IMSE3115 - Lecture Note

Peng-Chu Chen

Department of Industrial and Manufacturing Systems Engineering

The University of Hong Kong
[email protected]

October 28, 2024

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Topics

Bonds
Common Stocks
Return and Risk
Diversification Benefit
Market Risk
Global Minimum Variance Portfolio

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Origin of Bonds

To cover the cost of investment, a firm can

Use retained earnings.
Borrow from a bank for a short while.
Issue new shares of common stock.
Issue bonds for a long run.
Bonds are simply long term loans.
Government also issue bonds.

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Typical Cash Flows of a Bond
If you own (buy) a bond.
At the time of purchase, you pay the price of the bond.
Every t year until the bond matures, you collect an interest
payment (coupon).
At maturity, you also get back the face value, also called the
principal, or par value, of the bond.

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Bond Price - Example I

In July 2016, you purchase the bond of 100 HKD in Hong Kong
which pays a 5% interest every year. If the bond matures in July
2022, what is the value of the bond?

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Bond Price - Example II

Price of bond = PV(bond)

= PV(coupon payments + final payment).

What’s the cost of capital we should use?

We can use the return offered by a similar bond, say it is
3.8%, which can usually be observed in the market.
5 5 5 5 5 105
PV(bond) = + 2
+ 3
+ 4
+ 5
+
1.038 1.038 1.038 1.038 1.038 1.0386
1 1 100
= 5( − )+ = 106.33.
0.038 0.038 × 1.0386 1.0386
´¹¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¸¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¶
6 year annuity

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Yield to Maturity - Example I

In July 2016 you purchase the bond of 100 HKD in Hong Kong
which pays a 5% coupon every year. If the bond matures in July
2022 and the bond is priced at $106.33, what is the expected
return if the investor holds the bond until maturity?
We solve

PV(bond)
5 5 5 5 5 105
= + + + + + = 106.33.
1 + y (1 + y ) 2 (1 + y ) 3 (1 + y ) 4 (1 + y ) 5 (1 + y )6

Here, y is called the bond’s yield to maturity (YTM). It tells

that if you buy the bond at $106.33 and hold it to maturity,
you will earn a return of 3.8% over six years.

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Yield to Maturity - Example II

In July 2012 you purchase a 3 year US Government bond. The

bond has a face value $1000 and an annual coupon rate of 4%,
paid semi-annually. If the yields on this bond is quoted as 4.96%,
what is the price of the bond?
Because the interest is semiannual, the yield is quoted as a
semiannually compounded yield.
The yield over six months would be 4.96/2 = 2.48%.

20 20 20 20 20 1020
PV(bond) = + 2
+ 3
+ 4
+ 5
+
1.0248 1.0248 1.0248 1.0248 1.0248 1.02486
= 973.54.

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Topics

Bonds ✓
Common Stocks
Return and Risk
Diversification Benefit
Market Risk
Global Minimum Variance Portfolio

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Value of Common Stocks
A dividend is the distribution of a company’s earnings to its
shareholders.
Let Di be the dividend paid by a company to its shareholders at
the end of period i, P0 be the stock price (value), r be the cost of
capital.
If we forecast no growth in Di , and plan to hold a stock
indefinitely, we will then value the stock as a perpetuity, i.e.,
D1
P0 = .
r
If we plan to hold the stock for a finite time horizon with
length T , then
D1 D2 D T + PT
P0 = + + ⋅⋅⋅ + .
1 + r (1 + r ) 2 (1 + r )T

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Example

Current forecasts are for XYZ Company to pay dividends of

$3, $3.24, and $3.50 per share over the next three years,
respectively. At the end of three years you anticipate selling
your stock at a market price of $94.48. What is the price of
the stock given a 12% expected return?
If a stock with $3 dividends is selling for $100 in the stock
market, what might the market be assuming about the growth
in dividends given a 12% expected return?

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Payout and Plowback I
If a firm elects to pay a lower dividend, and reinvest the funds,
the stock price may increase because future dividends may be
higher.
Payout ratio is the fraction of earnings paid out as dividends,
i.e.,
dividend per share
payout ratio = .
earnings per share (EPS)

Plowback Ratio is the fraction of earnings retained by the firm.

dividend growth rate

= return on equity (ROE) × plowback ratio
EPS
= × plowback ratio.
book equity per share

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Present Value of Growth Opportunites

Our company forecasts to pay a $8.33 dividend per share next

year, which represents 100% of its earnings. This will provide
investors with a 15% expected return. Assume $8.33 dividend
will be paid every year.
If the company did not plowback some earnings, the stock
price would be?
Instead, we decide to plowback 40% of the earnings at the
firm’s current return on equity of 25%. With the plowback,
the price would be?
Present value of growth opportunities (PVGO) =?

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Topics

Bonds ✓
Common Stocks ✓
Return and Risk
Diversification Benefit
Market Risk
Global Minimum Variance Portfolio

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Returns on Different Assets

vt+1 −vt
Average Annual Rate of Return at t = vt .
rm (year) = rf (year) + risk premium.
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Risk of Market Portfolio
Returns on the U.S. stock market.

We can use the variance of return to measure risk, i.e.,

Var [˜
rm ] = E[(˜
rm − rm )2 ] = σr˜2m
where r˜m is a random return and rm is the expected return on the
market.
Estimate Var [˜
rm ] by a historical sample variance.

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Individual v.s. Portfolio

Individual stocks are for the most part more variable than the
market indexes.
Diversification reduces variability.
Diversification works because prices of different stocks do not
move exactly together.

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Topics

Common Stocks ✓
Return and Risk ✓
Diversification Benefit
Market Risk

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Market Setup

Consider a market with n risky assets labeled by i = 1, . . . , n and a

risk-free asset labeled by 0. An investor wish to invest B dollars.
Let
Bi , i = 0, . . . , n denotes the allocation of the budget B to asset
i so that ∑ni=0 Bi = B.
xi ∶= Bi /B denotes the portfolio weight of asset i.
Ri denotes the random one-period return on asset i, i.e., $1
dollar investment will become $Ri one-period later.
One-period random return of the portfolio is given by

∑ni=0 Bi Ri n
Bi n
Rp = = ∑ ( × Ri ) = ∑ xi Ri .
B i=0 B i=0

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Example

Consider a portfolio of 200 shares of firm A worth $30/share

and 100 shares of firm B worth $40/share. What are the total
value of the portfolio and portfolio weights?
Suppose you bought this portfolio, and suppose further that
firm A’s share price goes up to $36 and firm B’s share price
falls to $38.
What is the new value of the portfolio?
What is the return of this portfolio?
After the price change, what are the new portfolio weights?

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Portfolio Expected Return

The expected return of a portfolio P is given by

n n n
µ(x) ∶= E[Rp ] = E[∑ xi Ri ] = ∑ E[xi Ri ] = ∑ xi E[Ri ].
i=0 i=0 i=0

where x = [x0 . . . xn ]⊺ is a vector of portfolio weights.

You invest $1000 in stock A, $3000 in stock B. You expect a
return of 10% for stock A and 18% in stock B. What is your
portfolio’s expected return?

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Portfolio Variance
The variance of a portfolio’s return is given by
⎡n ⎤
⎢ ⎥
v (x) ∶= Var [Rp ] = Var ⎢ ⎢ ∑ x j R j
⎥
⎥
⎢j=0 ⎥
⎣ ⎦
⎡n ⎤ n n
⎢ n ⎥ n n
= Cov ⎢ ⎢∑ xi Ri , ∑ xj Rj ⎥ = ∑ ∑ Cov [xi Ri , xj Rj ] = ∑ ∑ xi xj Cov [Ri , Rj ]
⎥
⎢i=0 ⎥ i=0 j=0
⎣ j=0 ⎦ i=0 j=0
´¹¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¸ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹¶
due to the bilinear property of a covariance
n n
= ∑ ∑ xi xj σij = x ⊺ Σx
i=0 j=0

where Σ is the covariance matrix of stock returns with its

ij-th element equal to
σij ∶= Cov [Ri , Rj ] = E[(Ri − E[Ri ])(Rj − E[Rj ]).
We can further define the (Pearson) correlation matrix as the
matrix with its ij-th element ρij given by
Cov [Ri , Rj ]
ρij ∶= .
σi σj
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Example I

What’s the covariance between the returns for Microsoft and

Dell?
What’s the standard deviation of a portfolio with equal
amounts invested in these two stocks?
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Example II

Consider a portfolio of Intel and Coca-Cola stocks.

Intel’s expected return is 26% and its volatility (standard
deviation) is 50%.
Coca-Cola’s expected return is 6% and its volatility is 25%.
The stock returns are independent, and so the correlation
coefficient ρ = 0.
Suppose you have $20,000 in cash to invest. You decide to
short sell $10,000 worth of Coca-Cola stock and invest the
proceeds from your short sale plus your $20,000 in Intel.
What are the portfolio weights?
What is the portfolio’s expected return?
What is the portfolio’s volatility?

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Diversification Benefit I

Now consider an equally-weighted portfolio of theses stocks in

which xi = 1/n for i = 1, . . . , n. What is the variance of this
equally-weighted portfolio?
The covariance matrix Σ has n2 entries with n diagonal and
n2 − n off-diagonal entries.
The diagonal entries correspond to each stock’s variance,
whereas the off-diagonal entries correspond to the
covariances.

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Diversification Benefit II
Therefore, in this special setting
n n n n
Var [Rp ] = ∑ ∑ xi xj σij = ∑ ∑(1/n)2 σij
i=1 j=1 i=1 j=1
n n
= ∑(1/n)2 Var [Ri ] + ∑ ∑ (1/n)2 σij
i=1 i=1 j=1,...,n
j=
/i
n
∑i=1 ∑j=1,...,n σij
∑i=1 Var [Ri ]
n
j=
/i
= (1/n)2 × n × +(1/n)2 × (n2 − n)
n n2 − n
´¹¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¸¹¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¶ ´¹¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¸ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¶
AvgVar AvgCov
AvgVar
= + (1 − 1/n)AvgCov
n
and
AvgVar
lim Var [Rp ] = lim ( + (1 − 1/n)AvgCov ) = AvgCov .
n→∞ n→∞ n
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Diversification Benefit III

If the average covariance were zero, it would be possible to

eliminate all risk by holding a sufficient number of securities.
Unfortunately common stocks move together, not independently.
Thus, usually, AvgCov =/ 0.
The market risk of the equally-weighted portfolio is measured by its
average covariance.

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Topics

Bonds ✓
Common Stocks ✓
Return and Risk ✓
Diversification Benefit ✓
Market Risk
Global Minimum Variance Portfolio

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Security Market Risk

The risk of a portfolio depends on the market risk of the

securities included in the portfolio.
The market risk of an individual security is measured by its
beta value (β).
β measures how sensitive a security’s return is to market
movement:
change in security’s return
β= .
change in market return
Stocks with β > 1 tend to amplify the overall movements of
the market.
Stocks with 0 ≤ β ≤ 1 tend to move in the same direction as
the market, but not as far.

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Estimate Market Risk I

Statistically, the beta of stock i is given by βi = σim /σm

2
where
σim is the covariance between the stock returns and the
2
market returns and σm is the variance of the returns on the
market.

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Estimate Market Risk II

A line fitted to a plot of Dell’s returns versus market returns has a

slope of 1.41.
This shows that over the five years from January 2004 to December
2008, Dell had a beta of 1.41.
If the future resembles the past, this means that on average when
the market rises an extra 1%, Dell’s stock price will rise by an extra
1.41%.
When the market falls an extra 2%, Dell’s stock prices will fall an
extra 2 × 1.41 = 2.82%.
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Topics

Bonds ✓
Common Stocks ✓
Return and Risk ✓
Diversification Benefit ✓
Market Risk ✓
Global Minimum Variance Portfolio

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Global Minimum Variance Portfolio of Two Assets
The global minimum variance portfolio achieves the lowest
variance, regardless of expected return.
The variance of a two-asset portfolio is given by
Var (x1 R1 + x2 R2 ) = Var (x1 R1 + (1 − x1 )R2 )
= σ12 x12 + σ22 (1 − x1 )2 + 2x1 (1 − x1 )σ12 .
Since there are no constraints on x1 , the optimal x1 should
satisfy the first order condition:
dVar (x1 R1 + (1 − x1 )R2 )
= 2σ12 x1 − 2σ22 (1 − x1 ) + 2(1 − 2x1 )σ12
dx1
= 2(σ12 + σ22 − 2σ12 )x1 − 2(σ22 − σ12 ) = 0.
So
σ22 − σ12 σ12 − σ12
x1∗ = and x ∗
= .
σ12 + σ22 − 2σ12 2
σ12 + σ22 − 2σ12
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Example

Let’s return to the data for the Intel and Coca-Cola stocks. Intel’s
volatility is 50% and Coca-Cola’s volatility is 25%. Here, we
assume the correlation coefficient is 0.20.
What is the covariance between the returns of these two
stocks?
What are the portfolio weights of the global minimum
variance portfolio of these two stocks?
What is the global minimum variance portfolio’s volatility?

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More than Two Assets
Let e ∶= (1, . . . , 1)⊺ be the n-vector with all components equal to 1.
We want to solve
min Var(Rp ) = x ⊺ Σx s.t. x ⊺ e = 1.
x

It can be shown that the global minimum variance portfolio x ∗

satisfies
⊺
x ∗ = (x1∗ , . . . , xn∗ ) = v Σ−1 e.

x ∗ is proportional to the vector Σ−1 e.

Σ−1 e computes the vector with each component equal to the
corresponding row sum of Σ−1 .
v = 1/(e ⊺ Σ−1 e) is the reciprocal of the sum of the all
components in Σ−1 .
v : the minimum variance.
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Example

Consider three risky assets with covariance matrix

⎛ 216% 70% −324%⎞

Σ = ⎜ 70% 25% −150%⎟ .
⎝−324% −150% 1596% ⎠

Construct the global minimum variance portfolio (x1∗ , x2∗ , x3∗ ) using
these three risky assets.

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Topics

Bonds ✓
Common Stocks ✓
Return and Risk ✓
Diversification Benefit ✓
Market Risk ✓
Global Minimum Variance Portfolio ✓

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Reference

Brealey, R.A., Myers, S.C., and Allen, F. Principles of Corporate

Finance (10th Edition) Ch.5, Ch.6, Ch.8, Ch.9.

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