SUBJECT INDEX

A

Absolute risk aversion, 229

Active return, 280

Adjusted present value, 621–623

Adverse selection, 134, 193

Agency effects, 514

Agency theory, 180, 473–474

Agent sentiment, 192

Alignment, 121, 135–142

asset specificity, 140–141

cost-effectiveness, 139–140

deal attributes and, 138

deal terms, 141–142

governance capabilities and, 138

principles, 136–137

process, 137–139

Allocation decisions, by individuals, 4

Allocative efficiency, 157

Alternative trading systems (ATS), 482n4

Ambiguity aversion, 191

American options, 414, 442–443

Anchoring, 190

Arbitrage, 347–349, 479–497, See also Impediments to arbitrage

pricing derivatives by, 385–410

Arbitrage-free prices, 366

Arbitrage, pricing derivatives by, 414–448, See also Nonlinear payoff derivative

Arbitrage opportunities, 367–369

absence of, 368–369

efficient market hypothesis, 368

financial market efficiency, 368–369

forms of, 367n3

fundamental security analysis, 368

profit-seeking eliminating, 367–369

strong-form efficient market, 368

technical analysis, 368

Arbitrage Pricing Theory (APT), 236, 309, 317–337

arbitrage opportunity, 319

in multifactor model, 320–322

in one-factor model, 319–320

Arbitrage without risk-neutral pricing, 393–397

Arbitrary payoffs, 443–445

Arrow-Debreu price, 347

Arrow-Debreu security, 200

Arrow possibility theorem, 462–464

Arrow-Pratt risk aversion, 184, 184n16, 226–230, 272n2

Asset-backed securities, 136, 570

Asset liquidity, 132

Asset pricing, 7–8, 339–364

arbitrage, 347–349

Arrow-Debreu price, 347

complete market, 343–344

discount factor models, 354–359, See also individual entry

equity risk premium puzzle, 359–361

fundamental theorem of, 350–354, See also individual entry

law of one price, 344–347

linear pricing, 344–347

market completeness, 340–344

market completeness proposition, 344

one-period finite state economy, 339–340

portfolios, 340–344

positive state pricing, 347–349

principles of, 339–364

redundant assets, 342–343

state price, 345–347

state price vector, 347

Asset securitization, 159–160, 159n14

Asset specificity, 140–141

Asymmetric information, 4

Asymmetric payoff derivative, 388

Asymptotic principal components analysis (PCA), 330

At-the-money, 415

Aumann-Serrano axioms, 236n8, 238, 238–240

Availability biases, 190

Average yield to maturity, 65

B

Backward bending supply, 488–492

Bankruptcy process, 506–507

costs, 506–507

direct costs, 506

indirect costs, 506

Banks, 163

Bansal-Yaron model, 360–361

Barclay Group Inc. factor model, 324, 326

Behavioral asset pricing theory, 191

Behavioral theory, 189–192

anchoring, 190

belief perseverance, 190

beliefs, 189–190

conservativeness, 190

descriptive approach to individual preference and choice, 189–192

limits to arbitrage theories, 189

optimism and wishful thinking, 190

overconfidence, 190

preferences

ambiguity aversion, 191

prospect theory, 191

Shefrin's approach, 191–192

representativeness, 190

subjective expected utility, 190

Belief perseverance, 190

Beliefs, 189–190

Beta risk, estimating, 301–302

Bilateral monopoly, 473

Binomial model, 437–442

Black-Scholes formula and, 439–441

dividends, accommodating, 441–442

multiple periods, 437–439

two-period binomial model, 438

Bird in the hand theory, 515

Bisection method, 434

Black-Scholes formula, 424–437

derivation of, 444–445

dividends, accounting for, 430–431

formula, 427–430

historical volatility, estimating, 433

implied volatility, estimating, 433–435

lognormal stock price, 425–427

assumptions in, 426

price sensitivity measuring to inputs, 435–437

Bond prices, 377–379

Bond valuation, 376–379

Book-to-market equity ratios (B/M), 307

Boot-Thakor analysis, 568, 571

Borrowing terms, client reactions to, 486–488

‘Bottom up’ approach, 121n1

Break-even analysis, 513

Broker markets, 156

Budget constraint, 257

Burmeister-Ibbotson-Roll-Ross (BIRR) model, 324

Business and financial risk, 91–93

Business risk, 103

C

Call option, 414

Call value at expiration, 416

Callable bond, 208

Campbell-Cochrane model, 360

Capital asset pricing model (CAPM), 161, 236, 287–315, 317–319

in absence of risk-free asset, 296–297

assumptions, 288–289

homogeneous expectations assumption, 288

beta risk, estimating, 301–302

capital market, deriving, 289–293

capital market line, 289

capital market line (CML), 291

deriving, 293–296

implications of, 297–299

company specific risk, 298

company-unique risk, 298

decomposition of total risk, 297–298

idiosyncratic risk, 298

investment management, 302–303

pricing portfolios by, 298–299

Rubinstein's proof of, 314–315

tests of, 303–311

behavioral explanation, 311

CAPM empirical tests, critiques of, 308–309

cross-sectional approach, 304–306

empirical results reported in literature, 307–311

Fama-MacBeth test, 307

Gibbons, Ross, and Shanken (GRS) test, 304

methodology, 303–306

multifactor explanation, 309–311

standard ordinary least square (OLS) regression approach, 303

time-series approach, 303–304

univariate method, 303

zero-beta CAPM, 297

Capital budgeting, 6, 102, 104

Capital budgeting in a risky world, 582–586

capital expenditures with constant returns to investment, 586–587

with diminishing marginal returns to investment, 588–590

optimal capital expenditure plans, obtaining, 586–590

Capital expenditures, 105, 579–605, 624–629, See also Market value criterion

capital budgeting, 582–586, See also Capital budgeting in a risky world

contingency planning of, 624–629

depreciation tax shield, 593–594

economic conditions, 580

interest rates, 580

international conditions, 580

market conditions, 580

required rates of return, 590–593

firm, division, and project, 590–593

in a risky world, 579–605

single-period versus multi-period investment models, 594–602

taxes, 580

Capital gains, 51, 62–63

Capital goods, market for, 594–595

Capital investment, 6, 102

Capital loss, 681

Capital market imperfections, 26–27, 451–477

choosing criteria for financial decisions, 462–472

Arrow possibility theorem, 462–464

firm's utility function, 464–466

firm's utility function, implications of using, 465–466

preferences, 472

random variables, 472

single-peakedness condition, 464–465

using dominance criteria, 467–472

using utilities when possible, 466–467

effects of, 458–461

conglomerates, role for, 461

criterion function, absence of, 458–459

financing decisions, 459–460

firm's market value, 459–460

firm's utility function, restricted applicability of, 460

mutual funds, role for, 460–461

theory of share price determination, absence of, 459

heterogeneous expectations, 451–455

integrated approach need to financial decision making, 461–462

motivating managers to meet owners’ objectives, 473–474

agency theory, 473–474

tax differentials, 456–457

transactions costs, 456–457

types of, 451–458

unequally distributed information, 455–456

unsystematic risk, costs of, 457–458

Capital market line (CML), 291

Capital market, 7–8

Capital projects, 6

Capital rationing, IRR criterion and, 113

Capital structure, 5, 80–83, 501–520

bankruptcy costs, 506–507

bankruptcy, 506–507

corporate taxation effect on leverage, 502–504

decisions, 78

dynamic models, 516–517

and financial distress, 504–511

agency effects, 514

heterogeneous expectations, 511–514

probability of technical insolvency, 508–511

importance, 501–520

interest deductibility and, 84–85

limited liability role, 505–506

optimal capital structure, 516

in a perfect capital market, 87–97, See also Irrelevance theory

target capital structure, 516

and taxes, 83–85

theory of dividend payments, 514–516

Capital, 6

Cash-and-carry trade, 394

Cash flow risk, 103

Cash yield, 395

Central limit theorem, 712

Certainty-equivalent approach, 165n25, 227, 609–610

Certainty equivalent return, 273, 273n3

Chance-constrained approaches to controlling risk, 220

Cheapest-to-deliver issue, 408

Clearing and settling payments, 123

Coefficient of variation, 615

Coherent risk measures, 250–251

axioms for, 249–250

Collateral as screening device, 557–558

Commodity derivatives, 385

Company specific risk, 298

Company-unique risk, 298

Complementary projects, 106

Complete contracts, 558–560

costly verification, 558–559

incentives to report honestly, 559–560

Complete market, 205, 343–344

Complete versus incomplete contract, 135

Concave function, 184

Conditional form of discount factor model, 356

Conglomerates role for, 461

Conservativeness, 190

Consistent risk measures, 244–247

Constant dividend growth, 59–60

Constant investment policy, 279

Consumer choice theory, 1–2

Consumer financial decisions, 15–30, See also Consumption-investment problem

consumption-investment theory, practical importance of, 27–28

household investment decisions, 27–28

essential features of, 16

initial wealth as the only constraint of, 25–27, See also under Initial wealth

Consumption-based asset pricing model, 355

Consumption-investment problem, 15–25

describing individuals’ preferences, 17–18

indifference curves, 17–18

utility function, 17

financing consumption expenditures, opportunities for, 18–20

individual's wealth constraint, 20

wealth at time t, 19

mathematical example, 23–25

numerical example, 22–23

practical importance of, 27–28

household investment decisions, 27–28

reconciling preferences with opportunities, 20–22

individual's constrained utility-maximizing choice, 21

Contingency planning

of capital expenditures, 624–629

and capital structure choices, 539–540

Contingent claims, 199–215

financial instruments as packages of, 208–209

incomplete markets for, 205–206

investor's utility maximization in, 202–205

Modigliani-Miller theorem, 206–208

states of the world, 199–200

unit claim on state, 200

unit contingent claim, 200

value of, 200–202

Contingent claims, financial instruments as, 208–209

Contingent projects, 106

Contingent strategies, 209–212

formulating, 209

Continuous dividends, 430

Continuously compounded return, 425

Converted price, 407

Convertible securities, 208

Corporate taxation effect on leverage, 502–504

Cost complementarities, 142

Cost-effectiveness, 139–140

Cost of capital, 85–87, 103

corporation's, 86

unaffected by leverage, 93

Credit market equilibria, 486–493

Credit risk transfer (CRT) mechanisms, 160

Credit tranching, 571

Criterion choice, 221–222

Criterion function, absence of, 458–459

Cross-sectional approach, 304–306

Cumulative prospect theory, 191

Current assets, 7

Curvature factor, 332

D

Deal attributes, 131–132

Deal terms, 545–575

costs of deals, 546–547, See also individual entry

monitoring costs, 546–547

screening costs, 546–547

transactions costs, 546

Dealer versus broker markets, 156

Debt financing, governance value of, 83

Debt ratio, 80

Debt versus equity, 79–80, 373–376, 551–553

valuing debt and equity, 374

Debt-to-assets ratio, 80

Decision criteria, 219–222

criterion choice, 221–222

dispersion-based criteria, 219

target-based, 220–221

wealth-based criteria, 219

Default risk, 133

Delegated monitoring, 167–169

Deliverable basket, 407

Deliverable issues, 408

Delivery date, 388

Delivery options, 408

Depreciation tax shield, 593–594

Derivative instrument, 385

Descriptive approaches, 180–192, 180n4

Descriptive theory, 179, 189–192

Direct costs of bankruptcy, 506

Discount factor models, 351–359

APT application in, 356–357

CAPM application in, 356–357

conditional form of, 356

consumption-based asset pricing model, 355

Hansen-Jagannathan bound, 358–359

marginal rate of substitution, 356

stochastic discount factors, 354–356

unconditional form of, 356

Discrete dividends, 430

Discrete return, 425

Dispersion-based criteria, 219

Diversification/Diversifying, 223–225, 259–262

effect of, 259–262

imperfect correlation, 262

perfect negative correlation, 261–262

perfect positive correlation, 260–261

limits, 264–265

Dividend policy, 6, 531–533

Dividend reinvestment plan (DRP), 532

Dividends, 51, 51n2, 62–63, 78

accounting for, 430–431

continuous dividends, 430

discrete dividends, 430

dividend valuation models, 51–54, 56–58

Dominance orderings, 182

Dow Jones MicroSector Indexes, 405

Duality axiom, 238, 239

Dutch auction, 533

Dynamic complementarity, 128n9

Dynamic factor models, 334

Dynamic models, capital structure, 516–517

E

Early exercise premiums, 442

Earning by firms, valuation model based on, 54–58

Earnings, 50

earnings per share (EPS), 81

Economic life, investment projects classification and, 104–105

Economic theory of agency, 44, 473

Efficiency, market, 157–158

Efficient frontier, 236, 267

Efficient market hypothesis, 125, 157, 368

Efficient portfolios, 267

Elliptical distributions, 237

Embedded derivatives, 208

Entrepreneurial firms, 31–38

entrepreneurs

borrowing required capital, 38

with no initial resources, 37–38

opportunities, 32–37

entrepreneurs, with no initial resources, 37–38

investment decisions by managers on behalf of owners, 39–41

production and consumption decisions, 35–36

production and investment decisions, 31–38

productive and capital market opportunities, 35

productive opportunities, 33

wine aging example, 41–43

Epstein-Zin recursive utility function, 360

Equity, 54n5, 78

Equity risk premium puzzle, 359–361

Equity structure, 91

Equivalent portfolio, See Replicating portfolio

Estimation errors, 278, 281–283

European call, 418

European option, 414

Ex ante adjustment/information, 164, 546–549, 567

Ex ante screening, 128–130, 145

Ex Post adjustment/information, 128–131, 135, 137, 162, 546–548, 566–567

Ex post asymmetry, 164

Exercise price, 414

Expansion projects, 105

Expectation maximization (EM) algorithm, 333

Expected inflation, 377–379

Expected utility theory, 180, 226–230

External finance, 127

Externalities, financial system, 493–494

Extra-market sources of risk, 309

F

Factor models, 322–328

estimation, 328–335

application to bond returns, 331–332

computational procedure, 328–331

curvature factor, 332

dynamic factor models, 334

expectation maximization (EM) algorithm, 333

fixed N (Case 1), 329

large N (Case 2), 330

maximum likelihood (ML) method, 333

principal components analysis (PCA), 328

static factor models, 334

fundamental factor models, 325

known factors, 323–326

latent factors, 326–327

macroeconomic factor model, 325

business cycle, 325

inflationary expectations, 325

interest rates, 325

investor confidence, 325

short-term inflation, 325

normal factor model, 327

predictive factor models, 328

standardized, 327

strict factor model, 327

Factor risk premium, 318

Factors, 317

Fama-French three-factor model, 324–325

Fama-MacBeth approach, 304–305, 307

FE asset trust (FEAT), 570

Financial contracting, 545–575, See also Complete contracts; Incomplete contracts

informational conditions, 548–553, See also individual entry

moral hazard, 554–558

multiple debt claims, issuance of, 568

securitization, 568–572

2007–2009 Financial crisis, 9

Financial deals, 121, 131–135

types of, 131–135

asset liquidity, 132

complete versus incomplete contract, 135

deal attributes, 131–132

informational differences, 134–135

risk versus uncertainty, 132–134

Financial decision criteria, 451–477

Financial decisions

capital structure theory, 5

dividend policy, 6

by firm managers, 5–7

by individuals, 4–5

Modigliani-Miller theory, 6

Sharpe's model, 7

Financial derivatives, 385

Financial distress, 80

capital structure and, 504–507

costs of, 505

Financial economic theory, 4–8

individuals, managers, and markets, 4–8

Financial system functions, 121–126, See also Governance, financial system; Organization, financial system

clearing and settling payments, 123

information production, 125

managing incentives, 125–126

managing risks, 124–125

pooling resources, 123–124

transferring resources, 124

Financing decisions in practice, 522–543

agency costs, 530–531

contingency planning and, 539–540

creditors, investors, and capital structure choices, 527–528

dividend policy, 531–533

dividend reinvestment plan (DRP), 532

funding sources, estimating the costs of, 522–524

issuance of debt, timing, 524–527

preemptive rights offering, 535–539

dilution effect of rights issue, 537

repurchasing firm's common stock, 533–535

restrictive covenants, 530–531

stock dividends, 532–533

stock splits, 532–533

target versus actual capital structures, 526–527

technical insolvency, significance of, 529–530

upward-sloping supply curves, effects of, 526

Financing decisions, 44–46

Firm financing decisions, 78–101

in a perfect capital market, 78–101

capital structure, 80–83

cost of capital, 85–87

debt ratio, 80

debt vs. equity, 79–80

debt-to-assets ratio, 80

financial leverage, 80–83

governance value of debt financing, 83

implication for lenders, 79

implication for owners, 79

interest tax shield, 85

operating earnings, 79

Firm investment decisions, 102–117

investment projects, classification of, 104–106

owners’ wealth maximization and, 103–104

Firm managers, financial decisions by, 5–7

financing firms, 5

productive assets, selection, 5

Firms valuation, 50–76

by investors, 50–76, See also Investors way of firms valuation

Firms, types of, 156–157

large, 156

small, 156

First-degree stochastic dominance (FSD), 245, 468

First-order conditions (FOCs), 265

Fisher separation theorem, 37

Flexibility, financial, 83

‘Flight to quality’, 218

Flotation costs, 524

Forward contracts, 388–397

description, 388–389

determination, 391–393

marked-to-market (MTM), 389

nonmarked-to-market, 389

valuing, 389–391

Forward price, 388

Foster-Hart riskiness measure, 234n1, 238, 244

Foundations of Statistics, 3, 190

Free cash flow, 83

Frequency distribution, 616

Frictions, 289

Frontier portfolios, 267

Functions, 121

Fundamental factor models, 325

Fundamental Law of Active Portfolio Management, 300

Fundamental security analysis, 368

Fundamental theorem of asset pricing, 350–354

discount factor, 351–353

pricing using risk-neutral probabilities, 353–354

stochastic discount factor, 352

Funding costs, securitization and, 571–572

Futures pricing/contracts, 398–409

margin requirements, 398–399

initial margin, 398

investor's equity, 398

maintenance margin, 399

and non-marked-to-market forward prices, relation between, 399–401

stock index futures, pricing of, 405–406

treasury bond and note futures contracts, 406–409

G

Gaussian distribution, 225n17

Geometric mean rate of interest, 65

Gibbons, Ross, and Shanken (GRS) test, 304, 306–307

Global mean-variance portfolio, 267

Gordon growth model, 60

Gorton-Kahn model, 562

Governance value of debt financing, 83

Governance, financial system, 121, 126–142

intermediary-oriented systems, 127–128

market-based systems, 127–128

mechanisms, 128–131

intermediaries, 129–130

internal organizations, 128, 130–131

markets, 128–129

types of, 126–128

Governance, incomplete contracts, 565–566

Growing firm

meaning, 58–59

valuing, 67–69

Growth stocks, 58–63

description, 58–63

returns from, 58–63

H

Hansen-Jagannathan bound, 358–359

Hard commodities, 385

Heavy-tailed distributions, 226

Hedge ratio, 435

Hedging, 222–223

Hedging portfolio, 420, 422–423

Heterogeneous expectations, 451–455, 511–514

Hierarchical governance, 130–131

Higher moments, measures recognizing, 237

Historical volatility, 432–433

Holding period yields, 65

Homemade diversification argument, 683

Homemade leverage, 91

Homogeneous expectations assumption, 288

Household finance, 4

decisions, by individuals, 4

Household investment decisions, 27–28

I

Idiosyncratic risk, 298

Illiquid asset portfolios, funding, 159–160

Impediments to arbitrage, 479–497

adverse selection, 488–492

backward bending supply, 488–493

client reactions to borrowing terms, 486–488

credit market equilibria, 486–493

financial system externalities, 493–494

informational asymmetries, 486–493

limits to arbitrage, 482–483

liquidity, 479–482

differences in practice, 481–482

market failure, 493

market segmentation, 483–486

moral hazard, 492–493

securities markets, 479–482

Stiglitz-Weiss adverse selection model, 491–492

Imperfect correlation, 262

Implied repo rate, 408

Implied volatility, 433–435

Incentives to repay, 555–557

Incentives, managing, 125–126

Incomplete contracts, 135, 560–567

bondholder threat to liquidate, 560–562

bypassing uncertainty, 567

governance, 565–566

renegotiating a bank loan, 562–565

research findings, 567

uncertainty, 565–566

Incomplete markets for contingent claims, 205–206

Independent and identically distributed (IID), 279

Independent projects, 106–107

Index funds, 460

Index of absolute risk aversion, 228

Index tracking, 280–281

active return, 280

risk budget, 280

tracking error, 280

Indifference curves, 17–18

Indirect costs of bankruptcy, 506

Individual's wealth constraint, 20

Individuals, financial decisions by, 4–5

allocation decisions, 4

household finance, 4

household finance decision, 4

portfolio selection theory, 5

Information asymmetry, 193

Information economics, market failure, 3

asymmetric information, 4

Information production, 125, 158–159

Information sharing, intermediary governance, 164–167

Informational asymmetries, 486–493, 549–550

Informational conditions, 548–553

asymmetries and financing choice, 551–553

incomplete contract, 549

information and contract types, 548–549

third-party information, 550–551

Informational differences, 134–135

Initial wealth

as constraint on consumer decisions, 25–27

capital market imperfections effects, 26–27

income and initial wealth combined, 25–26

Insurance companies, 162

Insurance premium, 387

Insuring, 223

Integrated approach need to financial decision making, 461–462

Interest deductibility and capital structure, 84–85

Interest rate swap, mechanics of, 409

Interest tax shield, 85

Intermediary finance, 129–130

Intermediary governance, 160–169

information sharing, 164–167

adverse selection, 164–166

cooperative lending association, 167

delegated monitoring, 167–169

high-quality firms, 166

informational asymmetries, 164–166

low-quality firm, 166

signalling, 166

intermediary information processing, 169

maturity intermediation, 162

successful financial intermediaries, 162–164

banks, 163

insurance companies, 162

venture capital firms, 163

in value creation, question of, 160–162

Intermediary-oriented financial systems, 127–128

Internal governance, 169–173

investments and investment returns, 169

private benefits, 170

Internal rate of return (IRR), 111–114

and capital rationing, 113

multiple internal rates of return, 113–114

and mutually exclusive projects, 112

Internal governance, 128

Intertemporal capital asset pricing model (ICAPM), 309

In-the-money, 415

Intrinsic value, 416

Investment and financing decisions, consequences for, 43–47

Investment cash flows, 107

Investment decisions by managers on behalf of owners, 39–41

corporations and market value criterion, 39–40

maximizing market value thereby maximizing profits, 40–41

Investment management, CAPM application in, 302–303

Investment profile, 110–111

Investment projects, classification of, 104–106

according to dependence on other projects, 106

complementary projects, 106

contingent projects, 106

independent projects, 106

mutually exclusive projects, 106

according to economic life, 104–105

long-term investment, 105

short-term investment, 105

according to risk, 105–106

expansion projects, 105

mandated projects, 105

new products and markets, 105

replacement projects, 105

assessment criteria with a perfect capital market, 108–114

internal rate of return (IRR), 111–114

investment profile, 110–111

net present value (NPV), 108–111

investment criteria in practice, 114–115

market value rule application to independent projects, 107

project's incremental cash flows, 106–107

Investor's utility maximization in contingent claims, 202–205

Investors way of firms valuation, 50–76

based on firm's capacity to generate investor returns, 51–58

dividends size, 51–54

firm's earnings, 54–56

based on growth stocks, 58–63

capital gains, 62–63

constant dividend growth, 59–60

dividends, 62–63

low P/E stocks, underpricing, question of, 62

price-earnings ratios, 60–61

market values and different planning horizons, 64–74, See also individual entry

valuing the growing firm, 67–69

Invoice price, 407

Irrelevance theory, 87–97

business and financial risk, 91–93

consequences of Modigliani-Miller theorem, 90–91

me-first rules, 88–90

Issuance of debt, timing, 524–527

J

Jensen's free cash flow theory, 83

K

K-factor model, 309, 326

Knightian uncertainty, 2

Known factors, 323–326

L

Large firms, 156

Latent factors, 326–327

Law of one price (LOP), 344–347

Level effect, 332

Leverage, 80–83

corporate taxation effect on, 502–504

cost of capital unaffected by, 93

financial leverage and financial flexibility, 83

Limited liability, 505–506

Linear payoff derivatives, 385–410

derivative instruments, 386–387

nonlinear versus, 386–388

swaps, 409–410

Linear pricing, 344–347

Linear utility function, 185

Liquidity, 159, 479–482

illiquid asset portfolios, funding, 159–160

Local risk aversion, 227

Logarithmic utility function, 185

Lognormal stock price, 425–427

assumptions in, 426

Long position, 258

Long-term investment, 105, 279–280

Lotteries, 182, 182n13

M

Macroeconomic factor model, 325

Managers’ decisions, and owners’ decisions, separation of, 46–47

Mandated projects, 105

Many risky assets, 262–268

diversification and its limits, 264–265

efficient frontier, 267

optimal portfolios, derivation of, 265–267

two-fund theorem, 268

Marginal concept, 85

Marginal rate of substitution, 356

Marginal tax rate, 85

Marked-to-market (MTM) forward contracts, 389

Market-based financial systems, 127–128

Market completeness proposition, 344

Market completeness, 340–344

Market efficiency, 157–158

allocative efficiency, 157

efficient market hypothesis, 157

operational efficiency, 157

Market failure, 3–4, 153, 493

information economics, 3

market power, 3

Market finance, 128–129

Market governance, 151–160

dealer versus broker markets, 156

descriptive and economic characteristics, 154–156

financial markets, functions of, 152–154

central location creation, 152

firms, types of, 156–157

frequency of trading, 152

illiquid asset portfolios, funding, 159–160

information production, 158–159

liquidity, 159

market trade instruments, 153

non-market governance, 160–169, See also Intermediary governance

primary versus secondary markets, 155–156

public versus private markets, 154–155

volume of trading, 152

wholesale versus retail markets, 156

Market model, 302

Market opportunity line, 20

Market portfolio, 161, 290

Market price per unit of risk, 291

Market rate of interest, 27

Market risk, 376–379

premium, 295

Market segmentation, 483–486

consequences of, 485–486

Market value criterion, 580–586

capital budgeting, 582–586

Market value rule, 31

application to independent projects, 107

Market values and different planning horizons, 64–74

and time horizons, 65–66

financial instruments outstanding for several periods, returns on, 64–65

relations to profit maximization, 73–74

share price determination, 66–67

Markowitz efficient portfolios, 271–276

preferences, 271

quadratic utility function, 272–274

Markowitz risk premium, 227n21

Markowitzian portfolio theory, 236

Maturity intermediation, 162

Maximum likelihood (ML) method, 333

Mean absolute deviation, 235

Mean variance frontier, 267

Mean-variance portfolio choice, 257–285, See also Many risky assets; Two risky assets

advanced topics, 278–283

estimation errors, 281–283

index tracking, 280–281

long-term investment, 279–280

Markowitz portfolios, 271–276

portfolio weights, restrictions on, 276–278

practical issues, 276–278

estimation errors, 278

portfolio rebalancing, 278

restrictions on portfolio weights, 276–278

risk-free asset, adding, 268–270

Me-first rules, 88–90

Microeconomic foundation of financial economics, 179–198

assumptions underlying, 192–194

asymmetric information, 193

costly information, 193

costly transactions, 194

principal-agent relations, 193–194

descriptive approaches, 180–192

expected utility theory, 180, See also Utility theory

prescriptive approaches, 180–192

Microeconomic theory, 1–4

agents decisions, types, 1

consumer choice, 1–2

utility function, 1

economic decisions, 2–4

individuals, managers, and markets, 1–9

market failure, 3–4

objective probabilities, 3

price theory, 2

production theory, 2

for risk, 2–3

state-preference framework, 3

subjective probabilities, 3

for uncertainty, 2–3

Minimum portfolio risk, 267

Modigliani-Miller (MM) theorem, 6, 78, 87, 206–208, 551

consequences of, 90–91

Monitoring costs, 546–547

Monotonicity, 250

Moral hazard, 134, 193, 492–493, 554–558

avoiding, 554–555

collateral as a screening device, 557–558

incentives to repay, 555–557

MSCI Barra fundamental factor model, 324

Multifactor asset pricing theory, 309

Multifactor explanation, 309–311

Multifactor model, 320–322

with known factors, 324–326

Multi-period investment models, 594–602

Multi-period valuation in a risky world, 595–597

Multiple debt claims, issuance of, 568

Multiple internal rates of return, 113–114

Multiple periods, 437–439

Mutual funds, role for, 460–461

Mutually exclusive projects, 106

IRR criterion and, 112

N

Naperian logarithm, 242n25

Narrow-based index, 405

Negative exponential utility function, 185

Neoclassical paradigm, 160, 179, 192

Net financing cost, 397

Net operating loss, 85

Net present value (NPV), 108–111

Newton-Raphson algorithm, 434

No-mimicking condition, 166

Noncontingent NPV, 630

Noncontingent strategies, 211

Nonlinear payoff derivative, 385–388, 414–448, See also Black-Scholes formula

American options, 442–443

arbitrary payoffs and general models, 443–445

basic concepts, 414–417

derivative instruments, 387–388

linear versus, 386–388

options, 414–418

single-period binomial model, 420–424, See also Binomial model

Nonmarked-to-market (non-MTM) forward contracts, 389

Non-market governance, 160–169, See also Intermediary governance

Nonsatiable agent, 184

Normal distribution, 225

Normal factor model, 327

Notional amount, 409

Notional coupon, 406

Notional principal amount, 409

O

Objective probabilities, 3

One-factor model, 319–320

One-period finite state economy, 339–340

One-period-two-states model, 427

Operating decisions, 44–46

and financing decisions, separation, 44–46

Operating earnings, 79

Operating risk, 103

Operational efficiency, 157

Optimal capital structure, 78, 516

Optimal consumption choices, 21–22

Optimal portfolios

derivation of, 265–267

with risk-free asset, 269

Optimism and wishful thinking, 190

Option premium, 414

Option price, 414

Option's delta, 435

Option's gamma, 435

Option's rho, 436

Options, 414

simple uses of, 417–418

Ordinary least square (OLS) regression approach, 303

Organization, financial system, 142–144

financial firms, 143–144

intermediaries, 142–143

internal finance, 142–143

markets, 142–143

specializing, 143

Out-of-the-money, 415

Overconfidence, 190

Owners’ decisions, 46–47

Owners’ equity, 78

P

P/E stocks, underpricing, question of, 62

Parallel effect, 332

Partial ordering, 239

Pauline problem, 626

Perfect capital market, 7

capital structure in, 87–97, See also Irrelevance theory

extension of, 7–8

individuals decision, market failures of, 7–8

risk in financial decision making, 7

financing decisions of firms in, 78–101, See also under Firm financing decisions

Perfect negative correlation, 261–262

Perfect positive correlation, 260–261

Pooling resources, 123–124

Portfolio rebalancing, 278

Portfolio return, 257–259

Portfolio risk, 259

Portfolio selection theory, 5

Portfolio weights, restrictions on, 276–278

Portfolios, 340–344

Positive homogeneity axiom, 238–239, 250

Positive state pricing, 347–349

Power utility function, 185

Predictive factor models, 328

Preemptive rights offering, 535–539

Preferences, 271

individuals’, 17–18

reconciling preferences with opportunities, 20–22

Prescriptive approaches, 180–192, 180n4

Prescriptive financial economics, 179

Prescriptive theory, 179, 181–189

Present value, 22

Price-earnings ratios, 60–61

Price sensitivity measuring to inputs, 435–437

Pricing corporate securities, 366–381

arbitrage opportunities, 367–369

bond prices, 377–379

bond valuation, 376–379

debt versus equity, 373–376

expected inflation, 377–379

market risk, 376–379

pricing securities relative to each other, 369–370

risk-neutral probability measures, calculating, 370–372

risky debt, 374–376

Pricing derivatives by arbitrage, 385–410, 414–448 See also Linear payoff derivative, Nonlinear payoff derivative

Pricing of interest rate swaps, 410

Pricing portfolios by CAPM, 298–299

Primary security, 200

Primary versus secondary markets, 155–156

Primitive securities, 342

Principal-agent relations, 193–194

Principal component analysis (PCA), 328

Private markets, 154–155

Probability distribution function, 181, 225–226

Production theory, 2

Productive opportunities, investing in, wealth creation by, 31–49

Profit maximization, 73–74

Profit, 50

Profitability risk, 133

Project risk in capital budgeting, evaluating, 607–637, See also Stand-alone risk, measuring

certainty-equivalent approach, 609–610

contingency planning of capital expenditures, 624–629

project's market risk, measuring, 617–623, See also individual entry

risk-adjusted discount rate, 608–609

stochastic dominance, application of, 628–629

Projects, See also Investment projects

project's market risk, measuring, 610–623

adjusted present value, 621–623

financial leverage, 617–620

market risk, 617–620

pure-play firm, using, 620–621

project's operating cash flows (OCF), 107

Proprietary firms, 31

Prospect theory, 191

Public versus private markets, 154–155

Pure-play firm, using, 620–621

Put-call parity relationship, 418

Put option, 414

Put value at expiration, 416

Putable bond, 208

Q

Quadratic utility function, 185, 272–274

R

Random walk, 425

Rational behavior, 183

Rational expectations adjustment model, 600

Real options valuation (ROV), 630–634

challenges in implementing, 634

options on real assets, 630–632

Redundant assets, 264, 342–343

Reference rate, 409

Relative risk aversion, 229

Replacement projects, 105

Replicating portfolio, 420–422

Representativeness, 190

Required rate of return (RRR), 103

Resource pooling, 123–124

Retail markets, 156

Retained earnings, 78

Return on assets (ROA), 81

Reverse cash-and-carry trade, 395

ρ*(), Properties of, 240–244

Risk(s), 7–8, 216–233, See also Project risk in capital budgeting, evaluating; Two risky assets

Arrow-Pratt measures of risk aversion, 220n10

business and, 91–93

business risk, 103

cash flow risk, 103

decision criteria, 219–222, See also individual entry

default risk, 133

factors, 317

investment projects classification and, 105–106

management, 124–125, 216–233

measures, 234–253

Aumann-Serrano risk measure, 238–240

based on first two moments, 235–237

coherent risk measures, 247–251

consistent risk measures, 244–247

first-degree dominance, 244–245

Foster-Hart risk measure, 238

generalizations, 247, 251

limitations, 247, 251

monotonicity, 250

positive homogeneity, 250

recognizing higher moments, 237

ρ*(), properties of, 240–244

selecting, 234–253

stochastic orderings, 244–247

subadditivity, 250

translation invariance, 250

using, 234–237

value at risk, 247–251

variance, 236, 236n7

operating risk, 103

probability distributions, characteristics, 225–226

profitability risk, 133

risk-adjusted discount rate, 608–609

risk-adjusted rate of return, 582

risk averse, 184

risk budget, 280

risk-free asset, adding, 268–270

optimal portfolios with, 269

risk-free interest rate effect, 392

risk-neutral pricing

arbitrage without, 393–397

borrowing rates, 397

cash flows from underlying asset, 395–397

finding futures prices using, 401–404

lending rates, 397

risk-neutral probabilities, 370–372, 423

calculating, 370–372

pricing using, 353–354

risk-neutral probability measure, 354

for securities valuation, 372–373

valuation with, 376–377

risk-neutral valuation, 423–424

risk premium, 227, 367

risk sharing arrangement, 386

risk transfer methods, 222–225

diversifying, 223–225

hedging, 222–223

insuring, 223

Risk, Uncertainty and Profit,2

sales risk, 103

source of, 599–602

uncertainties and, 217–219

uncertainty versus, 2, 132–134

Risky debt, 374–376

Rothschild-Stiglitz dominance (RSD), 246–247

S

Sales risk, 103

Scale economies, 142, 194

Scope economies, 142

Screening costs, 546–547

Secondary markets, 155–156

Second-degree stochastic dominance (SSD), 245, 470–471

Securities

markets, 479–482

valuation, risk-neutral probabilities for, 372–373

Securitization, 10, 10n16, 136, 568–572

basics of, 569

and funding costs, 571–572

illustration of, 569–571

senior bond classes, 570

subordinate bond classes, 570

Security market line (SML), 295, 307

Semi-variance, 250n42

Senior bond classes, 570

Sensitivity analysis, 611–615

Separation principle, 31, 46

managers’ and owners’ decisions, 46–47

operating and financing decisions, 44–46

Servicing, 569

Settlement date, 388

Share price determination, 66–67

Sharpe ratio, 291

Shefrin's approach, 191–192

Short position, 258

Short selling, 258

Short-term investment, 105

Signalling, 166, 193

Simulation analysis, 615–617

Single-index market model, 302

Single-peakedness condition, 464–465

Single-period binomial model, 420–424

hedging portfolio, 422–423

replicating portfolio, 420–422

risk-neutral valuation, 423–424

Single-period versus multi-period investment models, 594–602

market for capital goods, 594–595

multi-period valuation in a risky world, 595–597

source of risk, 599–602

Skewness parameter, 226

Small firms, 156

Soft commodities, 385

Specializing, 143

Special-purpose entity (SPE), 570

Special-purpose vehicle (SPV), 570

St. Petersburg Paradox, 182

Stand-alone risk, measuring, 610–617

sensitivity analysis, 611–615

simulation analysis, 615–617

Standard Industrial Classification (SIC), 274

Standardized factor model, 327

Standby fee, 536

Standby underwriting arrangement, 536

State price, 345–347

state price condition, existence, 346

state price vector, 347

uniqueness of, 347

State-preference framework, 3

States of the world, 199–200

Static complementarity, 128n9

Static factor models, 334

Static NPV, 630

Steepness factor, 332

Stiglitz-Weiss adverse selection model, 491–492

Stochastic discount factors, 191–192, 352, 354–356

Stochastic dominance

types, 185–189

second-degree stochastic dominance, 188, 188n21

Stochastic orderings, 244–247

first-degree stochastic dominance (FSD), 244–245

Rothschild-Stiglitz dominance (RSD), 246–247

second-degree stochastic dominance (SSD), 245–246

Stochastically constant returns to scale, 587

Stock dividends, 532–533

Stock splits, 532–533

Straddle strategy, 418

Strategic NPV, 630

Strict factor model, 327

Strike price, 414

Strong-form efficient market, 368

Sub-additivity, 242, 250

Subjective expected utility, 190

Subjective probabilities, 3

Subordinate bond classes, 570

Subscription price, 535

Swaps, 409–410

interest rate swap interpretation of, 410

mechanics of, 409

pricing of, 410

Symmetric payoff derivative, 387

Systematic risk, 297

T

Takeover defense, 514

Tangency portfolio, 269

Target-based criteria, 220–221

Target capital structure, 516

versus actual capital structures, 526–527

Targeted block repurchase, 534

Tax differentials, 456–457

Technical analysis, 368

Technical insolvency, significance of, 529–530

Tender offer, 533

Theory of consumer choice, 15

Theory of dividend payments, 514–516

Theory of Games and Economic Behavior, The, 3, 181

Theory of screening, 193

Theory of share price determination, absence of, 459

Third-party information, 550–551

Three-factor Fama-French model, 310

Time horizons, market values and, 65–66

Time tranching, 570

Time-series approach, 303–307

Timing option, 408

‘Top-down’ approach, 121n1

Tracking error, 280

Tranches, 570

credit tranching, 571

time tranching, 570

Transactions costs, 194, 456–457, 546

Transferring resources, 124

Transformation curve, 32–34

Translation invariance, 250

Two-fund separation, 237

Two-fund theorem, 268

Two-period binomial model, 438

Two-period bond, 377

Two-point lotteries, 235

Two risky assets, 257–262

diversification effect, 259–262

portfolio return, 257–259

portfolio risk, 259

U

Uncertainties, 2, 218–219

incomplete contracts, 565–566

Knightian uncertainty, 2

new product development, 218

possible outcomes of a situation, 218

risk and, 217–219

Unconditional form of discount factor model, 356

Underlying asset, 385

Unequally distributed information, 455–456

Unit contingent claim, 200

Univariate method, 303, 306–307

Unsystematic risk, costs of, 457–458

Upward-sloping supply curves, effects of, 526

Utility function, 17

Utility theory, 181–189

prescriptive approach to preference and choice, 181–189

probability distribution, 181

St. Petersburg Paradox, 182

stochastic dominance, types, 185–189

utility functions, types, 184–185

linear, 185

logarithmic, 185

negative exponential, 185

power, 185

quadratic, 185

von Neumann—Morgenstern approach, 182

V

Value additivity principle, 107

Value at risk (VaR), 247–251

Valuing debt and equity, 374

Variance, 236, 236n7

variance-covariance model, 237

Venture capital firms, 163

von Neumann—Morgenstern approach, 182, 189

W

Wait value, 443

Wealth at time t, 19

Wealth creation by investing in productive opportunities, 31–49, See also Entrepreneurial firms

investment and financing decisions, consequences for, 43–47

managers’ and owners’ decisions, separation of, 46–47

operating and financing decisions, separation, 44–46

Wealth-based criteria, 219

Weighted average cost of capital (WACC), 87, 608

Wholesale versus retail markets, 156

Wildcard option, 408

Working capital, 7, 102

Z

Zero-beta CAPM, 297

Zero-coupon bonds, 376

Zero transactions costs, 595n11