Chapter 1: The World Of Finance

Risk Averse- An investor that will only take on increases risk if there is sufficient
prospective return to compensate.
Capital Market- A market in which individuals trade financial securities of greater than 1
year maturity such as stocks and bonds.

Privatisation- the sale of state-owned enterprises to the private sector, often through
the sale of shares to the public and institutions.
Key Roles of Financial Centre
-To facilitate the transfer of funds from the surplus agents to the deficit agents in an
efficient manner as possible
-Needs to provide a range of products to meet investors and borrowers diverse
demands at competitive prices
Chapter 10: The Efficiency of Financial Markets
Allocative Efficiency- The efficiency with which the capital markets allocate scarce
capital funds to the most productive uses.
Operational Efficiency- The cost efficiency of the financial markets and financial
institutions described in terms of charges to investors
Informational Efficiency-The extent to which market prices of securities fully incorporate
information and react to changes in information so the abnormal returns cannot be
made on a constant basis.
An efficient market is one in which prices always fully reflect available information
Weak-form efficiency-If current prices of securities instantly and fully reflect all
information of the past history of security prices.
Chartist & Technical Analysts only require past behavior in order to predict future
prices.
Semi-strong form efficiency- If current prices of the securities instantly and fully reflect
all publicly available information. This includes not only past history of security prices,
but also all publicly relevant information such as earnings, details in company reports,
information on the state of the economy, etc.
Investment and Research Analysts belief that it is the prospective for economic
fundamentals that indicate future security prices.

Strong form efficiency- If current prices of the securities instantly and fully reflect all
information, both public and private. Even traders etc with access to privileged inside
info should not be able to make consistent excess returns on securities by using
inside information as a basis for future trading.
If this theory were to hold, there is no need for security houses to have ways to keep
price sensitive information in one part of the business from another and no need for
insider-trading laws.

Efficiency Market Hypothesis (EMH)-Theory that states security prices reflect all
available information thus making it difficult for investors to make abnormal returns.
According to EMH, return on a security:
Rit+1=E(Rit+1/It) + Ut+1
Rit+1-the actual rate of return on security I in period t+1;
E(Rit+1/It)-the expected rate of return on security I in period t+1 at time t given the
information available at time t(It)
Ut+1 is the prediction error
The error term has certain properties that establish its randomness:
-It should have an expected value of zero
-It should be independent of the expected rate of return on the security, correlation
between them equal to zero
-It should not be predictable on the basis of any info available at time t
If EMH holds,
E(Rit+1/It) = Rit

- The expected return one period ahead will be the same as the actual

return today.
Thus,

Rit+1=Rit + Ut+1 -The random walk

Pit+1= Git+1+Pit + wt+1 -The Modified random walk, Git+1 is the expected rate if growth
of the security price given by Rit+1Pit which is presumed to be positive.

Active Vs Passive Fund Management

AFM-The use of fund managers skills and experience to buy and sell selected
securities; it can involve frequent buying and selling of shares
PFM-A strategy of buying and holding shares, usually to track a market index; it leads
to very low transaction costs
Testing for weak efficiency (very strong-thus it holds)
The random walk hypothesis-the best forecast of the future price of a security is the
current price, and that adding details of past security price movements will be of no
use in predicting the future course of the securitys price.
Filter-rule tests-designed to catch significant trends in securities prices and can be
based on any percentage. According to EMH, it should not be possible to make
abnormal returns from looking at past movements in security prices.
Testing for semi-strong efficiency (relatively strong-holds mostly)
Event studies- analyses the impact of a particular type of announcement on the share
prices of a group of firms for a period both prior and after the announcement.
Size effect
Price-earning effect-Return on company stocks with low P/E ratios is significantly higher
than the return on companies with relatively high P/E ratios. Study says its because
companies with low P/E ratios have a higher bankruptcy rate. However, empirical
evidence shows that companies with higher than average P/E ratios that tend to be
riskier, exhibiting a greater volatility of returns than stocks with low P/E ratios.
Testing for strong form efficiency (very weak!-does not hold)
Directors/Managers share purchases-To look at the effects of share purchases by them
of companies which they run. All such sales and purchases have to be registered
publicly and directors and managers are not permitted to trade n price sensitive
information. Study finds that managers/directors earn excess returns from their
purchases, suggesting that strong form market efficiency can be rejected.
Information content of analysts forecasts-To see whether the recommendations of
analysts, who presumably have a greater access to inside information about a
company and whose tips are not necessarily disseminated to the wider public, could
yield excess profits. Study found that excess returns could be made from their
forecasts.

Chapter 8: The Capital Asset Pricing Model

The Market Model-main idea-shares tend to move in varying degrees in line with
market itself
-looks at both risks-systematic and unsystematic risks
E(Ri)= ai + BiE(Rm)
Expected rate of return of security i
a is a constant factor that varies between securities; R i is actual return on an individual
security i; Rm is actual market return over the period;
B is the securitys beta that measures the sensitivity of the return on security I to the
return in the market as a whole.
Model introduces the idea via the B coefficient that the return on a security is sensitive
to fluctuations in the market as a whole. According to the model, the sole common
factor affecting all securities is the market rate of return.
E(Ri)= ai + BiE(Rm) +ei (for regression purposes) referred to sometimes as
characteristic line of a security
Total risk= Market risk + Specific risk
Unsystematic risk-Deviation of the squares of the observations from the reg line.
Portfolio Risk and return using market model
E(Rp)= ap + BpE(Rm)
ap-wiai similar for Bp
ap and Bp must sum to unity.
Total portfolio risk= Market risk + Specific Portfolio Risk
Since wi = 1/N, specific portfolio risk can be eliminated by increasing N.
(+) Reduces the number of variables required to evaluate the portfolio.
(-) Lacks a clear theoretical base, why?
To solve this problem, we look at CAPM.

The Capital Asset Pricing Model(CAPM)-attempts to explain the relationship between

the risk and return on a financial security, and this relationship can then be used to
determine the appropriate price for the security.
-main idea- if a share helps to stabilize a portfolio, that is make it more in line with the
market, than that share will earn a similar rate of return to the market portfolio.
- In an efficient market, all diversifiable risk will be eliminated, so that the only
risk that will be priced by the market on a portfolio is systematic or market risk. CAPM
model concentrates only on pricing of undiversifiable market risk.
Assumptions1. Capital Markets are perfect-only a single borrowing/lending rate,
all capital assets are perfectly divisible, there are no taxes, investors can sell short, info
is freely available to all market participants.
2. Investors attempt to max their utility, maximizing returns for a given
level of risk. Investors are risk averse and measure risk in terms of standard deviations
of risk.
3. Investors use a common one-period-ahead time horizon for investment
decisions. All investment decisions are made at the beginning of the period and no
changes are made during the investment horizon.
4. Investors have identical expectations of the risk and return on various
securities. Hence, the only reason why investors hold diff portfolios is due to diff risk
preferences.-all investors have the same efficiency frontier.
5. There exist a single risk free asset at which borrowing/lending can take
place-linear tradeoff between risk & return.
Assumptions make this model different to Markowitz.(especially 4 & 5)
Theory behind CAPM
In equilibrium, all investors will choose to allocate investment wealth between the
same mix of securities as given by portfolio M and risk free asset. Only difference is the
proportion in which they allocate their wealth between the portfolio of securities and
the risk free rate of interest.
Capital Market Line- shows there is a linear tradeoff between risk and return.
Frontier EF, is the market portfolio M (optimum). The only portfolio that all investors will
hold, then all the risky securities in the economy that make up portfolio M must be
correctly priced and willingly held by all investors. M is a portfolio with no diversifiable
risk. The only risk is market risk.
E(Rp)= (1-w)R*+ wE(Rm)

E(Rp)-expected return on a composite portfolio of the risk-free asset and market

portfolio
E(Rm)- same as previously
E(Rp)= R*+ w[E(Rm)- R*]
W= sigma p/sigma m
Capital market line : E(Rp)= R*+ (P/ P )[E(Rm)- R*]
CAPM in risk premium form
Risk Premium-The extra rate of return charged by investors above the risk-free rate of
return to compensate for risk.
RP of a portfolio is the difference between the expected return on the portfolio and the
risk free rate of return.
CML is useful only for pricing of efficient portfolios, thus combinations of market
portfolios and risk free security.
Security Market Line (SML)- measures the relationship between beta(systematic risk)
and firms expected rate of return
To measure the risk on an individual security:
E(Ri)= R*+ (im/ m2 )[E(Rm)- R*]
im is the covariance of security I with the market portfolio M,
m2 is the variance of the market portfolio
SML: E(Ri)= R*+ (iim/ m2 )[E(Rm)- R*] crucial difference to CML
im is the correlation coefficient of security I with the market portfolio
i= (iim/ m2 )
Stocks with (iim < m2 ) defensive securities expected to earn a lower rate of return
than the market
Stocks with (iim > m2 ) aggresive securities expected to earn a higher rate of return
than the market
The required rate of return on a security consist of 3 components(based on CAPM):
1. The price of time as measured by the risk-free rate of interest
2. The quantity of risk as measured by the beta of the security.

3. The market price of risk as measured by the difference between the expected
return on the market and risk-free rate of interest. [E(R m)- R*]
Key point* of CAPM: When adding a security to a portfolio an investor will only be
rewarded for the covariance of the security with the market, and not for its total risk as
represented by the standard deviation of the security.

CAPM makes 5 key predictions:

Empirical estimation of the CAPM involves looking at the portfolio betas.

E(RPp) = pE(RPm)
Empirically a reg:
RPp = a + b(RPm) + ep
1. The intercept of the reg eqn should be equal to zero, that is a=0; if this is not
true, it means that the CAPM model is missing something as a complete
explanation of the portfolios excess return.
2. The beta coefficient should be the sole explanation of the rate of return on the
risky portfolio. The estimated slope b should be positive and not differ
significantly from the risk premium on the market portfolio. RP m=Rm R*.
3. There should be a linear relationship given by beta between the average
portfolio risk premium and the average market risk premium.
4. Over time, Rm should exceed R*, since the market portfolio is riskier than the
risk-free asset.
5. Other explanatory variables such as dividend yield, firm size, etc should not
prove statistically significant in predicting the required rate of return.

Arbitrage Pricing Theory(APT) critique of the CAPM

CAPM model was empirically untestable.
A true market portfolio needs to contain all assets, both financial and non financial, in
an economy and many of these are not observable, such as human capital etc.
Investors utilty function is measured in terms of expected returns and risk as
measured by the standard deviation of return.[ APT does not require standard
deviations to be used to measure risk] & [APT does not require an unobservable market
index to be compiled]

Basic postulate of APT is that market risk is itself made up of a number(k) of separate
systematic factors. [Single beta reflecting market risk is insufficient]
Thus, APT says that the return on a security is linearly related to k systematic factors
without specifying exactly what these factors are.

Chapter 7: Portfolio Analysis: Risk & Return in Financial Markets

Determining the price of the financial asset
Debt security- a financial security that entitles the holder to a series of future cash
flows and which has a high creditor status
Equity security- a financial security that gives the holder an ownership stake and the
rights to a share in the profits usually in the form of dividends, but it has a lower status
than debt instruments in cases of default.
The rate of return on a security
Made up of 2 components: the income stream attached to ownership
any change in the value of the asset
R1 = (P1-P0)/P0 + C1/P0
Covariance & Correlation
AB= Pi[(RAi E(RA))(RBi (RB))]
AB= 1/N[(RAi E(RA))(RBi (RB))]
The correlation coefficient
AB= AB/ A B
(+) moving in same direction, vice versa.
Portfolio Theory
Assumptions:
1. Agents prefer more to less
2. Agents are risk averse and require higher expected return for taking on more
risk.
3. The rates of return follow a normal dist. Risk can be measured by its standard
deviation.

4. The wealth holder cannot affect the probability dist. of the security held.
5. The theory considers only existing assets not new issues. Return on portfolio:
Rp = wiRi
Measuring risk on a portfolio
2p = w2A2A + w2B2B + 2 w2Aw2B2A 2BAB

Chapter 14: Options

Options are special type of financial assets that give the holder the right but not the
obligation to buy or sell an underlying security at a predetermined price.
Involves 2 parties:- the writer- the one who sells a call/put option contract
the holder-the one who buys a call/put option contract
call option- a contract that gives the holder the right but not the obligation to buy an
underlying asset/security at a predetermined exercise price at some time in the future.
put option- a contract that gives the holder the right but not the obligation to sell an
underlying asset/security at a predetermined exercise price at some time in the future.
Important** The most an option holder can lose is the option premium
The most the option writer can gain is the option premium received
Options allow risks to be transferred from one party that wishes to reduce its risk
exposure to another party that is willing to take on that risk for a premium.
Differences between options & futures
F
: Obliged to buy/sell
O
: Not obliged to buy/ sell
F
: If buyer makes a pound, seller loses a pound etc
O
:Max loss of buyer is the option premium paid, maximum gain of writer is the
option premium received.
Chapter 15: Option Pricing
Fundamental principle underlying the pricing of an option is that the greater the
probability of an option being exercised, the higher the option premium will be, other
things being equal.
5 factors that determine the likelihood of the call option being exercised, thus influence
the price of the
Call option:
1. The current price of the share.(+)
2. The strike price.(-)
3. The time left to expiration(+)
4. The volatility. (+)
5. The risk free rate of interest(+)
Put option:
1. The current price of the share.(-)
2. The strike price.(+)
3. The time left to expiration(+)
4. The volatility. (+)
5. The risk free rate of interest(-)
Option premium is made of 2 components:

intrinsic value- the gain that would be realized if an option was exercised immediately :
Call option: Cash price-strike price = intrinsic value
time value- the remainder of the option premium after deducting its intrinsic value
Assumptions of theory of the Black-Scholes option pricing formula:
1. The natural logarithm of the cash price of the underlying asset is normally
distributed
2. The underlying asset being analyzed pays no dividends or interest during its
lifetime.
3. The option is a European option, it cannot be exercised prior to maturity.
4. The risk free rate of interest is fixed during the life of the option.
5. The financial market is perfectly efficient with not transaction costs, no taxes etc.
6. The price of the underlying asset is log-normally distributed, with a constant
mean and standard deviation.
7. The price of the underlying asset moves in a continuous fashion.
Basic idea of this model: A long position in the underlying stock is neutralized by a
short position in options.
Black-Scholes formula
Starting point: Intrinsic value of a call option on expiration is the spot price(S) less the
exercise price(X)
C=S-X > 0
C-Call premium
Sum of money that needs to be set aside:
Xe-rT the present value of the exercise price when continuous time discounting is used
r-risk free rate of interest T-time left to maturity
value of such an option:
C=S - Xe-rT
Assumption that the share price will close above the strike price is unrealistic.
Thus, need to be modified to be based on the expected value upon expiration.
C=SN(d1) - Xe-rTN(d2)
SN(d1) the expected value of the underlying security upon expiration
Xe-rTN(d2)- the expected present value of the strike price on expiration
d1=[ln(S/X) + (r + 2/2)T]/T1/2
d2=d1- T1/2
T-time to expiry in a fraction of a year
Feature of the model : expected volatility is a key factor in determining the price of an
option
Problems with the model
Only applicable to European options

Sensitivity of options prices:

Option theta-measures its sensitivity to the passing of time
Option delta-measures the sensitivity of its price to the price of the underlying share
Option gamma-measure of the rate at which an options theta is changing
Option lambda/kappa-measures the sensitivity of its price to changes in the underlying
volatility of the share
Option rho- measures the sensitivity of its price with respect to a percentage change in
the interest rate
Put-call parity
An arbitrage formula that shows how to price a put premium given the relevant call
premium, the strike price, time to expiration parameters and risk free rate of interest
that were used to price the call premium.
On the basis of combining a long position in the security with both a short call and a
long put contract with the same exercise price X and expiry date T creates a riskless
hedge portfolio.