B8306: Capital Markets & Investments Class 2

Professor John Handley

MARKETS II:
Capital Markets Magic

Class Outline

 Short Selling
 Expected Returns
 The Pricing of Risk
 Leverage
 Arbitrage

Reference

 BKM: 3.9, 5.3 – 5.8, 6.1, 12.1

OBJECTIVES FOR TODAY

 What is short selling and why would you do it ?

 How do you calculate the expected return on an asset ?

 How do you calculate the risk of the return on an asset ?

 What does it mean to say an investor is risk averse ?

 What is leverage and why would you use it ?

 Is leverage a good thing or a bad thing ?

 What is arbitrage and why is it important in financial markets ?

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1. SHORT SELLING

You normally need to buy an asset before you can sell it

… but not in financial markets 😊😊

What is Short Selling ?

Short selling an asset means you sell an asset before you buy it and involves the
following steps …
• borrow the asset from someone else (the lender) so that you can deliver it to
the party to whom you have sold it.
• buy the asset back later (perhaps from some other party) to repay the one you
borrowed from the lender
• pay the lender a fee for borrowing the asset (and likely post collateral with
the lender over the period of the short sale)

• if any income is paid on the asset during the period of the short sale then you
must pay an equivalent cash amount to the lender
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Why Would You Want to Short Sell An Asset ?

If you ignore transactions costs, borrowing fees and collateral requirements, then the
cash flows from short selling an asset are the just the opposite of the cash flows
from buying the asset …
Cash flows
Now Dividend Date Later
time 0 time t time T
Long Stock −𝑆𝑆0 +𝑑𝑑𝑡𝑡 +𝑆𝑆𝑇𝑇

Short Stock +𝑆𝑆0 −𝑑𝑑𝑡𝑡 −𝑆𝑆𝑇𝑇

This means short selling allows you to flip your exposure to the movements in the
price of an asset

 long stock → you gain when the price rises and lose when the price falls

 short stock → you gain when the price falls and lose when the price rises

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Extension Note: Naked short selling refers to putting through the sell order before borrowing the stock from the lender
(and sometimes involves the seller failing to deliver the stock to the buyer on the settlement date). Covered short selling
refers to borrowing the stock before you sell it. Both types are short selling are legal but the Securities and Exchange
Commission (SEC) prohibits abusive short selling practices which are designed to manipulate the price of the underlying
stock.

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2. EXPECTED RETURNS

Much of finance is concerned with the future such as the performance of a stock
over the next year or the future direction of interest rates or exchange rates

Uncertainty in finance is modelled by random variables

… which means we need to know the set of possible values that the variable may
take on in the future and the corresponding probabilities for each value in the
set – which is collectively referred to as the probability distribution of the
random variable

An important application is modelling the future returns on an asset

Extension Note: Strictly this is the definition of a discrete random variable. A continuous random variable can take on
any value from a range of possible values. Random variables are also called stochastic variables. In comparison, a
deterministic variable is one whose future value can be predicted today – such as the speed of a falling object or the
motion of the planets.

Extension Note: Rather than trying to identify all the different possible values of a random variable and assigning a
probability to each, we instead often assume a probability distribution for the random variable. A common (but not
exclusive) assumption in finance is that the random variable has a normal distribution – in which case we say the random
variable is a normal random variable or is normally distributed.

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2.1 Measuring the Expected Return on a Single Asset

Consider an investment in a single asset

Let 𝑟𝑟 be a random variable whose value measures the return on the asset over some
future period

… and assume the set of possible returns is {𝑅𝑅1 , 𝑅𝑅2 , . . , 𝑅𝑅𝑛𝑛 } with corresponding
probabilities {𝑝𝑝1 , 𝑝𝑝2 , . . , 𝑝𝑝𝑛𝑛 }

The expected return on the asset (over the period) is a probability weighted
average of the possible returns …

𝐸𝐸 (𝑟𝑟) = 𝑝𝑝1 𝑅𝑅1 + 𝑝𝑝2 𝑅𝑅2 + ⋯ + 𝑝𝑝𝑛𝑛 𝑅𝑅𝑛𝑛

… multiplying each possible return by its probability gives more weight to those
returns which are more likely to occur and less weight to those returns which
are less likely to occur

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Example
Assume you are considering investing in a stock and estimate the probability
distribution of the return on the stock over the next year to be:
Return (%) Probability (%)
9 10
10 20
11 40
12 20
13 10

What is the expected return on the stock next year ?

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2.2 Measuring the Risk of the Return on a Single Asset

The risk of the return on the asset (over the period) is measured by the variance
of the return …
2 2 2
𝑉𝑉𝑉𝑉𝑉𝑉(𝑟𝑟) = 𝑝𝑝1 �𝑅𝑅1 − 𝐸𝐸 (𝑟𝑟)� + 𝑝𝑝2 �𝑅𝑅2 − 𝐸𝐸 (𝑟𝑟)� + ⋯ + 𝑝𝑝𝑛𝑛 �𝑅𝑅𝑛𝑛 − 𝐸𝐸 (𝑟𝑟)�

We also use the symbol 𝜎𝜎𝑟𝑟2 to represent 𝑉𝑉𝑉𝑉𝑉𝑉(𝑟𝑟)

Alternatively, the risk of the return on the asset (over the period) is measured by
the standard deviation of the return …

𝜎𝜎𝑟𝑟 = �𝜎𝜎𝑟𝑟2

… an advantage of using standard deviation is that the standard deviation can

be interpreted as a % whereas variance is interpreted as a squared %

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Why Do We Measure Risk by Variance or Standard Deviation ?

The return that ends up occurring in the future period will be one of the possible
returns but will not necessarily be the expected return which means …

• one measure of the risk of the return is the extent to which the set of possible
returns differ from the expected return

• and this is exactly what the variance does since it represents a weighted average
of the squared deviations of the possible returns from the expected return

𝑅𝑅2 − 𝐸𝐸 (𝑟𝑟) 𝑅𝑅1 − 𝐸𝐸 (𝑟𝑟)

possible
returns
𝑅𝑅2 𝑅𝑅3 𝑅𝑅1
𝐸𝐸 (𝑟𝑟)

… in other words, the greater the dispersion of possible returns (around the
expected return) the greater the risk of the return
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Extension Note: Variance and standard deviation are not the only measures of risk. One popular alternative seeks to
measure an investor’s worst exposure to loss at the end of the future period under normal market conditions (“Value-
at-Risk”). Another view is that risk should be measured not only at the end of the future period but throughout the period
as well – particularly if margin calls are possible. Another important area of research concerns the modeling of extreme
or rare events. If a distribution is symmetric then there is a balance of positive and negative deviations from the expected
return, but not so if the distribution is skewed. The kurtosis of a distribution measures the relative likelihood of extreme
returns occurring.

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Risk Cuts Both Ways

Variance (and standard deviation) measure the dispersion of possible returns around
the expected return but …

 a return lower than expected (a negative deviation) is a bad outcome for the
investor

 a return higher than expected (a positive deviation) is a good outcome for the
investor

Key Takeaway

There is good (or upside) risk … and there is bad (or downside) risk

Extension Note: Variance does not distinguish between positive and negative deviations and so it is a sensible measure
of risk only if the probability distribution of returns is symmetric (or at least, is not highly skewed). If the distribution
is positively skewed then the positive deviations are usually bigger than the negative deviations. This excess of good
risk over bad risk means that variance will overestimate the risk of the return.

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3. THE PRICING OF RISK

A risk averse investor will invest in a higher risk asset only if it offers a higher
expected return … but what exactly is risk aversion and how do you measure it ?

What is Risk Aversion ?

Risk aversion is a natural characteristic which extends beyond investment decisions

In general, you are risk averse if all else equal you prefer less risk to more risk
… but it does not mean that you will not take on risk – and if you do then you
will want something extra in return
Would you sky dive ?

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Your level of risk aversion changes over time …

Would you swim here ?

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In financial markets this is often referred to as risk-on and risk-off

Are All Investors Risk Averse ?

Investors can be classified according to three types …

• risk averse
• risk neutral
• risk lover (or risk seeker)

Precise definitions of each investor type are based on the rather abstract (but none-
the-less important) concept of an investor’s utility-of-wealth

… you can think of utility-of-wealth as being the amount of "satisfaction" or "well-

being" that an investor gets out of each dollar of wealth

… a simpler approach would be to assume that the utility of one dollar is just one
dollar, but this is not general enough to take account of different circumstances
faced by different investors and changes in circumstances over time

In any event, it is rarely feasible to directly measure an investor's utility-of-wealth

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So How Else Do You Know If An Investor Is Risk Averse ?

The first way is …

• a risk averse investor would not participate in a fair game

• a fair game is one which has a zero expected profit (equivalently, the expected
winnings of the game is equal to the cost of playing the game)

Consider the following game …

 it costs you $1 to play. You then toss a fair coin and if it turns up heads – you
win $2 but if it turns up tails – you win nothing

State Probability Winnings Profit

Heads 0.5 $2 + $1
Tails 0.5 $0 – $1

Expected value $1 $0

Would you play ?

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Now consider another game …

 it costs you $100,000 to play. You then toss a fair coin and if it turns up heads
– you win $200,000 but if it turns up tails – you win nothing

State Probability Winnings Profit

Heads 0.5 $200,000 + $100,000
Tails 0.5 $0 – $100,000

Expected value $100,000 $0

Would you play ?

The second way is …

• a risk averse investor places more weight on unfavorable outcomes or

downside risk compared to favorable outcomes or upside risk of an equivalent
amount

The third way is …

• a risk averse investor likes higher expected returns but dislikes higher risk
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We often assume that an investor’s utility-of-wealth is a function of expected return
and risk – and we can represent this graphically by a set of indifference curves

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Indifference curves show how an individual investor chooses between different
combinations of risk and return and are like contour lines on a map …

• each point on an indifference curve represents a combination of risk and return

• all points on the same indifference curve have the same level of utility

• all points on a higher indifference curve have a higher level of utility

Example

Investor X is considering investing in the following three assets:

Asset Expected Return Risk

A 15% 18%
B 15% 26%
C 20% 32%

Which would she prefer ?

(compare A to B … then A to C … then B to C)

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Each investor has his/her own set of indifference curves – and the more risk
averse the investor the steeper the slope of his/her indifference curves

1
Extension note: An example of an investor’s utility function is: 𝑢𝑢 = 𝐸𝐸 (𝑟𝑟) − 𝐴𝐴𝜎𝜎𝑟𝑟2 where 𝐴𝐴 measures the investor’s level
2
of risk aversion.
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What Is The Pricing Of Risk ?

Indifference curves describe how individual investors choose between different

combinations of risk and expected return

… but who or what determines the link or trade-off between risk and expected
returns in the first place ?

… it’s the financial markets of course 😊😊

We will soon see (in a later class) that financial markets aggregate the risk-return
tradeoffs of all investors to determine the market price of risk

… and this in turn quantifies how much higher an expected return should be to
(fairly) compensate a risk averse investor to take on a higher risk

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4. LEVERAGE

Financial markets enable you to not only buy an asset with someone else’s money
but also to supercharge your returns 😊😊

What is Leverage ?

Leverage (or more precisely financial leverage) means you buy an asset using some
of your own money (that is, your own capital or equity) and using some borrowed
money (that is, debt)

Leverage is used not only to buy new assets but also to refinance existing assets

Why Would You Want To Use Leverage ?

Assume you buy an asset today using only your own money

If the return on the asset (over some future period) ends up being 𝑅𝑅𝑎𝑎 then the return
on equity is the same as the return on the asset …

𝑅𝑅 𝑒𝑒 = 𝑅𝑅𝑎𝑎
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If instead you use $𝐸𝐸 of equity and $𝐷𝐷 of debt to buy the asset, then it can be shown
that the return on equity will also depend on the interest rate paid on the debt 𝑖𝑖 and
on the amount of leverage used …
𝑒𝑒
𝐷𝐷 𝑎𝑎
𝑎𝑎
𝑅𝑅 = 𝑅𝑅 + (𝑅𝑅 − 𝑖𝑖 )
𝐸𝐸

This means that using leverage will …

 magnify the return on equity

… if the asset does well (𝑅𝑅 𝑎𝑎 > 𝑖𝑖 ) then you do even better but if the asset does
badly (𝑅𝑅 𝑎𝑎 < 𝑖𝑖 ) then you do even worse

… that is, small changes in asset returns cause big changes in equity returns

 increases the risk of the return on equity

 the more leverage you use the bigger the impact

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Extension Note: Buying on Margin (margin loans) is a popular source of leverage for investors. In this case, the investor
purchases a stock using funds borrowed from its broker who in turn holds the stock as collateral for the loan.

Example

Assume you buy an asset today for $1,000 using your own funds.

Calculate the return on the asset and the return on equity assuming the asset ends up
being worth between $900 and $1150 at the end of the year and no income is paid
on the asset during the year …

Value of asset 900 950 1000 1050 1100 1150

Value of equity 900 950 1000 1050 1100 1150

𝑅𝑅𝑎𝑎 – 0.10 – 0.05 0.00 0.05 0.10 0.15

𝑅𝑅𝑒𝑒 – 0.10 – 0.05 0.00 0.05 0.10 0.15

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Now recalculate the returns assuming you buy the asset using 50% equity ($500) and
50% debt ($500) at an interest rate of 5% per annum …

Value of asset 900 950 1000 1050 1100 1150

less: debt 525 525 525 525 525 525

Value of equity 375 425 475 525 575 625

𝑅𝑅𝑎𝑎 – 0.10 – 0.05 0.00 0.05 0.10 0.15

𝑅𝑅𝑒𝑒 (50% debt) – 0.25 – 0.15 – 0.05 0.05 0.15 0.25

And if you use 75% debt …

𝑅𝑅𝑒𝑒 (75% debt) – 0.55 – 0.35 – 0.15 0.05 0.25 0.45

Key Takeaway …

Your returns are supercharged … but so is your risk

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5. ARBITRAGE

If you buy a risky asset then you might make money or you might lose money but
this is not always the case in financial markets 😊😊

What is an Arbitrage ?

An arbitrage is a trading strategy which costs nothing today but has the
expectation of a cash inflow later with no chance of a cash outflow later

Compare the pattern of cash flows on the following trading strategies:

Trading Strategy Cash Now Cash Later

Long Asset − +
Short Asset + −
Arbitrage strategy I 0 +
Arbitrage strategy II 0 + in some states of the world and zero in all other states
Arbitrage strategy III + 0
Arbitrage strategy IV + +
The Key Idea … there is no negative cash flow and
at least some chance of a positive cash flow
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The trading strategy usually involves short selling something at a relatively high
price and simultaneously buying something else at a relatively low price

This is a variation of which well-known trading strategy ?

The Law of One Price (LOOP)

Assume there are two assets …

• Asset X has a current price of 𝑋𝑋0 and will generate a risky cash flow of 𝑋𝑋1 at
the end of the period
• Asset Y has a current price of 𝑌𝑌0 and will generate a risky cash flow of 𝑌𝑌1 at
the end of the period

LOOP says …
if 𝑋𝑋1 = 𝑌𝑌1 then 𝑋𝑋0 = 𝑌𝑌0 otherwise there is an arbitrage

The Key Idea …

if two assets have identical cash flows in the future
then they must have the same value today
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To illustrate, assume you know (for some reason) that 𝑋𝑋1 = 𝑌𝑌1

What would you do if you observe 𝑋𝑋0 > 𝑌𝑌0 ?

The following arbitrage is available …

𝑌𝑌0 is relatively too low so buy Y now

𝑋𝑋0 is relatively too high so short sell X now

Action Cash Now Cash Later

𝑡𝑡 = 0 𝑡𝑡 = 1
Buy 1 unit of Y −𝑌𝑌0 +𝑌𝑌1
Sell 1 unit of X +𝑋𝑋0 −𝑋𝑋1
Net cash flow 𝑋𝑋0 − 𝑌𝑌0 𝑌𝑌1 − 𝑋𝑋1
+ 𝟎𝟎

What would you do next ?

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In seeking to exploit an arbitrage opportunity, the buying and selling actions of
investors drives the prices together until the arbitrage disappears.

LOOP is a statement about the relative prices of two or more assets …

• in the above case, the action of traders would create selling pressure on X
(which would drive down its price) and create buying pressure on Y (which
would drive up its price)

… until the prices of the two assets equate and no further arbitrage is possible.

• it says the prices will equate but says nothing about the price at which this
will occur.

• it similarly applies to assets with cash flows at multiple times in the future, in
which case we would say …

if two assets have an identical series of cash flows in the future

then they must have the same value today

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Why Is Arbitrage Important ?

Arbitrage is a “fundamental force” in financial markets …

• arbitrage opportunities should be rare in well-functioning financial markets

with rational investors who prefer more wealth to less

• but when an arbitrage does arise, it tends to disappear very quickly as the
buying and selling actions of traders cause the relevant asset prices to adjust

• asset values given by many standard financial models used in practice

(especially those dealing with options, futures, interest rates and foreign
exchange rates) are more accurately described as the no-arbitrage value of the
asset

As Ross colourfully explains:

“With its emphasis on the absence of arbitrage, neoclassical finance takes a step back from
the requirement that the markets be in full equilibrium … The study of the implications of
no-arbitrage is the meat and potatoes of modern finance”. 1
1
Ross, Stephen A., 2004, Neoclassical Finance, p.2.
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Extension Note: What is the Relationship between LOOP and No-Arbitrage ? LOOP is an important special case of no-
arbitrage (equivalently no-arbitrage is a more general concept than LOOP) because arbitrage is not restricted to
circumstances where the two assets have identical payoffs but also applies when the payoff on one asset dominates the
payoff on another asset

Extension Note: What is the Relationship between No-Arbitrage and Equilibrium ? No-arbitrage is a necessary
condition for an equilibrium in a financial market i.e. if an arbitrage exists then by definition, the market is not in
equilibrium since there will be an excess demand for at least one asset and an excess supply of at least one other asset

What Is Valuation By Replication ?

Valuation by replication uses arbitrage arguments to determine the value of one

asset (or portfolio of assets) relative to the value of another asset (or portfolio of
assets)

You can use it if you can replicate (or copy or match) the future cash flows on one
asset (or portfolio of assets) using the future cash flows on another asset (or
portfolio of assets)

Let’s illustrate the valuation by replication approach using bonds.

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Consider the following three bonds …

• Bond A pays $1,000 in one year’s time

• Bond B pays $1,000 in two year’s time
• Bond C pays $100 in one year’s time and $1,000 in two year’s time.

Assume the current price of bond A is $990.10 and the current price of bond B is
$961.17.

What is the price of bond C assuming no-arbitrage ?

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Consider the cash flows on the following two portfolios …

• buy one bond A and buy ten bond B

• buy ten bond C

Cash flows
𝑡𝑡 = 0 𝑡𝑡 = 1 𝑡𝑡 = 2

Buy 1 bond A – 990.10 1,000.00 0.00

Buy 10 bond B – 9,611.70 0.00 10,000.00
net cash flow – 10,601.80 1,000.00 10,000.00

Buy 10 bond C – 10P 1,000.00 10,000.00

net cash flow – 10P 1,000.00 10,000.00

LOOP → current prices must be the same otherwise there is an arbitrage

→ 10𝑃𝑃 = 10,601.80
→ 𝑃𝑃 = 1,060.18
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