Student guide Facoltą di Economia A.A. 2011/12

Applied 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 security lending arrangement, a lease of vehicles, plant, and equipment;
▲ the design of financial contracts, such as a structured bond or a life insurance policy with 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, financial models, 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 or bonds, i.e. how to pick stocks and bonds 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 applied financial mathematics are reviewed. The acquired notions are then used to examine other applicative problems such as the measurement of a term structure of interest rates, the appraisal of real investment projects, the appraisal of companies, the management of a bond portfolio, the management of a stock portfolio.
Review of applied financial mathematics.
Simple and compound interest. Day count conventions. Money markets. Eonia and Euribor rates. Bilateral loans and bonds. Pure discount bonds. Capital markets. Equivalent rates of compound interest. Continuous compound interest. Term structure of interest rates: spot and forward rates, measurement (money market, Government bond market). Classical term structure explanations: financial insight and explanatory power. Annuities and perpetuities with payments in arrear. Repayment of a loan in instalments: collateral and personal guarantees, approval of a mortgage application, repayment schedule. Operating and financial leasing.
Appraisal of real investments.
Real investment plans, pro forma financial statements, and equity cash flows. Projections of pro forma financial statements on an electronic spreadsheet. Viability of a single investment project. Net present value, internal rate of return, and annual debt service cover ratio: properties and use. Product / industry life cycles; growth and value companies. Company evaluation formulae; implicit mean rates of return and critical line.
Basics of bond management.
Fixed rate bonds: clean and dirty price, yield to maturity, yield-price relation. Yield curves. Floating rate bonds: definition and valuation. Duration and variability of a bond price. Duration of a bond portfolio. Price and reinvestment risk. Immunisation of a bond portfolio against interest rate risk. Credit risk: default and recovery rates, credit rating by international agencies, actual yields on corporate bonds. Overview of bond management in practice.
Basics of stock management.
Portfolio selection: mean-variance framework, statistical properties of stock returns (heteroskedasticity and long-term mean reversion), analytical representation of feasible portfolios and derivation of efficient portfolios, inclusion of a risk-free asset, one-fund theorem, two-fund theorem. Risk diversification and selected historical data. Efficient stock markets hypothesis: theoretical principles, outline of the empirical evidence, and selected statistical tests. Overview of portfolio management in practice: the investment process (stages, tasks, and tools), passive and active management (market trend-timing and mispriced-asset selection, style switching and group rotation). Corporate competitive advantage and financial performance. Fundamentals of value investing.
▲ 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.
Individual active learning is needed on the basis of 1-2 hours per week, so as to keep up with all lesson and practical sessions (8 ECTS, 50 contact hours or so).
▲ After completing an individual homework as well as a communal one during the course, attenders willl 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.