MGMT 408: Security Markets and Investments

MBA -- Winter 2004

Professor: Pedro Santa-Clara, office C4.21, pedro.santa-clara@anderson.ucla.edu, 310-206-6077

TAs:  Alessio Saretto, alessio.saretto@anderson.ucla.edu, 310-825-8160
          Claudio Braidotti, claudio.braidotti.2004@anderson.ucla.edu

Students: MBA Section A

Contents

News and Announcements
Course Description
Schedule
Materials
Assignements and Grading
Laptops
Course Outline
Cases

Please read the first four chapters of the book ahead of the first class.

Please answer the first problem set before January 11, 2004.

I wrote a little Statistics Review that you may find helpful for the first few classes.

To help us keep things in perspective, and to remind us why we really want to learn about finance, read My First Gulfstream...;-)

This course is designed to provide you with a strong foundation for all of the fundamental concepts in investments.  Broad topics include discounting and present values, bond and stock valuation, risk and return, constructing optimal portfolios, asset pricing models, and an introduction to options and futures markets.  We will seek a balance between the theoretical paradigms, the empirical literature, and their applicability to the real world.  Emphasis will be on principles and problem solving.  Lectures and exams will concentrate on both quantitative and conceptual foundations. If you master the course material, you will be comfortable in applying all of the basic paradigms of financial theory and will be well prepared for more advanced courses on these topics.

I will assume that you are familiar with basic statistical concepts (including means, variances, covariances and linear regression), basic calculus (derivatives) and a standard spreadsheet package such as Excel.

The class meets on Mondays and Wednesdays from 3:30pm to 5:20pm in room TBA. Monday January 19 and February 16 are holidays. Since the midterm exams are held outside of class times (see below), there is no need for make-up classes.

Office hours: Tuesdays from 1:30pm to 3:00pm. When my office door is open outside of office hours, feel free to enter.  You may call me at any time during normal working hours to consult or to set up alternative appointments. I also will promptly respond to email messages.

The TAs will conduct a weekly review session in room TBA, from TBA to TBA.  You are required to email the TAs (at least 24 hours in advance) with the questions you would like to see addressed in the session.  Your attendance to these sessions is purely optional and your grade will not be affected by whether or not you attend them.

Claudio will hold office hours in room TBA, from TBA to TBA, and Alessio will hold office hours in room TBA, from TBA to TBA.

The text is: Bodie, Kane, and Marcus, Investments, Fifth Edition, 2002 (henceforth BKM).  There will not be a course reader.  All class materials will be available for download from this web page.  Check it regularly for data files, homework solutions, etc.

Students are strongly encouraged to subscribe to a periodical that carries news about global events in the financial world. The Wall Street Journal in one good possibility; more global in outlook is the Financial Times; also international, but carrying less financial news is the Economist.

You are required to read the assigned material before each lecture. Good class participation consists of asking informed questions or making informed comments, as well as answering well the questions asked in class.

There will be problem sets assigned in almost every week. These assignements will be posted online and will be available up to the respective class time. The assignments will include questions about the material covered during the previous week as well as questions related to the assigned readings for the coming week. These problem sets are to be done individually. I will trust you to work on them on your own. Any irregularity will be investigated and, if there is evidence of wrongdoing, will be referred to the administration.

The four cases may be done in groups of no more than five people -- with one report per group.  Please limit your case write-ups to three double-spaced pages, excluding supporting exhibits and figures. 

There will be two midterm exams held outside of class times. The first exam will be held on Thursday, February 5 from 6:00 to 9:00 pm. The second exam will be held on Thursday, February 26 from 6:00 to 9:00 pm in Korn Hall. The exams will cover class lectures, readings assigned in the textbook, additional readings, and materials distributed during class time. The final exam will be comprehensive.

Answers to the problem sets and to the exams will be available on this web page.

The weights determining your grade will be:

Problem sets and cases	20%
Midterm exams	40%
Final exam	40%

Students who are unable to take any one of the mid-term examinations for an approved reason will have 60% of their course grade determined by the final examination. There will be no ‘make-up’ examinations.

Grading will be done ‘on the curve’ for core courses.

Off-line use of laptops is allowed. Emailing, instant messaging, or surfing the web is not allowed during class times.

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Cases

Instructions for Case 1 - Asset Allocation

This homework will help you plan your retirement...;-)  Similar problems are frequently solved by pension plans, banks, and insurance companies.  (Actually, these institutions typically hire expensive consultants to recommend an asset allocation…)

This spreadsheet, StocksBondsCash, contains monthly returns for the stock market, the (long-term) T-bond, and the one-month T-bill from 1963 to the end of 2000.  Take the stock market and the long bond to be the only risky assets available and the T-bill to be the risk-free asset.  (In real life you would also want to consider international stock markets and alternative investments.)

Technical Note: The returns in the spreadsheet are log returns, computed as the difference between the log of the price at the end of the period (including dividends or coupon payments) and the log of the price at the beginning of the period.  Log returns are approximately the same as simple returns, only easier to annualize.  To annualize the mean, simply multiply the mean monthly return by 12.  To annualize variances, also multiply by 12.  (Which means that standard deviations are annualized by multiplying by the square-root of 12.)

 

1. Compute the annualized expected excess returns of the stock and bond indices.  Compute the annualized variances, standard deviations, covariance, and correlation of the two risky assets.  Compute annualized Sharpe ratios for each of the risky assets.
2. Compute the tangency portfolio weights on the two assets.  Compute the annualized expected excess return and standard deviation of this portfolio.  Compute the portfolio’s annualized Sharpe ratio.
3. Can you combine the tangency portfolio (that only includes risky assets) with the risk-free asset to obtain a portfolio with a standard deviation of 10% per year?  What are the portfolio weights on the three assets?  What is the expected return on the portfolio?  What happened to the Sharpe ratio of the new relative to the old portfolio?
4. Compute the expected return and variance of the new portfolio’s return 30 years from now. 
5. How would your answers change if the expected excess return on the stock market (also called the market premium) were 0.20% per month (approximately 2.5% per year)?
6. What implications does the expected return on the stock market have for the number of years you need to work and how much you need to save per year? Try to quantify your answer.  Explain the assumptions you need to make. (Isn’t the market premium a really important number?)
   

Instructions for Case 2 - Dimensional Fund Advisors

As background to this case, read the material in DFA's website.

The objective of this case is to analyze DFA's investment strategy and at the same time review the empirical evidence for (and against) the CAPM.  In particular, we want to examine two famous “anomalies”: small cap stocks and value stocks have historically outperformed other stocks (even after adjusting for risk).  DFA was set up to provide investment vehicles to exploit these anomalies.  In the beginning of the 1980’s, they created a small-cap fund, and in the beginning of the 1990’s, they created a value fund.

To help you with the analysis, the spreadsheet DFAdata contains the riskf-free rate (RF), monthly returns for the stock market (MKT), returns to three portfolios formed according to the firms' market capitalization (ME), and returns to three portfolios formed according to the firms' ratio of book value of equity to market value of equity (BTM) which is a measure of value or growth.

Technical Note: There is a LINEST function in Excel which performs regression analysis.  When using regression often, it is easier to use a function than the data analysis tool pack. LINEST is an array function, so to use it properly look up arrays in Excel help, or ask a classmate. 

1. Put yourself in the place of David Booth and Rex Sinquefield in 1981 and study the attractiveness of small-cap stocks.  You may want to run regressions of excess returns of the size-based portfolios on the excess return of the market.  For each portfolio, you will obtain an “alpha” and a “beta.”  What do you find?  As a fund manager, what opportunities do you see?
2. Repeat the analysis for BTM-decile portfolios in 1990.  What do you find?
3. What, do you think, has been the performance of the funds created by DFA since their inception?  Use the portfolio data you have as a proxy for the DFA funds.
4. Are the returns to small-caps and high book-to-market firms a “good deal” (the result of market mispricing possibly due to irrational investors), “compensation for risk” (in the sense of the CAPM or the APT), or a “statistical fluke” (resulting from a short sample or the use of incorrect statistical methods)?  What is DFA’s view and what is your view?

Instructions for Case 3 - Intel

Read Valuing Intel Corporation, Inc.

Construct three discounted cash flow (DCF) valuation models as follows:

1. Build a DCF valuation model to match Intel’s stock at the moment before the September 21, 2000 news release. You may want to base your model on revenues projected according to analyst expected growth rates.
2. After reading the announcement, what information would you change in your model?  What, according to your model would be the new stock price?
3. Actually, Intel’s stock price fell to about $43.50 in the days following the announcement.  Adjust the cash flow forecasts in your model to match this new stock price.  Do the required adjustments seem reasonable in the face of the actual news?  Please explain why.
4. Based on your studies and personal experience in the financial markets, why do you think Intel dropped so much? What does this imply about market efficiency and anomalies?
   Can you think of a trading strategy that might exploit situations such as Intel’s? What percentage of your own wealth would you commit to it?

To construct your DCF model:

• Build an income statement forecast of expected revenues for the future 10 years.  You might use either a single, constant growth rate for all years or employ sequential growth rates in forming these assumptions. You may want to download a few stock analyst reports published prior to September 21, 2000 to help you in your forecasts.  The Anderson School’s Rosenfeld Library provides students online access to two, top-notch research services used by investment professionals, FirstCall and Multex.
• Make assumptions for future below-line items (costs & taxes).  The percent-of-sales method works well.
• Construct cashflow forecasts and estimate the terminal value of the company (in year 10).
• Download historical stock market prices in order to compute Intel’s cost of capital via the CAPM.  You can easily get these data in spreadsheet format from Yahoo! Finance. Current interest rates are also available at the site.  Use your own estimate of the market premium.
• Given forecasted cashflows and the discount rate, you are ready to value the stock.
• Here is a lot of information about Intel, including press articles around the date of the announcement.
• Intel’s website contains a treasure trove of official statements and financial documents.  You can find there the full September 21, 2000 press release, as well as the company's annual reports.
• For those who are still insatiably curious, Uncle Sam keeps all of Intel’s public filings here.

Instructions for Case 4 - Option Pricing

Go to the Chicago Board of Options Exchange, type in the ticker symbol for a stock you like and download the corresponding option prices.  Pick one contract that has more than a month to expiration.  It can be a call or put, with any strike price, but make sure that there have been transactions on the option on that day.  Next, download a time series of prices for the underlying stock.  You may use Yahoo! Finance as a source of stock price data.  You will also need current interest rate data.

1. Use the stock price data to estimate the stock's volatility.
2. Price the option using the binomial or the Black-Scholes model.
3. Compare the price you computed for the option with its actual market price.
4. Compare the implied volatility of the option with the volatility you estimated.
5. Compute the Delta of the option.  Wait one day and compare the new value of the option with the value of your replicating portfolio.  Were there hedging errors?