Faculty
Professors Jonathan W. Lewellen, Richard J. Rogalski
Objectives
Managers in any corporate function should understand the pricing of financial instruments in the capital markets. This course will examine the main investment concepts in the fixed income, equity and derivatives markets. This will include topics such as the term structure of interest rates in bond markets, how stocks and bonds "should" be priced, and why those prices are sometimes not realized because of institutional factors or market frictions. We will also study the optimal construction of combinations (portfolios) of securities, emphasizing the tradeoff between risk and return in great detail. An extremely important final subject is the pricing and uses of derivative assets such as futures and options and how they may be used to control financial risk in corporations.
We plan to emphasize the concepts of capital markets in a real-world setting using real-world problems. Students should be aware that finance is inherently quantitative and that many of the important problems of the course must be attacked by theoretical and mathematical methods. The most important of these relationships need to be understood by all general managers, not just finance professionals. So, students should be forewarned that this course will be analytically rigorous.
Requirements
Preparation for and Participation in Class
Assignments for each class day are well defined. Homework assignment sheets for each class will detail the readings and problems that will be discussed in each class. Students will be expected to have prepared the homework problems prior to coming to class. Class participation, both voluntary and "involuntary," will contribute significantly toward your understanding of the material, so we want to emphasize that preparation for class is important. We encourage you to prepare for class with your study groups. Good class preparation leads to better class discussions and a more valuable learning experience. If you come to class unprepared on a given day, you should let the instructor know via e-mail before class begins. Class attendance is mandatory, and students missing class should account for their absences in writing before the missed class except in emergency situations.
Daily Review Sessions
There will be optional review sessions each class day. It is important that you do not fall behind in your conceptual understanding of the material or in your ability to solve homework problems. Thus, these daily review sessions give you an opportunity to review your understanding of the material and to practice problem solving on homework and additional problems.
Written Homework
There will be written homework assignments due each class day except for the first class session. All homework assignments are individual assignments. The Tuck Honor Code will govern homework assignments as follows: you may work and learn together in your study groups, but each individual should turn in his/her own version of the homework assignments.
When you turn in an assignment answer, you are certifying that you understand the answer and the finance principle underlying it (i.e. you did not simply copy it from members of your study group). If you do not understand an answer (that perhaps your group has solved, but that you do not understand), you should leave it blank. The benefit of this approach is that both you as the student and we as the instructors are alerted that more work and explanation are needed on that problem/topic. It is still possible to receive good homework grades if some problems are left blank.
All written homework should be word processed showing your work and putting your answer in a clearly marked box. Handwritten homework and/or homework on notebook paper is not acceptable.
Two In-class Quizzes
During the term, there may be two 10-minute, unannounced in-class quizzes. The quizzes will be closed-book and closed notes. You may use your calculator or computer. There are no quiz make-ups if you are not in class for them.
The Mid-term and Final Exams
The mid-term exam will be on Friday, November 13th at 9:00 AM. The final exam is scheduled on Wednesday, December 16th at 9:00 AM. You must take the mid-term and final exams in one of the announced rooms that you will be assigned. The examination will be closed-book and closed notes, except for a formula sheet, which we will supply ahead of time, and your calculator and/or computer. You are required to be in Hanover on these dates to take these exams--NO EXCEPTIONS.
Materials
Course Reading Materials
There is a course packet that will have most of the readings you need. We will supplement it from time to time with handouts. For part of the term, we will use the book, Corporate Finance 9th Edition by Ross, Westerfield, and Jaffe (hereafter, RWJ), which will also be used in the Corporate Finance course. Other reading materials, including some book chapters, helpful hints, and spreadsheets will be found in the course folder.
List of Course Packet Contents:
Homeworks 1-18
Financial Market Updates
Financial Math on Spreadsheet and Calculator Version 4.0
Corporate Finance 8th Edition, (RWJ, 8th Ed.), Chapter 1, pp. 15-18
Corporate Finance 9th Edition, Chapter 4
RWJ, 8th Ed., Chapter 5, pp. 129-134
Fabozzi (6th edition) BOND MARKETS, ANALYSIS, AND STRATEGIES, Chapter 1, pp 1-9, Chapter 2, pp. 24-top of 29, Chapter 3, 35-39, and Chapter 6, 127-128 and 142-146.
Livingston (2nd edition) BONDS AND BOND DERIVATIVES, Chapter 8 (pp. 133-141)
RWJ, 8th Ed., Appendix 5A, pp. 5A-1 to 5A-9
Fabozzi, Chapter 4 (pp. 58-top of 73 and 83)
Putting a Value on Google, by S. Kessler Business Week Online
Dimson, Marsh, and Staunton, "The World Wide Equity Premium: A Smaller Puzzle," Table 3 (p.488)
Credit Suisse Global Investment Returns Yearbook 2009 (pp. 5-9)
Understanding Risk & Return, the CAPM, and the Fama-French Three Factor Model," Tuck Case
Cap M. in Crunch Time: Evaluating Mutual Fund Styles with Performance, Tuck Case
A Note on Arbitrage-free Currency Forward Rates, Tuck Case
COMSAT (Communications Satellite Corporation), HBS Case #9-276-195
Financial Futures, HBS Case #9-286-068
Note on Option Pricing, HBS Case #9-286-112
Froot, Scharfstein, and Stein, A Framework for Risk Management, HBR 94604
Sally Jameson: Valuing Stock Options in a Compensation Package, HBS Case #9-293-053
Course Folder Contents
Bloomberg Basics
Yellow Sheet (PV Formulas)
Class Notes
The Tuck Honor Code
The professors treat the Honor Code seriously. The only particularly unusual Honor Code issue for this course is the homework "certification" as described above. Working in groups is allowed in preparing for class and in figuring out the written assignments. Turning in (for homework) identical copies of a spreadsheet produced by the group is not acceptable. The final exam and mid-term quizzes are closed-book and should be completed without outside help. Logging on to the internet or using e-mail during quizzes and exams is a violation of the Honor Code. Also, looking at copies of mid-term exams or homework answers from previous years is a violation of the Honor Code.
Laptops may be used in class only when required for the class session. You should never check email or surf the internet during class. In other words, the Tuck Laptop Policy applies in all respects in this course.
Grading
Class Participation 10%
Homework and in-class quizzes 15%
Mid-term exam 30%
Final Exam 45%
Schedule
10/12/2009
Introduction to Capital Markets
(Note: A Homework/Assignment Sheet (on green paper) will be handed out for each day in advance. These Homework/Assignment Sheets will provide you detailed guidance in preparing for class. They supersede this syllabus.)
Preparatory Readings:
Corporate Finance 8th Ed. (RWJ, 8th Ed.), Chapter 1 (pp. 15-18),(CP)
Corporate Finance 9th Ed., Chapter 4.(CP)
Primary securities and their issuers
Market transactions and market micro structure
The basic investment problem and the application of NPV
Identifying the cash flows of an investment
Review Reading: Standard & Poor's Guide to Understanding Money & Investing (you should have received this in the packet sent to you from the MBA Program Office)
Useful Reference: Financial Math on Spreadsheet and Calculators Version 4.0 (CP)
10/13/2009
Treasury Strips and Treasury Bonds and Notes
Preparatory Readings:
RWJ, 8th Ed., Chapter 5 (pp. 129-134)(CP)
Fabozzi (6th edition), BOND MARKETS, ANALYSIS, AND STRATEGIES, pp. 1-9, 24-top of 29, 35-39, 127-128, and 142-146.(CP)
Defining Characteristics of Coupon Bonds
Compounding Periods: annual, semi-annual & continuous
Risks Associated with Bond Investments
Interest Rates and Bond Prices
Treasury Strips and Strip (Spot) Rates
Calculating Bond Price and Yield to Maturity (YTM)
Calculating Accrued Interest: When and Why
On P:/Course-files/fall/core/CM/BondPricing.doc
On P:/Course-files/fall/core/CM/BondBuilder.xls
10/19/2009
Bond Arbitrage and T-Bills
Preparatory Readings:
Re-read Fabozzi, bottom of p. 142-143 (CP)
Livingston (2nd edition) BONDS AND BOND DERIVATIVES, Chapter 8 (pp. 133-141) (CP)
Spot Rates
Bonds as the sum of the PV of well-defined CFs
Pricing a Treasury Coupon Bond with Treasury Strips
Coupon stripping and Arbitrage between Bonds and Strips
Treasury Bills vs. Treasury Bonds
Treasury Bills: A special pricing convention
10/20/2009
The Yield Curve and the Term Structure of Interest Rates
Preparatory Reading:
RWJ, 8th Ed., Appendix 5A (pp. 5A-1 to 5A-9)(CP)
Calculating Forward Rates from Spot Rates
Distinguishing the Term Structure from the Yield Curve
Why YTM is an incomplete measure of return
Theories of the Term Structure
Interpreting the slope of the term structure
Credit risk premiums
10/26/2009
Bond Price Volatility and Managing Interest Rate Risk
Preparatory Reading:
Fabozzi, Chapter 4 (pp. 58-top of 73 and 83) (CP)
The Price-Yield Relationship
Duration of a Bond
Macaulay vs. Modified Duration
Convexity of a Bond
The Concept of Immunization
Immunizing a Bond Portfolio
Why Duration is only a partial immunization solution
On P:/Course-files/fall/core/CM/Immunization101.xls
10/27/2009
Introduction to Stock Valuation Models
Preparatory Readings:
RWJ, Chapter 9 (pp. 268-273 and Section 9.5)
Dividend discount models
Price-earnings ratio
Free cash flow discount models
Valuing high-tech companies
RWJ, Chapter 6 (Only Section 6.2)
You do NOT have to master the details regarding how to come up with free cash flow. Focus on line (6) and below in Table 6.4. You should know how to calculate the NPVs using the "total cash flow of project" on line (6) and the given discount rates at the bottom of the table.
Putting a Value on Google, by S. Kessler, Business Week Online(CP)
11/02/2009
Security and Portfolio Returns
Preparatory Readings:
RWJ, Chapter 10
Dimson, Marsh, and Staunton, "The World Wide Equity Premium: A Smaller Puzzle," Table 3 (p.488) (CP)
Credit Suisse Global Investment Returns Yearbook 2009 (pp. 5-9) (CP)
The investment opportunity set
Different types of return: holding period, compounded, average, nominal, real
Historical returns and risks of bonds and stocks
Expected Rate of Return and Risk Estimates
11/03/2009
Modern Portfolio Theory
Preparatory Reading:
RWJ, Chapter 11 (pp. 329-350) (Sections 11.1-11.6)
The mean and variance of a portfolio's return
Covariance and correlation coefficients
Diversification and efficient portfolios
Investors' Utility and Risk aversion
The mean-variance criterion/tradeoff
Optimal portfolio choice
11/09/2009
The Capital Asset Pricing Model
Preparatory Reading:
RWJ, Chapter 11 (pp. 350-361)(Section 11.7-p.361)
Riskless lending and borrowing: The Capital Market Line (CML)
Market equilibrium
Unsystematic and systematic risk
The security market line (SML)
11/10/2009
The Capital Asset Pricing Model and COMSAT Case
Prepartory Readings
RWJ, Chapter 13 (pp. 392-394, 412-414, Section 13.9 through example 13.5)
How CAPM is used in the real world
The assumptions underlying the CAPM
Case Assignment:
HBS Case: COMSAT (Communications Satellite Corporation) #9-276-195 (CP)
11/13/2009
Mid-term Exam, 9:00 AM - 12:00 PM
Exam
11/16/2009
Multi-Factor Asset Pricing Models
Preparatory Reading:
Tuck Case: Understanding Risk & Return, the CAPM, and the Fama-French Three Factor Model, (CP)
Case Assignment:
Tuck Case: Cap M. in Crunch Time: Evaluating Mutual Fund Styles and Performance (CP)
Factor models
Systematic risk and factor loadings
The linear relation between factor loadings and expected returns
The relation between the CAPM and multi-factor models
11/17/2009
Market Efficiency
Preparatory Readings:
RWJ, Chapter 14 (pp. 430-452)(Sections 14.2-14.6)
Definitions: weak, semi-strong, strong forms of efficiency
Implications of market efficiency
Evidence on market efficiency
11/23/2009
Futures I (Basics)
Preparatory Readings:
RWJ, Chapter 25 (pp. 763-771)(Sections 25.1-25.4)
HBS Case: "Financial Futures" #9-286-068(CP)
Futures terminology
Futures versus forward contracts
Spot-futures parity
Basis risk (Note: this topic is not explicitly discussed in any of the readings.)
Futures price versus expected spot prices
11/24/2009
Futures II (Hedging)
Preparatory Readings:
RWJ, Chapter 25 (pp. 771-778) (Section 25.5)
Stock index futures
Foreign exchange futures
Interest rates futures
Tuck Case: A Note on Arbitrage-free Currency Forward Rates (CP)
11/30/2009
Options I (Basics)
Preparatory Reading:
RWJ, Chapter 22 (pp. 676-690)(Sections 22.1-22.7)
Option terminology
Option payoff diagrams
Put-call parity
Bounding option values
Factors influencing option prices
12/01/2009
Options II (Option Valuation)
Preparatory Readings:
RWJ, Chapter 22 (pp. 690-698)(Section 22.8)
Binomial option pricing model
Black-Scholes option valuation
HBS Case: Note on Option Pricing, #9-286-112 (CP)
12/07/2009
Options III (Hedging with Options)
Preparatory Reading:
HBR: Froot, Scharfstein, and Stein, A Framework for Risk Management, #94604 (CP)
Delta Hedging vs. One-to-one Hedging
The costs and benefits of calls vs. puts in hedging
12/08/2009
Executive Stock Options and Course Summary/Review
Preparatory Reading:
RWJ, Chapter 23 (pp. 719-723) (Section 23.1)
Valuing Executive Stock Options
Review of the Most Important Capital Markets Concepts
Case Assignment:
HBS Case: Sally Jameson: Valuing Stock Options in a Compensation Package, #9-293-053 (CP)
12/16/2009
FINAL EXAM - 9:00 AM - 12:30 PM
Exam
