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6 (Equations, Portfolio theory, Efficient market hypothesis, behavioural…
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Portfolio theory
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Coefficient of variation = SD/expected return
use to compare the mean and SD of two different assets
(don't think ever need)
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Heuristics
NPV
PV of all future cashflows - initial price
when positive, project good
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lent
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Firms
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separation of ownership and management
shareholders are not managers but are entitiled to residual cashflows
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firms does not need to diversify itself as this is done by investors - should maximise profit in one area
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Mortgages
bond with face value, maturity, interest rate
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yield > rfr, therefore price < face value
mortgage risks:
- refinance risk - borrowers refinance when rates drop (lenders prefer higher rates)
- cash our refinance - as value of home increases, people refinance with larger loan and payoff original with cash spare
penalties can be used to disincentivise fast reactions
- default risk - if home value drops, or can no longer make payments
- interest rate risk - banks invest loan repayments into treasury bills, but if rates increase, the
regiulatory risk - risk that laws change
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Mortgage bonds and waterfall
- banks pool mortgages into a portfolio and issue bonds secured against mortgages
- mortgage payments are paid to bond investors (minus service fee)
- weighted average coupon, maturity and size
- pooling creates diversification and securitisation
- shortfalls from the collateral are Bourne by investor
Collateralised debt obligations (form of credit enhancement)
senior subordinated structure
- create tranches with different bond ratings,
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Bonds
duration
Macaulay Duration - how long to wait to receive cashflows back
longer duration, more sensitive to interest rate changes.
if payments are skewed later, then more payments will be subject to a change in interest rate.
higher duration = greater price drop when interest rates rise
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WACC - cost of financing assets - minimum return to satisfy debt holders and equity investors (composite of OCC for equity and debt)
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OCC
if dont invest in this project, what could we earn?
= expected return of all firm's exiting securities
- if there is no debt, then rate of return is from CAPM
if lenders lent elsewhere, what could they earn?
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