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Chapter 4 --Value-driven Chapter 4 --Value-driven Management -- Arbitrage Management -- Arbitrage Explain how arbitrage works to ensure that the prices of financial claims are equal to the present value of the expected future cash flows. You have two investments of equal risk below: Investment A -- price $120 with a $10 return forever. Investment B -- price $80 with a $10 return forever. What should happen in the market? Answer -- equal financial claims of equal risk sell for equal prices in the market. 1

Chapter 4 --Value-driven Management -- Arbitrage u Explain how arbitrage works to ensure that the prices of financial claims are equal to the present value

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Page 1: Chapter 4 --Value-driven Management -- Arbitrage u Explain how arbitrage works to ensure that the prices of financial claims are equal to the present value

Chapter 4 --Value-driven Chapter 4 --Value-driven Management -- ArbitrageManagement -- Arbitrage

Explain how arbitrage works to ensure that the prices of financial claims are equal to the present value of the expected future cash flows.

You have two investments of equal risk below: Investment A -- price $120 with a $10 return forever. Investment B -- price $80 with a $10 return forever. What should happen in the market?

Answer -- equal financial claims of equal risk sell for equal prices in the market.

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Page 2: Chapter 4 --Value-driven Management -- Arbitrage u Explain how arbitrage works to ensure that the prices of financial claims are equal to the present value

ArbitrageArbitrage Explain how arbitrage works to ensure that the prices of

financial claims are equal to the present value of the expected future cash flows.

Two investments of equal risk below: Investment A -- price $100 with a $12 return forever. Investment B -- price $100 with a $8 return forever.

What should happen in the market? Answer -- financial claims of equal risk sell for equal rates

of return in the market.2

Page 3: Chapter 4 --Value-driven Management -- Arbitrage u Explain how arbitrage works to ensure that the prices of financial claims are equal to the present value

Price TerminologyPrice Terminology

What is the difference between bid prices, the highest bid price, asked prices, the lowest asked price and market price?

What role does the existence of different information sets play in determining the different prices above?

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Page 4: Chapter 4 --Value-driven Management -- Arbitrage u Explain how arbitrage works to ensure that the prices of financial claims are equal to the present value

Information SetsInformation Sets

Who probably has the better information set pertaining to the future cash flows of Microsoft? Bill Gates -- the Chairman of the Board and

Chief Executive of Microsoft A typical stockholder of Microsoft

When we refer to the intrinsic value of Microsoft, to whose intrinsic value are we referring?

What happens when the intrinsic value is different than the market price of the stock?

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Page 5: Chapter 4 --Value-driven Management -- Arbitrage u Explain how arbitrage works to ensure that the prices of financial claims are equal to the present value

Information Sets – Financing Decisions & Information Sets – Financing Decisions & Capital InvestmentCapital Investment

When the information set of management does not match the information set of the stockholders, two situations may exist that have an impact on the financing decision.

Managers may be more optimistic than the market about the future cash flows of the company: What influence does this have on the financing of new

investment opportunities? The market may be more optimistic than management

about the future cash flows of the company: What influence does this have on the financing of new

investment opportunities?5

Page 6: Chapter 4 --Value-driven Management -- Arbitrage u Explain how arbitrage works to ensure that the prices of financial claims are equal to the present value

BondsBonds

Bonds are one claim on the value of a firm Know how to find the present value of a

bond Know how to use the IRR function on the

calculator to find the market return or yield to maturity

Know how to use the IRR function on the calculator to find the yield to call

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Page 7: Chapter 4 --Value-driven Management -- Arbitrage u Explain how arbitrage works to ensure that the prices of financial claims are equal to the present value

Bond TerminologyBond Terminology

Bond yield terminology Yield to maturity Yield to call Current yield Coupon rate

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Page 8: Chapter 4 --Value-driven Management -- Arbitrage u Explain how arbitrage works to ensure that the prices of financial claims are equal to the present value

Preferred StockPreferred Stock

Preferred stock is another claim on the value of a firm

The value of preferred stock can be found using the perpetual no-growth model in chapter 3

Value today = Expected dividend / required rate of return for preferred shareholders

Market typically tells you the price and the dividend in know – work backwards to get the required return

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Page 9: Chapter 4 --Value-driven Management -- Arbitrage u Explain how arbitrage works to ensure that the prices of financial claims are equal to the present value

Common StockCommon Stock Common stock is another claim on the value of a

firm: A short-cut method to value common stock is to

use the constant dividend growth model Value today = Expected dividend /(required return

for common shareholders - growth) Weaknesses of the model:

constant growth companies that do not pay dividends

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Page 10: Chapter 4 --Value-driven Management -- Arbitrage u Explain how arbitrage works to ensure that the prices of financial claims are equal to the present value

Asset View: Variables That Drive Stock Asset View: Variables That Drive Stock ValueValue

Looking at value from the asset side instead of the financing side, the firm value is driven by:

Existing projects -- dividends or cash flows from existing projects

NPV of new investment opportunities expected to be taken in the future -- with perfect information

Competitive advantage --> Economic Profit --> taken to present leads to net present value --> which measures the increase in value of the stock (with perfect information)

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Page 11: Chapter 4 --Value-driven Management -- Arbitrage u Explain how arbitrage works to ensure that the prices of financial claims are equal to the present value

Other Events Other Events

Factors that do not influence value -- smoke and mirrors

Stock splits Stock dividends

Factors that influence value Earnings Investment announcements

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Page 12: Chapter 4 --Value-driven Management -- Arbitrage u Explain how arbitrage works to ensure that the prices of financial claims are equal to the present value

Value of CurrencyValue of Currency

Purchasing power parity (PPP) theory states that equilibrium exchange rates between two countries will result in identical goods selling at identical prices.

Ex. The price of Big Macs.

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Page 13: Chapter 4 --Value-driven Management -- Arbitrage u Explain how arbitrage works to ensure that the prices of financial claims are equal to the present value

Ert = Ert-1(1 + INFd)/(1 + INFf)

but the differences in Interest Rates and Perceived Safety between countries. Market forces are not enough. And, the difficulty of movement between two countries.

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Page 14: Chapter 4 --Value-driven Management -- Arbitrage u Explain how arbitrage works to ensure that the prices of financial claims are equal to the present value

Interest Rate Parity TheoryInterest Rate Parity Theory

Rf = (ERspot/ERforward)(1 + Rd) -1

See these examples in p.122

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Page 15: Chapter 4 --Value-driven Management -- Arbitrage u Explain how arbitrage works to ensure that the prices of financial claims are equal to the present value

The Questions Are… The Questions Are…

Combine thinking about purchasing power and interest rate.

And, advanced thinking, expecting and speculating, and expecting the expecting.

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