Student guide Faculty of Economics A.Y. 2008/09

Financial Modelling
Lesson timetable, Notice board, Additional material
Lecturers
Luca Ghezzi
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, either guaranteed capital or return;
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;
▲ the supervision and control of financial risks.
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, quantitative models, and both statistical and empirical estimation procedures 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 principles and practical notions of other related subjects, such as accounting, industrial 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 measurement of a term structure of interest rates, the selection of real investment projects, the appraisal of companies, the management of a bond portfolio, and 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.
Syllabus
0. Review of financial mathematics.
Simple and compound interest. Pure discount bonds. Equivalent rates of compound interest. Money and capital markets. Term structure of interest rates: spot and forward rates, measurement (government bond market, money market). Term structure explanations. Annuities and perpetuities with payments in arrear. Repayment of a loan in instalments.
1. 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. Product / industry life cycles; growth and value companies. Company evaluation formulae; implicit mean rates of return.
2. Basics of bond management.
Fixed rate bonds: clean and dirty price, yield to maturity, yield-price relation, price and reinvestment risk, credit risk: default and recovery rates, credit rating by international agencies, actual yields on corporate bonds. Yield curves. Floating rate bonds: definition and valuation. Overview of bond management in practice.
3. Basics of stock management.
Stock return. Portfolio return. Portfolio selection: mean-variance framework, statistical properties of stock returns (short-term heteroskedasticity and long-term mean reversion), 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: the investment process, passive and active management (market timing, asset selection). Fundamentals of value investing.
Examinations
After completing individual as well as group class assignments 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.