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FINANCIAL MARKETS OF THE EUROPEAN UNION ROY DAHLSTEDT LASK3002 UNIVERSITY OF VAASA

FINANCIAL MARKETS OF THE EUROPEAN UNION ROY DAHLSTEDT LASK3002 UNIVERSITY OF VAASA. Roy Dahlstedt Helsinki School of Economics Department of Economics Economicum building

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FINANCIAL MARKETS OF THE EUROPEAN UNION ROY DAHLSTEDT LASK3002 UNIVERSITY OF VAASA

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  1. FINANCIAL MARKETS OF THE EUROPEAN UNION ROY DAHLSTEDT LASK3002 UNIVERSITY OF VAASA

  2. Roy Dahlstedt Helsinki School of Economics Department of Economics Economicum building Arkadiankatu 7 Helsinki 2. floor, room A 220 Office hours for students: mo 9 - 11 Tel.: 43138498 E-mail: roy.dahlstedt@hse.fi ROY DAHLSTEDT

  3. LASK3002 Financial Markets of the European Union Objectives: A knowledge of the mechanisms of foreign exchange rates. An insight into the European Central Bank monetary policy instruments. A familiarity with the money markets and their products and interest rates in Finland and in the European Union; a basic yield calculation ability. A familiarity with the capital/ Eurobond markets in Finland and in the European Union with a basic yield calculation ability. An understanding of the basics of stock valuation and a familiarity with the European stock exchanges and capital market integration. Contents: How to study money and capital markets? Currencies and foreign exchange rates. The European money market and bank liquidity as the platform of the monetary policy of the European Central Bank. The money markets and the money market instruments in Finland and in Europe, the European reference rates ( e.g. Euribor ) and money market integration. The national capital markets and the pan-European (Eurobond) capital market in the making. Eurobond issues and market analysis. The integration process of the European national stock markets. Analysis of the basic types of money and capital market products, pricing calculation exercises, current cases – reading the press. The concept of market efficiency explained. Literature: PETER HOWELLS & KEITH BAIN: The Economics of Money, Banking and Finance, a European Text, 4th edition, FT.Prentice Hall 2008, isbn 978-0-273-71039-4, chapters 1,8,9,10,11,15,16,17,18,21,22,23,24,25. Articles distributed as handouts during lectures Lecturer: Dr.Sc.(Econ.), docent Roy Dahlstedt Evaluation: 1. Lectures 30 h, Dr.Sc.(Econ.), docent Roy Dahlstedt 2. Exam. Teaching: Spring 2009 ROY DAHLSTEDT

  4. Lectures: 5. March, 2009 12 – 18 Palomäki A 201 6. March, 2009 8 – 12 Palomäki A 201 12. March, 2009 12 – 18 Palomäki A 201 13. March, 2009 8 – 12 Palomäki A 201 19. March, 2009 12 – 18 Palomäki A 201 20. March, 2009 8 – 12 Palomäki A 201 Exam opportunities: 1. 28th of March, 2009 2. 16th of May, 2009 3. autumn 2009, to be confirmed later Exam requirements: - textbook, as specified - lectures, with lecture materials - lecture handouts ROY DAHLSTEDT

  5. CONTENTS: 1. International Capital and Money Market Concepts 1.1. Maturity 1.2. Marketplaces, Exchanges 1.3. Market Operators 1.4. The Importance of the Market 1.5. Market Products/Instruments 2. The European Money Markets and Products 2.1. Market Products and Their Yields 2.2. Market Reference Rates: Eonia, Euribor,Eurepo 2.3. An Overview of the Markets 2.4. Case 3. The European Central Bank´s Monetary Policy Instruments and Money Market Liquidity 3.1. The European Central Bank, the European System of Central Banks 3.2. The Targets and Transmission of Monetary Policy Measures 3.3. The Minimum Reserve System and the Standing Facilities 3.4. The Open Market Operations 3.5. Case 4. The European Debt Capital Markets and Products 4.1. The Stereotype Product: the Fixed Coupon Bond 4.2. Yield Calculation for a Fixed Coupon Bond 4.3. International Bond Issues, Eurobonds 4.4. Bond Market Segments and European Marketplaces; An Overview 4.5. The Pricing of Risks in Yields – the Risk Premium 4.6. The Pricing of Maturity in Yields – the Term Structure 4.7. Case 5. The European Stock Markets 5.1. Stocks and Public Listing of Companies 5.2. Stock Portfolios and Market Indices 5.3. Concentration and Competition among the European Stock Exchanges 5.4. Diversification of a Security Portfolio 5.5. Rate of Return Calculation for Equities and the P/E-ratio 5.6. Case 6. A Note on the Importance of Forward Products and Markets ROY DAHLSTEDT

  6. 1. International Capital and Money Market Concepts 1.1. Maturity 1 DAY 3 DAYS 6 MONTHS 1 YEAR cash money:currency spot foreign exchange markets Money Markets short end long end overnight, t.o.m/ t/n liquidity market treasury/government private/corporate central bank Capital Markets debt markets equity markets treasury/government private/corporate domestic international *) domestic international *) Government bond, international = sovereign bond Government bond, domestic = treasury bond ( money market: treasury bill ) Domestic bond = denominated in the currency of the domestic market ( borrower´s view ) International = foreign bond, eurobond Foreign bond = denominated in the currency of the foreign market ( borrower´s view ) Eurobond = denominated in some ( international ) currency other than that of the market Eurodollarbond = denominated in US dollars, sold outside of US Euroeurobond = denominated in Euros, sold outside of the euroarea ( for instance: if a Swedish firm sells a Euro-denominated bond in the euroarea market, it is a foreign bond ( foreign market, the currency of the market ); if the firm sells the bond in Sweden it is a Euroeurobond ( domestic market, foreign currency ) ) Eurodollar = US dollar deposit/asset in a bank outside of the United States ( jurisdiction ) ROY DAHLSTEDT

  7. 1.2. Marketplaces, Exchanges The Banking IndustryCustomers equity OTC volume of trade in: bonds other Private Institutions Retail Trade Interbank OTC Wholesale Trade Exchanges volume of trade in: equity bonds other b r o k e r s Specialized Exchanges have limited product sortiments Clearing and Settlement Business connected with markets The geographical concentration of markets

  8. 1.3.Market Operators industrial firms insurance companies counties, cities states ( “sovereign”) private persons pension funds other funds ( investment funds, hedge funds, etc.) fund managers investment banks broker firms ( dealers ) banks ( allround ) central banks government agencies and institutions Internationalfinancialinstitutions ( World Bank, IMF etc. ) 1.4.The Importance of the Market 1. market price 2. market expectations 3. allocation 4. conversion 5. hedging risk externally: close position diversification 6. liquidity 7. information 8. know-how ROY DAHLSTEDT

  9. 1.5.Market Products/Instruments certificate of deposit (CD) repurchase agreement (repo) commercial paper (CP) zero coupon/discount bond treasury bill ( T-bill ) straight bond (plain vanilla) medium term note (MTN) debenture floating rate note (FRN) convertible (bond) bond&warrant treasury bond ( T-bond, long bond ) swap ( currency, interest rate ) forward rate agreement ( FRA ) financial future option ( currency, index, stock, other ) (common) stock depositary receipt (DR) etc. ROY DAHLSTEDT

  10. 2. The European Money Markets and Products 2.1. Market Products and Their Yields Zero coupon / Discount bond No coupons - yield based solely on price changes Initial data: 100 Nominal value of bond, euros 0 % coupon 3 months time left to expiry 95 marketprice of paper in euros a) buy and hold 95 pay market price 100 at expiry receive face/nominal value 100 - 95 yield on 3 months 5 / 95 = 5.26 % yield as percent of invested cap 4 * 5.26 = 21.04 % yield on p.a. basis b) take an interest rate position 95 pay market price 98 expect to get when sold after 1 month ( expect money price up, market rate of interest down; see the calculation for next investor below !!! ) 3 yield in euros on one month, which is: 3 / 95 * 12 = 37.89 % annual (p.a.) the next investor will get 2 / 98 * 6 = 12.24 % annual yield money price 100 21 98 95 12 0 1 2 3 time expiry ROY DAHLSTEDT

  11. the buyer of the paper is a lender, the seller of the paper is a borrower; the expected fall of the market interest rate is beneficial to the borrower, therefore he buys ( long position ) in the longer end ( 3 months) and sells (short position ) in the shorter end ( 2 months ) position: The rules of quoting short-term zero-coupon bonds: Quote short-term zero-coupon bonds of banks, homogeneous by general acceptance, expiry in e.g. 3 m (osto) 12.85 - 80 (myynti) ( buy ) ( sell ) the bank´s buy-quotation: the bank will buy the paper from the customer at a money price which is such that the bank will get a yield-to-maturity ( if held to maturity ) of 12.85 % p.a.! in an economist´s words: the bank will give the customer a loan for three months ( bank lending ) at this annual interest rate the bank´s sell- quotation: the bank will sell this kind of paper from its portfolio to the custo- mer at a money price which is such that paying that price the customer will earn a yield-to- maturity ( if held till maturity ) of 12.80 % p.a. in an economist´s words: the bank will borrow from the customer ( bank borrowing ) for three months at this annual interest rate spread : 12.85 - 12.80 = 0.05 % p.a., that is, 5 basis points These are called price quotations; money prices are not used but can of course be calculated ROY DAHLSTEDT

  12. Note ! the original length of maturity of the paper is irrelevant, the important thing is the time left from the present to maturity; in general, pricing moneys of different length and their markets are always based on the remaining length to maturity. Note ! The above quotation system is one where imaginary papers are being bought and sold and quoted An alternative system, also in use, is one where money is being quoted, bought and sold. ) Note ! The market rate of interest is calculated as the average of quoted prices, not transaction prices ! Notice the homogeneity assumption/agreement ! / / / / / / / / / / / / / / / Bank A Bank B Bank C homogeneity assumption/agreement homogeneity assumption/agreement 12.12.2000 1 monthhomogeneous paper 1 month paper 6 month paper buy sell buy sell 6 monthhomogeneous paper Bank A quotes Bank B quotes Bank C quotes 12.85 -80 12.95 -90 12.80 -75 13.00 -95 12.82 -80 12.98 -92 These are the market rates of interest of this day ! Average of buy-quotes = 12.82 12.97 market rate of interest (spot) ROY DAHLSTEDT

  13. As in the above, in many markets it is the convention to standardize the length of money ( in this case expiry dates move ): 1 month 3 months 6 months 1 month 3 months 6 months t0 t1 Also, in many markets it is the convention to standardize the expiry dates of money ( in this case the length of money is variable ): E E E t0 t1 ROY DAHLSTEDT

  14. EXAMPLES OF INTERNATIONAL ( EURO-) MONEY MARKET INSTRUMENTS *: Euro Fixed Time DepositEuro Certificate of DepositEurocommercial Paper ( Euronote ) 1) short-term short-term short-term 2) interbank-market instrument intended for non-bank clients´ interbank-market instrument for funding/liquidity purposes money market operations for funding/liquidity purposes 3) no secondary markets bearer paper / secondary market bearer paper / secondary market 4) loan contract loan contract zero-coupon bond 5) outside the jurisdiction of US outside the jurisdiction of US outside the jurisdiction of US 6) unsecured unsecured unsecured 7) unrated unrated unrated 8) European trading centered in London European trading centered in London European trading centered in London * other major money market products: overnight money – deposits tomorrow next money – deposits repurchase (repo) agreements - collateral ROY DAHLSTEDT

  15. 2.2. Market Reference Rates: Eonia, Euribor, Eurepo • Euribors ( European Interbank Offered Rate ) are used primarily in European money markets as short-term reference rates, • for money market deposits and debt securities. • The product is Euro Certificate of Term Deposit, a euro-denominated certificate of a deposit of a certain time period. • The lengths of the money ( the term ) are standardized, starting from every banking day and running for 1 week, 2 weeks, • and 1 – 12 months, in one-month intervals. • The market rates of interest of these lengths of moneys are expressed as annual rates, as averages of interest( offer ) quotations, • using a 360-day year. • The day´s market rates are calculated on the basis of quotations given daily by 49 appointed banks, some of which are • eurobanks, some EU-non-euro-banks, and some non-EU-banks. • Notice, that quotations are for the required interest rate on an offered deposit. • Notice, that the calculation is based on quotations, not transaction prices ( ” if we were to make this kind of a deposit with • any of the appointed banks, we would require this rate of interest ” ). • The quotation is for a standard money amount. • The quotations are given and the averages calculated ( market rates of interest determined ) and published every day at 11 óclock • Brussels time. • Notice, that the homogeneity assumption prevails: the appointed banks are equal as to the credit risk involved and one therefore • does not need to single out the bank with which the propounded deposit would be made, and from which the quoted rate is • required. The quoted rate applies to all system banks. • NOTE ! : Euribor is NOT determined NOR calculated by the European Central Bank. • Euribor is NOT a monetary policy instrument of the central bank. • Euribor is affected by the monetary policy rates determined by the central bank and is therefore an important immediate target • of central bank monetary policy measures. • Eonia ( European Overnight Index Average ) is the daily measure of the interbank overnight market rate. The same banks • partake as above. These banks´ quotations of the overnight lending rate is the basis of calculation. Eurepo; 38 appointed banks give their daily quotations for maturities: T/N, 1-3 weeks, 1,2,3,6,9,12 months. ROY DAHLSTEDT

  16. 2.3. An Overview of the Markets Material will be handed out at lectures ROY DAHLSTEDT

  17. CASE Case material will be handed out in advance at lectures; students are expected to familiarize themselves with the material and be prepared to discuss the case with the class. ROY DAHLSTEDT

  18. 3. The European Central Bank´s Monetary Policy Instruments and Money Market Liquidity 3.1. The European Central Bank, the European System of Central Banks ROY DAHLSTEDT

  19. 3.2. The Targets and Transmission of Monetary Policy Measures The monetary policy instruments contained in the different systems of the central bank Immediate targets: money market interest rates, the liquidity in the banking industry, foreign exchange rate Intermediate targets: the amount of money and credit in circulation, the interest rates in the capital markets, the prices of various types of assets Final targets: price stability, economic growth, employment, external balance (exports/imports) Monetary policy measure Expectations in the market Money market interest rates Foreign exchange rates Exports/imports, current acc. Interest rates in the capital markets Domestic demand Aggregate demand Economic growth, employment Price level stability/inflation ROY DAHLSTEDT

  20. 3.3. TheMinimum Reserve System and the Standing Facilities - The reserve requirement is a percentage of those of the bank´s deposits ( liabilities ), which are pointed out by the central bank - The percentageis determined by the central bank, and there may be different percentages for different types of liabilities - The money must be deposited in a current account, which the bank must have at its national central bank - The bank may lift money from its current account and deposit money into its current account freely but at the end of each month the average of the daily saldos of the account must be at least the reserve requirement stipulated above - The central bank pays an interest on the daily saldo, which is the marginal rate of the main refinancing operation ( cf. later ) - The national central banks approve financial institutions into this system; others do not have a right to use a central bank current account, cannot work in the pan-european interbank payments system ( Target ) and are obliged to keep the requirement deposited in the central bank at all times. ROY DAHLSTEDT

  21. STANDING FACILITIES ( “ LIQUIDITY CREDIT FACILITY “ ) - Marginal Lending Facility and Deposit Facility - The financial institutions which are counterparties in the Minimum Reserve System can use these facilities - The central bank stipulates the lending and deposit rates - Money is borrowed from the central bank and deposited into the central bank for one day in these facilities ( overnight money ) - In practice, the central bank lending rate will determine the ceiling of the interbank overnight market rate and the central bank deposit rate will determine the floor of the interbank market rate; also, the interest rate spread in the interbank market will be limited by the central bank rates and the level of the market rate is controlled by the central bank ROY DAHLSTEDT

  22. 3.4. The Open Market Operations A. The Main Refinancing Operations - This operation is a weekly auction, where the central bank is selling cash money as a one-week loan to the financial institutions which are counterparties in the Minimum Reserve System - The financial institutions make their bids, stating the amount of money they would like to buy and the price of that money (interest rate) they would be willing to pay, for a one-week loan ( ! ) - The loan will be paid back to the central bank after one week ( repo agreement ); at the same time, in that week´s auction, new money is sold; the net of the repayments and the new loans determines whether the money market is being tightened or lightened by the central bank - The central bank, in the auction, predetermines a minimum bid price; after having received the bids the central bank will set these in order, from the highest interest bid down, and determines the amount of money to be sold; the last bidder to get money is the marginal bidder, his/hers is the marginal rate. Everyone pays this marginal rate. The minimum bid rate is the ECB´s main refinancing operation rate ( also known as repo rate and auction rate ); the ECB´s principal monetary policy instrument ( principal steering rate ). B. The Longer-term Refinancing Operations - This operation is a monthly auction, the same financial institutions may partake as above, the central bank is selling three-month loans on the basis of the bids, repo- agreements are used - In this case the central bank predetermines the amount of money to be sold; the bank does not intend to send interest rate signals to the market; this is purely a longer-term liquidity regulation device C. The Fine-tuning Operations - Executed on an ad-hoc basis - Managing the liquidity situation in the market - Different types of money market instruments can be used; a small-scale auction may be held or one or more national central banks or the ECB itself may buy and/or sell on the market with bilateral transactions D. The Structural Operations - Adjust the position of the ESCB vis-a-vis the European money market ( E ). Open market operations on the international foreign exchange market

  23. CASE Case material will be handed out in advance at lectures; students are expected to familiarize themselves with the material and be prepared to discuss the case with the class. ROY DAHLSTEDT

  24. 4. The European Debt Capital Markets and Products 4.1. The Stereotype Product: the Fixed Coupon Bond bearer general issue / public offering coupon / fixed interest / fixed income annual or semi-annual coupon dates bullet guarantees priority face value / denomination currency of denomination maturity / expiry Yield from: 1) coupon 2) market price / invoice price 3) exchange rate 4) coupon reinvestment Market price depends on : 1)interest rate expectations 2) debtor/credit risk, other risks 3) exchange rate expectations 4) liquidity other factors ROY DAHLSTEDT

  25. ORIGINATION Supply of debt finance/financial investor/ Demand for debt finance/real investor/ buyer of instrument/lender/demand for financial investor/seller of instrument/ instrument/creditor/asset/(bank´s borrowing) borrower/supply of instrument/debtor/ liability/ (bank´s lending) bank client bank client money debt contract ”paper” assets bank´s debts bank´s money debt contract ”paper” Retail market/client market Retail market/client market Interbank Intermediation Market making ROY DAHLSTEDT

  26. 4.2. Yield Calculation for a Fixed Coupon Bond An investment is always an income stream. By calculating the present values of income streams they become comparable. The present value of an income stream is calculated by discounting elements of the stream with a discount coefficient( embodying the discount rate which is either the market interest rate or yield ) to the present moment and adding . If the present value of the stream is already known ( the market price of the investment at present time ) , the discount coefficient ( the yield embodied in the market price ) can be deduced when the stream is known. 6 % 8 % 7 % 7 % Discounted Income stream= present value of Income stream Expenditure Example Discounting: C or P t 0 t 1 t 2 t 3 T 92.59 = 100 / ( 1 + 0.08 ) exp 1 100 = income stream 1 + 0.08 = discount coefficient, 0.08 is the discount rate ( 8 % ) 92.59 = present value of income stream 100 when discounted over one time period (exp is 1)

  27. Let us adopt the following definitions: • 1) expected present value or 2 ) the cost of investment or price t 1) - 2) 3 ) expected net present value Rate of Return when productive/real investment Yield when equity/financial investment four basic types of security : 1) coupon, fixed rate note/bond 2) floating rate note/bond 3) zero coupon bond/note 4) common stock, dividend, no maturity ROY DAHLSTEDT

  28. In the following we calculate the yield of a fixed coupon bond, for instance a euro-denominated Finnish government bond, which is considered credit risk free, and which is not redeemed before maturity but the total principal/nominal value will be paid to the bearer at expiry ( a bullet loan ). We ask: what is the condition which makes the income from the investment equal to the cost of the investment ? That is: with what condition is the present value of the income stream from the bond equal to the price paid for the bond ? That is: when is the net present value of the bond zero ? We write an equation: on the left side the cost ( the price of the bond ) of the investment is equal to, on the right side, the present value of the income stream ( from the bond ) from the investment; we have now set the net present value ( remember the definition above ) equal to zero. The answer to the question above can be calculated, observing that we know all of the terms in the equation except YTM in the discount factor; YTM can be solved from the equation. This is by definition the bond´s yield-to-maturity ( Note ! to maturity ! ) Why are we interested in a condition which sets the result of our investment ( the net present value ) equal to zero ? The YTM tells us how large a discount factor can be applied to the income stream without making the net present value negative. That is : what is the rate of growth of the capital invested ( the price ) up till the day of expiry. That is : if compared with some market rate of interest, of this same market or some other market, is this investment giving us an income stream which is better than the average stream on the market ( the market rate of interest is the yield given by the average income stream on the market) and can therefore be discounted with a larger discount factor than the market rate of interest. That is : with comparable calculations, what is the rate of growth of this investment in comparison to alternatives with different income streams. ROY DAHLSTEDT

  29. On a certain market, defined by the characteristics of the product, the rules and conventions obeyed on the market and, often, a limited • number of operators, the average yield of the individual papers traded, at any time, is the market rate of interest on that market at that • time. • From the above YTM calculation one can see, that given the income stream, the yield is singularly dependent on the price paid for the bond One can also see, that if the bond is sold before expiry, in which case, in the calculation, the selling price is used instead of the face value, YTM depends on both the buying price and the selling price; the higher the selling price/ the lower the buying price, the better yield Notice, that you cannot know the selling price in advance, and so the yield calculation is risky: you have to use an expectation of price. Note ! YTM-calculation is routinely made to maturity and with the face value, if there is no particular reason to do otherwise ! • If the bond has been bought with the buy-and-hold strategy, what is the importance of the price changes of the bond after buying: wealth effect • Given the buying price, the larger the ( fixed ) coupon the better the yield. • If the buying price is the same as the nominal value/face value ( a par – bond ), the YTM is the same as the coupon rate. If the buying price • is above par the yield is less than the coupon rate and contrariwise. • Notice the general mathematical form of the YTM – equation : P = C / Y ( C = constant ) • The function is non-linear and the relation between P and Y is inverted: a reduction in the bond´s money price is a simultaneous • increase in the yield and contrariwise. • The calculation presented above solves for the annual yield of the bond ( if the unit of t is one year ) and assumes, that the investor • gets a coupon payment, which is made annually, 1,2,…T times.The investor buys the bond at the coupon (payment) date (C ) ( the coupon • is paid to the previous bearer, for the past year ) and will get the next coupon payment after one year if still owns the bond after one year. • Note ! If some other time unit is used ( e.g. t runs for number of months ), everything works analogously; always express yield on annual • basis ( p.a. ). To enable this, if one month is the time period used and t runs for the number of months, use YTM / 12 in the denominator, • or calculate YTM for one month and then multiply by 12 for the annual yield. If the bond is bought while the coupon period is running ( at buy B) , the buying price will include the part of the annual coupon ( for the first part of the year ) to which the previous bearer is entitled, and the buyer will then get ( in the next coupon day ) the coupon for the whole previous coupon period ( year ). C C C buy buy B ROY DAHLSTEDT

  30. Kuponki(korko)/ Nimellisarvo Coupon/ Face value (Osto)hinta/price = Tuotto ( hinta ) Yield ( price ) Markkinakorko Market rate of interest • The yield will increase either because of a higher coupon or a lower buying price ( discount ). The coupons of the bonds being traded • on the market ( secondary market ) cannot be changed, so the increase of yield takes place through the decrease of buying price. • The market rate of interest is determined by the prices of the papers. • An increase in the market rate of interest probably has an effect on the coupons of new issues of bonds ( primary market ) raising them; • the price of the bonds stands close to par value and there are no discounts. • The YTM-calculation encloses three of the four yield elements ( above ); the coupon and the buying price explicitly and the reinvestment • rate implicitly; the yield effect of a change in the exchange rate must be calculated separately. • If one takes the view of the borrower everything works the same way, only the nomenclature changes; income stream is expenditure • stream, market price is the amount borrowed, at expiry one pays the face value and the yield is the cost of the loan in annual percentages. • Problems&Drawbacks in using YTM-calculation: • 1) • As a solution we get one yield term/percentage, which means one discount factor for all pieces of the income stream. • Let us assume that the bond´s maturity is three years from now. Therefore, the yield that we calculate is used in calculating the • average yield of three-year bonds, which is then the three-year market interest rate on this market. We also notice that the • one-year and two-year market rates of interest are different from the three-year rate. We should use the relevant market rates to • discount the one-year and two-year pieces of the income stream of our investment, but we are now using the same three-year discount • factor for all pieces of the income stream ! The calculation makes the unrealistic assumption that the price of money does not depend • on the length of the money ( it assumes that the yield curve is horizontal ) See later: term structure of interests, yield curve ! 2) The calculation makes the assumption ( implicit ) that all coupon payments are immediately reinvested with an interest rate which is the same as the calculated yield percentage ! If it turns out that a coupon payment can be reinvested on the market with a higher rate this will of course be done. Consequently, the yield of the investment will ultimately be better than calculated. With decreasing market rates the opposite will be true. These reinvestment rates cannot be known in advance; the actually realizing yield of our investment will be dependent on the future market rates, therefore there is a risk. The yield-to-maturity is an approximation ! 3) The YTM-equation cannot normally be solved manually. Trial and error must be used if a suitable computer program is not available. ROY DAHLSTEDT

  31. Examples: 140 120 YTM = C=10 % 100 Vuosi/year 100 osto/buy myynti/sell osto/ buy 0-kuponki/ 0-coupon YTM 80 Par- bond : 100 = 10/ (1+YTM)1 + 10/ (1+YTM)2 + 10/ (1+YTM)3 + 10/ (1+YTM)4 + 100/ (1+YTM)4 YTM = 10 % p.a. C= 10 % nimellisarvosta/of nominal value Bond, juoksuaika 2 vuotta, hinta 80, C= 10 % = 80 = 10/ (1+YTM)1 + 10/ (1+YTM)2 + 100/ (1+YTM)2 maturity 2 years, price 80, C=10% YTM = 23.68 % p.a. Bond, pitoaika 2 vuotta, hinta 100, odotettu myyntihinta 80, C=10 % 100 = 10/ (1+YTM)1 + 10/ (1+YTM)2 + 80/ (1+YTM)2 YTM = 0 % p.a. maturity 2 years, price 100, expected selling price 80, C=10% Nollakuponkibondi, juoksuaika 2 vuotta hinta 80 80 = 100/ (1+YTM)2 YTM = 11.80 % p.a. tai, yksinkertaista korkolaskua käyttäen 20/80 * ½ = 12.50 % p.a. Zero-coupon bond, maturity 2 years, price 80 using simple interest calculation Semiannual bond, maturity 1½ years price 102, C = 7 % 102 = 3.50 / ( 1+ YTM/2 )1 + 3.50 / ( 1+YTM/2 )2 + 3.50 / ( 1 + YTM/2 )3 + 100 / ( 1 + YTM/2 )3 YTM = 5.59 % p.a. ROY DAHLSTEDT

  32. 4.3. International Bond Issues - The International Bond Market, Eurobonds Debtor Emission New Issue Primary Market Stock of Debt (Paper) EUROPEAN BOND MARKET / Banking Industry/ Investors Secondary Market Maturity Debtor ROY DAHLSTEDT

  33. Customer Lead Manager (Investment Bank) Preparing emission: -analyze the economic status of the borrower and the nature of the financing requirement -planning the characteristics of the issue (no details yet ) -analyze the market situation and the requirements for the issue -name co-managers, set up management group -prepare brochure, contracts, other documentation -meet with the group and agree on responsibilities Undertake the issue: -underwrite preliminary contracts (see later ) with underwriters and sellers -control of sales -collect and forward to borrower -during the subscription period ( see later ) collect and analyze market feedback and settle ( with borrower) the critical details of the loan; underwrite the final ( marke- ting ) contracts with the consortium Co-manager Co-manager Co-manager Co-manager Co-manager Co-manager -name underwriters and sellers for the consortium -control the sales of the loan - buy part of the loan to own portfolio -collect and forward Underwriter Underwriter The Organisation and Management of a New Issue of an International Bond Loan -buy loan and sell it to customers ( investors ) or keep in own portfolio; guarantees the quota -name sellers Seller Seller -mark or subscribe a quota to be sold -sell or buy to own portfolio; no guarantee of quota, unsold may be returned ROY DAHLSTEDT

  34. New Issue Process: 5-10 days 15 days Announcement Day Offering Day Closing Day Subscription Stabilization period period Announcement Day: The Lead Manager send a telex/fax/e-mail introducing the borrower, the guarantor, an the overall features of the planned loan as well as conditions, without crucial details to the members of the consortium, together with an invitation to the underwriters and sellers to participate in the sales campaign. Also, the documentation and the preliminary contracts are mailed to the consortium for signing ( the socalled open priced - method ). Subscription Period The answers and feedback information together with the undersigned preliminary contracts are returned to the Lead Manager. The Lead Manager ( bookrunner ) reanalyzes the market situation on the basis of this information and decides, in cooperation with the borrower, upon the details of the loan. The loan contract is undersigned with the borrower. The loan is allocated to the subscribers ( underwriters and sellers ) in proportion to subscriptions. Offering Day The final contracts with the underwriters and sellers are signed and they are informed of the details of the loan, as well as of their quotas. Stabilization Period The management group will try to stabilize the (secondary) market price of the loan at the issue price; if the price starts to rise from the issue price the borrower may find the coupon or other conditions of the loan overtly favorable ( the borrower is paying too much for the debt ) and critice the management group/lead manager for bad judgement or even incompetence; on the other hand, if the price of the paper starts to fall immediately after issue some of the investors may find themselves having paid an excess price for the paper and having already sustained a loss ( in wealth ) and blaming their banker ( the underwriter, seller ) for giving bad advice, selling bad stuff. Closing Day collection of the loan, tombstone ( If a group of investment banks buy up the loan by a mutual agreement, the loan is called syndicated, and the group a consortium ) ROY DAHLSTEDT

  35. 4.4. Bond Market Segments and European Marketplaces; An Overview Contemporary material which will be delivered at lectures ROY DAHLSTEDT

  36. 4.5. The Pricing of Risks in Yields – the Risk Premium 1) Interest Rate Risk Fixed coupon: 1. Price Risk 2. Reinvestment Risk Floating rate: the above plus Coupon Risk 2) Default/Credit Risk 3) Liquidity Risk 4) Inflation Risk 5) Exchange Rate Risk 6) Call Risk 7) Country Risk RISK AVERSION - RISK NEUTRALITY - RISK LOVING B is risk-averse: B´s non-gamble utility B´s gamble utility U tuottoRA(AI) RA(AC) E ( R ) RA(AD) preemio R(f) RN 0.5 U(0) + 0.5 U(100) tai/or RL(LC) tai 0 50 100 riski/risk U(50) f f B is risk-averse tai tai A is risk-neutral preemio tuotto yield tuotto/yield A B risk- risk- neutral averse a) probability 0.5: win 100 Which game ? probability 0.5: win 0 b) secured 50

  37. 4.6. The Pricing of Maturity in Yields – the Term Structure Tuotto/yield E1 eräpäivät/expiry dates E2 E3 tuoton laskentapäivät T0 E1 E2 E3 dates of calculation of yield eräpäivät/expiry dates Tuotto/yield T0 tuoton lasken T1 päivät dates of calculation E1 E2 E3of yield eräpäivät/expiry dates Tuotto/yield T0 T1 E1 E2 E3 eräpäivät/expiry dates laskenta- päivät/dates of calculation of y.

  38. TERM STRUCTURE OF INTEREST RATES ACCORDING TO THE EXPECTATIONS HYPOTHESIS IN PLAIN WORDS: HOW THE EXPECTATIONS CONCERNING THE FUTURE SHORT RATE CAN EXPLAIN THE TERM STRUCTURE AND MAY PREDICT, ON THE AVERAGE, THE FUTURE SHORT RATE Yield / Market Interest Rate The million euro question: where do all these original expectations come from ? yield curve at t0 5 4 F1 Time in months / expiry dates / closing dates T0 T1 T2 From expectations concerning the short rate to the long rate * At time T0 we expect the central bank to raise the one-month rate ( which is at 4 % ) to 5 %, we expect this raise to take place at T1 * The raise means that the money prices of papers will fall * We start to sell the papers we possess which expire at time T2, with the intention of buying them back at time T1 after their money price has fallen * The money price of T2-papers falls immediately ( increased supply ) and with it the long rate ( T0 T2 ) rises close to the expected 5 %; the expected raise of the short rate is realized in advance on the market as a rise of the long rate ! The general conclusion: the long rate is a measure of the markets expectation as to the future short rate ( term structure ! ) 1 2 From the long rate to the financial futures rate We can mathematically show that for the time interval T1 T2 ( financial future F1 )there is a rate which, together with the rate of 4 % for the first month, gives an investor a return which is equal to an investment for two months at 5 %; this is how the expectations ( which are ”embedded” in the two-month rate of 5 % ) determine a (theoretically correct ) rate for the financial futures contract T1 T2 ( financial futures F1 ), already at time T0 ! 3 From the financial futures rate to the average realization The Unbiased Forward Rate Hypothesis claims that operators ( majority ? ) use the financial futures´ market rate in formulating their expectations as to the future short rate, because this is close to the theoretically correct rate. If we now make the assumption that the market is efficient, this financial futures rate will be realized as the short rate at time T1, on the average.

  39. CASE Case material will be handed out in advance at lectures; students are expected to familiarize themselves with the material and be prepared to discuss the case with the class. ROY DAHLSTEDT

  40. 5. The European Stock Markets 5.1. Stocks and Public Listing of Companies Lecture commentary on: - A stock - Stock financing - Primary, secondary market - Stock financing vs. debt financing - Stocks vs. bonds as financing instruments - Ownership - Stock investor risk - Risks in stock financing vs. bond financing - Stock emissions - Initial public offering (IPO) - Dematerializing ROY DAHLSTEDT

  41. 5.2. Stock Portfolios and Market Indices Stock Exchange 1 / list Exchange 2 / list Exchange 3 / list country 1 country 2 country 3 Pankit ja rahoitus Vakuutus Sijoitus Kuljetus ja liikenne Kauppa Muut palvelut Metalliteollisuus Metsäteollisuus Monialayritykset Energia Elintarviketeollisuus Rakennusteollisuus Tietoliikenne ja elektr Kemianteollisuus Viestintä ja kustannus Muu teollisuus Pankit ja rahoitus Vakuutus Sijoitus Kuljetus ja liikenne Kauppa Muut palvelut Metalliteollisuus Metsäteollisuus Monialayritykset Energia Elintarviketeollisuus Rakennusteollisuus Tietoliikenne ja elektr Kemianteollisuus Viestintä ja kustannus Muu teollisuus Pankit ja rahoitus Vakuutus Sijoitus Kuljetus ja liikenne Kauppa Muut palvelut Metalliteollisuus Metsäteollisuus Monialayritykset Energia Elintarviketeollisuus Rakennusteollisuus Tietoliikenne ja elektr Kemianteollisuus Viestintä ja kustannus Muu teollisuus banking insurance investment transportation trade otherservice metal industries forestry multisector energy food processing construction communications chemical industries publishing other industries banking insurance investment transportation trade otherservice metal industries forestry multisector energy food processing construction communications chemical industries publishing other industries banking insurance investment transportation trade otherservice metal industries forestry multisector energy food processing construction communications chemical industries publishing other industries Country- based portfolio: Correlation between Price developments In national stock markets Secondarily: sector- based Sector-based portfolio: Correlation between performance of productive sectors Secondarily: country-based ROY DAHLSTEDT

  42. STOCK MARKET INDICES IN EUROPE 1. Dow Jones Stoxx ( DJ Stoxx ) Geographical Europe ; EU ( not Luxembourg ) plus Norway, Switzerland Eurozone ; EMU ( not Luxembourg ) Europe ex UK ; EU ( not Luxembourg, Great Britain ) plus Norway, Switzerland Europe ex Eurozone ; EU less EMU, plus Norway, Switzerland Nordic region ; Finland, Sweden, Norway, Denmark 2. Morgan Stanley Capital International ( MSCI ) Europe EMU 1. Morgan Stanley Capital International ( MSCI ) eight sector indices, 38 industry indices ; Europe, EMU, Europe less Great Britain, 1. Standard & Poor´s ( S & P ) S & P Euro Index ; EMU ; 160 companies S & P Euro Plus Index ; EMU plus Denmark, Norway, Sweden, Switzerland ; 200 companies 2. Financial Times International ( FTSE ) FTSE Eurotop 100 ; Great Britain, Germany, France, Switzerland, Netherlands, Italy, Sweden, Spain, Belgium ; 100 companies FTSE E - stars ; EMU ; 29 companies FTSE Eurobloc 100 ; EMU ; 100 companies FTSE Eurotop 300 ; Europe ; 300 companies Country/Exchange - lists Market indices Aggregate/General market index Country sector indices Aggregate/General sector index Company Index ROY DAHLSTEDT

  43. Nasdaq (Dubai) Stockholm Stock Exchange OM Stockholm AB/ OM Group Copenhagen Stock Exchange Helsinki Stock Exchange, HEX Helsinki Derivatives Exchange Amsterdam Exchanges Brussels Stock Exchange Dublin Stock Exchange London Stock Exchange Liffe Paris Stock Exchange Matif-Monep Vienna Stock Exchange Frankfurt Stock Exchange/ Deutsche Börse/ Euroboard Deutsche Terminbörse Zurich/Swiss Stock Exchange/SWX Milan Stock Exchange Miff Madrid Stock Exchange Meff 5.3. EUROPEAN EXCHANGES: COMPETITION AND CONCENTRATION OMX Norex EDX London Oslo Reykjavik Tallin NYSE Riga Euronext Luxembourg Warsaw Qatar Dubai Lisbon Chicago Board of Trade / Chicago Mercantile Exchange Seaq International London • Tradepoint Newex/Eastern Eur. Eurex Virt-x equity trading/ exchange derivatives trading/ exchange

  44. Integration of exchanges Lista/ List X Lista/ List Y Lista/ List Z Meklari X Meklari Y Meklari Z broker/dealer broker/dealer broker/dealer Sijoittaja Investor Lista/ List X Lista/ List Y Lista/ List Z broker/dealer Meklari Y platform Sijoittaja/Investor ROY DAHLSTEDT

  45. 5.4. Diversification of a Security Portfolio Market price – uncertainty – ( market ) risk – volatility – standard deviation/variance Single Asset Invest 90 for 1 year; buy one share; for instance 90 USD for one IBM-share ( no dividends ). After one year, possible outcomes with probabilities ( probability distribution ): bull market; probability 50 %; stock price( estimate ) 130; rate of return (130/90)-1 = 0.444^^44.4 % pa bear market; probability 50 %; stock price (estimate ) 80; rate of return ( 80/90)-1 = -0.111^^-11.1 % pa The distribution is defined by two measures: 1) Expected rate of return ( = the mean/average of the distribution ) 2) Standard deviation ( square root of variance ) of the distribution ( = volatility risk). 1) The expected rate of return is: ( 0.50 * 0.444 ) + ( 0.50 * -0.111 ) = 0.1665 ^^ 16.65 % pa 2) The standard deviation of the distribution; the risk : Consider four alternative assets: possible outcomes with probabilities ( after one year ) expected RR Asset A ( Treasury Bill ) RR 6 % 1 ( 100 % ) 6 % Asset B (bad) RR –10 % 0.25 (normal) RR 0 % 0.25 (good) RR 20 % 0.50 7.5 % Asset C (bad) RR -20 % 0.25 (normal) RR 10 % 0.50 ( good) RR 40 % 0.25 10 % Asset D (bad) RR 0 % 0.25 (normal) RR 10 % 0.50 (good) RR 20 % 0.25 10 % Calculate the variance and standard deviation ( risk ) of these assets: Asset A : variance = 0, standard deviation = 0 Asset B : variance = 0.25*(-0.10 – 0.075)2 + 0.25*(0 – 0.075)2 + 0.50*(0.20 – 0.075)2 = 0.01686^^1.7 % st.deviation = 0.1298 ^^ 13 % Asset C : variance = 0.25*(-0.20 – 0.10)2 + 0.50*(0.10 – 0.10)2 + 0.25*(0.40 – 0.10)2 = 0.045^^4.5 % st.deviation = 0.2121^^ 21.2 % Asset D : variance = 0.25*(0 – 0.10)2 + 0.50*(0.10 – 0.10)2 + 0.25*(0.20 – 0.10)2 = 0.005^^0.5 % st.deviation = 0.0707^^7.1 %

  46. ” Mean – variance ” –( also: risk – return ) setting : • 6 – 0 % • 7.5 – 1.7 % • 10 – 4.5 % • 10 – 0.5 % Risk neutrality: only expected return is relevant C or D (indifferent) Risk aversion: if equal expected returns, choose less risk D over C if equal risks choose higher expected return if risk is larger, expected return must be larger D over B D over A if a risk premium of 4%-points is subjectively enough to compensate for the (increased) risk Risk loving : if equal expected returns, choose more risk C over D if equal risks choose lower expected return if risk is larger, expected return must be smaller B over D choose A, B or C depending on a subjective evaluation of the risk-return ratios Portfolio • Let us make two assumptions: • You buy assets C and D into your portfolio in equal proportions ( weights ), 50 % of the total • sum for each. • These assets are positively correlated; when times are bad, they give bad outcomes,and vice versa • Let us calculate the expected return and the risk of this portfolio: • The expected return of portfolio ( the weighted average of the individual assets´ expected returns ): • 0.50*0.10 + 0.50*0.10 = 0.10^^ 10 % • The variance of the portfolio: • Method 1 : Direct calculation • sum of ( probabilities multiplied by the squared deviation of the portfolio´s rate of return • in this outcome from its expected rate of return ) • 0.25* ((0.50*-0.20+0.50*0) – 0.10 )2 + 0.50* ((0.50*0.10+0.50*0.10) – 0.10 )2 + • 0.25* ((0.50*0.40+0.50*0.20) – 0.10 )2 = 0.02 ^^ 2 % Compare to the individual assets !! • st.deviation = 0.1414 • Method 2 : Calculation with correlation ROY DAHLSTEDT

  47. Correlation coefficient ( CCc,d ) = covariance ( CVc,d ) / (st.deviation Sc * st.deviation Sd) c,d = the assets in the portfolio CCc,d = correlation between assets c and d CVc,d = covariance of assets c and d We already have the standard deviations of assets C and D, so in order to calculate the correlation coefficient we need the covariance: CVc,d = sum of ( the deviations of the rates of return of each stock from their expected rates of return, multiplied pairwise for each state of the world ( here: bad, normal, good ) )times the probability ( joint probability ) of the occurrence of this pair : 0.25*(-0.20-0.10)*(0-0.10) + 0.50*(0.10-0.10)*(0.10-0.10) + 0.25*(0.40-0.10)*(0.20-0.10) = 0.015 Correlation coefficient ( CCc,d) = 0.015 / ( 0.2121 * 0.0707 ) = 1.0 Portfolio variance can now be calculated with the following formula: portfolio variance ( Vp ) = (weight of C)2*variance of C + (weight of D)2*variance of D + 2 * weight of C * weight of D * st.deviation of C * st.deviation of D * CCc,d 0.25*0.045 + 0.25*0.005 + 2 * 0.50 * 0.50 * 0.2121 * 0.0707 * 1.0 = 0.02 st.deviation = 0.1414 Let us now change the second assumption: Assume that the assets are negatively correlated, that is, when times are bad for asset C, times are good for asset D and vice versa. Let us carry out the same calculations of portfolio risk as above ( the expected return, of course, does not change ): Method 1 : 0.25*((0.50*-0.20+0.50*0.20) – 0.10 )2 + 0.50*((0.50*0.10+0.50*0.10) – 0.10 )2 + 0.25*((0.50*0.40+0.50*0) – 0.10 )2 = 0.005 ; st.deviation = 0.0707 Method 2 : not used, because the variance would turn out to be negative ! ROY DAHLSTEDT

  48. 5.5. Rate of Return Calculation for Equities and the P/E - ratio • One can naturally use the IRR ( YTM ) – calculation, which has been treated above; • the dividend payments then replace the coupon payments; these will have to be forecasted/ • expected payments; the calculation will have to include an expected selling date and price • instead of the expiry date and the nominal/face value of the bond. The calculation, consequently, • involves more uncertainty/risk than a normal bond calculation. • The return/yield elements are equal to those of a bond. • 2. Gordon Constant Dividend Growth Model • Assuming that the dividend is paid regularly, for instance • annually, and always in the same amount, and infinitely ( socalled perpetuity ), one can show that : • P = D / K missä P = the money price of the stock • D = the money dividend of the stock • K = the (discount) yield, decim. • From this one can solve the yield, knowing price and dividend. This should be compared with the required • yield, which is derived with the CAP-model ( this will be presented next ). The CAP-model gives the • required yield as the riskfree interest rate plus the market risk premium, which is weighted with the riskiness • of the stock in relation to the riskiness of the market. • Assuming that the dividend is not constant but grows with a constant percentage: • P = D(1) / ( K – g ) missä D(1) = the first money dividend • g = the growth of dividend,decimal • P = the buying price of stock • K = the (discount) yield,dec. • from this one can solve for the yield. • In this model the firm is growing with a constant percentage, (g), and the dividend is • growing with the same percentage, and consequently, the price of the stock is growing with the same • percentage. It follows, that the denominator must be positive, in other words the growth of the firm cannot • exceed the yield of the investor ( which is also the cost of stock financing for the firm ). Constancy is the • drawback of this model. • Solve for K : • K = ( D(1) / P ) + g ROY DAHLSTEDT

  49. - Consider the growth percentage (g): the growth of the earnings E of the firm depends on two factors • if one assumes all prices and wages constant: the growth of the productive capital (net investment) • in use and the productivity of this new capital. Let us assume that the net investment is n percent of • the earnings ( retention ratio ) and that the purchased new capital gives new earnings which is w • percent of the investment: • g = w * n • the ratio of new earnings to net investment w • is the rate of return of this investment and it can be larger, smaller or equal to the cost of financing • of the firm. The cost of financing of the firm is ( above ) K. The firm will not invest if the rate of return • of the last investment is smaller than the cost; therefore, in the last investment, w = K: • g = K * n • the part of • the earnings which is not invested ( 1 – n percent )(payout ratio), will be paid out as dividends: • D = ( 1 – n )* E • Let us write the Gordon • K-formula anew using the above definitions: • K = ( ( 1 – n ) * E / P ) + K * n • K – K*n = ( 1 - n ) * E / P • K ( 1 – n ) = ( 1 – n ) * E / P • K = ( ( 1 – n ) * E ) / ( ( 1 – n ) * P ) = E / P ; P = E / K P / E = 1 / K PRICE – EARNINGS - RATIO Interpretations : Assuming that the firm is investing in projects which give a return close to the cost of financing; if the market price of the stock is higher than the earnings per stock divided by the rate of return the stock is overvalued and this would be a sell-signal; and vice versa. P/E-ratio tells us the ratio of the sum of money invested in one stock in proportion to the earnings given by that one stock; if we use annual numbers, this ratio tells us how many years it will take for the firm to earn the money invested in the stock. P/E-ratio tells us something about the strength of the expectations as to the ability of the firm to produce earnings; a high ratio tells us that the market is expecting the growth of the firm to accelerate ( and the rate of return to increase. ROY DAHLSTEDT

  50. 3. The Required/theoretical Rate of Return - The Capital Asset Pricing (CAP) – Model We start from the idea, that fluctuations in the rate of return from an individual stock depend on two types of factors: a) Developments in the market which are manifested in the fluctuations of the average rate of return of the stock in market ( systematic or market risk of the stock, not diversifiable within one market ) b) Firm-specific developments which affect the rate of return from the firm´s stock but do not affect other stocks ( non-systematic risk of the stock, diversifiable within the market, see above ! ) The nature of the dependency of the rate of return of the stock i ( Ki ) on the market ( or the average/ market rate of return Km ) ( importance of the systematic risk with regard to this stock ) can be estimated by using a simple regression model: Kit = ai + bi * Kmt where a is a constant parameter and t is unit of time We can use a computer to calculate the regression analysis and give us estimated values of a and b. But we also know that: bi = cov(Ki , Km) / var(Km) = CCi,m* sd(Ki)sd(Km) / var(Km) ( see above for CC ! ) = CCi,msd(Ki) / sd(Km) The calculated coefficient b ( referred to commonly as beta ) is important, because it measures the direction and strength of the influence of the market on the specific stock ! We use the coefficient b (beta) in the Capital Asset Pricing Model: Kri = Kf + bi * ( Km – Kf ) where: Kri = the required rate of return of stock i according to CAPM Kf = the risk-free rate of return Interpretation: A specific stock is required to give a rate of return which exceeds the risk-free rate by as much as the average market rate of return, taking into account the nature of the relationship between this specific stock and the market. If b exceeds plus one the required return exceeds the average market return; the return of the stock fluctuates with the market but in a more pronounced fashion; therefore, if you include this stock into your portfolio the risk of the portfolio will tend to exceed the average market risk and a compensation in the form of a higher required return is demanded. If b is less than plus one but positive the required return is less than the average on the market; this stock fluctuates with the market but in a subdued fashion; the systematic/market risk is withered; the required return is less than average. If b is negative the required return is less than the risk-free rate; this stock fluctuates ”countercyclically” and diversifies away some of the systematic risk; it is therefore worth having in the portfolio even at the cost of losing the risk-free rate, that is, with a negative risk premium. NOTE: According to this theory, the market redeems with an increased rate of return the market risk and its effect on the individual stock – this is because this risk cannot be diversified away within a market. There is no compensation/risk premium in the required rate of return for the nonsystematic risk of the stock because this risk is diversifiable within a market; a corollary of this is that a rational investor will always use well-diversified portfolios because there is no extra return for stock-specific risks ( according to this theory). ROY DAHLSTEDT

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