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Frans De Roon PhD, professor of Finance (Investments), University of Tilburg
F.A.deRoon@uvt.nl
Winfried G. Hallerbach PhD, associate professor of finance, EUR
hallerbach@few.eur.nl
Onno Steenbeek PhD, Head Risk Management ABP Pension Fund, and assistant professor of finance, EUR
onno.steenbeek@abp.nl
Laurens A.P. Swinkels PhD, Quantitative Researcher at Robeco Group, and assistant professor of finance, EUR
lswinkels@few.eur.nl
1. Introduction
The main objective of the first course “Investments & Financial Markets” in the second module is to provide an understanding of the various different aspects of the financial investment decision. This covers the working of financial markets, the characteristics of the financial instruments traded on these markets including their risk-return profile, and the description and analysis of the different stages of the investment decision process. In this first part of the course attention focuses on equities (stocks). Fixed income instruments are covered in the second part of the course, module 2.2
The course consists of eleven lecture sessions of each three hours, a guest lecture, plus a final examination. Students are also expected to spend an equivalent amount of time individually studying the literature and in groups preparing assignments and cases. Through the use of these assignments and cases, students are expected to develop a firm understanding of the aspects of financial investment analysis and decision-making.
2. Course details
The course is structured in seven thematic parts, concluded by a practical topic discussed by a guest speaker from the investment industry:
1. The investment decision process: this part outlines the key stages of the financial investment decision process. Different types of investment problems are discussed (ranging from small private investor to large institutional investor) as well as different types of investment opportunities. In framing the investment decision, the perceptions and preferences of the decision-maker and the (e-) valuation of investment opportunities are central.
In a class assignment the students are asked to formulate a mandate for a professional investment manager from the viewpoint of different types of investors.
Literature: BKM Chs 1, 2
2. Portfolio theory: in this part the conditional-normative portfolio selection decision is studied). Starting point is Markowitz’ Portfolio Theory where mean and variance are the relevant portfolio attributes. Central concepts in this mean-variance theory are risk reduction through diversification, portfolio efficiency and two-fund separation. For a richer description of risk, multi-factor models are introduced and it is shown how multi-dimensional risk profiles can be estimated.
In a case study the students are asked to implement a mean-variance portfolio selection model. The task ranges from estimating the required inputs to investigating the efficient set of portfolios.
Literature: BKM Chs 5, 6, 7, 8 & 10.1, Appx A ; BMA Chs. 7 & 8 ;
additional leaflets on discount/interest rates, mean-(co-)variance properties,
and geometric mean
3. Return predictability: this part focuses on the source and prediction of returns in financial markets. Central question is whether available information is incorporated in market prices in an immediate and unbiased fashion. This issue is relevant when considering asset pricing (in part 4) and active investment strategies (in part 7). The concepts of random walks and market efficiency are defined and the implications for asset pricing and investment strategies are evaluated.
Literature: BKM Ch.12; BMA Ch.13
4. Asset Pricing: When compared to part 2, the focus shifts from conditional-normative theory to positive (i.e. descriptive) theory. Positive or descriptive theories postulate relationships between required (expected) return and risk. The discussion of the mean-variance portfolio theory culminates in deriving the Capital Asset Pricing Model (CAPM). The model’s assumptions, its implications, the role of “beta” and the relationship with Markowitz’ normative portfolio theory is outlined. Next the focus shifts from a two-parameter equilibrium framework to a multi-factor no-arbitrage setting. Imposing no-arbitrage conditions on multi-factor models can lead to the Arbitrage Pricing Theory (APT). However, we will show how investor specific risks can lead to more general multi-factor models that have direct implications for optimal portfolios as well. Examples are the International CAPM and multi-factor versions of the CAPM where investors face exogenous risks like real estate risk e.g. Special attention is paid to the practical applicability of the portfolio and pricing models in the light of underlying assumptions and empirical validity.
Literature: BKM Chs 9, 10, 11 & 13; BMA Ch. 8
5. Performance evaluation: this is the last stage of the investment decision process. Here the outcome(s) of the investment decision(s) is (are) evaluated and feedback is provided to the first stage of the process. From an ex-post perspective performance evaluation allows a critical judgment of the followed investment strategy. From an ex-ante viewpoint performance evaluation provides valuable information that allows learning from previous decisions with the objective to improve on future decisions. Various risk-adjusted performance measures are discussed, compared and evaluated. A distinction is made between absolute performance and relative performance, and the importance of performance attribution is stressed. We focus on measures like the Jensen measure (alpha), the Sharpe ratio and the Information ratios and show how these measures are related. Also the implications of the performance for portfolio management will be discussed. A case study serves to explore practical aspects of performance evaluation.
Literature: BKM Chs 13 & 24, reader
6. Stock valuation: In essence, outperformance relates to market inefficiency and the question of market efficiency is about the question whether market price equals value. In that context several approaches to stock valuation are introduced. Special attention is devoted to dividend growth models: the assumptions underlying the models and the implications.
Literature: BKM Ch. 18; BMA Ch. 4
7. Professional investment management: we switch to investment management in practice. This part comprises a general typology of investment companies, their policies and investment styles. In addition, we study the specific investment management process of pension funds, illustrated by a case study. Finally, we will examine recent trends in the professional asset management industry.
Literature: BKM Chs 26 & 27
8. Guest speaker from the industry – to be announced
Upon completion of the course the students should be able to:
understand the importance and working of financial markets
frame the investment decision process in terms of outlining the various stages of this process in practice
understand the assumptions, implications and practical applicability of Markowitz’ portfolio theory and factor models (conditional-normative)
understand the assumptions, implications and practical applicability of the CAPM and the APT (descriptive)
grasp the content and implications of the EMH
apply various stock valuation models in practice
outline the characteristics of passive and active portfolio strategies
translate and evaluate the performance of investment portfolios in terms of risk-adjusted measures
3. Course organization details
Group submissions
Students must form themselves into groups and submit the names of their group members at the start of the second lecture. You should ensure that all members of the group are prepared prior to the lectures as students may be selected at random to represent the group.
Requirements for successful completion of the course
Students are expected to actively contribute during their group meetings and lecture sessions. The course is concluded by a written exam, which – together with the case / assignment solutions – provides the grading for the course.
4.Course material
Textbooks:
Primary texts:
BKM: Bodie, Z., A. Kane & A.J. Marcus, 2005, Investments, McGraw-Hill, Boston MA (6th ed.) (ISBN 0-07-286178-9) http://www.mhhe.com/bkm
BMA: Brealey, R.A., S.C. Myers & F. Allen, Corporate Finance, McGraw-Hill, New York NY, 8th international edition 2006 (ISBN 0-07-111551-X).
Additional suggested background reading:
LP: Levy, H. & Th. Post, 2005, Investments, Prentice Hall, Harlow (Eng.), (ISBN 0-273-65164-1), see http://www.pearsoned.co.uk/HigherEducation/Booksby/LevyPost/
Sharpe, W.F., G.J. Alexander & J.F. Bailey, 1999, Investments, 6th edition, Prentice Hall, Upper Saddle River, NJ (ISBN 0-13-010130-3).
Reader:
In addition to the textbook, a reader will be used. Selected papers and other material will be made available during the course on Blackboard.
Learning aids:
Brealey, R.A., S.C. Myers & F. Allen, Student CD-ROM Accompanying Corporate Finance, McGraw-Hill, New York NY, 8th int’l edition 2006.
On this CD-Rom you will find a wealth of additional material, including quizzes with each chapter (with automatic correction), financial analysis spreadsheet templates and web links.
Case studies, workshop material and assignments:
Will be handed out during class.
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