Capital Market Theory Rsm 332 – Week 2

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CAPITAL MARKET THEORY RSM 332 – Week 2 Week 1 – Introduction – Financial Accounting (Review) Week 2 – Financial Markets and Net Present Value Week 3 – Present Value Concepts Week 4 – Bond Valuation and Term Structure Theory Week 5 – Valuation of Stocks Week 6 – Risk and Return – Problem Set #1 Due Week 7* – Midterm (Tuesday*) Week 8 - Portfolio Theory Week 9 – Capital Asset Pricing Model Week 10 – Arbitrage Pricing Theory Week 11 – Operation and Efficiency of Capital Markets Week 12 – Course Review – Problem Set #2 Due Contact: otto. yung@alumni. utoronto. ca CAPITAL MARKET THEORY RSM 332 – Week 2

AGENDA 1. 2. 3. 4. 5. Announcements Financial Markets and Net Present Value Survey Results Optional Material (e. g. Cases, Practical Knowledge, News, etc. ) Suggestions/Practice for Exam(s) Contact: otto. yung@alumni. utoronto. ca Extended Office Hours Friday, October 19th (11:00am-3:00pm) • Room 6 - TZ6 (Tanz Neuroscience Bldg – 6 Queen’s Park Crescent West) TBD - Saturday, October 20th • Depends if there is enough demand Thursday, October 25th (5:00pm-7:00pm and 7:00pm-9:00pm) • During regular timeslot • Cover optional material (e. g. cases, practical knowledge, etc. ) Contact: otto. ung@alumni. utoronto. ca Exams Midterm (Tuesday, October 23rd – 8:00pm-10:00pm): • EX 100 (Examination Facility – 255 McCaul Street) • 2 Hours Final (TBA): • 2 Hours Preparation: • Problem Sets 1 & 2 • Crib Sheet (Start Early and 1-Sided) • Calculator (Silent) Contact: otto. yung@alumni. utoronto. ca Tutorials • Starting - September 19/20/21 • Wednesday (6:00pm-8:00pm) • TZ6 (Tanz Neuroscience Bldg – 6 Queen’s Park Crescent West) • Thursday (11:00am-1:00pm) • RW 110 (Ramsay Wright Laboratories – 25 Harbord Street) • Friday (5:00pm-7:00pm) • RW 110 (Ramsay Wright Laboratories – 25 Harbord Street) Review: • Midterms and Finals (2008-2011) Xiaofei Zhao (xiaofei. zhao08@rotman. utoronto. ca) • http://332ta. raykan. com • Contact: otto. yung@alumni. utoronto. ca Outside of Lecture Office Hours (Drop-In): • Wednesdays: 4:00pm-6:00pm • 105 St. George Street - Rotman (North Building) Room 413 or 417 Office Hours (Other Days/Times): • Extended Hours • By Appointment Contact: otto. yung@alumni. utoronto. ca Corporate Finance: What is Going On? 3) Firm’s Financial (5) Investors (4) (Financial Institutions, (1) Individuals, Other Firms) (1) (2) (3) (4) (5) Cash raised from investors by selling financial assets Cash invested in real assets (some are intangible) Cash generated by operations Cash reinvested in the firm (retained earnings) Cash repaid to investors (interest, dividends, etc. ) Operations (2) Decision Maker Reference: Alex MacKay Financial Markets: What is Going On? Firms (Users of Capital) Initial Public Offering (IPO) Secondary Offerings (SEO) Borrowing (Loans, Bonds)

Dividends, $ Repurchases, Interest Payments $ Market Mechanisms or Market Makers (Stock Exchanges, Banks, Investment Funds, …) $ $ Firms Issue Stock Certificates and Bonds $ $$$ Invested in Stocks and Bonds Investors (Providers of Capital) Investment Banks help firms make transactions Brokers/Dealers help investors make transactions Reference: Alex MacKay Financial Theory and Corporate Policy Chapter 1 (Copeland, Weston and Shastri) Course Reserve FINANCIAL MARKETS AND NET PRESENT VALUE Consumption Plan and Investment Rule

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Reference: Raymond Kan Contact: otto. yung@alumni. utoronto. ca Consumption and Investment without Capital Markets C1 U2 U1 U0 C0 Reference: Copeland, Weston, Shastri (Financial Theory Contact: otto. yung@alumni. utoronto. ca and Corporate Policy) 4 th Edition 2004 Consumption and Investment without Capital Markets C1 Slope of the Tangent (-ve) = (Marginal Rate of Substitution) (MRS) MRS = ? C1 ? C0 U1 U(C0, C1) MRS = ? U / ? C0 ?U / ? C1 C0 Reference: Copeland, Weston, Shastri (Financial Theory Contact: otto. yung@alumni. utoronto. ca and Corporate Policy) 4 th Edition 2004 Consumption and Investment without Capital Markets

C1 Production/Investment Opportunity Set C0 Reference: Copeland, Weston, Shastri (Financial Theory Contact: otto. yung@alumni. utoronto. ca and Corporate Policy) 4 th Edition 2004 Consumption and Investment without Capital Markets C1 Rate at which a dollar of consumption today (C0) is transformed by productive investment into a dollar of consumption (C1) tomorrow. C0 Reference: Copeland, Weston, Shastri (Financial Theory Contact: otto. yung@alumni. utoronto. ca and Corporate Policy) 4 th Edition 2004 Consumption and Investment without Capital Markets C1 C0 Reference: Copeland, Weston, Shastri (Financial Theory Contact: otto. ung@alumni. utoronto. ca and Corporate Policy) 4 th Edition 2004 Consumption and Investment without Capital Markets C1 Marginal Rate of Transformation (MRT) MRT = ? C1 ? C0 C0 Reference: Copeland, Weston, Shastri (Financial Theory Contact: otto. yung@alumni. utoronto. ca and Corporate Policy) 4 th Edition 2004 Consumption and Investment without Capital Markets C1 U1 C0 Reference: Copeland, Weston, Shastri (Financial Theory Contact: otto. yung@alumni. utoronto. ca and Corporate Policy) 4 th Edition 2004 Consumption and Investment without Capital Markets C1 Y1 U1 Resource Bundle: (Y0, Y1) Y0

Reference: Copeland, Weston, Shastri (Financial Theory Contact: otto. yung@alumni. utoronto. ca and Corporate Policy) 4 th C0 Edition 2004 Consumption and Investment without Capital Markets C1 Increase investment until MRT = MRS U1 C0 Reference: Copeland, Weston, Shastri (Financial Theory Contact: otto. yung@alumni. utoronto. ca and Corporate Policy) 4 th Edition 2004 Consumption and Investment without Capital Markets C1 U2 U1 C0 Reference: Copeland, Weston, Shastri (Financial Theory Contact: otto. yung@alumni. utoronto. ca and Corporate Policy) 4 th Edition 2004 Consumption and Investment without Capital Markets

C1 MRT = MRS U2 U1 C0 Reference: Copeland, Weston, Shastri (Financial Theory Contact: otto. yung@alumni. utoronto. ca and Corporate Policy) 4 th Edition 2004 Consumption and Investment without Capital Markets C1 U2 U1 (Increase Investment) Reference: Copeland, Weston, Shastri (Financial Theory Contact: otto. yung@alumni. utoronto. ca and Corporate Policy) 4 th C0 Edition 2004 Consumption and Investment with Capital Markets C1 Slope = -(1+r) Borrowing and Lending opportunities (Capital Market Line) (at market interest rate r) C0 Reference: Copeland, Weston, Shastri (Financial Theory Contact: otto. ung@alumni. utoronto. ca and Corporate Policy) 4 th Edition 2004 Consumption and Investment with Capital Markets C1 Interest plus Principal (Invest/Lending) Reference: Copeland, Weston, Shastri (Financial Theory Contact: otto. yung@alumni. utoronto. ca and Corporate Policy) 4 th C0 Edition 2004 Consumption and Investment with Capital Markets C1 Interest plus Principal (Borrowed Amount – Principal) Reference: Copeland, Weston, Shastri (Financial Theory Contact: otto. yung@alumni. utoronto. ca and Corporate Policy) 4 th C0 Edition 2004 Consumption and Investment with Capital Markets C1 U1 C0

Reference: Copeland, Weston, Shastri (Financial Theory Contact: otto. yung@alumni. utoronto. ca and Corporate Policy) 4 th Edition 2004 Consumption and Investment with Capital Markets C1 Y1 U1 Endowment: (Y0, Y1) Y0 Reference: Copeland, Weston, Shastri (Financial Theory Contact: otto. yung@alumni. utoronto. ca and Corporate Policy) 4 th C0 Edition 2004 Consumption and Investment with Capital Markets C1 (Invest) Y1 U1 Y0 Reference: Copeland, Weston, Shastri (Financial Theory Contact: otto. yung@alumni. utoronto. ca and Corporate Policy) 4 th C0 Edition 2004 Consumption and Investment with Capital Markets C1

Market rate of return > Subjective Time Preference (1+r) > (1+rtime preference) Y1 U1 Y0 Reference: Copeland, Weston, Shastri (Financial Theory Contact: otto. yung@alumni. utoronto. ca and Corporate Policy) 4 th C0 Edition 2004 Consumption and Investment with Capital Markets C1 U1 (Consume Less) Reference: Copeland, Weston, Shastri (Financial Theory Contact: otto. yung@alumni. utoronto. ca and Corporate Policy) 4 th C0 Edition 2004 Consumption and Investment with Capital Markets C1 U1 (Invest) Reference: Copeland, Weston, Shastri (Financial Theory Contact: otto. yung@alumni. utoronto. ca and Corporate Policy) 4 th C0

Edition 2004 Consumption and Investment with Capital Markets C1 U2 Y1 U1 Y0 Reference: Copeland, Weston, Shastri (Financial Theory Contact: otto. yung@alumni. utoronto. ca and Corporate Policy) 4 th C0 Edition 2004 Consumption and Investment with Capital Markets C1 Market Interest Rate = Subjective Time Preference U2 Y1 U1 Y0 Reference: Copeland, Weston, Shastri (Financial Theory Contact: otto. yung@alumni. utoronto. ca and Corporate Policy) 4 th C0 Edition 2004 Consumption and Investment with Capital Markets (With Production Set) C1 U1 C0 Reference: Copeland, Weston, Shastri (Financial Theory Contact: otto. yung@alumni. toronto. ca and Corporate Policy) 4 th Edition 2004 Consumption and Investment with Capital Markets (With Production Set) C1 C0 Reference: Copeland, Weston, Shastri (Financial Theory Contact: otto. yung@alumni. utoronto. ca and Corporate Policy) 4 th Edition 2004 Consumption and Investment with Capital Markets (With Production Set) C1 C0 Reference: Copeland, Weston, Shastri (Financial Theory Contact: otto. yung@alumni. utoronto. ca and Corporate Policy) 4 th Edition 2004 Consumption and Investment with Capital Markets (With Production Set) C1 C0 Reference: Copeland, Weston, Shastri (Financial Theory Contact: otto. ung@alumni. utoronto. ca and Corporate Policy) 4 th Edition 2004 Consumption and Investment with Capital Markets (With Production Set) C1 C0 Reference: Copeland, Weston, Shastri (Financial Theory Contact: otto. yung@alumni. utoronto. ca and Corporate Policy) 4 th Edition 2004 Consumption and Investment with Capital Markets (With Production Set) C1 U3 = (production and capital market) U2 = (with production alone) U1 = (initial endowment) C0 Reference: Copeland, Weston, Shastri (Financial Theory Contact: otto. yung@alumni. utoronto. ca and Corporate Policy) 4 th Edition 2004 Consumption Plan and Investment Rule

Consider 1 period problems Assumptions: • No uncertainty • One period (two dates), consumptions occur on date 0 and date 1 • A consumer is endowed with initial wealth (Y0) on date 0, and will receive income (Y1) on date 1 • Simple interest rate (r) Date 0 Reference: Raymond Kan Contact: otto. yung@alumni. utoronto. ca Date 1 Consumption Plan and Investment Rule 4 CASES • Case I: • Case II: No Capital Market, No Production Opportunities With Capital Market, No Production Opportunities • Case III: No Capital Market, With Production Opportunities • Case IV: With Capital Market, With Production Opportunities Reference: Raymond Kan Contact: otto. ung@alumni. utoronto. ca Consumption Plan and Investment Rule CASE I - No Capital Market, No Production Opportunities • Consumer can consume Y0 on date 0, and Y1 on date 1 Date 0 Reference: Raymond Kan Contact: otto. yung@alumni. utoronto. ca Date 1 Consumption Plan and Investment Rule CASE II - With Capital Market, No Production Opportunities The set of consumption plans is broadened 1. 2. Consumer can save from Y0, invests in financial assets, and consumes more on date 1 Borrow against Y1, consume more on date 0, pay back loan with interest on date 1 from Y1, and consume less on date 1 Date 0 Reference: Raymond Kan Contact: otto. ung@alumni. utoronto. ca Date 1 Consumption Plan and Investment Rule CASE II - With Capital Market, No Production Opportunities • Denote C0 and C1 as date 0 and date 1 consumption respectively • Constraint on them is: C1 = (Y0 - C0) (1+r) + Y1 Consumption Budget Line (Constraint) C0 + C1 = Y0 + Y1 1+ r 1+ r Y Date 0 Reference: Raymond Kan Contact: otto. yung@alumni. utoronto. ca Date 1 In general, the consumer will be better off with capital markets Consumption Plan and Investment Rule CASE II - With Capital Market, No Production Opportunities Present Value • For any cash flow, C0, C1, define its present value as: PV = C0 + C1 + r • Budget constraint can be restated as: • The present value of consumption equals the present value of income Date 0 Reference: Raymond Kan Contact: otto. yung@alumni. utoronto. ca Date 1 Consumption Plan and Investment Rule CASE II - With Capital Market, No Production Opportunities Example: • Assume an investor has a wealth of $1. 5M on date 0, and will have an income of $0. 55M on date 1 • The interest rate is 10%. • The present value of total income is: $2M = $1. 5M + $0. 55M (1+ 0. 10) Date 0 Reference: Raymond Kan Contact: otto. yung@alumni. utoronto. ca Date 1 Consumption Plan and Investment Rule

CASE III – No Capital Market, With Production Opportunities Physical Investment • Suppose the consumer is also an entrepreneur who identifies a physical investment opportunity • Initial investment requires $0. 5M on date 0 • Return of $0. 85M on date 1 • Should this consumer/investor take this project? • Without a capital market, it depends on her/his utility function Reference: Raymond Kan Contact: otto. yung@alumni. utoronto. ca Consumption Plan and Investment Rule CASE IV – With Capital Market, With Production Opportunities • By investing $0. 5M in a financial asset, receive $0. 55M in return (i. . 10% return) • By investing $0. 5M in a physical asset, receive $0. 85M in return (i. e. 70% return) • Consumer/Investor should take this project • Interest rate is also called the opportunity cost of capital • i. e. Return foregone by investing in a project rather than in comparable investment alternatives Reference: Raymond Kan Contact: otto. yung@alumni. utoronto. ca Consumption Plan and Investment Rule CASE IV – With Capital Market, With Production Opportunities Net Present Value (NPV) • Is the project’s net contribution to wealth (i. e. present value minus initial investment) NPV = C0 + C1 1+ r In the above example, the NPV of the project is: NPV = -$0. 5M + $0. 85M = $0. 2727M (1 + 0. 10) Reference: Raymond Kan Contact: otto. yung@alumni. utoronto. ca Consumption Plan and Investment Rule CASE IV – With Capital Market, With Production Opportunities NPV Rule • States that: • If a project has a positive NPV, we should accept it • If a project has a negative NPV, we should reject it Equivalent Rules • NPV Rule – Accept positive NPV projects • Rate-of-Return Rule – Invest in projects which offer a rate higher than the cost of capital Reference: Raymond Kan Contact: otto. yung@alumni. utoronto. ca A Separation Theorem You are at a Honda (HMC) shareholders’ meeting • Three shareholders are quite vocal about what the company should do Shareholder #1 – Old Lady • Wants money right now • Wants HMC to invest in sports cars which will yield a quick profit Shareholder #2 – Representative of a Little Boy’s Trust Fund • Wants money a long way in the future • Wants HMC to invest in building electric cars Shareholder #3 – Young Professional • Wants money at some specified time in future (i. e. 10 years) • Wants HMC to build smaller cars because of an expected oil crisis Reference: Raymond Kan Contact: otto. yung@alumni. utoronto. ca A Separation Theorem

What do you think Honda managers should do? Reference: Raymond Kan Contact: otto. yung@alumni. utoronto. ca A Separation Theorem What do you think Honda managers should do? MAXIMIZE VALUE Reference: Raymond Kan Contact: otto. yung@alumni. utoronto. ca A Separation Theorem In general, each shareholder may want: • Maximum wealth • Ability to transfer wealth across time into consumption • Choose risk characteristics of consumption plan Each shareholder, however, can: • Achieve own consumption plan through investments in financial assets • Achieve risk characteristics of plan by investing in more or less risky securities

EQUITY (CAPITAL GAINS, DIVIDENDS) Reference: Raymond Kan Contact: otto. yung@alumni. utoronto. ca A Separation Theorem In general, each shareholder may want: • Maximum wealth • Ability to transfer wealth across time into consumption • Choose risk characteristics of consumption plan Each shareholder, however, can: • Achieve own consumption plan through investments in financial assets • Achieve risk characteristics of plan by investing in more or less risky securities EQUITY (CAPITAL GAINS, DIVIDENDS) DEBT (INTEREST) TAX AGENCY COSTS Reference: Raymond Kan Contact: otto. ung@alumni. utoronto. ca A Separation Theorem In general, each shareholder may want: • Maximum wealth • Ability to transfer wealth across time into consumption • Choose risk characteristics of consumption plan Each shareholder, however, can: WHAT TYPE OF INCOME DO YOU PREFER? • Achieve own consumption plan through investments in financial assets • Achieve risk characteristics of plan by investing in more or less risky securities EQUITY (CAPITAL GAINS, DIVIDENDS) DEBT (INTEREST) TAX AGENCY COSTS Reference: Raymond Kan Contact: otto. yung@alumni. utoronto. ca

Consumption and Investment with Capital Markets (With Production Set) C1 U3 = (production and capital market) U2 = (with production alone) U1 = (initial endowment) C0 Reference: Copeland, Weston, Shastri (Financial Theory Contact: otto. yung@alumni. utoronto. ca and Corporate Policy) 4 th Edition 2004 Consumption and Investment with Capital Markets (With Production Set) C1 C0 Reference: Copeland, Weston, Shastri (Financial Theory Contact: otto. yung@alumni. utoronto. ca and Corporate Policy) 4 th Edition 2004 Consumption and Investment with Capital Markets (With Production Set) C1 Choose the optimal production decision by taking on projects until the marginal rate of return on investment equals the objective market rate) C0 Reference: Copeland, Weston, Shastri (Financial Theory Contact: otto. yung@alumni. utoronto. ca and Corporate Policy) 4 th Edition 2004 Consumption and Investment with Capital Markets (With Production Set) C1 (Choose the optimal consumption pattern by borrowing or lending along the capital market line to equate your subjective time preference with the market rate of return) C0 Reference: Copeland, Weston, Shastri (Financial Theory Contact: otto. yung@alumni. toronto. ca and Corporate Policy) 4 th Edition 2004 Consumption and Investment with Capital Markets (With Production Set) C1 (Production/Investment Decision) (Consumption Decision) C0 Reference: Copeland, Weston, Shastri (Financial Theory Contact: otto. yung@alumni. utoronto. ca and Corporate Policy) 4 th Edition 2004 Consumption and Investment with Capital Markets (With Production Set) C1 (Production/Investment Decision) (Consumption Decision) (Fisher Separation Theorem) C0 Reference: Copeland, Weston, Shastri (Financial Theory Contact: otto. yung@alumni. utoronto. ca and Corporate Policy) 4 th Edition 2004

Consumption and Investment with Capital Markets (With Production Set) C1 (Fisher Separation Theorem) Given perfect and complete capital markets, the production decision is governed solely by an objective market criterion (represented by maximizing attained wealth) without regard to individuals’ subjective preferences that enter into consumption decisions C0 Reference: Copeland, Weston, Shastri (Financial Theory Contact: otto. yung@alumni. utoronto. ca and Corporate Policy) 4 th Edition 2004 Consumption and Investment with Capital Markets (With Production Set) C1 (Production/Investment Decision) (Consumption Decision) Fisher Separation Theorem) C0 Reference: Copeland, Weston, Shastri (Financial Theory Contact: otto. yung@alumni. utoronto. ca and Corporate Policy) 4 th Edition 2004 Consumption and Investment with Capital Markets (With Production Set) C1 (Production/Investment Decision) (Consumption Decision) (Fisher Separation Theorem) MRS = MRT = 1+r C0 Reference: Copeland, Weston, Shastri (Financial Theory Contact: otto. yung@alumni. utoronto. ca and Corporate Policy) 4 th Edition 2004 Consumption and Investment with Capital Markets (With Production Set) C1 ALL INDIVIDUALS USE THE SAME TIME VALUE OF MONEY (i. e. ame market interest rate) IN MAKING THEIR PRODUCTION/INVESTMENT DECISIONS (Fisher Separation Theorem) MRS = MRT = 1+r C0 Reference: Copeland, Weston, Shastri (Financial Theory Contact: otto. yung@alumni. utoronto. ca and Corporate Policy) 4 th Edition 2004 Example Ronald, a finance student, has $400 cash-on-hand and has $1,100 in trust from his grandmother. Ronald will receive the trust funds next year. (Market interest rate is 10% or trust funds worth $1,000 today). Ronald has 2 mutually exclusive investment opportunities (i. e. AAA and BBB rated investments). Contact: otto. yung@alumni. utoronto. ca

Reference: Don Brean Example Ronald, a finance student, has $400 cash-on-hand and has $1,100 in trust from his grandmother. Ronald will receive the trust funds next year. (Market interest rate is 10% or trust funds worth $1,000 today). Ronald has 2 mutually exclusive investment opportunities (i. e. AAA and BBB rated investments). 1. 2. 3. Which investment should Ronald invest in, AAA or BBB? How much should he invest? If Ronald makes investment describe his cash flows? (i. e. Consumption spending divided equally in present value terms) Contact: otto. yung@alumni. utoronto. ca Reference: Don Brean Example

Ronald has 2 mutually exclusive investment opportunities (i. e. AAA and BBB rated investments). 1. Which investment should Ronald invest in, AAA or BBB? Contact: otto. yung@alumni. utoronto. ca Reference: Don Brean Example Ronald, a finance student, has $400 cash-on-hand and has $1,100 in trust from his grandmother. Ronald will receive the trust funds next year. (Market interest rate is 10% or trust funds worth $1,000 today). Ronald has 2 mutually exclusive investment opportunities (i. e. AAA and BBB rated investments). 1. Which investment should Ronald invest in, AAA or BBB? 2. How much should he invest? Contact: otto. yung@alumni. toronto. ca Reference: Don Brean Example Ronald, a finance student, has $400 cash-on-hand and has $1,100 in trust from his grandmother. Ronald will receive the trust funds next year. (Market interest rate is 10% or trust funds worth $1,000 today). Ronald has 2 mutually exclusive investment opportunities (i. e. AAA and BBB rated investments). 3. If Ronald makes investment describe his cash flows? (i. e. Consumption spending divided equally in present value terms) Contact: otto. yung@alumni. utoronto. ca Reference: Don Brean Example Ronald, a finance student, has $400 cash-on-hand and has $1,100 in trust from his grandmother.

Ronald will receive the trust funds next year. (Market interest rate is 10% or trust funds worth $1,000 today). Ronald has 2 mutually exclusive investment opportunities (i. e. AAA and BBB rated investments). 3. If Ronald makes investment describe his cash flows? (i. e. Consumption spending divided equally in present value terms) PV of Wealth = PV of Consumption PV (C0) = PV (C1) (i. e. C0 = C1 / (1+r) ) NPVBBB Ronald’s PV of Wealth = $400 + $1,000 + $87. 27 = $1,487. 27 $1,487. 27 = C0 + C1 / (1+r) = C0 + [C0 (1+r)] / (1+r) C0 = $743. 64 and C1 = $818 Contact: otto. yung@alumni. utoronto. ca Reference: Don Brean Example

Ronald, a finance student, has $400 cash-on-hand and has $1,100 in trust from his grandmother. Ronald will receive the trust funds next year. (Market interest rate is 10% or trust funds worth $1,000 today). Ronald has 2 mutually exclusive investment opportunities (i. e. AAA and BBB rated investments). 3. If Ronald makes investment describe his cash flows? (i. e. Consumption spending divided equally in present value terms) C1 = $818 Return from BBB Cash Inflow (next year) = $1,100 + $426 = $1,526 Cash Outflow (next year) = $818 + $643. 64 + $64. 36 = $1,526 Loan Repayment Interest on Loan @ 10% Contact: otto. yung@alumni. utoronto. a Reference: Don Brean Example Ronald, a finance student, has $400 cash-on-hand and has $1,100 in trust from his grandmother. Ronald will receive the trust funds next year. (Market interest rate is 10% or trust funds worth $1,000 today). Ronald has 2 mutually exclusive investment opportunities (i. e. AAA and BBB rated investments). CONCLUDING THOUGHT Ronald’s optimal investment decision (i. e. $300 in BBB) is independent or separate from his decision as to how he inter-temporally allocates his consumption (i. e. C0 and C1) The independence of those two decisions is referred to as the Fisher Separation Theorem. Contact: otto. ung@alumni. utoronto. ca Reference: Don Brean “GET TO KNOW YOU” SURVEY (Name: Optional) Question #1: • What has occurred in your other courses that you were happy about and would like to be incorporated into this course ? • What has occurred in your other courses that you were NOT happy about? Question #2: • Anything specific you would like to learn? What are your learning goals in this course? • Any specific requests from the instructor, TAs, program, other support staff, etc? Question #3: • Are you thinking of pursuing further education in Finance, if not then what do you have in mind? And/or... What job(s) are you interested in?

Question #4: • Tell me more about yourself (e. g. goals, program concentration, 2nd or 3rd year, etc... ) Question #5: • Any other comments, requests, suggestions, etc? TAKE ~3 MINUTES INDIVIDUALLY TO FILL OUT SURVEY TAKE ~ 5 MINUTES TO TALK TO 5 CLASSMATES WHOM YOU HAVEN’T MET YET (write down initials) SURVEY RESULTS (SUMMARY) • • • • • • • • • • • • • • • • • Real world experiences, practical (real-world) examples, cases... Relevant news (where to find news), Current issues in the market Relate course material to real world Exam tips/techniques Applications and excel models used in the real world Interactive class, games, videos...

Extended office hours (availability) to address questions Humour Practice questions and solutions; Past exams and solutions Capital markets (high-level overview) Typical jobs in finance, Leading finance organizations Additional tutorial time Stock picking, portfolio allocation/analysis, investment tools/strategies, trading tips Learning topics that can be applied in real life Relate designations/roles to course material and applications Better understanding of financial instruments (e. g. Mortgages, bonds, etc... ) View of finance from other functional areas (e. g. Marketing) 13 Popular Case Studies (Failures) 1. 2. 3. 4. 5. . Barings (Bank) - Operational Risk (Trading Activities – From arbitrageur to speculator) National Australia Bank – Operational and Market Risks (Currency Trading) Bankgesellschaft Berlin (Bank) – Credit and Operational Risks (Loans to Property Developers) Taisei Fire and Marine Insurance Co – Insurance & Governance Risks (Uninsured exposure – Lack of understanding) Washington Mutual (Bank) – Credit, Regulatory and Governance Risks; Stress and Scenario Testing (Low lending standards and bad quality acquisitions) Fannie Mae and Freddie Mac – Credit, Market, Operational, Regulatory Governance and Moral Risk; Politicians vs.

Financial Risk Management (Sub-prime loans) Long-Term Capital Management - LTCM (Hedge Fund) – Market & Model Risks (Short liquid vs. Long Illiquid Investments (e. g.

Bonds) – Russia Defaulted) Bankers Trust (Bank) – Operational Risk (Misled clients on derivatives sold to them) Orange County – Market and Interest Rate Risks (Wrong way bet on interest rates – Borrowing Short and Investing Long – Interest Rates Increased) Northern Rock (UK Bank) – Portfolio, Capital Funding, Operational and Reputational Risks; Stress and Scenario Testing (Sub-prime mortgages – Bank Run) Metallgesellschaft AG (Energy Group) – Market Risks (Cash Flow Issues from Written Forwards) Worldcom (Telecom) – Operational Risks (Accounting Fraud – Massive cquisitions & Debt) China Aviation Oil (Singapore) – Market and Governance Risks (Misreported oil futures trading losses, Un-hedged open short positions, Oil Prices Increased) Source: PRMIA 7. 8. 9. 10. 11. 12. 13. SURVEY AND BREAK 13 POPULAR CASE STUDIES Midterm 2011 – Q3 Contact: otto. yung@alumni. utoronto. ca Midterm 2011 – Q3 Part A - Assume that there is no capital market, which investment, A or B, will Jack choose? Justify your answer with calculations (6 marks) Contact: otto. yung@alumni. utoronto. ca Midterm 2011 – Q3 Part A - Assume that there is no capital market, which investment, A or B, will Jack choose?

Justify your answer with calculations (6 marks) • If Jack does not invest, his utility is zero • If Jack makes investment A (Utility is ? ) • If Jack makes investment B (Utility is ? ) • Y0 = $500 and Y1 = $0 • Savings = Investment = Y - C Contact: otto. yung@alumni. utoronto. ca Midterm 2011 – Q3 Part A - Assume that there is no capital market, which investment, A or B, will Jack choose? Justify your answer with calculations (6 marks) • Investment A • UA = (500-244)1/4 (400)1/2 = 80 Contact: otto. yung@alumni. utoronto. ca Midterm 2011 – Q3 Contact: otto. yung@alumni. utoronto. ca

Part A - Assume that there is no capital market, which investment, A or B, will Jack choose? Justify your answer with calculations (6 marks) • Investment B • UB (I) = (500-I)1/4 (50(I)1/2)1/2 • UB (I) = (50)1/2 [(500-I)I]1/4 • Find I* by differentiating UB (I) wrt I (set to zero) • dUB(I) = (50)1/2 (1/4) [(500-I)I]-3/4 (500-2I) dI I* = 250 Derivatives (Review) Reference: Martin J. Osborne http://www. economics. utoronto. ca/osborne/MathTutorial/CLCF. HTM Contact: otto. yung@alumni. utoronto. ca Midterm 2011 – Q3 Part A - Assume that there is no capital market, which investment, A or B, will Jack choose?

Justify your answer with calculations (6 marks) • Investment B • UB (250) = (50)1/2 [(500-I)I]1/4 • UB (250) = 111. 80 • UB > UA Contact: otto. yung@alumni. utoronto. ca Midterm 2011 – Q3 Part A - Assume that there is no capital market, which investment, A or B, will Jack choose? Justify your answer with calculations (6 marks) • Note: Two methods to calculate I* • 1st method (take derivative of Utility Function) • What’s the 2nd method? Contact: otto. yung@alumni. utoronto. ca Midterm 2011 – Q3 Alternatively - Investment B Contact: otto. yung@alumni. utoronto. ca Midterm 2011 – Q3

Part B – Which investment, A or B will Jack choose? What is his utilitymaximizing investment I* and the optimal consumption plan? (6 marks) (Assume a perfect capital market for borrowing and lending exists and the market interest rate is 20%) Contact: otto. yung@alumni. utoronto. ca Midterm 2011 – Q3 Part B – Which investment, A or B will Jack choose? What is his utilitymaximizing investment I* and the optimal consumption plan? (6 marks) • Jack will choose the investment with the highest NPV • Calculate NPVA and NPVB Contact: otto. yung@alumni. utoronto. ca Midterm 2011 – Q3

Part B – Which investment, A or B will Jack choose? What is his utilitymaximizing investment I* and the optimal consumption plan? (6 marks) • NPVA = -$244 + ($400)/(1+0. 20) = $89. 33 Contact: otto. yung@alumni. utoronto. ca Midterm 2011 – Q3 Contact: otto. yung@alumni. utoronto. ca Part B – Which investment, A or B will Jack choose? What is his utilitymaximizing investment I* and the optimal consumption plan? (6 marks) • To solve for NPVB • Need to find optimal investment (I*) • set MRT = -(1+r) = -1. 20 I* = $434. 03 • MRT = - dF/dI = -25/(I1/2) = -1. 20 • F = 50 ($434. 31/2) = $1041. 67 • NPVB = -$434. 03 + ($1041. 67/1. 20) = $434. 03 Midterm 2011 – Q3 Part B – Which investment, A or B will Jack choose? What is his utilitymaximizing investment I* and the optimal consumption plan? (6 marks) • To solve for optimal consumption plan (i. e. C0*and C1*) Contact: otto. yung@alumni. utoronto. ca Midterm 2011 – Q3 Part B – Which investment, A or B will Jack choose? What is his utilitymaximizing investment I* and the optimal consumption plan? (6 marks) • To solve for optimal consumption plan (i. e. C0*and C1*) • Total Wealth = $500 + $434. 03 = $934. 3 (set equal to C0 + C1/(1+r)) • PV Wealth = PV Consumption • C1 = 1120. 84 – 1. 2C0 Contact: otto. yung@alumni. utoronto. ca Midterm 2011 – Q3 Contact: otto. yung@alumni. utoronto. ca Part B – Which investment, A or B will Jack choose? What is his utilitymaximizing investment I* and the optimal consumption plan? (6 marks) • To solve for optimal consumption plan (i. e. C0*and C1*) • Total Wealth = $500 + $434. 03 = $934. 03 (set equal to C0 + C1/(1+r)) • U(C0, C1) = C01/4 (1120. 84 – 1. 2C0 )1/2 • dU/dC0 = (1/4)C0-3/4 (1120. 84 – 1. 2C0)1/2 – 1. 2 x (1/2)C01/4(1120. 4 – 1. 2C0)-1/2 • Setting it equal to zero: 1120. 84 – 1. 2C0 = 2. 4C0 C0* = $311. 34 • C1* = 1120. 84 – 1. 2C0 = $747. 22 Midterm 2011 – Q3 Part B – Which investment, A or B will Jack choose? What is his utilitymaximizing investment I* and the optimal consumption plan? (6 marks) (Assume a perfect capital market for borrowing and lending exists and the market interest rate is 20%) • Alternatively: To solve for optimal consumption plan (i. e. C0*and C1*) Contact: otto. yung@alumni. utoronto. ca Midterm 2011 – Q3 Part B – Which investment, A or B will Jack choose?

What is his utilitymaximizing investment I* and the optimal consumption plan? (6 marks) • Alternatively: To solve for optimal consumption plan (i. e. C0*and C1*) • MRS = - (1+r), which leads to • - (C1/2C0) = 1. 2 C1 = 2. 4 C0 • Budget constraint: C0 + C1 / (1+r) = Total Wealth = $934. 03 C1 = 1120. 84 – 1. 2C0 C0* = $311. 34 C1* = $747. 22 Contact: otto. yung@alumni. utoronto. ca Midterm 2011 – Q3 Part C - Jack can hire a worker to supervise one investment for him. As a result, he can now invest in both production opportunities if he wants.

If he hires a worker, he has to pay wages in equal instalments (i. e. Same wage today and next period). What maximum wage per period would Jack be willing to pay? (4 marks) Contact: otto. yung@alumni. utoronto. ca Midterm 2011 – Q3 Part C - Jack can hire a worker to supervise one investment for him. As a result, he can now invest in both production opportunities if he wants. If he hires a worker, he has to pay wages in equal instalments (i. e. Same wage today and next period). What maximum wage per period would Jack be willing to pay? (4 marks) • NPVA = $89. 33 = W + (W/1. 20) • W = $48. 3 (i. e. Maximum wage per period) Contact: otto. yung@alumni. utoronto. ca Midterm 2011 – Q3 Part D – Jill earns an income of $250 today and $250 next period but has no access to any production opportunities. She can, however spend some money today to purchase investment opportunity B. Her utility function is: U(C0, C1) = C0 + 2C1 + min(C0, C1) What is the highest price that Jill is willing to pay? (4 marks) Contact: otto. yung@alumni. utoronto. ca Midterm 2011 – Q3 Part D – Jill earns an income of $250 today and $250 next period but has no access to any production opportunities.

She can, however spend some money today to purchase investment opportunity B. Her utility function is: U(C0, C1) = C0 + 2C1 + min(C0, C1) What is the highest price that Jill is willing to pay? (4 marks) • With a perfect capital market, the Fisher Separation Theorem applies • So the maximum amount she will pay is $434. 03 (i. e. NPVB) Contact: otto. yung@alumni. utoronto. ca FINANCIAL MARKETS AND NET PRESENT VALUE (TO SUCCEED - PRACTICE, PRACTICE, PRACTICE) Week 3 – Quick Review (Self-Evaluation) of Week 2 “GET TO KNOW YOU” SURVEY (Name: Optional)

Question #1: • What has occurred in your other courses that you were happy about and would like to be incorporated into this course ? • What has occurred in your other courses that you were NOT happy about? Question #2: • Anything specific you would like to learn? What are your learning goals in this course? • Any specific requests from the instructor, TAs, program, other support staff, etc? Question #3: • Are you thinking of pursuing further education in Finance, if not then what do you have in mind? And/or... What job(s) are you interested in? Question #4: • Tell me more about yourself (e. . goals, program concentration, 2nd or 3rd year, etc... ) Question #5: • Any other comments, requests, suggestions, etc? TAKE ~3 MINUTES INDIVIDUALLY TO FILL OUT SURVEY TAKE ~ 5 MINUTES TO TALK TO 5 CLASSMATES WHOM YOU HAVEN’T MET YET (write down initials) SURVEY RESULTS (SUMMARY) • • • • • • • • • • • • • • • • • Real world experiences, practical (real-world) examples, cases... Relevant news (where to find news), Current issues in the market Relate course material to real world Exam tips/techniques Applications and excel models used in the real world Interactive class, games, videos...

Extended office hours (availability) to address questions Humour Practice questions and solutions; Past exams and solutions Capital markets (high-level overview) Typical jobs in finance, Leading finance organizations Additional tutorial time Stock picking, portfolio allocation/analysis, investment tools/strategies, trading tips Learning topics that can be applied in real life Relate designations/roles to course material and applications Better understanding of financial instruments (e. g. Mortgages, bonds, etc... ) View of finance from other functional areas (e. g. Marketing) http://www. explorefinancialservices. om/Options http://www. explorefinancialservices. com/ Financial Markets: What is Going On? Firms (Users of Capital) Initial Public Offering (IPO) Secondary Offerings (SEO) Borrowing (Loans, Bonds) Dividends, $ Repurchases, Interest Payments $ Market Mechanisms or Market Makers (Stock Exchanges, Banks, Investment Funds, …) $ $ Firms Issue Stock Certificates and Bonds $ $$$ Invested in Stocks and Bonds Investors (Providers of Capital) Investment Banks help firms make transactions Brokers/Dealers help investors make transactions Reference: Alex MacKay 113 Hedge Fund Strategies Dedicated Short

Source: AIMA Canada Further Reading Hedge Funds - Emerging Market Strategy • Emerging Markets (American Depository Receipts – ADRs vs. Foreign Securities) http://www. sec. gov/pdf/ininvest. pdf (Page 12) (SAP) Hedge Fund - Quants • Jim Simons (Renaissance Technologies) - Commodities/Futures – (Rapid Fire Trading) – (computer and system specialists, researchers and traders) (computational linguists–speech recognition/investing) • http://chinese-school. netfirms. com/abacus-hedge-funds-Jim-Simons. html • • Kenneth Griffin (Citadel Investment Group) – Convertible Bonds –> Long-Short • http://money. cnn. om/2008/12/08/news/companies/citadel_vickers. boyd. fortune/index. htm The Quants (Scott Patterson – Wall Street Journal Reporter) • • http://www. businessweek. com/magazine/content/10_09/b4168070829612. htm http://online. wsj. com/article/SB10001424052748704509704575019032416477138. html Steven Palmer (AlphaNorth Asset Management Inc) (Microcap – Tech) • http://www. theglobeandmail. com/globe-investor/funds-and-etfs/funds/top-hedge-fund-manager-turns-to-techmicro-caps/article1884049/ House Dems propose taxing equity trades to fund new federal programs • • • Financial transaction tax on all stock (0. 5%), bond (0. %) and derivatives (0. 005%) trades Protects financial markets from speculation Make high-frequency trading “unprofitable” http://thehill. com/blogs/floor-action/house/249893-house-dems-propose-taxing-equity-trades-to-fund-new-federal-programs Harsh HFT curbs could sneak into MiFID • • • • Introduction of minimum resting times between trades Could force HFT firms out of the market, widening spreads and making trading more costly Meetings held with the European Parliament’s Economic and Monetary Affairs Committee (ECON) MiFID (Markets in Financial Instruments Directive) – European Union Law http://www. hetradenews. com/news/Regions/Europe/Harsh_HFT_curbs_could_sneak_into_MiFID_II. aspx CAPITAL MARKET THEORY RSM 332 – Week 2 Week 1 – Introduction – Financial Accounting (Review) Week 2 – Financial Markets and Net Present Value Week 3 – Present Value Concepts Week 4 – Bond Valuation and Term Structure Theory Week 5 – Valuation of Stocks Week 6 – Risk and Return – Problem Set #1 Due Week 7* – Midterm (Tuesday*) Week 8 - Portfolio Theory Week 9 – Capital Asset Pricing Model Week 10 – Arbitrage Pricing Theory Week 11 – Operation and Efficiency of Capital Markets Week 12 – Course Review – Problem Set #2 Due

Contact: otto. yung@alumni. utoronto. ca THANK YOU SEE YOU NEXT WEEK! OFFICE HOURS WEDNESDAYS – 4:00PM-6:00PM ROOM 413 OR 417 105 ST. GEORGE STREET ROTMAN (NORTH BUILDING)

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