Student guide Facoltą di Economia A.A. 2007/08

Financial Modelling
Aim of the course
This course concerns the application of scientific tools to the investment activity. It deals with some of those scientific tools (models and procedures) that support financial decisions in the fields of
• the appraisal and comparison of real investment projects;
• the appraisal, comparison and design of financial contracts;
• the management of financial risks and returns.
There are two aims - to develop the students’ ability to represent reality by using models and to familiarise them with financial modelling, the latter being a premise to financial engineering; needless to say, financial modelling is based in some circumstances on notions that can be expressed only in mathematical terms. As for the investment activity, the course leads students to improve their understanding of its workings as well as of some of its procedures, which are often computer-based. As a consequence, students will learn what to analyse and how to approach a financial problem, whether it concerns a real investment or a financial investment in stocks and bonds.
All the relevant aspects of a problem are taken into account through a problem-oriented and hence multidisciplinary approach, in which
• reference may be made to the theoretical notions of other related subjects, such as accounting and statistics;
• attention may be paid to the empirical evidence on financial markets and their workings;
• use may be made of an electronic spreadsheet to carry out the various financial procedures (students will design their own spreadsheets during some computer sessions and as a home assignment).
To strengthen the link with professional practice
• when presenting each financial problem some connections are made, whenever possible, to the main features of the setting where it arises; for instance, when presenting stocks and bonds a brief examination is put forward of the financial markets which they are traded on;
• emphasis is placed on models and procedures which are referred to in the professional practice.
The material covered in each unit progresses from the simplest concept to the more advanced one. First the fundamentals of financial calculus are presented as well as their simplest applications. The acquired notions are then used to examine such applicative problems as the appraisal of companies, the selection of real investment projects, the valuation of bonds, the management of interest rate risk, the measurement of a term structure of interest rates, the management of a stock portfolio. To cover the last subject, use is made of basic notions of statistics.
To take this course, students must be familiar with mathematics (basics of calculus and optimisation), statistics (sample statistics and their distributions, hypothesis testing, linear regression) and accounting (reclassified financial statements, main accounting ratios). Knowledge of the financial system (markets and intermediaries as institutions and their functions, financial contracts and their use) is helpful.
1. Review of financial calculus.
Compound interest. Equivalent rates of compound interest. Continuous compound interest. Consistent accumulation factors. Annuities and perpetuities with payments in arrear. Repayment of a loan in instalments.
2. Investment appraisal.
Gordon’s model for the valuation of a company. Investment plans. Net present value, internal rate of return and benefit-cost ratio criteria: definition and properties. Viability of a single investment project. Mutually exclusive investment projects. Investment ranking in capital budgeting. Financial projections of a business plan on an electronic spreadsheet.
3. Fixed income securities
Money and capital markets. Pure discount and fixed rate coupon bonds: definition and valuation. Yield to maturity. Price and credit risk. Yield-price relation. Duration and variability of a bond price. Duration of a bond portfolio. Immunisation of a bond portfolio against interest rate risk.
4 Term structure of interest rates
Yield curves. Term structure of interest rates: definition and measurement. Spot and forward rates of interest. Floating rate coupon bonds: definition and valuation.
5. Basics of stock management.
Stock return. Portfolio return. Random variables and their statistical moments. Portfolio selection: mean-variance framework, statistical properties of stock returns, representation of feasible portfolios and derivation of efficient portfolios, risk diversification, inclusion of a risk-free asset, one-fund theorem, two-fund theorem. Selected empirical evidence on the workings of stock markets. Overview of portfolio management in practice: passive and active management (market timing, asset selection). Fundamentals of value investing.
After completing an individual as well as a group home assignment during the course, attenders will take a closed-book written exam at the end of the course. The exam for the remaining students is oral. Whether the final exam is written or oral, a pocket calculator is needed. Non-attenders may contact their lecturer for advice on how to go about this subject.
Reading list
Damodaran, A., Investment philosophies, Hoboken NJ, Wiley, 2003.
Farrell, J.L., Portfolio management: theory and applications, New York, Irwin / McGraw-Hill, 1997.
Luenberger, D.G., Investment Science, New York, Oxford University Press, 1998.
Additional references may be made available in class. Handouts are available at the International Office.