Major Theories in Finance
Introduction
2
Major Theories in Finance
Three major pillars of modern finance.
Capital Asset Pricing Model (CAPM)
Relates the risk of an asset to its required expected return.
Dividend and Capital Structure Irrelevance (M and M)
In a perfect world:
i) A firm's share value does not depend on the firm's dividend policy. ii) The firm‟s total value does not depend on the amount of debt it has.
Option Pricing Theory
Can find the value of an option.
Shares are a call option on the firm's assets.
3
Two concepts
Equilibrium
Equilibrium prices: those at which, on average, the number of buyers at that price equals the number of sellers.
Arbitrage
Two portfolios having identical cashflows (with identical risk) must have identical value.
Otherwise one may arbitrage between them.
CAPM is an equilibrium theory.
Option valuation relies on arbitrage pricing theory.
Construct a hedging portfolio with identical cashflows to the option.
Arbitrage concept.
Nick Webber, C++ modelling, introduction
4
What is a Financial Asset?
A financial asset is an entitlement to a cashflow.
Factors: Number of payments and when they occur.
Their size and their risk.
Examples
1) An entitlement to receive £100 in one year from
i) a bank, ii) a tenant.
2) A lottery ticket paying out
i) £100 in one week with probability ii) £10m in one week with probability
1.
20
1
.
2,000,000
3) An IOU from someone you lent £5 to.
Nick Webber, C++ modelling, introduction
5
Examples of Traded Financial Assets:
Shares and bonds
Shares
Bonds, sovereign coupons +
Cashflows: dividends principal Occurrence: ½ yearly (UK) ½ yearly (UK)
Size:
Risk:
unknown high known less risk
Bonds, corporate coupons + principal quarterly or semi-annually known intermediate risk
Dividend size fixed by managers each half-year. Essentially random.
Size of (promised) coupons known for sure, but can default.
Can have fixed and floating
2
Major Theories in Finance
Three major pillars of modern finance.
Capital Asset Pricing Model (CAPM)
Relates the risk of an asset to its required expected return.
Dividend and Capital Structure Irrelevance (M and M)
In a perfect world:
i) A firm's share value does not depend on the firm's dividend policy. ii) The firm‟s total value does not depend on the amount of debt it has.
Option Pricing Theory
Can find the value of an option.
Shares are a call option on the firm's assets.
3
Two concepts
Equilibrium
Equilibrium prices: those at which, on average, the number of buyers at that price equals the number of sellers.
Arbitrage
Two portfolios having identical cashflows (with identical risk) must have identical value.
Otherwise one may arbitrage between them.
CAPM is an equilibrium theory.
Option valuation relies on arbitrage pricing theory.
Construct a hedging portfolio with identical cashflows to the option.
Arbitrage concept.
Nick Webber, C++ modelling, introduction
4
What is a Financial Asset?
A financial asset is an entitlement to a cashflow.
Factors: Number of payments and when they occur.
Their size and their risk.
Examples
1) An entitlement to receive £100 in one year from
i) a bank, ii) a tenant.
2) A lottery ticket paying out
i) £100 in one week with probability ii) £10m in one week with probability
1.
20
1
.
2,000,000
3) An IOU from someone you lent £5 to.
Nick Webber, C++ modelling, introduction
5
Examples of Traded Financial Assets:
Shares and bonds
Shares
Bonds, sovereign coupons +
Cashflows: dividends principal Occurrence: ½ yearly (UK) ½ yearly (UK)
Size:
Risk:
unknown high known less risk
Bonds, corporate coupons + principal quarterly or semi-annually known intermediate risk
Dividend size fixed by managers each half-year. Essentially random.
Size of (promised) coupons known for sure, but can default.
Can have fixed and floating