Portfolio Theory:
Portfolios of n shares
n
rp = i =1 wi ri
Expected return
Here, wi denotes the value weight associated with the i th asset, rp denotes the
expected return of the portfolio and ri , the expected return on the i th asset.
n
2p = i =1 j =1 wi w j ij
Variance
rm , m2 denote the expected return and variance for the market as a whole.
p = i =1 wi i
4.
Annuity formulae
For per annum for T years at a rate of interest of r per annum;
b ge b g j
PV = / r 1 1 + r
For per annum forever;
PV = /r
5.
P0 = i =1
LM Div OP
MN b1 + r g PQ
t
P0 is the current share price, Divt is the dividend per share in year t and rE is
the expected return on equity. With no growth in dividends ( Divt = Div , a
constant), then from the annuity formula;
P0 = Div / rE
With a constant growth rate in dividends such that
Divt = Divt 1 1 + g , then
b g
P = Div / br g g = Div b1 + g g / br g g .
0
6.
P0 + t =1
Fr
b1 + ig b1 + ig
t
=0
Here P0 is the current bond market price, F its face value, r its coupon rate of
interest, and T the redemption date. The yield is the value of i which solves
this equation (i.e. it is the internal rate of return). For an irredeemable bond,
using the annuity formula, this collapses to:
P0 + Fr / i = 0 i = Fr / P0
(b) Modified Duration: Mod_D = MD (1 + y)
T
where MD = ( PV (CFt ) t ) P
t =1
P
CF t
PV
y
MD
=
=
=
=
=
dP
P
1
(convexity ).(dy ) 2
2
7.
g b
WACC = D / V rD + E / V rE
(where V = D+E is the value of the firm, D denotes the market value of the
debt, E, the market value of the equity, rD , rE are the expected returns on debt,
equity).
firm = D / V D + E / V E
In the MM model, firm is invariant to changes in capital structure.
F 1 I
GH 1 + b D / E gJK
This is a -degearing formula for deriving a firm- from an observed equity when debt is riskless.
8.
Capital Structure
gb
rE = rA + D / E rA rD
rA = ru (1 D V c )
(c)
= 1
b1 gb1 g
b1 g
c
Here is the apparent gain in value arising out of the tax shield on
debt.
(d)
In the Miller Debt and Taxes model, equilibrium in the market for debt
as a whole implies that
b1 g = b1 gb1 g
d
c + Div + Ke
rf T
= p + S0
where rf denotes the risk free rate of interest, and S0 , p, c, Div, K denote
the current share, put and call prices, Dividend and Exercise price
respectively.
(d) Black-Scholes Option Pricing Formula
c = S0 N (d1 ) Ke rT N (d 2 ); p = Ke rT N ( d 2 ) S0 N ( d1 )
d1 =
ln( S 0 / K ) + (r + 2 / 2)T
(e) Hedging
N* = P / F
N = (* - ) P / F
; d2 =
ln( S0 / K ) + (r 2 / 2)T
= d1 T