BUS 132 Exam 2

Efficient Market Hypothesis

• an asset’s current price fully and instantaneously reflects all available information about future economic fundamentals.

  • Eugene Fama (2013 Nobel Prize winner in Economics)

  • How is information reflected in security prices?

    • Us doing analysis, we know this price is secure

• In making most financial decisions, it is a good idea to start by assuming price is an accurate reflection of fundamentals.

• This is because many professionals look for mispriced assets and eliminate discrepancies between the market prices and fundamental values

BASICALLY

• How is “Relative Information” Defined?

it is extremely difficult to out perm the ,market bcs it is efficient

3 kinds market efficiency

weak, semi strong, strong

Market risk vs. unique risk

The first law of finance

The value of any asset is the present value of all future cash flows that that asset is expecting to produce but discounted at the required return (opportunity cost)

Highlander Inc. has a $1,000 face value bond        outstanding with a 9% annual coupon and a yield to maturity (YTM) of  7% . If Highlander's bonds mature in 5 years, what is the price of one bond?

par value

the stated, nominal face value of a financial instrument. For stocks, it represents a nominal baseline (often as little as $0.01). For bonds, it is the principal amount the issuer guarantees to repay the bondholder at maturity. Par value rarely reflects a security's actual market price

bond

Bonds are simply loans you make to a corporation or government. In exchange for your money, the issuer promises to pay you regular interest over a set period and return your original investment when the bond expires

cash flows

Cash flow is the total amount of money moving into and out of a business, project, or personal account over a specific period. It is the primary indicator of liquidity, determining if you have enough readily available funds to pay bills, invest, and meet financial obligations

represents the actual coins, notes, and bank transfers physically entering and leaving your accounts. A business can technically be "profitable" on paper but still go bankrupt if it runs out of cash to pay its suppliers

Where do investment ideas come from?

• Entrepreneurial spirit, R&D, customers, competition

Which to accept and which to reject

• (Payback Period, Dis-counted Payback Period, NPV, IRR, MIRR)

• The Nature of Project Analysis

  • The big picture

    • The goal of the firm

    • Forecasting

The Net Present Value Investment Rule

• Net present value is the amount by which a project       is expected to increase or decrease shareholders’       wealth

  • If NPV ≥ $0                     Accept!

  • If NPV < $0                      Reject!

k

• We can refer to it as…

  • The capitalization rate

  • The cost of capital

  • The opportunity cost of capital

  • The required return

  • The discount rate

NPV AND IRR Meaning

IRR tells you the project's percentage return, while NPV tells you how many actual dollars of value are created. Firms care most about creating value, so NPV wins.

1. Mutually exclusive projects

Mutually exclusive projects are projects where accepting one project means you cannot accept the other. The projects compete for the same resources or serve the same purpose.

A system of conveyor belts vs. a fleet of forklifts is a great example of mutually exclusive projects because both projects accomplish the same goal: moving materials around a warehouse.

Example

A company is building a new distribution center and needs a way to transport boxes from receiving docks to shipping areas.

Project Y: Install a System of Conveyor Belts

• Initial cost: $2,000,000

• NPV: $500,000

• Uses automated belts to move products through the warehouse.

Project Z: Purchase a Fleet of Forklifts

• Initial cost: $1,200,000

• NPV: $350,000

• Uses forklift operators to move products manually.

Why are they mutually exclusive?

• Both projects perform the same function: moving inventory throughout the warehouse.

• Installing conveyor belts would greatly reduce the need for forklifts.

• Buying forklifts would eliminate the need for an expensive conveyor system.

• Therefore, investing in both would be inefficient because the projects would cannibalize each other's benefits.

Why not invest in both?

Because they consume the same economic resources:

• The same warehouse space and layout,

• The same material-handling budget,

• The same transportation function within the facility.

If the company installed both systems, much of one system would sit unused, reducing the expected cash flows and potentially making one or both projects have a lower or even negative NPV.

Since the projects are mutually exclusive, the firm should choose the project with the higher NPV—in this example, the conveyor belt system with an NPV of $500,000.

• V_{Any Asset}= PV of all Future Cash Flows…

• An asset’s value is the price it would fetch if       sold in a competitive market

The Law of One Price

• in a competitive market, if two assets are equivalent they will tend to have the same price

• Enforced by arbitrage: purchase and immediate sale of equivalent assets to earn a sure profit.

• Even if arbitrage cannot be carried out, unknown asset values can be inferred from the prices of comparable assets.

• Don’t forget Transaction Costs.

• arbitrage

Immediate purchase no time involved,, Arbitrage is the practice of exploiting temporary price discrepancies of identical or similar assets across different markets to lock in a risk-free profit. A trader buys an asset at a lower price in one market and simultaneously sells it at a higher price in another. [1, 2, 3]

• value of a share of stock

value of a share of stock is equal to the PV of all future dividends, discounted at the required return.

Book value vs. Market value

Assets on the balance sheet can be dramatically different from their market value.  Balance sheets represent historical costs, or book values; however, in finance, we pay more attention to market values.

extremely high CAPE signals

• that the market   is overvalued

high is over 30

Weak Market Efficiency

Weak Form Efficiency

stock price fully and instantaneously reflects all relevant info but relevant is historical info

• Market prices reflect all historical information (available and relevant)

• Technical analysis won’t help. What does that mean?

  • Technical analysis: when looking at charts and graphs, historical data will drive future stock prices → stocks don’t follow patterns like that

• Looking at historical price movements won’t help.

• assumes market can be predicted, no

• Looking at charts and graphs won’t help.

Semi-strong Market Efficiency

Semi-Strong Form Efficiency

Market prices reflect all publicly available information.

adds more relative info to actual model, includes historical info

• Fundamental analysis won’t help- analysts reports already reflected in stock price

• Annual reports, analysts’ recommendations, financial statements, and the newspaper won’t help

strong Market Efficiency

Market prices reflect all information, both public and private

• Insider information won’t help (Yeah, right)

  • you know what EPS, audit told you and miss projection causing market dropping today

  • insider trading is illegal

• Check out Scott London, former KPMG Partner

  • sold financial data to golf buddies, invested and made millions, IRS got them and gave up Scott London

Common Stock Features

• Voting rights: Common stockholders have the right to elect directors (1 share = 1 vote).  The board of directors appoints the officers who manage the corporation.

• Classified common stocks: classify the common stock of a firm into two classes with different voting rights in order to provide management or family owners with voting power disproportionately greater than provided by their holdings under a "one share-one vote" rule. For example, firms may have Class “A” and “B” shares. What’s the reason?

  • Google: A, B, & C Class Shares; Berkshire Hathaway (Warren Buffett’s holding company*, Ticker: BRK-A and BRK-B): A & B Shares; SNAP

• Dividends: paid out of earnings; A firm cannot become bankrupt on missed dividend payments; Not tax deductible to the firm; Investors are taxed.

value of a share of stock

• present value of ALL future dividends.

k,i

required return, capitalization rate, cost of capital, rate of return,

Diversification

Unique Risk

Market Risk

• Diversification -  Strategy designed to reduce        risk by spreading the portfolio across many invest-ments

• Unique Risk - Risk factors affecting only (usually)  one firm.  Also called “diversifiable risk,” “company  specific risk,” “unsystematic risk”

  • Examples?

• Market Risk - Economy-wide sources of risk that   affect the overall stock market.  Also called              “systematic risk” and “non-diversifiable risk”

  • Examples? Think macro.

Portfolio theory

• Portfolio theory - the quantitative analysis of trade-offs to find an optimal course of action.

  • In other words, optimal risk management

  • Use a probability distribution to quantify the            trade-off between risk and expected return

  • Don’t forget the correlation coefficient, ρ

  • 68,95,99

What is Risk

• Risk – uncertainty that matters to people’s welfare. Not all uncertainty matters. Think about traffic, and the stock market.

  • Deviation from the expected value; downside and/or upside

• All risks are ultimately borne by people in their capacity as consumers, stakeholders or           taxpayers

What is Risk Aversion?

• Risk aversion – a willingness to pay to reduce      one’s exposure to risk (insurance). All else equal,      choose the alternative with lowest risk…

  • preferring a lower-risk alternative for the same cost.

What is Risk Management

• Risk management – “the process of formulating   the benefit-cost trade-offs of risk reduction and  deciding on a course of action to take.”

  • A decision should be judged based on the information available at the time of making the decision. Ex. with   “umbrella.” walking in the rain with it

• Risk management decisions are made under uncertain conditions and it costs $ to eliminate or reduce risk.

• Understand your Risk Exposure. Your broker should.

• Risks facing Households

• Risks facing Firms

• Risks facing Households

  • Sickness, disability, and death

  • job loss

  • consumer-durable asset  (house, for example) risk

  • liability risk

  • financial asset risk

• Risks facing Firms

  • production risk…machines break down

  • price risk of outputs…decreased demand

  • price risk of inputs…oil, education, etc.

Risk Assessment and Management Techniques

• Risk assessment: actuaries; asset allocation

  • Quantifying costs

• Selection of risk-management techniques

• Risk avoidance

• Loss prevention and control

• Risk retention

• Risk transfer: hedging, insuring and diversifying

• Implementation…shop around.