Table of Content

Lecture 1: Asset Classes and Financial Instruments

Part 1 Investment Process & the Consumption-Based Model

Part 2 Financial Assets
Part 3 Asset Classes

Lecture 2: Allocating Resources Over Time

Part 1 The Time Value of Money

Part 2 Stream of Payments
Part 3 Continuous Compounding, Logarithmic Return & Effective Rate

Lecture 3: Financial Markets

Part 1 Financial Markets

Part 2 Financial Intermediaries and How to Raise External Capital
Part 3 How to Trade Securities

Lecture 4: Risk and Returns

Part 1 Actual Returns & Expected Returns

Part 2 Risk & Risk Premium
Part 3 The Normal Distribution

Capital Allocation Decision and Risky Portfolios:

Lecture 5: Part I

Part 1 Asset Allocation & Portfolio Diversification

Part 2 Portfolio of Two Risky Assets
Part 3 Portfolio of Two Risky Assets

Lecture 6: Part II

Part 1 Portfolio of a Risk-Free Asset and Risky Assets

Part 2 The Markowitz Portfolio Selection Method
Part 3 The Markowitz Portfolio Selection Method: Examples

Lecture 7: Part III

Part 1 The Central Asset Pricing Formula

Part 2 Risk Aversion
Factor Pricing Models

Lecture 8

Part 1 The Single-Factor Model

Part 2 Estimating the Single-Index Model
Part 3 Portfolio Construction and the Single-Factor Model

Lecture 9

Part 1 The Capital Asset Pricing Model

Part 2 The Security Market Line

Lecture 10

Part 1 The Multi-Factor Models

Part 2 The Multi-Factor Models & the Fama and French Model
Part 3 The Arbitrage Pricing Theory

Lecture 11: The Efficient Market Hypothesis (EMH)

Part 1 Efficient Market Hypothesis

Part 2 Tests of the Efficient Market Hypothesis

Lecture 12: Behavioural Finance

Part 1 Behavioural Finance

Part 2 Technical Analysis

Estimating and Evaluating Asset Pricing Models

Lecture 13: Time-Series Regressions

Lecture 14: Cross-Sectional Regressions

Part 4
Lecture 1

Part 1: Investment Process & the Consumption-Based Model

Payoff x t +1= pt +1+ d t +1
x = Payoff
p = Price
d = Dividend
Utility Function U ( c t , c t +1 )=u ( c t ) + β E t [ u (c t +1) ]
(over current and future values of u ( c t ) = utility of the consumption at time t
consumption)
Et [ u (c t +1) ] = Expected utility of the
The Basic Pricing Model consumption at time t+1

While,
1 1−γ
u (ct )= c
1−γ t
lim [ u ( c t ) ]=lim
γ→1
(1 1−γ
γ → 1 1−γ
c t =ln( c) )
[ ]
Price '
u ( c t +1 )
pt =Et β '
x t +1
u (ct )
'
Stochastic Discount Factor u ( ct +1 )
m t +1 ≡ β '
u (ct )
Part 2: Financial Assets
Part 3: Asset Classes

Lecture 2

Part 1: The Time Value of Money

tm
Value (Compounding Interest) r
FV =PV (1+ )
m
FV
PV = tm
r
(1+ )
m
Value (Simple Interest) FV =( 1+rt ) PV
FV
PV =
(1+rt )
Investment Return FV −PV
k=
PV
Part 2: Stream of Payments

( )
Annuity 1−(1+ r )
−n
P=C
r

( )
Amortization r
C=P
1−(1+ r )−n
Perpetuity C
P=
r
C=rP
 Part 3: Continuous Compounding, Logarithmic Return & Effective Rate
rt
Future Value FV =e P
(Continuous Compounding) r = rate of return
t = time
−rt
PV =e FV
Logarithmic Return FV
R=ln
(Continuously Compounded Return) PV
r
Effective Rate r e =e −1
(Continuous Compounding)

Lecture 3

Part 1: Financial Markets

Part 2: Financial Intermediaries and How to Raise External Capital
Net Asset Value (NAV) Market value of assets−Liabilities
NAV =
Noof outstanding shares
Part 3: How to Trade Securities

Lecture 4

Part 1: Actual Returns & Expected Returns

Portfolio Value V t =( amount ) ( value )t + ( amount ) ( value )t + …t
Portfolio Return FV −PV
R=
PV
Holding-Period Return (HPR) A Final Value of an Investment
HPR=
An Initial Value of Investment
1
FV + ∑ CF t
t =0
HPR=
PV
CF t : Cash Flow received or paid
Holding-Period Yield (HPY) HPY =HPR−1
Annual Percentage Rates (APR) r
APR= × n
(Simple Interest) n
r
= Per-period rate of return
n
n = Number of compounding period

( ) r n
Effective Annual Return (EAR)
(Compounding Interest) EAR= 1+ −1
n
r = Annual Interest
n = Number of compounding period
r
= Per-period rate of return
n
Relationship between APR and EAR (1+ EAR)T −1
APR=
T
Where,
1
T = length of the investment =
n
 Hence,

[ ]
1
n
APR=n ( 1+ EAR ) −1
n = Number of compounding period

Therefore,

EAR= 1+ ( APR n
m
−1 )
n
Expected Return 1.0
E ( Ri ) =∑ (Pi )( Ri )
i=1
E ( Ri ) = Expected return on asset i
Ri = Possible return on asset i
Pi = Probability of possible return on asset i

n
E ( R P )=∑ wi E ( Ri )
i=1
E ( R P ) = Expected return on portfolio
Part 2: Risk & Risk Premium
n
1. Variance of the Returns
σ =∑ [ r i−E (r i ) ] Pi
2 2

i=1
r i = ALL (possible) return on the asset
E( r i) = Expected return on the asset
Pi = Probability associated the return

√∑ [
2. Standard Deviation of the n
σ =√ σ =
2
r i−E(r i ) ] Pi
2
Returns
i=1
3. Coefficient of Variation (CV) σ
CV =
(Level of risk per unit of expected E(r i )
return) The Lower CV the lesser risk
Risk Premium (RP) RP i=E ( r i ) −r f
E ( r i ) = Expected rate of return
Excess Return (ER) ER i=r i−r f
r i = Actual rate of return
Expected Return 2.0 Assuming all historical data have the identical probability.
n
(When computing historical data)
(Arithmetic Average Rate of Return) ∑ ri ( s)
s=1
E ( Ri ) =
n
Average of all historical data.
1
Geometric Average Rate of Return n
(Time-weighted average return) g= (Terminal Value ) −1

Terminal Value=( 1+ r 1 )( 1+ r 2 )( 1+ r 3 ) …(1+r n )

g = time-weighted average return

 The Reward-to-Volatility (Sharpe) Risk Premium
Sharpe Ratio=
Ratio Standard deviation of excess returns
Part 3: The Normal Distribution
n
Skew
∑ ( x i−x )
3

i=1

[ ]
3
σ
3
( x i−x )
Skew= = Average
n σ
3

Positive: Align Left

Zero: Normal
Negative: Align Right
n
Kurtosis
∑ ( x i−x ) 4

[ ]
i=1
4
σ
4
( x i−x )
Kurtosis= −3= Average −3
n σ
4

Positive: Skin but high

Zero: Normal
Negative: Fat but low

Lecture 5

Part 1: Asset Allocation & Portfolio Diversification

Part 2: Portfolio of Two Risky Assets
Weightage of an asset x i( t )Si ( t )
w i ( t )=
V (t )
w i t = Weightage for asset i at time t
x i t = Number of asset i held in a portfolio at time t
Si t = Value/price of asset i at time t
V (t ) = Value of a portfolio at time t
Portfolio’s rate of return R P=w1 R1 + w2 R 2+ …+w n Rn
n
Portfolio’s Expected Return
E ( R P )=∑ wi E( Ri )
i=1
While,
n
E ( Ri ) =∑ (Pi )( Ri )
i=1
Covariance, σ 12 n

∑ ( x i−x )( y i− y )
Cov ( x , y ) =σ 12= i=1
n−1
(N for populations, n-1 for sample)
Correlation Coefficient, ρ12 cov ( R1 , R 2) σ 12
ρ12 = =
σ1 σ2 σ1 σ2

2 2 2 2 2
Variance of return on a portfolio σ P=w1 σ 1 +w 2 σ 2+ 2 w1 w2 σ 12

σ 2P=w21 σ 21 +w 22 σ 22+ 2 w1 w2 ρ12 σ 1 σ 2

Part 3: Portfolios of Two Risky Assets
 Weightage of Asset 1 When −1< ρ12 <1,
(Minimum Portfolio Risk) 2
σ 2−ρ12 σ 1 σ 2
w 1= 2 2
σ 1 +σ 2 −2 ρ12 σ 1 σ 2
When ρ12=0 ,
2
σ2
w 1= 2 2
σ 1 +σ 2

Lecture 6

Part 1: Portfolios of a Risk-Free Asset and Risky Assets

Variance of the portfolio Assuming the portfolio has one risky asset and one risk
free asset
2 2 2
σ P=w1 σ 1
Standard Deviation of the portfolio Assuming the portfolio has one risky asset and one risk
free asset
σ p=w 1 σ 1
Expected return of a complete σ
portfolio E ( RC ) =Rf + C [ E ( R P )−R f ]
σP
Part 2: The Markowitz Portfolio Selection Method
n n
Variance of a risky portfolio
σ P=∑ ∑ w i w j cov ( Ri , R j )
2

i=1 j =1
Part 3: The Markowitz Portfolio Selection Method: Examples

Lecture 7

Part 1: The Central Asset Pricing Formula

[ ]
Central Asset Pricing Formula u ' (c t +1)
pt =Et β x t +1
u ' (c t )

While, Stochastic Discount Factor:

u' (c t +1)
mt +1 ≡ β
u ' (c t )

Hence,
pt =Et (mt+1 x t+ 1)
m = Stochastic Discount Factor
x = Payoff
Pricing Formula When payoff is certain: Certain = Risk Free
x t +1
pt =
Rf
1
= Risk Free Discount Factor
Rf

When payoff is uncertain: Uncertain = Asset-specific risk

 E [ x t +1 ]
pt =
Ri
1
= Asset-specific risk-adjusted discount factor.
Ri
Gross Return x
Rt +1= t+ 1
pt

Assuming pt = 1,
Rt +1=x t +1
1=E (mR)

( )
Stock’s payoff (with P/D ratio) pt +1 d t +1
x t +1= 1+
d t+ 1 d t
Real/Nominal Values Real:

[ ]
'
pt u ( ct +1 ) x t +1
=Et β '
Πt u (ct ) Π

Nominal:

Where,
pt =Et
[( u' ( c t +1) Π t
β '
u ( ct ) Π t +1
x t +1
) ]
Π = Price level (CPI)
Risk-Free Rate 1
Rf=
E(m)
E(m) = Estimated Stochastic Discount Factor

1=R f E ( m )
'
Price (Risk Correction) E( x ) cov [ β u ( c t +1 , x t +1 ) ]
p= +
Rf u ' (c t )
cov [ β u ( c t +1 , x t +1 ) ] =cov (m , x ) = Effect of a covariance
'

between payoffs and consumption

When cov(m,x) = 0 (Specific risk doesn’t affect prices),

E(x )
p=
Rf
Return (From the basic asset pricing) −cov [ u ( ct +1 ) , Ri ,t +1 ]
'

E ( Ri ) −Rf =
E [ u ( c t+ 1) ]
'

cov [ u ( ct +1 ) , Ri ,t +1 ]
'

=R f cov (m , Ri ) = Covariance of m
E [ u ( c t +1) ]
'

and Ri

E ( Ri ) =Rf + β i , m λ m
 β i ,m =
( cov ( m , Ri )
var ( m) ) = Beta = Regression coefficient from

the return Ri on the discount factor m (Specific to each

asset i)

λ m= ( −var ( m )
E (m) )
= Identical for all assets i

Since correlation coefficients are not larger than one,

σ (m)
|E ( Ri ) −Rf|≤ E ( m ) σ (Ri )
Mean-Variance Frontier E ( Ri ) =Rf + β i , mv [ E ( Rmv ) −R f ]

λ=E ( Rmv )−R f (Risk Factor Premium)

Slope of Frontier (= Sharpe Ratio) E(Ri −R f )
σ (Ri ) |=σ (m) Rf
|
m = Stochastic Discount Factor
n
Present-Value Equation
pt =Et ∑ mt ,t + j d t + j =Et [ mt +1 ( p t+1 +d t +1 ) ]
j=1

Actually… it is same as the present value formula.

Cash Flow/discount factor
n n
Present-Value Equation (with risk
adjustment) pt =Et ∑ mt ,t + j d t + j + ∑ cov (mt , t+ j , dt + j)
j=1 j=1

f 1
Since Rt ,t + j ≡ ,
Et ( mt ,t + j )
n
E t ( dt + j ) n
pt =Et ∑ f + ∑ cov (mt , t + j , d t+ j )
j=1 Rt ,t + j j=1

Part 2: Risk Aversion

Expected Stock Price, E ( S ( n ) ) Risky:
n
(based on the historical data) E ( S ( n ) ) =S (0) {1+ E [ K ( n ) ] }

Expected Return, E ( K ( n ) ) While,

E ( K ( n ) ) =E ( K ( 1 ) ) = pu+ ( 1− p ) d
u and d = possible returns
p = probability of return u will be achieve

Risk-free:
E ( S ( n ) ) =S (0)(1+r )
n

Comparing Risky and Risk-free:

Risk-Averse: E ( K ( 1 ) ) >r
Risk-Neutral: E ( K ( 1 ) )=r
Risk-Lover: E ( K ( 1 ) ) <r
 Utility Score, U 1 2
U =E ( r )− A σ
2
E ( r ) = Expected return
A = Index of the investor’s risk aversion
σ 2 = Variance of the returns

Key Notes:
 Negative A = risk lover, more satisfaction for
taking more risk, U will always be increasing
 0 A = risk neutral, investor’s utility is same as the
expected return
 Positive A = risk averse, investor might has a
negative U when the risk is increasing

Lecture 8

Part 1: The Single-Factor Model

Gross Return/Net Return Gross Return:
x t+ 1
Rt +1=
pt

Net Return:
x t+ 1
Rt +1= −1
pt
Actual Rate of Return Ri , t=E ( Ri , t ) + ei , t '
E ( Ri , t ) = Expected return
e i ,t ' = Unexpected return (mean of zero, sd of σ i)
Actual Rate of Return Ri , t=E ( Ri , t ) + β i mt +e i ,t '
(Single-Factor Model) E ( Ri , t ) = Expected return on asset i at time t
mt = Unexpected macroeconomic surprise
β i = sensitivity of asset i to common factor m
e i ,t ' = Asset-specific surprise component
Variance of an assets σ 2i =β 2i σ 2m+ σ 2e i
(Single-Factor Model)
σ 2i = Variance of asset i
2
σ m = Variance of the macroeconomic surprise factor m
(systematic risk)
σ 2e = Variance of the asset-specific surprise element
i

(unsystematic risk)
2
Covariance of any two assets cov ( r i , r j ) =cov ( m+e i , , m+ e j )=β i β j σ m
(Single-Factor Model)
For the three formula above, if Beta was not given, then
ignore the Beta in the formula.
Excess Return on Asset i Rei , t=Ri , t−R f , t=α i + β i R eM , t +e i ,t
(Single-Index Model) e
Ri , t = Excess return on asset i at time t
α i = Alpha of asset i
β i = Beta of asset i
 ReM ,t = Excess return on the market portfolio at time t (aka
Risk Premium)
e i ,t = Error term/Asset-specific surprise component at time
t

While,
ReM ,t =R M ,t −Rf ,t
Expected Return E ( Rie, t ) =α i+ βi E ( ReM ,t )
(Single-Index Model)
Where E ( e i ,t )=0 as you don’t expect an error in your
expectation
2
Correlation Cov (r i , r j ) β i β j σ m
(Single-Index Model) Corr ( r i ,r j )= ρij = = =ρ ℑ ρ jM
σi σ j σi σ j
n
Variance of the asset-specific
components of the equally weighted n ∑ σ 2e
()
2
1 2 t =1 i

portfolio of risky assets σ 2e =∑ σ =

p
i=1 n e n i

By diversifying the asset-specific risk/unsystematic risk.

Part 2: Estimating the Single-Index Model
Part 3: Portfolio Construction and the Single-Factor Model
Revised: Sharpe Ratio E ( RP )
S P=
σP
E ( R P ) = Expected excess return/Alpha/Risk Premium
Revised (Stock Market Index) 1. β=1.0
2. α =0
3. Stock Market Index has no firm-specific risk
Expected return on the stock market index contains no
non-market component.
Weight in Portfolio “A” (which is the When β A =1,
one an investor actively analysed in αA
a portfolio)
σ 2A
0
w = A
E(R A )
2
σM
When β A ≠1 ,
w0A
¿
w = ¿¿
A

w 0A = Optimal weight in Portfolio “A”

¿
w A = Adjusted position for optimal weight in Portfolio “A”

Hence,
¿ 0
w M =1−w A (¿ w A )

w M = Optimal weight in Portfolio “M”

( )
2
Sharpe Ratio of the Portfolio 2 2 αA
S P=S M +
σe A
 S2P = Sharpe ratio of the portfolio
2
S M = Sharpe ratio of the passive portfolio management
strategy (or the market index portfolio)

( )
2
αA
= Information ratio, telling the addition return we
σe A

could potentially get from conducting a security analysis

Key notes:
Investors want to maximize the information ratio, to
maximize the Sharpe ratio
Again, weight in each asset αi
When each asset is held in proportion to its ratio of ,
σ 2e i

the information ratio will be maximized.

αi
¿ ¿
σ 2e
w =w =
i A n
i

α
∑
i=1 σ
i
2
ei

Lecture 9

Part 1: The Capital Asset Pricing Model (CAPM)

Assumptions 1. Individual investors are price takers
2. Single-period investment horizon
3. Investments are limited to traded financial assets
4. No taxes and transaction costs (In a perfect world)
5. Information is costless and available to all investors
6. Investors are rational mean-variance optimizers
7. There are homogeneous expectations
2
Risk Premium E ( R M )−R f = A σ M '
(Of all investors) A = Average risk aversion ( A ) across all investors (aka
price of risk)
2
σ M ' = Variance of the market portfolio (aka the quantity of
risk)
Sharpe Ratio E ( R i )−R f E ( R m )−R f
= 2
cov (Ri , R M ) x σM
Sharpe ratio of any asset = Sharpe ratio of the portfolio
Risk premium of an asset cov ( Ri , R M )
E ( Ri ) −Rf =
σ 2M
[ E ( Rm ) −Rf ]
Asset’s Expected Return cov ( Ri , R M )
E ( Ri ) =
σ 2M
[ E ( Rm ) −Rf ]+ R f
cov (Ri , R M )
2 = Quantity of risk/Beta
σM
[ E ( R m )−R f ] = Expected market price of risk
 If an asset has no risk (covariance = 0),
E ( Ri ) =Rf
CAPM Ri=R f + β i ( E ( R M )−R f )
CAPM (Overall Portfolio) Portfolio expected return (weightage):
n
E ( R P )=∑ wk E(R k )
k=1
Portfolio beta (weightage):
n
β P =∑ w k β k
k=1

Market Portfolio Expected Return:

E ( R M )=R f + β M ( E ( R M ) −R f )
cov ( RM , R M ) 1
Where β M = 1 as β M = = 2
σ 2M σM
Part 2: The Security Market Line
SML, Equals E( R ¿¿ M )=R f + β M (E ( R M ) −Rf )¿
The Market Model R = α^ + ^β R + e
i,t i i M ,t i,t
(similar to the single-factor model) Ri , t = Rate of return for asset i at time t
R M ,t = Rate of return on the market portfolio
α^ i = Alpha obtained from a regression
^β i = Beta obtained from a regression

Keynote:
Risk free rate is not used to derive a prediction

When α
^ i = 0,
Ri , t= β^ i R M , t +e i ,t

a^ i ≠ 0 only happens when detailed analysis of a security

occurs, and the assumptions of CAPM has remove the
effect of a^ i
^β is the measure of the systematic risk of the asset.

Lecture 10

Part 1: The Multi-Factor Models

 Expected Return E ( Ri ) =Rf + β i , GDP RP GDP + β i ,∫ ¿ RP
∫ ¿+… ¿ ¿
(Multi-Factor Model)
E ( Ri ) = Expected return on asset i
R f = Risk-free rate of return
β i ,GDP = Sensitivity of asset i to GDP growth
β i ,∫ ¿ ¿ = Sensitivity of asset i to the interest rates
RP GDP = Risk premium for GDP growth
RP∫ ¿¿ = Risk premium for the interest rates

Addable factors:
FX = Foreign Exchange Rate
M = Stock Market Portfolio

Keynotes:
Positive β = positive correlated
Zero β = not correlated, give no risk adjustment/risk
correction
Negative β = negative correlated
Part 2: The Multi-Factor Models & the Fama and French Model
Fama-French Three-factor Model E ( Ri ) −Rf =ai +b i [ E ( R M ) −Rf ]+ s i E ( SMB ) +hi E ( HML )

E ( SMB )=E ( small )−E ( big ) : on size

E ( HML )=E high( M
B
) (
−E low
B
M )
: on growth

opportunities
a i = Intercept term, = 0
b i , s i , hi = Betas (aka loadings)
Part 3: The Arbitrage Pricing Theory
Excess return R P=α P + β P R M
 Well-diversified portfolio β P = Beta against the well-diversified market index
 No-arbitrage requirement
Expected Excess return E ( R P )=β P E( R M )
 Well-diversified portfolio Risk premium on portfolio P = Its beta and the risk
 No-arbitrage requirement premium of the market index

Lecture 11

Part 1: Efficient Market Hypothesis (EMH)

Part 2: Test of the Efficient Market Hypothesis

Lecture 12

Part 1: Behavioural Finance

Part 2: Technical Analysis
Trin Statistics Volume declining
Number declining
Trin=
Volume advancing
Number advancing
 Trin > 1.0, bearish
Trin < 1.0, bullish
Confidence Index r TCB
Confidence Index=
r ICB
Where,
r TCB = Average yield on 10 top-rated corporate bonds
r ICB = Average yield on 10 intermediate-grade corporate
bonds.

High Confidence Index, bullish

Low Confidence Index , bearish
Confidence Index should be < 1

Lecture 13

Part 1: Time-Series Regressions

CAPM (Revised) E ( r i , t ) =r f ,t + β i ( E ( r M ,t )−r f ,t )
Beta Cov(r i ,t , r M ,t )
β i=
Var (r M ,t )