The Basics of Finance: An Introduction to Financial Markets, Business Finance, and Portfolio Management

The Basics of Finance: An Introduction to Financial Markets, Business Finance, and Portfolio Management

Volumn , Issue , 2011, Pages

  Drake, Pamela Peterson ^a   Fabozzi, Frank J ^a  

^a NONE

Author keywords

[No Author keywords available]

Indexed keywords

EID: 84891585359     PISSN: None     EISSN: None     Source Type: Book    
DOI: 10.1002/9781118267790     Document Type: Book

References (144)

1. Economic profits are earnings beyond the cost of capital used to generate those earnings. In other words, economic profits are those in excess of normal profits-those returns expected based on the investment's risk.
2. Harry M. Markowitz, "Portfolio Selection," Journal of Finance 7(1952): 77-91.
3. Economies of scale are the reduction of costs per unit when the number of units produced and sold increases. In this context, this is the cost advantage an intermediary achieves when it increases the scale of its operations in contracting and processing.
4. Under certain circumstances, we consider preferred stock as a money market instrument.
5. This distinction between notes and bonds is not precisely true, but is consistent with common usage of the terms note and bond. In fact, notes and bonds are distinguished by whether or not there is an indenture agreement, a legal contract specifying the terms of the borrowing and any restrictions, and identifying a trustee to watch out for the debtholders' interests. A bond has an indenture agreement, whereas a note does not.
6. Eugene F. Fama, "Efficient Capital Markets: A Review of Theory and Empirical Work," Journal of Finance 25 (1970): 383-417.
7. Empirical evidence from the U.S. stock market suggests that in this market there is weak-form efficient. In other words, you cannot outperform ("beat") the market by using information on past stock prices.
8. In other countries, the term state-owned corporation is used.
9. The Federal Housing Finance Agency (FHFA) is the conservator of both Fannie Mae and Freddie Mac, which means that the FHFA has full power over the assets and operations of these firms.
10. This is, of course, not considering the currently conservatorship, which gives the federal government more power in GSEs than typical.
11. We discuss investment banking later, which covers a broad range of activities involving corporate financing and capital market and foreign exchange products and services.
12. At one time, some of these activities were restricted by the Banking Act of 1933, which contained four sections (popularly referred to as the Glass-Steagall Act) barring commercial banks from certain investment banking activities. The restrictions were effectively repealed with the enactment of the Gramm-Leach-Bliley Act in November 1999, which expanded the permissible activities for banks and bank holding companies.
13. Nondepository financial institutions are also referred to as nonbank financial institutions (NBFIs). The distinction of these types of companies as financial institutions was made starting with the Annuzio-Wylie Anti-Money Laundering Act of 1992, which broadened the definition of a financial institution beyond deposit accepting institutions.
14. Chairman Ben S. Bernanke, "Financial Reform to Address Systemic Risk," March 10, 2009.
15. Basically, a GIC is insuring that the policyholder will receive a guaranteed interest rate rather than risk that interest rates decline over the life of the policy. In the case of an annuity, the policyholder pays a single premium for the policy and the life insurance company agrees to make periodic payments over time to the policyholder.
16. The source of this information is the Insurance Information Institute.
17. The term hedge fund was first used by Fortune in 1966 to describe the private investment fund of Alfred Winslow Jones. In managing the portfolio, Jones sought to "hedge" the market risk of the fund by creating a portfolio that was long and short the stock market by an equal amount.
18. Financial Services Authority (2002, 8).
19. Defined in Securities and Exchange Commission Rule 501 of Regulation D.
20. Prior to Financial Accounting Standards Board Statement of Financial Accounting Standards No. 168, GAAP was a subject to a hierarchy of sources of principles, but this has been simplified, effective for companies with fiscal years ending after September 15, 2009.
21. Similar to deferred tax liabilities, there is also a possibility that the company has a deferred tax asset, which is a tax benefit expected in the future. For example, if a company has net operating losses that it will likely apply against future taxable income, the deferred tax asset is the amount by which future tax bills are likely to be reduced.
22. There are some other adjustments that are made for inter-corporate transactions, but we won't discuss those here.
23. In the case of diluted earnings per share, if the dilution potential is from convertible debt, earnings are adjusted for the interest on this convertible debt.
24. For example, for an asset with a five year life, the first year's depreciation is 5/15, the second year's depreciation is 4/15, and so on.
25. The current "roadmap" to convergence has a 2014 target for mandatory application of IFRS to U.S. companies.
26. The agency relationship was first described in Michael C. Jensen and William H. Meckling, "Theory of the Firm: Managerial Behavior, Agency Costs, and Ownership Structure," Journal of Financial Economics 3(1976): 305-360.
27. There was abuse by some companies during the merger mania of the 1980s. Some fought acquisition of their companies-which they labeled hostile takeovers-by proposing changes in the corporate charter or even lobbying for changes in state laws to discourage takeovers. Some adopted lucrative executive compensation packages-called golden parachutes-that were to go into effect if they lost their jobs.
28. Rule 33-8732, August 11, 2006.
29. Merrill Lynch is now a part of Bank of America.
30. Monsanto sold its sweetener division in 2000.
31. As you will see later in Chapter 13, this is when the net present value is equal to zero.
32. The case of Schlitz Brewing is detailed in George S. Day and Liam Fahey, "Putting Strategy into Shareholder Value Analysis," Harvard Business Review 68 (March-April 1990): 156-162.
33. It was not until 2009 that Nintendo's supply of Wii game consoles caught up to its demand.
34. You should not confuse a pro forma financial statement with pro forma earnings that a company may announce. Pro forma earnings, in the latter context, are earnings restated using principles that are not generally accepted accounting principles.
35. For a further discussion of these measures, see Frank J. Fabozzi and James L. Grant (eds.), Value Based Metrics: Foundations and Practice (Hoboken, NJ: John Wiley & Sons, 2000).
36. Robert S. Kaplan and David P. Norton, The Balanced Scorecard, (Boston: Harvard Business School Press, 1996);
37. Robert S. Kaplan and David P. Norton, The Strategy-Focused Organization (Boston: Harvard Business School Press, 2001).
38. "Different Paths to One Truth: Finance Brings Value Discipline to Strategy Execution."
39. CFO Research Services and Booz Allen Hamilton, "The Activist CFO-Alignment with Strategy, Not Just with the Business," p. 15.
40. Mark Frigo, The State of Management Accounting: The Ernst & Young and IMA Survey, Institute of Management Accounts Research Team Member, 2003, p. 7.
41. Michael Porter, Competitive Strategy: Techniques for Analyzing Industries and Competitors (New York: Simon & Schuster, 1998).
42. A barrier to entry is an impediment such as economies of scale, high initial startup costs, cost advantages due to experience of existing participants, loyalty among customers, protections such as patents, licenses, or copyrights, or regulatory or government action that limits entrants into the industry.
43. Therefore, a corporation may pay dividends on its preferred stock, but not on its common stock.
44. A reverse stock split, especially those such as 1:300 or 1:1,000, may also be used to reduce the number of shareholders, and hence take the company private.
45. See, for example, Maureen McNichols and Ajay Dravid, "Stock Dividends, Stock Splits, and Signaling," Journal of Finance 45, no. 3 (1990): 857-879.
46. General Motors increased dividends until cutting them once again in 2006 as it incurred substantial losses.
47. Merton Miller and Franco Modigliani, "Dividend Policy, Growth and the Valuation of Shares," Journal of Business 34 (1961): 411-433.
48. In other words, the dividends are included in income, but then the receiving corporation takes a large deduction.
49. Fischer Black, "The Dividend Puzzle," Journal of Portfolio Management 2 (1976):5-8.
50. Assuming that the interest rate on debt is the same, no matter the leverage, this will at least help illustrate the immediate issues.
51. Michael C. Jensen, "Agency Cost of Free Cash Flow, Corporate Finance, and Takeovers," American Economic Review 76 (1986): 323-329.
52. Michael C. Jensen and William H. Meckling, "Theory of the Firm: Managerial Behavior, Agency Costs, and Ownership Structure," Journal of Financial Economics 3 (1976): 305-360.
53. This is why we noted earlier in the chapter that we assumed that the interest on debt was the same for Company L and for Company LL, even though this was not realistic. Because of the increased likelihood of distress, Company LL's cost of debt should be higher than that of Company L.
54. For a more complete discussion of the pecking order explanation, especially the role of asymmetric information, see Stewart C. Myers, "The Capital Structure Puzzle," Midland Corporate Finance Journal 3 (1985): 65-76.
55. Franco Modigliani and Merton H. Miller, "The Cost of Capital, Corporation Finance, and the Theory of Investment," American Economic Review 48 (1958):261-297.
56. In theory and in practicality, there always must be some equity in a company, even if it is very little.
57. Jensen and Meckling, "Theory of the Firm: Managerial Behavior, Agency Costs, and Ownership Structure."
58. Myers, "The Capital Structure Puzzle"
59. Stewart C. Myers and N. S. Majluf, "Corporate Financing and Investment Decisions when Firms Have Information Investors Do Not Have," Journal of Financial Economics 13 (1984): 187-221.
60. Mark Grinblatt and Sheridan Titman, Financial Markets and Corporate Strategy (Boston: Irwin/McGraw-Hill, 2002).
61. Moody's, "Risk Management Assessments," Moody's Research Methodology (July 2004).
62. As the Society of Actuaries (SOA) points out, there are two main definitions [Society of Actuaries, Enterprise Risk Management Specialty Guide (May 2006), p. 9].
63. Harry M. Markowitz, "Portfolio Selection," Journal of Finance 7(1952): 77-91.
64. These are from the Committee of Sponsoring Organizations (COSO) framework.
65. The four themes are proposed by the Enterprise Risk Management Specialty Guide, pp. 26-38.
66. Exhibit 9.1 is a summary of the description of the themes of risk management provided by Enterprise Risk Management Specialty Guide, p. 26-28.
67. Enterprise Risk Management-Integrated Framework Executive Summary, p. 2.
68. For a detailed discussion of ART, see Christopher L. Culp, Structured Finance and Insurance: The ART of Managing Capital and Risk (Hoboken, NJ: John Wiley & Sons, 2006)
69. Erik Banks, Alternative Risk Transfer: Integrated Risk Management Through Insurance, Reinsurance and the Capital Markets (Hoboken, NJ: John Wiley & Sons, 2004).
70. For example, the FV function has the following arguments: interest rate, number of periods, payment, and present value. Because this last problem does not involve any periodic payments, we used a zero for that argument.
71. We could have also solved this problem using an annuity due in the first step, which would mean that we would discount the value from the first step three periods instead of two.
72. Unfortunately, there are no calculator functions or spreadsheet functions that perform deferred annuity calculations specifically, because there are so many variations possible on how these are designed.
73. If there is no cash flow for a given period, both the calculators and the spreadsheets require you to enter a zero in place of that cash flow; failing to do so will result in an incorrect IRR.
74. When we alter the interest coverage ratio to consider these other fixed obligations, we alter the numerator as well to restate it to reflect the funds available to cover these obligations.
75. Statement of Financial Accounting Standards No. 95, "Statement of Cash Flows."
76. The interest expense is deducted from earnings before interest and taxes, and, therefore, affects the net income and cash flow from operations.
77. This is based on the cash flow definition promoted by Martin Fridson in Financial Statement Analysis: A Practitioner's Guide (New York: John Wiley & Son, 1995). This definition results from reformatting the statement of cash flows to remove the nondiscretionary cash flows.
78. Michael C. Jensen, "Agency Costs of Free Cash Flow, Corporate Finance, and Takeovers," American Economic Review 76 (1985): 323-329.
79. The cost of capital is the cost to the company of funds from creditors and shareholders. The cost of capital is basically a hurdle: If a project returns more than its cost of capital, it is a profitable project spent on low-return exploration and development and on poor diversification attempts through acquisitions. Jensen argues that these companies would have been better off paying these excess cash flows to shareholders through share repurchases or exchanges with debt.
80. This definition is similar to still another definition of free cash flow, net free cash flow, which adjusts for both interest expenses, but only deducts cash taxes, not the sum of deferred taxes and cash taxes as represented by the tax expense on a company's income statement.
81. Fridson, Financial Statement Analysis: A Practitioner's Guide, 173.
82. This does not mean, however, that the project is profitable in terms of financial accounting.
83. For example, the 2008 cash flow of $200,000 is reinvested at 10.17188% for two periods (that is, for 2009 and 2010), or $200,000 (1 + 0.1017188)2 = $242,756.88.
84. Note that while the difference between the financing cost and the cash yield is a negative value, carry is said to be positive.
85. Of course, a futures buyer does not pay the seller to accept the obligation, while an option buyer pays the seller the option price.
86. Fischer Black and Myron Scholes, "Pricing of Options and Corporate Liabilities," Journal of Political Economy 81(1973): 637-654.
87. We obtain the value for N(.) from a normal distribution function that is tabulated in most statistics textbooks or from spreadsheets that have this built-in function.
88. Based on Robert D. Arnott and Frank J. Fabozzi, "The Many Dimensions of the Asset Allocation Decision," in Active Asset Allocation, ed. Robert D. Arnott and Frank J. Fabozzi, 3-8 (Chicago: Probus, 1992).
89. Statutory capital is the amount of equity and equivalents that a company must have to meet minimum regulatory standards. Risk-based capital standards specify that the amount of capital needed as a minimum is based on the riskiness of the assets of the company.
90. Leverage in this context is borrowing funds in order to make investments.
91. Jack Treynor, "How to Rate Management of Investment Funds," Harvard Business Review 44 (1965): 63-75;
92. William F. Sharpe, "Mutual Fund Performance," Journal of Business 34 (1966): 119-138;
93. Michael C. Jensen, "The Performance of Mutual Funds in the Period 1945-1964," Journal of Finance 23 (1968): 389-416.
94. Harry M. Markowitz, "Portfolio Selection," Journal of Finance 7 (1952): 77-91.
95. The expected value is the weighted mean of the probability distribution, where the probabilities are the weights.
96. For a review of the empirical evidence, see Svetlozar T. Rachev, Christian Menn, and Frank J. Fabozzi, Fat-Tailed and Skewed Asset Return Distributions: Implications for Risk Management, Portfolio Selection, and Option Pricing (Hoboken, NJ: John Wiley & Sons, 2005).
97. Harry M. Markowitz, Portfolio Selection: Efficient Diversification of Investment (New York: John Wiley & Sons, 1959), 190, 193-194.
98. The mean and the variance are the first two moments of a probability distribution. The third moment is a measure of skewness and the fourth moment is a measure of kurtosis. A generalization of the mean-variance framework that incorporates higher moments, such as skewness and kurtosis, has been developed. Because of the technical complexity of these models, we do not discuss them here.
99. See, among others, Andrew D. Roy, "Safety-First and the Holding of Assets," Econometrica 20 (1952): 431-449;
100. Lester G. Tesler, "Safety First and Hedging," Review of Economic Studies 23 (1955/1956): 1-16;
101. Vijay S. Bawa, "Admissible Portfolio for All Individuals," Journal of Finance 31 (1976): 1169-1183;
102. Vijay S. Bawa, "Safety-First Stochastic Dominance and Optimal Portfolio Choice," Journal of Financial and Quantitative Analysis 13 (1978): 255-271.
103. See Roy, "Safety-First and the Holding of Assets."
104. See Bawa, "Admissible Portfolio for All Individuals"
105. Peter C. Fishburn, "Meanrisk Analysis with Risk Associated with Below-Target Returns," American Economic Review 67 (1977): 116-126.
106. See Michael J. Best and Robert R. Grauer, "On the Sensitivity of Mean-Variance Efficient Portfolios to Changes in Asset Means: Some Analytical and Computational Results," Review of Financial Studies 4 (1991): 315-342;
107. Mark Broadie, "Computing Efficient Frontiers Using Estimated Parameters," Annals of Operations Research 45 (1993): 21-58;
108. Vijay K. Chopra and William T. Ziemba, "The Effects of Errors in Means, Variances, and Covariances on Optimal Portfolio Choice," Journal of Portfolio Management 19 (1993): 6-11.
109. See Daniel Kahneman and Amos Tversky, "Advances in Prospect Theory: Cumulative Representation of Uncertainty," Journal of Risk and Uncertainty 5 (1992):297-323.
110. "Prospect theory" does not relate to prospecting. As related by Peter Bernstein in his book Against the Gods: The Remarkable Story of Risk (New York: John Wiley& Sons, 1996), Kahneman states, "We just wanted a name that people would notice and remember."
111. For a further discussion of behavioral finance, see the following chapters in Frank J. Fabozzi (ed.), Handbook of Finance, vol. 2 (Hoboken, NJ: John Wiley & Sons, 2008)
112. Meir Statman, Chapter 9, "What Is Behavioral Finance";
113. Jarrod W. Wilcox, Chapter 8, "Behavioral Finance";
114. Victor Ricciardi, Chapter 10, "The Psychology of Risk: The Behavioral Finance Perspective"
115. Frank J. Fabozzi (ed.), Handbook of Finance, vol. 2 (Hoboken, NJ: John Wiley & Sons, 2008):
116. Victor Ricciardi, Chapter 2, "Risk: Traditional Finance versus Behavioral Finance."
117. These themes are from Hersh Shefrin, Beyond Greed and Fear: Understanding Behavioral Finance and the Psychology of Investing (New York: Oxford University Press, 2002) and are based on Daniel Kahneman, Paul Slovic, and Amos Tversky, Judgment under Uncertainty: Heuristics and Biases (New York: Cambridge University Press, 1982).
118. Shefrin, Beyond Greed and Fear: Understanding Behavioral Finance and the Psychology of Investing.
119. See Amos Tversky and Daniel Kahneman, "The Framing of Decisions and the Psychology of Choice," Science 211 (1961): 453-458;
120. Amos Tversky and Daniel Kahneman, "Rational Choice and the Framing of Decisions," Journal of Business 59 (1986): S251-S278.
121. William F. Sharpe, "Capital Asset Prices," Journal of Finance 19 (1964): 425-442;
122. John Lintner, "The Valuation of Risk Assets and the Selection of Risky Investments in Stock Portfolio and Capital Budgets," Review of Economics and Statistics 47 (1965): 13-37;
123. Jack L. Treynor, "Toward a Theory of Market Value of Risky Assets," unpublished manuscript, 1962;
124. Jan Mossin, "Equilibrium in Capital Asset Market," Econometrica 34 (1965): 768-783.
125. Harry M. Markowitz, "Portfolio Selection," Journal of Finance 7 (1952): 77-91.
126. Economists refer to these various costs and impediments as "frictions." The costs associated with frictions generally result in buyers paying more than in the absence of frictions and sellers receiving less.
127. Eugene F. Fama, "Efficient Capital Markets: A Review of Theory and Empirical Work," Journal of Finance 25 (1970): 383-417.
128. Sharpe, "Capital Asset Prices."
129. Wayne H. Wagner and Shiela C. Lau, "The Effect of Diversification on Risks," Financial Analysts Journal 27 (1971): 48-53.
130. Richard R. Roll, "A Critique of the Asset Pricing Theory's Tests," Journal of Financial Economic 4 (1977): 129-176.
131. Stephen A. Ross, "The Arbitrage Theory of Capital Asset Pricing," Journal of Economic Theory 13 (1976): 343-362.
132. Short selling means selling an asset that is not owned in anticipation of a price decline.
133. For more information, see Uri Ron, "A Practical Guide to Swap Curve Construction," in Frank J. Fabozzi (ed.), Interest Rate, Term Structure, and Valuation Modeling (Hoboken, NJ: John Wiley & Sons, 2002).
134. Historically, the dividend yield for U.S. stocks has been a little less than 5% according to a study by John Y. Campbell and Robert J. Shiller, "Valuation Ratios and the Long-Run Stock Market Outlook," Journal of Portfolio Management 24(1998):11-26.
135. The complement to the dividend payout ratio is the plowback ratio, which is the percentage of earnings retained by the company during the period.
136. This model was first suggested by John Burr Williams, The Theory of Investment Value (Boston, MA: Harvard University Press, 1938).
137. Using the CAPM, the expected return is the sum of the risk-free rate of interest and a premium for bearing risk. The premium for bearing risk of a specific asset is the product of the asset's beta and the market's risk premium.
138. Myron Gordon and Eli Shapiro, "Capital Equipment Analysis: The Required Rate of Profit," Management Science 3 (1956): 102-110.
139. This formula is equivalent to calculating the geometric mean of 1 plus the percentage change over the number of years.
140. For a pioneering work that modified the DDM to accommodate different growth rates, see Nicholas Molodovsky, Catherine May, and Sherman Chattiner, "Common Stock Valuation-Principles, Tables, and Applications," Financial Analysts Journal 21 (1965): 104-123.
141. The formula for this model can be found in Eric Sorensen and Williamson, "Some Evidence of the Value of Dividend Discount Models," Financial Analysts Journal 41 (1985): 60-69.
142. This may seem counterintuitive because by definition a zero-coupon bond does not pay interest, so a semiannual period is meaningless. However, we use the same convention for zero-coupon bonds as coupon bonds so that the valuation and yields are consistent between the two types of bonds.
143. We do not delve into the nuances of valuing a bond with accrued interest. Fortunately, you can use specific spreadsheet functions and financial calculator functions to value bonds between interest payments.
144. The lattice model for valuing bonds with embedded options was developed in Andrew J. Kalotay, George O. Williams, and Frank J. Fabozzi, "A Model for the Valuation of Bonds and Embedded Options," Financial Analysts Journal 49 (1993):35-46.