Business Management 410 Marriott School of Management Fall 2009 Brian Boyer

Objectives What is optimal portfolio allocation?  Given market conditions, what is the “best” way to combine financial assets into a portfolio? What determines asset prices?  What characteristics of a financial asset determines its price in equilibrium? Not a personal finance course!

Front Row Players Financial market Participants  Hedge fund managers  Pension fund managers  Wealthy Individuals  University Endowments  Average individuals Front Row Players  Have several $million or $billion under management  Work with teams of analysts  Can execute trades at very low cost

Example Rewards will be highest for those managing large portfolios. Suppose research will yield a guaranteed increase in return of 0.1% over the next year Suppose you have $10,000 invested  You get $10 woo-hoo! Now suppose you have $10 billion invested  You get $1 million

CFA Exam CFA: Charted Financial Analyst  Pass Level I, Level II, and Level III exams  At least four years of acceptable professional experience Curriculum:  Ethical and Professional Standards  Quantitative Methods  Economics  Financial Statement Analysis  Corporate Finance  Analysis of Fixed-Income Investments  Analysis of Equity Investments  Analysis of Derivatives  Analysis of Alternative Investments  Portfolio management

Teaching Assistants Bryce Bailey Matthew Cox Nathan Leishman

My History Grew up in Central California BYU after high school Mission in Sao Paulo Brazil Undergrad at BYU (economics) Federal Reserve in D.C. (two years) PhD at University of Michigan Married with three children

 What have your heard about this class?  What do you hope to get out of investments this semester?

Required Materials Essentials of Investments, Bodie, Kane, and Marcus, 7th Edition Business Statistics, Downing and Clark, 4 th Edition Fool’s Gold, Gillian Tett Financial Calculator Laptop with Excel including the analysis toolpack

Workload We will use a lot of math.  Working knowledge of algebra is required. Expectation:  Six hours per week out of class Homework Sets (15% of Grade)  Wall Street Survivor Trading Game Quizes (15% of Grade)  Wall Street Journal and Economist reading assignments. Exams  Exam 1: 20% of grade  Exam 2: 20% of grade  Exam 3: 30% of grade Tour of class web page.

Syllabus Review Syllabus. Make a formula sheet as you go along.  No notes allowed on exams  The formula sheet will help you prepare for exams

Investments: Background and Issues BKM: Chapter 1

Financial Markets and Assets Financial asset: a claim to a stream of future cash flows. Financial Market: a location or mechanism by which buyers and sellers get together and trade financial assets.

Financial Markets and Assets Firms Households and Institutional Investors Goods and Services

Types of Financial Markets  Direct Search Markets  Brokered Markets  Dealer Markets  Auction Markets

Types of Financial Instruments Reading BKM Chapter

Returns: Review Key Ideas Calculating Returns Present Value and Future Value Returns and Compounding Returns to a portfolio

Measuring Performance: Price, Payoff, and Return 1 Share of Cisco Stock  You buy it now for $100  In three months you sell it for $110 1 Share of Apache Stock  You buy it now for $200  In three months you sell it for $215 What is the correct “measuring stick?”  Payoff: what you get at the end of the investment  Profit:payoff minus price  Return:

Returns Returns are the “growth rate” of your investment Investment in Cisco “grew” by 10% (110/100-1) Investment in Apache “grew” by 7.5% Instead of buying Apache for $200 buy two shares of Cisco for the same price  Profit is $20

Gross Returns Gross returns measure what you get back as a percentage of the initial investment. Gross returns are simply payoff/price Gross return from buying Cisco:  110/100 = 110%  By investing in Cisco, you get back 110% of what you initially invested. Gross returns above 100% are good Gross returns below 100% are bad

Net Returns Net returns are growth rates. Net returns are simply payoff/price - 1 Net return from buying Cisco:  110/ = 10%  Or 10/100 = 10%  Your investment grows by 10%. Net returns above 0 are good Net returns below 0 are bad

Growth rates and Future Value Example:  Investment with net return of 5% per year.  Initial Investment: $100 After first year, what is the value of investment? After second year, what is the value of investment? After third year, what is the value of investment?

Future Value In general: FV=P 0 (1+r) n  P 0 = initial principal invested  r = net return on investment  N = number of time periods Financial Calculator  N=number of time periods  PV = -initial principal (remember “-” sign)  r = net return on investment  pmt=coupons paid before end of each period (0)

Present Value Suppose you are given the choice of two flows  Choice #1: Receive $X now  Choice #2: Receive $100 two years from now The present value of the cash flow from choice #2 is the amount, $X, that would make you indifferent between the two choices.

Present Value Case #1:  Suppose the cash flow from choice #2 is risk free  Risk-free accounts pay a net return of 4.5% per year  If you get $X now, you can invest it risk free and in two years get  For you to be indifferent between the two choices

Present Value Doing some algebra is the “present value” of the cash flow from choice #2

Present Value Case #2  What if the cash flow from investment #2 is not risk- free? That is, on average you expect to get paid $100, but it could be more or less.  Choice #1: Receive $X now  Choice #2: Receive $100 two years from now with some uncertainty.

Present Value Suppose an account exists with “similar risk” as choice #2 that pays an interest rate of 8%  Must be higher than 4.5% (risk-free rate) because of additional risk.  If you get $X now, you can invest it in the account and in two years and get  For you to be indifferent between the two choices

Present Value In general:  FV = payoff at the end of year n  r = return on investment of similar risk as FV  N = number of time periods until money is received Financial Calculator  N=number of time periods  FV=payoff  r = net return on investment of similar risk as payoff  pmt=coupons paid before end of each period (0)

Present Value of an Annuity Annuity: A constant stream of payments that last forever. PV = pmt/r Example: What is the PV of a stream of payments that pays $10 every year for ever? Assume rate of return is 10%.  PV=10/.10 = $100

Growth Rates and Time Net returns (growth rates) are attached to a unit of time. How can we transform growth rates to different units of time? Example:  Account pays 1% per month  What is the growth rate per year?  Hint: the answer is not 12%!

Growth Rates and Time If I invest $1 in this account the money has grown to Over one year, the net return is A monthly growth rate of 1% is equivalent to an annual growth rate of 12.68%

Growth Rates and Time Example:  Account pays 24% per 2 years  What is the growth rate per year?  Hint: the answer is not 12%! Let r A = the annual growth rate If I invest $1 in this account in two years I have

Growth Rates and Time Solving for r A gives us