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50 years of Finance

50 years of Finance. André Farber Université Libre de Bruxelles Inaugurale rede, Francqui Leerstoel VUB 2 December 2004. Outline. 1. What is finance? 2. The diffusion of the discounted cash flow method 3. Markowitz and the birth of modern portfolio theory

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50 years of Finance

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  1. 50 years of Finance André Farber Université Libre de Bruxelles Inaugurale rede, Francqui Leerstoel VUB 2 December 2004

  2. Outline • 1. What is finance? • 2. The diffusion of the discounted cash flow method • 3. Markowitz and the birth of modern portfolio theory • 4. CAPM: the relationship between expected returns and risk • 5. The Efficient Market Hypothesis: do stock prices move randomly? • 6. Modigliani-Miller: does financing matter? • 7. Black – Merton – Scholes: how to value options • 8. Beyond Black-Merton-Scholes: state prices, stochastic discount factors • 9. Outline of following lectures Francqui Leerstoel - Inaugurale Rede 2 december 2004

  3. What is Finance? Companies Investors Equity Capital expenditures Debt Portfolio management Dividends Operating cash flow Interests Francqui Leerstoel - Inaugurale Rede 2 december 2004

  4. Asset pricing models Time Discounted cash flow method State PricesArrow-Debreu Option Pricing ModelsBlack ScholesCox Ross Rubinstein Capital Asset Pricing ModelMarkowitzSharpe Lintner Uncertainty Stochastic discount factors Francqui Leerstoel - Inaugurale Rede 2 december 2004

  5. Outline • 1. What is finance? • 2. The diffusion of the discounted cash flow method • 3. Markowitz and the birth of modern portfolio theory • 4. CAPM: the relationship between expected returns and risk • 5. The Efficient Market Hypothesis: do stock prices move randomly? • 6. Modigliani-Miller: does financing matter? • 7. Black – Merton – Scholes: how to value options • 8. Beyond Black-Merton-Scholes: state prices, stochastic discount factors • 9. Outline of following lectures Francqui Leerstoel - Inaugurale Rede 2 december 2004

  6. Discounted cash flow method PV = C1v1 + C2v2 + …+Cn vn Cash flows Required rates of return Francqui Leerstoel - Inaugurale Rede 2 december 2004

  7. Penetration rate of discount cash flow Callahan, C. and S. Haka, A Model and Test of Interfirm Innovation Diffusion: the Case of Discounted Cash Flow Techniques, Manuscript January 2002 Francqui Leerstoel - Inaugurale Rede 2 december 2004

  8. Outline • 1. What is finance? • 2. The diffusion of the discounted cash flow method • 3. Markowitz and the birth of modern portfolio theory • 4. CAPM: the relationship between expected returns and risk • 5. The Efficient Market Hypothesis: do stock prices move randomly? • 6. Modigliani-Miller: does financing matter? • 7. Black – Merton – Scholes: how to value options • 8. Beyond Black-Merton-Scholes: state prices, stochastic discount factors • 9. Outline of following lectures Francqui Leerstoel - Inaugurale Rede 2 december 2004

  9. Markowitz (1952) Portfolio selection • Return of portfolio: normal distribution • Characteristics of a portfolio: • Expected return • Risk: Variance/Standard deviation Francqui Leerstoel - Inaugurale Rede 2 december 2004

  10. Calculation of optimal portfolio Francqui Leerstoel - Inaugurale Rede 2 december 2004

  11. Markowitz: the birth of modern portfolio theory Francqui Leerstoel - Inaugurale Rede 2 december 2004

  12. Outline • 1. What is finance? • 2. The diffusion of the discounted cash flow method • 3. Markowitz and the birth of modern portfolio theory • 4. CAPM: the relationship between expected returns and risk • 5. The Efficient Market Hypothesis: do stock prices move randomly? • 6. Modigliani-Miller: does financing matter? • 7. Black – Merton – Scholes: how to value options • 8. Outline of following lectures Francqui Leerstoel - Inaugurale Rede 2 december 2004

  13. Capital Asset Pricing Model Francqui Leerstoel - Inaugurale Rede 2 december 2004

  14. Capital Asset Pricing Model Expected return rM r Risk free interest rate β 1 Beta Francqui Leerstoel - Inaugurale Rede 2 december 2004

  15. Net Present Value Calculation with CAPM Francqui Leerstoel - Inaugurale Rede 2 december 2004

  16. Outline • 1. What is finance? • 2. The diffusion of the discounted cash flow method • 3. Markowitz and the birth of modern portfolio theory • 4. CAPM: the relationship between expected returns and risk • 5. The Efficient Market Hypothesis: do stock prices move randomly? • 6. Modigliani-Miller: does financing matter? • 7. Black – Merton – Scholes: how to value options • 8. Beyond Black-Merton-Scholes: state prices, stochastic discount factors • 9. Outline of following lectures Francqui Leerstoel - Inaugurale Rede 2 december 2004

  17. Jensen 1968 - Distribution of “t” values for excess return115 mutual funds 1955-1964 Not significantly different from 0 Francqui Leerstoel - Inaugurale Rede 2 december 2004

  18. US Equity Mutual Funds 1982-1991(Malkiel, Journal of Finance June 1995) • Average Annual Return • Capital appreciation funds 16.32% • Growth funds 15.81% • Small company growth funds 13.46% • Growth and income funds 15.97% • Equity income funds 15.66% • S&P 500 Index 17.52% • Average deviation from benchmark -3.20% (risk adjusted) Francqui Leerstoel - Inaugurale Rede 2 december 2004

  19. The Efficient Market Hypothesis S&P 500 2000-2004 Francqui Leerstoel - Inaugurale Rede 2 december 2004

  20. The Efficient Market Hypothesis S&P 500 2000-2004 Francqui Leerstoel - Inaugurale Rede 2 december 2004

  21. The Random Walk Model Francqui Leerstoel - Inaugurale Rede 2 december 2004

  22. Outline • 1. What is finance? • 2. The diffusion of the discounted cash flow method • 3. Markowitz and the birth of modern portfolio theory • 4. CAPM: the relationship between expected returns and risk • 5. The Efficient Market Hypothesis: do stock prices move randomly? • 6. Modigliani-Miller: does financing matter? • 7. Black – Merton – Scholes: how to value options • 8. Beyond Black-Merton-Scholes: state prices, stochastic discount factors • 9. Outline of following lectures Francqui Leerstoel - Inaugurale Rede 2 december 2004

  23. Does the capital structure matters? • Modigliani Miller 1958: NO, under some conditions Debt Equity Francqui Leerstoel - Inaugurale Rede 2 december 2004

  24. Trade-off theory Market value PV(Costs of financial distress) PV(Tax Shield) Value of all-equity firm Debt ratio Francqui Leerstoel - Inaugurale Rede 2 december 2004

  25. Outline • 1. What is finance? • 2. The diffusion of the discounted cash flow method • 3. Markowitz and the birth of modern portfolio theory • 4. CAPM: the relationship between expected returns and risk • 5. The Efficient Market Hypothesis: do stock prices move randomly? • 6. Modigliani-Miller: does financing matter? • 7. Black – Merton – Scholes: how to value options • 8. Beyond Black-Merton-Scholes: state prices, stochastic discount factors • 9. Outline of following lectures Francqui Leerstoel - Inaugurale Rede 2 december 2004

  26. Options • Right to: • Buy (CALL) • Sell (PUT) • an asset • at a fixed price (EXERCICE PRICE / STRIKING PRICE) • up to or at a future date (MATURITY) • at a future date (EUROPEAN OPTION) • up to a future date (AMERICAN OPTION) Francqui Leerstoel - Inaugurale Rede 2 december 2004

  27. Buy 1 Fortis share Francqui Leerstoel - Inaugurale Rede 2 december 2004

  28. Buying a put Stock + Put Stock Put Francqui Leerstoel - Inaugurale Rede 2 december 2004

  29. Buying a call Bond + Call Bond Call Francqui Leerstoel - Inaugurale Rede 2 december 2004

  30. How to value an option • Standard present value calculation fails • Value of option = f(Stock price, Time) • Required rate of return = f(Stock price, Time) • Black Merton Scholes • Combine stock and option to create a riskless position • Law of one price (no arbitrage) f=(#shares)(Stockprice)+Bond Francqui Leerstoel - Inaugurale Rede 2 december 2004

  31. The fundamental partial differential equation • Assume we are in a risk neutral world Expected change of the value of derivative security Change of the value with respect to time Change of the value with respect to the price of the underlying asset Change of the value with respect to volatility Francqui Leerstoel - Inaugurale Rede 2 december 2004

  32. And now, the Black Scholes formulas • Closed form solutions for European options on non dividend paying stocks assuming: • Constant volatility • Constant risk-free interest rate Call option: Put option: N(x) = cumulative probability distribution function for a standardized normal variable Francqui Leerstoel - Inaugurale Rede 2 december 2004

  33. Binomial option pricing model Risk neutral probability Stock price Su Option fu Stock price S Stock price Sd Option fd Time interval Δt Risk free interest rate Francqui Leerstoel - Inaugurale Rede 2 december 2004

  34. Outline • 1. What is finance? • 2. The diffusion of the discounted cash flow method • 3. Markowitz and the birth of modern portfolio theory • 4. CAPM: the relationship between expected returns and risk • 5. The Efficient Market Hypothesis: do stock prices move randomly? • 6. Modigliani-Miller: does financing matter? • 7. Black – Merton – Scholes: how to value options • 8. Beyond Black-Merton-Scholes: state prices, stochastic discount factors • 9. Outline of following lectures Francqui Leerstoel - Inaugurale Rede 2 december 2004

  35. State prices Law of one price (no free lunches) Price of a digital option Francqui Leerstoel - Inaugurale Rede 2 december 2004

  36. Stochastic discount factors • Valuing a derivative: Stochastic discount factor Random payoff of derivative Expectation operator Francqui Leerstoel - Inaugurale Rede 2 december 2004

  37. Outline • 1. What is finance? • 2. The diffusion of the discounted cash flow method • 3. Markowitz and the birth of modern portfolio theory • 4. CAPM: the relationship between expected returns and risk • 5. The Efficient Market Hypothesis: do stock prices move randomly? • 6. Modigliani-Miller: does financing matter? • 7. Black – Merton – Scholes: how to value options • 8. Beyond Black-Merton-Scholes: state prices, stochastic discount factors • 9. Outline of following lectures Francqui Leerstoel - Inaugurale Rede 2 december 2004

  38. Growth of derivative industry Francqui Leerstoel - Inaugurale Rede 2 december 2004

  39. Explosion of the market for options Francqui Leerstoel - Inaugurale Rede 2 december 2004

  40. Outline of next lectures • 1. Valuing option: inside Black-Merton-Scholes • 2. Option and portfolio management: portfolio insurance, hedge funds • 3. Options and capital budgeting: beyond NPV, real options • 4. Options and risky debt: Modigliani Miller revisited • 5. Options and capital structure: how much debt is optimal? • 6. Options and credit risk: when rating agencies fail All documents for these lectures will be available on my website: www.ulb.ac.be/cours/solvay/farber/vub.htm Francqui Leerstoel - Inaugurale Rede 2 december 2004

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