Foundations of Financial Markets

C15.0025.00 (Undergraduate Course)

Professor Stephen Brown

Spring 1996

Course Description

This course covers the elements of financial markets, financial securities and how they are valued and traded. The perspective is that of the investment manager, responsible for the investment portfolios of insurance companies, banks, pension funds, mutual funds, endowment funds and personal trusts. What we cover in this course has obvious implications for stock selection strategies by individuals and for financial decisions within firms. However, these topics are covered in greater depth in other courses (Investment Principles C15.0041, Corporate Finance Topics C15.0008) and are merely introduced here. We discuss several outstanding problems of investment management, including the definition of appropriate standards of prudence, security valuation, performance measurement, the asset mix decision and alternative risk control procedures.

Prerequisites

C15.0001 Financial Management

The textbook for this course is Bodie, Kane and Marcus Essentials of Investments (Irwin 1995). Other required readings will be distributed to the class. Students are asked to purchase and install The Investment Portfolio which will be the basis of at least one assignment. This software will be used extensively in the course. There will be a midterm and a final examination. The midterm will be optional in the sense that the grade will be counted only if the student performs better on the midterm than on the final. In other words, if you do not perform up to your expectation on the midterm examination, the midterm examination result will not be considered in determining a final grade.

It is most important that students keep up to date with the reading for this course. The closed book midterm and final examination questions will be taken from the Concept Checks⁽¹⁾ and mini cases that appear in the Syllabus, and from non-graded problem sets and assignments that are distributed on a regular basis through the Semester. Most of the mini cases are taken from the textbook (some are no more than glorified problem sets) and most of these appeared in past examinations for the Chartered Financial Analyst qualification. Cases not found in the textbook will be distributed to class, and most of these will be discussed in class.

I will make every effort to make available to the class copies of all overhead transparencies prior to class. If there is any material in the lectures or the handout material that you feel is unnecessarily obscure, please fill in the comment sheet at the end of the day's handout or see me in my office after class.

Foundations of Financial Markets C15.0025.00 Professor Stephen Brown

Spring 1996

Syllabus

Week 1: January 22-24

Investors and the Investment Process

Case: Matter of Morgan Guarantee Trust

Readings: BKM Chapters 1,4, Roth

Concept Check 4.1

What are the investment objectives of individual and institutional investors? What constraints apply? An examination of the prudent person rules that govern the behavior of investment managers reveals that the conduct of the manager based on the information available at the time investment decisions are made is crucial. Past performance alone is no guarantee that the manager is acting responsibly, particularly where the performance is obtained at the cost of unnecessary risk.

Week 2: January 29-31

Principles of Security Valuation

Case: BKM Problem 12.12

Readings: BKM Chapter 12

Concept Check: 12.1,12.2,12.5

The idea that a financial security is worth no more than the present value of the stream of anticipated payments is a very basic principle of security valuation. We motivate this general idea, and illustrate it in the context of equity, fixed income and real estate valuation. An understanding of this idea suggests why it is so hard to predict future movements in security values.

Week 3: February 5 - 7

Mathematics of Return

Case: BKM Problem 2.2

Readings BKM Chapter 2.1

Concept Check: 2.1

Comparison of rates of return is often a shortcut to valuing different financial securities. Unfortunately, there is no general consensus as to how to measure rates of return. Arithmetic, geometric, and internal rates of return are often confused with each other and with measures such as bank discount rates. Each of these measures of return are used in different contexts and for different purposes and should not be confused.

Week 4: February 12 - 14

Equity risk and return

Case: BKM Problem 5.7, 5.8

Readings: BKM Chapter 2.3,2.4,5

Concept Check: 2.5,2.6;5.1,5.1,5.2,5.3,5.4

Defines notions of return and risk for equity securities and for portfolios of securities. Compares the risk and return features of stocks and bonds, and shows how equity risk can be modified by considering a portfolio of stocks and bonds.

Week 5: February 21

Diversification with two risky assets

Case: BKM Problem 6.6

Readings: BKM Chapters 6.1-6.3

Concept Check: 6.1,6.2,6.3

Examines the risk and return attributes of portfolios of securities, and identifies the correlation between security returns as a central component of portfolio risk.

Week 6:

Asset Allocation

Case: BKM Problem 6.14,6.15,6.16

Readings: BKM Chapter 6

Concept Check: 6.4

Identifies the asset mix decision as the central policy problem of investment management, and shows how portfolio theory can be used to construct long term asset mix guidelines. Introduces the notion of asset liability matching

Week 7: March 4-6

International Diversification

Case: BKM Problem 19.1,19.2

Readings: BKM Chapter 19, pp.520-529

Concept Check: 19.1,19.2

Does international diversification increase portfolio risk or decrease it? The answer to this question depends on the extent to which the components of international risk, equity risk, currency risk, and political risk are diversifiable in the investor's portfolio

Week 7: (Continued) March 6

Capital Asset Pricing Models

Case: APT in Action

Readings: BKM Chapter 7

Concept Check: 7.1,7.2,7.3,7.4,7.6

The idea that there may be a finite (and small) number of nondiversifiable sources of risk leads to an Arbitrage Pricing Theory that defines the return investors expect from capital assets. We study the foundation of this model and the relationship to the related Capital Asset Pricing Model, and show how the model is applied in practical investment management.

Spring Break!

Week 8: March 18-20

Capital Asset Pricing Models (Continued)

Midterm Examination (March 15)

Week 9: March 25-27

Performance Measurement

Case: Growth Management

Readings: BKM Chapter 18

Concept Check: 18.1,18.2,18.3

Past performance alone does not guarantee future performance. Sophisticated performance measurement tools examine the extent to which components of performance can be related to the conduct of the manager.

Week 10: April 1-3

Fixed Income Analysis

Case: BKM Problem 9.25

Readings: BKM Chapter 9

Concept Check 9.1, 9.2, 9.3, 9.4, 9.5

How do fixed income securities work and how are they valued? Why should bonds of different maturities offer different yields? The fact that longer term bonds usually offer higher yields, suggest that part of the difference is a premium for bearing interest rate risk, since exposure to this risk increases with time to maturity.

Week 11: April 8-10

Managing Fixed Income Investments

Case: BKM Problem 10.15

Readings: BKM Chapter 10

Concept Check: 10.1, 10.2, 10.3, 10.4, 10.5

Duration measures how long investors tie their money up in fixed income securities. It is also for this reason, a measure of the investor's interest rate exposure. Immunization and related strategies attempt to minimize interest rate risk exposure by arranging the investment portfolio such that the duration of the assets matches the duration of the investor's liabilities.

Week 12: April 15 - 17

Options: characteristics and payoffs

Case: BKM Problem15.4

Readings: BKM Chapter 15

Concept Check: 15.1, 15.2, 15.4

Options and futures contracts are examples of derivative securities, whose value depends on the value of some other traded security. For some investors, derivative securities offer the cheapest way to capitalize on information that the underlying security will rise (or fall) in value. For other investors, derivative securities provide an insurance function. To understand derivative securities, it is first necessary to understand how the value of the derivative varies with the value of the underlying security.

Week 13: April 22-24

Option Valuation

Case: Analytic Optioned

Readings: BKM Chapter 16

Concept Check: 16.1, 16.2, 16.3

An analysis of the relationship between the value of the derivative and the value of the underlying security suggests a simple approach to valuing the derivative. We illustrate this in the context of option pricing, and introduce the notion of hedging.

Week 14: April 29-May 1

Futures Contracts

Case: BKM Problem 17.8

Readings: BKM Chapter 17

Concept Check: 17.1, 17.2, 17.3

Futures contracts are a special case of a derivative security. The special features of these contracts are best understood by reference to related forward contracts and to the history of futures contracts trading in the United States. In investment management, they are chiefly used to hedge security risk ("short positions") or to provide an inexpensive way to invest in the markets ("long positions").

Week 15: May 8

Portfolio Insurance

Case: Portfolio Insurance Case

Readings: BKM pp. 457-462

An analysis of this case provides a useful summary of the material covered in this course.

1. Concept Checks are problems that are interspersed in the text. A worked answer for each of these problems appears at the end of the chapter in which the concept check appears. For example, the Concept Check 4.1 that pertains to the first lecture can be found on page 91 of the text, and an answer is provided on page 107.