Exam IFM

Updated 11/26/2018
Adapt to Your Exam

INTRODUCTION TO DERIVATIVES INTRODUCTION TO DERIVATIVES

Reasons for Using Derivatives Short-Selling Option Moneyness

• To manage risk Process of short-selling: • In-the-money: Produce a positive payoff (not
• To speculate • Borrow an asset from a lender necessarily positive profit) if the option is
• To reduce transaction cost • Immediately sell the borrowed asset and receive exercised immediately.
• To minimize taxes / avoid regulatory issues the proceeds (usually kept by lender or a • At-the-money: The spot price is approximately

designated 3rd party) equal to the strike price.
Bid-ask Spread
• Buy the asset at a later date in the open market • Out-of-the-money: Produce a negative payoff if
• Bid price: The price at which market-makers will to repay the lender (close/cover the short the option is exercised immediately.
buy and end-users will sell. position)

• Ask/Offer price: The price at which market- Option Exercise Styles

makers will sell and end-users will buy. Haircut: Additional collateral placed with lender by • European-style options can only be exercised at
• Bid-ask spread = Ask price – Bid price short-seller. It belongs to the short-seller. expiration.

• Round-trip transaction cost: Difference between Interest rate on haircut is called: • American-style options can be exercised at any
what you pay and what you receive from a sale time during the life of the option.
• short rebate in the stock market
using the same set of bid/ask prices. • Bermudan-style options can be exercised during
• repo rate in the bond market

bounded periods (i.e., specified periods during the
Payoff and Profit Reasons for short-selling assets: life of the option).
• Payoff: Amount that one party would have if • Speculation – To speculate that the price of a

completely cashed out. Zero-coupon Bond (ZCB)

particular asset will decline.
• Profit: Accumulated value of cash flows at the Buying a risk-free ZCB = Lending at risk-free rate
• Financing – To borrow money for additional
risk-free rate. Selling a risk-free ZCB = Borrowing at risk-free rate
financing of a corporation.

Payoff on a risk-free ZCB = ZCB’s maturity value
Long vs. Short • Hedging – To hedge the risk of a long position on Profit on a risk-free ZCB = 0
• A long position in an asset benefits from an the asset.
increase in the price of the asset.
• A short position in an asset benefits from a
decrease in the price of the asset.

FORWARD CONTRACTS, CALL OPTIONS, AND PUT OPTIONS

FORWARD CONTRACTS, CALL OPTIONS, AND PUT OPTIONS
Position Position in Maximum Maximum
Contract Description Payoff Profit Strategy
in Contract Underlying Loss Gain
Obligation to buy Guarantee/lock in
Long
at the forward Long S" − F%," S" − F%," F%," ∞ purchase price of
Forward

Forward
price underlying
Guarantee/lock in
Short Obligation to sell at
Short F%," − S" F%," − S" ∞ F%," sale price of
Forward the forward price
underlying
Right (but not Insurance against
max [0, S" − K]
Long Call obligation) to buy Long max [0, S" − K] AV(Prem. ) ∞ high underlying
− AV(Prem. )
at the strike price price
Call

Obligation to sell at Sells insurance

the strike price if −max [0, S" − K] against
Short Call Short −max [0, S" − K] ∞ AV(Prem. )
the call is + AV(Prem. ) high underlying
exercised price
Right (but not Insurance against
max [0, K − S" ] K
Long Put obligation) to sell Short max [0, K − S" ] AV(Prem. ) low underlying
− AV(Prem. ) −AV(Prem. )
at the strike price price
Put

Obligation to buy Sells insurance

at the strike price − max[0, K − S" ] K against
Short Put Long −max [0, K − S" ] AV(Prem. )
if the put is + AV(Prem. ) −AV(Prem. ) low underlying
exercised price

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OPTION STRATEGIES OPTION STRATEGIES

Naked Writing vs. Covered Writing Graphing Payoffs from First Principles
• If an option writer does not have an offsetting position in the underlying Create a payoff table separated by the strike regions, and then graph the total
asset, then the option position is said to be naked. payoff in each region accordingly.

• If an option writer has an offsetting position in the underlying asset, then Shortcut Method for Graphing the Payoff of All Calls or All Puts
the option position is said to be covered.
• For calls, go left-to-right on the payoff diagram, and evaluate the slope of
Floor, Cap, Covered Call, Covered Put the payoff diagram at each strike price.
Key Relationship: Call – Put = Stock – Bond Going left-to-right means that a positive slope is one that increases left-
Rearranging, we have: to-right, and a negative slope is one that decreases left-to-right.
• Floor = + Stock + Put (guarantee a minimum selling price for stock) • For puts, go right-to-left on the payoff diagram, and evaluate the slope of
• Write a covered put = – Floor = – Stock – Put the payoff diagram at each strike price.
• Cap = – Stock + Call (guarantee a maximum purchase price for stock) Going right-to-left means that a positive slope is one that increases right-
• Write a covered call = – Cap = + Stock – Call to-left, and a negative slope is one that decreases right-to-left.

Bull Spread Bear Spread (opposite of bull spread) Box Spread

Call Bull: Long call (K1) + Short call (K2), K1 < K2 Call Bear: Short call (K1) + Long call (K2), K1 < K2 Long call (put) bull spread + Long put (call) bear
Put Bull: Long put (K1) + Short put (K2), K1 < K2 Put Bear: Short put (K1) + Long put (K2), K1 < K2 spread

Ratio Spread Collar Collared Stock
Long and short an unequal number of calls/puts Long put (K1) + Short call (K2), K1 < K2 Long collar + Long stock
with different strike prices

Straddle Strangle Butterfly Spread (Symmetric/Asymmetric)
Long put (K) + Long call (K) Long put (K1) + Long call (K2), K1 < K2 Buy high- and low-strike options. Sell middle-

strike option. Quantity sold = Quantity bought.












Example - For 3 strike prices 30, 43, 46:
• Buy 46 − 43 = 3 options with strike 30
• Buy 43 − 30 = 13 options with strike 46
• Sell 46 − 30 = 16 options with strike 43
Any multiple of (buy 3, sell 16, buy 13) would
work.

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FORWARDS FORWARDS FUTURES FUTURES European vs. American Put

KeN>" ≥ P~> ≥ maxÄ0, KeN>" − F ? (S)Å
4 Ways to Buy a Share of Stock Futures Compared to Forward

• Traded on an exchange K ≥ P{|}> ≥ max (0, K − S)
Receive
Payment • Standardized (size, expiration, underlying) Early Exercise of American Option
Ways Stock Payment
Time • More liquid American Call
at Time
• Marked-to-market and often settled daily • Nondividend-paying stock
Outright • Minimal credit risk o Early exercise is never optimal.
0 0 S%
purchase • Price limit is applicable o C{|}> = C~>

• Dividend-paying stock
Fully Features of Futures Contract
o It is rational to early exercise if:
leveraged T 0 S% e>" Notional Value = # Contracts × Multipler
PV(Divs) >
purchase × Futures price
PV(Interest on strike) + Implicit Put
Balt = BaltN_ ⋅ e>` + GainE o It may be rational to early exercise if:
Prepaid where PV(Divs) > PV(Interest on strike)
forward 0 T ? (S)
F%," • GainE = # Contracts × Multipler ×

contract Price Changet (for 𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙 position) American Put

• GainE = − # Contracts × Multipler × It is rational to early exercise if:
Forward Price Changet (for 𝑠𝑠ℎ𝑜𝑜𝑜𝑜𝑜𝑜 position) PV(Interest on strike) >
T T F%," (S) PV(Divs) + Implicit Call
contract • Price Changet = Future PriceE − Future PriceEN_
It may be rational to early exercise if:
𝐏𝐏 (𝐒𝐒)
Margin Call PV(Interest on strike) > PV(Divs)
Relationship between 𝐅𝐅𝐭𝐭,𝐓𝐓 (𝐒𝐒) and 𝐅𝐅𝐭𝐭,𝐓𝐓 • Maintenance margin: Minimum margin balance
?
FE," (S) = Accumulated Value of FE," (S) that the investor is required to maintain in Strike Price Effects
? (S)
= FE," ⋅ e>("NE) margin account at all times For K_ < K Ü < K á :

𝐏𝐏
• Margin call: If the margin balance falls below Call
Dividend Structure 𝐅𝐅𝐭𝐭,𝐓𝐓 (𝐒𝐒) the maintenance margin, then the investor will C(K_ ) ≥ C(K Ü ) ≥ C(K á)
No Divs SE get a request for an additional margin deposit. C(K_ ) − C(K Ü ) ≤ K Ü − K_
The investor has to add more funds to bring the European: C(K_) − C(K Ü) ≤ PV(K Ü − K_)
Discrete Divs SE − PVE," (Divs) margin balance back to the initial margin. C(K_ ) − C(K Ü ) C(K Ü ) − C(K á )
≥
Continuous Divs SE eNS("NE) K Ü − K_ Ká − KÜ


PUT-CALL PARITY (PCP)
PUT-CALL PARITY (PCP) Put
Dividend Structure 𝐅𝐅𝐭𝐭,𝐓𝐓 (𝐒𝐒) P(K_ ) ≤ P(K Ü ) ≤ P(K á )
PCP for Stocks P(K Ü ) − P(K_ ) ≤ K Ü − K_
No Divs SE e>("NE) ? (S)
C(S, K) − P(S, K) = FE," − KeN>("NE) European: P(K Ü ) − P(K_ ) ≤ PV(K Ü − K_ )
Discrete Divs SE e>("NE) − AVE,"(Divs) P(K Ü ) − P(K_ ) P(K á ) − P(K Ü)
PCP for Futures ≤
C(F, K) − P(F, K) = FeN>("NE) − KeN>("NE) K Ü − K_ Ká − KÜ
Continuous Divs SE e(>NS)("NE)

PCP for Bonds Time Until Expiration

F%," ? (B) For T_ < TÜ :
Forward premium = C(B, K) − P(B, K) = FE," − KeN>("NE)
S% C{|}> (S, K, T_ ) ≤ C{|}> (S, K, TÜ )
1 F%," where
Annualized forward premium rate = ln ? (B)
FE," = BE − PVE," (Coupons) P{|}> (S, K, T_ ) ≤ P{|}> (S, K, TÜ)

T S%
BE = Bond price at time t For a nondividend-paying stock:
Synthetic Forward
C~> (S, K, T_ ) ≤ C~> (S, K, TÜ )
PCP for Exchange Options
Synthetic long forward is created by:
This is also generally true for European call
• buying a stock and borrowing money (i.e., 𝐂𝐂(𝐀𝐀, 𝐁𝐁) 𝐏𝐏(𝐀𝐀, 𝐁𝐁) options on dividend-paying stocks and European
selling a bond), or
receive A, give up B give up A, receive B puts, with some exceptions.
• buying a call and selling a put at the same strike.

Synthetic short forward is the opposite, created by: C(A, B) − P(A, B) = ? (A)
FE," ? (B)
− FE,"
• selling a stock and lending money (i.e., buying a C(A, B) = P(B, A) BINOMIAL MODEL
BINOMIAL MODEL
bond), or
PCP for Currency Options Option Pricing: Replicating Portfolio
• selling a call and buying a put at the same strike.
Use the generalized PCP for exchange option. An option can be replicated by buying Δ shares
Arbitrage of the underlying stock and lending 𝐵𝐵 at the
A transaction which generates a positive cash flow For example, the prepaid forward price for 1 yen risk-free rate.
either today or in the future by simultaneous denominated in dollars is: V − Vt uVt − dV
Δ = eNS` ã å B = eN>` ã å
buying and selling of related assets, with no net $ S(u − d) u−d
? (¥1)
investment or risk. $F%," = qx% r (¥1eN>¥") = $x% eN>¥" V = ΔS + B
¥
Arbitrage strategy: “Buy Low, Sell High.”

Call Put
Alternatively:
Cash-and-Carry
S% → x% r → rt δ → rv
The actual forward is overpriced. Δ + −
Ct(f, K) − Pt(f, K) = x% eN>w" − KeN>x"
Short actual forward + Long synthetic forward
where x% is in d/f B − +

Reverse Cash-and-Carry
The actual forward is underpriced.

To replicate a call, buy shares and borrow money.

Long actual forward + Short synthetic forward COMPARING OPTIONS
COMPARING OPTIONS To replicate a put, sell shares and lend money.


Bounds of Option Prices
Option Pricing: Risk-neutral Valuation
Call and Put
e(>NS)` − d
S ≥ C{|}> ≥ C~> ≥ max(0, F ? (S) − KeN>" ) p∗ =
K ≥ P{|}> ≥ P~> ≥ maxÄ0, KeN>" − F ? (S)Å u−d
N>`
V% = e ⋅ E [Payoff] = eN>` [(p∗ )V + (1 − p∗ )Vt ]
∗

European vs. American Call S% e(>NS)` = (p∗)S + (1 − p∗ )St

F ? (S) ≥ C~> ≥ max(0, F ? (S) − KeN>" )
S ≥ C{|}> ≥ max (0, S − K)

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Constructing a Binomial Tree To find the pth percentile of S" : 5. Annualize the estimate of the expected return:
General Method 1. Determine the corresponding pth percentile of SEê` 1 Ü
S St E ®ln © = ãα
¬−δ− σ ¬ å h = r̅
the standard normal random variable Z. SE 2
u = d =
S% S% 2. Substitute the resulting value of Z into the r̅ 1 Ü

expression for S" . ⇒¬ α= +δ+ ¬ σ
Standard Binomial Tree h 2
Median = 50th percentile
This is the usual method in McDonald based on § §
= SE eıNSN%.¢ë Å("NE) = E[S" ] ⋅ eN%.¢ë ("NE)
forward prices. THE BLACK-SCHOLES (BS) FORMULA

THE BLACK-SCHOLES (BS) FORMULA
u = e(>NS)`êë√` d = e(>NS)`Në√` Prediction Interval
1 The 100%(1 − p) prediction interval is given by S"¥ BS Formula’s Assumptions:
p∗ = and S"µ such that Pr[S"¥ < S" < S"µ ] = 1 − p. • Continuously compounded returns on the stock
1 + eë√`
p p are normally distributed and independent over
Probability Pr[Z < z ¥ ] = ⇒ z ¥ = N N_ ì î
2 2 time. There are no sudden jumps in the stock
For n periods, let k be the number of "up" jumps p
z µ = −z ¥ = −N N_ ì î price.
needed to reach an ending node. Then, the risk- 2 • Volatility is known and constant.
§ π
neutral probability of reaching that node is given S"¥ = SE eıNSN%.¢ë Å("NE)êë√"NE⋅∏ • Future dividends are known.
by: µ ıNSN%.¢ë§ Å("NE)êë√"NE⋅∏∫
S" = SE e • The risk-free rate is known and constant (i.e.,
n
ì î (p∗)ï (1 − p∗ )ñNï , k = 0,1, … , n Probability the yield curve is flat).
k

Pr[S" < K] = NÄ−dªÜÅ Pr[S" > K] = NÄ+dªÜ Å • There are no taxes or transaction costs.
No-Arbitrage Condition • Short-selling is allowed at no cost.
S
Arbitrage is possible if the following inequality is ln ì E î + (α − δ − 0.5σÜ )(T − t) • Investors can borrow and lend at the risk-free
dªÜ = K
not satisfied: rate.
σ√T − t
0 < p∗ < 1 ⟺ d < e(>NS)` < u

Conditional and Partial Expectation Generalized BS Formula

Option on Currencies PE[S" |S" < K] Assume the current time is time 0 and the options
Substitutions: S% → x% r → rt δ → rv E[S" |S" < K] = expire at time T:
Pr[S" < K]
u = e(>xN>w)`êë√` d = e(>xN>w )`Në√` SE e (±NS)("NE)
NÄ−dª_ Å C = F ? (S) ⋅ N(d_ ) − F ? (K) ⋅ N(dÜ )
e(>xN>w)` − d =
ª
P = F ?(K) ⋅ N(−dÜ ) − F ? (S) ⋅ N(−d_ )
p∗ = NÄ−dÜ Å F ? (S) 1
u−d ln ã ? å + σÜ T
PE[S" |S" > K] F (K) 2
Option on Futures Contracts E[S" |S" > K] = d_ =
Pr[S" > K] σ√T
FE,"õ = SE e(>NS)("õNE) SE e(±NS)("NE) NÄ+dª_ Å ? (S)
F 1
T = Expiration date of the option = ln ã ? å − σÜ T
NÄ+dªÜ Å dÜ =
F (K) 2
= d_ − σ√T
Tú = Expiration date of the futures contract
S σ√T
T ≤ Tú ln ì E î + (α − δ + 0.5σÜ )(T − t)

dª_ = K Var{ln[SE ]}
Substitutions: SE → FE,"õ δ → r σ√T − t σ=√ , 0 < t ≤ T
t
uú = eë√` dú = eNë√` Expected Option Payoffs
1 − dú E[Call Payoff] = SE e(±NS)("NE)NÄdª_ Å − KNÄdªÜ Å
p∗ = Var∆ln•FE," (S)¶«
uú − dú E[Put Payoff] = KNÄ−dªÜÅ − SE e(±NS)("NE)NÄ−dª_Å =√ , 0 < t ≤ T
V − Vt
t
Δ= True Pricing
F(uú − dú ) ?
Var∆ln•FE," (S)¶«
B=e N>` [p∗
V + (1 − p∗)Vt ] To calculate option price, discount the true =√ , 0 < t ≤ T
expected option payoff at the expected rate of t
return on the option: The generalized BS formula can be applied to
V% = eNº" E[Payoff] various assets, including stocks, futures contracts,
LOGNORMAL MODEL
LOGNORMAL MODEL
and currencies.
Risk-Neutral Pricing
Normal vs. Lognormal

Assume α = γ = r. For a stock that pays continuous dividends, the

X~N(m, v Ü ) ⟺ Y = e† ~LogN(m, v Ü )
§ To calculate option price, discount the risk-neutral generalized BS formula can be written as:
• E[Y] = e|ê%.¢£ expected option payoff at the risk-free rate: C = S% eNS" ⋅ N(d_ ) − KeN>" ⋅ N(dÜ )
§
• Var[Y] = (E[Y])Ü •e£ − 1¶ V% = eN>" E ∗ [Payoff] P = KeN>" ⋅ N(−dÜ ) − S% eNS" ⋅ N(−d_ )

X = m + v ⋅ Z, Z~N(0,1) S 1
Estimating Return and Volatility ln ì % î + ìr − δ + σÜî T
N(−a) = 1 − N(a) d_ = K 2
Given S% , S_ , . . . , Sñ , where the observations are at
Two important properties of lognormal: σ√T
intervals of length h, we can estimate the S% 1
• It cannot be negative. ln ì î + ìr − δ − σÜ î T
lognormal parameters as follows: K 2
• The product of two lognormal is a lognormal. dÜ =
1. Calculate the continuously compounded σ√T
Lognormal Model for Stock Prices returns: = d_ − σ√T
Assume the current time is time t: Sæ
S" ræ = ln i = 1,2, … , n Options on Futures Contract
SæN_
For T > t, ln ® © ~N[m, v Ü] Use the generalized BS formula in conjunction
SE 2. Calculate the sample mean of the returns:
• m = (α − δ − 0.5σÜ )(T − t) ∑ñæ¡_ ræ with the appropriate prepaid forward prices.
r̅ =
• v Ü = σÜ(T − t) n The prepaid forward price for a futures contract is
≠
• Æ ~LogN(m, v Ü ) 3. Estimate the standard deviation of returns by just the present value of the futures price:

≠Ø taking the square root of the sample variance of
? (F)
For T > t, ln[S" ] ~N[m, v Ü ] the returns: F%," = FeN>"
• m = ln SE + (α − δ − 0.5σÜ )(T − t) ∑ñ (ræ − r̅)Ü Options on Currencies
• v Ü = σÜ(T − t) ¬` = √ æ¡_
σ Use the generalized BS formula in conjunction
n−1
• S" ~LogN(m, v Ü ) with the appropriate prepaid forward prices.
4. Annualize the estimate of the standard
E[S" ] = E[S"|SE ] = SE e(±NS)("NE) deviation: For example, the prepaid forward price for 1 yen
§
Var[S" ] = Var[S"|SE ] = (E[S"])Ü Äe£ − 1Å SEê` denominated in dollars is:
Var ®ln ©=σ σǛ
¬Ü h = ¬
§
S" = SE eıNSN%.¢ë Å("NE)êë√"NE⋅≤ , Z~N(0,1) SE $
S" ¬`
σ ? (¥1)
$F%," = qx% r (¥1eN>¥") = $x% eN>¥"
Cov(SE , S" ) = E ® © ⋅ Var[SE |S% ] ⇒σ ¬= ¥
SE √h

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 OPTION GREEKS
OPTION GREEKS DELTA & GAMMA HEDGING
DELTA & GAMMA HEDGING Earnings-Enhanced Death Benefit

• Pays the beneficiary an amount based on the
Greek Definition Long Call Long Put Overnight Profit
increase in the account value over the original
A delta-hedged portfolio has 3 components:
∂V amount invested, e.g., 40% ⋅ max( S" − K, 0).
Δ + − • Buy/sell options
∂S • The embedded option is a call option. Its value
• Buy/sell stocks
is:
∂Δ ∂Ü V • Borrow/lend money (sell/buy bond) ·
Γ = + +
E[C(Tœ )] = fl C(t)f"‡ (t)dt
∂S ∂S Ü Overnight profit is the sum of: %
∂V • Profit on options bought/sold

θ − * −* GMAB with a Return of Premium Guarantee

∂t • Profit on stocks bought/sold
• Similar to GMDB with ROP guarantee, but the
∂V • Profit on bond
benefit is contingent on the policyholder
Vega + +
∂σ Alternatively, overnight profit is the sum of: surviving to the end of the guarantee period.
∂V • Gain on options, ignoring interest • The embedded option is a put option. Its value
ρ + − • Gain on stocks, ignoring interest is:
∂r
• Interest on borrowed/lent money P(m) ⋅ Pr[T†∗ ≥ m]
∂V
ψ − + For a market-maker who writes an option and Mortgage Loan as Put
∂δ
delta-hedges the position, the market-maker’s For an uninsured position, the loss to the mortgage
* θ is usually negative. profit from time t to t + h is: lender is max(B + C ∗ − R, 0), where:

Note: For short positions, just reverse the signs. • B is the outstanding loan balance at default
= ΔE(SEê` − SE ) − (VEê` − VE )
Option Greeks Formulas • C ∗ is the lender’s total settlement cost
− Äe>` − 1Å(ΔE SE − VE )
The formulas for the six option Greeks for both call • R is the amount recovered on the sale of
1 Ü
and put options under the BS framework as well as ≈ − ϵ ΓE − hθE − Äe>` − 1Å(ΔE SE − VE ) property
2 This is a put payoff with K = B + C ∗ and S = R.
N Õ (x) will be provided on the exam. where ϵ = SEê` − SE

Static vs. Dynamic Hedging

ΔŒ = eNS("NE) N(d_), 0 ≤ ΔŒ ≤ 1 If h is small, then e >`
− 1 ≈ rh.
Static/hedge-and-forget: Buy options and hold to
Δ? = −eNS("NE) N(−d_), −1 ≤ Δ? ≤ 0

Breakeven expiration
ΔŒ − Δ? = eNS("NE)
If the price of the underlying stock changes by one Dynamic: Frequently buy/sell assets and/or
expÄ−δ(T − t)ÅN Õ (d_ ) derivatives with the goal of matching changes in
ΓŒ = Γ? = standard deviation over a short period of time,
Sσ√T − t then a delta-hedged portfolio does not produce the value of guarantee
NS("NE) N>("NE)
θŒ = δSe N(d_ ) − rKe N(dÜ) profits or losses.
KeN>("NE) N Õ (dÜ )σ

− Assuming the BS framework, given the current
2√T − t EXOTIC OPTIONS EXOTIC OPTIONS
N>("NE) NS("NE)
stock price, S, the two stock prices after a period of
θ? = θŒ + rKe − δSe h for which the market-maker would break even Asian Option
VegaŒ = Vega? = SeNS("NE) N Õ(d_ )√T − t are: A(S) arithmetic average
S‚ = „
ρŒ = (T − t)KeN>("NE) N(dÜ ) S ± Sσ√h G(S) geometric average
ρ? = −(T − t)KeN>("NE) N(−dÜ ) ‰
_
‰
ψŒ = −(T − t)SeNS("NE)N(d_) Multiple Greeks Hedging ∑‰
E¡_ SE
Δ≠E‘’ï = 1; all other Greeks of the stock = 0 A(S) = G(S) = ÂÊ SE Á
ψ? = (T − t)SeNS("NE) N(−d_ ) N
§ To hedge multiple Greeks, set the sum of the E¡_
eNœ /Ü G(S) ≤ A(S)
N Õ (x) = Greeks you are hedging to zero.
√2π
Average Price Average Strike
Risk Premium
The risk premium of an asset is defined as the ACTUARIAL-SPECIFIC RISK MANAGEMENT
ACTUARIAL-SPECIFIC RISK MANAGEMENT PayoffŒËÈÈ max[0, S‚ − K] max[0, S − S‚]
excess of the expected return of the asset over the Options Embedded in Insurance Products Payoff?E max[0, K − S‚] max[0, S‚ − S]
risk-free return: • A guaranteed minimum death benefit (GMDB)
• Risk Premium“”Eæ‘ñ = γ − r guarantees a minimum amount will be paid to a The value of an average price Asian option is less
• Risk Premium≠E‘’ï = α − r beneficiary when the policyholder dies. than or equal to the value of an otherwise

• A guaranteed minimum accumulation benefit equivalent ordinary option.
γ − r = Ω(α − r)

σ“”Eæ‘ñ = |Ω|σ≠E‘’ï (GMAB) guarantees a minimum value for the As N increases:

underlying account after some period of time, • Value of average price option decreases
Sharpe Ratio even if the account value is less. • Value of average strike option increases
OptionÕ s risk premium γ−r • A guaranteed minimum withdrawal benefit
ϕ“”Eæ‘ñ = =
OptionÕ s volatility σ“”Eæ‘ñ (GMWB) guarantees that upon the policyholder
Õ reaching a certain age, a minimum withdrawal
Stock s risk premium α − r
ϕ≠E‘’ï = = amount over a specified period will be provided.
Stock Õ s volatility σ≠E‘’ï
ϕŒ = ϕ≠E‘’ï ; ϕ? = −ϕ≠E‘’ï • A guaranteed minimum income benefit (GMIB)

guarantees the purchase price of a traditional
Elasticity annuity at a future time.
% change in option price Δ ⋅ S
Ω= = GMDB with a Return of Premium Guarantee
% change in stock price V
ΩŒ ≥ 1; Ω? ≤ 0 • A guarantee which returns the greater of the
account value and the original amount invested:
Portfolio Greek & Elasticity max(S" , K) = S" + max( K − S" , 0)
Greek for a portfolio = sum of the Greeks • The embedded option is a put option. Its value
Elasticity for a portfolio = weighted average of the is:
elasticities ·

Δ?‘>E ⋅ S
ñ E[P(Tœ )] = fl P(t)f"‡ (t)dt
Ω?‘>E = = ⁄ ωæ Ωæ %
V?‘>E
æ¡_
γ?‘>E − r = Ω?‘>E (α − r)

Delta-Gamma-Theta Approximation
1
VEê` ≈ VE + ΔE ϵ + ΓE ϵÜ + θE h; ϵ = SEê` − SE
2

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Barrier Option Exchange Option Shout Option
Three types: C(A, B) = F ? (A) ⋅ N(d_ ) − F ? (B) ⋅ N(dÜ ) An option that gives the owner the right to lock in
• Knock-in P(A, B) = F ? (B) ⋅ N(−dÜ ) − F ? (A) ⋅ N(−d_ ) a minimum payoff exactly once during the life of
Goes into existence if barrier is reached. F ? (A) 1 the option, at a time that the owner chooses. When
ln ã ? å + σÜ (T − t)
• Knock-out F (B) 2 the owner exercises the right to lock in a minimum
d_ =
Goes out of existence if barrier is reached. σ√T − t payoff, the owner is said to shout to the writer.

• Rebate dÜ = d_ − σ√T − t S ∗ is the value of the stock at the time when the
Pays fixed amount if barrier is reached. A option owner shouts to the option writer.
√Var Ïln BÌ


Down vs. Up: σ= Payoff for a shout call
• If S% < barrier: t
max[S" − K, S ∗ − K, 0] if shout is exercised
Up-and-in, up-and-out, up rebate = ÓσÜ{ + σÜÔ − 2Cov{,Ô =„
max[S" − K, 0] if shout is not exercised
• If S% > barrier:

Down-and-in, down-and-out, down rebate Payoff for a shout put

= ÓσÜ{ + σÜÔ − 2ρσ{ σÔ
max[K − S" , K − S ∗ , 0] if shout is exercised
Knock-in + Knock-out = Ordinary Option =„
Maxima and Minima max[K − S" , 0] if shout is not exercised
Barrier option ≤ Ordinary Option

Special relationships: • max(A, B) = max(0, B − A) + A Rainbow Option

• If S% ≤ barrier ≤ strike: max(A, B) = max(A − B, 0) + B An option whose payoff depends on two or more
Up-and-in Call = Ordinary Call • max(cA, cB) = c ⋅ max(A, B) c > 0 risky assets.
Up-and-out Call = 0 max(cA, cB) = c ⋅ min(A, B) c < 0
• If S% ≥ barrier ≥ strike: • max(A, B) + min(A, B) = A + B
⇒ min(A, B) = − max(A, B) + A + B MEAN-VARIANCE PORTFOLIO THEORY
MEAN-VARIANCE PORTFOLIO THEORY
Down-and-in Put = Ordinary Put
Down-and-out Put = 0 For Corporate Finance questions, unless you are

Forward Start Option told otherwise, assume that interest rates are
Compound Option For a call option expiring at time T whose strike is annual effective, consistent with the
A compound call allows the owner to buy another set on future date t to be XSE : Berk/DeMarzo text.

option at the strike price. C(SE , XSE , T − t)

A compound put allows the owner to sell another Risk and Return of a Single Asset
= SE eNS("NE)N(d_) − XSE eN>("NE)N(dÜ ) ñ
option at the strike price. = SE •eNS("NE) N(d_ ) − XeN>("NE)N(dÜ )¶
E[R] = ⁄ pæ ⋅ R æ
The value of the underlying option at time t_ S
ln ì E î + (r − δ + 0.5σÜ)(T − t) ¡_
= VÄSEÍ , K, T − t_ Å XSE ñ
d_ =
The value of the compound call at time t_ σ√T − t Var[R] = E[(R æ − E[R])Ü ] = ⁄ pæ ⋅ (R æ − E[R])Ü
= max•0, VÄSEÍ , K, T − t_ Å − x¶ 1 ¡_
ln ì î + (r − δ + 0.5σÜ )(T − t) = E[RÜ ] − (E[R])Ü
= X
The value of the compound put at time t_
σ√T − t SD[R] = ÒVar[R]
= max•0, x − VÄSEÍ , K, T − t_ Ŷ
dÜ = d_ − σ√T − t Realized Returns
where
R Eê_ = Capital Gain + Div Yield
• K is the strike of the underlying option The time-0 value of the forward start option is:
? (S) PEê_ − PE DEê_
• x is the strike of the compound option V% = F%,E × •eNS("NE) N(d_) − XeN>("NE) N(dÜ)¶ = +
PE PE
• T is the maturity of the underlying option
Same analysis applies to a put option. Annual Realized Returns
• t_ is the maturity of the compound option
R = Ä1 + R Ú_ ÅÄ1 + R ÚÜ ÅÄ1 + R Úá ÅÄ1 + R ÚÛ Å − 1

Chooser Option
Put-call parity for compound options: For an option that allows the owner to choose at Average Annual Returns
" "
• CallonCall − PutonCall = C~> − xeN>EÍ time t whether the option will become a European 1 1
• CallonPut − PutonPut = P~> − xeN>EÍ Ù=
R ⁄ R E Var[R] = Ù) Ü
⁄(R E − R
call or put with strike K and expiring at time T: T T−1
E¡_ E¡_
Gap Option VE = max[C(SE , K, T − t), P(SE , K, T − t)] SD(R)
K_ : Strike Price Standard Error =
= eNS("NE) max•0, KeN(>NS)("NE) − SE ¶ √# Observations
K Ü : Trigger Price + C(SE , K, T − t)
95% confidence interval for the expected return
K_ determines the amount of the nonzero payoff. The time-0 value is: = Average return ± 2 ⋅ Standard Error
K Ü determines whether the option will have a V% = eNS("NE) ⋅ PÄS% , KeN(>NS)("NE) , tÅ + C(S% , K, T) SD(R)
=RÙ±2⋅
nonzero payoff. √# Observations
Lookback Option
0, S" ≤ K Ü An option whose payoff at expiration depends on Risk and Return of a Portfolio
PayoffÎË” ŒËÈÈ = „
S" − K _ , S" > K Ü the maximum or minimum of the stock price over R ? = x_ R _ + x Ü R Ü + ⋯ + x ñ R ñ
K _ − S" , S" < K Ü the life of the option. E[R ? ] = x_ E[R_ ] + xÜ E[R Ü ] + ⋯ + xñ E[R ñ ]
PayoffÎË” ?E = „
0, S" ≥ K Ü
Value of Investment i
Negative payoffs are possible. Type Payoff xæ = ; ∑xæ = 1
Total Portfolio Value
GapCall = S% e N(d_ ) − K_ eN>" N(dÜ )
NS" Cov•R æ , R ˜ ¶ = E•(R æ − E[R æ ])ÄR ˜ − E•R ˜ ¶Å¶
Standard lookback call S" − min(S) "
GapPut = K_ eN>" N(−dÜ ) − S% eNS" N(−d_ ) 1
Standard lookback put max(S) − S" = Ù æ ÅÄR ˜,E − R
⁄ÄR æ,E − R Ù ˜ Å
where d_ and dÜ are based on K Ü
Extrema lookback call max[0, max(S) − K] T−1
GapCall − GapPut = S% eNS" − K_ eN>" æ¡_
Extrema lookback put max[0, K − min(S)] = ρæ,˜ ⋅ σæ ⋅ σ˜
For a 2-stock portfolio:
Standard lookback options are known as lookback R ? = x_ R _ + x Ü R Ü
options with a floating strike price. σÜ? = x_Ü σ_Ü + xÜÜ σÜÜ + 2x_ xÜ Cov[R_ , R Ü ]

Extrema lookback options are known as lookback For a 3-stock portfolio:
options with a fixed strike price. R ? = x_ R _ + x Ü R Ü + x á R á

σÜ? = x_Ü σ_Ü + xÜÜ σÜÜ + xáÜ σÜá + 2x_ xÜ Cov[R_ , R Ü ]
+ 2x_ xá Cov[R_ , R á ]
+ 2xÜ xá Cov[R Ü , R á ]

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For an n-stock portfolio: For a portfolio with n individual stocks with Combining Risky Assets with Risk-free Assets
ñ ñ ñ
arbitrary weights: Suppose we invest a proportion of funds (x) in a
σÜ? = ⁄ xæ Cov[R æ , R ? ] = ⁄ ⁄ xæ x˜ Cov•R æ , R ˜ ¶ ñ
risky portfolio and the remainder (1 − x) in a risk-
æ¡_ æ¡_ ˜¡_ σ? = ⁄ xæ ⋅ σæ ⋅ ρæ,? free asset. Then, we have:
In the covariance matrix, we have: æ¡_ E[R œ? ] = xE[R ? ] + (1 − x)rv = rv + x(E[R ? ] − rv)
• n × n = nÜ total elements • Each security contributes to the portfolio σœ? = x ⋅ σ?
• n variance terms volatility according to its total risk scaled by its Note: xP means x% is invested in P
• nÜ − n true covariance terms correlation with the portfolio, which adjusts for

the fraction of the total risk that is common to Capital Allocation Line (CAL) is a line representing
• (nÜ − n)/2 unique true covariance terms possible combinations from combining a risky
the portfolio.
Note that: • As long as the correlation is not +1, the volatility portfolio and a risk-free asset:
• Cov•R æ , R ˜ ¶ = Cov•R ˜ , R æ¶ = ρæ,˜ ⋅ σæ ⋅ σ˜ of the portfolio is always less than the weighted E[R ? ] − rv
E[R œ? ] = rv + q r σœ?
• Cov[R æ , R æ] = Var[R æ ] average volatility of the individual stocks. σ?

• Cov[aR_ + bR Ü , cR_ + dR Ü ] Mean-Variance Portfolio Theory
= acCov[R_ , R_ ] + adCov[R_ , R Ü ] Assumptions of Mean-Variance Analysis
+bcCov[R Ü , R_ ] + bdCov[R Ü , R Ü]
• All investors are risk-averse.
= acVar[R_] + adCov[R_ , R Ü]
• The expected returns, variances, and
+bcCov[R Ü , R_ ] + bdVar[R Ü ]
covariances of all assets are known. Risky
Diversification • To determine optimal portfolios, investors only Portfolio
Systematic risk need to know the expected returns, variances, Portfolio with x
• Also known as common, market, or non- and covariances of returns. invested in the
diversifiable risk. • There are no transactions costs or taxes. risky portfolio
• Fluctuations in a stock's return that are due to

Efficient Frontier
market-wide news.
• A portfolio is efficient if the portfolio offers the
Nonsystematic risk
highest level of expected return for a given level
• Also known as firm-specific, independent, • At the intercept, the portfolio only consists of
of volatility.
idiosyncratic, unique, or diversifiable risk. the risk-free asset.
• The portfolios that have the greatest expected
• Fluctuations in a stock's return that are due to • At point P, the portfolio only consists of risky
return for each level of volatility make up the
firm-specific news. assets.
efficient frontier.
Total risk = Systematic risk + Unsystematic risk • The line extending to the right of σ? represents

portfolios that invest more than 100% in the
Diversification reduces a portfolio's total risk by risky portfolio P. This is done by using leverage
averaging out nonsystematic fluctuations: (borrow money to invest). A portfolio that
• Investors can eliminate nonsystematic risk for consists of a short position in the risk-free asset
free by diversifying their portfolios. Thus, the is known as a levered portfolio.
risk premium for nonsystematic risk is zero.

Optimal Portfolio Choice

• The risk premium of a security is determined by
its systematic risk and does not depend on its • The optimal risky portfolio to combine with the
nonsystematic risk. risk-free asset is the one with the highest
Sharpe ratio, where the CAL just touches (i.e.,
For an equally-weighted n-stock portfolio: tangent to) the efficient frontier of risky
1 1 investments. The portfolio that generates this
σÜ? = ⋅ ‚‚‚‚‚
Var + ã1 − å ⋅ ‚‚‚‚‚
Cov
n n tangent line is known as the tangent portfolio.
• In a very large portfolio (n → ∞), the covariance
• The tangent line will always provide the best
among the stocks accounts for the bulk of
risk and return tradeoff available to investors.
portfolio risk: The Effect of Correlation All portfolios on the tangent line (i.e., all
σÜ? = ‚‚‚‚‚
Cov • If ρæ,˜ = 1, no diversification. The portfolio's portfolios that are combinations of the risk-free
• If the stocks are independent and have identical volatility is simply the weighted average asset and the tangent portfolio) are efficient
‚‚‚‚‚ = 0, and:
risks, then Cov volatility of the two risky assets. portfolios.
1 • If ρæ,˜ < 1, the portfolio's volatility is reduced • The tangent portfolio is the optimal risky
σÜ? = ⋅ ‚‚‚‚‚
Var due to diversification. It is less than the
n portfolio that will be selected by a rational
As n → ∞, σÜ? → 0. Thus, a very large portfolio weighted average volatility of the two risky investor regardless of risk preference.
with independent and identical risks will have assets.

zero risk. • If ρæ,˜ = −1, a zero-risk portfolio can be Capital Market Line (CML)
Portfolio constructed. • Assume investors have homogeneous
Volatility expectations.
o All investors have the same efficient frontier
25% of risky portfolios, and thus the same optimal
BA risky portfolio and CAL.
Elimination of
Expected Return

Corr. = -1
Non-Systematic 20% o Every investor will use the same optimal
Risk risky portfolio -- the market portfolio.
No Risk o When the market portfolio is used as the
15%
Systematic Corr. = +1 risky portfolio, the resulting CAL is CML.
Risk • The equation for CML is:
10%
E[R ¯ ] − rv
E[R œ¯ ] = rv + q r σœ¯
Number of Stocks WMT σ¯
5%
Observations: 0% 5% 10% 15% 20% 25% 30% • Only efficient portfolios plot on CML. Individual
• The diversification effect is most significant Volatility securities plot below this line.
initially.

Adding a New Investment

• Even with a very large portfolio, we cannot
Suppose we have a portfolio, P, with an expected
eliminate all risk. The remaining risk is
return of E[R ?] and a volatility of σ? .
systematic risk that cannot be avoided through
Add the new investment to the portfolio if:
diversification.
Sharpe Ratioñ}˘ > ρñ}˘,? ⋅ Sharpe Ratio?
E[R ñ}˘ ] − rv E[R ?] − rv
> ρñ}˘,? ⋅
σñ}˘ σ?

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 ASSET PRICING MODELS
ASSET PRICING MODELS Security Market Line (SML) The Debt Cost of Capital

SML is a graphical representation of CAPM: Two methods to estimate debt cost of capital:
Cost of capital is the rate of return that the
• Adjustment from debt yield:
providers of capital require in order for them to
rt = y − pL
contribute their capital to the firm.
= Yield to mat. − Pr(Default) E[Loss rate]
Equity cost of capital / cost of equity / required • CAPM using debt betas:
return on equity: the rate of return that the equity rt = rv + βt [E[R ¯ïE ] − rv ]
holders require in order for them to contribute Note that:
their capital to the firm. • It is difficult to get the beta estimates for

Debt cost of capital / cost of debt / required individual debt securities because they are
return on debt: the rate of return that the debt traded less frequently than stocks.
holders require in order for them to contribute • The average beta for debt tends to be low.
their capital to the firm. However, the beta for debt does increase as the
credit rating decreases.
Beta

Definitions and Key Facts CML vs. SML Required Return on All-Equity Project

• Measures the sensitivity of the asset's return to If a project is financed purely with equity, the
CML SML
the market return. equity is said to be unlevered; otherwise, it is
• Is defined as the expected percent change in an
The x-axis is based on The x-axis is based on levered.
total risk systematic risk
asset's return given a 1% change in the market Assuming a project is financed entirely with
(i.e., volatility) (i.e., beta)
return. equity, we can estimate the project’s cost of
• The beta for a stock, on average, is around 1. Only holds for Holds for any security capital and beta based on the asset or unlevered
• Cyclical industries (tech, luxury goods) tend to efficient portfolios or combination of cost of capital and the beta of comparable firms:
have higher betas. (b/c all combinations securities

• Non-cyclical industries (utility, pharmaceutical) of the risk-free asset (b/c the CAPM can be All-
Comparable Levered
tend to have lower betas. and the market used to calculate the Equity
portfolio are efficient expected return for
Interpreting Beta Beta βµ = β~ βµ = w ~ β~ + w ¸ β¸
portfolios) any security)
• If β = 1, then the asset has the same systematic
Cost of
Alpha rµ = r~ rµ = w ~ r~ + w ¸ r¸
risk as the market. The asset will tend to go up Capital
and down the same percentage as the market. The difference between a security's expected
• If β > 1, then the asset has more systematic risk return and the required return (as predicted by A firm's enterprise value is the risk of the firm's
than the market. The asset will tend to go up the CAPM) is called alpha: underlying business operations that is separate
and down more than the market, on a αæ = E[R æ ] − ræ from its cash holdings. It is the combined market
percentage basis. = E[R æ ] − (rv + βæ [E[R ¯ïE ] − rv ]) value of the firm's equity and debt, less any excess
If the market portfolio is efficient, then all cash:
• If β < 1, then the asset has less systematic risk
securities are on the SML, and: V = E + D − C
than the market. The asset will tend to go up
E[R æ ] = ræ and αæ = 0
and down less than the market, on a percentage To determine the enterprise value, we use the
If the market portfolio is not efficient, then the
basis. firm's net debt:
securities will not all lie on the SML, and:
• If β = 0, then the asset’s return is uncorrelated Net debt
E[R æ ] ≠ ræ and αæ ≠ 0
with the market return. = Debt − Excess cash and short-term investments
Investors can improve the market portfolio by:
Calculating Beta • buying stocks whose E[R æ ] > ræ (i.e., αæ > 0) The beta of the firm's underlying business
Cov[R æ , R ¯ïE ] σæ • selling stocks whose E[R æ] < ræ (i.e., αæ < 0) enterprise is:
βæ = βæ,¯ïE = = ρæ,¯ïE ⋅
σܯïE σ¯ïE βµ = w ~ β~ + w ¸ β¸ + w Œ βŒ
ñ Required Return on New Investment
where:
Adding the new investment will increase the E
β? = ⁄ x æ βæ
Sharpe ratio of portfolio P if its expected return w~ =

æ¡_
exceeds its required return, defined as: E+D−C
D
Beta can be estimated using linear regression: r‰}˘ = rv + β‰}˘,? [E[R ? ] − rv ] w¸ =
R æ − rv = αæ + βæ (R ¯ïE − rv) + ϵæ E+D−C

In general, the beta of an asset i with respect to a −C
portfolio P is: wΠ=
Capital Asset Pricing Model (CAPM) E+D−C
ræ = E[R æ ] = rv + βæ [E[R ¯ïE ] − rv ] Cov[R æ , R ? ] σæ
βæ,? = = ρæ,? ⋅ Required Return on a Leveraged Project
• E[R ¯ïE ] − rv is the market risk premium or the σÜ? σ?

expected excess return of the market. If the project is financed with both equity and debt,
Expected Returns and the Efficient Portfolio
• E[R æ ] − rv or βæ [E[R ¯ïE ] − rv ] is the risk premium then use the weighted-average cost of capital
A portfolio is efficient if and only if the expected
for security i or the expected excess return of (WACC):
return of every available asset equals its required
security i. return. Thus, we have: r˛{ŒŒ = w~ r~ + w¸ r¸ (1 − τŒ )
Since βæ only captures systematic risk, E[R æ ] under E[R æ ] = ræ = rv + β}vv
æ [E[R }vv ] − rv ] = rµ − w ¸ r¸ τŒ
the CAPM is not influenced by nonsystematic risk.

Market Risk Premium where w¸ r¸ (1 − τŒ ) is the effective after-tax cost
Assumptions of the CAPM Two methods to estimate the market risk of debt.
• Investors can buy and sell all securities at premium:

competitive market prices. There are no taxes Note that:

• The historical risk premium: Uses the
or transaction costs. Investors can borrow and • WACC is based on the firm’s after-tax cost of
historical average excess return of the market
lend at the risk-free interest rate. debt while the unlevered cost of capital is based
over the risk-free interest rate.
• Investors hold only efficient portfolios of traded on the firm’s pretax cost of debt.
• A fundamental approach: Uses the constant
securities. • Unlevered cost of capital is also called the asset
expected growth model to estimate the market
• Investors have homogeneous expectations cost of capital or the pretax WACC.
portfolio’s expected return.
regarding the volatilities, correlations, and Div_ Div_ • When we say “WACC” with no qualification, we
expected returns of securities. P% = ⇒ E[R ¯ïE ] = + g mean “after-tax WACC”.
E[R ¯ïE ] − g P%
The consequence of these assumptions is that the
market portfolio is the efficient portfolio.

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Multi-Factor Model MARKET EFFICIENCY
MARKET EFFICIENCY AND BEHAVIORAL Empirical Evidence Against EMH
• If the market portfolio is not efficient, a multi- FINANCE & BEHAVIORAL FINANCE

Calendar/Time Anomalies
factor model is an alternative.
An efficient market is a market in which security • January effect: Returns have been higher in
• It considers more than one factor when prices adjust rapidly to reflect any new January (and lower in December) than in other
estimating the expected return. information, i.e., security prices reflect all past and months.
• An efficient portfolio can be constructed from present information. • Monday effect: Returns have been lower on
other well-diversified portfolios.

Forms of Market Efficiency Monday (and higher on Friday) than on other

• Also known as the Arbitrage Pricing Theory days of the week.
(APT).
Market Prices Reflect: • Time-of-day effect: Returns are more volatile
• Similar to CAPM, but assumptions are not as close to the opening and closing hours for the
Past market Public Private
restrictive. Form market. Also, the trading volumes are higher
data info info
Key Equations Weak ✔ during these times.

Using a collection of N factor portfolios: Semi-strong ✔ ✔ Underreaction/Overreaction Anomalies
‰
Strong ✔ ✔ ✔ • New-Issue/IPO puzzle: Overreaction to new
E[R æ ] = rv + ⁄ βúñ
æ (E[ R úñ ] − rv )
Weak Form EMH issues pushes up stock prices initially.
ñ¡_
where: • It is impossible to consistently attain superior • Earnings announcement puzzle: Investors
• βú_ úñ profits by analyzing past returns. underreacted to the earnings announcement.
æ , … , βæ are the factor betas of asset i that
measure the sensitivity of the asset to a Semi-Strong-Form EMH • Momentum effect: There is a positive serial
particular factor, holding other factors constant. • It is impossible to consistently attain superior correlation in stock prices as investors
• E[R úñ ] − rv is the risk premium or the profits by analyzing public information. underreact to new information.
expected excess return for a factor portfolio. • Prices will adjust immediately upon the release • Reversal effect: There is a negative serial

of any public announcements (earnings, correlation in stock prices as investors
If all factor portfolios are self-financing, then we mergers, etc.). overreact to new information.
can rewrite the equation as: • A semi-strong-form efficient market is also

‰ Other Anomalies
weak-form efficient. • Siamese twins: Two stocks with claims to a
E[R æ ] = rv + ⁄ βúñ
æ (E[ R úñ ]) Strong-Form EMH common cash flow should be exposed to
ñ¡_
For a self-financing portfolio, the portfolio weights • There are only lucky and unlucky investors. No identical risks but perform differently.
sum to zero rather than one. one (not even company insiders) can • Political cycle effect: For a given political
consistently attain superior profits. administration, its first year and last year yield
Fama-French-Carhart (FFC) • Passive strategy is the best. higher returns than the years in between.
This model consists of 4 self-financing factor • A strong-form efficient market is also semi- • Stock split effect: Returns are higher before
portfolios: strong and weak-form efficient. and after the company announces the stock
• Market portfolio. Accounts for equity risk. Take Important Logic split.
a long position in the market portfolio and • If something supports the stronger form of the • Neglected firm effect: Lesser-known firms
finance itself with a short position in the risk- EMH, then it also supports the weaker forms. yield abnormally high returns.
free asset. Example: If something supports the semi- • Super Bowl effect: Historical data shows in the
• Small-minus-big (SMB) portfolio. Accounts strong form, then it must also support the year after the Super Bowl, the stock market is
for differences in company size based on market weak form. more likely to do better if an NFC team won and
capitalization. Buy small firms and finance itself • If something violates the weaker form of the worse if an AFC team won.
by short selling big firms. EMH, then it also violates the stronger forms. • Size effect: Small-cap companies have
• High-minus-low (HML) portfolio. Accounts for Example: If something violates the semi- outperformed large-cap companies on a risk-
differences in returns on value stocks and strong form, then it must also violate the adjusted basis.
growth stocks. Buy high book-to-market stocks strong form. • Value effect: Value stocks have consistently
(i.e., value stocks) and finance itself by short • However, the reverse is not necessarily true. outperformed growth stocks.
selling low book-to-market stocks (i.e., growth

stocks). Empirical Evidence Supporting EMH Bubbles also violate market efficiency. It happens

• Momentum. Accounts for the tendency of an Supporting Weak Form of EMH when the market value of the asset significantly
asset return to be positively correlated with the • Kendall found that prices followed a random deviates from its intrinsic value.

asset return from the previous year. Buy the top walk model, i.e., past stock prices have no The Efficiency of the Market Portfolio
30% stocks and finance itself by short selling bearing on future prices. Under the CAPM assumptions, the market portfolio
the bottom 30% stocks. • Brealey, Meyers, and Allen created a scatter plot is an efficient portfolio. All investors should hold

The FFC estimates the expected return as: for price changes of four stocks. the market portfolio (combined with risk-free
o No distinct pattern in the points, with the investments). This investment advice does not
E[R æ ] = rv + β¯ïE
æ (E[R ¯ïE ] − rv) + β≠¯Ô
æ E[R ≠¯Ô ] concentration of points around the origin. No depend on the quality of an investor’s
+ β!¯¥
æ E[R !¯¥ ] bias toward any quadrants. information or trading skill.
+ β?"_#"
æ E[R ?"_#" ] o Autocorrelation coefficients were close to 0.

where: • Poterba and Summers found that variance of The assumption of rational expectations is less
SMB = Small-minus-big portfolio multi-period change is approximately rigid than that of homogeneous expectations. If we
HML = High-minus-low portfolio proportional to number of periods. assume investors have rational expectations, then
PR1YR = Prior 1-year momentum portfolio all investors correctly interpret and use their own
Supporting Semi-Strong Form of EMH information, along with information from market
• 3 months prior to a takeover announcement, the prices and the trades of others.
stock price gradually increased. At the time of

The market portfolio can be inefficient (and thus it

announcement, stock price instantaneously
is possible to beat the market) only if a significant
jumped. After the announcement, the abnormal
number of investors:
returns dropped to zero.
• Do not have rational expectations (thus
Supporting Strong Form of EMH information is misinterpreted).
• Top performing fund managers in one year only • Care about aspects of their portfolio other than
have a 50% chance to beat their reference index expected return and volatility (thus they are
the following year. willing to hold portfolios that are mean-
• The performance of actively managed mutual variance inefficient).
funds from 1971 to 2013 only beat the Wilshire
5000 index 40% of the time.

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Takeover Offer: Excessive Trading and Overconfidence • Semi-variance ≤ Variance
• After the initial jump in the stock price at the Individual investors tend to trade very actively. • For a symmetric distribution:
time of the announcement, target stocks do not Explanations: 1
appear to generate abnormal subsequent • Overconfidence bias. They often overestimate Semi-variance = Variance
2
returns on average.

their knowledge or expertise. Men tend to be
Value-at-Risk (VaR)
• Stocks that are ultimately acquired tend to more overconfident than women.
• VaR of X at the 100α% confidence level is its
appreciate and have positive alphas, while • Trading activity increases with the number of
100αth percentile, denoted as VaR ± (X) or π± .
stocks that are not acquired tend to depress and speeding tickets an individual receives –
Pr[X ≤ π±] = α
have negative alphas. sensation seeking.
• If X is continuous, then:
Stock Recommendation: Systematic Trading Biases F† (π± ) = α ⇒ π± = F†N_ (α)
• When a stock recommendation is given at the The following behaviors lead investors to depart • VaR %.¢% (X) is the 50th percentile or the median
same time that news about the stock is released, from the CAPM in systematic ways and of X.

the initial stock price reaction appears correct. subsequently impact the efficiency of the market.
Tail Value-at-Risk (TVaR)
The stock price increases in the beginning, then
Holding on to Losers and the Disposition Effect • TVaR focuses on what happens in the adverse
it flattens out.
Investors tend to hold on to investments that have tail of the probability distribution.
• When a stock recommendation is given without lost value and sell investments that have increased • Also known as the conditional tail expectation or
news, the stock price seems to overreact. The in value. expected shortfall.
stock price surges the following day, then it falls
• People tend to prefer avoiding losses more than • If X represents gains, then the risk we are
compared to the market
achieving gains. They refuse to “admit a concerned about comes from the low end of the
The Performance of Fund Managers: mistake” by taking the loss. distribution:
• The median mutual fund actually destroys • Investors are more willing to take on risk in the 1 %&
value. face of possible losses. TVaR ± = E[X|X ≤ π± ] = fl x ⋅ f† (x)dx
α N·
• The mutual fund industry still has positive value • The disposition effect has negative tax • If X represents losses, then the risk we are
added because skilled managers manage consequences. concerned about comes from the high end of
more money and add value to the whole

Investor Attention, Mood, and Experience the distribution:

industry. 1 ·
• Individual investors tend to be influenced by TVaR ± = E[X|X > π± ] = fl x ⋅ f†(x)dx
• On average, an investor does not profit more 1 − α %&
attention-grabbing news or events. They buy
from investing in an actively managed mutual
stocks that have recently been in the news. • If the risk we are concerned about is unclear,
fund compared to investing in passive index
• Sunshine has a positive effect on mood and then use the following rule of thumb:
funds.
stock returns tend to be higher on a sunny day - If α < 0.5, then presumably the risk of
The value added by a fund manager is offset
at the stock exchange. concern comes from the low end.
by the mutual fund fees.
• Major sports events have impacts on mood. A - If α > 0.5, then presumably the risk of
• Superior past performance of funds was not a
loss in the World Cup reduces the next day’s concern comes from the high end.
good predictor of future ability to outperform
stock returns in the losing country. • TVaR will provide a more conservative number
the market
• Investors appear to put inordinate weight on than VaR.
Reasons Why the Market Portfolio Might Not Be their experience compared to empirical

Coherent Risk Measures

Efficient: evidence. People who grew up during a time of
g(X) is coherent if it satisfies (for c > 0):
• Proxy Error: Due to the lack of competitive high stock returns are more likely to invest in
• Translation invariance: g(X + c) = g(X) + c
price data, the market proxy cannot include stocks.
most of the tradable assets in the economy. • Positive homogeneity: g(cX) = c ⋅ g(X)
Herd Behavior • Subadditivity: g(X + Y) ≤ g(X) + g(Y)
• Behavioral Biases: Investors may be subject to
Investors actively try to follow each other's • Monotonicity: If X ≤ Y, then g(X) ≤ g(Y)
systematic behavioral biases and therefore hold
behavior. Explanations:
inefficient portfolios. VaR vs. TVaR:
• Investors believe others have superior
• Alternative Risk Preferences: Some investors • VaR is usually not coherent since it does not
information, resulting in information cascade
focus on risk characteristics other than the satisfy the subadditivity characteristic. If the
effect.
volatility of their portfolio, and they may choose distributions are assumed to be normal, then
• Investors follow others to avoid the risk of
inefficient portfolios as a result. VaR can be shown to be coherent.
underperforming compared to their peers
• Non-Tradable Wealth: Investors are exposed • TVaR is always coherent.
(relative wealth concerns).
to significant risks outside their portfolio. They
• Investment managers may risk damaging their Project Risk Analysis
may choose to invest less in their respective
reputations if their actions are far different from The net present value (NPV) of a project equals the
sectors to offset the inherent exposures from
their peers. If they feel they are going to fail, present value of all expected net cash flows from
their human capital.
then they would rather fail with most of their the project. The discount rate for a project is its
The Behavior of Individual Investors peers than fail while most succeed. cost of capital.
The following behaviors do not impact the

efficiency of the market and have no effect on Breakeven Analysis

market prices or returns. INVESTMENT RISK AND PROJECT ANALYSIS
INVESTMENT RISK & PROJECT ANALYSIS • Calculate the value of each parameter so that

the project has an NPV of zero.
Underdiversification Measures of Investment Risk • The internal rate of return (IRR) is the rate at
Individual investors fail to diversify their Variance which the NPV is zero.
portfolios adequately. They invest in stocks of • The average of the squared deviations above

companies that are in the same industry or are and below the mean: Sensitivity Analysis
geographically close. Explanations: Variance = E[(R − E[R])Ü ] • Change the input variables one at a time to see
• Investors suffer from familiarity bias, favoring
how sensitive NPV is to each variable. Using this
Semi-variance / Downside Semi-variance analysis, we can identify the most significant
investments in companies they are familiar
• Only cares about downside risk; ignores upside variables by their effect on the NPV.
with.
variability. • The range is the difference between the best-
• Investors have relative wealth concerns,
• The average of the squared deviations below case NPV and the worst-case NPV.
caring most about how their portfolio performs
the mean:
relative to their peers. Scenario Analysis
Semi-variance = E[min(0, R − E[R])Ü ]
• The sample semi-variance is: • Change several input variables at a time, then
1 calculate the NPV for each scenario. The greater
Semi-variance = ∑ min(0, R æ − E[R])Ü the dispersion in NPV across the given
n
scenarios, the higher the risk of the project.
• The underlying variables are interconnected.

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Monte Carlo Simulation • Dividends Disadvantages of IPO:
General steps: o It is better for an investor to wait unless the • Dispersed equity holdings
1. Build the model of interest, which is a function cost of waiting is greater than the value of • Compliance is costly and time-consuming
of several input variables. Assume a specific waiting.

probability distribution for each input variable. There are two major types of offerings:

2. Simulate random draws from the assumed Sizing Option • Primary offerings: New shares sold to raise
distribution for each input variable. new capital.
• Growth options give the company an option to
3. Given the inputs from Step 2, determine the make additional investments when it is • Secondary offerings: Existing shares sold by
value of the quantity of interest. optimistic about the future. current shareholders.

4. Repeat Steps 2 and 3 many times. • Abandonment options give the company an When issuing an IPO, the company and
5. Using the simulated values of the quantity of option to abandon the project when it is underwriter must decide on the best mechanism
interest, calculate the mean, variance, and other pessimistic about the future. to sell shares:
measures. • Best-efforts: Shares will be sold at the best
Inversion method: Set F† (x) = u. possible price. Usually used in smaller IPOs.

Real Options CAPITAL STRUCTURE

CAPITAL STRUCTURE • Firm commitment: All shares are guaranteed

Real options are capital budgeting options that Equity Financing to be sold at the offer price. Most common.
give managers the right, but not the obligation, to Equity Funding for Private Companies • Auction IPOs: Shares sold through an auction
make a particular business decision in the future Source of funding for private companies: system and directly to the public.

after new information becomes available. • Angel Investors Standard steps to launching a typical IPO:

Decision tree is a graphical approach that • Venture Capital Firms 1. Underwriters typically manage an IPO and they
illustrates alternative decisions and potential • Private Equity Firms are important because they:
outcomes in an uncertain economy. • Institutional Investors o Market the IPO.

• Corporate Investors o Assist in required filings.
2 kinds of nodes in the decision tree:
o Ensure the stock’s liquidity after the IPO.
• The square node (■) is the decision node When a private company first sells equity, it
2. Companies must file a registration statement,
where you have control over the decision. typically issues preferred stock instead of common
which contains two main parts:
• The circular node (●) is the information node stock.
o Preliminary prospectus/red herring.
where you have no control over the outcome. A funding round occurs when a private company o Final prospectus.

Solving a Decision Tree: raises money. An initial funding round might start 3. A fair valuation of the company is performed by
with a "seed round," and then in later funding the underwriter through road show and book
• Work backwards from the end of the tree.
rounds the securities are named "Series A," "Series building.
• At each decision node, determine the optimal
B," etc. 4. The company will pay the IPO underwriters an
choice by comparing the PV of remaining
underwriting spread. After the IPO,
payoffs along each branch. Pre-Money and Post-Money Valuation
underwriters can protect themselves more
• At each information node, compute the expected • The value of the firm before a funding round is against losses by using the over-allotment
present value of the payoffs from the called the pre-money valuation. allocation or greenshoe provision.
subsequent branches. • The value of the firm after a funding round is 4 IPO Puzzles:
• Discount rate: called the post-money valuation. • The average IPO seems to be priced too low.
- If the true probability is given, use the cost of

Post-money valuation • New issues appear cyclical.

capital to discount.
= Pre-money valuation + Amount invested • The transaction costs of an IPO are high.
- If the risk-neutral probability is given, use the
= # shares after the funding rounds • Long-run performance after an IPO is poor on
risk-free rate to discount.
× Pre-money price per share average.

Value of real option

= NPV(with option) – NPV(without option)

Percentage ownership Debt Financing
Amount invested Corporate Debt: Public Debt
Timing Option (Call Option) =
Post-money valuation Public debt trades on public exchanges. The bond
Gives a company the option to delay making an # shares owned × Pre-money price per share agreement takes the form of an indenture, which is
investment with the hope of having better = a legal agreement between the bond issuer and a
Post-money valuation
information in the future. # shares owned trust company.

= 4 common types of corporate debt:
Can be valued using the Black-Scholes formula: Total # shares


• Notes (Unsecured)
S = current market value of asset Venture Capital Financing Terms
• Debentures (Unsecured)
K = initial investment required Venture capitalists typically hold convertible
• Mortgage bonds (Secured)
T = final decision date preferred stock, which differs from common stock
• Asset-backed bonds (Secured)
rv = risk-free rate due to:

σ = volatility of asset value • Liquidity preference The new debt that has lower seniority than
Div = free cash flow (FCF) lost from delay Liquidity preference = Multiplier × Initial inv existing debenture issues is called a subordinated

• Participation rights debenture.
Discount FCF at the cost of capital. • Seniority

Discount K at the risk-free rate. International bonds are classified into four broadly
• Anti-dilution protection defined categories:
Factors affecting the timing of investment: • Board membership • Domestic bonds – issued by local, bought by

• NPV of the investment foreign
There are two ways to exit from a private
o Without the timing option, invest today if • Foreign bonds – issued by foreign, bought by
company:
NPV of investing today is positive. local
• Acquisition
o With the timing option, invest today only if • Eurobonds – issued by local or foreign
• Public offering
NPV of investing today exceeds the value of
• Global bonds
the option of waiting, assuming the NPV is Initial Public Offering

positive. An initial public offering (IPO) is the first time a Corporate Debt: Private Debt
• Volatility company sells its stock to the public. Private debt is negotiated directly with a bank or a
o When huge uncertainty exists regarding the

small group of investors. It is cheaper to issue due
Advantages of IPO: to the absence of the cost of registration.
future value of the investment (i.e., high
• Greater liquidity
volatility), the option to wait is more 2 main types of private debt:
valuable. • Better access to capital
• Term loan

• Private placement

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Other Types of Debt MM Proposition II Interest Tax Shield with a Target Debt-Equity
Government entities issue sovereign debt and • The cost of capital of levered equity increases Ratio
municipal bonds to finance their activities. with the firm's debt-to-equity ratio: When a firm adjusts its debt over time so that its

D debt-equity ratio is expected to remain constant,
Sovereign debt is issued by the national r~ = rµ + (rµ − r¸ )
E we can value the interest tax shield by:
government. In the US, sovereign debt is issued as
• Because there are no taxes in a perfect capital 1. Calculating the value of the unlevered firm, Vµ ,
bonds called "Treasury securities."
market, the firm’s WACC and the unlevered cost by discounting cash flows at the unlevered cost
There are four types of Treasury securities: of capital coincide: of capital (i.e., pre-tax WACC).
• Treasury bills E D 2. Calculating the value of the levered firm, V¥ , by
rµ = r˛{ŒŒ = r + r
• Treasury notes E+D ~ E+D ¸ discounting cash flows at the WACC (i.e., after-

• Treasury bonds tax WACC).
• Treasury inflation-protected securities (TIPS) 3. PV(Interest tax shield) = V¥ − Vµ

Municipal bond is issued by the state and local Financial Distress Costs
governments. A firm that fails to make its required payments to

debt holders is said to default on its debt.
There are also several types of municipal bonds

based on the source of funds that back them: After the firm defaults, the debt holders have
• Revenue bonds claims to the firm's assets through a legal process
• General obligation bonds called bankruptcy.

Asset-Backed Securities Two forms of bankruptcies:

An asset-backed security (ABS) is a security whose • Chapter 7 liquidation. A trustee supervises the
cash flows are backed by the cash flows of its liquidation of the firm's assets through an
underlying securities. auction. The proceeds from the liquidation are
used to pay the firm's creditors, and the firm
The biggest sector of the ABS market is the ceases to exist.
mortgage-backed security (MBS) sector. An MBS
Note: • Chapter 11 reorganization. The firm's existing
has its cash flows backed by home mortgages. management is given the opportunity to
Because mortgages can be repaid early, the • Since debt holders have a priority claim on
assets and income above equity holders, debt is propose a reorganization plan. While
holders of an MBS face prepayment risk. developing the plan, management continues to
less risky than equity, and thus r¸ < r~ .
Banks also issue ABS using consumer loans, such operate the business.
• As companies take on more debt, the risk to
as credit card receivables and automobile loans. equity holders increases, and subsequently the The present value of financial distress costs has

A private ABS can be backed by another ABS. This cost of equity increases. three components:
new ABS is known as a collateralized debt • As the amount of debt increases, the chance that 1. The costs of financial distress and
obligation (CDO). the firm will default increases, and subsequently bankruptcy, in the event they occur.

the cost of debt increases. o Direct costs – fees to outside professionals
Capital Structure Theory: Perfect Capital • Although both cost of debt and cost of equity like legal and accounting experts, consultants,
Markets increase as the company takes on more debt, appraisers, auctioneers, and investment
Perfect Capital Markets WACC remains unchanged because more weight bankers.
• Investors and firms can trade the same set of is placed on the lower-cost debt. o Indirect costs – loss of customers, loss of
securities at competitive market prices equal to
suppliers, loss of employees, loss of
the present value of their future cash flows. WACC with Multiple Securities:
receivables, fire sale of assets, inefficient
• No taxes, transaction costs, or issuance costs. rµ = r˛{ŒŒ = ⁄ wæ ⋅ ræ liquidation, cost to creditors.
• The financing and investment decisions are o Companies with marketable tangible assets
independent of each other. Levered and Unlevered Betas: (e.g., airlines, steel manufacturers) have

βµ = w ~ β~ + w ¸ β¸ lower costs of financial distress than
MM Proposition I D
• The total value of a firm is equal to the market β~ = βµ + (βµ − β¸ ) companies without these assets (e.g.,
E information technology companies,
value of the total cash flows generated by its

asset. Capital Structure Theory: Taxes and Financial companies in the service industry) because
• The value of a firm is unaffected by its choice of Distress Costs tangible assets can be sold relatively easily.
capital structure. Interest Tax Shield o Alternatives to bankruptcy designed to save
• The use of debt results in tax savings for the the direct costs:
• Changing a firm's capital structure merely
firm, which adds to the value of the firm. - Workout. The company negotiates
changes how the value of its assets is divided
• V¥ = Vµ + PV(Interest tax shield) directly with creditors and works out an
between debt and equity, but not the firm's total
Interest tax shield = Corp. Tax Rate × Int Pmt agreement.
value. - Prepackaged bankruptcy (or "prepack").
• V¥ = Vµ For a firm that borrows debt D and keeps the debt
The company will first create a
Homemade leverage: permanently, if the firm's marginal tax rate is τŒ , reorganization plan with the agreement of
• Investors can borrow or lend at no cost on their then the present value of the interest tax shield is: its primary creditors, and then file Chapter
own to achieve a capital structure different from PV(Interest tax shield) = τŒ ⋅ D 11 reorganization to implement the plan.

what the firm has chosen. WACC with Taxes 2. The probability of financial distress and
• If an investor adds $x worth of debt to the The firm’s effective after-tax WACC measures the bankruptcy occurring
capital structure, then he must reduce the required return to the firm’s investors after taking o Companies with a higher debt-to-equity ratio
equity by $x in order for the total firm’s value to into account the benefit of the interest tax shield: have a higher probability of bankruptcy.
remain unchanged. To determine x, set the r˛{ŒŒ = w~ r~ + w¸ r¸ (1 − τŒ ) o This probability increases when the volatility
adjusted current debt-equity ratio to equal the = w ~ r~ + w ¸ r¸ − w ¸ r¸ τ Œ of a firm's cash flows and asset values
target debt-equity ratio: increases.
D+x D where: o Firms with steady cash flows (e.g., utility
=ã å w~ r~ + w¸ r¸ = rµ = pretax WACC companies) can use high levels of debt and
E−x E "Ë>(}E
w¸ r¸ τŒ = reduction due to tax shield still have low probability of default.

Note: o Firms with volatile cash flows (e.g.,

• As debt increases, the reduction due to interest semiconductor firms) must have low levels
tax shield increases, WACC falls, and thus the of debt in order to have low probability of
value of the firm increases. default.

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3. The appropriate discount rate for the Leverage can provide incentives for managers to The optimal level of debt, D∗ , occurs at the point
distress costs run a firm more efficiently and effectively due to: where the firm's value is maximized. It balances
o The higher the firm's beta: • Increased ownership concentration. the benefits and costs of leverage.

- The more likely it will be in distress • Reduced wasteful investment. Characteristics of the firm will impact the relative
- The more negative the beta of the distress • Reduced managerial entrenchment and importance of these costs and benefits:
costs increased commitment. • R&D-Intensive Firms. Firms with high
- The lower the discount rate for the

Costs of Asymmetric Information research and development costs typically

distress costs
Lemons principle: When managers have private maintain low levels of debt.
- The higher the PV of distress costs
information about the value of a firm, investors • Low-Growth, Mature Firms. Mature, low-
Who Bears the Financial Distress Costs? will discount the price they are willing to pay for growth firms with stable cash flows and
• Debt holders recognize that when the firm new equity issue due to adverse selection. tangible assets benefit from high debt.
defaults, they will not be able to obtain the full

Adverse selection: A seller with private
value of the assets. As a result, they will pay less
information is likely to sell you worse-than-
(or demand higher yields) for the debt initially. USEFUL FORMULAS FROM EXAM P & FM
USEFUL FORMULAS FROM EXAM P & FM
average goods.
• It is the equity holders who most directly bears

the financial distress costs. Managers consider how their actions will be Poisson eN+ λñ

with mean λ Pr[N = n] =
perceived by investors in selecting financing n!
Capital Structure Theory: Agency Cost and
methods for new investments:
Asymmetric Information Exponential x
• Issuing equity is typically viewed as a negative F† (x) = 1 − exp ì− î
The Agency Costs of Leverage with mean θ θ
signal as managers tend to issue equity when
• Excessive risk-taking and asset substitution. they believe that the firm’s stock is overvalued. x−a
F† (x) =
A company replacing its low-risk assets with • Issuing more debt is typically viewed as a b−a
Uniform a+b
high-risk investments. Shareholders may positive signal as the company is taking on E[X] =
benefit from high-risk projects, even those with commitment to make timely interest and on [a, b] 2
negative NPV. (b − a)Ü
principal payments. Var[X] =
• Debt overhang or underinvestment. 12
Adverse selection has several implications for
Shareholders may be unwilling to finance new, Interest rate conversion:
equity issuance:
positive-NPV projects. i(|)
|E
• The stock price declines on the announcement (1 + i)E = q1 + = e>E
• Cashing out. When a firm faces financial m
r
of an equity issue.
distress, shareholders have an incentive to

liquidate assets at prices below their market • The stock price tends to rise prior to the Geometric series:
values and distribute the proceeds as dividends. announcement of an equity issue. First Term − First Omitted Term
• Firms tend to issue equity when information Sum =
1 − Common Ratio
Estimating the Debt Overhang asymmetries are minimized, such as

Equity holders will benefit from a new investment immediately after earnings announcement. Infinite geometric series:
requiring investment I only if: First Term
Pecking order hypothesis: Managers prefer to Sum =
NPV β¸ D 1 − Common Ratio
> make financing choices that send positive rather
I β~ E The PV of an annuity:
than negative signals to outside investors.
Who Bears the Agency Costs? 1 − vñ
The pecking order (from most favored to least añ| = v + v Ü + ⋯ + v ñ =
• When an unlevered firm issues new debt, equity i
favored financing option) 1
holders will ultimately bear the costs. a·| = v + v Ü + ⋯ =
• Internally generated equity (i.e., retained i
• Once a firm has debt already in place, some of
earnings)
the bankruptcy or agency costs from taking on The PV of an n-year annuity immediate with
• Debt
additional debt can fall on existing debt payments of 1, (1 + k), (1 + k)Ü , … , (1 + k)ñN_ :
• External equity (i.e., newly issued shares)
holders. 1+k ñ

Trade-Off Theory 1−ì î
The leverage ratchet effect explains that once PV = 1+i
Balance the value-enhancing effects of debt on a i−k
existing debt is in place:
firm's capital structure with the value-reducing
• Equity holders may have an incentive to take on The PV of a geometrically increasing perpetuity
effects.
more debt even if it reduces the firm value. immediate with payments of 1, (1 + k), (1 +
• Equity holders will not have an incentive to V¥ k)Ü , … :
decrease leverage by buying back debt even if it = Vµ + PV(Interest tax shield) 1
will increase the firm value. − PV(Financial distress costs) PV =
i−k

− PV(Agency costs of debt)
Reducing Agency Costs
+ PV(Agency benefits of debt)
To mitigate the agency costs of debt, firms and

debt holders can:

• Issue short-term debt
• Include debt covenants in bonds that place
restrictions on the actions a firm can take

The Agency Benefits of Leverage

Managers have interests that may differ from
shareholders' and debt holders' interests:
• Empire building. Managers tend to take on
investments that increase the size, rather than
the profitability, of the firm
• Managerial entrenchment. Because managers
face little threat of being replaced, managers can
run the firm to suit their interests.

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