PORTFOLIO THEORY

1
PORTFOLIO THEORY

• Capital Allocation Between Risky and Risk-Free
  Assets, Optimal Portfolio

2
Rates of Return Single Period

HPR Holding Period Return P0 Beginning
price P1 Ending price D1 Dividend during
period one
3
Annual Holding Period Returns,USA, 1926-1996

• Geom. Arith. Stan.
• Series Mean Mean Dev.
• Lg Stk 10.5 12.5 20.4
• Sm Stk 12.6 19.0 40.4
• LT Gov 5.0 5.3 8.0
• T-Bills 3.7 3.8 3.3
• Inflation 3.1 3.2 4.5

4
yes, markets can go SP 500 since 1938
Vir Bloomberg since 1938
5
Down across the globe 1900-2007
Wld
Svet
Svet
Svet
Wld
Svet
Svet
Svet
Wld
Svet
Svet
Svet
Svet
Wld
Svet
Svet
Svet
Wld
Svet
Svet
Nem
Nem
Ger
Nem
Nem
Nem
Nem
Ger
VB
VB
VB
UK
ZDA
ZDA
ZDA
US
Jap
Jap
Jap
Jap
Vir ABN AMRO/LBS Global Investment Returns
Yearbook 2008, Table 6
6
but mostly up
7
And across the world 1900-2007
Vir ABN AMRO/LBS Global Investment Returns
Yearbook 2008, Table 14
8
Risk Aversion Utility

• Investors view of risk
• Risk Averse
• Risk Neutral
• Risk Seeking
• Utility
• Utility Function
• U E ( r ) - 0.005 A s 2
• A measures the degree of risk aversion

Scaling factor for decimals
9
Risk Aversion and Value Using the Sample
Investment

• U E ( r ) - .005 A s 2
• 22 - .005 A (34) 2
• Risk Aversion A Value
• High 5 -6.90
• 3 4.66
• Low 1 16.22

T-bill 5
10
Dominance Principle
11
Utility and Indifference Curves

• Represent an investors willingness to trade-off
  return and risk
• Example
• Exp Ret St Deviation UE ( r ) - .005As2
• 10 20.0 2
• 15 25.5 2
• 20 30.0 2
• 25 33.9 2

12
Indifference Curves
13
Expected Return

• Rule 1
• The return for an asset is the probability
  weighted average return in all scenarios.

14
Variance of Return

• Rule 2
• The variance of an assets return is the
  expected value of the squared deviations from the
  expected return.

15
Characteristics of Probability Distributions

• 1) Mean most likely value
• 2) Variance or standard deviation
• 3) Skewness
• If a distribution is approximately normal, the
  distribution is described by characteristics 1
  and 2

16
Return on a Portfolio

• Rule 3
• The rate of return on a portfolio is a weighted
  average of the rates of return of each asset
  comprising the portfolio, with the portfolio
  proportions as weights.
• rp W1r1 W2r2
• W1 Proportion of funds in Security 1
• W2 Proportion of funds in Security 2
• r1 Expected return on Security 1
• r2 Expected return on Security 2

17
Portfolio Risk with Risk-Free Asset

• Rule 4
• When a risky asset is combined with a risk-free
  asset, the portfolio standard deviation equals
  the risky assets standard deviation multiplied
  by the portfolio proportion invested in the risky
  asset.

18
Portfolio Risk

• Rule 5
• When two risky assets with variances s12 and
  s22, respectively, are combined into a portfolio
  with portfolio weights w1 and w2, respectively,
  the portfolio variance is given by
• ?p2 w12?12 w22?22 2W1W2 Cov(r1r2)
• Cov(r1r2) Covariance of returns for
• Security 1 and Security 2

19
Covariance
Cov(r1r2) ?1,2 ?1?2
?1,2 Correlation coefficient of
returns
?1 Standard deviation of returns for
Security 1 ?2 Standard deviation of
returns for Security 2
20
Correlation Coefficients Possible Values
Range of values for ?1,2
1.0 gt ????gt ?-1.0
If ?? 1.0, the securities would be perfectly
positively correlated If ?? - 1.0, the
securities would be perfectly negatively
correlated
21
TOP-DOWN Analysis of Portfolio Construction

• CAPITAL ALLOCATION between safe and risky
• ASSET ALLOCATION across asset classes
• SECURITY SELECTION within asset types

22
1. Allocating Capital Between Risky Risk Free
Assets

• Possible to split investment funds between safe
  and risky assets
• Risk free asset proxy T-bills
• Risky asset stock (or a portfolio)

23
Allocating Capital Between Risky Risk Free
Assets (cont.)

• Issues
• Examine risk/ return tradeoff
• Demonstrate how different degrees of risk
  aversion will affect allocations between risky
  and risk free assets

24
Example
25
Expected Returns for Combinations
26
Possible Combinations of Risky and Risk Free
Asset
27
Variance on the Possible Combined Portfolios
?
?
Hence, y ?c/?p so E(rc) becomes .
28
Combinations Without Leverage
?
?
?
29
Using Leverage with Capital Allocation Line

• Borrow at the Risk-Free Rate and invest in
  stock. Using 50 Leverage
• w1? w2?
• rc (-.5) (.07) (1.5) (.15) .19
• ?c (1.5) (.22) .33

30
Investment Opportunity Set CAL (Capital
Allocation Line)
31
Risk Aversion and Allocation

• Greater levels of risk aversion lead to larger
  proportions of the risk free asset
• Lower levels of risk aversion lead to larger
  proportions of the portfolio of risky assets
• Willingness to accept high levels of risk for
  high levels of returns would result in leveraged
  combinations

32
CAL with Risk Preferences
33
CAL with Higher Borrowing Rate
34

• 2. Optimal Risky Portfolios
• (Efficient Portfolios)

35
Risk Reduction with Diversification
36
In General, for an n-Security Portfolio
rp Weighted average of the n securities
?p2 (Consider all pairwise
covariance measures)
37
Two-Security Portfolio Opportunity Set with
Different Correlations
38
Variance with 3 Securities
39
Portfolio Risk/Return Two Securities Correlation
Effects

• Relationship depends on correlation coefficient
• -1.0 lt ? lt 1.0
• The smaller the correlation, the greater the risk
  reduction potential
• If??? 1.0, no risk reduction is possible

40
Minimum-Variance Combination
1
??2
- Cov(r1r2)
2

W1
??2
??2
- 2Cov(r1r2)

1
2
W2
(1 - W1)
How do we get this?
41
Minimum-Variance Combination ? .2
42
Minimum -Variance Return and Risk with ? .2
rp .6733(.10) .3267(.14) .1131
?
(.6733)2(.15)2 (.3267)2(.2)2
p
1/2
2(.6733)(.3267)(.2)(.15)(.2)
1/2
?
.0171
.1308
p
43
Minimum -Variance Combination ? -0.3
44
Minimum -Variance Return and Risk with ? -0.3
rp .6087(.10) .3913(.14) .1157
?
(.6087)2(.15)2 (.3913)2(.2)2
p
1/2
2(.6087)(.3913)(.2)(.15)(-.3)
1/2
?
.0102
.1009
p
45
Extending Concepts to All Securities

• The optimal combinations result in lowest level
  of risk for a given return
• The optimal trade-off is described as the
  efficient frontier
• These portfolios are dominant to all other
  portfolios in the feasible set.

46
The Minimum-Variance Frontierof Risky Assets
(1. Risk-Return Combinations Available)
47
2. Extending to Include Riskless Asset

• The optimal combination becomes linear
• A single combination of risky and riskless assets
  will dominate the one with the steepest CAL
  the tangent portfolio. HOW DO WE GET THIS
  PORTFOLIO?

48
Alternative CALs with Optimal Risky P.
49
Efficient Frontier with Lending Borrowing(3.
Mix risk-free with optimal risky)
50
Portfolio Selection with Restrictions on
Risk-Free Asset

• Possible situations
• R-F asset not available
• Investors cannot borrow
• Investors can only borrow at rates, higher than rF

51
Portfolio Selection w/o a R-F Asset
52
Chapter 17

• MacroeconomicandIndustry Analysis

53
Framework of Analysis

• Fundamental Analysis
• Approach to Fundamental Analysis
• Domestic and global economic analysis
• Industry analysis
• Company analysis
• Why use the top-down approach?

54
Global Economic Considerations

• Performance in countries and regions is highly
  variable
• Political risk
• Exchange rate risk
• Sales
• Profits
• Stock returns

55
Key Economic Variables

• Gross domestic product
• Unemployment rates
• Interest rates inflation
• International measures
• Consumer sentiment

56
Federal Government Policy

• Fiscal Policy - government spending and taxing
  actions
• Direct policy
• Slowly implemented

57
Federal Government Policy (contd)

• Monetary Policy - manipulation of the money
  supply to influence economic activity
• Initial feedback effects
• Tools of monetary policy
• Open market operations
• Discount rate
• Reserve requirements

58
Inflation and Equity Valuation

• Inflation has an impact on equity valuations
• Historical costs underestimate economic costs
• Empirical research shows that (high) inflation
  has an adverse effect on equity values
• Research shows that real rates of return are
  lower with high rates of inflation

59
Potential Causes of Lower Equity Values with
Inflation

• Shocks cause expectation of lower earnings by
  market participants
• Returns are viewed as being riskier with higher
  rates of inflation
• ?

60
What Stock Market Data Tells Us About Inflation

• The last 30 years represent a period of high
  inflation compared to the last 200 years
• If a government spends more than it collects in
  taxes, inflation will usually result
• Inflation is measured through a consumers price
  index (CPI)
• As inflation increases interest rates rise
  leading to a decrease in bond prices

61
What Stock Market Data Tells Us About Inflation

• Some argue inflation is good for the stock market
  because corporations increase the selling price
  of their product and their costs do not rise
• This is a fallacy because
• Consumers resist price increases
• Corporations enter long-term contracts to sell
  products at a fixed price
• GAAP do not contain inflation adjustments for
  depreciation
• Thus depreciation cash flows are inadequate for
  equipment renewal during periods of inflation

62
What Stock Market Data Tells Us About Inflation
Real returns were below average during high
inflation periods.
Average real returns are negative during
extra-ordinary inflation periods.
Stock market returns were average during moderate
inflation.
63
Demand Shocks

• Demand shock - an event that affects demand for
  goods and services in the economy
• Tax rate cut
• Increases in government spending

64
Supply Shocks

• Supply shock - an event that influences
  production capacity or production costs
• Commodity price changes
• Educational level of economic participants

65
Business Cycles

• Business Cycle
• Peak
• Trough
• Industry relationship to business cycles
• Cyclical
• Defensive

66
NBER Cyclical Indicators Leading

• Leading Indicators - tend to rise and fall in
  advance of the economy
• Examples
• Avg. weekly hours of production workers
• Stock Prices
• http//www.google.com/trends

67
NBER Cyclical Indicators Coincident

• Coincident Indicators - indicators that tend to
  change directly with the economy
• Examples
• Industrial production
• Manufacturing and trade sales

68
NBER Cyclical Indicators Lagging

• Lagging Indicators - indicators that tend to
  follow the lag economic performance
• Examples
• Ratio of trade inventories to sales
• Ratio of consumer installment credit outstanding
  to personal income

69
Industry Analysis

• Sensitivity to business cycles
• Factors affecting sensitivity of earnings to
  business cycles
• Sensitivity of sales of the firms product to the
  business cycles
• Operating leverage
• Financial leverage
• Industry life cycles

70
Industry Analysis

• Industries are usually defined by a single
  product
• Thus, all companies within an industry usually
  profit or lose in tandem
• Therefore, it is worthwhile to examine an
  industrys prospects before bothering to examine
  specific firms within an industry

71
Product Life Cycle
72
Industry Life Cycles

• Stage Sales Growth
• Start-up Rapid Increasing
• Consolidation Stable
• Maturity Slowing
• Relative Decline Minimal or Negative

73
Product Life Cycle

• Industrys life cycle determined by type of
  product
• Example Musical groups vs. Coca-Cola
• Coca-Cola has been in product maturation stage
  for over 100 years
• Life cycle model is important to many security
  analysts
• Must determine stage the industry, product or
  firm is in

74
Financial Analysis of an Industry

• Many different sources compile industry data
  useful to investors
• Standard Poors Corporation
• Moodys Investors Services
• Trade associations
• Government
• Standard Poors provides stock price indexes on
  numerous U.S. industries and also offers balance
  sheets, income statements, and financial ratios
  for
• 87 Industrial
• 13 Technology
• 4 Transportation
• 2 Utility
• 10 Financial

75
Background

• Global market
• US Market is 40 - 45 of all markets
• Improved access technology
• New instruments
• Emphasis for our investigation
• Risk assessment
• Diversification

76
Issues

• What are the risks involved in investment in
  foreign securities?
• How do you measure benchmark returns on foreign
  investments?
• Are there benefits to diversification in foreign
  securities?

77
Diversification Benefits

• Evidence shows international diversification is
  beneficial
• Possible to expand the efficient frontier above
  domestic only frontier
• Possible to reduce the systematic risk level
  below the domestic only level

78
Efficient Frontier with International
Diversification
79
Systematic Risk Level with International
Diversification
80
Risks in International Investing

• Political Risks
• Expropriation of assets
• Restrictions on foreign exchange
• Political instability

81
Risks in International Investing

• Foreign Exchange Risk
• Variation in return related to changes in the
  relative value of the domestic and foreign
  currency
• Total return investment return return on
  foreign exchange
• Not possible to completely hedge a foreign
  investment

82
Returns with FX

• Return in US is a function of two factors
• 1. Return in the foreign market
• 2. Return on the foreign exchange

83
Returns with FX

• (1 rUS) (1 rFM) (1 rFX)
• rUS return on the foreign investment in US
  Dollars
• rFM return on the foreign market in local
  currency
• rFX return on the foreign exchange

84
Return Example Dollar Appreciates

• Initial Investment 100,000
• Initial Exchange 2.00/ Pound Sterling
• Final Exchange2.10/ Pound Sterling
• Return in British Security 10
• Return in US Dollars
• (1 rUS) (1.10) (1.05) (1.155)
• rUS 15.5

85
Return Example Dollar Depreciates

• Initial Investment 100,000
• Initial Exchange 2/ Pound Sterling
• Final Exchange 1.85/ Pound Sterling
• Return in British Security 10
• Return in US Dollars
• (1 rUS) (1.10) (.9250) (1.0175)
• rUS 1.75

86
International Risk

• Why invest internationally?
• World growth life cycle
• Importance of country risk
• Understanding diversification
• Should all countries be investment targets?

87
International RiskInternational Investment
Rationale

• Standard reasons
• Performance (but non-U.S. hasnt done well)
• Diversification (misunderstood)

88
International Risk International Investment
Rationale

• When U.S. down, other markets likely down
• Hence, correlation higher (less beneficial) when
  U.S. market is down
• Critical to distinguish long-run and short-run

89
International Risk/Harvey International
Investment Rationale
10 Worst Months - U.S. Equity Returns From
January 1985-
Return
Oct 87 Aug 98 Aug 90 Sept 86 Nov 87
Jan 90 Aug 97 Jul 86 Sept 90 Jun 91
90
International Risk International Investment
Rationale
1990 has 3 of 10 worst months
Return
Performance in full year of 1990
91
International RiskUnderstanding Growth

• Emerging economies-gt high growth prospects
• Emerging economies much like start-up companies
• Do not want to exclude these opportunities

92
International Risk Understanding Growth
Real GDP growth
93
International Risk Country Risk
Political risk. International Country Risk Guide
94
International Risk Country Risk
Financial risk. International Country Risk Guide
95
International Risk Country Risk
Ratings predict inflation
96
International Risk Country Risk
Ratings correlated with wealth
97
International Risk Country Risk
Fit is as good as it gets - lower rating (higher
risk) commands higher expected returns. Even in
among US firms, our best model gets about 30
explanatory power.
98
International Risk Understanding Diversification

• Diversification much misunderstood
• Diversification really means protection when the
  U.S. economy is bad
• But that is not how it is measured
• Correlation tells us average movement of these
  markets in both good and bad times

99
International Risk Understanding Diversification
Correlations of World Returns and Developed
Markets
100
International Risk Understanding Diversification
Correlations of World Equity Returns and Emerging
Markets
101
International Risk Should All Countries Be
Investment Targets?

• Should you invest in all countries?
• No
• Given the risk of some countries, it is unlikely
  they can meet their target returns
• May be excessively costly to transact
• Human rights issue of investing in certain
  countries
• May give up some return performance in the
  long-run by following this strategy and add
  tracking error

102
International Risk Should All Countries Be
Investment Targets?

• Selection criteria
• Economic
• Tactical criteria

103
International Risk/Harvey Should All Countries
Be Investment Targets?

• Selection criteria
• Political
• Catastrophe risk
• Rule of law, for example, insider trading
  regulations (foreign portfolio investors at
  distinct disadvantage)
• Human rights factors

104
International Risk/Harvey Should All Countries
Be Investment Targets?

• Selection criteria
• Financial
• Liberalization of capital markets
• Credibility of liberalizations
• Reliability of institutions

105
International Risk Should All Countries Be
Investment Targets?
CalPERS Limited Exposure Countries
ITInsider Trading
Source Bhattacharya Daouk (1999)
106
International Risk Should All Countries Be
Investment Targets?
CalPERS Prohibited Countries
ITInsider Trading
Source Bhattacharya Daouk (1999)
107
Chapter 18

• Equity ValuationModels

108
Common Stock

• Stockholders are owners of the firm.
• Stockholders are residual claimants.
• Stockholders have the right to
• vote at company meetings
• dividends and other distributions
• sell their shares
• Stockholders benefit in two ways
• dividends
• capital gains
• Stock is issued by public corporations to finance
  investments.
• Stock is initially issued in the primary market
  (IPOs and secondary offerings).
• Stock is traded in the secondary market on
  organized exchanges.

109
Fundamental Stock Analysis Models of Equity
Valuation

• Basic Types of Models
• Balance Sheet Models
• Dividend Discount Models
• Price/Earning Ratios
• Estimating Growth Rates and Opportunities

110
Intrinsic Value and Market Price

• Intrinsic Value
• Self assigned Value
• Variety of models are used for estimation
• Market Price
• Consensus value of all potential traders
• Trading Signal
• IV gt MP Buy
• IV lt MP Sell or Short Sell
• IV MP Hold or Fairly Priced

111
Dividend Discount ModelsGeneral Model

• V0 Value of Stock
• Dt Dividend
• k required return

112
No Growth Model

• Stocks that have earnings and dividends that are
  expected to remain constant
• Preferred Stock

113
No Growth Model Example

• E1 D1 5.00
• k .15
• V0 5.00 / .15 33.33

114
The Constant Growth Formula

• Assumption Dividends grow at a constant rate g
  for ever
• Then
• Issues
• constant growth
• g lt re.
• Is this a real or a nominal calculation?

115
Constant Growth Model

• g constant perpetual growth rate
• Limitations of the model
• Applied only to companies that pay dividends
• Applied only to companies whose dividends are
  expected to grow at a constant rate forever
• g lt re.
• Is this a real or a nominal calculation?

116
At what rate and for how long can a firms
dividends grow?

• A firms dividends cannot grow at a rate higher
  than the nominal rate of growth of the economy
  forever
• In applying the model, the constant growth rate
  must be constrained to be less than or equal to
  the economys nominal growth rate
• Recall Nominal growth rate real growth rate
  inflation rate

117

• In the case of the US economy, the nominal growth
  rate in the 1990s was 5
• Slovenia, Croatia?
• Use a maximum rate of 5-6 in your calculations
• What if we forecast a companys dividends to grow
  at a rate higher than 5-6 for, lets say, the
  next five years?

118
In this case, the companys stock value is the
sum of two components

• PV of expected dividends (based on our forecasts)
  during the high dividend growth period
• PV of Terminal price
• Terminal price present value of all future
  dividends beyond the high dividend growth period

119
How do we derive the terminal price?

• Suppose we have a forecast of a firms dividends
  for the next 6 years (the high dividend growth
  period) and that the forecasted dividend per
  share for the sixth year is 3
• We may then assume that after the sixth year the
  firms dividends will be growing at a constant
  growth rate of 3 per year
• Our assumption about this rate could be based on
• The companys average dividend growth rate over
  the past few years
• Information about the companys future dividend
  policy
• OR USE EXIT MULTIPLES

120
Constant Growth Model Example

• E1 5.00 b 40 k 15
• (1-b) 60 D1 3.00 g 8
• V0 3.00 / (.15 - .08) 42.86

121
Estimating Dividend Growth Rates

• g growth rate in dividends
• ROE Return on Equity for the firm
• b plowback or retention percentage rate
• (1- dividend payout percentage rate)

122
Specified Holding Period Model

• PN the expected sales price for the stock at
  time N
• N the specified number of years the stock is
  expected to be held

123
Partitioning Value Growth and No Growth
Components

• PVGO Present Value of Growth Opportunities
• E1 Earnings Per Share for period 1

124
Partitioning Value Example

• ROE 20 d 60 b 40
• E1 5.00 D1 3.00 k 15
• g .20 x .40 .08 or 8

125
Partitioning Value Example
Vo value with growth NGVo no growth component
value PVGO Present Value of Growth Opportunities
126
Price Earnings Ratios

• P/E Ratios are a function of two factors
• Required Rates of Return (k)
• Expected growth in Dividends
• Uses
• Relative valuation
• Extensive Use in industry

127
P/E Ratio No Expected Growth

• E1 - expected earnings for next year
• E1 is equal to D1 under no growth
• k - required rate of return

128
P/E Ratio with Constant Growth

• b retention ratio
• ROE Return on Equity

129
Numerical Example No Growth

• E0 2.50 g 0 k 12.5
• P0 D/k 2.50/.125 20.00
• PE 1/k 1/.125 8

130
Numerical Example with Growth

• b 60 ROE 15 (1-b) 40
• E1 2.50 (1 (.6)(.15)) 2.73
• D1 2.73 (1-.6) 1.09
• k 12.5 g 9
• P0 1.09/(.125-.09) 31.14
• PE 31.14/2.73 11.4
• PE (1 - .60) / (.125 - .09) 11.4

131
Pitfalls in P/E Analysis

• Use of accounting earnings
• Historical costs
• May not reflect economic earnings
• Reported earnings fluctuate around the business
  cycle

132
Price/Book Value Ratio

• Book value per share
• (Total Assets Total Liabilities )? of
  outstanding common stock shares
• Determined by economic events and accounting
  conventions
• Compared to market value
• Determined by markets assessment of earning
  power
• Some argue that if market price of stock lt
  (significantly gt) book value, stock is
  underpriced (over-priced)
• Can be measured by using Price/Book Value ratio

133
Price/Book Value Ratio

• Price/Book Value (PBV) ratio
• Market price per share ? Book value per share
• In 1990 Fama and French, Pontiff and Schall, etc.
  suggested that PBV ratio has explanatory power
  over stock prices and returns
• Fama and French grouped assets into portfolios
• Kim argues that using individual assets rather
  than portfolios offers several advantages
• Additional work has cast doubt on use of PBV ratio

134
Analysis of PBV Ratio

• The basic DDM is

• But given that Div1 can be calculated as
• Payout ratio x EPS0 x (1g)
• The DDM can be rewritten as

135
Analysis of PBV Ratio

• Since EPS0 ROE x Book value per share, this can
  be rewritten as

• The PBV ratio can be obtained by dividing both
  sides by BV0

• If everything else remains the same, the higher
  ROE, the higher PBV

136
Over- and Under-Priced Stocks

• This explains why firms with high (low) ROEs have
  stock prices in excess of (below) book values
• Consider the following

• If a firm has high PBV ratio coupled with low ROE
• May be overpriced
• Remembermarket places more emphasis on expected
  earnings than historical earnings (EPS0)

137
Tobins Q Ratio

• Tobin offers a ratio similar to the PBV ratio
• Tobins Q Market value of firms assets ?
  Replacement value of firms assets in place
• Useful in a highly inflationary environment
• Useful when technological advances have decreased
  cost of replacing existing assets

138
Price-Cash Flow Ratio

• Cash flows can also be used in this approach, and
  are often considered less susceptible to
  manipulation by management.
• The steps are similar to using the P/E ratio
• V CF1x(P/CF)

139
Price-Sales Ratio

• Finally, sales can be used in relation to stock
  price.
• Some drawbacks, in that sales do not necessarily
  produce profit and positive cash flows
• Advantage is that sales are also less susceptible
  to manipulation
• The steps are similar to using the P/E ratio
• V S1x(P/S)

140
Valuing Common Stock as a Call Option

• If a firms total liabilities gt total assets,
  creditors receive assets as partial payment
• Stockholders get nothing
• Can be equated to a call option model
• Creditors own the company and sell a call option
  on firms assets to stockholders
• Exercise price equals par value of firms debt
• If stockholders exercise option, they call in
  total assets but must pay all companys
  liabilities to keep assets
• If assets lt liabilities, option expires worthless
• Shareholders forfeit all claim on bankrupt firm
  to creditors

141
Conflicts of Interest

• Conflicts of interest exist between stockholders
  and bondholders
• Protective provisions of bond indenture
• Generally state that bonds coupon interest
  payments will be made on scheduled dates
• If scheduled payment is missed, bondholders can
  force firm into bankruptcy
• Bondholders are essentially exercising an option
  to call in assets before principal payment is due
• Bondholders gain control over corporation
• Offers evidence that shareholders have an
  American call option (not a European one)

142
Option Pricing Theory

• Option theory can also be used to gain insight on
• Pure speculations
• Firms near bankruptcy
• Firms currently being reorganized
• Leveraged buy-outs
• Management buy-outs
• Merged firms
• Emerging new firms
• Patents
• New technologies