SMG FE 323 Study Guide - Final Guide: Efficient-Market Hypothesis, Risk-Free Interest Rate, Risk Premium
FE323 Final Study Guide
Topic 7: Efficient Markets
Efficient markets hypothesis:
• Implies that securities will be fairly priced, based on their future cash flow, given all information that is available to investors
• Implies that 2 securities with the same cash flow and the same risk must have the same price
Public, easily available information:
• Information available to all investors includes information in news reports, financial
statements, corporate press releases, or other public data sources
Private or difficult-to-interpret information
Various forms of efficiency
• Inefficient
• Efficient
o Weak form: incorporates only past stock price history
o Semi-strong: incorporates all known public information
o Strong form: incorporates all information including inside information (including
non-public information)
Problem: Myox Labs announces that it is pulling one of its leading drugs from the market, owing
to the potential side effects associated with the drug. As a result, its future expected free cash flow will decline by $85 million per year
for the next 10 years. Myox has 50 million shares outstanding, no debt, and an equity cost of capital of 8%. If this news came as a
oplete supise to iestos, hat should happe to Mo’s stok pie upo the aoueet?
Plan:
• In this case, we can use the discounted free cash flow method. With no debt, rwacc = rE = 8%.
• The effet o the Mo’s etepise alue ill e the loss of a te-year annuity of $85 million.
• We can compute the effect today as the present value of that annuity.
Execute:
o Usig the auit foula, the delie i epeted fee ash flo ill edue Mo’s etepise alue
o N = 10; I/Yr = 8%; PMT = 85; FV = 0; PV =??
o Thus the share price should fall by $570.36/50 = $11.41 per share.
Evaluate:
• Beause this es is puli ad its effet o the fi’s epeted fee ash flo is lea, e ould epet the stok pie to drop by
$11.41 per share nearly instantaneously, as it comes as a surprise to the market.
Private or Difficult-to-interpret information
Example: Phenyx Pharmaceuticals had just announced the development of a new drug
for which the company is seeking approval from the FDA. If the drug is approved future
pofits ill iease Phe’s aket alue $ pe shae. Suppose the announcement
comes as a surprise to investors, and average likelihood of FDA approval is 10%.
• Solution: The announcement should lead to a 10% × $15.00 = $1.50 per share
immediate stock price increase
• Over time, investors will make their own assessments of the probable efficacy of the
drug
• If they conclude that the drug looks more (less) promising than average, they will
buy (sell) the stock and the price will drift higher (lower) over time
• At the time of the announcement, uninformed investors do not know which way it will go
Consequences for investors
• Investors must have some competitive advantage
o Expertise or access to information known to only a few people
o Lower trading costs than others
o If stocks are fairly priced according to valuation models, then investors who buy stocks can expect air compensation
for the risk they take
The Efficient Market Hypothesis and No Arbitrage
• Arbitrage opportunity: a situation in which 2 securities (or portfolios) with identical cash flows have different prices
o Because anyone can earn a sure profit in this situation by buying the low-priced security and selling the high-priced
one, we expect investors to immediately exploit and eliminate these opportunities
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o Thus, in a normal (efficient) market, arbitrage opportunities will not be found
• The efficient markets hypothesis states that securities with equivalent risk should have the same expected return
• Different investors may perceive risks and returns differently (based on their information and preferences)
• There is no reason to expect the efficient markets hypothesis to hold perfectly; rather, it is best viewed as an idealized
approximation for highly competitive markets
Topic 8: risk and return
• Required return on an investment depends upon the riskiness of the investment
• There is a reward to taking risk and it is equal to the risk premium/risk free rate
• The greater the risk, the greater the required return you need to entice (the greater the premium/risk free rate)
• When faced with 2 invesetments, same risk, choose the one with higher return
• When faced with 2 investments, same expected return choose the one with less risk
Return
• Give up opportunity cost
• Give up the ability to consume or spend money
• Have inflation risk
• Have credit risk (Default risk)
risk
• Security return: yield (dividends or interest) + capital gain (change in price beginning of year to end)
• Stock: dividends +gain/loss
• Bonds: interest +gain/loss or coupon+gain/loss
Higher premium/risk free= higher volatility of returns
Calculating return
Non dividend paying investments
1. Average return (just capital gain)
2. Geometric or compound annual return (CAGR)
Dividend paying investments
3. Realized return
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A.Average = 80.5/10 = 8.05%
B.Easier to do part C first:
C.Assume you invest $100 at time 0
After The first year the 100 would have grown to $100 x (1 – 19.9%) = 80.10
For the second year you invest the $80.10 and it should grown to $80.10 x (1 + 16.6%) = $93.39 etc. etc.
For the full 10 years the equation is:
100 x (0.801 x 1.166 x 1.18 x 0.50 x 1.433 x 1.012 x 0.835 x 1.456 x 1.452 x 0.97) = 100 x 1.3683
You should have $136.83 at the end of the 10 years
Do part B now: We need the Geometric mean or the compounded growth rate – use your financial calculator
PV = -$100 FV = $136.88 N = 10 years PMT = 0 I/Yr = ??
I/year = 3.185%
Alternatively, need to find the rate that make the compounded return of $100 equal to $136.83 over 10 years
100 x (1 + r)10 = 136.83 solve for r
1 + r = (1.3683) 1/10 = 1.03185 r = 3.185% same result as above.
Risk: large returns for increasing risk
- Small stock have the largest premium and corporate bonds has lowest premium
o Volatility of returns/variance of returns
Topic 9: Portfolio Risk & Return
Portfolio:
• A combination of stocks or bonds
• % invested in asset 1+% invested in asset 2
• To an almost unlimited number of assets
• A single mutual fund can be a portfolio
• A portfolio can be made up of different mutual fund
• Diversify can eliminate risk
Problem:
•“uppose ou u , shaes of Miosoft at $ pe shae ad 3,000 shares of Pepsi at $36 per share
•If Miosoft’s stok goes up to $ pe shae ad Pepsi stok falls to $ pe shae ad eithe paid diideds, hat is the new value
of the portfolio?
•What etu did the potfolio ea?
•What ae the e potfolio weights?
•The iitial potfolio eights ee $,/$, = .% fo Miosoft ad $,/$, = .% fo Pepsi
•“ie eithe stok paid a diideds, e alulate thei etus as the apital gai o loss diided the puhase pie. The return
on Microsoft stock was $8/$25 = 32%, and the return on Pepsi stock was -$4/$36 = -11.1%.
Portfolio Return:
%5.2%1.11684.0%32316.0
=-´+´=+=
PepsiPepsiMicrosoftMicrosoftP
RwRwR
Risk and Diversification
• Risk changes as we add stocks to a portfolio, decrease volatility
Individual Stock risk
- Systematic risk- affecting the system underlying the entire market
- Unsystematic- unique to the single company, only impacts one company
•The isk that the Foude ad CEO leaes the opa -unsystematic
•The isk that oil pies ise, ieasig podutio & distiutio osts-systematic
•The isk that a podut desig is fault ad podut a e ealled-unsystematic
•The isk that the economy slows, reducing demand for your product-systematic
2 2 2
12
1( ) ( ) ... ( )
1T
Var R R R R R R R
T
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Document Summary
Implies that securities will be fairly priced, based on their future cash flow, given all information that is available to investors. Implies that 2 securities with the same cash flow and the same risk must have the same price. Information available to all investors includes information in news reports, financial statements, corporate press releases, or other public data sources. Efficient: weak form: incorporates only past stock price history, semi-strong: incorporates all known public information, strong form: incorporates all information including inside information (including non-public information) Problem: myox labs announces that it is pulling one of its leading drugs from the market, owing to the potential side effects associated with the drug. As a result, its future expected free cash flow will decline by million per year for the next 10 years. Myox has 50 million shares outstanding, no debt, and an equity cost of capital of 8%.
