CFM 101

0 | Introduction

CFM Introduction

Course Purpose: Finance Knowledge in 1A term

What we’re using

• Python
• numpy, matplotlib
• Finance API

Introduction

• Finance = transferring money from those who have it to those who need it
• Importance of FinTech
  • VC = early stage capital for something important (eg. server costs)
• Why won’t investors give money for no reason?
  • Risk
  • No return
  • Opportunity Cost

How does FinTech divert from IB?

• Cross-List: Shopify trades on TSX and NASDAQ
  • Market Arbitrage = old job that purchases stock simultaneously to make a profit based on exchange rate
• ”if you want lots of money, go to the US”
• Tech makes markets more efficient (buy and sell every second, not month)
• Data collection makes FinTech better predictors than banks
  • eg. looking at people who defaulted before and finding the trustworthy ones

CFM Overview Seminar

Common WT1 co-op positions

• CS: Jr Web Dev, Jr Software Dev, Software QA
• Finance: Analyst, Junior Financial Analyst, Business Analytics Analyst

Co-op

• No co-op → WE Accelerate or Volunteering

International Exchange

• Does not count for a co op credit!

Upcoming Events

• Pizza tn
• 09/12 DC Fishbowl

Emails

• Follow up after 4 days

1 | The Capital Market

Introduction

Debt Contract (FIXED)

• Lender and Debtor
• Return is interest
• Rewards Debtors with high confidence

Equity Contract (VARIABLE)

• Return depends on how good the company does
• Tech startups almost EXCLUSIVELY use equity, because they take years to become profitable, thus it’s hard to pay off debt
  • eg. Jeff Bezos has a ~15% stake in Amazon because he required so much capital
• Side benefit: Mentorship from experienced lenders

Capital Markets make the transfer of money easier

• eg. Rural India has great ideas but no capital
• An IPO (Initial Public Offering) is done with an Investment Bank that tries to find buyers for your stock
  • Problem: These banks take too much of a share (7-8%)
  • FinTech has been bringing that down (Google used an auction for their IPO and got 2%)
  • Goal: Democratize Finance

3 components of wealth transfer process

1. Financial Instruments (what is bought / sold)
   1. Pepsi-Cola Company
2. Financial Markets (facilitate buying / selling of #1)
   1. TSX, NYSE, Japan Exchange Group, Shanghai Stock Exchange
3. Financial Intermediaries (People / Companies involved in #1 and #2)

Investment Types

Suppliers and Users of Investment Capital

• Capital = savings of:
  • Individuals
  • Corporations
  • Governments

Direct Investments

• Assets that generate wealth (land, real estate, equipment)

Indirect Investments

• Financial Assets
  • Stocks, Bonds, Treasury Bills
• Government Bonds have lower interest rate than companies because of increased stability
• Government can just print money
• Consequences of default: Lack of trust, no investors

Efficient Allocation of capital

• Capital is mobile, scarce and sensitive

Developing Nations are more sensitive

• Political environment
• Fiscal policy
• Monetary policy
  • Higher interest = more borrowing, less saving (good for businesses)
• Investment opportunities
• Labour force (highly educated / labour laws)

Capital

Sources of capital

• Investors provide capital
• Retail: normal people
• Institutional: high net worth
  • Pension Plans (Ontario Teachers Pension Plan)
• Foreign: foreign retail, institutional, and government investors

Users of Capital

• Individuals don’t
• Companies / businesses:
  • Raise money by issuing stocks / bonds

Ex: The Biggest IPOs of All Time

• All Asian / Middle Eastern countries

• Larger than the West because we IPO early

• Some companies IPO just to have a stock, to compensate workers in that stock

• Second IPO: Seasoned Equity Offer (SEO) means the firm needs money

• Governments (federal, provincial, municipal) issue debt:

  • Treasury Bills
  • Longer term debt
  • Spending funds on healthcare, infrastructure, etc.

Question: Why don’t governments issue equity?

• Answer: You can’t have voting power in a foreign country

Financial Instruments

• Mechanisms for wealth / capital transfer
• Debt
  • Funds are borrowed, then paid back at the maturity date
  • Interest payments are also paid
  • Clauses are important (eg. Restructuring Clauses w/ Marriot)
• Equity
  • Stock / shares in a company, representing partial ownership
  • Voting privileges at annual meetings (choosing board of directors, hiring / firing)
  • Also may receive regular dividend payments

Ex: Zuckerberg and co own shares in Facebook with 10:1 voting power to regular shares

• Investment Funds
  • ETF = Exchange-traded fund that gives you access to many companies
  • S&P 500 is just a number
  • Buying an ETF on the S&P 500 lets you own it
  • ETF technically gives you voting privileges, but practically you don’t (shares of a company that owns shares of a company)
• Derivatives
  • Deriving value from other assets (stocks, bonds, commodities, currency)
  • Used for hedging (eg. Mitigate the effect of a strong C$ or higher oil prices)
  • Options: Betting that a stock will go up / down
    • Most people trade options (stock call options) for higher risk-reward

Ex: Barings Bank (Britain’s oldest bank) got sunk by one guy, who bet that the Japanese Index would remain within a certain range. Earthquake hit, he traded on bank capital, whole bank went poof This ended up being because he used a SHORT STRANGLE (call + put option)

• Private Equity
  • Invests in both debt and equity
  • Typically investments are made directly in companies
  • Funds provided by pension funds, endowments, wealthy individuals

Why do authorities restrict who can invest funds in derivatives and private equity?

Financial Markets

Financial Markets only work well if accompanied by efficient markets

• Efficient Markets must be
  • Fast
  • Cheap
  • Liquid
• Buying or selling a house may not be efficient
  • No two houses are the same, but two share are the same
• Buying or selling a stock or bond should be efficient

Financial Intermediaries

• Where all transactions converge in one location
• In Canada:
  • TSX: main exchange for medium to large size
  • TSX Venture Exchange: junior companies
  • EXCEPTION: Canadian Securities Exchange (alternative exchange for junior companies) is an unlisted market
• 80 exchanges in over 60 countries
• TSX is 7th largest in the world, NYSE Is largest
• Most exchanges are public companies listed on exchanges themselves

Dealer Markets: The Unlisted Market

• Dealer Markets / Over-the-counter (OTC) markets
  • Investment dealers who trade directly with each other over phone or computer
  • Most bonds are traded, very few stocks
  • No listing requirements

Alternative Trading Systems (ATS)

• Computerized systems that trade outside of traditional exchanges
• Buyers and sellers contact each other directly
• Systems are privately owned
• Lower costs / fees
• Most customers are institutional

Question: are ATS a problem?

• Increased scrutiny and regulation is likely to come
• ATS are currently governed by the IIROC (Investment Industry Regulatory Organization of Canada)

2 | The Canadian Securities Industry

Regulation

Canadian Regulatory Structures

• Regulation is provincial (should it be?)
  • Quebec hates this
• Ontario Securities Commission (OSC) is the largest
• Self Regulatory Organizations (SROs) provide oversight - IIROC

Other SRO Players

• Canadian Depository for Securities (CDS)
  • Owned by TMX
• Canadian Investor Protection Fund (CIPF)
• Canadian Securities Institute (CSI)
  • Other courses required for licensing by regulators
  • Owned by Moody
  • Gave James money

Brokers

Investment Dealers

• National-scope ones (Big Banks)
  • RBC Cap, Mkts, etc
  • Most banks do hiring in summer
• Many small “boutique” investment dealers
  • Specialize in specific sectors or products, give you advice
  • Gravitas Securities
• Multiple Departments within an investment dealer
  • Underwriting (IPOs), trading, brokerage, research
  • CFM STRENGTH

Brokers

• Full-service or discount
  • Full-service ones offer high specialized service and advice
  • HIGH FEES
  • Discount brokers offer limited services (stock and bond trade execution), but no advice (Questrade, Wealthsimple)
  • LOW FEES
• Nothing is really free
  • Robinhood has free trades but sells your data

Leverage

• The Financial Services industry is highly leveraged
  • Short term borrowing finances long-term investments
  • Borrow money every 90 days to finance a 20-year mortgage
  • Demand deposits can happen anytime
• Bank runs!
  • CDIC Limit: $100kinCanada,$250k in US
  • Silicon Valley Bank - payroll issues

Globalization

• Canadian investors can buy US listed shares. etc
• Eurobond and Eurocurrency markets
  • ”euro” denotes a security trading outside of home jurisdiction
  • USD outside US are “euros”

Regulatory Changes

• Post- (credit) crisis financial regulation
  • Foreign Account Tax Compliance Act (FATCA)
  • Anti-Money Laundering (AML)
• Technology increasingly facilitates easier capital flows
• WSB / GameStop / Robinhood
  • Reddit artificially inflated the price of GameStop (short squeeze)
  • Tripped the mechanism for shorting
  • Hedge funds couldn’t buy back the shorted stock, and were forced to re-buy it at a higher price
  • That made the price go higher

Primary Markets / New Issues

• Also called Debt or Equity Underwriting / Financing
  • Investment dealers sell newly issued securities
• As PRINCIPALS (buying as a middleman)
  • Investment Dealer agrees to a price with the issuer and buys all the shares/bonds (“bought deal”)
  • They then sell the purchased shares / bonds to investors
• As AGENTS (marketing to buyers)
  • Investment Dealer markets shares / bonds on a “best efforts” basis, they don’t purchase

Which one gives the Investment Dealer more risk?

• As Principals, because they’re buying the shares

Secondary Markets

• As Principals
  • Invest their own capital and earn a spread between purchase and sale prices
  • ”proprietary or liability trading”
• As Agents
  • Invest their clients’ capital and earn a commission on executed trades
  • ”brokerage”

What role does an Investment dealer pay for a High Net Worth (HNW) individual buying 100,000 shares of Apple?

• Spread it out over a week for better prices
• For 100 shares of Apple, they won’t care

Trade Settlement

• Cash is transferred
• Canadian Depository for Securities (CDS) “clears” or “settles” the trade

Banking

Banking

• Collect money, lend money
  • Earn the difference between cost of borrowing (interest paid to depositors) - revenue from lending (interest paid by borrowers)
• 1950-70s: 3-6-3 rule:
  • Borrow at 3%, lend at 6%, golf course by 3pm

How does higher interest rates impact banks?

• Charge more for loans, but don’t give much interest for savings

Chartered banks

• Governed under the Bank Act
  • Schedule I: Domestic Banks
  • Schedule II: Subsidiaries of Foreign Banks
  • Schedule III: Institutional Branches of Foreign Banks
• Big Six Banks (BMO, BNS, CIBC, NA, RY, TD)
  • Schedule I or “conglomerate” banks

Other Bank-like companies

• Trust and Mortgage Companies
• Credit Unions and Caisses Populaires

Insurance

Life Insurance Companies

• Match liabilities (death) with assets
  • Annuity: set pay every year
• • They can collect the fact that someone smokes
• Insurers can own trusts and offer banking and investment products
• Large life insurers used to be owned by policyholders, but “demutualized” to become public companies

What are the risks in Life Insurance?

• Guy lives too long
• Moral hazard: people change their behaviour
• Example: investors in England noticed annuities being taken out on people, bet it on poor children, make them rich

Insurance changes behaviour:

• Insurance is required for houses with mortgages
• Insurance is required for cars in case you hit someone (liability of >1m)

Investment Funds

• Mutual funds, hedge funds, ETFs (Verizon, IShare, Vanguard)
  • Often formed as Trusts that distribute Units to investors
  • May also be corporations or Limited Partnerships (LPs)
  • Closed-end funds are listed on an exchange
  • Open-ended funds are not
• James recommends low cost ETFs
  • You can add risk to ETFs

Pension Plans

• Government sponsored
  • CPPIB (everyone), OMERs (municipal employees), OTPP (teachers)
• Company-sponsored
  • Rogers, Agrium, Bank of Montreal
• Conservative, long-term focus

8 | Common and Preferred Shares

Common vs Preferred Shares

Common shares

• Ownership in a company
• Value depends on total company equity and total shares outstanding

Why does share price change with the number of shares?

$$Value(V)=Debt(D)+Equity(E)$$

• There are fractional shares now, removing the use for a stock split

Preferred shares (prefs)

• Provides a cash payment / dividend that’s known
• Dividends can only be cut if firm is in serious trouble
• When firms go into bankruptcy, DEBT HOLDERS are paid off first, equity holders last

Limited Liability

• The shareholder can make infinite gain, but can only lose as much as they put in

Dividends

• Companies can, but don’t have to, pay dividends (cash) to shareholders)
• Meta/Facebook and Shopify don’t pay dividends; Canadian banks typically pay 40-50% of net income

Why do some companies pay dividends, and some don’t?

• Stable companies (Rogers) pay high dividends
• Unstable companies (tech) don’t

Timing of dividends (IMPORTANT)

• Share price declines by dividend amount on ex-dividend date (day after dividend)
  • Ex-dividend date = Dividend issued date - 2
• Markets run 9:30-4

Stock dividends

• Giving you more stock

Dividend Reinvestment Plan (DRIPs)

• Use the dividend to automatically buy more shares at a discount

DIVIDEND FORMULAS

Perpetuity Formula for Pricing:

$$P=\frac{D}{k}$$

• P = Price
• D = Preferred Dividend Received
• Dk = required rate of return on the preferred (for the investor)

Preferred Shares (Yield Valuation)

$$k=\frac{D}{P}$$

• P = Price
• D = preferred dividend received
• k = required rate of return on the preferred (for the investor)

Ex: Price = $30,Dividend=$3

• Yield = 6.67%
• We use percentage returns for everything:
  • Apples to Apples
  • Doesn’t matter if MSFT has a lower share price than Shopify

Debt vs Equity Example

Equity: if you have no confidence

• Less risk, hedging downside Debt: if you have more confidence
• More risk, expecting upside

Debt makes Equity risky

• You can’t go bankrupt if you have no debt

Stock Indices and Averages

Why are indices important?

• Bell-weather stocks: Home Depot
  • When times are bad, people put off home renovations

Value vs Price Weighted:

• Value-Weighted Index: Each stock is weighted according to market cap
  • Affected more by Apple
• Price-Weighted Index: Each stock is weighted according to stock price
  • Affected more by Berkshire Hathaway

Dow Jones Industrial Average (AJIA) was based on 30 stocks

• Price weighted (add up share prices and divide by 30)
• So much attention because they used to own the WSJ

9 | Equity Securities: Equity Trading

Cash and Margin Accounts

Cash Account

• Most basic type
• Not guaranteed credit
• Must make full payment

Margin Account

• Investment dealer / brokerage firm lends clients money
• Interest is charged on the borrowed account
• You still own the investment, but your brokerage has a claim (collateral)

Margin Accounts

Types of positions

• Long: up
• Short: down

Margin loan values: The maximum % that can be borrowed for purchasing securities

• Percentage goes down as stock price goes down
• 70% for securities eligible for reduced margin (most equities)
• No loan value for prices < $1.50 (risk too high)

Margin Call: When the margin falls below a certain level

• Firm realizes that they’re lending more than they can
• You have to put in the remaining money or they sell your stocks

Example: Share price goes from $6to$1.75

• Original cost = $6x1000shares=$6000
• Less: Revised max loan @ 40%
  • $1.75x40$700
• Gross margin requirement = $5300
• Less: original Margin Deposit = $5000
• Pay them additional = $2300

Example: Company value goes from $6000to$9000

• Original cost = $6x1000shares=$6000
• Less: Revised max loan @ 50%
  • $9.50x1000x50$4500
• Gross margin requirement = $1500
• Less: original margin deposit = $3000
• Withdraw (surplus) = $1500

Short Sales

• Occurs when an investor sells securities they do not own
• Brokerages charge extra money
• Stocks don’t have an upper bound - if I make a mistake on a short, I can lose infinite money

Required account balances (% of market value)

• 130% for blue chip equities
• 150% for prices > $2
• $3pershareforpricesbetween$1.50-$1.99
• 200% for prices between $0.25-$1.49
• 100% plus $0.25$0.25

Ex: How much should an investor deposit if they short 2,000 shares of Company B for $15?

• Min account balance = 130% x 15 x 2000 = $39000
• Less: Proceeds from short sales = 15 x 2000 = $30000
• Buffer = $39000-$30000 = $9000

What happens if the price increases to $18?

• Min balance = 130% x 15 x 2000 = $46800
• Less: proceeds from short = 15 x 2000 = $30000
• New Buffer = $16800
• Less: original margin deposit = $9000
• Margin Call: $16800-$9000 = $7800

What happens if price decreases to $12?

• Withdraw $7800 instead

Equity Transactions

Types of Orders

• Market order - executed at best available price
  • You don’t know your price - it’s determined by the limit book
• Limit order - Executed only if a certain price is possible (cur price is $58,limitorderat$55)
• Day order - only valid for the current day
• Open or Good Till Cancelled (GTC) order - until you turn it off
• All or Non (AON) order

Statistics

Standard Deviation

$$\sigma =\sqrt{\frac{\sum (x_1-\overline{x}{)}^2}{n}}$$

Variance = ${\sigma }^2$

X | Time Value of Money

Time Value of Money (TVOM)

“yesterdays price is not today’s price” - pusha t

The value of a dollar today is not the same as in a year Affected by interest rates and inflation

$$\frac{100}{1+r}+\frac{100}{(1+r{)}^2}$$

Discount Rates

• TVM is expressed as a discount rate
• Includes variables such as inflation, required returns, risk
• Allows cash to be assigned a value at different points in time:
  • $100 after a year
  • $100 after a year with 25% chance it disappears
• Today’s value = Present Value (PV)
• Next year’s value = Future Value (FV)

Timelines

• Adding together multiple cash flows

Future Value

• What is $100 worth in a year with 10% discount rate?
  • PV = $1000
  • FV = $1100
  • Discount rate = interest rate
• To move a cash flow forward in time: COMPOUND IT
  • 0 years: $1000
  • 1 year: $1100
  • 2 years: $1210
• To move a cash flow back in time: DISCOUNT IT
  • $1000today=$1210 in two years

Present Value

$$C_1=\frac{100}{1.05}=95.24$$ $$C_2=\frac{100}{1.05^2}=90.70$$

Can cashflows be negative?

• Yup: tech startups
• Negative cashflow: outflow
• Positive cashflow: inflow

Cashflow Examples

Ex: Find the rate of return:

$$100=\frac{100}{1+r}+\frac{100}{(1+r{)}^2}$$

Solve for r

Ex: Find the present and future value of $10000in6yearsand$10000 in 7 years

$$F{v}_2=10000(1.1{)}^7+10000(1.1{)}^6$$

Ex: Find the present value of $10000todayand$10000 in 1 year

$$PV=10000+\frac{10000}{1.1}$$

Ex: Prove:

$$\begin{array}{rl}P& =\frac{D}{1+r}+\frac{D}{(1+r{)}^2}+\frac{D}{(1+r{)}^3}+\frac{D}{(1+r{)}^4}+...\\ & =\sum _{n=1}^{\infty }\frac{D}{(1+r{)}^n}\\ & =\frac{D}{r}\end{array}$$

Proof (infinite geometric series)

$$\begin{array}{rl}P& =\frac{D}{1+r}+\frac{D}{(1+r{)}^2}+\frac{D}{(1+r{)}^3}+\frac{D}{(1+r{)}^4}+...\\ (1+r)P& =D+\frac{D}{1+r}+\frac{D}{(1+r{)}^2}+\frac{D}{(1+r{)}^3}+\frac{D}{(1+r{)}^4}+...\\ (1+r)P& =D+P\\ (1+r)P-P& =D\\ Pr& =D\\ P& =\frac{D}{r}\end{array}$$

Perpetuity Due (first payment is today)

$$P=D+\frac{D}{r}=\frac{(1+r)D}{r}$$

6 | Fixed Income Securities: Features and Types

Fixed Income Basics

Market Cap = Share Price x # shares

• This is fine for comparing big companies like AAPL and MSFT (similar amount of debt)
• But Market Cap is only a measure of Equity, not Debt
  • 40% D 60% E vs
  • 10% D 90% E
  • Firms can issue shares to pay off debt, raising market price
• Growing value means growing the whole pie (D+E), not just E

Basics

• Fixed income includes bonds, debentures, mortgages, swaps, preferred shares
  • Credit Default Swap = Firm gets many streams of money
• Fixed stream of cash flows
  • Coupon payments over time (interest payments on mortgage)
  • Principal repayment at maturity
• Fixed vs Variable Rates
  • Fixed = fixed, re-negotiated every 5 years
  • Variable = dependent on prime rate and federal interest rate
• Interest rates
  • Interest rates are going down - variable rate would be better
  • When inflation increases, the difference between fixed and variable is much more important

Bonds

Bonds vs Debentures

• Bonds are secured by collateral
• Debentures are unsecured
• Terms are interchanged

Bond Terms

• Bond terms are described in the indenture, which outlines the legal rights
  • Dates of amount coupon payments
  • Date of principal repayment
  • Covenants (restrictions)
• Ex: Mariott (hotels) did a massive restructure that took $100m in debtholder value and gave it to shareholders
  • Restructuring made the debt much riskier
  • Mariott ended up defaulting and got no punishment
• Bankruptcy
  • Debtholders > Equity Holders
  • If a firm defaults on a coupon payment, courts determine whether it’s Illiquid vs Insolvent
  • Illiquid = has assets, can eventually pay off
    • Courts can force the firm to restructure by giving them time
  • Insolvent = could never pay it off
    • The entire firm gets sold
    • Debtholders only get a percentage (haircut)
    • Equity holders get nothing

Discount Bonds

• Debt Market > Equity Market (biased by government debt)
• Some bonds do not include a coupon payment (T-Bills)
• Sold at a discount (“below par”)
• Price changes are considered interest income for tax purposes
  • Interest tax rate > Capital Gains Rate
  • Interest is income tax rate
  • Capital gains is usually half rate

Market Jargon

• Bonds have different time frames
  • Short term: 1-5 yrs
  • Medium term: 5-10
  • Long-term: 10+
  • Walt Disney and Air Canada (default) have issued indefinitely long bonds
• How to buy corporate debt?
  • Online
  • Debt considered illiquid, government liquid

Bond Maturity

• Callable Bonds can be repurchased before the maturity date
• Retractable bonds can be “put” back - bond holders can force the repurchase

Planned Repurchases

• Sinking funds require the issuer to pay the bonds back over time
• Purchase Fund requires the issuer to buy back the bonds over time as long as they’re priced below par

Convertible Bonds

• Some bonds contain a provision that allow the bond to be converted to equity
  • Bond contains “call option” - eg. $1000 of face value can purchase 10 shares
• Bank loans won’t be convertible

Protective Provisions / Covenants

• Limits to total debt allowed
• Limits to debt/interest as a proportion of revenue / EBITDA / Income
• Violating them leads to “technical default”

Government Bonds

Government Bonds

• Treasury Bonds
  • Canadian bonds are Canada’s
  • German bonds are Bunds
  • UK bonds are Gilts
• Treasury Bills (T-bills) are short term
• Marketable Bonds (Treasury Bonds) are medium and long-term
• Considered “risk-free”

Real Return Bonds

• Rate on the bond is adjusted to inflation
• We use these to infer market expectation of inflation
  • When these spike, we expect inflation

Corporate Bonds

Corporate Bonds

• Mortgage bonds use a specific asset
• First Mortgage has the first claim to assets
• Collateral trust (financial collateral)
• Equipment Trust (equipment collateral)

Corporate Debentures

• Are the riskiest form (secured by only whatever’s left)

Short-term Corporate Borrowing

• Commercial Paper

Strip Bonds

• Strip a bond of it’s coupon payments to create a series of discount bonds

7 | Fixed Income Securities: Pricing and Trading

Bond Cash Flows, Prices, Yields

Terminology

• Certificate: Terms of the bond
• Maturity Date: Final repayment date
• Term: Time remaining until repayment date
• Coupon: Promised interest payments
• Face Value: Nominal amount used to compute interest payments
• Coupon Rate: Determines the amount of each coupon payment, expressed as an APR (Annual Percentage Rate)
• Coupon Payment

$$CPN=\frac{\text{Coupon Rate}\times \text{Face Value}}{\text{Number of Coupon Payments per Year}}$$

Coupon Bonds

• Pay face value at maturity
• Pay regular coupon interest payments
• Government of Canada Bonds are sold with maturities of 2, 5, 10, 20, 30 years

Dynamic Behaviour of Bond Prices

Discounts and Premium

• If a coupon bond trades at a DISCOUNT (< face value)
  • An investor earns a return from the coupons and the lower price
  • It’s yield to maturity exceeds the coupon rate
• If a coupon bond trades at a PREMIUM (> face value)
  • It will earn a positive return from the coupons, but you lose money from the higher price
• If a coupon bond trades at PAR (= face value)

Ex: What if inflation goes up and the interest becomes less valuable?

Sell it at a discount rate

Bond Pricing

$$PV=\frac{50}{1+r}+\frac{50}{(1+r{)}^2}+\cdots +\frac{50+1000}{(1+r{)}^2}$$

Interest Rates

• Interest rates up = bond yields up = bond prices down
• Interest rates down = bond yields down = bond prices up

Duration and Sensitivity

• High durations are highly sensitive
• Low durations are less sensitive

Treasury Bills

• No Coupon Payments
• Thus, will never be sold at a premium

$$P=\frac{1000}{1+r}$$

15 | Portfolio Theory

Risk and Return

• Assume investors like return and dislike risk
• Low risk / Low return
  • GICs, T-Bills
• High risk / High returns
  • Options, Gold exploration companies, Gamestop, Tesla, Bitcoin

Ranking Risk and Returns

• T-bills < Bonds < Debentures < Preferred Shares < Common Shares < Derivatives

Returns

• Total return when you own a security

$$\text{Percent Return}=\frac{\text{Cash flow + Ending Value - Beginning value}}{\text{Beginning Value}}$$

• Cash flow = Interest (bonds), dividends received (equities)
• (ending value - beginning value) = capital gain / loss

Real rate of return

• How much an investment has increased in real terms, adjusted for inflation
• Real rate of return = nominal rate - inflation rate
• Inflation = 3%, return = 4.5%, real rate = 1.5%

Types of Risk

Types of Risk

• Inflation Risk
• Business Risk
  • Gold exploration companies and cyanide
• Political Risk
  • ETFs for Asia and EU
• Liquidity Risk
  • OTPP and Maple Leaf Entertainment
• Interest Rate Risk
  • Interest rates went up 50 points
• Foreign Exchange Risk
  • What happens to the CAD
• Default Risk
  • Hurts Equity holders more (Debt holders get something, equity holders get nothing)

Two parts of Risk:

• Systematic Market Risk (relating to overall market or economy)
  • THIS CANNOT BE DIVERSIFIED AWAY
  • Ex: Interest rates, COVID
• Idiosyncratic Risk
  • CEO Scandal
  • How to diversify: Go long in different stocks / industries / countries

Statistical Measures of Risk

• Variance / Standard Deviation (Square root of variance)
  • Unconditional risk of a security’s returns
  • Ex: Apple going up $50vsBerkshiregoingup$1k
  • Ex: Telus / Rogers / BCE closer than Shopify
• What data should we use?
  • Ex: Nike can go back 30-40 years
  • Ex: Apple / Netflix can’t go back more than 10 years
• Beta
  • Conditional risk of a security’s returns
  • Risk in relation to the overall market
  • The higher the firm’s beta, the greater its risk relative to the overall market

Expected returns

$$\begin{array}{r}E(X)=\overline{X}=\frac{\sum x_i}{N}\end{array}$$

where $x_i$ are individual returns of some security $X$, $N$ is the total number of observations (time periods)

Variance

$$\begin{array}{r}{\sigma }_X^2=\frac{\sum (x_i-\overline{X}{)}^2}{N}\end{array}$$

Standard Deviation

$$\begin{array}{r}{\sigma }_X=\sqrt{\frac{\sum (x_i-\overline{X}{)}^2}{N}}\end{array}$$

Covariance Let’s consider the relationship between two securities $X$ and $Y$.

$$\begin{array}{r}COV(X,Y)=\frac{\sum (x_i-\overline{X})\times (y_i-\overline{Y})}{N}\end{array}$$

Correlation Very similar to Covariance, except standardized so that it takes a value between $-1$ and $1$

$$\begin{array}{r}COR(X,Y)=\frac{COV(X,Y)}{{\sigma }_X\times {\sigma }_Y}\end{array}$$

Sharpe Ratio Balances returns and variance of a portfolio: $S=\frac{R_P-R_f}{{\sigma }_P}$Where S is the Sharpe ratio, $R_P$ is the expected return of the portfolio, found by taking a simple arithmetic average, $R_f$ is the risk-free rate, and ${\sigma }_P$ is the standard deviation of portfolio returns. Beta ${\beta }_i=\frac{\mathrm{Cov}(r_i,r_m)}{\mathrm{Var}(r_m)}$ ${\beta }_i$ = market beta of asset $i$ $Cov$ = covariance $Var$ = variance $r_m$ = average expected rate of return on the market $r_i$ = expected return on an asset i

Combining Securities / Correlation

We want to combine securities that are negatively correlated

• Negative vs Positive vs No Correlation
• Oil stocks and Airline stocks are typically negatively correlated
  • During Covid, Oil futures went negative because it cost too much to store oil
  • Oil and Airline both went down

10 | Derivatives

What are Derivatives?

• Something that derives value from the price of another asset
• Two types:
  • Options = does it go up or down?
  • Futures / forwards = next class

Where do they trade?

• Exchanges (better)
  • TMX / Montreal Exchange (ME)
  • US Markets are the most liquid
• Directly between investors (Over-The-Counter / OTC)
  • Counterparty risk (the other party just leaves)
  • During a credit crisis, the other party goes bankrupt
  • Lehman Brothers sold a lot of people contracts, but they went out of business

Options

• The right, not the obligation to buy / sell an asset at a pre-determined price
  • Ex: Bernie has the obligation to sell me Shopify at $100 (strike price) if I want it
• Call vs Put
  • Call Option: The right to buy
  • Put Option: The right to sell

Jargon

• Buyers are called “long”
• Sellers / writers are called “short”

Terms

• Exercise / Strike price (k) = Buy / sell price
• Maturity = expiration date
• Premium = option cost
• ”American” = Can be exercised any time
• ”European” = Can be exercised at maturity

Options Value

• Intrinsic Value = Value if exercised now
  • $s$ = terminal stock price, $k$ = strike price
  • Call: $\max (0,s-k)$
  • Put: $\max (0,k-s)$
• “In the money”
  • Call: strike < stock to buy it for less
  • Put: strike > stock to sell it for more
• Time value
  • Call option (200) of Shopify (100) for a day vs a year
  • Would be worth more in a year

Example: Call Option

• Strike price (k) = $27
• Stock price (s) = $31.50
• Option price = $6.35
• Intrinsic Value = s - k = $4.50
• Time Value = Price - Intrinsic = $1.85

Example: Put Option

• Strike price (k) = $35
• Stock price (s) = $28.90
• Premium = $9.45
• Intrinsic Value = k-s = $6.10
• Time Value = Price - Intrinsic = $3.35

Traditional Options

• Positions are either “naked” = don’t own the underlying
• Or “covered” = own the underlying

Strangles

• Long strangle = predicting that the price will change
• Short strangle = predicting that the market will be within a certain range

Hedging risk

• Long a stock = put option
• Short a stock = call option

Futures and Forwards

• Futures and forwards are an obligation of both the buyer and seller
• Futures contract trade on an exchange
• Forward contracts are OTC (one-time contracts)

Pricing

• Set the future price for an underlying asset
  • Ex: Transact a barrel of oil at $35 in 6 months
  • Future price is usually set as current (spot) price + “cost of carry” to reflect TVoM
  • Price may factor in dividends, cost of storage, etc

Trading

• Contracts are offset before expiry, but some are cash settled
  • Underlying asset is physically delivered (eg. barrel of oil, bushel of corn)
• Futures/Forwards used to
  • Hedge
  • Speculate

Common Futures/Forwards

• Stocks (indices)
• Interest rates
• Energy (oil, natural gas)
• Agriculture (corn)
• Base metals (copper)
• Previous metals (Gold)

Other Derivatives

• Made up of options and forwards
• Swaps
  • Credit Default Swaps
  • Currency Swaps
  • Interest Rate Swaps
  • Rights and Warrants

25 | Canadian Taxation

Tax Rates

Investment Taxation

• Investments generate 3 types of income
  • Capital Gains
  • Dividends
  • Interest
• Canada Revenue Agency (CRA) treat each differently

Marginal Tax Rate

• Brackets
• Average Tax Rate = Amount / Tax
• Progressive Taxation: Higher brackets have higher rates

Interest Income

• Full amount added to taxable income

Dividends (Strange)

• Receive $100 in dividends
• Taxable amount = $100\ast 138$138
• Tax Credit = $138\ast 25$34.50
• If you were in the $44.97% tax bracket, total tax is
  • $138\ast 44.97$34.40 = $27.56
  • Effective tax on the dividends is $27.56

Capital Gains / Losses

• On a cash basis
  • Payable only when you sell an investment (tax deferral)
  • Can be triggered strategically (tax loss selling)
  • Selling a stock that did poorly
• Gains are included in taxable income
  • Only 50% of the capital gain included
• Losses can be carried forward over time and used to reduce capital gains

Capital Gain Example

• You generate $2500 of capital gains in 2023
• $2500\ast 50$1250 is included in income
• If you’re in the $31.48% tax bracket, your federal tax on the capital gain is
  • $1250\ast 31.48$393.50
  • The effective tax rate is 15.7%

RRSP

Registered Pension Plans (RPP) / Registered Retirement Savings Plan (RRSP)

• Employers: RPP
• Individuals: RRSP
• Created to help save for retirement
  • Tax Deduction for contributions
  • Not taxed as investment income while in the plan
  • Withdrawals from the plan are taxed, but at a lower rate

RRSP Benefits

• Company gives income tax to government, $10k goes to you
• You get a tax credit from the government
• You can then put $13k into the RRSP

TFSA

TFSA

• All Canadians 18 and over can contribute
• Max contribution is $7k per year
• This can save you a lot of money
  • Deposits are not tax deductible
  • Investment income is not taxed
  • Withdrawals are not taxed

X | Money and Cryptocurrency

What is Money?

• Medium of Exchange
• Store of Value
• Unit of Account

Store of value

• Canada went off the gold standard in 1929
• Became a fiat currency

Feature of “Good” Money

• Long-lasting
• Portable
• Divisible
• Fungible - All 5$ is worth the same
• Hard to Counterfeit
• Limited Supply

Currency Instability Hyperinflation

• How to save it: Adopt another currency (eg. USD)

Gold as Money

• Long lasting, yes
• Portable, yes, as long as not too much needed
• Divisible, yes, may need to melt down
• Fungible, yes
• Hard to Counterfeit, yes, need trained eye
  • Cannot “double-spend”
• Limited Supply, yes

Digital Currency as Money

• Long lasting, yes
• Portable, yes
• Divisible, yes
• Fungible, yet
• Hard to Counterfeit, ???
  • Double-spend, ???
    • Limited Supply, ???

Cryptocurrency

Less adoption

• Only El Salvador and Central African Republic

Bitcoin as Digital Gold?

• Insurance against currency failing
  • The “bigger sucker” problem
• Bitcoin is closer with the market than gold

13 | Fundamental and Technical Analysis

Efficient Market Hypothesis

Valuing Securities

• Fundamental Analysis: using accounting data with well-studied financial models
• Technical Analysis: using statistics

Efficient Market Hypothesis (EMH, strong form)

• All available information is used to determine current prices, and is already in the price
  • Changes in prices follow a Random Walk, so beating the market is luck
  • Random Walk = up movement doesn’t say anything about going up or down later
• A lot of financial models rely on some form of EMH (most weaker)
  • Insider information exists
• Behavioral Finance is challenging the EMH
  • Emotional bias leads to systematic errors
  • The more traders in a market (especially more computational), the less bias
• Fundamental Analysis: combines
  • Macroeconomic factors
  • Industry (price of oil)
  • Company (financial statement)

Example: .com bubble (2000s)

• pets.com was losing money but had a $2.5bil valuation

• 75% of traders believe they’re better than average

  • Get out before the bubble bursts

Example: Challenger Space Shuttle Explosion

• US report concluded that an O-ring was to blame
• The market priced in that Morton Thiokol was to blame 20 minutes in
• Markets can be unbelievably efficient

Macroeconomy and Industry

Macroeconomic

• Government policy
  • Fiscal: taxes, budget deficits/surpluses
  • Monetary: interest rates
• Big macro indicators
  • Bond yields
  • GDP
  • Employment

Industry

• Life cycle
  • Start-up
  • Growth
  • Mature
  • Decline
• Industry structure and competitive dynamics
  • Competing on quality or price
  • Competitive Advantage

Measuring Performance

Measuring Performance

• Return-on-Equity: measure of how well a company is doing given macro and industry environment
• Net income = result of company operations
• Net income = investment made by shareholders

Fundamental Valuation

• More complex PV of future cash flows calculation:
  • Estimating future cash flow and discount rate
• Macro and Industry analysis is used to estimate
  • Pro-forma financial statements (project future revenue, future gross margins)
  • Risk (cost of equity and debt)

Dividend Discount Model (DDM)

$$\text{DDM value per share}=\frac{Di{v}_1}{r-g}$$

$Di{v}_1$ is the next period dividend, $r$ is the discount rate, $g$ is the growth rate of dividends

$$Di{v}_1=Di{v}_0\times (1+g)$$

Can be calculated as the Earnings Per Share (EPS) multiplied by payout ratio

$$Di{v}_1=EP{S}_1\times \text{Payout Ratio}$$ $$Di{v}_1=(EP{S}_0\times \text{Payout Ratio})\times (1+g)$$

P/E Ratios

• Price / Earnings, or earnings per share
• How much earnings you expect to get by spending $1
  • Tech companies would have high P/E

Technical Analysis

Technical Analysis

• Less popular in academia
• Assumes that markets are not fully efficient

Charting

• Seeking patterns in charts

Quant

• Moving Averages
• Assumes EMH imperfect

Market Indicators

• Volume
• Breadth

Behavioral Finance

• Human biases (Perceptual, emotional, cognitive)
• Overconfidence
• Cognitive Dissonance