Lecture1a Introduction To Investment

Introduction
Business Statistics
Interest Rate
Valuing Stock
Asset Pricing
Lecture 1a: Tools of Investment
Y. Zhang1
1 Hanqing Advanced Research Institute of Economics and Finance

Renmin University of China
September 26, 2018
Y.Z. Introduction
Introduction
Business Statistics
Interest Rate
Valuing Stock
Asset Pricing
Outline
1 Introduction
Financial Markets
Asset Classes
Trading Orders
2 Business Statistics
Self Reading
3 Interest Rate
Time Value of Money
Fundamentals of Interest Rate
Decision Rules
4 Valuing Stock
DDM
Reading
5 Asset Pricing
Equilibrium versus Arbitrage
Y.Z. Introduction
Introduction
Business Statistics Financial Markets
Interest Rate Asset Classes
Valuing Stock Trading Orders
Asset Pricing
Investment
AN INVESTMENT IS the current commitment of money or
other resources in the expectation of reaping future benefits.
Real Assets
The productive capacity of its economy that ultimately
determines the material wealth of a society
That is, the goods and services its members can create.
For example, the land, buildings, machines, and knowledge
that can be used to produce goods and services.
Financial Assets.
The claims to the income generated by real assets
While real assets generate net income to the economy,
financial assets simply define the allocation of income or
wealth among investors.
Y.Z. Introduction
Introduction
Asset Pricing
Three Types of Financial Assets
Fixed income.
Equity.
Derivatives
Some Example
Government Bond
IBM shares
Option and Futures
Y.Z. Introduction
Introduction
Asset Pricing
Three Types of Financial Assets
Fixed income.
Equity.
Derivatives
Some Example
Government Bond
IBM shares
Option and Futures
Y.Z. Introduction
Introduction
Asset Pricing
Financial Markets
Financial Markets + Institutions = Financial System
Financial System
A set of institutions and markets permitting the exchange of
contracts and the provision of services for the purpose of
allowing the income and consumption streams of economic
agents to be desynchronized
There are two dimensions to this function: Time Dimension
and Risk Dimension
Y.Z. Introduction
Introduction
Asset Pricing
Financial Markets
Financial Markets + Institutions = Financial System
Financial System
A set of institutions and markets permitting the exchange of
contracts and the provision of services for the purpose of
allowing the income and consumption streams of economic
agents to be desynchronized
There are two dimensions to this function: Time Dimension
and Risk Dimension
Y.Z. Introduction
Introduction
Asset Pricing
Time Dimension
Income is discrete, but our consumption is continuous.
There is a general desire for a smooth consumption stream.
For instance, a consumption bundle across time 1 and 2 =
(c1 , c2 ). U(c(4, 4)) > U(c(3, 5)) → u(4) + u(4) > u(3) + u(5)
u( 12 c1 + 21 c2 ) > 21 u(c1 ) + 12 u(c2 ) because of strict concavity

Y.Z. Introduction
Introduction
Asset Pricing
Time Dimension
Financial system should aim at matching the diverse

financing needs of different economic agents as perfectly as
possible
Y.Z. Introduction
Introduction
Asset Pricing
Risk Dimension
Time involves the present versus the future. The future is

uncertain.
The typical individual is motivated by the desire to smooth
consumption between ”Now” and ”Future”.
This characteristic of preferences is generally described as
”aversion to risk”
The typical ”risk averse” individual would like to experience
similar consumption levels across all future states of nature,
whether good or bad.
An efficient financial system offers ways for savers to reduce
or eliminate, at a fair price, the risks they are not willing to
bear (risk shifting).
Y.Z. Introduction
Introduction
Asset Pricing
Functions of Financial System
Screening and Monitoring Functions
If time implies uncertainty, uncertainty may imply not only risk,

but often asymmetric information as well.
We mean situations where the agents involved have different
information, with some being potentially better informed than
others.
It is the task of financial intermediaries to do so in such a way
that brings the socially beneficial projects to fruition.
An efficient financial system not only assists in these
information and monitoring tasks, but also provides a range of
instruments, thereby contributing to the channeling of savings
toward the most efficient projects.
Y.Z. Introduction
Introduction
Asset Pricing
Functions of Financial System
Screening and Monitoring Functions
If time implies uncertainty, uncertainty may imply not only risk,

but often asymmetric information as well.
We mean situations where the agents involved have different
information, with some being potentially better informed than
others.
It is the task of financial intermediaries to do so in such a way
that brings the socially beneficial projects to fruition.
An efficient financial system not only assists in these
information and monitoring tasks, but also provides a range of
instruments, thereby contributing to the channeling of savings
toward the most efficient projects.
Y.Z. Introduction
Introduction
Asset Pricing
Summarizing the Functions of Financial Systems
The Informational Role of Financial Markets

Consumption Timing
Allocation of Risk
Separation of Ownership and Management
Y.Z. Introduction
Introduction
Asset Pricing
Allocation of Resource
Time involves the present versus the future. The future is

uncertain.
The typical individual is motivated by the desire to smooth
consumption between ”Now” and ”Future”.
This characteristic of preferences is generally described as
”aversion to risk”
The typical ”risk averse” individual would like to experience
similar consumption levels across all future states of nature,
whether good or bad.
An efficient financial system offers ways for savers to reduce
or eliminate, at a fair price, the risks they are not willing to
bear (risk shifting).
Y.Z. Introduction
Introduction
Asset Pricing
The Money Market 1
Treasury Bill (T-Bill)

The government raises money by selling bills to the public.
Investors buy the bills at a discount from the stated maturity
value. At the bill’s maturity, the holder receives from the
government a payment equal to the face value of the bill. The
difference between the purchase price and ultimate maturity
value constitutes the investor’s earnings.
T-bills are issued with initial maturities of 4, 13, 26, or 52
weeks
Certificates of Deposit
A time deposit with a bank.
Time deposits may not be withdrawn on demand.
The bank pays interest and principal to the depositor only at
the end of the fixed term of the CD.
Y.Z. Introduction
Introduction
Asset Pricing
The Money Market 2

Commercial Paper
Large, well-known companies often issue their own short-term
unsecured debt notes rather than borrow directly from banks.
Bankers’Acceptances
An order to a bank by a bank’s customer to pay a sum of
money at a future date, typically within 6 months.
Repos and Reverses
The dealer sells government securities to an investor on an
overnight basis, with an agreement to buy back those
securities the next day at a slightly higher price.
Federal Funds
Each member bank of the Federal Reserve System is required
to maintain a minimum balance in a reserve account with the
Fed.
London Interbank Offered Rate (LIBOR) Market
LIBOR is the rate at which large banks in London are willing
to lend money amongY.Z.
themselves.
Introduction
Introduction
Asset Pricing
The Bond Market
Treasury Notes and Bonds

T-notes are issued with maturities ranging up to 10 years, while
bonds are issued with maturities ranging from 10 to 30 years.
Both notes and bonds make semiannual interest payments
called coupon payments.
Inflation-Protected Treasury Bonds
The bonds that are linked to an index of the cost of living.
inflation-protected Treasury bonds are called TIPS (Treasury
Inflation-Protected Securities).
Corporate Bonds
Mortgages and Mortgage-Backed Securities
Either an ownership claim in a pool of mortgages or an
obligation that is secured by such a pool.
Y.Z. Introduction
Introduction
Asset Pricing
Equity Securities
Common Stock as Ownership Shares
Preferred Stock
Promises to pay to its holder a fixed amount of income each
year.
Has not voting power regarding the management of the firm.
Has no contractual obligation to pay those dividends.
Its dividends are usually cumulative; Unpaid dividends
cumulate and must be paid in full before any dividends be paid
to holders of common stock.
Preferred stock payments are treated as dividends, which are
not tax-deductible expenses for the firm.
Preferred stock ranks after bonds in the event of corporate
bankruptcy.
Depository Receipts
American Depository Receipts, or ADRs, are certificates traded
in U.S. markets that represent ownership in shares of a foreign
company. Y.Z. Introduction
Introduction
Asset Pricing
Derivative Markets
Options
A call option gives its holder the right to purchase an asset for
a specified price, called the exercise or strike price , on or
before a specified expiration date.
a put option gives its holder the right to sell an asset for a
specified exercise price on or before a specified expiration date.
Futures Contracts
A futures contract calls for delivery of an asset (or in some
cases, its cash value) at a specified delivery or maturity date
for an agreed-upon price, called the futures price, to be paid at
contract maturity.
The long position is held by the trader who commits to
purchasing the asset on the delivery date.
The trader who takes the short position commits to delivering
the asset at contract maturity.
Y.Z. Introduction
Introduction
Asset Pricing
Types of Orders
Market Orders
Buy or sell orders that are to be executed immediately at
current market prices.
Buy at ask price and sell at bid price.
Ask price is a little bit higher than the bid price. The
difference is called ask-bid spread.
Price-Contingent Orders
A limit buy order buys some number of shares if the ask price
is at or below a stipulated price.
A limit sell order sells if the bid price rises above a specified
price.
A stop-loss order instructs that the stock is to be sold if its
price falls below a stipulated level.
A stop-buy order specifies that a stock should be bought when
its price rises above a limit.
Y.Z. Introduction
Introduction
Asset Pricing
Types of Orders 2
Figure: Price-Contingent Orders
Y.Z. Introduction
Introduction
Business Statistics
Interest Rate Self Reading
Valuing Stock
Asset Pricing
Outline
1 Introduction
Financial Markets
Asset Classes
Trading Orders
Self Reading
3 Interest Rate
Time Value of Money
Decision Rules
4 Valuing Stock
DDM
Reading
5 Asset Pricing
Y.Z. Introduction
Introduction
Business Statistics
Valuing Stock
Asset Pricing
Probability Theory
Chpater 1-4
George Casella and Roger L. Berger
Statistical Inference Second Edition.
DUXBURY Press, 2002.
Y.Z. Introduction
Introduction
Business Statistics
Valuing Stock
Asset Pricing
Common Probability Distributions

Discrete Random Variable can take on at most a countable
number of possible values.
Uniform Distribution (
P (X = 1) = p
Bernoulli Distribution:
P (X = 0) = 1 − p
Figure: One-Period Stock Price as a Bernoulli Random Variable

Y.Z. Introduction
Introduction
Business Statistics
Valuing Stock
Asset Pricing
Binomial Distribution
In n Bernoulli trails, we can have 0 ∼ n successes. The number of

success is also a random variable, and it is called Binomial
Distribution.
X = Y1 + Y2 + · · · + Yn
the
probability
of x success in n trails is p(x) = P (X = x) =
n n!
p x (1 − p)n−x = (n−x)!x! p x (1 − p)n−x
x
when p=0.5, binomial distribution is symmetric. otherwise it
is asymmetric or skewed.
mean = np
variance=np(1-p)
Y.Z. Introduction
Introduction
Business Statistics
Valuing Stock
Asset Pricing
Normal Approximation to Binomial
Y is defined as a sum of i.i.d. random variables.

If n is sufficiently large, Central Limit Theorem can be used to
Y
d
Z = √Y −np −→ N(0, 1)
np(1−p)
Example
Let0 s set n = 10 and p =0.5. P(Y = 5) = 10!
5!5! 0.5
10 = 0.2461
Under Normal distribution,
P(Y = 5) = P(4.5 ≤ Y ≤ 5.5) ≈ 0.251
Comments
The general rule of ”sufficiently large”: np > 5 and
n(1 − p) > 5
Y.Z. Introduction
Introduction
Business Statistics
Valuing Stock
Asset Pricing

Y
d
Z = √Y −np −→ N(0, 1)
np(1−p)
Example
Let0 s set n = 10 and p =0.5. P(Y = 5) = 10!
5!5! 0.5
10 = 0.2461
P(Y = 5) = P(4.5 ≤ Y ≤ 5.5) ≈ 0.251
Comments
n(1 − p) > 5
Y.Z. Introduction
Introduction
Business Statistics
Valuing Stock
Asset Pricing

Y
d
Z = √Y −np −→ N(0, 1)
np(1−p)
Example
Let0 s set n = 10 and p =0.5. P(Y = 5) = 10!
5!5! 0.5
10 = 0.2461
P(Y = 5) = P(4.5 ≤ Y ≤ 5.5) ≈ 0.251
Comments
n(1 − p) > 5
Y.Z. Introduction
Introduction
Business Statistics
Valuing Stock
Asset Pricing
Continuous Distribution
Uniform Distribution:
(
1
b−a a<x <b
pdf: f (x) =
0 otherwise

0
 x ≤a
x−a
CDF: F (x) = a<x <b
 b−a
1 b≤x

Standard Normal Distributions

(x−µ)2
f (x) = √1 e − 2σ 2 , for −∞ ≤ x ≤ +∞
σ 2π
Lognormal Distribution
X ∼ N(µ, σ 2 )
2
define Y = e X , Y ∼ Lognormal with mean = e (µ+σ ) and
2 2
variance = e σ −1 e (2µ+σ )
Y.Z. Introduction
Introduction
Business Statistics
Valuing Stock
Asset Pricing
Statistics
Chpater 6-8
George Casella and Roger L. Berger
Statistical Inference Second Edition.
DUXBURY Press, 2002.
Y.Z. Introduction
Introduction
Business Statistics
Valuing Stock
Asset Pricing
Correlation Analysis
Cov (X ,Y )
Correlation: corr = σX σY
Correlation measure the linear relationship.
two variables can have a strong nonlinear relation and still
have very low correlation.
P(X = x) = 0.5 for x = −1, 0, 1 and Y = X 2 . X and Y are
one-one mapping. But, their correlation is 0.
correlation maybe unreliable when time series has outliers,
which are rare extreme events.
Y.Z. Introduction
Introduction
Business Statistics
Valuing Stock
Asset Pricing
Linear Regression
yi = β0 + β1 xi1 + β2 xi2 + β3 xi3 + · · · + βp−1 xi,p−1 + εi , where

i = 1, 2, 3, . . . , n
Define    
y1 1 xi1 · · · x1,p−1
 ..   .. .. .. ..
Y =  . , X =  .  ∈ Rn×p ,

. . .
yn 1 xn,1 · · · xn,p−1
   
β0 ε1
β =  ...  and ε =  ... 
   
βp−1 εn
Model: Y = X β + ε
E (εi ) = 0, Var (ε) = σ 2 In×n ,Cov (εi , εj ) = 0 ∀i 6= j
Y.Z. Introduction
Introduction
Business Statistics
Valuing Stock
Asset Pricing
T-Test
−1 T
β̂ = X T X X Y
−1
β̂ ∼ Np×1 β, σ 2 X T X
q
−1
In practice, sd β̂i = σ̂ (X T X )ii
β̂i −βi
sd (β̂i )
∼ tn−p
If you want to do hypothesis testing that whether R T β = C

holds, you need to use F-test instead of t-test
Y.Z. Introduction
Introduction
Business Statistics
Valuing Stock
Asset Pricing
Econometrics
Chpater 1-5, 8, 10-11, 14-18, 21

James D. Hamilton
Time Series Analysis.
Princeton Press, 1994.
Y.Z. Introduction
Introduction
Business Statistics
Valuing Stock
Asset Pricing
Mathematics
Appendix Math Review

James D. Hamilton
Time Series Analysis.
Princeton Press, 1994.
Y.Z. Introduction
Introduction
Business Statistics
Valuing Stock
Asset Pricing
Matrix Derivative
Commonly Used Matrix derivatives:

∂x 0 a ∂a0 x
∂x = ∂x = a, where a and x are vectors
∂x 0 Bx
∂x = (B + B 0 ) x, where B is constant matrix
Y.Z. Introduction
Introduction
Business Statistics Time Value of Money
Interest Rate Fundamentals of Interest Rate
Valuing Stock Decision Rules
Asset Pricing
Outline
1 Introduction
Financial Markets
Asset Classes
Trading Orders
Self Reading
3 Interest Rate
Time Value of Money
Decision Rules
4 Valuing Stock
DDM
Reading
5 Asset Pricing
Y.Z. Introduction
Introduction
Asset Pricing
Time Line
We refer to a series of cash flows lasting several periods as a
stream of cash flows.
We can represent this stream of cash flows on a timeline, a
linear representation of the timing of the expected cash flows.
Drawing a timeline of the cash flows will help you visualize the
financial problem.
Assume that you are lending $10, 000 today and that the loan
will be repaid in two annual $6, 000 payments.
Figure: Time Line
Y.Z. Introduction
Introduction
Asset Pricing
Three Rules of Time Travel
1 A dollar today and a dollar in one year are not equivalent.

2 To move a cash flow forward in time, you must compound it.
FVn = C × (1 + r ) × (1 + r ) × · · · × (1 + r ) = C × (1 + r )n
| {z }
n times
3 To move a cash flow backward in time, we must discount it.
C
PV = (1+r )n
Y.Z. Introduction
Introduction
Asset Pricing
Example
Suppose you are offered an investment that pays $10, 000 in

five years. If you expect to earn a 10% return, what is the
value of this investment today?
Solution
$10,000
The $10, 000 is worth: 1.105
= $6, 209
Y.Z. Introduction
Introduction
Asset Pricing
Example
Suppose you are offered an investment that pays $10, 000 in

five years. If you expect to earn a 10% return, what is the
value of this investment today?
Solution
$10,000
The $10, 000 is worth: 1.105
= $6, 209
Y.Z. Introduction
Introduction
Asset Pricing
Present Value of a Stream of Cash Flows

Present Value of a Cash Flow Stream.
Figure: Present Value of a Cash Flow Stream

N
Cn
PV = Σ
n=0 (1+r0 )×···×(1+rn )
Y.Z. Introduction
Introduction
Asset Pricing
Future Value of a Stream of Cash Flows
Suppose we plan to save $1000 today, and $1000 at the end

of each of the next two years. If we can earn a fixed 10%
interest rate on our savings, how much will we have three
years from today?
Figure: Future Value
Y.Z. Introduction
Introduction
Asset Pricing
Application
When a constant cash flow will occur at regular intervals for a
finite number of N periods, it is called an annuity.
Figure: Annuity with Constant Payment
When a constant cash flow will occur at regular intervals

forever it is called a perpetuity.
Figure: Perpetuity with Constant Payment

Y.Z. Introduction
Introduction
Asset Pricing
Interest Rate
Nominal interest rate (rn): Growth rate of your money

Real interest rate (rr): Growth rate of your purchasing power
1+rn
if i is denoted as inflation rate: rr ≈ rn − i or 1 + rr = 1+i
Y.Z. Introduction
Introduction
Asset Pricing
Holding Period Return
Figure: HPR
Y.Z. Introduction
Introduction
Asset Pricing
Annualized Interest Rate

Effective Annual Rate (EAR): Percentage increase in funds
invested over a 1-year horizon: (1 + EAR)T = [1 + rf (T )]
Annual Percentage Rate (APR): Annualizing using simple
T −1
interest: APR = (1+EAR)T
Figure: EAR vs APR
Y.Z. Introduction
Introduction
Asset Pricing
Continuous Interest Rate
k x
= ek

lim 1+ x
x→+∞
1
r (T )∗ T1 T
1 + EAR = 1 + 1
T
1
when T → 0, T → +∞
r (T )∗ T1
1 + EAR = e = e rcc
1
when T → 0, we call r (T ) ∗ T as rcc , continuous compound
interest rate
rcc = ln (1 + EAR)
Y.Z. Introduction
Introduction
Asset Pricing
Decision Rules
NPV: Net Present Value

IRR: Internal Rate of Return
Payback
Y.Z. Introduction
Introduction
Asset Pricing
Payback
It is the amount of time it takes to recover or pay back the initial

investment. If the payback period is less than a pre-specified
length of time, you accept the project
Project A, B, and C each have an expected life of 5 years
A B C
Cost $80 $120 $150
Annual Cash Flow $25 $30 $35
What is the payback period for each project?
A B C
Payback 3.2 4 4.3
Y.Z. Introduction
Introduction
Asset Pricing
Payback
It is the amount of time it takes to recover or pay back the initial

investment. If the payback period is less than a pre-specified
length of time, you accept the project
Project A, B, and C each have an expected life of 5 years
A B C
Cost $80 $120 $150
Annual Cash Flow $25 $30 $35
What is the payback period for each project?
A B C
Payback 3.2 4 4.3
Y.Z. Introduction
Introduction
Asset Pricing
Pitfalls
Ignores the project0 s cost of capital and time value of money

Ignores cash flows after the payback period
Relies on an ad hoc decision criterion
Y.Z. Introduction
Introduction
Asset Pricing
IRR and NPV
IRR
Internal Rate or Return method, discount rate such that
NPV=0, works only for simple CFs
Rule: Take any investment where the IRR exceeds the cost of
capital. Turn down any investment whose IRR is less than the
cost of capital.
NPV
Calculate the Net Present Value
Select the project with the highest NPV
Y.Z. Introduction
Introduction
Asset Pricing
IRR and NPV
IRR
Internal Rate or Return method, discount rate such that
NPV=0, works only for simple CFs
Rule: Take any investment where the IRR exceeds the cost of
capital. Turn down any investment whose IRR is less than the
cost of capital.
NPV
Calculate the Net Present Value
Select the project with the highest NPV
Y.Z. Introduction
Introduction
Asset Pricing
IRR deficit
Delayed Investments
Assume you have just retired as the CEO of a successful company.
A major publisher has offered you a book deal. The publisher will
pay you $1 million upfront if you agree to write a book about your
experiences. You estimate that it will take three years to write the
book. The time you spend writing will cause you to give up
speaking engagements amounting to $500, 000 per year. You
estimate your opportunity cost to be 10%
IRR = 23.8%
It is really high.
500,000 500,000 500,000

NPV = 1, 000, 000 − 1.1 − 1.12
− 1.13
= −$243, 426
Y.Z. Introduction
Introduction
Asset Pricing
IRR deficit
Delayed Investments
IRR = 23.8%
It is really high.
500,000 500,000 500,000

NPV = 1, 000, 000 − 1.1 − 1.12
− 1.13
= −$243, 426
Y.Z. Introduction
Introduction
Asset Pricing
IRR deficit
Delayed Investments
IRR = 23.8%
It is really high.
500,000 500,000 500,000

NPV = 1, 000, 000 − 1.1 − 1.12
− 1.13
= −$243, 426
Y.Z. Introduction
Introduction
Asset Pricing
Multiple IRR roots
Suppose Star informs the publisher that it needs to sweeten the

deal before he will accept it. The publisher offers
550, 000advanceand1,000,000 in four years when the book is
published
Figure: Cash Flow of Project
Y.Z. Introduction
Introduction
Asset Pricing
Multiple IRR roots
Figure: Multiple IRR roots
Y.Z. Introduction
Introduction
Asset Pricing
Nonexist IRR roots
Delayed Investments
Finally, Star is able to get the publisher to increase his advance to
$750, 000, in addition to the $1 million when the book is published
in four years.
Y.Z. Introduction
Introduction
Asset Pricing
Nonexist IRR roots 2

Solution
Figure: Nonexist IRR roots
No IRR exists because the NPV is positive for all values of the
discount rate. Thus the IRR rule
Y.Z.
cannot be used
Introduction
Introduction
Asset Pricing
Additivity
IRR has no Additivity
Figure: Value-Additivity for Different Decision Rules
IRR(project 1) + IRR(project 3) 6= IRR(project 1+3)
Y.Z. Introduction
Introduction
Asset Pricing
Essential Properties
All Cash Flow should be considered

The Cash Flow should be discounted at the opportunity cost
of fund
The rule should select from a set of mutually exclusive
projects the one that maximizes the investor wealth
Managers can consider one project independently from all
others (Value-Additive Principle)
Y.Z. Introduction
Introduction
Business Statistics
DDM
Interest Rate
Reading
Valuing Stock
Asset Pricing
Dividend-Discount Model
A One-Year Investor
Time line for One-Year Investor
Figure: Timeline for One-Year Investor
Since the cash flows are risky, we must discount them at the equity
cost of capital.
Y.Z. Introduction
Introduction
Business Statistics
DDM
Interest Rate
Reading
Valuing Stock
Asset Pricing
Solution

P0 = P11+r
+Div1
E
If the current stock price were less than this amount, expect
investors to rush in and buy it, driving up the stock?s price
If the stock price exceeded this amount, selling it would cause
the stock price to quickly fall

rE = P1 +Div
P0
1
− 1 = P1P−P
0
0
+ Div
P0
1
Y.Z. Introduction
Introduction
Business Statistics
DDM
Interest Rate
Reading
Valuing Stock
Asset Pricing
Problem
3M (MMM) is expected to pay paid dividends of $1.92 per share in

the coming year. You expect the stock price to be $85 per share at
the end of the year. Investments with equivalent risk have an
expected return of 11%.
What is the most you would pay today for 3M stock?
What dividend yield and capital gain rate would you expect at
this price?
Y.Z. Introduction
Introduction
Business Statistics
DDM
Interest Rate
Reading
Valuing Stock
Asset Pricing
Solution

P1 +Div1 $1.92+$85
P0 = 1+rE = 1.11 = $78.31
Div1 $1.92
P0 = $78.31 = 2.45%
P1 −P0
P0 = $85−$78.31
$78.31 = 8.54%
Total Return is about 11%
Y.Z. Introduction
Introduction
Business Statistics
DDM
Interest Rate
Reading
Valuing Stock
Asset Pricing
A Multi-Year Investor
What is the price if we plan on holding the stock for two years?
Figure: Holding for 2 years
Y.Z. Introduction
Introduction
Business Statistics
DDM
Interest Rate
Reading
Valuing Stock
Asset Pricing
Div1 P2 +Div2
P0 = 1+rE + (1+rE )2
Div1 1 P2 + Div2 Div1 +P1
P0 = 1+rE + 1+rE = 1+rE
1+r
| {z E }
P1
DivN
Div1
P0 = 1+r Div2
+ (1+r 2 + ··· + + PN N
E E) (1+rE )N (1+rE )
For the special case in which the firm eventually pays dividends
and is never acquired, it is possible to hold the shares forever.
∞
Div1 Div2 Divn
P0 = 1+r E
+ (1+r )2
+ · · · = Σ (1+r )n
E n=1 E
Y.Z. Introduction
Introduction
Business Statistics
DDM
Interest Rate
Reading
Valuing Stock
Asset Pricing
Application
The simplest forecast for the firm?s future dividends states that
they will grow at a constant rate, g, forever
Figure: Growing Dividend Model
Y.Z. Introduction
Introduction
Business Statistics
DDM
Interest Rate
Reading
Valuing Stock
Asset Pricing
Model
Div1
P0 = rE −g
Div1
rE = P0 + g
Y.Z. Introduction
Introduction
Business Statistics
DDM
Interest Rate
Reading
Valuing Stock
Asset Pricing
Problem
Y.Z. Introduction
Introduction
Business Statistics
DDM
Interest Rate
Reading
Valuing Stock
Asset Pricing
Solution
Y.Z. Introduction
Introduction
Business Statistics
DDM
Interest Rate
Reading
Valuing Stock
Asset Pricing
Reading I
Chpater 1-5,7,9
Jonathan Berk and Peter DeMarzo
Corporate Finance, Third Edition.
Pearson Press, 2013.
Y.Z. Introduction
Introduction
Business Statistics Equilibrium versus Arbitrage
Interest Rate Modification of DDM
Valuing Stock Consumer Choice
Asset Pricing
The equilibrium approach consists of an analysis of the factors

determining the supply and demand for the cash flow (asset)
in question.
The arbitrage approach attempts to value a cash flow on the
basis of observations made on the values of the various
elements making up that cash flow.
Y.Z. Introduction
Introduction
Asset Pricing
T
ECF
Vp = Σ t
t=1 (1+rf +rp )
rp is the risk premium
rp = E (ri ) − rf
Y.Z. Introduction
Introduction
Asset Pricing
Economic theory describes individual behavior as the result of a

process of optimization under constraints
the objective to be reached being determined by individual
preferences
the constraints being a function of the person?s income or
wealth level and of market prices.
Y.Z. Introduction
Introduction
Asset Pricing
Choice Theory Under Certainty
A preference relation is represented by %

bundle a is strictly preferred to bundle b: a ≺ b
Pure indifference: a ∼ b
Y.Z. Introduction
Introduction
Asset Pricing
Economic rationality
A preference relation is represented by %

Every investor possesses such a preference relation and it is
complete, meaning that he is able to decide whether he
prefers a to b, b to a, or both, in which case he is indifferent
with respect to the two bundles.
The preference relation is transitive
The preference relation is continuous
Y.Z. Introduction
Introduction
Asset Pricing
Utility
Theorem: The stated assumptions are sufficient to guarantee the

existence of a continuous, time-invariant, real-valued utility
function u, such that for any two objects of choice (consumption
bundles of goods and services), % if and only if u(a) ≥ u(b).
Proof: See MWG (1995), Proposition 3.C.1.
Y.Z. Introduction

Lecture1a Introduction To Investment

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Introduction

Lecture 1a: Tools of Investment

1 Hanqing Advanced Research Institute of Economics and Finance

September 26, 2018

Three Types of Financial Assets

Three Types of Financial Assets

Financial Markets + Institutions = Financial System

Financial Markets + Institutions = Financial System

u( 12 c1 + 21 c2 ) > 21 u(c1 ) + 12 u(c2 ) because of strict concavity

Financial system should aim at matching the diverse

Time involves the present versus the future. The future is

Functions of Financial System

Screening and Monitoring Functions

If time implies uncertainty, uncertainty may imply not only risk,

Functions of Financial System

Screening and Monitoring Functions

If time implies uncertainty, uncertainty may imply not only risk,

Summarizing the Functions of Financial Systems

The Informational Role of Financial Markets

Time involves the present versus the future. The future is

The Money Market 1

Treasury Bill (T-Bill)

The Money Market 2

The Bond Market

Treasury Notes and Bonds

Figure: Price-Contingent Orders

Common Probability Distributions

Figure: One-Period Stock Price as a Bernoulli Random Variable

In n Bernoulli trails, we can have 0 ∼ n successes. The number of

Normal Approximation to Binomial

Y is defined as a sum of i.i.d. random variables.

Normal Approximation to Binomial

Y is defined as a sum of i.i.d. random variables.

Normal Approximation to Binomial

Y is defined as a sum of i.i.d. random variables.

Standard Normal Distributions

yi = β0 + β1 xi1 + β2 xi2 + β3 xi3 + · · · + βp−1 xi,p−1 + εi , where

If you want to do hypothesis testing that whether R T β = C

Chpater 1-5, 8, 10-11, 14-18, 21

Appendix Math Review

Commonly Used Matrix derivatives:

Figure: Time Line

Three Rules of Time Travel

1 A dollar today and a dollar in one year are not equivalent.

Suppose you are offered an investment that pays $10, 000 in

Suppose you are offered an investment that pays $10, 000 in

Present Value of a Stream of Cash Flows

Figure: Present Value of a Cash Flow Stream

Future Value of a Stream of Cash Flows

Suppose we plan to save $1000 today, and $1000 at the end

Figure: Future Value

Figure: Annuity with Constant Payment

When a constant cash flow will occur at regular intervals

Figure: Perpetuity with Constant Payment

Nominal interest rate (rn): Growth rate of your money

Holding Period Return

Annualized Interest Rate

Figure: EAR vs APR

Continuous Interest Rate

NPV: Net Present Value

It is the amount of time it takes to recover or pay back the initial

What is the payback period for each project?

It is the amount of time it takes to recover or pay back the initial