STAMFORD UNIVERSITY BANGLADESH

Department Of Business Administration Master of Business Administration Program 744, Satmosjid Road Dhanmondi, Dhaka Trimester: Summer-2011

Submitted by:
Engr. Mohd. Abdus Sattar MBA 044 12301

1. Combining a Risk-Free Asset with a Risky Portfolio

Expected return
The weighted average of the two returns
E(R
port

) = WRF (R FR) +(1 - WRF )E(R i )

This is a linear relationship

Standard deviation
The expected variance for a two-asset portfolio is
2 2 2 E( port ) = w 1 12 + w 22 + 2 w 1w 2 r1,2 12 2

Substituting the risk-free asset for Security 1, and the risky asset for Security 2, this formula
2 2 2 2 2 would become E( port ) = w RF RF + (1 w RF ) i + 2w RF (1 - w RF )rRF, i RF i

Since we know that the variance of the risk-free asset is zero and the correlation between the risk-free asset and any risky asset i is zero we can adjust the formula
2 E( port ) = (1 w RF ) 2 i2

Given the variance formula the standard deviation is

2 E( port ) = (1 w RF ) 2 i2

E( port ) = (1 w RF ) 2 i2 = (1 w RF ) i

Therefore, the standard deviation of a portfolio that combines the risk-free asset with risky assets is the linear proportion of the standard deviation of the risky asset portfolio.

Risk-Return Combination
Since both the expected return and the standard deviation of return for such a portfolio are linear combinations, a graph of possible portfolio returns and risks looks like a straight line between the two assets.
Exhibit 8.1: Portfolio Possibilities Combining the Risk-Free Asset and Risky Portfolios on the Efficient Frontier

E(R port )

E( port )

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Risk-Return Possibilities with Leverage

To attain a higher expected return than is available at point M (in exchange for accepting higher risk) Either invest along the efficient frontier beyond point M, such as point D Or, add leverage to the portfolio by borrowing money at the risk-free rate and investing in the risky portfolio at point M. This line is referred to as Capital Market Line (CML). NOTE: Leveraged Portfolio A portfolio that includes at least some securities that were bought with borrowed money. A leveraged portfolio is risky because the securities may result in a loss, which would leave the investor liable to repay the borrowed capital. However, if the securities result in a gain, the investor has essentially made a profit without using his/her own money.
Exhibit 8.2 Portfolio Possibilities Combining the Risk-Free Asset and Risky Portfolios on the Efficient Frontier

E(R port )

E( port )

Example: Please see example on page 234-235

The Market Portfolio

B ing d

ing w rro o

The Market Portfolio is a portfolio consisting of all assets available to investors, with each asset held in proportion to its market value relative to the total market value of all assets. Because portfolio M lies at the point of tangency, it has the highest portfolio possibility line. Everybody will want to invest in Portfolio M and borrow or lend to be somewhere on the CML. Therefore this portfolio must include ALL RISKY ASSETS portfolio in proportion to their market value

n Leis in equilibrium, all assets are included in this M Because the market
Because it contains all risky assets, it is a completely diversified portfolio.

RFR
Unsystematic risk
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The risk that is not formal and stemming from unhealthy competition like smuggling, monopoly, formation of trade blocks etc. is called unique risk or unsystematic risk. It is diversifiable. Systematic Risk The risk caused by the variability in all risky assets caused by macroeconomic variables is known as systematic risk. It can be measured by the standard deviation of returns of the market portfolio and can change over time. Only systematic risk remains in the market portfolio. Examples of Macroeconomic variables or Factors Affecting Systematic Risk Variability in growth of money supply Interest rate volatility Variability in industrial production corporate earnings cash flow

Diversification and the Elimination of Unsystematic Risk

All portfolios on the CML are perfectly positively correlated with each other and with the completely diversified market Portfolio M. A completely diversified portfolio would have a correlation with the market portfolio of +1.00 The purpose of diversification is to reduce the standard deviation of the total portfolio This assumes that imperfect correlations exist among securities As we add securities, we expect the average covariance for the portfolio to decline How many securities must we add to obtain a completely diversified portfolio depends on the observation of what happens as we increase the sample size of the portfolio by adding securities that have some positive correlation. Standard Deviation of Return

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Unsys

The CML and the Separation Theorem

The CML leads all investors to invest in the M portfolio. Individual investors should differ in position on the CML depending on risk preferences. How an investor gets to a point on the CML is based on financing decisions. Risk averse investors will lend part of the portfolio at the risk-free rate and invest the remainder in the market portfolio. Investors preferring more risk might borrow funds at the RFR and invest everything in the market portfolio. The decision of both investors is to invest in portfolio M along the CML (the investment decision). The decision to borrow or lend to obtain a point on the CML is a separate decision based on risk preferences (financing decision). Tobin refers to this separation of the investment decision from the financing decision known as the separation theorem.

E ( R port )

port
The Capital Asset Pricing Model: Expected Return and Risk
The existence of a risk-free asset resulted in deriving a capital market line (CML) that became the relevant frontier. An assets covariance with the market portfolio is the relevant risk measure. This can be used to determine an appropriate expected rate of return on a risky asset (CAPM). CAPM indicates what should be the expected or required rates of return on risky assets. This helps to value an asset by providing an appropriate discount rate to use in dividend valuation models Compare an estimated rate of return to the required rate of return implied by CAPM and identify whether it is overvalued or under valued.
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The Security Market Line (SML)

The line that reflects the combination of risk and return available on alternative investments is referred to as the Security Market Line (SML). The SML reflects the risk-return combinations available for all risky assets in the capital market at a given time. Investors would select investments that are consistent with their risk preferences: some would consider only low-risk investments, whereas others welcome high-risk investments. Beginning with an initial SML, three changes can occur: First: Individual investments can change positions on the SML, because of the changes in the perceived risk of the investments. Second: The slope of the SML can change because of a change in the attitudes of investors toward risk; and Third: The SML can experience a parallel shift due to a change in the RRFR or the expected rate of inflation-that is a change in the NRFR. The relevant risk measure for an individual risky asset is its covariance with the market portfolio (Covi,m) This is shown as the risk measure The return for the market portfolio should be consistent with its own risk, which is the covariance of the market with itself - or its variance: Exhibit 8.5 Graph of Security Market Line (SML)

E(R i )

Rm

2 m

Cov im

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The equation for the risk-return line is R - RFR E(R i ) = RFR + M 2 (Covi,M )

= RFR +

Cov i,M
2 M

(R M - RFR) Cov i, M
2 M

We then define

as beta

E(R i ) = RFR + i (R M - RFR)

Exhibit 8.6 Graph of SML with Normalized Systematic Risk

E(R i )

Rm

1.0

Beta(Cov im/ 2 )
M

Negative Beta RFR

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Determining the Expected Rate of Return for a Risky Asset

E(R i ) = RFR + i (R M - RFR)

The expected rate of return of a risk asset is determined by the RFR plus a risk premium for the individual asset The risk premium is determined by the systematic risk of the asset (beta) and the prevailing market risk premium (RM-RFR)

Stock A B C D E Assume:

Beta 0.70 1.00 1.15 1.40 -0.30 RFR = 5% (0.05), RM = 9% (0.09)

Implied market risk premium =

E(R i ) = RFR + i (R M - RFR)

4% (0.04)

E(RA) = 0.05 + 0.70 (0.09-0.05) = 0.078 = 7.8% E(RB) = 0.05 + 1.00 (0.09-0.05) = 0.090 = 09.0% E(RC) = 0.05 + 1.15 (0.09-0.05) = 0.096 = 09.6% E(RD) = 0.05 + 1.40 (0.09-0.05) = 0.106 = 10.6% E(RE) = 0.05 + -0.30 (0.09-0.05) = 0.038 = 03.8%

Identifying Undervalued and Overvalued Assets

Compare the required rate of return to the expected rate of return for a specific risky asset using the SML over a specific investment horizon to determine if it is an appropriate investment Independent estimates of return for the securities provide price and dividend outlooks

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Exhibit 8.7 : Price, Dividend, and Rate of Return Estimates Current Expected Expected Stock A B C D E Price (Pt) 25 40 33 64 50 Price (Pt=1) 26 42 37 66 53 Dividend (Dt=1) 1 0.5 1 1.1 0 Estimated Future Rate of Return (%) 8.00% 6.20% 15.15% 5.16% 6.00%

Exhibit 8.8 : Comparison of Required Rate of Return to Estimated Rate of Return Required Return Estimated Estimated Return Stock Beta E(Ri) Return minus E(Ri) Evaluation A 0.70 7.80% 8.00% 0.20% Properly Valued B 1.00 9.00% 6.20% -2.80% Overvalued C 1.15 9.60% 15.15% 5.55% Under Valued D 1.40 10.60% 5.16% -5.44% Overvalued E -0.30 3.80% 6.00% 2.20% Under Valued

Exhibit 8.9: Plot of Estimated Returns on SML Graph

E(R i )

Rm

1.0

Beta(Cov im/ 2 )
M

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Chapter 9 - Multifactor Models of Risk and Return

Arbitrage Pricing Theory (APT)
1. CAPM is criticized because of the difficulties in selecting a proxy for the market portfolio as a benchmark

2. An alternative pricing theory with fewer assumptions was developed: Arbitrage Pricing
Theory

Assumptions of CAPM that were not required by APT

APT does not assume A market portfolio that contains all risky assets, and is mean-variance efficient Normally distributed security returns

Quadratic utility function Three major assumptions: 1. Capital markets are perfectly competitive 2. Investors always prefer more wealth to less wealth with certainty

3. The stochastic process generating asset returns can be expressed as a linear function of a set
of K factors or indexes given by:
Ri = Ei + bi11 + bi 22 +... + bik k +i

For i = 1 to N where: Ri
Ei

= return on asset i during a specified time period = expected return for asset i = reaction in asset is returns to movements in a common factor k

bik

k = a common factor wit h a zero mean that influences the returns on all assets
i = a unique effect on asset is return tha t, by assumption , is completely
diversifia ble in large portfolios and has a mean of zero

N= number of assets Factors expected to have an impact on all assets: Inflation Growth in GNP Major political upheavals Changes in interest rates And many more.

Contrast with CAPM insistence that only beta is relevant

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bik determine how each asset reacts to this common factor

Each asset may be affected by growth in GNP, but the effects will differ In application of the theory, the factors are not identified Similar to the CAPM, the unique effects are independent and will be diversified away in a large portfolio APT assumes that, in equilibrium, the return on a zero-investment, zero-systematic-risk portfolio is zero when the unique effects are diversified away The expected return on any asset i (Ei) can be expressed as:

Where,

Ei = 0 + bi1 + 2bi 2 +... + k bik 1

[ [ 0 ] = the expectedreturn on an asset withzero systematicrisk where 0 = E0 ]

j = the risk premium related to each of the common factors - for example the risk premium
related to interest rate risk where j = E j E 0

bik = the pricing relationship between the risk premium and asset i - that is how responsive asset i is to this common factor k

Example of Two Stocks and a Two-Factor Model

1 = Changes in the rate of inflation. The risk premium related to this factor is 1 percent for every 1 % change in the rate (1 = .01)

2 = percent growth in real GNP. The average risk premium related to this factor is 2 % for every 1% change in the rate (2 = .02 )
0 = the rate of return on a zero - systematic - risk asset (zero beta : bik = 0) is 3 percent (0 = .03 )

bx1 = the response of asset X to changes in the rate of inflation is 0.50 (bx1 =.50 ) bx 2 = the response of asset X to changes in the growth rate of real GNP is 1.50 (bx 2 =1.50 )
by 2 =

the response of asset Y to changes in the growth rate of real GNP is 1.75 (by 2 =1.75 )

Ei = 0 + bi1 + 2bi 2 1

= .03 + (.01)bi1 = .065 = 6.5%

+ (.02)bi2

Ex = .03 + (.01)(0.50) + (.02)(1.50) Ey = .03 + (.01)(2.00) + (.02)(1.75) = .085 = 8.5%

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Chapter 11 - An Introduction to Security Valuation

Valuation Process
Two approaches 1. Top-down, three-step approach 2. Bottom-up, stock valuation, stock picking approach The difference between the two approaches is the perceived importance of economic and industry influence on individual firms and stocks Advocates of the top-down, three step approach believe that both the economy/market and the industry effect have a significant impact on the total returns for individual stocks. In contrast, those who employ the bottom-up, stock picking approach contend that it is possible to find stocks that are undervalued relative to their market price, and these stocks will provide superior returns regardless of the market and industry outlook. Why is a Three-Step Valuation Approach 1. General economic influences Decide how to allocate investment funds among countries, and within countries to bonds, stocks, and cash 2. Industry influences Determine which industries will prosper and which industries will suffer on a global basis and within countries 3. Company analysis Determine which companies in the selected industries will prosper and which stocks are undervalued Theory of Valuation The value of an asset is the present value of its expected returns You expect an asset to provide a stream of returns while you own it To convert this stream of returns to a value for the security, you must discount this stream at your required rate of return. To convert this stream of returns to a value for the security, you must discount this stream at your required rate of return This requires estimates of:
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The stream of expected returns, and The required rate of return on the investment

Stream of Expected Returns Form of returns Earnings Cash flows Dividends Interest payments Capital gains (increases in value)

Time pattern and growth rate of returns

Required Rate of Return Uncertainty of Return (cash flow) Determined by 1. Economys risk-free rate of return, plus 2. Expected rate of inflation during the holding period, plus 3. Risk premium determined by the uncertainty of returns Business risk; financial risk; liquidity risk; exchanger rate risk and country Investment Decision Process: A Comparison of Estimated Values and Market Prices You have to estimate the intrinsic value of the investment at your required rate of return and then compare this estimated intrinsic value to the prevailing market price. If Estimated Value > Market Price, Buy If Estimated Value < Market Price, Dont Buy Valuation of Bonds Example: in 2006, a $10,000 bond due in 2021 with 10% coupon will pay $500 every six months for its 15-year life Discount these payments at the investors required rate of return (if the risk-free rate is 7% and the investor requires a risk premium of 3%, then the required rate of return would be 10%)

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Valuation of Bonds Present value of the interest payments is an annuity for thirty periods at one-half the required rate of return: $500 x 15.3725 = $10,000 x .2314 = $7,686 $2,314 The present value of the principal is similarly discounted: Total value of bond at 10 percent = $10,000 Valuation of Preferred Stock Owner of preferred stock receives a promise to pay a stated dividend, usually quarterly, for perpetuity Since payments are only made after the firm meets its bond interest payments, there is more uncertainty of returns Tax treatment of dividends paid to corporations (80% tax-exempt) offsets the risk premium The value is simply the stated annual dividend divided by the required rate of return on preferred stock (kp)
V = Dividend kp

Assume a preferred stock has a $100 par value and a dividend of $8 a year and a required rate of return of 9 percent
V = $8 = $88 .89 .09

Given a market price, you can derive its promised yield At a market price of $85, this preferred stock yield would be Kp = $8/85 = 0.0941 or 9.41%

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Valuation Approaches and Specific Techniques

Approaches to the Valuation of Common Stock The value of a share of common stock is the present value of all future dividends
Vj = =
t =1 n

D1 D2 D3 D + + + ... + 2 3 (1 + k ) (1 + k ) (1 + k ) (1 + k ) Dt (1 + k ) t

Where: Vj = value of common stock j Dt = dividend during time period t k = required rate of return on stock j Infinite Period DDM and Growth Companies Assumptions of DDM: 1. Dividends grow at a constant rate 2. The constant growth rate will continue for an infinite period 3. The required rate of return (k) is greater than the infinite growth rate (g) The Dividend Discount Model (DDM) 1. Constant Growth Model 2. Zero Growth Model 3. Temporary Supernormal Growth Model 1. P0 =
D1 D , 2. P0 = 1 k g k

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Example: Say, Do = $2, g = 5%, k = 14% Then, P0 =

D1 $2(1 + 0.05 ) = = $23 .33 k g 0.14 0.05

Again, if Do = $2, k = 14% D $2(1 + 0) = $14 .29 Then, P0 = 1 = k 0.14

3. Valuation with Temporary Supernormal Growth

Dividend Year Growth Rate 1-3: 25% 4-6: 20% 7-9: 15% 10 on: 9% The value equation becomes 2.00 (1.25 ) 2.00 (1.25 ) 2 2.00 (1.25 ) 3 2.00 (1.25 ) 3 (1.20 ) 2.00 (1.25 ) 3 (1.20 ) 2 Vi = + + + + 1.14 1.14 2 1.14 3 1.14 4 1.14 5 2.00 (1.25 ) 3 (1.20 ) 3 2.00 (1.25 ) 3 (1.20 ) 3 (1.15 ) 2.00 (1.25 ) 3 (1.20 ) 3 (1.15 ) 2 + + + 1.14 6 1.14 7 1.14 8 2.00 (1.25 ) 3 (1.20 ) 3 (1.15 ) 3 (1.09 ) 2.00 (1.25 ) 3 (1.20 ) 3 (1.15 ) 3 (. 14 .09 ) + + 9 1.14 (1.14 ) 9
Discount Factor 0.8772 0.7695 0.6750 0.5921 0.5194 0.4556 0.3996 0.3506 0.3075 0.3075b Growth Rate 25% 25% 25% 20% 20% 20% 15% 15% 15% 9%

Year 1 2 3 4 5 6 7 8 9 10

Dividend $ 2.50 3.13 3.91 4.69 5.63 6.76 7.77 8.94 10.28 11.21

Present Value $ $ $ $ $ $ $ $ $ 2.193 2.408 2.639 2.777 2.924 3.080 3.105 3.134 3.161

$ 224.20a

$ 68.943 $ 94.365

Value of dividend stream for year 10 and all future dividends, that is $11.21/(0.14 - 0.09) = $224.20 The discount factor is the ninth-year factor because the valuation of the remaining stream is made at the end of Year 9 to reflect the dividend in Year 10 and all future dividends.
b

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Relative Valuation Techniques

Value can be determined by comparing to similar stocks based on relative ratios Relevant variables include earnings, cash flow, book value, and sales Relative valuation ratios include price/earning; price/cash flow; price/book value and price/sales The most popular relative valuation technique is based on price to earnings This values the stock based on expected annual earnings The price earnings (P/E) ratio, or
Current Market Price

Earnings Multiplier Model

Earnings Multiplier = Expected 12 - Month Earnings The infinite-period dividend discount model indicates the variables that should determine the value of the P/E ratio, Pi =
D1 k g

Dividing both sides by expected earnings during the next 12 months (E1)
Pi D /E = 1 1 E1 k g

Thus, the P/E ratio is determined by 1. Expected dividend payout ratio 2. Required rate of return on the stock (k) 3. Expected growth rate of dividends (g) As an example, assume: Dividend payout = 50% Required return = 12% Expected growth = 8% D/E = .50; k = .12; g=.08

P/E =

.50 .12- .08 = .50/.04 = 12.5

Given current earnings of $2.00 and growth of 9% You would expect E1 to be $2.18 D/E = .50; k=.12; g=.09 P/E = 16.7 V = 16.7 x $2.18 = $36.41 Compare this estimated value to market price to decide if you should invest in it
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The Price-Cash Flow Ratio Companies can manipulate earnings Cash-flow is less prone to manipulation Cash-flow is important for fundamental valuation and in credit analysis
Pt CFt +1

P / CFi =

Where: P/CFj = the price/cash flow ratio for firm j Pt = the price of the stock in period t CFt+1 = expected cash low per share for firm j The Price-Book Value Ratio Widely used to measure bank values (most bank assets are liquid (bonds and commercial loans) Fama and French study indicated inverse relationship between P/BV ratios and excess return for a cross section of stocks
P / BV j = Pt BVt +1

Where: P/BVj = the price/book value for firm j Pt = the end of year stock price for firm j BVt+1 = the estimated end of year book value per share for firm j The Price-Sales Ratio Strong, consistent growth rate is a requirement of a growth company Sales is subject to less manipulation than other financial data

P P = t S S t +1

Where:
Pj Sj = price to sales ratio for firm j

Pt = end of year stock price for firm j S t +1 = annual sales per share for firm j during Year t

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Determinants of Required Rates of Return(k)

Pure Time value of money Expected rate of inflation Uncertainty of future payments

The real risk-free rate (RFR)

The real risk-free rate, also called pure time value of money, is the basic interest rate, assuming no inflation and no uncertainty about future cash flows. Economists tend to believe that there is a positive relationship between the real The real risk-free rate is widely believed that it changes only gradually (so it is Factors: Expected rate of inflation Monetary environment or Conditions in the Capital Market. growth rate in the economy and the real risk-free rate. quite stable) over the long term.

Nominal RFR
The risk-free rate that we observe in the market, e.g., annualized 1-month T-bill rate, is called the nominal risk-free rate. This nominal rate is an aggregation of the real rate and expected inflation rate. It is not stable over the long term. Two other factors influence the nominal rate: (1) the relative ease of tightness

in the capital markets, and (2) changes in the expected rate of inflation. Nominal RFR Real RFR = (1+Real RFR) x (1+Expected Rate of Inflation) - 1

(1 + Nominal RFR) (1 + Rate of Inflation) 1

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Risk premium:
an expected return in excess of that on risk-free securities = expected return nominal riskfree rate

Components of Risk Premium:

1. Business risk : The risk that a company will not have sufficient cash flows to meet the operating expenses. 2. Financial risk: The risk that a company will not have sufficient cash flows to meet the financial obligations. 3. Liquidity risk: The risk stemming from the lack of marketability of an investment that cannot be bought or sold quickly enough to prevent or minimize a loss. 4. Exchange rate risk: The risk of an investments value changing due to changes in currency exchange rate. 5. Country risk: The risk that an investment return could suffer as a result of political changes or instability in a county. Instability affecting investment returns could stem from a change in government, legislative bodies, other policy makers, or military control. Also known as political risk. Expected Growth Rate Estimating growth from fundamentals Determined by the growth of earnings the proportion of earnings paid in dividends

In the short run, dividends can grow at a different rate than earnings due to changes in the payout ratio Earnings growth is also affected by compounding of earnings retention = RR x ROE

g = (Retention Rate) x (Return on Equity)

Breakdown of ROE
N Incom et e Sales Total A ssets Sales Total A ssets Com on Equity m = Profit M argin X Total A sset Turnover X Financial Leverage RO = E =

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Chapter 14 Industry Analysis

Why Do Industry Analysis?
Investment practitioners perform industry analysis because

They believe it helps to find profitable investment opportunities that have favorable riskreturn characteristics. It is a part of the three-step, top-down plan for valuing individual companies and selecting stocks for a portfolio. What Do We Learn from Industry Analysis? The following set of questions designed to pinpoint the benefits and limitations of industry analysis:

Is there a difference between the returns for alternative industries during specific time periods? Will an industry that performs well in one period continue to perform well in the future? That is, can we use past relationships between the market and an individual industry to predict future trends for the industry?

Do firms within an industry show consistent performance over time? Is there a difference in the risk for alternative industries? Does the risk for individual industries vary or does it remain relatively constant over time?

Industry Performance
Studies of the annual performance by numerous industries found that different industries have consistently shown

wide dispersion in rates of return in different industries

Performance varies from year to year Company performance varies within industries Risks vary widely by industry but are fairly stable over time The results imply that industry analysis is important and necessary to uncover the substantial performance differences-that is it helps identify both unprofitable and profitable opportunities.

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The Business Cycle and Industry Sectors

Economic trends can and do affect industry performance By identifying and monitoring key assumptions and variables, we can monitor the economy and gauge the implications of new information on our economic outlook and industry analysis Economic trends can take two basic forms: Cyclical Change or Structural Change Cyclical changes in the economy arise from the ups and downs of the business cycle Structure changes occur when the economy undergoes a major change in organization or how it functions Switching from one industry group to another over the course of a business cycle is known as Rotation Strategy. Economic Variables and Different Industries Inflation Interest Rates International Economics Consumer Sentiment

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Inflation:
Higher inflation is generally negative for the stock market, because It causes high market interest rates It increases uncertainty about future prices and costs, and It harms farms that cannot pass through their cost increases. Exception: Natural resource industries benefit if their production cost do not rise with inflation. Industries with high operating leverage may benefit because many of their costs are fixed in normal terms whereas revenues increase with inflation. Industries with high financial leverage may also gain, because their debts are repaid in cheaper currency.

Interest Rates:
Financial Institutions including banks are typically adversely impacted by higher interest rates because They find it difficult to pass on these higher rates to customers. High interest rates harm the housing and construction industry, BUT They might benefit industries that supply do-it-yourselfer. High interest rates also benefit retirees whose income is dependant on interest income.

International Economics
Economic growth in world regions or specific countries benefits industries that have a large presence in those areas. The creation of EC and NAFTA assist industries that produce goods and services that previously faced quotas or tariffs in partner countries.

Consumer Sentiment
Because it comprises about two-thirds of GDP, consumption spending has a large impact on the economy. Optimistic consumers are willing to spend and borrow money for expensive goods. Therefore, the performance of consumer cyclical industries will be affected by changes in consumer sentiment and by consumers willingness and ability to borrow and spend money.

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Structural Economic Changes and Alternative Industries

Influences other than the economy are the part of the business environment. Social Influences Demographics Lifestyles

Technology Politics and regulations Economic reasoning Fairness Regulatory changes affect numerous industries Regulations affect international commerce

The above mentioned influences can have a significant effect on the cash flow and risk prospects of different industries.

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Chapter 16 Technical Analysis

Underlying Assumptions of Technical Analysis
1. The market value of any good or service is determined solely by the interaction of supply and demand 2. Supply and demand are governed by numerous factors, both rational and irrational 3. Disregarding minor fluctuations, the prices for individual securities and the overall value of the market tend to move in trends, which persist for appreciable lengths of time 4. Prevailing trends change in reaction to shifts in supply and demand relationships and these shifts can be detected in the action of the market

Advantages of Technical Analysis

A major advantage of technical analysis is that it is not heavily dependent on financial accounting statements. Problems with accounting statements: 1. Lack information needed by security analysts 2. GAAP allows firms to select reporting procedures, resulting in difficulty comparing statements from two firms 3. Non-quantifiable factors do not show up in financial statements Fundamental analyst must process new information and quickly determine a new intrinsic value, but technical analyst merely has to recognize a movement to a new equilibrium Technicians trade when a move to a new equilibrium is underway but a fundamental analyst finds undervalued securities that may not adjust their prices as quickly

Challenges to Technical Analysis

Assumptions of Technical Analysis trends Technical Trading rules The past may not be repeated Patterns may become self-fulfilling prophecies A successful rule will gain followers and become less successful Rules require a great deal of subjective judgment
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Empirical tests of Efficient Market Hypothesis (EMH) show that prices do not move in

Technical Trading Rules and Indicators

Stock cycles typically go through a peak and trough Analyze the following chart of a typical stock price cycle and we will show a rising trend channel, a flat trend channel, a declining trend channel, and indications of when a technical analyst would want to trade

Stock
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Chapter 17 Equity Portfolio Management Strategies

Passive versus Active Management
Passive equity portfolio management Long-term buy-and-hold strategy Usually tracks an index over time Designed to match market performance Manager is judged on how well they track the target index Attempts to outperform a passive benchmark portfolio on a risk-adjusted basis

Active equity portfolio management

An Overview of Passive Equity Portfolio Management Strategies

Replicate the performance of an index May slightly under perform the target index due to fees and commissions Costs of active management (1 to 2 percent) are hard to overcome in risk-adjusted performance Many different market indexes are used for tracking portfolios

Index Portfolio Strategy Construction Techniques

Full replication Sampling Quadratic optimization or programming

Full Replication All securities in the index are purchased in proportion to weights in the index This helps ensure close tracking Increases transaction costs, particularly with dividend reinvestment

Sampling Buys a representative sample of stocks in the benchmark index according to their weights in the index Fewer stocks means lower commissions Reinvestment of dividends is less difficult Will not track the index as closely, so there will be some tracking error

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Expected tracking error between the S&P 500 index and portfolio samples of less than 500 Stocks

Quadratic Optimization (or programming techniques): Historical information on price changes and correlations between securities are input into a computer program that determines the composition of a portfolio that will minimize tracking error with the benchmark This relies on historical correlations, which may change over time, leading to failure to track the index.

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E E