Chapter 1
Investments - Background and Issues
Investments & Financial Assets
Essential nature of investment
Reduced current consumption
Planned later consumption
Real Assets
Assets used to produce goods and services
Financial Assets
Claims on real assets
The Investment Process
Asset allocation
Security selection
Risk-return trade-off
Market efficiency
Active vs. passive management
Active vs. Passive Management
Active Management
Finding undervalued securities
Timing the market
Passive Management
No attempt to find undervalued securities
No attempt to time
Holding an efficient portfolio
Major Classes of Financial Assets or Securities
Debt
Money market instruments
Bonds
Common stock
Preferred stock
Derivative securities
Investments and Innovation
Technology and Delivery of Service
Computer advancements
More complete and timely information
Globalization
Domestic firms compete in global markets
Performance in regions depends on other regions
Causes additional elements of risk
Key Trends - Globalization
International and Global Markets Continue Developing
Managing foreign exchange
Diversification to improve performance
Instruments and vehicles continue to develop
Information and analysis improves
Key Trends - Securitization
Securitization & Credit Enhancement
Offers opportunities for investors and originators
Changes in financial institutions and regulation
Improvement in information capabilities
Credit enhancement and its role
Key Trends -
Financial Engineering
Repackaging Services of Financial Intermediaries
Bundling and unbundling of cash flows
Slicing and dicing of cash flows
Examples: strips, CMOs, dual purpose funds, principal/interest splits
The Future
Globalization continues and offers more opportunities
Securitization continues to develop
Continued development of derivatives and exotics
Strong fundamental foundation is critical
Integration of investments & corporate finance
Chapter 2
Financial Markets and Instruments
Major Classes of Financial Assets or Securities
Debt
Money market instruments
Bonds
Common stock
Preferred stock
Derivative securities
Markets and Instruments
Money Market
Debt Instruments
Derivatives
Capital Market
Bonds
Equity
Derivatives
Money Market Instruments
Treasury bills
Certificates of deposit
Commercial Paper
Bankers Acceptances
Eurodollars
Repurchase Agreements (RPs) and Reverse RPs
Federal Funds
Money Market Instrument Yields
Yields on Money Market Instruments are not always directly comparable
Factors influencing yields
Par value vs. investment value
360 vs. 365 days assumed in a year (366 leap year)
Bond equivalent yield
Interest rates that arise in connection with money market securities
.Bank discount rate (rBD )
.This is a rate that is used solely for determining the
price of a MM security for trading purposes.
.Bond equivalent yield (rBEY )
.In general, a yield is an interest rate that (under very
specific, sometimes unrealistic, assumptions) represents
a rate of return.
.rBEY is such a rate of return. It is an annual percentage
rate (APR)
.For comparing different MM instruments, we often use the
effective annual rate (EAR) of the rBEY .
Bank Discount Rate (T-Bills)
rBD = bank discount rate
P = market price of the T-bill
n = number of days to maturity
r
BD
=
10,000
-
P
10,000
x
360
n
90-day T-bill, P = $9,875
r
BD
=
10,000
-
9,875
10,000
x
360
90
=
5%
Example
Bond Equivalent Yield
Can’t compare T-bill directly to bond
360 vs 365 days
Return is figured on par vs. price paid
Adjust the bank discounted rate to make it comparable
Bond Equivalent Yield
P = price of the T-bill
n = number of days to maturity
r
BEY
=
10,000
-
P
P
x
365
n
r
BEY
=
10,000
-
9,875
9,875
x
365
90
rBEY = .0127 x = .0513 = %
Example Using Sample T-Bill
Capital Market - Fixed Income Instruments
Publicly Issued Instruments
US Treasury Bonds and Notes
Agency Issues (Fed Gov)
Municipal Bonds
Privately Issued Instruments
Corporate Bonds
Mortgage-Backed Securities
Capital Market - Equity
Common stock
Residual claim
Limited liability
Preferred stock
Fixed dividends - limited
Priority over common
Tax treatment
Stock Indexes
Uses
Track average returns
Comparing performance of managers
Base of derivatives
Factors in constructing or using an Index
Representative?
Broad or narrow?
How is it constructed?
Examples of Indexes - Domestic
Dow Jones Industrial Average (30 Stocks)
Standard & Poor’s 500 Composite
NASDAQ Composite
NYSE Composite
Wilshire 5000
Examples of Indexes - Int’l
Nikkei 225 & Nikkei 300
FTSE (Financial Times of London)
Dax
Region and Country Indexes
EAFE
Far East
United Kingdom
Construction of Indexes
How are stocks weighted?
Price weighted (DJIA)
Market-value weighted (S&P500, NASDAQ)
Equally weighted (Value Line Index)
Example
.Suppose we have two stocks
#Shares
Stock Pr 9/19/01 Pr 9/20/01 Return Outstand
A 100 120 20% 10M
B 10 9 –10% 500M
.Computation of a price-weighted index (like the Dow)
.Index on 9/19/01 (100+10)/2 = 55
Index on 9/20/01 (120+9)/2 =
Return on index %
.This is called a price-weighted index because the index
return is the price-weighted average of the component
(100/110) x 20% + (10/110) x –10% = %
.Portfolio: one share in each stock.
Market-value weighted index
.A market-value weighted average (like the S&P).
.Index on 9/19/01 = “100” (an arbitary base level)
.Market value of A = $100 x 10M = $1,000M
Market value of B = $10 x 500M = $5,000M
.Return on index is
(1,000/6,000) x 20% + (5,000/6000) x –10% = –5%
.Index on 9/20/01 = 100 x (1–5%) = 95
.Portfolio: 1/6 in A; 5/6 in B
.An equally-weighted index (like the Wilshire 5000)
.Index on 9/19/01 = “100” (an arbitary base level)
.Return on index is
(20% + –10%)/2 = +5%
.Index on 9/20/01 = 100 x (1+5%) = 105
.Portfolio: equal amounts in A and B
Chapter 3
How Securities are Traded
Primary vs. Secondary Security Sales
Primary
New issue
Key factor: issuer receives the proceeds from the sale
Secondary
Existing owner sells to another party
Issuing firm doesn’t receive proceeds and is not directly involved
Investment Banking Arrangements
Underwritten vs. “Best Efforts”
Underwritten: firm commitment on proceeds to the issuing firm
Best Efforts: no firm commitment
Negotiated vs. Competitive Bid
Negotiated: issuing firm negotiates terms with investment banker
Competitive bid: issuer structures the offering and secures bids
Public Offerings
Public offerings: registered with the SEC and sale is made to the investing public
Shelf registration (Rule 415, since 1982)
Initial Public Offerings (IPOs)
Evidence of underpricing
Performance
Private Placements
Private placement: sale to a limited
number of sophisticated investors not
requiring the protection of registration
Dominated by institutions
Very active market for debt securities
Not active for stock offerings
Organization of Secondary Markets
Organized exchanges
OTC market
Third market
Fourth market
Organized Exchanges
Auction markets with centralized order flow
Dealership function: can be competitive or assigned by the exchange (Specialists)
Securities: stock, futures contracts, options, and to a lesser extent, bonds
Examples: NYSE, AMEX, Regionals, CBOE
Types of Orders
Instructions to the brokers on how to
complete the order
Market
Limit
Stop loss
Margin Trading
Using only a portion of the proceeds for an investment
Borrow remaining component
Margin arrangements differ for stocks and futures
Stock Margin Trading
Maximum margin is currently 50%; you can borrow up to 50% of the stock value
Set by the Fed
Maintenance margin: minimum amount equity in trading can be before additional funds must be put into the account
Margin call: notification from broker you must put up additional funds
Margin Trading - Initial Conditions
X Corp $70
50% Initial Margin
40% Maintenance Margin
1000 Shares Purchased
Initial Position
Stock $70,000 Borrowed $35,000
Equity 35,000
Margin Trading - Maintenance Margin
Stock price falls to $60 per share
New Position
Stock $60,000 Borrowed $35,000
Equity 25,000
Margin% = $25,000/$60,000 = %
Margin Trading - Margin Call
How far can the stock price fall before a margin call?
(1000P - $35,000)* / 1000P = 40%
P = $
* 1000P - Amt Borrowed = Equity
Short Sales
Purpose: to profit from a decline in the price of a stock or security
Mechanics
Borrow stock through a dealer
Sell it and deposit proceeds and margin in an account
Closing out the position: buy the stock and return to the party from which is was borrowed
Short Sale - Initial Conditions
Z Corp 100 Shares
50% Initial Margin
30% Maintenance Margin
$100 Initial Price
Sale Proceeds $10,000
Margin & Equity 5,000
Stock Owed 10,000
Short Sale - Maintenance Margin
Stock Price Rises to $110
Sale Proceeds $10,000
Initial Margin 5,000
Stock Owed 11,000
Net Equity 4,000
Margin % (4000/11000) 36%
Short Sale - Margin Call
How much can the stock price rise before a margin call?
($15,000* - 100P) / (100P) = 30%
P = $
* Initial margin plus sale proceeds
