RISK MANAGEMENT II

LECTURE NOTES

THE TIME VALUE OF MONEY

The phrase the time value of money refers to the idea that a given amount of is worth much more in hand presently than at a later period. A recurring concept is that of future value, which refers to the amount of money an investment will grow to over some time period at some given interest rate. Future value of a specific amount will depend on the nature of the interest element. In the case of simple interest, interest is only earned on the initial amount invested over any given period. So for example, an amount of $100 invested at a rate of 5% per year, will at the end of the first year grow to $105, while at the end of the second year, it will grow to $110. The amount of $110 obtained after the two years consists of the initial amount invested and the constant interest earned over each of the two years. There is also compound interest, in which case, interest is also earned on all interest accumulated prior to the current period. If the $100 had been invested at a rate of 5% compounded, the invested amount will grow to $105 after the first year but in the second year, interest will also be earned on the additional $5 that the initial sum of $100 has grown by. So in the second year, 5% interest is earned on the initial amount of $100, and 5% is earned on the additional $5 that has accumulated. This gives a total additional interest element of $5.25 ($5 on the $100, and $0.25 on the $5 gained after one year). Adding this up gives a total amount of $110.25, after two years. In our analysis we shall be resorting more often to compound interest. Under compound interest, the future value of any amount C invested for time t at a rate r is given by: Future Value = C (1 + r)t Note thatr is very often the rate per annum and thatt is often given in years. The expression (1 + r)t is referred to as the future value interest factor or just future value factor. In the case of an investment of $100 for five years at a rate of 5% per annum, the future value after the five years will be: $100(1 + 0.05)5 = $127.63 Present Value: Assuming at a rate r we wish to determine the amount that has to be invested presently in order for us to have C dollars in t years, we use the formula: PV = C / (1 + r)t, where PV or the Present Value is the amount to be invested presently at rate r for t years in order for us to have C dollars by time t. In this instance, r is known as the discount rate and the expression 1 / (1 + r)t is known as the discount factor of the present value factor.

Calculating the present value of a future cash flow to determine its worth today is commonly called Discounted Cash Flow Valuation. For example, assuming we wanted to determine how much we have to invest today in order to have $1000 in 3 years if we earn 15% per annum, on our investment. Let us first determine the discount factor. In this instance, r is 0.15 and t is 3. The discount factor therefore becomes: 1 / (1 + 0.15)3 = 0.6575 This means PV is $1000 X 0.6575 = $657.50 Present Value for Annuity Cash flows Suppose we want to examine an asset that promises to pay $500 at the end of each of the next three years, assuming we wanted to earn 10% on our money each year. Applying the formula PV = C / (1 + r)t for each of the three years, we end up with PV = 500/1.1 + 500/1.12 + 500/1.13 = 454.55 + 413.22 + 375.66 = 1243.43 The general formula for the present value of an annuity of C dollars per period for t periods at a rate of return or interest rate of r is given by: PV of annuity: C x [ 1 (1/(1 + r)t)]/r

Future Value for Annuity Cash flows Suppose you plan to contribute $2000 every year to a retirement account paying 8%. How much will you have in 30 years when you retire? The future value of an annuity of C dollars per period for t periods at a rate of return or interest rate of r is given by: FV of annuity: C x [( 1 + r)t 1]/r Annuity due An important alteration of an annuity, is an annuity due, in which cash flows occur at the beginning of each period. For a loan repayments, the initial installment is usually made a month after the loan is granted; this is an example of an ordinary annuity. However in the case of a lease of an apartment, the first payment is usually due immediately

An ordinary annuity is converted to an annuity due simply by multiplying the ordinary annuity by the discount factor (1 + r). Hence the present value or future value of an annuity due is obtained simply by multiplying the present value or the future value (respectively) of the corresponding ordinary annuity by (1 + r) Perpetuities An annuity in which the cash flows continue forever are referred to as a perpetuity. In Canada and the United Kingdom, perpetuities are called consols. The present value of a perpetuity of C dollars per period at a rate r is given by C/r

Preferred Stock Preferred stock or preference stock is an important example of a perpetuity. When a corporation sells preferred stock, the buyer is promised a fixed cash dividend every period usually quarterly forever. This dividend must be paid before any dividend can be paid to regular stockholders, hence the term preferred.

Effective Annual Rates and Compounding The stated interest rate is the interest rate expressed in terms of the interest payment made each period. Effective annual rate is the interest rate expressed as if it were compounded once per year. If a rate is quoted as 10% compounded semiannually, it means that the investment actually pays 5% every six months. But 5% every six months does not yield 10% (the stated interest rate); rather it yields 10.25% (the effective annual interest rate (EAR)) Given a quoted rate and m,the number of times the interest is compounded, the formula for the effective annual interest is given by: EAR = [1 + (Quoted rate / m)]m 1 Now there is no limit to the number of times that a particular amount may be compounded within a year or a unit period. Generally, as the number of times the amount is compounded increases, the effective annual rate also increases. If q is the number of times the interest is compounded, as q gets extremely large, the effective annual rate (EAR) approaches: eq 1

Loan types and loan amortization Whenever a lender grants a loan, some provision will be made for the repayment of the principal. A loan might be repaid in equal installments for example, or it might be repaid in a single lump sum. There is actually an unlimited number of possible repayment arrangements, as the repayment arrangement is usually determined by the parties involved. There are however some forms of repayment that come up more often than the rest; we have pure discount loans, interest-only loans and amortization loans. Pure discount loan: The borrower receives money today and repays a single lump sum at some time in the future. A one-year 10% pure discount loan requires the borrower to repay $1.10 for every dollar borrowed today. Assuming a lender wants a 12% rate on a five year loan that requires the borrower to repay $25,000 at the end of the loan term, how much would the borrower have to lend today? The answer would be to find the present value of $25,000 paid five years from now at a rate of 12%. PV = C / (1 + r)t, with r = 12% and t = 5 and C = $25,000 = $25,000/(1.12)5 = $14,186 Interest-only loans: Require the borrower to pay interest each period and to repay the entire principal at some point in the future. For example, with a three-year 10% interest-only loan of $1,000, the borrower will pay $1000 x 0.1 = $100 at the end of each of the first two years and pay the $1000 in addition to the interest of $100 for the last year. In the extreme, the borrower pays the interest every period forever and never repays the principal. This would be an example of a perpetuity. Most corporate bonds have the general form of an interest-only loan. Amortized loans: The process of providing for a loan to be paid off by making regular principal reductions is called amortizing the loan. A simple way of amortizing a loan is to have the borrower pay interest each period plus some fixed amount. For example, suppose a business takes out a $5000, fiveyear loan at 9%. The loan agreement calls for the borrower to pay the interest on the loan balance each year and to reduce the loan balance each year by $1000. Because the loan amount declines by $1000 each year, it is fully paid in five years. The total payment will decline each year. The reason is that the loan balance goes down, resulting in a lower interest charge each year, whereas the $1000 principal reduction is constant. For example, the interest in the first year will be $5000 x 0.09 = $450. The total payment will be $1000 +$450 = $1450. In the second year, the loan balance is $4000, so the interest is $4000 x 0.09 = $360, and the total payment is $1,360. Probably the most common way of amortizing a loan is to have the borrower make a single, fixed payment every period. Almost all consumer loans such as car loans and mortgages work this way. Suppose the initial five-year, 9%, $5000 loan was amortized this way, how would the amortization schedule look? We would first have to determine the payment. From earlier discussions, we know that the cash flows are in the form of an ordinary annuity, solved as follows: $5000 = C [1 (1/( 1 + 0.09)5)]/0.09

Solving, we find C to be $1285.46. So for fixed payments every period, the borrower will have to pay $1285.46 every year.

INTEREST RATES AND BOND VALUATION Usually, when the government or a corporation wishes to borrow money from the public on a long-term basis, it issues or sells debts securities that are generically called bonds. A bond is normally an interest-only loan, meaning simple interest charged on the loan is paid every period and the principal is paid in full only at the end of the loan duration. Suppose a corporation wishes to borrow $1000 for 30 years. The interest rate on similar debts issued by similar corporations is 12%. So our corporation decides to pay 0.12 x $1000 = $120 in interest each of the 30 years. At the end of the 30 years, the corporation will also have to repay the initial $1000. The $120 that the corporation promises to make in regular interest payments is termed as the bonds coupons. Constant annual coupon payments characterize a level coupon bond. The amount that will be repaid at the end of the loan tenure is called the bonds face value or par value. In the example cited above, the face value is $1000. When a bond sells for its face value or par value, it is termed as a par value bond. Dividing the annual coupon by the face value of a bond gives you the coupon rate on the bond. The coupe on rate in the example cited above is $120/$1000 = 12%. The number of years remaining till the face value of the bond is paid is termed as the time to maturity of the bond. Interest rates change in the market place but the cash flows from a bond however, stay the same. The value of a bond tends to fluctuate as a result. A rise in market interest rates results in a decline of the present value of a bonds remaining cash flows, decreasing the v alue of the bond. When interest rates fall, there is an increase in the present value of the bonds remaining cash flows and the bond is worth more. To determine the value of a bond at a particular point in time, we need to know the number of periods remaining until maturity, the face value, the coupon and the market interest rate for bonds with similar features. The interest rate required on a bond in the market is termed as the bonds yield to maturity. Suppose a corporation were to issue a bond with a maturity of 10 years and an annual coupon of $80. Similar bonds are known to have a yield to maturity of 8%. How much would this bond sell for? We know the corporation will pay $80 per year for the next 10 years in coupon interest. And in 10 years, the corporation will pay the owner of the bond $1000. The coupons constitute an annuity component whilst the face value to be paid at maturity is a lump sum.

This suggests that the value of the bond can be determined as follows, if C is the coupon paid per year and F is the face value of the bond. Bond Value = C [ 1 (1/(1 + r)t)]/r + F / (1 + r)t
This is equivalent to the sum of the present value of the coupons and the present value of face value of the bond. Applying this to the above example, we obtain

Bond Value =
= = = =

$ 80 [1 (1/(1 + 0.08)10)]/0.08
$ 80 (1 1/2.1589)/0.08 $ 80 x 6.7101 $ 536.81 $ 1000 + $ 463.19

+ + +

$ 1000 / (1 + 0.08)10 $ 1000 / 2.1589 $ 1000 / 2.1589

The bond sells for exactly its face valued. This is similar to an interest-only loan issue at 8% for 10 years. To illustrate what happens when interest rates increase, let us assume that after a year, the market interest rate has risen to 10%. The time to maturity is now 9 years and the new bond value is given by: Bond Value = = = = $ 80 [1 (1 / (1 + 0.10)9)]/0.10 $ 80 x 5.7590 $ 460.72 $ 884.82 + $ 424.10 + + $ 1000 / (1 + 0.10)9 $ 1000 / 2.3579

It can be seen that the present value of the bond now declines. The market rate is now 10%, meaning that the bond now pays less than the going rate. Investors are therefore now willing to lend something less than the $1000 promised repayment. A bond that sells for less than its face value is called a discount bond. Let us now consider a scenario in which the yield to maturity of the bond declines.To illustrate what happens when interest rates decreases, let us assume that in the previous scenario instead of the market interest rate rising after a year, it drops to 6%. The time to maturity is still 9 years and the new bond value is given by: Bond Value = = = = $ 80 [1 (1 / (1 + 0.06)9)]/0.06 $ 80 x 6.8017 $ 544.14 $ 1136.03 + $ 591.89 + + $ 1000 / (1 + 0.06)9 $ 1000 / 1.6895

The value of the bond now is about $136 in excess of the par value. The bond has a coupon rate of 8% when the yield to maturity is 6%. Investors are therefore willing to pay premium to get the amount in excess of the coupon that should be offered at the prevailing yield to maturity. A bond that sells at a premium sells for more than the face value is called a premium bond. Interest rate risk and bonds Generally, all other things being equal: 1. The longer the time to maturity of a bond, the greater the interest rate risk. 2. The lower the coupon rate, the greater the interest rate risk. The other thing to note about interest rate risk is that, like most elements in finance and economics, it increases at a decreasing rate. If we compare a 10-year bond to a 1-year bond, it becomes evident that the 10-year bond has a much higher interest rate risk. If we were to compare a 20-year bond to a 30year bond, we would find that the 30-year bond has a somewhat greater interest rate risk than the 20year bond though the difference between the interest rate risks of the 20-year bond and that of the 30year bond will not be as pronounced as the difference between the interest rate risks of the 1-year bond and the 10-year bond. If two bonds have different coupon rates with the same maturity, the value of the one with the lower coupon is proportionately more dependent on the face value to be received at maturity. As a result, the value of the bond with the lower coupon will fluctuate with changes in interest rate, all other things being equal. Another way of explaining this is to say that the bond with the higher coupon has a larger cash flow earlier on in its life, rendering its value less sensitive to changes in the discount rate. Some useful terms in the analysis of bonds Indenture: The indenture is the written agreement between a corporation (borrower) and its creditors. It is sometimes referred to as the deed of trust. Usually a trustee (such as a bank) is appointed by the corporation to represent bondholders. The trust company must: 1. Make sure the terms of the indenture are obeyed. 2. Manage the sinking fund 3. Represent the bondholders in default, ie, if the company defaults on its payments to the bondholders. A bond indenture is a legal document and usually includes the following provisions: 1. 2. 3. 4. 5. 6. The basic terms of the bond The total amount of bonds issued A description of the property used as security. The repayment arrangements The call provisions Details of the protective covenant.

A bond can either be in a registered form or a bearer form. Registered Form: In registered form, the registrar of the company records the ownership of each bond; payment is made directly to the owner of the record. Bearer Form: the form of bond issue in which the bond is issued without record of the owners name; payment is made to whoever holds the bond. Collateral:This is a general term that frequently means securities such as bonds and stocks that are pledged as security for payment of debts. For example, collateral trust bonds often involve a pledge of common stock held by the corporation. However, the term collateral is more commonly used to refer to any asset pledged on a debt. Mortgages security: are securities secured by a mortgage on the real property of the borrower. The property involved is usually real estate such as land or buildings. The legal document that describes the mortgage is called a mortgage trust indenture ortrust deed. Sometimes mortgages are on specific properties, for example, a railroad car. More often blanket mortgages are used. A blanket mortgage pledges all thereal property owned by the company. Debentures: are unsecured debts usually with a maturity of 10 years or more. A Note is an unsecured debt usually with a maturity of less than 10 years. Sinking Fund: An account managed by the bond trustee for early bond redemption. Call provision: An agreement giving the corporation the option to repurchase the bond at a specified price prior to maturity. Call premium: The amount by which the call price exceeds the par value of the bond. Deferred Call Provision: A call provision prohibiting the company from redeeming the bond prior to a certain date. Call protected bond: A bond which, during a certain period, cannot be redeemed by the issuer. Protective Covenant: A part of the indenture limiting certain actions that might be taken during the term of the loan, usually to protect the lenders interest.

Types of Bonds Government Bonds: these are bonds that are issued by government. In America, there are treasury issues and there are municipal bonds. Municipal bonds have varying degrees of default risk and are rated much in the same manner as corporate bonds. Coupons on municipal bonds are also exempt from federal income taxes not state income taxes making them attractive to high-income, high-tax bracket investors. Because of the enormous tax break they receive, the yields on municipal bonds are much lower than those on taxable bonds. Example, suppose taxable bonds are currently yielding 8%, while at the same time, municipal bonds of comparable risk and maturity are yielding 6%. Which is more attractive to an investor in a 40% tax bracket? What is the break-even tax rate? How do you interpret this rate? For an investor in a 40% tax bracket, a taxable bond yields 8 x (1 0.4) = 4.8% after taxes, making the municipal bond more attractive. The break-even tax rate is the tax rate at which an investor is indifferent between a taxable and a non-taxable issue. If we let t stand for the break-even tax rate, then we can solve for it as follows. 0.08 x (1 t) = 0.06 =>t = 0.25 Implying, an investor in a 25% tax bracket would make 6% after taxes in either scenario.

Zero coupon bonds: is a bond that pays no coupons at all. Such bonds are offered at price that is far less than their stated value. Floating Rate bonds: have adjustable coupon payments. The adjustments are tied to an interest rate index such as the Treasury bill interest rate or the 30-year Treasury bond rate. The value of a floatingrate bond depends on exactly how the coupon payment adjustments are defined.

Inflation and Interest Rates Real rates of interest are rates that have been adjusted for inflation. Nominal rates of interest are rates that have not been adjusted for inflation. Let us assume that prices are rising by 5% annually. We say the rate of inflation is 5%. If there is an investment that costs $100 today and will be worth $115.50 in one year, the investment will have a 15.5% rate of return. This percentage does not account for the effect of inflation. Assuming bread costs $5 apiece at the beginning of the year, we can buy 20 loaves with our initial investment of $100. A 5% rate of inflation brings the price of bread to $5.25 at the end of the year. The $115.50 that our $100 grows to after being invested for a year, can buy 115.50/5.25 = 22 loaves of bread at the end of the year. This is a 10% increase on the initial amount of 20 loaves that could be bought at the beginning of the

year. In this scenario, our 15.5% is the nominal rate of return, which has not been adjusted for inflation. The 10% by which our buying power actually goes up is termed the real rate of return. Another way of looking at this is to say that at 5% inflation, each nominal dollar that we now have is worth 5% less in real terms. So the real dollar value in an investment of 115.50 is: $115.50/1.05 = $110. The nominal rate on an investment is the percentage change in the amount of money the number of say, dollars in hand at the end of the investment period. The real rate on an investment is the percentage change in how much you can buy with the dollars in hand the percentage change in the buying power. The Fisher Effect goes further to shed light on the real relationship between the nominal and real rates of interest or return. Let R stand for the nominal rate and r stand for the real rate. According to the Fisher effect, the relationship between the two rates can be written as: 1 + R = (1 + r) (1 + h), where h is the inflation rate. Referring back to the example involving the bread, we have: 1 + 0.1550 = (1 + r) (1 + 0.05) =>r = 10% The following terms are of significance when discussing the determinants of bond yields: Term Structure of Interest Rates:refers to the relationship between short- and long-term interest rates. It refers to the relationship between nominal interest rates on default-free, pure discount securities and time to maturity ie, the pure time value of money. Inflation premium: The portion of a nominal interest rate that represents compensation for expected future inflation. Interest rate risk premium: The compensation investors demand for bearing interest rate risk. Default risk premium: The portion of a nominal interest rate or bond yield that represents compensation for the possibility of default. Taxability premium: The portion of a nominal interest rate or bond yield that represents compensation for unfavorable tax status. Liquidity premium: the portion of a nominal interest rate or bond yield that represents compensation for lack of liquidity.

STOCK VALUATION
A share of common stock is more difficult to value in practice than a bond for at least three reasons: 1. Not even the promised cash flows are known in advance. 2. The life of the investment is essentially forever, since common stock has no maturity. 3. There is no way to easily observe the rate of return that the market requires.

Three simplifying assumptions about the pattern of future dividends can be made to enable us come up with a value for the stock. The assumptions include the following: 1. The dividend has a zero growth rate. 2. The dividend grows at a constant rate. 3. The dividend grows at a constant rate after some length of time. Zero Growth Rate: For a zero growth share of common stock, such as a share of preferred stock, the dividend Dthas zero growth and is constant through time. Therefore D1 = D2= D3= Dt= D =constant The value of the stock at time 0, P0 = [D1/(1+R)] + [D2/(1+R)2] + [D3/(1+R)3] + .. Therefore, P0 = D/R, where R is the required rate of return Constant Growth Rate: Suppose the dividend for some company always grows at a steady rate g. If D0 is the dividend just paid, then the next dividend D1 is given by D1 = D0 (1 + g). The dividend in two periods is D2 = D1 (1 + g) = D0 (1 + g) (1 + g) = D0 (1 + g)2. Accordingly, the dividend at time t is given by: Dt = D0 (1 + g)t An asset with cash flows that grow at a constant rate forever is called a growing perpetuity. Assuming the Ashanti Corporation has just paid a dividend of $3 per share and the dividend of this company grows at a steady rate of 8% per annum, what will the dividend be in five years. Here, t is 5 and g is 0.08 andD0 is $3. Therefore, D5 =$ 3 x (1 + 0.08)5 = $4.41 In the case of constant growth, assuming a rate of return R, P0, the price/value of the stock at the present, becomes: P0= [D1/(1+R)] + [D2/(1+R)2] + [D3/(1+R)3] + = [D0 (1 + g)/(1+R)] + [D0 (1 + g)2/(1+R)2] + [D0 (1 + g)3/(1+R)3] + = D0 (1 + g) / R g = D1/( R g)

The final result is what is termed as the dividend growth model. And it can be expressed thus: Pt = Dt (1 + g) / R g = Dt+1/( R g) Suppose = D0 is $2.30, R is 13% and g is 5%. The price per share in this case becomes: P0 = D0 (1 + g) / R g = $2.30 x (1 + 0.05) /(0.13 0.05) = $30.19 D5 = D0 (1 + g)5 = $2.30 x 1.055 = $2.935 P5 = D5 (1 + 0.05) / 0.13 0.05 = $2.935 x 1.05 / 0.08 = $38.53 Suppose the next dividend a company will pay is $4 and investors require 16% return on such companies as the one we are considering. The companys dividend increases by 6% every year. Based on the dividend growth model, what is the value of the companys stock today? What is the value in four years?

Nonconstant growth: For a simple example of nonconstant growth, assume a company is currently not paying dividends. It is predicted that in five years the company will pay a dividend for the first time to the tune of $0.50 per share. It is expected that this dividend will grow at a rate of 10% per year indefinitely. The required rate of return on companies such as this one is 20%. What is the price of the stock today? The first dividend will be paid in 5 years and will grow steadily from then on so using the dividend growth model we can say that the price in four years will be: P4 = D4 (1 + g) / R g = D5 / R g = $0.05/ (0.2 0.1) = $5 If this is how much the stock will be worth in four years, then we can calculate the present value by discounting this price back four years at 20%. P0 = $5 /(1 + 0.2)4 = $2.41 What happens if the dividends are not zero for the first few years. Let us suppose that the expected dividend after the first year is $1, $2 after the second year and $2.50 after the third year. After the third year, dividends will grow at a constant 5% per annum. The required rate of return is 10%. What is the value of the stock today?

A most important thing to notice in this question, is when constant growth starts. It starts at Time 3, implying the stock price at Time 3, P3, can be determined using the constant growth model. P3 = D3 (1 + g) / R g = $2.50 x (1 + 0.05)/(0.10 0.05) = $52.50 The total value of the stock can now be determined as the present value of the first three dividends plus the present value of the price at Time 3, P3. P0 = [D1/(1+R)] + [D2/(1+R)2] + [D3/(1+R)3] + [P3/(1+R)3] = [$1/(1+0.1)] + [$2/(1+0.1)2] + [$2.50/(1+0.1)3] + [$52.50/(1+0.1)3] = $0.91 + $1.65 + $1.88 + $39.44 = 43.88 Components of a required return From the formula P0 = D1 / R g , we derive R = D1 / P0 + g. R is therefore said to have two components. The expression D1 / P0 is termed as the dividend yield. Because the dividend yield is calculated as the expected cash dividend divided by the current price, it is conceptually similar to the current yield on a bond. Is the dividend growth rate as well as the rate at which stock price grows. Thus this growth rate can be interpreted as the Capital gains yield ie the rate at which the value of the investment grows. Therefore R = Dividend yield + Capital gains yield. If a stock sells for $20 per share and the next dividend will be $1 per share and the dividend is expected to grow by 10% per year more or less indefinitely. What return does this stock offer if the expected growth rate is correct? The total return, R = Dividend yield + Capital gains yield = D1 / P0 + g Therefore R = $1/20 + 10% = 5% + 10% = 15%. The stock therefore has an expected return of 15%.

Some terms used in the Stock Market Primary market: the market in which new securities are originally sold to investors. Secondary market: The market in which previously issued securities are traded among investors. Dealer: An agent who buys and sells securities from inventory. He maintains an inventory and stands ready to buy or sell at any time. Broker: An agent who arranges security transactions among investors.

RETURN, RISK AND THE SECURITY MARKET LINE

Suppose there are two different stocks, namely Stock A and Stock B, with expected returns of 20% and 25% respectively, questions arise as why any investor will choose Stock A over B. The reason depends on the level of risk of each of these investments. The return on B, though expected to be 15% could actually end up being much lower. Suppose there are only two possible situations in the economy; a boom and a recession, both of which are equally likely to happen. Assuming the rate of return on Stock A is 30% during a recession and 10% during a boom, the expected rate of return on Stock A is: E(RA) = 0.50 x 30% + 0.50 x 10% = 20%. If the rate of return on Stock B is 20% in a recession and 70% in a boon, the expected rate of return on Stock B is: E(RB) = 0.50 x 20% + 0.50 x 70% = 25% In the market, there is a reward, on average, for bearing risk. The reward is commonly known as the risk premium. The risk premium is the difference between the return on a risky investment and that on a risk-free investment. When projected returns are used, we determine the expected risk premium as the difference between the expected return on a risky investment and the certain return on a risk-free investment. Risk premiums are generally larger for riskier investments. Suppose risk-free investments are currently offering 8% ie the risk-free rate, Rf is 8%, and the expected return on Stock A is 20%, Risk premium = Expected return Risk-free rate = 20% 8% = 12% Similarly, the risk premium on Stock B is: 25% 8% = 17%. To calculate the variance of the returns on Stock A and Stock B, we first determine the squared deviations from the expected return and then sum the products of each squared deviation and its corresponding probability. The standard deviation is always the square root of the variance. In the case of Stock A, the variance will be: 0.5 x (30% 20% )2 + 0.5 x (10% 20%)2 = 0.01. The standard deviation will be the square root of the variance: 0.01 = 0.1 = 10% The variance for Stock B will be: 0.5 x ( 20% 25%)2 + 0.5 x (70% 25%)2 = 0.2025 And the standard deviation for Stock B will be: 0.2025 = 0.45 = 45% From this, it is evident that Stock B may have the higher expected return, but it also has the higher risk

The Expected Return on a Portfolio Let us now consider a portfolio of assets. A portfolio weight is the percentage of the portfolios total value that is invested in a particular asset. Assuming we have a portfolio with half its portfolio weight invested in Stock A and the other half invested in Stock B. Suppose the economy enters a recession. In this case, the return on the half of the money invested in Stock B is 20% and the returns on the other half of the money invested in Stock A is 30%. The portfolio return in a recession, is therefore: RP = 0.50 x 20% + 0.50 x 30% = 5% In case there is a boom, the portfolio return will be: RP = 0.50 x 70% + 0.50 x 10% = 40% The expected return on the portfolio can therefore be found as the sum of the products of each portfolio return and the probability of the corresponding state of the economy that yields it. And therefore, E(RP) = 0.50 x 5% + 0.50 x 40% = 22.5% Alternatively, the expected return on the portfolio can be found as the sum of the product of the expected return of each asset in the portfolio and its corresponding portfolio weight. In this instance, the portfolio expected return is: E(RP) = 0.50 x E(RA)+ 0.50 x E(RB) = 0.5 x 20% + 0.5 x 25% = 22.5% Let xi be the percentage of the total value of our portfolio invested in Asset i in a portfolio consisting of n assets. The expected return on our portfolio is then given by: E(RP) = x1 E(R1) + x2 E(R2) + x3 E(R3) + x4 E(R4) +. + xn E(Rn) Suppose we have a portfolio consisting of Stocks A, B and C. The economy has a 60% chance of going into recession and a 40% chance of experiencing a boom. In a boom, the returns on each of Stocks A, B and C are 10%, 15% and 20% respectively. In a recession, the returns on Stocks A, B and C are 8%, 4% and 0% respectively. What would be the expected return on the portfolio if the portfolio is equally weighted, ie the portfolio has equal investments in each asset or the portfolio weights are the same for all assets? We would first have to determine the expected return on each asset. For Stock A: E(RA) = 0.40 x 10% + 0.60 x 8% = 8.8% For Stock B: E(RB) = 0.40 x 15% + 0.60 x 4% = 8.4% For Stock C: E(RC) = 0.40 x 20% + 0.60 x 0% = 8.0%

Because the portfolio weights are the same and there are three assets in this portfolio, the portfolio weight is . The expected return on the portfolio can therefore be calculated as: E(RP) = xA E(RA) + xB E(RB) + xC E(RC) E(RP) = x 8.8% + x 8.4% + x 8.0% = 8.4% Assuming instead of the portfolio being equally weighted, half of the portfolio were in Stock A and the remaining weight were equally divided between Stock B and Stock C? In that case, xAwill be 2 , xBwill be 4 and xCwill be 4 and E(RP) = 2 x 8.8% + 4 x 8.4% + 4 x 8.0% = 8.5%

The Variance of a Portfolio We refer back to Stock A with returns of 30% during a recession and 10% during a boom and an expected rate of return of 20%; and Stock B, with the return of 20% in a recession and 70% in a boom and an expected rate of return of 25%. Let us assume that this time round, 9/11 of the portfolio is invested in Stock A and 2/11 of the portfolio is invested in Stock B. During a recession, the portfolio will now have a return of: RP = 2/11 x 20% + 9/11 x 30% = 20.91% During a boom, we expect the portfolio to have a return of: RP = 2/11 x 70% + 9/11 x 10% = 20.91% The return does not change in spite of what happens. No further calculations are needed. This portfolio has zero variance. Combining assets into portfolios can substantially alter the risks faces by the investor; a point whose implications we will explore as we go along. The variance on a portfolio is not a simple combination of the variances of the assets in the portfolio. Referring back to the portfolio consisting of Stocks A, B and C. The economy has a 60% chance of going into recession and a 40% chance of experiencing a boom. In a boom, the returns on each of Stocks A, B and C are 10%, 15% and 20% respectively. In a recession, the returns on Stocks A, B and C are 8%, 4% and 0% respectively. What would be the variance on the portfolio if half of the portfolio is invested in Stock A and the remaining half is equally split between Stock B and Stock C?

In a boom, the portfolio return will be: RP = 2 x 10% + 4 x 15% + 4 x 20% = 13.75% In a recession, the portfolio return will be: RP = 2 x 8% + 4 x 4% + 4 x 0% = 5% The expected return of the portfolio was initially calculated to be 8.5% The variance of the portfolio is thus given as: 0.4 x (0.1375 0.085) + 0.6 x (0.05 0.085) = 0.0018375

Systematic and Unsystematic Risk The unanticipated part of the return; that portion resulting from surprises, is the true risk of any investment. Investments will be rendered risk-free if our expectations of the market were always met. The risk of owning an asset comes from surprises; the occurrences that we do not anticipate. There are however, important differences among the various sources of risk. There are certain events whose implications may be specific to a corporation. On the other hand, announcements about interest rates, of GDP are clearly important for nearly all companies, whereas developments involving the president of a corporation, the corporations research or its sales, is of specific interest to the corporation. The type of unanticipated development that affects a large number of assets, each to a greater or lesser extent, is termed as systematic risk. Owing to the fact that systematic risks usually result in effect that impact the market in its entirety, they are often termed as market risks. An unsystematic risk is one that affects a single asset or a small group of assets. Because these risks are unique or specific to individual assets, they are sometimes termed as unique or asset-specific risks. Actual return in the business environment is said to consist of the expected component and the surprise component. Therefore, R = E(R) + U. The total surprise component, however, has a systematic portion and an unsystematic portion so: R = E(R) + Systematic portion + Unsystematic portion The significant thing about this equation is that it isolates the portion of the total surprise that is specific to a company or an asset or a small group of assets.

Diversification and Portfolio Risk It was seen earlier that in principle, the risk of a portfolio can be quite different from the risk of the assets that make up the portfolio. Some of the risk associated with individual assets can be eliminated by forming portfolios. The process of spreading investments across assets and thereby forming a portfolio is known as diversification. The principle of diversification tells us that spreading an investment across a number of assets will eliminate some of the risk. The degree of risk that can be

eliminated by diversification is termed as diversifiable risk. There is however a minimum level of risk that cannot be eliminated simply by diversifying. This minimum level is oftentimes referred to as nondiversifiable risk. Together, these suggest that diversification reduces risk, but only up to a point. Unsystematic risk is essentially eliminated by diversification, so a portfolio with many assets has almost no unsystematic risk. For this reason, the terms unsystematic risk and diversifiable risk are often used interchangeably. Systematic risk on the other hand cannot be eliminated by diversification because by definition, systematic risk affects all assets in the market to some degree. Systematic risk is sometimes referred to as nondiversifiable risk.

Systematic Risk and Beta

The Systematic Risk Principle states that the reward for bearing risk depends only on the systematic of an investment. The reason for this is that because unsystematic risk can be eliminated at virtually no cost by diversification, there is no reward for bearing it. The market does not reward risk that is borne unnecessarily. The implication of the systematic risk principle is that the expected return on an asset depends only on the systematic risk of the asset. It follows from this that no matter how much total risk an asset has, only the systematic portion is relevant in determining the expected return and thereby the risk premium on that asset. A specific measure used to determine the degree of systematic risk in an asset is the beta coefficient, which is represented with the Greek letter. The beta coefficient gives an indication of howmuch systematic risk a particular asset has relative to an average asset. By definition, an average asset has a beta coefficient or simply beta of 1.0, relative to itself. An asset of 0.50, therefore has half as much systematic risk as an average asset, and an asset with a beta of 2.0 has twice as much systematic risk as an average asset. A risk-free asset has a beta of 0. The expected return on an asset, as well as its risk premium,both depend only on its systematic risk. Because assets with larger betas have greater systematic risks, they will have greater expected returns. Consider two securities, Security A and Security B, with standard deviations of 40% and 20% respectively and betas of 0.50 and 1.50 respectively. Security A has the greater total risk since it has the larger standard deviation but it has substantially less systematic risk. Total risk consists of systematic and unsystematic risk, implying that Security A has the greater unsystematic risk. By virtue of the systematic principle, we expect Security B to have a higher risk premium and a greater expected return, despite the fact that it has less total risk.

Portfolio Beta The beta for a portfolio is calculated in much the same way as the expected return for a portfolio. Assume a portfolio consists of equal weights of Lions Corporation stock and Dealers Company Limited stock. Lions has a beta of 0.80 and Dealers has a beta of 1.65. What will be the beta of this portfolio? Let L be the beta for Lions and D be the beta for Dealers. The beta for the portfolio, P, is given as: P = 0.5 x L + 0.5 x D = 0.5 x 0.8 + 0.5 x 1.65 = 1.225 To obtain the beta of a portfolio, we sum the products of each assets beta and its corresponding portfolio weight. Suppose a portfolio consists of $1000 invested in Stock A, with an expected return of 8% and a beta of 0.8, $2000 invested in Stock B, which has an expected return of 12% and a beta of 0.95, $3000 invested in Stock C with an expected return of 15% and a beta of 1.1 and $4000 invested in Stock D with an expected return of 18% and a beta of 1.4, what is the expected return on this portfolio? Does this portfolio have more or less systematic risk than the average asset? The portfolio weights for the Stocks A, B, C and D are, 10%, 20%, 30% and 40% respectively. The expected return on the portfolio E(RP), is therefore: E(RP) = 0.1 x E(RA) + 0.2 x E(RB) + 0.3 x E(RC) + 0.4 x E(RD) E(RP) = 0.1 x 8% + 0.2 x 12% + 0.3 x 15% + 0.4 x 18% = 14.9% The portfolio beta P is determined as: P = 0.1 x A + 0.2 x B + 0.3 C + 0.4 x D P = 0.1 x 0.8 + 0.2 x 0.95 + 0.3 x 1.1 + 0.4 x 1.4 = 1.16 > 1.0 Because the beta is larger than 1, this portfolio has greater systematic risk than an average asset.

The Security Market Line Beta and the Risk Premium Consider a portfolio made up of an Asset A, with an expected return of 20% and a beta of 1.6 and a riskfree asset. Suppose the risk-free rate is 8%. Different values for the expected return and beta of this portfolio can be derived, by altering the portfolio weights of one of the two assets in the portfolio. If we assume the portfolio weight for Asset A is 25%, then the portfolios expected return becomes: E(RP) = 0.25 x E(RA) + (1 0.25) x Rf = 0.25 x 20% + 0.75 x 8% = 11% The beta on the portfolio would be: P = 0.25 x A + (1 0.25) x f P = 0.25 x 1.6 + 0.75 x 0 = 0.4 Assuming an investor has $50, all of which he invests in Asset A, and then proceeds to borrow $25 at the risk-free rate, all of which he also invests in Asset A, the total investment in Asset A now becomes $75, or 150% of the investors wealth. The expected return in this case is: E(RP) = 1.5 x E(RA) + (1 1.5) x Rf = 1.5 x 20% 0.5 x 8% = 26% The beta on the portfolio would be: P = 1.5 x A + (1 1.5) x f P = 1.5 x 1.6 0.5 x 0 = 2.4 It can be seen from the above calculations that as the portfolio weight for Asset A increases, the expected return on the portfolio increases and so does the beta. Plotting the portfolio expected return against the portfolio betas, we obtain a graph of the form below.

The slope of the line obtained from plotting the portfolio expected returns against the portfolio betas can be determined as the rise over the run. It should be noted that this ratio is equivalent to dividing the risk premium on Asset A, by Asset As beta. The slope of the line is: (E(RA) Rf) / P

= (20% 8%) / 1.6 = 7.5% The slope is accordingly termed as the reward-to-risk ratio for Asset A. Assuming second asset, Asset B is available in the market, offering a beta of 1.2 and an expected return of 16%, whiles Asset A still offers an expected return of 20% at a beta of 1.6. Investors are always going tochoose Asset A over B every time because Asset B offers less compensation for its level of systematic risk, relative to Asset A. Let us consider a portfolio consisting of 25% investment in Asset B and a risk-free asset, given a risk-free interest rate of 8% as in the case of Asset A. E(RP) = 0.25 x E(RB) + (1 0.25) x Rf = 0.25 x 16% + 0.75 x 8% = 10%

The beta on the portfolio would be:

P = 0.25 x B + (1 0.25) x f P = 0.25 x 1.2 + 0.75 x 0 = 0.3

Should we plot the portfolio expected returns against the portfolio betas like we did in the case of the portfolio consisting of Asset A and a risk-free asset, we will end up with a straight line just like we did in the case of Asset A. But the slope for the line obtained for the portfolio expected returns and betas for Asset B will be (E(RB) Rf) / P = (16% 8%) / 1.2 = 6.67% Therefore, Asset B has a reward-to-risk ratio of 6.67%, which is less than the 7.5% that was obtained in the case of Asset A. The situation for Assets A and B cannot persist in a well-organised, active market because investors would be attracted to Asset A every time and away from Asset B, till Asset As price rises as a result and Asset Bs price falls. The expected return on Asset A would then decline and that for Asset B would increase. The phenomenon will continue until the two assets plot exactly on the same line. In an active, competitive market, we must have the situation that: (E(RA) Rf) / P = (E(RB) Rf) / P This is the fundamental relationship between risk and return. No matter the number of assets considered, this is the conclusion that would always be reached. The reward-to-risk ratio must be the same for all the assets in the market. The line that results when expected returns are plotted against beta coefficients; the line used to describe the relationship between systematic risk and expected return in financial markets is referred to as the Security Market Line. A market portfolio is a portfolio consisting of all the assets in the market. The expected return on a market portfolio is denoted E(RM). All assets in the market must plot on the Security Market Line (SML), so a market portfolio must also plot on the SML, since it consists of all assets in the market. Being representative of all the assets in the market, the market portfolio must have average systematic risk and therefore a beta of 1.0. The slope of the SML is therefore given as: (E(RM) Rf) / P = (E(RM) Rf) / 1 = E(RM) Rf The derived term E(RM) Rf is referred to as the market risk premium, because it is the risk premium on a market portfolio.

Capital Asset Pricing Model Let E(Ri) and i be the expected return and beta, respectively, on any asset in the market. The asset must plot on the SML and as a result, the reward-to-risk ratio is the same as the overall markets. Therefore (E(Ri) Rf) / i = E(RM) Rf Rearranging the above equation, making E(Ri) the subject, we obtain: E(Ri) = Rf + [E(RM) Rf]i The resulting equation is the Capital Asset Pricing Model (CAPM). The CAPM shows that the expected return for a particular asset depends on three things: 1. The pure time value of money: As measured by the risk-free rate, Rf , is the rewardfor merely waiting for your money, without taking any risk. 2. The reward for bearing systematic risk: As measured by the market risk premium, E(RM) Rf, the reward the market offers for bearing average systematic risk in addition to waiting. 3. The amount of systematic risk: As measured by i , this is the amount of systematic risk present in a particular asset or portfolio, relative to that in an average asset. CAPM is equally applicable to individual assets as it is to portfolios. Suppose the risk-free rate is 4%, the market premium is 8.6% and a particular stock has a beta of 1.3. Based on CAPM, what is the expected return on this stock? What would the expected return be if the beta were to double? With a beta of 1.3, the risk premium for the stock is 1.3 x 8.6% = 11.18%. The risk-free rate is 4%, so the expected return would be 15.8%. If the beta were to double to 2.6, the risk premium would double to 22.36 and the expected return would be 26.36%.

FOREIGN EXCHANGE MARKETS AND EXCHANGE RATES The foreign exchange market is the worlds largest financial market. It is the market where one countrys currency is traded for another. Most of the trading takes place in a few currencies such as the U. S dollar and the Euro. It is an over-the-counter market, which implies that there is no single location where traders get together. Instead market participants are located I major commercial and investment banks. They communicate using computer terminals, telephones and other telecommunication devices. An exchange rate is simply the price of one countrys currency expressed in terms of another countrys currency. In practice, almost all trading of currencies takes place in terms of the U. S. dollar. For example, both the Swiss franc and the Japanese yen are traded with their prices quoted in US dollars. So for the purposes of this course, an exchange rate is simply the price of the US dollar expressed in terms of another currency. Suppose the exchange rate in terms of yen per dollar is 119.6 and you have a $1000, how much will your $1000 get you? $1000 x 119.6 per dollar = 119,600 If the exchange rate in terms of dollars per euro is given as 0.8883 and we need 100,000 to pay off a debt, we will need 100,000 x $0.8883 per euro = $88,830.

Cross Rates and Triangle Arbitrage A cross rate is the exchange rate for a non-US currency expressed in terms of another currency. For example, suppose we observe that the exchange rate for euro is 1 per dollar and that of the Swiss franc is SF2 per dollar. Suppose the cross-rate is quoted as per SF = 0.4, this would mean the cross rate is inconsistent with the exchange rates, as at the given exchange rates, we should get per SF = 0.5. Let us assume we have $100. If we convert this to Swiss francs at the given rate of SF2 per dollar, we receive: $100 x SF2 per dollar = SF200. And if this is converted to euros at the cross rate, we get: SF2 x per Swiss franc = 80. However, if we just convert the $100 to euros without first changing it into Swiss francs, we get: $100 x per dollar = 100. It is evident from this scenario that the euro has two prices. 1 per $1 and 0.8 per $1, with the price we pay, depending on the steps taken in getting the euros. We could make some money by buying low and selling high. The important step here is to note that euros are cheaper when purchased with dollars because you get 1 per $1 instead of 0.8 per $1. In order to make some money with our initial $100, we could proceed as follows:

1. Buy 100 for $100. 2. Use the 100 to buy Swiss francs at the cross-rate. Because it takes 0.4 to buy a Swiss franc, we will receive 100/0.4 = SF 250 3. Use the Swiss francs to buy dollars. Because the exchange rate is SF2 per dollar, we will receive SF250/2 = $125, for a concluding profit of $25. 4. We can repeat step s 1 through 3 to make more money.

This particular activity is called triangle arbitrage because the arbitrage involves moving through three different exchange rates. To prevent such opportunities from existing, because a dollar will buy you either 1 or SF2, the cross-rate must be: (1/$1) / (SF2/$1) = 1/SF2 = 0.5/SF. The cross rate must be 1 per SF2 as anything else would result in an arbitrage opportunity.

Types of Transactions There are two basic types of trade in the foreign exchange market: spot trades and forward trades. A spot trade is an agreement to exchange currency within two business days. The exchange rate on a spot trade is called the spot exchange rate. Implicitly, the exchange rates and transactions that we have discussed so far have all referred to the spot market. A forward trade is an agreement to exchange currency at some time in the future. The exchange rate that will be used is agreed upon in the present and is called the forward exchange rate. A forward trade will normally be settled sometime within the next 12 months. Assuming the spot exchange rate for a Swiss franc today is SF1 = $0.5871 and the 180-day (6 months) forward exchange rate is SF1 = 0.5887, it implies that you can buy a Swiss franc today or $0.5871 or you can agree to take delivery a Swiss franc in six months and pay $0.5887. It should be noted that the Swiss franc is more expensive in the forward market. This is because the forward market allows businesses to lock in a future exchange rate today, thereby eliminating any risk from unfavorable shifts in the exchange rate. When a currency is more expensive in the future than it is today, ie if it requires more dollars to buy a unit of that particular currency today than it does in the future, it is said to be selling at a premium. In this scenario, because the dollar sells for more now than it will in the future, the dollar is said to be selling at a discount relative to the Swiss franc.

Purchasing Power Parity A question that may have occurred to us repetitively up to this point, may be that of how the level of spot exchange rates are determined. In addition, we may want to know what is responsible for the rate of change in exchange rates. Part of the answer in both cases is what may be termed as purchasing power parity (PPP), the idea that the exchange rate adjusts to keep purchasing power constant among currencies. There are two forms of purchasing power parity; absolute purchasing power parity and relative purchasing power parity.

Absolute Purchasing Power Parity: The basic idea behind this concept is that a commodity costs the same regardless of the currency used to purchase it or where it is selling. In other words, if a beer costs 2 in London and the exchange rate is 0.6, then a beer costs 2/0.6 = $3.33 in New York. Absolute purchasing power parity implies that any amount in dollars will buy you the same quantity of a specific product anywhere in the world. Let S0 be the spot exchange rate between the British pound and the US dollar today. It should be noted that we are quoting exchange rates as the amount of foreign currency per dollar. Let PUS and PUK be the current US and British prices, respectively on a particular commodity, say bread. Absolute PPP says that: PUK = S0 x PUS Implying that the British price for something is equal to the product of the exchange rate and the US price for that same commodity. It is worth noting that if PPP does not hold, arbitrage opportunities would be possible if one commodity was transported from one country to another. Suppose apples are selling in New York for $4 per bushel, whereas in London they are selling for 2.40 per bushel. Absolute PPP implies that: PUK = S0 x PUS 2.40 = S0 x $4 S0 = 2.40 / $4 = 0.6 That is, the implied spot exchange rate is 0.60 per $1. Equivalently, a pound is worth $1/0.60 = $1.67 Suppose the actual exchange rate is 0.50. Starting with $4, a trader could buy a bushel of apples in New York, ship it to London and sell it there for 2.40. Our trader would then convert the 2.40 into dollars at the prevailing exchange rate, S0 = 0.50, yielding a total of 2.40/0.50 = $4.80. The round-trip gain would be 80 cents. If such profit potential existed, forces would be set in motion to change the exchange rate or the price of the apples. In our example, apples would begin moving from New York to London at such a rate as to reduce the supply of apples in New York. The reduction in the supply of apples in New York would raise the price of apples in New York and the increased supply of apples in Britain would lower the price of apples in London. In addition, apple traders would be busily converting pounds back into

dollars to buy some more apples. This would increase the supply of pounds and simultaneously increase the demand for dollars. We would expect the value of the pound to fall as the dollar increases in value. Because the exchange rate is quoted as pounds per dollar, the exchange rate would increase from 0.50. For absolute PPP to hold absolutely, several things must hold: 1. The transactions costs of trading the particular commodity concerned shipping, insurance, spoilage and others must be zero. 2. There must be no barriers to the trading of the commodity concerned no tariffs, taxes or other political barriers such as voluntary restraint agreements. 3. Finally, the concerned commodity must be identical in the geographic areas relevant to the trade. There would be no point in exporting a prohduct to a location where it is of no use.

Relative Purchasing Power Parity: This concept does not tell us what determines the absolute level of the exchange rate. Rather, it tells us what determines the change in the exchange rate over time. Suppose the exchange rate for the British pound is currently S0 = 0.50 and that the inflation rate in Britain is predicted to be 10% over the coming year and that in the United States is predicted to be zero. What would the exchange rate be in a year? With 10% inflation, we would expect prices in Britain generally to rise by 10%. So we expect the price of a dollar to increase by 10% and the exchange rate should be 0.50 x 1.1 = 0.55. If the inflation rate inthe United States is not zero, then we need to be concerned with the relative inflation rates in the two countries. For example, suppose the inflation rate is 4%, relative to prices in the United States, prices in Britain are rising at a rate of 10% 4% = 6% per year. So we expect the price of the dollar to rise by 6% and the predicted exchange rate is 0.50 x 1.06 = 0.53. Relative PPP says that the change in the exchange rate is determined by the difference in the inflation rates of the two countries. To be more specific, we will use the following notation: S0 = Current (Time 0) spot exchange rate (foreign currency per dollar) E(St) = Expected exchange rate in t periods hUS = inflation rate in the United States hFC = inflation rate in the foreign country Relative PPP says that the expected percentage change in the exchange rate over the next year, [E(S1) S0], is: [E(S1) S0] / S0 = hFC hUS. Relative PPP says that the expected percentage change in the exchange rate is equal to the difference in inflation rates. If we rearrange this slightly, we get: E(S1) =S0 [1 + (hFC hUS)]

Back to the example involving Britain and the United States, relative PPP says that the exchange rate will rise by hFC hUS = 10% 4% = 6% per year. Assuming the difference in inflation rates doesnt change, the expected exchange rate in two years, E(S3), will therefore be: E(S2) =E(S1) (1 + 0.06) = 0.53 x 1.06 = 0.562 It should be noted that: E(S2) =E(S1) (1 + 0.06) = 0.53 x 1.06 = (0.5 x 1.06) x 1.06 = 0.5 x 1.062 Generally, relative PPP says that the expected exchange rate at some time t in the future : E(St), is: E(St) =S0 [1 + (hFC hUS)]t

In reality, we expect only relative PPP to hold so it will be the focus of the course from this point onwards. Suppose the Japanese exchange rate is currently 105 per dollar. The inflation rate in Japan over the next three years will run, say 2% per year, whereas the US inflation rate will be 6%. Based on relative PPP, what will the exchange rate be in three years? Because the US inflation rate is higher, we expect that a dollar will become less valuable. The exchange rate change will be 2% 6% = 4 per year. Over three years, the exchange rate will fall to: E(S3) =S0 [1 + (hFC hUS)]3 = 105 x [1 + ( 0.04 )]3 = 92.90

Interest Rate Parity, Unbiased Forward rates and the International Fischer Effect

Covered Interest Arbitrage A relationship exists between the spot exchange rate, forward exchange rates and interest rates. T get started, we need some additional notation: Ft = Forward exchange rate for settlement at time t RUS = the nominal risk-free interest rate in the United States RFC = the nominal risk-free interest rate in a foreign country S0 = Current (Time 0) spot exchange rate (foreign currency per dollar)

Suppose RUS is the T-bill rate and that we observe the following about US and Swiss currency in the market: S0 = SF2 Ft = SF1.90 RUS = 10% RS =5%

where RS is the nominal risk-free interest rate in Switzerland. Assuming one decided to invest a dollar in risk-free venture in the US, come a years time, at the prevailing interest rate, the $1 will be worth $1.1. Alternatively, one could decide to invest in the Swiss risk-free investment by converting the dollar into Swiss francs and simultaneously executing a forward contract to trade francs back to dollars in a year. It can be done as follows. 1. Convert $1 to Swiss francs; $1 x S0 = SF2 2. At the same time, enter into a forward agreement to convert Swiss francs back to dollars in a year. Because the forward rate will be SF1.90, you will get $1 for every SF1.90 instead of every SF2. 3. Invest the SF2 in Switzerland at RS; in one year SF2 (1 + RS) = 2 x 1.05 = 2.10 4. Convert the SF2.10 obtained back to dollars at the agreed-upon rate of SF1.90 = $1; so that SF2.1/1.90 = 1.1053 is obtained. This is higher than the 10% that is obtained by investing in a risk-free investment in the United States. This activity is referred to as covered interest arbitrage. Covered because, we are covered in the event of a change in the exchange rate because we lock in the forward exchange rate today.

Interest Rate Parity Assuming that significant covered arbitrage opportunities do not exist, there must be some relationship between spot exchange rates, forward rates and relative interest rates. From our initial example of the risk-free dollar investment, we obtained 1 + RUS for every dollar invested. By investing in the Swiss risk-free investment, we obtained S0 x (1 +RS) /F1 for every dollar invested. With no arbitrage present, these two investments must yield the same returns so: 1 + RUS = S0 x (1 +RS) /F1 Rearranging this equation gives the condition known as the interest rate parity (IRP): F1/ S0 = (1 +RFC) (1 +RUS) If we define the percentage forward premium or discount as (F1 S0)/ S0, interest rate parity says the percentage premium or discount is approximately equal to the differences in interest rates: (F1 S0)/ S0 = RFC RUS In general, if we have t periods instead of just one, the IRP approximation is written as: Ft =S0 [1 + (RFC RUS)]t Suppose the exchange rate for Japanese yen, S0 , is currently 120 = $1. If the interest rate in the United States is RUS = 10% and the interest rate in Japan is RJ = 5%, then what must the forward rate be to prevent covered interest arbitrage? Ft =S0 [1 + (RFC RUS)]t F1 =S0 [1 + (RJ RUS)]1 F1 =S0 [1 + (RJ RUS)] = 120 [1 + (0.05 0.10)] = 120 x 0.95 = 114

The Unbiased Forward Rates condition says that the forward rate, Ft , is equal to the expected future spot rate, thereby, outlining the relationship between the forward rate and the expected future spot rate. The condition states that the current forward rates an unbiased predictor of the future spot exchange rate. In other words Ft = E(St)

Now, since Ft = E(St), we could proceed to figure out the relationship between the expected future spot rate and the risk-free nominal interest rate prevailing in the United States and the risk-free nominal interest rate prevailing in other countries: E(St) =S0 [1 + (RFC RUS)]t This important relationship is known as the uncovered interest parity (UIP). It is the condition stating that the expected percentage change in the exchange rate is equal to the difference in the interest rates.

The International Fisher Effect

Relative PPP states that E(St) =S0 [1 + (hFC hUS)]t . And UIP states that E(St) =S0 [1 + (RFC RUS)]t

So

S0 [1 + (hFC hUS)]t = S0 [1 + (RFC RUS)]t

and

hFC hUS = RFC RUS This tells us that the difference between the returns between the United States and foreign country is just equal to the difference in inflation rates. Rearranging this equation gives: RUS hUS = RFC hFC This equation is known as the international fisher effect (IFE). The theory states that real interest rates are equal across countries. This conclusion is rather basic economics because if real returns were higher in say, Mexico than in the United States, money would flow out the United States financial markets into Mexican markets. Asset prices in Mexico would rise and their returns would fall, while asset prices in the United States would fall and their returns would rise. The process would act to equal returns.

International Capital Budgeting Assuming a US-based international company is evaluating an overseas investment. The companys exports of meat have increased to such a degree that it is considering building a distribution center in Britain. The project is expected to cost 2 million to launch. The cash flows are expected to 0.9 million a year for the next three years. The current spot exchange rate is 0.5. the risk-free rate in

the United States is 5% and the risk-free rate in Britain is 7 %. The interest rates are observed in financial markets, not estimated. The company requires a 10% rate of return. Should the company take this investment? Whether or not this investment is worthwhile depends on the net present value. So we need to calculate the net present value of this investment in US dollars. There are 2 basic ways to go about doing this. 1. The home currency approach requires you to convert all pound cash flows into dollars, and then discount at 10% to find the net present value in dollars. For this approach, we have to come up with the future exchange rates to convert the future projected pound-cash flows into dollars. 2. The foreign currency approach requires you to determine the required return on the pound investments and then discount the pound investments to find the net present value in pounds. Then convert the pound net present value to a dollar net present value. This approach requires you to somehow convert the 10% dollar required return to the equivalent pound required return. The difference between these two approaches is primarily a matter of when the pounds are converted to dollars. In the first case, the pounds are converted before estimating the net present value. In the second case, the conversion is done after estimating the net present value. It might appear that the second method is superior because for it, we only have to come up with one number, the pound discount rate. Furthermore, because the first approach required us to forecast future exchange rates, it probably seems that there is greater room for error with this approach.

The Home Currency Approach The expected exchange rate at time t, E(St) = S0 x [1 + (R RUS)]t Where R stands for the nominal risk-free rate in Germany = 7% RUS = 5% and S0 = 0.5 And therefore E(St) = 0.5 x [1 + (0.07 + 0.05)] t = 0.5 x 1.02 t Year 1 2 3 Expected Exchange Rate 0.5 x 1.021 = 0.5100 0.5 x 1.022 = 0.5202 0.5 x 1.023 = 0.5306

Using these exchange rates along with the appropriate current exchange rate, all of the Euro cashflows are converted to dollars

Year 0 1 2 3

(1)Cashflow in mil 2.0 0.9 0.9 0.9

(2) Expected Exchange Rate 0.5000 0.5100 0.5202 0.5306

Cashflow in $ mil (1)(2) $ 4.00 $1.76 $1.73 $1.70

Platinum Dealers require a rate of 10% on this investment so: NPV$ = $4 + $1.76/(1 +0.1) + $1.73/(1 +0.1)2 + 1.70/(1 +0.1)3 = $ 0.3 million And therefore, the project is profitable

The Foreign Currency Approach

The company requires a 10% nominal rate of return on the dollar denominated cash flows. This would have to be converted to a rate suitable for pound-denominated cash flows. Based on the international fisher effect, the nominal rates can be determined as: R RUS= h hUS = 7% 5% = 2% The appropriate discount rate for estimating the pound cash flows from the project is approximately equal to 10% plus an extra 2% to compensate for the greater pound inflation rate. If we calculate the net present value of the pound cash flows at this rate, we get: NPV = 2 + 0.9/(1 +0.12) + 0.9/(1 +0.12)2 + 0.9/(1 +0.12)3 = 0.16 million

The net present value of this project is 0.16 million. Taking the project makes the company 0.16 million richer today. What would this be in dollars? Because the exchange rate today is 0.5, the dollar net present value of the project will be: NPV$ = NPV/S0 = $0.3 milliion.

OPTIONS, HEDGING AND PRICE VOLATILITY An option is a contract that gives its owner the right to buy or sell some asset at a fixed price on or before a given date. An option on a building might give the holder of the option the right to buy the building for say $1million anytime on or before the Saturday prior to the third Wednesday of January 2010. The act of selling or buying the underlying asset via the option contract is referred to as exercising the option. The fixed price specified in the option contract at which the holder can buy or sell the underlying asset is called the strike price or exercise price. An option usually has a limited life. The option is said to expire at the end of its life. The last day on which the option may be exercised is called the expiration date. An American option may be exercised anytime up to and including the expiration date. A European option on the other hand, may be exercised only on the expiration date. Options come in two basic types. A call option gives the owner the right to buy an asset at a fixed price curing a particular time period. A put option gives the holder the right to sell the asset for a fixed exercise price. If an investor sells a call option, the investor receives money up front and has the obligation to sell that asset at the exercise price if the option holder so desires. Similarly, an investor who sells a put option receives cash upfront and is then obligated to buy the asset at the exercise price if the option holder demands it.

Fundamentals of Option Valuation Some notation that comes in handy when determining the value of a call option at expiration, are S1, the stock price at expiration in one period, S0, the stock price today, C1, the value of the call option o the expiration date in one period, C0 , the value of the call option today, and E, the exercise price of the option. In determining the value of a call option, two quantities are of interest; the upper bound of the call options value and the lower bound of the call options value. The upper bound of the value of the call option is C0 <S0, implying that the call option can never be worth more than the stock. However, in the case of the lower bound, in order to prevent arbitrage, the value of the call today must be greater than the stock price less the exercise price. Therefore, the lower bound becomes C0 >S0 E. Putting these two conditions together, we have C0 > 0 if S0 E< 0 and C0 >S0 E if S0 E> 0. These conditions simply state that the lower bound on the calls value is either 0 or S0 E , whichever is bigger. The lower bound is called the intrinsicvalue of an option and it is simply what the option would be worth if it were about to expire. The value of a call option is given as the difference between the stock value and the present value of the exercise price. Hence, C0= S0 E/(1 + Rf)t, where t is the time to expiration of the call

Let us consider a call option on a stock, with an exercise price of $20. The stock currently sells for $35. Its future price in one period will either be $25 or $50. If the risk-free rate is 10%, what is the value of this call option. C0= S0 E/(1 + Rf)t, in this case, t is 1. = $35 20/(1 + 0.1) = $16.82 In the above example, it can be seen that either way, there is no way that the stock sells for a price lower than or equal to its exercise price. In this case, we say the option finishes in the money. When an option. Assuming the exercise price was $30, the option would be worth $0, when the price of the stock one period from now is $25. In that case, we say the option finishes out of the money. If we take a look at the expression, we realize that the value of the call depends on four things: 1. The stock price: The higher the stock price, (S0) is, the more the call is worth. This should come as no surprise because the option gives us the right to buy the stock at a fixed price. 2. The exercise price: The higher the exercise price (E) is, theless the call is worth. This holds because the exercise price is what we have to pay to get the stock. 3. The time to expiration: The longer the time to expiration (t) is, the more the option is worth. Because the option gives us the right to buy for a fixed length of time, its value goes up as that length of time increases. 4. The risk-free rate: The higher the risk-free rate (Rf) is, the more the call is worth. Normally, we think of asset values as going down as rates rise. In this case, the exercise price is a cash outflow; a liability. The current value of that liability goes down as the discount rate goes up. 5. There is however, a fifth factor that determines the value of a call, which is the variance of the underlying asset. The greater the variance is, the more the call is worth. This is because increasing the variance of the possible future prices on the underlying asset does not affect the options value when the option finishes out of the money.

HEDGING AND PRICE VOLATILITY Hedging refers to the act of reducing a firms exposure to price or rate fluctuations. It is also termed as immunization. There is usually no direct way of hedging any particular risk. It is usually the financial managers job to create a way by using available financial instruments to create innovative ways. The process of coming up with ways to hedge risks is known as financial engineering. Corporate risk management involves the buying and selling of derivative securities. A derivative security is a financial asset that represents a claim to another financial asset. A stock option for example, fives the owner the right to buy or sell stock, which is a financial asset. Stock options are therefore derivative securities.

There are three specific areas of particular importance to businesses in which price volatility can increase dramatically. These three are interest rates, exchange rates and commodity prices. Exchange rate risk will usually comprise of short-run exposure, long-run exposure and translation exposure. The basic tool for identifying and measuring a firms exposure to financial risk is known as the risk profile. It is a plot showing how the value of the firm is affected by changes in prices of goods, some particularservice or rates. To illustrate, let us consider a firm that is into the production of wheat and another firm that buys wheat for the purposes of its commercial activities. The diagram below shows how each party is affected by an increase in wheat prices.

If the two firms manage to come to an agreement that at a set date in the future, the grower will deliver a certain quantity of wheat and the processor will pay a set price for the wheat, then much risk would have been eliminated. Once the agreement is signed, both firms would have locked in a price of wheat for as long as the contract is in effect and both their risk profiles with regard to the wheat prices will be completely flat during that time. However, in reality, a firm that hedges financial risk usually will not be able to create a completely flat risk profile. The wheat grower cannot know the size of the harvest of wheat ahead of time. If the harvest is bigger than the quantity that has been hedged, some portion of the produce will not be hedged. If the crop is smaller than the quantity that has been hedged, then the grower will have to buy more to fulfill the contract and thereby will be exposed to the risk of price fluctuations. There is still some exposure to wheat price fluctuations, however by hedging that exposure is sharply reduced.