Bank Investment Analysis

Introduction
 Agenda
• Syllabus
• What is finance? What are financial markets and financial
assets.
• Time Value of Money
– Calculating Present Values (Discounting)
– Calculating Future Values (Compounding)
• Statistics
– Mean, Expected Value
– Variance, Standard Deviation
– Sharpe Value
– Covariance, correlation
– Normal distribution
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 Logistics

• No cell phones or laptops.

• Only Scientific Calculator Allowed

 People and Places
Instructor: Professor Dr. Abdullah Al Mahmud
PhD (USA), MBA in Finance (USA), M.Sc. in Int. Econ & Fin. (USA)

Office: 3050

Email: [email protected]

Google Classroom Link:

https://classroom.google.com/c/NzA2NTcxNzc2NTA5?cjc=mmfecqh

Class Hours: Saturday 4:00pm

Class Room: 5056

 Readings
• Textbook: Bodie, Kane, and Marcus (BKM), Investments,
Latest Edition.

• Wall Street Journal, Financial Times, Economist

• Blogs: Greg Mankiw, Paul Krugman, Marginal Revolution, Brad

DeLong
 Learning Goals
• Understand the definition and properties of the main financial assets:
bonds, stocks and options.

• Understand how prices of each of these assets are determined. Be able to

correctly perform quantitative calculations for determining prices and
returns on these assets.

• Understand what determines the risk of different investment strategies

and learn methods for reducing investment risk.

• Obtain a basic working knowledge of Excel.

 Coursework and Grading
Assessment criteria Weight (%)
1st Mid term 15
2nd Mid term 15
Final Examination 40
Assignments, Report 20
and Presentation
Class Attendance/ 10
Participation
Total 100
 Course Outline
• What is finance? Review of basic financial and mathematical concepts

• Risk, return, risk aversion and capital allocation.

• Portfolio selection

• Capital Asset Pricing Model (CAPM)

• Equity, e.g. stocks. Valuation.

• Options, e.g. stock option.

• Future, Swaps
 What’s interesting about investments?

• Attributes
– Dividends, yields, returns, prices.
• What do we want to explain/predict?
– Prices, volatility, returns
• Risk
– What does it mean?
– What are the types of risk? Default, price
– Is an insurance contract risky?
– When is a mortgage risky?
 Financial Markets
• Money Market Accounts
– Savings Accounts, CDs, Money Market accounts
– Liquid, Safe
• Capital Market
– Stocks, Bonds
– Less liquid, riskier
 Money Market
• Instruments
– T-bill
– CD
– CP
• Who Invests
– Risk adverse
– Need money soon (e.g. tuition).
 Capital Market
• Bond market
• Equity market
• Stock market indexes
• Derivatives
 Bond Market
• Fixed income stream.
• Instruments (different issuers):
– Government: Federal, state, local
– Corporate bonds
– Securitized Debt: Mortgages, Loans
• Issues
– Default
– Inflation
 Equity
• Stock: ownership in part of a company
• Characteristics:
– Exchange traded
– Dividends
– Voting rights
– Can be private.
• Issues
Riskier cash flow
Speculation
• Indexes
Dow, S&P, Wilshire, Nikkei, FTSE
 Derivative
• Value derives from an asset.
• Examples
– Stock option
– Future
– Swap
– Credit Default Swap
 Trading
• Exchanges
– NYSE, NASDAQ, AMEX
– Specialists
• Orders
– Market Order
– Limit Order, Stop loss
• Prices
– Ask price – buy at
– Bid price – sell at
• Costs
– Trading costs, broker fees
 Leverage and Short Sales
• Buying on margin – leverage
– Borrow money to buy stock
– Riskier
$10 stock. Falls to $5. Lose 50% or 100%
– Housing
• Short sale
– Borrow stock
– Pay back stock in the future.
– Price speculation
 Mutual Funds
• Own shares in the fund

• Managers pool money and invest in lots of options

• Examples: American, Fidelity, Vanguard

• Loads

• Fees
Time Value of Money

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 Time Value of Money
• Incremental cash flows in earlier years are more
valuable than incremental cash flows in later
years.
– Why?
– Exactly how much?

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 Present Value / Future Value
• Cash flows across time cannot be added up. They have
to be brought back to the same point in time before we
aggregate them.
• The process of moving cash flows in time is:
– Discounting, if future cash flows are brought to the present
• Present Value of Cash Flows
– Compounding, if present cash flows are taken to the future
• Future Value of Cash Flows

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 Time Line

$100 $100 $100 $100

0 1 2 3 4

10% 10% 10% 10%

• This time line represents a cash flow stream of $100 at

the end of each of the next 4 periods.
• The period discount rate is 10% for each period.

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 Discount Rate
• Why to discount the future cash flows?
– Individuals prefer present consumption to future
consumption,
– Monetary inflation,
– Uncertainty about future cash flows.

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 Types of Cash Flows
➢Simple cash flows
➢Annuities
➢Growing annuities
➢Perpetuities
➢Growing perpetuities

➢Note: Any other type of cash flow can be represented by

a combination of the above…
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 Notation

Notation Stands for:

PV Present Value
FV Future Value
CFt Cash flow at the end of period t
A Annuity
r Discount Rate
g Expected Growth Rate
n Number of years

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 Compounding a Simple Cash Flow

• A simple cash flow is a single cash flow at a

specified time.
CF0 FVt

0 t

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 Discounting a Simple Cash Flow

• A simple cash flow is a single cash flow at a

specified time.
PV CFt

0 t

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 Example
• Assume that you own Infosoft, a small software firm. You
are currently leasing your office space, and expect to make a
lump sum payment to the owner of the real estate of
$500,000 ten years from now. Assume that an appropriate
discount rate for this cash flow is 10%. The present value of
this cash flow can then be estimated as:

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Discount Rates and Present Values –
Negative Relationship

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 Present Value of Annuities
• An annuity is a constant cash flow that occurs
at regular intervals for a fixed period of time.

$100 $100 $100 $100

0 1 2 3 4

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 Example: Budget decision

• Assume that you are the owner of Infosoft, and that you
have the following two alternative:
– Buying a copier for $10,000 cash down or
– Paying $ 3,000 a year for 5 years for the same copier.
• If the opportunity cost is 12%, which would you rather do?

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 3,000 3,000 3,000 3,000 3,000 5 3,000
+ + + + =
1.12 1.122 1.123 1.124 1.125 i =1 1.12i
where the general formula is :
n
CF
PV =  i = 1,2,..., n
i =1 (1 + r ) i

Or use the annuity formula…

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 Future Value of Annuities
FV=?

$100 $100 $100 $100

0 1 2 3 4

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 Example

• An individual sets aside $2,000 at the end of every

year for three years.
• She expects to make 8% a year on her investments.
The expected value of the account on the end of
the 3 years:

2,000 + 2,000 *1.08 + 2,000 *1.082

where the general formula is :
n
FV =  CF (1 + r )i i = 1,2,..., n
i =1

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 Example

• An individual sets aside $2,000 at the end of every

year, starting when she is 25 years old, for an
expected retirement at the age of 65.
• She expects to make 8% a year on her investments.
The expected value of the account on her
retirement date would be:

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 Annuity due example
• You are going to rent an apartment for a year. You
have 2 choices: (1) pay the monthly rent, $500, at the
beginning of the month, or (2) pay the entire year’s
rent, $5,000, today. Suppose that you can earn 1%
every month. Which is the better choice?
• Annuity due PV = ordinary PV  (1 + i) = $5,627.5387
 1.01 = $5,683.8141.
• You would want to pay $5,000 today if you can.
 Present Value of Growing Annuities
• A growing annuity is a cash flow that grows at a
constant rate for a specified period of time.
A(1+g) A(1+g)2 A(1+g)3 A(1+g)n

0 1 2 3 ………. n

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 Growing annuity example
• Emily has just been offered a job at $80,000 a
year. She anticipates her salary increasing by 9%
a year until her retirement in 40 years. Given an
interest rate of 20%, what is the present value
of her lifetime salary?
PV = C (1+g) × { [ 1 – ((1 + g) / (1 + i))N ] / (i – g) }
= $80,000 ×(1+9%) × { [ 1 – ((1 + 9%) / (1 + 20%))^40 ] /(20% – 9%) }
= $775,786.5
 Present Value of a Perpetuity
• A perpetuity is a constant cash flow at regular
intervals forever.

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 Example
• A console bond is a bond that has no maturity and pays
a fixed coupon. Assume that you have a $60 coupon
console bond. The value of this bond, if the interest
rate is 9%, would be:

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 Present Value of a Growing Perpetuity
• A growing perpetuity is a cash flow that is
expected to grow at a constant rate forever.

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 Example
• Valuing a Stock with Stable Growth in Dividends
– In 1992, Southwestern Bell paid dividends per share of
$2.73. Its earnings and dividends had grown at 6% a year
between 1988 and 1992 and were expected to grow at the
same rate in the long term. The rate of return required by
investors on stocks of equivalent risk was 12.23%. What
is the value of this stock?

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Statistics

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 Return, Risk, Co-movement
• When investing in financial assets, we care about performance of
the assets, the riskiness of the assets and the co-movement of
the prices of different assets.
– Measure performance by “expected returns”.
– Measure risk by the “variance of the expected returns”.
– Measure co-movement by the covariance (or correlation)
of the expected returns.

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 Rates of Return for Stocks:
Single Period
P 1 − P 0 + D1
HPR =
P0
HPR = r = Holding period return
P0 = Beginning price
P1 = Ending price
D1 = Dividend during period one
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 Rates of Return:
Single Period Example

Ending Price = 48
Beginning Price = 40
Dividend = 2

HPR = (48 - 40 + 2 )/ (40) = 25%

Problem: When we invest in a stock, we do not know the
ending price.
One Solution: Assign probabilities to the expected ending
prices, and calculate the expected returns. 46
 Expected Returns
(Mean Returns)
ps= probability of a state
rs = return if a state occurs
N = Number of probable states

The expected return (the mean return) is a measure of

performance.
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 Scenario Returns: Example

State Prob. of State r in State

1 .1 -.05
2 .2 .05
3 .4 .15
4 .2 .25
5 .1 .35

E(r) = (.1)(-.05) + (.2)(.05)… + (.1)(.35)

E(r) = .15

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Characteristics of Probability
Distributions
1) Mean: most likely value
2) Variance or standard deviation
3) Skewness

• If a distribution is approximately normal, the

distribution is described by characteristics 1
and 2.

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 Variance
• Measure how spread out variable is:
N
var[ r ] = E[( r − E[r ]) ] =  pi (ri − E[r ]) 2
2

i =1
• Why subtract mean [E(r)]? Why squared?
• Standard deviation
 = sd[r ] = var[ r ]
• Example
Var(r)=.25*(-23 – 6.5)2+.25*(0-6.5)2
+.25*(15-6.5)2 +.25*(35-6.5)2=449.25
Sd(r) = 21.2%
• What’s point of sd?
 Properties
• Multiplying by a constant changes variance by the square of the constant.

var[ aX ] = a 2 var[ X ]
• But

sd[aX ] = a * sd[ X ]

• Not true: Var(X+Y) = Var(X) + Var(Y)

 Calculating EV and Variance
• Using data on stock returns {r(1), r(2),…,r(N)}
• Calculate the mean and standard deviation:
• Compute the sample average and the sample variance:
N
1
X=
N
X
i =1
i

N
1
S2 = 
N − 1 i =1
( X i − X )2

• Standard deviation

sd = S 2
 Using our example…

Var =[(.1)(-.05-.15)2+(.2)(.05- .15)2…+ .1(.35-.15)2]

Var= .01199
S.D.= [ .01199] 1/2 = .1095

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 Measuring Co-movement:
Covariance and Correlation

• Imagine you are holding IBM and Google stocks

in your portfolio.
• The risk of your portfolio return will depend on
whether or not the prices of IBM and Google
move together.
– If the returns move together, your risk is higher.

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 Covariance
• To what extent do variables move together?
• Portfolio
– 100% in AOL to 50% in Apple and 50% in AOL
– Is this riskier? Less risky
– Depend on how these two assets move together

cov( x, y ) =  xy = E[( x − E[ x])( y − E[ y ])]

N
cov(x, y ) =  pi (xi − E[ x])( yi − E[ y ])
i =1

• Note can be positive or negative

 Covariance Properties
• Cov(aX,bY)=a*b*Cov(X,Y)
• Cov(X,X) = Var(X)
• E(XY) = E(X)+E(Y) +Cov(X,Y)
• Var(X+Y) = Var(X) + Var(Y) + 2Cov(X,Y)
• Independent → Cov(X,Y) = 0

• Correlation cov( x, y )
corr ( x, y ) =  xy =
sd ( x) sd ( y )

• Always between -1 and 1

• Positive if they move together. Negative if they move in opposite directions.
 Calculating Portfolio Risk and Return
Two-asset model

• The expected return is calculated as:

E(rP ) = w1E(r1 ) + w 2 E(r2 )

Where: E(r1) = Expected return on the first asset
E(r2) = Expected return on the second asset
w = weights
 Calculating Portfolio Risk and Return

• The risk of a portfolio with two assets is

calculated as

 P = w  + w  + 2w1w1COV (r1, r 2)
2
1
2
1
2
2
2
2

 P = w12 12 + w 22 22 + 2w1w 2 1 2 12

Where: σ = standard deviation of assets
 = correlation coefficient of the two assets
 Example
You are thinking about investing your money in the stock market. You have the following two
stocks in mind: stock A and stock B. You know that the economy can either go in recession or it
will boom. Being an optimistic investor, you believe the likelihood of observing an economic boom
is two times as high as observing an economic depression. You also know the following about your
two stocks:

State of the Economy Probability RA RB

Boom 10% –2%
Recession 6% 40%

a) Calculate the expected return for stock A and stock B

b) Calculate the total risk (variance and standard deviation) for stock A and for stock B
c) Calculate the expected return on a portfolio consisting of equal proportions in both stocks.
d) Calculate the expected return on a portfolio consisting of 10% invested in stock A and the
remainder in stock B.
e) Calculate the covariance between stock A and stock B.
f) Calculate the correlation coefficient between stock A and stock B.
g) Calculate the variance of the portfolio with equal proportions in both stocks using the
covariance from answer e.)
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 Multiple Asset Model

• Portfolio Return:
N
E(rP ) =  w i E(ri )
i =1

• Portfolio Risk:

N N -1 N
 P =  w  +   w i w j i j  ij
2
i
2
j
i =1 i =1 j=i +1
 Example:
Three-Security Portfolio

rp = W1r1 + W2r2 + W3r3

2p = W1212 + W2212 + W3232

+ 2W1W2 Cov(r1r2)
+ 2W1W3 Cov(r1r3)
+ 2W2W3 Cov(r2r3)
 Systematic and Unsystematic Risk
VARIANCE

Total Risk = Diversifiable Risk + Market Risk

(unsystematic) (systematic)

Portfolio of
U.S. stocks

Total
Systematic
risk
risk

1 10 20 30 40 50
Number of stocks in portfolio
By diversifying the portfolio, the variance of the portfolio’s return relative to the variance of the
market’s return (beta) is reduced to the level of systematic risk -- the risk of the market itself.
 Measuring Comovement:
Correlation
• The correlation between two variables is:
– Positive when they move together
– Negative when they move in the opposite directions.
• The correlation ranges from –1 to 1.
• By combining securities whose returns are not perfectly positively correlated
with each other in a portfolio, the portfolio standard deviation
characteristically falls.
• The lower the correlation coefficient between investments, the greater the
benefit of diversification.

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 Excess Returns
• The reward for investing in a stock is the return in excess of the
risk-free rate
• Risk-free rate
– Depositing the money to a savings account,
– Buying government bonds.
• The difference between the return on a risky investment and
risk-free investment is called the “risk premium,” or “excess
return.”

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 How do We Compare Different
Investments?

➢Remember: We care for both return and risk.

➢Sharpe Ratio
– The ratio of the expected excess returns to the
standard deviation of excess returns.
➢An investment with a higher Sharpe Ratio is a
better investment…
– Why?

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 Sharpe Ratio
• The Sharpe Ratio is:

Excess Return E[ Ri ] − rf
=
Standard deviation of excess return i

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 Risk of a Portfolio
➢The variance of a portfolio depends on the
variances of the individual stocks and the
covariance (correlation) between the individual
stocks

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