Annuities

WhereRispayment

AMR=1/T Ri

GMR=(Pt/Pt1)1/t1
Consumption
y1
W0=y0+ 1+r

whereyoiscurrentincome,y1isendofperiodincomeandW0iscurrentwealth
Optimal consumption at(C*0,C*1) ExogenousIR Utility .Lenders becomeborrowers
Market rate of interest cannot fall below the storage rate. I.e. Noone will lend/borrow at
negative rates Production opportunity set = Current Consumption vs End of Period
Consumption
Investment
CFadjusted=(InflowsOutflows)(1Taxrate)+(Taxrate)(Depn)
NPV=Outflow+CFadjusted(PVfactor)
FCF=EBIT(1Taxrate)+ Dep Income
UtilityTheory
LogarithmicfunctionofWealth
Expectedutilityofgamble=E[U(W)]=Ln(W)=
whereW=eLn(W)
Investoravoidgamblebypayinginsuranceof:
W0eLn(W)
AsW0 ,E[U(W)] ,W1 ,andInsuranceavoidgamble
Stochastic dominance is where one gamblecanberanked as superiortoanother gamble
forabroadclassofdecisionmakers.

BinaryGamble
Independence:Volvo~Saab.
Then G ( Volvo , Subaru : a ) ~ G ( Saab , Subaru: a ) = Indifferent =Strong preference
between the 2 gambles isindependentof the relevant alternative(Subaru). Volvo~Saabis
universal and all priced in. Cannot say BUTSAAB issafer. Volvo(Allpricedin)~Saab (All
pricedin)
MeanVariancePortfolioTheory
The standard deviation(sigma) isthesquarerootof the varianceof Xi.e., itisthesquare
rootoftheaveragevalueof(X)2
BetaisNOTRho
p(R E(R ))(R
E(R
))

firm = firm firm 2market market

m

whereCovarianceisthenumerator(measureofrisktothemarketvolatility)
Azerobetaportfoliohaszerocovariancewiththemarketportfolio.I.e.Setcovarianceto0

Systematicriskofaportfolioistheweightedaverageoftheassets
ExpectedReturn

piri

E(ax+by)= pi(axi+byi)=aE(x)+bE(y)

orwhereb=(1a)
Varianceforassetandportfolio
1.
2.
3.

pi(ri E(r)) SemiVariancedownside(sumnegativevaronly)

Var(Rm)=E[Rm2](E[Rm])2
a2 x 2+2abCov(x,y)+b2 x2

orwhereb=(1a),solveforaorbforZerovariance

portfolio

4.

Vary= 2Varx

5.
6.

(Rir)2

SampleVariancedata= N1 sincelosing1degreeoffreedom
If AB
2= 0, then A and B are uncorrelated andthereisadiversificationbenefit,
assumingRhoislessthan1
CorrelationCoefficientbetweenxandy
cov(x,y)
x,y= y =Rho
x

where 1 < x,y < 1anddoesnotaffectexpectedreturn

A/ B =Penetration
IfRho= A/ BthenAistheGMVP
Covariance(meandeviation)betweenx,y

Cov(x,y)= [(x x )(x y )]

GMVP
y2cov(x,y)
a*= x2+y22cov(x,y)
wherea*istheamountinvestedinx
MarketModel
E(Ri)=Rf+[E(Rm)Rf] + i
Residualorthogonallayer( i = unsystematicrisk )arecorrelated,butnotcorrelatedtoRm
SML,CAPM(REQUIREDRATEOFRETURN)andAPT
SML=E(R*i)=Rf+[E(Rm)Rf]
cov(R ,Rm)
= i2 =Covariance/Variance=SystematicRisk=MarketRisk=Undiversifiable
m

IfE(R*i)>RqdRRthenAssetPrice
IfRqdRR>E(R*i)thenAssetPrice

Cov(P ,Rm)((E(Rm)R )

$Insurance Premium=AVL=ActuarialValueLoss=Expectedvalueofloss
Wealthyindividualmaychoosenoinsurance
Differentiation
f(x)=ln(5x2)thenthederivatived/dx[f(x)]=f(x)=2/x
f(x)becomes=1/x2
f(x)=e2xthend/dx[f(x)]=f(x)=2e2x

t
f
1 [E(P )
AssetPrice=P0= 1+Rf
]
t
V ar(Rm)
UndertheCMLlineOvervaluedOvertheCMLlineUndervalued
EfficientPortfolios
2
TotalRisk= 2j = j 2m + 2
Specific/SystematicRisk= 2 >0
NonSpecific/UnsystematicRisk= 2 is0
Perfectlycorrelatedtomarket
StockPricing
E(P )Po
E(Rj)= 1Po =Rf+[E(Rm)Rf] j
WherePispriceofstockatTime0and1
Covariancebetween2portfolios
cov=W1 W2
where
W1=therowvectorofweightsinPortfolioA
=thevariancecovariancematrixofAandB
W2=thecolumnvectorofweightsinPortfolioB
Portfolio variance is not a function of the variance of securities because each security
fluctuatesandoffseteachother
NonMarketableAssets/3Fundseparation
Equilibriumpricingequation(Mayers)
E(Rj)=Rf+ [VmCov(Rj,Rm)+Cov(Rj,RH)]
WhereVm=currentMVofallmarketableassets
RH=totaldollarreturnonallnonmarketableassets
=marketpriceofrisk=E(Rmarket)Rf/ m
*Cov(Pe,Rmarket)=riskpremiumindollars=CE.C/Fs

PricingwiththeCAPM

TermStructureofIR,Forwards,Futures
1yearImpliedforwardrate
(1+ R )3
1+2f3= (1+0 R3 )2
0 2

2yearImpliedforwardrate
(1+ R )4
(1+2f3)(1+3f4)= (1+0 R4 )2 2yearimplied rate 1=1yearaverageimpliedforward
0 2

e.g.(1.155)4/(1.140)2 2yearrateofinterest1.3693 1.3694 1=17.02%avg.1yr

Futures
Spotpriceoffuturescontract=S0=E(ST)eRf.T

NondiversifiableandPricedNondiversifiableandNotPricedDiversifiableandNotPriced
NonpricedriskcouldbenondiversifiableNondiversifiableriskcouldnotbepriced
DEFINITIONof'ZeroBetaPortfolio'
A portfolio constructed to have zero systematicrisk or, in otherwords, a beta of zero. A
zerobeta portfolio would have the same expected return as the riskfree rate. Such a
portfolio would havezero correlation withmarket movements,given thatits expectedreturn
equalstheriskfreerate,alowrateofreturn.

StatePreferenceTheory
PriceofPureSecurities
P1QA1+P2QA2=PA
P1QB1+P2QB2=PB
Sale/PurchaseofSecurities
Forsaleofjandpurchasesofk
njpj+Wo
(Qk2)=njQj2
P
k

where W0 is initial wealth, n is number ofshares, p is price ofsecurity,and Qis payoffin

state1,2..

OPTIONS
Theorem1:AnAmericancallonanonDivstockwillnotbeexercisedbeforethecallexpiry
Theorem2: Premature exercise of American call mayoccurona Divpaying stockandif the
optionisinadequatelyprotectedagainstthedividendpayment
Early Exercise: Gain more from exercising immediately for XS when S falls below a
predetermined level and putting proceeds in riskfree asset instead of holding Put to
maturity.Conditionisexpressedas,(XS)erf.T>X
American options, whose pricesareneverbelowtheirEuropeancounterparts,should never
beexercisedearlyexceptforbeforeexdividenddateifD>Foregoneinterest
PUTCALLPARITY
CP=SXerf.TorS+PC=Xerf.TorP=CS+Xerf.T
C>SXerf.TandP>Xerf.TS
Exercisepricemustequalsyntheticforwardprice,PortfoliowillalwaysequalX
Optionpricedoesnotdependoninvestorriskorexpectedreturnoftheunderlying
DoNOTsubtractpremiumforthepayoffdiagramintheexam
Property 1 (i)The early exerciseof acalloption on astock thatpaysnodividends priorto
expiration is never optimal. (ii) For suchastock,thepriceofanAmerican call optionequals
thepriceofanotherwiseidenticalEuropeancall.
Property 2 The exercise of a call option is optimal only at expiration, orpossibly at the
instantpriortotheexdividenddate.

OPTIONBOUNDARIES

M&A
5 mergerdefensives, 1. Defensive restructuring (sell offattractiveunitsofthecompany),2.
Poison pills (warrants for existing shareholders to buyequity at low price), 3. Poison puts
(bondholders have option of early repayment in event of takeover), 4. Antitakeover
amendments and 5. Golden parachutes (reduce conflict of interest in change of control
situations,andencouragesmanagerstomakefirmspecificinvestmentsandtakeLTview).
RELOADOPTIONS
A CEO holdsa reloadoption.Each option is to purchase 1,000sharesat $25each.Ifthe
stockprice isat $40, andsheexercises,shepaysthecostofexercising(1000*25=25,000)
by foregoing 625 shares (625*40= 25,000), and receiving 375 shares (this is the
stockforstock option).Shealsoreceivesnewatthemoneyoptionstopurchase625shares
(for$40,thecurrentprice,thisisthereload).NotethattheESOcannotbetradedexternally.


Prices need to fluctuate with perfectly correlated with information / fundamentals =Best
Truth.Pricescannotbeperfectlycorrelated
Marketefficiencydoesnotrequirepricestobeequaltofairvalueallthetime.

where,e.g.

EfficientCapitalMarketsTheory
Strong = Allprivateand publicrelevantinformationisknownandin the price(noabnormal
returns)
SemiStrong = Privateinformationgivesabnormalreturnsandnotin price,mayexperience
abnormalreturnsiftradingonprivateinformation
Weak=Publicinformationinprice(i.e.abnormalreturnsgreatest)
Rolls critique based on assumption that capital markets areinequilibrium, diversification
islimited, andthat theCAPMholds byconstructionwhenperformanceismeasured against
ameanvarianceefficientindexotherwise,itholdsnotatall.

FlatYTM=AERmustbeincreasing(AER,MRPB=0)
IfMRPBis0,thenAERincreasing
IfMRPBis0,dependingonsize,ismoreflatthanwhenMRPB=0
YTM=AERifMRPB=JEB,MRPB>0
AER<YTMisMRPB>JEB,MRPB>0
Preferred habitat theory: Longerterm bonds tend to pay more interest than two
shorterterm bonds investors prefer shortterm bonds and are only interested in
longerterm bonds ifthey pay a risk premium. Expectation: investors onlycareaboutyield.
Habitat:careaboutyieldandmaturity
Expectations theory: This theory is sometimes used to explain the yieldcurve but has
proven inaccurate in practice as interest rates tendto remain flat whentheyield curveis
normal.Inotherwords,expectationstheoryoftenoverstatesfutureshortterminterestrates.


CostofCapitalwithRiskyDebt

The Treynor ratio relates excess returnover theriskfree rate to the additional risktaken
however,systematicriskisusedinsteadoftotalrisk.
Sharpeappliestoallportfolios,whereasTreynoronlyforwelldiversifiedportfolios.
Jensensalphaisthereturnofportfoliolessreturnofmarketportfolio
JensensalphaandTreynorratioarebothusedtorankportfoliosasbothusesystemicrisk
A negative Treynor ratiomay imply thatthe fundmanager has outperformed the risk free
ratewhilereducingsystemicrisk(negativeBeta)whichisafavorablesituation.
CapitalStructure
Vunlevered=Bondslevered+Stocklevered=Vlevered
Vlevered=Vunlevered+TcBwhereTcBisgainonleverageduetotaxshieldofinterestondebt
Therefore, the value of the firm will decrease astheleverage decreases, since reducing
leveragereducesthevalueofthedebttaxshield
MM Proposition1 =MVfirmisindependentofits capitalstructure,advantages fora firmtobe
leveredinaworldwithtaxesastheinterestisdeductible

MMPropositionII
PropositionIIwithriskydebt.Asleverage(D/E)increases,

theWACC(k0)staysconstant.

is the required rate of return on

equity,orcostofequity.
istherequiredrateofreturnonborrowings,orcostofdebt.

isthedebttoequityratio.

A higher debttoequity ratio leads to a higher required return on equity, because of the
higherriskinvolved for equityholdersina companywithdebt.Higherthedebt,thelowerthe
WACC. Proposition 2 assumes that debt holders have upperhand as far as claim on
earningsisconcerned.Thus,thecostofdebtreduces.
DividendPolicy
Dividenddecisionsdonotaffectthestreamofexpectedfutureinvestments.
MMpropositionsuggestdividendpolicyisirrelevanttovalue,riskinessoffutureCFisimport
PricepersharewillequalfuturedividendsplusfuturepricePo=(D+P1)*1/(1+R)
Clientele effect:If Firm changes dividendpolicy (larger orsmaller), changeinaveragerisk
aversion of its clientele (shareholders), and no effect on the value of the firm.
The market required rate of return depends on the market price of risk and the firms
covariance of risk and does not depend on the risk aversion of shareholders. Old
shareholdersreplacenewshareholders.
Miller:Alowleveragedfirmwillattractinvestorsinhightaxbrackets
Farrar & Selwyn: If tax liability of capital gains is less than tax liability of distribution,
Vunlevered=[E(EBIT1)(1Tc)]/p
investorsprefercapitalgains
Vlevered=[E(EBIT1)(1Tc)]/WACC
Dividend payout: Higher payout is interpreted as message that future cash flows from
Shareprice=(VleveredB)/n=S/nwheren=numberofsharesoutstanding
investment are expected to be permanently higher. The dividend has no effect on
BetaUnleveredNotobservablebutremainsthesameaslongasbusinessriskisconstant
shareholderwealthorvalueofthefirm.ExpectedreturnoffirmisdeterminedbyCAPM.
BetaLeveredObservablefromstockmarketandchangeswithcapitalstructurechange
Dividend variability is irrelevant, whereas riskiness of anticipated cash flows from future
Forlowlevelsofdebt,bankruptcyistrivial,butitrisesasD/Vincreases
investmentremainunchanged.
A company can capitalise itsrequirementswithaslongas the costof bankruptcy> valueof
RetentionRate:Differencebetweenearningsanddividends=EBITD
taxbenefits
Firm can retain anyamountwithoutaffectingplannedinvestmentifit balancesthesourceof
Tax Advantages: (1tpB)=(1tc)(1tpS) If personalincometaxonstockis lessthanthetax
fundbysellingnewsharesorrepurchasing(ifexcessfundsremainafterIandD)
on bonds, then the before tax return on bonds has to be high enough to offset this
i.e.EBIT+mP=I+DwheremP=Externalfunding
disadvantageotherwisewillholdbonds.
Gordongrowthmodel:Vo=[EBIT1(1T)(1K)]/[pKr]=D/(pg)

WhereEBIT1(1T)=EBIT0(1T)(1+g)andp=Costofcapitalforallequityfirm

g = growth rate on dividends = Kr where K=Dividendpayoutratior= Futureinvestment

earnings,p=discountrate

OPM: Market value of firms debt shouldfallwhen dividends are paid from cash (due to
diminished asset base and greater risk of firm as MV of equity increases). However,
bondholders may believe MV of their collateral may increase in spite of dividend payout
which may leave them better off. If div payout carries no implications about CF from
investment,thenobserveOPM.