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    MAF759/904: Quantitative Methods For Finance

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    This document provides information about the Quantitative Methods for Finance course MAF759/904 including the contact details for the unit chair, textbook and workbook details, assessment breakdown, lecture times and topics to be covered each week such as time value of money, probability, statistics, and portfolio theory. It also outlines the expectations for students including previewing materials, attending lectures, reviewing topics, and committing 10 hours per week to the unit as a full-time student.

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    MAF759/904: Quantitative Methods For Finance

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    SangVo
    48 views46 pages
    This document provides information about the Quantitative Methods for Finance course MAF759/904 including the contact details for the unit chair, textbook and workbook details, assessment breakdown, lecture times and topics to be covered each week such as time value of money, probability, statistics, and portfolio theory. It also outlines the expectations for students including previewing materials, attending lectures, reviewing topics, and committing 10 hours per week to the unit as a full-time student.

    Original Description:

    Deakin Quantitative Analysis Lecture 1

    Original Title

    Lecture 01

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    This document provides information about the Quantitative Methods for Finance course MAF759/904 including the contact details for the unit chair, textbook and workbook details, assessment breakdown, lecture times and topics to be covered each week such as time value of money, probability, statistics, and portfolio theory. It also outlines the expectations for students including previewing materials, attending lectures, reviewing topics, and committing 10 hours per week to the unit as a full-time student.

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    © All Rights Reserved
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    48 views46 pages

    MAF759/904: Quantitative Methods For Finance

    Uploaded by

    SangVo
    This document provides information about the Quantitative Methods for Finance course MAF759/904 including the contact details for the unit chair, textbook and workbook details, assessment breakdown, lecture times and topics to be covered each week such as time value of money, probability, statistics, and portfolio theory. It also outlines the expectations for students including previewing materials, attending lectures, reviewing topics, and committing 10 hours per week to the unit as a full-time student.

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    of 46

    MAF759/904:

    Quantitative Methods for Finance


    Dr. Ruipeng Liu
    Unit Chair, Senior Lecturer
    Office: LB4.121, Burwood campus
    Tel: 03 9244 6359
    Fax: 03 9244 6283
    Email: ruipeng.liu@deakin.edu.au
    Office hours: 9:30-11:30am Thursdays

    Prescribed Textbook
    Quantitative Investment Analysis,
    2nd Edition, Wiley.
    Richard A. Defusco, Dennis W. McLeavey,
    Jerald E. Pinto and David E. Runkle
    Workbook of Quantitative Investment Analysis

    Lecture:
    Mondays 17:00 - 19:50
    Pls bring your textbook, workbook and calculator)

    Assessments:
    Online test: 5% +5%
    Group assignment: 30%
    Examination: 60% (Hurdle: 50%)
    3

    Topics covered
    Week

    1: Time value of money and


    Discounted cash flow
    Week 2 &3: Statistical concepts, and
    Probability concepts.
    1st online test: 24th March 2016
    Week

    4: Probability distribution
    Week 5: Estimation and Hypothesis test.
    4

    Topics covered
    Week

    6: Correlation and regression


    2nd online test: 22nd April 2016

    Week

    7 : Anzac Day Monday (no lecture).


    Week 8&9: Regression analysis.
    Assignment due 11th May 2016
    Week

    10: Time series analysis.


    Week 11: Portfolio theory.
    5

    My expectations to you

    Preview unit materials prior to lecture;


    Lecture attendance (on-campus only);
    Review after each topic;
    Full-time student load: 10 hours per
    unit per week.

    Time value of Money

    Suppose you as an investor lend $10,000 to Y for a


    year. How much money do you want after a year?

    You want your $10,000 back plus some


    compensation in the year end.

    What does this compensation consist of?

    Time value of Money


    1. You want some compensation for postponing your current consumption.
    2. You want some compensation to account for the expected inflation in a
    year.
    3. You want some compensation to account for the fact that the borrower may
    fail to return your money in an year. Essentially you will recover this
    money from good debt than bad debt.
    4. you want some compensation to account for the loss of liquidity, i.e, you
    can not get your cash back whenever you want within that year.
    5. You also want some compensation because you are lending the money for a
    longer period.

    Interest Rate

    So what are these terms?


    Real risk free rate
    Inflation premium
    Default risk premium
    Liquidity premium
    Maturity premium

    Future value (FV) & Present value (PV)

    What is Time value of Money and why is it important?

    The value of money does not remain constant over time and i.e, money earns
    interest over time. So it is important from the view point of capital budgeting
    and investing and many other investment related decisions.

    Suppose A wants to borrow $10,000 from B for a year. Let the market
    rate of interest be 10%. How much should A pay B in a year?
    FV = PV + interest at the rate of 10% p.a.
    = PV + PV *10%
    = PV(1 + 10%)
    = PV(1 + r)
    10

    Future value of a Lump Sum

    Suppose you invest $10,000 today at 8% p.a,


    how much will this be worth in 2 years?
    PV $10,000
    r 8%
    N 2
    FVN PV (1 r ) N
    $10,000(1 0.08) 2
    $11,664
    11

    Frequency of Compounding
    rs
    FVN PV 1
    m

    mN

    rs stated annual rate


    m number of compounding periods in a year
    e.g. 4 for quarterly, 12 for monthly
    N number of years

    12

    Future Value with Quarterly Compounding

    Find the FV of $10,000 after two years invested today at 8%


    and if the interest is compounded quarterly.
    PV $10,000
    rs 8%
    m4
    N2
    mN

    r
    FVN PV1 s
    m
    $10,000(1.02)8
    $11,716.59
    13

    Frequency of Compounding

    14

    Continuous Compounding

    Interest can be compounded in discrete intervals


    such as daily, monthly or quarterly, or it can
    compound continuously.
    For continuous compounding we use,
    FVN PVe rs N
    e 2.7182818
    15

    Present Value (PV)

    Present value is the amount of money today that yields a


    certain amount in the future at a fixed rate of interest.
    Suppose we loan someone an amount of PV today for n years
    at a rate of r p.a. What is the total amount to be repaid after n
    periods?
    FV = PV(1 + r )n .
    PV

    FV
    n

    FV
    (
    1

    r
    )
    (1 r ) n
    16

    Present Value of a Lump Sum

    An insurance company promises to pay


    $100,000 in six years with an 8% rate. What
    amount must the insurer invest today at 8% to
    make the promised payment?
    PV

    FV
    N
    FV
    r

    (
    1

    )
    (1 r ) N

    $100,000(1 0.08) 6
    $63,016.96
    17

    Present Value of a Lump Sum

    Find the present value of 5 million received 10 years


    from today if the interest rate is 6% and monthly
    compounding is used.
    rs
    PV FVN 1
    m

    mN

    .06
    5,000,0001

    12
    2,748,163.67

    12 (10 )

    18

    Present Value with Continuous


    Compounding

    19

    Present Value (PV) and Future Value (FV)

    FV
    r

    PV

    1/ N

    ln( FV / PV )
    N
    ln(1 r )
    20

    Stated and Effective Rates

    Stated rates do not account for the number of compounding


    periods and so we need to compute the effective annual rate
    (EAR)

    EAR (1 Periodic interest rate) m 1


    m

    rs
    EAR 1 1
    m

    The effective annual rate with continuous compounding is

    EAR e rs 1
    21

    Stated and Effective Rates

    Find the EAR if the stated interest rate is 8%


    and semiannual compounding is used.
    m

    rs
    EAR 1 1
    m
    2

    .08
    1
    1
    2

    .0816
    22

    The Future Value of a Series of Cash Flows

    Suppose we save $1000 each period


    (beginning next year) at an interest rate of 5%
    for 5 periods, how much money will we have
    after the last deposit is made?

    23

    Geometric Progression/series
    A sequence in which each element is obtained by multiplying
    the preceding element by a constant.
    n

    x 0 x1 x 2 x 3 . . . x n

    k 0

    (1 x) x k
    k 0

    1 x n 1
    A x A

    ,
    k 0
    1- x
    n

    x m x n 1
    A x A

    1
    x
    k m

    24

    The Future Value of Annuity


    Annuity: finite set of level sequential cash flows:
    ordinary annuity; annuity due; perpetuity.

    FVN A[(1 r) N 1 (1 r) N 2 (1 r) N 3 . . . (1 r) 1]
    which simplifies to
    (1 r) N 1
    FVN A

    25

    The Present Value of Annuity

    Suppose you will receive $A each period for


    N periods (beginning next year) with interest
    rate of r, what is this stream of payments
    worth today?
    PV

    which

    PV

    A
    A

    (1 r)
    (1 r)
    simplifies

    A
    (1 r)

    ...

    A
    (1 r)

    N 1

    A
    (1 r)

    to

    (1 r)
    A
    r

    26

    Ordinary Annuity

    How much you should pay to receive 1,000 per


    year for 5 yrs, with the first payment one year
    from now and if the required return is 12%?
    1

    (1 r) N
    PV N A

    (1 .12) 5
    1,000
    .12

    3,604.78

    27

    Annuity due:
    An immediate cash flow + ordinary annuity

    Suppose you will receive $200,000/yr for 20 years, with the


    first payment today. What is the PV if the interest rate is 7%?
    1

    (1 r) N -1
    PVN A A

    (1 .07)19
    200,000 200,000

    .07

    200,000 2,067,119.05
    2,267,119.05
    28

    Perpetuity

    What is $A received every year (beginning next


    year) forever, worth to us today?
    1
    PVN A
    t
    (1
    r)

    t 1

    which simplifies to

    A
    PVN
    r
    29

    Present Value of a Perpetuity

    A British consol bond promises to pay 100


    per year in perpetuity. If the required rate is
    5%, what is the bond worth today?
    PV

    r
    100

    0 . 05
    2 , 000
    30

    Solving for Interest Rates / Growth Rates

    If we are interested in knowing the return or


    growth rate, r, we can use the relationship
    between PV and FV.

    FVN
    r

    PV

    1/ N

    31

    Solving for the Annuity


    If we want to accumulate FV in N periods, what
    amount, A, do we need to deposit each period to
    reach this goal.

    FV
    A
    (1 r ) N 1

    32

    Computing the Annuity that will Grow to FV

    Suppose you would like to save for 30 years (beginning next


    year). How much will you need to save each year so you will
    have $1 million after the last deposit is made if the interest
    rate is 6%?

    FV
    $1,000,000
    A

    $12,648.91
    N
    30
    (1 r ) 1 (1.06) 1

    r
    .
    06

    33

    Solving for the Annuity

    If we borrow certain ammount, what is the


    annuity, A, that will be needed to repay the loan.
    PV
    A
    1

    (1 r ) N

    34

    An example: Annuity payment

    35

    Discounted Cash Flow Applications

    Discounted cash flow (DCF) has numerous


    applications including:
    determining

    if an investment is desirable (capital

    budgeting).
    valuing securities (stock and bonds).

    36

    Calculate PV using Excel


    COMPUTING THE PRESENT VALUE
    Discount rate

    10%

    Year

    Cash flow

    Present
    value

    100

    90.9091 <-- =B5/(1+$B$2)^A5

    100

    82.6446 <-- =B6/(1+$B$2)^A6

    100

    75.1315 <-- =B7/(1+$B$2)^A7

    100

    68.3013 <-- =B8/(1+$B$2)^A8

    100

    62.0921 <-- =B9/(1+$B$2)^A9

    Net present value


    Summing cells C5:C9

    379.08 <-- =SUM(C5:C9)

    Using Excel's NPV function

    379.08 <-- =NPV(B2,B5:B9)

    Using Excel's PV function

    379.08 <-- =PV(B2,5,-100)

    37

    Calculate PV using Excel


    COMPUTING THE PRESENT VALUE
    In this example the cash flows are not equal
    Either discount each cash flow separately or use Excel's NPV function
    Excel's PV doesn't work for this case

    Discount rate

    10%

    Year

    Cash
    flow

    Present
    value

    Present value
    of each cash flow

    100

    90.9091 <-- =B5/(1+$B$2)^A5

    200

    165.2893 <-- =B6/(1+$B$2)^A6

    300

    225.3944 <-- =B7/(1+$B$2)^A7

    400

    273.2054 <-- =B8/(1+$B$2)^A8

    500

    310.4607 <-- =B9/(1+$B$2)^A9

    Net present value


    Summing cells C5:C9

    1065.26 <-- =SUM(C5:C9)

    Using Excel's NPV function

    1065.26 <-- =NPV(B2,B5:B9)

    38

    Net Present Value

    Net present value (NPV) is one of the important


    application of the DCF concept.
    NPV compares the cash outflow to the present value
    of the cash flows from the project.
    If NPV 0 we accept the project. If NPV < 0, we
    reject the project.
    N

    CFt
    NPV
    t
    t 0 (1 r )
    39

    Example 2-1 Using NPV

    RAD Corporation intends to invest $1 million in


    R&D and expects incremental cash flows of $150,000
    in perpetuity from this investment. If the opportunity
    cost of capital is 10%, will RAD Corp. invest in the
    project?
    CF
    NPV CF0
    r
    $1,000,000

    $150,000
    $500,000 0, accept
    .10

    40

    Internal Rate of Return

    Assumption: Cash flows are reinvested at IRR.


    The internal rate of return on a project is the interest
    rate that makes the NPV = 0.
    If IRR discount rate (opportunity cost of the
    project), we accept the project.

    CFN
    CF1
    CF2

    ...
    0
    NPV CF0
    1
    2
    N
    (1 IRR )
    (1 IRR ) (1 IRR )

    41

    Internal Rate of Return

    INTERNAL RATE OF RETURN


    Year

    Cash flow
    0

    -800

    200

    250

    300

    350

    400

    USING EXCEL'S RATE FUNCTION TO


    COMPUTE THE IRR
    Initial investment
    Periodic cash flow
    Number of payments

    IRR
    Internal rate of return

    1,000
    100
    30
    <-- =RATE(B4,B3,9.307% B2)

    22.16% <-- =IRR(B3:B8)

    42

    Multiple IRRs
    Discount rate
    NPV

    Year
    0
    1
    2
    3
    4
    5

    6%
    -3.99<-- =NPV(B2,B7:B11)+B6

    Cash flow
    -145
    100
    100
    100
    100
    -275

    Two IRRs
    5.00

    Net present value

    0.00
    0%

    10%

    20%

    30%

    40%

    -5.00
    -10.00
    Discount rate
    -15.00
    -20.00
    -25.00

    Identifying the two IRRs


    First IRR
    Second IRR

    8.78%<-- =IRR(B6:B11,0)
    26.65%<-- =IRR(B6:B11,0.3)

    43

    Further issues: NPV &IRR

    If we are comparing different size projects,


    the one with the highest IRR may not add
    the greatest value to the firm.

    If the timing of cash flows differ.

    If the sign of the cash flows changes more


    than once, we may get more than one IRR.

    44

    Money Market Measurements

    Money market is the market for short-term debt instrument


    (one year maturity or less).
    Treasury bills (T-bills) are pure discount instruments (pays no
    income until maturity, whereupon the investor receives the
    face value of the instrument . These instruments are issued at
    a price lower than face value).
    T-bills are quoted on a bank discount basis:
    rBD

    F P 360

    F
    t

    purchase price P, F is the face value, t = the actual number of days remaining to maturity
    45

    Money Market Measurements


    Holding Period Yield

    Effective Annual Yield

    Money Market Yield

    P1 P0 D1
    HPY
    P0

    EAY (1 HPY)365 / t 1

    rMM (HPY )(360 / t )


    46

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