Advanced Investments

224 Pages·2014·2.271 MB·English

by  Steve L. Slezak

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t Course Guidebook
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Professor Steve L. Slezak
University of Cincinnati
Professor Steve L. Slezak is an Associate Professor of
Finance at the University of Cincinnati and Director of the
university’s Carl H. Lindner III Center for Insurance and
Risk Management. He received his Ph.D. in Economics from
the University of California, San Diego. Professor Slezak’s
teaching focuses on investments, risk management, and
insurance, and his research examines the adverse effects
of informational problems on managerial incentives and
risk management. The results of his work have appeared in
top-tier journals, including The Journal of Finance and the
Journal of Economics and Management Strategy.
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Course No. 5751 © 2014 The Teaching Company. PB5751A k
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The Teaching Company.
Steve L. Slezak, Ph.D.
Associate Professor of Finance
Director of the Carl H. Lindner III Center for
Insurance and Risk Management
University of Cincinnati
Professor Steve L. Slezak is an Associate
Professor of Finance and the Director of
the Carl H. Lindner III Center for Insurance
and Risk Management in the Carl H. Lindner
College of Business at the University of Cincinnati.
Before joining the University of Cincinnati, he served as a faculty member
in the finance departments of the Stephen M. Ross School of Business at
the University of Michigan and the Kenan-Flagler Business School at
The University of North Carolina at Chapel Hill. He received his Ph.D. in
Economics from the University of California, San Diego.
At the University of Cincinnati, Professor Slezak’s teaching focuses on
investments (including portfolio management, fixed income analytics,
and derivative securities), risk management, and insurance. Until recently,
he was the Faculty Advisor to the Johnson Investment Counsel Student-
Managed Fund. He has received a number of awards at the University of
Cincinnati, including the Harold J. Grilliot Award for Exemplary Service
to Undergraduate Organizations and the Michael L. Dean Excellence in
Classroom Education and Learning EXCEL Graduate Teaching Award. He
also received the Weatherspoon Award for Excellence in MBA Teaching
while at UNC–Chapel Hill. Professor Slezak has had various administrative
and leadership roles at the University of Cincinnati, including Academic
Director of MBA Programs, Undergraduate Program Director of Finance,
and Finance Department Head.
Professor Slezak’s recent research focuses on how informational problems
adversely affect managerial incentives and the effective management of
risk. More specifically, his work examines optimal portfolio construction
with liquidity costs and model uncertainty, managerial and investor “short-
termism,” corporate fraud, and the pricing of idiosyncratic risk. The results
i
of his research have appeared in top-tier finance and economics journals,
including The Journal of Finance, the Journal of Financial Economics,
The Review of Financial Studies, the Journal of Financial and Quantitative
Analysis, and the Journal of Economics and Management Strategy. ■
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Table of Contents
INTRODUCTION
Professor Biography ............................................................................i
Course Scope .....................................................................................1
LECTURE GUIDES
LECTURE 1
Investment Decisions and Goals ........................................................4
LECTURE 2
A Framework for Investing ................................................................12
LECTURE 3
Mistakes Investors Make ..................................................................19
LECTURE 4
The Characteristics of Security Returns ...........................................25
LECTURE 5
The Theory of Efficient Markets ........................................................33
LECTURE 6
Evidence on Efficient Markets ..........................................................41
LECTURE 7
Valuation Formulas ...........................................................................48
LECTURE 8
Bond Pricing .....................................................................................57
LECTURE 9
The Term Structure of Interest Rates ...............................................64
LECTURE 10
The Risks in Bonds...........................................................................73
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Table of Contents
LECTURE 11
Quantifying Interest Rate Risk ..........................................................83
LECTURE 12
Value Creation and Stock Prices ......................................................91
LECTURE 13
Present Value of Growth Opportunities ............................................99
LECTURE 14
Modeling Investor Behavior ............................................................106
LECTURE 15
Managing Risk in Portfolios ............................................................113
LECTURE 16
The Behavior of Stock Prices .........................................................122
LECTURE 17
The Capital Asset Pricing Model (CAPM) .......................................130
LECTURE 18
How to Exploit Mispriced Securities ...............................................138
LECTURE 19
Performance Evaluation .................................................................146
LECTURE 20
Market Making and Liquidity ...........................................................154
LECTURE 21
Understanding Derivatives .............................................................162
LECTURE 22
Using Derivatives............................................................................170
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Table of Contents
LECTURE 23
Pricing Derivatives ..........................................................................176
LECTURE 24
Trade Opportunities or Risk? ..........................................................183
SUPPLEmENTaL maTERIaL
Glossary .........................................................................................190
Bibliography ....................................................................................209
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advanced Investments
Scope:
Increasingly, individual investors have access to a wide variety of
investment opportunities and a rich array of information about such
opportunities. Much of this information is quantitative, providing either
metrics based on mathematical models from financial economics or the
raw data with which investors can conduct their own analysis. This course
examines the analytical aspects of investing to allow you to produce and/
or translate quantitative information so that you can create an effective
investment strategy.
Because the material is analytical, the course does not shy away from
quantitative methods. However, the goal of the course is to create an
intuitive understanding of the underpinnings, justification, and the strategic
role of each analytical method. Whether you intend to manage your own
investments or delegate the management of your wealth to professionals, it
is critically important to have such an understanding.
Effective investing is a 5-step process. Step 1 is to define a set of investment
objectives. Step 2 is to collect and analyze information on the variety of
investment opportunities available in the market. Step 3 is to react to the
output of step 2 to develop and implement an investment strategy that aligns
with the investment objectives. Step 4 is to evaluate the effectiveness of
steps 2 and 3 relative to the objectives. Step 5 is to revise steps 2 and 3 based
on the feedback from step 4—and so on. That is, effective investing is a
continual process of defining, analyzing, reacting, evaluating, and revising.
The goal of this course is to provide you with a systematic and quantitative
approach to each of these steps.
The examination of step 1 begins with Lecture 1, which delineates the
investment goals investors might have. Lecture 2 then develops a framework
for investing that combines passive investing (investing in index funds
designed to “be” the market) with active strategies (actively seeking to
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“beat” the market). This framework lets you pick how active to be, given
the demands on your time and the return from active investing. Given this
context, Lecture 3 examines the evidence from psychology that humans make
systematic cognitive mistakes when processing and reacting to information.
This lecture warns that these mistakes negatively impact the efficacy of
active investment strategies. You will also learn about the efficient market
hypothesis (lectures 5 and 6), which states that market prices accurately
reflect information. The goal of these lectures is to examine whether active
investing is profitable. The evidence is mixed.
The analysis of step 2 begins with Lecture 7, which develops time value
of money concepts and formulas, the building blocks of security valuation.
Using these techniques, the course examines pricing and the sources of
variability in returns for stocks and bonds. For bonds, the course examines
pricing (Lecture 8), why bond yields vary with time to maturity (Lecture 9),
and bond risk (including interest rate risk and credit risk metrics in lectures
10 and 11). For stocks, the course examines how value is created in firms
and how that value translates into stock returns and risk (lectures 12 and 13).
For step 3 (optimal reaction), lectures 15 and 16 examine how to quantify
the behavior of security returns and how to combine securities in portfolios
to control risk while achieving investment portfolio growth. These lectures
provide a baseline portfolio approach to investing; no particular view on
active versus passive investing is taken. However, these lectures highlight
one of the most important concepts of the course—namely that the efficacy
of any particular investment must be assessed by considering its contribution
to risk and return in an optimally formed investment portfolio. Using this
insight, Lecture 17 develops the capital asset pricing model (CAPM), the
most commonly used equilibrium asset pricing model. The CAPM justifies
the market “beta” as the appropriate measure of risk for any security; it also
specifies how efficient (or fair) prices of securities should vary with beta.
In doing so, the CAPM provides a useful benchmark for active portfolio
management; by specifying when a security’s price is “just right,” it specifies
when a security is mispriced. Lecture 18 examines how to exploit mispriced
securities; lectures 20–23 analyze financial options and show how they can
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