McMaster University

Commerce 3FD3: Financial Modelling

Week 3
Amortization Basics

TVM equations are nice, but I’m … not so hot at math.

Is there not something simpler?

We can use an amortization table.

We demonstrate in tabular form, that if you make the required payments as they come
due, the loan balance will amortize to zero as at the loan maturity date.

The mechanics of an amortization table

An amortization table is a mechanical reconciliation of a loan balance over time. It starts
with the amount borrowed on day-1, and ends with a ‘zero’ loan balance as at the
maturity date. Along the way it shows the periodic loan payments, the amount of
principal and interest that will be paid, and the outstanding loan balance reducing by the
amount of principal repaid.

The general form of an amortization table is as below:

Example: A 4-year $100,000 loan at 5%, with a year-end loan payment of $28,201

In most nations, by law, a lender must provide the borrower with an amortization table
every time any kind of fixed-rate term loan (ie: a fixed-rate mortgage) is extended. The
exceptions are if the loan interest is floating-rate, or if the loan has a ‘revolving’ term (ie:
line of credit) - as an amortization table cannot be calculated under these
circumstances.

The advantage of an amortization table is that the borrower need not have an
understanding of the time value of money. As a result, a great many more people can
borrow money with confidence, than might otherwise be the case.

Designer amortization possibilities

A lenders business is loan generation/collection, but not everyone wants to make the
same payment throughout the life of the loan, or at the same rate of interest.
 A real-estate developer may prefer a loan that better matches a project expected
cashflow; zero payments but higher interest while the project is under
construction, then high payments and a low interest rate once completed units
are in the process of being sold.

Source: Martin Butcher, MBA, CPA, FCSI

Financial Analysis and Modeling 2nd Edition, Chandan Sengupta, Chapter 14
 McMaster University
Commerce 3FD3: Financial Modelling
 A new vehicle purchaser may prefer a loan with higher payments and low
interest in the early years, so that the smaller loan balance more closely
matches the market value of the vehicle over time.

Model 6 shows how we might accommodate a change in interest rate, should we wish
to do so. Model 7 shows how we might accommodate a change in payment. A material
value-add if we are lending to either the developer or new car markets.

Data validation, goal seek, and custom formatting.

All good models will use color coded input cells that the user keys some kind of value
into. We use data validation to prevent the user keying in a cell value outside of a
certain range, or a specified parameter. Keying in a wrong value results in an error
message being displayed, and an instruction to key in something within the permissible
range.
 To use data validation, go to the data tab in MS Excel. Go to data tools, click on
the cell you want to validate, and click on data validation. Go to settings, and
click on allow. Click on any of the possibilities and follow the displayed
instructions.

The secret to amortization tables is to build a working table first, then use ‘goal seek’ to
determine the payment necessary to make the amortization table go to zero. ‘Goal seek’
will not work, if the table is either incomplete, or not working.
 To use ‘goal seek’, go to the data tab in MS Excel. Go to forecast, go to what if,
click on goal seek, and follow instructions. Set your closing loan balance cell to
equal zero, by changing your first payment cell; and click OK. MS Excel will go
through a number of loops, and ultimately populate your payment cell with the
correct value.

All good models will accommodate tables up to their maximum possible size (eg: 25-
year mortgage with a monthly payment, or 300 [25 x 12 months] lines of data). But if the
required table is less than the maximum possible size (eg: 5-year mortgage with a
monthly payment, or 60 [5 x 12 months] lines of data) …. lines 61 through 300 of the
table will display a value of zero; correct - but unsightly. We can make the table more
visually pleasing, by using custom formats.
 To use custom formatting, go to the home tab in MS Excel. Go to number, click
on the range of cells you want to format, and click on custom. Select any of the
listed possibilities, and click OK.

Source: Martin Butcher, MBA, CPA, FCSI

Financial Analysis and Modeling 2nd Edition, Chandan Sengupta, Chapter 14
 McMaster University
Commerce 3FD3: Financial Modelling

Week 2
Annuity Basics

The basic formulas of annuities FV=PV*(1+i)^N

The proverb ‘The bird in the hand is worth two in the bush” is a simplified general truth,
which recognizes that a dollar today is worth more than a dollar tomorrow.
 In some circles, the proverb is thought to date back until at least 1202 when
Fibonacci (inventor of the Fibonacci sequence) documented the concept in Liber
Abaci (1202).
 The concept was codified into today’s formulas by Irving Fisher in his 1907
theory ‘The Rate of Interest”.

Fisher’s Time Value of Money (TMV) equation is the basic equation that underlies
everything we do with annuities. It is expressed as FV=PV(1+i)^N, where;
PV = Present Value (The bird in the hand)
FV = Future Value (The two birds in the bush)
i = Annual Interest Rate
N = Time in years

An annuity is simply a series of identical payments (ie: $100) made over a specified
number of periods. If the payment is made at the beginning of the period, as in a lease,
we refer to the annuity as an ‘annuity in advance’. If the payment is made at the end of
the period, as in a loan, we refer to the annuity as an ‘annuity in arrears’. Each type of
annuity is a different equation.

We can make the future payments grow (bigger or smaller) at a constant rate, through
simple formula modifications. We can accommodate more frequent payment (ie: $500
every 6 months versus $1,000 once/year), by dividing the payment by two, the Annual
Interest Rate by two, and multiplying the number of periods by 2.
 A $1,000 annual payment discounted at 5% for 10 years, becomes a $500
payment discounted at 2.5%/period for 20 periods.

Chapter 14 of the textbook outlines the basic annuity formulas. For ease of reference I
have added them to the back of this document as an Appendix.

The annuity formula in a calculator, and MS Excel, are the same.

The purpose of this week’s lab is to start you working in your groups; and for you to
build a model that proves the formula in your ‘finance’ calculator (HP12C, TI-BAII) are
the same as those in the finance functions of MS Excel. You will do this by calculating
the values as per the Fisher formula, and comparing them to the values obtained by
using the finance functions.

Source: Martin Butcher, MBA, CPA, FCSI

Financial Analysis and Modeling 2nd Edition, Chandan Sengupta, Chapter 14
 McMaster University
Commerce 3FD3: Financial Modelling

Use custom tables to get around formula restrictions.

This week’s lab will also require you to prove that the values as per your custom table,
are the same as those you would get using your ‘finance’ calculator, or the finance
functions of MS Excel. The reason for the comparison, is to prove that your custom
table works.

Streams of same sized payments, or payments growing at constant rates, are extremely
restrictive. What if we do not have orderly payment streams that the formula can use?
We use a custom table.
 As you have proved that your custom table produces identical results to the
formulas (when payments meet the same parameters), you know that it works.
 Now put different payment values into your custom table. You get a PV or FV
that you know is correct, but which the calculator, or MS Excel finance functions
could not calculate. Very powerful ‘value add’.

Source: Martin Butcher, MBA, CPA, FCSI

Financial Analysis and Modeling 2nd Edition, Chandan Sengupta, Chapter 14
 McMaster University
Commerce 3FD3: Financial Modelling

APPENDIX FORMULA

The present value of a constant annuity (PVC 0) in arrears is:

PVC0 = A ((1-(1/(1+r)^n))/r)

The future value of a constant annuity (FVC n) in arrears is:

FVCn = A (((1+r)^n)-1)/r)

The present value of a constant annuity (PVC 0) in advance is:

PVC0 = A (1+r)((1-(1/(1+r)^n))/r)

The future value of a constant annuity in advance is:

FVCn = A (1+r)(((1+r)^n)-1)/r)

The present value of a growing annuity (PVG0) in arrears is:

PVG0 = A(1+g)((1-(((1+g)/(1+r))^n)/(r-g))

The future value of a growing annuity (FVG n) in arrears is:

FVGn = A(1+g)(((1+r)^n-(1+g)^n)/(r-g))

The present value of a growing annuity (PVG0) in advance is:

PVG0 = A(1+r)((1-(((1+g)/(1+r))^n)/(r-g))

The future value of a growing annuity in advance is:

FVGn = A(1+r)(1+g)(((1+r)^n-(1+g)^n)/(r-g))

Source: Martin Butcher, MBA, CPA, FCSI

Financial Analysis and Modeling 2nd Edition, Chandan Sengupta, Chapter 14
 McMaster University
Commerce 3FD3: Financial Modelling

Week 8
Chapter 17_Bond Research

The biggest capital market in Canada is the bond market.

During 2018, $C Billion 230 of debt was issued in 5 categories:
 $C Billion 99.9 of corporate debt (43%)
 $C Billion 1.8 of high yield debt (1%),
 $C Billion 9.0 of maple debt (4%),
 $C Billion 6.3 of green bonds (3%)
 $C Billion 113.0 of government debt (49%)

Prior to building any type of financial model, a modeler needs to do research to see if
there is any theory or industry practice relevant to what he/she plans to build. In this
case, academic literature for information on bonds; Google, and the MS Excel ‘help’ for
information on how to build ‘spinner’ controls.

The modeler then needs to apply the research to the problem at hand, map out how to
build the model, and decide upon whether it makes sense or not to use Visual Basic on
portions of the model. You do not have to build the whole model in VBA.

What is a bond?

A bond is simply a contractual obligation issued under a ‘bond indenture’.

In return for an upfront cash payment today, the bond issuer agrees to pay $X back in N
years, and $Y of interest every year, on specific dates.

Every bond issued under the ‘bond indenture’ will specify the face value ($X), the
maturity date, and the coupon rate.

The face value of the bond, times the coupon rate, equals the ($Y) of total interest that
the bond will be pay every year until the maturity date. This total coupon interest could
be paid once a year, as an annual payment; or as two semi-annual payments – each
consisting of half the total interest owed.

Bonds are normally denominated in face values of either $100, or $1000. Asian bonds
are typically denominated in 10,000 units of local currency; the major currencies being
either Yen (Japan) or Renminbi (China)

Bond features?

The bond issuer may add a number of features to the bond, to either make the bond
more marketable, or reduce the amount of annual coupon interest that must be
paid.

Source: Martin Butcher, MBA, CPA, FCSI

Financial Analysis and Modeling 2nd Edition, Chandan Sengupta, Chapter 17
 McMaster University
Commerce 3FD3: Financial Modelling
 A bond with a high coupon rate tends to be less sensitive to a change in
interest rates (convexity), and will appeal to certain segments of the bond
market.
 A bond issuer with a poor credit rating may add a periodic bond redemption
feature (sinking fund), requiring the issuer to repurchase a specified quantity of
the outstanding bonds, as at pre-specified dates.
 A bond issuer with only a temporary need for the funds may add a call feature
(callable), that enables the issuer to prematurely repurchase ALL the
outstanding bonds, at a specified premium, as at a pre-determined date.

Relationship between interest rate and bond price

Bond price is inversely related to change in interest rate.

 This means that if the market rate of interest (YTM) increases, the price of the
bond will fall. If the market rate of interest (YTM) falls, the price of the bond will
rise. If the market rate of interest (YTM) is equal to the coupon rate, the bond will
trade at ‘par’ or its face value ($100, $1000, etc.).
 McCauley Duration (duration) is a measure of how many years it will take for
coupon payments invested at the now different YTM, to recover the immediate
gain or loss in the price of the bond, that resulted from the change in YTM.
Essentially, how long in years, will it take to get your money back.

The current price of a bond may be determined using the PV function of MS Excel. The
future price of a bond may be similarly determined, using the FV function of MS Excel.
 To determine current price, substitute into the PV function today’s market
Interest rate (YTM) for ‘i’, the remaining time to maturity as ‘N”, the coupon rate
for ‘payment’, and face value for ‘FV’.
 To determine future price, substitute into the FV function today’s market Interest
rate (YTM) for ‘i’, the remaining holding period for ‘N”, the coupon amount for
‘payment’, and 0 for ‘PV’. Add to it the PV function and substitute today’s market
Interest rate (YTM) for ‘i’, the remaining time to maturity minus the investment
horizon for ‘N”, the coupon rate times the face value for ‘payment’, and face
value for ‘FV’)
 The duration of the bond may be determined by using the DURATION function of
MS Excel

What is bond immunization?

To immunize a bond is to protect the market value of the bond from a change in the
market rate of interest. When applied correctly, the market value of the bond will no
change with a change in the market interest rate.

There are three major techniques that can be used to immunize a bond; cash-flow
matching, convexity matching, or duration matching. For Assignment #3 we will be using
duration matching.

Source: Martin Butcher, MBA, CPA, FCSI

Financial Analysis and Modeling 2nd Edition, Chandan Sengupta, Chapter 17
 McMaster University
Commerce 3FD3: Financial Modelling
To immunize a bond portfolio, the user must make the duration of the bond portfolio
equal to the investment horizon of the portfolio. This ensures that if there is a one-time
significant increase in the market interest rate, the day after the bonds are purchased;
the immediate loss in the value of the bonds will have been fully recovered by the time
the portfolio reaches its investment horizon. And is liquidated.

The weakness with duration matching is that the portfolio must be periodically re-
balanced, as the remaining investment horizon declines to zero. If the portfolio is NOT
re-balanced, the portfolio loss to a rise in the market rate of interest will NOT have been
fully recovered by the time the portfolio is liquidated.

Applying this to Assignment #3?

To apply the above, groups will need to:

 Specify the inputs for each of two bonds, as well as the investment horizon and
future value requirements of the portfolio itself.
 Determine both the duration and the current and future prices of each bond,
using todays 6% YTM.
 Determine the number of each bond that would be required were the $20 million
portfolio to consist entirely, of just that one bond.
 Include a spinner mechanism by which to change the weighting of the bonds and
calculate portfolio duration.
 Recognize that the portfolio is immunized when the portfolio duration is equal to
the investment horizon.
 Recognize that the sum of the PV of the portfolio, at the bond weightings than
immunize the portfolio, will be the cost of the portfolio today.
 Recognize that to demonstrate immunization, there will need to be a graphical
plot of future value versus YTM. When the portfolio is immunized, the actual
value will intersect with target value at the current 6% YTM.

Exactly as we saw in the sample Assignment 3 assignment.

Source: Martin Butcher, MBA, CPA, FCSI

Financial Analysis and Modeling 2nd Edition, Chandan Sengupta, Chapter 17
 McMaster University
Commerce 3FD3: Financial Modelling

Week 5
Chapter 14_Model 4_VBA Details

Everything that you can write in VBA, can be done in ‘Python’; the coding language of
choice for the blockchain smart-contract applications of both fintech and robotics. A
material ‘value-add’ if you see yourself working as a financial analyst at some point.

VBA looks complicated, but is actually very logical.

Follow the rules, and you should have few difficulties.

The below detail should be read in conjunction with Ch 14_Model 4_VBA MS Excel file
posted in this week’s folder.
 Please open the Ch 14_Model 4_VBA MS Excel file and click on the ‘Enable
Content’ button.
 Notice that the worksheet consists of an inputs section, the inputs are data
validated, and there is documentation as to what the parameters are. To run this
model, change any of the variables within their given range, and press Ctrl+y.
 Change the loan amount to $250,000, and press Ctrl+y. The model fails to run,
tells you there is a ‘compile’ error, and returns you to the macro page; click Ok.
Close the Ch 14_Model 4_VBA MS Excel file without saving, open the Ch
14_Model 4_VBA_Corrected MS Excel file, click on Enable Content.
 Change loan life to 10.5 years and press Ctrl+y. The loan does not amortize to
zero – indicating a model failure. Change loan life back to 10 years and press
Ctrl+y.
 Notice that the values in the ‘Year, ‘Year-beg Balance’, ‘Annual Payment’,
‘Interest Component’, ‘Principal Repaid’, and ‘Year-end Balance’ are all
populated from the VBA macro.
o Click on any one of cells C9 through cell H18. When you did this as a MS
Excel model you had to use complicated programing, that was visible to a
reviewer; here there is just a number – placed there by a macro.
o To gain comfort that these macro generated numbers are correct, the
reviewer has to see the whole amortization table, see that the annual
payment is the same, and that the year10 year-end balance ends at zero.
If any one of these things are not occurring, the reviewer would have no
confidence in the model. Hence to be believed, the VBA model has to be
perfect.
o If the macro is not perfect; the reviewer has to look at the VBA
programing, attempt to isolate the code error, debug, and check if the
rerun output now gives the expected result. If the macro is not adequately
documented, and the reviewer does not know what the end-result should
look like, this would be an extremely frustrating process. Hence in
practice there is reluctance to use VBA, despite its many advantages.

Source: Martin Butcher, MBA, CPA, FCSI

Financial Analysis and Modeling 2nd Edition, Chandan Sengupta, Chapter 22
 McMaster University
Commerce 3FD3: Financial Modelling

Please click on the ‘developer’ tab, and then the ‘visual basic’ tab. This is the coding for
the model, that is printed on pages 514-515 of the textbook. Rather than build the model
from scratch, and inadvertently create a Visual Basic course, we will analyze what the
existing model does.
 An MS Excel worksheet was populated as per cells A1 through D4. Cells B2
through B4 were also data validated to ensure that inputs could not exceed
prescribed parameters. Amortization is populated as per the macro we are
reviewing.
 Lines 1-8: The coder has created a sub-routine called ‘loan_amortization’,
documented what it does, and that to ‘run’ this macro the user must use ‘Ctrl+y’.
Documentation in VBA is achieved by putting an apostrophe before your
comment.
 Lines 10-13. The coder is naming the variables that the VBA macro will use;
some of which will be input by the user in cells B2 through B4. Variable naming
in VBA is done through use of a Dim statement, and you will be expected to tell
me what these Dim variables stand for when documenting your assignment
submission.
 Lines 15-17, 27-29, 42-44, 69-71. The coder is breaking up the VBA program
into easy to find (& debug) sections. While the practice helps when ‘debugging’,
how it is done is personal preference.
 Lines 18-26. The coder is telling VBA to put a specific value into the Dim
statement variable outRow, and output into a specific worksheet called ‘Loan
Amort’. VBA will then use the current values in the ‘Loan Amort’ worksheet for all
future calculations, and clear the current values in rows 8 through 105 of the
‘Loan Amort’ worksheet.
 Lines 30-41. The coder is telling VBA to read the input data from intRate,
loanLife, and initLoanAmnt. In this program VBA, cell (2,2) means the value in
Row 2, Column 2 of the ‘Loan Amort’ worksheet. The coder then uses an IF
statement to check that the interest rate in the intRate variable is less than 15%;
and display the message Interest rate cannot be greater than 15%, if that value
exceeds 15%. Had the intRate variable been validated, this coding could have
been ignored.
 Lines 46-49. The coder is telling VBA to calculate the loan payment using the
Pmt in MS Excel and store the value in a new variable called annualPmnt. The
coder then tells VBA to create a 2nd new variable called yrBegBal and populate it
with the value in initLoanAmnt.
 Lines 52-67.
o The coder is telling VBA to repeat calculations using a loop. The ‘For’
statement is the counter, and specifies a row count of 1 through to the
end of the loan life. For each row Interest is calculated as the beginning
loan balance times the interest rate, principal repayment is calculated as
annualPmnt less the interest owed, and the ending loan balance is
calculated as the beginning loan balance less the principal repayment.
o The coder then tells VBA to write out the values of selected variables into
specific locations in the active worksheet which is ‘Loan Amort’. As

Source: Martin Butcher, MBA, CPA, FCSI

Financial Analysis and Modeling 2nd Edition, Chandan Sengupta, Chapter 22
 McMaster University
Commerce 3FD3: Financial Modelling
rowNum increments by 1 every time VBA repeats the calculation, the
result will be a table.
o Finally, the coder then tells VBA to reset the beginning balance for next
year equal to the year end balance for the current year, and ends the
loop.
 Lines 72-76. The coder is telling VBA the range of cells to format, format as
currency with zero decimal places ($#,##$), and end the macro.

Close the Ch 14_Model 4_VBA_Corrected MS Excel file, re-open the Ch 14_Model

4_VBA MS Excel file, click on Enable Content, change the loan amount to $250,000,
and press Ctrl+y. We are back to the compile error, and ready to ‘de-bug’.
 Click OK and look at the coding; on line 78 the code vba. is highlighted in red,
and the line 1 Sub Loan Amortization () highlighted in yellow. This indicates that
the compile error is in the Sub Loan Amortization () procedure – and that it is
related to the vba. line of code.
 Look at pages 514-515 of the textbook. The Sub Loan Amortization () procedure
should end with End Sub and there should not be a .vba line of code after it.
Delete the blank line and vba line of code below End, replace End with End Sub,
and save. Re-open the file, go to the Loan Amortization worksheet, change the
to $250,000, and press Ctrl+y. Your model should now work.

Your take-away from this model should be a high-level understanding as to how this
amortization model could have been programmed in VBA. You should also realize that
elements of this program could be ‘re-used’ in the Assignment #2 submission that you
are about to build!

Remember the time saving tips in the Week 1: Financial Modeling In The Investment
World document? Wherever possible, Refuse, Reduce, Reuse, Repurpose, Recycle.

Source: Martin Butcher, MBA, CPA, FCSI

Financial Analysis and Modeling 2nd Edition, Chandan Sengupta, Chapter 22
 McMaster University
Commerce 3FD3: Financial Modelling

Week 12
Chapter 18_29_Simulating Stock Prices

Anyone can posit a ‘theory’; but to test if it works – we need to turn it into an algorithm,
simulate the results against a time series of data, check the simulated results against
the expectation, and then conclude whether the theory is right or not.

Exactly as we will be doing with Assignment #6!

When we are pricing derivatives, we assume that while the second-to-second price of
the underlying reference asset is unpredictable; the random change in the price of the
reference asset follows a movement process similar to that observed in Geometric
Brownian Motion (GBM).
 Brownian motion itself is simply the random motion of particles suspended in
gasses and liquids that can be observed under a microscope. The value of GBM
to us, is that if we could model this motion via a series of equations, or
algorithms, we could those algorithms to generate a time series market
simulation.
o In our case, we will be using the algorithm to simulate the closing stock
market price of a security, over a 90-day period, 1,500 times.
o Were we engineers, we might use the algorithm to simulate the
development of metal fatigue in aircraft wings, or engines; over a series of
take-off and landing cycles.
 In 1905 Albert Einstein explained that the particles were being moved by
molecules; which begot particle theory, which begot the GBM equations that we
use in stock price simulation today.

The Geometric Brownian Motion (GBM) Model

As we are not nuclear scientists, we will only do a high-level review of GBM.

 GBM posits that over very short time intervals (ie: 1 nanosecond), we can say
with a high degree of conviction, that a particle will continue to move in the
direction that it is already traveling. We call this ‘drift’.
 As the number of time intervals increase, the particle will start to collide with
other particles traveling in different directions. As we have no idea how many
particle collisions there will be, or the direction that the other particles are
traveling in; the result is less confidence in the continuing direction of a particles
current ‘drift’, as the number of time intervals increase.
 If we permit a large number of time intervals (ie: 1 second); all that we can say
about the particle is that it will travel in an expected direction, but we cannot say
exactly where it will be. Convection tells us that were we were heating a gas; the
particle would be expected to travel from the hot zone to the cooler one.

Source: Martin Butcher, MBA, CPA, FCSI

Financial Analysis and Modeling 2nd Edition, Chandan Sengupta, Chapter 18,
29
 McMaster University
Commerce 3FD3: Financial Modelling

The key takeaways of GBM for market simulation purposes are;

 If we hold a stock for only very short periods, the more certain we can be that we
will capture the current price drift (price momentum) of the stock. If the stock
price is currently trending higher, we can theoretically expect to resell it at a
higher price. This is the main theoretical support for quantitative algorithmic high
frequency trading (HFT), and holding periods of no more than the micro-
seconds.
 The longer we hold the stock (ie: days versus micro-seconds), the more likely
than we will earn only the expected market return on the stock. Hence if the
market is expecting a negative return, we would lose money by not getting rid of
the stock quickly enough!

GBM as applied to stock market simulation, assumes the 5 below properties:

1. The security (stock) continuously and freely trades for different values.
a. The reality is that very few stocks are ‘inter-listed’ in sufficiently
geographically dispersed markets to permit 24-hour trading; most stocks
will cease trading for at least a part of the 24-hour clock. However, for
simplification purposes this is a reasonable assumption.

2. Markov process. Only the current price is relevant for predicting future prices,
the historic pricing record is irrelevant.
a. This is the weak form of efficient market theory, and is the underlying
basis for ‘Technical Analysis’. The process has more predictive power if
only short time intervals are considered.

3. Over very short periods (∆t) the return on the security (stock) is normally
distributed.
a. The theoretical basis for this is complex, but explained on p 430-431 of
the text. The key takeaways are that
i. the longer the hold period, the more variable the return becomes
ii. model return is the mean of the drift (µ), plus the standard
deviation.

4. The security (stock) price is lognormally distributed.

a. The theoretical basis for this is explained on p 432-433 of the text.
The key takeaways are that
i. the natural logarithm of prices is normally distributed
ii. the variability will be much less than it would be under a longer
hold period

Source: Martin Butcher, MBA, CPA, FCSI

Financial Analysis and Modeling 2nd Edition, Chandan Sengupta, Chapter 18,
29
 McMaster University
Commerce 3FD3: Financial Modelling

1. The continuously compounded return on the asset (stock) is normally distributed.

b. The theoretical basis for this is explained on p 434.
The key takeaways are that
i. the longer the holding period the more likely the investor will earn
the ‘expected return’
ii. the volatility of a stock is the standard deviation of its continuous
return over a 1-year period, and that the higher the volatility – the
riskier the stock is.

We can estimate the values for µ, k, and volatility from the equations on
p 434 – 436 of the text.

Reference model for Assignment #6

I would highly recommend that you use the Chapter 28, Model 4 as the starting point for
your Assignment #6. The GBM coding that drives the model, is visible in the VBA editor,
and lends itself to both re-cycling and re-purposing.

If you are not to sure as to the value of using GBM for randomization purposes, you will
still be able to deliver an assignment. However, just be sure that you can speak to GBM
in the final exam!

Source: Martin Butcher, MBA, CPA, FCSI

Financial Analysis and Modeling 2nd Edition, Chandan Sengupta, Chapter 18,
29
 McMaster University
Commerce 3FD3: Financial Modelling

Week 1
Financial Modelling Basics

Financial models have some basic attributes, and their presence (or lack of) will be part
of each assignment mark. Each of the financial models that you submit for grading must
be;

 Realistic. Models are used to make decisions, if the model does not produce
realistic outputs, it does not matter how good it looks.
 Documented. The information someone else will need to figure out what the
model does, how it is structured, what assumptions are built in, etc. There is no
standard format.
 Data validated. Filtered for the more likely errors in data input
 Error-free. An error-free model is evidence that you have systematically
executed a de-bugging process.
 Flexible. To maximize flexibility the model has to cover a range of inputs, and
most often through a series of data tables.
 Easy to use. Clear description of what the model does, how to use it, clustering
and color coding of input data, and clear labelling.
 Appropriate formatting. Minimum number of decimal points, uniform formatting
throughout the model and as little as possible, display in thousands or millions.
 Minimum hard coding. Wherever possible, values in formulas set up as inputs.
 Well organized. Clustered inputs and outputs, different analysis in different
worksheets, good titles, headings and labels.
 Produce good output. User generated built in reporting. Un-cluttered, easy-to-
read, layered, and inclusive of charts wherever appropriate.

Model documentation is an art form and the bigger and more complex a model; the
more likely the requirement for a book of formal documentation, and/or a user manual.
In this course you will not be required to produce either of these, but you will be required
to document;

 Assumptions, inputs, outputs. Single worksheet model, all assumptions,

inputs, and outputs clustered in one clearly labelled color-coded area.
 Cell comments. Inserted only as needed, and in places where updating is
unlikely to be required.
 Model description. Label called ‘Model Description’. Paragraph describing what
the model does, how it should run, what theory it is based on, what external files
it needs to access.
 Version description. Not required for Commerce 3FD3 as we will not be
developing large models in various versions.

Source: Martin Butcher, MBA, CPA, FCSI

Financial Analysis and Modeling 2nd Edition, Chandan Sengupta, Chapters
12,13
 McMaster University
Commerce 3FD3: Financial Modelling

De-bugging gets easier and faster with experience, but you must be systematic and
thorough. De-bugging is essentially a two-step process;
 Using Excel to find the obvious syntax formula errors, value errors, and spelling
mistakes; the software will suggest to you what is wrong.
 Correcting logic errors.
o You’ve programed formula incorrectly.
o You’ve used the wrong formula
o You’ve programmed a circular reference
o You’ve used wrong names or cell addresses

The most common type of financial model is pro-forma financial statements; used for
financial planning, capital adequacy testing, credit analysis, merger and acquisition
review, and business valuation. Typically, you will model an Income Statement, a
Statement of Financial Position, a Statement of Cash Flows, a Statement of Changes in
Equity, accompanying sensitivity tables, and key financial indicators.

In most cases this will be a 5-step process;

 Understanding the models expected uses and required outputs. Why is this
model being created? and what type of decisions will be made based on these
outputs?
 Collecting 3-5 years of historical data. On the company, the industry
benchmarks, and the major competitors. Useful to have an accounting
background, re financial footnotes.
 Understand the company plan. Develop a set of financial assumptions that will
enable you to forecast the relevant financial statement line items.
 Build the model and debug it. To maintain integrity, pay particular attention to
depreciation/amortization, retained earnings, interest expense, and sign
convention,
 Improve the model based on feedback. Typically, this will mean adding a
Statement of Cash Flows, calculating Free Cash Flow, and a Statement of
Changes in Equity.

Source: Martin Butcher, MBA, CPA, FCSI

Financial Analysis and Modeling 2nd Edition, Chandan Sengupta, Chapters
12,13
 McMaster University
Commerce 3FD3: Financial Modelling

Week 1:
Financial Modeling in The Investment World

The more that we move to the everyday use of blockchain, smart contracts, and
artificial intelligence; the MORE reliance we place on financial modelling.
All great for job security!

The purpose of a financial model in the Investment World is to answer the question, “If
we invest in this company, are we likely to hit our targeted Internal Rate of Return over
the next 3-5 years?” The valuation is used to justify an investment recommendation that
we should either go ‘long’ or ‘short’ on Company X.
 If Company X is undervalued. In the worst case there is a 50% chance of losing
10%, and a 50% chance of gaining 40%.
 If Company X is overvalued. In the best case there is a 50% chance of the share
price falling 40%, and a 50% chance of it rising 10%.

The typical modelling process is:

 Identify the 2-3 key value drivers of Company X: such as revenue growth,
EBIT/EBITDA margin, CapEx, etc.
 Gather historical financial and metrics data on Company X for trend purposes.
 Build a pro-forma financial model of Company X with these key drivers as your
inputs to the model. Statement of Changes in Financial Position, Income
Statement, and Statement of Changes in Equity over a 3-5-year period.
 Select public comparables and precedent transactions for Company X.
 Build a discounted cash flow analysis for Company X where you can vary the
discount rate, the terminal value, and the 2-3 key drivers you have identified.
 Summarize. “In the worst- case scenario, we expect a value of $XX per share,
and in the best-case scenario, we expect a value of $YY per share.”

The analyst’s objectives are to:

 Evidence key understanding of the Company X value drivers, and how Company
X makes money. The more short-term orientated the audience, the more
granular the required level of detail.
 Produce a timely predictive model for the least amount of effort. The guiding
principle is timeliness and ‘good enough’.
During earnings season you may have 4-5 models to develop/update each
week. If you plan to sleep, don’t focus on ‘pretty’.

The top mistakes that investment analysts make are as below.

 Bad marketing. Unclear and confusing recommendation.
 Winging It. Weak explanation of risk factors and mitigants.
 Don’t know. Cannot explain parts of the model, or the data used
 No confidence. Lack of energy and conviction.
You may be the best model builder in the world. But if you can’t ‘sell’ your
model to decision makers, you’re unemployable.

Source: Martin Butcher, MBA, CPA, FCSI

Mergers and Inquisition
 McMaster University
Commerce 3FD3: Financial Modelling

On-the-job tips that will save you time, are:

1. Refuse, Reduce, Reuse, Repurpose, Recycle. Refuse and reduce reliance on
other analysts’ projections and historical data. Reuse and repurpose company
financial statements provided in Excel. Recycle investor presentations, earnings call
transcripts, and primary vendor research. Your risk is that you cannot justify the
numbers used, therefore garbage in garbage out.
2. Use the CHOOSE and OFFSET functions in Excel. Apply it to the drivers and
make sure the downside case is a TRUE downside case. Where possible, get your
probability estimates from the option market.
3. Sniff test. A company that is in-line with its peers in terms of revenue growth and
margins but trades at a different multiple, must be either overvalued or undervalued.

Did you notice how close this is to the five-step modeling process?
1. Understand the models expected uses and required outputs
2. Collect 3-5 years of historic data
3. Understand the company plan
4. Build a model and debug it
5. Improve the model based on feedback.

Source: Martin Butcher, MBA, CPA, FCSI

Mergers and Inquisition
 McMaster University
Commerce 3FD3: Financial Modelling

Putting it all together

(courtesy, Mergers and Inquisition)

Recommendation: I recommend shorting Retailer X, which currently trades at $45.00

per share, because it’s overvalued vs. peers by approximately 20-25%, its key metrics
such as sales per square foot have been stagnant despite rising valuation multiples,
and the company has had increasingly poor transparency on many of these key metrics
over the past few years.

Catalysts to push down its stock price in the next 6 months include the expiration of key
reseller agreements with 3 of its top 10 vendors and the first earnings results post-
acquisition close of a smaller retailer last year. Investment risks include potentially
better-than-expected integrated company results, as well as faster-than-expected
market growth, but we could mitigate those by longing one of its competitors to reduce
potential losses from unexpected market growth.”

Company Background: Summary of the company’s business, key geographies and

customers, and what its current market cap, valuation multiples, and growth and
profitability are.

Investment Thesis: The company is overvalued by at least 20-25% vs. peers, but
consensus hasn’t “noticed” because the company has done a good job of obfuscating
key metrics and not disclosing its reliance on its top 5-10 vendors. Its recent acquisition
has also under-performed relative to expectations and the premium paid.

Catalysts: The upcoming renewal of key vendor contracts and the first earnings call
post-transaction-close could push down the company’s stock price as the market finally
notes its weaknesses.

Valuation: Even in an “Upside” scenario, with Sales per Square Foot and Total # Stores
increasing at a 5% premium to management’s expectations, the company is still
overvalued by approximately 5-10% vs. peers; and in the Base case and Downside
scenarios, which have been reduced from consensus estimates based on conversations
with vendors and suppliers, the company is overvalued by 15-25%. These results hold
for both public comps and the DCF analysis (paste in the model output).

Source: Martin Butcher, MBA, CPA, FCSI

Mergers and Inquisition
 Commerce 3FD3: Financial Modelling
‘How To’ create and use a Data Table

Courtesy: Tech Republic.com

https://www.techrepublic.com/blog/windows-and-office/create-an-excel-data-table-to-
compare-multiple-results/

A data table just evaluates a range of changing variables in a single formula.

Build the simple mortgage calculator shown below.

Suppose you want to compare the impact of changing interest rates, on monthly
payment, total payment, and total interest.
 Create the results cells
 Make cell E4 = B4-B5
 Make cell E5 = IFERROR(PMT(B7/12, B6*12,-B4--B5),0)
 Make cell E6 = IFERROR(E5*B6*12,0)
 Make cell E7 = IFERROR(E6-E4,0)
 Enter the data table's labels; make the first column your variable (interest rate).
 Make cell B11 = E5
 Make C11 = E6.
 Make D11 = E7

Source: Martin Butcher, MBA, CPA, FCSI

Mergers and Inquisition
 Commerce 3FD3: Financial Modelling
‘How To’ create and use a Data Table

Create the data table:

 Select the data table range. A11:D30.
 Data tab, What-If Analysis, Data Table option in the Forecast group.
 Enter B7, in the Column Input Cell (because the interest rate values are in a
column, versus a row). This is the input value Excel will change for each row in
the data table.
 Click OK.

Source: Martin Butcher, MBA, CPA, FCSI

Mergers and Inquisition
 Commerce 3FD3: Financial Modelling
‘How To’ create and use a Data Table

The resulting data table should look like the below.

Were we to use the What-If Analysis, Data Table option in Assignment #3, we could
generate a data table similar to the below – and use it to build the graph that
demonstrates portfolio immunization. Furthermore, as the results cells would also
change as we change bond weightings, the data table (& graph) would also
automatically change as we change bond weightings.

Our financial model now becomes both interactive, and dynamic.

Always good for impressing a future potential boss!

Source: Martin Butcher, MBA, CPA, FCSI

Mergers and Inquisition
 McMaster University
Commerce 3FD3: Financial Modelling

Week 4
Introduction to VBA

What makes you ‘special’ as a financial modeller, is your creativity … and your ability to
make it happen in VBA. Ability to use VBA is a valuable skill to have, so tell only the
interviewer, your ‘boss’, and very few others.
…. Or you will be programming for ‘everybody’, at no additional pay!

Finding VBA, and putting it on the ribbon.

For many of you, the immediate question will be

…… ‘Where do I even find this VBA ‘thing’ in MS Excel?

Open MS Excel and load the ‘Developer’ tab onto your ribbon. Upon successful
completion the ‘Developer’ tab will appear between the ‘View’ and ‘Help’ tabs on your
ribbon.
 Click on the ‘File’ tab, look at the bottom left corner, and click on ‘Options’.
 Look at the left-hand box and click on ‘Customize Ribbon;
 Look at the right-hand box and click on ‘Developer’.
 Click on the ‘OK’ tab in the bottom right corner.
 Close MS Excel and re-open it.

To use VBA, click on the ‘Developer’ tab, and click on the left-hand side ‘Visual Basic’
tab. This will take to the Visual Basic Editor (VBE), where you will be using the ‘Project
Explorer’ tab, ‘Insert’ and ‘Procedure’ tabs extensively.

The pro’s/con’s of using VBA.

There are three main reasons for learning VBA.

 Complex formulas can be made easy by breaking them into shorter formulas
and writing them using variables with descriptive names. This is a key principal
in programing robotics.
… think of each formula as a command to the robot to ‘do’ something (ie;
move right foot up 15 degrees, right foot down 15 degrees, left foot up
15%, etc.). Sequence the execution of these formulas in a particular order,
and you can make the robot ‘climb’ stairs.
 In VBA a formula usually appears just once. Hence when reusing formula, it is
much easier to detect inadvertent cell addressing from copying.
… the time constraints that a financial analyst typically works under,
means that the analyst must re-cycle, or re-purpose, existing models as
much as possible. Programing in VBA makes this both a lot easier, and a
lot more reliable.
 Step-by-step programing is much easier to follow in VBA than Excel.
… the reason WHY we document what we’re doing as we go along.
Update somebody else’s file just once, and you will immediately
understand what this means!

Source: Martin Butcher, MBA, CPA, FCSI

August 2019
 McMaster University
Commerce 3FD3: Financial Modelling

MS Excel vs VBA has 4 main differences:

 Whether working in Excel or VBA, you are performing actions (calculation, chart
creation, etc.). In Excel the actions take place as you write the instruction. In
VBA you write code, then execute using Ctrl+y.
….. when your MS Excel model is ‘small’ (< 2MB) this doesn’t really
matter. However, when your MS Excel model is big (Assignment 6); this
can mean the difference between having a coffee while waiting for your
model to finish running, and seeing it ‘done’ in 3-10 seconds!
 In VBA you store the code in logical modules, which run when the program
executes. Modules are the equivalent of pages in an Excel workbook.
….. same outcomes, but different processes.
 In Excel everything happens only once and each cell represents only one thing.
In VBA the same variable is used multiple times, if you want VBA to store a value
you must code an instruction.
….. this means that you must think ‘differently’ when using VBA. Be
conscious of what must happen if you plan to re-use this code (in VBA),
versus just once (in MS Excel).
 Excel does not have to be explicitly told in which order to execute the instruction,
VBA does. Unless you code VBA otherwise, VBA will always use the latest value
of the variable.
….. a prime source of error, if your VBA program does not work!

Commerce 3FD3 is NOT a VBA course.

Our experience with Commerce 3FD3 is that typically no more than 5-10% of students
in a given class know anything about VBA. However, as knowledge of VBA is a valuable
skill for a modeler, we need to develop some expertise in it.

We need to know how to use VBA, but not necessarily know how to program to the level
that you might expect of a computer science major. We achieve this through ‘guided
learning’.
 You will be teaching yourself how to program in VBA, helped with guidance from
both your classmates and I, as to how to how to ‘do’ things. It is why the
assignments are group efforts, why you are encouraged to talk to other groups,
and is a standard way by which to learn programing.
 I will provide weekly reference models in both MS Excel and VBA, relevant to the
assignment that we are doing, that you are free to copy VBA code from, and
modify as you see fit. Periodically, I will also provide specific guidance as to how
to do something in VBA.
 The final exam will not include any VBA, other than those areas where I have
provided you with specific guidance as to how to do something in VBA. How
much you choose to learn and apply VBA, is entirely up to you.

Source: Martin Butcher, MBA, CPA, FCSI

August 2019
 McMaster University
Commerce 3FD3: Financial Modelling

Week 11
Chapter 19_30_Options_Option Portfolio’s_ Option Pricing

Life is full of options.

An option is the right, but not the obligation, to support the Toronto Raptors at
Jurassic Park, in Game 5, in the rain!

Fortunately, The Black Scholes Merton (BSM) option equation, allows us to calculate
the value of a financial ‘put’ or ‘call’ option. Combining the put and call options in a
particular way; allows us to mimic the pay-off of a stock position without incurring its
risk.

What is a financial option?

An option is a derivative security; the price of which depends on the price of the
reference security or asset. For example;
 The price of an option on Royal Bank common shares, depends upon the
current market price of Royal Bank common shares trading on the Toronto Stock
Exchange.
 The price of an option on West Texas Intermediate (WTI) crude oil depends
upon the current market price of WTI trading at Cushing, Oklahoma.

There are two types of option.

 Call Option. A call option gives the holder the right (but not the obligation) to buy
the underlying security from the option seller at a specified exercise price, for a
specified period of time. The price the holder pays for this option is the premium,
and the holder hopes that during the specified time frame, the price of the
security will rise above the price he/she has agreed to pay for it.
o To buy a call option is the equivalent of a long position on the reference
security. If the price of the reference security goes up, the price of the call
option will increase as well.
o To write (sell) a call option is the equivalent of a short position on the
reference security. If the price of the reference security goes down, the
call option will expire worthless, and the seller gets to keep the call
premium paid by the buyer.
 Put Option. A put option gives the holder the right (but not the obligation) to sell
the underlying security to the option seller at a specified exercise price, for a
specified period of time. The price the holder pays for this option is also called
the premium, and the holder hopes that during the specified time frame, the
price of the security will fall below the price he/she has agreed to sell it at.
o To buy a put option is the equivalent of a short position on the reference
security. If the price of the reference security goes down, the price of the
put option will increase; as the option holder can buy the security out of
the market at a cheap price – and re-sell it, ie: ‘put’, to the option seller at
a higher price.

Source: Martin Butcher, MBA, CPA, FCSI

Financial Analysis and Modeling 2nd Edition, Chandan Sengupta, Chapter 19,
30
 McMaster University
Commerce 3FD3: Financial Modelling
o To write (sell) a put option is the equivalent of a long position on the
reference security. If the price of the reference security goes up, the put
option will expire worthless, and the seller gets to keep the put premium
paid by the buyer.

There are two styles of option.

 A European style option allows the option holder to exercise the option only on
the date the option expires. The option may have been profitable throughout its
life, but expires worthless on the day it matures.
 An American style option allows the option holder to exercise the option at any
time up to the date the option expires. It is a more valuable option as the option
holder may exercise their right anytime the option is profitable, and whenever
they think the option will be most profitable.

Upon expiry date, the option will be in one of three positions.

 At-the-money. This means that the market price of the security is the same as
the specified exercise price, and that the option will expire at a profit of zero.
 In-the-money.
o For a call option, this means that the market price of the security is higher
than the specified exercise price, and that the buyer will either receive the
underlying shares, or a payment equal to the difference in price x the
quantity specified in the option. The gross amount of this payment is the
options intrinsic value.
o For a put option, this means that the market price of the security is lower
than the specified exercise price, and that the seller will either ‘put’ the
quantity specified on the buyer at the specified exercise price, or receive
a payment equal to the difference in price x the quantity. The gross
amount of this payment is the options intrinsic value.
 Out-of-the-money.
o For a call option, this means that the market price of the security is lower
than the specified exercise price, and that the buyer would not exercise
their right to sell as they could make more by selling in the market. The
option expires worthless.
o For a put option, this means that the market price of the security is higher
than the specified exercise price, and that the seller would not exercise
their right to ‘put’ as they could make more by selling in the market. The
option expires worthless.

Source: Martin Butcher, MBA, CPA, FCSI

Financial Analysis and Modeling 2nd Edition, Chandan Sengupta, Chapter 19,
30
 McMaster University
Commerce 3FD3: Financial Modelling

How can financial options be used?

Financial options can be used to take-on risk for speculation purposes, or remove risk
through an opposing hedge position.

 When used for speculation

o Options allow the holder to purchase exposure to the reference asset at a
fraction of its cost. For the cost of 100 shares and ‘control’ for an unlimited
length of time, the options holder may ‘control’ 1000 shares for maybe 6
months instead. If the share price moves in his/her favour, he/she can make
10 times the profit.
o Options may also be used in combinations that safely mimic an exposure to
the reference asset that may be either costly, or risky to maintain. This is what
Assignment #5 is doing when the put and call option are combined.

 When used for removing risk

o Options allow the holder to purchase ‘insurance’, by creating an opposing
exposure to the reference asset at a fraction of its cost. The option holder has
a long exposure to the reference asset, and is attempting to generate a
speculative profit, should the price of the reference asset decline. If the loss
on the existing long exposure, is exactly matched (offset) by the gain on the
option position, the reference asset is said to be perfectly hedged.
o A typical user may be a farmer attempting to insure the value of his/her crop
against a decline in the market value of his/her crop at harvest. Other users
may be manufacturers/processors (technology companies, coffee chains, oil
refiners, etc.) attempting to fix the cost of commodities used in their
production processes.

What are the ‘Greeks’ and how do they change valuation?

The primary method by which to determine the value of an option premium is the Black-
Scholes-Merton (BSM) equation, shown on p452. BSM showed that the premium (S) for
a European option depends on 5 variables;
 K, the exercise price
 r, the continuously compounded annual risk-free interest rate
 q, the continuously compounded annual dividend yield
 T, the time to maturity in years
 σ, the securities annualized volatility

All the variables can be observed directly, except σ, which must be determined by
iteration using the BSM equation. If the underlying security pays a dividend it reduces
the price of call options, and increases the price of put options.

Source: Martin Butcher, MBA, CPA, FCSI

Financial Analysis and Modeling 2nd Edition, Chandan Sengupta, Chapter 19,
30
 McMaster University
Commerce 3FD3: Financial Modelling

Put and call premiums must always equal other, as expressed in the put-call parity
equation on p454
c + Ke-rt = p + Se-qt
As the magnitude of the premium will change as both the securities value, and
remaining time to maturity changes, we would like to know the price change sensitivity
of each variable in the BSM equation. These price sensitivities are known as the
‘Greeks’, p456-457 of the text. Many of the models posted in the model’s folder,
graphically illustrate how specific ‘Greeks’ behave over time.

 Delta measures sensitivity of the premium (price) to changes in the price of the
security. The closer the strike price is to the market price; the more impact delta
will have on the price of the option. It is the first derivative of the BSM equation.
 Gamma measures the sensitivity of delta to changes in the price of the security.
Gamma is highest when the strike price and the market price are identical;
thereafter it rapidly declines as the difference between the strike and market
price increase. It is the second derivative of the BSM equation.
 Vega measures the rate of change in the securities annualized volatility. Vega is
highest when daily market price fluctuations are extreme, and lowest when
market fluctuations are calm. It is the first derivative of the σ equation.
 Rho measures sensitivity to change in the risk-free interest rate. Rho generally
does not change unless there is speculation in the financial market that the
nations central bank is about to change discount rates. It is the first derivative of
the interest rate r.
 Theta measures how the premium (price) changes over time. The value of all
options decay at an accelerating rate, the closer the option gets to expiry. Hence
an option with many months to expiry will be expensive, and its value will be
declining very slowly; whereas an option close to expiry will be cheap, but its
value will be declining every day.

In practice, the price of an option will typically act as described below.

 The more volatile the underlying securities price is, the higher the option
premium will be. Hence an investor would like to sell options in a volatile market
(around earnings dates), and buy them back later when the market is calmer.
This is known as a Vega trade.
 Time reduces (decays) the value of an option at an accelerating rate as the
option approaches maturity. Hence to hedge a position and minimize time decay,
an investor would like to buy the longest maturity option possible, resell it well
before maturity, and replace with another longer dated maturity. This is known as
a Gamma trade.

Source: Martin Butcher, MBA, CPA, FCSI

Financial Analysis and Modeling 2nd Edition, Chandan Sengupta, Chapter 19,
30
 McMaster University
Commerce 3FD3: Financial Modelling

Option advantages/disadvantages versus holding stock?

Options have two main advantages versus holding stock

 Leverage. The same dollar investment in the reference asset, will allow the
option holder to control many times the quantity of reference asset. Should the
share price move in favour of the option holder, gains can be material.
 Limited loss. The option holder can lose no more than the amount paid in
premium; if the reference asset were held and its price fell to zero, the investor
would lose their entire investment,

Options have two major disadvantages versus holding stock

 Premium decline to zero. For all options, the premium paid for the option will
decline to zero on the day the option expires. To avoid a total loss; the option
holder must sell to someone else before the option expires.
 History of loss. Historically, approximately 70% of all options expire worthless.
Option holders expect to continuously lose money on the bulk of their portfolio,
and recover it through large gains on a few winners.

When used to mimic a short position, options offer five major advantages;
 No margin requirement. A short sale of the reference asset, will require the seller
to maintain margin in their account as security against a rise in the price of the
asset sold. There is no such requirement under an options position
 No share loan recall. A short sale of the reference asset cannot execute until the
seller borrows the asset from someone else. As the lender can ask for the return
of the asset at any time, the short seller is exposed to potential loss if he/she has
to buy back the shares prematurely. There is no such requirement under an
options position
 No borrowing fees. Short sellers must pay a borrow fee for the reference asset
sold, and fees can often exceed 30% for ‘rare’ reference assets. There is no
such requirement under an options position
 No regulatory reporting. Portfolio managers must periodically disclose short
positions, both at the time the reference asset is sold, and again when the
portfolio is reported on. There is no such requirement under an options position
 Easier execution. There are often occasions where the desired reference asset
is just not available to borrow, and thereby short. However, this is not a problem
if the reference asset has an options market; and we hold call options on that
reference asset.
o If upon maturity, our call option expires ‘in-the-money’; we can demand
that the option seller deliver the reference asset to us – in exchange for
the agreed upon option strike price. We receive the reference asset, and
a mark-to-market unrealized gain; while the option seller suffers a realized
loss.

Source: Martin Butcher, MBA, CPA, FCSI

Financial Analysis and Modeling 2nd Edition, Chandan Sengupta, Chapter 19,
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 McMaster University
Commerce 3FD3: Financial Modelling

Week 10
Risk and Return

Risk is your friend - but your ability to take on risk depends on age and
circumstance. As a young person you have everything to gain and little to lose; as an
old person you have a lot to lose and little to gain.

Risk means the risk of an unexpected loss,

NOT the risk of an unexpected gain.

In finance, ‘risk’ refers to the degree of uncertainty about the rate of return on an asset;
and the potential harm that could arise, when financial returns are not what the investor
expected. US-SEC definition of risk

We typically interpret this to mean that the more an outcome could differ from what we
expect, the ‘riskier’ we deem that activity to be. If we could bankrupt, or lose our life, we
interpret the activity to be extremely risk. However, we are not concerned if the
investment turns out better than expected.

We know that risk can be mitigated.

If we go sky-diving, or bungee-jumping, with both professionals and high-tech gear – we
know that both these activities become much less risky. But if we choose to bungee-
jump in dangerous places, or ‘dip’ our heads in crocodile infested waters, that risk
mitigation is of little value.

http://www.victoriafalls.net/explore-victoria-falls/victoria-falls/bungee.aspx#.Xb8MNppKjIU
Locals refer to Victoria Falls bungee-jumping as ‘Teaching the crocodiles how to jump.’

Coefficient of Variation as a measure of risk.

In practice, we quantify ‘risk’ through the use of expected value (EV), and standard
deviation (Sigma), to determine the Coefficient of Variation. The Coefficient of Variation
is measured as volatility/expected value, or Standard Deviation (σ)/Expected Value
(EV). The higher the Coefficient of Variation is, the riskier the proposed investment is.

In the below example, the Coefficient of Variation is 0.099:1 ($100,000/1,010,000),

which suggests a low-risk project.

 Uncertainty as to the volatility of the potential outcomes is addressed through

the use of standard deviation; where the smaller the better. Per the below
example, the standard deviation of the above sample is $100,000.

Source: Martin Butcher, MBA, CPA, FCSI

Financial Analysis and Modeling 2nd Edition, Chandan Sengupta, Chapter 16,
28
 McMaster University
Commerce 3FD3: Financial Modelling

 Uncertainty as to the expected value of the potential outcomes is addressed

through the use of probability, to determine the expected value of the
investment. Per the below example the standard practice is to multiply a best,
expected, and worst-case scenario by their probability of occurrence; and sum
the expected value.

Capital Asset Pricing Model (CAPM).

Investors require a higher return for higher risk; we determine that required return
through the use of the CAPM model. Beta (B) in the CAPM model described below, is
the Coefficient of Variation of the company’s closing common-stock market value over
the last 200 trading days, divided by the Coefficient of Variation of the comparable
market exchange index on which the company stock trades.

When applied to a market index, the result is the Securities Market Line (SML), which
may be summarized as per the below equation:

Ra = Rf + B(Rm-Rf)
Where:
Ra = Required Return
Rf = Risk Free Rate (Treasury Bond Yield Curve)
B = Coefficient of Variation on Market Exchange ‘X’, as described above.
Rm = Market Rate of Return
Source: Martin Butcher, MBA, CPA, FCSI
Financial Analysis and Modeling 2nd Edition, Chandan Sengupta, Chapter 16,
28
 McMaster University
Commerce 3FD3: Financial Modelling

As a company’s Beta (Coefficient of Variation) gets bigger, an investor return on the

company becomes riskier; which moves Beta to the right, and increases the Expected
Return (Ra) that an investor would require were he/she to invest in the company.

There are a number of implications related to CAPM:

 A company that trades on many exchanges (ie: an inter-listed security) will have
multiple Beta’s, and the Ra will be different in each market that the company
shares trades in (ie: Germany, New York, Hong Kong). A Daimler-Benz will trade
with a different return on the Frankfurt, versus NY market, simply because they
are different markets.
 Comparing company performance against a market index, means including
distortion from the market index construction, and selection bias. If the company
is not representative of the companies in the market index; the comparison is of
little value.
 Market indexes (S&P 500, Russell 2000, Wilshire 5000, etc.) typically do not
include dividend reinvestment, and do not represent total return – whereas
CAPM does

Industry convention

Industry convention is that for comparative purposes - index returns, should include
total return adjustments; on the assumption that all dividend payments were
reinvested in fractional new shares of the company, at the prevailing market price on the
date of the dividend payment. As the index total return is a ‘nominal’ return that includes
inflation, to get to the real return, we must deduct inflation. There are two methods;

Source: Martin Butcher, MBA, CPA, FCSI

Financial Analysis and Modeling 2nd Edition, Chandan Sengupta, Chapter 16,
28
 McMaster University
Commerce 3FD3: Financial Modelling
 Calculate the periods inflation rate from the Consumer Price Index and deduct
from the nominal total return;
 Calculate from the formula 1+k = (1+r)/(1+i), where k = real rate of return, r =
nominal rate of return, and i = inflation rate.

Industry convention is to display the performance of an asset over time, by showing the
real (total return – inflation) growth of $1 over the years. There are a number of ways by
which this may be done.
 An analyst may download a time-series of data of opening price, dividend, and
the Consumer Price Index level, as per the Chapter 16, Model 1, The analyst
then assumes an initial investment of $X, and continuous reinvestment of the
dividend in new shares, to arrive at an annual new share count. The new share
count is then multiplied by the new share price, and multiplied again by a CPI
adjustment factor to adjust for inflation.
o Inflation makes returns appear larger than they actually are, and the
longer the time series the more severe the effect. In Model 1,
approximately 37% of the cumulative return was due to inflation.
 An analyst may instead download a time-series of annual return and CPI data as
per the Chapter 16, Model 3. An initial investment of $1 is then multiplied by the
annual return, multiplied again by a CPI adjustment factor to adjust for inflation,
and the resulting table graphed.
o The graph demonstrates that as the $1 investment moves through time,
the inflation gap between the two lines gets bigger.
 Alternatively, an analyst might simply download a time-series of different asset
class returns as per Chapter 16, Model 2, and add a disclosure note. For each
asset class an initial investment of $1 is then multiplied by the annual return, and
the resulting table graphed.

Occasionally an analyst will be asked to provide a rolling-return graph, to support risk

management statements such as “in 80% of the possible ten-year windows. stocks
outperformed bonds”. The Chapter 16, Model 4 is a typical rolling-return model.
 When statements of this nature are being made, Chartered Financial Analysts
need to be highly aware of their ethical obligations; and include a disclosure
statement such as “past performance is not indicative of future results”.
 The regulatory expectation is that both the historic time period, and the
length of the rolling window, were cherry-picked to show the best possible
result.

We have learnt to date that is advantageous to be able to program at least portions of a

MS Excel model in VBA. To that end I have published 3 VBA models in the Chapter 28
folder, that mimic much of the programing of the Chapter 15 and Chapter 16 models.
The VBA code, and its analysis, is published on p 691- 718 of the text book.

Source: Martin Butcher, MBA, CPA, FCSI

Financial Analysis and Modeling 2nd Edition, Chandan Sengupta, Chapter 16,
28
 McMaster University
Commerce 3FD3: Financial Modelling

Industry convention also posits a number of standard approaches by which investors

can adjust for changing returns over time.
 We learnt two weeks ago that many investors invest in bond portfolio’s, and that
a bond portfolio can be immunized against the effects of a change in the market
interest rate, by making the portfolio duration equal the investment horizon of the
portfolio.
 Equity investment is typically for retirement purposes, via pension or mutual
funds. Industry convention typically requires that clients periodically review their
ongoing performance and objectives over time.
o The downloaded Chapter 15, Model 2, and Model 3 are indicative of the
type of modeling that an analyst might do.
o Immediately prior to retirement, spread-sheets focus on how retirement
withdrawals will be paid for, and how portfolios are expected to perform
over time.
o The downloaded Chapter 15, Model 4 is indicative of the type of
modeling that an analyst might do.
 A typical process is to diversify a portfolio across many asset classes, or
holdings of multiple securities of different risk. As we do when determining
expected value (EV), an investor holds proportional investments in differing
securities &/or asset classes, that sum to the value of the portfolio.
o The downloaded Chapter 15, Model 5 does exactly this; and allows an
investor to change their portfolio by both asset class and fund.

Source: Martin Butcher, MBA, CPA, FCSI

Financial Analysis and Modeling 2nd Edition, Chandan Sengupta, Chapter 16,
28
 Commerce 3FD3
Sample Final Exam Questions

The final exam is on Saturday December 14.

It will go for 2.5 hours from 7:30-10:00pm, and will be at the
Canadian Martyrs School, 1365 Main Street West

The final exam will be a combination of 75 multiple choice, and true/false questions that will
focus primarily on best practices, and the financial theory behind some of the chapters that
we covered. The below 18 sample questions are fairly representative of what you can
expect to see on the exam.

1. Good financial models have the following attributes:

a) Documented, error-free, usable, and good output
b) Well documented, few errors, easy to use, and good output
c) Documented, few errors, usable, and good output
d) Well documented, error-free, easy to use, and good output

2. Building a model includes the following processes:

a) Knowing what the company plan is
b) Improving the model based on feedback
c) Using Visual Basic wherever possible
d) None of the above

3. The typical modelling process will:

a) Identify the relevant drivers affecting the outcome
b) Use historic financial and metrics data for trending purposes
c) Assess against public comparable data.
d) All of the above

4. In the investment world, the analyst’s objectives are to evidence key understanding of
XYZ company, and produce both a timely and predictive model.:
a) True
b) False

5. The top mistakes an investment analyst’s typically make, are:

a) Unclear or confusing recommendations
b) Weak explanations of risk factors and mitigation
c) Cannot explain parts of the model, or the data used
d) All of the above

Source: Martin Butcher, MBA, CPA, FCSI

 6. The present value of an annuity in
arrears, or advance, can be modelled 3 ways:
a) Using the financial functions of Excel
b) Using formulas
c) Using a custom table
d) All of the above

7. Functions and formulas assume that cash flows are for equal length periods, and that
they discount at the same rate of return:
a) True
b) False

8. When using ‘Goal Seek’ in Excel, the user must:

a) Open the data tab, click on ‘What If’ analysis, and click ‘Goal Seek’
b) Then set the cell they wish to change
c) To value based on some other cell
d) All of the above

9. To data validate in Excel, the user must:

a) Open the data tab,
b) Click on data validation,
c) Click on the allow, and data drop-down boxes
d) All of the above

10. There are 2 main reasons for programing in VBA; re-using formula is much easier in
VBA than in Excel, and complex formula can be made a lot easier in VBA.
a) True
b) False

11. The price of a bond moves inversely to market yield to market, and we use concavity to
measure the bonds sensitivity to a change in yield.
a) True
b) False

12. Credit risk recognizes that:

a) Coupon payments and par value may not be received as they come due.
b) The more risk there is, the higher the discount rate will be
c) The least risky bond is a treasury bill
d) All of the above

13. To price a bond in a model, an analyst would:

a) Plot the yield to maturity (YTM) of treasury bills over an extended timeframe
b) Add a premium for the credit risk, and recalculate the yield curve
c) Discount future cashflow at the yield curve rate, and sum
d) All of the above

Source: Martin Butcher, MBA, CPA, FCSI

14. When we think of ‘risk’ we think of the following:
a) The uncertainty around the expected return
b) The magnitude of the potential return
c) The possibility of a negative return
d) All of the above

15. Market indexes typically include dividend reinvestment, and hence represent a total
index return. This is?
a) True
b) False

16. An option is a derivative security where;

a) The price depends upon the price of other securities
b) The option can be used to take on risk for speculative purposes
c) The option can be used to hedge an existing position against risk
d) All of the above

17. The Black-Scholes-Morton (BSM) model makes use of five price sensitivities; Delta,
Gamma, Vega, Rho, and Theta. Is this accurate?
a) True
b) False

18. The key take-aways from the Geometric Brownian Motion (GBM) Model are:
a) The longer we hold a stock, the more uncertain we become as to what the actual
final price will be versus the expected final price.
b) The longer we hold a stock, the less certain we can be of earning the expected
rate of return.
c) None of the above
d) All of the above

See next page for the answer key

Source: Martin Butcher, MBA, CPA, FCSI

 Answer Key

Q1 d
Q2 b
Q3 d
Q4 a
Q5 d
Q6 d
Q7 a
Q8 d
Q9 d

Q10 b
Q11 b
Q12 d
Q13 d
Q14 d
Q15 b
Q16 d
Q17 a
Q18 a

Source: Martin Butcher, MBA, CPA, FCSI

 McMaster University
Commerce 3FD3: Financial Modelling

Week 4
Steps to building a good financial model

The purpose of this document is to walk you through the steps to building a good
financial model. If you hope to score well on your group assignments; following this
process, and modeling according to the requirements of the Assignment Marking
Rubric, will be critical to your success.

The most effective way to build a good model is to sketch out the model first - before
starting to program in either MS Excel or VBA. It is a five-step process.
1. Research relevant theory
2. Visualize what you will need, to produce the result required.
3. Visualize the major steps, or blocks of VBA code, that you will require.
4. Document what the model does, and what each major step, or block does.
5. Document the order of step or block processing, and why.

To visualize what you will need,

use the Input=>Process=>Output=>Test approach
.
 Perform a Google search to see if there is any relevant financial theory relating
to your assignment requirements. If Assignment #1 is the example, you will find
that there is a specific formula that will calculate interest according to the
parameters specified.
 Visualize what the output, and input, should look like. What specific things, what
format, what reports, etc. If Assignment #1 is the example:
 A documentation worksheet outlining
 What this model does
 What loans officers must input to use the model
 How the loan amortization and interest compounding works
 APR increases in 25bp increments
 A color-coded ‘input’ section.
 Term in months. Hard-coded at 30
 Loan amount formatted in currency, data validated between $7,500
and $30,000
 Amortization period in months, data validated between 48 and 96
 ARP in percent, with 25bp data validation between 6 and 10%
 A color-coded ‘output’ section
 Bi-weekly payment, formatted in currency
 Balance owing at the end of the term, formatted in currency
 Total interest paid, formatted in currency
 A ‘background’ amortization table (opening balance, bi-weekly payment,
interest, closing balance) extending over 208 bi-weekly periods (8 years of 26
periods/year). Displayed as a separate worksheet in the workbook.
 The amortization table must start with the amount borrowed in $, and
conclude at $0.00, with all cells formatted as currency.

Source: Martin Butcher, MBA, CPA, FCSI

January 2019
 McMaster University
Commerce 3FD3: Financial Modelling
 The amortization table must only display interest, and a month of
interest, every 2nd period.

 Visualize what the processing should look like. Using Assignment #1 as the
example:
 Would a VBA or a MS Excel model be the better choice for this?
 Could an existing amortization model be re-purposed? Model 5?
 APR data validation using a list … (6.00, 6.25, 6.50, 6.75 … 10.00)
 Interest calculation and addition using a reference list. Model 6?
 Who in the group is programing this, when and how?

 Visualize what the test approach should be.

 Compare outputs to the non-VBA model marking rubric
 Who in the group is testing, when and how?
 Who in the group is fixing bugs, when and how?

Most people will try to program immediately, versus map out the process first. You may
be able to successfully do that for the first 2-3 assignments, but it will not be possible
once these assignments become more complex and you are programing in VBA. Hence
take the time to develop good habits early, and stick with them.

Once you complete Commerce 3FD3, there will be nobody telling you the relevant
theory applicable to what you want to do, showing you what a good model should look
like, or showing you the coding/programing that ‘makes it happen’. You will be relying on
the 5-step process that you have learnt, and the good habits you developed while doing
this course.

Good luck!

Source: Martin Butcher, MBA, CPA, FCSI

January 2019
 McMaster University
Commerce 3FD3: Financial Modelling

Week 6
VBA sub-routine and function procedures

Mid term recess is a week with no lectures or assignments, that students can use to get
on top of work, and prepare for upcoming deadlines. For those in the class who wish to
get a firm grip on VBA … this free time is a gift.

Use it well, but be sure to take some time off for yourself as well.

Not everyone wants to learn how to do ‘advanced’ VBA.

Just as I don’t need to know how to build a calculator if I just want to use one; knowing
the basics is ‘good enough’. There is nothing wrong in that; it is simply a different point
of view.

However, for many other people, the opportunity to both learn and apply VBA in a
business setting, was a major reason for taking the course. For these people, this
document will give you some guidance, as you take the time over mid-term recess to
strengthen your grip on VBA.

Spinners, Data Tables, Reset, Active-X control

Chapter 23 and chapter 24 of the textbook is where the VBA rubber hits the road.
Mastering these chapters, is akin to learning to drive in 4 th gear, versus 1st. Doing it well
is the difference between driving a sports car, and driving a truck; both will work, but the
sports car is a lot more responsive.

In Assignment #3 we will be using a ‘spinner’ to change a portfolio allocation, and a data

table to drive a graphical proof of immunization. You will discover that using a VBA sub-
routine will typically turn a simple spreadsheet into an interactive tool.

To add a spinner
 Developer tab, controls group.
 Click on ‘insert’, form controls, and click on ‘Spin Button’.
 Click on the worksheet where you want the spinner to appear.
 Right click the control, click on format control.
 In the current value box, enter the initial value of the spin button.
 In the minimum value box, enter the lowest value that a user can specify.
 In the maximum value box, enter the highest value that a user can specify.
 In the incremental change box, enter the amount by which the value can change.
 In the cell link box, enter a cell reference that contains the current position of the
spin button.

Source: Martin Butcher, MBA, CPA, FCSI

August 2019
 McMaster University
Commerce 3FD3: Financial Modelling

As data tables are best learnt through doing, please refer to the ‘Week 06 Learnings’
folder in Avenue-To-Learn. Once you are comfortable with how to set up, and use a data
table, you will be very well positioned for the remainder of the course. Practice, using
the below 2 two files;
 How to create and use a Data Table
 Data Table Example

To add a data table

 Data tab, forecast group.
 Click on ‘what-if analysis’, data table.
 Select either a column or a row reference

Practice creating different data tables from different inputs, and then using the table to
create a graph. Notice that as soon as the inputs change, the table changes, AND the
graph using that table. In Assignment #3 the inputs will be controlled via a spinner, that
will change the graph every time the spinner is clicked.

In Assignment #5 we will be using a ‘reset’ button to return a model to its original

position. A ‘reset’ button is added to a spreadsheet in a very similar way to a spinner.

In Assignment #6 we will be using an ‘active X’ scroll-bar control to show the result of a

specific iteration, out of a possible 1500 iterations.

Happy Mid-Term Recess Week!

Source: Martin Butcher, MBA, CPA, FCSI

August 2019
 McMaster University
Commerce 3FD3: Financial Modelling

Week 9
Yield Curve Research

Money is a product, and like any other product – there is a cost to use it.
That cost is the interest rate, and it is determined from the yield curve.

The shape of the yield conveys predictive economic information.

Learn how to interpret this information, and you could become very wealthy.

What is a yield curve, and how is it used?

The ‘price’ of money is the market rate of interest, or yield; and it is set at every
‘maturity’ (month or year), by the supply and demand for money at that maturity. If we
graph yield (interest rate) against maturity (time), the resultant ‘price’ function is called
the yield curve.
 The yield at the point where the graph intersects the vertical y-axis, is known as the
risk-free free rate. It is calculated as the yield-to-maturity on an overnight treasury
bill, issued by the nation’s central bank; and represents the lowest possible cost of
borrowing, by the most credit worthy entity in the nation.
 Most borrowers are of course not nations, and borrowers differ materially in their
credit worthiness. Hence for an individual borrower, we must add a risk premium to
the risk-free rate, to adjust for the credit worthiness of the borrower. The size of the
risk premium depends on the liquidity of the market at the time the money is
borrowed, and the credit rating of the borrower.
o Market liquidity fluctuates daily, and depends on a number of factors that
have greater/lessor influence according to the economic conditions of the
day.
 When there is an excess supply of money (very high liquidity) at a
specific term, the cost of money at that term will be very low.
 When there is an excess demand for money at that specific term (very
low liquidity), the cost of money at that term will be very high.
o Credit worthiness is measured as a credit rating, the more famous of which
are the ‘AAA’ to ‘D’ Standard and Poor’s Long-Term Bond ratings. A ‘AAA’
rating means that the borrower has the best credit possible, and will pay a
risk premium of zero when borrowing. A ‘D’ rating will typically exclude the
borrower from the credit market entirely,
https://www.spratings.com/documents/20184/86966/Standard+%26+Poor
%27s+Ratings+Definitions/fd2a2a96-be56-47b8-9ad2-390f3878d6c6
 We use the yield curve to present value the benefit of a future cash flow. Given that
an asset is simply a collection of future benefits; the yield curve gives us a way by
which to value the present value of those future benefits, and determine the value of
that asset today.
o If the asset is a stream of future cash payments from a borrower with poor
credit; we will discount the future payments at a higher rate, and arrive at a
lower value for the asset.

Source: Martin Butcher, MBA, CPA, FCSI

August 2019
 McMaster University
Commerce 3FD3: Financial Modelling
o If the asset is a stream of future cash payments from a borrower with good
credit; we will discount the future payments at a lower rate, and arrive at a
higher value for the asset.
o Hence, credit worthiness clearly matters!

LPT and the shape of the yield curve

Liquidity Preference Theory (LPT) argues that the longer the term that a borrower wants
the money for, the more they will have to pay for it. Hence, 5-year money will be more
expensive than 90-day money, but cheaper than 25-year money. When we graph this
observation, we get the ‘normal’ yield curve as shown below; a yield curve that slopes
upwards, at a declining rate, as time increases.

We can take the shape of the yield curve, and use it to calculate the forward rate; which
is the cost of one-year money today, borrowed ‘N’ years from today. We can calculate
multiple forward rates such as the cost of two-year, four-year, or seven-year money; the
same way.

We can calculate the forward rate using the formula shown on page 416 of the textbook,
and it tells us todays price for the money that we want in the future.
 In a graph of yield versus maturity, the forward curve will typically plot above the
yield curve; indicating that LPT is present in the market. The cost of one-year
money is increasing by ‘X’ basis points at different points in time, because we
want the money for a longer period of time.
 Regulators will frequently use the forward rate to test whether debtors can afford
a floating rate mortgage or not. If the forward rate indicates that the future
interest rate will increase by 150 bp in 18 months, a mortgage may not be
extended if the borrower cannot evidence that he/she could afford the resultant
higher monthly payment. https://mortgagepal.ca/b-20/

Source: Martin Butcher, MBA, CPA, FCSI

August 2019
 McMaster University
Commerce 3FD3: Financial Modelling

Occasionally market abnormalities will overwhelm LPT, and produce yield curves with
disturbing shapes. Consistent correct interpretation, and positioning yourself to benefit
from these shapes, could make you very wealthy.
 An ‘inverted’ yield curve occurs when the cost of short-term money is more
expensive than the cost of longer-term money, and plots out as below. When it
occurs, the inverted yield curve is a bell-weather predictor of a coming recession
within the next 6-24 months.
 Canada’s yield curve inverted late March 2019; implying that the Canadian
economy will enter a recession sometime between October 2019 and March
2021. https://www.bloomberg.com/news/articles/2019-03-25/canada-s-inverted-yield-curve-signals-
holding-pattern-for-poloz

Periodically, global central bankers are forced to collectively intervene in bond markets
via Quantitative Easing (QE), or ‘Helicopter Money’, to avert global depressions similar
to what occurred in the US during the 1930’s. https://en.wikipedia.org/wiki/Great_Depression

While we, the people, may be forever grateful; it can produce unpredictable effects.
 As at June 2019, the world had approximately $ 13T of negative yield sovereign
debt outstanding. Investors were willing to pay the lender for the privilege of
lending money to them. https://www.marketwatch.com/story/value-of-debt-with-negative-yields-
nears-12-trillion-2019-06-18
 Currently Danish banks are offering 10-year mortgages at negative 0.5%. The
bank is essentially paying borrowers to borrow money from it.
https://www.businessinsider.com/danish-bank-offers-mortgages-at-negative-interest-rates-2019-8

How NPV and Capital Budgeting works

Source: Martin Butcher, MBA, CPA, FCSI

August 2019
 McMaster University
Commerce 3FD3: Financial Modelling

The value of an asset is the sum of the present value (PV) of its future cash flows,
discounted at the market yield applicable to each cash-flow.
 In practice the discount rate will be the asset owners Weighted Average Cost of
Capital (WACC), and the owner would apply the same WACC to each distant
cash flow.
 When applied to capital budgeting, the owner would subtract the cost of the
project, from the sum of the present value (PV) of its future cash flows, to arrive
at a Net Present Value (NPV). If the NPV is positive, the owner would consider
undertaking the project.

As all those involved in project work know (engineers, computer science); it is not
enough for a project to simply have a positive NPV - we also need to maximize the
value of the project opportunity.
 In practice this means calculating the NPV of the project future cash-flow using a
series of increasing discount rates, and plotting the NPV against discount rate.
 The result is typically the plot of a curve that will cross the x axis (discount rate)
in at least two places.
 To get the most NPV out of the project, we need to finance it at the
discount rate corresponding to the curves peak NPV.
 The points where the plot crosses the x axis (discount rate), are the
projects Internal Rate of Returns (IRRs)

The Meeting 9 Chapter 17, Model 1 Yield Curves and Forward Rates demonstrates how
to chart both a Yield Curve and a One-Year Forward Rate Curve, from a series of zero-
coupon maturities (column A) and yield to maturity (YTM) interest rates (column D). It is
essentially a 3-step process.
1. Express the maturity dates in years. Create another column (column B), divide
the number of months by 12 (column B), and express to 2 decimal places.
2. Create an additional column (column D). Populate with the one-year forward
rate values determined by the formula shown on p416. The formula, expressed
in MS Excel is visible in cell D6 of Model 1.
3. Create the chart. Select cells B5 through D17 as your data, clink on the ‘Insert’
tab, click on recommended charts, click on ‘scatter’ graph, click OK. Label as
you see fit.

Assignment 4 gives you a series of bond quotes as at September 08, 2014.

 To convert the maturity in years, into values as per column B of Model 1; you
must subtract the maturity date from the quote date, and divide the number of
months by 12.
 To determine the YTM, as per column C of Model 1, you must use the finance
functions to determine the YTM for each bond. If you know payment, maturity,
PV, and FV; you can calculate YTM.
 To determine the one-year forward rate, as per column D of Model 1, you would
replicate the programing of the Week 8 Chapter 17, Model 1 Yield Curves and
Forward Rates.

Source: Martin Butcher, MBA, CPA, FCSI

August 2019
 McMaster University
Commerce 3FD3: Financial Modelling

The Meeting 9 Chapter 17, Budgeting Model demonstrates how to graph a NPV versus
time plot, a version of which you will need to use in part b) of Assignment #4.

Source: Martin Butcher, MBA, CPA, FCSI

August 2019