FT Guide to Understanding Finance: A no-nonsense companion to financial tools and techniques (Financial Times) (The FT Guides)

433 Pages·2011·2.562 MB·English

by  Javier Estrada

FT

‘This delivers the essential concepts of modern fi nance clearly and FT Guides
concisely. My advice: buy this book and keep it close at hand!’ Guides
Mark Kritzman, President and CIO, Windham Capital Management, LLC
UNDERSTANDING
Guides
FINANCIAL TIMES
‘Whilst there are a number of books that purport to offer a quick reference U FINANCE
for business professionals, this is the only one that really manages to do
N
this in an effective way.’
UNDERSTANDING
D
Valerio Potì, Director of the MSc in Finance and Capital Markets Program, Even the best read and informed fi nancial
Dublin City University Business School E professionals will forget some fi nancial
R FINANCE concepts, and others may not have learned
‘This is corporate fi nance served in bite-sized and digestible portions.’ them properly in the fi rst place. Some may
S
Elroy Dimson, Emeritus Professor of Finance, London Business School want to broaden the scope of their fi nancial
T knowledge and others may want a desktop
A NO-NONSENSE COMPANION TO
‘Javier Estrada is to be commended for translating deep economic ideas A companion for quick and practical help in
ABOUT THE AUTHOR
FINANCIAL TOOLS AND TECHNIQUES applying the tools and techniques of fi nance
into terms that are immediately usable, compelling and valuable.’ N
to their everyday work.
Robert F. Bruner, Dean of Darden Business School, University of Virginia
D SECOND EDITION
Javier Estrada holds an MS in fi nance and a If there’s a fi nancial concept that you fi nd hard
PhD in economics both from the University of I to understand, easy to forget or necessary to
N JAVIER ESTRADA
Illinois at Urbana-Champaign. He is professor of apply with confi dence, The Financial Times
fi nance at the IESE Business School in Barcelona, G Guide to Understanding Finance gives you all
Spain, founding editor of the Emerging Markets the information you need. It includes:
Whether you are an executive or a student, beginner or expert, this book is designed
Review, and a wealth management advisor at F
to explain and illustrate the working essentials of fi nance with clarity and speed. • Basic concepts • Reverse valuation
Sport Global Consulting Investments where he
I • Mean returns • Relative valuation
advises professional athletes on how to manage The Financial Times Guide to Understanding Finance deliberately combines N
• Total risk • Prices and yields
their money. essential theory with real-world application, using short, focused chapters to help
A • Portfolios • Default risk and
you fi nd what you need and implement right away.
He has published extensively in international N • Diversifi cation market risk
journals, written many cases for class discussion, Originally published as Finance in a Nutshell, this new edition includes: • Systematic risk • Duration and
and lectured throughout the world to undergraduate C
• CAPM and the cost convexity
• Full coverage of risk and return including CAPM, the three-factor model and
students, graduate students and executives.
E of capital • NPV and IRR
risk-adjusted returns
• The three-factor • Real options
• Stocks and bonds including versions of the DCF model, reverse valuation,
model • Corporate value
relative valuation and issues related to fi xed-income securities, pricing and SECOND
• Downside risk creation
sources of risk EDITION
• Risk-adjusted returns • Options
• Case studies and examples from companies such as Apple, Merrill Lynch,
• Portfolio optimization • Futures and forwards
Microsoft, Berkshire Hathaway and Johnson & Johnson E
S • The long term • Currencies
• Accompanying Excel spreadsheets of all the calculations and formulas at T • The dividend • Summary statistics
www.pearsoned.co.uk/estrada R discount model • Normality
A
• The WACC model • Non-normality
D
A • Other DCF models • Regression analysis
FINANCE

Front cover image
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CVR_ESTR8022_02_SE_CVR.indd 1 05/04/2011 14:56
The Financial Times Guide
to Understanding Finance
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The Financial
Times Guide to
Understanding
Finance
A no-nonsense companion to financial tools
and techniques
Second edition
Javier Estrada
PEARSON EDUCATION LIMITED
Edinburgh Gate
Harlow CM20 2JE
Tel: [phone]
Fax: [phone]
Website: www.pearsoned.co.uk
First published in Great Britain in 2005 as Finance in a Nutshell: A no-nonsense companion to
the tools and techniques of finance
Second edition published 2011
© Pearson Education Limited 2005, 2011
The right of Javier Estrada to be identified as author of this work has been asserted by him in
accordance with the Copyright, Designs and Patents Act 1988.
Pearson Education is not responsible for the content of third party internet sites.
ISBN: 978-0-273-73802-2
British Library Cataloguing in Publication Data
A catalogue record for this book is available from the British Library
Library of Congress Cataloging-in-Publication Data
Estrada, Javier, 1964-
The Financial Times guide to understanding finance : a no-nonsense companion to financial
tools and techniques / Javier Estrada. -- 2nd ed.
p. cm.
Previously published under title: Finance in a nutshell.
Includes bibliographical references and index.
ISBN 978-0-273-73802-2 (pbk. : alk. paper) 1. Business enterprises--Finance--Handbooks,
manuals, etc. 2. Corporations--Finance--Handbooks, manuals, etc. I. Title. II. Title: Guide to
understanding finance.
HG4027.3.E88 2011
658.15--dc22
2011005720
All rights reserved. No part of this publication may be reproduced, stored in a retrieval
system, or transmitted in any form or by any means, electronic, mechanical, photocopying,
recording or otherwise, without either the prior written permission of the publisher or a
licence permitting restricted copying in the United Kingdom issued by the Copyright
Licensing Agency Ltd, Saffron House, 6–10 Kirby Street, London EC1N 8TS. This book may
not be lent, resold, hired out or otherwise disposed of by way of trade in any form of binding or
cover other than that in which it is published, without the prior consent of the publishers.
This publication is designed to provide accurate and authoritative information in regard to the
subject matter covered. It is sold with the understanding that neither the authors nor the
publisher is engaged in rendering legal, investing, or any other professional service. If legal
advice or other expert assistance is required, the service of a competent professional person
should be sought.
The publisher and contributors make no representation, express or implied, with regard to the
accuracy of the information contained in this book and cannot accept any responsibility or
liability for any errors or omissions that it may contain.
All trademarks used herein are the property of their respective owners. The use of any trademark in this
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does the use of such trademarks imply any affiliation with or endorsement of this book by such owners.
Microsoft, Excel, and Windows are either registered trademarks or trademarks of Microsoft Corporation
in the United States and/or other countries.
10 9 8 7 6 5 4 3 2 1
15 14 13 12 11
Typeset in 9.5/14pt ITC Stone Serif by 30
Printed and bound in Great Britain by Ashford Colour Press, Gosport, Hampshire.
Contents
Publisher’s acknowledgments / vii
Preface to the second edition / ix
Preface to the first edition / xiii
part 1 Risk and return
1 Returns I: Basic concepts / 3
2 Returns II: Mean returns / 11
3 Risk I: Total risk / 23
4 Risk and return I: Portfolios / 33
5 Risk II: Diversification / 43
6 Risk III: Systematic risk / 55
7 Risk and return II: CAPM and the cost of capital / 65
8 Risk and return III: The three-factor model / 81
9 Risk IV: Downside risk / 95
10 Risk and return IV: Risk-adjusted returns / 109
11 Risk and return V: Portfolio optimization / 123
12 Risk and return VI: The long term / 137
part 2 Valuation
13 Stocks I: The dividend discount model / 155
14 Stocks II: The WACC model / 169
15 Stocks III: Other DCF models / 183
vi Contents
16 Stocks IV: Reverse valuation / 197
17 Stocks V: Relative valuation / 207
18 Bonds I: Prices and yields / 219
19 Bonds II: Default risk and market risk / 235
20 Bonds III: Duration and convexity / 247
part 3 Other important topics
21 NPV and IRR / 261
22 Real options / 277
23 Corporate value creation / 289
24 Options / 299
25 Futures and forwards / 311
26 Currencies / 325
part 4 Statistical background
27 Stats I: Summary statistics / 341
28 Stats II: Normality / 355
29 Stats III: Non-normality / 369
30 Stats IV: Regression analysis / 383
Index / 397
Excel examples
The Excel files to accompany this book can be downloaded from:
www.pearsoned.co.uk/estrada
Publisher’s acknowledgments
We are grateful to the following for permission to reproduce copyright material:
Tables 7.1 and 12.1 adapted from DIMSON, ELROY; TRIUMPH OF THE
OPTIMISTS, © 2002 Elroy Dimson, Paul Marsh, and Mike Staunton.
Published by Princeton University Press. Reprinted by permission of
Princeton University Press; Table 19.1 from ‘Standard & Poor’s Ratings
Definitions’, © August 2010, published by Standard & Poor’s. Reproduced
with permission of Standard & Poor’s Financial Services LLC; Table 19.2
adapted from ‘Defaults and Returns in the High-Yield Bond Market: The Year
2007 in Review and Outlook’, Working Paper (Altman, E. and Karlin, B.
2008). Reproduced with permission of E. Altman.
In some instances we have been unable to trace the owners of copyright
material, and we would appreciate any information that would enable us to
do so.

Preface to the second edition
I had mixed feelings when I received the request to write a second edition of
Finance in a Nutshell. On the one hand it made me happy. I thought that
publishers ask authors to write a new edition of a book only when they
make a positive evaluation of the previous edition and are bullish about the
prospects of a follow-up. I also thought it was a good chance to clarify
explanations, update the data, correct typos, and ultimately take a fresh look
at all the material discussed in the first edition and improve it.
But on the other hand I was not so happy. Writing a book is fun, or at least
it was to me; but rewriting it is not, or at least not nearly as much. I also had
many more time constraints than I had when I wrote the first edition. So I
did think long and hard about it, at times leaning one way and at other
times leaning the other way.
It was a hard decision but in the end I accepted, as evidenced by the book
you’re holding in your hands. And I’m glad I did, because this edition
retains all the positive characteristics of the first but also improves upon it
in more than one way. If you liked Finance in a Nutshell, I have no doubt
you’ll like The FT Guide to Understanding Finance even more.
Why do I say this? Two reasons. First, I did not try to fix what was not
broken. I received a lot of positive feedback about both the coverage and the
style of the first edition. Readers found that the topics discussed properly
reflected those they considered most relevant, and liked the conversational
style in which those topics were discussed. Retaining both the topic
selection and the style, then, was a no-brainer. Second, I tried to repair what
was damaged. Very often when working on this second edition, I found
things that I could have explained better. So, whatever readers thought was
well done in the first edition, I’m sure it’s better done in this one.