15.

401

15.401 Finance Theory

MIT Sloan MBA Program

Andrew W. Lo
Harris & Harris Group Professor, MIT Sloan School

Lecture 7: Equities

© 2007–2008 by Andrew W. Lo
 Critical Concepts 15.401

Industry Overview
The Dividend Discount Model
DDM with Multiple-Stage Growth
EPS and P/E
Growth Opportunities and Growth Stocks

Reading
Brealey, Myers and Allen, Chapter 4

© 2007–2008 by Andrew W. Lo Slide 2

Lecture 7: Equities
 Industry Overview 15.401

What Is Common Stock?

Equity, an ownership position, in a corporation
Payouts to common stock are dividends, in two forms:
– Cash dividends
– Stock dividends
Unlike bonds, payouts are uncertain in both magnitude and timing
Equity can be sold (private vs. public equity)

Key Characteristics of Common Stock:

Residual claimant to corporate assets (after bondholders)
Limited liability
Voting rights
Access to public markets and ease of shortsales

© 2007–2008 by Andrew W. Lo Slide 3

Lecture 7: Equities
 Industry Overview 15.401

The Primary Market (Underwriting)

Venture capital: A company issues shares to special investment
partnerships, investment institutions, and wealthy individuals
Initial public offering (IPO): A company issues shares to the general
public for the first time (i.e., going public)
Secondary or seasoned equity offerings (SEO): A public company
issues additional shares
Stock issuance to the general public is usually organized by an
investment bank who acts as an underwriter: it buys part or all of the
issue and resells it to the public

Secondary Market (Resale Market)

Organized exchanges: NYSE, AMEX, NASDAQ, etc.
Specialists, broker/dealers, and electronic market-making (ECNs)
OTC: NASDAQ

© 2007–2008 by Andrew W. Lo Slide 4

Lecture 7: Equities
 Industry Overview 15.401

3500
90
3000 2890 2859 76
75
2535 2581
2500 64
60
1868 1960 1851
$ Billions

2000

$ Billions
50 48
45 41 43
1500 1317 37 36
1063 979 30
1000 856 30 28 26
716 722 24
587
16 16
500 312
15
5
0
'90 '91 '92 '93 '94 '95 '96 '97 '98 '99 '00 '01 '02 '03 '04 0
'90 '91 '92 '93 '94 '95 '96 '97 '98 '99 '00 '01 '02 '03 '04
Industry Underwrites Nearly $3 Trillion in United
States for Second-Straight Year Initial Public Offerings* Rebound In 2004
Source: Thomson Financial
Source: Thomson Financial *Excludes Closed-End Funds

1800 1735 1741 1768

1563
1500
Announced 1314 1314

1200 Completed 1160

1031
$ Billions

900 834
771 749
731 718
613 592
600 558 528
440 451
376 383
300 279 269
162 167
112
0
'92 '93 '94 '95 '96 '97 '98 '99 '00 '01 '02 '03 '04

Source: Thomson Financial U.S. M&A Cycle Turns Up

Images by MIT OpenCourseWare.

© 2007–2008 by Andrew W. Lo Slide 5

Lecture 7: Equities
 Industry Overview 15.401

NYSE Daily Share Volume vs.

NYSE Composite Index
7,250
1600 8,000
5,000 1457
6,876 6,946 6,440
1400 7,000

Average Daily Volume in Millions

6,300 6,236
1441
1200 5,405 1398 6,000
1042

NYSE Composite
1240
1000 5,000
4,148
809

of Shares
800 3,384 4,000
2,739 674
2,540 2,653
600 2,426 527 3,000
1,908 412
400 346 2,000
265 291
200 157 179 202
1,000

0 0
'90 '91 '92 '93 '94 '95 '96 '97 '98 '99 '00 '01 '02 '03 '04

NYSE Volume NYSE Composite

NASDAQ Daily Share Volume vs.

NASDAQ Composite Index
2000 1900 4,500
4,069 1801
Average Daily Volume in Millions

1757 1753
1800 1686 4,000
1600 3,500

NASDAQ Composite
1400
3,000
of Shares

1200 1082 2,471

2,193 2,175 2,500
1000 1,950 2,003
802 2,000
800 1,570 1,336
1,291 1,500
600 1,052 648
544 1,000
400 374 586 677 777 752 401
268 295
132 163 191 500
200
0 0
'90 '91 '92 '93 '94 '95 '96 '97 '98 '99 '00 '01 '02 '03 '04

NASDAQ Volume NASDAQ Composite

Images by MIT OpenCourseWare.

Lecture 7: Equities © 2007–2008 by Andrew W. Lo Slide 6

 The Dividend Discount Model 15.401

Most Basic Valuation Model for Common Stock

Applies PV formulas to common-stock payouts
Two inputs: expected future dividends, discount rate
Notation:
– Pt: Price of stock at t (ex-dividend)
– Dt: Cash dividend at t
– Et [ ]: Expectation operator (forecast) at t
– rt: Risk-adjusted discount rate for cashflow at t

© 2007–2008 by Andrew W. Lo Slide 7

Lecture 7: Equities
 The Dividend Discount Model 15.401

Most Basic Valuation Model for Common Stock

Two additional simplifying assumptions:

In this case, we have the first version of the dividend discount model
or the discounted cashflow (DCF) model

Suppose dividends grow at rate g over time (Gordon growth model):

© 2007–2008 by Andrew W. Lo Slide 8

Lecture 7: Equities
 The Dividend Discount Model 15.401

Most Basic Valuation Model for Common Stock

This provides a convenient expression for the discount rate:

© 2007–2008 by Andrew W. Lo Slide 9

Lecture 7: Equities
 The Dividend Discount Model 15.401

Example:

Dividends are expected to grow at 6% per year and the current dividend
is $1 per share. The expected rate of return is 20%. What should the
current stock price be?

Note: DDM with constant growth gives a relation between current

stock price, current dividend, dividend growth rate and the expected
return. Knowing three of the variables determines the fourth.

© 2007–2008 by Andrew W. Lo Slide 10

Lecture 7: Equities
 The Dividend Discount Model 15.401

Example:

Determine the cost of capital of Duke Power. In 09/92, the dividend yield
for Duke Power was D0/P0 = 0.052. Estimates of long-run growth:

The cost of capital is given by

Thus,

© 2007–2008 by Andrew W. Lo Slide 11

Lecture 7: Equities
 DDM with Multiple-Stage Growth 15.401

Firms May Have Multiple Stages of Growth

Growth Stage: rapidly expanding sales, high profit margins, and
abnormally high growth in earnings per share, many new investment
opportunities, low dividend payout ratio
Transition Stage: growth rate and profit margin reduced by
competition, fewer new investment opportunities, high payout ratio
Mature Stage: earnings growth, payout ratio and average return on
equity stabilizes for the remaining life of the firm

Example:
A company with D0 = $1 and r = 20% grows at 6% for the first 7 years
and then drops to zero thereafter. What should its current price be?

© 2007–2008 by Andrew W. Lo Slide 12

Lecture 7: Equities
 EPS and P/E 15.401

Dividend Forecasts Involve Many Practical Challenges

Terminology:
– Earnings: total profit net of depreciation and taxes
– Payout Ratio p: dividend/earnings = DPS/EPS
– Retained Earnings: (earnings - dividends)
– Plowback Ratio b: retained earnings/total earnings
– Book Value BV: cumulative retained earnings
– Return on Book Equity ROE: earnings/BV
Using these concepts, different valuation formulas may be derived
Note: these are mostly based on accounting data, not market values

© 2007–2008 by Andrew W. Lo Slide 13

Lecture 7: Equities
 EPS and P/E 15.401

Example:
(Myers) Texas Western (TW) is expected to earn $1.00 next year. Book
value per share is $10.00 now. TW plans an investment program
which will increase net book assets by 8% per year. Earnings are
expected to grow proportionally. The investment is financed by
retained earnings. The discount rate is 10%, which is assumed to be
the same as the rate of return on new investments. Price TW's share
price if
– TW expands at 8% forever
– TW's expansion slows down to 4% after year 5
Observe that
– Plowback Ratio b = (10)(0.08)/(1) = 0.8
– Payout Ratio p = (1-0.8)/(1) = 0.2
– ROE = 10%

© 2007–2008 by Andrew W. Lo Slide 14

Lecture 7: Equities
 EPS and P/E 15.401

Example (cont):
Continuing Expansion Case:

© 2007–2008 by Andrew W. Lo Slide 15

Lecture 7: Equities
 EPS and P/E 15.401

Example (cont):

2-Stage Expansion Case. Forecast EPS, D, BVPS by year:

Question: Why are the values the same under both scenarios?

© 2007–2008 by Andrew W. Lo Slide 16

Lecture 7: Equities
 Growth Opportunities and Growth Stocks 15.401

What Are Growth Stocks?

Stocks of companies that have access to growth opportunities are
considered growth stocks
Growth opportunities are investment opportunities that earn
expected returns higher than the required rate of return on capital
Example: IBM in the 60's and 70's.
Note: The following may not be growth stocks
– A stock with growing EPS
– A stock with growing dividends
– A stock with growing assets
Note: The following may be growth stocks
– A stock with EPS growing slower than required rate of return
– A stock with DPS growing slower than required rate of return

© 2007–2008 by Andrew W. Lo Slide 17

Lecture 7: Equities
 Growth Opportunities and Growth Stocks 15.401

Example:
ABC Software has: Expected EPS next year of $8.33; Payout ratio of
0.6; ROE of 25%; and, cost of capital of r=15%

Following a no-growth strategy (g=0,p=1), its value is

Following a growth strategy, its price is

Difference of $100 - $55.56 = $44.44 comes from growth

opportunities, which offers a return of 25%, higher than the required
rate of return 15%

© 2007–2008 by Andrew W. Lo Slide 18

Lecture 7: Equities
 Growth Opportunities and Growth Stocks 15.401

Example (cont):
At t = 1: ABC can invest (0.4)(8.33)=$3.33 at a permanent 25% rate of
return. This investment generates a cash flow of (0.25)(3.33) = $0.83
per year starting at the t=2. Its NPV at t=1 is

At t = 2: Everything is the same except that ABC will invest $3.67,

10% more than at t = 1 (the growth is 10%). The investment is made
with NPV being

The total present value of growth opportunities (PVGO) is

This makes up the difference in value between growth and no-growth

© 2007–2008 by Andrew W. Lo Slide 19

Lecture 7: Equities
 Growth Opportunities and Growth Stocks 15.401

Stock Price Can Be Decomposed Into Two Components

1. Present value of earnings under a no-growth policy
2. Present value of growth opportunities

Terminology*:
– Earnings yield: E/P = EPS1/P0
– P/E ratio: P/E = P0/EPS1

*Note: In newspapers, P/E ratios are often computed with the most recent earnings, but investors
are more concerned with price relative to future earnings.

© 2007–2008 by Andrew W. Lo Slide 20

Lecture 7: Equities
 Growth Opportunities and Growth Stocks 15.401

If PVGO = 0, P/E ratio equals inverse of cost of capital

If PVGO > 0, P/E ratio becomes higher:

PVGO is positive only if the firm earns more than its cost of capital

© 2007–2008 by Andrew W. Lo Slide 21

Lecture 7: Equities
 Key Points 15.401

The Dividend Discount Model

The Gordon Growth Model
Discount rate, cost of capital, required rate of return
Estimating discount rates with D/P and g
EPS, P/E, and PVGO
Definitions of growth stocks and growth opportunities

© 2007–2008 by Andrew W. Lo Slide 22

Lecture 7: Equities
 Additional References 15.401

Harris, L., 2002, Trading and Exchanges: Market Microstructure for Practitioners. New York: Oxford
University Press.
Lefevre, E., 2006, Reminiscences of a Stock Operator. New York: John Wiley & Sons.
Malkiel, B., 1996, A Random Walk Down Wall Street: Including a Life-Cycle Guide to Personal
Investing. New York: W.W. Norton.

© 2007–2008 by Andrew W. Lo Slide 23

Lecture 7: Equities
MIT OpenCourseWare
http://ocw.mit.edu

15.401 Finance Theory I

Fall 2008

For information about citing these materials or our Terms of Use, visit: http://ocw.mit.edu/terms.
 15.401

15.401 Finance Theory

Andrew W. Lo
Harris & Harris Group Professor, MIT Sloan School

© 2007–2008 by Andrew W. Lo
 Critical Concepts 15.401

Industry Overview
Valuation
Valuation of Discount Bonds
Valuation of Coupon Bonds
Measures of Interest-Rate Risk
Corporate Bonds and Default Risk
The Sub-Prime Crisis

Readings
Brealey, Myers, and Allen Chapters 23–25

© 2007–2008 by Andrew W. Lo Slide 2

Lectures 4–6: Fixed-Income Securities
 Industry Overview 15.401

Fixed-income securities are financial claims with promised cashflows of

known fixed amount paid at fixed dates.
Classification of Fixed-Income Securities:
Treasury Securities
– U.S. Treasury securities (bills, notes, bonds)
– Bunds, JGBs, U.K. Gilts
– ….
Federal Agency Securities
– Securities issued by federal agencies (FHLB, FNMA $\ldots$)
Corporate Securities
– Commercial paper
– Medium-term notes (MTNs)
– Corporate bonds
– ….
Municipal Securities
Mortgage-Backed Securities
Derivatives (CDO’s, CDS’s, etc.)

© 2007–2008 by Andrew W. Lo Slide 3

Lectures 4–6: Fixed-Income Securities
 Industry Overview 15.401

U.S. Bond Market Debt 2006 ($Billions)

Asset-Backed, Municipal,
2,016.70, 8% 2,337.50, 9%
Money Treasury,
Markets, 4,283.80, 16%
3,818.90, 14%

Federal
Agency,
2,665.20, 10%

Mortgage-
Corporate, Related,
5,209.70, 19% 6,400.40, 24%

© 2007–2008 by Andrew W. Lo Slide 4

Lectures 4–6: Fixed-Income Securities
 Industry Overview 15.401

Courtesy of SIFMA. Used with permission. The Securities Industry and Financial Markets Association (SIFMA) prepared
this material for informational purposes only. SIFMA obtained this information from multiple sources believed to be reliable
as of the date of publication; SIFMA, however, makes no representations as to the accuracy or completeness of such third
party information. SIFMA has no obligation to update, modify or amend this information or to otherwise notify a reader
thereof in the event that any such information becomes outdated, inaccurate, or incomplete.

© 2007–2008 by Andrew W. Lo Slide 5

Lectures 4–6: Fixed-Income Securities
 Industry Overview 15.401

U.S. Bond Market Issuance 2006 ($Billions)

Municipal,
Asset-Backed,
265.3, 6%
674.6, 16%
Treasury,
Federal 599.8, 14%
Agency, 546.9,
13%

Corporate, Mortgage-
748.7, 17% Related,
1,475.30, 34%

© 2007–2008 by Andrew W. Lo Slide 6

Lectures 4–6: Fixed-Income Securities
 Industry Overview 15.401

Courtesy of SIFMA.Used with permission. The Securities Industry and Financial Markets Association (SIFMA) prepared
this material for informational purposes only. SIFMA obtained this information from multiple sources believed to be reliable
as of the date of publication; SIFMA, however, makes no representations as to the accuracy or completeness of such third
party information. SIFMA has no obligation to update, modify or amend this information or to otherwise notify a reader
thereof in the event that any such information becomes outdated, inaccurate, or incomplete

© 2007–2008 by Andrew W. Lo Slide 7

Lectures 4–6: Fixed-Income Securities
 Industry Overview 15.401

Courtesy of SIFMA. Used with permission. The Securities Industry and Financial Markets Association (SIFMA) prepared
this material for informational purposes only. SIFMA obtained this information from multiple sources believed to be reliable
as of the date of publication; SIFMA, however, makes no representations as to the accuracy or completeness of such third
party information. SIFMA has no obligation to update, modify or amend this information or to otherwise notify a reader
thereof in the event that any such information becomes outdated, inaccurate, or incomplete.

© 2007–2008 by Andrew W. Lo Slide 8

Lectures 4–6: Fixed-Income Securities
 Industry Overview 15.401

Fixed-Income Market Participants

Investors:
Issuers:
Intermediaries: Governments
Governments
Primary Dealers Pension Funds
Corporations
Other Dealers Insurance Companies
Commercial Banks
Investment Banks Commercial Banks
States
Credit-rating Agencies Mutual Funds
Municipalities
Credit Enhancers Hedge Funds
SPVs
Liquidity Enhancers Foreign Institutions
Foreign Institutions
Individuals

© 2007–2008 by Andrew W. Lo Slide 9

Lectures 4–6: Fixed-Income Securities
 Valuation 15.401

Cashflow:
Maturity
Example. A 3-year bond with principal of $1,000
Coupon and annual coupon payment of 5% has the
Principal following cashflow:

© 2007–2008 by Andrew W. Lo Slide 10

Lectures 4–6: Fixed-Income Securities
 Valuation 15.401

Components of Valuation
Time value of principal and coupons
Risks
– Inflation
– Credit
– Timing (callability)
– Liquidity
– Currency

For Now, Consider Riskless Debt Only

U.S. government debt (is it truly riskless?)
Consider risky debt later

© 2007–2008 by Andrew W. Lo Slide 11

Lectures 4–6: Fixed-Income Securities
 Valuation of Discount Bonds 15.401

Pure Discount Bond

No coupons, single payment of principal at maturity
Bond trades at a “discount” to face value
Also known as zero-coupon bonds or STRIPS*
Valuation is straightforward application of NPV

Note: ( 0, , ) is “over-determined”; given two, the third is determined

Now What If r Varies Over Time?

Different interest rates from one year to the next
Denote by the spot rate of interest in year
*Separate Trading of Registered Interest and Principal Securities

© 2007–2008 by Andrew W. Lo Slide 12

Lectures 4–6: Fixed-Income Securities
 Valuation of Discount Bonds 15.401

If r Varies Over Time

Denote by the one-year spot rate of interest in year

But we don’t observe the entire sequence of future spot rates today!

Today’s T-year spot rate is an “average” of one-year future spot rates

( 0 ) is over-determined

© 2007–2008 by Andrew W. Lo Slide 13

Lectures 4–6: Fixed-Income Securities
 Valuation of Discount Bonds 15.401

Example:
On 20010801, STRIPS are traded at the following prices:

For the 5-year STRIPS, we have

© 2007–2008 by Andrew W. Lo Slide 14

Lectures 4–6: Fixed-Income Securities
 Valuation of Discount Bonds 15.401

Suppose We Observe Several Discount Bond Prices Today

Term Structure of Interest Rates

© 2007–2008 by Andrew W. Lo Slide 15

Lectures 4–6: Fixed-Income Securities
 Valuation of Discount Bonds 15.401

Term Structure Contain Information About Future Interest Rates

r0,t

Maturity

What are the implications of each of the two term structures?

© 2007–2008 by Andrew W. Lo Slide 16

Lectures 4–6: Fixed-Income Securities
 Valuation of Discount Bonds 15.401

Term Structure Contain Information About Future Interest Rates

Implicit in current bond prices are forecasts of future spot rates!

These current forecasts are called one-year forward rates
To distinguish them from spot rates, we use new notation:

© 2007–2008 by Andrew W. Lo Slide 17

Lectures 4–6: Fixed-Income Securities
 Valuation of Discount Bonds 15.401

Term Structure Contain Information About Future Interest Rates

© 2007–2008 by Andrew W. Lo Slide 18

Lectures 4–6: Fixed-Income Securities
 Valuation of Discount Bonds 15.401

More Generally:
Forward interest rates are today’s rates for transactions between two
future dates, for instance, 1 and 2.
For a forward transaction to borrow money in the future:
– Terms of transaction is agreed on today, = 0
– Loan is received on a future date 1
– Repayment of the loan occurs on date 2
Note: future spot rates can be (and usually are) different from current
corresponding forward rates

© 2007–2008 by Andrew W. Lo Slide 19

Lectures 4–6: Fixed-Income Securities
 Valuation of Discount Bonds 15.401

Example:

As the CFO of a U.S. multinational, you expect to repatriate $10MM from

a foreign subsidiary in one year, which will be used to pay dividends
one year afterwards. Not knowing the interest rates in one year, you
would like to lock into a lending rate one year from now for a period of
one year. What should you do? The current interest rates are:

Strategy:
Borrow $9.524MM now for one year at 5%
Invest the proceeds $9.524MM for two years at 7%

© 2007–2008 by Andrew W. Lo Slide 20

Lectures 4–6: Fixed-Income Securities
 Valuation of Discount Bonds 15.401

Example (cont):

Outcome (in millions of dollars):

The locked-in 1-year lending rate one year from now is 9.04%, which
is the one-year forward rate for Year 2

© 2007–2008 by Andrew W. Lo Slide 21

Lectures 4–6: Fixed-Income Securities
 Valuation of Discount Bonds 15.401

Example:
Suppose that discount bond prices are as follows:

A customer would like to have a forward contract to borrow $20MM three

years from now for one year. Can you (a bank) quote a rate for this
forward loan?

All you need is the forward rate 4 which should be your quote for the
forward loan

© 2007–2008 by Andrew W. Lo Slide 22

Lectures 4–6: Fixed-Income Securities
 Valuation of Discount Bonds 15.401

Example (cont):

Strategy:
Buy 20,000,000 of 3 year discount bonds, costing

Finance this by (short)selling 4 year discount bonds of amount

This creates a liability in year 4 in the amount $21,701,403

Aside: A shortsales is a particular financial transaction in which an
individual can sell a security that s/he does not own by borrowing the
security from another party, selling it and receiving the proceeds, and
then buying back the security and returning it to the orginal owner at a
later date, possibly with a capital gain or loss.

© 2007–2008 by Andrew W. Lo Slide 23

Lectures 4–6: Fixed-Income Securities
 Valuation of Discount Bonds 15.401

Example (cont):
Cashflows from this strategy (in million dollars):

The yield for this strategy or “synthetic bond return” is given by:

© 2007–2008 by Andrew W. Lo Slide 24

Lectures 4–6: Fixed-Income Securities
 Valuation of Coupon Bonds 15.401

Coupon Bonds
Intermediate payments in addition to final principal payment
Coupon bonds can trade at discounts or premiums to face value
Valuation is straightforward application of NPV (how?)

Example:
3-year bond of $1,000 par value with 5% coupon

© 2007–2008 by Andrew W. Lo Slide 25

Lectures 4–6: Fixed-Income Securities
 Valuation of Coupon Bonds 15.401

Valuation of Coupon Bonds

Since future spot rates are unobservable, summarize them with

is called the yield-to-maturity of a bond

It is a complex average of all future spot rates
There is usually no closed-form solution for ; numerical methods
must be used to compute it ( th-degree polynomial)
( 0, , ) is over-determined; any two determines the third
For pure discount bonds, the YTM’s are the current spot rates
Graph of coupon-bond against maturities is called the yield curve

© 2007–2008 by Andrew W. Lo Slide 26

Lectures 4–6: Fixed-Income Securities
 Valuation of Coupon Bonds 15.401

U.S. Treasury Yield Curves

Source: Bloomberg

© 2007–2008 by Andrew W. Lo Slide 27

Lectures 4–6: Fixed-Income Securities
 Valuation of Coupon Bonds 15.401

Time Series of U.S. Treasury Security Yields

© 2007–2008 by Andrew W. Lo Slide 28

Lectures 4–6: Fixed-Income Securities
 Valuation of Coupon Bonds 15.401

© 2007–2008 by Andrew W. Lo Slide 29

Lectures 4–6: Fixed-Income Securities
 Valuation of Coupon Bonds 15.401

Models of the Term Structure

Expectations Hypothesis
Liquidity Preference
Preferred Habitat
Market Segmentation
Continuous-Time Models
– Vasicek, Cox-Ingersoll-Ross, Heath-Jarrow-Morton

Expectations Hypothesis
Expected Future Spot = Current Forward

E0[Rk ] = fk

© 2007–2008 by Andrew W. Lo Slide 30

Lectures 4–6: Fixed-Income Securities
 Valuation of Coupon Bonds 15.401

Liquidity Preference Model

Investors prefer liquidity
Long-term borrowing requires a premium
Expected future spot < current forward

E[Rk ] < fk
E[Rk ] = fk Liquidity Premium

© 2007–2008 by Andrew W. Lo Slide 31

Lectures 4–6: Fixed-Income Securities
 Valuation of Coupon Bonds 15.401

Another Valuation Method for Coupon Bonds

Theorem: All coupon bonds are portfolios of pure discount bonds
Valuation of discount bonds implies valuation of coupon bonds
Proof?

Example:
3-Year 5% bond
Sum of the following
discount bonds:
– 50 1-Year STRIPS
– 50 2-Year STRIPS
– 1050 3-Year STRIPS

© 2007–2008 by Andrew W. Lo Slide 32

Lectures 4–6: Fixed-Income Securities
 Valuation of Coupon Bonds 15.401

Example (cont):
Price of 3-Year coupon bond must equal the cost of this portfolio
What if it does not?

In General:
P = C P0,1 + C P0,2 + · · · + (C + F )PO,T

If this relation is violated, arbitrage opportunities exist

For example, suppose that
P > C P0,1 + C P0,2 + · · · + (C + F )PO,T
Short the coupon bond, buy discount bonds of all maturities up to
and F discount bonds of maturity
No risk, positive profits arbitrage

© 2007–2008 by Andrew W. Lo Slide 33

Lectures 4–6: Fixed-Income Securities
 Valuation of Coupon Bonds 15.401

What About Multiple Coupon Bonds?

Suppose n is much bigger than T (more bonds than maturity dates)

This system is over-determined: unknowns, linear equations
What happens if a solution does not exist?
This is the basis for fixed-income arbitrage strategies

© 2007–2008 by Andrew W. Lo Slide 34

Lectures 4–6: Fixed-Income Securities
 Measures of Interest-Rate Risk 15.401

Bonds Subject To Interest-Rate Risk

As interest rates change, bond prices also change
Sensitivity of price to changes in yield measures risk

© 2007–2008 by Andrew W. Lo Slide 35

Lectures 4–6: Fixed-Income Securities
 Measures of Interest-Rate Risk 15.401

Macaulay Duration
Weighted average term to maturity
T
X q
X
Dm = k· k k=1
k=1 k=1
Ck /(1 + y)k PV(Ck )
k = =
P P
Sensitivity of bond prices to yield changes
T
X Ck
P =
k=1
(1 + y)k
XT
P 1 Ck
= k·
y 1 + y k=1 (1 + y)k
1 P Dm
=
P y 1+y
= Dm Modified Duration

© 2007–2008 by Andrew W. Lo Slide 36

Lectures 4–6: Fixed-Income Securities
 Measures of Interest-Rate Risk 15.401

Example:

Consider a 4-year T-note with face value $100 and 7% coupon, selling at
$103.50, yielding 6%.
For T-notes, coupons are paid semi-annually. Using 6-month intervals,
the coupon rate is 3.5% and the yield is 3%.

© 2007–2008 by Andrew W. Lo Slide 37

Lectures 4–6: Fixed-Income Securities
 Measures of Interest-Rate Risk 15.401

Example (cont):
Duration (in 1/2 year units) is

Modified duration (volatility) is

Price risk at y=0.03 is

Note: If the yield moves up by 0.1%,

the bond price decreases by 0.6860%

© 2007–2008 by Andrew W. Lo Slide 38

Lectures 4–6: Fixed-Income Securities
 Measures of Interest-Rate Risk 15.401

Macaulay Duration
Duration decreases with coupon rate
Duration decreases with YTM
Duration usually increases with maturity
– For bonds selling at par or at a premium, duration always increases
with maturity
– For deep discount bonds, duration can decrease with maturity
– Empirically, duration usually increases with maturity

© 2007–2008 by Andrew W. Lo Slide 39

Lectures 4–6: Fixed-Income Securities
 Measures of Interest-Rate Risk 15.401

Macaulay Duration
For intra-year coupons and annual yield
T
X
Annual Dm = k · k /q
k=1
y
Annual Dm = Annual Dm/(1 + )
q
Convexity
Sensitivity of duration to yield changes

2P T
X
1 Ck
= k · (k + 1) ·
y2 (1 + y)2 k=1 (1 + y)k
1 2P
= Vm
P y2

© 2007–2008 by Andrew W. Lo Slide 40

Lectures 4–6: Fixed-Income Securities
 Measures of Interest-Rate Risk 15.401

Relation between duration and convexity:

P 2P (y 0 y)2
P (y 0) P (y) + (y) · (y 0 y) + (y) ·
y y2 2
· ¸
1
= P (y) · 1 Dm(y 0 y) + Vm(y 0 y)2
2

Second-order approximation to bond-price function

Portfolio versions:
X
P = Pj
j
1 P X Pj
Dm(P ) = Dm,j
P y j P
1 2P X Pj
Vm(P ) = Vm,j
P y2 j P

© 2007–2008 by Andrew W. Lo Slide 41

Lectures 4–6: Fixed-Income Securities
 Measures of Interest-Rate Risk 15.401

© 2007–2008 by Andrew W. Lo Slide 42

Lectures 4–6: Fixed-Income Securities
 Measures of Interest-Rate Risk 15.401

8
X
1 kCk
Dm = = 3.509846
1 + 0.06
2 k=1 2P (1 + 0.06 )k
2
X8
1 k(k + 1)Ck
Vm = = 14.805972
(1 + 0.06 ) 2
2 ³ k=1 4P (1 + 0.06 )k
2
P (y 0) P (0.06) 1 3.509846(y 0 0.06) +
!
(y 0 0.06) 2
14.805972
2

P (0.08) P (0.06)(1 0.0701969 + 0.0029611)

93.276427

P (0.08) = 93.267255

© 2007–2008 by Andrew W. Lo Slide 43

Lectures 4–6: Fixed-Income Securities
 Corporate Bonds and Default Risk 15.401

Non-Government Bonds Carry Default Risk

A default is when a debt issuer fails to make a promised payment
(interest or principal)
Credit ratings by rating agencies (e.g., Moody's and S&P) provide
indications of the likelihood of default by each issuer.
Credit Risk Moody's S&P Fitch

Investment Grade
Highest Quality Aaa AAA AAA
High Quality (Very Strong) Aa AA AA
Upper Medium Grade (Strong) A A A
Medium Grade Baa BBB BBB

Not Investment Grade

Somewhat Speculative Ba BB BB
Speculative B B B
Highly Speculative Caa CCC CCC
Most Speculative Ca CC CC
Imminent Default C C C
Default C D D

© 2007–2008 by Andrew W. Lo Slide 44

Lectures 4–6: Fixed-Income Securities
 Corporate Bonds and Default Risk 15.401

Moody’s Baa 10-Year Treasury Yield

Source: Fung and Hsieh (2007)

© 2007–2008 by Andrew W. Lo Slide 45
Lectures 4–6: Fixed-Income Securities
 Corporate Bonds and Default Risk 15.401

What’s In The Premium?

Expected default loss, tax premium, systematic risk premium (Elton, et
al 2001)
– 17.8% contribution from default on 10-year A-rated industrials
Default, recovery, tax, jumps, liquidity, and market factors (Delianedis
and Geske, 2001)
– 5-22% contribution from default
Credit risk, illiquidity, call and conversion features, asymmetric tax
treatments of corporates and Treasuries (Huang and Huang 2002)
– 20-30% contribution from credit risk
Liquidity premium, carrying costs, taxes, or simply pricing errors
(Saunders and Allen 2002)

© 2007–2008 by Andrew W. Lo Slide 46

Lectures 4–6: Fixed-Income Securities
 Corporate Bonds and Default Risk 15.401

Decomposition of Corporate Bond Yields

Promised YTM is the yield if default does not occur
Expected YTM is the probability-weighted average of all possible
yields
Default premium is the difference between promised yield and
expected yield
Risk premium (of a bond) is the difference between the expected
yield on a risky bond and the yield on a risk-free bond of similar
maturity and coupon rate

Example: Suppose all bonds have par value $1,000 and

10-year Treasury STRIPS is selling at $463.19, yielding 8%
10-year zero issued by XYZ Inc. is selling at $321.97
Expected payoff from XYZ's 10-year zero is $762.22

© 2007–2008 by Andrew W. Lo Slide 47

Lectures 4–6: Fixed-Income Securities
 Corporate Bonds and Default Risk 15.401

For the 10-year zero issued by XYZ:

© 2007–2008 by Andrew W. Lo Slide 48

Lectures 4–6: Fixed-Income Securities
 Corporate Bonds and Default Risk 15.401

Decomposition of Corporate Bond Yields

© 2007–2008 by Andrew W. Lo Slide 49

Lectures 4–6: Fixed-Income Securities
 The Sub-Prime Crisis 15.401

Why Securitize Loans?

Repack risks to yield more homogeneity within categories
More efficient allocation of risk
Creates more risk-bearing capacity
Provides greater transparency
Supports economic growth
Benefits of sub-prime market

But Successful Securitization Requires:

Diversification
Accurate risk measurement
“Normal” market conditions
Reasonably sophisticated investors

© 2007–2008 by Andrew W. Lo Slide 50

Lectures 4–6: Fixed-Income Securities
 The Sub-Prime Crisis 15.401

“Confessions of a Risk Manager” in The Economist, August 7, 2008:

Like most banks we owned a portfolio of different tranches of

collateralised-debt obligations (CDOs), which are packages of
asset-backed securities. Our business and risk strategy was to buy
pools of assets, mainly bonds; warehouse them on our own
balance-sheet and structure them into CDOs; and finally distribute
them to end investors. We were most eager to sell the non-
investment-grade tranches, and our risk approvals were
conditional on reducing these to zero. We would allow positions
of the top-rated AAA and super-senior (even better than AAA)
tranches to be held on our own balance-sheet as the default risk
was deemed to be well protected by all the lower tranches, which
would have to absorb any prior losses.
© The Economist. All rights reserved. This content is excluded from our Creative Commons license.
For more information, see http://ocw.mit.edu/fairuse .

© 2007–2008 by Andrew W. Lo Slide 51

Lectures 4–6: Fixed-Income Securities
 The Sub-Prime Crisis 15.401

“Confessions of a Risk Manager” in The Economist, August 7, 2008:

In May 2005 we held AAA tranches, expecting them to rise in
value, and sold non-investment-grade tranches, expecting them to
go down. From a risk-management point of view, this was perfect:
have a long position in the low-risk asset, and a short one in the
higher-risk one. But the reverse happened of what we had
expected: AAA tranches went down in price and non-
investment-grade tranches went up, resulting in losses as we
marked the positions to market.
This was entirely counter-intuitive. Explanations of why this had
happened were confusing and focused on complicated cross-
correlations between tranches. In essence it turned out that there
had been a short squeeze in non-investment-grade tranches,
driving their prices up, and a general selling of all more senior
structured tranches, even the very best AAA ones.
© The Economist. All rights reserved. This content is excluded from our Creative Commons license.
For more information, see http://ocw.mit.edu/fairuse .

© 2007–2008 by Andrew W. Lo Slide 52

Lectures 4–6: Fixed-Income Securities
 An Illustrative Example 15.401

Consider Simple Securitization Example:

Two identical one-period loans, face value $1,000
Loans are risky; they can default with prob. 10%
Consider packing them into a portfolio
Issue two new claims on this portfolio, S and J
Let S have different (higher) priority than J
What are the properties of S and J?
What have we accomplished with this “innovation”?
Let’s Look At The Numbers!

© 2007–2008 by Andrew W. Lo Slide 53

Lectures 4–6: Fixed-Income Securities
 An Illustrative Example 15.401

90%
$1,000 Price = 90% × $1,000 + 10% × $0
I.O.U. = $900

10% $0 (Default)

90%
$1,000 Price = 90% × $1,000 + 10% × $0
I.O.U. = $900

10% $0 (Default)

© 2007–2008 by Andrew W. Lo Slide 54

Lectures 4–6: Fixed-Income Securities
 An Illustrative Example 15.401

Assuming
$1,000 Independent Defaults
I.O.U. Portfolio
Value Prob.

$2,000 81%
Portfolio
$1,000 18%

$0 1%
$1,000
I.O.U.

© 2007–2008 by Andrew W. Lo Slide 55

Lectures 4–6: Fixed-Income Securities
 An Illustrative Example 15.401

$1,000 $1,000
I.O.U. C.D.O.

Senior Tranche
Portfolio

$1,000 $1,000
I.O.U. C.D.O.

Junior Tranche

© 2007–2008 by Andrew W. Lo Slide 56

Lectures 4–6: Fixed-Income Securities
 An Illustrative Example 15.401

Assuming Independent Defaults

$1,000 Portfolio Senior Junior

Value Prob.
C.D.O. Tranche Tranche
$2,000 81% $1,000 $1,000
Senior Tranche $1,000 18% $1,000 $0

$0 1% $0 $0

$1,000 Bad State

C.D.O. For Senior Bad State
Tranche (1%) For Junior
Tranche (19%)
Junior Tranche

© 2007–2008 by Andrew W. Lo Slide 57

Lectures 4–6: Fixed-Income Securities
 An Illustrative Example 15.401

“Similar” to Non-Investment Grade

Junior
Tranche?

“Similar” to
Senior
Tranche?

Source: Moody’s

© 2007–2008 by Andrew W. Lo Slide 58

Lectures 4–6: Fixed-Income Securities
 An Illustrative Example 15.401

Assuming Independent Defaults

$1,000 Portfolio Senior Junior

Value Prob.
C.D.O. Tranche Tranche
$2,000 81% $1,000 $1,000
Senior Tranche $1,000 18% $1,000 $0

$0 1% $0 $0

$1,000 Price for Senior Tranche = 99% × $1,000 + 1% × $0

C.D.O. = $990
Price for Junior Tranche = 81% × $1,000 + 19% × $0
= $810
Junior Tranche

© 2007–2008 by Andrew W. Lo Slide 59

Lectures 4–6: Fixed-Income Securities
 An Illustrative Example 15.401

Assuming Independent Defaults

$1,000 Portfolio Senior Junior

Value Prob.
C.D.O. Tranche Tranche
$2,000 81% $1,000 $1,000
Senior Tranche $1,000 18% $1,000 $0

$0 1% $0 $0

$1,000
C.D.O. But What If Defaults Become Highly Correlated?

Junior Tranche

© 2007–2008 by Andrew W. Lo Slide 60

Lectures 4–6: Fixed-Income Securities
 An Illustrative Example 15.401

Assuming Perfectly Correlated Defaults

$1,000 Portfolio Senior Junior

Value Prob.
C.D.O. Tranche Tranche
$2,000 90% $1,000 $1,000
Senior Tranche $0 10% $0 $0

Bad State
For Senior
$1,000 Tranche (10%) Bad State
C.D.O. For Junior
Tranche (10%)

Junior Tranche

© 2007–2008 by Andrew W. Lo Slide 61

Lectures 4–6: Fixed-Income Securities
 An Illustrative Example 15.401

Assuming Perfectly Correlated Defaults

$1,000 Portfolio Senior Junior

Value Prob.
C.D.O. Tranche Tranche
$2,000 90% $1,000 $1,000
Senior Tranche $0 10% $0 $0

Price for Senior Tranche = 90% × $1,000 + 10% × $0

$1,000 = $900 (was $990)
C.D.O. Price for Junior Tranche = 90% × $1,000 + 10% × $0
= $900 (was $810)

Junior Tranche

© 2007–2008 by Andrew W. Lo Slide 62

Lectures 4–6: Fixed-Income Securities
 Implications 15.401

To This Basic Story, Add:

Very low default rates (new securities)
Very low correlation of defaults (initially)
Aaa for senior tranche (almost riskless)
Demand for senior tranche (pension funds)
Demand for junior tranche (hedge funds) $1,000
Fees for origination, rating, leverage, etc. C.D.O.
Insurance (monoline, CDS, etc.)
Equity bear market, FANNIE, FREDDIE

Then, National Real-Estate Market Declines

Default correlation rises
Senior tranche declines
Junior tranche increases
Ratings decline
Unwind Losses Unwind …

© 2007–2008 by Andrew W. Lo Slide 63

Lectures 4–6: Fixed-Income Securities
 Key Points 15.401

Valuation of riskless pure discount bonds using NPV tools

Coupon bonds can be priced from discount bonds via arbitrage
Current bond prices contain information about future interest rates
Spot rates, forward rates, yield-to-maturity, yield curve
Interest-rate risk can be measured by duration and convexity
Corporate bonds contain other sources of risk

© 2007–2008 by Andrew W. Lo Slide 64

Lectures 4–6: Fixed-Income Securities
 Additional References 15.401

Brennan, M. and E. Schwartz, 1977, “Savings Bonds, Retractable Bonds and Callable Bonds”,
5, 67–88.
Brown, S. and P. Dybvig, 1986, “The Empirical Implications of the Cox, Ingersoll, Ross Theory of the Term Structure of
Interest Rates”, 41,617–632.
Campbell, J., 1986, “A Defense for the Traditional Hypotheses about the Term Structure of Interest Rates”,
36, 769–800.
Cox, J., Ingersoll, J. and S. Ross, 1981, “A Re-examination of Traditional Hypotheses About the Term Structure of
Interest Rates”, 36, 769–799.
Cox, J., Ingersoll, J. and S. Ross, 1985, “A Theory of the Term Structure of Interest Rates”, 53, 385-–407.
Heath, D., Jarrow, R., and A. Morton, 1992, “Bond Pricing and the Term Structure of Interest Rates: A New Methodology
for Contingent Claims Valuation”, 60, 77-–105.
Ho, T. and S. Lee, 1986, “Term Structure Movements and Pricing Interest Rate Contingent Claims'',
41, 1011–1029.
Jegadeesh, N. and B. Tuckman, eds., 2000, . New York: John Wiley & Sons.
McCulloch, H., 1990, “U.S. Government Term Structure Data”, Appendix to R. Shiller, “The Term Structure of Interest
Rates”, in Benjamin M. Friedman and Frank H. Hahn eds. Handbook of Monetary Economics. Amsterdam: North-
Holland.
Sundaresan, S., 1997, Fixed Income Markets and Their Derivatives. Cincinnati, OH: South-Western College Publishing.
Tuckman, B., 1995, Fixed Income Securities: Tools for Today's Markets. New York: John Wiley & Sons.
Vasicek, O., 1977, “An Equilibrium Characterization of the Term Structure”, Journal of Financial Economics 5, 177–188.

© 2007–2008 by Andrew W. Lo Slide 65

Lectures 4–6: Fixed-Income Securities
MIT OpenCourseWare
http://ocw.mit.edu

15.401 Finance Theory I

Fall 2008

For information about citing these materials or our Terms of Use, visit: http://ocw.mit.edu/terms.
 15.401

15.401 Finance Theory

MIT Sloan MBA Program

Andrew W. Lo
Harris & Harris Group Professor, MIT Sloan School

Lectures 2–3: Present Value Relations

© 2007–2008 by Andrew W. Lo
 Critical Concepts 15.401

Cashflows and Assets

The Present Value Operator
The Time Value of Money
Special Cashflows: The Perpetuity
Special Cashflows: The Annuity
Compounding
Inflation
Extensions and Qualifications

Readings:
Brealey, Myers, and Allen Chapters 2–3

© 2007–2008 by Andrew W. Lo Slide 2

Lecture 2-3: Present Value Relations
 Cashflows and Assets 15.401

Key Question: What Is An “Asset”?

Business entity
Property, plant, and equipment
Patents, R&D
Stocks, bonds, options, …
Knowledge, reputation, opportunities, etc.

From A Business Perspective, An Asset Is A Sequence of Cashflows

© 2007–2008 by Andrew W. Lo Slide 3

Lecture 2-3: Present Value Relations
 Cashflows and Assets 15.401

Examples of Assets as Cashflows

Boeing is evaluating whether to proceed with development of a new
regional jet. You expect development to take 3 years, cost roughly
$850 million, and you hope to get unit costs down to $33 million. You
forecast that Boeing can sell 30 planes every year at an average price
of $41 million.
Firms in the S&P 500 are expected to earn, collectively, $66 this year
and to pay dividends of $24 per share, adjusted to index. Dividends
and earnings have grown 6.6% annually (or about 3.2% in real terms)
since 1926.
You were just hired by HP. Your initial pay package includes a grant
of 50,000 stock options with a strike price of $24.92 and an expiration
date of 10 years. HP’s stock price has varied between $16.08 and
$26.03 during the past two years.

© 2007–2008 by Andrew W. Lo Slide 4

Lecture 2-3: Present Value Relations
 Cashflows and Assets 15.401

Valuing An Asset Requires Valuing A Sequence of Cashflows

Sequences of cashflows are the “basic building blocks” of finance

Always Draw A Timeline To Visualize The Timing of Cashflows

© 2007–2008 by Andrew W. Lo Slide 5

Lecture 2-3: Present Value Relations
 The Present Value Operator 15.401

What is Vt?
What factors are involved in determining the value of any object?
– Subjective?
– Objective?
How is value determined?

There Are Two Distinct Cases

No Uncertainty
– We have a complete solution
Uncertainty
– We have a partial solution (approximation)
– The reason: synergies and other interaction effects
Value is determined the same way, but we want to understand how

© 2007–2008 by Andrew W. Lo Slide 6

Lecture 2-3: Present Value Relations
 The Present Value Operator 15.401

Key Insight: Cashflows At Different Dates Are Different “Currencies”

Consider manipulating foreign currencies

?
¥150 + £300 = ??

© 2007–2008 by Andrew W. Lo Slide 7

Lecture 2-3: Present Value Relations
 The Present Value Operator 15.401

Key Insight: Cashflows At Different Dates Are Different “Currencies”

Consider manipulating foreign currencies

?
¥150 + £300 = ??450

Cannot add currencies without first converting into common currency

¥150 + (£300) × (153 ¥ / £) = ¥46,050.00

( ¥150) × (0.0065 £ / ¥ ) + £300 = £ 300.98

Given exchange rates, either currency can be used as “numeraire”

Same idea for cashflows of different dates

© 2007–2008 by Andrew W. Lo Slide 8

Lecture 2-3: Present Value Relations
 The Present Value Operator 15.401

Key Insight: Cashflows At Different Dates Are Different “Currencies”

Past and future cannot be combined without first converting them
Once “exchange rates” are given, combining cashflows is trivial

A numeraire date should be picked, typically t=0 or “today”

Cashflows can then be converted to present value

© 2007–2008 by Andrew W. Lo Slide 9

Lecture 2-3: Present Value Relations
 The Present Value Operator 15.401

Net Present Value: “Net” of Initial Cost or Investment

Can be captured by date-0 cashflow CF0

If there is an initial investment, then CF0 < 0

Note that any CFt can be negative (future costs)
V0 is a completely general expression for net present value

How Can We Decompose V0 Into Present Value of Revenues and Costs?

© 2007–2008 by Andrew W. Lo Slide 10

Lecture 2-3: Present Value Relations
 The Present Value Operator 15.401

Example:
Suppose we have the following “exchange rates”:

What is the net present value of a project requiring a current

investment of $10MM with cashflows of $5MM in Year 1 and $7MM in
Year 2?

Suppose a buyer wishes to purchase this project but pay for it two
years from now. How much should you ask for?

© 2007–2008 by Andrew W. Lo Slide 11

Lecture 2-3: Present Value Relations
 The Present Value Operator 15.401

Example:
Suppose we have the following “exchange rates”:

What is the net present value of a project requiring an investment of

$8MM in Year 2, with a cashflow of $2MM immediately and a cashflow
of $5 in Year 1?

Suppose a buyer wishes to purchase this project but pay for it two
years from now. How much should you ask for?

© 2007–2008 by Andrew W. Lo Slide 12

Lecture 2-3: Present Value Relations
 The Time Value of Money 15.401

Implicit Assumptions/Requirements For NPV Calculations

Cashflows are known (magnitudes, signs, timing)
Exchange rates are known
No frictions in currency conversions

Do These Assumptions Hold in Practice?

Which assumptions are most often violated?
Which assumptions are most plausible?

Until Lecture 12, We Will Take These Assumptions As Truth

Focus now on exchange rates
Where do they come from, how are they determined?

© 2007–2008 by Andrew W. Lo Slide 13

Lecture 2-3: Present Value Relations
 The Time Value of Money 15.401

What Determines The Growth of $1 Over T Years?

$1 today should be worth more than $1 in the future (why?)
Supply and demand
Opportunity cost of capital r

$1 in Year 0 = $1 × (1 + r) in Year 1
$1 in Year 0 = $1 × (1 + r)2 in Year 2
..
$1 in Year 0 = $1 × (1 + r)T in Year T

Equivalence of $1 today and any other single choice above

Other choices are future values of $1 today

© 2007–2008 by Andrew W. Lo Slide 14

Lecture 2-3: Present Value Relations
 The Time Value of Money 15.401

What Determines The Value Today of $1 In Year-T?

$1 in Year-T should be worth less than $1 today (why?)
Supply and demand
Opportunity cost of capital r

$1/(1 + r) in Year 0 = $1 in Year 1

$1/(1 + r)2 in Year 0 = $1 in Year 2
..
$1/(1 + r)T in Year 0 = $1 in Year T

These are our “exchange rates” ($t/$0) or discount factors

© 2007–2008 by Andrew W. Lo Slide 15

Lecture 2-3: Present Value Relations
 The Time Value of Money 15.401

We Now Have An Explicit Expression for V0:

1 1
V0 = CF0 + × CF1 + 2
× CF2 + · · ·
(1 + r) (1 + r)

CF1 CF2
V0 = CF0 + + 2
+ ···
(1 + r) (1 + r)

Using this expression, any cashflow can be valued!

Take positive-NPV projects, reject negative NPV-projects
Projects ranked by magnitudes of NPV
All capital budgeting and corporate finance reduces to this expression
However, we still require many assumptions (perfect markets)

© 2007–2008 by Andrew W. Lo Slide 16

Lecture 2-3: Present Value Relations
 The Time Value of Money 15.401

Example:
Suppose you have $1 today and the interest rate is 5%. How much
will you have in …

1 year … $1 × 1.05 = $1.05

2 years … $1 × 1.05 × 1.05 = $1.103
3 years … $1 × 1.05 × 1.05 × 1.05 = $1.158

$1 today is equivalent to $ in t years

$1 in t years is equivalent to $ today

© 2007–2008 by Andrew W. Lo Slide 17

Lecture 2-3: Present Value Relations
 The Time Value of Money 15.401

PV of $1 Received In Year t
$1.0
r = 0.04 r = 0.08 r = 0.12
$0.8

$0.6

$0.4

$0.2

$0.0
0 2 4 6 8 10 12 14 16 18 20 22 24 26 28 30
Year when $1 is received

© 2007–2008 by Andrew W. Lo Slide 18

Lecture 2-3: Present Value Relations
 The Time Value of Money 15.401

Example:
Your firm spends $800,000 annually for electricity at its Boston
headquarters. Johnson Controls offers to install a new computer-
controlled lighting system that will reduce electric bills by $90,000 in
each of the next three years. If the system costs $230,000 fully
installed, is this a good investment?

Lighting System*

Year 0 1 2 3
Cashflow -230,000 90,000 90,000 90,000

* Assume the cost savings are known with certainty and the interest rate
is 4%

© 2007–2008 by Andrew W. Lo Slide 19

Lecture 2-3: Present Value Relations
 The Time Value of Money 15.401

Example:

Lighting System

Year 0 1 2 3
Cashflow -230,000 90,000 90,000 90,000
÷ 1.04 (1.04)2 (1.04)3
PV -230,000 86,538 83,210 80,010

NPV = -230,000 + 86,538 + 83,210 + 80,010 = $19,758

Go ahead – project looks good!

© 2007–2008 by Andrew W. Lo Slide 20

Lecture 2-3: Present Value Relations
 The Time Value of Money 15.401

Example:
CNOOC recently made an offer of $67 per share for Unocal. As part of
the takeover, CNOOC will receive $7 billion in ‘cheap’ loans from its
parent company: a zero-interest, 2-year loan of $2.5 billion and a
3.5%, 30-year loan of $4.5 billion. If CNOOC normal borrowing rate is
8%, how much is the interest subsidy worth?

Interest Savings, Loan 1: 2.5 × (0.08 – 0.000) = $0.2 billion

Interest Savings, Loan 2: 4.5 × (0.08 – 0.035) = $0.2 billion

© 2007–2008 by Andrew W. Lo Slide 21

Lecture 2-3: Present Value Relations
 Special Cashflows: The Perpetuity 15.401

Perpetuity Pays Constant Cashflow C Forever

How much is an infinite cashflow of C each year worth?
How can we value it?

© 2007–2008 by Andrew W. Lo Slide 22

Lecture 2-3: Present Value Relations
 Special Cashflows: The Perpetuity 15.401

Growing Perpetuity Pays Growing Cashflow C(1+g)t Forever

How much is an infinite growing cashflow of C each year worth?
How can we value it?

© 2007–2008 by Andrew W. Lo Slide 23

Lecture 2-3: Present Value Relations
 Special Cashflows: The Annuity 15.401

Annuity Pays Constant Cashflow C For T Periods

Simple application of V0

© 2007–2008 by Andrew W. Lo Slide 24

Lecture 2-3: Present Value Relations
 Special Cashflows: The Annuity 15.401

Annuity Pays Constant Cashflow C For T Periods

Sometimes written as a product:

© 2007–2008 by Andrew W. Lo Slide 25

Lecture 2-3: Present Value Relations
 Special Cashflows: The Annuity 15.401

Annuity Pays Constant Cashflow C For T Periods

Related to perpetuity formula

Perpetuity

Minus

Date-T Perpetuity

Equals

T-Period Annuity

© 2007–2008 by Andrew W. Lo Slide 26

Lecture 2-3: Present Value Relations
 Special Cashflows: The Annuity 15.401

Example:

You just won the lottery and it pays $100,000 a year for 20 years. Are you
a millionaire? Suppose that r = 10%.

What if the payments last for 50 years?

How about forever (a perpetuity)?

© 2007–2008 by Andrew W. Lo Slide 27

Lecture 2-3: Present Value Relations
 Compounding 15.401

Interest May Be Credited/Charged More Often Than Annually

Bank accounts: daily
Mortgages and leases: monthly
Bonds: semiannually
Effective annual rate may differ from annual percentage rate
Why?
10% Compounded Annually, Semi-
Annually, Quarterly, and Monthly

Typical Compounding Conventions:

Let r denote APR, n periods of compounding
r/n is per-period rate for each period
Effective annual rate (EAR) is
rEAR (1 + r/n)n 1

© 2007–2008 by Andrew W. Lo Slide 28

Lecture 2-3: Present Value Relations
 Compounding 15.401

Example:
Car loan—‘Finance charge on the unpaid balance, computed daily, at the
rate of 6.75% per year.’
If you borrow $10,000, how much would you owe in a year?

Daily interest rate = 6.75 / 365 = 0.0185%

Day 1: Balance = 10,000.00 × 1.000185 = 10,001.85
Day 2: Balance = 10,001.85 × 1.000185 = 10,003.70
… …
Day 365: Balance = 10,696.26 × 1.000185 = 10,698.24

EAR = 6.982% > 6.750%

© 2007–2008 by Andrew W. Lo Slide 29

Lecture 2-3: Present Value Relations
 Inflation 15.401

What Is Inflation?
Change in real purchasing power of $1 over time
Different from time-value of money (how?)
For some countries, inflation is extremely problematic
How to quantify its effects?

Wealth Wt Price Index It

Wealth Wt+k Price Index It+k
Increase in Cost of Living It+k /It = (1 + )k

f
“Real Wealth” Wt+k Wt+k /(1 + )k

© 2007–2008 by Andrew W. Lo Slide 30

Lecture 2-3: Present Value Relations
 Inflation 15.401

© 2007–2008 by Andrew W. Lo Slide 31

Lecture 2-3: Present Value Relations
 Inflation 15.401

For NPV Calculations, Treat Inflation Consistently

Discount real cashflows using real interest rates
Discount nominal cashflows using nominal interest rates
– Nominal cashflows expressed in actual-dollar cashflows
– Real cashflows expressed in constant purchasing power
– Nominal rate actual prevailing interest rate
– Real rate interest rate adjusted for inflation

© 2007–2008 by Andrew W. Lo Slide 32

Lecture 2-3: Present Value Relations
 Inflation 15.401

Example:
This year you earned $100,000. You expect your earnings to grow 2%
annually, in real terms, for the remaining 20 years of your career.
Interest rates are currently 5% and inflation is 2%. What is the present
value of your income?

Real Interest Rate = 1.05 / 1.02 – 1 = 2.94%

Real Cashflows
Year 1 2 … 20
Cashflow 102,000 104,040 … 148,595
÷ 1.0294 1.029422 … 1.0294220
PV 99,086 98,180 … 83,219

Present Value = $1,818,674

© 2007–2008 by Andrew W. Lo Slide 33

Lecture 2-3: Present Value Relations
 Extensions and Qualifications 15.401

Taxes
Currencies
Term structure of interest rates
Forecasting cashflows
Choosing the right discount rate (risk adjustments)

© 2007–2008 by Andrew W. Lo Slide 34

Lecture 2-3: Present Value Relations
 Key Points 15.401

Assets are sequences of cashflows

Date-t cashflows are different from date-(t+k) cashflows
Use “exchange rates” to convert one type of cashflow into another
PV and FV related by “exchange rates”
Exchange rates are determined by supply/demand
Opportunity cost of capital: expected return on equivalent investments
in financial markets
For NPV calculations, visualize cashflows first
Decision rule: accept positive NPV projects, reject negative ones
Special cashflows: perpetuities and annuities
Compounding
Inflation
Extensions and Qualifications

© 2007–2008 by Andrew W. Lo Slide 35

Lecture 2-3: Present Value Relations
 Additional References 15.401

Bodie, Z. and R. Merton, 2000, Finance. New Jersey: Prentice Hall.

Brealey, R., Myers, S., and F. Allen, 2006, Principles of Corporate Finance. New York: McGraw-Hill
Irwin.
Copeland, T., Weston, F. and K. Shastri, 2003, Financial Theory and Corporate Policy, (4th Edition).
Reading, MA: Addison-Wesley.

© 2007–2008 by Andrew W. Lo Slide 36

Lecture 2-3: Present Value Relations
MIT OpenCourseWare
http://ocw.mit.edu

15.401 Finance Theory I

Fall 2008

For information about citing these materials or our Terms of Use, visit: http://ocw.mit.edu/terms.
 15.401

15.401 Finance Theory

MIT Sloan MBA Program

Andrew W. Lo
Harris & Harris Group Professor, MIT Sloan School

Lecture 1: Introduction and Course Overview

© 2007–2008 by Andrew W. Lo
 Critical Concepts 15.401

Motivation
Dramatis Personae
Fundamental Challenges of Finance
Framework for Financial Analysis
Importance of Time and Risk
Six Principles of Finance
Course Overview
How to Get the Most Out of This Course

Readings:
Brealey, Myers, and Allen Chapters 1–2

© 2007–2008 by Andrew W. Lo Slide 2

Lecture 1: Intro and Overview
 Motivation 15.401

Mathematics + $$$ = Finance

Photographs removed due to copyright restrictions.

James Simons Jack Welch Warren Buffett

Renaissance Technologies General Electric Berkshire Hathaway

© 2007–2008 by Andrew W. Lo Slide 3

Lecture 1: Intro and Overview
 Dramatis Personae 15.401

A Flow Model of the Economy

Households

Labor Product Financial

Capital Markets
Markets Markets Intermediaries

Nonfinancial
Corporations

The Financial System

© 2007–2008 by Andrew W. Lo Slide 4

Lecture 1: Intro and Overview
 Fundamental Challenges of Finance 15.401

All Business Activities Reduce To Two Functions:

Valuation of assets (real/financial, tangible/intangible)
Management of assets (acquiring/selling)

Business Decisions Involve Valuation and Management

“You cannot manage what you cannot measure”
Valuation is the starting point for management
Once value is established, management is easier

Objectives + Valuations Decisions

Valuation is generally independent of objectives (why?)

Role of financial markets and the “price discovery” process

© 2007–2008 by Andrew W. Lo Slide 5

Lecture 1: Intro and Overview
 Fundamental Challenges of Finance 15.401

Valuation
How are financial assets valued?
How should financial assets be valued?
How do financial markets determine asset values?
How well do financial markets work?

Management
How much should I save/spend?
What should I buy/sell?
When should I buy/sell?
How should I finance the transaction?

Applies To Both Personal and Corporate Financial Decisions (How?)

© 2007–2008 by Andrew W. Lo Slide 6

Lecture 1: Intro and Overview
 The Framework of Financial Analysis 15.401

Accounting
The language of finance
Vocabulary, syntax, grammar, prose, and poetry!
Language frames and circumscribes the analysis
Basic concepts should be familiar to you by now
“Stock” (not equities) vs. “flow” variables

Balance Sheet and Income Statement Perspectives

Balance sheet: snapshot of financial status quo (stock)
Income statement: rate of change of the status quo (flow)
Financial status ⇔ balance sheet
Financial decisions ⇔ income statement
What about the “rate of change of the rate of change”?

© 2007–2008 by Andrew W. Lo Slide 7

Lecture 1: Intro and Overview
 The Framework of Financial Analysis 15.401

Balance Sheet

Assets Liabilities

Cash
Equity
Capital
Debt
Intangibles

Value Value

Income Statement

© 2007–2008 by Andrew W. Lo Slide 8

Lecture 1: Intro and Overview
 The Framework of Financial Analysis 15.401

Corporate Financial Decisions

1. Cash raised from investors (selling financial assets)
2. Cash invested in real assets (tangible and intangible)
3. Cash generated by operations
4. Cash reinvested
5. Cash returned to investors (debt payments, dividends, etc.)

2 1
Individual
Corporate Financial 4 and
Operations Manager Institutional
Investors
3 5

© 2007–2008 by Andrew W. Lo Slide 9

Lecture 1: Intro and Overview
 The Framework of Financial Analysis 15.401

Corporate Financial Decisions

1. Cash raised from investors (selling financial assets)
2. Cash invested in real assets (tangible and intangible)
3. Cash generated by operations
4. Cash reinvested
5. Cash returned to investors (debt payments, dividends, etc.)

Management
Real Investment: 2, 3
Financing: 1, 4
Payout: 5
Risk management: 1, 5
Objective: create and maximize shareholder value

© 2007–2008 by Andrew W. Lo Slide 10

Lecture 1: Intro and Overview
 The Framework of Financial Analysis 15.401

Personal Financial Decisions

1. Cash raised from financial institutions (selling financial assets)
2. Cash invested in real assets (tangible and intangible)
3. Cash generated by labor supply
4. Cash consumed and reinvested in real assets
5. Cash invested in financial assets

2 1 Financial
Assets and
Real Liabilities
Household 4
Economic (stocks,
Activities bonds,
3 5
mortgage,
etc.)

© 2007–2008 by Andrew W. Lo Slide 11

Lecture 1: Intro and Overview
 The Framework of Financial Analysis 15.401

Personal Financial Decisions

1. Cash raised from financial institutions (selling financial assets)
2. Cash invested in real assets (tangible and intangible)
3. Cash generated by labor supply
4. Cash consumed and reinvested in real assets
5. Cash invested in financial assets

Management
Real investment: 2, 3
Consumption/financing: 1, 4
Saving/investment: 5
Risk management: 1, 5
Objective: maximize lifetime “happiness” or expected utility

© 2007–2008 by Andrew W. Lo Slide 12

Lecture 1: Intro and Overview
 Time and Risk 15.401

Two Other Factors That Make Finance Challenging

1. Time
Cashflows now are different from cashflows later
Time flows in only one direction (as far as we know)
How should we model temporal differences?
2. Risk
Under perfect certainty, finance theory is complete
Risk creates significant challenges
How should we model the unknown?

To Address These Two Issues:

Use historical data
Use mathematics (probability and statistics)
Challenges can easily overwhelm current mathematical abilities

© 2007–2008 by Andrew W. Lo Slide 13

Lecture 1: Intro and Overview
 Six Fundamental Principles of Finance 15.401

P1: There Is No Such Thing As A Free Lunch

P2: Other Things Equal, Individuals :

Prefer more money to less (non-satiation)
Prefer money now to later (impatience)
Prefer to avoid risk (risk aversion)

P3: All Agents Act To Further Their Own Self-Interest

P4: Financial Market Prices Shift to Equalize Supply and Demand

P5: Financial Markets Are Highly Adaptive and Competitive

P6: Risk-Sharing and Frictions Are Central to Financial Innovation

© 2007–2008 by Andrew W. Lo Slide 14

Lecture 1: Intro and Overview
 Course Overview 15.401

Four Sections
A. Introduction
Fundamental challenges of finance
A framework for financial analysis
Six principles of finance
Cashflows and the time-value of money
B. Valuation
Discounting and the mathematics of net present value
Pricing stocks, bonds, futures, forwards, and options
C. Risk
Measuring risk
Managing risk (portfolio theory)
Incorporating risk into valuation methods

© 2007–2008 by Andrew W. Lo Slide 15

Lecture 1: Intro and Overview
 Course Overview 15.401

Four Sections
D. Corporate Finance
Capital budgeting and project finance

Final Lecture: Market Efficiency (putting it all together)

Do financial markets always work well in discovering prices?
What about behavioral biases and human psychology?
How should finance theory be used in practice?

© 2007–2008 by Andrew W. Lo Slide 16

Lecture 1: Intro and Overview
 Course Overview 15.401

Course Requirements
Lectures and Readings (attendance and participation, 10%)
Acid Rain Case Study (10%)
Mid-Term (25%) and Final (55%) Examinations

Implicit Contract
Faculty should
– Come to class on time and be well prepared
– Provide clear and time-appropriate exposition of material
– Manage class discussions effectively
Students should
– Come to class on time and be well prepared
– Contribute to class discussions
– Refrain from non-class activities (email, newspapers, etc.)

© 2007–2008 by Andrew W. Lo Slide 17

Lecture 1: Intro and Overview
 How to Get the Most Out of This Course 15.401

Theory vs. Practice

Most of this course will be devoted to theory
What about practice?
The origins of theory is common elements deduced from practice!

Some Helpful Hints

Do readings ahead of time (skim textbook chapters in advance)
Take copious notes during lectures (lecture notes are not complete)
Review the lectures afterwards with your study group
Work on assignments in groups and alone
“Finance is not a spectator sport”
Ask Ask Ask Questions!

Finance Is One of The Most Difficult Subjects You Will Ever Love!

© 2007–2008 by Andrew W. Lo Slide 18

Lecture 1: Intro and Overview
 Critical Concepts 15.401

Motivation
Dramatis Personae
Fundamental Challenges of Finance
Framework for Financial Analysis
Importance of Time and Risk
Six Principles of Finance
Course Overview
How to Get the Most Out of This Course

© 2007–2008 by Andrew W. Lo Slide 19

Lecture 1: Intro and Overview
 Additional References 15.401

Bernstein, P., 1993, Capital Ideas. New York: Free Press.

Lo, A., 1999, “The Three P’s of Total Risk Management”, Financial Analysts Journal 55, 13–26.
Malkiel, B., 1996, A Random Walk Down Wall Street. New York: W. W. Norton and Company.

© 2007–2008 by Andrew W. Lo Slide 20

Lecture 1: Intro and Overview
MIT OpenCourseWare
http://ocw.mit.edu

15.401 Finance Theory I

Fall 2008

For information about citing these materials or our Terms of Use, visit: http://ocw.mit.edu/terms.