Syllabus for Course Finance 3000 Hawaii Pacific University
Professor: Dr. Gunter Meissner, Business: 544 0807, Office: FHT 5th floor #1 E-mail: [email protected], Web: www.dersoft.com
Contents: The course focuses on three main issues: a) Basics of Finance b) Asset management c) Debt Management
Goals: a) The student will be familiar with basic financial concepts such as the Time value of money concept,Capital Budgeting (Investment decision process) and Working capital
management.
b) Asset management:In the field of asset management every student will be a competent fund manager and financial adviser at the end of the semester. The student will learn about the two major investments: Bonds and stocks. The student will know how to apply the latest concepts and strategies of trading.
Syllabus for Course Finance 3000 cont.
c)Debt management:In the field of debt management the student will be familiar with the classical types of liabilities of a company (stocks, bonds, loans). Also, the student will learn how to use financial innovations such as interest rate and currency swaps, caps, floors, dual-currency bonds and convertibles in order to reduce cost and the various types of risk.
Literature: 1) Slides on www.dersoft.com/hpu 2) Essentials of Corporate Finance, Ross, Westerfield, Jordan 3) Trading Financial Derivatives, Gunter Meissner 4) Outperform the Dow: Using Options, Futures and Portfolio Strategies to Beat the Market, Gunter Meissner 5) Credit Derivatives : Application, Pricing, and Risk Management, Gunter Meissner (will be used for Risk Management) 6) Dictionary of Finance and Investment Terms, Downes, Goodman 7) RISK Magazine (available at Library desk)
Grading: Participation/Homework 10% Trading game 10% Financial paper 20% Presentation of Financial Paper 10% Mid-Term 25% Final 25%
F < 60.00
95.00 =< A =< 100
90.00 =< A- < 95.00
Grading
Point System
86.66 =< B+ < 90.00
83.33 =< B < 86.66
80.00 =< B- < 83.33
76.66 =< C+ < 80.00
73.33 =< C < 76.66
70.00 =< C- < 73.33
65.00 =< D+ < 70.00
60.00 =< D < 65.00
Syllabus for Course Finance 3000 cont.
Financial paper: Each student will write a 10 page paper and present it leading a 30 minute discussion on his/her findings. The paper has to be handed in one week before presentation.
APA style, have a Table of Contents, have a Conclusion!
The paper has to show your own thought process !
Don’t cite too much, but analyze !
Permanent homework:Read, listen to financial news!! Bring questions to class!
The quality of the argument is important, not the argument itself !
Finance as a Science
Hard Sciences
• Math/Statistics• CS/IT• Nature Sciences (Physics, Chemistry, Astrophysics Gene Technology)
These sciences use Math, Logic and Computers to solve problems; there is usually a “right “ or
“wrong”
Soft Sciences
• Marketing• Management• Communication
These sciences use Psychology, Sociology and common sense to solve problems; there is usually a “probably better” or “probably
worse”
Finance
• Time Value of Money Concept
• Corporate Finance
• Stock/Bond Analysis
• Portfolio Theory (CAPM) • Derivatives (Futures, Swaps, Options)
• Risk Management
•Accounting
• Behavioral Finance
• Investments
Should we learn Finance?
Of course!!!!
Why should we learn Finance??
Topics for financial paper1)Analysis of the financial system of a certain country, especially the exchange
2) The American Bond Market: History (Junk Bonds in the 80’s to today), Types of Bonds (Plain vanilla, floater…), Correlation of major Bond markets
3) Bond theory: Rate of return, Duration, Convexity, Bond stripping 4) The American stock market, History (1929 to today), Correlation to other major markets Perspective, where does it go?
5)Stock analyses, P/E ratio, dividend yield, certificate, dividends, buybacks, stock splits,
6) World stock indices, Dow, Nasdaq, S&P, NYSE, Russel 2000, Dax , Nikkei, FTSE, Hang-Seng, Indices of Emerging Markets, (B-share, Bolsa…), Correlation! Perspective
7) World commodity markets, Overview, indices (CRB), recent developments, Outlook - which one’s to buy
8) CAPM, Theory, Implication, Practical relevance today?
9) Monetary policy in the US, Instruments, Usage, Success
10) European Monetary Union, Too early?, too unprepared?
11) Balance sheet of a company, Structure and Contents, Valuable for a potential investor? How to improve it
12) Hong-Kong July 1, 1997, One country - Two systems, Status quo analyses - Outlook 13)Economic indicators: NAPM, CPI, PPI, initial jobless claims, employment cost index (ECI), non-farm payrolls, unemployment, GDP, consumer confidence, beige book
14) Mergermania – A threat to the capitalistic system?
15) Swaps – Theory and Practice
16)Convertibles – Types and Pricing
17) Dividend Policy – Effects on the stock price
18) The World bank and the IMF – Structure and Goals
19) Insider Trading
20) Technical Analysis – Trick or Treat
21) Capital gains tax in the USA
22) Mortgage backed securities in the USA
Topics for financial paper cont.
Topics for financial paper cont.
23) Mutual funds – Buy the one that has performed best?
25) Futures - Practical application and pricing
26) Options - Practical application and pricing
27) Programming the Black-Scholes model or binomial option pricing model
28) US Retirement Tools: IRA’s and 401K’s
29) The Asian financial crises part 2 – Impact on the US and world economy with a time lag?
30) Business cycles – Obsolete? 31) The Japanese economy: solutions to a 10-year recession
32) The Hawaiian economy: solutions to a 10-year ailing economy
33) Forecasting methodologies for stocks; an overview
34) Chapter 11 bankruptcy protection 35) Working capital management
36) Mergers and Aquisitions
Topics for financial paper cont.
38) Finance and Neural Networks
39) Finance and Fuzzy Logic
40) Finance and Chaos Theory
41) Derivatives: Curse or Blessing for Society ?
42) Internet IPO’s: A sure bet for professionals ?
43) Has the Fed done a good job lately?
44) Technical Analysis: An empirical test
37) Foreclosures, A sure bet?
45) US Retirement Plans (IRA’s and 401 K’s)
46) Do Stocks outperform Bonds in the long run?
47) Is the US sliding into a recession?48) Day-trading – Only for Professionals?
49) E-Banking and E-Trading – Pros and Cons
50) Can international market correlations be exploited by traders?
51) Do Intra-day trends exist, that can be exploited by traders?
52) Collateralized Debt Obligations (CDO’s) – Pros and Cons
53) How to write a Business Plan – Write a detailed plan for your own company
54) Buy outs – Types, Pros Cons, Success rates
Topics for financial paper cont.
55) Are Bond Prices and Stock Prices positively or negatively correlated?
61) Malaysia’s Lesson from the Asian Financial Crisis: Should we ignore help from the IMF?
56) Are Stock Prices and Volatility negatively correlated?
57) Does an Increase in Volatility indicate an Market Reversal?
58) Does the Internet reduce company's cost of capital?
60) Venture Capital: A Good Investment?
59) Will the Internet make Brokers obsolete?
67) Choose your own topic
62) Bush’s Anti Missile Shield: Technologically and financially ridiculous?
63) Credit Derivatives: What are they, what are they good for?
64) Where is the value in Behavioral Finance?
65) Investing in Hedge Funds – Too risky?66) The Tobin tax – Can it decrease currency speculation and volatility?
Topics for financial paper cont.
68) The recent accounting scandals – What happened, what has to be done?
71) The Value at Risk concept
72) Basel II – The BIS proposal to banking supervision
73) Corporate Risk Management: Market Risk, Credit Risk, Operational Risk
75) Credit Risk Management
76) A survey of credit risk vendors
78) Pricing Credit Derivatives (Chapter 5 in Meissner’s book)
79) Investing in ETFs – A good idea? What are the costs?
80) The Daimler-Chrysler Merger - A success story? The $275 million lawsuit
77) Operational Risk – The next generation
81) Dell’s direct sales strategy – The model of the future?
69) The Enron – Arthur Anderson saga – What went wrong? Lessons to learn
70) The WorldCom accounting scandal
74) Credit Derivatives – An Overview
Topics for financial paper cont.
82) CEO and executive management compensation - Just a disgrace or harmful for shareholder value? Should there be a cap?
83) Is the stock market crash over? Prediction for the future!
84) The US credit score - How is it derived, Is there to much emphasis on it?
85) The target Fed Funds rate – How does it exactly work?
86) The US bankruptcy law – Too lenient?
87) The Sarbanes-Oxley Compliance Solution – Pros and Cons
88) The US Double Deficit – A Danger for International Financial Markets?
89) Should China float its Yuan?
90) Hedge Funds – What are their main strategies? Should they be regulated?
91) Market Timing – How does it exactly work? Should it be restricted?
92) Reits – Invest now?
93) The US corporate tax law – Favoring the big?
94) Martha Stuart – Wrongfully Convicted?
Topics for financial paper cont.
95) Bondstripping – How does it work?
96) The weak dollar – Curse or Blessing for the US economy?
97) Nanotechnology stocks – A good investment?
98) The EU expansion to 25 states – Chaos in the making?
99) Robert Engle’s 2003 Nobel-Prize rewarded GARCH theory – Justified?
100) Volatility on Volatility – A good trading indicator?
101) “Mexifornia” - Should illegal immigrants receive the green card?
102) Microsoft – A falling giant?
103) A Model for a Fair Exchange Rate
104) A Fundamental Analysis Model to forecast stock prices
105) Fannie Mae and Freddy Mac – Too much profit, too little benefit for mortgagors? Should they be privatized?
106) Should stock options be expensed?
107) Kmart – Sears, Another Failed Merger?
108) Hedgestreet – Derivatives for the small investor. A useful tool?
Topics for financial paper cont.
109) Stock market forecast for the next year
110) Fundamental and Technical Analysis of the Hawaii’s “Big Four”
111) High-Tech in Hawaii – An Analysis of Kamakura Corporation www.kamakuraco.com
112) An Analysis and Improvement of Kamakura’s ‘Technical Report’
113) IBM selling its PC division to Lenovo – A good idea?
114) The Shareholder Value Concept – Outdated, Too shortsighted?
115) Is Management Compensation in the US too high? – Should there be a Cap?
116) Hyundai –Currently number 7, soon number 1?
117) Walmart, 2% of US GDP – Success by employee discrimination?
118) The Boeing –Airbus Battle, No chance for Boeing?
119) The IPO process – Unfair? Corrupt?
120) How are Stock prices and Bond prices correlated? An empirical Study
121) A Model for a Fair Stock Price – Combining fundamental and technical analysis
122) Are we in the middle of a housing bubble, which will pop soon?
Topics for financial paper cont.
Choose your own topic, preferably finance related!!
123) Investible Hedge Fund Indexes – Where do we stand?
124) GM and Ford – What to do to fight Asia and Europe?
125) Do markets bottom and top on high volatility?
126) Private Equity Firms – Course or Blessing for the Economy?
127) Islamic Law (Shari’ah) – Opportunities and Challenges
128) Can we exploit the downturn during the earnings warning season?
129) Should GM merge with Nissan-Renault?
130) Ethics in Finance – Is there any?
Jobs Jobs Jobs
MBA FINANCE
CFP
Treasury Department
of any Company
(CFO, CRO, FRM)
Banking(Trader, Marketer,
Manager, Sales, CFA)
CommercialBank
InvestmentBank /
BrokerageHouse
To be Successfulon the Job:
Intelligence/Knowledge
ExperienceEmotional
Intelligence
• Self-awareness (realize how you come across)
• Self-regulation (suspend a decision, analyze first)
• Sensitivity (cultural; sense emotional problems)
• Motivation / Ambition (work smart and work hard)
• Social Skills (Communication, Team-skill, Persuasiveness)
Stay single !!!
Who manages Money???
Individuals Companies Countries Economic UnionsEU, Nafta, Asean
Debt
Assets
Reasons:
Reasons:
Recorded on a
Conclusion:
Dow Jones Industrial Average (Dow)
0
2000
4000
6000
8000
10000
12000
140001/
4/19
32
1/4/
1935
1/4/
1938
1/4/
1941
1/4/
1944
1/4/
1947
1/4/
1950
1/4/
1953
1/4/
1956
1/4/
1959
1/4/
1962
1/4/
1965
1/4/
1968
1/4/
1971
1/4/
1974
1/4/
1977
1/4/
1980
1/4/
1983
1/4/
1986
1/4/
1989
1/4/
1992
1/4/
1995
1/4/
1998
1/4/
2001
1/4/
2004
Bear Market Bull Market Bear Market Bull Market Bear
Great Depression
PostWar
Growth
1973 and 1978 OPEC
Crises
Black Monday1987
Start of new Bear Market, March 2000
Conclusion:
The Dow from 1928 to today
The Dow Jones Industrial Average (Dow)
0
2000
4000
6000
8000
10000
12000
14000
28
/10
/01
32
/07
/30
36
/05
/27
40
/03
/12
43
/12
/20
47
/12
/06
51
/12
/15
56
/05
/22
60
/11
/25
65
/06
/04
70
/01
/20
74
/07
/22
79
/01
/19
83
/07
/20
88
/01
/19
92
/07
/17
97
/01
/15
01
/07
/17
-100%
-50%
0%
50%
100%
150%
200%
Comparing the Major Indices
Conclusion:
0
200
400
600
800
1000
1200
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2001 2002 2003
S&P 500 (^SPX) Dow (^DJI) NASDAQ (^ixic)
Trading in the New Millenium
Criteria of good trader
What we trade
What we do
When we trade
How trades are executed
How we trade
•Fundamental analysis•Technical analyses
•Intuition(Book chapter 2)
Where we trade
•Seasons
Broker versus Trader
Broker versus TraderWhat is a broker?
A broker is a person who invests your money until is gone (Woody Allan)
A broker is an
Trader at Bank A(Buyer)
Trader at Bank B(Seller)
Broker
There are interbank brokers:
Private Investor A
ExchangeBroker
There are “private investor” brokers
Who takes price risk??
Investment Products
Mutual Funds are
About of all mutual fund managers underperform their benchmark!!!
Why????
General Reason:
Specific Reasons:
Investment Products
What about Hedge Fund or Fund of Funds performance??
Difficult to know..
Performance results suffer from ‘survivorship bias’ and ‘reporting bias’ (also called backfill bias)
Investment Products
Considering the mutual fund performance disaster, what shall we do ?
Invest passively in
as QQQQ, SPY, DIA, etc
or
(Holding company depositary receipts) as BBH (Biotech), Internet (HHH) or UTH (Utilities) etc
Where we trade
• on an exchange
• OTC (over the counter)
(Book p.10,11)
How trades are executed
• Electronically
• Open outcry
(Book p.13,14)
On-line TradingFirst step:
To trade:
Executionof the trade:
The broker checks the order (in terms of sizeand price) and puts it into the pit or computerizedtrading system
The execution of the trade is displayed on yourcomputer screen
On-line Trading, cont.
Advantages of On-line trading:
Disadvantages of On-line trading:
Open Outcry
Seat
Exchange
Hawaii
Pit
Book p.13
Pit
Pit
Computerized Trading (as the NASDAQ)
Bid Size Offer Size
$ 88 3000
$ 90 200
$ 91 100
$ 99 300
$ 96 250
$ 94 50
AMZN
Book p.13
Computerized Trading (as the NASDAQ)
Bid Size Offer Size
$ 88 3000
$ 90 200
$ 91 100
$ 99 300
$ 96 250
$ 94 50
Book p.13
AMZN
Computerized Trading (as the NASDAQ)
“Level 2” trading allows an investor to see anECN (Electronic Communication Network) screen
What we do
• Speculate
• Arbitrage
• Hedge
(Book p.5,6,9)
More on Speculation
Difference Gambling - Speculation - Investing
The chances of winning when gambling are
The chances of winning when speculating are
Example:
Exception:
In contrary to speculation, investing is
More on Speculation
These days, speculation is done ON MARGIN
This means
Example:
An investor wants to buy Yahoo, which trades at $100.He buys it on margin, which is 40%, and only pays
The same logic applies to short selling.
Short selling is
Warning: Only speculate with money you can afford to lose
More on ArbitrageExample:
Two traders quote the following prices for 1oz of Gold
London
Bid Offer
Tokyo
Bid Offer
Is arbitrage possible?
The term Arbitrage is often deliberately misused asin “Risk-Arbitrage = Take-over Arbitrage” or“Interest rate Arbitrage = Yield curve Arbitrage”
Criteria of a good trader
(Book p.15,16)
The Philosophy of Stock Price Forecasting
No Forecast Possible:
The markets are “efficient”=All information about a stockis incorporated in the currentstock price. This is equivalentto the“Random Walk Hypothesis”=
tS
Forecast Possible:
• Fundamental Analysis• Technical Analysis
• Seasonalities
• Times Series Analysis
• Neural Networks
• Chaos Theory
• Econometric Models
(“Outperform the Dow” Book chapter 2)
How we trade
trading are decisions based on
• Fundamental analysis
• Technical analyses
• Intuition
(Book p.16,17)
• Seasons
Fundamental analysisFundamental analysis is trying to forecast the movement of a stock price based on political, economical, sector-specific and company-specific data.
• Political stability is essential
• Macro-economic data are to be analyzed
• Sector is of importance• Company specific data are crucial
(Book p.16,17)
Financial RatiosAn Overview of Popular Financial Ratios
2) Liquidity Ratios
Current Ratio = Total Current Assets / Total Current Liabilities
Net Working Capital = Total Current Assets - Total Current Liabilities
Cash Flow = (Cash +Marketable Securities) / Total Current Liabilities
1) Earnings Ratios
PE Ratio = Market Price / Earnings per Share (will be discussed)
Earnings per Share = Earnings / Number of Outstanding Stock (will be discussed)
Dividend Yield = (Annual) Paid Dividend / Current Market Price (will be discussed)
PEG Ratio = Market Price / Earnings per Share / Growth Rate (will be discussed)
Financial RatiosAn Overview of Popular Financial Ratios
3) Profitability Ratios
Return On Equity = Earnings / Net Worth of Company1) (will be discussed)
Operating Profit Margin = Operating Income / Net Sales
Net Profit Margin = Net Income / Net Sales
Book Value = Net worth of company1) / Number of outstanding stock
4) Capitalization Ratios
Debt-to-Equity Ratio (also called leverage) = (Bonds + Preferred Stock) / Net Worth of Company 1)
1) The Net Worth of a company = Shareholders Equity = Total Current Assets – Total Current Liabilities
Earnings ratiosOne of the most important ratios is the price-earnings ratio, PE
The PE is the price of the stock divided by the earnings per share of the company.
The earnings in the PE ratio can be trailing, current or expected.
If the company is healthy and earnings are growing, the trailing PE ratio is higher than the current PE ratio, which is again higher than the expected (also called forward) PE ratio.
The PE, which is published in newspapers and on screens, is usually the expected PE.
As an example, if the stock of a company trades at $100 andnext years expected earnings per share is $5, then the expected PE ratio is
Result:
A fairly new ratio is the Price Earnings Growth ratio, PEG
It is the PE ratio divided by next years expected growth rate:
GS
EP
Example: The price of IBM is $100, the earnings per share is $2,And the next years expected growth rate is 50 (%). What is the PEG ratio?
PEG ratios below 1 are considered fairly cheap, PEG’s of over 1are considered fairly expensive
Earnings ratios
Of importance is also the earnings per share ratio.
It shows the allocation of the earnings to each share.
For example, if the earnings last year was $10 million and the number of outstanding stock is 10 million shares, the earnings per share is
This number is calculated after deducting taxes and dividends from the earnings.
Earnings ratios
Closely related to the earnings per share is the return on equity
The return of equity shows how profitable each share is.
Return on equity is calculated as the return (= earnings) divided by the common stock at par (the original issue price of the stock) + capital surplus (difference between the current stock price and the par stock price) + retained earnings.
For example, if the yearly return of a company is $1,000,000, and the sum of common stock at par + capital surplus + retained earnings is $10,000,000, the return on equity is
Earnings/Profitability ratios
Another important ratio is the dividend yield
It is the dividend divided by the current price of the stock.
For example, if the dividend per year is $2 and the price of the stock is $100, then the dividend yield is
High tech stocks e.g. Yahoo often do not paya dividend.
Earnings ratios
Technical analysis
Technical analysis is trying to forecast the movement of a stock price from the pattern it has moved in the past.
The philosophy of technical analysis
• Chart patterns reflect the fundamental data in an economy or a company
• The markets move in trends
• History repeats itself
(Book p.17,18)
Theories of Technical Analysis
a) Simple chart patternsTrend, support resistance, double tops and bottoms,triple tops bottoms, head and shoulders, flag
b) Moving average convergence-divergence (MACD)
c) Fibonacci Ratios and Elliot Wave principle
d) Relative strength index (RSI)
(Book p.17-33)
a) Simple chart patternsThe trend is your friend
An upward trend is a movement with consecutive higher lows and consecutive higher highs:
A downward trend is a movement with consecutive lower lows and consecutive lower highs.
A sideward trend is a movement which does not exceed a certain high and which does not fall below a certain low.
t
Price of Asset
(Book p.18)
a) Simple chart patterns cont.
Support - Resistance
A support level is a level, where the market is expected to from dropping, and possibly reverse to the upside. If however the support level is broken to the downside, a further significant is to be expected.
A resistance level is a level, where the market is expected to from rising, and possibly reverse to the downside. If however the resistance is broken to the upside, a further significant is to be expected.
(Book p.22-25)
Support - Resistance cont.
t
Price of Asset
Breaking of a resistance (dashed line)
t
Price of Asset
Resistance and support as the previous low and high
(Book p.22-23)
Support - Resistance cont.
t
Price of Asset
A support line, created by connecting previous lows
t
Price of Asset
False breakout
(Book p.23-25)
a) Simple chart patterns cont.
t
Price of Asset
a
b
c
Ae
B
Cd f
An ideal double top formation
t
Price of Asset
Triple top formation
(Book p.25-26)
a) Simple chart patterns cont.
t
Price of Asset
a
b
A
e
B
c
d
f
C
g
Ideal head and shoulders formation
t
Price of Asset
Flag formation with an upward breakout
(Book p.27-28)
b) Moving average convergence-divergence (MACD)
The MACD uses three exponentially smoothed averages to identify, like the concepts a) through c), a trend reversal or the continuation of a trend.
The first, called the MACD1 indicator, is the difference between two exponential averages, usually a 26-day and a 12-day average. The second, called Signal indicator, is the 9-day moving average of the MACD1 indicator.
The MACD indicator reduces to two indicators:
The term convergence and divergence refers to a narrowing respectively widening of the MACD1 and the Signal indicator.
A buy signal is given, when the more volatile average, the MACD1 indicator, crosses the less volatile average, the Signal indicator, from beneath. If the MACD1 line crosses the Signal line from above, a sell signal is given.
(Book p.2-29)
Moving average convergence - divergence (MACD)
(Book p.28,29)
b) Moving average convergence-divergence (MACD)
EMAt = (Pt K - EMAt-1 K) + EMAt-1
EMAt : current value of exponential moving average
Pt = current price of underlying asset
K = 2 / (number of periods + 1)
Example:
What is the EMAt for EMAt-1 = 10 and K = 0.2 (9 periods)
Pt = 12 EMAt =
Pt = 8 EMAt =
Pt = 4 EMAt =
So?
Calculation:
Fibonacci Ratios and Elliot Wave Principle
In the 13th century the mathematician Fibonacci discovered a number series with some quite astonishing results.
Adding two numbers to derive a result, then taking the last added number and adding it to the result, gives
1+1=2; 1+2=3; 2+3=5; 3+5=8 and so on, which gives the number series
Dividing consecutive numbers in this series by one another:
Dividing a number by the one following two places behind:
Technical analysts consider these numbers crucial.
(Book p.30)
Fibonacci Ratios and Elliot Wave Principle cont.
In its most basic form, the principle says, that markets move in a repetitive cycle of five waves to the upside, followed by three waves to the downside.
(Book p.30,31)
Elliot set certain rules for his principle, which are necessary for a certain pattern to qualify as an Elliot wave:
In 1946 the retired accountant Ralph Elliot wrote his book "Nature's law - The Secret of the Universe".
In this book he stated the “Elliot Wave Principle”.
Fibonacci Ratios and Elliot Wave Principle cont.
1) correction wave 2 can never retrace more than 100% of wave 12) wave 3 can never be the shortest wave of waves 1, 3, or 53) the low of wave 4 is higher than the high of wave 1
t
Price of Asset
1 2
3
4
5 a
bc
Mandatory Elliot Wave rules:
(Book p.30,31)
Voluntary Elliot Wave rules based on Fibonacci numbers:
•The minimum length of wave 3 is the length of wave 1 plus 61.8% of wave 1
• Wave 4 should reverse to the upside, after having retraced 38.2% of wave 3
• Highs and lows of the Elliot wave can be expected on day 13, 21, 34, 55, and 89
Fibonacci Ratios and Elliot Wave Principle cont.
The disadvantage of the Elliot Wave principle is the
(Book p.30,31)
t
Price of Asset
1 2
3
4
5 a
bc
Relative strength index (RSI)
The RSI was developed by Welles Wilder in 1978
It is based on the assumption, that after a strong rally the market is overbought and will enter into a downward correction phase.
Similarly, after a strong fall, the market is assumed to be oversold and it will enter into an upward correction phase.
The RSI tries to measure the degree of overboughtness respectively oversoldness and tries to identify, when the correction phase is likely to begin.
The RSI does not work well in markets that have a verylong and strong upward or downward trend.
(Book p.30,31)
Relative strength index (RSI) cont.The RSI is calculated as
(2.2) RSI = 100 - (100 /( 1 + (Avg Up/Avg Dn)))
Avg Up=Sum of all changes for advancing periods divided by total of periodsAvg Dn = Sum of all changes for declining periods divided by total of periods
Day 1 2 3 4 5 6Market close 100 103 106 101 99 103
Given these data, Avg Up = Avg Dn =
According to equation (2.2) RSI =
Due to equation (2.2), the RSI can take values between 0 and 100
An example:
(Book p.32)
Relative strength index (RSI) cont.Price
2
4
6
8
10
12
14
16
18
40-day price movement of a stock
Resulting 10-day RSI
RSI
0102030405060708090
100S1
-----------------------------------------------------------------------------------
----------------------------------------------------------------------------------- B
S2
An RSI of over 70 indicates an overbought market; an RSI of below 30 indicates an oversold market.
Result:
Critical appraisal of technical analysis
Technical analysis is not voodoo,
Does technical analysis implicitly include fundamental data?
Not much empirical evidence!
Main justification of technical analysis:
(Book p.33)
or is it?
Trading according to SeasonsSince 1950, 86.97% of the Dow gain occurred in the month from
November to April !!!
Sell in May and go away
-10.00%
-5.00%
0.00%
5.00%
10.00%
15.00%
20.00%
J F M A M J J A S O N D
Percentage change of the Dow by month
(Data since 1968)
Trading according to Seasons cont.
Month Number ofmonths
Total PointChange
Average PointChange
PercentageChange
January 30 + 1,545.20 + 51.51 +19.24%February 30 + 1,218.42 + 40.61 + 15.17%March 30 + 497.48 + 16.58 +6.19%April 30 + 1,096.20 + 36.54 + 13.65%May 30 + 1,024.10 +34.14 + 12.75%June 30 + 331.50 + 11.05 + 4.13%July 30 + 1,099.20 + 36.64 +13.69%August 30 - 387.40 - 12.91 - 4.82%September 30 + 143.50 + 04.78 + 1.79%October 30 -651.00 - 21.70 - 8.10%November 30 + 1168.00 + 38.93 + 14.54%December 30 + 946.90 + 31.56 +11.79%
Sum + 8.032.10 + 267.74 + 100%
Table of monthly graph
Trading according to Seasons cont.
MonthNumber
ofmonths
Total PointChange
AveragePoint Change
PercentageChange
January 1 & 2 week 3 & 4 week 30
+ 538.70+ 1,006.50
+ 17.96+ 33.55
+ 6.71%+ 12.53%
February 1 & 2 week 3 & 4 week
30+ 1,199.80
+ 98.62+ 37.33+ 3.29
+ 13.94%+ 1.23%
March 1 & 2 week 3 & 4 week 30
+ 799.84- 302.36
+ 26.66- 10.08
+ 9.96%-10.08%
April 1 & 2 week 3 & 4 week 30
+ 638.1+458.1
+ 21.27+15.27
+ 7.94%+5.70%
May 1 & 2 week 3 & 4 week 30
+ 641.4+ 382.7
+ 21.38+ 12.76
+ 7.99%+ 4.76%
June 1 & 2 week 3 & 4 week 30
+ 713.6- 382.1
+ 23.79- 12.74
+ 8.88%- 4.76%
July 1 & 2 week 3 & 4 week 30
+ 684.2+ 415
+ 22.81+13.83
+ 8.52%- 5.17%
August 1 & 2 week 3 & 4 week 30
- 515.1+ 127.7
- 17.17 + 4.26
- 6.41%+ 1.59%
September1& 2 week 3 & 4 week 30
+ 407.9- 264.4
+ 13.6- 8.81
+ 5.08%- 3.29 %
October 1& 2 week 3 & 4 week 30
+ 162.2- 813.2
+ 5.41- 27.11
+ 2.02%- 27.11 %
November 1& 2 week 3 & 4 week 30
+ 582.2+ 585.3
+ 19.42+ 19.51
+ 7.25%+ 7.29%
December 1& 2 week 3 & 4 week 30
+ 144.5+ 802.4
+ 4.82+ 26.75
+ 1.80%+ 9.99%
Sum 360 + 8032.10 + 267.76 100.00%
Trading according to Seasons cont.
From the former table we can see that in 8 out of 12 month, the increase in the first two weeks of the month was higher than in the second half of the month.
The increase in week 3 and 4 was only higher than the increase in week 1 and 2 in
If we look at the absolute changes and sum up all the increases in the first two weeks of each month, we get 73.68%.
Also, 12.53% + 13.94% = 26.47% of the Dow increase occurred in the
Trading according to Seasons cont.
What’s the “best” trading day of the week??
Observednumber of days
Point Change of theDow
Point Change of theDow in percent
Monday 1,450 + 1,874.32 + 23.34%Tuesday 1,548 + 4,106.68 + 51.19%Wednesday 1,527 + 1,681.99 + 20.94%Thursday 1,515 - 738.19 - 9.19%Friday 1,509 + 1107.30 + 13.79%
Sum 7,549 + 8032.10 100%
Results do depend on the time frame of data selection
Intra-day Performance of the Dow
-15.00%
-10.00%
-5.00%
0.00%
5.00%
10.00%
15.00%
20.00%
9:30-10:00
10:00-10:30
10:30-11:00
11:00-11:30
11:30-12:00
12:00-12:30
12:30-13:00
13:00-13:30
13:30-14:00
14:00-14:30
14:30-15:00
15:00-15:30
15:30-16:00
Trading according to Seasons cont.
Result:
Summary of Investing
Diversify! Diversify! Diversify! CAPM shows that Diversification increases the ratio!
Mutual Funds are outdated! underperform their benchmark!
Hence, invest ‘passively’ in
Use seasonal patterns if you invest shorter term
Use the business cycles!
What about Hedge Funds?
Summary of Investing cont.
Growth stocks or value stocks ? Buy growth stocks, small caps and junk bonds in an
Trend is your friend! Enjoy the ride; don’t try to predict a trend-reversal
Realize once a while!
Is patience is a virtue ?;
Invest, don’t speculate; If you do speculate, watch the market and only speculate with the money you can afford to
Buy beaten up-high tech stocks
lose
admit your are wrong!
What should we base our trading decision on ??
Fundamental analysis ?
Technical analysis ?
Seasons ?
Intuition ?
2) Bonds versus Stocks
Bonds
Definition:
A bond is a promissory note. The bond issuer promises to pay a specific sum of cash flows to the bond holder.
Types of bonds:•Debentures (unsecured debt obligation, i.e. savings account)
•Short term bonds: Commercial paper (2 to 270 days, issued by top banks and companies), Certificates of deposit (CD’s)(several days to years, issued by banks)
•Mortgage bonds (secured by real estate)•Zero bonds (pay no coupon)
Bonds cont.
•Treasuries:
Treasury bills: Maturity up to 1 year, auctions of 91 and 270 day treasury bills take place weekly, minimum $5,000Treasury notes: Maturity 1 year to 10 years, minimum $1,000
Treasury bonds: Maturity 10 years to 30 years, minimum $1,000 Treasury Bonds are local and state but not federal tax exempt
• Savings Bonds: Issued by US Government for small investors, Denomination from $50, usually local, state, and federal tax exempt but lower yield than Treasuries
Bonds cont.Types of bonds cont.
•Eurobonds (An American company issues a bond outside the US and pays dollar interest and dollar principal)
(Australian company, which invests in Japan and believes the Yen will devalue, issues a bond in yen, pays yen coupon and returns Australian Dollar at maturity (at maturity the issuer exchanges yen into Austral. $ at a fixed exchange rate, which is guaranteed by the underwriter))
•Dual currency bonds
•Floating rate bonds
•Inflation linked bonds
•Credit linked bonds
•Junk bonds (credit rating of issuer is bad)
Main differences between bonds and stocks
1) Bond prices return to their issue price (Fish-effect)Stock prices are assumed normally or log-normally distributed
tT
P
(Book p.203)
Main differences between bonds and stocks cont.
tT
P
“Distribution function” of a bond and a stock
(Book p.203)
Main differences between bonds and stocks cont.Normal versus log-normal distribution of a stock
Result:(Book p.197)
0
0.1
0.2
0.3
0.4
0.5
0.6
0.7
0 3
0
0.05
0.1
0.15
0.2
0.25
0.3
0.35
0.4
0.45
-4 -3 -2 -1 0 1 2 3 4
Main differences between bonds and stocks cont.
2)
3)
4)
Main differences between bonds and stocks cont.
Main criteria of stocks
• Preferred stock• Convertible
• IPO’s (going public)
• Buy backs
• Stock splits
• Mergers / Spin-offs
• Ratios: P/E ratio, earnings per share, return on equity, dividend yield
• Beta
Bond pricing
The price of a bond B is the sum of all discounted future cash flows.
The cash flows of a 5 year coupon bond with a principal amount of $100 and a 3% annual coupon looks as follows:
1y 2y 3y 4y 5yB?
Bond pricing cont.Mathematically, the discounted sum of all future cash flows is
whereB : Bond pricen : number of coupon paymentsct : coupon at time t (known interest rate payments, paid every 6 months in the US) y : yield to maturity PA : principal amount
Treating the last coupon and tbe PA as one coupon cn, we get
n
1t
tt )y1(cB
(Book p.105,106)
(4.24)
nn
n
1tt
t
y)(1
PA
y)(1
cB
Bond pricing cont.
Example 1: What is the price of 4 year 5% annual coupon bond with a 3% yield and a principal amount of 100?
B
Example 2: What is the price of 4 year 5%-coupon bond with a 5% yield and a principal amount of 100?
(Book p.105,106)
Bond pricing cont.
What is the Yield???
a) The yield (also called yield to maturity) is the of the bondexpressed as an annual percentage, if the bond is bought at the currentmarket price and held to maturity, assuming no default risk
c) The yield curve (yield with respect to time) expresses in an economy for AAA rated bonds
The higher the yield, the better to buy the bond????
b) The yield is the used in the discount factor df = 1 / (1+y) t
to derive the present value (the price of the bond). [FV x df = PV]
Bond pricing cont.
Dirty versus Clean Price
The price found on screens and in newspapers usually the Clean Price
If an investor buys a bond, he has to pay the clean price Plus the ACCRUED INTEREST
The accrued interest is the interest that is calculated daily and hasaccumulated since the last coupon date
The price that is actually paid when buying the bond is therefore the
Dirty Price = Clean Price + Accrued Interest
(Book p.291)
Bond pricing cont.
Example: A bond trades at 103.00, has a coupon of 6% andthe last coupon date was 50 days ago. What does an investorhave to pay when he buys the bond?
He has to pay the dirty price, which is the clean price+ accrued interest:
Naturally, when you sell a bond, you sell it at theDirty price
(Book p.291)
Stocks PricingBonds are priced by discounting all the (known) future cash flows back to today.
The same logic can be applied for stocks.
However, the dividend of a stock is unknown, so we have to make an assumption about future dividends.
Usually companies let their dividends grow with a constant rate g, for example 3%.
Also, since stocks do not have a maturity date, we have to useinfinite time periods.
This leads us to the following equation for the price of a stock:
Stocks Pricing with the Constant-Growth Dividend Model
1tt
t0
i)(1
g)(1DS
S = Stock price, D0 = last paid Dividend, g = dividend growth rate,i = discount rate (also called required return of the stock)
Example:
A company's last paid dividend was $2. The growth rate of the dividendis expected to be 3%. The discount rate is 6%. What is the stock price using 5 future periods?
S
Stocks Pricing with the Constant-Growth Dividend Model
Critical Appraisal of the Constant Growth Dividend Model
The model shows the inverse relationship between interest rates andStock prices!
The model shows ONE factor that influences the price of a stock.Other factors are expected revenue and earnings growth rate, quality of management, market product, competitors, economy, sector, psychology, legal battles, etc.
Many high-tech companies do not pay a dividend (such as Microsoftor Yahoo). In this case the constant dividend growth model is of no value
Dividend Policy
As mentioned earlier, companies often have a long-term moderate growth rate of their dividend.
This policy is supposed to give confidence in the long term prospective of the company.
The share price of companies that have to reduce their dividends, usually suffer a severe decline in the share price.
(Emery p.476f)
Dividend Policy
The timeline of dividends
Dividenddeclaration
date (Amountand Ex-dividend
date are announced)
Ex-dividend date
(Stock pricedrops by the
dividend amount)
Holder of Record date
(List of share-holders
is established)
Dividendpayment
date
An investor has to own the stock BEFORE the ex-dividend date in order to receive the dividend. That is why the stock drops at the dividend date.
Dividend PolicyDividends Irrelevance Theorem
There is a school of thought lead by Miller and Modigliani, that thepayment of dividends is irrelevant for a company and that shareholders should be indifferent to dividends.
The theorem says that the payment of dividends will equal the lossof price appreciation of a stock. Thus, the share holder is indifferentto receiving dividends or the stock price increase.
This theorem is correct if the following assumptions hold:
• No transaction costs when selling stocks (Otherwise dividends would be preferable) or paying dividends (otherwise stock price increases are preferred. • Same tax treatment of dividends and share price increases
• The companies management is uninfluenced by dividends and share price increases
Do theses assumptions hold in reality???
Dividend Policy
In most countries, like the US, dividends are treated less favorablefrom a tax perspective than stock price increases.
One could argue that there is “double taxation” of dividends dueto the fact that they are taxed on a corporate level as income,and as income for the individual investor.
That is why some countries, like Germany, have a lower tax rateon dividends than on retained earnings of a company.
If dividends are taxed higher than stock price increases,it follows, that it is in the companies and share holders interestthat no dividends should be paid!!
Dividend Policy
It can be argued that some investors simply like receiving dividends(clientele effect)
This would make a company that pays dividends a popular choiceresulting in an increasing stock price. However, these days investorsbehave fairly rational, and the clientele effect should be rater small.
Conclusion of dividend policy:
The Time Value of Money
One dollar today is worth more than one dollar tomorrow.
WHY???
The Time Value of Money cont.
How much less is a dollar worth in the future?
a) Without interest on interest:$100 now are worth in three years with 10% pa:
FV = PV (1 + i n) FV : Future valuePV : Present valuei : interest rate pan : time in years
Book p. 73
The Time Value of Money cont.b) with discrete interest on interest
b1) annual interest on interest
FV = PV (1+i)n
100 1y 2y 3y
The Time Value of Money cont.
b3) monthly interest on interest
FV = PV (1+i/m)nm with m = 12
b2) semiannual interest on interest
FV = PV (1+i/m)nm with m = 2
(Book p. 74)
The Time Value of Money cont.
c) continuously compounded interest on interest
With m infinity, FV = PV (1+i/m)nm becomes
e = Eulers number = 2.7182...
(Book p. 74)
The Time Value of Money - Application
GROI stand for Guaranteed return on investment
How does that work???
The investor invests $10,000 and is guaranteed at least $10,000 at maturity
The arranger takes a certain amount, invests it at the risk free rate and takes the rest to invest in a risky trade.
Example: A Groi has an original investment of $10,000, 7 year maturity, annual interest rate 6%. How much does the arranger invest in the risk-free asset to guarantee the payback of $10,000?
=
(The $ grows to in 7 years, since
The rest,
$6,651Invested in
risk-freeasset
t0 T
grows to
$3,349invested in risky asset
may grow to
The Groi graphically
Converting Interest Rates
a1) To convert a sub-annual rate into an annual rate, we use
(3.7) Eff = ((Nom / m) + 1) m -1
where Eff : annual interest rate (effective rate)Nom : sub-annual interest rate (nominal rate)m : interest rate payment frequency per year
Thus, a semiannual rate of 9.84% equals an annual rate of
A quarterly rate of 9.84% equals an annual rate of
Book p.75
Converting Interest Rates cont.a2) Converting an annual (effective) rate into a sub-annual (nominal) rate, so solving equation (3.7) for Nom, gives
So an annual (effective) rate of 10.08% results in an semiannual (nominal) rate of
An annual (effective) rate of 0.1021 results in a quarterly (nominal) rate of
Book p. 75
Converting Interest Rates cont.b1)The conversion of an annual or sub-annual, also called discrete rate, into a continuously compounded rate, is done by equation
(3.9) ln (1 + Dis / m ) * m = cc
where ln : natural logarithmDis : discrete interest rate (annual, sub-annual, etc.)m : interest rate payment frequency per yearcc : continuously compounded interest rate
So an annual (discrete or effective) rate of 10.08% results in a continuously compounded rate of
A semiannual (discrete) rate of 9.84% results in a continuously compounded rate of
(Book p. 75,76)
Converting Interest Rates cont.
b2) Converting a continuously compounded rate into a discrete rate, so solving (3.9) for Dis, gives
(3.10) Dis = (ecc/m - 1) * m
where Dis, cc, and m are defined as in equation (3.9)
A continuously compounded rate of 10% is equal to an annual rate of
A continuously compounded rate of 9.61% is equal to a semiannual rateof
(Book p. 75,76)
What is the APR (Annual Percentage Rate)?
An APR is a nominal interest rate!, thus it ignores interest on interest.
Example 1:
The APR is calculated as the sub-annual rate (Nom) times the number payments in a year (m).
APR = Nom * m
An entrepreneur pays 2% interest every 3 months. Whatis the APR?
Thus, interest on interest is ignored
Example 2:
A car dealer tells you the APR, which has to be paid twice a year is 4%. What do you have to pay and when?
Thus, interest on interest is ignored.
What is the APR (Annual Percentage Rate) cont.
What is the APR (Annual Percentage Rate) cont.
Example 2 cont:
The car dealer tells you to pay 2% every 6 months, thus the nominal interest rate is 4%.What is the effective (= annual and “real”, ) interest rate?
We use equation:
Therefore the effective (=annual) interest rate is
Result:
More on Corporate Finance
•Capital Budgeting
•Dividend policy (already discussed)
•Working Capital Management
•Budgeting and financial forecasting
Capital BudgetingCapital budgeting is another term for the
Investment decision process
When should a company do a certain investment???
Also, an investment can be done because of strategic reasons:
•Increase market share
•Improve customer relations
•Hurt a competitor
(Emery p.298f)
Criteria for the Investment Decision
Net present value criteria:
Do the investment if the net present value of all future cash flows is >0.
(How can we tell, if a an investment will be good or bad)
n
1tt
t IO)k1(
CFNPV
NPV : net present valueCFt :outgoing and incoming cash flow at time t (after tax)k : discount rate (=required rate of return)IO : Initial cash outlay
Net present value criteria cont.
Example: Volkswagen is considering investing in a new 3-Liter car.The company expects an initial investment in R&D(research and development) of $10,000,000.It expects negative outflows in year 1 and 2 of $2,000,000and $1,000,000 resp.. It expects profits in year 3 and 4 of $4,000,000 and $5,000,000 resp. and $8,000,000 for the years 5. The discount factor is 4%.Should Volkswagen build the 3-Liter car?
NPV =
Result:
Capital Budgeting cont.
Closely related to the NPV criteria is the
Profitability Index or Benefit/Cost ratio
IO
)k1(
CF
PI
n
1tt
t
According to the profitability index, should Volkswagen do the investment?
PI=
Result:
Comparing the NPV criteria and the PI Index
If the NPV is positive, it follows that the PI will be
Thus, the NPV criteria and the PI index are basically identical.
Advantage of NPV and PI:
Disadvantage of NPV and PI:
Capital Budgeting cont.
Internal rate of return (IRR)
The internal rate of return measures the return or profit of the investment.
It is equivalent to the yield of a bond!!
Mathematically, the IRR is the discount rate, that guaranteesthe future cash flows of the investment (CF) equal the initial outflow (IO):
n
1tt
t
)IRR1(
CFIO
Features of the Internal rate of return (IRR)
Unfortunately, we can’t solve the equationeasily for IRR (we have to use search procedures) like Newton-Raphson)
n
1tt
t
)IRR1(
CFIO
Usually , a company has a target IRR. If the calculatedIRR is higher than the target IRR, so investment isdone, vice versa.
As the yield of the bond, the IRR concept (and the NPV and the PI assume), that all cash flows are reinvested at the discount = IRR rate. This is obviously a disadvantage.
The modified IRR (MIRR)The drawback, that in the IRR model the cash flows are reinvestedat the IRR rate, is solved in the MIRR model.
In the MIRR model the cash flows are reinvested at the MIRR rate.
The MIRR rate can be calculated in 2 steps:1) Calculate the future value of the cash flows using
n
1t
tnt i)(1cFV
2) Calculate the MIRR using
1IO
FVMIRR n (is derived from )
n
1tt
t
)IRR1(
CFIO
The modified IRR (MIRR)Example:
A company has an IO of $1,000, and expects inflows of $300 at the end of year 1, $400 at the end of year 2, $500 at the end of year 3 and $600 at the end of year 4. The cash flows are expected to be reinvested at 15%.What is the MIRR rate?
1) The future value of the cash flows is, following
n
1t
tnt i)(1cFV
FV =
The modified IRR (MIRR)
2) Using 1)IO
FV(1
IO
FVMIRR 1/nn the MIRR is
As a comparison, the standard IRR of the above example is24.89% (see ECXEL file NPV IRR comparison)
Comparing the NPV and IRR Method
Question: If the NPV and IRR model return different results, what modelshould we trust???
Example: Project A Project B-1000 -1000100 400100 400200 300600 4001000 200
NPV $322.31 $288.18IRR 18.74% 22.83%
(see EXCEL file“NPV IRR comparison”)
Solution: Compare the NPV and IRR of the difference in cash flows
Comparing the NPV and IRR Method
Project A Project B A - B-1000 -1000 0100 400 -300100 400 -300200 300 -100600 400 2001000 200 800
NPV $322.31 $288.18 $34.13IRR 18.74% 22.83% 12.18%
Result:
Working Capital ManagementFirstly, the Yield Curve (= Interest rate curve) in an economyis usually steep
3m 2y 5y 10y 20y 30y
1%
2%
3%
4%
5%
6%
Yield
t
US
Germany
Japan
Yield curves of the US, Germany and Japan on July 15, 1998
Result: Investing money short term results in a lower return
(Emery p.579f)
Working Capital Management cont.
Liquidity is the ability to pay off debt
Profitability is the ability to make profits
Working capital and liquidity are often used as synonyms andconsist of cash and short term assets.
Net working capital is the difference between short term assetsand short term liabilities.
Short Term assets consist of treasury bills, commercial paper (issued by banks and corporations) and CD’s (issued by banks)
Net working capital has to be positive, otherwise you are
Working Capital Management cont.
The higher the liquidity (=cash and short term assets) the the risk of defaulting on debt , but
The lower the liquidity (=cash and short term assets) the the profitability (long term assets and investment in the firm’sbusiness), but
The working capital trade off is the trade-off between liquidity and profitability
Working Capital Management cont.
How can we solve the liquidity - profitability trade-off??
We can reduce the trade-off by the
Maturity Matching Principle
Match long term investments (real estate, trucks, machinery) with
Short term assets (computers, software) can be matched with
Financial Forecasting and Budgeting
Forecasting in financial management is necessary to determinea companies financial need.
Financial Forecasting is principally done in 3 steps:
1. Forecasting of the companies sales revenues and other income over the planing period.
2. Forecasting of the level of necessary investments and other expenses
3. Use 1. and 2 to determine the financial need
((Emery p.648f))
Financial Forecasting and Budgeting cont.
Important for a company is the forecast of Sales.
There are many forecasting methods is finance:
Linear regression analysis, Non-linear regression analysis,Multi-variate regression analysis, Time series analysis,Econometric models, Stochastic processes, Monte-Carlo simulation and more
Lets look at a linear regression-analysis to forecast sales:
Financial Forecasting and Budgeting cont.
One form of regression analysis is time series analysis.
In time series analysis time t is on the x-axis.
Example:Let’s assume the sales of Turbodyne (TRBD) are:
In January $30,000, in February $34,000, in March $35,000 and in April 39,000.
What are the expected sales in May, calculated on a lineartime series analysis?
Financial Forecasting and Budgeting cont.
1 2 3 4 5Jan Feb Mar Apr May
$30,000
$40,000
The goal is to find a linear regression function r, which minimizes the differences between the observed points and r.
We then extrapolate r to find the sales for May.
Sales
time t
r
Financial Forecasting and Budgeting cont.
1 2 3 4 5Jan Feb Mar Apr May
$30,000
$40,000
Sales
time t
r
t
a
b = S
In order to find the regression function r, we have to find a and b.
Financial Forecasting and Budgeting cont.
b =
n
1i
2_2i
__n
1iii
ttn
1
StStn
1
a = __
tbS
where
n:
:t_
average of times t;
n
1ii
_
tn
1t
average of times S;:S_
n
1ii
_
Sn
1S
number of observations
Financial Forecasting and Budgeting cont.With t = 1,2,3,4 and S= 30,000; 34,000; 35,000; 39,000
n
1ii
_
tn
1t
n
1ii
_
Sn
1S
b =
n
1i
2_2i
__n
1iii
ttn
1
StStn
1
a = __
tbS
Financial Forecasting and Budgeting cont.
It follows that the estimated Sales at time t =5, so in May, are
S = a +b t =
This forecast is based on the assumption, that the saleswill increase linearly on the basis of historical data.
Financial Forecasting and Budgeting cont.
The Sales forecast is often used as a basis to plan otherfinancial items, such as inventories.
The Percent of sales method for Financial Forecasting uses alinear forecasting:
ForecastedSales
Inventories
30,000 70,000
20,000
30,000
Financial Forecasting and Budgeting cont.
Creating a budget
A budget is an estimate of revenues and expenditures.
A Cash-budget estimates a company’s necessary financial needs based on expected revenues and expenditures.
A budget tells you what you can’t afford, but it doesn’t keep you from buying it (William Feather)
Revenue = Number of sales * price per sales unit
Example:Dell sells 1 million PC’s in the year 2000 for $500 each. What is Dell’s revenue for 2000?
((Emery p.648f))
A Cash budget consists of
•Estimated Cash receipts•Estimated Cash payments•Expected monthly cash balance•Financial need
Financial Forecasting and Budgeting cont.
Financial Forecasting and Budgeting cont.
Calculating the Cash receipts form Sales
Nov Dec Jan Feb Mar Apr May
Expected Sales 55,000$ 75,000$ 55,000$ 60,000$ 75,000$ 88,000$ 90,000$ Expected Cash receipts30% pay 2 month later 16,500$ 22,500$ 16,500$ 18,000$ 22,500$ 50% pay 1 month later 37,500$ 27,500$ 30,000$ 37,500$ 44,000$ 20% pay immediately 11,000$ 12,000$ 15,000$ 17,600$ 18,000$ Total Cash receipts 65,000$ 62,000$ 61,500$ 73,100$ 84,500$
Creating a cash budget
Creating a cash- budget
Financial Forecasting and Budgeting cont.
Cash Budget
Jan Feb Mar Apr MayExpected Cash receipts 65,000$ 62,000$ 61,500$ 73,100$ 84,500$
Expected Cash PaymentsWages and Salaries 32,000$ 32,000$ 35,000$ 40,000$ 45,000$
Rent 3,000$ 3,000$ 3,000$ 3,500$ 4,000$ Taxes 7,000$
Purchase of new PC's 50,000$ 40,000$ Total 85,000$ 35,000$ 45,000$ 83,500$ 49,000$
Expected monthly cash (20,000)$ 27,000$ 16,500$ (10,400)$ 35,500$ balance (Total - exp. Cash receipt)
Desired cash balance 10,000$ 10,000$ 10,000$ 10,000$ 10,000$
Financing need (30,000)$ 17,000$ 6,500$ (20,400)$ 25,500$
Cumulative Borrowing (30,000)$ (13,000)$ (6,500)$ (26,900)$ (1,400)$
Practice Exam
Task 1 (25 points)
1)If the market rises and breaks an important resistance line, technical analysis recommends buying
True False
2) If the market falls and breaks an important support line, technical analysis recommends selling. True False
3) Speculation means trying to exploit the movement of an asset. True False
4) Traders take risks, brokers don’t True False
5) In the long run, stocks tend to outperform bonds True False
6) Arbitrage is another word for risk-less profit True False
7) The yield curve of an economy is usually down-ward sloping True False
8) When buying on margin, you trade with borrowed money True False
9) The Nasdaq has outperformed the Dow in the last half year True False
10) The unemployment rate in the USA is close to 7.2% True False
Task 2 (25 points)
a) The annual market interest rate is 10%. An investor wants to invest $1000 for 5 years.The banker offers the client to pay back $1000 + $1000 * 0.1 * 5 = $1,500. Is the banker trying to rip off the client?
b) If you were the banker, what would you pay back to the client after 5 years?
c)A client wants to invest $1000 for 5 years. The banker offers to pay 5% quarterly or 5.2% annually. The client decides to take 5% quarterly. Did he do the right thing?
Use (Eff = ((Nom / m) + 1) m –1) Eff and Nom in %!
Task 3 (25 points)
a)The annual coupon of a bond is 5%. The annual yield isalso 5%. What is the price of the bond with a principal of $1000?
b) What is the 20 day accrued interest of the bond?
c) What is the difference between the coupon of a bond and
the dividend of a stock?
Task 4 (25 points)
a) After attending the Fin300 class at HPU, you have become a successful financial advisor. One of your clients wants to invest$100,000 dollars. What are the two questions you ask him first?
b) Your client wants to open up a savings account. What is yourreply
c)What do you suggest to the client as investment alternatives?
Learning e and ln
The number e -Eulers number- is an irrational number (anumber that cannot be divided by tow integers (an integer isa number without decimals, so -3 and 4 are integers,-3.1 or 4.55 are not)
The value of e = 2.71828182…. The decimals of e are indefinite
Mathematically e = 1+ 1/1! + 1/2! + 1/3! =… = (1 + 1/m) m
with m to infinity
e has nice features such as if y = e x then y’ = e x y = e f(x) then y’ = f’(x) e f(x)
The logarithm of the number N to the base a is the exponent to which x has to raised to yield N. Thus
Loga N = x if and only if ax = N
Examples:
Log 10 1 = 0 since 100 = 1
Log 10 10 = 1
Log 10 100 = 2
Log 10 1000 = 3
Log 4 16 =
Log 10 (0.001) =
Logarithm
If the base of the logarithm is e, the logarithm is callednatural logarithm.
Log e = ln
Examples:
ln 1 = 0 since 2.71830 = 1
ln 10 = 2.326 since 2.71832.3026 = 10
ln 100 = 4.6052 since 2.71834.6052 = 100
ln -3
Three important rules apply to logarithms:
a) ln (a * b) = ln a + ln b
b) ln (a / b) = ln a - ln b
c) ln ab = b * ln a
Rule c) comes in handy for solving equations:
Solve for x, when 10x = 7, using rule c)
Mathematically logarithms have nice features such as
If y = ln x then y’ = 1/x
If y = ax then y’ = ax ln a
Graphically ln x and e are reflected across the y = x line
y = x
y = ex
y = ln x
y
x1
1
Logarithmic functions are often used in psychology toexplain human behavior.