FINANCIAL ECONOMICS

VI SEMESTER
CORE COURSE

ECO6 B11

B.A. ECONOMICS
(2019 Admission onwards)
CBCSS

UNIVERSITY OF CALICUT
School of Distance Education,
Calicut University P.O.,
Malappuram - 673 635, Kerala.

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UNIVERSITY OF CALICUT
School of Distance Education

Study Material

VI Semester

Core Course (ECO6 B18)

B.A. ECONOMICS

FINANCIAL ECONOMICS

Prepared by:
Dr. Shima K .M,
Assistant Professor,
SDE, University of Calicut.

Scrutinized by:
Anisha Ramdas
Assistant Professor, PG & Research Dept. of Economics.
Mar Dionysius College, Pazhanji.

DISCLAIMER
“The author shall be solely responsible for the
content and views expressed in this book”

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CONTENTS

Module I - 7

Module II - 30

Module III - 61

Module IV - 76

Module V - 93

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Semester VI
FINANCIAL ECONOMICS
Syllabus

Module I:Investment Theory and Structure of Interest rates

Introduction to financial economics, Time Value of Money:
Future Value, Present Value, Future value of an annuity, Present
value of annuity, Present rate of perpetuity. Investment Criteria:
Net Present Value, Benefit Cost Ratio, Internal Rate of Return,
Modified Internal Rate of Return.

Module II: Valuation of Bonds and Securities

Fundamentals of Valuation of Securities: Valuation of Bonds and
Stocks; Bond Yield, Yield to Maturity. Equity Valuation:
Dividend Discount Model, The P/E Ratio Approach; Irrelevance
of Dividends: Modigliani and Miller Hypothesis.
Module III: Risk and Return
Types of risk, Historical returns and Risk, computing historical
returns, average annual returns, variance of returns, Measurement
of Risk and Return of an asset, Measurement of Risk and Return
of a Portfolio, Determinants of Beta, Risk-Return trade off.

Module IV: Cost of Capital and Capital Asset Pricing Model

The Cost of Capital: Debt and equity; Cost of Debt, Cost of
Preference Capital and Equity Capital. The capital market line;
the capital asset pricing model; the beta of an asset and of a
portfolio; security market line; use of the CAPM model in
investment analysis and as a pricing formula.

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Module V:Derivative Markets

An introduction to financial derivatives: Types and uses of
derivatives; Forward Contracts: determination of forward prices,
Futures Contract: theories of future prices- the cost of carry
model, the expectation model, capital asset pricing model.
Relation between Spot and Future Prices, forward vs future
contract, Hedging in Futures; Options: types, value of an option,
the Pay-Offs from Buying and Selling of Options; the Put Call
Parity Theorem; Binomial option pricing model (BOPM) and
Black-Scholes option pricing model.
References
1. L. M. Bhole and J. Mahukud, Financial Institutions and
Markets, Tata McGraw Hill, 5th edition, 2011.
2. Hull, John C., Options, Futures and Other Derivatives, Pearson
Education, 6th edition, 2005.
1. David G. Luenberger, Investment Science, Oxford University
Press, USA, 1997.
2. Thomas E. Copeland, J. Fred Weston and KuldeepShastri,
Financial Theory and Corporate Policy, Prentice Hall, 4th edition,
2003.
3. Richard A. Brealey and Stewart C. Myers, Principles of
Corporate Finance, McGrawHill, 7th edition, 2002.
4. Stephen A. Ross, Randolph W. Westerfield and Bradford D.
Jordan, Fundamentals of Corporate Finance.McGraw-Hill, 7th
edition, 2005.

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Module I:
Investment Theory and Structure of Interest rates

1.1.Financial Economics
Financial economics is a branch of economics that analyzes the
use and distribution of resources in markets. Financial decisions
must often take into account future events, whether those be
related to individual stocks, portfolios, or the market as a whole.
It employs economic theory to evaluate how time, risk,
opportunity costs, and information can create incentives or
disincentives for a particular decision. Financial economics often
involves the creation of sophisticated models to test the variables
affecting a particular decision.
Financial economics necessitates familiarity with basic
probability and statistics since these are the standard tools used to
measure and evaluate risk. Financial economics studies fair value,
risk and returns, and the financing of securities and assets.
Numerous monetary factors are taken into account, too, including
interest rates and inflation.
1.2.Time Value of Money
Time value of money (TVM) is the idea that money that is
available at the present time is worth more than the same amount
in the future, due to its potential earning capacity. This core
principle of finance holds that provided money can earn interest,
any amount of money is worth more the sooner it is received. One
of the most fundamental concepts in finance is that money has a
time value attached to it. In simpler terms, it would be safe to say
that a dollar was worth more yesterday than today and a dollar

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today is worth more than a dollar tomorrow. This is because

money can grow only through investing. An investment delayed
is an opportunity lost. The time value of money is also referred to
as present discounted value. The formula for computing the time
value of money considers the amount of money, its future value,
the amount it can earn, and the time frame.
In general, the most fundamental TVM formula takes into
account the following variables:
Present value (PV) - This is your current starting amount. It is
the money you have in your hand at the present time, your initial
investment for your future.
Future value (FV) - This is your ending amount at a point in time
in the future. It should be worth more than the present value,
provided it is earning interest and growing over time.
The number of periods (N) - This is the timeline for your
investment (or debts). It is usually measured in years, but it could
be any scale of time such as quarterly, monthly, or even daily.
Interest rate (I) - This is the growth rate of your money over the
lifetime of the investment. It is stated in a percentage value, such
as 8% or .08.
Payment amount (PMT) - These are a series of equal, evenly-
spaced cash flows.
Based on these variables, the formula for TVM is:
( × )
= × [1 +

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A simple example of this would be: If you invest one dollar (PV)
for one year (N) at 6% (I), you will receive $1.06 (FV). This
would be the same as saying the present value of $1.06 you expect
to receive in one year, is only $1.00 (PV).
Examples: Assume a sum of $10,000 is invested for one year at
10% interest compounded annually. The future value of that
money is:
FV = $10,000 x [1 + (10% / 1)] ^ (1 x 1) = $11,000
The formula can also be rearranged to find the value of the future
sum in present day dollars. For example, the present day dollar
amount compounded annually at 7% interest that would be worth
$5,000 one year from today is:
PV = $5,000 / [1 + (7% / 1)] ^ (1 x 1) = $4,673

 The Time Value of Money Relate to Opportunity Cost

Opportunity cost is key to the concept of the time value of money.
Money can grow only if it is invested over time and earns a

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positive return. Money that is not invested loses value over time.
Therefore, a sum of money that is expected to be paid in the
future, no matter how confidently it is expected, is losing value in
the meantime.

 Significance of Time Value of Money

The concept of the time value of money can help guide
investment decisions. For instance, suppose an investor can
choose between two projects: Project A and Project B. They are
identical except that Project A promises a $1 million cash payout
in year one, whereas Project B offers a $1 million cash payout in
year five. The payouts are not equal. The $1 million payout
received after one year has a higher present value than the $1
million payout after five years.

 Use of Time Value of Money in Finance

It would be hard to find a single area of finance where the time
value of money does not influence the decision-making process.
The time value of money is the central concept in discounted cash
flow (DCF) analysis, which is one of the most popular and
influential methods for valuing investment opportunities. It is also
an integral part of financial planning and risk management
activities. Pension fund managers, for instance, consider the time
value of money to ensure that their account holders will receive
adequate funds in retirement.

1.3.Future Value
Future value (FV) is the value of a current asset at a future date
based on an assumed rate of growth. The future value is important
to investors and financial planners, as they use it to estimate how
much an investment made today will be worth in the future.
Knowing the future value enables investors to make sound
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investment decisions based on their anticipated needs. However,

external economic factors, such as inflation, can adversely affect
the future value of the asset by eroding its value. The FV
calculation allows investors to predict, with varying degrees of
accuracy, the amount of profit that can be generated by different
investments. The amount of growth generated by holding a given
amount in cash will likely be different than if that same amount
were invested in stocks; therefore, the FV equation is used to
compare multiple options.
Determining the FV of an asset can become complicated,
depending on the type of asset. Also, the FV calculation is based
on the assumption of a stable growth rate. If money is placed in
a savings account with a guaranteed interest rate, then the FV is
easy to determine accurately. However, investments in the stock
market or other securities with a more volatile rate of return can
present greater difficulty. To understand the core concept,
however, simple and compound interest rates are the most
straightforward examples of the FV calculation.
Types of Future Value
Future Value Using Simple Annual Interest
The FV formula assumes a constant rate of growth and a single
up-front payment left untouched for the duration of the
investment. The FV calculation can be done one of two ways,
depending on the type of interest being earned. If an investment
earns simple interest, then the FV formula is:

= × (1 + ( × ))
Where: I=Investment amount, R=Interest rate,
T=Number of years

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For example, assume a $1,000 investment is held for five years in

a savings account with 10% simple interest paid annually. In this
case, the FV of the $1,000 initial investment is $1,000 × [1 + (0.10
x 5)], or $1,500.
Future Value Using Compounded Annual Interest
With simple interest, it is assumed that the interest rate is earned
only on the initial investment. With compounded interest, the rate
is applied to each period’s cumulative account balance. In the
example above, the first year of investment earns 10% × $1,000,
or $100, in interest. The following year, however, the account
total is $1,100 rather than $1,000; so, to calculate compounded
interest, the 10% interest rate is applied to the full balance for
second-year interest earnings of 10% × $1,100, or $110.
The formula for the FV of an investment
earning compounding interest is:

= × (1 + )
Where: I=Investment amount, R=Interest rate,
T=Number of years
Using the above example, the same $1,000 invested for five years
in a savings account with a 10% compounding interest rate would
have an FV of $1,000 × [(1 + 0.10)5], or $1,610.51.
1.4.Present Value
Present value (PV) is the current value of a future sum of money
or stream of cash flows given a specified rate of return. The
concept that states an amount of money today is worth more than
that same amount in the future. In other words, money received
in the future is not worth as much as an equal amount received

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today. Receiving $1,000 today is worth more than $1,000 five

years from now. An investor can invest the $1,000 today and
presumably earn a rate of return over the next five years. Present
value takes into account any interest rate an investment might
earn. For example, if an investor receives $1,000 today and can
earn a rate of return 5% per year, the $1,000 today is certainly
worth more than receiving $1,000 five years from now. If an
investor waited five years for $1,000, there would be an
opportunity cost or the investor would lose out on the rate of
return for the five years.
Inflation is the process in which prices of goods and services rise
over time. If you receive money today, you can buy goods at
today's prices. Presumably, inflation will cause the price of goods
to rise in the future, which would lower the purchasing power of
your money.
Money not spent today could be expected to lose value in the
future by some implied annual rate, which could be inflation or
the rate of return if the money was invested. The present value
formula discounts the future value to today's dollars by factoring
in the implied annual rate from either inflation or the rate of return
that could be achieved if a sum was invested.
Discount Rate for Finding Present Value
The discount rate is the investment rate of return that is applied to
the present value calculation. In other words, the discount rate
would be the forgone rate of return if an investor chose to accept
an amount in the future versus the same amount today. The
discount rate that is chosen for the present value calculation is
highly subjective because it's the expected rate of return you'd
receive if you had invested today's dollars for a period of time.

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The discount rate is the sum of the time value and a relevant
interest rate that mathematically increases future value in nominal
or absolute terms. Conversely, the discount rate is used to work
out future value in terms of present value, allowing a lender to
settle on the fair amount of any future earnings or obligations in
relation to the present value of the capital. The word "discount"
refers to future value being discounted to present value.
The calculation of discounted or present value is extremely
important in many financial calculations. For example, net
present value, bond yields, and pension obligations all rely on
discounted or present value. Learning how to use a financial
calculator to make present value calculations can help you decide
whether you should accept such offers as a cash rebate, 0%
financing on the purchase of a car, or pay points on a mortgage.
PV Formula and Calculation

=
(1 + )
Where, FV=Future Value; r=Rate of return; n=Number of periods

 Input the future amount that you expect to receive in the

numerator of the formula.

 Determine the interest rate that you expect to receive

between now and the future and plug the rate as a decimal
in place of "r" in the denominator.

 Input the time period as the exponent "n" in the

denominator. So, if you want to calculate the present value
of an amount you expect to receive in three years, you
would plug the number three in for "n" in the
denominator.
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Future Value vs. Present Value

A comparison of present value with future value (FV) best
illustrates the principle of the time value of money and the need
for charging or paying additional risk-based interest rates. Simply
put, the money today is worth more than the same money
tomorrow because of the passage of time. Future value can relate
to the future cash inflows from investing today's money, or the
future payment required to repay money borrowed today.
Future value (FV) is the value of a current asset at a specified date
in the future based on an assumed rate of growth. The FV
equation assumes a constant rate of growth and a single upfront
payment left untouched for the duration of the investment. The
FV calculation allows investors to predict, with varying degrees
of accuracy, the amount of profit that can be generated by
different investments.
Present value (PV) is the current value of a future sum of money
or stream of cash flows given a specified rate of return. Present
value takes the future value and applies a discount rate or the
interest rate that could be earned if invested. Future value tells
you what an investment is worth in the future while the present
value tells you how much you'd need in today's dollars to earn a
specific amount in the future.
1.5.Annuity
Annuities are financial products that offer a guaranteed income
stream, usually for retirees. The accumulation phase is the first
stage of an annuity, whereby investors fund the product with
either a lump-sum or periodic payments. The annuitant begins
receiving payments after the annuitization period for a fixed
period or for the rest of their life. Annuities can be structured into
different kinds of instruments, which gives investors flexibility.
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These products can be categorized into immediate and deferred

annuities, and may be structured as fixed or variable.
Types of Annuities
Annuities can be structured according to a wide array of details
and factors, such as the duration of time that payments from the
annuity can be guaranteed to continue. Annuities can be created
so that payments continue so long as either the annuitant or their
spouse (if survivorship benefit is elected) is alive. Alternatively,
annuities can be structured to pay out funds for a fixed amount of
time, such as 20 years, regardless of how long the annuitant lives.

 Immediate and Deferred Annuities

Annuities can begin immediately upon deposit of a lump sum, or
they can be structured as deferred benefits. The immediate
payment annuity begins paying immediately after the annuitant
deposits a lump sum. Deferred income annuities, on the other
hand, don't begin paying out after the initial investment. Instead,
the client specifies an age at which they would like to begin
receiving payments from the insurance company.

 Fixed and Variable Annuities

Annuities can be structured generally as either fixed or variable:
Fixed annuities provide regular periodic payments to the
annuitant. Variable annuities allow the owner to receive larger
future payments if investments of the annuity fund do well and
smaller payments if its investments do poorly, which provides for
less stable cash flow than a fixed annuity but allows the annuitant
to reap the benefits of strong returns from their fund's
investments.

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While variable annuities carry some market risk and the potential
to lose principal, riders and features can be added to annuity
contracts—usually for an extra cost. This allows them to function
as hybrid fixed-variable annuities. Contract owners can benefit
from upside portfolio potential while enjoying the protection of a
guaranteed lifetime minimum withdrawal benefit if the portfolio
drops in value.
1.6.The Present Value of an annuity
The present value of an annuity is the current value of future
payments from an annuity, given a specified rate of return, or
discount rate. The higher the discount rate, the lower the present
value of the annuity. The present value of an annuity refers to how
much money would be needed today to fund a series of future
annuity payments. Because of the time value of money, a sum of
money received today is worth more than the same sum at a future
date.
The formula for the present value of an ordinary annuity, as
opposed to an annuity due, is below. (An ordinary annuity pays
interest at the end of a particular period, rather than at the
beginning, as is the case with an annuity due.)
1
1−( )
(1 + )
= ×

Where: P=Present value of an annuity stream

PMT=Dollar amount of each annuity payment
r=Interest rate (also known as discount rate)
n=Number of periods in which payments will be made

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Future Value of an Annuity

The future value of an annuity is a way of calculating how much
money a series of payments will be worth at a certain point in the
future. By contrast, the present value of an annuity measures how
much money will be required to produce a series of future
payments. In an ordinary annuity, payments are made at the end
of each agreed-upon period. In an annuity due, payments are
made at the beginning of each period.
Because of the time value of money, money received or paid out
today is worth more than the same amount of money will be in
the future. That's because the money can be invested and allowed
to grow over time. By the same logic, a lump sum of $5,000 today
is worth more than a series of five $1,000 annuity payments
spread out over five years.
The formula for the future value of an ordinary annuity is as
follows. (An ordinary annuity pays interest at the end of a
particular period, rather than at the beginning, as is the case with
an annuity due.)
((1 + ) − 1)
= ×

where: P=Future value of an annuity stream

PMT=Dollar amount of each annuity payment
r=Interest rate (also known as discount rate)
n=Number of periods in which payments will be made

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1.8. Present Rate of Perpetuity

An annuity is a stream of cash flows. A perpetuity is a type of
annuity that lasts forever, into perpetuity. The stream of cash
flows continues for an infinite amount of time. In finance, a
person uses the perpetuity calculation in valuation methodologies
to find the present value of a company's cash flows when
discounted back at a certain rate.
A perpetuity is a security that pays for an infinite amount of time.
In finance, perpetuity is a constant stream of identical cash flows
with no end. The concept of perpetuity is also used in several
financial theories, such as in the dividend discount model (DDM).
An infinite series of cash flows can have a finite present value.
Because of the time value of money, each payment is only a
fraction of the last. The present value of a perpetuity is determined
by dividing cash flows by the discount rate. Specifically, the
perpetuity formula determines the amount of cash flows in the
terminal year of operation. In valuation, a company is said to be
a going concern, meaning that it goes on forever. For this reason,
the terminal year is a perpetuity, and analysts use the perpetuity
formula to find its value.

= + + ….=
(1 + ) (1 + ) (1 + )
where: PV=present value; C=cash flow; r=discount rate
The basic method used to calculate a perpetuity is to divide cash
flows by some discount rate. The formula used to calculate the
terminal value in a stream of cash flows for valuation purposes is
a bit more complicated. It is the estimate of cash flows in year 10
of the company, multiplied by one plus the company’s long-term
growth rate, and then divided by the difference between the cost

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of capital and the growth rate. Simply put, the terminal value is
some amount of cash flows divided by some discount rate, which
is the basic formula for a perpetuity.
1.7.Investment criteria
Investment criteria are the defined set of parameters used by
financial and strategic buyers to assess an acquisition target.
Sophisticated buyers will usually have two sets of criteria:
The parameters that are disclosed publicly to intermediaries such
as investment bankers, so they know what the buyer is looking
for in order to source deals that fit; and The parameters developed
for internal review that allow a buyer to quickly determine if the
acquisition should be pursued further. The most common publicly
disclosed investment criteria include the geography, size of the
investment or company targeted, and industry. Some buyers also
disclose criteria regarding the investment type which may include
management buyouts (MBO), distressed opportunities, or
succession situations.

 Net Present Value

Net present value, or NPV, is used to calculate the current total
value of a future stream of payments. In other words, Net present
value (NPV) is the difference between the present value of cash
inflows and the present value of cash outflows over a period of
time. If the NPV of a project or investment is positive, it means
that the discounted present value of all future cash flows related
to that project or investment will be positive, and therefore
attractive. To calculate NPV, you need to estimate future cash
flows for each period and determine the correct discount rate.
NPV is used in capital budgeting and investment planning to
analyze the profitability of a projected investment or project.
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NPV is the result of calculations used to find today’s value of a

future stream of payments.

=
(1 + )

Where: Rt = Net cash inflow –outflow during a single period t; i

= Discount rate or return that could be earned in alternative
investments; t = Number of timer periods
In theory, an NPV is “good” if it is greater than zero. After all,
the NPV calculation already takes into account factors such as the
investor’s cost of capital, opportunity cost, and risk tolerance
through the discount rate. And the future cash flows of the project,
together with the time value of money, are also captured.
Therefore, even an NPV of ₹1 should theoretically qualify as
“good.”
Positive and Negative NPV
A positive NPV indicates that the projected earnings generated by
a project or investment—in present dollars—exceeds the
anticipated costs, also in present dollars. It is assumed that an
investment with a positive NPV will be profitable.
An investment with a negative NPV will result in a net loss. This
concept is the basis for the Net Present Value Rule, which dictates
that only investments with positive NPV values should be
considered.

 Benefit-Cost Ratio (BRC)

A benefit-cost ratio (BCR) is a ratio used in a cost-benefit analysis
to summarize the overall relationship between the relative costs
and benefits of a proposed project. BCR can be expressed in
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monetary or qualitative terms. A benefit-cost ratio (BCR) is an

indicator showing the relationship between the relative costs and
benefits of a proposed project, expressed in monetary or
qualitative terms. If a project has a BCR greater than 1.0, the
project is expected to deliver a positive net present value to a firm
and its investors. If a project's BCR is less than 1.0, the project's
costs outweigh the benefits, and it should not be considered.
Benefit-cost ratios (BCRs) are most often used in capital
budgeting to analyze the overall value for money of undertaking
a new project. However, the cost-benefit analyses for large
projects can be hard to get right, because there are so many
assumptions and uncertainties that are hard to quantify. This is
why there is usually a wide range of potential BCR outcomes.
The BCR also does not provide any sense of how much economic
value will be created, and so the BCR is usually used to get a
rough idea about the viability of a project and how much the
internal rate of return (IRR) exceeds the discount rate, which is
the company’s weighted-average cost of capital (WACC) – the
opportunity cost of that capital.
The BCR is calculated by dividing the proposed total cash benefit
of a project by the proposed total cash cost of the project. Prior to
dividing the numbers, the net present value of the respective cash
flows over the proposed lifetime of the project – taking into
account the terminal values, including salvage/remediation costs
– are calculated.
Limitations of BCR
The primary limitation of the BCR is that it reduces a project to a
simple number when the success or failure of an investment or
expansion relies on many factors and can be undermined by
unforeseen events. Simply following a rule that above 1.0 means
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success and below 1.0 spells failure is misleading and can provide
a false sense of comfort with a project. The BCR must be used as
a tool in conjunction with other types of analysis to make a well-
informed decision.

 The internal rate of return (IRR)

The internal rate of return (IRR) is a discounting cash flow
technique which gives a rate of return earned by a project. The
internal rate of return is the discounting rate where the total of
initial cash outlay and discounted cash inflows are equal to zero.
In other words, it is the discounting rate at which the net present
value (NPV) is equal to zero. It is the rate of return at which the
net present value of a project becomes zero. They call it ‘internal’
because it does not take any external factor (like inflation) into
consideration.
The internal rate of return (IRR) determines the worthiness of any
project. In addition, the IRR determines the efficiency of a project
in generating profits. Therefore, companies use the metric to plan
before investing in any project. The hurdle rate or required rate of
return is a minimum return expected by an organization on its
investment. Any project with an internal rate of return exceeding
the hurdle rate is considered profitable. It is expressed in the form
of percentage return a firm expects from the project.
The internal rate of return (IRR) is a metric used in financial
analysis to estimate the profitability of potential investments. IRR
is a discount rate that makes the net present value (NPV) of all
cash flows equal to zero in a discounted cash flow analysis.
Generally speaking, the higher an internal rate of return, the more
desirable an investment is to undertake. IRR is uniform for
investments of varying types and, as such, can be used to rank
multiple prospective investments or projects on a relatively even
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basis. In general, when comparing investment options with other

similar characteristics, the investment with the highest IRR
probably would be considered the best.
The formula and calculation used to determine this figure are as
follows:

0= = −
(1 + )

Where: Ct = Net cash inflow during the period t; C0 = Total initial

investment costs; IRR = The internal rate of return; t = The
number of time periods.
The ultimate goal of IRR is to identify the rate of discount, which
makes the present value of the sum of annual nominal cash
inflows equal to the initial net cash outlay for the investment.
Several methods can be used when seeking to identify an
expected return, but IRR is often ideal for analyzing the potential
return of a new project that a company is considering undertaking.
Think of IRR as the rate of growth that an investment is expected
to generate annually. Thus, it can be most similar to a compound
annual growth rate (CAGR). In reality, an investment will usually
not have the same rate of return each year. Usually, the actual rate
of return that a given investment ends up generating will differ
from its estimated IRR.
Uses of IRR

 In capital planning, one popular scenario for IRR is

comparing the profitability of establishing new operations
with that of expanding existing operations.

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 IRR is also useful for corporations in evaluating stock

buyback programs.

 Individuals can also use IRR when making financial

decisions—for instance, when evaluating different
insurance policies using their premiums and death
benefits.

 Another common use of IRR is in analyzing investment

returns.

 IRR is a calculation used for an investment’s money-

weighted rate of return (MWRR). The MWRR helps
determine the rate of return needed to start with the initial
investment amount factoring in all of the changes to cash
flows during the investment period, including sales
proceeds.
Modified Internal Rate of Return (MIRR)
The modified internal rate of return (MIRR) assumes that positive
cash flows are reinvested at the firm's cost of capital and that the
initial outlays are financed at the firm's financing cost. By
contrast, the traditional internal rate of return (IRR) assumes the
cash flows from a project are reinvested at the IRR itself. The
MIRR, therefore, more accurately reflects the cost and
profitability of a project.
Formula and Calculation of MIRR
Given the variables, the formula for MIRR is expressed as:

( ℎ × )
= −1
( × )

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where:
FVCF(c)=the future value of positive cash flows at the cost of
capital for the company
PVCF(fc)=the present value of negative cash flows at the
financing cost of the company
n=number of periods
Meanwhile, the internal rate of return (IRR) is a discount rate that
makes the net present value (NPV) of all cash flows from a
particular project equal to zero. Both MIRR and IRR calculations
rely on the formula for NPV.
The MIRR is used to rank investments or projects of unequal size.
The calculation is a solution to two major problems that exist with
the popular IRR calculation. The first main problem with IRR is
that multiple solutions can be found for the same project. The
second problem is that the assumption that positive cash flows are
reinvested at the IRR is considered impractical in practice. With
the MIRR, only a single solution exists for a given project, and
the reinvestment rate of positive cash flows is much more valid
in practice.
The MIRR allows project managers to change the assumed rate
of reinvested growth from stage to stage in a project. The most
common method is to input the average estimated cost of capital,
but there is flexibility to add any specific anticipated reinvestment
rate.

 The Difference Between MIRR and IRR

Even though the internal rate of return (IRR) metric is popular
among business managers, it tends to overstate the profitability of

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a project and can lead to capital budgeting mistakes based on an

overly optimistic estimate. The modified internal rate of return
(MIRR) compensates for this flaw and gives managers more
control over the assumed reinvestment rate from future cash flow.
An IRR calculation acts like an inverted compounding growth
rate. It has to discount the growth from the initial investment in
addition to reinvested cash flows. However, the IRR does not
paint a realistic picture of how cash flows are actually pumped
back into future projects.
Cash flows are often reinvested at the cost of capital, not at the
same rate at which they were generated in the first place. IRR
assumes that the growth rate remains constant from project to
project. It is very easy to overstate potential future value with
basic IRR figures.
Another major issue with IRR occurs when a project has different
periods of positive and negative cash flows. In these cases, the
IRR produces more than one number, causing uncertainty and
confusion. MIRR solves this issue as well.
Advantages of IRR

 Finds the Time Value of Money

Internal rate of return is measured by calculating the interest rate
at which the present value of future cash flows equals the required
capital investment. The timing of cash flows in all future years
are considered and, therefore, each cash flow is given equal
weight by using the time value of money.

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 Simple to Use and Understand

The IRR is an easy measure to calculate and provides a simple
means by which to compare the worth of various projects under
consideration. The IRR provides any small business owner with
a quick snapshot of what capital projects would provide the
greatest potential cash flow. It can also be used for budgeting
purposes such as to provide a quick snapshot of the potential
value or savings of purchasing new equipment as opposed to
repairing old equipment.

 Hurdle Rate Not Required

In capital budgeting analysis, the hurdle rate, or cost of capital, is
the required rate of return at which investors agree to fund a
project. It can be a subjective figure and typically ends up as a
rough estimate. The IRR method does not require the hurdle rate,
mitigating the risk of determining a wrong rate. Once the IRR is
calculated, projects can be selected where the IRR exceeds the
estimated cost of capital.

Disadvantage

 Ignores Size of Project

It does not account for the project size when comparing
projects. Cash flows are simply compared to the amount of
capital outlay generating those cash flows. This can be
troublesome when two projects require a significantly
different amount of capital outlay, but the smaller project
returns a higher IRR.

 Ignores Future Costs

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The IRR method only concerns itself with the projected cash
flows generated by a capital injection and ignores the
potential future costs that may affect profit.

 Ignores Reinvestment Rates

The IRR allows you to calculate the value of future cash
flows, it makes an implicit assumption that those cash flows
can be reinvested at the same rate as the IRR. That assumption
is not practical as the IRR is sometimes a very high number
and opportunities that yield such a return are generally not
available or significantly limited.

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Module II
Valuation of Bonds and Securities

2.1. Valuation of securities

Valuation means professionally estimating, assessing,

determining, setting the price, worth and value of a thing or an
asset. As the objective of any investment is to find out an asset
which is worth more than its cost, a proper understanding of the
process of valuation is necessary for any real or financial
investment decision, portfolio selection and management and
financing decision. The valuation techniques provide investors a
benchmark or standard of comparison be valued between assets
and firms which have varying financial characteristics; it enables
investors to appraise the relative attractiveness of assets and
firms. Therefore, we discuss below certain (a) value concepts, (b)
general principles of valuation and (c) the way in which certain
specific securities can be valued.

Value Concepts
Book Value
The book value of an asset or a firm is based on accounting
reports. In case of a physical asset, it is equal to the asset's
historical cost less accumulated depreciation. In case of a
common stock, it is equal to the net worth (paid-up capital +
reserves and surplus) of the firm divided by the number of
outstanding shares. Symbolically,

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ℎ
=
−

ℎ
ℎ( +
=
ℎ
Going-Concern Value
This concept applies to a business firm as a continuing operating
unit. It is based primarily on how profitable a firm's operations
would be as a continuing entity that is, the entity which is unlikely
to go out of business in the foreseeable future.
Liquidation Value
In contrast to the going-concern value, the liquidation value is the
value of the business firm which has cease or wound up its
business, or which has gone into liquidation. The liquidation
value of an ordinary share is equal to the value realised from
liquidating all the assets of the firm minus the amount to be paid
to all the creditors, preference shareholders, and other prior
claimants divided by the number of outstanding ordinary shares.
Market Value
The market value of an asset is simply the price at which it is
traded in the market at a given point of time.
Intrinsic or Present Value
Intrinsic value is also known as fair market value or investment
value. It is equal to the present value of a stream of cash flows
expected to be generated by the asset. The technique for finding

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out present value is known as discounting. Market value truly

reflects intrinsic value if the market is perfectly competitive.
Terminal Value
The terminal value of the asset or money is the value of today's
money at some point of time in future, and the method for
ascertaining it is known as compounding.
Time Value of Money
It connotes that a rupee today in hand is worth more than a rupee
tomorrow (in future) because it can be invested and made to earn
interest immediately, and because the present consumption is
valued more than the future consumption by the people.

General Principles of Valuation

Any asset or security derives its value from the cash flows it is
expected to generate in future. The present value of the future or
delayed pay-off can be found by multiplying that pay-off by the
discount factor which is less than one and which can be expressed
as follows:
1
=
1+
It follows that to obtain the value of the asset, we need to know
two things. One, the expected or projected future cash flows; and
two, the discount rate which is also known as the hurdle rate or
the opportunity cost of investment. The discount rate is equal to
the RRR which is approximated by the rate of return available on
the next best opportunity for investment which the investor
forgoes by investing in the asset in question. We illustrate below
the basic valuation model by giving the present value formulae

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for only five types of future cash flows, although there is a wide
range of possibilities in respect of the types of cash flows.
(i) Cash flow to be received at the end of one year:

=
(1 + )
(ii) cash flow to be received at the end of the fifth year:

=
(1 + )
(iii) continuous uneven (not the same) stream of cash flows
to be received at the end of each year for a period of time:

= + + ⋯+
(1 + ) (1 + ) (1 + )

=
(1 + )

(iv) Continuous even (fixed) stream of cash flows to be

received at the end of each year for a given period of
time. This is known as annuity which can be valued as
follows:

= + + ⋯+
(1 + ) (1 + ) (1 + )

=
(1 + )

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Or
1 1
= [ −
(1 + )
(v) Continuous even (fixed) stream of cash flows to be
received indefinitely. This is known as perpetuity and
can be valued as follows:

In all of the above formulae,

PV= Present Value;
C=Cash flow;
t=End of the year (period);
n=Duration of cash flow; and
r=Discount rate.
The term rt, in these equations implies that, in principle, there has to
be a different discount rate for different future periods. The higher
rate can be applied for the longer maturity. However, since normally
a flat term structure of interest rates is assumed in this context, the
term rt, can be replaced by the term r. The level of PV of the asset
depends upon the timing of the cash flow and the level of discount
rate. Given the discount rate, the more further off the pay-off, the
lower the PV. Similarly, given the timing the higher the discount
rate, the lower the PV. Thus, the PV is inversely related to both the
timing of the cash flow and the discount rate. Closely related to the
concept of PV is that of Net Present Value (NPV), which is equal to

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PV minus the required investment or the cash outflows (costs)

associated with the investment.

= (1 + )

= (1 + )

2.2. Valuation of Bonds and Stocks

A bond is a debt instrument that provides a steady income stream to
the investor in the form of coupon payments. At the maturity date,
the full face value of the bond is repaid to the bondholder. The
characteristics of a regular bond include:
• Coupon rate: Some bonds have an interest rate, also known
as the coupon rate, which is paid to bondholders semi-annually. The
coupon rate is the fixed return that an investor earns periodically
until it matures.
• Maturity date: All bonds have maturity dates, some short-
term, others long-term. When a bond matures, the bond issuer repays
the investor the full face value of the bond. For corporate bonds, the
face value of a bond is usually $1,000 and for government bonds,
the face value is $10,000. The face value is not necessarily the
invested principal or purchase price of the bond.
• Current price: Depending on the level of interest rate in the
environment, the investor may purchase a bond at par, below par, or
above par. For example, if interest rates increase, the value of a bond
will decrease since the coupon rate will be lower than the interest
rate in the economy. When this occurs, the bond will trade at a
discount, that is, below par. However, the bondholder will be paid
the full face value of the bond at maturity even though he purchased
it for less than the par value.

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Since bonds are an essential part of the capital markets, investors and
analysts seek to understand how the different features of a bond
interact in order to determine its intrinsic value. Like a stock, the
value of a bond determines whether it is a suitable investment for a
portfolio and hence, is an integral step in bond investing. Bond
valuation, in effect, is calculating the present value of a bond’s
expected future coupon payments. The theoretical fair value of a
bond is calculated by discounting the future value of its coupon
payments by an appropriate discount rate. The discount rate used is
the yield to maturity, which is the rate of return that an investor will
get if they reinvested every coupon payment from the bond at a fixed
interest rate until the bond matures. It takes into account the price of
a bond, par value, coupon rate, and time to maturity.
Bond valuation is a technique for determining the theoretical fair
value of a particular bond. Bond valuation includes calculating the
present value of a bond's future interest payments, also known as its
cash flow, and the bond's value upon maturity, also known as its face
value or par value. Because a bond's par value and interest payments
are fixed, an investor uses bond valuation to determine what rate of
return is required for a bond investment to be worthwhile.
• Coupon Bond Valuation
Calculating the value of a coupon bond factors in the annual or semi-
annual coupon payment and the par value of the bond. The present
value of expected cash flows is added to the present value of the face
value of the bond as seen in the following formula:

=
(1 + )

=
(1 + )

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Where:
C= future cash flows, that is, coupon payment
r = discount rate, that is , yield to maturity
F = face value of the bond
t = number of periods
T = time to maturity
• Zero-Coupon Bond Valuation
A zero-coupon bond makes no annual or semi-annual coupon
payments for the duration of the bond. Instead, it is sold at a deep
discount to par when issued. The difference between the purchase
price and par value is the investor’s interest earned on the bond. To
calculate the value of a zero-coupon bond, we only need to find the
present value of the face value.
Under both calculations, a coupon-paying bond is more valuable
than a zero-coupon bond.
• Convertible Bonds Valuation
A convertible bond is a debt instrument that has an embedded option
that allows investors to convert the bonds into shares of the
company's common stock. Convertible bond valuations take a
multitude of factors into account, including the variance in
underlying stock price, the conversion ratio, and interest rates that
could affect the stocks that such bonds might eventually become. At
its most basic, the convertible is priced as the sum of the straight
bond and the value of the embedded option to convert.

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Stock Valuation
Stock valuation is a method of determining the intrinsic value (or
theoretical value) of a stock. The importance of valuing stocks
evolves from the fact that the intrinsic value of a stock is not attached
to its current price. By knowing a stock’s intrinsic value, an investor
may determine whether the stock is over- or under-valued at its
current market price. Valuing stocks is an extremely complicated
process that can be generally viewed as a combination of both art
and science. Investors may be overwhelmed by the amount of
available information that can be potentially used in valuing stocks
(company’s financials, newspapers, economic reports, stock reports,
etc.).

 Types of Stock Valuation

Stock valuation methods can be primarily categorized into two main
types: absolute and relative.
1. Absolute
Absolute stock valuation relies on the company’s fundamental
information. The method generally involves the analysis of various
financial information that can be found in or derived from a
company’s financial statements. Many techniques of absolute stock
valuation primarily investigate the company’s cash flows,
dividends, and growth rates. Notable absolute stock valuation
methods include the dividend discount model (DDM) and the
discounted cash flow model (DCF).
2. Relative
Relative stock valuation concerns the comparison of the investment
with similar companies. The relative stock valuation method deals
with the calculation of the key financial ratios of similar companies

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and derivation of the same ratio for the target company. The best
example of relative stock valuation is comparable companies
analysis.

 Stock Valuation Methods

Below, we will briefly discuss the most popular methods of stock
valuation.
1. Dividend Discount Model (DDM)
The dividend discount model is one of the basic techniques of
absolute stock valuation. The DDM is based on the assumption that
the company’s dividends represent the company’s cash flow to its
shareholders. Essentially, the model states that the intrinsic value of
the company’s stock price equals the present value of the company’s
future dividends. Note that the dividend discount model is applicable
only if a company distributes dividends regularly and the
distribution is stable.
2. Discounted Cash Flow Model (DCF)
The discounted cash flow model is another popular method of
absolute stock valuation. Under the DCF approach, the intrinsic
value of a stock is calculated by discounting the company’s free cash
flows to its present value. The main advantage of the DCF model is
that it does not require any assumptions regarding the distribution of
dividends. Thus, it is suitable for companies with unknown or
unpredictable dividend distribution. However, the DCF model is
sophisticated from a technical perspective.
3. Comparable Companies Analysis
The comparable analysis is an example of relative stock valuation.
Instead of determining the intrinsic value of a stock using the

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company’s fundamentals, the comparable approach aims to derive a

stock’s theoretical price using the price multiples of similar
companies. The most commonly used multiples include the price-
to-earnings (P/E), price-to-book (P/B), and enterprise value-to-
EBITDA (EV/EBITDA). The comparable companies analysis
method is one of the simplest from a technical perspective.
However, the most challenging part is the determination of truly
comparable companies.
Bond Yield
Bond is an instrument to borrow money. A bond could be issued by
a country’s government or by a company to raise funds. A bond's
yield refers to the expected earnings generated and realized on a
fixed-income investment over a particular period of time, expressed
as a percentage or interest rate. In other words, Bond yield is the
return an investor realizes on a bond. The mathematical formula for
calculating yield is the annual coupon rate divided by the current
market price of the bond
When investors buy bonds, they essentially lend bond issuers
money. In return, bond issuers agree to pay investors interest on
bonds through the life of the bond and to repay the face value of
bonds upon maturity. The simplest way to calculate a bond yield is
to divide its coupon payment by the face value of the bond. This is
called the coupon rate. Coupon Rate is the rate of interest paid by
bond issuers on the bond's face value. If a bond is purchased for
more than its face value (premium) or less than its face value
(discount), which will change the yield an investor earns on the
bond.

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As bond prices increase, bond yields fall. Its coupon rate is the
interest divided by its par value.
If interest rates rise above 10%, the bond's price will fall if the
investor decides to sell it. If the original bond owner wants to sell the
bond, the price can be lowered so that the coupon payments and
maturity value equal a yield of 12%. In this case, that means the
investor would drop the price of the bond. If interest rates were to
fall in value, the bond's price would rise because its coupon payment
is more attractive. The further rates fall, the higher the bond's price
will rise, and the same is true in reverse when interest rates rise. In
either scenario, the coupon rate no longer has any meaning for a new
investor. However, if the annual coupon payment is divided by the
bond's price, the investor can calculate the current yield and get a
rough estimate of the bond's true yield.

The current yield and the coupon rate are incomplete calculations for
a bond's yield because they do not account for the time value of
money, maturity value, or payment frequency.

 Yield to Maturity
A bond's yield to maturity (YTM) is equal to the interest rate that
makes the present value of all a bond's future cash flows equal to its
current price. These cash flows include all the coupon payments and
its maturity value. Solving for YTM is a trial and error process that
can be done on a financial calculator, but the formula is as follows:

ℎ
=
(1 + )

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Where: YTM = Yield to maturity

 Bond Equivalent Yield – BEY

Bond yields are normally quoted as a bond equivalent yield (BEY),
which makes an adjustment for the fact that most bonds pay their
annual coupon in two semi-annual payments.
The BEY is a simple annualized version of the semi-annual YTM
and is calculated by multiplying the YTM by two. The BEY does
not account for the time value of money for the adjustment from a
semi-annual YTM to an annual rate.
Effective Annual Yield – EAY
Investors can find a more precise annual yield once they know the
BEY for a bond if they account for the time value of money in the
calculation. In the case of a semi-annual coupon payment, the
effective annual yield (EAY) would be calculated as follows:

= (1 + ) −1
2
Where:
EAY=Effective Annual Yield

 Complications Finding a Bond's Yield

There are a few factors that can make finding a bond's yield more
complicated. For instance, in the previous examples, it was assumed
that the bond had exactly five years left to maturity when it was sold,
which would rarely be the case.
When calculating a bond's yield, the fractional periods can be dealt
with simply; the accrued interest is more difficult. For example,

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imagine a bond that has four years and eight months left to maturity.
The exponent in the yield calculations can be turned into a decimal
to adjust for the partial year. However, this means that four months
in the current coupon period have elapsed and there are two more to
go, which requires an adjustment for accrued interest. A new bond
buyer will be paid the full coupon, so the bond's price will be inflated
slightly to compensate the seller for the four months in the current
coupon period that have elapsed.
Bonds can be quoted with a "clean price" that excludes the accrued
interest or the "dirty price" that includes the amount owed to
reconcile the accrued interest. When bonds are quoted in a system
like a Bloomberg or Reuters terminal, the clean price is used.
What does a bond's yield tell investors?
A bond's yield is the return to an investor from the bond's coupon
(interest) payments. It can be calculated as a simple coupon yield,
which ignores the time value of money and any changes in the bond's
price or using a more complex method like yield to maturity. Higher
yields mean that bond investors are owed larger interest payments,
but may also be a sign of greater risk. The riskier a borrower is, the
more yield investors demand to hold their debts. Higher yields are
also associated with longer maturity bonds.
Are high-yield bonds better investments than low-yield bonds?
Like any investment, it depends on one's individual circumstances,
goals, and risk tolerance. Low-yield bonds may be better for
investors who want a virtually risk-free asset, or one who is hedging
a mixed portfolio by keeping a portion of it in a low-risk asset. High-
yield bonds may instead be better-suited for investors who are
willing to accept a degree of risk in return for a higher return. The
risk is that the company or government issuing the bond will default

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on its debts. Diversification can help lower portfolio risk while

boosting expected returns.
What are some common yield calculations?
The yield to maturity (YTM) is the total return anticipated on a bond
if the bond is held until it matures. Yield to maturity is considered a
long-term bond yield but is expressed as an annual rate. YTM is
usually quoted as a bond equivalent yield (BEY), which makes
bonds with coupon payment periods less than a year easy to
compare. The annual percentage yield (APY) is the real rate of return
earned on a savings deposit or investment taking into account the
effect of compounding interest. The annual percentage rate (APR)
includes any fees or additional costs associated with the transaction,
but it does not take into account the compounding of interest within
a specific year. An investor in a callable bond also wants to estimate
the yield to call (YTC), or the total return that will be received if the
bond purchased is held only until its call date instead of full maturity.
How do investors utilize bond yields?
In addition to evaluating the expected cash flows from individual
bonds, yields are used for more sophisticated analyses. Traders may
buy and sell bonds of different maturities to take advantage of the
yield curve, which plots the interest rates of bonds having equal
credit quality but differing maturity dates. The slope of the yield
curve gives an idea of future interest rate changes and economic
activity. They may also look to the difference in interest rates
between different categories of bonds, holding some characteristics
constant. A yield spread is the difference between yields on differing
debt instruments of varying maturities, credit ratings, issuer, or risk
level, calculated by deducting the yield of one instrument from the
other -- for example the spread between AAA corporate bonds and

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U.S. Treasuries. This difference is most often expressed in basis

points (bps) or percentage points.
Yield to Maturity (YTM)
Yield to maturity (YTM) is the total return anticipated on a bond if
the bond is held until it matures. Yield to maturity is considered a
long-term bond yield but is expressed as an annual rate. In other
words, it is the internal rate of return (IRR) of an investment in a
bond if the investor holds the bond until maturity, with all payments
made as scheduled and reinvested at the same rate.
Yield to maturity is also referred to as "book yield" or "redemption
yield."
Yield to maturity (YTM) is the total rate of return that will have been
earned by a bond when it makes all interest payments and repays the
original principal.
YTM is essentially a bond's internal rate of return (IRR) if held to
maturity.
Calculating the yield to maturity can be a complicated process, and
it assumes all coupon or interest, payments can be reinvested at the
same rate of return as the bond.
1:56
Bond Yields: Current Yield And YTM
Understanding Yield to Maturity (YTM)
Yield to maturity is similar to current yield, which divides annual
cash inflows from a bond by the market price of that bond to
determine how much money one would make by buying a bond and
holding it for one year. Yet, unlike current yield, YTM accounts for
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the present value of a bond's future coupon payments. In other

words, it factors in the time value of money, whereas a simple
current yield calculation does not. As such, it is often considered a
more thorough means of calculating the return from a bond.
The YTM of a discount bond that does not pay a coupon is a good
starting place in order to understand some of the more complex
issues with coupon bonds.

Calculating YTM
The formula to calculate YTM of a discount bond is as follows:

= −1

Where:
n = Number of years to maturity
Face value = bond’s maturity value or par value
Current price = the bond’s price today
Because YTM is the interest rate an investor would earn by
reinvesting every coupon payment from the bond at a constant
interest rate until the bond's maturity date, the present value of all the
future cash flows equals the bond's market price. An investor knows
the current bond price, its coupon payments, and its maturity value,
but the discount rate cannot be calculated directly. However, there is
a trial-and-error method for finding YTM with the following present
value formula:

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= ×( )
+( ×

( )
)

Each one of the future cash flows of the bond is known and because
the bond's current price is also known, a trial-and-error process can
be applied to the YTM variable in the equation until the present
value of the stream of payments equals the bond's price.
Solving the equation by hand requires an understanding of the
relationship between a bond's price and its yield, as well as the
different types of bond pricings. Bonds can be priced at a discount,
at par, or at a premium. When the bond is priced at par, the bond's
interest rate is equal to its coupon rate. A bond priced above par,
called a premium bond, has a coupon rate higher than the realized
interest rate, and a bond priced below par, called a discount bond,
has a coupon rate lower than the realized interest rate.
If an investor were calculating YTM on a bond priced below par,
they would solve the equation by plugging in various annual interest
rates that were higher than the coupon rate until finding a bond price
close to the price of the bond in question.
Calculations of yield to maturity (YTM) assume that all coupon
payments are reinvested at the same rate as the bond's current yield
and take into account the bond's current market price, par value,
coupon interest rate, and term to maturity. The YTM is merely a
snapshot of the return on a bond because coupon payments cannot
always be reinvested at the same interest rate. As interest rates rise,
the YTM will increase; as interest rates fall, the YTM will decrease.
The complex process of determining yield to maturity means it is
often difficult to calculate a precise YTM value. Instead, one can

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approximate YTM by using a bond yield table, financial calculator,

or online yield to maturity calculator.

 Uses of Yield to Maturity (YTM)

Yield to maturity can be quite useful for estimating whether buying
a bond is a good investment. An investor will determine a required
yield (the return on a bond that will make the bond worthwhile).
Once an investor has determined the YTM of a bond they are
considering buying, the investor can compare the YTM with the
required yield to determine if the bond is a good buy.
Because YTM is expressed as an annual rate regardless of the bond's
term to maturity, it can be used to compare bonds that have different
maturities and coupons since YTM expresses the value of different
bonds in the same annual terms.

 Variations of Yield to Maturity (YTM)

Yield to maturity has a few common variations that account for
bonds that have embedded options:
Yield to call (YTC) assumes that the bond will be called. That is, a
bond is repurchased by the issuer before it reaches maturity and thus
has a shorter cash flow period. YTC is calculated with the
assumption that the bond will be called at soon as it is possible and
financially feasible.
Yield to put (YTP) is similar to YTC, except the holder of a put bond
can choose to sell the bond back to the issuer at a fixed price based
on the terms of the bond. YTP is calculated based on the assumption
that the bond will be put back to the issuer as soon as it is possible
and financially feasible.

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Yield to worst (YTW) is a calculation used when a bond has multiple

options. For example, if an investor was evaluating a bond with both
calls and put provisions, they would calculate the YTW based on the
option terms that give the lowest yield.
Limitations of Yield to Maturity (YTM)
YTM calculations usually do not account for taxes that an investor
pays on the bond.1 In this case, YTM is known as the gross
redemption yield. YTM calculations also do not account for
purchasing or selling costs.
YTM also makes assumptions about the future that cannot be known
in advance. An investor may not be able to reinvest all coupons, the
bond may not be held to maturity, and the bond issuer may default
on the bond.

 Yield to Maturity (YTM)

A bond's yield to maturity (YTM) is the internal rate of return
required for the present value of all the future cash flows of the bond
(face value and coupon payments) to equal the current bond price.
YTM assumes that all coupon payments are reinvested at a yield
equal to the YTM and that the bond is held to maturity.
Some of the more known bond investments include municipal,
treasury, corporate, and foreign. While municipal, treasury, and
foreign bonds are typically acquired through local, state, or federal
governments, corporate bonds are purchased through brokerages.2
If you have an interest in corporate bonds then you will need a
brokerage account.

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 What Is a Bond’s Yield to Maturity (YTM)?

The YTM of a bond is essentially the internal rate of return (IRR)
associated with buying that bond and holding it until its maturity
date. In other words, it is the return on investment associated with
buying the bond and reinvesting its coupon payments at a constant
interest rate. All else being equal, the YTM of a bond will be higher
if the price paid for the bond is lower, and vice-versa.

 What Is the Difference Between a Bond’s YTM and Its

Coupon Rate?
The main difference between the YTM of a bond and its coupon rate
is that the coupon rate is fixed whereas the YTM fluctuates over
time. The coupon rate is contractually fixed, whereas the YTM
changes based on the price paid for the bond as well as the interest
rates available elsewhere in the marketplace. If the YTM is higher
than the coupon rate, this suggests that the bond is being sold at a
discount to its par value. If, on the other hand, the YTM is lower than
the coupon rate, then the bond is being sold at a premium.

 Is It Better to Have a Higher YTM?

Whether or not a higher YTM is positive depends on the specific
circumstances. On the one hand, a higher YTM might indicate that
a bargain opportunity is available since the bond in question is
available for less than its par value. But the key question is whether
or not this discount is justified by fundamentals such as the
creditworthiness of the company issuing the bond, or the interest
rates presented by alternative investments. As is often the case in
investing, further due diligence would be required.

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2.3. Equity Valuation

Equity valuation is a blanket term and is used to refer to all tools and
techniques used by investors to find out the true value of a
company’s equity. It is often seen as the most crucial element of a
successful investment decision. Investment Banks typically have a
equity research department, where research analysts produce equity
research reports of select securities in various industries.
Every participant in the stock market either implicitly or explicitly
makes use of equity valuation while making investment decisions.
Everyone from small individual investors to large institutional
investors use equity valuations to make investment decisions in
equity markets. The total size of the global equity market is
estimated to be around $70 trillion and every participant in the stock
market, from professional fund managers to academic researchers,
is trying to find mispriced stocks.
Inputs in the Equity Valuation Process
The true value of any financial asset is thought to be a good indicator
of how that asset will do in the long run. In equity markets, a
financial asset with a relatively high intrinsic value is expected to
command a high price, and a financial asset with a relatively low
intrinsic value is expected to command a low price.
Distortions can take place in the short run, i.e., financial assets with
relatively low intrinsic value might command a high price and vice-
a-versa, but such distortions are expected to disappear over time. In
the long run, the true value of a stock (and thereby the market price
of that stock) depends only on the fundamental factors affecting the
stock. The factors can be broadly classified into four categories.

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 Macroeconomic variables

 Management of the business

 Financial health of the business

 Profits of the business

2.4. Dividend Discount Model

The Dividend Discount Model (DDM) is a quantitative method
of valuing a company’s stock price based on the assumption that
the current fair price of a stock equals the sum of all of the
company’s future dividends discounted back to their present
value.
The dividend discount model was developed under the
assumption that the intrinsic value of a stock reflects the present
value of all future cash flows generated by a security. At the same
time, dividends are essentially the positive cash flows generated
by a company and distributed to the shareholders.
Generally, the dividend discount model provides an easy way to
calculate a fair stock price from a mathematical perspective with
minimum input variables required. However, the model relies on
several assumptions that cannot be easily forecasted.
Depending on the variation of the dividend discount model, an
analyst requires forecasting future dividend payments, the growth
of dividend payments, and the cost of equity capital. Forecasting
all the variables precisely is almost impossible. Thus, in many
cases, the theoretical fair stock price is far from reality.

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Formula for the Dividend Discount Model

The dividend discount model can take several variations
depending on the stated assumptions. The variations include the
following:

1. Gordon Growth Model

The Gordon Growth Model (GGM) is one of the most commonly
used variations of the dividend discount model. The model is
called after American economist Myron J. Gordon, who proposed
the variation. The GGM assists an investor in evaluating a stock’s
intrinsic value based on the potential dividend’s constant rate of
growth.
The GGM is based on the assumption that the stream of future
dividends will grow at some constant rate in the future for an
infinite time. The model is helpful in assessing the value of stable
businesses with strong cash flow and steady levels of dividend
growth. It generally assumes that the company being evaluated
possesses a constant and stable business model and that the
growth of the company occurs at a constant rate over time.
Mathematically, the model is expressed in the following way:

=
−
Where:
V0 – The current fair value of a stock
D1 – The dividend payment in one period from now
r – The estimated cost of equity capital (usually calculated using
CAPM)
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g – The constant growth rate of the company’s dividends for an

infinite time
2. One-Period Dividend Discount Model
The one-period discount dividend model is used much less
frequently than the Gordon Growth model. The former is applied
when an investor wants to determine the intrinsic price of a stock
that he or she will sell in one period (usually one year) from now.
The one-period DDM generally assumes that an investor is
prepared to hold the stock for only one year. Because of the short
holding period, the cash flows expected to be generated by the
stock are the single dividend payment and the selling price of the
respective stock.
Hence, to determine the fair price of the stock, the sum of the
future dividend payment and that of the estimated selling price,
must be computed and discounted back to their present values.
The one-period dividend discount model uses the following
equation:

= +
1+ 1+
Where:
V0 – The current fair value of a stock
D1 – The dividend payment in one period from now
P1 – The stock price in one period from now
r – The estimated cost of equity capital

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3. Multi-Period Dividend Discount Model

The multi-period dividend discount model is an extension of the
one-period dividend discount model wherein an investor expects
to hold a stock for multiple periods. The main challenge of the
multi-period model variation is that forecasting dividend
payments for different periods is required.
In the multiple-period DDM, an investor expects to hold the stock
he or she purchased for multiple time periods. Therefore, the
expected future cash flows will consist of numerous dividend
payments, and the estimated selling price of the stock at the end
of the holding period.
The intrinsic value of a stock (via the Multiple-Period DDM) is
found by estimating the sum value of the expected dividend
payments and the selling price, discounted to find their present
values.
The model’s mathematical formula is below:

= + + ⋯+ +
(1 + ) (1 + ) (1 + ) (1 + )
Shortcomings of Dividend Discount Model
A shortcoming of the DDM is that the model follows a perpetual
constant dividend growth rate assumption. This assumption is not
ideal for companies with fluctuating dividend growth rates or
irregular dividend payments, as it increases the chances of
imprecision.
Another drawback is the sensitivity of the outputs to the inputs.
Furthermore, the model is not fit for companies with rates of
return that are lower than the dividend growth rate.

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2.5. The P/E Ratio Approach

The Price Earnings Ratio (P/E Ratio) is the relationship between
a company’s stock price and earnings per share (EPS). EPS is a
financial ratio, which divides net earnings available to common
shareholders by the average outstanding shares over a certain
period of time. The EPS formula indicates a company’s ability to
produce net profits for common shareholders. This guide breaks
down the Earnings per Share formula in detail. It is a popular ratio
that gives investors a better sense of the value of the company.
The P/E ratio shows the expectations of the market and is the price
you must pay per unit of current earnings (or future earnings, as
the case may be).
Earnings are important when valuing a company’s stock because
investors want to know how profitable a company is and how
profitable it will be in the future. Furthermore, if the company
doesn’t grow and the current level of earnings remains constant,
the P/E can be interpreted as the number of years it will take for
the company to pay back the amount paid for each share.
The P/E ratio is standardizes stocks of different prices and
earnings levels. The P/E is also called an earnings multiple. There
are two types of P/E: trailing and forward. The former is based on
previous periods of earnings per share, while a leading or forward
P/E ratio is when EPS calculations are based on future estimates,
which predicted numbers (often provided by management or
equity research analysts).
Price Earnings Ratio Formula
P/E = Stock Price Per Share / Earnings Per Share or
P/E = Market Capitalization / Total Net Earnings or

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Justified P/E = Dividend Payout Ratio / R – G

where;
R = Required Rate of Return
G = Sustainable Growth Rate
The basic P/E formula takes the current stock price and EPS to
find the current P/E. EPS is found by taking earnings from the last
twelve months divided by the weighted average shares
outstanding. Earnings can be normalized for unusual or one-off
items that can impact earnings abnormally. Learn more about
normalized EPS.
The justified P/E ratio is used to find the P/E ratio that an investor
should be paying for, based on the companies dividend and
retention policy, growth rate, and the investor’s required rate of
return. Comparing justified P/E to basic P/E is a common stock
valuation method.
Investors want to buy financially sound companies that offer a
good return on investment (ROI). Among the many ratios, the P/E
is part of the research process for selecting stocks because we can
figure out whether we are paying a fair price. Similar companies
within the same industry are grouped together for comparison,
regardless of the varying stock prices. Moreover, it’s quick and
easy to use when we’re trying to value a company using earnings.
When a high or a low P/E is found, we can quickly assess what
kind of stock or company we are dealing with.

2.6. Modigliani – Miller Theorem

The M&M Theorem, or the Modigliani-Miller Theorem, is one
of the most important theorems in corporate finance. The theorem

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was developed by economists Franco Modigliani and Merton

Miller in 1958. This theorem also known as ‘Capital Structure
Irrelevance Theorem’. The main idea of the M&M theory is that
the capital structure of a company does not affect its overall value.
The first version of the M&M theory was full of limitations as it
was developed under the assumption of perfectly efficient
markets, in which the companies do not pay taxes, while there are
no bankruptcy costs or asymmetric information. Subsequently,
Miller and Modigliani developed the second version of their
theory by including taxes, bankruptcy costs, and asymmetric
information.

The M&M Theorem in Perfectly Efficient Markets

This is the first version of the M&M Theorem with the
assumption of perfectly efficient markets. The assumption
implies that companies operating in the world of perfectly
efficient markets do not pay any taxes, the trading of securities is
executed without any transaction costs, bankruptcy is possible but
there are no bankruptcy costs, and information is perfectly
symmetrical.
Proposition 1 (M&M I): =
Where:
VU = Value of the unlevered firm (financing only through equity)
VL = Value of the levered firm (financing through a mix of debt
and equity)
The first proposition essentially claims that the company’s capital
structure does not impact its value. Since the value of a company
is calculated as the present value of future cash flows, the capital

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structure cannot affect it. Also, in perfectly efficient markets,

companies do not pay any taxes. Therefore, the company with a
100% leveraged capital structure does not obtain any benefits
from tax-deductible interest payments.
Proposition 2 (M&M I):

= + ( − )

Where:
rE = Cost of levered equity
ra = Cost of unlevered equity
rD = Cost of debt
D/E = Debt-to-equity ratio
The second proposition of the M&M Theorem states that the
company’s cost of equity is directly proportional to the
company’s leverage level. (Cost of Equity is the rate of return a
company pays out to equity investors. A firm uses cost of equity
to assess the relative attractiveness of investments, including both
internal projects and external acquisition opportunities.
Companies typically use a combination of equity and debt
financing, with equity capital being more expensive.) An increase
in leverage level induces higher default probability to a company.
Therefore, investors tend to demand a higher cost of equity
(return) to be compensated for the additional risk.
M&M Theorem in the Real World
Conversely, the second version of the M&M Theorem was
developed to better suit real-world conditions. The assumptions
of the newer version imply that companies pay taxes; there are
transaction, bankruptcy, and agency costs; and information is not
symmetrical.
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Proposition 1 (M&M II):

= + ×
Where:
tc = Tax rate
D = Debt
The first proposition states that tax shields that result from the
tax-deductible interest payments make the value of a levered
company higher than the value of an unlevered company. The
main rationale behind the theorem is that tax-deductible interest
payments positively affect a company’s cash flows. Since a
company’s value is determined as the present value of the future
cash flows, the value of a levered company increases.
Proposition 2 (M&M II):

= + × (1 − )×( − )

The second proposition for the real-world condition states that the
cost of equity has a directly proportional relationship with the
leverage level.
Nonetheless, the presence of tax shields affects the relationship
by making the cost of equity less sensitive to the leverage level.
Although the extra debt still increases the chance of a company’s
default, investors are less prone to negatively reacting to the
company taking additional leverage, as it creates the tax shields
that boost its value.

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Module III
Risk and Return
Certainty is a situation where in the value the variable can take
is known with a probability of unity. In a situation of uncertainty,
the objective probability distribution of values is not known, but
the experts can have a feel about the range of values a variable
can take along with the chances of their occurrence. These
subjective feelings can be translated into subjective probabilities
and can be used when objective probabilities are not available.
Risk is a situation where in the objective probability distribution
of the values a variable can take is known, even though the exact
values it would take are not known. The objective probability is
one which is supported by rigorous theory, past experience and
the laws of chance. Strictly speaking, while the risk is measurable,
uncertainty is not. Since a situation of uncertainty can be reduced
to a situation of risk by using subjective probabilities, the two
terms, risk and uncertainty, are generally used interchangeably.
In a practically useful way, the risk can be defined as the chance
that the expected or prospective advantage, gain, profit or return
may not materialise and that the actual outcome of investment
may be less than the expected outcome.
3.1. Types of Risk
Systematic versus Unsystematic Risk
The different types of risks are broadly classified as systematic
and unsystematic risks. The variability in a security's total return
that is directly associated with the overall movements in the
general market or economy is called systematic risk. This type of

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risk is inescapable no matter how well the portfolio is diversified.

It is caused by a wide range of factors exogenous to securities
themselves, viz., recession, war and structural changes in the
economy. The other names for systematic risk are market risk or
non-diversifiable risk: it would be more appropriate to call it a
'systemic' risk. The systematic risk arises due to the fluctuations
of the macroeconomic fundamentals such as interest rate,
inflation and so on.
The variability in a security's total return that is not related to the
overall market variability is called unsystematic risk. An investor
can build a diversified portfolio and reduce or eliminate this type
of risk. Therefore, it has also been defined as that risk which can
be reduced or eliminated through diversification of security
holdings. The other names for unsystematic risk are 'non-market
risk' or 'diversifiable risk'; it would be more appropriate to call it
a 'non-systemic' risk. The unsystematic risk can also be called as
idiosyncratic risk, which is specific to the company or any
individual.
Market Risk (Beta)
The capital market and portfolio theories have developed a
'critically important concept of beta (β) measure of relative risk
of a security or its sensitivity to the movements in the market.
Beta indicate extent to which the risk of a given asset is non-
diversifiable; it is a coefficient measuring a security's relative
volatility, Statistically, beta is the covariance of a security's return
with that of the market for a security Alternatively, it is the slope
of the regression line relating a security return with the market
return. The security with a higher (than 1) beta is more volatile
than the market, and the asset with a lower (than 1) beta would
rise or fall more slowly than the market.

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Figure.3.1 Concept of Beta

Figure 3.1 portrays the concept of beta. Line β (45 degree line)
represents β= 1 which means that for every one percentage
change in the market return, on an average, the security return
also will change by 1 percent, that is, both the returns will be
volatile to the same extent. Line A means that the security return
is more volatile than the market return, while, line C means that
the former is less volatile than the latter.
Interest Rate Risk
Interest rate risk is the variability in return on security due to
changes in the level of market interest rates, or it is the loss of
principal of a fixed-return security due to an increase in the
general level of interest rates. When interest rates rise, the value
or market price of the security drops, and vice versa. The degree
of interest rate risk is directly related to the length of time to
maturity of the security, if the term to maturity is long. market
value of the security may fluctuate widely.

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Interest rate risk has two parts; first, the price risk resulting from
the inverse relationship between the security price and interest
rates, and second, the reinvestment risk resulting from the
uncertainty about the interest rate at which the future coupon
income or principal can be reinvested. These two parts of interest
rate risk move in opposite directions. If interest rates increase, the
price risk increases (because the security price declines) but the
reinvestment risk declines (because the reinvestment rate
increases). Interest rate risk exists in case of all types of securities
including common stock, although it affects bonds more directly
than equities.
Inflation Risk
Inflation risk is the risk that the real return on a security may be
less than the nominal return. In case of fixed income securities,
since payments in terms of rupees are fixed, the value of the
payments in real terms declines as the level of commodity prices
increases. Inflation risk is also known as purchasing power risk
as there is always a chance or possibility that the purchasing
power of invested money will decline, or that the real (inflation-
adjusted) return will decline due to inflation. It may be noted that
inflation risk is really the risk of unanticipated or uncertain
inflation. If anticipated, inflation can be compensated. Similarly,
inflation risk, like default risk, is more relevant in case of fixed
income securities; common stocks are regarded as hedges against
inflation. Inflation risk is closely related to interest rate risk since
interest rates generally rise when inflation occurs.

Exchange Rate or Currency Risk

Exchange rate risk refers to cash-flow variability experienced by
economic units engaged in international transactions or
international exchange, on account of uncertain or unexpected

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changes in exchange rates. It is the risk that changes in currency

exchange rates may have an unfavourable impact on costs or
revenues of, say, business units. There is no exchange rate risk
under the fixed exchange rate system, while it is the highest under
the freely floating exchange rate system.
Business Risk
Business risk is the uncertainty of income flows that is caused by
the nature of a firm's business, that is, by doing business in a
particular environment. This risk has two components: internal
and external. The former results from the operating conditions or
operating efficiency of the firm, and it is manageable within or by
the firm. The latter is the result of operating conditions which the
firm faces but which are beyond its control. Business risk is
measured by the distribution of the firm's operating income (i.e.
firm's earnings before interest and tax) over time.
Financial Risk
Financial risk is associated with the use of debt financing by firms
or companies. Since the presence of debt involves the legal or
mandatory obligation make specified payments at specified time
periods, there is a risk that the earnings of the firm may not be
sufficient to meet these obligations towards the creditors. In case
of shareholders, the financial risk arises because of not only the
mandatory nature of debt obligations but also the property of prior
payments of these obligations. In short, the use of debt by the firm
causes variability of return for both creditors and shareholders.
Financial risk is usually measured by the debt equity ratio of the
firm; the higher this ratio, the greater the variability of return and
higher the financial risk

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Default Risk
Default risk arises from the failure on the part of the borrower or
debtor to pay the specified amount of interest and/or to repay the
principal, both at the time specified in the debt contractor
covenant or indenture. It may be noted that the default risk has
the capital risk and income risk as its components, and that it
means not only the complete failure to pay but also the delay in
payment.

Liquidity Risk
Liquidity risk refers to a situation wherein it may not be possible
to dispose off or sell the asset, or it may be possible to do so only
at great inconvenience and cost in terms of money and time. An
asset that can be bought and sold quickly, and without significant
price concession and transaction cost is said to be liquid. The
greater the uncertainty about time element, price concession and
transaction cost, the greater the liquidity risk. Liquidity risk refers
to their inability to meet the liabilities towards depositors when
they want to withdraw their deposits.
Maturity Risk
Maturity risk arises when the term of maturity of the security
happens to be longer. Since foreseeing, forecasting and
envisioning the environment, conditions and situations become
more and more difficult as we stretch more and more into the
future, the long-term investment involves risk. The longer the
term to maturity, the greater is the risk.

Call Risk
Call risk is associated with the corporate bonds which are issued
with call-back provision or option whereby the issuer has the right

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of redeeming the bonds before their maturity. In case of such

bonds, the band holders face the risk of giving up higher coupon
bonds, reinvesting proceeds only at lower interest rates, and
incurring the cost and inconvenience of reinvestment.
Total Risk
Total risk is the total variability in the return on the asset or the
portfolio, whatever the source(s) of that variability. It is the
uncertainty or volatility in return due to both security-specific and
economy-wide factors. We can say that total risk is the
summation of the systematic and unsystematic risk.
Country Risk
The uncertainty or variability of return in respect of an investment
in a foreign country is known as country risk. It is a complicated
concept and it has many elements or sources. The political risk is
one of its major elements, and the common denominator of
political risk is the government intervention in the working of the
economy that affects the value of the firm or investment.
Economic stability is its another important element.
3.2. Historical returns and Risk
Historical (Ex-Post) Returns
Historical returns are often associated with the past performance
of a security or index, such as the S&P 500. Investors study
historical return data when trying to forecast future returns or to
estimate how a security might react in a situation. Calculating the
historical return is done by subtracting the most recent price from
the oldest price and divide the result by the oldest price.

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The return is the total gain or loss experienced on an investment

over a given period of time. It is commonly measured as cash
distributions during the period plus the change in value, expressed
as a percentage of the beginning-of-period investment value. For
stocks, the return for a particular time period is equal to the sum
of the price change plus dividends received, divided by the price
at the beginning of the time period. Assuming there are many
stocks, we can have the general measure of returns for the ith
stock, for the time period t-1 to t:

− , +
=
,

Suppose we are concerned only with the ith stock and are
interested in obtaining a measure of historical performance of his
stock, that is a measure of average returns on this stock over the
time period t = 1, 2, …, T. We get is straightforward arithmetic
mean:

= ( + + +⋯

This can be written more compactly as:

1
=

Of course, other than finding out the average returns over time for
a single stock, we can as well obtain the average returns for
several stock for a single time period. The method is the same,
except that we aggregate over the number of shares rather than
number of time periods. Let there be n shares: i = 1,2,3,…,n. Then

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1
=

Historical (Ex-Post) Risk

In investment analysis, basically risk is associated with variability
of rates of return. Variability is usually measured as individual
returns in relation to the average. In statistics, one of the basic
measures of variability is the variance. The positive square root
of the variance is the standard deviation, usually denoted by the
lower-case Greek letter sigma (σ) .The variance (square of
standard deviation) is defined as:

1
= ( − )
−1

Thus the variance can be considered as the average square

deviation from the mean return. To calculate the variance, we first
calculate the mean return. Then the difference between the return
for each period and the mean return is obtained. These deviations
from the mean are squared and added together. This sum is
divided by T – 1 (the total number of time periods minus one).
The standard deviation is the positive square root of the variance:

= +
3.3. Average Annual Returns
The average annual return (AAR) is a percentage used when
reporting the historical return, such as the three-, five-, and 10-
year average returns of an asset. The average annual return is
stated net of a fund's operating expense ratio. Additionally, it does

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not include sales charges, if applicable, or portfolio transaction

brokerage commissions. The three components that contribute to
the average annual return of a fund are share price appreciation,
capital gains, and dividends. Average annual return (AAR)
measures the money made or lost by a fund over a given period.
Investors considering any investment will often review the AAR
and compare it with other similar funds as part of their investment
strategy.
Components of an Average Annual Return (AAR)
There are three components that contribute to the average annual
return (AAR) of any financial asset: share price appreciation,
capital gains, and dividends.

 Share Price Appreciation

Share price appreciation results from unrealized gains or losses in
the underlying stocks held in a portfolio. As the share price of a
stock fluctuates over a year, it proportionately contributes to or
detracts from the AAR of the fund that maintains a holding in the
issue.

 Capital Gains Distributions

Capital gains distributions paid from a mutual fund result from
the generation of income or sale of stocks from which a manager
realizes a profit in a growth portfolio. Shareholders can opt to
receive the distributions in cash or reinvest them in the fund.
Capital gains are the realized portion of AAR. The distribution,
which reduces share price by the dollar amount paid out,
represents a taxable gain for shareholders.

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 Dividends
A dividend is the distribution of some of a company's earnings to
a class of its shareholders, as determined by the company's board
of directors. Common shareholders of dividend-paying
companies are typically eligible as long as they own the stock
before the ex-dividend date. Dividends may be paid out as cash
or in the form of additional stock. Dividend income received from
the portfolio can be reinvested or taken in cash.

Risk and Return of a Portfolio

Here we set out the basics of risk and return associated with a
portfolio of assets. This type of analysis was pioneered by Harry
Markowitz. Markowitz observed that investors do not always try
to maximize returns. If they wanted to do so, they would simply
hold only that security which they expected would give the
highest returns. Thus investors are concerned both with return and
risk, and since they hold a portfolio of assets, it showed that
diversification can lower risk without adversely affecting returns.
The return for a portfolio is simply a weighted average of the
returns of the securities in the portfolio. For a single time period
t, the portfolio return is calculated as:

Where, Wit is the market value of the ith asset divided by the
market value of the entire portfolio.
The variance of a portfolio is a little complicated because we also
have to consider any two assets of a portfolio together. The
general formula for variance of a portfolio is

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Where Covij represents the covariance between any two assets I

and j. We can calculate the correlation coefficient :

The correlation coefficient always lies between –1 and +1 and is

a measure of the strength of the linear association between assets
i and j. A value of –1 or +1 shows perfect linear relation (the
former an inverse relation) while a value of 0 shows no
relationship.

Determinants of Beta

The capital market and portfolio theories have developed a

'critically important concept of beta (β) measure of relative risk
of a security or its sensitivity to the movements in the market.
Beta indicate extent to which the risk of a given asset is non-
diversifiable; it is a coefficient measuring a security's relative
volatility, Statistically, beta is the covariance of a security's return
with that of the market for a security Alternatively, it is the slope
of the regression line relating a security return with the market
return. The security with a higher (than 1) beta is more volatile
than the market, and the asset with a lower (than 1) beta would
rise or fall more slowly than the market.

Beta is calculated as the covariance between returns on the asset

and returns on the market portfolio divided by the variance of
returns on the market portfolio. Or, it is typically found by
regressing stock or portfolio return on a proxy for market return.
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It measures the volatility of the portfolio related to the stock

market index like the BSE Sensex.

Figure.3.1 Concept of Beta

Figure 3.1 portrays the concept of beta. Line β (45 degree line)
represents β= 1 which means that for every one percentage
change in the market return, on an average, the security return
also will change by 1 percent, that is, both the returns will be
volatile to the same extent. Line A means that the security return
is more volatile than the market return, while, line C means that
the former is less volatile than the latter.

Beta Coefficient or Factor: It is a measure of performance of a

particular share or class of shares in relation to the general
movement of the market in terms of the price of respective shares.
It indicates systematic risk of investment in a share. It is
calculated as the covariance between returns on the asset and
returns on the market portfolio divided by the variance of the
returns

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Risk Return Trade off

The objective of maximizing return can be pursued only at the

cost of incurring higher risk. The financial markets offer a wide
range of assets from very safe to very risky with corresponding
low to high returns. While selecting the asset for investment, the
investor has to consider both its return potential and the risk
involved. The empirical evidence shows that generally there is a
high correlation between risk and return over longer periods of
time. The securities are generally priced such that high risk is
rewarded with high return, and low risk is accompanied by return.
This relationship is known as risk-return trade-off.

Figures and portray risk-return trade-off in an ex ante sense. In

Figure 2.2, the line AB (capital market line) depicts the expected
return-risk spectrum; the representative asset classes are arrayed
over risk on it. As we move from government bonds to
international equity, the investor assumes increasing risk in the
hope of earning a higher expected return. AB is upward sloping
and its slope indicates the required return per unit of risk. The
figure shows a positive linear relationship between expected
return and risk. The rational risk-averse investors will not
willingly assume greater risk unless they expect to receive
additional return, or if the investors wish to earn larger return,
they must be willing to assume greater risk.

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Trade-off
Figure: Risk Return Trade off

Figure 2.3 shows the same relationship slightly differently; it

relates RRR with beta (risk). It shows that the relationship
between them, represented by the line RFX (security market line)
is linear. The securities with high beta have high RRR. The
securities with betas (risk) greater than the market beta of 1
should have large risk premium than that of the average stock,
and, therefore, when added to MR, they yield a larger RRR.
Conversely, securities with beta less than that of the market are
less risky and have RRR lower than that for the market as a whole.
Figure: Required Rate of Return and Beta Trade off

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Module IV
Cost of Capital and Capital Asset Pricing Model

4.1. Cost of capital

Cost of capital is a company's calculation of the minimum return
that would be necessary in order to justify undertaking a capital
budgeting project, such as building a new factory. The term cost
of capital is used by analysts and investors, but it is always an
evaluation of whether a projected decision can be justified by its
cost. Investors may also use the term to refer to an evaluation of
an investment's potential return in relation to its cost and its risks.
Many companies use a combination of debt and equity to finance
business expansion. For such companies, the overall cost of
capital is derived from the weighted average cost of all capital
sources. This is known as the weighted average cost of capital
(WACC).
Cost of capital represents the return a company needs to achieve
in order to justify the cost of a capital project, such as purchasing
new equipment or constructing a new building. Cost of capital
encompasses the cost of both equity and debt, weighted according
to the company's preferred or existing capital structure. This is
known as the weighted average cost of capital (WACC).
A company's investment decisions for new projects should
always generate a return that exceeds the firm's cost of the capital
used to finance the project. Otherwise, the project will not
generate a return for investors.

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The concept of the cost of capital is key information used to

determine a project's hurdle rate. A company embarking on a
major project must know how much money the project will have
to generate in order to offset the cost of undertaking it and then
continue to generate profits for the company.
Cost of capital, from the perspective of an investor, is an
assessment of the return that can be expected from the acquisition
of stock shares or any other investment. This is an estimate and
might include best- and worst-case scenarios. An investor might
look at the volatility (beta) of a company's financial results to
determine whether a stock's cost is justified by its potential return.
Weighted Average Cost of Capital (WACC)
A firm's cost of capital is typically calculated using the weighted
average cost of capital formula that considers the cost of both debt
and equity capital.
Each category of the firm's capital is weighted proportionately to
arrive at a blended rate, and the formula considers every type of
debt and equity on the company's balance sheet, including
common and preferred stock, bonds, and other forms of debt.
4.2. Cost of Debt
The cost of capital becomes a factor in deciding which financing
track to follow: debt, equity, or a combination of the two.
Early-stage companies rarely have sizable assets to pledge as
collateral for loans, so equity financing becomes the default mode
of funding. Less-established companies with limited operating
histories will pay a higher cost for capital than older companies
with solid track records since lenders and investors will demand
a higher risk premium for the former.

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The cost of debt is merely the interest rate paid by the company
on its debt. However, since interest expense is tax-deductible, the
debt is calculated on an after-tax basis as follows:

= × (1 − )

Where:
Interest expense= initial paid on the firm’s current debt
T = The company’s marginal tax rate
The cost of debt can also be estimated by adding a credit spread
to the risk-free rate and multiplying the result by (1 - T).

4.3. Cost of equity

The cost of equity is more complicated since the rate of return
demanded by equity investors is not as clearly defined as it is by
lenders. The cost of equity is approximated by the capital asset
pricing model as follows:
( )= + ( − )

Where:
Rf = Risk free rate of return
Rm = market rate of return
Beta is used in the CAPM formula to estimate risk, and the
formula would require a public company's own stock beta. For
private companies, a beta is estimated based on the average beta
among a group of similar public companies. Analysts may refine
this beta by calculating it on an after-tax basis. The assumption is

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that a private firm's beta will become the same as the industry
average beta. The firm’s overall cost of capital is based on the
weighted average of these costs.
4.4. Cost Preference Capital
The cost of preference capital is a function of the dividend
expected by investors. Preference capital is never issued with an
intention not to pay dividends. Although it is not legally binding
upon the firm to pay dividends on preference capital, yet it is
generally paid when the fim1 makes sufficient profits. The failure
to pay dividends, although does not cause bankruptcy, yet it can
be a serious matter from the common (ordinary) shareholders’
point of view. The nonpayment of dividends on preference capital
may result in voting rights and control to the preference
shareholders. More than this, the firm’s credit standing may be
damaged. The accumulation of preference dividend arrears may
adversely affect the prospects of ordinary shareholders for
receiving any dividends, because dividends on preference capital
represent a prior claim on profits. As a consequence, the fim1 may
find difficulty in raising funds by issuing preference or equity
shares. Also, the market value of the equity shares can be
adversely affected if dividends are not paid to the preference
shareholders and, therefore, to the equity shareholders. For these
reasons, dividends on preference capital should be paid regularly
except when the firm does not make profits, or it is in a very tight
cash position.
The measurement of the cost of preference capital poses some
conceptual difficulty. In the case of debt, there is a binding legal
obligation on the firm to pay interest, and the interest constitutes
the basis to calculate the cost of debt. However, in the case of
preference capital, payment of dividends is not legally binding on
the firm and even if the dividends are paid, it is not a charge on
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earnings; rather it is a distribution or appropriation of earnings to

preference shareholders.
4.5. Capital Market Line (CML)
The Capital Market Line is a graphical representation of all the
portfolios that optimally combine risk and return. CML is a
theoretical concept that gives optimal combinations of a risk-free
asset and the market portfolio. The CML is superior to Efficient
Frontier in the sense that it combines the risky assets with the risk-
free asset.
• The slope of the Capital Market Line(CML) is the sharp
ratio of the market portfolio.
• The efficient frontier represents combinations of risky
assets.
• If we draw a line from the risk-free rate of return, which is
tangential to the efficient frontier, we get the Capital
Market Line. The point of tangency is the most efficient
portfolio.
• Moving up the CML will increase the risk of the portfolio,
and moving down will decrease the risk. Subsequently, the
return expectation will also increase or decrease,
respectively.
All investors will choose the same market portfolio, given a
specific mix of assets and the associated risk with them.
Capital Market Line Formula
The Capital Market Line (CML) formula can be written as
follows:

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−
= + ×

where,

 ERp= Expected Return of Portfolio

 Rf = Risk – free rate

 SDp= Standard deviation of Portfolio

 ERm = Expected Return of the Market

 SDm = Standard Deviation of Market

Portfolios that fall on the capital market line (CML), in theory,

optimize the risk/return relationship, thereby maximizing
performance. The capital allocation line (CAL) makes up the
allotment of risk-free assets and risky portfolios for an investor.
CML is a special case of the CAL where the risk portfolio is the
market portfolio. Thus, the slope of the CML is the Sharpe ratio
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of the market portfolio. As a generalization, buy assets if the

Sharpe ratio is above the CML and sell if the Sharpe ratio is below
the CML.
As an investor moves up the CML, the overall portfolio risk and
returns increase. Risk-averse investors will select portfolios close
to the risk-free asset, preferring low variance to higher returns.
Less risk-averse investors will prefer portfolios higher up on the
CML, with a higher expected return, but more variance. By
borrowing funds at the risk-free rate, they can also invest more
than 100% of their investable funds in the risky market portfolio,
increasing both the expected return and the risk beyond that
offered by the market portfolio.

4.6. Security Market Line (SML)

The security market line (SML) is the graphical representation of
the Capital Asset Pricing Model (CAPM) and gives the expected
return of the market at different levels of systematic or market
risk. It is also called ‘characteristic line’ where the x-axis
represents beta or the risk of the assets, and the y-axis represents
the expected return.
Also known as the "characteristic line," the SML is a visualization
of the CAPM, where the x-axis of the chart represents risk (in
terms of beta), and the y-axis of the chart represents expected
return. The market risk premium of a given security is determined
by where it is plotted on the chart relative to the SML.
The security market line is an investment evaluation tool derived
from the CAPM—a model that describes risk-return relationship
for securities—and is based on the assumption that investors need
to be compensated for both the time value of money (TVM) and
the corresponding level of risk associated with any investment,
referred to as the risk premium.
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The security market line is commonly used by money managers

and investors to evaluate an investment product that they're
thinking of including in a portfolio. The SML is useful in
determining whether the security offers a favorable expected
return compared to its level of risk.
When a security is plotted on the SML chart, if it appears above
the SML, it is considered undervalued because the position on the
chart indicates that the security offers a greater return against its
inherent risk.
Conversely, if the security plots below the SML, it is considered
overvalued in price because the expected return does not
overcome the inherent risk. The SML is frequently used in
comparing two similar securities that offer approximately the
same return, in order to determine which of them involves the
least amount of inherent market risk relative to the expected
return. The SML can also be used to compare securities of equal
risk to see which one offers the highest expected return against
that level of risk.

4.7. Beta of an Asset and of a Portfolio

Beta is a measure of the volatility—or systematic risk—of a
security or portfolio compared to the market as a whole. Beta is
used in the capital asset pricing model (CAPM), which describes
the relationship between systematic risk and expected return for
assets (usually stocks). CAPM is widely used as a method for
pricing risky securities and for generating estimates of the
expected returns of assets, considering both the risk of those
assets and the cost of capital.
A beta coefficient can measure the volatility of an individual
stock compared to the systematic risk of the entire market. In
statistical terms, beta represents the slope of the line through a
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regression of data points. In finance, each of these data points

represents an individual stock's returns against those of the market
as a whole.
Beta effectively describes the activity of a security's returns as it
responds to swings in the market. A security's beta is calculated
by dividing the product of the covariance of the security's returns
and the market's returns by the variance of the market's returns
over a specified period.
The calculation for beta is as follows:
( , )
( )=
( )
Where:
Re = the return on an individual stock
Rm the return on the overall market
Covariance = how changes in a stock’s returns are related to
changes in the market’s returns
Variance = how far the market’s data points spread out from their
average value
The beta calculation is used to help investors understand whether
a stock moves in the same direction as the rest of the market. It
also provides insights about how volatile–or how risky–a stock is
relative to the rest of the market. For beta to provide any useful
insight, the market that is used as a benchmark should be related
to the stock. For example, calculating a bond ETF's beta using the
S&P 500 as the benchmark would not provide much helpful
insight for an investor because bonds and stocks are too
dissimilar.
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Ultimately, an investor is using beta to try to gauge how much

risk a stock is adding to a portfolio. While a stock that deviates
very little from the market doesn’t add a lot of risk to a portfolio,
it also doesn’t increase the potential for greater returns.
In order to make sure that a specific stock is being compared to
the right benchmark, it should have a high R-squared value in
relation to the benchmark. R-squared is a statistical measure that
shows the percentage of a security's historical price movements
that can be explained by movements in the benchmark index.
When using beta to determine the degree of systematic risk, a
security with a high R-squared value, in relation to its benchmark,
could indicate a more relevant benchmark.
One way for a stock investor to think about risk is to split it into
two categories. The first category is called systematic risk, which
is the risk of the entire market declining. The financial crisis in
2008 is an example of a systematic-risk event; no amount of
diversification could have prevented investors from losing value
in their stock portfolios. Systematic risk is also known as un-
diversifiable risk.
Unsystematic risk, also known as diversifiable risk, is the
uncertainty associated with an individual stock or industry. For
example, the surprise announcement that the company Lumber
Liquidators (LL) had been selling hardwood flooring with
dangerous levels of formaldehyde in 2015 is an example of
unsystematic risk.2 It was risk that was specific to that company.
Unsystematic risk can be partially mitigated through
diversification.

Types of Beta Values

 Beta Value Equal to 1.0: If a stock has a beta of 1.0, it

indicates that its price activity is strongly correlated with
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the market. A stock with a beta of 1.0 has systematic risk.

However, the beta calculation can’t detect any
unsystematic risk. Adding a stock to a portfolio with a
beta of 1.0 doesn’t add any risk to the portfolio, but it also
doesn’t increase the likelihood that the portfolio will
provide an excess return.

 Beta Value Less Than One: A beta value that is less than
1.0 means that the security is theoretically less volatile
than the market. Including this stock in a portfolio makes
it less risky than the same portfolio without the stock. For
example, utility stocks often have low betas because they
tend to move more slowly than market averages.

 Beta Value Greater Than One: A beta that is greater

than 1.0 indicates that the security's price is theoretically
more volatile than the market. For example, if a stock's
beta is 1.2, it is assumed to be 20% more volatile than the
market. Technology stocks and small cap stocks tend to
have higher betas than the market benchmark. This
indicates that adding the stock to a portfolio will increase
the portfolio’s risk, but may also increase its expected
return.

 Negative Beta Value: Some stocks have negative betas.

A beta of -1.0 means that the stock is inversely correlated
to the market benchmark. This stock could be thought of
as an opposite, mirror image of the benchmark’s trends.
Put options and inverse ETFs are designed to have
negative betas. There are also a few industry groups, like
gold miners, where a negative beta is also common.

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Beta in Theory vs. Beta in Practice

The beta coefficient theory assumes that stock returns are
normally distributed from a statistical perspective. However,
financial markets are prone to large surprises. In reality, returns
aren’t always normally distributed. Therefore, what a stock's beta
might predict about a stock’s future movement isn’t always true.
A stock with a very low beta could have smaller price swings, yet
it could still be in a long-term downtrend. So, adding a down-
trending stock with a low beta decreases risk in a portfolio only if
the investor defines risk strictly in terms of volatility (rather than
as the potential for losses). From a practical perspective, a low
beta stock that's experiencing a downtrend isn’t likely to improve
a portfolio’s performance.
Similarly, a high beta stock that is volatile in a mostly upward
direction will increase the risk of a portfolio, but it may add gains
as well. It's recommended that investors using beta to evaluate a
stock also evaluate it from other perspectives—such as
fundamental or technical factors—before assuming it will add or
remove risk from a portfolio.

 Disadvantages of Beta
While beta can offer some useful information when evaluating a
stock, it does have some limitations. Beta is useful in determining
a security's short-term risk, and for analyzing volatility to arrive
at equity costs when using the CAPM. However, since beta is
calculated using historical data points, it becomes less meaningful
for investors looking to predict a stock's future movements.
Beta is also less useful for long-term investments since a stock's
volatility can change significantly from year to year, depending
upon the company's growth stage and other factors.
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4.8. Capital Asset Pricing Model (CAPM)

The Capital Asset Pricing Model (CAPM) describes the
relationship between systematic risk and expected return for
assets, particularly stocks. CAPM is widely used throughout
finance for pricing risky securities and generating expected
returns for assets given the risk of those assets and cost of capital.
It shows that the expected return on a security is equal to the risk-
free return plus a risk premium, which is based on the beta of that
security.
The formula for calculating the expected return of an asset given
its risk is as follows:

= + ( − )

Where:
ERi = expected return of investment
Rf = risk free rate
Βi = beta of the investment
(ERm- Rf) = market risk premium

 A risk premium is a rate of return greater than the risk-

free rate. When investing, investors desire a higher risk
premium when taking on more risky investments.

 “Expected return” is a long-term assumption about how

an investment will play out over its entire life.

 The risk-free rate should correspond to the country where

the investment is being made, and the maturity of the bond
should match the time horizon of the investment.
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Professional convention, however, is to typically use the

10-year rate no matter what, because it’s the most heavily
quoted and most liquid bond.

 The beta (denoted as “Bi” in the CAPM formula) is a

measure of a stock’s risk (volatility of returns) reflected
by measuring the fluctuation of its price changes relative
to the overall market. In other words, it is the stock’s
sensitivity to market risk.

 The market risk premium represents the additional return

over and above the risk-free rate, which is required to
compensate investors for investing in a riskier asset class.
Investors expect to be compensated for risk and the time value of
money. The risk-free rate in the CAPM formula accounts for the
time value of money. The other components of the CAPM
formula account for the investor taking on additional risk.
The beta of a potential investment is a measure of how much risk
the investment will add to a portfolio that looks like the market.
If a stock is riskier than the market, it will have a beta greater than
one. If a stock has a beta of less than one, the formula assumes it
will reduce the risk of a portfolio.
A stock’s beta is then multiplied by the market risk premium,
which is the return expected from the market above the risk-free
rate. The risk-free rate is then added to the product of the stock’s
beta and the market risk premium. The result should give an
investor the required return or discount rate they can use to find
the value of an asset.
The goal of the CAPM formula is to evaluate whether a stock is
fairly valued when its risk and the time value of money are
compared to its expected return.
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 Problems With the CAPM

There are several assumptions behind the CAPM formula that
have been shown not to hold in reality. Modern financial theory
rests on two assumptions: (1) securities markets are very
competitive and efficient (that is, relevant information about the
companies is quickly and universally distributed and absorbed);
(2) these markets are dominated by rational, risk-averse investors,
who seek to maximize satisfaction from returns on their
investments.
Despite these issues, the CAPM formula is still widely used
because it is simple and allows for easy comparisons of
investment alternatives.
Including beta in the formula assumes that risk can be measured
by a stock’s price volatility. However, price movements in both
directions are not equally risky. The look-back period to
determine a stock’s volatility is not standard because stock returns
(and risk) are not normally distributed.
The CAPM also assumes that the risk-free rate will remain
constant over the discounting period. An increase in the risk-free
rate also increases the cost of the capital used in the investment
and could make the stock look overvalued. The market portfolio
that is used to find the market risk premium is only a theoretical
value and is not an asset that can be purchased or invested in as
an alternative to the stock. Most of the time, investors will use a
major stock index, like the S&P 500, to substitute for the market,
which is an imperfect comparison.
The most serious critique of the CAPM is the assumption that
future cash flows can be estimated for the discounting process. If
an investor could estimate the future return of a stock with a high
level of accuracy, the CAPM would not be necessary.
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 The CAPM and the Efficient Frontier

Using the CAPM to build a portfolio is supposed to help an
investor manage their risk. If an investor were able to use the
CAPM to perfectly optimize a portfolio’s return relative to risk,
it would exist on a curve called the efficient frontier, as shown on
the following graph.

The graph shows how greater expected returns (y-axis) require

greater expected risk (x-axis). Modern Portfolio Theory suggests
that starting with the risk-free rate, the expected return of a
portfolio increases as the risk increases. Any portfolio that fits on
the Capital Market Line (CML) is better than any possible
portfolio to the right of that line, but at some point, a theoretical
portfolio can be constructed on the CML with the best return for
the amount of risk being taken.
The CML and efficient frontier may be difficult to define, but it
illustrates an important concept for investors: there is a trade-off
between increased return and increased risk. Because it isn’t
possible to perfectly build a portfolio that fits on the CML, it is

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more common for investors to take on too much risk as they seek
additional return.
The CAPM uses the principles of Modern Portfolio Theory to
determine if a security is fairly valued. It relies on assumptions
about investor behaviors, risk and return distributions, and market
fundamentals that don’t match reality. However, the underlying
concepts of CAPM and the associated efficient frontier can help
investors understand the relationship between expected risk and
reward as they make better decisions about adding securities to a
portfolio.

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Module V
Derivative Markets

5.1. Derivative Markets

The word Derivative is derived from mathematics which refers to
a variable that has been derived from another variable. In simple
sense, Derivative has no independent value of its own; its value
is obtained from the value of an underlying asset. For example
curd is a derivative of milk or similarly, measure of temperature
is derived from the measurement of Fahrenheit. In financial
world, a derivative is a financial product which derives its value
from another asset. For ex. Sensex is a derivative of 30 shares at
Bombay Stock Exchange and NIFTY is a derivative of 50 shares
at NSE.
Features of Derivatives
1. Derivatives are the part of secondary market and no funds can
be raised through derivatives.
2. The transactions in the Derivative are settled by taking
offsetting position in the same derivatives.
3. No limit on the number of units transacted because there is no
physical asset involved.
4. Derivative market is quite liquid in nature.
5. These are tailor made instruments and its use depends upon
investors requirement.
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Two Purposes of Derivatives

 Price Discovery of the underlying asset

Prices in an organized derivative market reflect the perception of
market participants about the future and lead the prices of
underlying to the perceived future level. Price of derivative
coincides with price of underlying at the expiration date. Thus, it
helps in price discovery.

 Tool for Risk management

Derivative instruments helps in transfer risks through hedging
from the hedger to the speculator.
Derivative Types

 Options: Options are financial derivative contracts that

give the buyer the right, but not the obligation, to buy or
sell an underlying asset at a specific price (referred to as
the strike price) during a specific period of time.
American options can be exercised at any time before the
expiry of its option period. On the other hand, European
options can only be exercised on its expiration date.

 A forward contract is a non-standardized contract

between two parties to buy or sell an asset at a specified
future time, at a price agreed upon today. The party
agreeing to buy the underlying asset in the future assumes
a long position, and the party agreeing to sell the asset in
the future assumes a short position. The price agreed upon
is called the delivery price, which is equal to the forward
price at the time the contract is entered into. The forward
price of such a contract is commonly contrasted with the
spot price, which is the price at which the asset changes
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hands on the spot date. The difference between the spot

and the forward price is the forward premium or forward
discount, generally considered in the form of a profit, or
loss, by the purchasing party.

 A futures contract differs from a forward contract in that

the futures contract is a standardized contract written by a
clearing house that operates an exchange where the
contract can be bought and sold. On the other hand, the
forward contract is a non-standardized contract written by
the parties themselves. Forwards also typically have no
interim partial settlements – or “true-ups” – in margin
requirements like futures, such that the parties do not
exchange additional property, securing the party at gain,
and the entire unrealized gain or loss builds up while the
contract is open.

 Swaps are derivatives in which counterparties exchange

cash flows of one party’s financial instrument for those of
the other party’s financial instrument. For example, in the
case of a swap involving two bonds, the benefits in
question can be the periodic interest (or coupon) payments
associated with the bonds. Specifically, the two
counterparties agree to exchange one stream of cash flows
against another stream. The swap agreement defines the
dates when the cash flows are to be paid and the way they
are calculated. Usually at the time when the contract is
initiated at least one of these series of cash flows is
determined by a random or uncertain variable such as an
interest rate, foreign exchange rate, equity price or
commodity price.

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Participants of Derivatives Market:

1. Hedgers
2. Speculators
3. Arbitrageurs
1. Hedgers
One of the main purposes for which derivative trading has been
initiated is to hedge or provide protection to the parties to a
contract. Hedgers have risk exposure which they offset by a
derivative and seek to protect themselves against price
movements in an asset in which they have interest. For example,
an American buying shares of an Indian company on an Indian
exchange would be exposed to exchange-rate risk while holding
that stock. In order to reduce this risk, the investor could purchase
currency futures of dollars to lock in a specified exchange rate for
the future stock sale and currency conversion back into dollars.
2. Speculators
Speculators are the participants who are ready to take risk in
expectation of return. They take position in the market either
expecting that the prices will go up or expecting that the prices
will go down. They may go long (buy) or short (sell) based on
their expectations. However, they have naked positions and
therefore, they are inviting risk for earning a return. The
speculators create volumes of trading in the derivative market and
hedgers & arbitrageurs get counter party for other traders. The
speculators create volumes of trading in the derivative market and
hedgers & arbitrageurs get counterparty for their trades.

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3. Arbitrageurs
The arbitraging refers to locking in a risk less profit by
simultaneously entering into two transactions in two different
markets separated geographically or timing. The profit
opportunities may occur due to price differences in two different
markets but could not last for long due to arbitraging.
Arbitrageurs may deal in to cash and derivatives market or only
derivatives market for different periods of time earning arbitrage
profits. Their actions shall narrow down the differential in prices.
For example, arbitrageurs may buy in the spot market and sell in
the futures market

5.2. Forward Contracts

Forward Contract is an agreement made today between a buyer
and a seller wherein the seller is under obligation to deliver a
specified asset of specified quality and quantity to the buyer on a
future date and place is specified at a price agreed upon today.
The buyer in return has to pay the seller a pre-negotiated price in
exchange for the delivery. Forwards are not marketable; once a
firm enters into a forward contract there is no convenient way to
trade out of it except that of reversing the trade between the same
parties. For example: Wheat farmer selling his harvest at a known
price at a future date in order to eliminate price risk.
Features of Forward Contract
1. Forward contracts are not standardized form of contracts.
2. They are over the counter transactions.(not traded recognized
exchanges )
3. Every order is separate and is determined with respect to the
contract size, expiration date, asset type and quality. The date

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and price of the contract is unique and decided in advance by

the two trading parties.
4. Futures contracts are bilateral agreements and exposed to
counter party risk.
5. In forward contract, both the parties takes the opposite
position. One party agrees to buy the asset at specified price
at future date; it is said to have taken a long position. Another
party takes opposite i.e short position; agrees to sell the same
asset at the same date on the price agreed upon. A party
without obligation offsetting futures contract is said to have
an open position.
Benefits of Forward contracts
Forward contract can be used to secure or hedge or lock in the
price of purchase of asset on the future commitment date For Ex.
A bread factory may want to buy wheat forward in order to assist
production planning without taking risk of price fluctuations.
Price discovery is another use of forward prices to predict spot
price that will prevail in future. Also, no cost is involved as
margins are involved in forward contracts. It is entered in to by
two parties generally known to each other.
Limitations of Forward contract
1. Forward contract have counter party risk and in case of default
by other party, the aggrieved party may have to suffer a loss.
2. No party can take benefit of favorable price movements as
squaring off is not possible in forward contracts.
3. Forward contracts are illiquid contracts as it is difficult to get
counter party at one’s terms

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Determination of Forward Prices

Forward price is the predetermined delivery price for an
underlying commodity, currency, or financial asset as decided by
the buyer and the seller of the forward contract, to be paid at a
predetermined date in the future. At the inception of a forward
contract, the forward price makes the value of the contract zero,
but changes in the price of the underlying will cause the forward
to take on a positive or negative value.
When the underlying asset in the forward contract does not pay
any dividends, the forward price can be calculated using the
following formula:
( × )
= ×
Where:
F = the contract’s forward price
S = the underlying asset’s current spot price
e = the mathematical irrational constant approximated by 2.7183
r = the risk free rate that applies to the life of the forward contract
t = the delivery date in years

5.3.Futures Contracts
Any contract which is standardized involving two parties having
an agreement to buy or sell an asset with specific quantity and
quality on a price which is agreed today for future delivery.
Standardization of Future contract

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1. Underlying asset can be stock, commodity, interest rate, bonds,

Govt securities.
2. Settlement can be cash or physical delivery.
3. The amount and units of the underlying asset per contract is
specified.
4. Delivery month and the grade in deliverable is specified.
5. Last trading date id specified.

Features of Future contract

1. Futures are standardized contracts that are to run in either
the final cash settlement or assets are delivered at later
stage. Certain future contracts such as stocks or currency,
settled in cash on the price differentials. For example, the
futures of Reliance share can be traded on NSE and future
of gold can be traded on MCX.
2. These contracts trading on organized futures exchanges
with a clearing organization that serves as an
intermediary between the parties.
3. Both parties pay margin on Clearing Association and are
generally settled by marked to market every day.
4. Each futures contract has identified a relevant month
which is the month of the contract delivery or
permanently settlement. These contracts are recognised
with their delivery month. For example: .Futures of
Reliance in January can be future of January, futures of
February or futures of March for 1, 2, 3 months
respectively.

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Future contract is different from trading an underlying

stock in the sense that when you buy a stock you pay full
value of the transaction (i.e. the number of shares
multiplied by market price of each share) but in case of
futures, you have to pay margin.

Difference between Forward and Futures

contract
Feature Forward contracts Future contracts
Operational Traded directly Traded on the
mechanism between contracting exchanges
parties (not traded on
the exchanges)

Contract Differ from trade on Contracts are

specifications trade standardised contracts

Counter party Exists. But, Exists. But, assumed

risk sometimes jettisoned by the clearing agency,
to a guarantor which becomes the
counter party to all
trades or
unconditionally
guarantees their
settlement.

Liquidation Low, as contracts are High, as contracts are

profile tailor-made standardised exchange-
contracts catering to traded contracts
the needs of the
parties involved.
Further, they are not

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easily accessible to
other market
participants.

Price Not efficient, as Efficient, as markets

discovery markets are scattered are centralised and all
buyers and sellers
come to a common
platform to discover
the price through a
common order book

Quality of Quality of As futures are traded on

information information may be a nation-wide basis,
and its poor. Speed of every bit of decision-
dissemination information related information
dissemination is gets disseminated very
weak fast

Examples Currency market in Commodities futures,

India index futures and
individual stock futures
in India

Key Differences between Forwards and Futures

A standardised forward contract is a futures contract. The key
differences between forwards and futures are as follows:

 A forward contract is tailor-made contract (the terms are

negotiated between the buyer and seller), whereas a
futures contract is a standardised contract (quantity, date
and delivery conditions are standardised).
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 While there is no secondary market for forward contracts,

the futures contracts are traded on organised exchanges.

 Forward contracts usually end with deliveries, where as

futures contracts are typically settled with the differences.

 Usually no collateral is required for a forward contract. In

a futures contract, however, a margin is required.

 Forward contracts are settled on the maturity date,

whereas futures contracts are ‘market to market’ on a
daily basis. This means that profits and losses on futures
contracts are settled daily.

 In a forward contract, both the parties are exposed to

credit risk, because irrespective of which way the price
moves, one of the parties will have an incentive to default.
5.4.Theories of Future Prices
Futures are derivative products whose value depends largely on
the price of the underlying stocks or indices. However, the pricing
is not that direct. There remains a difference between the prices
of the underlying asset in the cash segment and in the derivatives
segment. This difference can be understood through three pricing
models for futures contracts. These will allow you to estimate
how the price of a stock futures or index futures contract might
behave. These are:
• The Cost of Carry Model
• The Expectation Model
• Capital Asset Pricing Model

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However, that these models merely gives a platform on which to

base our understanding of futures prices. That said, being aware
of these theories gives a feel of what we can expect from the
futures price of a stock or an index.
1. The cost of carry model
The Cost of Carry Model assumes that markets tend to be
perfectly efficient. This means there are no differences in the cash
and futures price. This, thereby, eliminates any opportunity for
arbitrage – the phenomenon where traders take advantage of price
differences in two or more markets. When there is no opportunity
for arbitrage, investors are indifferent to the spot and futures
market prices while they trade in the underlying asset. This is
because their final earnings are eventually the same. The model
also assumes, for simplicity sake, that the contract is held till
maturity, so that a fair price can be arrived at. In short, the price
of a futures contract (FC) will be equal to the spot price (SP) plus
the net cost incurred in carrying the asset till the maturity date of
the futures contract.

= +( − )
Here Carry Cost refers to the cost of holding the asset till the
futures contract matures. This could include storage cost, interest
paid to acquire and hold the asset, financing costs, etc. Carry
Return refers to any income derived from the asset while holding
it like dividends, bonuses, etc. While calculating the futures price
of an index, the Carry Return refers to the average returns given
by the index during the holding period in the cash market. A net
of these two is called the Net Cost of Carry. The bottom line of
this pricing model is that keeping a position open in the cash
market can have benefits or costs. The price of a futures contract

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basically reflects these costs or benefits to charge or reward you

accordingly.
2. Expectancy model of futures pricing
The Expectancy Model of futures pricing states that the futures
price of an asset is basically what the spot price of the asset is
expected to be in the future. This means, if the overall market
sentiment leans towards a higher price for an asset in the future,
the futures price of the asset will be positive. In the exact same
way, a rise in bearish sentiments in the market would lead to a fall
in the futures price of the asset. Unlike the Cost of Carry model,
this model believes that there is no relationship between the
present spot price of the asset and its futures price. What matters
is only what the future spot price of the asset is expected to be.
This is also why many stock market participants look to the trends
in futures prices to anticipate the price fluctuation in the cash
segment.
3. Capital Asset Pricing Model (CAPM)
The capital asset pricing model, or CAPM, is a special model
that's used in finance to calculate the relationship between
expected dividends as well as the risk of investing in specific
equity. The CAPM model is used to determine the expected
returns for a security. This can be compared with the risk-free
returns and the addition of a beta.
To properly assess the capital asset pricing model, it is necessary
to understand both systematic and unsystematic risk. Systematic
risks are all general dangers that are involved in the investment of
any type. There are many risks that could occur, such as inflation,
wars, and recessions. These are just a few examples of systematic
risk. On the other hand, unsystematic risks refer to specific risks
associated with investing in particular stocks or equity.
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Unsystematic risks, on the other hand, are not considered to be

threats and are generally shared by the market. CAPM focuses on
systematic risks in securities and can thus predict whether certain
investments will fail.
The CAPM formula is provided by –

= + ( − )

These are the different elements of this equation: -

1) Ra = Expected dividend of investment
2) Rf = Risk-free rate
3) Beta = The transaction's underlying transaction
4) (Rm-Rf) = Current Market Risk Premium
The entire formula takes into account the potential returns that an
investor could receive due to their risk-taking abilities and longer
investment time. In conjunction with current market conditions,
the beta factor is considered a risk. If the investment risk is greater
than the current conditions, then the beta value will be lower than
1. A beta value in this equation will always equal 1. Finally, if the
risk is greater than the market norm, the formula's 'Be' value will
be higher than 1.
5.5 Relation between Spot Price and Future Price
The main differences between commodity spot prices and futures
prices are the delivery dates. Spot prices and futures prices is that
spot prices are for immediate buying and selling, while futures
contracts delay payment and delivery to predetermined future
dates.

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The spot price of a commodity is the current cash cost of it for

immediate purchase and delivery. The futures price locks in the
cost of the commodity that will be delivered at some point other
than the present—usually, some months hence.
The difference between the spot price and futures price in the
market is called the basis.
Futures prices and spot prices are different numbers because the
market is always forward-looking.
The spot price is usually below the futures price. The situation is
known as contango. On the other hand, there is backwardation,
which is a situation when the spot price exceeds the futures price.
In either situation, the futures price is expected to eventually
converge with the current market price.
5.6.Hedging in Futures
Hedging is buying or selling futures contract as protection against
the risk of loss due to changing prices in the cash market. A short
hedge is used when you plan on selling your product at a future
date and want to protect yourself against falling prices. A long
hedge is used when you plan on buying a commodity such as
soybean meal and want to protect against prices increasing. The
relationship of local cash price and the futures price is called
basis. Basis is calculated by subtracting the price of the
appropriate futures contract from the local cash market price. For
a short hedge, the more positive (stronger) the basis, the higher
the price received for commodity. For a long hedge, the more
negative (weaker) the basis, the lower the price paid for
commodity. It is very important to note that hedging does not
necessarily improve the financial outcome, it just reduces the
uncertainty.

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5.7.Options
Options are agreements between two parties to buy or sell a
security at a certain price. They are most often used to trade stock
options, but may be used for other investments as well. If an
investor purchases the right to buy an asset at a specific price
within a given time frame, he has purchased a call option. On the
contrary, if he purchases the right to sell an asset at a given price,
he has purchased a put option. The seller has the corresponding
obligation to fulfill the transaction that is to sell or buy if the buyer
(owner) exercises the option. The buyer pays a premium to the
seller for this right. An option that conveys to the owner the right
to buy something at a certain price is a "call option"; an option
that conveys the right of the owner to sell something at a certain
price is a "put option". Both are commonly traded, but for
transparency, the call option is more frequently discussed.
Options valuation is a topic of ongoing research in academic and
practical finance. Fundamentally, the value of an option is
commonly decomposed into two parts. The first part is the
"intrinsic value", described as the difference between the market
value of the underlying and the strike price of the given option.
The second part is the "time value", which depends on a set of
other factors which, through a multivariable, non-linear
interrelationship, reflect the discounted expected value of that
difference at expiration.
Although options valuation has been done since the 19th century,
the modern approach is based on the Black–Scholes model, which
was first published in 1973. Options contracts were used for many
centuries, however both trading activity and academic interest
increased when, as from 1973, options were issued with
standardized terms and traded through a guaranteed clearing
house at the Chicago Board Options Exchange. Today many
options are created in a standardized form and traded through
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clearing houses on regulated options exchanges, while other over-

the-counter options are written as bilateral, customized contracts
between a single buyer and seller, one or both of which may be a
dealer or market-maker. Options are part of major category of
financial instruments termed as derivative products or simply
derivatives.
Features of options:

 A fixed maturity date on which they expire (Expiry date).

 The price at which the option is exercised is called the

exercise price or strike price.

 The person who writes the option and is the seller is

denoted as the "option writer", and who holds the option
and is the buyer, is called "option holder".

 The premium is the price paid for the option by the buyer
to the seller.

 A clearing house is interposed between the seller and the

buyer which guarantees performance of the contract.
Types of Options:
1.Call Options
A call option gives the purchaser (or buyer) the right to buy an
underlying security (e.g., a stock) at a prespecified price called
the exercise or strike price (X). In return, the buyer of the call
option must pay the writer (or seller) an up-front fee known as a
call premium (C). This premium is an immediate negative cash
flow for the buyer of the call option. However, he or she
potentially stands to make a profit should the underlying stock’s

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price be greater than the exercise price (by an amount exceeding

the premium). If the price of the underlying stock is greater than
X (the option is referred to as “in the money”), the buyer can
exercise the option, buying the stock at X and selling it
immediately in the stock market at the current market price,
greater than X. If the price of the underlying stock is less than X
(the option is referred to as “out of the money”), the buyer of the
call would not exercise the option (i.e., buy the stock at X when
its market value is less than X). If this is the case when the option
matures, the option expires unexercised. The same is true when
the underlying stock price is exactly equal to X when the option
expires (the option is referred to as “at the money”). The call
buyer incurs a cost C (the call premium) for the option, and no
other cash flows result.
2. A Put Option
A put option gives the option buyer the right to sell an underlying
security (e.g., a stock) at a pre-specified price to the writer of the
put option. In return, the buyer of the put option must pay the
writer (or seller) the put premium (P). If the underlying stock’s
price is less than the exercise price (X) (the put option is “in the
money”), the buyer will buy the underlying stock in the stock
market at less than X and immediately sell it at X by exercising
the put option. If the price of the underlying stock is greater than
X (the put option is “out of the money”), the buyer of the put
option would not exercise the option (i.e., selling the stock at X
when its market value is more than X). If this is the case when the
option matures, the option expires unexercised. This is also true
if the price of the underlying stock is exactly equal to X when the
option expires (the put option is trading “at the money”). The put
option buyer incurs a cost P for the option, and no other cash
flows result.

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3. Stock Options.
The underlying asset on a stock option contract is the stock of a
publicly traded company. One option generally involves 100
shares of the underlying company’s stock. The same stock can
have many different call and put options differentiated by
expiration and strike price. Further, the quote gives an indication
of whether the call and put options are trading in, out of, or at the
money.

4. Credit Options
Options also have a potential use in hedging the credit risk of a
financial institution. Compared to their use in hedging interest
rate risk, options used to hedge credit risk are a relatively new
phenomenon. Two alternative credit option derivatives exist to
hedge credit risk on a balance sheet: credit spread call options and
digital default options. A credit spread call option is a call option
whose payoff increases as the (default) risk premium or yield
spread on a specified benchmark bond of the borrower increases
above some exercise spread.
Different Uses of Options:
There are a number of reasons for being either a writer or a buyer
of options. The writer assures an uncertain amount of risk for a
certain amount of money, whereas the buyer assures an uncertain
potential gain for a fixed cost. Such a situation can lead to a
number of reasons for using options.
However, fundamental to either writing or buying an option is the
promise that option is fairly valued in terms of the possible
outcomes. If the option is not fairly priced then, of course, an
additional source of profit or loss is introduced, and the writer or

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buyer of such a contract may be subject to an additional handicap

that will reduce his or her return.
The reasons for writing option contracts are varied, but three of
the most common are to cash additional income on a securities
portfolio, the fact that option buyers are not as sophisticated as
writers, and to hedge a long position.
It is sometimes argued that option writing is a source of additional
income for the portfolio of an investor with a large portfolio of
securities. Such an approach assumes that the portfolio manager
can guess the direction of specific stock prices closely rough to
make this strategy worth-while.
What cannot be overlooked is that the writer gives up certain
rights when the option is written. For example, suppose a call
option is written. In this case, the writer would presumably cover
the call by giving up securities from his or her portfolio. Hence,
the writer is giving up any appreciation beyond the striking price
plus the option premium.
Second, it is believed by some that the buyer of options is not as
sophisticated as the writers. The proponents of this view argue
that option writers are the most sophisticated participants in the
securities market and view argue that option premiums simply as
additional income.
However, it should be held that this view pre-supposes that the
buyers are “lambs ready to be shorn” whether this view is correct
or not is unclear, but it follows that over the long-term they may
find option writing an unprofitable undertaking. There are a
number of reasons for buying options; two of the most common
are leverage and changing the risk complexion of a portfolio. The
term leverage in connection with options indicates buyer being

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able to control more securities than could be done with realistic

margin requirements.
In other words, with the use of margins, the buyer of securities
can but more securities and hopefully make a greater profit than
could be done by taking a basic long position. Puts and calls can
be used in much the same fashion and perhaps provide a higher
return. Another reason of buying options is to change the risk
complexion of a portfolio of securities. It should be noted that this
benefit of options is available not only to buyers but also to
writers. Therefore, they permit the portfolio manager to undertake
as much or as little risk as he or she feels is appropriate at a point
of time. They also give additional flexibility in setting the amount
or risk the portfolio manager is willing to accept with respect to a
specific portfolio.

5.8.Put-Call parity theorem

Put-Call parity theorem says that premium (price) of a call option
implies a certain the fair price for corresponding put options
provided the put options have the same strike price, underlying
and expiry, and vice versa. It also shows the three-sided
relationship between a call, a put, and underlying security. The
theory was first identified by Hans Stoll in 1969.
The term "put-call" parity refers to a principle that defines the
relationship between the price of European put and call options
of the same class. Put simply, this concept highlights the
consistencies of these same classes. Put and call options must
have the same underlying asset, strike price, and expiration date
in order to be in the same class. The put-call parity, which only
applies to European options, can be determined by a set equation.
There exists a connection between the European call options and
the European put options prices, and this relationship is defined
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by the Put call parity. Though, the security, the strike price, and
the ending month should be the same for the securities to establish
the relation.
Put call parity states that holding up of the long European call
with the short European put simultaneously will yield out the
same return when you will be holding up a forward contract
having the identical basic asset, as well as the expiry date. And
here the forward price will be equivalent to the option’s strike
amount.
Put call parity equation:

+ ( )= +
Where in the above put call parity equation:
 C = the European call options price
 PV(x) = the current value of the strike price (x), which is
reduced from the price on the end date at the risk-free
amount
 P = the European put options or security price
 S = the present market value of the underlying asset or the
spot price
Need for Put Call Parity
The need for Put-Call Parity arises to compute the current worth
of the cash element, that exists with an appropriate risk permitted
interest rate.
For Example: Take two portfolio A and portfolio B, where
Portfolio A has a European call decision and cash which is

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equivalent to the total shares enclosed by the call option that is

being grown up by the call’s striking price. And taking portfolio
B which has a European put option as well as the underlying asset.
So, we get the options as follows:
 Portfolio A (having options as) = Call + Cash, (wherever
the Cash is equal to the Call Strike Price)
 Portfolio B (having options as) = Put + Underlying Asset
The Portfolio A and Portfolio B having Call, put, cash and asset
option is depicted in the above figure. And from the above figure
of Portfolio A having call option and cash, and the portfolio B
having put option and asset. we observe that:
 Call + Cash = Put + Underlying Asset
 For example: Sept 20 Call + $2500 = Sept 20 Put + 100
ABC Stock
 Thus, in order to calculate the current value of the cash
component in the above equation we need the put call
parity equation which is as: C + PV(x) = P + S
Important Terminologies used in put call Options
 S0 = Stock price existing today,
 X = the Strike price
 T = Time to expiration of the securities
 r = Risk-free rate of return
 C0 = the European call option premium
 P0 = the European put option premium
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Put call parity arbitrage:

The put call parity arbitrage defines the opportunity to yield out
profit from the price variances that exists in a different market of
a financial security. So, the put call parity arbitrage exits where
the call put option does not apply at all. Or where we see that one
side of the put call equation is greater than the other, or there
exists some variation in the put call equation, there the put call
parity arbitrage exists.

5.9.Option Pricing Models

Option pricing theory has made vast strides since 1972, when
Black and Scholes published their path-breaking paper providing
a model for valuing dividend-protected European options. Black
and Scholes used a “replicating portfolio” –– a portfolio
composed of the underlying asset and the risk-free asset that had
the same cash flows as the option being valued –– to come up
with their final formulation. While their derivation is
mathematically complicated, there is a simpler binomial model
for valuing options that draws on the same logic.
The Binomial Option Pricing Model
In finance, the binomial options pricing model (BOPM) provides
a generalizable numerical method for the valuation of options.
Essentially, the model uses a "discrete-time" (lattice based) model
of the varying price over time of the underlying financial
instrument, addressing cases where the closed-form Black–
Scholes formula is wanting. The binomial model was first
proposed by William Sharpe in the 1978 edition of Investments
and formalized by Cox, Ross and Rubinstein in 1979 and by
Rendleman and Bartter in that same year.

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The binomial option pricing model is based upon a simple

formulation for the asset price process in which the asset, in any
time period, can move to one of two possible prices. It has been
widely used since it is able to handle a variety of conditions for
which other models cannot easily be applied. This is largely
because the BOPM is based on the description of an underlying
instrument over a period of time rather than a single point. As a
consequence, it is used to value American options that are
exercisable at any time in a given interval as well as Bermudan
options that are exercisable at specific instances of time. Being
relatively simple, the model is readily implementable in computer
software (including a spreadsheet).
Although computationally slower than the Black–Scholes
formula, it is more accurate, particularly for longer-dated options
on securities with dividend payments. For these reasons, various
versions of the binomial model are widely used by practitioners
in the options markets
The general formulation of a stock price process that follows the
binomial is shown in figure 5.1. In this figure, S is the current
stock price; the price moves up to Su with probability p and down
to Sd with probability 1-p in any time period.
Figure 5.1.: General Formulation for Binomial Price Path

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The Determinants of Value

The binomial model provides insight into the determinants of
option value. The value of an option is not determined by the
expected price of the asset but by its current price, which, of
course, reflects expectations about the future. This is a direct
consequence of arbitrage. If the option value deviates from the
value of the replicating portfolio, investors can create an arbitrage
position, i.e., one that requires no investment, involves no risk,
and delivers positive returns. The cash flows on the two positions
will offset each other, leading to no cash flows in subsequent
periods. The option value also increases as the time to expiration
is extended, as the price movements (u and d) increase, and with
increases in the interest rate.
While the binomial model provides an intuitive feel for the
determinants of option value, it requires a large number of inputs,
in terms of expected future prices at each node. As we make time
periods shorter in the binomial model, we can make one of two
assumptions about asset prices. We can assume that price changes
become smaller as periods get shorter; this leads to price changes

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becoming infinitesimally small as time periods approach zero,

leading to a continuous price process. Alternatively, we can
assume that price changes stay large even as the period gets
shorter; this leads to a jump price process, where prices can jump
in any period.
The Black-Scholes Option Pricing Model
Black-Scholes is a pricing model used to determine the fair price
or theoretical value for a call or a put option based on six variables
such as volatility, type of option, underlying stock price, time,
strike price, and risk-free rate. The quantum of speculation is
more in case of stock market derivatives, and hence proper
pricing of options eliminates the opportunity for any arbitrage.
There are two important models for option pricing – Binomial
Model and Black-Scholes Model. The model is used to determine
the price of a European call option, which simply means that the
option can only be exercised on the expiration date.
Black-Scholes pricing model is largely used by option traders
who buy options that are priced under the formula calculated
value, and sell options that are priced higher than the Black-
Schole calculated value
When the price process is continuous, i.e. price changes becomes
smaller as time periods get shorter, the binomial model for pricing
options converges on the BlackScholes model. The model, named
after its co-creators, Fischer Black and Myron Scholes, allows us
to estimate the value of any option using a small number of inputs
and has been shown to be remarkably robust in valuing many
listed options.

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The Model
While the derivation of the Black-Scholes model is far too
complicated to present here, it is also based upon the idea of
creating a portfolio of the underlying asset and the riskless asset
with the same cashflows and hence the same cost as the option
being valued. The value of a call option in the Black-Scholes
model can be written as a function of the five variables:
S = Current value of the underlying asset
K = Strike price of the option
t = Life to expiration of the option
r = Riskless interest rate corresponding to the life of the option
σ2 = Variance in the ln(value) of the underlying asset
The value of a call is then:

= ( )− ( )
Where,
2
ln +( + 2 )
=
√
= − √
Note that e-rt is the present value factor and reflects the fact that
the exercise price on the call option does not have to be paid until
expiration. N(d1) and N(d2) are probabilities, estimated by using
a cumulative standardized normal distribution and the values of
d1 and d2 obtained for an option. The cumulative distribution is
shown in Figure 5.2.:
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Figure 5.2.: Cumulative Normal Distribution

In approximate terms, these probabilities yield the likelihood that

an option will generate positive cash flows for its owner at
exercise, i.e., when S>K in the case of a call option and when K>S
in the case of a put option. The portfolio that replicates the call
option is created by buying N(d1) units of the underlying asset,
and borrowing Ke-rtN(d2). The portfolio will have the same cash
flows as the call option and thus the same value as the option.
N(d1), which is the number of units of the underlying asset that
are needed to create the replicating portfolio, is called the option
delta.

Model Limitations and Fixes

The Black-Scholes model was designed to value options that can
be exercised only at maturity and on underlying assets that do not
pay dividends. In addition, options are valued based upon the
assumption that option exercise does not affect the value of the
underlying asset. In practice, assets do pay dividends, options
sometimes get exercised early and exercising an option can affect
the value of the underlying asset. Adjustments exist. While they
are not perfect, adjustments provide partial corrections to the
BlackScholes model.

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1. Dividends
The payment of a dividend reduces the stock price; note that on
the ex-dividend day, the stock price generally declines.
Consequently, call options will become less valuable and put
options more valuable as expected dividend payments increase.
There are two ways of dealing with dividends in the Black
Scholes:
1· Short-term Options: One approach to dealing with
dividends is to estimate the present value of expected
dividends that will be paid by the underlying asset during
the option life and subtract it from the current value of the
asset to use as S in the model. Modified Stock Price =
Current Stock Price – Present value of expected dividends
during the life of the option
2.· Long Term Options: Since it becomes impractical to
estimate the present value of dividends as the option life
becomes longer, we would suggest an alternate approach.
If the dividend yield (y = dividends/current value of the
asset) on the underlying asset is expected to remain
unchanged during the life of the option, the Black-Scholes
model can be modified to take dividends into account.

= ( )− ( )

ln + − + 2
=
√
= − √

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From an intuitive standpoint, the adjustments have two

effects. First, the value of the asset is discounted back to the
present at the dividend yield to take into account the expected
drop in asset value resulting from dividend payments.
Second, the interest rate is offset by the dividend yield to
reflect the lower carrying cost from holding the asset (in the
replicating portfolio). The net effect will be a reduction in the
value of calls estimated using this model.
1. Early Exercise
The Black-Scholes model was designed to value options that
can be exercised only at expiration. Options with this
characteristic are called European options. In contrast, most
options that we encounter in practice can be exercised any
time until expiration. These options are called American
options. The possibility of early exercise makes American
options more valuable than otherwise similar European
options; it also makes them more difficult to value. In
general, though, with traded options, it is almost always
better to sell the option to someone else rather than exercise
early, since options have a time premium, i.e., they sell for
more than their exercise value. There are two exceptions.
One occurs when the underlying asset pays large dividends,
thus reducing the expected value of the asset. In this case,
call options may be exercised just before an ex-dividend
date, if the time premium on the options is less than the
expected decline in asset value as a consequence of the
dividend payment. The other exception arises when an
investor holds both the underlying asset and deep in-the-
money puts, i.e., puts with strike prices well above the
current price of the underlying asset, on that asset and at a
time when interest rates are high. In this case, the time
premium on the put may be less than the potential gain from
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exercising the put early and earning interest on the exercise

price.
There are two basic ways of dealing with the possibility of
early exercise. One is to continue to use the unadjusted
Black-Scholes model and regard the resulting value as a floor
or conservative estimate of the true value. The other is to try
to adjust the value of the option for the possibility of early
exercise. There are two approaches for doing so. One uses
the Black-Scholes to value the option to each potential
exercise date. With options on stocks, this basically requires
that we value options to each ex-dividend day and choose the
maximum of the estimated call values. The second approach
is to use a modified version of the binomial model to
consider the possibility of early exercise. In this version, the
up and down movements for asset prices in each period can
be estimated from the variance and the length of each period.
2. The Impact of Exercise On The Value Of The
Underlying Asset
The Black-Scholes model is based upon the assumption
that exercising an option does not affect the value of the
underlying asset. This may be true for listed options on
stocks, but it is not true for some types of options. For
instance, the exercise of warrants increases the number of
shares outstanding and brings fresh cash into the firm,
both of which will affect the stock price. The expected
negative impact (dilution) of exercise will decrease the
value of warrants compared to otherwise similar call
options. The adjustment for dilution in the Black-Scholes
to the stock price is fairly simple. The stock price is
adjusted for the expected dilution from the exercise of the
options.
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