Duke University

Durham NC 27708-0120

The objective of this course is to provide a rigorous introduction to the fundamental principles of asset valuation and financing in competitive global financial markets. The course is designed to provide the student with the tools that are necessary to analyze the financial issues presented in the elective courses. The course is organized around the three main ideas in Finance:

- The time value of money
- Diversification and risk
- Arbitrage and hedging.

Students completing this course will be fully conversant with the **time
value of money** and will be able to value income streams of all forms.
The time value of money is a basic determinant in the valuation of assets
such as bonds, stocks, futures, and options. The classes on **diversification
and risk** provide a thorough grounding in the trade off between risk
and return given by modern portfolio theory. In discussing **arbitrage
and hedging**, we demonstrate how to hedge market risk, interest rate
risk, and foreign exchange risk. This involves using futures and options.
The uses and valuation of futures and options by arbitrage are considered
in some detail.

The learning experience takes a number of different forms. Each method of learning is meant to complement the other methods.

- WWW-based lecture notes
- Proprietary Java-based interactive learning experiences
- Proprietary Java-based animations
- Downloadable Powerpoint slides
- MPEG video clips and streaming vidio
- Textbooks
- Class bulletin board
- On-line lecture experience
- Lotus screen-cam off-line lecture experience
- On-line review sessions

The course materials are designed to be long-lasting.The goal is to
develop a learning experience which can be revisited through the years.
Students and *graduates* will have access to these experiences.

There are six learning modules (problem sets) that accompany the classes. All of the assignments will require computations. Knowledge of a spreadsheet package such as or EXCEL is very important. Problem sets are to be completed individually. All students must adhere to the Fuqua honor code

Note that Learning Module 1 runs the entire six weeks. In this assignment,
you must track a portfolio of stocks, futures and options. *It is critical
that you spend time early in the term to set up this assignment* so
that at the end of the term you need only to enter a few prices to your
spreadsheet and it prints the final assignnment submission.

The grade for the course will be based on performance on the assignments and two exams. The course grade is determined by the following formula:

Course Grade = A + Max[F, .4M + .6F] where A = Assignment Grade (Maximum 20) F = Final Exam Grade (Maximum 80) M = Midterm Grade (Maximum 80)

I realize that it is difficult to have a midterm after only five lectures.
This grading algorithm makes the midterm __optional__. However, to pass
BA350, students must score at least 50% on the exam portion of the assessment.
That is, the percentage score on the exam portion, Max[F, .4M + .6F], must
exceed 50% in order to pass the course.
The grading scheme for the GEMBA is slightly different. Due to the extended distance learning
module, there are two additional assignments, one of which involves group work. These
additional assignments replace the midterm exam.

The following is the procedure for extra help. First, most questions can be answered with the bulletin boards. I monitor the board every day. It ishighly likely that ``your question" is the same question that a number of students have. The bulletin boards make it possible to share your question and solution to a number of students to enhance everyone's learning experience.

Second, there is an extensive list of tutors for the course. Feel free to contact them if you do not get a satisfactory answer on the board (they also monitor the board). There will also be weekly problem sessions.

Third, send me an email. If you choose to send me email, I reserve the right to post your question and my response on the bulletin board. My user name is cam.harvey@duke.edu .

Chat groups. There will be a weekly chat group. Details will be posted on the bulletin board.

If you are on-site, the best time to talk to me is directly after class. If you need to schedule an office visit, call my secretary Carol Bass at 660-7775 to arrange an appointment.I will be arranging a time to meet with students and it will be posted here.

Sharpe, William F., Gordon J. Alexander and Jeffery V. Bailey, *Investments*,
Most recent edition, Prentice-Hall. [Recommended, not required.]

Brealey, Richard and Stewart Myers, *Principles of Corporate Finance*,
Most recent edition, McGraw-Hill. [Required, you will need it anways for
BA351.]

Grabbe, Orlin J., *International Financial Markets*, Most recent edition,
Prentice-Hall. [Recommended, not required.]

Ross, Stephen, Randolph Westerfield and Jeffery Jaffe, *Corporate
Finance*, Most recent edition, Richard D. Irwin, [Supplemental, substitute
for Brealey and Myers.].

- Although the exams are closed book, students may bring into the exams one 8 1/2 x 11 sheet of paper with notes on both sides.
- Students are allowed to bring in silent battery operated calculators to exams. Laptops, while useful for assignments, are not needed in my Daytime MBA exams. For off-site exams, you will need a Laptop to complete the exam.
*There are no verbal appeals of grades*. I am glad to regrade any assignment or exam. However, you must provide a statement as to where and why there is a problem. Importantly, the entire exam or assignment will be regraded. As a result, the regraded score may increase, remain the same or decrease.

The course is self contained on the Web. However, much of the material is reinforced by reading the relevant sections of Sharpe, Alexander and Bailey (SAB) and either Brealey and Myers (BM) or Ross, Westerfield and Jaffe (RWJ).

This class provides an overview of financial mathematics. The tools developed in this module perform the basis for valuing all assets including stocks, bonds, and investment proposals. The main theme is the time value of money -- the idea that a dollar received today is worth more than a dollar to be received in the future. Given an interest rate or discount rate, the tools developed in this module allow us to quantify this idea. In particular, we can determine what lump sum received today is equivalent to a specific series of cash flows to be received in the future. This module also has many practical applications for personal finance relating to comparing mortgages and other loans and to valuing fixed interest investments.

The following files relate to slides, examples, and exercises from the class notes. Clicking on the name of the file will result in it being automatically downloaded to your machine. The video files are provided in two forms: MPEG files and Streaming video files. For fast connections, i.e. T1 lines, I recommend playing the MPEG files with Windows media player. For slower connections, use the streaming files. I recommend Real Player version 7 or higher.

- Value a fixed-rate mortgage.
- Prepare an amortization schedule for a fixed-rate mortgage.
- Value a straight bond.
- Value a zero-coupon bond.
- Understand the bond reporting conventions and determine the actual price of a bond from the reported figures.
- Compute the duration and elasticity of a bond.
- Explain the relationship between real and nominal interest rates.
- Understand the term structure of interest rates.
- Class notes.
- Brealey and Myers, Chapters 3 and 23 (optional).
- Value a stock that pays a constant dividend.
- Value a stock that pays a dividend that grows at a constant rate.
- Determine which cash flows are relevant in evaluating an investment proposal.
- Compute straight-line depreciation.
- Compute tax payable on the cash flows produced by an investment.
- Compute tax payable on the gain or loss on sale of a capital asset.
- Class notes.
- Brealey and Myers, Chapter 4 (optional).
- Compute the net present value of an investment proposal.
- Compute the internal rate of return of an investment proposal.
- Compute the payback period of an investment proposal.
- Determine whether a particular investment proposal should be undertaken.
- Determine which (if either) of two mutually exclusive investment proposals should be undertaken.
- Determine which (if any) of a set of investment proposals should be undertaken when the firm is capital constrained.
- Determine which (if either) of two mutually exclusive investment proposals with different lives should be undertaken.
- Class notes.
- Brealey and Myers, Chapters 5 and 6 (optional).
- Determine the possible payoffs of forward and futures contracts.
- Understand the mechanics of buying, selling, exercising, and settling forward and futures contracts.
- Determine the possible payoffs of portfolios of futures, forwards, and the underlying asset.
- Examine market prices to determine whether arbitrage bounds are violated in futures and forward markets.
- Understand the directional effects of relevant variables on the value of derivative securities.
- Use standard valuation techniques to determine the price of forward and futures contracts.
- Class notes.
- Brealey and Myers, Chapter 25 (optional).
- Determine the possible payoffs of option contracts.
- Understand the mechanics of buying, selling, exercising, and settling option contracts.
- Determine the possible payoffs of portfolios of options, bonds, and the underlying asset.
- Examine market prices to determine whether arbitrage bounds are violated in option markets.
- Understand the directional effects of relevant variables on the value of options.
- Use standard valuation techniques to determine the value of options.
- Class notes.
- Brealey and Myers, Chapter 20 (optional).
- Compute the expected return of a portfolio.
- Compute the variance and standard deviation of the return of a portfolio.
- Find the composition of the minimum-variance two-asset portfolio.
- Explain the concept of diversification.
- Explain how to construct a diversified portfolio in practice.
- Class notes.
- Brealey and Myers, Chapter 7 (optional).
- Show that, in large diversified portfolios, an individual asset's contribution to the risk of the portfolio is its covariance with the returns of the existing portfolio and that individual variances are irrelevant.
- Explain why, in the absence of a riskless asset, all investors will
hold different portfolios that lie on the
*efficient frontier*. - Explain why, when a riskless asset is introduced, all investors will hold the market portfolio and the riskless asset in some proportion.
- Understand and use the Capital Market Line where appropriate.
- Understand and use the Security Market Line or CAPM where appropriate.
- Understand the difference between systematic and diversifiable risk.
- Use the CAPM in a capital budgeting exercise.
- Class notes.
- Brealey and Myers, Chapter 8 (optional).
- Understand the different types of market efficiency.
- Compute the Jensen, Sharpe, and Treynor measures of performance.
- Understand when the Jensen, Sharpe, and Treynor measures of performance are appropriate and when they give misleading results.
- Explain the difference between specific stock selection ability and market timing ability.
- Class notes.
- Brealey and Myers, Chapter 13 (optional).
- Compute the firm's Weighted Average Cost of Capital (W ACC) when there are no taxes and when there are corporate taxes.
- Compute the required return demanded by equity-holders when there are no taxes and when there are corporate taxes.
- Evaluate investment decisions where the project is financed in a different proportion of debt and equity than is the existing firm and has a different risk.
- Lever and unlever betas to reflect differences in capital structures.
- Compute appropriate required returns for projects in industries different from the existing assets of the firm.
- Class notes.
- Brealey and Myers, Chapters 17-19 (optional).
- Understand how forward exchange rates are determined.
- Evaluate the attractiveness of offshore borrowing.
- Recognize real options in project evaluation exercises.
- Value project proposals with straightforward real option components.
- Construct NPV profiles for projects with real option components.
- Understand the kinds of problems involved with corporate mergers and acquisitions.
- Class notes.
- Brealey and Myers, Chapter 20 (optional).

Brief biographical of Professor Harvey. (Video, 10 minutes)

Historical behavior of U.S. and international asset returns. (Video, 17 minutes)

This class reviews the present value mechanics developed in Class 0 and provides an overview of one of the two classes of the source of funds available to firms. Equity securities (or stocks or shares) provide an ownership interest in the firm and debt securities (or loans or bonds or fixed-interest securities) provide a creditor relationship with the firm. After a brief overview of some of the institutional details of bonds, this class focuses on valuing these securities in a world of certainty. Debt securities can be valued as the present value of coupon payments and the face value of the instrument as a direct application of the financial mathematics techniques developed in Class 0.

After completing this class, you should be able to:

The following files relate to slides, examples, and exercises from the class notes. Clicking on the name of the file will result in it being automatically downloaded to your machine. The video files are provided in two forms: MPEG files and Streaming video files. For fast connections, i.e. T1 lines, I recommend playing the MPEG files with Windows media player. For slower connections, use the streaming files. I recommend Real Player version 7 or higher.

This file is an EXCEL spreadsheet that contains the data and analysis for the amortization schedule example from the notes.

This file is an EXCEL spreadsheet that contains the data and analysis for the example from the notes regarding the estimation of the yield to maturity of a bond, using SOLVER.

This file is a POWERPOINT presentation that contains the slides used in Class 1.

An analysis of what interest rates mean. How interest rates are tied to the economy. Interest rates and expected inflation. Nominal vs. Real interest rates. Annual percentage rates. True interest rates. Valuing a Treasury bond. (13 minutes)

The basics of replicating cash flows. Zero coupon bonds. Zero coupon corporate bonds. No arbitrage. Intuition behind present values. Future value vs. Present value. (Video)

Bond price dynamics. Simple example with zero coupon bonds. Negative relation between interest rates and bond prices. (Video, 12 minutes)

Sensitivity of bond prices to changes in the interest rate, duration, modified duration and elasticity. (Video, 17 minutes)

How to set up a simple interest rate hedge. Modified duration matching. Introduction to futures markets. Interest rate risk management. (Video, 15 minutes)

Determinants of the term structure. Different theories of the term structure. (Video)

The mechanics of forward interest rates. (Video)

Bond
Price Dynamics (Java)

Zero Coupon Bond Price
Dynamics (Java)

Notes on
Duration and Bond Price Dynamics

The
Term Structure of Interest Rates and the Economy

Term
Structure Surfaces

Duration
Measures: Historical Perspective

Interpreting
Bond Prices

This class provides an overview of **equity securities** (or stocks
or shares). These securities provide an ownership interest in the firm
whereas debt securities (or loans or bonds or fixed-interest securities)
provide a creditor relationship with the firm. After a brief overview of
some of the institutional details of these securities, this module focuses
on valuing the securities in a world of certainty. Equity securities can
be valued as the present value of the future dividend stream. The analysis
is extended to evaluating investment proposals with a focus on determining
which cash flows are relevant in deciding whether a particular proposal
should be undertaken.

After completing this class, you should be able to:

The following files relate to slides, examples, and exercises from the class notes. Clicking on the name of the file will result in it being automatically downloaded to your machine. The video files are provided in two forms: MPEG files and Streaming video files. For fast connections, i.e. T1 lines, I recommend playing the MPEG files with Windows media player. For slower connections, use the streaming files. I recommend Real Player version 7 or higher.

This file is a POWERPOINT presentation that contains the slides used in Class 2.

Common stock, preferred stock, voting rights. Simple valuation models. Dividend discount model. (Video)

Mechanics of short selling. Long vs. Short positions. IBM example. Practical considerations. Limited and unlimited liabilities. Risk management implications. (Video)

Growth vs. Value investing. Momentum vs. Contrarian investing. How does risk come into play? (Video)

How to do a simple calculation. The role of depreciation. What discount rate should be used? (Video)

**Supplemental Material:**

This class provides an overview of capital budgeting - determining which
investments a firm should undertake. The **net present value (NPV)**
rule, which is widely used in practice, is developed and illustrated wiyh
several examples. A number of alternative evaluation techniques including
**internal rate of return** and **paybeack period** are also illustrated,
highlighting potential problems with their use. The NPV technique is illustrated
in the context of choosing between mutually exclusive projects and projects
with different lives.

After completing this class, you should be able to:

This file is a POWERPOINT presentation that contains the slides used in Class 3.

Net present value, internal rate of return, payback. Advantages and disadvantages. (Video)

What interest rate do we use for discounting each year's cash flows. How the term structure of interest rates comes into the capital budgeting decision. (Video)

How to value projects with unequal lives. Calculation of the annual equivalent cost. (Video)

This class provides an overview of **forward** and **futures**
contracts. Forwards and futures belong to the class of securities known
as **derivatives** since their value is derived from the value of some
other security. The price of a foreign exchange forward contract, for example,
depends on the price of the underlying currency and the price of a pork
belly futures contract depends on the price of pork bellies. Derivatives
trade both on exchanges (where contracts are standardized) and over-the-counter
(where the contract specification can be customized). The focus of this
class is on (1) definitions and contract specifications of the major exchange-traded
derivatives, (2) the mechanics of buying, selling, exercising, and settling
forward and futures contracts, (3) derivative trading strategies including
hedging, and (4) the relationships between derivatives, the underlying
security, and riskless bonds.

After completing this class, you should be able to:

This file is a POWERPOINT presentation that contains the slides used in Class 4.

The mechanics of forward interest rates. (Video)

Agricultural examples. Why use forward contracts? Cost of carry. Forward prices for various commodities. Speculation and forward markets. (Video)

Difference between forwards and futures. Examples of futures. (Video)

Various examples. Stock hedging, bond hedging. (Video)

Margins and volatility. Risk of investing in futures. Setting the risk by determining how much margin to use. How margins are set by exchanges. (Video)

Major
U.S. Futures Markets

Margin
on Futures

A Guide to
Futures and Options Quotations

Examples
of Hedging Risk with Futures

This class provides an overview of **option** contracts. As for forwards
and futures, options belong to the class of securities known as **derivatives**
since their value is derived from the value of some other security. The
price of a stock option, for example, depends on the price of the underlying
stock and the price of a foreign currency option depends on the price of
the underlying currency. Options trade both on exchanges (where contracts
are standardized) and over-the-counter (where the contract specification
can be customized). The focus of this class is on (1) definitions and contract
specifications of the major exchange-traded options, (2) the mechanics
of buying, selling, exercising, and settling option contracts, (3) option
trading strategies including hedging, and (4) the relationships between
options, the underlying security, and riskless bonds. In particular, it
is possible to form combinations of derivatives and the underlying security
that are riskless, providing a means of valuing options.

After completing this class, you should be able to:

This file is an EXCEL spreadsheet that contains the data and analysis for the example in the notes relating to the lognormal distribution.

This file is an EXCEL spreadsheet that contains the data and analysis for the example from the notes regarding the implementation of the Black-Scholes model.

This file is an EXCEL spreadsheet that computes the implied volatility of a call option on a non-dividend-paying stock.

This file is a POWERPOINT presentation that contains the slides used in Class 5.

The difference between calls and puts. The difference between options and futures. (Video)

Writing options vs. Buying options. Some examples. Differences between options and futures revisited. (Video)

Details on how the underlying stock price, the exercise price, the volatility and the time to expiration impact the value of calls and puts. (Video)

Intuition behind the Black-Scholes option pricing model. (Video)

The meaning of implied volatility. (Video)

Examples of using options to hedge with bonds and stocks. (Video)

Example of finding overvalued option and taking a hedge position. Revisit the bond hedging example. (Video)

Options Dynamics
(Java)

The mid-term exam is held during Class 6.

This class provides an overview of individual asset allocation. It is shown that an individual can reduce the risk of his portfolio without sacrificing any expected return simply by spreading his wealth over a number of assets in an appropriate way. This technique of diversification is explained in some detail in terms of a simple two-asset example in order to build intuition. The analysis is then extended to the N-asset case, followed by some discussion of practical issues and a comprehensive worked example. Since the concepts build on the basic principles of statistics and utility theory, these areas are briefly reviewed.

After completing this class, you should be able to:

This file is a POWERPOINT presentation that contains the slides used in Class 7.

Diversification mechanics. Selecting securities based on correlation. Correlation among developed and emerging markets as an application. (Video)

Introduction to the minimum variance portfolio with many assets. The quadratic program. Optimal portfolio selection. Risk aversion and portfolio choice. (Video)

Adding risk aversion to the portfolio selection problem. Obtaining efficient portfolios and obtaining optimal portfolios for investors with different degrees of risk aversion. (Video)

How the introduction of a risk free asset changes the portfolio problem. Optimal portfolios with a risk free rate. (Video)

Mean-Standard
Deviation Analysis (Efficient Frontier) (Java)

The
Cost of Risk

Mathematical
Derivation of Optimal Portfolio Selection

Index
of Year-End Cumulative Wealth Relatives

Year
by Year Rates of Return

Annual
Rates of Return on Alternative Investments

Correlation
Matrix of Annual Rates of Return

Nominal
Rates of Return on Selected Common Stock-Commodity Futures Portfolios

This class extends the material of Class 7 in deriving the Capital Asset Pricing Model (CAPM). This model is widely used in capital budgeting exercises in practice and is one of the cornerstones of modern finance. The primary use of the CAPM is in determining the appropriate discount rate to use in computing Net Present Values (NPVs). This module, highlights the difference between systematic risk (which is priced or rewarded by the market) and diversifiable risk (which is not priced). An intuitive proof is presented along with a formal mathematical proof.

After completing this class, you should be able to:

This file is a POWERPOINT presentation that contains the slides used in Class 8.

Verbal derivation of the CAPM. Intuition behind model. What is beta. (Video)

Infrequent trading. What is the right benchmark in global markets. (Video)

Black CAPM. Arbitrage pricing theory, multibeta CAPM. Implications and intuition of these alternative models. (Video)

This class considers the efficiency of capital markets and how to measure the performance of individual stocks and mutual funds over time. Three notions of efficiency are introduced based on the type of information being used to forecast returns. A number of technical trading rules are introduced and their success is evaluated. Three traditional measures of portfolio performance are reviewed, and some more recent measures are introduced. The relative strengths and weaknesses of the various measures are compared and contrasted.

After completing this class, you should be able to:

This file is a POWERPOINT presentation that contains the slides used in Class 9.

Sharpe measure, Treynor measure, Jensen's alpha, Graham-Harvey measure. Implications for the evaluation of portfolio managers. (VDO)

This class considers the financing decision of the firm. What mix of debt (loans/bonds) and equity (shares) should the firm use to raise funds to finance its investments? The seminal Modigliani and Miller propositions, with and without corporate taxes, are reviewed. The main theme of the class is to evaluate a new investment opportunity for the firm where the appropriate discount rate is unknown. This discount rate could be computed directly from the CAPM if the appropriate beta was known, however in this class we consider the case where the beta of the new project is unknown. In many cases, the beta of another company that is made up primarily of assets like the new project is available. However, adjustments must be made to reflect how differences in capital structure affect beta risk. The procedure for doing this is illustrated via a comprehensive example.

After completing this class, you should be able to:

This file is a POWERPOINT presentation that contains the slides used in Class 10.

This class considers two applications of the tools developed earlier in the course. The topic of international project evaluation considers (1) whether funds should be borrowed offshore if foreign interest rates are lower than domestic interest rates, and (2) how to evaluate offshore investments with cash flows in a foreign currency. The topic of real options applies the option valuation techniques of Class 5 to capital budgeting exercises in which a project is coupled with a put or call option. For example, the firm may have the option to abandon a project during its life. This amounts to a put option on the remaining cash flows associated with the project. Ignoring the value of these real options (as in standard discounted cash flow techniques) can lead to incorrect investment evaluation decisions.

In addition, the problems involved with corporate mergers and acquisitions are mentioned. These topics are treated in great detail in the Corporate Finance electives.

After completing this class, you should be able to:

This file is a POWERPOINT presentation that contains the slides used in Class 11.

This class consists of a review of the material presented throughout the course with an emphasis on the material in Classes 7-11. The various tools and techniques developed in the course are drawn together via a series of worked examples.