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BF2201 Cheatsheet

Investments (Nanyang Technological University)

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ASSET CLASSES & FINANCIAL INSTRUMENTS RISK & RETURN (PAST & PROLOGUE) Single Factor Index Model:
Money Market [1] Measure returns under certainty  HPR Estimate components of risk for a security/portfolio
T-Bills: 0 coupon, s (<=52 wks), highly liquid, not callable, risk-free [2] Measure returns under uncertainty  Risk & returns - uses historical HPR to separate sys & idio risk
(backed by full-faith of govt) Holding Period Return (HPR)  for AAR / GAR - practical:  # inputs needed to diversification in
- Used to adjust exposure to risk.
Ask price: you (buy) pay dealer (sell)
Expressed as % of PAR
Bid-asked spread: ask – bid
P t−Pt −1+ Cashdividend W1 + W2 = 1 portfolio
Portfolio risk < weighted-avg risk of stocks- convenient: easy starting point for understanding
Bid price: dealer (buy) pays you (sell) = dealer’s profit HPR = in portfolio. risk using ).
SGS Bills & Bonds: proceeds invested, can’t use for govt expenditures Pt −1 Ri,t = i + iRm,t + i,t
HPR
Ri,t = ri,t – rf,t = excess return of indiv stock i = E(rM) – rf
Bond Market Assume all div accrued from t-1 to t are paid at t
- ignore cpding eff from reinvested div within ea period Rm,t = rm,t – rf,t = excess return of well diversified
- semi-annual coupon pmts portfolio β determines the risk
- par value $1,000 Rates of return over multiple periods Arithmetic Avg -1 1,2  +1 When 1,2 = -1, it is possible to choose - β determines the RP of all premium
indiv stocks.
of all indiv stocks.
i = sensitivity of a security’s excess return to the
- quotes – % of par Treasury notes (up to 10 yrs) W1 and W2 such that (1,2) = 0 (NO risk). - All stocks should have the All
same risk-return
stocks trade the
should have
(AAR): has an upward bias relative to GAR that  with benchmark index.
- ‘nearly’ default risk free & bonds (10 - 30 yrs): off, as measured by slope. same risk-return trade off,
volatility of return. i,t = unexpected firm-specific events.
- substantial i/r risk Asset allocation between 2 RISKY assets - All stocks {E(r), β} pairs should be on SML.
as measured by slope.
- When volatility = 0, AAR = GAR - realized return – predicted return
Treasury Inflation-Protected Securities Minimum variance portfolio α = Trader’s estimated return– theoretical
All stocks {E(r),E(R)
β} pairs
Geometric Avg (GAR): HPRGAR = per-period RoR that i = avg excess return not reflected by i & avg
- principal adjusted by CPI - measures how much E(r) differshouldfrom CAPM-
be on the SML
when cpded over T periods gives the same return/dollar excess returns of the mkt.
- Expected Inflation  Nom YTM – Real YTM implied E(r).
invested as cumulative buy & hold returns over T periods - “risk-adjusted” avg excess returns
- expected excess returns (E(ri) - rf ) adjusted for
n - not time-specific
compensation for sys risk (β i[E(rM) - rf]).
Stock & Bond Indexes HPR T
HPR AAR=∑
Purposes: =0.3 - CAPM eqm, α = 0: E(ri)=(α =0) + rf + β i[E(rM) - rf]
- Track avg returns - dis-equilibrium, α ≠ 0. α = E(ri) - rf - bi[E(rM) - rf]
- Compare perf of money managers (agst index) t=1 n Risk averse  invest
in portfolios above
- E(ri) - rf: Ex-ante RP/Ex-post avg excess returns
- Base of derivatives - > 0: +ve risk adjusted expected excess returns
n 1 green line (same risk,
Factors in use: representative? broad/narrow? construction? - E(r) > CAPM E(r)  underpriced (offers too high
HPR GAR=⌊ ∏ ( 1+HPR T )⌋ n −1
higher E(r))
Mutual Fund: pool funds from investors to buy securities of E(r) for its lvl of risk)
Index Fund: MF which buys securities to track index
Exchange Traded Funds: IF which trades on an X T =1 I,t > 0 ARBITRAGE PRICING THEORY
Construction: Incl which stocks? How much $ in stock? Risk & Risk Premiums I,t > 0
Mkt-value weighted: amt invested in ea stock  mkt value of ea stock Ex-ante measure of E(r): Under index model, β i is an estimate of security
-  in large-cap stock impact value-weighted indice >  in small-cap s Ea graph rep a portfolio w 2 risky assets of some .
stocks
E ( r )= ∑ p ( s ) r ( s )
- +ve eff of diversification  as .
Portfolio A (=0) vs Portfolio B (=0.3): A is better as
i ' s sensitivity to the (sys) factor portfolio m .
SECURITIES MARKET - for the same , A has higher E(r) IF t+1 = 0, forecasted price = realized price, &
Types of orders
s=1 - for a given target E(r), A has lower risk (). ONLY  in the price of mkt portfolio drives  in

[
σ =∑ p ( s ) × [ r s−E(r ) ] ]
Market Order: Buy/Sell immediately at curr mkt price. (Lowest broker fee) 2 2 PXYZ.
Limit-Buy Order: buy at or below a stipulated price Diversification with MANY risky assets
Limit-Sell order: sell at or above a stipulated price become mkt orders CAPM: 1 source of sys risk: Unexpected  in mkt
s portfolio.
Stop-Loss orders: sell if price fall below a level when trigger price is Var (I, constant) = 0 APT:  1 sources of sys risk (eg unexpected  in
Stop-Buy orders: buy if price rises above a limit reached Ex-post avg returns & σ to approx. E(r) & ex-ante :
Use AAR (large
σ Var (Ri) = Var (i +iRm + i)
i/r, in inflation, in aggregate corporate default risk
Discretionary Order: gives broker the σi2 = Var(i Rm) + Var(i) = i2σ2m + Var(i)
sample theory, and in industrial prdn)
power to buy & sell for your account at Total risk = sys risk + idio risk
law of large #) - Pervasive – must potentially impact most co,
the broker’s discretion E(I) = 0 as impact of unanticipated events must avg
leading stock prices to unexpectedly .
Time dimension on orders: eg IOC out to 0
- Undiversifiable
(immediate or cancel), Day (by default), Var(i) =0 in CAPM as no diversifiable risk.
Assumptions:
GTC (good until cancelled – usu 60 days 0 < R2 = i2σ2m / σi2 < 1: how much of variation of - No taxes
Trading Costs max) Ri is explained by variation in mkt returns, Rm - no transaction costs
Commission: fee paid to broker for making transaction Bid-ask spread - how close are plots to line - Investors can form well-diversified portfolios
- buy + sell = 2 trades  pay commission twice
- No arbitrage opp (same payoff, same price.
Capital Asset Pricing Model Portfolio requiring 0 initial investment  produce 0
Buying on margin: borrow part of purchase price from broker Assumptions:
(Optimal trade-off payout in future)
 magnifies gains & losses - Indiv investors are “price takers.”
between risk & return) Arbitrage opp: 2 securities always have the same
*Note possible interests, dividends & commission fees - Investments are limited to traded financial assets payoff but NOT the same price.
Initial Margin Requirement (IMR): min % of initial investor equity - No taxes & no transaction costs - Arbitrage: exploit mispricing of  2 securities to
Maintenance margin requirement (MMR): Min % of equity b4 additional - Ppl only care about mean & var of returns achieve a rf profit.
funds must be put into account  risk,  IMR - Ppl all have same expectations, & the  & 2 of
Risk Premiumasset = E[rasset] – rf - Profitable arbitrage opp quickly disappear in
returns are known (Homogeneous expectations). efficient mkt.
Position (only 1 stock in margin account) Initial New When estimated using historical data, RP is also avg
excess return. - More assets in portfolio  more likely for returns of -α≠0
Mkt value = price  # of shares
the stock to offset ea other   risk   sharpe ratio
Borrowed No-arb E(r): E(rP) = rf + βP,1*(E(r1)-rf) + βP,2*(E(r2)-rf)
Asset allocation across RISKY and RF portfolios - Investors want a portfolio on efficient frontier of ALL
Equity 1. βP,1 & βP,2: How security’s return “co-vary” w risk
Subsequent  Complete Portfolio: incl risky & rf assets RISKY assets, until we add the rf asset.
¿ Mkt value−loan−∫ + Add Cas in price is 
from equity
- Proxy rf with T-bills/money mkt fund.
Capital Allocation Line: y=weight in risky portfolio Combining Risk-free Asset with Efficient Frontier
factor portfolio’s return
2. Factor RP: E(r1)-rf & E(r2)-rf (RP associated w
Capital Mkt Line risk factor portfolio.)
*ignore interest if considering  equity immediately 0 idio risk
after purchase. Incl if considering equity over a if buying on margin,
y = 1 + % leverage >1 Risk Factor Portfolio: well-diversified portfolio
time period
- =1 (w.r.t to 1 risk factor), 0 (w.r.t other factors)

Margin =
Equity∈ Account Rate of return =
*Use Std Dev, NOT Var.
Eqm: reward-to-risk ratio of portfolios are equal
- reward-to-risk ratio = (E(rP) – rf)/P)
Value of Stock - Arbitrage activities push prices of portfolio to eqm.
w = 0  = 0

Final MV −loan−
∫¿ ¿-1
E (r p Slope = sharpe ratio  All investors will hold combi of mkt portfolio & rf
Strategy: 0 initial investment, earn +ve profit w
complete certainty
slope/sharpe ratio= Cov(r i , r M ) Compare E(rARB) =no-arb E(r) & E(rP) = trader’s est.
initial investment σPortfolio P consists only of risky assets, no rf asset. β i= measure asset’s sys
- Buy higher E(r), sell lower E(r) w > 0: cash outflow
- αi>0: buy portfolio P; αi <0: buy arbi, short P
Margin call occurs when (need to restore to IMR):
- Slope (P) > Slope A: investors can combine P with rf σ 2M - buy/borrow rf: borrow = cash inflow = sell rf (wrf<0)

MMR 
Equity asset & get higher E(r) for the same risk lvl as A risk rel to mkt.
WP =1: buy P; WP = -1: Short P rf = 0
Market value = - optimal risky portfolio/tangency portfolio - 1-factor: ARB = wMM + (1 – wM)rf = P
Market Value Risk Aversion & Allocation
Investor cares abt complete portfolio RP vs complete
- Everyone, regardless of risk aversion, holds a - 2-factor: wM = M, wIR = IR. wP+ wM + wIR + wrf = 0
portfolio along CML [max sharpe ratio]
portfolio risk. A=0 if risk neutral (cares only
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A>0 if risk averse.
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E (r C ) - r f
Loan+ Interest − Additional Cash A = > 0
INDEX MODEL & CAPITAL ASSET PRICING n
β pfor a portfolio ¿ ∑ wi β i
2 Holding indiv securities in a portfolio diversifies away
C
idiosyncratic/firm specific/diversifiable/unique risk.
(1−MMR) The remaining is systematic/mkt risk which arises
i=1
from events that affect the entire economy.
Short sales: profit from  in price (liable for CFs eg div)
EFFICIENT DIVERSIFICATION
- w i = prop of portfolio wealth invested in stock “i”
Initial Margin Account = sale proceed + cash to meet requirement
MMR = % of MV. Margin call when MV = - Mkt portfolio has beta of 1
- > 1: more sensitive to econ than avg stock in mkt
Total Margin Account−¿ - < 1: below-avg sensitivity
- small cap stocks have higher 
(1+MMR)
Equity = Total (Initial) Margin Account – MV – Div
To restore to initial margin,
Margin % =
Equity - necessary equity = initial margin %  MV
Amt received: sale proceeds - current equity
MV
Amt paid: Div, Buy back shares - diff btw the 2 = amt needed to restore.
(Don’t incl cash paid to meet
margin requirement)

Rate of investment =
Amt received− Amt paid
meet margin rquir
cash paid ¿
EFFICIENT MARKET HYPOTHESIS Net Asset Value (price/share) = MANAGING BOND PORTFOLIOS Put (Sell): Write option ST – X
Fama & French 3 Factor Model:
E( r p) - r f
Aver age Ret ur n
Aver age Ret ur ns and Bet a f or Si ze- r anked
Por t f ol i os: US St ock Mar ket
Asset MV −liabilities Interest Rate Sensitivity: (price sensitivity/volatility)
How much will bond price  when i/r ?
ST – X + p
Payoff = - Max(X - ST, 0)
= Min (0, ST – X)
maturity,  sensitivity - Pay CFs sooner  sensitivity Profit = Payoff + p
0. 016
0. 014
0. 012 Higher , higher return
Sm
al l est
Compani es

shares outstanding coupon,  sensitivity -  price sensitivity  experience ST* = X – p
- liabilities: Unpaid admin exp, mgt fee, & borrowed  YTM,  sensitivity larger price appreciation
0. 01 If put-call parity doesn’t holdarbitrage opp
0. 008 fund (for leverage). fund
0. 006
0. 004
Lar gest r CAPM- r f =bet a*0. 0064
CAPM -calculated at 4pm close each trading day Duration: measure of effective maturity Protective Put: long stock + long put
Compani es
0. 002 turnover rate = (stock value sold/replaced)/asset value - maturity for portfolio of 0 cpn bonds of diff maturities - guarantee min floor on long stock position = X
0 - pmts (cpns) b4 maturity duration < actual maturity
0. 9 1 1. 1 1. 2 1. 3 1. 4 1. 5
Fees: don’t affect NAV BUT affect return - duration of perpetuity = (1+y) / y Put (buy)
Beta
ST
Front-end load: %commission (subscription fee) 1) PV of each 0 cpn bond
Firm size (measured by MV of equity) historically explain
- pay offer price = NAV/(1-FEL) to buy shares with diff maturities
bk-to-mkt ratio = (bk value of equity) / (MV of equity) stock returns
- for every $1 invested, actually buy $(1 – FEL) 2) Weight of ea bond = ST – S0
Factors:
Don’t minus rf: Finding diff btw Back-end load: %commission on exit NAV price PV/price
- Mkt Index Excess Return (rM – rf)
- sell get redeem price = NAV * (1-BEL) per share 3) (PV/price) * maturity of Stock
- SMB (small firm returns – big firm returns) returns alr cancelled out rf Replace ‘Offer’ &
- S0
Expense ratio: % of NAV ea yr ea bond
- HML (high B/M firm returns – low B/M firm returns) ‘Redeem’ w NAV Add lines in (A) & (B)
Return= 4)  values in step 3
E(rG)– rf = βG,M(E(rM) – rf ) +βG,SMBE(rSMB) + βG,HMLE(rHML)
Redeem t −Offert −1+ Distributions if no F/BEL.
ST
Efficient Mkt Hypothesis: Security prices accurately reflect all avail info
Efficient: On avg, no risk-adjusted +ve profit from public avail info.
- unpredictable news  unpredictable returns
Offer t−1 Modified Duration:
X ST – S0 - p Black-Scholes Formula
Inefficient: active strategy α > 0 & outperform passive strategy NAVt+1= NAVt (1+ %  in asset value/price)(1–exp ratio) Assumptions:
Investor competition  stock prices fully & accurately reflect relevant, Hold for long time  like F/BEL over exp ratio (annual) - investors trade in continuous time.
avail info quickly (frequent, low-cost trading) Net annual return - S0 + X + p - (log)returns over ea time instant r norm
PORTFOLIO PERFORMANCE EVALUATION Duration Pricing Error: distributed.
-  info efficiency if  access to info, structural mkt friction, investor
Benchmark Portfolio: Compare dir w index (S&P500) - Duration is linear approx
psycho
- doesn’t adjust to risk (return may be due to risk) - but price-yield curve is non-linearconvexity From Binomial option pricing model,
Stock priceRandom Walk if unpredictable & random prices  (info eff). - benchmark outperform = MF didn’t outperform -  # time intervals until expiration  the amt of time
random  in stock price in period t. Risk Model: risk-to-reward (, sharpe/Treynor ratio) impt for large i/r  btw each interval.
Pi,t = Bi Pi,t-1 +ei,t - As # time intervals , the time btw each interval
Security prices  with time
Bi = 1 + E(ri) gets infinitesimally small.
Weak Semi-strong Strong If X = S0, - At the limit, investors trade in continuous time as
y > 0: overestimate Min profit = -p
Prices info in hist price & PUBLIC info public the time btw each interval gets infinitesimally small.
reflect trading (vol) data + pte y < 0: underestimate - S0 Max profit = unlimited Call option value Stock div rf i/r
can’t earn hist price & trading growth forecast, fin any
+ve risk- data statement, old info Covered Call: long stock + write call
y = ytm N(d1) & N(d2) r
adjusted price, vol data & - collect call premium Call (Sell)
Ex-post roughly the prob
profits using earnings
the option will be
SS holds = W form holds. S holds = SS & W form holds. (NOT vice versa) ITM
Check if > 1 form (doesn’t) hold
Technical Analysis uses hist stock prices & vol info to predict future price Volatility of stock
es (assume violates weak form) (implied from mkt price)
Fundamental Analysis uses financial statements & future prospects to
OPTION MARKETS
identify mis-priced securities (assume violates semi-strong form) Same as protective put Likely to finish ITM
Call Put
- forecast future earnings, disc to PV using required RoR, curr stock price Mkt eff: b4 exp, avg MF’s =0. (after fee underperf) Add lines in (A) & (B)
vs estimated price __ fixed qty of underlying asset Buy Sell
To be better off with actively MF:
Active mgt: identify mispriced securities – security analysis, timing for strike price (X) by fixed date More time for S to 
- no semi-strong mkt efficiency  
strategies, investment newsletters (assumes mkt inefficient) Buy if think underlying asset value
- find fund manager outperforms benchmark after exp.
Passive mgt: Buy & Hold well-diversified portfolios, index funds w/o Across all fund managers, avg =1. Underlying asset: indiv stock or index S  unlikely ITM
searching for security mispricing (assumes SS form efficient) Expiration date (T): last day to exercise option X
- European option: exercised only on this date
Peer Gp Analysis: Rank perf to competitors within cat
Abnormal returns (Index Model)   t Cumulative (“Buy - Morningstar ratings: rank funds within each peer grp - American option: exercised b4/on this date
Lot size: # shares
& Hold”) AR: Add - Fund inflows (new investment $)  after initial rating
Premium: purchase (closing) price of option
the ARs ea period - fund inflows: greatest for newly rated 5-star funds. C - S0 - S0 + X + C
In (Out of) the money: exercise generates + (-) CF ST – S0 + C
over time - After initial 5-star rating, fund perf .
At the money: X = underlying asset price
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ST > X: ITM Call (Buy)
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OPTION VALUATION
RM,t Select funds: evaluate based on obj & assets size ST – X Binomial Option Pricing
Abnormal returns (FF 3 Factor) Entire-wealth portfolio: only 1 portfolio Form Riskless portfolio (same payout in all
X ST* ITM: ST – X
- can’t diversify across funds Total risk: sharpe ratio scenario)
Fund of funds: many funds, incl non-well-diversified C - H shares of underlying asset
- complete portfolio is well-diversified -C Max loss = -C ST – X - C - write 1 call contract New stock price/S 0

- sys risk: Treynor ratio (no idio risk, not sharpe ratio) Today’s value V0 = H*S0 – C OTM: 0
ST = price of underlying asset on T
Testing Market Efficiency Breakeven price ST*: ST where profit = 0 At expiration (up state): Vu = H*u*S0 - Cu = Vd
Event studies: how quickly info integrates into prices around info event Put (Call) with higher (lower) X cost more At expiration (down state): Vd = H*d*S0 – Cd = Vu
- EMH suggests rapid integration Call (Sell): Write option V0 = PV of Vu or d = Vu or d / (1 + rf)^
- Compare avg excess return to sys risk (not total risk)
Test trading rule: Use trading rule based on past trading info to earn AR. Portfolio added to passive benchmark: hold passive- Payoff = - Max(ST – X, 0)
p C u +(1− p) Cd Hedge ratio,
- EMH suggests that such rules will not work
Assessing perf of prof managers: Can prof managers, using their
managed portfolio, wish to add actively-managed fund
- delivers benefit of , but adds idio risk
= Min(X – ST, 0)
Profit = Payoff + C C= C −C
resources and tools, “beat” the mkt after adjusting for risk? -  per unit of unsys risk buy underlying asset at 1+ r
- EMH suggests on avg, they won’t outperform the mkt. α p - Unsys risk σ : s.d of (index spot mkt
- by luck, #managers that consistently beat = (0.5) #periods tested (#managers) - Info ratio ¿ ε εp ST* = X + C 1
σε Put (Buy) risk−neutral probability , p=
Issues: FM Revision
p Payoff = Max (X – ST, 0)
Model Mis-specification: - often used to evaluate hedge funds (short-sell & Profit = Payoff – p
Calculating AR requires adjusting returns for the risk of the stock/strategy. invest in derivatives) ST* = X – p Put-Call Parity: relation btw C & p
- Test = joint test of: model used to (1) measure risk & (2) mkt efficiency - Many hedge funds try to follow mkt neutral strategy Call & put must have same (1) underlying asset (2)
- Findings agst mkt eff may be caused by using wrong model (produce returns with: =0 (no sys risk) &  >0) X (3) maturity date
Lucky Event: large grp of prof managers some out-perform due to luck
Selection Bias Issue: We only learn about FAILED trading strategies. BOND PRICE & YIELD
yield curve/term structure of i/r: longer maturity, yield Long call, short put
MUTUAL FUNDS: portfolio of financial securities Expectation Hypothesis:
- many investors provide capital LT rate = cumulative expected future ST rates
- prof manager invests (1+yn)n=(1+yn-1)n-1(1+fn) fn: expected rate for next C – p = S0 – Xe-rT e =exponential; r = annual i/r;
- benefits: prof mgt, diversification & divisibility for small investors,  LT rate ST rate period
Liquidity premium should  T = time to maturity in yrs
transaction cost, admin & record keeping Liquidity Preference:
- Investors require LP to hold LT
bonds due to exposure to i/r risk.
- Combi of varying expectations &
LPs can result in diff yield-curve
profiles.

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