Student guide Facoltą di Economia A.A. 2008/09

Financial Modelling
Aim of the course
This course concerns the application of scientific tools to investment and funding activities. It deals with some validated quantitative models and processes that support financial decisions in such fields as
▲ the appraisal and comparison of real investment projects;
▲ the comparison of banking and near banking transactions, such as a time deposit, a home mortgage loan, a leasing of vehicles, plant, and equipment;
▲ the design of financial contracts, such as a structured bond or a life insurance policy;
as well as
▲ the management of financial risks and returns, as in the case of a portfolio of bank loans, a pension fund, or a mutual fund.
As for the investment activity, the course provides a technical overview and lets students get accustomed to some of its procedures, which are usually computer-based. To strengthen the link with professional practice, emphasis is placed on data and quantitative models that are referred to in the workplace. 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, especially in stocks and bonds. This is essential for understanding in depth such operative issues as
▲ how to detect mispriced stocks, i.e. how to pick stocks effectively;
▲ how to obtain the greatest possible return from a financial portfolio with a given degree of risk.
All the relevant aspects of a financial 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, business economics, and applied 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.
The material covered in each unit progresses from the simplest concept to the more advanced one. First the fundamentals of financial mathematics are reviewed. The acquired notions are then used to examine such applicative problems as the selection of real investment projects, the appraisal of companies, the management of a bond portfolio, the measurement of a term structure of interest rates, the management of a stock portfolio.

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 mathematics.
Simple and compound interest. Pure discount bonds. Equivalent rates of compound interest. Annuities and perpetuities with payments in arrear. Repayment of a loan in instalments.
2. Appraisal of a real investment.
Real investment plans and equity cash flows. Net present value and internal rate of return: definition and properties. Viability of a single investment project. Mutually exclusive investment projects. Projections of pro forma financial statements on an electronic spreadsheet. Gordon’s formula for the evaluation of a company. Growth and value companies. Implicit mean rates of return.
3. Fixed income securities.
Money and capital markets. Fixed rate 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. Overview of bond management in practice.
4 Term structure of interest rates.
Yield curves. Term structure of interest rates: definition and measurement (Government bonds, money market); spot and forward rates of interest. Term structure explanations. Floating rate bonds: definition and valuation.
5. Basics of stock management.
Stock return. Portfolio return. 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
Farrell, J.L., Portfolio management: theory and applications, New York, Irwin / McGraw-Hill, 1997.
Keasey, K., Hudson, R., Littler, K., The intelligent guide to stock market investment, Chichester, Wiley, 1998.
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.