Dr. Samuel Xin Liang Dr. Samuel Xin Liang Fina 110 Spring 2009
Dr. Samuel Xin Liang Dr. Samuel Xin Liang Fina 110 Spring 2009
Dr. Samuel Xin Liang Dr. Samuel Xin Liang Fina 110 Spring 2009
Hutchison expects the 10-year notes to be ranked A- by Standard & Poor’s and
Fitch Ratings, the seventh-highest investment grade, and a comparable A3 by
Moody’s Investors Service, according to an e-mail sent to investors today. The
sale will be “benchmark” in size, it said, which typically means at least $500
million.
….
Hutchison’s bonds may be priced at about 500 basis points above U.S.
Treasuries to yield 8 percent, said three people familiar with the matter, who
asked not to be identified as discussions are private.
Note: The current Treasuries yield is low, but credit spread is still quite high.
What is the purpose of the debt issuance? Retiring existing debt or financing new
projects?
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Midterm Statistic
Question# Accuracy Rate
1 62.67% Summary
2 88.00%
3 66.67% Max 100
4 92.00% Min 40
5 66.67%
6 93.33% Average 83.8
7 78.67%
Std Dev 13.1
8 94.67%
9 96.00%
10 93.33%
11 97.33%
12 81.33%
13 97.33%
14 84.00%
15 58.67%
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Addressing some confusions
“fairly priced” – Misconception: the price is right and cannot generate positive
return or will always generate positive return
It is the price that reflects all public information about a particular stock at
equilibrium. In other word, all public information tells investors or the
market about the expected future cash flows.
The price can generate negative return when there will be new negative
information known to the public or the market (example Loss
announcement or projections, Citigroup, GM, Bank of America)
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Clarification of Abnormal Return
Abnormal return or excess return: Misconception: Risk premium
Risk premium is the expected return of a stock/risky asset minus the risk-free
rate
Abnormal return is the additional realized return on top of the risk
premium that is compensating the risk (volatility) associated with the stock
or risky assets
The fact that a risky asset/stock can have a abnormal return implies that the
stock is either currently or will be underpriced or overpriced
Overpriced
The stock is overvalued or the price reflects a discount rate less than
required rate of return or overestimates of future cash flows
Underpriced
The stock is oversold or undervalue which means that its price reflects a
discount rate or expected return larger than required rate of return or
underestimates of futures cash flows.
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A Positive News Market Reaction
Overpriced!
Underpriced!
On March 11, Citigroup CEO said in a letter to employees that the bank
had operated at a profit for the first two months of this year and was on
track, based on historical trends, to make $8.3 billion for the quarter. The
correction can take more than days or months !
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Market Correction Process
Overpriced! Abnormal positive return
Assuming Fair Price
Abnormal Negative
return
Underpriced!
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Graphical Illustration on negative news
Bloomberg (April 1): Obama Said to Find Bankruptcy Likely for GM, Chrysler …
This is a negative news for GM as the probability of its bankruptcy increased!
Therefore, investors will demand (require) higher return for investing in GM.
(will discuss expected return later)
The process of finding “fair price” can be viewed as price discovery or market
$ price
corrections
Negative News (increasing probability of bankruptcy) Assuming fair price
Overpriced!
Overpriced!
Abnormal
negative return
Realized returns contain the expected component and the unexpected component
At any point in time, the unexpected return can be either positive or negative
If market is efficient, the average of the unexpected component is zero in a
very long time.
It is the surprise component that affects a stock’s price and generates its unexpected
return
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Implication for Efficient Markets
We learn from Citigroup example that stock prices move when an unexpected
announcement is made, or earnings are different from anticipated (unexpected
profit in first two months.
If the markets are more efficient, the stock prices will take shorter time to
convert a fair price.
Efficient markets assumes the price changes are random because we cannot
predict surprises
We learn from the history that there are still abnormal returns on top of returns
generated by earning surprise!
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Implication for non-financial markets
Strong efficient markets implies that stock prices reflect past, public and private
information (inside information)
The hypothesis of strong efficient market has weak empirical support
Semi-strong efficient markets implies that stock prices reflect past and public
information.
Weak efficient markets implies that stock prices reflect past information.
We know that financial markets are more efficient than non-financial markets
eg. Real estate and physical goods
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How do investors generate expected returns
on risky assets?
We learn that a corporation can go bankruptcy even though it might be very
large and had been successful. (eg. Nortel, Lehman).
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Consider a simple scenario
We assume that there are two possible outcomes regarding GM’s bankruptcy:
Case 1) the probability of GM’s bankruptcy is 100%,
Its expected returns should be -100%
Case 2) the probability of GM’s bankruptcy is 70%, and we can assume
that GM will have a 400% return if it does not go bankrupt. What is its
expected return?
Therefore, in this case, GM’s expected return is 50% and its fair price should
be trading at a price that reflects its future cash flow with 50% discount rate.
Market will require 50% rate of return from investing in GM’s stock when
market is efficient. This discount rate reflects the reward or compensation that
investors are willing to pay for bearing the risk of holding GM’s stock.
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We will cover the following
Expected Returns and Variances
Portfolios
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