• Key idea: to value an asset you have to

Cheatsheet - FMF I find other traded securities with similar

Compounding
rAP R k
Liquidity preference hypothesis
Anderson Arroyo rEAR = (1 + ) −1 The slope of the term structure reflects the
cash flows (time and risk) to estimate a k market’s expectations of future short-term
December 20, 2021
proper discount rate. interest rates and risk premium demanded by
• rEAR : Effective Annual Rate
• rAP R : Annual Percentage Rate investors in long bonds:
Present and future value
• k: periods of compounding
E[CF ] (1 + rt+1 (0))t+1
L2: Market Prices and Present PV = • Continuous compounding: E0 [r˜1 (t)] + λt = −1
(1 + r) (1 + rt (0))t
Value
e = limk→0 (1 + kr )k
 r
F V = P V ∗ (1 + r)
Arrow-Debreu securities
rEAR = er − 1 • r̃1 (t): one-year forward rate at time t or
• An AD security is the one that pays 1$ * E[CF ]: expected cash flow * r: discount rate future expected spot rate
if a given state is reached, and 0 or cost of opportunity - return offered by L4: Fixed Income Securities • λt : risk/liquidity premium of long
otherwise. similar assets traded in the market. Yield curve is the term structure of interest bonds compared to short bonds.
• For instance, ϕj is the price of an AD Nominal vs real CFs rates. In other words, the set of spot interest
rates for different maturities. Why long-term bonds earn a positive risk
security that has a claim on state j. We must treat inflation consistently: premium?
• Discount bond or zero-coupon bond:

0
 • Discount nominal cash flows using • Liquidity: short-term bonds are
returns the principal at time t. Useful to

0

nominal discount rates

money-like, so they require a lower rate

get spot interest rates.

..

• Discount real cash flows using real

of return.

ϕj = 1, state = j • Coupon bond: pays a stream of regular
discount rates • Inflation risk: long-term bonds are
.. coupon payments and a principal at


exposed to interest rate risk

maturity. It is a portfolio of discount

0 N ominal CFt


Real CF = (i.e. inflation).

bonds.

0 (1 + i)t


• ϕj has to be positive in order to comply 1 + rnominal Arbitrage strategy Interest rate risk
rreal = −1 ≈ rnominal −i 1 dP D
with the non-arbitrage assumption. 1+i • Self-financing strategy: no infusion of MD = − =−
capital is required. P dy 1+y
• The market is called complete (liquid) if L3: Discounting and compounding • Non risk strategy.
you can trade A-D securities on each T
P V (CFt )
Discount rate and asset return • Positive profits with a positive
X
possible state. D= ( )t
• Return of an asset: r = P1P+D 1
− 1 probability. t=1
P
• Absence of arbitrage imposes strong
0
Arbitrage pricing • Expected return: r = E[r]
• Excess return: r − rf restrictions on prices of securities • Modified duration - MD: measure
• Law of one price: two assets with the
• Expected excess return or risk premium: relative to each other. bond’s interest rate risk by its relative
same payoffs and level of risk should
• Prices of coupon bonds contain price change with respect to a unit
have the same market price. π = r − rf
information about the yield curve change in yield (with negative sign).
• We can price other securities just by
Special cash flows (interest rates). • Macaulay duration - D: weighted
replicate them as a portfolio of A-D
average term to maturity, center of
securities: • Perpetuity: P V = Cr
Yield to Maturity - YTM gravity of payment tenors. The higher
 • Perpetuity with constant growth:
α1 C It is a weighted average of spot rates at duration of the bond, the more the bond
P V = r−g


α2 different maturities. price is affected by small parallel shifts

P ayof ft=1 = • Annuity: P V = Cr ∗ (1 − (1+r)
1
T )
 .. in the yield curve.
• Annuity with constant growth:

αn • Bond price is inversely related to YTM.


n
( • Par bond: coupon rate = Y T M Duration rule: approximation valid for small
C 1+g T
r−g ∗ (1 − ( 1+r ) ), if r > g • Discount bond: coupon rate < Y T M yield changes. For large yield changes, the DR
X
Security price = αi ∗ ϕi C∗T
i=1 1+r , if r = g • Premium bond: coupon rate > Y T M underestimates bond prices.
 Forecasting dividends Valuation of operating business Relative risk aversion coefficient
DP S T
F CFt P VT The RRA(W ) depends on the shape of the
∆P D∆ y P ayout ratio = =p
X
=− EP S PV = (
(1 + r)t
)+
(1 + r)T utility function and the return variance or
P 1+y t=1 return risk σx2 and is defined as follows:
DP S = p ∗ EP S
Convexity: Bond price is not a linear Retained earnings(RE) = • It is necessary to forecast CFs for W u′′ (W )
function of the yield. Earnings(E) − Dividends(D) t = 1, 2, . . . , T . RRA(W ) = −
u′ (W )
• P VT can be estimated using:
RE
dP 1 d2 P P lowback ratio = =b=1−p – Comparable P/E and P/B ratios. Examples of utility functions:
∆P = ∆y + (∆y)2 + ... ≈ E
dy 2 dy 2
BV P St = BV P St−1 + EP St ∗ b – DCF approach: choose a T such • Linear utility - agent is risk-neutral:
[−M D ∗ ∆y + CX ∗ (∆y)2 ] ∗ P that P V GO = 0, then P VT = u(w) = a + bW, b > 0 then
At what rate should a company plow back F CFT +1 (N o growth)
= EP SrT +1 RRA(W ) = 0.
r
earnings to achieve a g growth rate? • Power utility - constant RRA:
1 d2 P
CX = L6: Risk and return
2P dy 2
 1
g = ROEproject ∗ b W ( 1 − gamma), γ > 0, ̸= 1
Expected utility theory u(W ) = 1−γ
ln W, γ = 1
L5: Stock Valuation Just projects with a rproject > r create value • It is the leading model of consistent
for the firm N P V > 0. decision making under uncertainty. RRA(W ) = γ
Discounted cash flow model
• Payoffs are transformed non linearly
Growth stocks
XT
Dt PT with the utility function. Portfolios: risk and return
P0 = ( t
)+ Stocks that have investment opportunities • Individuals compare investments based • Expected return on the portfolio:
(1 + r) (1 + r)T that generate a positive NPV.
t=1 on their expected utility E[u(x)] >
n
E[u(y)] ⇐⇒ x is pref erred over y.
If we assume that limT →∞ = 0, then:
PT
X
(1+r)T P V GO0 = P0 − P0no growth rp = E[rp ] = wi ri
Risk aversion i=1
∞
X Dt • P V GO0 : present value of growth • Utility function is non-decreasing • Variance of the return on the portfolio:
P0 = opportunities.
(1 + r)t u′ (x) >= 0.
t=1 • P0 : actual stock price. • Aversion to risk u(E[x]) >= E[u(x)],
n X
X n

• P0no growth : price without growth (100% σp2 = V ar[r˜p ] = wi wj σij , σii = σi2
• Flat interest rates term structure rt = r. then u(x) is concave u′′ (x) ≤ 0. The
• Discount rate = expected return. payout, no investment). mean of the gamble is always preferred
i=1 j=1

to the gamble itself. L7: Arbitrage Pricing Theory

P/E and PVGO
Constant growth - Gordon Model Given that the idiosyncratic risk can be
The price of a stock is equal to the no-growth Risk premium
eliminated through portfolio diversification,
D1 price and the price allocated to growth E[u(W (1 + x))] ≤ u(W )
P0 = then it is not rewarded by the market.
r−g opportunities. E[u(W (1 + x))] = u(W (1 − π)) Therefore, the expected return of risky assets
EP S1 can be modeled by their exposure to
• Constant discount rate r. • W : initial investment.
P0 = + P V GO systematic risks.
• Constant growth rate of dividends
r • x: random rate of return. E[x] = 0 and
g < r in perpetuity. P0 σx2 = E[x2 ] • Asset return:r˜i =
P/E = • π: risk premium. Penalty for ri + bi,1 f˜1 + bi,2 f˜2 + · · · + bi,K f˜K + ϵ˜i
EP S1
undertaking a risky investment. • f˜1 , f˜2 , . . . , f˜K : common factors.
From the Gordon Model, the expected return
is equal to the dividend yield plus the • If P V GO = 0, then P/E = 1r . E[f˜k ] = 0, ∀k ∈ 1, . . . , K
The risk premium π is given by (using Taylor
dividend growth rate: • If P V GO > 0, then • bi,1 , bi,2 , . . . , bi,K : factor sensitivities or
Expansion):
P/E = 1r + PEP S1 > r . The growth factor betas.
V GO 1

D1 D0 opportunities are reflected in higher P/E 1 W u′′ (W ) 2 • The residuals are firm-specific:
r= + g = (1 + g) +g ratios. π=− σ Cov(ϵ˜i , ϵ˜j ) = 0, ∀i ̸= j.
P0 P0 2 u′ (W ) x
For a well-diversified portfolio, the other factors. The risk premium of this L9: Introduction to corporate • τ : effective tax rate.
idiosyncratic risk is diversified away: portfolio will equal to the target factor risk finance • CAP EX: capital expenditure.
premium. • ∆W C: change in working capital.
r˜p = rp + bp,1 f˜1 + bp,2 f˜2 + · · · + bp,K f˜K What is corporate finance?
W C = Inventory + A/R − A/P
• Average factor loadings:
• Capital budgeting: What projects (real
PK
APT pricing relation bj = i=1 wi bPi ,j .
• Solve a system of equations to get investments) to invest in? Expansions,
Risk premium = Price of risk * Quantity of
weights such that: new products, new businesses, Capital investments decisions
risk:
acquisitions, . . .
bi = 1, i = j = target f actor • NPV rule: choose positive and the
rp − rf = λ ∗ bp • Financing: How to finance a project?
bi = 0, i ̸= j Selling financial assets/securities/claims highest NPV projects.
* λ: factor risk premium or market price of PK (bank loans, public debt, stocks, • Payback period: minimum length of
• Risk premium: λj = wi ∗ RPi
risk, how much compensation one earns in
i=1
convertibles, . . . ) time such that the sum of net CFs from a
the market for a unit of factor risk exposure. L8: Market efficiency • Payout : What to pay back to project becomes positive. An alternative
Multi-factors models Three forms of market efficiency hypothesis - shareholders? Paying dividends, can be the discounted payback period
EMH: buyback shares, . . . CF0 + CF CF2 CFs
1+r + (1+r)2 + · · · + (1+r)s ≥ 0.
1

rp −rf = λ1 ∗bp,1 +λ2 ∗bp,2 +· · ·+λK ∗bp,K • Risk management: What risk to take/to • IRR: the discount rate that sets the NPV
• Weak form: security prices reflect all avoid and how? to zero. Just valid under some
• Each factor exposure carries its own information contained in past prices circumstances:
risk premium. =⇒ Technical analysis does not provide Task of financial manager:
• The portfolio risk premium is abnormal excess returns.
• Semi-strong form: security prices reflect – Cash outflow occurs just at time 0.
determined by its factor loadings. The • Asset side (LHS): Real investments.
all publicly available information =⇒ – Only project under consideration.
factor risk premiums λi are the same • Liability side (RHS): Financing, payout
Fundamental analysis does not provide – Flat financing curve = constant
across different well-diversified and risk management.
abnormal excess returns. discount rate.
portfolios.
• Strong form: security prices reflect all
Factor-mimicking portfolio information, both public and private
L10: Capital budgeting I • Profitability index - PI: is the ratio
It tries to simulate a portfolio that has a beta =⇒ Inside information does not provide CF = (1 − τ )Operating P rof its − CAP EX+ between the PV of future cash flows and
equal to 1 to a given factor and zero to the abnormal excess returns. τ ∗ Depreciation − ∆W C the initial cost of a project P I = PI0V .