Money market – anything under 1 year in maturity
- Short term debt (Repo, CDs, T-Bills)
Capital Markets – anything greater than 1 year maturity
- Equities, bonds, derivatives
Liquidity = the ability to turn something into cash quickly and with little price impact
Price impact = Absolute value(price you start selling at minus price you end selling at)
Liquidity = volume
Liquidity = bid-ask spread
.01% = basis point
Basis points matter in high volume trades
Basis point trade by HFs = picking up pennies in front of a steamroller
T-Bills main money market instrument we will pay attention to
T-Bills = 3 month T-Bill = Risk Free rate (default risk free)= Rf
Yield of Rf = 4.18%
When we quote yields it is always annualized
Investment v speculative grade cutoff
PE ratio = main valuation ratio we use in finance
30T in market cap
1T in earning per year (net income)
PE ratio = 30
PEG ratio
PE/Growth in earnings
Micron has 20 PE ratio
And growth rate in earnings of 200%
PEG = 0.1
Forward PE ratio is 30 and growth in earnings is estimated to be 20%
PEG ratio will be 30/20 = 1.5
CFOs like share buybacks because you can do it just one time and it doesn’t commit you to
anything
Dividends commit you to pay out quarterly and if you miss it, it is a disaster
Chapter 2:
Calculate a return of the S&P 500
= Sum of Wi*Ri
Where Wi is the weight on a stock and Ri is the return on each stock
Stock A market cap = 100 -> Wa = 100/1000 = .1
Stock B market cap = 500 -> Wb = 500/1000 = .5
Stock C market cap = 400-> Wc = 400/1000 =.4
Stock A goes up 2%
Stock B goes up 10%
Stock C goes up 0%
Return of value weighted index = .1*(2%) + .5*(10%) + .4*(0%) = .2% + 5% = 5.2%
Return of an equally weighted index = 1/3 * (2%) + 1/3* (10%) + 1/3* (0%) = 4%
Stock trades at 100
I place a limit sale of 110 if I want to sell if it hits that level
I place a stop loss at 90 to protect myself on the downside
Problem of market order – stale prices and low liquididty
Short sale: bet that the stock will go down
You turn to your broker (Charles schwab) who has 1M shares of NVIDIA
You borrow 1 share of NVIDIA from them, and post 100 dollar margin
Then you sell the shares immediately. Collect 200
Wait 6 months
Go back into the market and buy NVDIA back for 150. Return that share you borrowed to
Scwab
Profit = 200 – 150 – interest paid to Scwab
R(Disney) = alpha + Beta*Rm + e
Alpha = y intercept – positive alpha is good (excess return)
Beta = level of systematic risk (level of market risk that Disney has)
= Cov(Ri, Rm)/Var(Rm)
Beta = slope = describes how much Disney will move for a 1% move in the Market
Rm = Market return = S&P 500 return
e = the amount of scatter on the graph = firm specific risk for Disney = amount of
unexplained variation about the line of best fit
Beta(i) = cov(Ri, Rm)/sigma^2(Rm)
Cov(Rm,Rm) = Sigma^2 (Rm)
Beta (S&P 500) = 1
Value companies have beta<1
Growth companies have beta >1
Beta =0 means the stock is uncorrelated with the market
T-bills have beta 0
CAPM:
1) All investors hold the Market portfolio and Rf. Market is the optimal risky portfolio on
the EF
Market portfolio = value weighted portfolio of all traded assets
Best approx. is the S&P 500 (70% of world assets)
Everyone moves up and down the CML according to their risk aversion
2) CAPM formula
Derivation of CAPM:
Everyone trades until this equality holds:
[E(Ri) -Rf]/Beta(i) = [E(Rj) -Rf]/Beta(j)
For all assets i, j
[E(Ri) -Rf]/Beta(i) = [E(Rm) -Rf]/Beta(m)
[E(Ri) -Rf]/Beta(i) = [E(Rm) -Rf]/1
E(Ri) = Beta(i) * [E(Rm) -Rf] + Rf
E(R campbell) = 0 *(10%) + 2% = 2%
E(Tesla) = 2*(10%) + 2% = 22%
The more systematic risk you take on in your stock (or portfolio) the greater the returns
you can expect
In a CAPM world (and in reality for that matter), you do not get compensated for taking on
firm-specific risk (i.e. if you buy a company with a lot of firm specific risk, don’t expect a
higher return for doing so, because that risk can be diversified away)
Why not sigma on the denominator?
If we were in a weird world, where I was only allowed to own 1 asset, then this would be
the equilibrium condition:
[E(Ri) -Rf]/sigma(i) = [E(Rj) -Rf]/sigma(j)
ETF fund:
1 million of NVIDIA
1 million in Apple
And issues 1 million shares of the fund are issued
NAV = (1M + 1M)/(1M) = 2 dollars per share
If I want to buy into this fund at end of day, I pay 2 dollars per share
Fund is selling for 1.90 per share (irrationally). What would you do to take advantage of
this?
I want to take advantage of this but still have no Market exposure (have a 0 beta)
- Buy all the Fund shares (“Own” by proxy 1 million of NVIDIA and 1 million of Apple) at
1.90
- And Short 1 million apple, 1 million NVIDIA
Profit = 1 million shares of fund * (2 dollars – 1.90) = 100,000 with a 0 beta
Arbitrage pricing
This is how we get efficient markets – how we get prices converging to their true value
Benefits of ETFs:
- 1 dollar to get in
- Liquidity throughout the day, can sell whenever you want
- Leverage ETFs – can take large beta bets with them
- Redeem in kind – no taxes in trading stocks within the ETF wrapper
Benefits of MFs:
Trades at exactly its NAV (no tracking error like ETFs might have)
Active MF v Passive MFs – active MFs are actively trying to beat the market
Efficient Markets Hypothesis Definition (EMH):
1) Looking at past pricing info, I cannot predict whether the stock is going up next or if it is
going down
2) Cannot achieve risk adjusted positive returns on a consistent basis (i.e. for 20+ years)
given my information at the time of investment.
- Alpha cannot last over many years (CAPM adjusted return)
3) Markets follow a random Walk
4) Cov(Rit, Rit+1) = 0 for two non overlapping sets of returns in time
- Cov (S&P 500 in January, S&P 500 in February) = 0
- Observing how the market did in January does not help me make a bet on how it will do in
February
- Cov(Rit, Rit+1) > 0 == Momentum (Momentum is a violation of EMH)
- Cov(Rit, Rit+1) < 0 == Reversal (Reversal is a violation of EMH)
5) Prices reflect all available information
- Weak form – Current price reflects all past pricing and volume data
- Semi Strong form - Current price reflects all past pricing and volume data and all publicly
available information about the stock
- Strong form - Current price reflects all past pricing and volume data and all publicly
available information about the stock and all private information about the stock (all
information)
We are close to semi strong efficient (in the 60s to 80s we were definitely weak form)
Call option=
Buyer has the right (but not the obligation) to buy a share of stock at a prespecified price
(X) up until some Time (T)
X= prespecified price (strike price or Exercise price)
Expiration date = T
S= Current stock price
C= Price of your Call option (and can be traded at anytime)
So if S>X you will exercise your Call and buy the stock for X (in the money)
If S<X, you just don’t do anything (no exercise) (out of the money)
Otherside: Call Writer (Call Seller): They agree to sell to the call Buyer if they want the
shares
Payout at the end of a call option = Max(S-X,0)
Max(a,b) = a if a is bigger; b is b is bigger
Max(90-80,0) = 10
Max(78-80,0) = 0
Profit to a Call = Max (S-X, 0) – C
Where C is the amount you paid for the call (you pay for the option up front so it is a sunk
cost)
S=82, X=80, C=5
Profit = Max(82-80,0) – 5 = 2 – 5 = -3
S=71, X=80, C=5
Profit = Max(71-80,0) – 5 = Max(-9,0) – 5 = 0 – 5 = -5
Put Option:
Buyer has the right (but not the obligation) to SELL a share of stock at a prespecified price
(X) up until some Time (T)
So if S<X you will exercise your Put and Sell the stock for X
If S>X, you just don’t do anything (no exercise) (out of the money)
Put Profit =
Max(X-S,0) – P
S= 70, X=80, P= 4
Max(80-70,0) – 4 = 10 -4 = 6
For every call that is purchased, someone else wrote the call -> profits of both of them
together have to
For every put that is purchased, someone else wrote the put -> profits of both of them
together have to
Options market is 0 sum
Payout to writing call option:
X=100, S= 120, C = 7
Profit to writing the call:
-1* [ Max(S-X, 0) – C] =
-1* [Max(120-100,0) – 7] = -1* (20-7) = -13
Put buyer maximum profit if company goes bankrupt (S=0) : Max(X-S, 0) – P
X=100, S=0, P=6
Max(100-0,0) – 6 = 94
Price of Call Option:
C goes up when S goes up
C goes up when X is lower
C goes up when Vol goes up‘
C goes up when T is longer
Price of Put Option:
P goes up when S goes down
P goes up when X is higher
P goes up when Vol goes up
P goes up when T is longer
Protective Put =
Buy stock + buy Put = synthetic call
Put Call parity =
(Stock price-X) + P = C
(no arbitrage argument)
Write Covered Call = Sell Call + own stock
Bull Straddle:
Own Call and Own Put
C= 3
P=7
X=100
S=115
Profit=?
Profit = Max (115-100,0) – 3 +
Max (100-115,0) – 7 = 15 – 3 + 0 -7 = 5
Break evens on this be? 110 and 90
Bear straddle – max profit = 10 dollars when S stays right at X=100
Protective Put =
Buy stock + buy Put = synthetic call
Put Call parity =
(Stock price-X) + P = C
(no arbitrage argument)
Write Covered Call = Sell Call + own stock
Bull Straddle:
Own Call and Own Put
C= 3
P=7
X=100
S=115
Profit=?
Profit = Max (115-100,0) – 3 +
Max (100-115,0) – 7 = 15 – 3 + 0 -7 = 5
Break evens on this be? 110 and 90
Bear straddle – max profit = 10 dollars when S stays right at X=100