CFA Information Session and Scholarship Information

Some of you might be interested in participating in an upcoming CFA Institute webinar. Here’s a copy of an email I received from Brandon Troegle about this webinar. Mr. Troegle teaches the various investment practicum courses offered by the Department of Finance, Insurance & Real Estate here at Baylor.

From: "Troegle, Brandon" <Brandon_Troegle@baylor.edu>
Date: Thursday, October 21, 2021 at 7:45 AM
To: FIRE Department Faculty
Subject: CFA Information Session and Scholarship Information

Professors,

All of you teach investment-related classes and may have students who might be interested in earning the CFA charter. I typically host an information session on campus each fall discussing the charter and scholarships, but this year will instead direct students to the webinar hosted by the CFA Institute. Please share the information below regarding the CFA program with your students that may be interested in learning more. I’ve attached powerpoint slides with info on the webinar and importantly information on scholarships that are specifically available to Baylor students and cover most of the exam and registration fees. I can be contacted by you or students with any questions at “brandon_troegle@baylor.edu”.

Thank you,

Brandon Troegle

Webinar Info

The CFA Institute Americas University Relations team will be offering CFA Program information sessions for students at affiliated universities across the Americas region including Baylor in late October. Webinar dates, times and registration links are available below, as well as in the attached powerpoint. Presentations will be customized by sub-region, but all sessions are open to all students.

These live virtual webinars will highlight how the CFA Program equips aspiring or practicing investment professionals with the knowledge and skills to thrive in a highly competitive industry. Information will be shared on the scope of the CFA Program, benefits of the CFA charter and details on exam administration will. The webinars will include a live Q&A. All registrants will be emailed a link to the video recording of the presentation after the event, so even those who are not able to attend should register to receive the link to the recording to watch on-demand when it suits their schedule.

United States Sessions

Tuesday, 26 October, 2-2:45pm ET — US Session 1
Wednesday, 27 October, 3:30-4:15pm ET — US Session 2

Chartered Financial Analyst (CFA) Program Overview

• Globally recognized, graduate-level curriculum that provides a strong foundation of the real-world investment analysis and portfolio management skills and practical knowledge you need in today’s investment industry.
• Organized into three levels, each culminating in a six-hour exam. Candidates report dedicating +300 hours of study per level. Completing the entire program is a significant challenge that takes most candidates between two and five years.
• As the global marketplace becomes increasingly competitive, employers recognize the CFA charter as a reliable way to differentiate the most qualified job applicants and the most committed employees.
• Most popular job categories for CFA charterholders: equities, fixed income, private equity, derivatives, real estate, hedge funds, commodities, currency

CFA Info Session and Scholarship Announcement.pptx

Capital Market Theory Class Problem, and reminders about next week in Finance 4335

I have posted a Capital Market Theory class problem at http://fin4335.garven.com/fall2021/Capital%20Market%20Theory%20Class%20Problem.pdf.   Prior to next Tuesday’s in-class midterm exam review session, it’s important that you work through the Capital Market Theory class problem and the sample exam, read  the Finance 4335 synopsis for Midterm Exam 2, and review Midterm 2 exam topics and related problem set solutions, including insurance economics, asymmetric information, portfolio theory, and capital market theory.  Come to class that day to get any questions you may have about Problem Set 7 and various resources and topics listed above.

As I wrote in a previous blog posting, Midterm Exam 2 is scheduled to occur (in-class) on Thursday, October 28.  The formula sheet for Midterm Exam 2 is available at http://fin4335.garven.com/fall2021/formulas_part2.pdf, and will be included as the last page of the Midterm 2 exam booklet.

Synopsis of Capital Market theory topic

Our coverage of the Capital Market Theory topic provides the following important insights:

1. Borrowing and lending at the riskless rate of interest in combination with investing in (mean-variance efficient) risky portfolios enable investors to obtain superior risk-return trade-offs compared with investing only in mean-variance efficient risky portfolios. In the figure below (taken from page 17 of the Capital Market Theory lecture note), investors select portfolios along the Capital Market Line, which is given by the following equation: $E({r_p}) = {r_f} + \left[ {\displaystyle\frac{{E({r_m}) - {r_f}}}{{{\sigma _m}}}} \right]{\sigma _p}$.In the above figure, $\alpha$ corresponds to the optimal level of exposure to the market index which is labled as point M. When $\alpha = 0$, the investor is fully invested in the riskless asset. When $0 < \alpha < 1$, the investor is partially invested in the riskless asset and in the market index; such portfolios are referred to as “lending” portfolios. When $\alpha = 1$, the investor is fully invested in the market index. Finally, when $\alpha> 1$, the investor funds her investment in the market index with her initial wealth plus borrowed money; such portfolios are referred to as “borrowing” portfolios.
2. Given that investors select (based upon their level of tolerance for risk) portfolios that lie on the Capital Market Line, this behavior has implications for the pricing of risk for individual securities. Specifically, the Capital Market Line implies that for individual securities, the Security Market Line must hold. The equation for the Security Market Line (which is commonly referred to as the Capital Asset Pricing Model, or CAPM) is given by the following equation: $E({r_i}) = {r_f} + \left[ {E({r_m}) - {r_f}} \right]{\beta _i}$, where ${\beta _i} = {\sigma _{i,m}}/\sigma _m^2.$
3. According to the CAPM, the appropriate measure of risk for an individual stock is its beta, which indicates how much systematic risk the stock has compared with an average risk investment such as the market portfolio. Beta for security i (${\beta _i}$) is measured by dividing the covariance between i and the market (${\sigma _{i,m}}$) by market variance ($\sigma _m^2$). If the investor purchases an average risk security, then its beta is 1 and the expected return on such a security is the same as the expected return on the market. On the other hand, if the security is riskier (safer) than an average risk security, then it’s expected return is higher (lower) than the same as the expected return on the market.
4. If the expected return on a security is higher (lower) than the expected return indicated by the CAPM equation, this means that the security is under-priced (over-priced). Investors will recognize this mispricing and bid up (down) the under-priced (over-priced) security until its expected return conforms to the CAPM equation.
5. According to the CAPM, only systematic (i.e., non-diversifiable) risk is priced. Systematic risks are risks which are common to all firms (e.g., return fluctuations caused by macroeconomic factors which affect all risky assets). On the other hand, unsystematic (i.e., diversifiable) risk is not priced since its impact on a diversified asset portfolio is negligible. Diversifiable risks comprise risks that are firm-specific (e.g., the risk that a particular company will lose market share or go bankrupt).

What’s up in Finance 4335 for tomorrow (10/21), next Tuesday (10/26), and one week from tomorrow (10/28)

During tomorrow’s Finance 4335 class meeting, we will discuss the Capital Market Theory lecture note, and if time permits, work through a capital market theory class problem. Next Tuesday’s class meeting (October 26) will be devoted to a review session for the 2nd midterm exam in Finance 4335, which is scheduled to occur (in-class) on Thursday, October 28

The formula sheet for Midterm Exam 2 is now available at http://fin4335.garven.com/fall2021/formulas_part2.pdf. This document will also be included as part of the exam booklet on Thursday, October 28. The three most important Midterm 2 – related documents are the formula sheet, the Finance 4335 synopsis for Midterm Exam 2, and the sample Midterm 2 exam booklet that I just posted on the Sample Exams page.

As you prepare for next Tuesday’s midterm exam review session, please take the time to work through the sample exam, and also devote some time reviewing Midterm 2 exam topics, which include insurance economics, asymmetric information, portfolio theory, and capital market theory.

Finance 4335 Course Policy Concerning the Use of Excel for Problem Sets

In Finance 4335, students are welcome to rely on either Excel or hand-held calculators to calculate answers for problems that appear in problem sets. However, in order to earn credit, students must show their work by providing logical explanations of how they get their answers, using properly formed English grammar, along with references to the appropriate theoretical concepts. The best examples I can think of how to “show work” appear in most of the various linked PDF documents comprising solutions for class problems, problem sets, and sample exams @ http://risk.garven.com/category/problem-set-solutions/.

Keeping this policy in mind, do not upload Excel spreadsheets to Canvas when you turn in your problem set assignments. I base your grades solely on how well you explain and support the answers you provide in the PDF documents which you upload to Canvas.

A (non-technical) Summary of Portfolio Theory and Capital Market Theory

I would like to provide everyone with some historical context for the upcoming portfolio theory and capital market theory topics we will cover, starting on Thursday, October 14. The required reading for these topics is my Portfolio and Capital Market Theory note, and next Tuesday’s quiz is based on that reading. I also listed as “optional” readings Chapters 4 (Portfolio Theory and Risk Management) and 5 (Capital Market Theory) on the Finance 4335 readings page.

One of the better non-technical summaries of portfolio theory and capital market theory that I am aware of appears as part of a press release put out by The Royal Swedish Academy of Sciences in commemoration of the Nobel prizes won in 1990 by Harry Markowitz on the topic of portfolio theory, and by William F. Sharpe on the topic of capital market theory (see http://www.nobelprize.org/nobel_prizes/economic-sciences/laureates/1990/press.html). I have included an appropriately edited version of that press release below for your further consideration below:

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Financial markets serve a key purpose in a modern market economy by allocating productive resources among various areas of production. It is to a large extent through financial markets that saving in different sectors of the economy is transferred to firms for investments in buildings and machines. Financial markets also reflect firms’ expected prospects and risks, which implies that risks can be spread and that savers and investors can acquire valuable information for their investment decisions.

The first pioneering contribution in the field of financial economics was made in the 1950s by Harry Markowitz who developed a theory for households’ and firms’ allocation of financial assets under uncertainty, the so-called theory of portfolio choice. This theory analyzes how wealth can be optimally invested in assets which differ in regard to their expected return and risk, and thereby also how risks can be reduced.

A second significant contribution to the theory of financial economics occurred during the 1960s when a number of researchers, among whom William Sharpe was the leading figure, used Markowitz’s portfolio theory as a basis for developing a theory of price formation for financial assets, the so-called Capital Asset Pricing Model, or CAPM.

Harrv M. Markowitz
The contribution for which Harry Markowitz now receives his award was first published in an essay entitled “Portfolio Selection” (1952), and later, more extensively, in his book, Portfolio Selection: Efficient Diversification (1959). The so-called theory of portfolio selection that was developed in this early work was originally a normative theory for investment managers, i.e., a theory for optimal investment of wealth in assets which differ in regard to their expected return and risk. On a general level, of course, investment managers and academic economists have long been aware of the necessity of taking returns as well as risk into account: “all the eggs should not be placed in the same basket”. Markowitz’s primary contribution consisted of developing a rigorously formulated, operational theory for portfolio selection under uncertainty – a theory which evolved into a foundation for further research in financial economics.

Markowitz showed that under certain given conditions, an investor’s portfolio choice can be reduced to balancing two dimensions, i.e., the expected return on the portfolio and its variance. Due to the possibility of reducing risk through diversification, the risk of the portfolio, measured as its variance, will depend not only on the individual variances of the return on different assets, but also on the pairwise covariances of all assets.

Hence, the essential aspect pertaining to the risk of an asset is not the risk of each asset in isolation, but the contribution of each asset to the risk of the aggregate portfolio. However, the “law of large numbers” is not wholly applicable to the diversification of risks in portfolio choice because the returns on different assets are correlated in practice. Thus, in general, risk cannot be totally eliminated, regardless of how many types of securities are represented in a portfolio.

In this way, the complicated and multidimensional problem of portfolio choice with respect to a large number of different assets, each with varying properties, is reduced to a conceptually simple two-dimensional problem – known as mean-variance analysis. In an essay in 1956, Markowitz also showed how the problem of actually calculating the optimal portfolio could be solved. (In technical terms, this means that the analysis is formulated as a quadratic programming problem; the building blocks are a quadratic utility function, expected returns on the different assets, the variance and covariance of the assets and the investor’s budget restrictions.) The model has won wide acclaim due to its algebraic simplicity and suitability for empirical applications.

Generally speaking, Markowitz’s work on portfolio theory may be regarded as having established financial micro analysis as a respectable research area in economic analysis.

William F. Sharpe

With the formulation of the so-called Capital Asset Pricing Model, or CAPM, which used Markowitz’s model as a “positive” (explanatory) theory, the step was taken from micro analysis to market analysis of price formation for financial assets. In the mid-1960s, several researchers – independently of one another – contributed to this development. William Sharpe’s pioneering achievement in this field was contained in his essay entitled, Capital Asset Prices: A Theory of Market Equilibrium under Conditions of Risk (1964).

The basis of the CAPM is that an individual investor can choose exposure to risk through a combination of lending-borrowing and a suitably composed (optimal) portfolio of risky securities. According to the CAPM, the composition of this optimal risk portfolio depends on the investor’s assessment of the future prospects of different securities, and not on the investors’ own attitudes towards risk. The latter is reflected solely in the choice of a combination of a risk portfolio and risk-free investment (for instance treasury bills) or borrowing. In the case of an investor who does not have any special information, i.e., better information than other investors, there is no reason to hold a different portfolio of shares than other investors, i.e., a so-called market portfolio of shares.

What is known as the “beta value” of a specific share indicates its marginal contribution to the risk of the entire market portfolio of risky securities. Shares with a beta coefficient greater than 1 have an above-average effect on the risk of the aggregate portfolio, whereas shares with a beta coefficient of less than 1 have a lower than average effect on the risk of the aggregate portfolio. According to the CAPM, in an efficient capital market, the risk premium and thus also the expected return on an asset, will vary in direct proportion to the beta value. These relations are generated by equilibrium price formation on efficient capital markets.

An important result is that the expected return on an asset is determined by the beta coefficient on the asset, which also measures the covariance between the return on the asset and the return on the market portfolio. The CAPM shows that risks can be shifted to the capital market, where risks can be bought, sold and evaluated. In this way, the prices of risky assets are adjusted so that portfolio decisions become consistent.

The CAPM is considered the backbone of modern price theory for financial markets. It is also widely used in empirical analysis, so that the abundance of financial statistical data can be utilized systematically and efficiently. Moreover, the model is applied extensively in practical research and has thus become an important basis for decision-making in different areas. This is related to the fact that such studies require information about firms’ costs of capital, where the risk premium is an essential component. Risk premiums which are specific to an industry can thus be determined using information on the beta value of the industry in question.

Important examples of areas where the CAPM and its beta coefficients are used routinely, include calculations of costs of capital associated with investment and takeover decisions (in order to arrive at a discount factor); estimates of costs of capital as a basis for pricing in regulated public utilities; and judicial inquiries related to court decisions regarding compensation to expropriated firms whose shares are not listed on the stock market. The CAPM is also applied in comparative analyses of the success of different investors.

Along with Markowitz’ portfolio model, the CAPM has also become the framework in textbooks on financial economics throughout the world.

Adverse Selection Class Problem and Solution

The adverse selection class problem that we worked on today is available at http://fin4335.garven.com/fall2021/Adverse_Selection_Class_Problem.pdf, and its solution is available at http://fin4335.garven.com/fall2021/Adverse_Selection_Class_Problem_Solutions.pdf.  Furthermore, the spreadsheet for solving this model of the “insurance death spiral” is available at http://fin4335.garven.com/fall2021/Dynamic%20adverse%20selection%20numerical%20example.xlsx.