town where the company is located may have more information about this company
and find its stock to be a bargain.
4.5 Performance Evaluation

Often, we need to evaluate the performance of investments. We may need to evaluate
the performance of our own investments or to check the claim of superior performance by
others. Performance evaluation is very important in the mutual fund industry because the
salaries of mutual fund managers are tied to the performance of their portfolios. Performance
measurement is also used to verify the claims of profitable trading rules by investors.
It would be incorrect to use the return on investment to judge performance because
returns could be high or low for reasons beyond the control of the investor. For example, the
interest rates in the economy in general could be high because of inflationary expectations,
or the market as a whole could move up because of good news about the budget deficit.
These economy-wide movements will affect the investment returns also. Movements related
to the economy as a whole, however, do not reflect the ability of the investor. Furthermore,
a high return may be the result of high risk associated with the investment rather than the
ability of the investment manager.
2
Even if the information is correct in an absolute sense, there could be harmful consequences if the market
does not believe the information and therefore the price does not react the way the investor had expected
it. For the price to change in a desired direction, other investors have to believe the information also.
Two measures of performance—Sharpe and Treynor ratios—assess the performance of

an investment by determining the rate of return earned per unit of risk. The ratios are
calculated as the excess return, the rate of return on investment minus the risk-free rate of
return, divided by the measure of risk. The ratios differ in how they define risk. The Sharpe
Ratio uses the standard deviation of returns as the measure of risk while the Treynor Ratio
uses the beta as a measure of the risk. Mathematically the two ratios for an investment i
are:
r̄i − r̄f
Sharpe Ratio = SRi = (4.9)
σi
r̄i − r̄f
Treynor Ratio = TRi = (4.10)
βi
where r̄ and r̄f are the average rates of return on the investment portfolio and the risk-
free security, respectively. σ is the standard deviation of the portfolio returns and β is its
systematic risk. The risk-free rate is subtracted from the portfolio return because the risk-
free rate can be earned without taking any risk. Subtracting the risk-free rate also adjusts for
the influences of some economywide factors such as the inflation. Since these ratios measure
return earned by a portfolio per unit of risk, a higher value of the ratio indicates superior
performance.
In popular press, claims of superior performance are made by comparing the returns
earned by an investment with that of a market index such as the S&P 500. This comparison
is inappropriate if the risk of the investment is not equal to that of the S&P 500, because we
know that investments with different risks are expected to earn different returns. Therefore,
an investment may have earned a high average return by taking a high risk.
To measure performance, we need to control the effects of market-wide factors and risk.
This is done by taking the difference between the return on an investment and the return
that should be expected based on the risk and the economic conditions. The expected return
based on the risk and economic conditions can be calculated using the CAPM. Suppose we
want to measure the performance of an investment that earned ri during a period. The risk
of the investment was βi and the average returns on the risk-free security and the market
were rf and rm . According to the CAPM, the return on the security should have been3
rf + βi (rm − rf ). The security’s performance may be measured by abnormal return (ari )
calculated by subtracting the expected return from the actual return:
ari = ri − [rf + βi (rm − rf )] (4.11)
All the returns on the right hand side of this equation are the actual, realized returns. To
measure the performance over several periods, we may calculate average abnormal return,
3
Since one observation is used to calculate the expected returns, the expected return is equal to the
observation itself.
Table 4.1: Performance evaluation for Janus Fund.
MM/YY ri rm rf ri rm rm
2
1 01/90 −0.0790 −0.0671 0.0057 0.005301 0.004502

2 02/90 0.0020 0.0129 0.0057 0.000026 0.000166
3 03/90 0.0430 0.0263 0.0064 0.001131 0.000692
4 04/90 −0.0160 −0.0247 0.0069 0.000395 0.000610
5 05/90 0.1270 0.0975 0.0068 0.012382 0.009506
.. .. .. .. .. .. ..
. . . . . . .
57 09/94 −0.0310 −0.0241 0.0037 0.000747 0.000581
58 10/94 0.0250 0.0229 0.0038 0.000572 0.000524
59 11/94 −0.0260 −0.0367 0.0037 0.000954 0.001347
60 12/94 0.0030 0.0146 0.0044 0.000044 0.000213
60 0.5540 0.4560 0.2318 0.080448 0.080374
ār. Using r̄i , r̄f and r̄m to denote the average returns,4 we can write the average abnormal
return. This measure of performance is also known as alpha or Jensen alpha (JA).
JAi = ar i = r̄i − [r̄f + βi (r̄m − r̄f )] (4.12)
This measure of performance is also known as alpha or Jensen alpha.

Let us take Janus Fund as an example. Table 4.1 shows monthly returns for the fund, the
S&P 500 index, and the Treasury bills from January 1990 to December 1994. The bottom
row shows the statistics needed for calculations.
Using Table 4.1, we can calculate the following statistics:
P
ri 0.5540
r̄i = = = 0.0092,
PT 60
rm 0.4560
r̄m = = = 0.0076,
PT 60
rf 0.2318
r̄f = = = 0.0039,
T 60
P P
P ri rm
ri rm − T
0.080448 − (0.5540)(0.4560)
60
σim = = = 0.001292,
T− P
1 59
P ( r )2 (0.4560)2
2
2
rm − Tm 0.080374 − 60
σm = = = 0.001304,
T −1 59
4
We are not using µ here because µ is used for expected value. We use r̄ to denote simple historical
average.
v P v
uP u
u r 2 − ( ri )2 u 0.090940 − (0.5540)2
t i T t 60
σi = = = 0.0381,
T −1 59
σim 0.001292
βi = 2
= = 0.9913.
σm 0.001304
The β can also be calculated by running the market model regression equation (3.21) on page
92 with ri being the dependent variable and rm being the independent variable. Now the
performance measures for Janus Fund for the 60 months during January 1990 to December
1994 are calculated as:
r̄i − r̄f 0.0092 − 0.0039
SRi = = = 0.1408
σi 0.0381
r̄i − r̄f 0.0092 − 0.0039
TRi = = = 0.0054
βi 0.9913
JAi = r̄i − [r̄f + βi (r̄m − r̄f )]
= 0.0092 − [0.0039 + (0.9913)(0.0076 − 0.0039)]
= 0.0017
Since the Jensen alpha for the Janus Fund is positive, the fund exhibited superior perfor-
mance during the period. To draw meaningful conclusions from Sharpe and Treynor ratios,
we should compare these ratios for the fund with similar ratios for the benchmark S&P 500
index. The Sharpe and Treynor ratios for the S&P 500 are:
r̄m − r̄f 0.0076 − 0.0039
SRm = = = 0.1035
σm 0.0361
r̄m − r̄f 0.0076 − 0.0039
TRm = = = 0.0037
βm 1
Since the Sharpe and Treynor ratios for the Janus fund are greater than those for the S&P
500, the fund was a superior performer during the five year period.
Recall that the market model regression to estimate β can be run using the excess re-
turns also as shown in equation (3.22) on page 92. Table 4.2 shows the data for statistical
calculations using excess returns. The returns shown here are all in excess of the risk-free
rate. For example, the excess return for the fund (ri ) in January 1990 is calculated as
−0.0790 − 0.0057 = −0.0847.
The covariance, variance, and β are now calculated using excess returns as:
P P
P (r −r ) (r −rf )
(ri − rf )(rm − rf ) − i f
T
m
σim =
T −1
0.077574 − (0.3222)(0.2242)
60
= = 0.001294,
59
Table 4.2: Performance evaluation for Janus Fund using excess returns.
MM/YY ri − rf rm − rf (ri − rf )(rm − rf ) (rm − rf )2
1 01/90 −0.0847 −0.0728 0.006166 0.005300

2 02/90 −0.0037 0.0072 −0.000027 0.000052
3 03/90 0.0366 0.0199 0.000728 0.000396
4 04/90 −0.0229 −0.0316 0.000724 0.000999
5 05/90 0.1202 0.0907 0.010902 0.008226
.. .. .. .. .. ..
. . . . . .
57 09/94 −0.0347 −0.0278 0.000965 0.000773
58 10/94 0.0212 0.0191 0.000405 0.000365
59 11/94 −0.0297 −0.0404 0.001200 0.001632
60 12/94 −0.0014 0.0102 −0.000014 0.000104
60 0.3222 0.2242 0.077574 0.077993
P
P ( (r −r ))2
2 (rm − rf ) −
2 m
T
f
σm =
T −1
2
0.077993 − (0.2242)
60
= = 0.001308,
59
σim 0.001294
βi = 2
= = 0.9898.
σm 0.001308
The β, once again, can also be calculated by running the market model regression with
(ri − rf ) being the dependent variable and (rm − rf ) being the independent variable. The
average abnormal return is now calculated as:
ar i = r̄i − [r̄f + (βi )(r̄m − r̄f )]

= 0.0092 − [0.0039 + 0.9898(0.0037 − 0.0039)]
= 0.0017
The average abnormal return is almost the same as the one calculated using the full
returns β. The excess returns calculations are preferred because they take into account
the reality of the changing Treasury bill rates while the full return calculation ignores that
variability. Furthermore, the average abnormal performance calculated using the excess
returns β is exactly equal to the intercept in the excess return market model regression.
Therefore, the excess return market model regression gives us the β, as well as the average
abnormal return, eliminating the need for extra calculations.
4.5.1 Do Mutual Funds Exhibit Superior Performance?

Claims of superior performance are frequently made by financial companies to attract in-
vestors to buy shares in their funds. The fund managers claim that they beat the market
in the past using their timing and selectivity skills. Timing refers to the ability to predict
which way the market as a whole will go. Selectivity refers to the ability to predict which
securities will be superior performers. Such claims, however, are always presented with the
caveat that the historical performance is not necessarily a guarantee of future performance.
Studies done by finance academics find little evidence for superior performance by mutual
funds or their managers on an average. Most studies find that the timing ability of the fund
managers are particularly suspect. There are, however, periods during which a fund or a
group of funds may perform well. For example, Fidelity’s Magellan Fund produced excellent
results during the 1980’s. The conclusion most performance measurement studies draw from
long term studies is that the returns an investor earns by investing in mutual funds are in
line with or less than what the investor should have earned based on the risk taken. Even if
some mutual fund managers have superior skills, they charge fees commensurate with their
skills, so that the benefits of their skills accrue to them and not to the investors. Investors,
therefore, should invest in mutual funds for reasons of diversification, and not necessarily for
superior performance.
4.6 Conclusion
The procedure for selecting securities using the principles of present value was described
in this chapter. Due to the efficiency of the competitive securities markets, the practical
usefulness of such selection rules depends on the nature of information used to arrive at the
security values and the speed with which the decisions are made and implemented. Finally,
we studied the procedures for measuring the performance of investments.
Exercises
4.1 Present Value Calculations
Calculate the present value for the following cashflows. Assume that the discount rate for all these cases
is 10% per period.
10 10 10 10
a.
0 1 2 3 4 5
10 10 10 10
b.
0 1 2 3 4 5
10 10 10 10 10
c.
0 1 2 3 4 5
10 10 10 10
d.
0 1 2 3 4 5
10 10 10 10 10
e.
... ∞
0 1 2 3 4 5
10 10
f.
... ∞
0 1 2 3 4 5
10 10.50 11.025 11.576 12.155
g.
... ∞
0 1 2 3 4 5
10 10.50 11.025
h.
... ∞
0 1 2 3 4 5
4.2 Present Value
(a) Calculate the present value of the following cashflows. The discount rate is 9% per period.
30 33 36.3 37.03 37.77 38.52
... ∞
0 1 2 3 4 5 6
(b) Calculate the present value of the following cashflows. The discount rate is 11.5% per period.
300 300 300 300 315 330.75 347.29 364.65 382.82
... ∞
0 1 2 3 4 5 6 7 8 9 10
4.3 Annuity Formula

An annuity can be viewed as a difference between two perpetuities. Use this principle to derive the
formula for valuing an annuity. Use a similar idea to derive the formula for a growing annuity.
4.4 Rate of Return Calculations
Calculate the rates of returns for the cashflows in exercise 4.1 assuming that the initial investment in
each case is $30.
4.5 Rule of 72
In popular financial press you often read about the rule of 72. The rule is that the number of years it
takes for your money to double can be approximated by dividing 72 by the interest rate. For example, at
8% per year it will take about 9 years for your money to double. Test the rule of 72 for 4%, 6%, . . ., 16%,
18%.
4.6 Continuous Compounding
A Treasury bill is selling for $9,823. On maturity, in 2 months, the buyer will receive $10,000. What is
the continuously compounded annual rate for this Treasury bill?
4.7 Present Value and IRR
On January 1, 1988 I purchased 100 shares of a common stock at $45. I received per share dividends
of $0.30, $0.30, $0.35, and $0.30 on March 31, June 30, September 30, and December 31 of 1988. I sold the
shares on December 31, 1988 for $44 each.
(a) Show these cashflows on a time line.
(b) Calculate the PV of the cash inflows assuming that the discount rate is 14% per year.
(c) Calculate the quarterly rate of return on this stock. What is the annualized rate of return?
4.8 Rate of Return

Calculate the rate of return implied by the following cashflows:
−200 30 30 30 30 280
1/1/89 12/31/89 12/31/90 12/31/91 12/31/92 12/31/93
4.9 Rate of Return

Thelma Houston bought 100 shares of a preferred stock on January 1, 1987 for $30 each. The stock
paid dividends of $0.60 per share every quarter with the following exception: dividends were skipped during
quarter 2 of 1988 but Thelma received $1.25 in quarter 3 of 1988—$0.60 regular dividend and $0.65 for the
skipped dividend. Thelma sold the shares on January 1, 1989 for $32 each.
(a) Show the cashflows for this investment on a time line.
(b) Calculate the quarterly rate of return earned by Thelma on her investment. Compound this return to
obtain the annualized rate.
(c) The discount rate for the stock is 9% per year. Was this a good investment for Thelma?
4.10 Return on Investment

The market price of UP Systems on January 1, 1987 was $32 per share. The stock paid regular quarterly
dividends of 0.30 per share in 1987, 0.35 per share in 1988, and 0.40 per share in 1989. The price on December
31, 1989 (after the dividend payment) was $31 per share. What was the annual rate of return on the stock
of UP Systems?
4.11 Expected Rate of Return
Ms. Bonnie Raitt is considering purchasing shares of Moon Macrosystems. Moon is currently selling for
$12 per share. Ms. Raitt expects to receive quarterly cash dividends of $0.20 per share, the first one coming
exactly one quarter from now. She believes that she will be able to sell the stock for $14 per share two years
from now.
(a) Show the cashflows on a time line.
(b) What is the expected rate of return based on Ms. Raitt’s information?
(c) Ms. Raitt believes that the discount rate for the stock is 14% per year. Is this a good investment for
Ms. Raitt?
4.12 Expected Rate of Return

After considerable research, Julia Child has figured out that due to a gimmick employed by the master
chef, the dividends from Grandma’s Kitchen will grow at 15% per year during the next three years. After
that, the growth rate will be 5% per year for two years, and will finally settle down to constant dividends
after that. The dividends this year were $0.50 per share.
(a) Show the dividends expected by Julia Child on a time line.
(b) Calculate the rate of return from investing in the stock, if the current price is $9.75.
(c) Ms. Child has also estimated that a return of 16% per year would be the proper compensation for the
risk in this stock. What should Ms. Child’s decision be regarding the common stock of Grandma’s
Kitchen?
4.13 Security Valuation

Ziggy is considering investing in common stock of Murphy. The correlation between the returns on the
common stock of Murphy and the market is 0.80. The annualized standard deviation for Murphy and the
market are 0.24 and 0.16. The annualized returns on the risk free securities and the S&P 500 are expected
to be 8% and 14% during the next two years.
Ziggy expects Murphy to pay quarterly dividends of $0.40 per share for the next 8 quarters. The current
market price of the stock is $10.50 and Ziggy believes that two years later the price will be $15. What should
be Ziggy’s strategy regarding this common stock?
4.14 Security Selection
Mary Ross feels that the price of Orpheus will jump to $12 next month because of a takeover bid from
Nimbus. The current price of Orpheus is $10.20. Orpheus is a growing company and pays no cash dividends.
To analyze the stock, Mary collected monthly prices for 5 years for Orpheus and the S&P 500. She converted
these prices into monthly returns. From the market model regression she found the β of Orpheus to be 1.08.
Mary expects the risk-free rate to be at 8% per year during the next month. She expects that the market
will go up by 1.2% during the next month. Should Mary buy shares of Orpheus or sell them? Analyze the
problem using both the present value and the internal rate of return methods.
The common stock of DeBondt Corporation paid a dividend of $0.20 per share this quarter. The
dividends are expected to grow at the rate of 1.5% every quarter, forever. The returns on the Treasury
bills and the market are expected to be 7.8% per year and 13.5% per year. The β of the stock of DeBondt
Corporation is 1.2. The market price of the stock of DeBondt Corporation is 10 7/8. What should you do
about the stock if you believe that your expectations about the stock and the economy are correct?
Carol Carney expects that there will be significant changes in the national energy policy during this
decade. Therefore, she is interested in the common stock of Surya, an emerging firm specializing in solar
energy. The stock of Surya is selling at $8. Carol has done a fair amount of research on the stock and
expects that the stock will not be in a position to pay any dividends for the next 4 years. After that, the
stock should pay quarterly dividends of $0.50 per share for 3 years. After 3 years of constant dividend, the
dividends should grow at the rate of 1% per quarter forever.
(a) Show the cashflows expected by Carol on a time line.
(b) Calculate the quarterly rate of return Carol expects from the stock.
(c) Carol believes that Surya is twice as risky as the average stock in the market. The average stock in the
market is offering a rate of return of 12% per year. The risk-free rate is 7% per year. What is the annual
rate of return that Carol should expect from the stock of Surya?
(d) Should Carol invest in the stock of Surya?
4.17 Market Efficiency

Discuss the following statements:
(a) “The high volatility in the market prices these days is clear evidence that the markets are not efficient.”
(b) “Why invest in the stock market? The market is efficient and therefore you can’t make any money
anyway.”

Refer to exercise 4.14. Suppose Mary bought 100 shares at $10 per share. A month has passed and the
expectations of Mary did come true to some extent—she sold the stock for $11.60 per share. What is her
realized return? During the month, the market returned 2.6% and the risk-free rate averaged at 9% per year.
Calculate the proper expected return on Orpheus based on the market conditions. Calculate the abnormal
return. Was it a good investment for Mary Ross?
The Jupiter Fund has a β of 1.5. Analysts are predicting that over the next year the risk-free rate will
be 8% and the market will go up by 18%. What rate of return can the shareholders in Jupiter Fund expect?
At the end of the year the following results were actually observed: rf = 0.07, rm = 0.20, rJ = 0.25,
where f, m and J denote the risk-free security, the market, and Jupiter, respectively. Portfolio managers at
Jupiter were ecstatic and claiming that they not only beat the market but also came out ahead of their own
expectations. Are their celebrations justified?
The document accompanying the account statement to the shareholders of the Alliance Fund stated:
During the past 3 months your fund showed excellent performance—it provided an annualized
return of 12%. In comparison the annualized return on the S&P 500 during this period was
10%.
Comment on this statement.
4.21 Performance Measurement
During the last five years, the growth fund managed by E. John had an average return of 17.2% per year
while the growth fund managed by S. Denny had an average return of 18.9% per year. The β’s of the two
funds are 1.3 and 1.5 while the standard deviations of their returns are 28% and 26%. The average return
on the S&P 500 during this period was 14.5% per year while the risk-free rate was 8.2% per year.
(a) Calculate the abnormal returns for the funds managed by E. John and S. Denny.
(b) Briefly discuss the relative performance of the two funds. Which one would you invest in? Why?

The 1990 New Account Kit for Fidelity Magellan Fund gave the following table:
Magellan Fund S&P

Year Ended 3/31 Total Return Total Return
1980 20.37% 5.91%

1981 100.13 39.73
1982 −.68 −13.08
1983 87.70 44.04
1984 8.77 8.60
1985 21.01 18.67
1986 56.59 37.42
1987 24.26 26.14
1988 −9.64 −8.43
1989 22.26 18.13
The average risk-free rate during the period of 1980 to 1989 was 6.2% per year.
(a) Calculate the average and the standard deviation of returns on the fund and the S&P, and the β for the
fund.
(b) The managers at Fidelity are quite proud of the performance of their fund because, on an average, it
has done better than the S&P. Do you agree with their argument?
(c) Calculate a proper measure of performance of Fidelity.

The Marginal Fund has shown an average return of 12.6% per year during the previous 10 years. The
S&P 500 on the other hand, has had an average annual return of 14.2%. The risk-free rate during these ten
years has averaged to 7.4% per year. The standard deviation of the returns on the Fund and the S&P 500
are 0.33 and 0.42, respectively. The Marginal Fund has a correlation of 0.60 with the S&P 500 index. Has
the Marginal Fund exhibited superior performance during the previous 10 years?
Venus Group of Funds, in a recent advertisement, claimed that their growth fund was the fund of the
80’s. They claimed that in seven of the ten years, the fund kept pace with or outperformed the S&P 500.
As an evidence, they provided the following table that shows the total annual returns on the fund and the
S&P 500 for each of the ten years.
Year → 80 81 82 83 84 85 86 87 88 89
Fund −7 40 −4 60 12 −10 61 33 −25 35
S&P 500 6 40 −13 44 9 18 37 26 −8 18
The advertisement also mentioned that the annualized rate of return on the Treasury bills during this
period was 8.2% per year.
(a) Discuss the claim made in the advertisement.
(b) Calculate a measure of performance of the fund in the CAPM framework.
Chapter 5
Common Stocks
Common stock is the most popular security. To many people, investing in securities is
synonymous with buying and selling stocks. In the same spirit, the well-being of the economy
is usually judged by looking at indices such as the Dow Jones Industrial Average and the
S&P 500 index, which are made up of stocks. This Chapter describes the characteristics of
common stock and sources of specific information needed for valuing them.
5.1 Stockholder Rights

Shares of common stock are issued by corporations to finance real investment projects.
Purchasing shares of common stock gives an investor partial ownership in the company. Let
us consider the ABC company. The market value of the assets of ABC is $150 million and
the market value of its debt is $50 million.1 Therefore, the market value of equity is $100
million. If the company has 1 million shares outstanding then the market price of each share
is $100. If you own 1,000 shares of this company, you own one thousandth (1,000/1,000,000)
of the company. The total value of your investment is 1,000 × $100 = $100,000
Ownership in the company gives you certain rights:
Voting rights: As an owner of the company you have a say in how the company is run.
Investors exercise this right by voting for the board of directors who then oversee the
operations of the company. Some matters may be so important that they should not
be decided by the board of directors only. In such matters, stockholders are asked to
cast their votes directly. Stockholders are allowed one vote for every share they own.
The more shares an investor owns, the more influence the investor can have on the
decisions. Companies hold annual meetings to elect the board of directors and discuss
1
Market value of assets refers to the value for which the assets may be sold. Market values are not easily
determinable. Corporate balance sheets show book values which are based on historical costs and are often
used as a basis for comparison.
133
Common Stocks 134
other important matters. Stockholders are invited to attend these meetings. Most
investors, however, send in proxy votes by mail rather than bearing the expense of
attending the annual meeting.
Preemptive rights: Companies may give their shareholders rights to purchase any new
shares to be issued by the company before they are sold in the open market. This right
is valuable because it can be used by investors to maintain their fractional ownership
in the company. To continue with the example used above, if ABC decides to issue
100,000 new shares, the preemptive right would allow you to buy 100 shares of this
new issue to enable you to maintain your share of ownership of the company at one-
thousandth (1,100/1,100,000). Preemptive rights are transferable and can be traded
in the market. In the recent years, the number of companies issuing preemptive rights
has been on decline.
Value rights: As an owner of the company, an investor also has the right to the firm value
and any earnings resulting from it. For example, if in a particular year ABC has net
earnings of $10,000,000 (after interest and taxes), you are entitled to $10,000 of the
firm’s earnings. Similarly, if the firm dissolves (or is bought out), you have a right to
1,000th of the net proceeds (after paying the claims of the creditors). Corporations
pass some of their earnings to investors in form of cash dividends and retain the rest
for reinvestment. To most investors, the value rights are the only ones that matter.
5.2 Issue and Repurchase of Shares

Shares of common stock are issued by corporations in the primary market and are traded in
the secondary market to provide liquidity to the investors. The number of shares outstanding
may be changed by the company through many different means:
New issue: If a corporation needs capital it may issue new shares. Firms like to issue shares
when the share price is relatively high. At a high share price the company has to issue
fewer shares to raise the desired capital. This causes less dilution to the ownership of
the original stockholders. Usually, new shares are issued at a price below the market
price of the existing shares. The discount is expected to ensure a brisk sale of the
shares.
Issue of shares by a new company is known as an initial public offering (IPO). IPO’s
are very risky because of the lack of information about the issuer. It is not uncommon
for the price of shares issued by a new firm to double or half within weeks of the IPO.
Share repurchase: If a company has excess funds, it may purchase its own stock in the
market. Usually, shares are repurchased when the share price is relatively low. Besides
being a good investment, repurchasing shares has a beneficial side effect—it raises the
Common Stocks 135
demand for shares which, in turn, raises the market price of shares and provides a price
support. Investors feel more confident about a company if the company is willing to
buy its own shares.
Stock splits and stock dividends: A stock split is an exchange of a smaller number of
high priced shares for a larger number of low priced shares. Stocks are split because
many companies believe that investors prefer shares in the $10–$50 price range. At a
high price, say $100, a round lot of shares may be too expensive for small investors.
Therefore, if the price goes too much above $50 the company may split the stock. A
2-for-1 stock split is an exchange of 2 new shares for 1 old share. If one million shares
were outstanding before the split at the price of $100 each then there will be two million
shares after the split at the market price of $50 each. Other than the ability to attract
investors who may otherwise shy away from the stock, stock split does not have a real
advantage. In fact, it ends up costing the company and the stockholders quite a bit to
recall old shares and print and issue new ones.2
A stock dividend is an issue of new shares directly to the existing stockholders. Stock
dividends are issued when a company is short of cash. Let us suppose the ABC company
does not have enough cash to pay dividends this year because all the cash is needed for
reinvestment. The company, in this situation may declare a 10% stock dividend. This
will cause the number of shares to go up by 10% to 1,000,000 × (1 + 0.10) = 1,100,000
and the share price to go down to $100/(1 + 0.10) = $90.91. You will receive 100 shares
(10% of 1,000) in the mail. Now you will own 1,100 shares but the price of each share
will be $90.91. The total value of your investment will be 1,100 × $90.91 = $100,000,
same as before the stock dividend. On the whole, stock dividend is an expensive activity
because, new shares have to be printed and mailed to the investors. Therefore, it is
not clear as to why investors like to receive stock dividend and why companies like to
pay them.
Even though they are motivated by different reasons, stock splits and stock dividends
result in an increase in the number of shares outstanding and a corresponding decrease
in the share price but do not cause any change in the market value of equity. A 2-for-1
stock split has the same effect as a 100% stock dividend: both double the number of
shares and half the price. Stock are usually split in proportions such as 3-for-1, 3-for-2,
or 4-for-3. Stock dividends are usually paid in fractions such as 2%, 5%, or 10%.
Sometimes firms split their stock in reverse, e.g., 1-for-2. In a reverse stock split the
firm is issuing one new share for two old shares. This has the effect of increasing the
share price. Stock may be split in reverse if the company wants to increase the share
price. A higher share price may be desirable because extremely low priced stocks are
perceived to be very risky by some investors because a small drop in price means a big
loss on investment. Also, per share transaction costs may be relatively high for small
2
Printing new shares of stock is also harmful to the environment because of the paper and chemicals used
in the process.
Common Stocks 136
priced stocks because some brokerage houses charge a fixed minimum commission for
a trade.
5.3 Cash Dividends

Cash dividends are the payments made by the company to the stockholders. Dividends are
an extremely important part of stock investments. Common stocks have value only because
of the expectation of dividends. An investor is able to sell the shares only because the
investor buying them would receive the dividends, or would sell them to someone else who
would receive the dividends.
This, however, does not mean that a common stock must pay dividends regularly. Div-
idends are discretionary payments. A corporation may pay dividends if it has excess cash
and may not pay dividends if it does not have excess cash. This suggests that the dividends
may fluctuate depending on the cash position of the company. However, we don’t find this
behavior in reality. Most firms have well defined policies about dividends. They pay fixed
dividends on a regular basis. The reason for fixed dividends is that investors do not like
the uncertainty of fluctuating dividends. They react negatively to any unexpected decline
in dividends. Companies, therefore, keep dividends steady and change them only under
extreme situations. Sometimes, companies even raise money by borrowing or issuing shares
to pay dividends. Companies do not increase the regular dividends even if they have excess
cash during a period, if they are unsure of the their ability to maintain the increased divi-
dend. A corporation which has excess cash usually declares an extra dividend or irregular
dividend, clearly indicating a bonus situation.
A company’s dividend policy, i.e., how much dividends to pay, is related to some extent
with its growth level. A growing company needs most of its earnings for reinvestment pur-
poses. Retained earnings are used to acquire assets or invested in research and development
which may lead to increased earnings and dividends in the future. Mature companies do
not need as much of their earnings and are therefore more likely to pay most of it out as
dividends.
Two important ratios involving dividends are the payout ratio and the plowback ratio.
The payout ratio measures the fraction of earnings that is paid out as dividends and the
plowback ratio is the fraction that is retained and reinvested. Usually, growth firms have
low payout ratios while mature firms have high payout ratios. There are many well known
firms such as Digital Equipment Corporation and Federal Express which do not pay regular
dividends.
Some dividend related information appears in The Wall Street Journal under the title
corporate dividend news. This information is divided into two parts. In the first part
we see the information about dividends declared during the previous trading day. In Table
5.1, we see an excerpt from this part of the corporate dividend news of August 8, 1995.
We see that American Eagle Corp announced on August 7 that it will pay a regular,
Common Stocks 137
Table 5.1: Corporate Dividend News.
Dividends Reported August 7

Payable Record
Company Period Amt. date date
regular
AlaPwr pf7.60% 2nd . . . Q .47 1/2 10– 1–95 9– 5
American Eagle Grp . . . Q .03 10–20–95 10– 6
Beckman Instrments . . . Q .11 8–31–95 8–11
General Motors . . . . . . . . Q .30 9– 9–95 8–17
General Motors clH . . . . Q .23 9– 9–95 8–17
Metro Finl Corp . . . . . . . Q .05 8–22–95 8–10
Weyco Group . . . . . . . . . . Q .21 10– 1–95 9– 1
funds - reits - investment cos - lps
EatonVance Divers . . . . Q .55 9–29–95 9–15
LordAbbot BdDeb . . . . . M .073 8–15–95 8– 7
Source Capital . . . . . . . . . Q .90 9–15–95 8–25
stock
Money Store . . . . . . . . . . . – rr 9–21–95 9– 6
rr–Three-for-two stock split.
quarterly dividend to the investors who are registered as stockholders in the company records
on 10–6. The dividend checks will be mailed out on 10–20–95. Most corporations pay
dividends on a quarterly basis. Others pay monthly, semiannual or annual dividends. The
report also shows stock dividends. Money Store declared a stock split of three-for-two which
has the same effect as a 50% stock dividend. Entries under the heading funds - reits -
investment cos - lps show dividends declared by mutual funds, real estate investment
trusts, investment companies, and limited partnerships. Not shown in Table 5.1 are some
other special cases such as irregular, extra, increased, reduced, foreign, initial, special, and
deferred dividends. Information about these cases is presented in the same format as shown
in Table 5.1.
From Table 5.1, we see that the important dates connected with dividend payments are
declaration date, record date, and payable date. For investors there is a date that is
even more important than these dates. This date is known as the ex-dividend date. Let
us understand the importance of this date using the General Motors case. The record date
for the dividend is 8–17. Therefore, an investor who is a registered owner on August 17 is
Common Stocks 138
Table 5.2: Corporate Dividend News.
Stocks Ex-Dividend August 9

Company Amount Company Amount
AIM Strategic Inco .05 MCN Corp .22 1/4
Amer Home Prod .75 MGIC Invest .04
AmerWaterWrks5%pf .31 1/4 Micron Technol new .05
AmerWaterWks5%pref .31 1/4 Monsanto Co .69
Applied Pwr clA .03 Muni Inco Opp Tr .05 1/4
entitled to receive the dividend. An investor who buys the shares on August 17, however,
may not become a registered stockholder on that very day because it takes time for the
information to be received by the corporation and recorded. Without proper control this
could become a problem. Investors buying the shares would not know if they are going to
get the dividend or not. The time lag for the information to be recorded is usually 4 or 5
days. The stock exchange in which the shares are traded, therefore, sets the ex-dividend
date for a stock 4 or 5 days before the record date. This way, all investors know that if they
buy shares of a stock before the ex-dividend date, they will get the dividend. If they buy
the shares on or after the ex-dividend date, they will get the stock ex-dividend, i.e., without
the dividend. All four dates associated with a dividend are shown in sequence in the time
line below:
Declaration Ex-Dividend Record Payable
date date date date
The second part of the corporate dividends news contains the ex-dividend infor-
mation as shown in Table 5.2. Table 5.2 informs the investors that if they buy shares of
these stocks on or after August 9 they will not be entitled to the dividends. For investments
calculations, the relevant date with respect to dividends is the ex-dividend date, even though
the dividend is received a few days after (due to mailing delay) the payable date.
On the ex-dividend date, the stock price drops due to the exclusion of dividends from the
shares. If there were no taxes or transaction costs, the price drop would equal the dividend
amount. For example, if the closing price on the trading day before the stock goes ex-dividend
is $10 and the dividend amount is $1, then on the ex-dividend day, the price will drop to $9.
Investors who buy the shares on the day before the ex-dividend date buy it cum-dividend
for $10 and will receive the $1 dividend. Investors who buy the shares ex-dividend, pay only
$9 and will not receive the dividend. With differential taxes, transaction costs of dividends
versus capital gains, and the fact that stock prices move in ticks (1/8th of a dollar) rather
Common Stocks 139
than pennies, the drop in stock price may not be equal to the dividend amount. Because
of different taxes and transaction costs paid by different investors, some may prefer to buy
the shares cum-dividend at a high price and receive the dividend, while others may prefer to
buy the shares ex-dividend at a lower price and forgo the dividends. Some investors, because
of their tax status, prefer dividends so much that they buy the shares just before they go
ex-dividend and sell them immediately after the shares go ex-dividend. In this way, they
trade the drop in stock price for the dividends. This process of buying shares just to receive
a dividend is known as dividend capture.
5.4 Reading Stock Quotations

Common stock price and trading volume quotations are listed in various tables in The Wall
Street Journal. Tables entitled new york stock exchange composite transactions,
american stock exchange composite transactions, and nasdaq national mar-
ket issues provide complete information on major stocks.3 Two other tables—nasdaq bid
and asked quotations and additional nasdaq quotes—provide bid and asked prices
for other stocks traded over-the-counter.
Table 5.3 shows a few quotations from the new york stock exchange composite
transactions from The Wall Street Journal of August 8, 1995. These quotations are for
the transactions on August 7, 1995. To identify the columns during our discussion below,
the columns have been numbered.
Column (1) is used for special symbols. and indicate that the stock price reached a

new high or low during the trading day. An ‘s’ indicates that the stock went through a split
during the past twelve months. An ‘x’ means that the stock was traded ex-dividend. An
‘n’ is used to denote a newly issued stock. There are various other symbols and notations
which are not shown here. For details you should consult the explanatory notes associated
with the table.
Columns (2) and (3) are used for the lowest and the highest prices of the stock during
the past 52 weeks. Columns (4) and (5) give the name of the stock and its trading symbol.
Column (6) gives the total dividends paid by the stock during the past year. Column
(7) gives the dividend yield of the stock. The dividend yield is calculated by dividing the
dividend paid during the year (column (6)) by the closing price for the day (column (12)).
The dividend yield is an estimate of the rate of return to the investor from the dividends
alone. Therefore it is a measure of the current income potential of the stock. We can check
this calculation for AmBrand. The closing price is listed as 41 and during the year the
company paid $2.00 per share in dividends. Assuming that the next year’s dividends will
equal this year’s the dividend yield is calculated as 2.00/41 = 0.04878 or 4.9% per year.
3
nasdaq stands for National Automated Security Dealers Association Quotation and refers to the over-
the-counter market.
Common Stocks 140
Table 5.3: New York Stock Exchange Composite Transactions.
52 Weeks Yld Vol Net

Hi Lo Stock Sym Div % PE 100s Hi Lo Close Chg
(1) (2) (3) (4) (5) (6) (7) (8) (9) (10) (11) (12) (13)
55 7/8 47 1/4 AT&T Cp T 1.32 2.6 16 18443 52 51 3/8 51 5/8 − 1/8
42 1/8 32 7/8 AmBrand AMB 2.00 4.9 12 2799 42 3/8 40 1/8 41 + 3/4
40 5/8 25 5/8 BrownFer BFI .68 2.0 18 36778 34 /21 33 33 /8 − 5/8
7
34 7/8 19 1/4 Chilgener CHR .99e 3.4 ... 455 29 3/8 29 29 − 3/8
52 7/8 30 3/8 Compaq CPQ ... 15 13835 50 3/4 49 3/8 49 5/8 −1
25 1/8 17 India GrFd IGF .92e 5.0 ... 180 18 2 18 4 18 4 − 1/8
1/ 1/ 1/
36 10 1/8 MexicoFd MXF .22e 1.2 . . . 2565 19 1/4 18 7/8 19 1/8 + 3/8
4 7/8 1/2 SmithCorona SCO ... ... 745 5/8 1/2 5/8 + 1/8
187 3/8 140 3/4 WellsF WFC 4.60 2.5 11 657 181 7/8 180 3/8 181 5/8 +1 7/8
26 3/4 24 1/4 WellsF pfC 2.25 8.7 ... 413 26 1/8 26 26 − 1/8
26 5/8 24 1/8 WellsF pfD 2.22e 8.5 ... 46 26 81/ 26 26 − 1/4
Column (8) gives the price earnings (PE) ratio for the stock. It is calculated by dividing
the closing price by the earnings per share. The PE ratio measures the price per dollar
of the current earnings of the company. A high PE ratio means that investors are paying
a high price for the company’s current earnings. Therefore, they must expect company’s
future earnings to be high. Therefore, a high PE ratio is believed to be an indicator of the
company’s growth potential. Many investment advisors, therefore, recommend stocks based
on the PE ratios. The PE ratio for AmBrand is 12 and the closing price is $41. Therefore,
the earnings per share for AmBrand were $41/12 = $3.42. Since we know that the company
paid $2.00 in dividends, the dividend payout ratio for AmBrand is 2.00/3.42 = 0.58 or 58%.
In other words, this year AmBrand paid out 58% of its earnings in dividends and reinvested
the remaining 42%.
Column (9) gives the number of shares traded in 100s. For example, 2799×100 = 279,900
shares of AmBrand were traded. Columns (10), (11) and (12) give the highest, the lowest,
and the closing (last) prices for the day. Column (13) gives the net change in the closing
prices since the previous trading day. A negative net change indicates that the price went
down while a positive number indicates that the price went up. For example, the previous
day’s closing price for BrownFer was 33 7/8 + 5/8 = 34 1/2.
Some other things are also worth noticing about Table 5.3.
• Compaq does not pay regular dividend. Therefore, the dividend amount and the
Common Stocks 141
dividend yield columns do not have any information.
• As mentioned in Chapter 3, closed end mutual funds are traded on the exchanges. The
two examples shown in the Table are India GrFd and MexicoFd which are closed end
funds that invest in India and Mexico, respectively.
• A company may have more than one of its issues (securities) being traded on the
exchange. For example, there are three issues being traded for Wells Fargo (WellsF):
A common stock and 2 preferred stocks.
Other stock quotation tables contain similar information. nasdaq bid and asked quo-
tations contain the bid and asked prices and the share volume and additional nasdaq
quotes contain only the bid and ask prices.
5.5 Common Stock Valuation

The value of a share of common stock is the present value of the cashflows from the stock.
This fact is denoted by the following equation:
X
T
dt
PV = t
(5.1)
t=1 (1 + k)
where dt is the expected dividend per share t periods from now and k is the discount rate.
Usually, a stock has an infinite time horizon i.e., T → ∞. Assuming an infinite horizon for
the common stock, equation (5.1) can be simplified to provide compact valuation equations.
We will consider two special cases in the following subsections.
5.5.1 Mature Firm

A mature firm pays out all its earnings as dividends. Therefore, it experiences no growth and
the dividends remain unchanged over time. If this situation continues forever, the dividends
from this stock of a mature firm result in a perpetuity. The present value formula then gives
us:
d e
PV = = , (5.2)
k k
where e is the earnings per share of the company.
5.5.2 Growth Firm

Consider a stock that starts out paying only a part of its earnings as dividends and retains
the rest for reinvestment. If the company has a policy of maintaining a fixed payout ratio,
Common Stocks 142
the dividends will grow at a uniform rate g (because of reinvestment). If the growth rate g
is less than k the present value can be written as:
d
PV = (5.3)
k−g
where d is the dividend expected one period from now. The growth in dividends arises from
reinvestment. In fact, the growth rate is equal to the product of the plowback ratio and the
rate of return on the reinvestment. If the payout ratio is π, so that the plowback ratio is
(1 − π), and the rate of return on firm’s reinvestment is i, the growth rate is given by:
g = (1 − π)i (5.4)
The effect of the reinvestment policy of the company on the value is usually expressed
by the following equation:
e
P V = + PVGO (5.5)
k
The first term on the right hand side is the value that the stock would have if the firm were
paying out all the earnings as dividends and not reinvesting anything. The second term,
PVGO, is the additional value from reinvestment and is known as the present value of
growth opportunities. As you may expect intuitively, PVGO is positive only if the firm
is reinvesting in those opportunities that provide better returns than the usual operations of
the company, i.e., are positive NPV projects.
To use the growing perpetuity formula given in equation (5.3), one needs to know the
growth rate in dividends. The growth rate may be estimated using the historical growth rate.
The growth rate in the formula is the compound growth, rather than simple. Therefore, if
a dividend d grows at a uniform rate of g per year, in n years, it will become d(1 + g)n .
Therefore, if the dividends on two dates n periods apart are known to be d0 and dn then the
growth rate can g can be determined as:
!(1/n)
dn
dn = d0 (1 + g)n ⇒ g= − 1. (5.6)
d0
As an example, suppose the quarterly dividend for a company in Quarter 1, 1985 was
$0.30 per share and in Quarter 4, 1988 it was $0.48. Then the quarterly dividend growth
rate can be estimated as:
0.48 (1/15)
g= − 1 = 0.03183
0.30
or 3.18% per quarter. Note that it takes 15 quarters of growth to go from Quarter 1, 1985
to Quarter 4, 1988, which is why we use 15 in the example above. To determine if the
growth rate was constant through this period, one should calculate the growth rate for every
quarter, e.g., Quarter 1, 1985 to Quarter 2, 1985, Quarter 2, 1985 to Quarter 3, 1985, and so
Common Stocks 143
on. Each of these growth rates should be close to the 3.18% for the constant growth model
to be reliable.
A double check may be done for the growth rate calculation using the earnings. If there
is a constant growth, then the earnings should grow at the same rate as the dividends. In
fact, because of the companies’ policy about not changing dividends frequently, it is possible
that the dividends change in steps rather than continuously while the earnings change from
quarter to quarter. In these situations, the growth rate estimated using earnings is more
reliable than the one estimated using dividends.
5.5.3 Finite Holding Period

Usually, the valuation process does not lead to simplified equations such as (5.2) and (5.3)
because, while the stock may have an infinite horizon, investors do not. In other words,
investors buy shares, hold them for some time and sell them. In that case one has to use a
variation of equation (5.1). Suppose the investor will hold the shares for T periods and sell
them at a price of pT then the following equation can be written:
X
T
dt pT
PV = t
+ (5.7)
t=1 (1 + k) (1 + k)T
5.6 Obtaining Information for Valuation Decisions

To make an investment decision about a stock, an investor has to know the current price, the
discount rate, the future dividends and prices. The market price is the easiest information
to obtain. It is readily available from The Wall Street Journal or other publications. More
current prices can be obtained from other information sources. The discount rate can be
estimated using CAPM provided the investor knows the stock’s β and has estimates of the
expected returns on the market and the risk-free rate.
Estimates of future dividends and prices are the most difficult data items to obtain. His-
torical information is the starting point in this exercise. Historical data about the company
may be obtained from sources such as Moody’s Manuals, Standard and Poor’s Stock Guides,
and Value Line Investment Surveys. The estimates obtained using historical data should be
adjusted to reflect the changes expected in the future. Publications such as Standard and
Poor’s Outlook and Value Line Investment Surveys provide such analysis as well.
5.7 Factors Affecting Stock Prices

A reasonable estimate of future stock prices can be obtained if one has reliable information
about the economic variables affecting the stock prices and one knows the relationship be-
tween these variables and the stock prices. The stock price, in equilibrium, is equal to the
Common Stocks 144
present value of future dividends, i.e.,

d1 d2 d3
Price = + 2
+ +···
(1 + k) (1 + k) (1 + k)3
The numerator, dividends, depend on the firm’s earnings while the denominator contains the
discount rate, which depends on the interest rates in the economy (the risk-free rate and the
market rate) and the stock’s risk β. Economic variables affect stock prices by affecting the
dividends, the interest rates and the risk of the company. Therefore, if one can estimate the
effect of an economic factor on these variables, the effect on the stock price can be estimated
easily. Here are some examples:
Inflation: Expectation of inflation increases the rates in the economy. Therefore, the dis-
count rate goes up as higher inflation is expected. This has a negative effect on the
price. A higher inflation rate, however, also increases a firms revenues and costs which
may have a net effect of an increase in the firms earnings (assuming the demand is un-
changed). In popular press, common stock is viewed as an inflation hedge because the
dividends go up with inflation so that the real dollar value of dividends is unaffected by
inflation. Increased dividends have a positive effect on the stock price. The net effect
of increases in discount rate and dividends on stock prices, in general, is uncertain and
depends on the sensitivity of the firms to inflation. One can determine the effect of
inflation on a particular company by doing some simple calculations using the formula
above.
Taxes: Increased taxes require investors to demand higher returns on their investments and
therefore the discount rate goes up. At the same time earnings decline due to a bigger
tax burden so that the dividends decline. The net effect on the stock price is negative.
Macroeconomic conditions: Macroeconomic conditions affect stock prices through their

effect on interest rates and corporate earning power. Poor economic conditions lead to
lower earnings. However, the interest rates also decline with poor economic conditions.
The net effect on stocks is therefore indeterminable in general but it can be determined
for a particular stock using information about that company.
5.8 Conclusion
In this chapter you learned about the characteristics of common stocks and how to interpret
the information about the common stocks. This information is used in determining values
of the stocks and making investment decisions.
Exercises
Common Stocks 145
5.1 Stock Splits and Stock Dividends

What stock dividend is equivalent to a stock split of 5-for-3? 7-for-5?
5.2 Dividend Preference
On February 15, 1989 ABC Corporation declared a dividend of $1 per share with the record date of
March 18, 1989. The ex-dividend date was set to be March 13, 1989.
The common stock of ABC closed at $12 on March 12, 1989. On March 13, 1989 the stock opened at
$11.20—a $0.80 drop to reflect the loss of dividend.
Consider three investors:
• An individual who pays 28% taxes on capital gains and dividends.
• An American corporation that pays 34% taxes on capital gains and 8% on dividends.
• A Japanese corporation that pays 30% taxes on capital gains and no taxes on dividends.
Imagine that each of these groups bought 100 shares of ABC on January 2, 1989 for $10 per share.
Calculate the net after-tax profit to these investors if they sold the shares on the evening of March 12.
Calculate the net after-tax profit if they sold the shares on the morning of March 13. Which timing is
preferred for which investor?
On January 1, 1988 the common stock of Khilona Inc. was listed as:

41 7/8 40 3/8 Khilona KHL 2.55 6.07 7 20 42 42 42 + 3/8
(a) Explain each entry in the listing. Do any calculations necessary to confirm the dividend yield.
(b) What was the dividend payout ratio for Khilona during the year? Would you classify Khilona as a
mature or a growth firm?
(c) Khilona pays dividends quarterly. Based on your private information you expect the next four dividends
per share to be $0.60, $0.60, $0.80, and $0.60, respectively; and you expect to be able to sell the common
stock of Khilona for $46 on January 1, 1989.
You want to determine whether, based on your information, the common stock of Khilona is over-
or underpriced. You do some research and collect the following information: the expected rate of return
on the S&P 500 over the next year is 12%, the risk-free rate over the next year would be 7%, the
standard deviation of the annual returns on the S&P 500 is 14%. The standard deviation of returns on
the common stock of Khilona is 22%, and the correlation between the returns on Khilona and the S&P
500 is 0.80.
Calculate the β for the common stock of Khilona; and then calculate the discount rate—the expected
rate of return expected based on the risk. Using this information calculate the proper price (the present
value) of the common stock of Khilona. Should you buy the stock?

The listing for the common stock of Jumbo Peanuts, Inc. reads as follows:

30 18 Jumbo Peanuts JP 2.70 12.3 6 20 23 21 22 +1
Common Stocks 146
Table 5.4: Data for Exercise 5.5.
Curio Curio
Month Price Dividend S&P 500 Month Price Dividend S&P 500
0 20.40 0.60 230 13 21.50 0.00 264

1 20.00 0.00 235 14 22.00 0.00 267
2 19.50 0.00 237 15 21.00 0.60 264
3 18.50 0.60 235 16 19.00 0.00 270
4 19.00 0.00 239 17 18.00 0.00 265
5 19.60 0.00 242 18 17.00 0.60 278
6 18.90 0.60 245 19 17.50 0.00 282
7 19.10 0.00 243 20 18.00 0.00 282
8 19.00 0.00 246 21 18.00 0.60 287
9 18.50 0.60 249 22 18.50 0.00 290
10 18.70 0.00 255 23 19.00 0.00 292
11 19.00 0.00 258 24 19.20 0.60 293
12 19.20 0.60 262
(a) Explain all the entries in the listing.

(b) What were the earnings per share for this company during the last year? What is this company’s
dividend payout ratio? Is this company growing?
(c) Suppose the β of the stock is 1.4, the expected return on the market portfolio is 12.55% per year, and
the risk-free rate is 6.14% per year. What is the discount rate for the common stock of Jumbo Peanuts?
(d) Assume that the company has a policy of paying dividends quarterly. The last quarterly dividend was
$0.70 per share, and the next dividend is expected one quarter from now. Suppose the market expects
this company (and therefore its earnings and dividends) to grow at a constant rate forever. What is the
value of the growth rate expected by the market?
5.5 Valuation of Common Stock

Table 5.4 shows the closing prices for the past 25 months and the dividends for the common stock of
Curio Inc. and the levels of the S&P 500:
(a) Calculate the β for the common stock of Curio Inc. How much return do you expect the market to
provide during the next month? The monthly risk-free rate is 0.6%. What is the proper rate of return
that you expect from Curio based on its risk?
(b) Your private and reliable information sources lead you to expect that the closing price of Curio’s common
stock next month would be $20.00. What is the expected rate of return based on your information?
(c) What would be your trading strategy based on your analysis and information?
Common Stocks 147
5.6 Price Earning Ratios

Show that under the assumptions of uniform growth of future dividends and earnings, the price earnings
ratio can be written as:
p π(1 + g)
=
e k−g
where p is the current price, e is the current earning per share, π is the dividend payout ratio, k is the
discount rate, and g is the rate of growth in the dividends. What kind of stocks would have a high PE ratio?
5.7 Price Earnings Ratio
The WSJ of June 5, 1990 reported the PE ratio for American Express company to be 52. The annual
dividends paid by the company were listed to be 0.92 and the closing price was listed to be 31 5/8.
(a) What were the earnings per share for American Express during the past year?
(b) What is the dividend payout ratio for American Express company?
(c) The β for American Express company is 1.2. The long term expectation of the risk-free rate is 6.5% per
year and that of the market is 13% per year. Estimate the discount rate for the American Express.
(d) Assuming that the market believes that American Express is a steady growth company, estimate the
appropriate value of the rate of growth in dividends that would justify such as high PE ratio for American
Express?
5.8 PVGO
The next year’s earnings per share for nIce Cream, Incorporated is expected to be $1.20. The discount
rate applicable to the common stock is 10% per year. Calculate the PVGO for nIce Cream if its current
stock price is $14.
5.9 PVGO
Show that the present value of growth opportunities (PVGO) is given by:

(1 − π) e(i − k)
P V GO = ·
k k − (1 − π)i
where
π = payout ratio.
k = discount rate for the firm.
i = rate of return on the plowed back reinvestment.
e = earnings per share for the firm one period from now.
As a special case note that PVGO=0 if i = k.
5.10 Valuing a Growth Stock

The discount rate for the common stock of BULL Corporation is estimated to be 15% per year. The
BULL Corporation paid $0.79 per share in dividends this year, $0.70 last year, 0.62 the year before that,
and $0.55 the year before that. An analyst classifies BULL as a growth company. Determine the value of
the common stock of BULL.
5.11 Delayed Growth
Imagine that today is January 1, 1990. The earnings per share for Pixel Technologies in the last quarter
of 1989 were $0.75 but the company paid no dividends, and is not expected to pay any dividends till the
first quarter of 1995. The analysts expect that because of reinvestment the earnings per share will grow at
the rate of 2% per quarter till then. It is expected that in the first quarter of 1995 the company will adopt
Common Stocks 148
a policy of paying 60% of its earnings as dividends. Because of this change in policy the rate of growth in
earnings is expected to decline to 1.4% per quarter.
The long term return on the market is expected to be 12.5% per year while the risk-free rate is expected
to average 6.5% per year. Finally, the β of the common stock of Pixel is 1.4. Calculate the proper price of
the common stock of Pixel Technologies.
5.12 Information and Price Reaction
The return on S&P 500 is expected to be 13% per year with the standard deviation of 20%. The risk-free
rate is expected to be 6% per year. The common stock of Merit Company has a standard deviation of 25%,
and a 0.20 correlation with the S&P 500.
(a) What is the proper expected return from the common stock of Merit Company?
(b) Merit Company is a mature company with 100% dividend payout. The market price of the stock is
currently $20. What annual dividend does the market expect from Merit?
(c) The IRS announces a small change in the corporate tax laws, which would allow Merit to pay less in
taxes and therefore, increase its annual dividends by $0.07 per share. What effect will this announcement
have on the price of Merit’s stock?
Chapter 6
Fixed Income Securities
Bonds and preferred stocks are fixed income securities because they promise to pay fixed
sums of money to the security holder. By buying these securities investors lend money to
the issuer. For tax purposes, the income from the bonds is treated as interest while that
from the preferred stock is treated as a dividend. This feature makes preferred stocks very
attractive for corporate investors because 80% of the dividend income is tax-free for them.
The effective tax rate on dividend income for corporations with marginal tax rate of 34%,
therefore, is only 0.20 × 0.34 = 0.068 or 6.8%.
While both bonds and preferred stocks are fixed income securities they have many dif-
ferences. A major difference between bonds and preferred stocks is that bonds must pay
interest regularly without skipping a single payment. Skipping even one interest payment
would put the bond into default. Preferred stocks are not that restrictive. A company
may skip a dividend on a preferred stock. Most preferred stocks, however, have cumula-
tive dividends which means that the skipped dividend is accumulated and must be paid
later—usually before any dividends are paid to the common stockholders.
Another difference between bonds and preferred stock is that bonds have a finite life and
the principal amount (the face value) must be paid back at maturity while preferred stocks
usually do not have a stipulated time for retiring. This difference, however, should not be of
major consequence because there are active secondary markets for both bonds and preferred
stocks. Preferred stocks are traded in the stock markets along with common stocks while
the bonds are traded in separate bond markets.
6.1 Basic Terminology and Valuation

A bond buyer becomes entitled to regular (usually semiannual) payments called the coupon
payments. The amount of coupon payment is determined by the coupon rate.1 If a bond of
XYZ corporation has a coupon rate of 12% then the annual coupon amount would be 12%
1
The corresponding term in the preferred stock is dividend rate.
149
Fixed Income Securities 150
of the face value of the bond.2 The coupon payments are usually made in two semiannual
installments. For example, if the XYZ bond mentioned above has a face value of $1,000, it
will make coupon payments of $60 every six months. The face or par value of the bond is
promised to be paid at the maturity of the bond. Bonds usually have face values of $1,000
or $10,000.
The maturity date for a bond is set at the time the bond is issued. It ranges from 3 months
to 30 years. The information about the coupon rate, the face value, and the maturity date is
sufficient for determining the promised cashflows from the bond.3 For example, if the XYZ
bond mentioned above is maturing on December 31, 1996 and an investor buys the bond on
July 1, 1994, the investor is promised the following cashflows:
$60 $60 $60 $60 $1,060
7/1/94 12/31/94 6/30/95 12/31/95 6/30/96 12/31/96

Note that at the time of maturity (December 31, 1996), the investor is promised the face
value and the coupon amount for the last six month period. To decide whether the bond is
a good investment, the investor will have to use the principles developed in Chapter 4, i.e.,
compare the bond’s present value with its market price, or compare its rate of return with
the discount rate.
The rate of return offered by a bond is known as its yield. You may calculate the yield
to maturity for a bond by assuming that the bond will be held till maturity, or you may
calculate a holding period yield or holding period return by assuming that the bond
will be sold before its maturity. To do the holding period computation you will have to
estimate the price at which you can sell the bond at the end of the holding period.
Let us say that the market price of the bond described above is $956.70. To find the yield
to maturity, we solve for the semiannual yield to maturity r using the following equation:
956.70 = 60af r5 + 1000df r5 .
This equation can be solved for r using the trial-and-error and interpolation techniques. On
doing the calculations we get r = 0.0706, or 7.06% per half year which is compounded to
give the annual yield of (1 + 0.0706)2 − 1 = 0.1461 or 14.61%. Similar calculations can be
done for any desired holding period. To make an investment decision, this yield should be
compared with the discount rate. Alternatively, we could have used the discount rate to
calculate the present value and compared the present value with the price.
The price of the bond is what the market is willing to pay for the bond. Therefore, the
price of the bond is the market’s estimate of the bond’s value. The rate of return calculated
2
Some bonds do not pay fixed coupon amounts. The coupon payments on these bonds are variable and
are tied to the conditions of the economy in a predetermined manner. Usually, if the interest rates in the
economy are higher, these bonds pay a higher coupon amount and vice versa.
3
Similarly, the dividend rate, the face value, and the retirement date, if any, are sufficient for determining
the cashflows promised by a preferred stock.
Table 6.1: Bond prices and yields.
Market Price Market Terminology Yield to Maturity

< the face value Below par or at a discount > the coupon rate
= the face value At par = the coupon rate
> the face value Above par or at a premium < the coupon rate
using the price, therefore, is an estimate of the market’s expectations of the return from the
bond based on its risk; i.e., the market’s estimate of the discount rate. An investor buys or
sells a security because his estimate differs from that of the market.
The bond valuation equation shows an important relationship between the prices and
yields. The price—the number on the left hand side—has an inverse relationship with the
yield. As the yield goes up, bond price goes down and vice versa. Since all the interest rates
in the economy are connected (through the risk-free and the market rates), an announcement
of a reduction in the basic rates (federal funds rate, prime rate, etc.) causes bond prices
to go up. Movements in interest rates are often measured in basis points. A basis point is
1/100 of 1 percent. Therefore, if the yield on a bond changes from 7.25% to 7.27%, it moves
up 2 basis points.
There is a special terminology for bond prices in the market. The bond is said to be
selling at par if the market price of the bond is equal to its face value. It can be shown that
if a bond is selling at par then its yield to maturity is equal to the coupon rate (see exercise
6.2). For example, if the XYZ bond mentioned above were selling for $1,000, its semiannual
yield to maturity would be 6%. If the bond is selling at a price below its face value, it is
selling below par or at a discount. If a bond is selling at a price above its face value, it
is selling above par or at a premium. Realizing that the price and the yield to maturity
are inversely related we can summarize our information in Table 6.1
6.2 Bond Features

The valuation process presented above applies to all the securities once the cashflows—
promised or expected—are known. One must understand other features of the bonds—their
issuers, risks, tax implications etc.—before making a decision because these factors affect the
cashflows and risk of the bond. Here we discuss some important features and terminology
of the bonds. Most of this discussion is pertinent to the preferred stocks also.
A bond may have a call feature which gives the issuer a right to recall (buy back) the
bond during a specified period by paying the bondholders a pre-agreed price. This gives the
issuer an opportunity to reissue the debt at a lower interest rate if the rates in the market go
down. Since this feature does not favor the investors, a callable bond sells for a lower price
than a similar non-callable bond. Some bonds have a put feature which gives the bondholder
(the investor) a right to sell the bond to the issuer at a pre-specified price. The put feature
is useful for those bonds that do not have an active secondary market because it ensures
that the investor can sell the bond. Bonds with put features have a lower yield than those
without the put features.
Some bonds have a convertibility feature. This feature gives the investor a right to
exchange the bond for a pre-specified number of shares of the issuer. This pre-specified
number is known as the conversion ratio. Convertibility gives the investor an option to
take part in the profits of the company if the company does well. Convertible bonds sell
at a price higher than the corresponding non-convertible bonds. Let us take an example.
Suppose ABC has two bonds outstanding. The bonds differ in only one way: one bond
is convertible with a conversion ratio of 40 while the other one is non-convertible. The
convertible bond is at least as good as the non-convertible bond because it gives all the
rights that the non-convertible bond gives. Therefore, if the non-convertible bond is selling
for $980 then the convertible bond must also sell for at least $980. Now suppose that the
share price of ABC is $26. The convertible bond can be exchanged for shares with a total
value of 40 × $26 = $1,040. Therefore, the convertible bond is worth at least $1,040. We say
at least because there is time remaining before the maturity of the bond and in that time
the share price may go up further.
A bond may have a sinking fund provision to pay back the face value. The sinking
fund is usually a bank or an investment account in which the company deposits regular sums
which will grow to the total amount to be paid at the time of maturity. Bonds with sinking
funds are considered safer and sell at a price higher then the corresponding bonds without
the sinking fund.
An investor should also be aware of the security and the seniority level of the bond. Some
bonds are secured by a particular piece of property or asset. These are known as secured
or mortgage bonds and are considered safer and therefore carry a premium over unsecured
bonds. Most corporate bonds are unsecured and are called debentures. There may be a
seniority structure among bonds. In case of bankruptcy, junior bonds receive payments only
if something is left over after paying the senior bonds.
6.3 Risks of Fixed Income Securities

While fixed income securities promise payments to the investors, they are not free of risk.
Their risks, however, are substantially less than those of the common stocks. The three main
components of the risks of fixed income securities are the interest rate risk, marketability
risk, and default risk.
Interest rate risk refers to the risk that fluctuating interest rates pose to the bondholder.
Suppose you purchase a bond which is priced to yield 14% per year. A month later, the rates
in the market change so that bonds of similar risk are yielding 15%. This change in interest
rates is a loss to you because comparable bonds in the market are yielding higher than your
bond. If you decide to sell the bond you will get a lower price than what you paid. The
interest rate risk exists even if the bond makes all the payments as promised. Appendix 6A
provides a detailed discussion of this issue.
Marketability risk refers to the risk of not being able to sell the bond. Even if there
is a market maker (a specialist) for the bond, if the bond is traded infrequently the investor
will have to pay a higher commission to sell the bond. Bonds of relatively unknown issuers
have a higher marketability risk.
Default risk refers to the chance that the company may not keep its promise of making
the payment. Usually, companies default on their payments because of cashflow troubles.
One can ascertain the ability of a company to make the payments by examining its financial
statements. Historically, less than 1% of the bonds issued have defaulted. Junk bond is the
term for a bond that has a very high risk of default. These bonds, therefore, offer relatively
high yields.
Bonds are rated for their safety from default risk by Standard and Poor’s and Moody’s.
Standard and Poor’s rates bonds by symbols such as AAA, AA, A, BBB, BB, B, CCC, CC,
C, D. AAA is the highest rating and indicates that the bond has very low chances of default.
D is the lowest rating and suggests that the bond is already in default. Moody’s, similarly,
rates bonds as Aaa, Aa, A, Baa, Ba, B, Caa, Ca, or C.
6.4 Bond Issuers

Bonds are issued by several different agencies, e.g., the U.S. Treasury and government agen-
cies, municipalities, corporations, and financial institutions. Bonds backed by the U.S. gov-
ernment do not have any default or marketability risk. They do have the risk of interest rate
fluctuation. Municipal and corporate bonds suffer from all three sources of risk.
Municipal and government bonds are classified as revenue bonds or general obligation
bonds depending on the purpose for which they are issued and how they are backed. General
obligation bonds are backed by all the assets of the issuer while the revenue bonds are
backed only by the income from the particular project financed. Holders of revenue bonds
may not receive a payment if there are insufficient funds from the project. The New York
State Thruway was financed using revenue bonds.
The Treasury issues three kinds of bonds: short term bonds known as Treasury bills
or just T bills, medium term bonds known as Treasury notes, and long term bonds known
as Treasury bonds. Corporations also issue short term bonds known as commercial paper,
medium term bonds known as notes, and long term bonds. Short term bonds—Treasury bills
and commercial paper—are zero coupon bonds, i.e., they do not pay any coupon interest
before maturity. They are sold on a discount basis. For example, an investor may buy
a T-bill for $9,920 and on maturity receive $10,000. Treasury bills usually have maturity
periods of 3 months, 6 months, or 1 year.
The taxability of interest income depends on the investor and the issuer. Interest from
corporate bonds is taxed both at the state and the federal level. Interest from municipal
bonds is exempt from federal taxes. It is also exempt from state taxes if the investor resides in
the same state as the issuer. Interest from the U.S. Treasury securities is exempt from state
taxes. The tax effects should be incorporated into the calculations before deciding to invest
in bonds. Let us take the example of an investor living in New York State. This investor may
be deciding between the Treasury bonds and the bonds of a local municipality. Let us assume
that the bonds have identical risks and investor falls in the 28% federal income tax bracket.
Suppose the municipal bond is offering a yield of 7% and the Treasury bond is offering a
yield of 9.5%. It would be incorrect to compare the two bonds using their stated pre-tax
yields. The municipal bond will offer 7% on the after-tax basis because its income is exempt
from all taxes. The Treasury bond, on the other hand, will offer 0.095(1 − 0.28) = 6.84%.4
The municipal bond is the better choice because it offers a higher after-tax yield. For the
Treasury bond to be as good as the municipal bond, it has to offer a higher yield. This yield
is called the fully taxable equivalent yield of the bond. It can be calculated as:
tax-exempt yield
fully taxable equivalent yield = , (6.1)
1 − exempt tax rate
where exempt tax rate is the amount of taxes that the bond is exempt from. For example,
our municipal bond is exempt from 28% taxes and therefore its fully taxable equivalent yield
is 9.72%. In other words, a Treasury bond that is offering a pre-tax yield of 9.72% will offer
the same after-tax yield as the municipal bond.
6.5 Reading Bond Tables

Corporate and municipal bonds are issued in the primary market with the help of investment
bankers. Treasury securities (bills, notes, and bonds) are issued in weekly auctions and
investors can bid on them directly or through dealers. There are secondary markets for
most bonds. Information about the transactions in the secondary markets is available in the
bond tables in The Wall Street Journal. The Wall Street Journal reports information for the
corporate bonds on the New York Exchange, the municipal bonds, the Treasury bonds, notes,
and bills. Each table has its own unique features, so you have to be careful in interpreting
the numbers. It is very important to read and understand the footnotes associated with the
tables.
The following subsections present brief discussions of the numbers in the major bond
tables from The Wall Street Journal of Tuesday, August 8, 1995. The tables reflect the
trading for August 7, 1995. A comment that applies to all coupon bonds is that the listed
price is not the actual price at which the bond is traded. The actual price is the listed price
4
This is only an approximate calculation. To take the effect of taxes into account you should calculate
the yield to maturity using the after-tax cashflows. See exercises 6.4 and 6.7 for more realistic examples.
Table 6.2: New York Exchange Bonds.
Cur Net
Bonds Yld Vol Close Chg.
AMR 9s16 8.6 10 105 1/8 ...
AMR 6 1/824 cv 31 102 1/2 + 1/2
ATT 7 1/206 7.2 37 103 7/8 − 1/4
AlskAr 6 7/814 cv 40 84 1/2 ...

AlldC zr2000 ... 69 71 + 1/2
Chryslr 10.4s99 9.7 95 107 1/4 + 1/4
IBM 7 1/213 7.4 39 101 3/4 + 3/4
plus the accrued interest since the last coupon payment. For example, if the listed price is
$900, the annual coupon rate is 14% payable in two installments each year, the face value is
$1,000, and it has been 40 days since the last coupon payment then the actual transaction
price is $900 + (40/182) × $70 = $915.38. In this calculation we have assumed that the
coupon payment is made every 182 days (6 months).
6.5.1 Corporate Bonds

We begin by looking at the corporate bonds listed in the table entitled new york exchange
bonds. A few entries from this table are reproduced in Table 6.2.
The first column shows the name of the issuer, the annual coupon rate, and the year of
maturity. For example, the issuer of the first bond shown in Table 6.2 is AMR, the bond
has a coupon rate of 9% per year, and it matures in 2016.5 The Chrysler 10.4s99 bond has a
coupon rate of 10.4% per year and matures in 1999. Notice that there are two bonds for the
issuer AMR. In fact, if you look at the full tables, you will find that there are many issuers
with more than one bond.
The second column gives the current yield of the bond. The current yield is a measure
of current income from the bond. Consider an investor who buys the bond today, holds it for
one year, and then sells it. During the year the investor will receive the coupon payments.
The current yield measures this coupon income as a percentage of the current price of the
bond. For AlskAr 6 7/814, the current yield column shows cv. cv is a symbol for convertible
bond. The current yield for these bonds can be calculated easily. Peeking ahead, we can see
5
To the best of my knowledge, the s has no special significance. Some people say that it is put in there
to separate the maturity year from the coupon rate and others say that the s makes it easy to read the bond
name, for example AMR 9s16 would be read as “AMR nine’s sixteen.”
Table 6.3: Govt. Bonds and Notes
Maturity Ask
Rate Mo/Yr Bid Asked Chg. Yld.
4 5/8 Aug 95n 99:31 100:01 ... 2.68
9 1/2 Nov 95n 101:00 101:02 ... 5.34
11 1/2 Nov 95 101:17 101:21 ... 5.06
1
7 /4 May 04n 104:31 105:01 + 3 6.49
7 5/8 Feb 02–07 105.03 105.07 + 5 6.63
11 1/4 Feb 15 146:16 146:18 + 7 6.88
5
7 /8 Feb 25 109:07 109:09 + 5 6.89
that the listed price of AlskAr 6 7/814 is 84 1/2 or 84.5% of the face value. We know that the
bondholder will receive 6 7/8% or 6.875% of face value in coupon, therefore, the current yield
is 6.875/83 or 8.1%. For AMR 9s16, the current yield is calculated as 9/105.125 = 0.0856
or 8.6%. AlldC zr2000 is a zero coupon bond maturing in 2000. The current yield for this
bond is zero.
The third column gives the trading volume for the bond in terms of the number of bonds
traded. For example, 10 bonds of AMR 9s16 were traded. Often, there is no trading for
a bond during a session. The information for that bond is not printed in the bond tables.
Therefore, it is possible that you may not see every bond listed every day.
The last two columns give the price of the bond when the trading closed in the market and
the change in the price since the previous day. For example, the closing price of ATT 7 1/206
was 103 7/8 (103.875% of face value) which was down 1/4 from the previous day. The price of
Chryslr 10.4s99 went up by 1/4 and the price of IBM 7 1/213 went up by 3/4 since the previous
trading day.
Note that the face value is not mentioned anywhere in the table. The numbers—coupon
rate, current yield, price—are given as a percentage of the face value. The face value is not
very crucial because it is only a scaling factor.
6.5.2 Treasury Securities

The information for Treasury securities is grouped into three parts. Treasury bonds and
notes are presented in the first part. Table 6.3 shows the information about some Treasury
bonds and notes. The only difference between the two is the number of original years to
maturity. Many of the explanations given above for the corporate bonds hold true for the
Treasury bonds and notes too.
Table 6.4: Treasury Strips.
Bid
Mat. Type Bid Asked Chg. Yld.
Nov 98 ci 82:05 82:08 + 1 6.08
Nov 98 np 82:04 82:07 + 2 6.09
May 21 ci 15:31 16:03 + 1 7.22
May 21 bp 16:05 16:09 + 1 7.17
The first column of Table 6.3 gives the coupon rate and the next column specifies the
maturity date. The symbols following the date specify the special features of the bond, if
any. For example n means that it is a note. p means that it is a note and non-resident aliens
are exempt from withholding taxes on interest income. k means that non-resident aliens
are exempt from withholding taxes on interest income. If there is no symbol then it is an
ordinary bond. There are other symbols that the table in the Journal explains. The next
two columns give the last bid and the asked (ask) price quoted by the bond dealer. The
number after the colon in the prices represents 32nd s. For example, 100:02 stands for 100 2/32.
The next column gives the change in bid price in 32nd s since the previous trading day. The
last column is the approximate annualized yield to maturity based on the ask price.
The second part of the Treasury securities table contains information about Treasury
Strips. Treasury Strips are long term zero coupon bonds created by financial companies by
stripping individual coupons and face value and selling them in the market. For example,
Merrill Lynch may buy 1000 Treasury bonds maturing in 10 years and sell claims to individual
coupons and face values to separate investors. This creates long term zero coupon Treasury
bonds which are not otherwise available. Table 6.4 shows information for Treasury Strips.
The first column shows the maturity date in month and year. For example, the last
strip shown in Table 6.4 matures in May 2021. The next column shows the type of strip.
ci indicates that it is a stripped coupon interest, np indicates that it is a stripped principal
from a note, and bp indicates a stripped principal from a bond. The next two columns give
the bid and the asked prices in the same format as the Treasury bonds. The next column
shows the change in the bid price. The last column shows the annualized yield to maturity
based on Bid price.
The last part of the Treasury securities table contains information about Treasury bills.
Treasury bills are important for our analysis because they are the closest substitute for the
risk-free security. Information for Treasury bills in Table 6.5.
The first column in Table 6.5 shows the maturity date. The next column gives the days to
Table 6.5: Treasury Bills.
Days to Ask
Maturity Mat. Bid Asked Chg. Yld.
Aug 10 ’95 1 5.50 5.40 +0.11 5.48
Sep 14 ’95 36 5.37 5.33 −0.01 5.45
Nov 02 ’95 85 5.40 5.38 −0.01 5.54
Dec 07 ’95 120 5.38 5.36 ... 5.55
Feb 08 ’96 183 5.39 5.37 −0.01 5.60
Jul 25 ’96 351 5.35 5.33 −0.01 5.64
maturity.6 The next two columns give the annualized discounts for the T bill. The discount
here refers to the annualized discount on the price compared to the face value. For example,
if a $100 face value T bill that will mature in 3 months is selling for $98, its discount is 2%
for three months and the annualized discount is 8% because there are 4 quarters per year.
Quoting discounts rather than the price is a unique feature of Treasury bills. Keep in mind
that the higher the discount the lower the price. As the numbers in Table 6.5 show, the ask
discount is lower than the bid discount because the ask price is higher than the bid price.
Before any calculations can be done with a Treasury bill information, we have to convert
the discount to price. The annualized discount d is related to the price p as:

100 − p 360
d= × ,
100 n
where n is the days to maturity. This formula always uses 360 for the number of days in the
year, regardless of the actual number of days in the year. The formula can be simplified for
p as:
100nd
p = 100 − .
360
To use the formula, let us take the T-bill maturing on Sep 14, 1995. There are 36 days
to maturity for this T bill. Therefore the ask price can be calculated as:
100 × 36 × 0.0533
p = 100 − = 99.4670.
360
This means that it will cost $99.4670 to buy the Treasury bill which will pay $100 in 36
days. The 36-day rate of return, therefore can be calculated as:
100 − 99.4670
= 0.0053586 ' .0.0054
99.4670
6
The days to maturity may differ from the calendar days because of the procedure followed in settlement
of Treasury bills.
which can be converted into the annual rate—without compounding—as:

365
(0.0054) × = 0.0545 or 5.45% per year.
36
This is the number given in the last column of the table. As we saw, this calculation is based
on simple interest and ignores compounding. A more realistic calculation should consider
the effect of compounding. The compounded annual rate can be calculated as:
(1 + 0.0053586)365/36 − 1 = 0.0556797 or 5.57% per year.
Often, we are interested in finding out what stated annual rate, when compounded con-
tinuously, will give us the return offered by a T bill. If the rate is r per year compounded
continuously, then the present value of $100 to be received n days from now must equal the
price of the T bill, so that:
100
p = r(n/365)
e
from which we get the return as:
!
365 100
r= ln
n p
Applying this equation to the T bill in our example, we get

365 100
r= ln = 0.0541848,
36 99.4670
or 5.42% per year. The effective annual rate because of the continuous compounding effect
can be calculated as:
reff = e0.0541848 − 1 = 0.0556797
or 5.57% per year. Note that this is the same rate we got above by using compounding the
36-day rate. This shows that the effective annual rate is the same regardless of how we view
it.
6.6 Bond Portfolios

Many retirement and pension funds invest in portfolios made up of bonds because of their low
risk. These bond portfolios can be analyzed in the same manner as the portfolios of stocks.
However, the biggest component of risk of bond portfolios arises from the interest rate
sensitivity of bonds. Different bonds have different sensitivities to interest rate fluctuations
depending on their coupon rate and years to maturity. For example, low coupon bonds are
more sensitive to interest rate changes than high coupon bonds and long term bonds are
more sensitive than short term bonds. To understand the interest rate sensitivity, consider
three Treasury bonds.
• Bond 1 has a semiannual coupon rate of 6% and matures in 2.5 years.

• Bond 2 has a semiannual coupon rate of 6% and matures in 6 years.
• Bond 3 has a semiannual coupon rate of 12% and matures in 6 years.
At a particular moment, the semiannual yield to maturities on these bonds are equal
to 4%. Therefore, the bonds are priced at 108.9036, 118.7701, and 175.0805, respectively.
We would like to know the impact of change in interest rates on the prices of these bonds.
Suppose the interest rates go up so that the semiannual yield on these bonds become 5%. As
the rates go up, the prices come down but different bonds respond differently. The new bond
prices become 104.3294, 108.8632, and 162.0427. The relative price changes in the bonds
are 4.2%, 8.3%, and 7.4%, respectively. At the same coupon rate, the long term bond (bond
2) is more sensitive than the short term bond (bond 1). For the same time to maturity, the
low coupon bond (bond 2) is more sensitive than the high coupon bond (bond 3).
There is a pattern to sensitivity. Those bonds from whom more income is to be received
earlier (either because of high coupon or shorter maturity) are less sensitive to interest rates
than the bonds from whom less income is to be received earlier. The exposure of an investor’s
capital to interest rate risk can be controlled by combining bonds of various maturities and
coupon rates. The process of combining different bonds to form a portfolio so that it would
have as little interest rate risk as possible is known as immunization. See Appendix 6A
for more details.
6.7 Conclusion
This chapter described the characteristics of many different kind of bonds. We also saw some
sources of bond information and how to interpret the information properly.
Exercises
6.1 Bond Valuation
A bond issued by AT&T with face value of $1,000 was selling for $910 on July 1, 1991. The bond has
a coupon rate of 5 5/8 and it matures on December 31, 1995. Calculate the yield to maturity of the bond.
Would you buy this bond if the rate you expect from the bond based on its risk is 9.2% per year?
6.2 Yield of a Bond Selling at Par
On January 1, 1990, a 7% coupon bond maturing on December 31, 1995 was listed at 100. Calculate
the yield to maturity for the bond.
6.3 Convertible Bonds
ABC9s92 is a convertible bond with a conversion ratio of 50 and ABC8s91 is a debenture without the
convertibility feature. On January 1, 1991, ABC8s91 was priced at $920 and shares of ABC were selling
at $18. Investors believe that all bonds of ABC are equally risky. What must be the minimum price of
ABC9s92?
6.4 Pre-tax and After-tax Yields

It is commonly believed that the after-tax yield from a bond can be calculated as pre-tax yield × (1−
tax-rate). Let us see how good this formula is. Consider a bond with semiannual coupon rate of 5% and
maturing in 5 years. The bond is priced at $920. Calculate the pre-tax yield to maturity of this bond.
Consider an investor who pays taxes at the rate of 28% on both the interest income and the capital gains.
Calculate the after-tax yield to maturity for this investor by using the after-tax cashflows. Does your answer
agree with the intuition mentioned above?
6.5 Basic Bond Calculations
Imagine that today is January 1, 1990. The listed price for Ace9s06 is $985. The bond pays coupon
interests on June 30 and December 31, and will mature on December 31. The bond is callable in 1997 for
$1075.
(a) Is the bond selling above, at, or below par? What do you expect the bond’s yield to maturity to be in
relation to the coupon rate?
(b) Calculate the current yield for the bond. Explain the information conveyed by this number.
(c) Calculate the yield to maturity for the bond. Explain the meaning of this number.
(d) Calculate the yield to call for the bond, assuming that the bond will be called on December 31, 1997,
after the payment of coupon interest. Explain the meaning of this number.
6.6 Bond Pricing

Here is a conversation between two graduates of a reputed business school employed by a Wall Street
firm. The conversation was recorded on May 12, 1988. Read it carefully:
Steve: Hi Laura! How are things going?

Laura: (in a tired voice) Oh, I don’t know. I am stumped by this new assignment my boss gave me.
Steve: What’s the problem?
Laura: I have to figure the proper price of this new bond to be issued on July 1. All I know is that the
bond has a coupon rate of 9% and it will mature in 1999.
Steve: That’s a start. Do you know the discount rate for the bond?
Laura: (frustrated) That’s the problem. I did do some research but all I could learn was that the risk of
this bond would be equivalent to that of an existing bond... here it is... CRX8.25s1995.
Steve: Do you know the market price of this CRX bond?
Laura: Yes. I just looked it up. It is $952.50.
Steve: (with a smile) Then you have your problem solved.
Laura: (in disbelief) What do you mean? Tell me.
Steve: Can you calculate the yield to maturity for CRX?
Laura: Sure. I do remember how to do that.
Steve: Now, do you remember that the yield to maturity is the market’s estimate of the discount rate of a
bond?
Laura: Yes. But how will that help? I only know the discount rate for CRX, not for my bond.
Steve: Remember what Prof. Shukla told us about the discount rate? The discount rate is the rate of
return required based on the risk.
Laura: And if two bonds are equivalent in risk they will have equal discount rates! Steve you are a genius.
I owe you a lunch for this. Now be a dear and let me finish this job.
Steve: See you later, Laura. Good luck. (With a foreign accent) Don’t forget the time lines.
Laura: (smiles) Bye, Steve.
Following this conversation, calculate the price of the bond that Laura has to evaluate. Show all your
steps clearly.
6.7 Bond Yields Using Real Data
The bond of Dow Chemical is listed on the New York Exchange. The bond has a coupon rate of 8 5/8
and it matures on December 31, 2008. The bond splits the coupon payments into two parts—one is paid on
June 30 and the other on December 31 of the year. The closing price of the bond on February 9, 1988 was
$940. The bond can be purchased for the listed price plus the accrued interest, if any, since the last coupon
payment (this is true for all bonds).
(a) On a time line show the cashflows that would arise from this bond. Clearly identify them as inflows
or outflows. Assume that there are no transactions costs or taxes. Calculate the annualized yield to
maturity on the bond.
(b) Now assume that the purchaser would have to pay transaction costs of 3% of the price paid. Also,
the investor will pay taxes at the rate of 28% on the coupon income and the capital gains. Show the
cashflows and calculate the annualized yield to maturity.
(c) The previous two calculations assume that the promised coupon and principal will be paid and on time.
In real life there is always the chance that the bond may default on its payments. To keep things simple
but still give some flavor of real life let us assume that the investor expects that the firm will not default
during the coupon payments. The investor believes that there is an 80% chance that the principal (face
value) will be paid as promised but there is a 20% chance that the firm will go into default and the
investor will only get $850. The resulting capital loss would be tax-deductible. Show the cashflows now
with other assumptions as in part b and calculate the annualized yield to maturity.
6.8 Treasury Note

Review the following entry for a U. S. Treasury Note from The Wall Street Journal of May 4, 1988:
Maturity Ask
Rate Mo/Yr Bid Asked Chg. Yld.
13 7/8 Jun 92n 105:13 105:17 − 2 8.85
(a) Explain the entries for the note.

(b) Calculate the yield to maturity for the note.
6.9 Comparing Bond Investments

A 15-year, Treasury strip is selling for 26:02 while a 15-year, 12% coupon Treasury bond is selling
for 123:14. Which bond is offering a higher annual rate of return? Compare the risks of these two bond
investments.
6.10 Treasury Bill

Calculate the bid and ask prices of the Treasury bill shown below. Show the calculations to determine the
ask yield shown. What is its effective annual yield using ask price? What is the continuously compounded
rate for this Treasury bill using the ask price?
Days to Ask
Maturity Mat. Bid Asked Chg. Yld.
Sep 05 ’91 77 5.58 5.56 +0.01 5.71
6.11 Yield of a Bond Portfolio

Consider two bonds:
• Bond A matures in 3 years from now, has a semiannual coupon rate of 8% and is priced at $1,050.
• Bond B matures in 2 years from now, has a semiannual coupon rate of 6% and is priced at $940.
(a) Calculate the semiannual yields to maturity for the bonds.

(b) Consider an investor who buys two A bonds and 3 B bonds. What is his total dollar investment? What
fractions of his money are invested in A and B? What is the weighted average yield of his bond portfolio?
(c) Calculate the yield to maturity of his total bond investment.
6.12 Interest Rate Sensitivity
(a) A 5% coupon Treasury bond maturing in 8 years is priced at 978. What is its yield to maturity?
(b) What would be the price of the bond if the interest rates were to go up so that the bond’s yield to
maturity were to go up by 1%? What is the sensitivity of the bond price to interest rate?
Appendix 6A
Interest Rate Risk and Duration
6A.1 Introduction
The common and probably the biggest single influence on stock investments is the market.
If the market as a whole goes up, most stocks will go up with the market. If the market
goes down, the stocks will go down with it. For bonds, the common influencing factor is the
interest rate. Changes in interest rates affect the bond investments severely. Therefore, bond
investors, especially institutions such as pension and endowment funds, spend considerable
effort to minimize the effects of interest rate fluctuations on their investments. Rates of
return realized by bond investors are affected by changes in interest rates in two ways:
• The price of the bond moves inversely with interest rates. Therefore, if the interest
rates were to go up after an investor bought a bond, the bond price would decline
causing the realized rate of return to come down. Of course, if the rates were to come
down, the bond price would go up with the associated beneficial effect. Let us call this
component of interest rate’s effect on bond return the price effect. An investor who
holds the bond until maturity does not face the price effect because upon maturity, he
is promised the face amount by the issuer regardless of the prevailing interest rates.
• The coupon income has to be reinvested at the prevailing interest rates. If the rates
go up after an investor bought a bond, the coupon income will be reinvested at the
higher rates, causing the overall rate of return on the bond to go up. The opposite will
be true if the rates were to come down. Let us call this component of interest rate’s
effect on bond return the reinvestment effect.
The price and reinvestment effects work in opposite directions. An increase in interest
rate causes a detrimental price effect but beneficial reinvestment effect. In this note, we will
examine the combined effect of these two components of the interest rate changes on bond
returns.
164
Interest Rate Risk and Duration 165
Throughout this note, we will use an 18% coupon bond maturing in 6 years as an example.
The bond has a face value of $1,000 and is priced at $1,098.00. It pays coupon semiannually
and the next coupon is due in six months. The bond cashflows are shown below:
−1,098.00 $90 $90 $90 $1,090

...
0 1 2 11 12
It can be verified that the yield to maturity on the bond is 7.718% per six-month period
or 16.033% per year. The realized rate of return may not be 7.718% per six-month period
depending on the holding period and interest rates changes.
6A.2 Interest Rate Changes and Realized Return

Let us consider two investors: Larry and Sandy. Larry will buy the bond and hold it for five
years, i.e., 10 six-month periods. Sandy will buy the bond and hold it for three years, i.e., 6
six-month periods. Let us calculate realized rates of return for these investors. The investors
do not have any need for the coupon income so the coupon amounts will be reinvested at
the prevailing interest rates. To simplify calculations, let us assume that the coupons will
be reinvested in pure discount instruments whose maturity will coincide with the end of the
investor’s holding period. For example, the first coupon will be invested for 9 periods by
Larry and 5 periods by Sandy.
6A.2.1 Case 1: Interest Rates Remain Unchanged

Let us first consider the scenario where the interest rate environment does not change for
the next 5 years. Therefore, the rate of return on investments with the same level of risk as
the initial bond investment will remain 7.718% per six-month period.
Five years from now, when Larry has to liquidate his investment, he will receive some
money from his coupon reinvestments and some from the sale of the bond. The amount from
the coupon reinvestments will be:
90(1 + 0.07718)9 + 90(1 + 0.07718)8 + · · · + 90(1 + 0.07718)1 + 90 = $1,286.49
Note that in this calculation, the first coupon is invested for 9 six-month periods, second for
eight six-month periods, etc.
The price of the bond will be the present value of the remaining cashflows and will be
calculated as:
90 1,090
1
+ = $1,022.94
(1 + 0.07718) (1 + 0.07718)2
The total value, therefore, would be:
90(1 + 0.07718)9 + 90(1 + 0.07718)8 + · · · + 90(1 + 0.07718)1 + 90

90 1,090
+ 1
+
(1 + 0.07718) (1 + 0.07718)2
= $1,286.49 + $1,022.94 = $2,309.43
Considering that Larry invested $1,098.00 today and will receive $2,309.43 ten six-month
periods from today, his rate of return can be calculated as:
! 1
2,309.43 10
1,098.00(1 + r) 10
= 2,309.43 ⇒ r= − 1 = 0.07718 = 7.718%
1,098.00
This makes sense. When Larry made his investment, he was going to earn 7.718% per six-
month period from his investment, and over the 10 six-month periods that he was invested
in the bond, the rates didn’t change causing him to really earn 7.718% per period.
A similar calculation for Sandy shows that three years from now, when she decides to
liquidate, she will receive:
90(1 + 0.07718)5 + 90(1 + 0.07718)4 + · · · + 90(1 + 0.07718)1 + 90 +

90 90 1,090
1
+···+ 5
+
(1 + 0.07718) (1 + 0.07718) (1 + 0.07718)6
= $655.56 + $1,059.75 = $1,715.32
which results in a realized rate of return calculated as:

!1
1,715.32 6
1,098.00(1 + r)6 = 1,715.32 ⇒ r= − 1 = 0.07718 = 7.718%
1,098.00
For the same reason as for Larry, the realized rate of return on Sandy’s investment is
7.718% per six-month period.
6A.2.2 Case 2: Interest Rates Go Up

Now let us consider a case where the interest rates do not stay fixed over the life of the
investment. To keep things tractable, we will consider one shock to the interest rates, i.e.,
the interest rates change once after the initial investment and then remain at that level for
the rest of the life of the bond.
First let us consider the case of an interest rate increase. Suppose the rates go up by
0.01% per six-month period. So the coupon reinvestments will be made at 7.728% per six-
month period and the bond will be priced using the interest rate of 7.728% per six-month
period. The cashflow to Larry at time point 10 would be:
90(1 + 0.07728)9 + 90(1 + 0.07728)8 + · · · + 90(1 + 0.07728)1 + 90

90 1,090
+ 1
+
(1 + 0.07728) (1 + 0.07728)2
= $1,287.10 + $1,022.76 = $2,309.86
The component of cashflow from coupon reinvestments went up with the increased inter-
est rate but the bond price component went down. The net effect is an increased cashflow.
The rate of return to Larry is calculated as:
! 1
2,309.86 10
1,098.00(1 + r) 10
= 2,309.86 ⇒ r= − 1 = 0.0772 = 7.720%
1,098.00
Similar calculations for Sandy show that her cashflow would be:
90(1 + 0.07728)5 + 90(1 + 0.07728)4 + · · · + 90(1 + 0.07728)1 + 90 +

90 90 1,090
1
+···+ 5
+
(1 + 0.07728) (1 + 0.07728) (1 + 0.07728)6
= $655.73 + $1,059.27 = $1,715.00
For Sandy, just as for Larry, the coupon income went up and the bond price went down.
However, the combined effect is that unlike for Larry, the total cashflow to her went down.
Her rate of return would be:
!1
1,715.00 6
6
1,098.00(1 + r) = 1,715.00 ⇒ r= − 1 = 0.07715 = 7.715%
1,098.00
6A.2.3 Case 3: Interest Rates Go Down

Next let us consider the scenario where the interest rates are shocked downwards by 0.01%
from 7.718% per six-month period to 7.708% per six-month period. The cashflow and return
to Larry would be:
90(1 + 0.07708)9 + 90(1 + 0.07708)8 + · · · + 90(1 + 0.07708)1 + 90

90 1,090
+ +
(1 + 0.07708)1 (1 + 0.07708)2
= $1,285.88 + $1,023.12 = $2,309.00
! 1
2,309.00 10
1,098.00(1 + r) 10
= 2,309.00 ⇒ r= − 1 = 0.07716 = 7.716%
1,098.00
The cashflows and return to Sandy would be:
90(1 + 0.07708)5 + 90(1 + 0.07708)4 + · · · + 90(1 + 0.07708)1 + 90 +

90 90 1,090
1
+···+ 5
+
(1 + 0.07708) (1 + 0.07708) (1 + 0.07708)6
= $655.40 + $1,060.24 = $1,715.63
!1
1,715.63 6
6
1,098.00(1 + r) = 1,715.63 ⇒ r= − 1 = 0.07722 = 7.722%
1,098.00
6A.2.4 Summary
The following table summarizes the results of our calculations:
Larry: 10 period horizon Sandy: 6 period horizon

Interest Value of Bond Total Rate of Value of Bond Total Rate of
Rate Coupons Price Cashflow Return Coupons Price Cashflow Return
7.708% 1,285.88 1,023.12 2,309.00 7.716% 655.40 1,060.24 1,715.63 7.722%
7.718% 1,286.49 1,022.94 2,309.43 7.718% 655.56 1,059.75 1,715.32 7.718%
7.728% 1,287.10 1,022.76 2,309.86 7.720% 655.73 1,059.27 1,715.00 7.715%
The table shows that when the interest rate goes down to 7.708% per six-month period
the coupon value declines and the bond price goes up, and the opposite happens when the
interest rate goes up to 7.728% per six-month period. The total value and rate of return
for Larry and Sandy depend on what happens to interest rates. If the rates go up, Larry
is better off because the total cash flow to him increases but Sandy is worse off. If the
returns go down, Larry is worse off but Sandy is better off. The only difference between
these two investors is their investment horizon. Larry is investing for 10 six-month periods
while Sandy is investing for 6 six-month periods. It seems natural, therefore, to expect that
for an intermediate holding period, the value and returns wouldn’t be affected by the change
in interest rate, i.e., the investor will have the same cashflow and rate of return, regardless
of whether the interest rate goes up or down. This special holding period, called duration,
is 8 six-month periods for our bond.
6A.3 Duration
Bond portfolio managers are always looking for ways to minimize the sensitivity of their
portfolio to interest rate shocks. One may think that the risk associated with interest rate
changes can be minimized or even eliminated by holding the bond to maturity or for a very
short while. Both the answers are incorrect. The correct holding period lies somewhere
inbetween.
The duration is that holding period for which the terminal value and therefore realized
rate of return from a bond holding will not be affected by small changes in interest rates.1
The terminal value (TV ) from a bond for D holding periods can be written as:
X
n
TV = CF t (1 + k)(D−t)
t=1
where CF t is the cashflow from the bond at the end of period t and k is the appropriate
discount rate. We are trying to find a value of D such that TV is unaffected by changes in
the discount rate k. Using basic calculus, we find that:
Pn CF t
t=1 t (1+k)t
D = Pn CF t
t=1 (1+k)t
The numerator in the expression for duration (D) is the sum of discounted values of
the cashflows weighted by the times of the cashflows. The denominator is the sum of the
discounted values of the cashflows, which is the price of the bond itself. For our bond, the
duration is:
P CF t P CF t
t (1+k) t t (1+k) t
D = P CF t =
(1+k)t
Bond Price
1 × (1+0.07718)
90
+ 2 × (1+0.07718)
90
2 + · · · + 12 × 1,090
(1+0.07718)12
= = 8.00
1,098.00
6A.3.1 Sensitivity of Duration

The duration is sensitive to interest rate and time changes. Let us consider the example
of our bond: Suppose the bond’s yield to maturity were 7.5% per six-month period, rather
than 7.718% per six-month period. Then the bond price would be $1,116.03 and its duration
would be 7.88 years. This means that unlike the bond maturity, the bond’s duration is not
fixed. It changes with the interest rate. Therefore, the bond duration needs to be evaluated
constantly and bond holding period needs to be adjusted in response to interest rate changes.
Suppose today is Jan 1, 1995. With maturity and duration of 12 and 8 six-month periods,
respectively, our bond matures on Dec 31, 2000, and its duration ends on Dec 31, 1998,
respectively. Therefore, based on today’s conditions, if the bond is held until Dec 31, 1998,
small changes in interest rates will not affect the realized rate of return. Now consider our
bond six months later. Suppose the interest rates have not changed, so the yield to maturity
is still 7.718%. The bond price would be $1,092.75 and its duration would be 7.58 periods.
Therefore, the passage of one six-month period reduced the bond’s duration by only 0.42
1
It is impossible to find a holding period for which the terminal value will not be affected by big changes.
six-month periods. The bond’s maturity would still be Dec 31, 2000 but its duration ends
in March 1999. In general, as time expires, bond’s duration changes such that the end of
duration becomes closer to the end of bond’s life. Therefore, the bond duration and holding
period strategy needs to be adjusted with passage of time as well.
6A.3.2 Duration for a Zero Coupon Bond

A zero coupon bond makes just one cashflow upon maturity. Therefore, its duration coincides
with the end of the life of the bond.
P CF t CF T
t (1+k) t T (1+k) T
D= P CF t = CF T =T
(1+k)t (1+k)T
6A.4 Applications of Duration

Consider a pension fund manager who knows that on December 31, 1999 he will have to
pay out $3 million in pension checks. Therefore, he would like to invest in relatively safe
securities, maybe in bonds issued by the Treasury, in such a way that the proceeds from
the bond portfolio on December 31, 1999 should be exactly $3 million. Suppose today is
January 1, 1995. The bond manager is looking at a five year investment horizon.
One may think that a strategy would be to buy five year notes and bonds, i.e., bonds
maturing on December 31, 1999. That however will not immunize the bond portfolio from the
effects of interest rate changes. The face value is guaranteed but the coupon reinvestments
are not.
As an alternative, one may, therefore, suggest zero coupon bonds. That would be ideal
but zero coupon bonds are not always available for desired maturity and amounts.
The most practical solution for the manager is to invest in bonds with duration of 5
years. The problem here is that there may not be enough bonds of manager’s choice with 5
year duration either. However, a property of duration helps the manager. The duration of
a portfolio of bonds is the weighted average of durations of the bonds, i.e.,:
X
Dp = xi Di
where xi is the weight of bond i in the portfolio and Di is the duration of bond i. For example,
suppose the manager has two bonds available, one with the duration of 3 years and another
one with the duration of 8 years. The manager can create a portfolio with the duration of 5
years by investing 60% in bond 1 and 40% in bond 2, because 0.6 × 3 + 0.4 × 8 = 5.
Of course, the manager will need to continuously monitor the bond portfolio’s duration to
correct for the passage of time and changes in interest rates. Most bond portfolios consist of
dozens or even hundreds of bonds making this problem much more complicated. Therefore,
bond portfolio managers utilize computers for this application.
Chapter 7
Options
Options have existed for centuries but they have become a very popular part of investments
only since 1973 due to a significant progress in their systematic trading. Options allow
investors to trade risk. Therefore, they allow some investors to hedge and others to bear the
risk inherent in securities. Options are created when two investors enter a contract involving
a security. Through the contract, the risk of the security is transferred from one investor to
the other. In this chapter, we will study the characteristics and uses of stock options,1 and
techniques for determining their values.
7.1 Terminology
An option contract gives the option buyer a right which may be exercised at his will and
the option seller will have to comply. The seller is said to have written the option and is
known as the option writer. The buyer holds the option after purchasing it and is known
as the option holder. Sometimes, the terminology of long and short is used with options
to indicate the transactions of buying and selling. The option buyer goes long on the option
and the option writer goes short. The option writer charges a price for the option which is
known as the option price or the option premium.
There are two kind of options: calls and puts. A call option involves a right to buy and
a put option involves a right to sell. Options can be of American or European type.2 An
American type call option gives the option buyer a right to buy a specified number of shares
of a certain stock at a specified price by (on or before) a specified date. An American type
put option gives the buyer a right to sell a specified number of shares of a certain stock
1
The term stock option should not be confused with the stock options given by companies to their
employees as part of wages. While those stock options are similar to the stock options discussed in this
chapter, they are not publicly traded.
2
The names American and European do not mean that options traded in America are American type
and options traded in Europe are European type.
171
Options 172
at a specified price by (on or before) a specified date. European type call and put options
involve the rights to buy or sell only on the maturity date, not before the maturity date.
An option is described completely by the following characteristics:
• The underlying stock and the number of shares: Options are traded primarily on active
stocks such as IBM, AT&T, Kodak, and Digital Equipment. An option is written on
100 shares (a round lot) of stock.
• The specified date by or on which the option may be exercised: The options are
usually written for maturities ranging from 3 months to 9 months.3 They mature on
the Saturday following the third Friday in the month of maturity. The last trading
day for an option, therefore, is the third Friday of the month.
• The specified price at which the stock may be bought or sold: This price is known as
the strike price or the exercise price.
• The type of option: An option can either be a call or a put. Many more call options
are traded in the market than put options. Unless specified otherwise, options are of
the American type.
For example, IBM Jan 80 call is the full description of an option. It is an American type
call option on the common stock of IBM. The option may be exercised anytime up to the
Saturday following the third Friday in January to purchase 100 shares of IBM for $80 each.
A special feature of options is that the option holder is not obligated to exercise the
option. The option holder will exercise the option only if exercising it will benefit him. Since
a call option allows the option holder to buy shares at the strike price, he will exercise it
only if the stock price is more than the strike price. For example, if you own IBM Jan 80
call option and the market price of IBM stock is 85, you may want to exercise the option to
buy the shares for $80. On the other hand, if the stock price is $75, you will not exercise the
option because by exercising the option you will be paying $80 for shares that are available in
the market for only $75. Because of this contingent relationship between the exercise of the
option and the price of the stock, options are known as contingent claim securities. Many
other securities are either directly or indirectly contingent claim. For example, convertible
bonds are contingent claim because the bondholder will convert the bond to shares only if
the share price is high enough. With a good imagination one may view many other financial
contracts as options also. For example, an automobile collision insurance can be treated as
an option which gives the insured a right to recover the losses from the insurer if the car is
wrecked.
Option contracts are adjusted for stock splits and stock dividends. For example, if the
IBM stock has a 2-for-1 split then the option mentioned above will be adjusted to allow the
option holder to buy 100 × 2 = 200 new shares at the strike price of $80/2 = $40 each.
3
Longer term options have also become available since 1989.
Options 173
Options, however, are not protected from the change in price due to cash dividends. For
example, if the price of IBM stock is $81 and you own IBM Jan 80 call, your option is
valuable because it can be exercised for a net profit of $1. If IBM pays a dividend of $2.00,
the stock price will drop by about the value of the dividend, which may render your option
worthless.
Options are transferable, i.e., an option holder may sell the option to someone else.
Options are bought and sold in the secondary markets. The biggest options market is the
Chicago Board Options Exchange (CBOE). American Stock Exchange, Philadelphia Stock
Exchange, and New York Stock Exchange are the other major markets for options. Trading
of options is managed by the exchanges and an organization called the Options Clearing
Corporation (OCC). The OCC decides which options may be created and traded. It also
acts as an intermediary and guarantor for option buyers and sellers. Suppose investor A
wants to sell an option contract and investor B wants to buy it. Once the investors have
identified each other, they contact the OCC. The OCC enters into opposite contracts with
the investors to complete the trade. It buys the option from A and sells an identical option
to B. Since, the option buyers and sellers actually trade with the OCC, the OCC takes the
responsibility of meeting the obligation implied in the option. When an option is exercised
by an option holder, the OCC makes the required payment to the option holder and in turn
asks the option writer to make the payment to the OCC.4 The option contracts are settled
in cash, rather than in terms of stock. For example, if you own an IBM Oct 90 call option
and you choose to exercise it today when IBM’s stock price is 108 3/4, rather than you having
to buy the stock for $90 and then selling it for 108 3/4 to realize a payoff of $18.75, the option
writer pays you $18.75 in cash. This is also convenient for the option writer because if there
were no cash settlement, the option writer may have to buy the share in the market and the
hand it over to you. Cash settlement avoids the transaction costs of buying and selling the
shares.
At any time there may be several different options for the common stock of a company.
These options differ from each other by the strike price or maturity. The strike prices are set
at intervals of $2.50, $5, or $10. For example, there may be call options on IBM maturing
in various months with several different strike prices. Each combination of strike price and
maturity month is a different option.
The listed options quotations in The Wall Street Journal lists the prices of options.
Even though the option contracts are issued for 100 shares, the listed prices are on a per
share basis. We will also follow this system, i.e., assume that the options are on one share
rather than 100. Table 7.1 shows the extract from The Wall Street Journal of August 8,
1995 for the options of IBM. These prices reflect the trading completed on August 7, 1995.
The first column in Table 7.1 shows the name of the underlying stock and its closing
4
The OCC does not necessarily seek out the writer of the original option to settle the contract. It
essentially uses a random selection method to pick one of the many investors who are short on the particular
option.
Options 174
Table 7.1: Listed Options Quotations.
– Call – – Put –
Option/Strike Exp. Vol. Last Vol. Last
IBM 70 Oct 54 39 3/4 54 1/16
3
108 4/ 80 Oct 54 30 1/8 74 1/4
108 3/4 80 Jan 37 31 ... ...

3
108 4/ 85 Oct 186 1
25 /2 194 3/8
108 3/4 85 Jan ... ... 79 1

3
108 /4 90 Aug 2605 18 3/4 320 1 /16
3
108 4/ 90 Sep 2790 19 3/4 153 1/4
108 3/4 90 Oct 108 20 1/2 94 9/16

3
108 4/ 90 Jan 7 22 1/8 35 1 3/8
108 3/4 95 Aug 203 13 3/4 50 1/16
3
108 /4 95 Oct 24 16 1/8 36 1
3
108 4/ 100 Aug 1028 9 949 1/4
108 3/4 100 Sep 1106 10 1/2 86 1 1/8
3
108 /4 100 Oct 230 11 5/8 252 1 7/8
108 3/4 100 Jan 533 14 1/4 444 3 1/2
3
108 /4 105 Aug 571 4 1/2 1097 7/8
3
108 4/ 105 Sep 104 6 1/2 208 2 3/8
108 3/4 105 Oct 220 8 1/8 73 3 1/2
3
108 /4 110 Aug 2187 1 9/16 645 2 3/4
3
108 4/ 110 Sep 844 3 3/4 26 4 1/2
108 3/4 110 Oct 318 5 1/4 50 5 3/8
3
108 4/ 110 Jan 619 8 1/8 11 7 1/2
108 3/4 115 Aug 310 7/16 80 6 5/8
3
108 /4 115 Sep 173 1 7/8 ... ...
3
108 4/ 115 Oct 142 3 3/8 10 8 5/8
108 3/4 115 Jan 84 6 1/8 ... ...
3
108 4/ 120 Aug 62 1/16 ... ...
108 3/4 120 Sep 153 1 ... ...
3
108 /4 120 Oct 65 15
1 /16 ... ...
3
108 4/ 120 Jan 111 4 1/2 ... ...
Options 175
stock price. For example, IBM stock closed at 108 3/4. The second column shows the strike
price. The third column shows the maturity month. The next four columns show the trading
volumes and closing prices for the call and put options corresponding to the combination of
strike price and maturity. For example, the IBM Jan 90 call option closed at 22 1/8 per share.
Since the option contract is written on a round lot of 100 shares, the cost of an option on
100 shares is $2,212.50. The IBM Oct 115 call is priced at 3 3/8 and the IBM Aug 95 put
is priced at 1/16. 220 contracts of IBM Oct 105 call were traded during the day while 645
contracts of IBM Aug 110 put were traded.
7.2 Option as Risk Transferring Contracts

As mentioned above, options allow an investor to transfer risk to another investor. Let us
understand this using examples. Suppose today is August 7, 1995 and you know that you
will buy 100 shares of IBM in the middle of October. You can see from Table 7.1 that the
price of IBM is 108 3/4. You believe that IBM is a good deal at this price. However, you would
not want to pay more than $110 for the stock in October. To hedge against the risk of the
price going above $110, you may buy an IBM Oct 110 call option. It will cost you 5 1/4 per
share, but that is the price you are paying for the insurance. Once you have the option, you
can buy the shares for $110, regardless of how high the market price becomes. Therefore, if
the price in October is $120, you can use your option to buy the stock for $110. However, if
the price in June is $100, you will not exercise your option because you can buy the stock
for less in the market. You buy this option because you expect the price to go above $110.
The person who sells you the call option believes that the probability of the price of IBM
going above $110 by October is very small, and he is willing to take that chance.
Now let us take an example involving a put option. Suppose today is August 7, 1995
and you own 100 shares of IBM. You want to hold these shares because you believe that
IBM stock is a good long term investment. However, you want to insure against the loss if
the stock price goes below $100 in the short run. You may buy IBM Oct 100 put option for
$1 7/8 per share. Purchasing this option gives you a right to sell your shares at $100 anytime
between now and the option maturity date in October. If the price of IBM stock goes below
$100, say to $90, you can recover your losses by exercising your put and selling the shares at
$100. On the other hand if the price does not go below $100, you will let your option expire.
The option premium is like an insurance premium. If there is no casualty, the premium goes
unused. However, if there is a casualty, the option is used to recover some of the losses. The
strategy described here is known as a protective put.
7.3 Option vs. Stock

Since options involve stocks as the underlying asset, they allow for an indirect investment in
stocks. To compare an investment in options with an investment in stocks, let us consider
Options 176
Table 7.2: Payoffs and Returns on Stock and Option Investments.

Capital=$10,875 Option exercise price=$120
Share price=$108.75 Option price=$4.50
Number of shares purchased=100 Number of options purchased=2,416.67
Payoff ($) Profit ($) Return (%)

Stock
Price ($) Stock Option Stock Option Stock Option
90 9,000 0.00 −1,875.00 −10,875.00 −17.24 −100.00

95 9,500 0.00 −1,375.00 −10,875.00 −12.64 −100.00
100 10,000 0.00 −875.00 −10,875.00 −8.05 −100.00
105 10,500 0.00 −375.00 −10,875.00 −3.45 −100.00
110 11,000 0.00 125.00 −10,875.00 1.15 −100.00
115 11,500 0.00 625.00 −10,875.00 5.75 −100.00
120 12,000 0.00 1,125.00 −10,875.00 10.34 −100.00
125 12,500 12,083.33 1,625.00 1,208.33 14.94 11.11
130 13,000 24,166.67 2,125.00 13,291.67 19.54 122.22
135 13,500 36,250.00 2,625.00 25,375.00 24.14 233.33
140 14,000 48,333.33 3,125.00 37,458.33 28.74 344.44
an example using the data from Table 7.1. On August 7, 1995, John and Mary both had
$10,875 to invest. John bought shares of IBM using his money. Since the share price was
$108.75, he bought 100 shares. Mary, instead, bought IBM Jan 120 call options. Since an
option on one share was priced at $4 1/2, she bought options on about 2,416.67 shares.5
Let us see how their investments fare on September 10, 1995. Suppose the price of IBM
stock on that day is $110. John sells his shares to receive a payoff of $110 per share, and
a profit of $110 − $108.75 = $1.25 per share. This results in a total profit of $125 and a
return of 1.15%. Mary’s call options give her a right to buy the shares for $120. Since the
market price of the shares is $110, she will not exercise her options. The value of her options,
therefore, is zero. She has lost all her money and has earned a return of −100%. We can
do similar calculations assuming other values for the stock price. Suppose the stock price is
$130. John receives a profit of $130 − $108.75 = $21.25 per share, or a total profit of $2,125.
Mary’s call options are valuable now. She exercises them to buy shares of IBM for $120 and
sells them in the market for $130. This gives her a payoff of $10 per share. Her total payoff
is $10 × 2,416.67 = $24,166.67. Her profit, therefore, is $24,166.67 − $10,875 = $13,291.67.
Table 7.2 shows the results from several such calculations.
Figures 7.1 and 7.2 plot the payoffs and returns against the stock price. As you can see,
5
I am using fractional number of option contracts only to make the investments in stock and option equal
to each other.
Options 177
Figure 7.1: Options versus stocks: Comparison of payoffs.
50 ..
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30 ...
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90 100 110 120 130 140
Stock Price
Figure 7.2: Options versus stocks: Comparison of returns.
400
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300 Option → . .. ....
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Return (%)
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90 100 110 120 130 140
Stock Price
Options 178
the payoff from the options is zero (a −100% return) if the stock price is less than or equal to
the exercise price. If the stock price is above the exercise price, the options provide positive
payoffs. Once the stock price is above the exercise price, the profit from an option increases
by $1 for every $1 that the stock price goes up. As a result, the return on the options goes
up much faster than the return on the stock because the same profit is realized on a much
lower investment with the options than with the stock.
This example shows that options are a very risky but potentially very rewarding invest-
ments. The risk and high potential reward from options arises from their ability to magnify
the gain or loss on stocks. This characteristic is just like that of a leveraged investment.
Therefore, options are also known as leveraged securities. In our example, using the
same amount of money ($10,875), John controlled 100 shares of IBM while Mary controlled
2,416.67 shares. To control 2,416.67 shares, John would have had to take out a loan, i.e.,
leverage his investment. Mary’s leverage was automatically built into the options.
7.4 Option Strategies

As we saw in section 7.3, changes in the price of an option are directly associated with the
changes in the price of the underlying stock. Therefore, options can be used to capture the
movements in the stock price. For example, if an investor believes that the price of IBM
shares will go above $110 by September, he should buy IBM Sep 110 call. An investor who
believes that the price of IBM shares will not go above $110 should sell the option. Similarly,
if an investor believes that the price of IBM will go below $90 by September, he should buy
IBM Sep 90 put. Another investor who believes that the price will not go below $90 should
sell the option.
Selling a call should not be confused with buying a put. While both these positions
indicate that the investor is not too enthusiastic about the stock, the extent of the lack of
enthusiasm is different. An investor should sell a call if he believes that the stock price will
not go above the exercise price. This means that the investor is not bullish on the stock.
The investor does not necessarily have to believe that the price will go down. If the investor
believes that the price will go down, i.e., he is bearish on the stock, he should buy a put
option. Similar relationship exists between a long position on a call and a short position on
a put. The following table shows these relationships:
Long Short
Call Bullish Not Bullish
Put Bearish Not Bearish
Buying and selling options by themselves is a very risky activity. An investor buying a
call option is speculating on the movement of the stock price. As we saw in the previous
section, this can result in significantly higher profits than investing in the stock itself, but
Options 179
it can also result in a loss of all the investment capital. Options are often combined with
the shares of the underlying stock, or other options for specific strategic reasons. Protective
put, described in section 7.2, is one such strategy.
In a strategy called covered call writing, an investor writes a call option on the stock he
owns. Writing the option generates cash for the option writer because the option buyer pays
him the premium. If the stock price goes up, the option buyer will exercise the option, and
the option writer will have to sell the shares at the exercise price. However, if the market
price of shares does not go above the exercise price, the call option will not be exercised and
the option writer will keep the premium.
7.5 Option Valuation

Like common stocks and bonds, the value of an option depends on the cashflows from the
option. Suppose you own the IBM Sep 105 call option. If you were to exercise this option
today (August 7, 1995) you will force the option writer to sell the shares of IBM to you
for $105 each. It will, therefore, cost you $105, but the shares that you receive can be
sold in the market for $108 3/4 or $108.75. This transaction would give you a payoff of
$108.75 − $105 = $3.75 per share. The option, therefore, is worth at least $3.75 to you.
If someone wants to buy the option from you, you should charge at least $3.75. At least
because there is one more month before the option matures and during this time the stock
price may go up, increasing the payoff from the option. The option price, therefore, should
be at least $3.75. The extra amount you charge would depend on your expectation about
the stock price of IBM going up. From Table 7.1, we see that the market price of this option
is $6.50. The $6.50 price can be divided into two parts: $3.75, the amount one would make
by exercising the option today, and $2.75, the premium for the probability that the stock
price may go up in the one month before the option expires. The first part is known as the
intrinsic value of the call option and the second part is known as the time value.
Let us consider IBM Oct 110 call option. If you exercise it now, you will face a loss of
$1.25. Since the exercise is optional, you will not exercise the option. The intrinsic value
of this option, therefore, is zero today. This option has only time value because of the
possibility that the stock price may go up before the option expires. The time value of this
option makes up the entire price of $5.25. The intrinsic value of an option, therefore, is
the payoff from exercising the option if it is prudent to exercise the option; otherwise the
intrinsic value of the option is zero.
Let us use Ps to denote the stock price and E to denote the exercise price. The intrinsic
value of the call option is given by Ps − E, if the option should be exercised. Otherwise,
the intrinsic value is zero. The option will not be exercised if the payoff from exercising the
option will be negative. This condition will be true if the stock price is less than the exercise
price, making Ps − E negative. Therefore, the intrinsic value is Ps − E, if Ps − E is positive,
and it is zero if Ps − E is negative. This leads to the following relationship for the price of
Options 180
a call option, Pc :
Price of a call option = Intrinsic Value + Time value,

Pc = Max[0, Ps − E] + Time value (7.1)
Max[0, Ps − E] denotes maximum of the two values: 0 and Ps − E. Note that by taking the
maximum of 0 and Ps − E, we pick 0 if Ps − E is negative.
Similar arguments can be made for a put option. The intrinsic value of a put option
results from the potential of buying a share in the market at a low price and then selling it
at a higher price by exercising the option. The corresponding equation for the price of a put
option, Pp , is:
Pp = Max[0, E − Ps ] + Time value. (7.2)
Options that would result in a positive payoff if exercised, and therefore have positive
intrinsic values, are said to be in the money. All call options with Ps > E are in the money
while all put options with Ps < E are in the money. Those options for which the payoff would
be exactly zero if exercised, are known as on the money. All on the money options have
Ps = E. Options that would result in a negative payoff if exercised (and therefore would not
be exercised), are known as out of the money options. Call options with Ps < E and put
options with Ps > E are out of the money. An option which would provide a large positive
payoff, if exercised, is known as deep in the money. Similarly, an option that would result
in a large negative payoff, if exercised, is known as deep out of the money. The in, on, and
out of the money options can be identified using the following block structure:
Call Put
Ps > E In the money Out of the money
Ps = E On the money On the money
Ps < E Out of the money In the money
The relationships between the market price of an option and the characteristics of the
option and the underlying stock are described below:
• An increase in the stock price has a positive effect on the value of the call option.6 If
the price of IBM were $115 rather than $108.75, all call options would be worth more
because of the increased intrinsic value. The intrinsic value of the IBM Sep 110 call,
for example, would be $115 − $110 = $5. The effect of an increase in the stock price
on put options is opposite to that of the call option. An increase in the stock price
makes a put option less valuable.
6
The relationship is not necessarily one-for-one because of the time value. The movement is closer to
one-for-one for in the money options.
Options 181
• An increase in the exercise price has a negative impact on the call option and a positive
impact on the put option. This effect can be understood by finding the intrinsic values
of options for different strike prices while keeping other things the same. The option
quotations in Table 7.1 also verifies this effect. The prices of IBM call options maturing
in January with exercise prices of 80, 90, 100, 110, 115, and 120 are 31, 22 1/8, 14 1/4,
8 1/8, 6 1/8, and 4 1/2, respectively, and the prices of IBM put options maturing in January
with exercise prices of 90, 100, and 110 are 1 3/8, 3 1/2, and 7 1/2, respectively. We see
that the prices of call options decrease and those of the put options increase as the
exercise prices increases.
• An increase in the time to maturity has a positive impact on the values of both the call
and the put options. The more the time to maturity the higher the chances that the
stock price will go up (for call option) or go down (for put option) and make the options
more valuable. Again, the option quotations in Table 7.1 confirm this behavior. For
the same strike price, the January options are more valuable than the October options
which are more valuable than the September options.
• The volatility of the stock price movement has a positive effect on the values of the call
and put options. The reason is that the higher the volatility the higher the chances
that the price will go up or down and cross the exercise price. Therefore, other things
being the same, a higher volatility stock has a higher value.
• Cash dividends have a negative impact on the value of a call option and a positive
effect on the value of a put option. The price of a dividend paying stock drops by
about the dividend amount on the ex-dividend day. The drop in stock price makes the
call option worth less and put option worth more as we saw above.
• One factor that does not seem obvious but has an effect on values of options is the
risk-free rate. The risk-free rate enters the picture to ensure that the rate of return one
earns on an option investment should be in line with other investments. The risk-free
rate has a positive effect on the value of a call option and a negative effect on the value
of a put option.
We can summarize these relationships as follows:
Pc = f (Ps [+], E[−], T [+], σ[+], d[−], rf [+]) (7.3)

Pp = f (Ps [−], E[+], T [+], σ[+], d[+], rf [−]) (7.4)
where Pc = the value of a call option

Pp = the value of a put option,
Ps = current stock price,
E = the exercise price,
T = time to maturity,
Options 182
σ = standard deviation (volatility) of stock returns,

d = dividend yield of the stock,
rf = the risk-free rate,
[+] = the relationship is positive,
[−] = the relationship is negative.
7.5.1 American Options vs. European Options

American options can be exercised before their maturity while European options cannot.
This flexibility of American options makes them at least as valuable as the correspond-
ing European options. The difference in the value of the American and European options
diminishes as the time to maturity decreases.
Even though an American option may be exercised before maturity, under some condi-
tions it may be optimal not to exercise an American option before maturity. It may be more
beneficial to sell the option to someone else rather than exercise. The decision to exercise
the option depends on the comparison of the market price of the option and the payoff from
the option if exercised.
Let us examine an American call option. If the option is exercised, the payoff will be the
intrinsic value, Ps − E (assuming that Ps > E so that it makes sense to exercise the option).
The market value of the option, however, is Ps − E + time value. The option is worth more
than its payoff if exercised. Therefore, the option holder can sell it in the market to get a
higher value than the payoff from exercising it. Let us verify this using the IBM Sep 105
call option. If the option holder exercises the option, he would force the option writer to sell
shares of IBM for $105 each. These shares have a market value of $108.75. Exercising the
option will result in a payoff of $3.75 to the option holder. On the other hand, the option
holder will receive $6.50 if he sells the option in the market. Therefore, the option holder
will sell the option rather than exercise it. The option price is higher than its intrinsic value
because of the time value. As the option approaches expiration, its time value declines and
ultimately becomes zero on the expiration date. On the expiration date, therefore, the option
would be exercised. This analysis, however, is valid only for an option written on a stock
that will not pay any dividends before the maturity. If the stock has an ex-dividend day
before maturity, the stock price will drop on the ex-dividend day making the option worth
less, maybe even worthless. Therefore, it may be prudent to exercise the option before the
stock goes ex-dividend. In summary, an American type call option on a stock that would
not pay any dividends before the maturity of the option will not be exercised before the day
of the maturity and therefore may be treated as a European option.
The case of American put options is different. It may be rational to exercised them early,
regardless of whether the underlying stock will go ex-dividend or not. Consider the extreme
case when the price of the underlying stock becomes zero. The put option, at this point will
have no time value because the stock price can only go up which will hurt the value of the
Options 183
put option. Furthermore, any movement in the stock price will also hurt the intrinsic value
of the put. Therefore, the holder of the put option will be better off exercising the option.
In general, this result will hold if the stock price falls to a low enough level.
7.5.2 Payoff Diagrams

As we saw above, the value of an option is a function of the cashflows or the payoffs from the
options. The payoff, however, depends on the stock price. A payoff diagram describes the
cashflow as a function of the stock price. We have already seen examples of payoff diagrams
in Figure 7.1. The payoff diagrams are quite useful in analysis and valuation. While the
payoff diagrams can be drawn for any day, we will draw them for the day the option matures.
On the maturity date, the options have no time value. Therefore, the payoffs and the market
prices of options are equal to their intrinsic values.
While payoff diagrams are useful in the context of options, they can be drawn for any
security. Let us start by looking at the payoff diagram for a share of common stock. This
payoff diagram is shown in Figure 7.3a. The payoff from the common stock would come from
selling the share. The higher the stock price, the higher the payoff would be. For each dollar
change in the stock price, there is a dollar change in the payoff. The slope of the payoff line,
therefore, is 45 degrees. Figure 7.3a shows the payoff to an investor who is long on a share.
For an investor who is short a share, the payoff line would be sloping downward from the
origin. We will denote a long stock position as +s and a short stock position as −s.
Figure 7.3b shows the payoff from a risk-free asset. The payoff on a risk-free asset is
independent of the stock price. Figure 7.3b shows the payoff to an investor who is long on
the risk-free asset. The payoff for the investor short on the risk-free asset would be negative
and therefore the payoff diagram would be a mirror image (with the mirror placed along the
x-axis).
Figure 7.3c shows the payoff to a call option holder, i.e., an investor who is long on a call
option. We denote this position as +c. The payoff is zero till the stock price reaches the
exercise price E. This is because the option holder would not exercise the option unless the
stock price is above the exercise price. Beyond the exercise price, the payoff on the option
changes one-to-one with the price of the stock. This means that as long as the stock price
is above the exercise price, the gain on a call option is just like it would be from buying
the stock itself. This feature of options make them a substitute for common stock for many
investors.
Figure 7.3d shows the payoff to a call writer, i.e., an investor who is short on the call
option. This investment position is denoted by −c. If the call holder decides to exercise the
option, the writer has to go along with the wish of the option holder. Every dollar gained
by the option holder comes from the pocket of the option writer. For this reason, the payoff
diagram for a call option writer is a mirror image of that of the call option holder. Consider
the IBM Sep 105 call option. The stock price is $108.75. If the option holder decides to
exercise the option, the following transactions will take place: The option writer will buy the
Options 184
Figure 7.3: Payoff as a function of the stock price.
a. +s b. +f c. +c d. −c
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Options 185
shares in the market for $108.75 and sell them to option holder for $105 realizing a negative
payoff of $3.75 per share. The option holder will buy the shares for $105 and sell them in
the market for $108.75 making a positive payoff of $3.75 per share.
Figures 7.3e and 7.3f show payoff diagrams to a put holder (+p) and a put writer (−p).
They can be understood in the same manner as the diagrams for the call options.
Investors often hold options in conjunction with other securities. Payoff diagrams for
these joint positions can be drawn by combining the individual payoff diagrams. Figures
7.3g and 7.3h are two examples. The dashed lines in these diagrams show the payoff for the
components while the solid line shows the payoff on the portfolio. Figure 7.3g shows the
payoff on a portfolio which is long on stock (+s) and long on put (+p). This strategy is
called protective put. Notice that because of this strategy, the payoff has no upper limit
but the payoff will not be less than the exercise price of the option. Figure 7.3h shows the
payoff on a portfolio which is long on a call (+c) and long on a put (+p). This strategy is
known as a straddle. With a straddle the investor realizes a payoff regardless of whether
the stock price goes up or goes down.
The payoff diagrams only show the cashflow. They do not show the profits or losses. The
profit/loss diagram can be constructed by appropriately taking into account the cashflow at
the time the option contract was made. For example, the person who went long on a call
option, paid a price to buy the option. To draw the profit/loss diagram we should subtract
this price from the payoff diagram for the call option, thus shifting the entire payoff diagram
down. The option writer, on the other hand, received the price and therefore the payoff
diagram for the option writer would get shifted up.
7.5.3 Put-Call Parity

Call and put options on the same stock with the same exercise price and same maturity
date have many features in common. Therefore, it seems natural to expect that their prices
should be related in some way. They indeed are. To see the relationship, let us consider
a portfolio that is composed as follows: it is long on stock (+s), long on a European put
(+p), and short on a European call (−c). The put and call options are on the stock in the
portfolio and they have the same exercise price and maturity date. Now let us consider the
payoff on this portfolio on the day of the maturity of the options. The stock price on the
maturity date will either be above the exercise price, equal to the exercise price, or below
the exercise price. Below we discuss the payoffs on the portfolio in these situations:
Ps > E: The payoff from the stock will be Ps . Since Ps > E, the put will not be exercised
so that the payoff from the put will be 0. Since Ps > E, the call will be exercised, and
since the portfolio is short a call, the payoff on the portfolio will be −(Ps − E). The
payoff on the portfolio will be Ps + 0 − (Ps − E) or E.
Ps = E: The payoff from the stock will be Ps . Since Ps = E, the put will not be exercised so
that the payoff from the put will be 0. Since Ps = E, the call will also not be exercised,
Options 186
Figure 7.4: Payoff diagram for s + p − c.

...
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so that the payoff from the call will be 0. The payoff on the portfolio will be Ps + 0 − 0
or Ps which is equal to E.
Ps < E: The payoff from the stock will be Ps . Since Ps < E, the put will be exercised,
and since the portfolio is long on a put, the payoff will be E − Ps . Since Ps < E, the
call will not be exercised so that the payoff from the call will be 0. The payoff on the
portfolio will be Ps + (E − Ps ) + 0 or E.
This means that the payoff from the portfolio is guaranteed to be equal to the exercise
price E regardless of the value of the stock price. The payoff diagram shown in Figure 7.4
also confirms this. A fixed payoff makes the portfolio perfectly risk-free. The cost of the
portfolio, therefore, should be E/(1 + rf )T , where rf is the risk-free rate and T is the time
to option maturity. If the risk-free rate is being compounded continuously, then the value
should be Ee−rf T . This gives us the following equation:
E
Ps + Pp − Pc = (7.5a)
(1 + rf )T
or
Ps + Pp − Pc = Ee−rf T (7.5b)
The relationship described by this equation is called put-call parity. This equation holds
only for the European options. Since most option valuation formulae are derived for call
Options 187
options, this equation can be used to value a put option by first valuing the corresponding
call option and then using the equation to find the price of the put option.
The put-call parity can also be used to identify arbitrage opportunities. An arbitrage
opportunity exists if it is possible to create a portfolio that costs nothing, has no risk, and
results in a positive payoff. Arbitrage opportunities arise because of the temporary mispricing
of securities. The put-call parity describes the relationship between the proper prices of the
put and call options, the stock, and the risk-free security. If the put-call parity is violated,
one of the securities is mispriced and an arbitrage opportunity exists.7 Let us consider an
example. The market price of stock of ABC is $20. The call and put options on the stock
with exercise price of $25 are selling for $0.75 and $5.50, respectively. The options mature
in exactly 6 months. A Treasury bill is offering a semiannual yield of 4%.
To check if the put-call parity is violated, calculate the left hand side of the equation:
it is 20 + 5.50 − 0.75 = 24.75. The right hand side of the equation is 25/(1.04)1 = 24.04.
The two sides are not equal to each other. This indicates that an arbitrage opportunity
exists. To identify the arbitrage opportunity, imagine s + p − c to be one portfolio and
the Treasury bill to be another. Both the portfolios are perfectly risk free and yield E on
maturity. Since the two are not priced equally, one should sell the higher priced portfolio,
buy the lower priced portfolio, and pocket the difference. On the maturity date, the payoff
on the portfolio bought will pay for the portfolio sold. Therefore, we should go short on the
portfolio s + p − c, i.e., we should sell a share of stock, sell the put, and buy the call. This
would result in a cashflow of 20 + 5.50 − 0.75 = 24.75. Use $24.04 of this amount to buy a
Treasury bill with face value of $25 and pocket the difference of $0.71. Six months later we
redeem the Treasury bill and get $25 and use these $25 to settle the claims resulting from
the portfolio we sold.8
If the put-call parity were violated in the other direction we would sell the Treasury bill
and buy the stock, put, call portfolio.
7.5.4 Call Valuation—Binomial Formulation

The valuation of puts and calls is done using the ideas of hedging. As we did for the put-call
parity, options are combined with other securities to form a risk-free hedge and the valuation
of the risk-free hedge leads to the valuation of the option. In this section we will see how to
value a European call option in a very specialized situation. A similar formulation can also
be used to value a European put option. The binomial formulation assumes that at the time
the option matures, the underlying stock can have one of the two possible prices. Obviously,
7
We do not know which security is mispriced. All we know is that one of the securities is mispriced
relative to the others.
8
Don’t worry about there not being a Treasury bill with face value of $25. We are considering the
transaction for 1 share. You can do this transaction for 400 shares. This would result in everything getting
scaled by 400 and you can buy one $10,000 face value Treasury bill. The profit in this case would be 400×0.71
or $284.00.
Options 188
Figure 7.5: Binomial Option Pricing.
.................
... .
....... ...
uPs .................
... .
....... ...
mPcu .................
... .
....... ...
uPs − mPcu
....... ....... .......
.....
........ .....
........ .....
........
.
......... .
......... .
.........
...... ...... ......
....... ....... .......
....... ....... .......
....... ....... .......
............
. ............
. ............
.
. . .
....... ....... .......
...... ...... ......
Ps •............
.......
.......
mPc •
............
.......
.......
Ps − mPc •
............
.......
.......
....... ....... .......
....... ....... .......
....... ....... .......
....... ....... .......
....... ....... .......
....... ....... .......
....... ....... .......
....... ....... .......
....... ....... .......
....... ....... .......
....... ... ....... ... ....... ...
.... . .... . .... .
.................
lPs .................
mPcl .................
lPs − mPcl
this is nowhere near the reality but later this formulation can be generalized to let the stock
take many different values (even infinitely many).
Consider a stock which is currently priced at Ps . T periods from now, the stock can
take two values: an upper value (uPs ) and a lower value (lPs ). The upper and lower values
are relative to each other, not relative to the current stock price.9 As a numerical example
let us follow the stock of LMN which is currently priced at $102 and the price 6 months
from now can either be $110 or $105. The values of u and l, therefore, are 1.078 and 1.029,
respectively.
Now consider a call option which has the exercise price of E. For the numerical example,
take the exercise price to be $105. The payoffs on the option at the time of maturity are
denoted by Pcu and Pcl corresponding to the two stock prices. The option has no time value
on the day of its maturity, therefore, the option value consists of the intrinsic value only.
Using our notation Pcu = Max[0, uPs − E] and Pcl = Max[0, lPs − E]. For the numerical
example Pcu = 5 and Pcl = 0.
Now consider a portfolio that is created by buying 1 share of stock and selling m calls, i.e.,
selling m calls for each share bought. The payoff on this portfolio will be either uPs − mPcu
or lPs − mPcl depending on the stock price. These payoffs are shown in Figure 7.5.
The objective is to make the portfolio risk-free. To be risk-free, the portfolio should
provide the same payoff regardless of the stock price. The only variable in our portfolio is
m, the number of calls per share of stock. So, we want to find out a value of m which would
result in the same payoff regardless of which of the two prices the stock takes. In other
words, we want to choose a value of m such that, uPs − mPcu = lPs − mPcl , which gives us:
(uPs − lPs )
m= (7.6)
(Pcu − Pcl )
9
If the price can take two different values, one has to be lower than the other.
Options 189
For the numerical example, we get m = (110 − 105)/(5 − 0) = 1, i.e., if we sell one call
option for each share we purchase, the payoff on our portfolio will be the same regardless of
which of the two prices the stock takes. Let us calculate the value of this payoff. If the price
becomes uPs then the payoff will be uPs − mPcu = (110) − (1)(5) = 105. If the price becomes
lPs then the payoff will lPs − mPcl = (105) − (1)(0) = 105. The payoff on the portfolio is
the same regardless of the price of the stock. The cost of such a portfolio today should be
such that the rate of return on the portfolio is equal to the risk-free rate. Since the cost of
the portfolio today is Ps − mPc , the present value of the payoff discounted using the risk-free
rate should be equal to Ps − mPc . This is shown in the equations below:
uPs − mPcu
Ps − mPc = (7.7a)
(1 + rf )T
or
lPs − mPcl
Ps − mPc = (7.7b)
(1 + rf )T
where rf is the risk-free rate and T is the time to maturity.10 Either of these two equations
can now be used to solve for the proper price of the call option, Pc , because all the other
parameters are known. For our numerical example let us assume that the call option expires
in six months and the six monthly risk-free rate is 4% or 0.04. Therefore, T =1 and rf = 0.04.
You should check that both the equations above give Pc = 1.038. Therefore, the price of the
call option should be $1.038 today.
The equations above can be modified to express the price of the call option explicitly in
terms of the known quantities. For that, we substitute for m from equation (7.6) in either
equation in (7.7) and simplify to get:

(1 + rf )T − l u − (1 + rf )T
Pc = Pcu + Pcl ÷ (1 + rf )T (7.8)
u−l u−l
7.5.5 Call Valuation—Black-Scholes Formulation

The formula for pricing call options developed by Fischer Black and Myron Scholes does not
impose the constraint of the stock price being able to take only two prices in the future. It
assumes that the stock price can take infinitely many values. The formula, however, is valid
only for a European type call option or an American type call option on a stock that will
not pay any dividends before the option expires. Similar formulae, however, are available
for valuing American type call options on dividend paying stocks as well. The Black-Scholes
valuation equation for a European call option is given by the following equation:
E
Pc = Ps N(d1 ) − N(d2 ) (7.9)
(1 + rf )T
10
If rf is continuously compounded then (1 + rf )T should be replaced by erf T .
Options 190
where Pc = the value of the call option,

Ps = current stock price,
E = the exercise price,
rf = the risk-free rate,
T = the time to maturity of option,
N(·) = the area under the normal curve from −∞,
ln( PEs ) + rf T 1 √
d1 = √ + σ T (7.10a)
σ T 2
Ps
ln( E ) + rf T 1 √
d2 = √ − σ T (7.10b)
σ T 2
where σ = the standard deviation of the stock returns.
In the equation above (1+r1 f )T is replaced by e−rf T if the risk-free rate is compounded
continuously. The standard deviation of the stock returns is the most difficult quantity to
estimate in the above formula. Two commonly used approaches to estimating it are historical
standard deviation (hsd) and implied standard deviation (isd).
In the historical method, one uses past stock returns to estimate the standard deviation.
This estimate may be adjusted to incorporate additional information. In the implied stan-
dard deviation method, one applies the Black-Scholes formula to a call option whose market
price is known to estimate the standard deviation of stock returns. This estimate of the
standard deviation is then used for the other options on the stock. Sometimes, more than
one call option is used to calculate the standard deviations, and the standard deviations are
then averaged to arrive at the implied standard deviation.
Let us consider an example using the numbers we used in the binomial formulation.
Ps = 102, E = 105, T = 1, rf = 0.04. The standard deviation of stock returns can be
estimated using the historical data. Here, let us come up with a rough estimate of the
standard deviation using some statistical principles. Since the highest and the lowest prices
for the stock are 110 and 105, the highest and the lowest six-monthly returns for the stock
are (110 − 102)/102 = 0.0784313 and (105 − 102)/102 = 0.0294117. From the normal
distribution tables we know that 95% of the observed values lie within 2 standard deviations
of the mean, which means that the distance between the highest and the lowest values is
approximately 4 standard deviations. Assuming that the returns are distributed normally,
we get 4σ = 0.0784313 − 0.0294117 or σ = 0.012254. Now we apply these numbers to the
Black-Scholes formula.
We get d1 = 0.90 and d2 = 0.89 so that from the normal distribution table, N(d1 ) =
0.8172 and N(d2 ) = 0.8140. Using these numbers in the Black-Scholes formula we get
Pc = 1.24. The answer given by Black-Scholes formula is different than the one given by
the binomial formulation because of the obvious differences between the two methods and
because of our assumptions.
Options 191
The price of the put options can be estimated using the put-call parity once the price of
a call option with the same parameters is known.
7.6 Conclusion
We studied some basic characteristics of options in this chapter. We also studied how to
value call options. Options are extremely important in today’s investment world and deserve
a much more detailed study than presented in this chapter. You should consult one of the
many books devoted entirely to options for further details.
Exercises
7.1 Options—Terminology and Strategy
The option quotes shown in Table 7.3 are taken from The Wall Street Journal of May 4, 1988.
(a) Pick four options of your choice: one in the money call, one out of the money call, one in the money put,
and one out of the money put. For each option determine the payoff to an option holder if the option
holder decides to close the position at the listed prices. Also determine the time value for each option.
(b) By taking suitable examples show what effects the time to maturity and the exercise price have on the
price of a call option.
(c) An investor is long on a June 110 call and long on a June 100 put. Show the payoff diagram to the
investor from this portfolio on the date of maturity of these options.
7.2 Option Pricing

On April 19, the price of the common stock of Pfizer was 58 1/4. On the same day, the Pfizer May 55 call
option was trading at 3 7/8. What are the two components that make up the price of the option.
What do you think the price of the option would be if the stock price were $60? What do you think the
price of the option would be if it were expiring on April 20?
7.3 Payoff Diagrams
Consider the option quotes for Digital Equipment given in exercise Draw the payoff diagram for an
investor who is long on 1 Dig Eq May 100 call, long on 1 Dig Eq May 120 call, short on 2 Dig Eq May 110
calls.
Note: This combination is known as the butterfly spread.
7.4 Put-call Parity
The price of XYZ Sep 40 call option is $6.75. The risk free rate is 0.08 per year and there are 6 months
to expiration. Calculate the price of XYZ Sep 40 put assuming that the put-call parity holds and the current
stock price of XYZ is $45.
7.5 Binomial Option Pricing
The common stock of DMB Corporation is priced at $40. A year from now the stock price may be either
$48 or $34. Calculate the price of a put option with exercise price of $45 if the risk-free rate is 6% per year.
7.6 Black-Scholes Formula
Given Ps = 30, E = 20, T = 0.25 years, rf = 0.08 per year compounded continuously, σ = 0.10, calculate
the price of the call option, Pc , using Black-Scholes formula.
Options 192
Table 7.3: Options quotations for Exercise 7.1.
– Call – – Put –
Option/Strike Exp. Vol. Last Vol. Last
Dig Eq 95 May 28 11 7/8 2 3/16
5
106 8/ 95 Jun ... ... 12 13/16
106 5/8 95 Sep 106 13 1/2 20 1 1/8

5
106 8/ 100 May 12 7 3/8 18 5/8
106 5/8 100 Jun 205 9 1/2 25 1 3/4

5
106 /8 100 Sep 134 12 7/8 45 2 9/16
5
106 8/ 105 May 87 3 5/8 71 2
106 5/8 105 Jun 139 6 43 3 1/4
5
106 /8 105 Sep 432 3
7 /4 84 4 3/4
106 5/8 110 May 232 1 3/8 22 4 1/2
5
106 /8 110 Jun 157 3 3/8 132 5 7/8
5
106 8/ 110 Sep 387 5 ... ...
106 5/8 115 May 815 7/16 122 8 1/4
5
106 /8 115 Jun 467 1 3/4 ... ...
5
106 8/ 115 Sep 832 3 1/8 57 10
106 5/8 120 May 216 1/8 ... ...
5
106 8/ 120 Jun 378 7/8 ... ...
106 5/8 120 Sep 87 1 7/8 ... ...
5
106 /8 125 May 82 1/16 ... ...
5
106 8/ 125 Sep 25 1 1/8 ... ...
106 5/8 130 Sep 46 3/4 221 23 3/4
5
106 8/ 140 Sep 25 1/4 ... ...
Appendix 7A
Futures
Let us understand futures contracts through a simple example. Suppose you own Breakfeast
Inc., a company that produces breakfast foods. Suppose today is April 1, 1989 and you are
planning for the coming six months. You realize that you will need 60,000 bushels of corn 5
months later, in September 1989. The prevailing cash price of corn is $2.58 per bushel. Of
course, you do not know what price the corn will sell for in September. This uncertainty is
going to affect all your planning. Suppose, I approach you with the following proposition: we
enter a contract for 60,000 bushels of corn at the price of $2.63 per bushel; I will deliver the
corn to you in September at this contract price. This contract is beneficial for you because it
reduces your uncertainty. You know exactly what your expense for corn will be in September.
In addition, you also pass on any risk of an unexpected price increase to me. Of course, your
decision will seem incorrect if the price of corn goes down by September. Nevertheless, the
biggest benefit to you is the removal of uncertainty. The contract described above is known
as a forward contract. When such forward contracts are traded under strict regulations
regarding the size of the contract, the quality of the commodity, the delivery dates and
arrangements, etc, they are known as futures contract. For example, corn futures are
traded in contract sizes of 5,000 bushels and the delivery dates are limited to March, May,
July, September, and December.
Futures traders may be classified as hedgers and speculators. Hedgers trade in futures
to hedge from the risk. In the example above, you were the hedger. Similarly, if a farmer
enters into a contract to deliver the corn, he would be hedging because he would be locking
in a price for his product. Speculators assume the risk that the hedgers do not want to take.
In the example above I was the speculator. On the day of the delivery I would buy the corn
at the prevailing market price and deliver it to you. The difference between the prevailing
market price and our contract price would determine my profit or loss. The example should
not be taken to mean that the a futures contract always involves a hedger and a speculator.
It may be also be between two hedgers or two speculators.
One important point about modern futures trading is that most futures contracts do not
result in an actual delivery. Traders buy a futures contract, hold it for a while, and then
193
Futures 194
sell the contract or take an opposing position canceling their original position. They make
profits because of the movement in the futures contract price. Consider our example above.
Suppose after we entered the contract the cash price of corn falls so that the contract price
for September corn futures falls to $2.60 per bushel. This drop reflects a profit of $0.03 per
bushel to me because I could buy a futures contract from someone else who would deliver
the corn to me for $2.60 per bushel and I will deliver it to you for $2.63, our agreed price. I
can take advantage of this situation by buying the September futures contract for the same
quantity as I am supposed to deliver, thus zeroing my net position. Alternatively, I could
sell our futures contract to another futures trader who would pay me the difference $0.03
per bushel.
Futures contracts can be compared with options contracts. The main difference between
a futures contract and an options contract is that in a futures contract the parties involved
are obliged to make a trade on the date of the expiration of contract regardless of the market
price. The exercise of an option, on the other hand, depends on the person who bought the
option: the buyer would exercise the option only if the market price of the share is higher is
than the exercise price for a call option or is lower than the exercise price for a put option.
Futures and options contract have become an extremely important part of the investment
world today. New contracts are being designed almost every day. The range of contracts
traded currently include, options on futures, options and futures on market indices, etc. A
serious investor cannot afford to ignore these new developments.
Normal Distribution Table
Entries in the table give the area under the normal
.................
...
...... .............
..... .
................. distribution curve from z = 0. For example, the area
.... .............
.
...
.
.
...
..
..............
.......... ..... between z = 0 and z = 2.24 is 0.4875. Other areas
... .......... .....
....
..
..
.
....
.....
..........
..........
....
.....
......
can be determined by using the fact that the normal
.... .......
distribution is symmetric about z = 0.
...
... .......... ...........
...
................... ... .. .............
0 z
z 0.00 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09
0.0 0.0000 0.0040 0.0080 0.0120 0.0160 0.0199 0.0239 0.0279 0.0319 0.0359
0.1 0.0398 0.0438 0.0478 0.0517 0.0557 0.0596 0.0636 0.0675 0.0714 0.0753
0.2 0.0793 0.0832 0.0871 0.0910 0.0948 0.0987 0.1026 0.1064 0.1103 0.1141
0.3 0.1179 0.1217 0.1255 0.1293 0.1331 0.1368 0.1406 0.1443 0.1480 0.1517
0.4 0.1554 0.1591 0.1628 0.1664 0.1700 0.1736 0.1772 0.1808 0.1844 0.1879
0.5 0.1915 0.1950 0.1985 0.2019 0.2054 0.2088 0.2123 0.2157 0.2190 0.2224
0.6 0.2257 0.2291 0.2324 0.2357 0.2389 0.2422 0.2454 0.2486 0.2517 0.2549
0.7 0.2580 0.2611 0.2642 0.2673 0.2703 0.2734 0.2764 0.2794 0.2823 0.2852
0.8 0.2881 0.2910 0.2939 0.2967 0.2995 0.3023 0.3051 0.3078 0.3106 0.3133
0.9 0.3159 0.3186 0.3212 0.3238 0.3264 0.3289 0.3315 0.3340 0.3365 0.3389
1.0 0.3413 0.3438 0.3461 0.3485 0.3508 0.3531 0.3554 0.3577 0.3599 0.3621
1.1 0.3643 0.3665 0.3686 0.3708 0.3729 0.3749 0.3770 0.3790 0.3810 0.3830
1.2 0.3849 0.3869 0.3888 0.3907 0.3925 0.3944 0.3962 0.3980 0.3997 0.4015
1.3 0.4032 0.4049 0.4066 0.4082 0.4099 0.4115 0.4131 0.4147 0.4162 0.4177
1.4 0.4192 0.4207 0.4222 0.4236 0.4251 0.4265 0.4279 0.4292 0.4306 0.4319
1.5 0.4332 0.4345 0.4357 0.4370 0.4382 0.4394 0.4406 0.4418 0.4429 0.4441
1.6 0.4452 0.4463 0.4474 0.4484 0.4495 0.4505 0.4515 0.4525 0.4535 0.4545
1.7 0.4554 0.4564 0.4573 0.4582 0.4591 0.4599 0.4608 0.4616 0.4625 0.4633
1.8 0.4641 0.4649 0.4656 0.4664 0.4671 0.4678 0.4686 0.4693 0.4699 0.4706
1.9 0.4713 0.4719 0.4726 0.4732 0.4738 0.4744 0.4750 0.4756 0.4761 0.4767
2.0 0.4772 0.4778 0.4783 0.4788 0.4793 0.4798 0.4803 0.4808 0.4812 0.4817
2.1 0.4821 0.4826 0.4830 0.4834 0.4838 0.4842 0.4846 0.4850 0.4854 0.4857
2.2 0.4861 0.4864 0.4868 0.4871 0.4875 0.4878 0.4881 0.4884 0.4887 0.4890
2.3 0.4893 0.4896 0.4898 0.4901 0.4904 0.4906 0.4909 0.4911 0.4913 0.4916
2.4 0.4918 0.4920 0.4922 0.4925 0.4927 0.4929 0.4931 0.4932 0.4934 0.4936
2.5 0.4938 0.4940 0.4941 0.4943 0.4945 0.4946 0.4948 0.4949 0.4951 0.4952
2.6 0.4953 0.4955 0.4956 0.4957 0.4959 0.4960 0.4961 0.4962 0.4963 0.4964
2.7 0.4965 0.4966 0.4967 0.4968 0.4969 0.4970 0.4971 0.4972 0.4973 0.4974
2.8 0.4974 0.4975 0.4976 0.4977 0.4977 0.4978 0.4979 0.4979 0.4980 0.4981
2.9 0.4981 0.4982 0.4982 0.4983 0.4984 0.4984 0.4985 0.4985 0.4986 0.4986
3.0 0.4987 0.4987 0.4987 0.4988 0.4988 0.4989 0.4989 0.4989 0.4990 0.4990
195
Normal Distribution Table 196
Data
Many examples in Chapters 2, 3 and 4 use monthly returns from January 1990 to De-
cember 1994 on the stocks of AT&T, Kodak, IBM and Sears, S&P 500, Treasury bills and
Janus Fund. This data is presented below in its entirety. The data is available from me in
a spreadsheet form if you are interested.
Month AT&T IBM Kodak Sears S&P 500 T Bills Janus
01/90 −0.1429 0.0478 −0.0729 0.0459 −0.0671 0.0057 −0.0790

02/90 0.0192 0.0660 0.0001 0.0410 0.0129 0.0057 0.0020
03/90 0.0650 0.0217 0.0399 −0.0427 0.0263 0.0064 0.0430
04/90 −0.0446 0.0271 −0.0575 −0.0955 −0.0247 0.0069 −0.0160
05/90 0.0748 0.1130 0.1050 0.0353 0.0975 0.0068 0.1270
06/90 −0.1001 −0.0208 0.0062 0.0069 −0.0070 0.0063 0.0140
07/90 −0.0390 −0.0511 −0.0586 −0.0788 −0.0032 0.0068 −0.0250
08/90 −0.1250 −0.0757 0.0691 −0.1150 −0.0903 0.0066 −0.1010
09/90 −0.0362 0.0442 −0.0435 −0.1325 −0.0492 0.0060 −0.0170
10/90 0.1012 −0.0094 0.0325 −0.0296 −0.0037 0.0068 0.0010
11/90 −0.0551 0.0904 0.0784 0.0820 0.0644 0.0057 0.0420
12/90 −0.0520 −0.0055 −0.0177 −0.0287 0.0274 0.0060 0.0210
01/91 0.0830 0.1217 0.0240 0.1330 0.0442 0.0052 0.0620
02/91 0.0230 0.0254 0.0379 0.0993 0.0716 0.0048 0.0660
03/91 0.0365 −0.1155 −0.0029 0.1245 0.0238 0.0044 0.0520
04/91 0.0912 −0.0955 −0.0458 0.0679 0.0028 0.0053 −0.0010
05/91 −0.0067 0.0424 0.0305 0.1011 0.0428 0.0047 0.0250
06/91 0.0394 −0.0848 −0.0855 −0.0677 −0.0457 0.0042 −0.0390
07/91 0.0425 0.0425 0.0581 0.0825 0.0468 0.0049 0.0700
08/91 −0.0219 −0.0317 0.0639 0.0242 0.0235 0.0046 0.0410
09/91 −0.0301 0.0697 −0.0116 −0.0723 −0.0164 0.0046 −0.0100
10/91 0.0367 −0.0519 0.0587 −0.0260 0.0134 0.0042 0.0260
11/91 −0.0643 −0.0468 0.0445 −0.0434 −0.0404 0.0039 −0.0350
12/91 0.0848 −0.0378 0.0349 0.0707 0.1143 0.0038 0.1180
01/92 −0.0479 0.0112 0.0466 0.0825 −0.0186 0.0034 −0.0140
02/92 −0.0034 −0.0217 −0.1067 0.0702 0.0128 0.0028 0.0170
03/92 0.1065 −0.0388 −0.0896 0.0346 −0.0196 0.0034 −0.0300
04/92 0.0613 0.0868 −0.0246 −0.0279 0.0291 0.0032 0.0080
05/92 −0.0173 0.0129 0.0190 0.0113 0.0054 0.0028 0.0140
06/92 0.0198 0.0785 0.0063 −0.0888 −0.0145 0.0032 −0.0180
197
Data 198
Month AT&T IBM Kodak Sears S&P 500 T Bills Janus
07/92 0.0203 −0.0319 0.0841 0.0063 0.0403 0.0031 0.0150

08/92 −0.0370 −0.0732 0.0285 0.0500 −0.0202 0.0026 −0.0240
09/92 0.0403 −0.0678 0.0056 0.0783 0.0115 0.0026 0.0140
10/92 0.0000 −0.1718 −0.0815 −0.0615 0.0036 0.0023 0.0330
11/92 0.0802 0.0393 0.0368 0.0418 0.0337 0.0023 0.0420
12/92 0.0890 −0.2619 −0.0328 0.0520 0.0131 0.0028 0.0110
01/93 0.0368 0.0223 0.2315 0.0797 0.0073 0.0023 0.0100
02/93 0.0567 0.0669 0.0858 0.0843 0.0135 0.0022 0.0160
03/93 0.0215 −0.0644 0.0117 0.0355 0.0215 0.0025 0.0260
04/93 −0.0154 −0.0442 −0.1014 −0.0434 −0.0245 0.0024 −0.0300
05/93 0.1007 0.0970 0.0716 0.0458 0.0270 0.0022 0.0160
06/93 0.0298 −0.0640 −0.0338 0.0115 0.0033 0.0025 0.0130
07/93 0.0060 −0.0987 0.0725 0.2200 −0.0047 0.0024 0.0010
08/93 −0.0079 0.0340 0.1468 0.0955 0.0381 0.0025 0.0260
09/93 −0.0584 −0.0820 −0.0266 −0.0115 −0.0074 0.0026 0.0060
10/93 −0.0234 0.0952 0.0589 0.0650 0.0203 0.0022 0.0260
11/93 −0.0500 0.1771 −0.0240 −0.0453 −0.0094 0.0025 −0.0140
12/93 −0.0331 0.0487 −0.0760 −0.0276 0.0123 0.0023 0.0100
01/94 0.0810 0.0000 −0.0227 0.0378 0.0335 0.0025 0.0300
02/94 −0.0749 −0.0597 −0.0160 −0.1615 −0.0270 0.0021 −0.0210
03/94 −0.0177 0.0331 0.0320 −0.0548 −0.0435 0.0027 −0.0340
04/94 0.0000 0.0526 −0.0648 0.0899 0.0130 0.0027 0.0120
05/94 0.0659 0.1004 0.1392 0.0856 0.0163 0.0032 0.0050
06/94 0.0015 −0.0675 0.0267 −0.0519 −0.0247 0.0031 −0.0280
07/94 0.0046 0.0532 0.0052 −0.0156 0.0331 0.0028 0.0280
08/94 0.0000 0.1115 0.0368 0.0112 0.0407 0.0037 0.0300
09/94 −0.0054 0.0164 0.0402 0.0132 −0.0241 0.0037 −0.0310
10/94 0.0185 0.0700 −0.0700 0.0312 0.0229 0.0038 0.0250
11/94 −0.1068 −0.0470 −0.0463 −0.0373 −0.0367 0.0037 −0.0260
12/94 0.0295 0.0389 0.0495 −0.0265 0.0146 0.0044 0.0030
Index
abnormal return, 117 characteristic line, 92

account executive, 12 Chicago Board Options Exchange, 173
aggressive securities, 93 Closed end funds, 88
annuity, 108 Commercial paper, 3
annuity factor, 109 Commission brokers, 11
arbitrage opportunities, 187 compounding, 33
ask price, 13 confidence interval, 43
conservative securities, 93
bankruptcy, 45 contingent claim securities, 172
basis points, 151 continuous compounding, 35
beating the market, 117 continuous probability distribution, 38
best efforts, 10 conversion ratio, 152
beta (beta), 91 Convertible bonds, 152
beta services, 93 Correlation, 63
bid price, 13 coupon rate, 149
bid-ask spread, 13 covariance, 63
big board, 12 covered call, 179
block trade, 7 cumulative dividends, 149
Bonds, 149 current yield, 31, 155
bonds, 3
brokerage house, 12 day order, 12
buy and hold, 119 debentures, 152
declaration date, 137
call feature, 151 default, 45
call option, 171 Default risk, 153
callable bond, 151 degree of risk aversion, 47
Capital gain, 31 direct investment, 5
capital gains yield, 31 discount rate, 106
capital market, 4 discounted value, 105
capital market line, 90 discounting, 105
capital market securities, 4 Diversification, 61
CAPM, 94 diversification and correlation, 63, 81
cash account, 16 Diversification Efficiency, 65
CBOE, 173 dividend, 4, 136
199
Index 200
dividend capture, 139 holding period yield, 150

dividend rate, 149
dividend yield, 31, 139 immunization, 160
DJIA, 23 in the money, 180
Dominance, 48 Income, 31
Dow Jones Industrial Average, 23 indifference curve, 47
Dow Jones News Retrieval, 23 indirect investment, 5
duration, 168 initial margin, 17
initial public offering, 134
effective rates, 34 insider trading, 24, 121
efficient frontier, 71 Institutional investors, 7
efficient market, 117 interest rate, 30
Efficient market hypothesis, 118 Interest rate risk, 152
semi-strong form, 119 interest rate risk, 45
strong form, 119 internal rate of return, 111
weak form, 119 intrinsic value, 179
efficient portfolios, 71 investment, 2
equilibrium, 6 investment bankers, 8
ex-dividend date, 137 investment banking firms, 8
exercise price, 172 investment objective, 48
expectations hypothesis, 53 irregular dividend, 136
extra dividend, 136
Junk bond, 153
face value, 4, 150
financial instruments, 3 leveraged securities, 178
financial investment, 2 leveraging, 36
Financial markets, 2 Limit order, 13
firm commitment, 8 limited liability, 4
fixed income securities, 4, 149 Liquidity motivated investors, 7
Floor brokers, 11 liquidity preference hypothesis, 52
forward contract, 193 load funds, 88
fully taxable equivalent yield, 154 maintenance margin, 17
futures, 5, 193 margin account, 16
futures contract, 5, 193 margin call, 17
General obligation bonds, 153 margin ratio, 16
good till cancelled order, 12 market makers, 11
growing perpetuity, 109 market manipulation, 24
market model, 92
hedge portfolio, 83 Market order, 13
Hedging, 8 market portfolio, 90
holding period return, 150 market segmentation hypothesis, 53
Index 201
Marketability risk, 153 portfolio, 58

marketability risk, 45 portfolio weights, 59
marketable security, 2 portfolios, 4
mean-standard deviation frontier, 71 positively weighted portfolios, 79
members, 11 Preemptive rights, 134
Microsoft Excel, 43, 65 preferred stocks, 4, 149
mispriced, 95 present value, 105
mispriced security, 95, 117, 118 primary market, 8
money market, 3 Privately placed securities, 2
money market funds, 5, 87 prospectus, 10
municipal bonds, 154 protective put, 175, 185
Mutual Funds, 87 put option, 171
mutual funds, 4
random variable, 38
NASDAQ, 11 Real investments, 2
Need for liquidity, 7 record date, 137
Net Asset Value, 88 reinvestment risk, 45
New issue, 134 residual income security, 4
New York Stock Exchange, 10 Retained earnings, 4
no-load funds, 88 revenue bonds, 153
NPV and IRR, 116 reverse stock split, 135
NYSE, 10 risk, 38
risk loving, 47
OCC, 173 risk neutral, 47
on the money, 180 risk premium, 49
Open end funds, 88 risk tolerance, 47
open outcry system, 10 risk-free security, 50
option contract, 5 risk-return trade-off, 81
option premium, 171 risk-return trade-offs, 71
option writer, 171 Round trip, 13
Options, 5, 171
Options Clearing Corporation, 173 seats, 11
out of the money, 180 SEC, 8
over-the-counter, 11 Sector funds, 88
overpriced, 95 secured, 152
Securities, 3
payable date, 137 Securities and Exchange Commission, 24
payout ratio, 136 security, 2
PE ratio, 140, 147 security market line, 94
perfect market, 90 selectivity, 127
perpetuity, 109 Share repurchase, 134
plowback ratio, 136
Index 202
Short interest, 15 value weighted, 90

short interest report, 16 variance of the portfolio returns, 70
shorting against the box, 15 Voting rights, 133
single period, 32
sinking fund, 152 yield, 30
Specialists, 11 yield to maturity, 150
Speculation, 7 zero coupon bonds, 153
stated rates, 34
stock dividends, 135
Stock splits, 135
Stop loss order, 13
straddle, 185
street name, 16
strike price, 172
supply and demand, 6
systematic risk, 91
tangency line, 77
tangency portfolio, 76
term structure of interest rates, 52
tick, 13
ticker tape, 1, 23
time value, 179
timing, 127
Traders, 11
trading rule, 119
transaction costs, 13
Treasury bills, 3, 157
Treasury bond, 156
Treasury note, 156
Treasury Strips, 157
Treasury Yield Curve, 52
trial-and-error method, 112
underpriced, 95
underwriters, 8
unexpected inflation, 45
up-tick rule, 15
utility, 2
utility maximization, 48
Value rights, 134

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Investments

2 Return and Risk 30

2.3 Leverage and Return . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36

4 Security Selection and Performance Evaluation 104

5 Common Stocks 133

6 Fixed Income Securities 149

6AInterest Rate Risk and Duration 164

Normal Distribution Table 195

August 16, 1995 Ravi Shukla

1.1 The Securities

1.1.1 Money Market Securities

1.1.2 Capital Market Securities

1.1.3 Mutual Funds

1.1.4 Options and Futures

1.2 Security Prices

1.3 Investment Profits and Returns

from the investment is w1 − w0 and the return r is:

1.4 Investors and their Motives

• Hedging: An investment that is made to reduce risk is called hedging. Hedging is

1.5 The Markets

1.5.1 Primary Market

◦ Under a firm commitment agreement, the corporation sells the securities to

Figure 1.1: A security offerings announcement.

June 17, 1991

Dillon, Read & Co. Inc.

Piper, Jaffray & Hopwood

PaineWebber Incorporated Robertson, Stephens & Company

Deutsche Bank Capital Advest. Inc. Arnhold and S. Bleichroeder, Inc.

Interstate/Johnson Lane Janney Montgomery Scott Inc.

Nordberg Capital Inc. Pennsylvania Merchant Group Ltd

Source: The Wall Street Journal, June 17, 1991.

1.5.2 Secondary Market

• Traders buy and sell on their personal account.

• Commission brokers execute orders for their customers.

1.6 The Trading Process

1.7 Long and Short Positions

Figure 1.2: Transactions in short selling.

1.8 Cash and Margin Accounts

a fraction of the market value of securities:

1.8.1 Long Position

Assets ($) Liabilities and Equity ($)

Mkt. Val. of QVC 3,100 Loan 1,240

Total 3,100 Total 3,100

Now we will examine Mr. Garner’s account under different scenarios.

Assets ($) Liabilities and Equity ($)

Mkt. Val. of QVC 4,000 Loan 1,240

Total 4,000 Total 4,000

Assets ($) Liabilities and Equity ($)

Mkt. Val. of QVC 40(100 − n) Loan 1,240

Total 40(100 − n) Total 40(100 − n)

Assets ($) Liabilities and Equity ($)

Mkt. Val. of QVC 2,080 Loan 1,240

Total 2,080 Total 2,080

Assets ($) Liabilities and Equity ($)

Mkt. Val. of QVC 4,000 Loan 4,140

Total 6,900 Total 6,900

Assets ($) Liabilities and Equity ($)

Mkt. Val. of QVC 1,500 Loan 1,240

Total 1,500 Total 1,500

Assets ($) Liabilities and Equity ($)

Mkt. Val. of QVC 1,500 Loan 1,240

Total 2,140 Total 2,140

Assets ($) Liabilities and Equity ($)

Mkt. Val. of QVC 420 Loan 1,240