1. Applied Finance Lectures
1. What is finance?
2. The diffusion of the discounted cash flow method
3. Markowitz and the birth of modern portfolio theory
4. CAPM: the relationship between expected returns and risk
5. The Efficient Market Hypothesis: do stock prices move randomly?
6. Modigliani-Miller: does financing matter?
7. Black – Merton – Scholes: how to value options
8. Beyond Black-Merton-Scholes: state prices, stochastic discount factors

2. What is Finance? Companies Investors Equity Capital expenditures Debt
Portfolio management
Dividends
Operating cash flow
Interests

3. Time Uncertainty Asset pricing models Discounted cash flow method
Capital Asset Pricing Model Markowitz Sharpe Lintner
Option Pricing Models Black Scholes Cox Ross Rubinstein
State Prices Arrow-Debreu
Stochastic discount factors

4. Outline 1. What is finance?
2. The diffusion of the discounted cash flow method
3. Markowitz and the birth of modern portfolio theory
4. CAPM: the relationship between expected returns and risk
5. The Efficient Market Hypothesis: do stock prices move randomly?
6. Modigliani-Miller: does financing matter?
7. Black – Merton – Scholes: how to value options
8. Beyond Black-Merton-Scholes: state prices, stochastic discount factors

5. Discounted cash flow method
PV = C1 v1 + C2 v2 + …+Cn vn
Cash flows
Required rates of return

6. Penetration rate of discount cash flow
Callahan, C. and S. Haka, A Model and Test of Interfirm Innovation Diffusion: the Case of Discounted Cash Flow Techniques, Manuscript January 2002

7. Outline 1. What is finance?
2. The diffusion of the discounted cash flow method
3. Markowitz and the birth of modern portfolio theory
4. CAPM: the relationship between expected returns and risk
5. The Efficient Market Hypothesis: do stock prices move randomly?
6. Modigliani-Miller: does financing matter?
7. Black – Merton – Scholes: how to value options
8. Beyond Black-Merton-Scholes: state prices, stochastic discount factors

8. Markowitz (1952) Portfolio selection
Return of portfolio: normal distribution
Characteristics of a portfolio:
Expected return
Risk: Variance/Standard deviation

9. Calculation of optimal portfolio

10. Markowitz: the birth of modern portfolio theory

11. Outline 1. What is finance?
2. The diffusion of the discounted cash flow method
3. Markowitz and the birth of modern portfolio theory
4. CAPM: the relationship between expected returns and risk
5. The Efficient Market Hypothesis: do stock prices move randomly?
6. Modigliani-Miller: does financing matter?
7. Black – Merton – Scholes: how to value options

12. Capital Asset Pricing Model

13. Capital Asset Pricing Model
Expected return rM r
Risk free interest rate β 1
Beta

14. Net Present Value Calculation with CAPM

15. Outline 1. What is finance?
2. The diffusion of the discounted cash flow method
3. Markowitz and the birth of modern portfolio theory
4. CAPM: the relationship between expected returns and risk
5. The Efficient Market Hypothesis: do stock prices move randomly?
6. Modigliani-Miller: does financing matter?
7. Black – Merton – Scholes: how to value options
8. Beyond Black-Merton-Scholes: state prices, stochastic discount factors

16. Jensen 1968 - Distribution of “t” values for excess return 115 mutual funds 1955-1964
Not significantly different from 0

17. US Equity Mutual Funds 1982-1991 (Malkiel, Journal of Finance June 1995)
Average Annual Return
Capital appreciation funds %
Growth funds %
Small company growth funds %
Growth and income funds %
Equity income funds %
S&P 500 Index %
Average deviation from benchmark %
(risk adjusted)

18. The Efficient Market Hypothesis
S&P

19. The Efficient Market Hypothesis
S&P

20. The Random Walk Model

21. Outline 1. What is finance?
2. The diffusion of the discounted cash flow method
3. Markowitz and the birth of modern portfolio theory
4. CAPM: the relationship between expected returns and risk
5. The Efficient Market Hypothesis: do stock prices move randomly?
6. Modigliani-Miller: does financing matter?
7. Black – Merton – Scholes: how to value options
8. Beyond Black-Merton-Scholes: state prices, stochastic discount factors

22. Does the capital structure matters?
Modigliani Miller 1958: NO, under some conditions
Debt
Equity

23. Trade-off theory Market value PV(Costs of financial distress)
PV(Tax Shield)
Value of all-equity firm
Debt ratio

24. Outline 1. What is finance?
2. The diffusion of the discounted cash flow method
3. Markowitz and the birth of modern portfolio theory
4. CAPM: the relationship between expected returns and risk
5. The Efficient Market Hypothesis: do stock prices move randomly?
6. Modigliani-Miller: does financing matter?
7. Black – Merton – Scholes: how to value options
8. Beyond Black-Merton-Scholes: state prices, stochastic discount factors

25. Options Right to: Buy (CALL) Sell (PUT) an asset
at a fixed price (EXERCICE PRICE / STRIKING PRICE)
up to or at a future date (MATURITY)
at a future date (EUROPEAN OPTION)
up to a future date (AMERICAN OPTION)

26. Buy 1 Fortis share

27. Buying a put
Stock + Put
Stock
Put

28. Buying a call
Bond + Call
Bond
Call

29. f=(#shares)(Stockprice)+Bond
How to value an option
Standard present value calculation fails
Value of option = f(Stock price, Time)
Required rate of return = f(Stock price, Time)
Black Merton Scholes
Combine stock and option to create a riskless position
Law of one price (no arbitrage)
f=(#shares)(Stockprice)+Bond

30. The fundamental partial differential equation
Assume we are in a risk neutral world
Expected change of the value of derivative security
Change of the value with respect to time
Change of the value with respect to the price of the underlying asset
Change of the value with respect to volatility

31. And now, the Black Scholes formulas
Closed form solutions for European options on non dividend paying stocks assuming:
Constant volatility
Constant risk-free interest rate
Call option:
Put option:
N(x) = cumulative probability distribution function for a standardized normal variable

32. Binomial option pricing model
Risk neutral probability
Stock price Su
Option fu
Stock price S
Stock price Sd
Option fd
Time interval Δt
Risk free interest rate

33. Outline 1. What is finance?
2. The diffusion of the discounted cash flow method
3. Markowitz and the birth of modern portfolio theory
4. CAPM: the relationship between expected returns and risk
5. The Efficient Market Hypothesis: do stock prices move randomly?
6. Modigliani-Miller: does financing matter?
7. Black – Merton – Scholes: how to value options
8. Beyond Black-Merton-Scholes: state prices, stochastic discount factors

34. State prices Law of one price (no free lunches) Current price State Up
Down
Stock S Su Sd
Risk free bond 1
1+rΔt
Law of one price
(no free lunches)
Price of a digital option

35. Stochastic discount factors
Valuing a derivative:
Expectation operator
Stochastic discount factor
Random payoff of derivative

36. Growth of derivative industry

37. Explosion of the market for options