Undergraduate study in
Economics, Management,
Finance and the Social Sciences
This guide was prepared for the University of London External System by:
Dr Pascal Frantz, Lecturer in Accountancy and Finance, The London School of Economics and
Political Science
and
R. Payne, former Lecturer in Finance, The London School of Economics and Political Science.
This is one of a series of subject guides published by the University. We regret that due to
pressure of work the authors are unable to enter into any correspondence relating to, or aris-
ing from, the guide. If you have any comments on this subject guide, favourable or unfavour-
able, please use the form at the back of this guide.
This subject guide is for the use of University of London External students registered for
programmes in the fields of Economics, Management, Finance and the Social Sciences (as
applicable). The programmes currently available in these subject areas are:
Access route
Diploma in Economics
Diploma in Social Sciences
Diplomas for Graduates
BSc Accounting and Finance
BSc Accounting with Law/Law with Accounting
BSc Banking and Finance
BSc Business
BSc Development and Economics
BSc Economics
BSc Economics and Finance
BSc Economics and Management
BSc Geography and Environment
BSc Information Systems and Management
BSc International Relations
BSc Management
BSc Management with Law/Law with Management
BSc Mathematics and Economics
BSc Politics
BSc Politics and International Relations
BSc Sociology
BSc Sociology with Law.
Contents
Introduction to the subject guide .......................................................................... 1
Aims of the unit............................................................................................................. 1
Learning objectives ........................................................................................................ 1
Syllabus......................................................................................................................... 2
Essential reading ........................................................................................................... 2
Further reading.............................................................................................................. 3
Subject guide structure and use ..................................................................................... 5
Examination structure .................................................................................................... 5
Glossary of abbreviations used in this subject guide ....................................................... 6
Chapter 1: Present-value calculations and the valuation of
physical investment projects .................................................................................. 7
Aim of the chapter......................................................................................................... 7
Learning objectives ........................................................................................................ 7
Essential reading ........................................................................................................... 7
Further reading.............................................................................................................. 7
Overview ....................................................................................................................... 7
Introduction .................................................................................................................. 8
Fisher separation and optimal decision-making .............................................................. 8
Fisher separation and project evaluation ...................................................................... 11
The time value of money .............................................................................................. 12
The net present-value rule............................................................................................ 13
Other project appraisal techniques ............................................................................... 15
Using present-value techniques to value stocks and bonds ........................................... 18
A reminder of your learning outcomes.......................................................................... 19
Key terms .................................................................................................................... 20
Sample examination questions ..................................................................................... 20
Chapter 2: Risk and return: mean–variance analysis and the CAPM.................... 21
Aim of the chapter....................................................................................................... 21
Learning objectives ...................................................................................................... 21
Essential reading ......................................................................................................... 21
Further reading............................................................................................................ 21
Introduction ................................................................................................................ 21
Statistical characteristics of portfolios ........................................................................... 22
Diversification.............................................................................................................. 24
Mean–variance analysis ............................................................................................... 25
The capital asset pricing model .................................................................................... 30
The Roll critique and empirical tests of the CAPM......................................................... 33
A reminder of your learning outcomes.......................................................................... 34
Key terms .................................................................................................................... 34
Sample examination questions ..................................................................................... 35
Solutions to activities ................................................................................................... 35
Chapter 3: The arbitrage pricing theory ............................................................... 37
Aim of the chapter....................................................................................................... 37
Learning objectives ...................................................................................................... 37
Essential reading ......................................................................................................... 37
Further reading............................................................................................................ 37
Overview ..................................................................................................................... 37
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92 Corporate finance
Introduction ................................................................................................................ 37
Single-factor models .................................................................................................... 38
Multi-factor models ..................................................................................................... 40
Broad-based portfolios and idiosyncratic returns........................................................... 41
Factor-replicating portfolios ......................................................................................... 41
The arbitrage pricing theory ......................................................................................... 42
Summary ..................................................................................................................... 43
A reminder of your learning outcomes.......................................................................... 44
Key terms .................................................................................................................... 44
Chapter 4: Derivative assets: properties and pricing ........................................... 45
Aim of the chapter....................................................................................................... 45
Learning objectives ...................................................................................................... 45
Essential reading ......................................................................................................... 45
Further reading............................................................................................................ 45
Overview ..................................................................................................................... 45
Varieties of derivatives ................................................................................................. 45
Derivative asset pay-off profiles ................................................................................... 47
Pricing forward contracts ............................................................................................. 49
Binomial option pricing setting .................................................................................... 50
Bounds on option prices and exercise strategies ........................................................... 53
Black–Scholes option pricing ....................................................................................... 55
Put–call parity ............................................................................................................. 56
Pricing interest rate swaps ........................................................................................... 58
Summary ..................................................................................................................... 58
A reminder of your learning outcomes.......................................................................... 58
Key terms .................................................................................................................... 59
Sample examination questions ..................................................................................... 59
Chapter 5: Efficient markets: theory and empirical evidence .............................. 61
Aim of the chapter....................................................................................................... 61
Learning objectives ...................................................................................................... 61
Essential reading ......................................................................................................... 61
Further reading............................................................................................................ 61
Overview ..................................................................................................................... 62
Varieties of efficiency ................................................................................................... 62
Risk adjustments and the joint hypothesis problem ...................................................... 63
Weak-form efficiency: implications and tests ................................................................ 64
Weak-form efficiency: empirical results......................................................................... 66
Semi-strong-form efficiency: event studies .................................................................... 69
Semi-strong-form efficiency: empirical evidence ............................................................ 71
Strong-form efficiency.................................................................................................. 71
Summary ..................................................................................................................... 71
A reminder of your learning outcomes.......................................................................... 72
Key terms .................................................................................................................... 72
Sample examination questions ..................................................................................... 72
Chapter 6: The choice of corporate capital structure ........................................... 73
Aim of the chapter....................................................................................................... 73
Learning objectives ...................................................................................................... 73
Essential reading ......................................................................................................... 73
Further reading............................................................................................................ 73
Overview ..................................................................................................................... 73
ii
Contents
iii
92 Corporate finance
iv
Introduction to the subject guide
Learning objectives
At the end of this unit, and having completed the essential reading and
activities, you should be able to:
explain how to value projects, and use the key capital budgeting
techniques (NPV and IRR)
understand the mathematics of portfolios and how risk affects the
value of the asset in equilibrium under the fundaments asset pricing
paradigms (CAPM and APT)
explain the characteristics of derivative assets (forwards, futures
and options), and how to use the main pricing techniques (binomial
methods in derivatives pricing and the Black–Scholes analysis)
discuss the theoretical framework of informational efficiency in
financial markets and evaluate the related empirical evidence
understand and explain the capital structure theory, and how
information asymmetries affect it
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92 Corporate finance
understand and explain the relevance, facts and role of the dividend
policy
understand how corporate governance can contribute to firm value
discuss why merger and acquisition activities exist, and calculate the
related gains and losses.
Syllabus
Note: There has been a minor revision to this syllabus in 2009.
Students may bring into the examination hall their own hand-held
electronic calculator. If calculators are used they must satisfy the
requirements listed in paragraphs 10.5 to 10.7 of the General Regulations.
If you are taking this unit as part of a BSc degree, units which must be
passed before this unit may be attempted are 02 Introduction to
economics and either 05a Mathematics 1 or 05b Mathematics 2.
This unit may not be taken with unit 59 Financial management.
Project evaluation: Hirschleifer analysis and Fisher separation; the NPV rule
and IRR rules of investment appraisal; comparison of NPV and IRR; ‘wrong’
investment appraisal rules: payback and accounting rate of return.
Risk and return – the CAPM and APT: the mathematics of portfolios; mean-
variance analysis; two-fund separation and the CAPM; Roll’s critique of the
CAPM; factor models; the arbitrage pricing theory.
Derivative assets – characteristics and pricing: definitions: forwards and futures;
replication, arbitrage and pricing; a general approach to derivative pricing
using binomial methods; options: characteristics and types; bounding and
linking option prices; the Black–Scholes analysis.
Efficient markets – theory and empirical evidence: underpinning and definitions
of market efficiency; weak-form tests: return predictability; the joint
hypothesis problem; semi-strong form tests: the event study methodology
and examples; strong form tests: tests for private information.
Capital structure: the Modigliani–Miller theorem: capital structure irrelevancy;
taxation, bankruptcy costs and capital structure; the Miller equilibrium;
asymmetric information: 1) the under-investment problem, asymmetric
information; 2) the risk-shifting problem, asymmetric information; 3) free
cash-flow arguments; 4) the pecking order theory; 5) debt overhang.
Dividend theory: the Modigliani–Miller and dividend irrelevancy; Lintner’s
fact about dividend policy; dividends, taxes and clienteles; asymmetric
information and signalling through dividend policy.
Corporate governance: separation of ownership and control; management
incentives; management shareholdings and firm value; corporate
governance.
Mergers and acquisitions: motivations for merger activity; calculating the gains
and losses from merger/takeover; the free-rider problem and takeover
activity.
Essential reading
There are a number of excellent textbooks that cover this area. However,
the following text has been chosen as the core text for this unit due to
its extensive treatment of many of the issues covered and up-to-date
discussions:
Grinblatt, M. and S. Titman Financial Markets and Corporate Strategy. (Boston,
Mass.; London: McGraw-Hill, 2002) second edition
[ISBN 9780072294330].
At the start of each chapter of this guide, we will indicate the reading that
you need to do from Grinblatt and Titman (2002).
2
Introduction to the subject guide
Further reading
As further material, we will also direct you to the relevant chapters in
two other texts. You may wish to look at the following two texts that are
standard for many undergraduate finance courses:
Brealey, R., S. Myers and F. Allen Principles of Corporate Finance. (Boston,
Mass., London: McGraw-Hill, 2008) ninth international edition [ISBN
9780071266758].
Copeland, T., J. Weston and K. Shastri Financial Theory and Corporate Policy.
(Reading, Mass.; Wokingham: Addison-Wesley, 2005) fourth edition
[ISBN 9780321223531].
Journal articles
Asquith, P. and D. Mullins ‘The impact of initiating dividend payments on
shareholders’ wealth’, Journal of Business 56(1) 1983, pp.77–96.
Ball, R. and P. Brown ‘An empirical evaluation of accounting income numbers’,
Journal of Accounting Research 6(2) 1968, pp.159–78.
Blume, M., J. Crockett and I. Friend ‘Stock Ownership in the United States:
Characteristics and Trends’, Survey of Current Business 54(11) 1974,
pp.16–40.
Bradley, M., A. Desai and E. Kim ‘Synergistic Gains from Corporate Acquisitions
and Their Division Between the Stockholders of Target and Acquiring
Firms’, Journal of Financial Economics 21(1) 1988, pp.3–40.
Brock, W., J. Lakonishok and B. LeBaron ‘Simple technical trading rules and
stochastic properties of stock returns’, Journal of Finance 47(5) 1992,
pp.1731–764.
DeBondt, W. and R. Thaler ‘Does the stock market overreact?’, Journal of
Finance 40(3) 1984, pp.793–805.
Fama, E. ‘The behavior of stock market prices’, Journal of Business 38(1) 1965,
pp.34–105.
Fama, E. ‘Efficient capital markets: a review of theory and empirical work’,
Journal of Finance 25(2) 1970, pp.383–417.
Fama, E. ‘Efficient capital markets: II’, Journal of Finance 46(5) 1991,
pp.1575–617.
Fama, E. and K. French ‘Dividend yields and expected stock returns’, Journal of
Financial Economics 22(1) 1988, pp.3–25.
French, K. ‘Stock returns and the weekend effect’, Journal of Financial
Economics 8(1) 1980, pp.55–70.
Fama, E. and K. French ‘The cross-section of expected stock returns’, Journal of
Finance 47(2) 1992, pp.427–65.
Grossman, S. and O. Hart ‘Takeover Bids, the Free-Rider Problem and the
Theory of the Corporation’, Bell Journal of Economics 11(1) 1980, pp.42–64.
Healy, P. and K. Palepu ‘Earnings Information Conveyed by Dividend Initiations
and Omissions’, Journal of Financial Economics 21(2) 1988, pp.149–76.
Healy, P., K. Palepu and R. Ruback ‘Does Corporate Performance Improve after
Mergers?’, Journal of Financial Economics 31(2) 1992, pp.135–76.
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92 Corporate finance
Books
Allen, F. and R. Michaely ‘Dividend Policy’ in Jarrow, Maksimovic and Ziemba
(eds) Handbook of Finance. (Elsevier Science, 1995). [No ISBN available].
Haugen, R. and J. Lakonishok The incredible January effect. (Homewood, Ill.:
Dow Jones-Irwin, 1988) [ISBN 9781556230424].
Ravenscraft, D. and F. Scherer Mergers, Selloffs, and Economic Efficiency.
(Washington D.C.: Brookings Institution, 1987) [ISBN 9780815773481].
4
Introduction to the subject guide
Examination structure
Important: the information and advice given in the following section
are based on the examination structure used at the time this guide
was written. Please note that subject guides may be used for several
years. Because of this, we strongly advise you to always check both the
current Regulations for relevant information about the examination, and
the current Examiners’ commentaries where you should be advised of
any forthcoming changes. You should also carefully check the rubric/
instructions on the paper you actually sit and follow those instructions.
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92 Corporate finance
6
Chapter 1: Present-value calculations and the valuation of physical investment projects
Learning objectives
At the end of this chapter, and having completed the essential reading and
activities, you should be able to:
analyse optimal physical and financial investment in perfect capital
markets and derive the Fisher separation result
justify the use of the NPV rules via Fisher separation
compute present and future values of cash-flow streams and appraise
projects using the NPV rule
evaluate the NPV rule in relation to other commonly used evaluation
criteria
value stocks and bonds via NPV.
Essential reading
Grinblatt, M. and S. Titman Financial Markets and Corporate Strategy. (Boston,
Mass.; London: McGraw-Hill, 2002) Chapter 10.
Further reading
Brealey, R., S. Myers and F. Allen Principles of Corporate Finance. (Boston,
Mass.; London: McGraw-Hill, 2008) Chapters 2, 3, 5, 6 and 7.
Copeland, T. and J. Weston Financial Theory and Corporate Policy. (Reading,
Mass.; Wokingham: Addison-Wesley, 2005) Chapters 1 and 2.
Roll, R. ‘A Critique of the Asset Pricing Theory’s Texts. Part 1: On Past and
Potential Testability of the Theory’, Journal of Financial Economics 4(2)
1977, pp.129–76.
Overview
In this chapter we present the basics of the present-value methodology
for the valuation of investment projects. The chapter develops the net
present-value (NPV) technique before presenting a comparison with the
other project evaluation criteria that are common in practice. We will also
discuss the optimality of NPV and give a number of extensive examples.
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92 Corporate finance
Introduction
Let us begin by defining how we are going to think about a firm in this
chapter. For the purposes of this chapter, we will consider a firm to be a
package of investment projects. The key question, therefore, is how do the
firm’s shareholders or managers decide on which investment projects to
undertake and which to discard? Developing the tools that should be used
for project evaluation is the emphasis of this chapter.
It may seem, at this point, that our definition of the firm is rather limited.
It is clear that, in only examining the investment operations of the firm,
we are ignoring a number of potentially important firm characteristics.
In particular, we have made no reference to the financial structure or
decisions of the firm (i.e. its capital structure, borrowing or lending
activities, or dividend policy). The first part of this chapter presents what
is known as the Fisher separation theorem. What follows is a statement
of the theorem. This theorem allows us to say the following: under
certain conditions (which will be presented in the following section), the
shareholders can delegate to the management the task of choosing which
projects to undertake (i.e. determining the optimal package of investment
projects), whereas they themselves determine the optimal financial
decisions. Hence, the theory implies that the investment and financing
choices can be completely disconnected from each other and justifies our
limited definition of the firm for the time being.
8
Chapter 1: Present-value calculations and the valuation of physical investment projects
Figure 1.1
The financial investment allows firms to borrow or lend unlimited
amounts at rate r. Assuming that the firm undertakes no physical
investment, we can define the firm’s consumption opportunities quite
easily. Assume the firm neither borrows nor lends. This implies that
current consumption (c0) must be identically m, whereas period 1
consumption (c1) is zero. Alternatively the firm could lend all of its funds.
This leads to c0 being zero and c1 = (1 + r) m. The relationship between
period 0 and period 1 consumption is therefore given as below:
c1 = (1 + r)(m – c0 ). (1.1)
This implies that the curve which represents capital market investments is
a straight line with slope –(1+r). This curve is labeled CML on Figure 1.2.
Again, we have on Figure 1.2 plotted the optimal financial investments for
two different sets of preferences (assuming that no physical investment is
undertaken).
Figure 1.2
Now we can proceed to analyse optimal decision-making when firms
invest in both financial and physical assets. Assume the firm is at the
beginning of period 0 and trying to decide on its investment plan. It is
clear that, to maximise firm value, the projects undertaken should be those
9
92 Corporate finance
with the greatest return. Knowing that the return on financial investment
is always (1+r), the firm will first invest in all physical investment
projects with returns greater than (1+r ). These are those projects on the
production possibility frontier (PPF) between points m and I on Figure
1.3.1 Projects above I on the PPF have returns that are dominated by the 1
The absolute value of
return from financial investment. the slope of the PPF can
be equated with the
Hence the firm physically invests up to point I. Note that, at this point, return on physical
we have not mentioned the firm’s preferences over period 0 and period investment. For all points
1 consumption. Hence, the decision to physically invest to I will be taken below I on the PPF, this
by all firms regardless of the preferences of their owners. Preferences slope exceeds that of
the capital market line
come into play when we consider what financial investments should be
CPFJGPEGFGƂPGUVJG
undertaken. set of desirable physical
The firm’s physical investment policy takes it to point I, from where it can investment projects.
borrow or lend on the capital market. Borrowing will move the firm to
the south-east along a line starting at I and with slope –(1+r); lending will
take the firm north-west along a similarly sloped line. Two possible optima
are shown on Figure 1.3. The optimum at point X is that for a firm whose
owners prefer period 1 consumption relative to period 0 consumption (and
have hence lent on the capital market), whereas a firm locating at Y has
borrowed, as its owners prefer date 0 to date 1 consumption.
Figure 1.3 demonstrates the key insight of Fisher separation. All firms,
regardless of preferences, will have the same optimal physical investment
policy, investing to the point where the PPF and capital market line are
tangent. Preferences then dictate the firm’s borrowing or lending policy
and shift the optimum along the capital market line. The implication of
this is that, as it is physical investment that alters firm value, all agents
(i.e. regardless of preferences) agree on the physical investment policy that
will maximise firm value. More specifically, the shareholders of the firm
can delegate choice of investment policy to a manager whose preferences
may differ from their own, while controlling financial investment policy in
order to suit their preferences.
Figure 1.3
10
Chapter 1: Present-value calculations and the valuation of physical investment projects
The prior objective is the net present-value rule for project appraisal. It
says that an optimal physical investment policy maximises the difference
between investment proceeds divided by one plus the interest rate and the
investment cost. Here, the term ‘optimal’ is being defined as that which leads
to maximisation of shareholder utility. We will discuss the NPV rule more
fully (and for cases involving more than one time period) later in this chapter.
The assumption of perfect capital markets is vital for our Fisher separation
results to hold. We have assumed that borrowing and lending occur at the
same rate and are unrestricted in amount and that there are no transaction
costs associated with the use of the capital market. However, in practical
situations, these conditions are unlikely to be met. A particular example is
given in Figure 1.4. Here we have assumed that the rate at which borrowing
occurs is greater than the rate of interest paid on lending (as the real world
would dictate). Figure 1.3 shows that there are now two points at which the
capital market lines and the production opportunities frontier are tangential.
This then implies that agents with different preferences will choose differing
physical investment decisions and, therefore, Fisher separation breaks down.
Figure 1.4
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92 Corporate finance
12
Chapter 1: Present-value calculations and the valuation of physical investment projects
You can see the present and future value concepts pictured in Figure 1.2.
If you recall, Figure 1.2 just plots the CML for a given level of initial funds
(m) assuming no funds are to be received in the future. The future value
of this amount of money is simply the vertical intercept of the CML (i.e.
m(1+r)), and obviously the present value of m(1+r) is just m.
The present and future value concepts are straightforwardly extended
to cover more than one period. Assume an annual compound interest rate
of r. The present value of $100 to be received in k year’s time is:
Activity
Below, there are a few applications of the present and future value concepts. You should
attempt to verify that you can replicate the calculations given below.
Assume a compound borrowing and lending rate of 10 per cent annually.
a. The present value of $2,000 to be received in three years time is $1,502.63.
b. The present value of $500 to be received in five years time is $310.46.
c. The future value of $6,000 evaluated four years hence is $8,784.60.
d. The future value of $250 evaluated 10 years hence is $648.44.
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92 Corporate finance
Once we have calculated the NPV, what should we do? Clearly, if the NPV
is positive, it implies that the present value of receipts exceeds the present
value of payments. Hence, the project generates revenues that outweigh its
costs and should therefore be accepted. If the NPV is negative the project
should be rejected, and if it is zero the firm will be indifferent between
accepting and rejecting the project.
This gives a very straightforward method for project evaluation. Compute
the NPV of the project (which is a simple calculation), and if it is greater
than zero, the project is acceptable.
Example
Consider a manufacturing firm, which is contemplating the purchase of a new piece of
plant. The rate of interest relevant to the firm is 10 per cent. The purchase price is £1,000.
If purchased, the machine will last for three years and in each year generate extra revenue
equivalent to £750. The resale value of the machine at the end of its lifetime is zero. The
NPV of this project is:
Activity
Assume an interest rate of 5 per cent. Compute the NPV of each of the following projects,
and state whether each project should be accepted or not.
Project A has an immediate cost of $5,000, generates $1,000 for each of the next
six years and zero thereafter.
Project B costs £1,000 immediately, generates cash flows of £600 in year 1,
£300 in year 2 and £300 in year 3.
Project C costs ¥10,000 and generates ¥6,000 in year 1. Over the following years,
the cash flows decline by ¥2,000 each year, until the cash flow reaches zero.
Project D costs £1,500 immediately. In year 1 it generates £1,000. In year 2 there
is a further cost of £2,000. In years 3, 4 and 5 the project generates revenues of
£1,500 per annum.
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Chapter 1: Present-value calculations and the valuation of physical investment projects
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92 Corporate finance
where Ci is the project cash flow in year i, and I is the initial (i.e. year 0)
investment outlay. Comparison of equation 1.7 with 1.6 shows that the
project IRR is the discount rate that would set the project NPV to zero.
Once the IRR has been calculated, the project is evaluated by comparing
the IRR to a predetermined required rate of return known as a hurdle
rate. If the IRR exceeds the hurdle rate, then the project is acceptable,
and if the IRR is less than the hurdle rate it should be rejected. A graphical
analysis of this is presented in Figure 1.5, which plots project NPV against
the rate of return used in NPV calculation. If r* is the hurdle rate used
in project evaluation, then the project represented by the curve on the
figure is acceptable as the IRR exceeds r*. Clearly, if r* is also the correct
required rate of return, which would be used in NPV calculations, then
application of the IRR and NPV rules to assessment of the project in Figure
1.5 gives identical results (as at rate r* the NPV exceeds zero).
Figure 1.5
Calculation of the IRR need not be straightforward. Rearranging equation
1.7 shows us that the IRR is a solution to a kth order polynomial in r.
In general, the solution must be found by some iterative process, for
example, a (progressively finer) grid search method. This also points to
a first weakness of the IRR approach; as the solution to a polynomial,
the IRR may not be unique. Several different rates of return might satisfy
equation 1.7; in this case, which one should be used as the IRR? Figure 1.6
gives a graphical example of this case.
16
Chapter 1: Present-value calculations and the valuation of physical investment projects
Figure 1.6
The graphical approach can also be used to illustrate another weakness
of the IRR rule. Consider a firm that is faced with a choice between two
mutually exclusive investment projects (A and B). The locus of NPV-rate of
return pairings for each of these projects is given on Figure 1.7.
The first thing to note from the figure is that the IRR of project A
exceeds that of B. Also, both IRRs exceed the hurdle rate, r*. Hence,
both projects are acceptable but, using the IRR rule, one would choose
project A as its IRR is greatest. However, if we assume the hurdle rate is
the true opportunity cost of capital (which should be employed in an NPV
calculation), then Figure 1.7 indicates that the NPV of project B exceeds
that of project A. Hence, in the evaluation of mutually exclusive projects,
use of the IRR rule may lead to choices that do not maximise expected
shareholder wealth.
Figure 1.7
The lesson of this section is therefore as follows. The most commonly
used alternative project evaluation criteria to the NPV rule can lead to
poor decisions being made under some circumstances. By contrast, NPV
performs well under all circumstances and thus should be employed.
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92 Corporate finance
Stocks
Consider holding a common equity share from a given corporation. To
what does this equity share entitle the holder? Aside from issues such as
voting rights, the share simply delivers a stream of future dividends to
the holder. Assume that we are currently at time t, that the corporation is
infinitely long-lived (such that the stream of dividends goes on forever)
and that we denote the dividend to be paid at time t+i by Dt+i. Also
assume that dividends are paid annually. Denoting the required annual
rate of return on this equity share to be re, then a present value argument
would dictate that the share price (P) should be defined by the following
formula:
∞ D
P= ∑ (1 + rt+i) i . (1.8)
i =1 e
re = D0 ( 1 + ) + g .
g
(1.10)
P
The first term in 1.10 is the expected dividend yield on the stock, and the
second is expected dividend growth. Hence, with empirical estimates of
the previous two quantities, we can easily calculate the required rate of
return on any equity share.
Activity
Attempt the following questions:
1. An investor is considering buying a certain equity share. The stock has just paid
a dividend of £0.50, and both the investor and the market expect the future
dividend to be precisely at this level forever. The required rate of return on
similar equities is 8 per cent. What price should the investor be prepared to pay
for a single equity share?
18
Chapter 1: Present-value calculations and the valuation of physical investment projects
2. A stock has just paid a dividend of $0.25. Dividends are expected to grow at
a constant annual rate of 5 per cent. The required rate of return on the share
is 10 per cent. Calculate the price of the stock.
3. A single share of XYZ Corporation is priced at $25. Dividends are expected
to grow at a rate of 8 per cent, and the dividend just paid was $0.50. What is
the required rate of return on the stock?
Bonds
In principle, bonds are just as easy to value.
A discount or zero coupon bond is an instrument that promises
to pay the bearer a given sum (known as the principal) at the end of
the instrument’s lifetime. For example, a simple five-year discount bond
might pay the bearer $1,000 after five years have elapsed.
Slightly more complex instruments are coupon bonds. These not
only repay the principal at the end of the term but in the interim entitle
the bearer to coupon payments that are a specified percentage of
the principal. Assuming annual coupon payments, a three-year bond
with principal of £100 and coupon rate of 8 per cent will give annual
payments of £8, £8 and £108 in years 1, 2 and 3.
In more general terms, assuming the coupon rate is c, the principal is P
and the required annual rate of return on this type of bond is rb, the price
of the bond can be written as:4 4
In our notation a
coupon rate of 12
cP + p ( 1 + c) .
k –1
PB = ∑ (1 + rb ) i (1 + rb ) k
(1.11) per cent, for example,
i =1 implies that c = 0.12;
Note that it is straightforward to value discount bonds in this framework the discount rate used
here, rb, is called the
by setting c to zero.
yield to maturity of the
bond.
Activity
Using the previous formula, value a seven-year bond with principal $1,000, annual
coupon rate of 5 per cent and required annual rate of return of 12 per cent.
(Hint: the use of a set of annuity tables might help.)
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92 Corporate finance
Key terms
capital market line (CML)
consumption
Fisher separation theorem
Gordon growth model
indifference curve
internal rate of return (IRR) criterion
investment policy
net present value rule
payback rule
production opportunity frontier (POF)
production possibility frontier (PPF)
time value of money
utility function
20
Chapter 2: Risk and return: mean–variance analysis and the CAPM
Learning objectives
At the end of this chapter, and having completed the essential reading and
activities, you should be able to:
discuss concepts such as a portfolio’s expected return and variance as
well as the covariance and correlation between portfolios’ returns
calculate portfolio expected return and variance from the expected
returns and return variances of constituent assets
describe the effects of diversification on portfolio characteristics
derive the CAPM using mean–variance analysis
describe some theoretical and practical limitations of the CAPM.
Essential reading
Grinblatt, M. and S. Titman Financial Markets and Corporate Strategy. (Boston,
Mass.; London: McGraw-Hill, 2002) Chapters 4 and 5.
Further reading
Brealey, R., S. Myers and F. Allen Principles of Corporate Finance. (Boston,
Mass.; London: McGraw-Hill, 2008) Chapters 8 and 9.
Copeland, T. and J. Weston Financial Theory and Corporate Policy.
(Reading, Mass.; Wokingham: Addison-Wesley, 2005) Chapters 5 and 6.
Roll, R. ‘A Critique of the Asset Pricing Theory’s Texts. Part 1: On Past and
Potential Testability of the Theory’, Journal of Financial Economics 4(2)
1977, pp.129–76.
Introduction
In Chapter 1 we examined the use of present-value techniques in the
evaluation of physical investment projects and in the valuation of primitive
financial assets (i.e. stocks and bonds). A key input into NPV calculations
is the rate of return used in the construction of the discount factor but,
thus far, we have said little regarding where this rate of return comes
from. Our objective in this chapter is to demonstrate how the risk of a
given security or project impacts on the rate of return required from it and
hence affects the value assigned to that asset in equilibrium.
We begin by introducing the basic statistical tools that will be needed
in our analysis, these being expected values, variances and
covariances. This leads to an analysis of the statistical characteristics
21
92 Corporate finance
Activity
Calculate the portfolio weight for Microsoft, using the method presented above.
22
Chapter 2: Risk and return: mean–variance analysis and the CAPM
can use equations 2.1 and 2.6 to derive the expected return and variance
of the investor’s portfolio. These calculations yield:
E ( R p) = 2
3 (0.1) + 1
3 (0.16) = 0.12 = 12 % (2.7)
Activity
Assume that Uxy = – 0.5. Calculate the portfolio return variance in this case, using the
data on portfolio weights and asset return variances given above.
Now, given the expected returns, return variances and covariances for
any set of assets, we should be able to calculate the expected return and
variance of any portfolio created from those assets. At the end of this
chapter, you will find activities that require you to do precisely this, along
with solutions to some of these activities.
Diversification
A point that we noted from the calculations of expected portfolio returns
and variances above was that, in all of our calculations, the variance of the
portfolio return was lower than that on any individual component’s asset
return.2 Hence, it seems as though, by forming bundles of assets, we can 2
Note that this result
eliminate risk. This is true and is known as diversification: through holding does not hold in general
(i.e. it may be the case
portfolios of assets, we can reduce the risk associated with our position.
that the return variance
Why is this the case? The key is that, in our prior analysis and in real stock of a portfolio exceeds
return data, the correlations between returns are less than perfect. If two the return variance of
returns are imperfectly correlated it implies that when returns on the first are one of the component
assets).
above average, those on the second need not be above average. Hence, to an
extent, the returns on such assets will tend to cancel each other out, implying
that the return variance for a portfolio of these stocks will be smaller than
the corresponding weighted average of the individual asset variances.
To illustrate this point in a general setting, consider the following scenario.
An investor holds a portfolio consisting of N stocks, with each stock having
the same portfolio weight (i.e. each stock has portfolio weight N-1). Denote
the return variances for the individual assets by ı2i where i = 1 to N, and
the covariance between returns on assets i and j by ıij. Using equation 2.4,
the variance of the investor’s portfolio return can be written as:
N
σP2 = 12 ∑ σi2 + N12 ∑ σij . (2.10)
N i =1 i≠ j
24
Chapter 2: Risk and return: mean–variance analysis and the CAPM
N ( N (
σP2 = 12 σ 2 + 1 – 1 C . (2.12)
Now we ask the following question. How does the portfolio variance change
as the number of assets combined in the portfolio increases towards infinity
(i.e. N of). It is clear from 2.12 that, as the number of assets held increases,
the first term will shrink towards zero. Also, as N increases the second term
in 2.12 tends towards C. Together, these observations imply the following.
1. The portfolio variance falls as the number of assets held increases.
2. The limiting portfolio return variance is simply the average covariance
between asset returns: this average covariance can be thought of as
the risk of the market as a whole, with the influence of individual asset
return variances disappearing in the limit.
The moral of the preceding statistical story is clear. Holding portfolios
consisting of greater and greater numbers of assets allows an investor to reduce
the risk he or she bears. This is illustrated diagrammatically in Figure 2.1.
Figure 2.1
Mean–variance analysis
In the preceding two sections, we have demonstrated two important facts:
1. The expected return on a portfolio of assets is a linear combination of
the expected returns on the component assets.
2. An investor holding a diversified portfolio gains through the reduction
in portfolio variance, when asset returns are not perfectly correlated.
In this section, we use these facts to characterise the optimal holding of
risky assets for a risk-averse agent. Our fundamental assumption is that all
agents have preferences that only involve their expected portfolio return
and return variance. Utility is assumed to be increasing in the former
and decreasing in the latter. For illustrative purposes we begin using the
assumption that only two risky assets are available. The results presented,
however, generalise to the N asset case.
25
92 Corporate finance
To begin, assume there is no risk-free aset. The investor can hence only
form his or her portfolio from risky assets named X and Y. These assets
have expected returns of E(Rx) and E(Ry) and return variances of ı2x and ı2y.
The first question the investor wishes to answer is how the characteristics
of a portfolio of these assets (i.e. portfolio expected return and variance)
change as the portfolio weights on the assets change. Given equation 2.6,
the answer to this question is obviously dependent on the correlation
between the returns on the two assets.
First assume the assets are perfectly correlated and, further, assume asset
X has lower expected returns and return variance than asset Y. We form a
portfolio with weights Į on asset X and 1±Į on asset Y. Equation 2.6 then
implies that the portfolio variance can be written as follows:
ı2P = (Įıx + (1±Į)ıy )2. (2.13)
Taking the square root of equation 2.13, it is clear that the portfolio
standard deviation is linear in Į. As the portfolio expected return is linear
in Į, the locus of expected return–standard deviation combinations is a
straight line. This is shown in Figure 2.2.
Figure 2.2
If the correlation between returns is less than unity, however, the investor
can benefit from diversifying his portfolio. As previously discussed, in this
scenario, portfolio standard deviation is not a linear combination of ıx
and ıy. The reduction of portfolio risk through diversification will imply
that the mean–standard deviation frontier bows towards the y-axis. This
is also shown on Figure 2.2. The final curve on Figure 2.2 represents the
case where returns are perfectly negatively correlated. In this situation, a
portfolio can be constructed, which has zero standard deviation.
Activities
1. Assuming asset returns are perfectly negatively correlated, use equation 2.6
to find the portfolio weights that give a portfolio with zero standard deviation.
(Hint: write down 2.6 with the correlation set to minus one and a Į and
b ±Į. Then minimise portfolio variance with respect to Į.)
2. Assume that the returns on Microsoft and Bethlehem Steel have correlation of
0.5. Using the data provided earlier in the chapter, construct the mean–variance
frontier for portfolios of these two assets. Start with a portfolio consisting only
of Microsoft stock and then increase the portfolio weight on Bethlehem Steel by
0.1 repeatedly, until the portfolio consists of Bethlehem Steel stock only.
26
Chapter 2: Risk and return: mean–variance analysis and the CAPM
From here on we will assume that return correlation is between plus and
minus one. The expected return–standard deviation locus for this case
is redrawn in Figure 2.3. In the absence of a risk-free asset, this locus is
named the mean–variance frontier. As our investor’s preferences are
increasing in expected return and decreasing in standard deviation, it is
clear that his or her optimal portfolio will always lie on the frontier and
to the right of the point labelled V. This point represents the minimum-
variance portfolio. He or she will always choose a frontier portfolio at or
to the right of V, as these portfolios maximise expected return for a given
portfolio standard deviation. In the absence of a risk-free asset, this set of
portfolios is called the efficient set.
Figure 2.3
We can now, given a set of preferences for the investor, find his or her
optimal portfolio. The condition characterising the optimum is that
an investor’s indifference curve must be tangent to the mean–variance
frontier.3 Two such optima are identified on Figure 2.3 at R and S. The 3
In technical terms the
investor locating at equilibrium point R is relatively risk-averse (i.e. his optimum is characterised
by the marginal rate of
or her indifference curves are quite steep), whereas the equilibrium at
substitution being equal
S is that for a less risk-averse individual (with correspondingly flatter to the marginal rate of
indifference curves). Figure 2.3 also shows sub-optimal indifference curves transformation (i.e. the
for each set of preferences. slope of the indifference
curve equals the slope of
the frontier).
Figure 2.4
27
92 Corporate finance
In order to analyse the variation in the risk and expected return of the
portfolio Q with respect to changes in the portfolio weights, we construct
the following expression:
dE(R Q) dE(R Q) /da
= . (2.16)
dσQ dσQ /da
Using equations 2.14 and 2.15 we find that:
dE(R Q) E(R p) – r f
= . (2.17)
dσQ σp
As this slope is independent of a, the risk–return profile of the portfolio Q
is linear. This is known as the capital market line, and two such CMLs are
shown in Figure 2.5 for two different portfolios of risky assets.
We now have all the components required to describe the optimal portfolio
choice of an investor faced with N risky assets and a risk-free investment.
Figure 2.6 replots the feasible set of risky asset portfolios. The key question
to answer is, what portfolio of risky assets should an investor hold? Using
the analysis from Figure 2.5, it is clear that the optimal choice of risky
asset portfolio is at K. Combining K with the risk-free asset places an
investor on a capital market line (labelled rfKZ), which dominates in utility
terms the CML generated by the choice of any other feasible portfolio of
risky assets.4 The optimal portfolio choice and a sub-optimal CML (labelled
4
That is, choosing
portfolio K places an
CML2) are shown on Figure 2.6 along with the indifference curves of two
investor on a CML with
investors. greater expected returns
Recall that we previously defined the efficient set as the group of at each level of return
portfolios that both minimised risk for a given level of expected return and variance than does any
other.
28
Chapter 2: Risk and return: mean–variance analysis and the CAPM
maximised expected return for a given level of risk. With the introduction
of the risk-free asset, the efficient set is exactly the optimal CML.
Figure 2.5
The key result that is depicted in Figure 2.6 is known as two-fund
separation. Any risk-averse investor (regardless of his or her degree
of risk-aversion) can form his or her optimal portfolio by combining two
mutual funds. The first of these is the tangency portfolio of risky assets,
labelled K, and the second is the risk-free asset. All that the degree of risk-
aversion dictates is the portfolio weights placed on each of the two funds.
The investor with the optimum depicted at X on Figure 2.6, for example, is
relatively risk-averse and has placed positive portfolio weights on both the
risk-free asset and K. An investor locating at Y, however, is less risk-averse
and has sold the risk-free asset short in order to invest more in K.5 5
A short sale is the sale
of an asset that one
does not actually own.
One borrows the asset
in order to complete the
transactions and imme-
diately receives the sale
price. Subsequently, one
uses the proceeds from
the sale to repurchase
a unit of the asset, and
deliver it to the creditor.
If the price of the asset
has dropped in the
interim, one makes a
ECUJRTQƂV
Figure 2.6
Two-fund separation is the result that underlies the capital asset pricing
model (CAPM), which is developed in the next section.
29
92 Corporate finance
Using the same method as shown in equation 2.16 to derive the risk–
return trade-off at the point represented by portfolio I, we get:
dE(R 1) (2.21)
= E(R j) – E(R K) .
da
dσ 1
= 0.5[a 2σ j2+(1–a) 2σ K2+2a(1–a)σ jK] -0.5 (2aσ j2–2(1–a)σ K2+2(1–2a)σ jK).
da
(2.22)
30
Chapter 2: Risk and return: mean–variance analysis and the CAPM
Definition
The market portfolio is the portfolio comprising all assets, where the
weights used in the construction of the portfolio are calculated as
the market capitalisation of each asset divided by the sum of market
capitalisations across all assets.
Two-fund separation gives us the fundamental result that all investors hold
efficient portfolios and, further, that all investors hold risky securities in the
same proportions (i.e. those proportions dictated by the tangency portfolio
(K)).7 For demand to be equal to supply in capital markets, it must be the case 7
All investors perceive
that the market portfolio is constructed with identical portfolio weights. The VJGUCOGGHƂEKGPVUGV
and tangency portfolio
implication of this is simple: the market portfolio and the tangency portfolio
due to our assumption
are identical. This allows us to express the CAPM in the following form. that they have homo-
geneous expectations
The capital asset pricing model regarding asset returns.
Under the prior assumptions, the following relationship holds for all
expected portfolio returns:
E(Rj ) = Rfȕj [E(rM ) – rf ], (2.27)
where E(RM ) is the expected return on the market portfolio, andȕj is the
covariance of the returns on asset j with those on the market divided by
the variance of the market return.
Equation 2.27 gives the equilibrium relationship between risk and return
under the CAPM assumptions. In the CAPM framework, the relevant
measure of an asset’s risk is its ȕ, and 2.27 implies that expected returns
increase linearly with risk.
To clarify the source of the CAPM equation, note that the identification of
the tangency portfolio and the linear ȕrepresentation are implied by mean–
variance analysis. The CAPM then imposes equilibrium on capital markets
and identifies the market portfolio as identical to the tangency portfolio.
31
92 Corporate finance
Figure 2.7
32
Chapter 2: Risk and return: mean–variance analysis and the CAPM
The final term on the right-hand side of equation 2.29 is the variance of
the error term and represents diversifiable risk. This source of risk is also
known as unsystematic and idiosyncratic risk. As emphasised previously,
this risk is unrelated to market fluctuations and, therefore, does not affect
expected returns. The first term on the right-hand side of 2.29 represents
undiversifiable risk, also known as systematic risk. This is risk that cannot
be escaped and hence increases equilibrium expected returns.
Activities8 8
;QWYKNNƂPFVJG
solutions to these
1. An investor forms a portfolio of two assets, X and Y. These assets have activities at the end of
expected returns of 9 per cent and 6 per cent and standard deviations of 0.8 this chapter.
and 0.6 respectively. Assuming that the investor places a portfolio weight of
0.5 on each asset, calculate the portfolio expected return and variance if the
correlation between returns on X and Y is unity.
2. Using the data from Question 1, recalculate the portfolio expected return and
variance, assuming that the correlation between returns is 0.5.
3. An investor forms a portfolio from two assets, P and Q, using portfolio weights
of one-third and two-thirds respectively. The expected returns on P and Q are
5 per cent and 7 per cent, and their respective return standard deviations are
0.4 and 0.5. Assuming the return correlation is zero, calculate the expected
return and variance of the investor’s portfolio.
4. Assuming identical data to that in Question 3, recalculate the statistical
properties of the portfolio, assuming the return correlation for P and Q is –0.5.
The statement of the CAPM is identical to the proposition that the market
portfolio is mean–variance efficient. Hence, Roll pointed out that empirical
tests of the CAPM should seek to examine whether this is indeed the case.
However, he also noted that the market portfolio (or the return on the
market) is not observable to an econometrician, who wishes to conduct a
test. Empirical researchers generally use a broad-based equity index such
as the FTSE-100, S&P-500 or Nikkei 250 to proxy the market. But the true
market portfolio will contain other financial assets (such as bonds and
stocks not included in such indices) as well as non-financial assets such as
real estate, durable goods and even human capital. Hence, the validity of
tests of the CAPM depend critically on the quality of the proxy used for the
market portfolio.
Based on the above, Roll’s critique is simply that, due to the fact that
the market portfolio is not observable, the CAPM is not testable. We can
understand this through the following arguments. First, it might be the
case that the market portfolio is efficient (and hence the CAPM is valid),
but our chosen proxy for the market is not efficient, and hence our
empirical test rejects the CAPM. Second, our proxy for the market might
be efficient whereas the market portfolio itself is not. In this case our test
33
92 Corporate finance
will falsely indicate that the CAPM is valid. Put simply, the fact that we
can’t guarantee the quality of our proxy for the market implies that we
can’t place any faith in the results that tests based upon it generate, and
hence it’s impossible to test the CAPM.
The Roll critique is clearly damaging in that it implies that we can’t judge
the predictions of the CAPM against reality and trust the results. However,
many researchers have disregarded the prior discussion and estimated
the empirical counterpart of equation 2.27. From these estimates such
researchers pass judgment on the CAPM.
One prediction of the CAPM upon which some have focused is that the
expected excess return of a given portfolio over the risk-free rate (the risk
premium) is linearly related to ȕ with the slope of this relationship given
by the market risk premium. Historically, however, when one plots actual
excess portfolio returns against their estimated ȕs one finds that the line
traced out is flatter than one would expect from the theory (i.e. low ȕ
portfolios earn greater expected returns than the CAPM predicts, and high
ȕ portfolios earn less). This is clearly evidence against the CAPM.10 10
See pp.185–86 of
Brealey and Myers
Another prediction of the CAPM, which is also empirically tested, is that (2008).
ȕ is the only factor that should cause expected returns to differ (i.e. no
other variable should explain expected returns once we’ve accounted for
the effects of ȕ). Again, the evidence from this line of attack is not good
for the CAPM. Among other factors, firm size, book-to-market ratios, P/E
ratios and dividend yields have all been shown to explain ex-post realised
returns (after accounting for ȕ).
Amalgamating the above evidence implies that, if you are willing to
disregard the Roll critique, you should probably conclude that the CAPM
does not hold. This has led certain authors to investigate other asset-
pricing paradigms such as the APT (which we discuss in the next chapter).
An alternative viewpoint would be to argue that such results tell us little or
nothing about the validity of the CAPM due to the insight of Roll (1977).
Key terms
beta (ȕ)
capital asset pricing model (CAPM)
correlation
covariance
diversification
expected return
34
Chapter 2: Risk and return: mean–variance analysis and the CAPM
market portfolio
mean–variance analysis
Roll critique
security market line
standard deviation
systematic risk
two-fund separation
unsystematic risk
variance
Showing all your workings, compute the ȕ for ABC’s equity. (7%)
3. Assume that the risk-free rate is 5 per cent. What is the expected return
on ABC’s stock? (3%)
Solutions to activities
1. The expected return on the equally weighted portfolio is 7.5%. The
portfolio return variance is 0.49, and hence the portfolio return
standard deviation is 0.7.
2. Obviously, the expected return is the same as in Question 1. With
correlation of 0.5, the portfolio return variance is 0.37.
3. The expected return on the portfolio is 6.33%, and the portfolio has a
return variance of 0.1289.
4. When the correlation changes to –0.5, the portfolio return variance
drops to 0.0844. The expected return on the portfolio doesn’t change
from that calculated in Question 3.
35
92 Corporate finance
Notes
36
Chapter 3: The arbitrage pricing theory
Learning objectives
At the end of this chapter, and having completed the essential reading and
activities, you should be able to:
understand single-factor and multi-factor model representations
derive factor-replicating portfolios from a set of asset returns
understand the notion of arbitrage strategies and that well-functioning
financial markets should be arbitrage-free
derive arbitrage pricing theory and calculate expected returns using the
pricing formula.
Essential reading
Grinblatt, M. and S. Titman Financial Markets and Corporate Strategy. (Boston,
Mass.; London: McGraw-Hill, 2002) Chapter 6.
Further reading
Brealey, R., S. Myers and F. Allen Principles of Corporate Finance. (Boston,
Mass.; London: McGraw-Hill, 2008) Chapter 9.
Chen, N-F. ‘Some Empirical Tests of the Theory of Arbitrage Pricing’, The
Journal of Finance 38(5) 1983, pp.1393–1414.
Chen, N-F., R. Roll and S. Ross ‘Economic Forces and the Stock Market’, Journal
of Business 59, 1986, pp.383–403.
Copeland, T., J. Weston and K. Shastri Financial Theory and Corporate Policy.
(Reading, Mass.; Wokingham: Addison-Wesley, 2005) Chapter 6.
Overview
The arbitrage pricing theory is an alternative paradigm used to calculate
equilibrium expected returns on financial assets. As its name suggests,
it rests on the notion that well-functioning financial markets should
be arbitrage-free. This, using a factor model of asset returns, implies
restrictions on the relationships between asset returns and generates an
equilibrium pricing relationship.
Introduction
The arbitrage pricing theory (APT) developed in this chapter gives an
alternative to the CAPM as a method to compute the expected returns on
stocks. The basis for the APT is a factor model of stock returns, and we will
define and discuss these models first. From there we will demonstrate how
to derive expected returns using the idea that the returns on stocks, which
are exposed to a common set of factors, must be mutually consistent, given
each stock’s sensitivity to each factor.
37
92 Corporate finance
Single-factor models
Before using the notion of absence of arbitrage to provide pricing relations,
we need a basis for the generation of stock returns. Within the context of
the APT, this basis is given by the assumption that the population of stock
returns is generated by a factor model. The simplest factor model, given
below, is a one-factor model:
ri = Įi + ȕi ) İi E(İi) = 0. (3.1)
In equation 3.1, the returns on stock i are related to two main components:
1. The first of these is a component that involves the factor F. This factor
is posited to affect all stock returns, although with differing sensitivities.
The sensitivity of stock i’s return to F is ȕi. Stocks that have small values
for this parameter will react only slightly as F changes, whereas when ȕi
is large, variations in F cause very large movements in the return on stock
i. As a concrete example, think of F as the return on a market index (e.g.
the S&P-500 or the FTSE-100), the variations in which cause variations in
individual stock returns. Hence, this term causes movements in individual
stock returns that are related. If two stocks have positive sensitivities to
the factor, both will tend to move in the same direction.
2. The second term in the factor model is a random shock to returns, which
is assumed to be uncorrelated across different stocks. We have denoted
this term İi and call it the idiosyncratic return component for stock i. An
important property of the idiosyncratic component is that it is also assumed
to be uncorrelated with F, the common factor in stock returns. In statistical
terms we can write the conditions on the idiosyncratic component as follows:
Application exercise
Consider an economy in which the risk-free rate of return is 4% and the expected rate of
return on the market index is 9%. The variance of the return on the market index is 20%.
Two portfolios A and B have expected return 7% and 10%, and variance 20% and 50%,
respectively.
a) Work out the portfolios’ beta coefficients.
According to the CAPM:
E(rA) = rFȕA [E(rM) – rF]
and
E(rB) = rFȕB [E(rM) – rF].
Hence:
ȕA = [E(rA) – rF]/[E(rM) – rF@ íí
ȕB = [E(rB) – rF]/[E(rM) – rF@ íí
b) The risk of a portfolio can be decomposed into market risk and idiosyncratic
risk. What are the proportions of market risk and idiosyncratic risk for the two
portfolios A and B?
From the market model:
rA ĮAȕA rMİA
rB ĮBȕB rMİB
with cov(rMİA) = cov(rMİB) = 0.
It hence follows that the variance of portfolio A’s returns, ı2A, has two
components, systematic and idiosyncratic risk:
ı2A ȕ2Aı2Mı2İA.
Similarly:
ı2B ȕ2Bı2Mı2İB.
Portfolio B is much riskier than portfolio A as the variance of its returns is 50%
compared with 20% for A. The main reason why it is riskier is that it is much
more sensitive to the return of the market index than portfolio A as its beta is
1.2 compared with 0.6 for portfolio A.
c) Assume the two portfolios have uncorrelated idiosyncratic risk. What is the
covariance between the returns on the two portfolios?
Cov(rA,rB &RYĮAȕA rMİAĮBȕB rMİB ȕA ȕB ı2M
The returns of portfolios A and B are hence (positively) correlated even though
their idiosyncratic return components are not. These returns are positively
correlated because they are positively correlated with the returns of the market
index.
39
92 Corporate finance
Multi-factor models
A generalisation of the structure presented in equation 3.1 posits k factors
or sources of common variation in stock returns.
ri =Įi + ȕ1iF1 + ȕ2iF2 + .... + ȕkiFk + İi E(İi) = 0. (3.2)
Again the idiosyncratic component is assumed uncorrelated across stocks
and with all of the factors. Further, we’ll assume that each of the factors
has a mean of zero. These factors can be thought of as representing news
on economic conditions, financial conditions or political events. Note that
this assumption implies that the expected return on asset i is just given by
the constant in equation 3.2 (i.e. E(ri) Įi). Each stock has a complement
of factor sensitivities or factor betas, which determine how sensitive the
return on the stock in question is to variations in each of the factors.
A pertinent question to ask at this point is how do we determine the return
on a portfolio of assets given the k-factor structure assumed? The answer
is surprisingly simple: the factor sensitivities for a portfolio of assets are
calculable as the portfolio weighted averages of the individual factor
sensitivities. The following example will demonstrate the point.
Example
The returns on stocks X, Y, and Z are determined by the following two-factor model:
rX = 0.05 + F1 – 0.5F2 + İX
rY = 0.03 + 0.75 F1 + 0.5F2 + İY
rz F1 – 0.3F2 + İz
Given the factor sensitivities in the prior three equations, we wish to derive the factor
structure followed by an equally weighted portfolio of the three assets (i.e. a portfolio
with one-third of the weights on each of the assets). Following the result mentioned
above, all we need to do is form a weighted average of the stock sensitivities on the
individual assets. Subscripting the coefficients for the equally weighted portfolio with a p
we have:
1
Įp =
3
ȕ1p = 1 (1 + 0.75 – 0.25) = 0.5
3
1
ȕ2p = (–0.5 + 0.5 –0.3) = –0.1;;
3
and hence; the factor representation for the portfolio return can be written as:
rp F1 – 0.1F2 + İp
where the final term is the idiosyncratic component in the portfolio return.
Activity
Using the data given in the previous example, compute the return representation for a
portfolio of assets X, Y and Z with portfolio weights –0.25, 0.5 and 0.75.
40
Chapter 3: The arbitrage pricing theory
Factor-replicating portfolios
An important application of the technology developed previously in this
chapter is the construction of factor-replicating portfolio. A factor-replicating
portfolio is a portfolio with unit exposure to one factor and zero exposure to
all others. For example, the portfolio replicating factor 1 in model 3.2 would
have ȕ1 = 1 and ȕj = 0 for all j = 2 to k.
Activity
Assume that stock returns are generated by a two-factor model. The returns on three
well-diversified portfolios, A, B and C, are given by the following representations:
rA = 0.10 F1 – 0.5F2
rB = 0.08 + 2F1 + F2
rC = 0.05 + 0.5F1 + 0.5F2.
Determine the portfolio weights you need to place on A, B and C in order to construct
the two factor-replicating portfolios plus a portfolio which has zero exposure to both
factors. What are the expected returns of the factor-replicating portfolios and what is the
expected return of the risk-free portfolio?
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92 Corporate finance
The question to ask at this point is: why bother constructing factor-
replicating portfolios? The reason is as follows. Suppose I want to build a
portfolio that has identical factor exposures to a given asset, X. Assume a
two-factor world and that asset X has exposure of 0.75 to factor 1 and –0.3
to factor 2. Assume also that I know the two factor-replicating portfolios.
Building a portfolio with the same factor exposures as X is now simple.
Construct a new portfolio, Y, which has portfolio weight 0.75 on the
replicating portfolio for the first factor, portfolio weight –0.3 on the
replicating portfolio for the second factor and the rest of the portfolio
weight (i.e. a weight of 1 – 0.75 + 0.3 = 0.55) on the risk-free asset.
Via the results on the factor representations of a portfolio of assets and
the definition of a factor-replicating portfolio it is easy to see that Y is
guaranteed to have identical factor exposures to X.
The replication in the preceding paragraph forms the basis for the APT. For
absence of arbitrage we require all assets with identical factor exposures
to earn the same return. If they did not, then we would have the chance to
make unlimited amounts of money. For example, assume that the expected
return on the replicating portfolio Y was greater than that on asset X. Then
I should short X and buy Y. The risk exposures of the two portfolios are
identical and hence risks cancel out and I am left with an excess return
that is riskless (i.e. an arbitrage gain).
In order to progress, let us introduce some notation. Denote the risk-
free rate with rf. Denote the expected return on the ith factor-replicating
portfolio with rf + Ȝi such that Ȝi is the risk premium associated with the
ith factor. Again, for simplicity, assume that the world is generated by
a two-factor model, and assume that I wish to replicate asset X, which
has sensitivity ȕ1X to the first factor and ȕ2X to the second factor. Finally,
we will assume that the primary securities being worked with are well-
diversified portfolios themselves. Hence, we will ignore any idiosyncratic
risk in this derivation.
Using the prior argument, to replicate asset X’s factor sensitivities,
we construct a portfolio with weight ȕ1X on the first factor-replicating
portfolio, weight ȕ2X on the second factor-replicating portfolio and weight
1 – ȕ1X – ȕ2X on the risk-free asset. The expected return of the replicating
portfolio is hence:
ȕ1X (rf + Ȝ1) + ȕ2X (rf + Ȝ2) + (1 – ȕ1X – ȕ2X) rf = rf + ȕ1X Ȝ1+ ȕ2XȜ2. (3.6)
Hence, using our factor-replicating portfolios we can write the expected
return on a portfolio which replicates X’s factor exposures as the risk-free
rate plus each factor exposure multiplied by the risk premium on the
relevant factor-replicating portfolio.
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Chapter 3: The arbitrage pricing theory
Equation 3.7 is the statement of the APT. The expected return on a financial
asset can be written as the risk-free rate plus sum of the asset’s factor
sensitivities multiplied by the factor-risk premiums (which are invariant
across assets). If such an expression does not hold at all times, arbitrage
opportunities exist. Note the assumptions that are required to achieve this
result. First, we require that asset returns are generated by a two-factor (or
in general k-factor) model. Second, we assume that arbitrage opportunities
cannot exist. Lastly, we assume that enough assets are available such that
firm-specific risk washes away when portfolios are formed.
Example
In the previous two-factor example, we determined the expected returns on the two
factor-replicating portfolios. Denoting the expected return on the ith factor-replicating
portfolio by E(ri) we have:
E(r1 E(r2) = 1.71% E(r3
Hence, the premiums associated with the two factors are:
Ȝ1 ± Ȝ2 ±
This implies that the expected return on any asset in this world can be written as:
E(ri ȕ1i±ȕ2i.
To check that this works, substitute portfolio C’s (for example) factor sensitivities into the
preceding expression. This gives:
E(rC ±
and hence, agrees with the expected return implied by the original representation for
asset C. Check that the expected returns on assets A and B also come out correctly.
Activity
Assume that a new well-diversified portfolio, D, is added to our world. This asset has
sensitivities of 3 and –1 to the two factors and an expected return of 15 per cent.
Using the equilibrium expected return equation given above, derive the equilibrium
expected return on an asset with identical factor exposures to D. Is there now an
arbitrage opportunity available? If so, dictate a strategy that could be employed to exploit
the arbitrage opportunity.
Summary
The APT gives us a straightforward, alternative view of the world from
the CAPM. The CAPM implies that the only factor that is important
in generating expected returns is the market return and, further, that
expected stock returns are linear in the return on the market. The APT
allows there to be k sources of systematic risk in the economy. Some may
reflect macroeconomic factors, like inflation, and interest rate risk, whereas
others may reflect characteristics specific to a firm’s industry or sector.
Empirical research has indicated that some of the well-known empirical
problems with the CAPM are driven by the fact that the APT is really the
proper model of expected return generation. Chen (1983), for example,
argues that the size effect found in CAPM studies disappears in a multi-
factor setting. Chen, Roll and Ross (1986) argue that factors representing
default spreads, yield spreads and GDP growth are important in expected
return generation. Work in this area is still progressing.
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Key terms
arbitrage pricing theory
factor-replicating portfolio
factor sensitivity
multi-factor model
single-factor model
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Chapter 4: Derivative assets: properties and pricing
Learning objectives
At the end of this chapter, and having completed the essential reading and
activities, you should be able to:
discuss the main features of the most widely traded derivative securities
describe the pay-off profiles of such assets
understand absence-of-arbitrage pricing of forwards, futures and swaps
construct bounds on option prices and relationships between put and
call prices
price options in a binomial framework using the portfolio replicating
and the risk-neutral valuation methods.
Essential reading
Grinblatt, M. and S. Titman Financial Markets and Corporate Strategy. (Boston,
Mass.; London: McGraw-Hill, 2002) Chapters 7 and 8.
Further reading
Brealey, R., S. Myers and F. Allen Principles of Corporate Finance. (Boston,
Mass.; London: McGraw-Hill, 2008) Chapters 21, 22 and 23.
Copeland, T., J. Weston and K. Shastri Financial Theory and Corporate Policy.
(Reading, Mass.; Wokingham: Addison-Wesley, 2005) Chapters 8 and 9.
Overview
A derivative asset is one whose pay-off depends entirely on the value of
another asset, usually called the underlying asset. In the last 20 years,
traded volume in these assets has increased tremendously. Derivatives
are widely used for hedging purposes by financial institutions and are
also used for speculative purposes. In this chapter we discuss the most
commonly traded types of derivative. We go on to introduce the underlying
principles of derivative pricing. We devote the final section of the chapter
to a more detailed description of the features and pricing of options.
Varieties of derivatives
Forwards and futures
Perhaps the oldest type of derivative asset is the simple forward
contract. A forward is an agreement between two parties (called A and
B) and has the following features.
1. Party A agrees to supply party B with a specified amount of a specified
asset, k periods in the future.
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Example
Assume that party B is American and that in three months he must pay ¥250,000 for a
Japanese machine he has purchased. Party B enters into a contract to buy yen three months
forward. Party A (the agent who is to supply the yen) specifies that the cost of ¥100 will be
$1.20. The total price that party B must pay in three months is therefore $3,000.
Options
The option is a less straightforward type of derivative. Although the
forward or future contract implies an obligation to trade once the contract
is entered into, the option (as its name suggests) gives the agent who is
long a right but not an obligation to buy or sell a given asset at a pre-
specified price. This price is known as the exercise price and is specified
in the option contract. Just as with the forward, another factor specified
in the contract is the date on which the exchange is to take place. If, on
the maturity date, the holder of an option decides to buy or sell in line
with the terms of the contract, he or she is said to have exercised his or
her right. A big difference between options and forwards is that, with an
option, the agent who is long must pay a price (or premium) at the outset.
This is essentially a price paid by the holder for the exercise choice he or
she faces at maturity.
Options to buy the specified asset are called call options. Options to sell
are called puts. Another distinction is made on the timing of the exercise
decision. With European options, the right can only be exercised on the
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Chapter 4: Derivative assets: properties and pricing
maturity date itself. With American options, in contrast, the option can be
exercised on any date at or before maturity. American options are traded
far more frequently than their European counterpart, but for reasons of
simplicity, we will focus on the European variety.
Example
A 12-month European call option on IBM has exercise price $45. It gives me the right
to purchase IBM stock in one year at a cost of $45 per share. In line with the prior
discussion, I am under no obligation to buy at $45 such that, if the market price were less
than this amount, I could choose not to exercise and buy in the market instead.
Swaps
Swaps are another type of derivative, which do exactly what their name
says. Two counterparties agree to exchange (or swap) periodic interest
payments on a given notional amount of money (the notional principal)
for a given length of time.
A very common type of swap involves an exchange of interest payments
based on a market-determined floating rate (such as the London InterBank
Offer Rate (LIBOR)) for those calculated on a fixed-rate basis. Another
frequently traded variety of swap involves the exchange of interest
payments in different currencies. For example, fixed sterling interest
payments may be exchanged for fixed dollar interest payments.2 2
The notional principal
is not exchanged in an
interest rate swap (they
Derivative asset pay-off profiles would net out anyway)
but are generally
For now we are going to concentrate on forwards and options. As exchanged in currency
mentioned above, futures are closely related to forwards, and their pricing swaps.
is based on the technique presented below. The relationship between
forwards and swaps will be made clear later.
Before getting on to the principles of derivative pricing, let us take a look
at the pay-off profiles of the basic forward and option contracts. The pay-
off profile of a long forward position is shown in Figure 4.1. In the figure,
F is the price agreed upon in the forward contract, and S is the spot price
of the asset at the settlement date. Note that the pay-off profile is linear,
positive for values of S greater than F and negative when S is less than F.
Figure 4.1
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Understanding the forward pay-off is simple. If the spot price for the asset
at maturity exceeds the forward price, then the party that is long has
gained by entering into the forward (i.e. he’s got the asset for a lower price
than it would have cost if bought in the spot market). If the spot price at
maturity is lower than the forward price, then the long pay-off is negative,
as it would have been cheaper for the long party to buy the asset in the
spot market rather than entering into the forward. Obviously, the pay-off
of a short forward position is the negative of that shown in Figure 4.1.
Let’s now consider the pay-off to a holder of a European call option.
This is given in Figure 4.2 where the option’s exercise price is labelled
X. Remember that a call option gives the holder the right but not the
obligation to purchase the asset. What occurs when the price of the
spot asset at maturity exceeds the exercise price of the option? Well it is
cheaper to buy the asset using the option than in the spot market; hence
the option is exercised, and the holder makes a gain of the spot price less
the exercise price. When the spot price is lower than the exercise price,
then the holder would find it cheaper to buy the asset at spot and hence
does not exercise the option. The pay-off to the holder is then zero.
Figure 4.2
The pay-off to the holder of a European put is given in Figure 4.3. As the
put gives the holder the right to sell the underlying asset, the holder gains
when the exercise price exceeds the spot price and has a zero pay-off when
the spot price at maturity is greater than or equal to the exercise price.
Figure 4.3
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Chapter 4: Derivative assets: properties and pricing
Each option must have one agent who is long and one who is short, with
the pay-offs to the long position given in Figures 4.2 and 4.3. An agent
who is short is said to have written the option, and his or her pay-offs
are the negative of those given above. Note that an agent with a long
option position never has a negative pay-off, whereas an agent who has
written an option never has a positive pay-off at maturity. The option
price, paid at the outset by the agent who is long to that who is short, is
the compensation to the writer of the option for holding a position that
exposes him or her to weakly negative cash flows.
The key to pricing options, and other derivative assets, is constructing
a portfolio of assets that is priced in the market and that has a pay-
off structure identical to that of the derivative. As the derivative and
replicating portfolio have identical pay-offs, absence-of-arbitrage
arguments imply that the cost of these portfolios must be identical. The
no-arbitrage price of the derivative is hence just the initial investment cost
needed to set up the replicating portfolio.
Why is this the case? Well, consider the following pair of investment
strategies.
The first is simply a long position in the forward contract. This costs
nothing at the present time and yields Sk – Fk at maturity.
The second strategy involves buying a unit of the asset at spot and
borrowing Fk(1+r)–k at the risk-free rate for k periods. The k period pay-
off of this strategy is also Sk – Fk, and its net current cost is S0 – Fk(1+r)–k.
The pay-offs of the two strategies are identical. This implies that the two
investments should have identical costs. As the cost of investment in the
forward is zero, this implies that the following condition must hold:
S0 – Fk(1+r)–k = 0. (4.2)
Rearranging equation 4.2 we derive the no-arbitrage price for the k period
forward contract, which is precisely that given in equation 4.1.
Activity
The current value of a share in Robotronics is $12.50.
1. The one-year riskless rate is 6 per cent. What are the prices of three- and five-
year forward contracts on Robotronics stock?
2. Three-year forward contracts are currently being sold for $16 in the market.
Outline an investment strategy that could take advantage of the opportunities
this presents.
Some of the most active forward markets are those for foreign currency.
The forward pricing analysis above, however, is suited only for assets
valued in the domestic currency (e.g. individual stocks or stock indices).
To illustrate the pricing of currency forwards, consider the following
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92 Corporate finance
( (
1+r k
Fk = S 1 + r .
f
(4.4)
Activity
The current spot exchange rate is £0.64 = $1. The riskless rate in the UK is currently 6
per cent and that in the US is 4 per cent. Using equation 4.4, derive the implied five- and
10-year forward exchange rates.
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Chapter 4: Derivative assets: properties and pricing
In order to price this derivate asset, we will consider two different methods:
the portfolio replicating method
the risk-neutral valuation method.
and
SLKH – SHKL .
b= (4.8)
(1 + rf )(SL – SH)
Example
A one-period European call option on ABC stock has an exercise price of 120. The current
price of ABC stock is 100, and if things go well, the price in the following period will be
150. If things go badly over the coming period, the future price will be 90. The risk-free
rate is 10 per cent. What is the no-arbitrage price of this option?
First we need to know the option pay-offs. In the bad state it pays zero, as the underlying
price is less than the exercise price. In the good state it pays the excess of the underlying
price over the exercise price (i.e. 30).
Next we construct the replicating portfolio. Using equations 4.3 and 4.4, the quantities of 5
You should check
the underlying and risk-free asset we must buy are 0.5 and –40.91 (i.e. we buy half a unit all these calculations
of stock and short 40.91 units of the risk-free asset).5 This portfolio replicates the option and further check that
the portfolio we’ve
pay-off, and therefore the option price is given by the cost of constructing the portfolio.
constructed does indeed
The call price (c) is hence: replicate the option
c =± pay-off.
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92 Corporate finance
Activity
Using the stock price data from the previous example, price a European put option on
ABC stock with a strike price of 100.
Activity
Using the risk-neutral valuation method, price both a European call option and a
European put option on the ABC stock (introduced in the previous example) with a strike
price of 100.
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Chapter 4: Derivative assets: properties and pricing
Activity
Show that the current price of the derivative obtained from the portfolio replicating
method in equation 4.9 is the same as the one obtained from the risk-neutral valuation
method in equation 4.13.
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Chapter 4: Derivative assets: properties and pricing
Figure 4.4
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92 Corporate finance
Example
The current price of Glaxo Wellcome shares is £2.88. An investor writes a two-year call
option on Glaxo with exercise price £3.00. If the annualised, continuously compounded
interest rate is 8 per cent, and the volatility of Glaxo’s stock price is 25 per cent, what is
the B–S option price?
First we need to derive the values d1 and d2 defined as above. Using 4.24 and 4.25
these are 0.5139 and 0.1603. The values of the cumulative normal distribution function
at 0.5139 and 0.1603 are 0.696 and 0.564. Then, plugging all the available data into
equation 4.23 yields a call price of £0.5644.
What does equation 4.23 tell us about the determinants of call prices?
Well, there are clearly a number of influences on the price of an option,
and these are summarised below.
The effect of the current stock price: the B–S equation tells us
that call option prices increase as the current spot asset price increases.
This is pretty unsurprising as a higher underlying price implies that the
option gives one a claim on a more valuable asset.
The effect of the exercise price: again, as you would expect,
higher exercise prices imply lower option prices. The reason for this is
clear: a higher exercise price implies lower pay-offs from the option at
all underlying prices at maturity.
The effect of volatility: Figure 4.2 gives the pay-off function of a
European call option. Note that, although extremely good outcomes
(underlying price very high) are rewarded highly, extremely bad
outcomes are not penalised due to the kink in the option pay-off
function. This would imply that an increase in the likelihood of extreme
outcomes should increase option prices, as large pay-offs are increased
in likelihood. The B–S formula verifies this intuition, as it shows that
call prices increase with volatility, and increased volatility implies a
more diverse spread of future underlying price outcomes.
The effect of time to maturity: call option prices increase with time
to maturity for similar reasons that they increase with volatility. As the
horizon over which the option is written increases, the relevant future
underlying price distribution becomes more spread-out, implying increased
option prices. Furthermore, as the time to maturity increases, the present
value of the exercise that one must pay falls, reinforcing the first effect.
The effect of riskless interest rates: call option prices rise when
the risk-free rate rises. This is due to the same effect as above, in that the
discounted value of the exercise price to be paid falls when rates rise.
Put–call parity
The B–S formula gives us a closed-form solution for the price of a
European call option under certain assumptions on the underlying asset
price process. However, as yet, we have said nothing about the pricing of
put options. Fortunately, a simple arbitrage relationship involving put and
call options allows us to do this. This relationship is known as put–call
parity. In what follows we assume the options have the same strike price
(X), time to maturity (T) and are written on the same underlying stock.
Consider an investment consisting of a long position in the underlying
asset and a put option, called portfolio A. The cost of this position is
S0 + p. A second portfolio, denoted B, comprises a long position in a call
option and lending Xe–rT. Hence the cost of this position is c + Xe–rT.
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Chapter 4: Derivative assets: properties and pricing
What are the possible pay-offs of these positions at maturity? Given the
pay-off structure on the put shown in Figure 4.3, the pay-off on portfolio A
can be written as follows:
max[X – ST,0] + ST = max[X,ST]. (4.26)
Similarly, the pay-off on portfolio B can be written as:
max[0,ST – X] + X = max[X,ST]. (4.27)
Comparison of equations 4.26 and 4.27 implies that the two portfolios
always pay identical amounts. Hence, using no-arbitrage arguments,
portfolios A and B must cost the same amount. Equating their costs we have:
S + p = c + Xe–rT. (4.28)
Equation 4.28 is the put–call parity relationship. Given the price of a call,
the value of the underlying asset and knowledge of the riskless rate, we
can deduce the price of a put. Similarly, given the put price, we can deduce
the price of a call with similar features.
Example
A call option on BAC stock, with an exercise price of £3.75, costs £0.25 and expires
in three years. The current price of BAC stock is £2.00. Assuming the continuously
compounded (annual) risk-free rate to be 10 per cent, calculate the price of a put option
with three years to expiry and exercise price of £3.75.
From equation 4.28 we have:
p = c + Xe–rT – S.
Plugging in the data we’re given yields:
p = 0.25 + 3.75e–0.1(3) – 2 = 1.03.
Hence, the no-arbitrage put price is £1.03.
Activity
ABC corporation’s shares currently sell at $17.50 each. The volatility of ABC stock is 15
per cent. Given a risk-free rate of 7 per cent, price a European call with strike price of
$15 and time to maturity 5 years. Use put-call parity to price a put with similar
specifications. What are the no-arbitrage prices of the call and the put if the risk-free
rate rises to 10 per cent?
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92 Corporate finance
Summary
This chapter has treated the nature and pricing of the most important
and heavily traded derivative securities. We have looked at the basic
specifications of forward, futures, option and swap contracts and what
these specifications imply for the pay-off functions of long and short
positions. Further, we have looked at methods that can be used to price
these securities. The basis of pricing is absence of arbitrage in all cases. We
looked most deeply at option contracts, detailing the relationships between
put, and call prices, and bounds on option prices, and finally we examined
the continuous time option pricing formula of Black and Scholes.
Although we’ve covered a lot of material here, the continual evolution and
innovation of derivatives markets and assets means that we missed much
more than we’ve treated. However, the basic features of derivatives pricing
that we’ve looked at can be extended to new and more complex securities.
Key terms
American option
binomial method
Black–Scholes
call option
covered interest rate parity relationship
derivative
European option
exercise price
forward contract
futures contracts
long position
marked-to-market
notional pricing
put option
risk-neutral method
settlement date
short position time to maturity
underlying price
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Notes
60