Transcript Chapter 1. Introduction: Discounted Cash Flow Method

The Oxford Guide to Financial Modeling by Ho & Lee
Chapter 2. Equity Market:
Capital Asset Pricing Model
The Oxford Guide to
Financial Modeling
Thomas S. Y. Ho and Sang Bin Lee
Copyright © 2004 by Thomas Ho and Sang Bin Lee. All rights reserved.
The Oxford Guide to Financial Modeling by Ho & Lee
2.1 Real and Financial Sectors
• Tangible assets, commodities
– metals, buildings, factories, inventories,
• Intangible assets
– patents, branding
• Financial securities
– Stocks, bonds, options, mortgages
• Role of a corporation
– Economic units
– Organization of a corporation
Chapter 2. Equity Market: The Capital Asset Pricing Model
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The Oxford Guide to Financial Modeling by Ho & Lee
2.2 Stocks and Stock Market
• Dividends, capital gains
– Announcement date, ex-dividends
• Types of orders
– Market orders: immediate execution at the market price
– Limit orders: wait for the execution at the stated price
• Factors affecting the bid ask spreads
– Market makers, competition, trading volume
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The Oxford Guide to Financial Modeling by Ho & Lee
Spot Market
• Primary market
– new issuance
– Investment banking
• Secondary market:
– Exchanges: central location, specialists
– Over-the-counter
• Open limit order book
• Market makers
• Electronic Communication Network (ECN)
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The Oxford Guide to Financial Modeling by Ho & Lee
Future and Forward Markets
•
•
•
•
•
•
Forward contracts
Futures contracts
Counter-parties
Open interests
Marking to market
Indices: S&P 500, Nikkei 225
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2.3 Perfect Capital Market
•
•
•
•
•
•
•
All financial claims are perfectly divisible
No transaction costs
No taxes
Competitive markets
No limit in short selling
Information symmetry
Increasing utility of wealth and risk aversion
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The Oxford Guide to Financial Modeling by Ho & Lee
2.4 Efficient Capital Market
Hypothesis
• Weak form efficiency
• Semi-strong form efficiency
• Strong form efficiency
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The Oxford Guide to Financial Modeling by Ho & Lee
2.4 Efficient Capital Market
Hypothesis
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The Oxford Guide to Financial Modeling by Ho & Lee
2.5 Diversification
• A portfolio in general reduces the risk of an
individual stock
• Contribution of risk from each stock
• A measure of risk: standard deviation
• The example of 2 coins shows that the
standard deviation is lowered in betting on 2
coins than putting all the bet on one coin
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The Oxford Guide to Financial Modeling by Ho & Lee
Diversification (an Example)
Head/Head
Head/Tail
Tail/Tail
Probability
0.25
0.5
0.25
Outcomes
$200
$100
0
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The Oxford Guide to Financial Modeling by Ho & Lee
Lognormal and normal distributions with a
mean and a standard deviation
Normal Density
Lognormal Density
0.4
0.4
0.3
0.3
0.2
0.2
0.1
0.1
-1.96
0
1.96
0.23
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The Oxford Guide to Financial Modeling by Ho & Lee
Diversification Effect
0.07
Total Risk
0.06
Risk %
Systematic Risk
0.05
0.04
0.03
10
20
The number of stocks
30
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The Oxford Guide to Financial Modeling by Ho & Lee
Diversification Effect
2
2
2
2







 k2  ABC BCD CDA DAB
4
the average risk of portfolios :
2
 ABC

2
 BCD

2
 CDA

2
 DAB

 k2 

1
3
1
3
1
9
1
9
1
9
1
9
  A2 
 B2 
 C2 
 D2 



2
A
 i2 
1
9
1
9
1
9
1
9
 B2 
 C 2 
 D2 
  A2 
1
9
1
9
1
9
1
9
 C 2 
 D2 
  A2 
 B2 
2
9
2
9
2
9
2
9
  B2   C 2   D2
4
2
3
 ( AB   BC   CA )
 ( BC   CD   DA )
 ( CD   DA   AC )
 ( DA   AB   BD )
  2  2(
3
AB
  AC   AD   BC   BD   CD )
12
  ij
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Diversification Effect
 P2   A2 A2  2 AB A, B  B2 B2
  A2 A2   AB A, B   A B A, B   B2 B2
  A ( A A2  B A, B )   B ( A A, B   B B2 )
  A A, P  B B , P
 A, P  Cov( RA , RP )  Cov( RA , A RA  B RB )  Cov( RA , A RA )  Cov( RA , B RB )
 ACov( RA , RA )  B Cov( RA , RB )  A A2  B A, B
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The Oxford Guide to Financial Modeling by Ho & Lee
Capital Asset Pricing Model
E[ Ri ]  rf  i  E[ RM ]  rf 
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The Oxford Guide to Financial Modeling by Ho & Lee
Capital Market Line
CML
M
D
A
B
C
E
0
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The Oxford Guide to Financial Modeling by Ho & Lee
the variance of the market portfolio
 M2  1 cov(R1, RM )  2 cov( R2 , RM )  ....  N cov( RN , RM )
1  1
cov( R1 , RM )
 2
cov( R2 , RM )


= 11  2 2  ...  N  N
2
M
cov( Ri , RM )
i 
, i  1,
2
M
2
M
 ...  N
cov( RN , RM )
 M2
,N
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The Oxford Guide to Financial Modeling by Ho & Lee
2.7 Beta – the Systematic Risk
Ri
Ri
Ri  ˆi  ˆi RM

 ˆi  ˆi RM
 ei
ei

ˆi  ˆi RM

ˆi RM
ˆi
ˆi
O
RM

RM
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The Oxford Guide to Financial Modeling by Ho & Lee
Security Market Line: relationship between
expected return and beta
Expected Return (%)
100
Buying Stock at a margin
Buying Stock
50
Riskless Asset
0
(50)
(100)
(10)
Short Stock
(5)
0
5
Chapter 2. Equity Market: The Capital Asset Pricing Model
Beta
10
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The Oxford Guide to Financial Modeling by Ho & Lee
The Constant Growth Stock Model
•
•
•
•
S the stock price
D the dividends
The required return of the stock
The constant growth rate
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The Oxford Guide to Financial Modeling by Ho & Lee
2.8 The Dividend Discount Model
div(n  1)  div(n)(1  g )
div(1)
div(1)(1  g ) div(1)(1  g )2
S



2
3
(1  Rreq ) (1  Rreq )
(1  Rreq )
S
div(1)
( Rreq  g )
div(T  1)
S  PV (forecasted dividends over T periods) 
( Rreq  g )(1  Rreq )T
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The Oxford Guide to Financial Modeling by Ho & Lee
2.10 Empirical Tests of the Capital
Asset Pricing Model
• Black, Jensen, Scholes (1972)
• Fama and Macbeth (1974)
– Relate the stock betas with the long term stock
returns
• Roll (1977)
– Is CAPM testable?
• Stambaugh(1982)
– What is the market portfolio?
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