Corporate Finance Course: Factor Models – Announcements, Actual Returns and Expected Returns

In this new series of videos, I’ll be spending some time on factor models, which are different ways of looking at security returns.  Because of this, we’ll reconsider concepts like risk and expected return but from a different perspective.  We’ll also be introducing the Arbitrage Pricing Theory, or APT in a few videos time.

In my books to date, I’ve treated factor models as a separate chapter but I’m seriously considering merging this with the CAPM material in future editions. This would hopefully avoid a bit of duplication and lead to a more integrated approach to asset pricing. I’d appreciate any feedback you may have on whether this is sensible.

Key points Introduced in this video:

  • Impact of Announcements on share prices
  • Expected and surprise components of returns

Corporate Finance Course: Variations of the CAPM

This video closes off my short series on the Capital Asset Pricing Model with a very brief discussion of two CAPM variations: Consumption CAPM or CCAPM and CAPM with Human Capital or HCAPM.

I’ve never used these in practice because it is so difficult to get good historical data on consumption growth and non financial assets so I only really deal with the models from a theoretical perspective. Nevertheless, they do give you insights into other perspectives of asset pricing.

I’ll continue this in future videos when I cover Asset Pricing in more detail.

Key points introduced in this video:

  • Consumption CAPM
  • CAPM with Human Capital

Corporate Finance Course: Criticisms of CAPM

Time flies when you’re busy.  I realise I haven’t updated the course for a wee while so plan to become more active again.  I’m also working hard on the 3rd Edition of Corporate Finance and my research projects so it’s natural that things tend to slip.

This video covers some criticisms of CAPM.  I’ve tried to be balanced by giving the criticisms and then the counterarguments.  Basically, I am of the view that it is pretty difficult to use ex-post data to validate an ex-ante model.  There are just too many pitfalls.

So, CAPM is a good model to give you general insights about how things work.  However, should you use it to predict the future? I’m not so sure…

Key points introduced in this video:

  • Roll’s Criticism of CAPM tests
  • Some asset pricing anomalies
  • Some arguments why it is too difficult to reliably test CAPM

Corporate Finance Course: An Introduction to the Capital Asset Pricing Model (CAPM)

I’ve been away for a few days and haven’t had the opportunity to update the site.  This video introduces (in an intuitive way) the Capital Asset Pricing Model or CAPM.  The CAPM is one of the most common ways for firms to identify their cost of equity capital, which is important for calculating the discount rate to be used in investment appraisal.

Key points introduced in this video:

  1. The Expected Return on the Market and the Equity Risk Premium
  2. Expected Return on an Individual Security
  3. The Security Market  Line

Corporate Finance Course: Market Equilibrium and Introduction to Beta

The next instalment of my corporate finance course on YouTube has now gone live.  I introduce the concept of Market Equilibrium, explain what is meant by Homogeneous and Heterogeneous Expectations.  I then return to the concept of risk and use this to introduce ‘beta’, which is the systematic risk of a security.

Key points introduced in this video:

  1. Market Equilibrium;
  2. Heterogeneous and Homogeneous Expectations;
  3. Systematic Risk or Beta;
  4. Security Characteristic Line;

Corporate Finance: 3rd Edition

I’ve started writing the 3rd Edition of Corporate Finance, for publication in January 2016.  This means a few things:

  • My writing efforts will shift from the blog to the book over the coming months.
  • I’ll be giving updates on the chapters as I write them.
  • I will continue to write blog posts on current events when I see something worth writing about or I get a request.

If you have any comments  or recommendations to improve the book, please get in touch and I’ll try my best to incorporate your views.

David

A Four Step Guide to Improving Personal Financial Decisions

Personal FinancesYou’ll be surprised at just how few individuals approach their personal finances in a robust and objective manner.  It is definitely the case that many people review their spending on a regular basis.  However, very few analyse their spending behaviour and/or periodically monitor it.

In this article, I draw from standard corporate governance principles, which are embedded in all successful businesses and apply them to the personal finance space.

The key principles of Corporate Governance are as follows:

  • There should be an effective framework for business decision-making;
  • Resources are employed to maximize the wealth of all shareholders;
  • Stakeholder interests should be reflected in all decisions;
  • All decisions are completely transparent;
  • Managers are held accountable for their decisions.

Can the principles of good corporate governance help individuals with their own personal finances? You’ll be interested to know how easy it is to adapt these to the personal level.

In the following 4 steps, I propose a structure for personal decision-making that replicates the business decision framework seen in modern corporations.  I am sure that if the steps are followed each month, readers will soon see identifiable improvements in their own financial situation.

Step 1: Create an Effective Framework for Decision-Making

No matter what your personal circumstances (single, married, divorced, single parent, etc), you should have explicit constraints on what you can spend your money on and how much. Having these boundaries in place will reduce the likelihood of impulse spending.

An effective personal finance framework (that draws on the principles of good corporate governance) requires the following:

  1. All financial transactions (buying goods, borrowing, opening a credit card, etc.) should enhance your utility (i.e. quality of life);
  2. You must only spend within your means;
  3. Your financial decisions are legal;
  4. If you share your finances with someone else, (i.e. a partner), there is a clear articulation of how spending decisions are made.

Recommendations:

  1. Ensure you keep records of your monthly income and all your spending.
  2. Sit down once a month (with your partner if you have one) and objectively analyse the major financial decisions of the previous thirty days and any issues that are likely to come up over the coming four weeks.  This is called your monthly spending review.

Checklist for monthly review:

  1. Did you spend money on goods/services you didn’t really require?
  2. Did you throw out food? What did you buy too much of? What is your monthly/weekly/daily food bill?
  3. Is your mortgage/rent too high? Can you get a better rate elsewhere?
  4. Are you paying too much for electricity and gas? Can you get a better deal elsewhere?
  5. What is the total cost of your car (monthly car payment + monthly fuel cost + monthly road tax cost + monthly car insurance + monthly maintenance/servicing)? For some of these, find the annual spend and divide by twelve to get the monthly amount. Is it substantially cheaper to take public transport/hire taxis?
  6. Is your spending balanced across all areas of your life?

Step 2: Create a savings plan and spending targets for the next month

In personal finance, strict budgets don’t work.  Unanticipated events regularly destroy the best plans and it is impossible to fully keep to strict spending limits.  In the corporate world, businesses keep a cash float to deal with any one-off unexpected spending, but in the personal finance world these unanticipated spending demands are much more common.

Recommendations:

  1. At your monthly spending review, choose how much you want to save over the coming month and transfer that amount into a separate account.
  2. Of the remaining money left, subtract your fixed recurring expenditure (such as mortgage, rent, car loan, etc).
  3. Of the remaining amount, this is what is left for the unexpected and discretionary spending.  Aim to spend only 80% of this amount over the coming month.
  4. At the end of the month, you should have 20% of your discretionary funds minus any unanticipated spend during the period.  This should be diverted to a different emergency savings fund to deal with any one-off spending shocks (replacement central heating, car repairs, etc.).

Step 3: Identify one of your repeating expenditures and attempt to shave 5% off the spend

Companies continually seek efficiencies and the same should be done with personal finances.  In any one month, choose one of your spending accounts and look to cut a permanent 5% from the recurring monthly spend. This may entail renegotiating terms, switching suppliers, or cutting down on usage.

Recommended accounts to target are:

  1. Mortgage
  2. Car Loan
  3. Insurance (home, car, buildings, life, mobile phone, travel, or dental)
  4. Utility Bills (electricity, gas, water)
  5. Phone (home, mobile)
  6. Credit Card Interest
  7. Car Fuel
  8. Satellite or Cable Subscriptions
  9. Groceries
  10. Home (Furnishing, maintenance, garden)
  11. Internet spending
  12. Clothing
  13. Dining
  14. Entertainment
  15. Music
  16. Carry Outs

Step 4: The Monthly Spending Review

At your monthly spending review meeting, objectively assess your spending performance over the previous month. Identify spending requirements (including one off expenditures) and set targets for your spending in the coming period.

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Would Scotland need a Central Bank if it voted for Independence?

LOLR

One of my readers asked this week if I could write something on what is involved in setting up a central bank. I am sure it was related to the leaders’ debate on TV a few days ago when Alex Salmond was put under sustained pressure to explain what would happen if monetary union is not possible with the rest of the UK.

The reality is that whether an independent Scotland had a currency union with the UK or had its own currency, it would still need a central bank.

The responsibilities of a central bank are:

  1. To control monetary policy (set interest rates, manage currency, and the supply of money);
  2. Supervision of the financial sector (financial services and banks);
  3. Supervision of the financial markets;
  4. Ensure the payment and settlements system is fully functional;
  5. Oversight of the country’s cash savings, debt and investments;
  6. Act as lender of last resort.

Given that the UK government has stated it would not enter into a currency union with an independent Scotland, there have naturally been no discussions over what responsibilities the Bank of England would bear (in the event of a currency union) with respect to Scotland.

If there was monetary union, I do not think it is politically likely that the Bank of England would take over all six central bank responsibilities for an independent Scotland.  The most likely would be (1) monetary policy and (6) lender of last resort.

This means that a Scottish central bank would still need to be created to carry out the other responsibilities listed above.

In answer to the original query, given the degree of existing regulation in the EU and the UK, I do not think it would be that difficult to set up an institution (Central Bank of Scotland) to undertake oversight activities.

However, the big (but not insurmountable) challenge is if a Central Bank of Scotland had to deal with monetary policy and become a lender of last resort. This would happen if the UK government continues its refusal to enter into a monetary union.

I now discuss each in turn.

  1. Monetary policy.

The Scottish Government’s plan A is for full monetary union and they have completely avoided discussion of any other option.  If Scotland had to take control of its own currency, it would need to manage its interest rates and decide on money supply to ensure that prices (inflation) remained stable.

Without a doubt, this would be a challenge but given that the objective of the Scottish government is to enter the EU, many monetary policy decisions are constrained by the union.

Verdict: Challenging, but there would be a lot of support from the Bank of England and the EU.

  1. Lender of Last Resort

This is the elephant in the room when discussing Scottish independence and monetary union.  As soon as the SNP says it would consider other currency options, the next question would automatically be, ‘How could Scotland afford to be a lender of last resort?’

It is this that is the really difficult question to answer as the only options I can see are:

  1. Divert oil revenues to create reserves
  2. Raise taxes
  3. Change regulation so that Scottish banks cannot grow to such an extent that they are too big to fail.

Verdict: No option is particularly palatable and it would be the biggest challenge facing a new Scottish government. Each solution is achievable but there would be drawbacks for each option that would be politically upopular.

Conclusions

In the event of independence, I fully expect Scotland to create a central bank whether it is able to enter into a monetary union or not.

How much power it has will be dependent upon whether monetary union is agreed and the outcome of negotiations in other areas, notably the share of oil and UK debt.

If you are interested in following my blog, you can subscribe (see button at the side of the page) and receive an e-mail when I put up a new post.

 

Corporate Finance Course: Riskless Borrowing and Lending

I have just uploaded a new video (16 minutes) to Youtube as part of my Corporate Finance course.  In this video, I extend the material of previous lectures on creating investment portfolios, and now include the risk-free asset (Government T-Bill) and the Risky Portfolio.

Key points introduced in this video:

  1. Introduction to the optimal risky portfolio.
  2. Introduction to the concept of a risk-free rate.
  3. Fisher Separation Theorem

Using Corporate Finance to Make Better Personal Financial Decisions

Personal FinancesI realize there is an almost infinite amount of personal finance websites on the internet and anything that could be said about this topic has probably been written many times over.

However, as a Finance academic, I’ve always wondered whether it is possible to apply corporate finance theory to the personal finance domain.

I think it can be done and many valuable insights could be gained in approaching individual spending decisions in such a way.  I also think Corporate Finance can provide a framework for responsible personal financial decision-making in a different mode to what has been discussed before.

Being honest up front, it is important to state that I am not a personal finance specialist.  I’ve never even read a personal finance book. In fact, I’m shamefully careless with my own spending.  As a husband and father of teenagers, it is one of the areas where I am least happy with how I go about things.

With more order and control, I believe that I can cut my expenditure by a significant amount and make better spending decisions without lowering my quality of life.

So it is in this spirit I will meander through a number of topics in corporate finance and ask whether they can be applied to optimising my own personal financial decisions.

As I’ve said, this is a new topic for me and the concept may or may not work (if it doesn’t, I’ll just drop it). However, I’m excited by the idea of applying what I know in one sphere to another similar but subtly different one.

I hope also to learn new things about my own spending and decision-making and through my journey, maybe others will find out things about their spending as well.

Setting the Scene

At the beginning of any general Finance course I state that the topic consists of three distinct areas:

  1. How to make the best investments (The Investment Decision).
  2. How to finance those investments (The Financing Decision).
  3. How to ensure you have enough liquidity (Short-Term Capital Management).

In personal finance, we face the same decisions but in a different context. So over the coming weeks, I’ll be discussing the following:

  1. How to efficiently monitor your finances and introduce accountability and transparency to your spending behaviour (Corporate Governance).
  2. How to objectively measure your spending decisions and behavior over time (Financial Statement Analysis).
  3. A Framework for optimal financial decision-making (Time Value of Money).
  4. How to assess the value of your personal goods (Valuation).
  5. An overview of different personal finance decision techniques (Investment Appraisal).
  6. Dealing with future uncertainty and options in personal finance (Risk and Sensitivity).
  7. Investing in the Stock Market (Risk and Return)
  8. How to build an optimal investment portfolio (Investments and Portfolio Theory).
  9. How behavioural biases affect your personal financial decisions (Behavioural Finance and Efficient Markets).
  10. The characteristics of debt and other types of financing (Long-Term Financing).
  11. When to borrow money (Capital Structure).
  12. The hidden costs of borrowing money (Capital Structure Theories).
  13. How to deal with Family Financial Demands (Dividend Policy, Options, Financial Engineering)
  14. What is leasing and hire purchase and how to decide between buying and leasing (Leasing).
  15. How to incentivize good behavior in children via pocket money (Executive Compensation!).
  16. Credit cards and bank overdrafts (Short-Term Capital Management)
  17. How to recognize financial difficulty and techniques to get out of it (Financial Distress)

These are my initial ideas and I admit that some seem a bit stupid. However, I’m willing to explore these areas and see where my thoughts take me. If you have any other ideas on how to apply finance concepts to personal finance then please get in touch and I’ll add them to the list.

 

Simplifying Business