TEERTHANKER MAHAVEER

UNIVERSITY MORADABAD, INDIA

CENTRE FOR DISTANCE AND

ONLINE EDUCATION

Programme: Bachelor of Arts

(Economics)
Semester-III

Course: Financial Economics

Financial Economics 2
Syllabus

Module I:Investment Theory and Structure of Interest rates

Introduction to financial economics, Time Value of Money:
Future Value, Present Value, Future value of an annuity, Present
value of annuity, Present rate of perpetuity. Investment Criteria:
Net Present Value, Benefit Cost Ratio, Internal Rate of Return,
Modified Internal Rate of Return.

Module II: Valuation of Bonds and Securities

Fundamentals of Valuation of Securities: Valuation of Bonds
and Stocks; Bond Yield, Yield to Maturity. Equity Valuation:
Dividend Discount Model, The P/E Ratio Approach; Irrelevance
of Dividends: Modigliani and Miller Hypothesis.
Module III: Risk and Return
Types of risk, Historical returns and Risk, computing historical
returns, average annual returns, variance of returns, Measurement
of Risk and Return of an asset, Measurement of Risk and Return of
a Portfolio, Determinants of Beta, Risk-Return trade off.

Module IV: Cost of Capital and Capital Asset Pricing Model

The Cost of Capital: Debt and equity; Cost of Debt, Cost of
Preference Capital and Equity Capital. The capital market line;
the capital asset pricing model; the beta of an asset and of a
portfolio; security market line; use of the CAPM model in
investment analysis and as a pricing formula.

Financial Economics 4
Module V:Derivative Markets
An introduction to financial derivatives: Types and uses of
derivatives; Forward Contracts: determination of forward prices,
Futures Contract: theories of future prices- the cost of carry
model, the expectation model, capital asset pricing model.
Relation between Spot and Future Prices, forward vs future
contract, Hedging in Futures; Options: types, value of an option,
the Pay-Offs from Buying and Selling of Options; the Put Call
Parity Theorem; Binomial option pricing model (BOPM) and
Black-Scholes option pricing model.

References
1. L. M. Bhole and J. Mahukud, Financial Institutions and
Markets, Tata McGraw Hill, 5th edition, 2011.
2. Hull, John C., Options, Futures and Other Derivatives,
Pearson Education, 6th edition, 2005.
1. David G. Luenberger, Investment Science, Oxford University
Press, USA, 1997.
2. Thomas E. Copeland, J. Fred Weston and KuldeepShastri,
Financial Theory and Corporate Policy, Prentice Hall, 4th
edition, 2003.
3. Richard A. Brealey and Stewart C. Myers, Principles of
Corporate Finance, McGrawHill, 7th edition, 2002.
4. Stephen A. Ross, Randolph W. Westerfield and Bradford D.
Jordan, Fundamentals of Corporate Finance.McGraw-Hill, 7th
edition, 2005.

Financial Economics 5
 Module I:
Investment Theory and Structure of Interest rates

1.1. Financial Economics

Financial economics is a branch of economics that analyzes the

use and distribution of resources in markets. Financial decisions
must often take into account future events, whether those be
related to individual stocks, portfolios, or the market as a whole.
It employs economic theory to evaluate how time, risk,
opportunity costs, and information can create incentives or
disincentives for a particular decision. Financial economics
often involves the creation of sophisticated models to test the
variables affecting a particular decision.

Financial economics necessitates familiarity with basic

probability and statistics since these are the standard tools used
to measure and evaluate risk. Financial economics studies fair
value, risk and returns, and the financing of securities and assets.
Numerous monetary factors are taken into account, too,
including interest rates and inflation.

1.2. Time Value of Money

Time value of money (TVM) is the idea that money that is

available at the present time is worth more than the same amount in
the future, due to its potential earning capacity. This core principle
of finance holds that provided money can earn interest, any amount
of money is worth more the sooner it is received. One of the most
fundamental concepts in finance is that money has a time value
attached to it. In simpler terms, it would be safe to say that a dollar
was worth more yesterday than today and a dollar

Financial Economics 6
today is worth more than a dollar tomorrow. This is because
money can grow only through investing. An investment delayed
is an opportunity lost. The time value of money is also referred
to as present discounted value. The formula for computing the
time value of money considers the amount of money, its future
value, the amount it can earn, and the time frame.

In general, the most fundamental TVM formula takes into

account the following variables:

Present value (PV) - This is your current starting amount. It is

the money you have in your hand at the present time, your initial
investment for your future.

Future value (FV) - This is your ending amount at a point in

time in the future. It should be worth more than the present
value, provided it is earning interest and growing over time.
The number of periods (N) - This is the timeline for your
investment (or debts). It is usually measured in years, but it could
be any scale of time such as quarterly, monthly, or even daily.

Interest rate (I) - This is the growth rate of your money over
the lifetime of the investment. It is stated in a percentage value,
such as 8% or .08.

Payment amount (PMT) - These are a series of equal, evenly-

spaced cash flows.
Based on these variables, the formula for TVM is:
(×)
= ×[1+

Financial Economics 7
A simple example of this would be: If you invest one dollar
(PV) for one year (N) at 6% (I), you will receive $1.06 (FV).
This would be the same as saying the present value of $1.06 you
expect to receive in one year, is only $1.00 (PV).

Examples: Assume a sum of $10,000 is invested for one year at

10% interest compounded annually. The future value of that
money is:

FV = $10,000 x [1 + (10% / 1)] ^ (1 x 1) = $11,000

The formula can also be rearranged to find the value of the

future sum in present day dollars. For example, the present day
dollar amount compounded annually at 7% interest that would
be worth $5,000 one year from today is:
PV = $5,000 / [1 + (7% / 1)] ^ (1 x 1) = $4,673

 The Time Value of Money Relate to Opportunity Cost

Opportunity cost is key to the concept of the time value of money.
Money can grow only if it is invested over time and earns a

Financial Economics 8
positive return. Money that is not invested loses value over time.
Therefore, a sum of money that is expected to be paid in the
future, no matter how confidently it is expected, is losing value
in the meantime.

 Significance of Time Value of Money

The concept of the time value of money can help guide

investment decisions. For instance, suppose an investor can
choose between two projects: Project A and Project B. They are
identical except that Project A promises a $1 million cash
payout in year one, whereas Project B offers a $1 million cash
payout in year five. The payouts are not equal. The $1 million
payout received after one year has a higher present value than
the $1 million payout after five years.

 Use of Time Value of Money in Finance

It would be hard to find a single area of finance where the time

value of money does not influence the decision-making process.
The time value of money is the central concept in discounted
cash flow (DCF) analysis, which is one of the most popular and
influential methods for valuing investment opportunities. It is
also an integral part of financial planning and risk management
activities. Pension fund managers, for instance, consider the
time value of money to ensure that their account holders will
receive adequate funds in retirement.

1.3. Future Value

Future value (FV) is the value of a current asset at a future date

based on an assumed rate of growth. The future value is important
to investors and financial planners, as they use it to estimate how
much an investment made today will be worth in the future.
Knowing the future value enables investors to make sound
Financial Economics 9
investment decisions based on their anticipated needs. However,
external economic factors, such as inflation, can adversely affect
the future value of the asset by eroding its value. The FV
calculation allows investors to predict, with varying degrees of
accuracy, the amount of profit that can be generated by different
investments. The amount of growth generated by holding a
given amount in cash will likely be different than if that same
amount were invested in stocks; therefore, the FV equation is
used to compare multiple options.

Determining the FV of an asset can become complicated,

depending on the type of asset. Also, the FV calculation is based
on the assumption of a stable growth rate. If money is placed in
a savings account with a guaranteed interest rate, then the FV is
easy to determine accurately. However, investments in the stock
market or other securities with a more volatile rate of return can
present greater difficulty. To understand the core concept,
however, simple and compound interest rates are the most
straightforward examples of the FV calculation.

Types of Future Value

Future Value Using Simple Annual Interest

The FV formula assumes a constant rate of growth and a single
up-front payment left untouched for the duration of the
investment. The FV calculation can be done one of two ways,
depending on the type of interest being earned. If an investment
earns simple interest, then the FV formula is:
= ×(1+( × ))

Where: I=Investment amount, R=Interest rate,

T=Number of years

Financial Economics 10
For example, assume a $1,000 investment is held for five years
in a savings account with 10% simple interest paid annually. In
this case, the FV of the $1,000 initial investment is $1,000 × [1
+ (0.10 x 5)], or $1,500.

Future Value Using Compounded Annual Interest

With simple interest, it is assumed that the interest rate is earned
only on the initial investment. With compounded interest, the rate
is applied to each period‘s cumulative account balance. In the
example above, the first year of investment earns 10% × $1,000, or
$100, in interest. The following year, however, the account total is
$1,100 rather than $1,000; so, to calculate compounded interest,
the 10% interest rate is applied to the full balance for second-year
interest earnings of 10% × $1,100, or $110.

The formula for the FV of an investment

earning compounding interest is:
= ×(1+ )

Where: I=Investment amount, R=Interest rate,

T=Number of years

Using the above example, the same $1,000 invested for five
years in a savings account with a 10% compounding interest rate
would have an FV of $1,000 × [(1 + 0.10)5], or $1,610.51.
1.4. Present Value

Present value (PV) is the current value of a future sum of money or

stream of cash flows given a specified rate of return. The concept
that states an amount of money today is worth more than that same
amount in the future. In other words, money received in the future
is not worth as much as an equal amount received

Financial Economics 11
today. Receiving $1,000 today is worth more than $1,000 five
years from now. An investor can invest the $1,000 today and
presumably earn a rate of return over the next five years. Present
value takes into account any interest rate an investment might
earn. For example, if an investor receives $1,000 today and can
earn a rate of return 5% per year, the $1,000 today is certainly
worth more than receiving $1,000 five years from now. If an
investor waited five years for $1,000, there would be an
opportunity cost or the investor would lose out on the rate of
return for the five years.

Inflation is the process in which prices of goods and services

rise over time. If you receive money today, you can buy goods at
today's prices. Presumably, inflation will cause the price of
goods to rise in the future, which would lower the purchasing
power of your money.

Money not spent today could be expected to lose value in the

future by some implied annual rate, which could be inflation or
the rate of return if the money was invested. The present value
formula discounts the future value to today's dollars by factoring
in the implied annual rate from either inflation or the rate of
return that could be achieved if a sum was invested.

Discount Rate for Finding Present Value

The discount rate is the investment rate of return that is applied

to the present value calculation. In other words, the discount rate
would be the forgone rate of return if an investor chose to accept
an amount in the future versus the same amount today. The
discount rate that is chosen for the present value calculation is
highly subjective because it's the expected rate of return you'd
receive if you had invested today's dollars for a period of time.

Financial Economics 12
The discount rate is the sum of the time value and a relevant
interest rate that mathematically increases future value in nominal
or absolute terms. Conversely, the discount rate is used to work out
future value in terms of present value, allowing a lender to settle on
the fair amount of any future earnings or obligations in relation to
the present value of the capital. The word "discount" refers to
future value being discounted to present value.

The calculation of discounted or present value is extremely

important in many financial calculations. For example, net present
value, bond yields, and pension obligations all rely on discounted
or present value. Learning how to use a financial calculator to make
present value calculations can help you decide whether you should
accept such offers as a cash rebate, 0% financing on the purchase of
a car, or pay points on a mortgage.

PV Formula and Calculation

=(1+)

Where, FV=Future Value; r=Rate of return; n=Number of periods

 Input the future amount that you expect to receive in the

numerator of the formula.

 Determine the interest rate that you expect to receive
between now and the future and plug the rate as a
decimal in place of "r" in the denominator.

 Input the time period as the exponent "n" in the
denominator. So, if you want to calculate the present
value of an amount you expect to receive in three years,
you would plug the number three in for "n" in the
denominator.
Financial Economics 13
Future Value vs. Present Value
A comparison of present value with future value (FV) best
illustrates the principle of the time value of money and the need for
charging or paying additional risk-based interest rates. Simply put,
the money today is worth more than the same money tomorrow
because of the passage of time. Future value can relate to the future
cash inflows from investing today's money, or the future payment
required to repay money borrowed today.

Future value (FV) is the value of a current asset at a specified

date in the future based on an assumed rate of growth. The FV
equation assumes a constant rate of growth and a single upfront
payment left untouched for the duration of the investment. The
FV calculation allows investors to predict, with varying degrees
of accuracy, the amount of profit that can be generated by
different investments.

Present value (PV) is the current value of a future sum of money

or stream of cash flows given a specified rate of return. Present
value takes the future value and applies a discount rate or the
interest rate that could be earned if invested. Future value tells
you what an investment is worth in the future while the present
value tells you how much you'd need in today's dollars to earn a
specific amount in the future.

1.5. Annuity

Annuities are financial products that offer a guaranteed income

stream, usually for retirees. The accumulation phase is the first
stage of an annuity, whereby investors fund the product with either
a lump-sum or periodic payments. The annuitant begins receiving
payments after the annuitization period for a fixed period or for the
rest of their life. Annuities can be structured into different kinds of
instruments, which gives investors flexibility.
Financial Economics 14
These products can be categorized into immediate and deferred
annuities, and may be structured as fixed or variable.

Types of Annuities
Annuities can be structured according to a wide array of details and
factors, such as the duration of time that payments from the annuity
can be guaranteed to continue. Annuities can be created so that
payments continue so long as either the annuitant or their spouse (if
survivorship benefit is elected) is alive. Alternatively, annuities can
be structured to pay out funds for a fixed amount of time, such as
20 years, regardless of how long the annuitant lives.

 Immediate and Deferred Annuities

Annuities can begin immediately upon deposit of a lump sum, or
they can be structured as deferred benefits. The immediate
payment annuity begins paying immediately after the annuitant
deposits a lump sum. Deferred income annuities, on the other
hand, don't begin paying out after the initial investment. Instead,
the client specifies an age at which they would like to begin
receiving payments from the insurance company.

 Fixed and Variable Annuities

Annuities can be structured generally as either fixed or variable:
Fixed annuities provide regular periodic payments to the
annuitant. Variable annuities allow the owner to receive larger
future payments if investments of the annuity fund do well and
smaller payments if its investments do poorly, which provides
for less stable cash flow than a fixed annuity but allows the
annuitant to reap the benefits of strong returns from their fund's
investments.

Financial Economics 15
While variable annuities carry some market risk and the
potential to lose principal, riders and features can be added to
annuity contracts—usually for an extra cost. This allows them to
function as hybrid fixed-variable annuities. Contract owners can
benefit from upside portfolio potential while enjoying the
protection of a guaranteed lifetime minimum withdrawal benefit
if the portfolio drops in value.

1.6. The Present Value of an annuity

The present value of an annuity is the current value of future

payments from an annuity, given a specified rate of return, or
discount rate. The higher the discount rate, the lower the present
value of the annuity. The present value of an annuity refers to
how much money would be needed today to fund a series of
future annuity payments. Because of the time value of money, a
sum of money received today is worth more than the same sum
at a future date.

The formula for the present value of an ordinary annuity, as

opposed to an annuity due, is below. (An ordinary annuity pays
interest at the end of a particular period, rather than at the
beginning, as is the case with an annuity due.)
1
1−((1+ ))
= ×

Where: P=Present value of an annuity stream

PMT=Dollar amount of each annuity payment
r=Interest rate (also known as discount rate)
n=Number of periods in which payments will be made

Financial Economics 16
Future Value of an Annuity
The future value of an annuity is a way of calculating how much
money a series of payments will be worth at a certain point in
the future. By contrast, the present value of an annuity measures
how much money will be required to produce a series of future
payments. In an ordinary annuity, payments are made at the end
of each agreed-upon period. In an annuity due, payments are
made at the beginning of each period.

Because of the time value of money, money received or paid out

today is worth more than the same amount of money will be in
the future. That's because the money can be invested and
allowed to grow over time. By the same logic, a lump sum of
$5,000 today is worth more than a series of five $1,000 annuity
payments spread out over five years.

The formula for the future value of an ordinary annuity is as

follows. (An ordinary annuity pays interest at the end of a
particular period, rather than at the beginning, as is the case with
an annuity due.)
= ×((1+ ) −1)

where: P=Future value of an annuity stream

PMT=Dollar amount of each annuity payment
r=Interest rate (also known as discount rate)
n=Number of periods in which payments will be made

Financial Economics 17
1.8. Present Rate of Perpetuity
An annuity is a stream of cash flows. A perpetuity is a type of
annuity that lasts forever, into perpetuity. The stream of cash
flows continues for an infinite amount of time. In finance, a
person uses the perpetuity calculation in valuation
methodologies to find the present value of a company's cash
flows when discounted back at a certain rate.

A perpetuity is a security that pays for an infinite amount of

time. In finance, perpetuity is a constant stream of identical cash
flows with no end. The concept of perpetuity is also used in
several financial theories, such as in the dividend discount model
(DDM). An infinite series of cash flows can have a finite present
value. Because of the time value of money, each payment is only
a fraction of the last. The present value of a perpetuity is
determined by dividing cash flows by the discount rate.
Specifically, the perpetuity formula determines the amount of
cash flows in the terminal year of operation. In valuation, a
company is said to be a going concern, meaning that it goes on
forever. For this reason, the terminal year is a perpetuity, and
analysts use the perpetuity formula to find its value.
= (1+ ) +(1+ ) +(1+ ) ….=
where: PV=present value; C=cash flow; r=discount rate
The basic method used to calculate a perpetuity is to divide cash
flows by some discount rate. The formula used to calculate the
terminal value in a stream of cash flows for valuation purposes is a
bit more complicated. It is the estimate of cash flows in year 10 of
the company, multiplied by one plus the company‘s long-term
growth rate, and then divided by the difference between the cost

Financial Economics 18
of capital and the growth rate. Simply put, the terminal value is
some amount of cash flows divided by some discount rate,
which is the basic formula for a perpetuity.

1.7. Investment criteria

Investment criteria are the defined set of parameters used by

financial and strategic buyers to assess an acquisition target.
Sophisticated buyers will usually have two sets of criteria:

The parameters that are disclosed publicly to intermediaries such

as investment bankers, so they know what the buyer is looking
for in order to source deals that fit; and The parameters
developed for internal review that allow a buyer to quickly
determine if the acquisition should be pursued further. The most
common publicly disclosed investment criteria include the
geography, size of the investment or company targeted, and
industry. Some buyers also disclose criteria regarding the
investment type which may include management buyouts
(MBO), distressed opportunities, or succession situations.

 Net Present Value

Net present value, or NPV, is used to calculate the current total
value of a future stream of payments. In other words, Net present
value (NPV) is the difference between the present value of cash
inflows and the present value of cash outflows over a period of
time. If the NPV of a project or investment is positive, it means
that the discounted present value of all future cash flows related to
that project or investment will be positive, and therefore attractive.
To calculate NPV, you need to estimate future cash flows for each
period and determine the correct discount rate.

NPV is used in capital budgeting and investment planning to

analyze the profitability of a projected investment or project.
Financial Economics 19
NPV is the result of calculations used to find today‘s value of a
future stream of payments.
= (1+ )

Where: Rt = Net cash inflow –outflow during a single period t; i

= Discount rate or return that could be earned in alternative
investments; t = Number of timer periods

In theory, an NPV is ―good‖ if it is greater than zero. After all,

the NPV calculation already takes into account factors such as
the investor‘s cost of capital, opportunity cost, and risk tolerance
through the discount rate. And the future cash flows of the
project, together with the time value of money, are also
captured. Therefore, even an NPV of ₹1 should theoretically
qualify as ―good.‖

Positive and Negative NPV

A positive NPV indicates that the projected earnings generated by
a project or investment—in present dollars—exceeds the
anticipated costs, also in present dollars. It is assumed that an
investment with a positive NPV will be profitable.

An investment with a negative NPV will result in a net loss.

This concept is the basis for the Net Present Value Rule, which
dictates that only investments with positive NPV values should
be considered.

 Benefit-Cost Ratio (BRC)

A benefit-cost ratio (BCR) is a ratio used in a cost-benefit analysis
to summarize the overall relationship between the relative costs and
benefits of a proposed project. BCR can be expressed in
Financial Economics 20
monetary or qualitative terms. A benefit-cost ratio (BCR) is an
indicator showing the relationship between the relative costs and
benefits of a proposed project, expressed in monetary or qualitative
terms. If a project has a BCR greater than 1.0, the project is
expected to deliver a positive net present value to a firm and its
investors. If a project's BCR is less than 1.0, the project's costs
outweigh the benefits, and it should not be considered.

Benefit-cost ratios (BCRs) are most often used in capital

budgeting to analyze the overall value for money of undertaking
a new project. However, the cost-benefit analyses for large
projects can be hard to get right, because there are so many
assumptions and uncertainties that are hard to quantify. This is
why there is usually a wide range of potential BCR outcomes.

The BCR also does not provide any sense of how much
economic value will be created, and so the BCR is usually used
to get a rough idea about the viability of a project and how much
the internal rate of return (IRR) exceeds the discount rate, which
is the company‘s weighted-average cost of capital (WACC) –
the opportunity cost of that capital.

The BCR is calculated by dividing the proposed total cash benefit

of a project by the proposed total cash cost of the project. Prior to
dividing the numbers, the net present value of the respective cash
flows over the proposed lifetime of the project – taking into
account the terminal values, including salvage/remediation costs
– are calculated.

Limitations of BCR

The primary limitation of the BCR is that it reduces a project to

a simple number when the success or failure of an investment or
expansion relies on many factors and can be undermined by
unforeseen events. Simply following a rule that above 1.0 means
Financial Economics 21
success and below 1.0 spells failure is misleading and can
provide a false sense of comfort with a project. The BCR must
be used as a tool in conjunction with other types of analysis to
make a well-informed decision.

 The internal rate of return (IRR)

The internal rate of return (IRR) is a discounting cash flow
technique which gives a rate of return earned by a project. The
internal rate of return is the discounting rate where the total of
initial cash outlay and discounted cash inflows are equal to zero.
In other words, it is the discounting rate at which the net present
value (NPV) is equal to zero. It is the rate of return at which the
net present value of a project becomes zero. They call it
‗internal‘ because it does not take any external factor (like
inflation) into consideration.

The internal rate of return (IRR) determines the worthiness of any

project. In addition, the IRR determines the efficiency of a project
in generating profits. Therefore, companies use the metric to plan
before investing in any project. The hurdle rate or required rate of
return is a minimum return expected by an organization on its
investment. Any project with an internal rate of return exceeding
the hurdle rate is considered profitable. It is expressed in the form
of percentage return a firm expects from the project.

The internal rate of return (IRR) is a metric used in financial

analysis to estimate the profitability of potential investments.
IRR is a discount rate that makes the net present value (NPV) of
all cash flows equal to zero in a discounted cash flow analysis.

Generally speaking, the higher an internal rate of return, the

more desirable an investment is to undertake. IRR is uniform for
investments of varying types and, as such, can be used to rank
multiple prospective investments or projects on a relatively even
Financial Economics 22
basis. In general, when comparing investment options with other
similar characteristics, the investment with the highest IRR
probably would be considered the best.

The formula and calculation used to determine this figure are as

follows:
0= = (1+ )−

Where: Ct = Net cash inflow during the period t; C0 = Total

initial investment costs; IRR = The internal rate of return; t =
The number of time periods.
The ultimate goal of IRR is to identify the rate of discount, which
makes the present value of the sum of annual nominal cash inflows
equal to the initial net cash outlay for the investment. Several
methods can be used when seeking to identify an expected return,
but IRR is often ideal for analyzing the potential return of a new
project that a company is considering undertaking.

Think of IRR as the rate of growth that an investment is

expected to generate annually. Thus, it can be most similar to a
compound annual growth rate (CAGR). In reality, an investment
will usually not have the same rate of return each year. Usually,
the actual rate of return that a given investment ends up
generating will differ from its estimated IRR.

Uses of IRR

 In capital planning, one popular scenario for IRR is

comparing the profitability of establishing new
operations with that of expanding existing operations.

Financial Economics 23
  IRR is also useful for corporations in evaluating stock
buyback programs.

 Individuals can also use IRR when making financial
decisions—for instance, when evaluating different
insurance policies using their premiums and death
benefits.

 Another common use of IRR is in analyzing investment
returns.

 IRR is a calculation used for an investment‘s money-
weighted rate of return (MWRR). The MWRR helps
determine the rate of return needed to start with the
initial investment amount factoring in all of the changes
to cash flows during the investment period, including
sales proceeds.

Modified Internal Rate of Return (MIRR)

The modified internal rate of return (MIRR) assumes that
positive cash flows are reinvested at the firm's cost of capital and
that the initial outlays are financed at the firm's financing cost.
By contrast, the traditional internal rate of return (IRR) assumes
the cash flows from a project are reinvested at the IRR itself.
The MIRR, therefore, more accurately reflects the cost and
profitability of a project.

Formula and Calculation of MIRR

Given the variables, the formula for MIRR is expressed as:

( ℎ × )
=
−1

( × )

Financial Economics 24
where:

FVCF(c)=the future value of positive cash flows at the cost of

capital for the company

PVCF(fc)=the present value of negative cash flows at the

financing cost of the company
n=number of periods

Meanwhile, the internal rate of return (IRR) is a discount rate

that makes the net present value (NPV) of all cash flows from a
particular project equal to zero. Both MIRR and IRR
calculations rely on the formula for NPV.

The MIRR is used to rank investments or projects of unequal

size. The calculation is a solution to two major problems that
exist with the popular IRR calculation. The first main problem
with IRR is that multiple solutions can be found for the same
project. The second problem is that the assumption that positive
cash flows are reinvested at the IRR is considered impractical in
practice. With the MIRR, only a single solution exists for a
given project, and the reinvestment rate of positive cash flows is
much more valid in practice.

The MIRR allows project managers to change the assumed rate

of reinvested growth from stage to stage in a project. The most
common method is to input the average estimated cost of
capital, but there is flexibility to add any specific anticipated
reinvestment rate.

 The Difference Between MIRR and IRR

Even though the internal rate of return (IRR) metric is popular
among business managers, it tends to overstate the profitability of

Financial Economics 25
a project and can lead to capital budgeting mistakes based on an
overly optimistic estimate. The modified internal rate of return
(MIRR) compensates for this flaw and gives managers more
control over the assumed reinvestment rate from future cash flow.

An IRR calculation acts like an inverted compounding growth

rate. It has to discount the growth from the initial investment in
addition to reinvested cash flows. However, the IRR does not
paint a realistic picture of how cash flows are actually pumped
back into future projects.

Cash flows are often reinvested at the cost of capital, not at the
same rate at which they were generated in the first place. IRR
assumes that the growth rate remains constant from project to
project. It is very easy to overstate potential future value with
basic IRR figures.

Another major issue with IRR occurs when a project has

different periods of positive and negative cash flows. In these
cases, the IRR produces more than one number, causing
uncertainty and confusion. MIRR solves this issue as well.

Advantages of IRR

 Finds the Time Value of Money

Internal rate of return is measured by calculating the interest rate

at which the present value of future cash flows equals the
required capital investment. The timing of cash flows in all
future years are considered and, therefore, each cash flow is
given equal weight by using the time value of money.

Financial Economics 26
  Simple to Use and Understand

The IRR is an easy measure to calculate and provides a simple

means by which to compare the worth of various projects under
consideration. The IRR provides any small business owner with
a quick snapshot of what capital projects would provide the
greatest potential cash flow. It can also be used for budgeting
purposes such as to provide a quick snapshot of the potential
value or savings of purchasing new equipment as opposed to
repairing old equipment.

 Hurdle Rate Not Required

In capital budgeting analysis, the hurdle rate, or cost of capital,

is the required rate of return at which investors agree to fund a
project. It can be a subjective figure and typically ends up as a
rough estimate. The IRR method does not require the hurdle
rate, mitigating the risk of determining a wrong rate. Once the
IRR is calculated, projects can be selected where the IRR
exceeds the estimated cost of capital.

Disadvantage
 Ignores Size of Project
It does not account for the project size when comparing
projects. Cash flows are simply compared to the amount of
capital outlay generating those cash flows. This can be
troublesome when two projects require a significantly
different amount of capital outlay, but the smaller project
returns a higher IRR.

 Ignores Future Costs

Financial Economics 27
 The IRR method only concerns itself with the projected cash
flows generated by a capital injection and ignores the
potential future costs that may affect profit.

 Ignores Reinvestment Rates

The IRR allows you to calculate the value of future cash

flows, it makes an implicit assumption that those cash flows
can be reinvested at the same rate as the IRR. That
assumption is not practical as the IRR is sometimes a very
high number and opportunities that yield such a return are
generally not available or significantly limited.

Financial Economics 28
 Module II
Valuation of Bonds and Securities

2.1. Valuation of securities

Valuation means professionally estimating, assessing,

determining, setting the price, worth and value of a thing or an
asset. As the objective of any investment is to find out an asset
which is worth more than its cost, a proper understanding of the
process of valuation is necessary for any real or financial
investment decision, portfolio selection and management and
financing decision. The valuation techniques provide investors a
benchmark or standard of comparison be valued between assets
and firms which have varying financial characteristics; it enables
investors to appraise the relative attractiveness of assets and
firms. Therefore, we discuss below certain (a) value concepts,
(b) general principles of valuation and (c) the way in which
certain specific securities can be valued.

Value Concepts
Book Value
The book value of an asset or a firm is based on accounting
reports. In case of a physical asset, it is equal to the asset's
historical cost less accumulated depreciation. In case of a
common stock, it is equal to the net worth (paid-up capital +
reserves and surplus) of the firm divided by the number of
outstanding shares. Symbolically,

Financial Economics 29
 School of Distance Education
ℎ
=
−

ℎ(
ℎ +
=
ℎ

Going-Concern Value
This concept applies to a business firm as a continuing operating
unit. It is based primarily on how profitable a firm's operations
would be as a continuing entity that is, the entity which is
unlikely to go out of business in the foreseeable future.

Liquidation Value
In contrast to the going-concern value, the liquidation value is
the value of the business firm which has cease or wound up its
business, or which has gone into liquidation. The liquidation
value of an ordinary share is equal to the value realised from
liquidating all the assets of the firm minus the amount to be paid
to all the creditors, preference shareholders, and other prior
claimants divided by the number of outstanding ordinary shares.

Market Value
The market value of an asset is simply the price at which it is
traded in the market at a given point of time.

Intrinsic or Present Value

Intrinsic value is also known as fair market value or investment
value. It is equal to the present value of a stream of cash flows
expected to be generated by the asset. The technique for finding

Financial Economics 30
out present value is known as discounting. Market value truly
reflects intrinsic value if the market is perfectly competitive.

Terminal Value
The terminal value of the asset or money is the value of today's
money at some point of time in future, and the method for
ascertaining it is known as compounding.

Time Value of Money

It connotes that a rupee today in hand is worth more than a rupee
tomorrow (in future) because it can be invested and made to
earn interest immediately, and because the present consumption
is valued more than the future consumption by the people.

General Principles of Valuation

Any asset or security derives its value from the cash flows it is
expected to generate in future. The present value of the future or
delayed pay-off can be found by multiplying that pay-off by the
discount factor which is less than one and which can be
expressed as follows:
= 1
1+

It follows that to obtain the value of the asset, we need to know

two things. One, the expected or projected future cash flows;
and two, the discount rate which is also known as the hurdle rate
or the opportunity cost of investment. The discount rate is equal
to the RRR which is approximated by the rate of return available
on the next best opportunity for investment which the investor
forgoes by investing in the asset in question. We illustrate below
the basic valuation model by giving the present value formulae

Financial Economics 31
for only five types of future cash flows, although there is a wide
range of possibilities in respect of the types of cash flows.
(i) Cash flow to be received at the end of one year:
= (1+ )

(ii) cash flow to be received at the end of the fifth year:

= (1+ )

(iii) continuous uneven (not the same) stream of cash flows to

be received at the end of each year for a period of time:
= (1+ ) +(1+ ) +⋯+(1+ )
= (1+ )

(iv) Continuous even (fixed) stream of cash flows to be

received at the end of each year for a given period of
time. This is known as annuity which can be valued
as follows:
= (1+ ) + (1+ ) +⋯+(1+ )
=
(1+ )

Financial Economics 32
 Or
1 1
= [−(1+)

(v) Continuous even (fixed) stream of cash flows to be

received indefinitely. This is known as perpetuity and
can be valued as follows:
=

In all of the above formulae,

PV= Present Value;
C=Cash flow;
t=End of the year (period);
n=Duration of cash flow; and
r=Discount rate.
The term rt, in these equations implies that, in principle, there has to be
a different discount rate for different future periods. The higher rate
can be applied for the longer maturity. However, since normally a flat
term structure of interest rates is assumed in this context, the term r t,
can be replaced by the term r. The level of PV of the asset depends
upon the timing of the cash flow and the level of discount rate. Given
the discount rate, the more further off the pay-off, the lower the PV.
Similarly, given the timing the higher the discount rate, the lower the
PV. Thus, the PV is inversely related to both the timing of the cash
flow and the discount rate. Closely related to the concept of PV is that
of Net Present Value (NPV), which is equal to

Financial Economics 33
PV minus the required investment or the cash outflows (costs)
associated with the investment.
= (1+ )
= (1+ )

2.2. Valuation of Bonds and Stocks

A bond is a debt instrument that provides a steady income
stream to the investor in the form of coupon payments. At the
maturity date, the full face value of the bond is repaid to the
bondholder. The characteristics of a regular bond include:

• Coupon rate: Some bonds have an interest rate, also

known as the coupon rate, which is paid to bondholders semi-
annually. The coupon rate is the fixed return that an investor
earns periodically until it matures.

• Maturity date: All bonds have maturity dates, some short-

term, others long-term. When a bond matures, the bond issuer
repays the investor the full face value of the bond. For corporate
bonds, the face value of a bond is usually $1,000 and for
government bonds, the face value is $10,000. The face value is not
necessarily the invested principal or purchase price of the bond.

• Current price: Depending on the level of interest rate in

the environment, the investor may purchase a bond at par, below
par, or above par. For example, if interest rates increase, the
value of a bond will decrease since the coupon rate will be lower
than the interest rate in the economy. When this occurs, the bond
will trade at a discount, that is, below par. However, the
bondholder will be paid the full face value of the bond at
maturity even though he purchased it for less than the par value.

Financial Economics 34
Since bonds are an essential part of the capital markets, investors
and analysts seek to understand how the different features of a bond
interact in order to determine its intrinsic value. Like a stock, the
value of a bond determines whether it is a suitable investment for a
portfolio and hence, is an integral step in bond investing. Bond
valuation, in effect, is calculating the present value of a bond‘s
expected future coupon payments. The theoretical fair value of a
bond is calculated by discounting the future value of its coupon
payments by an appropriate discount rate. The discount rate used is
the yield to maturity, which is the rate of return that an investor will
get if they reinvested every coupon payment from the bond at a
fixed interest rate until the bond matures. It takes into account the
price of a bond, par value, coupon rate, and time to maturity.

Bond valuation is a technique for determining the theoretical fair value

of a particular bond. Bond valuation includes calculating the present
value of a bond's future interest payments, also known as its cash flow,
and the bond's value upon maturity, also known as its face value or par
value. Because a bond's par value and interest payments are fixed, an
investor uses bond valuation to determine what rate of return is
required for a bond investment to be worthwhile.

• Coupon Bond Valuation

Calculating the value of a coupon bond factors in the annual or
semi-annual coupon payment and the par value of the bond. The
present value of expected cash flows is added to the present value
of the face value of the bond as seen in the following formula:
= (1+ )

=(1+ )

Financial Economics 35
Where:
C= future cash flows, that is, coupon payment
r = discount rate, that is , yield to maturity

F = face value of the bond

t = number of periods
T = time to maturity
• Zero-Coupon Bond Valuation

A zero-coupon bond makes no annual or semi-annual coupon

payments for the duration of the bond. Instead, it is sold at a
deep discount to par when issued. The difference between the
purchase price and par value is the investor‘s interest earned on
the bond. To calculate the value of a zero-coupon bond, we only
need to find the present value of the face value.

Under both calculations, a coupon-paying bond is more valuable

than a zero-coupon bond.
• Convertible Bonds Valuation
A convertible bond is a debt instrument that has an embedded
option that allows investors to convert the bonds into shares of the
company's common stock. Convertible bond valuations take a
multitude of factors into account, including the variance in
underlying stock price, the conversion ratio, and interest rates that
could affect the stocks that such bonds might eventually become.
At its most basic, the convertible is priced as the sum of the straight
bond and the value of the embedded option to convert.

Financial Economics 36
Stock Valuation
Stock valuation is a method of determining the intrinsic value
(or theoretical value) of a stock. The importance of valuing
stocks evolves from the fact that the intrinsic value of a stock is
not attached to its current price. By knowing a stock‘s intrinsic
value, an investor may determine whether the stock is over- or
under-valued at its current market price. Valuing stocks is an
extremely complicated process that can be generally viewed as a
combination of both art and science. Investors may be
overwhelmed by the amount of available information that can be
potentially used in valuing stocks (company‘s financials,
newspapers, economic reports, stock reports, etc.).

 Types of Stock Valuation

Stock valuation methods can be primarily categorized into two
main types: absolute and relative.
1. Absolute

Absolute stock valuation relies on the company‘s fundamental

information. The method generally involves the analysis of
various financial information that can be found in or derived
from a company‘s financial statements. Many techniques of
absolute stock valuation primarily investigate the company‘s
cash flows, dividends, and growth rates. Notable absolute stock
valuation methods include the dividend discount model (DDM)
and the discounted cash flow model (DCF).

2. Relative
Relative stock valuation concerns the comparison of the investment
with similar companies. The relative stock valuation method deals
with the calculation of the key financial ratios of similar companies

Financial Economics 37
and derivation of the same ratio for the target company. The best
example of relative stock valuation is comparable companies
analysis.

 Stock Valuation Methods

Below, we will briefly discuss the most popular methods of
stock valuation.
1. Dividend Discount Model (DDM)

The dividend discount model is one of the basic techniques of

absolute stock valuation. The DDM is based on the assumption
that the company‘s dividends represent the company‘s cash flow
to its shareholders. Essentially, the model states that the intrinsic
value of the company‘s stock price equals the present value of
the company‘s future dividends. Note that the dividend discount
model is applicable only if a company distributes dividends
regularly and the distribution is stable.

2. Discounted Cash Flow Model (DCF)

The discounted cash flow model is another popular method of

absolute stock valuation. Under the DCF approach, the intrinsic
value of a stock is calculated by discounting the company‘s free
cash flows to its present value. The main advantage of the DCF
model is that it does not require any assumptions regarding the
distribution of dividends. Thus, it is suitable for companies with
unknown or unpredictable dividend distribution. However, the
DCF model is sophisticated from a technical perspective.

3. Comparable Companies Analysis

The comparable analysis is an example of relative stock valuation.
Instead of determining the intrinsic value of a stock using the

Financial Economics 38
company‘s fundamentals, the comparable approach aims to
derive a stock‘s theoretical price using the price multiples of
similar companies. The most commonly used multiples include
the price-to-earnings (P/E), price-to-book (P/B), and enterprise
value-to-EBITDA (EV/EBITDA). The comparable companies
analysis method is one of the simplest from a technical
perspective. However, the most challenging part is the
determination of truly comparable companies.

Bond Yield
Bond is an instrument to borrow money. A bond could be issued
by a country‘s government or by a company to raise funds. A
bond's yield refers to the expected earnings generated and
realized on a fixed-income investment over a particular period of
time, expressed as a percentage or interest rate. In other words,
Bond yield is the return an investor realizes on a bond. The
mathematical formula for calculating yield is the annual coupon
rate divided by the current market price of the bond

When investors buy bonds, they essentially lend bond issuers

money. In return, bond issuers agree to pay investors interest on
bonds through the life of the bond and to repay the face value of
bonds upon maturity. The simplest way to calculate a bond yield
is to divide its coupon payment by the face value of the bond.
This is called the coupon rate. Coupon Rate is the rate of interest
paid by bond issuers on the bond's face value. If a bond is
purchased for more than its face value (premium) or less than its
face value (discount), which will change the yield an investor
earns on the bond.
=

Financial Economics 39
As bond prices increase, bond yields fall. Its coupon rate is the
interest divided by its par value.
If interest rates rise above 10%, the bond's price will fall if the
investor decides to sell it. If the original bond owner wants to sell
the bond, the price can be lowered so that the coupon payments and
maturity value equal a yield of 12%. In this case, that means the
investor would drop the price of the bond. If interest rates were to
fall in value, the bond's price would rise because its coupon
payment is more attractive. The further rates fall, the higher the
bond's price will rise, and the same is true in reverse when interest
rates rise. In either scenario, the coupon rate no longer has any
meaning for a new investor. However, if the annual coupon
payment is divided by the bond's price, the investor can calculate
the current yield and get a rough estimate of the bond's true yield.
=

The current yield and the coupon rate are incomplete

calculations for a bond's yield because they do not account for
the time value of money, maturity value, or payment frequency.

 Yield to Maturity
A bond's yield to maturity (YTM) is equal to the interest rate that
makes the present value of all a bond's future cash flows equal to its
current price. These cash flows include all the coupon payments and
its maturity value. Solving for YTM is a trial and error process that
can be done on a financial calculator, but the formula is as follows:
= ℎ
(1+ )

Financial Economics 40
Where: YTM = Yield to maturity

 Bond Equivalent Yield – BEY

Bond yields are normally quoted as a bond equivalent yield

(BEY), which makes an adjustment for the fact that most bonds
pay their annual coupon in two semi-annual payments.

The BEY is a simple annualized version of the semi-annual

YTM and is calculated by multiplying the YTM by two. The
BEY does not account for the time value of money for the
adjustment from a semi-annual YTM to an annual rate.

Effective Annual Yield – EAY

Investors can find a more precise annual yield once they know
the BEY for a bond if they account for the time value of money
in the calculation. In the case of a semi-annual coupon payment,
the effective annual yield (EAY) would be calculated as follows:
=(1+ 2 ) −1

Where:
EAY=Effective Annual Yield

 Complications Finding a Bond's Yield

There are a few factors that can make finding a bond's yield
more complicated. For instance, in the previous examples, it was
assumed that the bond had exactly five years left to maturity
when it was sold, which would rarely be the case.

When calculating a bond's yield, the fractional periods can be dealt

with simply; the accrued interest is more difficult. For example,

Financial Economics 41
imagine a bond that has four years and eight months left to
maturity. The exponent in the yield calculations can be turned into
a decimal to adjust for the partial year. However, this means that
four months in the current coupon period have elapsed and there
are two more to go, which requires an adjustment for accrued
interest. A new bond buyer will be paid the full coupon, so the
bond's price will be inflated slightly to compensate the seller for the
four months in the current coupon period that have elapsed.

Bonds can be quoted with a "clean price" that excludes the accrued
interest or the "dirty price" that includes the amount owed to
reconcile the accrued interest. When bonds are quoted in a system
like a Bloomberg or Reuters terminal, the clean price is used.

What does a bond's yield tell investors?

A bond's yield is the return to an investor from the bond's coupon
(interest) payments. It can be calculated as a simple coupon yield,
which ignores the time value of money and any changes in the
bond's price or using a more complex method like yield to maturity.
Higher yields mean that bond investors are owed larger interest
payments, but may also be a sign of greater risk. The riskier a
borrower is, the more yield investors demand to hold their debts.
Higher yields are also associated with longer maturity bonds.

Are high-yield bonds better investments than low-yield bonds?

Like any investment, it depends on one's individual circumstances,
goals, and risk tolerance. Low-yield bonds may be better for investors
who want a virtually risk-free asset, or one who is hedging a mixed
portfolio by keeping a portion of it in a low-risk asset. High-yield
bonds may instead be better-suited for investors who are willing to
accept a degree of risk in return for a higher return. The risk is that the
company or government issuing the bond will default

Financial Economics 42
on its debts. Diversification can help lower portfolio risk while
boosting expected returns.
What are some common yield calculations?
The yield to maturity (YTM) is the total return anticipated on a bond if
the bond is held until it matures. Yield to maturity is considered a
long-term bond yield but is expressed as an annual rate. YTM is
usually quoted as a bond equivalent yield (BEY), which makes bonds
with coupon payment periods less than a year easy to compare. The
annual percentage yield (APY) is the real rate of return earned on a
savings deposit or investment taking into account the effect of
compounding interest. The annual percentage rate (APR) includes any
fees or additional costs associated with the transaction, but it does not
take into account the compounding of interest within a specific year.
An investor in a callable bond also wants to estimate the yield to call
(YTC), or the total return that will be received if the bond purchased is
held only until its call dateinstead of full maturity.

How do investors utilize bond yields?

In addition to evaluating the expected cash flows from individual
bonds, yields are used for more sophisticated analyses. Traders may
buy and sell bonds of different maturities to take advantage of the
yield curve, which plots the interest rates of bonds having equal credit
quality but differing maturity dates. The slope of the yield curve gives
an idea of future interest rate changes and economic activity. They
may also look to the difference in interest rates between different
categories of bonds, holding some characteristics constant. A yield
spread is the difference between yields on differing debt instruments of
varying maturities, credit ratings, issuer, or risk level, calculated by
deducting the yield of one instrument from the other -- for example the
spread between AAA corporate bonds and

Financial Economics 43
U.S. Treasuries. This difference is most often expressed in basis
points (bps) or percentage points.

Yield to Maturity (YTM)

Yield to maturity (YTM) is the total return anticipated on a bond if
the bond is held until it matures. Yield to maturity is considered a
long-term bond yield but is expressed as an annual rate. In other
words, it is the internal rate of return (IRR) of an investment in a
bond if the investor holds the bond until maturity, with all
payments made as scheduled and reinvested at the same rate.

Yield to maturity is also referred to as "book yield" or

"redemption yield."

Yield to maturity (YTM) is the total rate of return that will have
been earned by a bond when it makes all interest payments and
repays the original principal.

YTM is essentially a bond's internal rate of return (IRR) if held

to maturity.
Calculating the yield to maturity can be a complicated process,
and it assumes all coupon or interest, payments can be reinvested
at the same rate of return as the bond.

1:56
Bond Yields: Current Yield And YTM

Understanding Yield to Maturity (YTM)

Yield to maturity is similar to current yield, which divides annual

cash inflows from a bond by the market price of that bond to
determine how much money one would make by buying a bond and
holding it for one year. Yet, unlike current yield, YTM accounts for

Financial Economics 44
the present value of a bond's future coupon payments. In other
words, it factors in the time value of money, whereas a simple
current yield calculation does not. As such, it is often considered
a more thorough means of calculating the return from a bond.

The YTM of a discount bond that does not pay a coupon is a

good starting place in order to understand some of the more
complex issues with coupon bonds.

Calculating YTM
The formula to calculate YTM of a discount bond is as follows:

= −1

Where:
n = Number of years to maturity

Face value = bond‘s maturity value or par value

Current price = the bond‘s price today

Because YTM is the interest rate an investor would earn by

reinvesting every coupon payment from the bond at a constant
interest rate until the bond's maturity date, the present value of
all the future cash flows equals the bond's market price. An
investor knows the current bond price, its coupon payments, and
its maturity value, but the discount rate cannot be calculated
directly. However, there is a trial-and-error method for finding
YTM with the following present value formula:

Financial Economics 45
 = ×( ) +( ×

( )

Each one of the future cash flows of the bond is known and because
the bond's current price is also known, a trial-and-error process can
be applied to the YTM variable in the equation until the present
value of the stream of payments equals the bond's price.

Solving the equation by hand requires an understanding of the

relationship between a bond's price and its yield, as well as the
different types of bond pricings. Bonds can be priced at a discount,
at par, or at a premium. When the bond is priced at par, the bond's
interest rate is equal to its coupon rate. A bond priced above par,
called a premium bond, has a coupon rate higher than the realized
interest rate, and a bond priced below par, called a discount bond,
has a coupon rate lower than the realized interest rate.

If an investor were calculating YTM on a bond priced below par,

they would solve the equation by plugging in various annual
interest rates that were higher than the coupon rate until finding
a bond price close to the price of the bond in question.
Calculations of yield to maturity (YTM) assume that all coupon
payments are reinvested at the same rate as the bond's current yield
and take into account the bond's current market price, par value,
coupon interest rate, and term to maturity. The YTM is merely a
snapshot of the return on a bond because coupon payments cannot
always be reinvested at the same interest rate. As interest rates rise, the
YTM will increase; as interest rates fall, the YTM will decrease.

The complex process of determining yield to maturity means it is

often difficult to calculate a precise YTM value. Instead, one can

Financial Economics 46
approximate YTM by using a bond yield table, financial
calculator, or online yield to maturity calculator.

 Uses of Yield to Maturity (YTM)

Yield to maturity can be quite useful for estimating whether buying
a bond is a good investment. An investor will determine a required
yield (the return on a bond that will make the bond worthwhile).
Once an investor has determined the YTM of a bond they are
considering buying, the investor can compare the YTM with the
required yield to determine if the bond is a good buy.

Because YTM is expressed as an annual rate regardless of the

bond's term to maturity, it can be used to compare bonds that
have different maturities and coupons since YTM expresses the
value of different bonds in the same annual terms.

 Variations of Yield to Maturity (YTM)

Yield to maturity has a few common variations that account for

bonds that have embedded options:

Yield to call (YTC) assumes that the bond will be called. That is,
a bond is repurchased by the issuer before it reaches maturity
and thus has a shorter cash flow period. YTC is calculated with
the assumption that the bond will be called at soon as it is
possible and financially feasible.

Yield to put (YTP) is similar to YTC, except the holder of a put

bond can choose to sell the bond back to the issuer at a fixed
price based on the terms of the bond. YTP is calculated based on
the assumption that the bond will be put back to the issuer as
soon as it is possible and financially feasible.

Financial Economics 47
Yield to worst (YTW) is a calculation used when a bond has
multiple options. For example, if an investor was evaluating a
bond with both calls and put provisions, they would calculate the
YTW based on the option terms that give the lowest yield.

Limitations of Yield to Maturity (YTM)

YTM calculations usually do not account for taxes that an
investor pays on the bond.1 In this case, YTM is known as the
gross redemption yield. YTM calculations also do not account
for purchasing or selling costs.

YTM also makes assumptions about the future that cannot be

known in advance. An investor may not be able to reinvest all
coupons, the bond may not be held to maturity, and the bond
issuer may default on the bond.

 Yield to Maturity (YTM)

A bond's yield to maturity (YTM) is the internal rate of return
required for the present value of all the future cash flows of the
bond (face value and coupon payments) to equal the current bond
price. YTM assumes that all coupon payments are reinvested at a
yield equal to the YTM and that the bond is held to maturity.

Some of the more known bond investments include municipal,

treasury, corporate, and foreign. While municipal, treasury, and
foreign bonds are typically acquired through local, state, or
federal governments, corporate bonds are purchased through
brokerages.2 If you have an interest in corporate bonds then you
will need a brokerage account.

Financial Economics 48
  What Is a Bond‘s Yield to Maturity (YTM)?
The YTM of a bond is essentially the internal rate of return (IRR)
associated with buying that bond and holding it until its maturity
date. In other words, it is the return on investment associated with
buying the bond and reinvesting its coupon payments at a constant
interest rate. All else being equal, the YTM of a bond will be higher
if the price paid for the bond is lower, and vice-versa.

 What Is the Difference Between a Bond‘s YTM and Its

Coupon Rate?
The main difference between the YTM of a bond and its coupon rate is
that the coupon rate is fixed whereas the YTM fluctuates over time.
The coupon rate is contractually fixed, whereas the YTM changes
based on the price paid for the bond as well as the interest rates
available elsewhere in the marketplace. If the YTM is higher than the
coupon rate, this suggests that the bond is being sold at a discount to
its par value. If, on the other hand, the YTM is lower than the coupon
rate, then the bond is being sold at a premium.

 Is It Better to Have a Higher YTM?

Whether or not a higher YTM is positive depends on the specific

circumstances. On the one hand, a higher YTM might indicate
that a bargain opportunity is available since the bond in question
is available for less than its par value. But the key question is
whether or not this discount is justified by fundamentals such as
the creditworthiness of the company issuing the bond, or the
interest rates presented by alternative investments. As is often
the case in investing, further due diligence would be required.

Financial Economics 49
2.3. Equity Valuation
Equity valuation is a blanket term and is used to refer to all tools
and techniques used by investors to find out the true value of a
company‘s equity. It is often seen as the most crucial element of a
successful investment decision. Investment Banks typically have a
equity research department, where research analysts produce equity
research reports of select securities in various industries.

Every participant in the stock market either implicitly or explicitly

makes use of equity valuation while making investment decisions.
Everyone from small individual investors to large institutional
investors use equity valuations to make investment decisions in
equity markets. The total size of the global equity market is
estimated to be around $70 trillion and every participant in the
stock market, from professional fund managers to academic
researchers, is trying to find mispriced stocks.

Inputs in the Equity Valuation Process

The true value of any financial asset is thought to be a good
indicator of how that asset will do in the long run. In equity
markets, a financial asset with a relatively high intrinsic value is
expected to command a high price, and a financial asset with a
relatively low intrinsic value is expected to command a low price.

Distortions can take place in the short run, i.e., financial assets with
relatively low intrinsic value might command a high price and vice-
a-versa, but such distortions are expected to disappear over time. In
the long run, the true value of a stock (and thereby the market price
of that stock) depends only on the fundamental factors affecting the
stock. The factors can be broadly classified into four categories.

Financial Economics 50
  Macroeconomic variables

 Management of the business

 Financial health of the business

 Profits of the business

2.4. Dividend Discount Model

The Dividend Discount Model (DDM) is a quantitative method
of valuing a company‘s stock price based on the assumption that
the current fair price of a stock equals the sum of all of the
company‘s future dividends discounted back to their present
value.

The dividend discount model was developed under the

assumption that the intrinsic value of a stock reflects the present
value of all future cash flows generated by a security. At the
same time, dividends are essentially the positive cash flows
generated by a company and distributed to the shareholders.

Generally, the dividend discount model provides an easy way to

calculate a fair stock price from a mathematical perspective with
minimum input variables required. However, the model relies on
several assumptions that cannot be easily forecasted.

Depending on the variation of the dividend discount model, an

analyst requires forecasting future dividend payments, the growth
of dividend payments, and the cost of equity capital. Forecasting all
the variables precisely is almost impossible. Thus, in many cases,
the theoretical fair stock price is far from reality.

Financial Economics 51
Formula for the Dividend Discount Model
The dividend discount model can take several variations
depending on the stated assumptions. The variations include the
following:

1. Gordon Growth Model

The Gordon Growth Model (GGM) is one of the most
commonly used variations of the dividend discount model. The
model is called after American economist Myron J. Gordon, who
proposed the variation. The GGM assists an investor in
evaluating a stock‘s intrinsic value based on the potential
dividend‘s constant rate of growth.

The GGM is based on the assumption that the stream of future

dividends will grow at some constant rate in the future for an
infinite time. The model is helpful in assessing the value of stable
businesses with strong cash flow and steady levels of dividend
growth. It generally assumes that the company being evaluated
possesses a constant and stable business model and that the growth
of the company occurs at a constant rate over time.

Mathematically, the model is expressed in the following way:

= −

Where:
V0 – The current fair value of a stock
D1 – The dividend payment in one period from now

r – The estimated cost of equity capital (usually calculated using

CAPM)
Financial Economics 52
g – The constant growth rate of the company‘s dividends for an
infinite time

2. One-Period Dividend Discount Model

The one-period discount dividend model is used much less
frequently than the Gordon Growth model. The former is applied
when an investor wants to determine the intrinsic price of a stock
that he or she will sell in one period (usually one year) from now.

The one-period DDM generally assumes that an investor is

prepared to hold the stock for only one year. Because of the
short holding period, the cash flows expected to be generated by
the stock are the single dividend payment and the selling price
of the respective stock.

Hence, to determine the fair price of the stock, the sum of the
future dividend payment and that of the estimated selling price,
must be computed and discounted back to their present values.

The one-period dividend discount model uses the following

equation:
=1+ +1+

Where:
V0 – The current fair value of a stock
D1 – The dividend payment in one period from now
P1 – The stock price in one period from now

r – The estimated cost of equity capital

Financial Economics 53
3. Multi-Period Dividend Discount Model
The multi-period dividend discount model is an extension of the
one-period dividend discount model wherein an investor expects
to hold a stock for multiple periods. The main challenge of the
multi-period model variation is that forecasting dividend
payments for different periods is required.

In the multiple-period DDM, an investor expects to hold the

stock he or she purchased for multiple time periods. Therefore,
the expected future cash flows will consist of numerous
dividend payments, and the estimated selling price of the stock
at the end of the holding period.

The intrinsic value of a stock (via the Multiple-Period DDM) is

found by estimating the sum value of the expected dividend
payments and the selling price, discounted to find their present
values.
The model‘s mathematical formula is below:

= (1+ ) +(1+ ) +⋯+(1+ ) +(1+ ) Shortcomings of Dividend Discount Model

A shortcoming of the DDM is that the model follows a perpetual

constant dividend growth rate assumption. This assumption is
not ideal for companies with fluctuating dividend growth rates
or irregular dividend payments, as it increases the chances of
imprecision.

Another drawback is the sensitivity of the outputs to the inputs.

Furthermore, the model is not fit for companies with rates of
return that are lower than the dividend growth rate.

Financial Economics 54
2.5. The P/E Ratio Approach
The Price Earnings Ratio (P/E Ratio) is the relationship between
a company‘s stock price and earnings per share (EPS). EPS is a
financial ratio, which divides net earnings available to common
shareholders by the average outstanding shares over a certain
period of time. The EPS formula indicates a company‘s ability to
produce net profits for common shareholders. This guide breaks
down the Earnings per Share formula in detail. It is a popular
ratio that gives investors a better sense of the value of the
company. The P/E ratio shows the expectations of the market
and is the price you must pay per unit of current earnings (or
future earnings, as the case may be).

Earnings are important when valuing a company‘s stock because

investors want to know how profitable a company is and how
profitable it will be in the future. Furthermore, if the company
doesn‘t grow and the current level of earnings remains constant,
the P/E can be interpreted as the number of years it will take for
the company to pay back the amount paid for each share.

The P/E ratio is standardizes stocks of different prices and

earnings levels. The P/E is also called an earnings multiple.
There are two types of P/E: trailing and forward. The former is
based on previous periods of earnings per share, while a leading
or forward P/E ratio is when EPS calculations are based on
future estimates, which predicted numbers (often provided by
management or equity research analysts).

Price Earnings Ratio Formula

P/E = Stock Price Per Share / Earnings Per Share or
P/E = Market Capitalization / Total Net Earnings or

Financial Economics 55
Justified P/E = Dividend Payout Ratio / R – G
where;
R = Required Rate of Return
G = Sustainable Growth Rate

The basic P/E formula takes the current stock price and EPS to
find the current P/E. EPS is found by taking earnings from the
last twelve months divided by the weighted average shares
outstanding. Earnings can be normalized for unusual or one-off
items that can impact earnings abnormally. Learn more about
normalized EPS.

The justified P/E ratio is used to find the P/E ratio that an
investor should be paying for, based on the companies dividend
and retention policy, growth rate, and the investor‘s required
rate of return. Comparing justified P/E to basic P/E is a common
stock valuation method.

Investors want to buy financially sound companies that offer a

good return on investment (ROI). Among the many ratios, the P/E
is part of the research process for selecting stocks because we can
figure out whether we are paying a fair price. Similar companies
within the same industry are grouped together for comparison,
regardless of the varying stock prices. Moreover, it‘s quick and
easy to use when we‘re trying to value a company using earnings.
When a high or a low P/E is found, we can quickly assess what
kind of stock or company we are dealing with.

2.6. Modigliani – Miller Theorem

The M&M Theorem, or the Modigliani-Miller Theorem, is one of
the most important theorems in corporate finance. The theorem

Financial Economics 56
was developed by economists Franco Modigliani and Merton
Miller in 1958. This theorem also known as ‗Capital Structure
Irrelevance Theorem‘. The main idea of the M&M theory is that
the capital structure of a company does not affect its overall value.

The first version of the M&M theory was full of limitations as it

was developed under the assumption of perfectly efficient
markets, in which the companies do not pay taxes, while there
are no bankruptcy costs or asymmetric information.
Subsequently, Miller and Modigliani developed the second
version of their theory by including taxes, bankruptcy costs, and
asymmetric information.

The M&M Theorem in Perfectly Efficient Markets

This is the first version of the M&M Theorem with the
assumption of perfectly efficient markets. The assumption
implies that companies operating in the world of perfectly
efficient markets do not pay any taxes, the trading of securities is
executed without any transaction costs, bankruptcy is possible
but there are no bankruptcy costs, and information is perfectly
symmetrical.
Proposition 1 (M&M I): =
Where:
VU = Value of the unlevered firm (financing only through equity)

VL = Value of the levered firm (financing through a mix of debt

and equity)

The first proposition essentially claims that the company‘s capital

structure does not impact its value. Since the value of a company is
calculated as the present value of future cash flows, the capital

Financial Economics 57
structure cannot affect it. Also, in perfectly efficient markets,
companies do not pay any taxes. Therefore, the company with a
100% leveraged capital structure does not obtain any benefits
from tax-deductible interest payments.

Proposition 2 (M&M I):

= +(−)

Where:
rE = Cost of levered equity
ra = Cost of unlevered equity
rD = Cost of debt
D/E = Debt-to-equity ratio
The second proposition of the M&M Theorem states that the
company‘s cost of equity is directly proportional to the
company‘s leverage level. (Cost of Equity is the rate of return a
company pays out to equity investors. A firm uses cost of equity
to assess the relative attractiveness of investments, including
both internal projects and external acquisition opportunities.
Companies typically use a combination of equity and debt
financing, with equity capital being more expensive.) An
increase in leverage level induces higher default probability to a
company. Therefore, investors tend to demand a higher cost of
equity (return) to be compensated for the additional risk.
M&M Theorem in the Real World
Conversely, the second version of the M&M Theorem was
developed to better suit real-world conditions. The assumptions
of the newer version imply that companies pay taxes; there are
transaction, bankruptcy, and agency costs; and information is
not symmetrical.
Financial Economics 58
 The first proposition states that tax shields that result from the
tax-deductible interest payments make the value of a levered
company higher than the value of an unlevered company. The
main rationale behind the theorem is that tax-deductible interest
payments positively affect a company‘s cash flows. Since a
company‘s value is determined as the present value of the future
cash flows, the value of a levered company increases.
Proposition 2 (M&M II):
= + ×(1− )×( − )

The second proposition for the real-world condition states that

the cost of equity has a directly proportional relationship with
the leverage level.
Nonetheless, the presence of tax shields affects the relationship
by making the cost of equity less sensitive to the leverage level.
Although the extra debt still increases the chance of a
company‘s default, investors are less prone to negatively
reacting to the company taking additional leverage, as it creates
the tax shields that boost its value.

Financial Economics 59
 Module III
Risk and Return
Certainty is a situation where in the value the variable can take is
known with a probability of unity. In a situation of uncertainty, the
objective probability distribution of values is not known, but the
experts can have a feel about the range of values a variable can take
along with the chances of their occurrence. These subjective
feelings can be translated into subjective probabilities and can be
used when objective probabilities are not available.

Risk is a situation where in the objective probability distribution of

the values a variable can take is known, even though the exact
values it would take are not known. The objective probability is
one which is supported by rigorous theory, past experience and the
laws of chance. Strictly speaking, while the risk is measurable,
uncertainty is not. Since a situation of uncertainty can be reduced
to a situation of risk by using subjective probabilities, the two
terms, risk and uncertainty, are generally used interchangeably. In a
practically useful way, the risk can be defined as the chance that
the expected or prospective advantage, gain, profit or return may
not materialise and that the actual outcome of investment may be
less than the expected outcome.

3.1. Types of Risk

Systematic versus Unsystematic Risk
The different types of risks are broadly classified as systematic and
unsystematic risks. The variability in a security's total return that is
directly associated with the overall movements in the general
market or economy is called systematic risk. This type of

Financial Economics 60
risk is inescapable no matter how well the portfolio is
diversified. It is caused by a wide range of factors exogenous to
securities themselves, viz., recession, war and structural changes
in the economy. The other names for systematic risk are market
risk or non-diversifiable risk: it would be more appropriate to
call it a 'systemic' risk. The systematic risk arises due to the
fluctuations of the macroeconomic fundamentals such as interest
rate, inflation and so on.

The variability in a security's total return that is not related to the

overall market variability is called unsystematic risk. An
investor can build a diversified portfolio and reduce or eliminate
this type of risk. Therefore, it has also been defined as that risk
which can be reduced or eliminated through diversification of
security holdings. The other names for unsystematic risk are
'non-market risk' or 'diversifiable risk'; it would be more
appropriate to call it a 'non-systemic' risk. The unsystematic risk
can also be called as idiosyncratic risk, which is specific to the
company or any individual.

Market Risk (Beta)

The capital market and portfolio theories have developed a
'critically important concept of beta (β) measure of relative risk
of a security or its sensitivity to the movements in the market.
Beta indicate extent to which the risk of a given asset is non-
diversifiable; it is a coefficient measuring a security's relative
volatility, Statistically, beta is the covariance of a security's
return with that of the market for a security Alternatively, it is
the slope of the regression line relating a security return with the
market return. The security with a higher (than 1) beta is more
volatile than the market, and the asset with a lower (than 1) beta
would rise or fall more slowly than the market.

Financial Economics 61
Figure.3.1 Concept of Beta

Figure 3.1 portrays the concept of beta. Line β (45 degree line)
represents β= 1 which means that for every one percentage
change in the market return, on an average, the security return
also will change by 1 percent, that is, both the returns will be
volatile to the same extent. Line A means that the security return
is more volatile than the market return, while, line C means that
the former is less volatile than the latter.

Interest Rate Risk

Interest rate risk is the variability in return on security due to
changes in the level of market interest rates, or it is the loss of
principal of a fixed-return security due to an increase in the
general level of interest rates. When interest rates rise, the value
or market price of the security drops, and vice versa. The degree
of interest rate risk is directly related to the length of time to
maturity of the security, if the term to maturity is long. market
value of the security may fluctuate widely.

Financial Economics 62
Interest rate risk has two parts; first, the price risk resulting from
the inverse relationship between the security price and interest
rates, and second, the reinvestment risk resulting from the
uncertainty about the interest rate at which the future coupon
income or principal can be reinvested. These two parts of
interest rate risk move in opposite directions. If interest rates
increase, the price risk increases (because the security price
declines) but the reinvestment risk declines (because the
reinvestment rate increases). Interest rate risk exists in case of
all types of securities including common stock, although it
affects bonds more directly than equities.

Inflation Risk
Inflation risk is the risk that the real return on a security may be
less than the nominal return. In case of fixed income securities,
since payments in terms of rupees are fixed, the value of the
payments in real terms declines as the level of commodity prices
increases. Inflation risk is also known as purchasing power risk
as there is always a chance or possibility that the purchasing
power of invested money will decline, or that the real (inflation-
adjusted) return will decline due to inflation. It may be noted
that inflation risk is really the risk of unanticipated or uncertain
inflation. If anticipated, inflation can be compensated. Similarly,
inflation risk, like default risk, is more relevant in case of fixed
income securities; common stocks are regarded as hedges
against inflation. Inflation risk is closely related to interest rate
risk since interest rates generally rise when inflation occurs.

Exchange Rate or Currency Risk

Exchange rate risk refers to cash-flow variability experienced by
economic units engaged in international transactions or
international exchange, on account of uncertain or unexpected

Financial Economics 63
changes in exchange rates. It is the risk that changes in currency
exchange rates may have an unfavourable impact on costs or
revenues of, say, business units. There is no exchange rate risk
under the fixed exchange rate system, while it is the highest
under the freely floating exchange rate system.

Business Risk
Business risk is the uncertainty of income flows that is caused by
the nature of a firm's business, that is, by doing business in a
particular environment. This risk has two components: internal
and external. The former results from the operating conditions or
operating efficiency of the firm, and it is manageable within or
by the firm. The latter is the result of operating conditions which
the firm faces but which are beyond its control. Business risk is
measured by the distribution of the firm's operating income (i.e.
firm's earnings before interest and tax) over time.

Financial Risk
Financial risk is associated with the use of debt financing by
firms or companies. Since the presence of debt involves the
legal or mandatory obligation make specified payments at
specified time periods, there is a risk that the earnings of the
firm may not be sufficient to meet these obligations towards the
creditors. In case of shareholders, the financial risk arises
because of not only the mandatory nature of debt obligations but
also the property of prior payments of these obligations. In short,
the use of debt by the firm causes variability of return for both
creditors and shareholders. Financial risk is usually measured by
the debt equity ratio of the firm; the higher this ratio, the greater
the variability of return and higher the financial risk

Financial Economics 64
Default Risk
Default risk arises from the failure on the part of the borrower or
debtor to pay the specified amount of interest and/or to repay the
principal, both at the time specified in the debt contractor
covenant or indenture. It may be noted that the default risk has
the capital risk and income risk as its components, and that it
means not only the complete failure to pay but also the delay in
payment.

Liquidity Risk
Liquidity risk refers to a situation wherein it may not be possible
to dispose off or sell the asset, or it may be possible to do so
only at great inconvenience and cost in terms of money and
time. An asset that can be bought and sold quickly, and without
significant price concession and transaction cost is said to be
liquid. The greater the uncertainty about time element, price
concession and transaction cost, the greater the liquidity risk.
Liquidity risk refers to their inability to meet the liabilities
towards depositors when they want to withdraw their deposits.

Maturity Risk
Maturity risk arises when the term of maturity of the security
happens to be longer. Since foreseeing, forecasting and
envisioning the environment, conditions and situations become
more and more difficult as we stretch more and more into the
future, the long-term investment involves risk. The longer the
term to maturity, the greater is the risk.

Call Risk
Call risk is associated with the corporate bonds which are issued
with call-back provision or option whereby the issuer has the right

Financial Economics 65
of redeeming the bonds before their maturity. In case of such
bonds, the band holders face the risk of giving up higher coupon
bonds, reinvesting proceeds only at lower interest rates, and
incurring the cost and inconvenience of reinvestment.

Total Risk
Total risk is the total variability in the return on the asset or the
portfolio, whatever the source(s) of that variability. It is the
uncertainty or volatility in return due to both security-specific
and economy-wide factors. We can say that total risk is the
summation of the systematic and unsystematic risk.

Country Risk
The uncertainty or variability of return in respect of an
investment in a foreign country is known as country risk. It is a
complicated concept and it has many elements or sources. The
political risk is one of its major elements, and the common
denominator of political risk is the government intervention in
the working of the economy that affects the value of the firm or
investment. Economic stability is its another important element.

3.2. Historical returns and Risk

Historical (Ex-Post) Returns
Historical returns are often associated with the past performance
of a security or index, such as the S&P 500. Investors study
historical return data when trying to forecast future returns or to
estimate how a security might react in a situation. Calculating
the historical return is done by subtracting the most recent price
from the oldest price and divide the result by the oldest price.

Financial Economics 66
The return is the total gain or loss experienced on an investment
over a given period of time. It is commonly measured as cash
distributions during the period plus the change in value,
expressed as a percentage of the beginning-of-period investment
value. For stocks, the return for a particular time period is equal
to the sum of the price change plus dividends received, divided
by the price at the beginning of the time period. Assuming there
are many stocks, we can have the general measure of returns for
the ith stock, for the time period t-1 to t:
= − , +
,

Suppose we are concerned only with the ith stock and are
interested in obtaining a measure of historical performance of
his stock, that is a measure of average returns on this stock over
the time period t = 1, 2, …, T. We get is straightforward
arithmetic mean:
=( + + +⋯

This can be written more compactly as:

=1

Of course, other than finding out the average returns over time for a
single stock, we can as well obtain the average returns for several
stock for a single time period. The method is the same, except that
we aggregate over the number of shares rather than number of time
periods. Let there be n shares: i = 1,2,3,…,n. Then

Financial Economics 67
Historical (Ex-Post) Risk
In investment analysis, basically risk is associated with
variability of rates of return. Variability is usually measured as
individual returns in relation to the average. In statistics, one of
the basic measures of variability is the variance. The positive
square root of the variance is the standard deviation, usually
denoted by the lower-case Greek letter sigma (σ) .The variance
(square of standard deviation) is defined as:
1
=
( − )

−1

Thus the variance can be considered as the average square

deviation from the mean return. To calculate the variance, we first
calculate the mean return. Then the difference between the return
for each period and the mean return is obtained. These deviations
from the mean are squared and added together. This sum is divided
by T – 1 (the total number of time periods minus one).

The standard deviation is the positive square root of the variance:

=+

3.3. Average Annual Returns

The average annual return (AAR) is a percentage used when
reporting the historical return, such as the three-, five-, and 10-year
average returns of an asset. The average annual return is stated net
of a fund's operating expense ratio. Additionally, it does

Financial Economics 68
not include sales charges, if applicable, or portfolio transaction
brokerage commissions. The three components that contribute to
the average annual return of a fund are share price appreciation,
capital gains, and dividends. Average annual return (AAR)
measures the money made or lost by a fund over a given period.
Investors considering any investment will often review the AAR
and compare it with other similar funds as part of their
investment strategy.

Components of an Average Annual Return (AAR)

There are three components that contribute to the average annual

return (AAR) of any financial asset: share price appreciation,
capital gains, and dividends.

 Share Price Appreciation

Share price appreciation results from unrealized gains or losses

in the underlying stocks held in a portfolio. As the share price of
a stock fluctuates over a year, it proportionately contributes to or
detracts from the AAR of the fund that maintains a holding in
the issue.

 Capital Gains Distributions

Capital gains distributions paid from a mutual fund result from

the generation of income or sale of stocks from which a manager
realizes a profit in a growth portfolio. Shareholders can opt to
receive the distributions in cash or reinvest them in the fund.
Capital gains are the realized portion of AAR. The distribution,
which reduces share price by the dollar amount paid out,
represents a taxable gain for shareholders.

Financial Economics 69
  Dividends

A dividend is the distribution of some of a company's earnings

to a class of its shareholders, as determined by the company's
board of directors. Common shareholders of dividend-paying
companies are typically eligible as long as they own the stock
before the ex-dividend date. Dividends may be paid out as cash
or in the form of additional stock. Dividend income received
from the portfolio can be reinvested or taken in cash.

Risk and Return of a Portfolio

Here we set out the basics of risk and return associated with a
portfolio of assets. This type of analysis was pioneered by Harry
Markowitz. Markowitz observed that investors do not always try to
maximize returns. If they wanted to do so, they would simply hold
only that security which they expected would give the highest
returns. Thus investors are concerned both with return and risk, and
since they hold a portfolio of assets, it showed that diversification
can lower risk without adversely affecting returns.

The return for a portfolio is simply a weighted average of the

returns of the securities in the portfolio. For a single time period
t, the portfolio return is calculated as:
=

Where, Wit is the market value of the ith asset divided by the
market value of the entire portfolio.
The variance of a portfolio is a little complicated because we
also have to consider any two assets of a portfolio together. The
general formula for variance of a portfolio is

Financial Economics 70
Where Covij represents the covariance between any two assets I
and j. We can calculate the correlation coefficient :
=

The correlation coefficient always lies between –1 and +1 and is

a measure of the strength of the linear association between assets
i and j. A value of –1 or +1 shows perfect linear relation (the
former an inverse relation) while a value of 0 shows no
relationship.

Determinants of Beta

The capital market and portfolio theories have developed a

'critically important concept of beta (β) measure of relative risk
of a security or its sensitivity to the movements in the market.
Beta indicate extent to which the risk of a given asset is non-
diversifiable; it is a coefficient measuring a security's relative
volatility, Statistically, beta is the covariance of a security's
return with that of the market for a security Alternatively, it is
the slope of the regression line relating a security return with the
market return. The security with a higher (than 1) beta is more
volatile than the market, and the asset with a lower (than 1) beta
would rise or fall more slowly than the market.

Beta is calculated as the covariance between returns on the asset

and returns on the market portfolio divided by the variance of
returns on the market portfolio. Or, it is typically found by
regressing stock or portfolio return on a proxy for market return.

Financial Economics 71
It measures the volatility of the portfolio related to the stock
market index like the BSE Sensex.

Figure.3.1 Concept of Beta

Figure 3.1 portrays the concept of beta. Line β (45 degree line)
represents β= 1 which means that for every one percentage
change in the market return, on an average, the security return
also will change by 1 percent, that is, both the returns will be
volatile to the same extent. Line A means that the security return
is more volatile than the market return, while, line C means that
the former is less volatile than the latter.

Beta Coefficient or Factor: It is a measure of performance of a

particular share or class of shares in relation to the general
movement of the market in terms of the price of respective
shares. It indicates systematic risk of investment in a share. It is
calculated as the covariance between returns on the asset and
returns on the market portfolio divided by the variance of the
returns

Financial Economics 72
Risk Return Trade off

The objective of maximizing return can be pursued only at the

cost of incurring higher risk. The financial markets offer a wide
range of assets from very safe to very risky with corresponding
low to high returns. While selecting the asset for investment, the
investor has to consider both its return potential and the risk
involved. The empirical evidence shows that generally there is a
high correlation between risk and return over longer periods of
time. The securities are generally priced such that high risk is
rewarded with high return, and low risk is accompanied by
return. This relationship is known as risk-return trade-off.

Figures and portray risk-return trade-off in an ex ante sense. In

Figure 2.2, the line AB (capital market line) depicts the expected
return-risk spectrum; the representative asset classes are arrayed
over risk on it. As we move from government bonds to
international equity, the investor assumes increasing risk in the
hope of earning a higher expected return. AB is upward sloping
and its slope indicates the required return per unit of risk. The
figure shows a positive linear relationship between expected
return and risk. The rational risk-averse investors will not
willingly assume greater risk unless they expect to receive
additional return, or if the investors wish to earn larger return,
they must be willing to assume greater risk.

Financial Economics 73
Trade-off
Figure: Risk Return Trade off

Figure 2.3 shows the same relationship slightly differently; it

relates RRR with beta (risk). It shows that the relationship between
them, represented by the line RFX (security market line) is linear.
The securities with high beta have high RRR. The securities with
betas (risk) greater than the market beta of 1 should have large risk
premium than that of the average stock, and, therefore, when added
to MR, they yield a larger RRR. Conversely, securities with beta
less than that of the market are less risky and have RRR lower than
that for the market as a whole.
Figure: Required Rate of Return and Beta Trade off

Financial Economics 74
 Module IV
Cost of Capital and Capital Asset Pricing Model

4.1. Cost of capital

Cost of capital is a company's calculation of the minimum return
that would be necessary in order to justify undertaking a capital
budgeting project, such as building a new factory. The term cost
of capital is used by analysts and investors, but it is always an
evaluation of whether a projected decision can be justified by its
cost. Investors may also use the term to refer to an evaluation of
an investment's potential return in relation to its cost and its
risks. Many companies use a combination of debt and equity to
finance business expansion. For such companies, the overall cost
of capital is derived from the weighted average cost of all capital
sources. This is known as the weighted average cost of capital
(WACC).

Cost of capital represents the return a company needs to achieve in

order to justify the cost of a capital project, such as purchasing new
equipment or constructing a new building. Cost of capital
encompasses the cost of both equity and debt, weighted according
to the company's preferred or existing capital structure. This is
known as the weighted average cost of capital (WACC).

A company's investment decisions for new projects should

always generate a return that exceeds the firm's cost of the
capital used to finance the project. Otherwise, the project will
not generate a return for investors.

Financial Economics 75
The concept of the cost of capital is key information used to
determine a project's hurdle rate. A company embarking on a
major project must know how much money the project will have
to generate in order to offset the cost of undertaking it and then
continue to generate profits for the company.

Cost of capital, from the perspective of an investor, is an

assessment of the return that can be expected from the acquisition
of stock shares or any other investment. This is an estimate and
might include best- and worst-case scenarios. An investor might
look at the volatility (beta) of a company's financial results to
determine whether a stock's cost is justified by its potential return.

Weighted Average Cost of Capital (WACC)

A firm's cost of capital is typically calculated using the weighted

average cost of capital formula that considers the cost of both
debt and equity capital.

Each category of the firm's capital is weighted proportionately to

arrive at a blended rate, and the formula considers every type of
debt and equity on the company's balance sheet, including
common and preferred stock, bonds, and other forms of debt.

4.2. Cost of Debt

The cost of capital becomes a factor in deciding which financing
track to follow: debt, equity, or a combination of the two.

Early-stage companies rarely have sizable assets to pledge as

collateral for loans, so equity financing becomes the default
mode of funding. Less-established companies with limited
operating histories will pay a higher cost for capital than older
companies with solid track records since lenders and investors
will demand a higher risk premium for the former.

Financial Economics 76
The cost of debt is merely the interest rate paid by the company
on its debt. However, since interest expense is tax-deductible,
the debt is calculated on an after-tax basis as follows:
= ×(1− )

Where:

Interest expense= initial paid on the firm‘s current

debt T = The company‘s marginal tax rate
The cost of debt can also be estimated by adding a credit spread
to the risk-free rate and multiplying the result by (1 - T).

4.3. Cost of equity

The cost of equity is more complicated since the rate of return
demanded by equity investors is not as clearly defined as it is by
lenders. The cost of equity is approximated by the capital asset
pricing model as follows:
( )= +( − )

Where:

Rf = Risk free rate of return

Rm = market rate of return
Beta is used in the CAPM formula to estimate risk, and the formula
would require a public company's own stock beta. For private
companies, a beta is estimated based on the average beta among a
group of similar public companies. Analysts may refine this beta
by calculating it on an after-tax basis. The assumption is

Financial Economics 77
that a private firm's beta will become the same as the industry
average beta. The firm‘s overall cost of capital is based on the
weighted average of these costs.

4.4. Cost Preference Capital

The cost of preference capital is a function of the dividend
expected by investors. Preference capital is never issued with an
intention not to pay dividends. Although it is not legally binding
upon the firm to pay dividends on preference capital, yet it is
generally paid when the fim1 makes sufficient profits. The
failure to pay dividends, although does not cause bankruptcy, yet
it can be a serious matter from the common (ordinary)
shareholders‘ point of view. The nonpayment of dividends on
preference capital may result in voting rights and control to the
preference shareholders. More than this, the firm‘s credit
standing may be damaged. The accumulation of preference
dividend arrears may adversely affect the prospects of ordinary
shareholders for receiving any dividends, because dividends on
preference capital represent a prior claim on profits. As a
consequence, the fim1 may find difficulty in raising funds by
issuing preference or equity shares. Also, the market value of the
equity shares can be adversely affected if dividends are not paid
to the preference shareholders and, therefore, to the equity
shareholders. For these reasons, dividends on preference capital
should be paid regularly except when the firm does not make
profits, or it is in a very tight cash position.

The measurement of the cost of preference capital poses some

conceptual difficulty. In the case of debt, there is a binding legal
obligation on the firm to pay interest, and the interest constitutes
the basis to calculate the cost of debt. However, in the case of
preference capital, payment of dividends is not legally binding on
the firm and even if the dividends are paid, it is not a charge on

Financial Economics 78
earnings; rather it is a distribution or appropriation of earnings to
preference shareholders.

4.5. Capital Market Line (CML)

The Capital Market Line is a graphical representation of all the
portfolios that optimally combine risk and return. CML is a
theoretical concept that gives optimal combinations of a risk-
free asset and the market portfolio. The CML is superior to
Efficient Frontier in the sense that it combines the risky assets
with the risk-free asset.

• The slope of the Capital Market Line(CML) is the sharp

ratio of the market portfolio.

• The efficient frontier represents combinations of risky

assets.

• If we draw a line from the risk-free rate of return, which is

tangential to the efficient frontier, we get the Capital
Market Line. The point of tangency is the most efficient
portfolio.

• Moving up the CML will increase the risk of the portfolio,

and moving down will decrease the risk. Subsequently,
the return expectation will also increase or decrease,
respectively.

All investors will choose the same market portfolio, given a

specific mix of assets and the associated risk with them.

Capital Market Line Formula

The Capital Market Line (CML) formula can be written as
follows:

Financial Economics 79
where,

 ERp= Expected Return of Portfolio


 Rf = Risk – free rate

 SDp= Standard deviation of Portfolio

 ERm = Expected Return of the Market

 SDm = Standard Deviation of Market

Portfolios that fall on the capital market line (CML), in theory,

optimize the risk/return relationship, thereby maximizing
performance. The capital allocation line (CAL) makes up the
allotment of risk-free assets and risky portfolios for an investor.
CML is a special case of the CAL where the risk portfolio is the
market portfolio. Thus, the slope of the CML is the Sharpe ratio

Financial Economics 80
of the market portfolio. As a generalization, buy assets if the
Sharpe ratio is above the CML and sell if the Sharpe ratio is
below the CML.

As an investor moves up the CML, the overall portfolio risk and

returns increase. Risk-averse investors will select portfolios
close to the risk-free asset, preferring low variance to higher
returns. Less risk-averse investors will prefer portfolios higher
up on the CML, with a higher expected return, but more
variance. By borrowing funds at the risk-free rate, they can also
invest more than 100% of their investable funds in the risky
market portfolio, increasing both the expected return and the risk
beyond that offered by the market portfolio.

4.6. Security Market Line (SML)

The security market line (SML) is the graphical representation
of the Capital Asset Pricing Model (CAPM) and gives the
expected return of the market at different levels of systematic or
market risk. It is also called ‗characteristic line‘ where the x-
axis represents beta or the risk of the assets, and the y-axis
represents the expected return.
Also known as the "characteristic line," the SML is a visualization
of the CAPM, where the x-axis of the chart represents risk (in
terms of beta), and the y-axis of the chart represents expected
return. The market risk premium of a given security is determined
by where it is plotted on the chart relative to the SML.

The security market line is an investment evaluation tool derived

from the CAPM—a model that describes risk-return relationship
for securities—and is based on the assumption that investors
need to be compensated for both the time value of money
(TVM) and the corresponding level of risk associated with any
investment, referred to as the risk premium.
Financial Economics 81
The security market line is commonly used by money managers
and investors to evaluate an investment product that they're
thinking of including in a portfolio. The SML is useful in
determining whether the security offers a favorable expected
return compared to its level of risk.

When a security is plotted on the SML chart, if it appears above

the SML, it is considered undervalued because the position on
the chart indicates that the security offers a greater return against
its inherent risk.

Conversely, if the security plots below the SML, it is considered

overvalued in price because the expected return does not
overcome the inherent risk. The SML is frequently used in
comparing two similar securities that offer approximately the
same return, in order to determine which of them involves the
least amount of inherent market risk relative to the expected
return. The SML can also be used to compare securities of equal
risk to see which one offers the highest expected return against
that level of risk.

4.7. Beta of an Asset and of a Portfolio

Beta is a measure of the volatility—or systematic risk—of a
security or portfolio compared to the market as a whole. Beta is
used in the capital asset pricing model (CAPM), which describes
the relationship between systematic risk and expected return for
assets (usually stocks). CAPM is widely used as a method for
pricing risky securities and for generating estimates of the
expected returns of assets, considering both the risk of those
assets and the cost of capital.

A beta coefficient can measure the volatility of an individual

stock compared to the systematic risk of the entire market. In
statistical terms, beta represents the slope of the line through a
Financial Economics 82
regression of data points. In finance, each of these data points
represents an individual stock's returns against those of the
market as a whole.

Beta effectively describes the activity of a security's returns as it

responds to swings in the market. A security's beta is calculated
by dividing the product of the covariance of the security's
returns and the market's returns by the variance of the market's
returns over a specified period.

The calculation for beta is as follows:

( , )
()=
( )

Where:

Re = the return on an individual stock

Rm the return on the overall market

Covariance = how changes in a stock‘s returns are related to

changes in the market‘s returns

Variance = how far the market‘s data points spread out from
their average value

The beta calculation is used to help investors understand

whether a stock moves in the same direction as the rest of the
market. It also provides insights about how volatile–or how
risky–a stock is relative to the rest of the market. For beta to
provide any useful insight, the market that is used as a
benchmark should be related to the stock. For example,
calculating a bond ETF's beta using the S&P 500 as the
benchmark would not provide much helpful insight for an
investor because bonds and stocks are too dissimilar.
Financial Economics 83
Ultimately, an investor is using beta to try to gauge how much
risk a stock is adding to a portfolio. While a stock that deviates
very little from the market doesn‘t add a lot of risk to a portfolio,
it also doesn‘t increase the potential for greater returns.

In order to make sure that a specific stock is being compared to

the right benchmark, it should have a high R-squared value in
relation to the benchmark. R-squared is a statistical measure that
shows the percentage of a security's historical price movements
that can be explained by movements in the benchmark index.
When using beta to determine the degree of systematic risk, a
security with a high R-squared value, in relation to its
benchmark, could indicate a more relevant benchmark.

One way for a stock investor to think about risk is to split it into
two categories. The first category is called systematic risk,
which is the risk of the entire market declining. The financial
crisis in 2008 is an example of a systematic-risk event; no
amount of diversification could have prevented investors from
losing value in their stock portfolios. Systematic risk is also
known as un-diversifiable risk.

Unsystematic risk, also known as diversifiable risk, is the

uncertainty associated with an individual stock or industry. For
example, the surprise announcement that the company Lumber
Liquidators (LL) had been selling hardwood flooring with
dangerous levels of formaldehyde in 2015 is an example of
unsystematic risk.2 It was risk that was specific to that company.
Unsystematic risk can be partially mitigated through
diversification.

Types of Beta Values

 Beta Value Equal to 1.0: If a stock has a beta of 1.0, it

indicates that its price activity is strongly correlated with
Financial Economics 84
 the market. A stock with a beta of 1.0 has systematic
risk. However, the beta calculation can‘t detect any
unsystematic risk. Adding a stock to a portfolio with a
beta of 1.0 doesn‘t add any risk to the portfolio, but it
also doesn‘t increase the likelihood that the portfolio will
provide an excess return.

 Beta Value Less Than One: A beta value that is less than
1.0 means that the security is theoretically less volatile than
the market. Including this stock in a portfolio makes it less
risky than the same portfolio without the stock. For
example, utility stocks often have low betas because they
tend to move more slowly than market averages.

 Beta Value Greater Than One: A beta that is greater
than 1.0 indicates that the security's price is theoretically
more volatile than the market. For example, if a stock's
beta is 1.2, it is assumed to be 20% more volatile than
the market. Technology stocks and small cap stocks tend
to have higher betas than the market benchmark. This
indicates that adding the stock to a portfolio will increase
the portfolio‘s risk, but may also increase its expected
return.

 Negative Beta Value: Some stocks have negative betas. A
beta of -1.0 means that the stock is inversely correlated to
the market benchmark. This stock could be thought of as an
 opposite, mirror image of the benchmark‘s trends.
Put options and inverse ETFs are designed to have
negative betas. There are also a few industry groups, like
gold miners, where a negative beta is also common.

Financial Economics 85
Beta in Theory vs. Beta in Practice
The beta coefficient theory assumes that stock returns are normally
distributed from a statistical perspective. However, financial
markets are prone to large surprises. In reality, returns aren‘t
always normally distributed. Therefore, what a stock's beta might
predict about a stock‘s future movement isn‘t always true.

A stock with a very low beta could have smaller price swings,
yet it could still be in a long-term downtrend. So, adding a
down-trending stock with a low beta decreases risk in a portfolio
only if the investor defines risk strictly in terms of volatility
(rather than as the potential for losses). From a practical
perspective, a low beta stock that's experiencing a downtrend
isn‘t likely to improve a portfolio‘s performance.

Similarly, a high beta stock that is volatile in a mostly upward

direction will increase the risk of a portfolio, but it may add
gains as well. It's recommended that investors using beta to
evaluate a stock also evaluate it from other perspectives—such
as fundamental or technical factors—before assuming it will add
or remove risk from a portfolio.

 Disadvantages of Beta
While beta can offer some useful information when evaluating a
stock, it does have some limitations. Beta is useful in determining a
security's short-term risk, and for analyzing volatility to arrive at
equity costs when using the CAPM. However, since beta is
calculated using historical data points, it becomes less meaningful
for investors looking to predict a stock's future movements.

Beta is also less useful for long-term investments since a stock's

volatility can change significantly from year to year, depending
upon the company's growth stage and other factors.
Financial Economics 86
4.8. Capital Asset Pricing Model (CAPM)
The Capital Asset Pricing Model (CAPM) describes the
relationship between systematic risk and expected return for
assets, particularly stocks. CAPM is widely used throughout
finance for pricing risky securities and generating expected
returns for assets given the risk of those assets and cost of
capital. It shows that the expected return on a security is equal to
the risk-free return plus a risk premium, which is based on the
beta of that security.

The formula for calculating the expected return of an asset given

its risk is as follows:
= + ( − )

Where:

ERi = expected return of investment

Rf = risk free rate
Βi = beta of the investment
(ERm- Rf) = market risk premium

 A risk premium is a rate of return greater than the risk-

free rate. When investing, investors desire a higher risk
premium when taking on more risky investments.

 ―Expected return‖ is a long-term assumption about how
an investment will play out over its entire life.

 The risk-free rate should correspond to the country where
the investment is being made, and the maturity of the bond
should match the time horizon of the investment.

Financial Economics 87
 Professional convention, however, is to typically use the
10-year rate no matter what, because it‘s the most
heavily quoted and most liquid bond.

 The beta (denoted as ―Bi‖ in the CAPM formula) is a

measure of a stock‘s risk (volatility of returns) reflected
by measuring the fluctuation of its price changes relative
to the overall market. In other words, it is the stock‘s
sensitivity to market risk.

 The market risk premium represents the additional return
over and above the risk-free rate, which is required to
compensate investors for investing in a riskier asset class.

Investors expect to be compensated for risk and the time value

of money. The risk-free rate in the CAPM formula accounts for
the time value of money. The other components of the CAPM
formula account for the investor taking on additional risk.

The beta of a potential investment is a measure of how much

risk the investment will add to a portfolio that looks like the
market. If a stock is riskier than the market, it will have a beta
greater than one. If a stock has a beta of less than one, the
formula assumes it will reduce the risk of a portfolio.

A stock‘s beta is then multiplied by the market risk premium,

which is the return expected from the market above the risk-free
rate. The risk-free rate is then added to the product of the stock‘s
beta and the market risk premium. The result should give an
investor the required return or discount rate they can use to find
the value of an asset.

The goal of the CAPM formula is to evaluate whether a stock is

fairly valued when its risk and the time value of money are
compared to its expected return.
Financial Economics 88
  Problems With the CAPM
There are several assumptions behind the CAPM formula that
have been shown not to hold in reality. Modern financial theory
rests on two assumptions: (1) securities markets are very
competitive and efficient (that is, relevant information about the
companies is quickly and universally distributed and absorbed);
(2) these markets are dominated by rational, risk-averse
investors, who seek to maximize satisfaction from returns on
their investments.

Despite these issues, the CAPM formula is still widely used

because it is simple and allows for easy comparisons of
investment alternatives.

Including beta in the formula assumes that risk can be measured

by a stock‘s price volatility. However, price movements in both
directions are not equally risky. The look-back period to
determine a stock‘s volatility is not standard because stock
returns (and risk) are not normally distributed.

The CAPM also assumes that the risk-free rate will remain
constant over the discounting period. An increase in the risk-free
rate also increases the cost of the capital used in the investment
and could make the stock look overvalued. The market portfolio
that is used to find the market risk premium is only a theoretical
value and is not an asset that can be purchased or invested in as
an alternative to the stock. Most of the time, investors will use a
major stock index, like the S&P 500, to substitute for the
market, which is an imperfect comparison.

The most serious critique of the CAPM is the assumption that

future cash flows can be estimated for the discounting process.
If an investor could estimate the future return of a stock with a
high level of accuracy, the CAPM would not be necessary.
Financial Economics 89
  The CAPM and the Efficient Frontier
Using the CAPM to build a portfolio is supposed to help an
investor manage their risk. If an investor were able to use the
CAPM to perfectly optimize a portfolio‘s return relative to risk,
it would exist on a curve called the efficient frontier, as shown
on the following graph.

The graph shows how greater expected returns (y-axis) require

greater expected risk (x-axis). Modern Portfolio Theory suggests
that starting with the risk-free rate, the expected return of a
portfolio increases as the risk increases. Any portfolio that fits
on the Capital Market Line (CML) is better than any possible
portfolio to the right of that line, but at some point, a theoretical
portfolio can be constructed on the CML with the best return for
the amount of risk being taken.

The CML and efficient frontier may be difficult to define, but it

illustrates an important concept for investors: there is a trade-off
between increased return and increased risk. Because it isn‘t
possible to perfectly build a portfolio that fits on the CML, it is

Financial Economics 90
more common for investors to take on too much risk as they
seek additional return.

The CAPM uses the principles of Modern Portfolio Theory to

determine if a security is fairly valued. It relies on assumptions
about investor behaviors, risk and return distributions, and
market fundamentals that don‘t match reality. However, the
underlying concepts of CAPM and the associated efficient
frontier can help investors understand the relationship between
expected risk and reward as they make better decisions about
adding securities to a portfolio.

Financial Economics 91
 Module V
Derivative Markets

5.1. Derivative Markets

The word Derivative is derived from mathematics which refers
to a variable that has been derived from another variable. In
simple sense, Derivative has no independent value of its own; its
value is obtained from the value of an underlying asset. For
example curd is a derivative of milk or similarly, measure of
temperature is derived from the measurement of Fahrenheit. In
financial world, a derivative is a financial product which derives
its value from another asset. For ex. Sensex is a derivative of 30
shares at Bombay Stock Exchange and NIFTY is a derivative of
50 shares at NSE.

Features of Derivatives
1. Derivatives are the part of secondary market and no funds can
be raised through derivatives.

2. The transactions in the Derivative are settled by taking

offsetting position in the same derivatives.

3. No limit on the number of units transacted because there is no

physical asset involved.
4. Derivative market is quite liquid in nature.

5. These are tailor made instruments and its use depends upon
investors requirement.
Financial Economics 92
Two Purposes of Derivatives
 Price Discovery of the underlying asset

Prices in an organized derivative market reflect the perception

of market participants about the future and lead the prices of
underlying to the perceived future level. Price of derivative
coincides with price of underlying at the expiration date. Thus, it
helps in price discovery.

 Tool for Risk management

Derivative instruments helps in transfer risks through hedging

from the hedger to the speculator.

Derivative Types

 Options: Options are financial derivative contracts that

give the buyer the right, but not the obligation, to buy or
sell an underlying asset at a specific price (referred to as
the strike price) during a specific period of time.
American options can be exercised at any time before the
expiry of its option period. On the other hand, European
options can only be exercised on its expiration date.

 A forward contract is a non-standardized contract between
two parties to buy or sell an asset at a specified future time,
at a price agreed upon today. The party agreeing to buy the
underlying asset in the future assumes a long position, and
the party agreeing to sell the asset in the future assumes a
short position. The price agreed upon is called the delivery
price, which is equal to the forward price at the time the
contract is entered into. The forward price of such a
contract is commonly contrasted with the spot price, which
is the price at which the asset changes

Financial Economics 93
 hands on the spot date. The difference between the spot
and the forward price is the forward premium or forward
discount, generally considered in the form of a profit, or
loss, by the purchasing party.

 A futures contract differs from a forward contract in

that the futures contract is a standardized contract written
by a clearing house that operates an exchange where the
contract can be bought and sold. On the other hand, the
forward contract is a non-standardized contract written
by the parties themselves. Forwards also typically have
no interim partial settlements – or ―true-ups‖ – in
margin requirements like futures, such that the parties do
not exchange additional property, securing the party at
gain, and the entire unrealized gain or loss builds up
while the contract is open.

 Swaps are derivatives in which counterparties exchange
cash flows of one party‘s financial instrument for those
of the other party‘s financial instrument. For example, in
the case of a swap involving two bonds, the benefits in
question can be the periodic interest (or coupon)
payments associated with the bonds. Specifically, the two
counterparties agree to exchange one stream of cash
flows against another stream. The swap agreement
defines the dates when the cash flows are to be paid and
the way they are calculated. Usually at the time when the
contract is initiated at least one of these series of cash
flows is determined by a random or uncertain variable
such as an interest rate, foreign exchange rate, equity
price or commodity price.

Financial Economics 94
Participants of Derivatives Market:
1. Hedgers

2. Speculators
3. Arbitrageurs

1. Hedgers
One of the main purposes for which derivative trading has been
initiated is to hedge or provide protection to the parties to a
contract. Hedgers have risk exposure which they offset by a
derivative and seek to protect themselves against price movements
in an asset in which they have interest. For example, an American
buying shares of an Indian company on an Indian exchange would
be exposed to exchange-rate risk while holding that stock. In order
to reduce this risk, the investor could purchase currency futures of
dollars to lock in a specified exchange rate for the future stock sale
and currency conversion back into dollars.

2. Speculators
Speculators are the participants who are ready to take risk in
expectation of return. They take position in the market either
expecting that the prices will go up or expecting that the prices will
go down. They may go long (buy) or short (sell) based on their
expectations. However, they have naked positions and therefore,
they are inviting risk for earning a return. The speculators create
volumes of trading in the derivative market and hedgers &
arbitrageurs get counter party for other traders. The speculators
create volumes of trading in the derivative market and hedgers &
arbitrageurs get counterparty for their trades.

Financial Economics 95
 3. Arbitrageurs
The arbitraging refers to locking in a risk less profit by
simultaneously entering into two transactions in two different
markets separated geographically or timing. The profit
opportunities may occur due to price differences in two different
markets but could not last for long due to arbitraging.
Arbitrageurs may deal in to cash and derivatives market or only
derivatives market for different periods of time earning arbitrage
profits. Their actions shall narrow down the differential in
prices. For example, arbitrageurs may buy in the spot market and
sell in the futures market

5.2. Forward Contracts

Forward Contract is an agreement made today between a buyer
and a seller wherein the seller is under obligation to deliver a
specified asset of specified quality and quantity to the buyer on a
future date and place is specified at a price agreed upon today.
The buyer in return has to pay the seller a pre-negotiated price in
exchange for the delivery. Forwards are not marketable; once a
firm enters into a forward contract there is no convenient way to
trade out of it except that of reversing the trade between the
same parties. For example: Wheat farmer selling his harvest at a
known price at a future date in order to eliminate price risk.

Features of Forward Contract

1. Forward contracts are not standardized form of contracts.

2. They are over the counter transactions.(not traded

recognized exchanges )
3. Every order is separate and is determined with respect to the
contract size, expiration date, asset type and quality. The date

Financial Economics 96
 and price of the contract is unique and decided in advance
by the two trading parties.
4. Futures contracts are bilateral agreements and exposed to
counter party risk.

5. In forward contract, both the parties takes the opposite

position. One party agrees to buy the asset at specified price
at future date; it is said to have taken a long position.
Another party takes opposite i.e short position; agrees to sell
the same asset at the same date on the price agreed upon. A
party without obligation offsetting futures contract is said to
have an open position.

Benefits of Forward contracts

Forward contract can be used to secure or hedge or lock in the
price of purchase of asset on the future commitment date For Ex.
A bread factory may want to buy wheat forward in order to
assist production planning without taking risk of price
fluctuations. Price discovery is another use of forward prices to
predict spot price that will prevail in future. Also, no cost is
involved as margins are involved in forward contracts. It is
entered in to by two parties generally known to each other.

Limitations of Forward contract

1. Forward contract have counter party risk and in case of default
by other party, the aggrieved party may have to suffer a loss.

2. No party can take benefit of favorable price movements as

squaring off is not possible in forward contracts.
3. Forward contracts are illiquid contracts as it is difficult to get
counter party at one‘s terms

Financial Economics 97
Determination of Forward Prices
Forward price is the predetermined delivery price for an
underlying commodity, currency, or financial asset as decided
by the buyer and the seller of the forward contract, to be paid at
a predetermined date in the future. At the inception of a forward
contract, the forward price makes the value of the contract zero,
but changes in the price of the underlying will cause the forward
to take on a positive or negative value.

When the underlying asset in the forward contract does not pay
any dividends, the forward price can be calculated using the
following formula:
= × (×)

Where:
F = the contract‘s forward price
S = the underlying asset‘s current spot price

e = the mathematical irrational constant approximated by 2.7183

r = the risk free rate that applies to the life of the forward contract

t = the delivery date in years

5.3. Futures Contracts

Any contract which is standardized involving two parties having
an agreement to buy or sell an asset with specific quantity and
quality on a price which is agreed today for future delivery.
Standardization of Future contract

Financial Economics 98
1. Underlying asset can be stock, commodity, interest rate,
bonds, Govt securities.
2. Settlement can be cash or physical delivery.

3. The amount and units of the underlying asset per contract is

specified.
4. Delivery month and the grade in deliverable is specified.
5. Last trading date id specified.

Features of Future contract

1. Futures are standardized contracts that are to run in
either the final cash settlement or assets are delivered at
later stage. Certain future contracts such as stocks or
currency, settled in cash on the price differentials. For
example, the futures of Reliance share can be traded on
NSE and future of gold can be traded on MCX.

2. These contracts trading on organized futures exchanges

with a clearing organization that serves as an
intermediary between the parties.

3. Both parties pay margin on Clearing Association and are

generally settled by marked to market every day.

4. Each futures contract has identified a relevant month

which is the month of the contract delivery or
permanently settlement. These contracts are recognised
with their delivery month. For example: .Futures of
Reliance in January can be future of January, futures of
February or futures of March for 1, 2, 3 months
respectively.

Financial Economics 99
 Future contract is different from trading an underlying
stock in the sense that when you buy a stock you pay
full value of the transaction (i.e. the number of shares
multiplied by market price of each share) but in case of
futures, you have to pay margin.

Difference between Forward and Futures

contract
Feature Forward contracts Future contracts

Operational Traded directly Traded on the

mechanism between contracting exchanges
parties (not traded on
the exchanges)

Contract Differ from trade on Contracts are

specifications trade standardised contracts

Counter party Exists. But, Exists. But, assumed

risk sometimes jettisoned by the clearing agency,
to a guarantor which becomes the
counter party to all
trades or
unconditionally
guarantees their
settlement.

Liquidation Low, as contracts are High, as contracts are

profile tailor-made standardised exchange-
contracts catering to traded contracts
the needs of the
parties involved.
Further, they are not

Financial Economics 100

 easily accessible to
other market
participants.

Price Not efficient, as Efficient, as markets

discovery markets are scattered are centralised and all
buyers and sellers
come to a common
platform to discover
the price through a
common order book

Quality of Quality of As futures are traded on

information information may be a nation-wide basis,
and its poor. Speed of every bit of decision-
dissemination information related information
dissemination is gets disseminated very
weak fast

Examples Currency market in Commodities futures,

India index futures and
individual stock futures
in India

Key Differences between Forwards and Futures

A standardised forward contract is a futures contract. The key

differences between forwards and futures are as follows:

 A forward contract is tailor-made contract (the terms are

negotiated between the buyer and seller), whereas a
futures contract is a standardised contract (quantity, date
and delivery conditions are standardised).
Financial Economics 101
  While there is no secondary market for forward contracts,
the futures contracts are traded on organised exchanges.

 Forward contracts usually end with deliveries, where as
futures contracts are typically settled with the differences.

 Usually no collateral is required for a forward contract.
In a futures contract, however, a margin is required.

 Forward contracts are settled on the maturity date,
whereas futures contracts are ‗market to market‘ on a
daily basis. This means that profits and losses on futures
contracts are settled daily.

 In a forward contract, both the parties are exposed to credit
risk, because irrespective of which way the price moves,
one of the parties will have an incentive to default.

5.4. Theories of Future Prices

Futures are derivative products whose value depends largely on
the price of the underlying stocks or indices. However, the
pricing is not that direct. There remains a difference between the
prices of the underlying asset in the cash segment and in the
derivatives segment. This difference can be understood through
three pricing models for futures contracts. These will allow you
to estimate how the price of a stock futures or index futures
contract might behave. These are:

• The Cost of Carry Model

• The Expectation Model
• Capital Asset Pricing Model

Financial Economics 102

 However, that these models merely gives a platform on which
to base our understanding of futures prices. That said, being
aware of these theories gives a feel of what we can expect from
the futures price of a stock or an index.

1. The cost of carry model

The Cost of Carry Model assumes that markets tend to be
perfectly efficient. This means there are no differences in the
cash and futures price. This, thereby, eliminates any opportunity
for arbitrage – the phenomenon where traders take advantage of
price differences in two or more markets. When there is no
opportunity for arbitrage, investors are indifferent to the spot and
futures market prices while they trade in the underlying asset.
This is because their final earnings are eventually the same. The
model also assumes, for simplicity sake, that the contract is held
till maturity, so that a fair price can be arrived at. In short, the
price of a futures contract (FC) will be equal to the spot price
(SP) plus the net cost incurred in carrying the asset till the
maturity date of the futures contract.
= +( − )

Here Carry Cost refers to the cost of holding the asset till the
futures contract matures. This could include storage cost, interest
paid to acquire and hold the asset, financing costs, etc. Carry
Return refers to any income derived from the asset while holding it
like dividends, bonuses, etc. While calculating the futures price of
an index, the Carry Return refers to the average returns given by
the index during the holding period in the cash market. A net of
these two is called the Net Cost of Carry. The bottom line of this
pricing model is that keeping a position open in the cash market can
have benefits or costs. The price of a futures contract

Financial Economics 103

basically reflects these costs or benefits to charge or reward you
accordingly.

2. Expectancy model of futures pricing

The Expectancy Model of futures pricing states that the futures

price of an asset is basically what the spot price of the asset is
expected to be in the future. This means, if the overall market
sentiment leans towards a higher price for an asset in the future,
the futures price of the asset will be positive. In the exact same
way, a rise in bearish sentiments in the market would lead to a
fall in the futures price of the asset. Unlike the Cost of Carry
model, this model believes that there is no relationship between
the present spot price of the asset and its futures price. What
matters is only what the future spot price of the asset is expected
to be. This is also why many stock market participants look to
the trends in futures prices to anticipate the price fluctuation in
the cash segment.

3. Capital Asset Pricing Model (CAPM)

The capital asset pricing model, or CAPM, is a special model

that's used in finance to calculate the relationship between
expected dividends as well as the risk of investing in specific
equity. The CAPM model is used to determine the expected
returns for a security. This can be compared with the risk-free
returns and the addition of a beta.

To properly assess the capital asset pricing model, it is necessary to

understand both systematic and unsystematic risk. Systematic risks
are all general dangers that are involved in the investment of any
type. There are many risks that could occur, such as inflation, wars,
and recessions. These are just a few examples of systematic risk.
On the other hand, unsystematic risks refer to specific risks
associated with investing in particular stocks or equity.
Financial Economics 104
Unsystematic risks, on the other hand, are not considered to be
threats and are generally shared by the market. CAPM focuses
on systematic risks in securities and can thus predict whether
certain investments will fail.

The CAPM formula is provided by –

= +(−)

These are the different elements of this equation: -

1) Ra = Expected dividend of investment

2) Rf = Risk-free rate
3) Beta = The transaction's underlying transaction
4) (Rm-Rf) = Current Market Risk Premium

The entire formula takes into account the potential returns that an
investor could receive due to their risk-taking abilities and longer
investment time. In conjunction with current market conditions, the
beta factor is considered a risk. If the investment risk is greater than
the current conditions, then the beta value will be lower than
1. A beta value in this equation will always equal 1. Finally, if
the risk is greater than the market norm, the formula's 'Be' value
will be higher than 1.

5.5 Relation between Spot Price and Future Price

The main differences between commodity spot prices and
futures prices are the delivery dates. Spot prices and futures
prices is that spot prices are for immediate buying and selling,
while futures contracts delay payment and delivery to
predetermined future dates.

Financial Economics 105

The spot price of a commodity is the current cash cost of it for
immediate purchase and delivery. The futures price locks in the
cost of the commodity that will be delivered at some point other
than the present—usually, some months hence.

The difference between the spot price and futures price in the
market is called the basis.

Futures prices and spot prices are different numbers because the
market is always forward-looking.

The spot price is usually below the futures price. The situation is
known as contango. On the other hand, there is backwardation,
which is a situation when the spot price exceeds the futures
price. In either situation, the futures price is expected to
eventually converge with the current market price.

5.6. Hedging in Futures

Hedging is buying or selling futures contract as protection

against the risk of loss due to changing prices in the cash
market. A short hedge is used when you plan on selling your
product at a future date and want to protect yourself against
falling prices. A long hedge is used when you plan on buying a
commodity such as soybean meal and want to protect against
prices increasing. The relationship of local cash price and the
futures price is called basis. Basis is calculated by subtracting
the price of the appropriate futures contract from the local cash
market price. For a short hedge, the more positive (stronger) the
basis, the higher the price received for commodity. For a long
hedge, the more negative (weaker) the basis, the lower the price
paid for commodity. It is very important to note that hedging
does not necessarily improve the financial outcome, it just
reduces the uncertainty.

Financial Economics 106

5.7. Options

Options are agreements between two parties to buy or sell a

security at a certain price. They are most often used to trade
stock options, but may be used for other investments as well. If
an investor purchases the right to buy an asset at a specific price
within a given time frame, he has purchased a call option. On
the contrary, if he purchases the right to sell an asset at a given
price, he has purchased a put option. The seller has the
corresponding obligation to fulfill the transaction that is to sell
or buy if the buyer (owner) exercises the option. The buyer pays
a premium to the seller for this right. An option that conveys to
the owner the right to buy something at a certain price is a "call
option"; an option that conveys the right of the owner to sell
something at a certain price is a "put option". Both are
commonly traded, but for transparency, the call option is more
frequently discussed. Options valuation is a topic of ongoing
research in academic and practical finance. Fundamentally, the
value of an option is commonly decomposed into two parts. The
first part is the "intrinsic value", described as the difference
between the market value of the underlying and the strike price
of the given option. The second part is the "time value", which
depends on a set of other factors which, through a multivariable,
non-linear interrelationship, reflect the discounted expected
value of that difference at expiration.

Although options valuation has been done since the 19th century,
the modern approach is based on the Black–Scholes model, which
was first published in 1973. Options contracts were used for many
centuries, however both trading activity and academic interest
increased when, as from 1973, options were issued with
standardized terms and traded through a guaranteed clearing house
at the Chicago Board Options Exchange. Today many options are
created in a standardized form and traded through
Financial Economics 107
clearing houses on regulated options exchanges, while other
over-the-counter options are written as bilateral, customized
contracts between a single buyer and seller, one or both of which
may be a dealer or market-maker. Options are part of major
category of financial instruments termed as derivative products
or simply derivatives.

Features of options:

 A fixed maturity date on which they expire (Expiry date).


 The price at which the option is exercised is called the
exercise price or strike price.

 The person who writes the option and is the seller is
denoted as the "option writer", and who holds the option
and is the buyer, is called "option holder".

 The premium is the price paid for the option by the
buyer to the seller.

 A clearing house is interposed between the seller and the
buyer which guarantees performance of the contract.
Types of Options:

1. Call Options

A call option gives the purchaser (or buyer) the right to buy an
underlying security (e.g., a stock) at a prespecified price called
the exercise or strike price (X). In return, the buyer of the call
option must pay the writer (or seller) an up-front fee known as a
call premium (C). This premium is an immediate negative cash
flow for the buyer of the call option. However, he or she
potentially stands to make a profit should the underlying stock‘s

Financial Economics 108

price be greater than the exercise price (by an amount exceeding
the premium). If the price of the underlying stock is greater than
X (the option is referred to as ―in the money‖), the buyer can
exercise the option, buying the stock at X and selling it
immediately in the stock market at the current market price,
greater than X. If the price of the underlying stock is less than X
(the option is referred to as ―out of the money‖), the buyer of
the call would not exercise the option (i.e., buy the stock at X
when its market value is less than X). If this is the case when the
option matures, the option expires unexercised. The same is true
when the underlying stock price is exactly equal to X when the
option expires (the option is referred to as ―at the money‖). The
call buyer incurs a cost C (the call premium) for the option, and
no other cash flows result.

2. A Put Option

A put option gives the option buyer the right to sell an

underlying security (e.g., a stock) at a pre-specified price to the
writer of the put option. In return, the buyer of the put option
must pay the writer (or seller) the put premium (P). If the
underlying stock‘s price is less than the exercise price (X) (the
put option is ―in the money‖), the buyer will buy the underlying
stock in the stock market at less than X and immediately sell it at
X by exercising the put option. If the price of the underlying
stock is greater than X (the put option is ―out of the money‖),
the buyer of the put option would not exercise the option (i.e.,
selling the stock at X when its market value is more than X). If
this is the case when the option matures, the option expires
unexercised. This is also true if the price of the underlying stock
is exactly equal to X when the option expires (the put option is
trading ―at the money‖). The put option buyer incurs a cost P
for the option, and no other cash flows result.

Financial Economics 109

3. Stock Options.

The underlying asset on a stock option contract is the stock of a

publicly traded company. One option generally involves 100
shares of the underlying company‘s stock. The same stock can
have many different call and put options differentiated by
expiration and strike price. Further, the quote gives an indication
of whether the call and put options are trading in, out of, or at
the money.

4. Credit Options

Options also have a potential use in hedging the credit risk of a

financial institution. Compared to their use in hedging interest
rate risk, options used to hedge credit risk are a relatively new
phenomenon. Two alternative credit option derivatives exist to
hedge credit risk on a balance sheet: credit spread call options
and digital default options. A credit spread call option is a call
option whose payoff increases as the (default) risk premium or
yield spread on a specified benchmark bond of the borrower
increases above some exercise spread.

Different Uses of Options:

There are a number of reasons for being either a writer or a
buyer of options. The writer assures an uncertain amount of risk
for a certain amount of money, whereas the buyer assures an
uncertain potential gain for a fixed cost. Such a situation can
lead to a number of reasons for using options.

However, fundamental to either writing or buying an option is

the promise that option is fairly valued in terms of the possible
outcomes. If the option is not fairly priced then, of course, an
additional source of profit or loss is introduced, and the writer or

Financial Economics 110

buyer of such a contract may be subject to an additional
handicap that will reduce his or her return.

The reasons for writing option contracts are varied, but three of
the most common are to cash additional income on a securities
portfolio, the fact that option buyers are not as sophisticated as
writers, and to hedge a long position.

It is sometimes argued that option writing is a source of

additional income for the portfolio of an investor with a large
portfolio of securities. Such an approach assumes that the
portfolio manager can guess the direction of specific stock
prices closely rough to make this strategy worth-while.

What cannot be overlooked is that the writer gives up certain

rights when the option is written. For example, suppose a call
option is written. In this case, the writer would presumably
cover the call by giving up securities from his or her portfolio.
Hence, the writer is giving up any appreciation beyond the
striking price plus the option premium.

Second, it is believed by some that the buyer of options is not as

sophisticated as the writers. The proponents of this view argue
that option writers are the most sophisticated participants in the
securities market and view argue that option premiums simply
as additional income.

However, it should be held that this view pre-supposes that the

buyers are ―lambs ready to be shorn‖ whether this view is correct
or not is unclear, but it follows that over the long-term they may
find option writing an unprofitable undertaking. There are a
number of reasons for buying options; two of the most common are
leverage and changing the risk complexion of a portfolio. The term
leverage in connection with options indicates buyer being

Financial Economics 111

able to control more securities than could be done with realistic
margin requirements.

In other words, with the use of margins, the buyer of securities

can but more securities and hopefully make a greater profit than
could be done by taking a basic long position. Puts and calls can
be used in much the same fashion and perhaps provide a higher
return. Another reason of buying options is to change the risk
complexion of a portfolio of securities. It should be noted that
this benefit of options is available not only to buyers but also to
writers. Therefore, they permit the portfolio manager to
undertake as much or as little risk as he or she feels is
appropriate at a point of time. They also give additional
flexibility in setting the amount or risk the portfolio manager is
willing to accept with respect to a specific portfolio.

5.8. Put-Call parity theorem

Put-Call parity theorem says that premium (price) of a call

option implies a certain the fair price for corresponding put
options provided the put options have the same strike price,
underlying and expiry, and vice versa. It also shows the three-
sided relationship between a call, a put, and underlying security.
The theory was first identified by Hans Stoll in 1969.
The term "put-call" parity refers to a principle that defines the
relationship between the price of European put and call options of
the same class. Put simply, this concept highlights the consistencies
of these same classes. Put and call options must have the same
underlying asset, strike price, and expiration date in order to be in
the same class. The put-call parity, which only applies to European
options, can be determined by a set equation.

There exists a connection between the European call options and

the European put options prices, and this relationship is defined
Financial Economics 112
by the Put call parity. Though, the security, the strike price, and
the ending month should be the same for the securities to
establish the relation.

Put call parity states that holding up of the long European call
with the short European put simultaneously will yield out the
same return when you will be holding up a forward contract
having the identical basic asset, as well as the expiry date. And
here the forward price will be equivalent to the option‘s strike
amount.

Put call parity equation:

+ ()= +

Where in the above put call parity equation:

 C = the European call options price

 PV(x) = the current value of the strike price (x), which is
reduced from the price on the end date at the risk-free
amount

 P = the European put options or security price

 S = the present market value of the underlying asset or
the spot price
Need for Put Call Parity

The need for Put-Call Parity arises to compute the current worth
of the cash element, that exists with an appropriate risk
permitted interest rate.

For Example: Take two portfolio A and portfolio B, where

Portfolio A has a European call decision and cash which is

Financial Economics 113

equivalent to the total shares enclosed by the call option that is
being grown up by the call‘s striking price. And taking portfolio
B which has a European put option as well as the underlying
asset. So, we get the options as follows:

 Portfolio A (having options as) = Call + Cash,

(wherever the Cash is equal to the Call Strike Price)

 Portfolio B (having options as) = Put + Underlying Asset

The Portfolio A and Portfolio B having Call, put, cash and asset
option is depicted in the above figure. And from the above
figure of Portfolio A having call option and cash, and the
portfolio B having put option and asset. we observe that:

 Call + Cash = Put + Underlying Asset


 For example: Sept 20 Call + $2500 = Sept 20 Put + 100
ABC Stock

 Thus, in order to calculate the current value of the cash
component in the above equation we need the put call
parity equation which is as: C + PV(x) = P + S

Important Terminologies used in put call Options

 S0 = Stock price existing today,

 X = the Strike price

 T = Time to expiration of the securities

 r = Risk-free rate of return

 C0 = the European call option premium

 P0 = the European put option premium
Financial Economics 114
Put call parity arbitrage:

The put call parity arbitrage defines the opportunity to yield out
profit from the price variances that exists in a different market of
a financial security. So, the put call parity arbitrage exits where
the call put option does not apply at all. Or where we see that
one side of the put call equation is greater than the other, or there
exists some variation in the put call equation, there the put call
parity arbitrage exists.

5.9. Option Pricing Models

Option pricing theory has made vast strides since 1972, when
Black and Scholes published their path-breaking paper
providing a model for valuing dividend-protected European
options. Black and Scholes used a ―replicating portfolio‖ –– a
portfolio composed of the underlying asset and the risk-free
asset that had the same cash flows as the option being valued ––
to come up with their final formulation. While their derivation is
mathematically complicated, there is a simpler binomial model
for valuing options that draws on the same logic.

The Binomial Option Pricing Model

In finance, the binomial options pricing model (BOPM)
provides a generalizable numerical method for the valuation of
options. Essentially, the model uses a "discrete-time" (lattice
based) model of the varying price over time of the underlying
financial instrument, addressing cases where the closed-form
Black– Scholes formula is wanting. The binomial model was
first proposed by William Sharpe in the 1978 edition of
Investments and formalized by Cox, Ross and Rubinstein in
1979 and by Rendleman and Bartter in that same year.

Financial Economics 115

 The binomial option pricing model is based upon a simple
formulation for the asset price process in which the asset, in any
time period, can move to one of two possible prices. It has been
widely used since it is able to handle a variety of conditions for
which other models cannot easily be applied. This is largely
because the BOPM is based on the description of an underlying
instrument over a period of time rather than a single point. As a
consequence, it is used to value American options that are
exercisable at any time in a given interval as well as Bermudan
options that are exercisable at specific instances of time. Being
relatively simple, the model is readily implementable in
computer software (including a spreadsheet).

Although computationally slower than the Black–Scholes

formula, it is more accurate, particularly for longer-dated
options on securities with dividend payments. For these reasons,
various versions of the binomial model are widely used by
practitioners in the options markets

The general formulation of a stock price process that follows the

binomial is shown in figure 5.1. In this figure, S is the current
stock price; the price moves up to Su with probability p and
down to Sd with probability 1-p in any time period.

Figure 5.1.: General Formulation for Binomial Price Path

Financial Economics 116

The Determinants of Value

The binomial model provides insight into the determinants of

option value. The value of an option is not determined by the
expected price of the asset but by its current price, which, of
course, reflects expectations about the future. This is a direct
consequence of arbitrage. If the option value deviates from the
value of the replicating portfolio, investors can create an
arbitrage position, i.e., one that requires no investment, involves
no risk, and delivers positive returns. The cash flows on the two
positions will offset each other, leading to no cash flows in
subsequent periods. The option value also increases as the time
to expiration is extended, as the price movements (u and d)
increase, and with increases in the interest rate.

While the binomial model provides an intuitive feel for the

determinants of option value, it requires a large number of inputs,
in terms of expected future prices at each node. As we make time
periods shorter in the binomial model, we can make one of two
assumptions about asset prices. We can assume that price changes
become smaller as periods get shorter; this leads to price changes

Financial Economics 117

becoming infinitesimally small as time periods approach zero,
leading to a continuous price process. Alternatively, we can
assume that price changes stay large even as the period gets
shorter; this leads to a jump price process, where prices can
jump in any period.

The Black-Scholes Option Pricing Model

Black-Scholes is a pricing model used to determine the fair price or
theoretical value for a call or a put option based on six variables
such as volatility, type of option, underlying stock price, time,
strike price, and risk-free rate. The quantum of speculation is more
in case of stock market derivatives, and hence proper pricing of
options eliminates the opportunity for any arbitrage. There are two
important models for option pricing – Binomial Model and Black-
Scholes Model. The model is used to determine the price of a
European call option, which simply means that the option can only
be exercised on the expiration date.

Black-Scholes pricing model is largely used by option traders

who buy options that are priced under the formula calculated
value, and sell options that are priced higher than the Black-
Schole calculated value

When the price process is continuous, i.e. price changes

becomes smaller as time periods get shorter, the binomial model
for pricing options converges on the BlackScholes model. The
model, named after its co-creators, Fischer Black and Myron
Scholes, allows us to estimate the value of any option using a
small number of inputs and has been shown to be remarkably
robust in valuing many listed options.

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The Model

While the derivation of the Black-Scholes model is far too

complicated to present here, it is also based upon the idea of
creating a portfolio of the underlying asset and the riskless asset
with the same cashflows and hence the same cost as the option
being valued. The value of a call option in the Black-Scholes
model can be written as a function of the five variables:

S = Current value of the underlying asset

K = Strike price of the option
t = Life to expiration of the option
r = Riskless interest rate corresponding to the life of the option

σ2 = Variance in the ln(value) of the underlying asset

The value of a call is then:
= ( )− ( )

Where, 2
ln +(+ )
= 2
√
= −√

Note that e-rt is the present value factor and reflects the fact that
the exercise price on the call option does not have to be paid
until expiration. N(d1) and N(d2) are probabilities, estimated by
using a cumulative standardized normal distribution and the
values of d1 and d2 obtained for an option. The cumulative
distribution is shown in Figure 5.2.:
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Figure 5.2.: Cumulative Normal Distribution

In approximate terms, these probabilities yield the likelihood

that an option will generate positive cash flows for its owner at
exercise, i.e., when S>K in the case of a call option and when
K>S in the case of a put option. The portfolio that replicates the
call option is created by buying N(d1) units of the underlying
asset, and borrowing Ke-rtN(d2). The portfolio will have the
same cash flows as the call option and thus the same value as the
option. N(d1), which is the number of units of the underlying
asset that are needed to create the replicating portfolio, is called
the option delta.

Model Limitations and Fixes

The Black-Scholes model was designed to value options that can
be exercised only at maturity and on underlying assets that do
not pay dividends. In addition, options are valued based upon
the assumption that option exercise does not affect the value of
the underlying asset. In practice, assets do pay dividends,
options sometimes get exercised early and exercising an option
can affect the value of the underlying asset. Adjustments exist.
While they are not perfect, adjustments provide partial
corrections to the BlackScholes model.

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 1. Dividends

The payment of a dividend reduces the stock price; note that on

the ex-dividend day, the stock price generally declines.
Consequently, call options will become less valuable and put
options more valuable as expected dividend payments increase.
There are two ways of dealing with dividends in the Black
Scholes:

1· Short-term Options: One approach to dealing with

dividends is to estimate the present value of expected
dividends that will be paid by the underlying asset during
the option life and subtract it from the current value of
the asset to use as S in the model. Modified Stock Price
= Current Stock Price – Present value of expected
dividends during the life of the option

2. · Long Term Options: Since it becomes impractical to

estimate the present value of dividends as the option life
becomes longer, we would suggest an alternate approach. If
the dividend yield (y = dividends/current value of the asset)
on the underlying asset is expected to remain unchanged
during the life of the option, the Black-Scholes model can
be modified to take dividends into account.

= ( )− ( )

ln + − +
2

= −√

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 From an intuitive standpoint, the adjustments have two
effects. First, the value of the asset is discounted back to the
present at the dividend yield to take into account the
expected drop in asset value resulting from dividend
payments. Second, the interest rate is offset by the dividend
yield to reflect the lower carrying cost from holding the
asset (in the replicating portfolio). The net effect will be a
reduction in the value of calls estimated using this model.

1. Early Exercise

The Black-Scholes model was designed to value options

that can be exercised only at expiration. Options with this
characteristic are called European options. In contrast, most
options that we encounter in practice can be exercised any
time until expiration. These options are called American
options. The possibility of early exercise makes American
options more valuable than otherwise similar European
options; it also makes them more difficult to value. In
general, though, with traded options, it is almost always
better to sell the option to someone else rather than exercise
early, since options have a time premium, i.e., they sell for
more than their exercise value. There are two exceptions.
One occurs when the underlying asset pays large dividends,
thus reducing the expected value of the asset. In this case,
call options may be exercised just before an ex-dividend
date, if the time premium on the options is less than the
expected decline in asset value as a consequence of the
dividend payment. The other exception arises when an
investor holds both the underlying asset and deep in-the-
money puts, i.e., puts with strike prices well above the
current price of the underlying asset, on that asset and at a
time when interest rates are high. In this case, the time
premium on the put may be less than the potential gain from
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 exercising the put early and earning interest on the exercise
price.
There are two basic ways of dealing with the possibility of
early exercise. One is to continue to use the unadjusted Black-
Scholes model and regard the resulting value as a floor or
conservative estimate of the true value. The other is to try to
adjust the value of the option for the possibility of early
exercise. There are two approaches for doing so. One uses the
Black-Scholes to value the option to each potential exercise
date. With options on stocks, this basically requires that we
value options to each ex-dividend day and choose the
maximum of the estimated call values. The second approach is
to use a modified version of the binomial model to consider
the possibility of early exercise. In this version, the up and
down movements for asset prices in each period can be
estimated from the variance and the length of each period.

2. The Impact of Exercise On The Value Of The

Underlying Asset

The Black-Scholes model is based upon the assumption

that exercising an option does not affect the value of the
underlying asset. This may be true for listed options on
stocks, but it is not true for some types of options. For
instance, the exercise of warrants increases the number
of shares outstanding and brings fresh cash into the firm,
both of which will affect the stock price. The expected
negative impact (dilution) of exercise will decrease the
value of warrants compared to otherwise similar call
options. The adjustment for dilution in the Black-Scholes
to the stock price is fairly simple. The stock price is
adjusted for the expected dilution from the exercise of
the options.

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