R S M 2 3 0 S P R I N G 2 0 2 2
FINAL R E V I E W P A C K A G E
导师：AMY ZENG | UTSG 校区 1









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R S M 2 3 0 S P R I N G 2 0 2 2
FINAL R E V I E W P A C K A G E
导师：AMY ZENG | UTSG 校区 2



EQUITY AND STOCK MARKET

OVERVIEW

Two Ways Corporations Can Raise Capital
1. Debts (e.g. bonds): individuals lend money to a corporation and become its debtors
2. Equity (stock) – individuals contribute money to corporations and become its shareholders.

What Are Stocks (Equity)?

Ø Stocks represent ownership of a company, which is generally accompanied by voting rights that give
stock owners some control over the organization
• Voting rights on appointments to the firm’s board of directors and other matters

Ø A share of common stock gives the holder claims to the cash flows and assets of a firm after all fixed
obligations have been met (including principal and interest to debtholders)– claim on residual income
• Common stockholders are residual claimants because cash flows to (common) stockholders are
uncertain in magnitude and timing. There is no guarantee that stockholders will receive anything.
• Stockholders will demand a higher return (r) in order to bear these risks.

Ø Cash flows to stockholders take the form of dividends and capital gains/losses.
• Firms produce cash flow. After all expenses are paid and necessary reinvestment (Capex) is
made, the remaining “free cash flow” is distributed to equity holders and debtholders.

FORECAST STOCK PRICE

Ø Believe that stock prices move in response to financial results & economic conditions
Ø Forecast stock price based on anticipated future earnings & cash flow. Common methods:
• Free cash flow method
• Dividend discount model
• Comparable (multiples)

1. Free-cash flow (FCF) method

Ø Free cash flow represents the amount available to be potentially distributed to shareholders.
Ø Stock price of the firm is valued based on FCF as:
• Free cash flow = Revenue – Expenses (Excluding depreciation) – CAPEX – Taxes
• Firm value = PV of expected free cash flow
• Equity value = Firm value – Debt Value
• Stock price = Equity value / # of shares outstanding
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FINAL R E V I E W P A C K A G E
导师：AMY ZENG | UTSG 校区 3



Ø Example:
Free cash flow to firm for ABC Inc. is currently $300 million and is expected to grow by 4% each year
forever. The current market value of debt is $3,000 million. If the company’s cost of capital is 10% and
ABC has 200 million shares outstanding, how is the per share value of ABC?

Firm value = $"## % &.#((#,& + #.#() = $5,200 million

Equity value = $5,200 - $3,000 = $2,200 million

Stock price = $2,200 / 200 = $11 per shares


2. Dividend discount method

2.1 Constant dividend: =

Ø Example: Suppose that the cost of equity is 15%, the expected dividend next year is $1.
The share price today is: ℎ = -!. = $&&/% = $6.67
2.2 Growth dividend: = (%)

• g: growth rate of dividend, g = Retention ratio (b) x Return on equity
• = -!1" + = dividend yield + growth rate

Ø Example: Suppose that the cost of equity is 15%, the expected dividend next year is $1 and the growth
rate of earnings is 10%. The share price today is: ℎ = -!(.+2) = $&(&/%+&#%) = $20
2.3 Growth Opportunities

Ø = × : Retention ratio (b) x Return on equity

Ø If b = 0, then D1 = EPS1 (no reinvest, no growth)

• = -!1" = 314!1"

• # = 314!.

Now, let consider growth opportunities:

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R S M 2 3 0 S P R I N G 2 0 2 2
FINAL R E V I E W P A C K A G E
导师：AMY ZENG | UTSG 校区 4



Ø Growth adds value if and only if ROE > r, such as if projects have positive NPV to the firm.

• “Good growth” results from reinvest back the money into the firm and generate positive NPV
growth opportunities.

• “Bad growth” results from reinvest back the money into the firm and generate negative NPV
project

Ø # = 314. + , where PVGO = present value of growth opportunities


Ø Example
ABC expects to earn $1 million per year in perpetuity if it undertakes no new investment opportunities.
There are 100,000 shares outstanding, so EPS is $10 ($1,000,000 / 100,000). The firm will have an
opportunity next year to spend $1,000,000 on a new marketing campaign. The new campaign will
increase earnings in every subsequent period by $210,000 (or $2.10 per share). This is a 21% return per
year on the project. The firm’s discount rate is 10%. What is the value per share before and after deciding
to accept the marketing campaign?

• Stock price before accepting the marketing campaign: $10 / 0.1 = $100

• Stock price after accepting the marketing campaign:
o Value of marketing campaign at Date 1: $210,000 / 0.1 - $1,000,000 = $1,100,000
o PVGO of the marketing campaign at Date 0: $1,100,000 / 1.1 = $1,000,000
o PVGO per share: $1,000,000 / 100,000 shares = $10
o Stock price: $100 + $10 = $110

Practice:

S1. Evaluate the following claim: Microsoft (MSFT) is trading at $178 per share and Oracle (ORCL) is trading at
$60 per share. Therefore, Microsoft is three times as valuable as Oracle.








S2. Last year at this time, XYZ announced quarterly earnings of 12 cents per share. This year, analysts were
expecting quarterly earnings to rise to 20 cents per share. Today, XYZ announced that earnings were 18 cents per
share for this past quarter. (i) Will the stock price likely go up or go down after the announcement? Explain. (ii)
What might the size of the price change depend on? Explain.




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R S M 2 3 0 S P R I N G 2 0 2 2
FINAL R E V I E W P A C K A G E
导师：AMY ZENG | UTSG 校区 5



S5. Today (in February 2020), the government announces that starting January 1, 2022 there will be a reduction in
the corporate tax rate. How will stock prices likely change today (immediately after the announcement)? How will
this affect share prices likely change in January 2022? Explain.









S6. It has been argued that liquidity in the secondary market for stocks can affect real economic activity, such as
opening new businesses and growing existing business. Briefly explain and evaluate this claim.








P4. (6 points) The Rotman School Corporation (RSC) is expecting free cash flow next year of $200 million, $260
million the following year, $300 million in three years from now. After that, free cash flow is expecting to grow at
3% per year forever. The appropriate discount rate is 10%.

a) What is the total value of the company?








b) Now that you know the total value of the company, you learn that RSC previously raised capital in both the
equity and debt markets. It has 60 million shares of common stock outstanding. It also has long-term bonds
outstanding that are valued at $600 million. What is the fair price per share of RSC?



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R S M 2 3 0 S P R I N G 2 0 2 2
FINAL R E V I E W P A C K A G E
导师：AMY ZENG | UTSG 校区 6



PORTFOLIO MANAGEMENT

Risk – Return Trade Off

Ø High expected returns usually go hand in hand with high risk. Thus, financial decisions usually entail the
classic risk-return trade-off: reducing risk tends to reduce expected returns, while increasing expected
returns tend to increase risk.

Ø Expected return can equivalently be interpreted as:
• Required return of investor on an investment
• Discount rate for valuation
• Cost of capital for a firm

Ø Shareholder’s required rate of return on equity, = + , compensates for
• Time value of value: riskless rate of return, rf, (yield on government bonds)
• Risk: a risk premium depending on the risk level

Measuring Risk

Example: Suppose you invest $100 as follows
- T = 0, pay $100
- T =1, 50% receive $100 and 50% receive $120
Return = 0% or 20%

Expected Return: () = 50%(20%) + 50%(0%) = 10%
Standard deviation: = W50%(20%− 10%)7 + 50%(0%− 10%)7 = 10% 「excel: = stdev.p(.)」
• SD is a statistical measure which measures by how much you are likely to miss the average

Diversification – “Don’t Put All Your Eggs in One Basket”

Example: Suppose you split your investment of $100 into two independent investment of $50 each
- T = 0, pay $50 for each
- T =1, receive $50 or $60 for each, equal probability
Total payoff: $100 (prob. 25%), $110 (prob. 50%); or $120 (prob. 25%)

Expected Return: () = 25%(20%) + 50%(10%) + 25%(0%) = 10%
Standard deviation: = W25%(20%− 10%)7 + 50%(10%− 10%)7 + 25%(0%− 10%)7 = 7.07%

• When diversifying, expect return average still at 10%, but standard deviation decreases to 7.1%
• Diversification reduces risk. To diversify the portfolio, invest in assets which are not exposed to the same
risks.

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FINAL R E V I E W P A C K A G E
导师：AMY ZENG | UTSG 校区 7



Correlation

Ø Correlation is a statistical measure (ρ) of the co-movement of two random variables. Better
diversification is achieved when there is low correlation between assets.

Ø Correlation is away measured between -1 and +1
• Correlation = 1: perfectly positively correlated
• Correlation > 0: tendency to move together
• Correlation = 0: uncorrelated
• Correlation < 0: tendency to move opposite
• Correlation = -1: perfectly negatively correlated

Diversification with Two Stocks

Ø Stocks are less correlated, the standard deviation of the portfolio is lower, reflecting a larger gain from
diversification
• Diversification always reduces risk unless assets are perfectly correlated
• Even with a positive correlation, there is less risk in holder a portfolio than in holding individual
stocks

Diversification with Many Stocks

Ø Many risks facing individual securities are unique and so these unique risks are offset by holding many
securities in a portfolio. However, “the more” is not necessarily “the better”.

Ø According to statistical data, risk of a portfolio is
halved with just randomly selected 20 equities,
most of the benefits of diversification can be
achieved by investing in 40 to 50 different
“positions” (investments).

“As portfolio size increases, risk declines, but
does not disappear.”


Systematic and Unsystematic Risk

Ø Total Risk = Systemic Risk + Unsystematic Risk

Ø Unsystematic risk (also known as specific risk; unique risk; idiosyncratic risk; diversifiable risk). Affect
a particular company and can be reduced by diversification.

Ø Systematic (also known as market risk; non-diversifiable risk), Affect all companies and cannot be
reduced by diversification. The risk of the overall market cannot be avoided.



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导师：AMY ZENG | UTSG 校区 8



Investment in the index
Standard deviations for individual stocks (2000-2020)
Stock (U.S.)
Amazon.com 46.6%
Microsoft 28.9%
Ford 48.3%
General Electric 28.3%
Coca-cola 17.2%
Pfizer 19.3%
Exxon Mobil 18.3%
S&P 500 14.6%

- Individual stocks are riskier than the S&P 500
- The risk of the S&P 500 is well above 0

S&P 500: A stock market index that measures the stock performance of 500 large companies listed on stock
exchanges in the United States.

Dow Jones Industrial Average (DJIA): A stock market index that measures the stock performance of 30 large
companies listed on stock exchanges in the United States.

Nasdaq: A stock market index of the common stocks and similar securities listed on the Nasdaq stock market.
The composition of the NASDAQ Composite is heavily weighted towards information technology companies.

Practice:
3) (8 marks) These questions are about diversification.
a) Explain how diversification works (in words!) (2 marks)




S1. (2 points) In order to achieve diversification, you are considering investing in an S&P500 index fund or a
Dow Jones (DJIA) index fund. Compare these two possibilities in terms of the extent of diversification.




S9. (3 points) What are the main differences between systematic and unsystematic risk?

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导师：AMY ZENG | UTSG 校区 9



OPTIONS

Basic Options Concepts

Ø Options are contracts that give the buyers the right not the obligation to buy or sell a fixed quantity of
the underlying asset at a predetermined price sometime in the future. However, seller of the option is
obligated to fulfill the contract if buyer decides to execute.

Ø Types of options:
• Call option: the buyer has the right to buy the underlying asset at the exercise price
• Put option: the buyer has the right to sell the underlying asset at the exercise price

Ø Key terms:
• Long option: buy the option & pay premium
• Short option: sell the option & receive premium
• Exercise/Strike price: price at which option is exercised
• Moneyness: An option is “in the money”/ “at the money”/ “out of the money” if exercising it
immediately yields a positive/negative/zero profit
• European options: options that can be exercised only at maturity
• American options: options that can be exercised anytime until the maturity date.

Position Diagrams
Call Option Put Option
Long
(Pay
Premium)












Short
(Receive
Premium)












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Summary
Potential Gain Downside Risk
Long call Unlimited Limited
Long put High Limited
Short call Limited Unlimited
Short put Limited High

Options Price Valuation

Option Price (Premium) = Intrinsic Value + Time Value

Ø Intrinsic value: the value of the option if it were exercised today – i.e. the value of certainty
• Intrinsic value of call option = price of underlying asset – strike price = P – X
• Intrinsic value of put option = strike price – price of underlying asset = X – P
• If an option is out of money, it has zero intrinsic value

Ø Time value: the value of an option arising from the time left to maturity – i.e. the value of uncertainty.


Value of Call Option

• Increases when the price of the underlying asset increases

• Increase when the time to expiration increases since there is
more opportunities to hold the right to buy the asset for a fixed
price is available for a longer period.

• Increases when the volatility of the underlying asset price
increases since the downside is limited to zero, but the option
value is higher as the price of the underlying asset increases.


Value of Put Option

• Decreases when the price of the underlying asset increases

• Generally (but not always) increases when the time to
expiration is longer since there is longer time to exercise the
option. In rare cases, for European options, the put option value
can decrease since the PV of the strike price that will be getting
lower.

• Increases with the volatility of the underlying asset price since
the downside limited to zero, but the option value is higher as the
price of the underlying asset decrease.

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Option Combination Strategy

Straddle: One call option and one put option on the same underlying asset with same exercise price and same
expiration date.
Ø Example: A straddle of one XYZ call and one XYZ put with strike price of $100 and three month to
expiration. This straddle costs $3 + $7 = $10.
o At the money: when XYZ price is $100 - both are worthless and the net loss is $10.
o At prices different than $100, one option is in the money and the other is out of the money. Thus,
the payoff diagram increases with a slope of 45-degrees to the left and to the right of $100.

Ø A straddle is a way to bet on volatility. Since both call and put premiums increase with the volatility of
the underlying asset, you should buy a straddle if you believe that volatility is about to increase. With the
now higher volatility the straddle value increases and you can sell it for more.

Strangle: Similar to a straddle but it has a lower cost and less upside. Call option has higher exercise price than
the put option.
Ø Example: A strangle consisting of one $95 put option and one $105 call option on XYZ with three month
to expiration. Suppose the put sells for $4 and the call sells for $2. Your loss is limited to $6. Comparing
to the $100 straddle, you need larger price movement to start profiting.


Ø When the underlying asset is priced between the two exercise prices both options are out of the money
and the strangle holder makes no profit.
Ø A strangle is cheaper than a straddle with an exercise price between those of the put and the call
of the strangle since both the call option and the put option are cheaper.
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Portfolio Insurance: used to hedge or insure from adverse movement of a stock or portfolio.
Ø For example, if you hold the S&P 500 portfolio, you can reduce your downward risk by buying a put
option on the S&P 500 Index. This practice is called portfolio insurance.
Ø Portfolio insurance is a common practice among professional portfolio managers who try to avoid big
losses on their portfolios.




Practice:
S8. (3 points) Bob buys a call option on Walmart shares with a strike price of $70 and 6 months to
maturity. Mary writes a put option on Walmart shares with a strike price of $70 and 6 months to maturity.
In what ways are Bob’s and Mary’s gambles similar? In what way are they different?






11. The strike price of an option is:
a) the value of the underlying asset at expiration.
b) the price of the option.
c) the proceeds generated if today was the expiration day.
d) the price at which an investor can buy or sell the underlying asset.

12. Jay writes a call option with a strike price of $50. What will be Jay’s payoff in dollars if the underlying
asset price at expiration is $55?
a) $5
b) −$5
c) 0
d) $105

13. The strike price on a call option is $8 and the price of the underlying stock is $10. What is the time
value of money of the call option if the option premium is $3?
a) $4
b) $3
c) −$2
d) $1
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INVESTMENT FUNDS

Trading Stock – Type of Accounts
Cash Account
Ø Only hold position that are long, i.e. positive holdings
Ø Full payment is required by the settlement date, which is 2 business days after the trade date

Margin Account
Ø Margin accounts are used by clients who wish to buy or sell securities on partial credit. Margin accounts
require only partial payment for a purchase of securities.
Ø The word margin refers to the amount of funds the investor must personally provide.
Ø Minimum margin requirements vary with the price of the stock
o Initial margin: the percentage of the purchase price that must be covered by the investor's own
money
o Maintenance margin: amount of equity the investor must maintain in margin account


Example

Client buys 1,000 shares of ABC on margin at $50.00
with margin = 50% and maintenance margin = 30%

Total costs: $50,000
Margin loan @ 50% $25,000
Margin (cash put up by client) $25,000 à your own money
Account balance $50,000 (value of shares)

The shares purchased are used as collateral against the borrowed amount

If stock price falls to $40.00
New value of shares $40,000 (value of shares)
Margin loan $25,000
Equity value (37.5%) $15,000

If stock price falls to $35.00
New value of shares $35,000
Margin loan $25,000
Equity value (28.6%) $10,000 (below maintenance margin)
Minimum balanced needs $17,500 ($35,000 x 50%)
Additional fund required $(7,500)

Margin call for extra cash of $7,500 needed

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Short Selling Stocks
Ø Short selling is selling shares that you don’t own à so you have a negative position in the market (betting
the stock price will go down)

Ø Example: short sell 100 shares of ABC at $140. Collect $14,000
• If ABC falls to $130 per share, buy back 100 shares for $13,000 (profit = $1,000)
• If ABC rises to $150, buy back 100 shares for $15,000 (loss = $1,000)

Ø How do you sell something you don’t own
• When you short sell, your broker will borrow shares from someone else on your behalf. Those
shares will be sold. When you cover your position (buy back shares), those shares will be
returned to lender.
• When you short sell, you pay any dividends that happen.

Investment Funds (Indirect Investing)
Overview of Investment Funds

1. Basic structure of investment funds

Ø Provide an easy alternative to direct ownership of individual securities

Ø Fund gives everyone an opportunity to invest in the market. Investment funds are financial
intermediaries that manage investments on behalf of a group of investors who share in the fund’s return

Ø Individuals invest in the fund do not directly own the securities held in the underlying portfolio, but
benefit from shared ownership

Ø Asset management of the fund is delegated to a professional fund manager who has legal authority to
invest their client’s assets (money)

2. Benefits of investment funds

Ø Diversification: Investors may not have enough money to properly diversify their portfolio across many
different securities. With investment funds, investors can lower their risks by diversifying across many
investments.

Ø Liquidity: Investors easily can buy or sell units of the fund on a daily basis, can quickly convert
investments into cash

Ø Cost advantage: Large size of the fund means that the mutual funds can negotiate lower transaction fees
than would be available to the individual investor.

Ø Professional management
o Investors may have limited knowledge in investment
o Many investors prefer to rely on professional many managers for their investment expertise and
enforcement of claims

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3. How do investment funds work

• The fund is a separate legal entity – a “trust” or an investment company
• Investor hold “units” or share of the fund
• All income & capital gains earned by the fund are paid out to investors on a pre-tax basis, based on
number of units they own.
• Investors pay a management fee to the fund manager, based on the market value of the units they own

Type of Funds Overview
Ø Open-ended mutual funds: the number of units or shares can change
Ø Closed-end funds: public traded investment companies with a fixed number of units or share
Ø Exchange traded funds (ETF): the number of unit or shares can change
Ø Hedge funds: available only to very large “accredited investors”

1. Open End Funds - Mutual Funds

Ø A mutual fund is an investment vehicle made up of a pool of funds collected from many investors for
the purpose of investing in securities such as stocks, bonds, money market instruments and similar assets.

a) Pricing of (open-ended) mutual funds: Each share/unit of mutual fund is priced at its NAV
• Net Asset Value is the value of a fund's asset less the value of its liabilities per unit
• NAV = 89.:;< =9>?; @A BCC;Go Calculated at the end of business day based on the closing market prices of securities
o Accrued liabilities include the expenses of the fund (e.g. management/administrative fees,
legal fees, audit fees) à NAV is calculated net of expenses
o Investors can buy or sell units from/to the fund at NAV (daily)

• Example: a mutual fund owns following assets and liabilities. There are 15,000 units outstanding.
§ 1000 shares of Canadian Tire (CTR.A) at $37.75/share
§ 2000 shares of Encana (ECA) at $43.70/share
§ 1500 shares of CIBC (CM) at $46.67/share
§ Professional fees payable of $15,000
§ Audit fees payable of $10,000

Assets Liabilities
CTR.A $37,750 Professional Fees Payable $15,000
ECA $87,400 Audit Fees Payable $10,000
CM $70,005
Total $195,155 Total $25,000

NAV = ($195,155 – $25,000) /15,000 units = $11.34
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If the share price of Canadian Tire increases from $37.75 to $40, NAV will increase to $11.49:
Assets Liabilities
CTR.A $40,000 Professional Fees Payable $15,000
ECA $87,400 Audit Fees Payable $10,000
CM $70,005
Total $197,405 Total $25,000

NAV = ($197,405 – $25,000) /15,000 units = $11.49

If people now buy 1,000 units of the fund with cash, there is no effect on NAV:
Assets Liabilities
Cash $11,490 Professional Fees Payable $15,000
CTR.A $40,000 Audit Fees Payable $10,000
ECA $87,400
CM $70,005
Total $208,895 Total $25,000

NAV = ($208,895 – $25,000) /(15,000 + 1,000) units = $11.49

b) Cost of Investing in Mutual Funds
• MER (Management Expense Ratio): MER is an ongoing fee automatically paid from assets under
management (AUM) to pay for fund services. Components include:
o Management fees (approximately 40% of MER)
o Operating/Administration expenses including audit & legal fees (20% of MER)
o Distribution costs & trailer fees paid to the broker who sells the fund (40% of MER)
o MER is charged by all funds & deducted before calculation the NAV
o MER is charged directly to the fund and not to the investor and reduce the return to investors.
For example, a fund that earned a gross return of 15% and had an MER of 4% would report a
return of 11%.

• Load fees: charged by some funds (less common)
o Sales commission paid to the broker who sells units of the fund to investors
o A 5% front end load means $100 invested in a mutual fund (when units are purchased) will
result in $95 invested in the fund and $5 paid to the broker
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o A 5% back end load means when you take out $100 from the fund (when the units are sold), you
receive $95 and the broker keeps $5

• Net returns reported on the mutual fund statement:
o Change in NAV and amount of any income or capital gains distributed by the fund
o DO NOT include load costs

c) Open-ended Fund Classifications
• Funds classified by type of assets - investors can compare similar funds by various fund companies:

Classification Details
International • Country specific (US Equity Fund)
• Global funds
Domestic Equity • Value investing (find low P/E stocks)
• Growth investing (capital appreciation, high P/E)
• Sized based (small cap vs. large cap)
• Divined funds (amount of dividend payment)
Index Funds • Replicate market index (i.e. S&P 500, TSX 60)
• Low MER – charge lower fees relative to actively managed funds
Balanced • Usually a combination of approximately 40% fixed income and 60% equity
• Balanced funds are geared toward investors who are looking for a mixture of
safety, income and modest capital appreciation
Fixed Income • Buy investments that pay a fixed rate of return like government bonds,
investment-grade corporate bonds and high-yield corporate bonds.
• They aim to have money coming into the fund on a regular basis, mostly
through interest that the fund earns.
• Term: long or short term bonds
Money Market • Invest in short-term debt securities such as Treasury bills and commercial paper.
• Only invest in security with maturities up to ~ 1years
• Money market funds are widely (though not necessarily accurately) regarded as
being as safe as bank deposits yet providing a higher yield.
Specialty • Industry specific (i.e. energy funds, technology funds)

Equity and Balanced funds are most popular among investors

d) Restriction on Canadian Mutual funds
• Can’t borrow
• Can’t go short
• Can’t hold more than 10% of any company
• Can’t buy commodities
• Can’t exceed limits on illiquid securities
• Can’t use deverbatives expect hedge underlying risk or to create synthetics securities
Restrictions are designed to protect small investors form excessive risk taking by the managers of the fund.
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2. Closed-End Funds - Mutual Funds

Ø A close-end fund is an investment fund issuing limited shares of investments through an initial public
offering (IPO), so the number of shares or units is fixed

Ø Bought & sold only on a stock exchange or over-the-counter (OTC), and never with a fund company

Ø Units can be sold at premium or discount to the market value of the underlying securities ( ≠ ):
• If P < NAV, sold at discount (often trade at approximately 10% discount)
• If P > NAV, sold at premium (it is a puzzle what causes the fluctuation)

Ø Closed-ended funds can hold more illiquid assets because they are never forced to sell to generate cash to
cover the redemption of units (e.g. Real estate investment trusts are a type of closed-ended funds)

3. Exchange Traded Funds (ETFs)
(Combined the best features of open- and closed-end funds)

Ø ETFs are similar to closed end funds because it allows investors to trade investment funds like shares of
stock on a stock exchange

Ø ETFs are similar to open ended funds because:
• Number of units outstanding can change as authorized participants can create/unbundle units
• ETFs may hold a diversified portfolio of securities that replicates a market index, or gives
exposure to certain types of securities

Ø ETFs are traded at a price close to NAV

Ø Advantages of ETFs compared to open ended mutual funds:
• Better Liquidity: ETFs are traded continuously on a stock exchange
• Cost efficient: Unlike fully managed mutual funds, there are no front-end load or deferred sales
charges with ETFs, which are bought and sold like stocks; the MER is also much lower.
However, brokerage commissions apply when you buy or sell ETFs.
• Fully invested: ETFs don't need to hold cash in anticipation of redemptions. This means ETFs
save trading costs and minimize the cash drag effect, which occurs when funds are required to
hold cash and therefore are not able to maximize the total return of the fund.

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导师：AMY ZENG | UTSG 校区 19



Summary: Open Ended Fund, Closed Ended Fund, ETF
Open end Close end ETF
Where traded With mutual fund
through brokers or direct
Exchange or OTC Exchange
Number of shares Changes daily Fixed Changes infrequently
Price P = NAV P≠NAV (P< or >NAV) P≈NAV
Investment Strategy Many investment
categories
Many categories; often
hold illiquid assets
Originally index funds;
now many categories
Cash holdings Have to hold cash for
redemptions
No need to hold cash for
redemptions
No need to hold cash for
redemptions because of
in-kind share exchange
Trading costs and tax High; forced trading
from inflow/outflow
investors (frequent
trading)
Low; no forced trades
and no realized capital
gains tax
Low; no forced trades
and no realized capital
gains tax

4. Exchange Traded Funds (ETFs)

Ø Hedge fund is a special type of mutual fund with more flexible and complex strategies and less
regulations, and generally do not open to the average investors
• Hedge funds take long and short positions
• Hedge funds can be highly levered (can borrow)
• Hedge funds often buy derivatives
• Hedge funds may buy up failing companies and become active Board members

Ø Key features of hedge funds include:
• High minimum investment: averaging around $1 million
• Long-term commitment of funds: first year lock-in and infrequent redemption (little liquidity)
• High fees: typically 2% of assets plus 20% of profits

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导师：AMY ZENG | UTSG 校区 20



Summary – Mutual Funds vs Hedge Funds
Mutual Funds Hedge Funds
Regulation • Prospectus offering;
• Brokers and dealer register with IIROC,
MFDA, OSC
• Ongoing disclosure requirements
• Minimal oversight;
• Now must register with OSC;
• No prospectus only offering memorandum;
• Not required to disclose returns or holdings
Strategies Restricted to long only positions, limited derivative
usage and little leverage:
• Can’t borrow
• Can’t go short
• Can’t buy commodities
• Can’t use derivatives except hedging
underlying risk/creating synthetics securities
• Can’t hold more than 10% of any company
• Can’t exceed limits on illiquid securities
More flexible and complex strategies:
• Can borrow (can be highly levered)
• Can go short
• Can buy commodities
• Often buy derivatives
• May buy up failing companies and become
active Board members
Fees • % of Total net assets • Base fee + Incentive fee
= 1-2% of TNA and 10-20% of profits
Investors • Average investors can buy
• Buy and sell shares on retail and institutional
market through exchanges, OTC and brokers
• Can buy and sell shares easily
• Must be accredited investors (asset > 5M)
• Limited # of investors: Buy and sell shares
through private placement
• Restrictions on when enter/exit the funds


Investment Funds Comparison and Analysis

Mutual Funds styles

1. Active Managed Funds

Ø The fund manager actively selects stocks expected to outperform the market index

Ø Type of actively managed mutual funds include:
• Value Funds: investing (low P/E stocks)
• Growth Funds: investing (high P/E stocks
• Size based Funds: small vs. large cap stocks
• Sector Funds: invest in stock of specific industry sector (i.e. energy funds)

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导师：AMY ZENG | UTSG 校区 21



2. Index Fund

Ø A type of mutual fund that passively replicates a market index
o Example: S&P 500 index fund
o Lower MER, charge lower fees relative to actively managed funds

Ø Rationale for Index Funds: most actively managed funds underperformed the index after fees, so index
funds often produce higher returns for investors.

3. Reasons for Investing in an Index Fund or ETF

1) Lower costs so fees (MERs) are lower
• Less portfolio turnover since the composition of the portfolio changes only when stocks enter or
leave the index à Turnover of active funds can be > 100% while index funds is < 5%
• Less skill / research involved since the manager simply replicates the index

2) Mixed result of active managers beating the market
• Most “actively managed” funds do not outperform the index, especially after fees which are high
relative to the fees charged by index funds.

3) Some active managers are “closet indexers” charge much higher fees and deliver a passive product
• Difficult to distinguish the “closet” indexers from the true active managers who charge higher
MERs to cover their research & implementation costs
• Closet indexers charge high MERs but provide only a passive fund

Practice:
1) (8 marks) An open ended no-load equity mutual fund owns 500 shares of RBC and 500 shares of Suncor. It
holds no other assets. RBC’s share price is currently $100 and Suncor’s share price is $45. Assume that these
stocks do not pay a dividend. The fund has 1000 units outstanding and Total Liabilities of $10,000. You just
bought 100 units.

a) What is the Net Asset Value (NAV) of the mutual fund? (2 marks)






b) How much money did you invest in the fund? (2 marks)


c) Suppose that, one year later, the price of RBC shares has increased to $108 and Suncor has increased to
$48. The fund's Total Liabilities remain the same. What rate of return did you earn on your investment in
the fund? Assume the mutual fund has a MER of 2%. (4 Marks)







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导师：AMY ZENG | UTSG 校区 22



S7. (2 points) From the point of view of an investor, what are the key differences between S&P500 index
mutual funds and S&P500 ETFs?







9. Mutual funds are normally not allowed to do the following except:
a) Use derivatives for risk management
b) Take large positions in illiquid securities
c) Take short positions
d) Use leverage

10. The net asset asset value (NAV) of a mutual fund is determined by:
a.) The total market value of all its assets multiplied by the number of fund shares outstanding.
b.) The total market value of all its assets divided by the number of fund shares outstanding.
c.) The total market value of all its assets divided by the number of shareholders.
d.) Supply and demand for shares of the mutual fund in the secondary market.
e.) Supply and demand for the shares of the mutual fund in the primary market.

14. The advantages of investment funds are that they:
a) Pool investor money allowing them to invest in securities not otherwise available b) Allow indirect trading in
otherwise illiquid investments
c) Provide in house buy side research that enhances information
d) Have professional management
e) All of the above are advantages

11. You bought 1000 shares of EDC priced at $5.00. You bought 1000 shares priced at $5.00. If the price
drops to $3.00 how much will you be required to deposit into your margin account? Assume a margin of
30%.
a) 3500
b) $2100
c) $1400
d) $600

25.Which of the following statements is true of hedge funds:
a) They are best suited for wealthy investors
b) Can use leverage and derivatives without limits
c) Have poor liquidity because investors cannot easily withdraw their funds
d) All of the above are true

26.The best fund for an investor whose objectives are short term, capital preservation, and good liquidity
with little possibility of capital gains is:
a) Money market fund
b) Bond fund
c) Balanced fund
d) None of the above. The investor should buy a GIC.
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导师：AMY ZENG | UTSG 校区 23



BANKING

Overview of Banking Business

Ø Banks are very important because they are the key financial institutions. Banks are involved in most
aspects of the Canadian financial system and their stability is critical.

Ø Banks enter in many large contracts with each other, so the health of one affects the health of the others
(“systemic risk”)
• All the big five banks are “domestic systemically important banks” (D-SIBs)
• RBC is a “global systemically important bank” (G-SIBs)

Banking Business Activities - Banks involves in all financial activities in the economics include:

Ø Commercial banking: taking in deposits and making loans, e.g. consumer loans and mortgages. Banks
make money from the spread between interest rate on deposits and loans (“Net Interest Margin”)
• Mortgage, Consumers loans, Credit cards

Ø Investment banking
• Making markets: sales & trading; brokerage / investment advisors
• Advisory services: mergers and acquisitions, corporate financing & wealth management

Ø Insurance: Restriction applied on products provided through distribution channels

Ø Trust business: Bank’s trust business refers to the traditional custodial work which is managing
documents and OPM (other people’s money). Banks will act as a trustee and administers financial assets
on behalf of their clients until it gets paid out to the beneficiary.

Ø Funds management: Bank also acts as a fund company and sells mutual funds.

A Bank’s Balance Sheet
Assets Liabilities
Cash 4.6% Deposits
Securities Demand 13.14%
Governments 6.66% Notice 11.44%
Other 15.74% Fixed Term 39.55%
Loans Insurance-related liabilities 0.41%
Mortgage 18.58% Non-deposits liabilities
Non-Mortgage Loans 35.62% BAs/Repos 5.61%
Insurance related assets 0.07% Derivatives 12.47%
Land/Building 0.50% Borrowed securities 3.42%
Other assets 18.24% Other liabilities 8.08%
Subordinated debt 1.36%
Shareholder Equity
Preferred shares 0.45%
Common shares 1.53%
Retained earnings 2.54%
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导师：AMY ZENG | UTSG 校区 24



Key Observations:
Ø Assets: Biggest assets are mortgages and loans
Ø Liabilities:
• Banks’ liabilities are mainly deposits:
§ Short-term and liquid, compared to their assets which are loans
§ Maturity mismatch can cause problems
• Types of deposits: demand & term:
§ Demand deposits are Chequing accounts. Depositors can withdraw any or all of the fund
at any time without penalty or prior notice required
§ Notice deposit are Savings account on which the account holder is required to give a
notice of withdrawal a specified number of days before making the withdrawal to avoid
penalties.
§ Term deposit like Guaranteed Investment Certificates (GICs) have a fixed maturity
§ Deposits are federally guaranteed (CDIC) up to CDN$100,000; US deposits guaranteed
up to US$250,000
• Non-deposit liabilities:
§ Interbank borrowing
§ Repos (repurchase agreement): borrow cash using a financial security as collateral.
Promise to repay the cash at a specified date and receive collateral back. (called
“purchase & resale agreement (PRA)” when conducted with Bank of Canada)
Ø Equity or Capital
• Banks need capital to absorb potential losses (default loans) on the asset side of the balance sheet
• Protect depositors
• Common shares, preferred shares, subordinated debt, conditional convertibles (bail in bonds)
Ø Basic rules: banks must have 8% capital to support their risk-weighted assets
• Not all the assets are equally risky (e.g. T-bills)
• No reserve requirement in Canada (i.e. % of deposits)
• Banks are subject to a liquidity requirement 100% of past 30 days’ cash outflows
Ø Fact: Heavily regulated by the Office for Superintendent of Financial Institutions (OSFI)

Basic Banking Operations
Money Multiplier & Fractional Reserve System

Suppose $100 cash was deposited into the bank and the bank decides to keep reserves at 10%
Assets Liabilities
Desired reserves (cash) $100 Deposits $1,000
Loans $900
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导师：AMY ZENG | UTSG 校区 25



Ø This is called a fractional reserve system
o () = &N;C;.O;C (%) = &&#% = 10
o = × = $100 × 10 = $1,000

Risk in Banking

Ø Three risks for chartered banks that provide maturity transformation
(accept short-term deposits & invest in long-term loans)

1) Liquidity risk: Depositors want to withdraw their money but the bank has no more cash or liquid assets.
Use the above example: bank only has $100 reserve, if someone withdrawal $100, bank uses up all its
reserve, bank will want to call in loans to rebuild its reserves of cash, but loans are usually fixed in longer
maturity. In other words, they are not liquid. If someone else wants their cash, bank won’t have it,
resulting in a Bank run.

Assets Liabilities
Desired reserves $0
Loans $900 Deposits $900
o The more banks in the system, the greater the risk of bank runs as no one bank captures the
deposit made by loans: the US has close to 5,000 banks; Canada has 35+ banks.
o Banks have always been heavily regulated to prevent bank runs damaging the ability of banks to
make loans.
o Canadian Deposit Insurance Corporation (CDIC) insures all C$ deposits at Canadian banks up to
$100,000 to minimize the risk of bank runs

2) Default risk: A loan is not repaid so bank will have to write it off. Depositors realize that they cannot all
get repaid so they will run to the bank to get their cash out before others, resulting in a Bank run.

Assets Liabilities
Desired reserves $100 Deposits $1,000
Loans $800 Loss -$100
o Bank needs equity or other risk capital to bear the cost of default, so that depositors will not
suffer and will not run.
o Deposit insurance protects investors, but leads to excess risk taking – moral hazard (savings &
loan crisis)

3) Interest rate risk: refers to the risk resulting from the fluctuation of the interest rates
Assume interest rate increased; a bank made long-term loans (5-10 years) at fixed interest rate, but rates
paid on short-term bank deposits have to increase to remain competitive à Spread shrinks and could even
go negative, resulting in losses


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导师：AMY ZENG | UTSG 校区 26



Practice
1. Which of the following statements is true?
a) For consumers, mortgages are assets and deposits are also assets
b) For banks, mortgages are assets and deposits are liabilities
c) For banks, deposits are assets and business loans are also assets
d) For consumers, mortgages are assets and credit card debt is a liability e) none of the above are true

33. Chartered banks are regulated by:
a) CMHC
b) OSFI
c) LVTS
d) CDIC

34. Deposit insurance is provided in Canada by:
a) Canada Deposit Insurance Corporation
b) Insurance Bureau of Canada
c) Investment Industry Regulatory Organization of Canada
d) Superintendent of Financial Institutions

42. All of the following are types of investment funds available for purchase by individual investors
EXCEPT:
a) Mutual funds
b) Closed-end funds
c) Pension funds
d) Exchange-traded funds







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导师：AMY ZENG | UTSG 校区 27



MARKET EFFICIENCY

Overview of An Efficient Market

Description of Theory
Ø Price fully reflects all available information; therefore,
it is impossible to beat the market consistently on risk-
adjusted basis.
Ø The only way to obtain higher return is either by
chance or buying risker assets. If two assets have the
same risk, the return should be identical.
Ø In short: Trust Market Price!

Assumptions of Efficient Market
Ø Market prices are always the fair price since price reacts to new information quickly.
Ø All public information (even if not universally known) is impounded into securities prices very quickly.
Formally:
• Pt = PV of expected future cash flow
• Pt = PV of expected (cash flows | available information)
Ø We expect markets to be efficient because the market is comprised of many buyers and sellers who put
money on the believes. Mispriced securities are quickly corrected since underpriced securities attract
buyers and overpriced securities attract sellers.
Ø What is available information?

Three Forms of Market Efficiency
1. Weak form: All information is past price are incorporated in current prices. Investment strategies based
on historical price will not generate excess return in the long run.
§ < = PV of E (cash flows | information in past prices)
2. Semi-strong form: All public information is incorporated into current
prices. Fundamental analysis based on financial statements will not
generate excess return.
§ < = PV of E (cash flows | publicly available information)
3. Strong form: All public and private information are incorporated into
current price. No one should be able to outperform the market in the long
run.
§ < = PV of E (cash flows | all possibly available information)

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Implications of Market Efficiency

Ø Random walk of stock prices – prices unpredictable

Ø Cyclical variations in company’s sales are predictable, hence should already be captured in the stock
price, abnormal returns are not possible if the fact is well known to the public

Ø Expected return on assets with different risk level can be different. Investors require higher risk premium
for higher risk. This is consistent with EMH.

Ø EMH only says abnormal return should be zero in the long run. While it is entirely alright for any
investors to earn a market return, and even abnormal return just by chance.

Ø Empirical studies show that mutual funds on average do not exceed the return of the market index,
so it is very hard to outperform the market. Performance over the past 1,3,5,10 years is not predictive
of the future performance.

Ø Factors for a more efficient market
• Active market
• High volume
• High liquidity
• Easily accessible information
• Transparent information
• Many analysts
• Developed markets

Puzzle / Anomalies (EMH vs. Real World)
Market Anomalies

1. Post-earnings announcement drift (earning surprise)
After positive earnings, firms outperform for a number of months
- Common size suggests that prices should be rise when earnings are reported to be higher than
expected and prices should be fall when the reserve occurs.
- EHM implies that prices will be adjusted immediately to the announcement, however, empirical
evidence finds that firms with positive surprises earnings outperforming the firms with negative
surprise earnings for a number of months.
- Why does prices adjust slowly? Behavioral finance suggests that investors exhibit conservatism
because they are slow to adjust to the information contained in the announcements.
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2. Small-firm effect (size effect or January effect): Small firms outperform large firms
- Empirical evidence shows that returns of small capitalization outperformed stocks of large
capitalizations.
- While much of the differential performance is merely compensation for the extra risk of small
stocks according to EMH, researchers have identified that not all of it can be explained by risk
difference.
- In addition, empirical evidence shows that most of the difference in performance occurs in the
month of January. Why does this happen?

o Tax losses selling theory suggests that small cap stocks usually fracture more than large
cap stocks, investors sell losing small cap stock to realized capital losses to offset the
capital gains before year end. Investors will buy the stocks back in the new year; hence
stock prices go up in January

- Another observation for January Effect is that seasonal increase in stock prices, explanations
could be that
o Investors use year-end cash bonuses to purchase investments in the following month
o Investor psychology: some investors believe that January is the best month to begin an
investment program or perhaps are following through on a New Year's resolution to
begin investing for the future.

3. Value vs Growth (Investor over-reaction): Value stocks outperform growth stocks
- Value stocks: low P/E ratio and P/B (price to book) ratios, relatively stable growth and cheaper
- Growth stock: higher P/E and higher P/B ratio, higher growth rate and more expensive.
- Empirical evidence shows that value stocks outperform growth stocks. However, according to
EHM that value stocks are not risker than growth stocks, so they shouldn't have higher return.
- Why does this happen? Explanations could be that Investor tends to over-react to good news for
growth stocks and bad news for value stocks, this causes growth stocks to be over-priced and
value stock under-priced. Overtime, under-priced value stocks will have higher return due to cost
efficiency.

4. Momentum (investor under-reaction): Past winners tend to outperform
- Empirical evidence shows that winning stocks will keep going rising, losing stocks will keep
falling.
- According to the EMH, such increase / decrease is warranted only by changes in demand and
supply or new information. This shouldn't happen as an increase / decrease, in and of itself,
should not warrant further increase / decrease.
- Why does this anomaly happen? Behavioral finance suggests that investors are irrational, in that
they under-react to new information, it might take longer time for the investors to react to the
same news and make investment decisions.

5. Crashed and Bubbles
- Bubbles occurs when asset prices rise far above their true economic value and then fall rapidly.
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- The EMH cannot explain the economic bubbles because, strictly speaking, according to EMH,
asset prices reflect true economic value since information is shared among market participants
and rapidly incorporate into the stock price, therefore, economic bubbles don't really exist.
- Why is there still bubble in the economy? Behavioral finance suggests that market and investors
could act inefficiently and as a result, misinterpret a bubble as a bull market due to several
reasons:
o Market information: all investors review information differently and could, therefore,
apply different stock valuations.
o Human emotions: stock prices can be affected by human error and emotional decision
making.
o Human bias: confirmation bias can occur when investors only accept and research
information that supports their view of the investment.

Final Thoughts

Data Mining

Ø If you look at enough historical data, you will find statistical relations that are completely spurious.
(Distinguish from data mining in computer science). How to distinguish spurious correlations from the
real thing?
• Out of sample testing
• Be careful of survivorship bias
• Theory

Behavioral Finance

Ø Psychology has identified certain biases (irrationalities) that people have.
• Overconfidence
• Disposition effect – investors are less willing to recognize losses than they are to recognize gains
• Loss aversion – the loss of $1 is considered more harmful than the gain of $1 is considered
beneficial
• Availability bias – extra weight on recent news
Ø The major question is how these individual effects play out in a market with many buyers and sellers.

Moral

Ø Without giving a final verdict on the Efficient Markets Hypothesis (EMH), we should shill take the
following lessons:
o Have respect for market prices
o Be skeptical of easy predictions (including technical analysis)
o Use past market prices to interpret information





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导师：AMY ZENG | UTSG 校区 31



KEY PV CALCULATION FROM MIDTERM

Present Value: ( = )*"(+,-)"

Present value with compounding n time per year: ( = )*".+,#"/"$

Present Value with continuous compounding: ( = 0%-1

Present Value of Ordinary Annuity: ( = *+% %(%'#)"- +

Present Value of Annuity Due: ( = + *+% %(%'#)")%- +

Perpetuities: ( = 234-

Growing Perpetuities: ( = 234%-%5 = 234*(+,5)-%5

Effective Annual Rate: = 01 + 670 20 − 1

Effective rate for “any” period: = 01 + 670 2"+ − 1 ( is the payment frequency)

Net Present Value: = 8)%+,- + 8),(+,-), +⋯+ 8)"(+,-)" − ( = ∑ 8$(+,-)$ − (

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