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FIN670: Investment Analysis

Chapter 1: Background and Financial Instruments

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What this course is aboutBasic knowledge of invesment process and financial marketsValuation of bonds and related bond investment strategiesPortfolio theory: diversification and how it reduces portfolio riskAsset pricing models for expected returnsFundamental and technical analysis

Investments & Financial Assets

Essential nature of investmentReduced current consumptionPlanned later consumption

How to investReal Assets: Assets used to produce goods and services• produce income to economy

Financial Assets• Claims on real assets or income generated by

them• Allocation of income, real assets among

investors, individuals in the economy

Balance Sheet – U.S. Households

Financial Assets

Financial assets

Fixed-income (Bonds) Equity (Stocks) Derivatives

Money Market(Short-term)

Common StocksPreferred Stocks

OptionsFutures

Bond Market(Long-term)

Role of Financial asset and financial markets in the Economy

Consumption TimingAllocation of RiskSeparation of Ownership and Management

Consumption Timing

Savers

(earn more than spend)

Borrowers

(spend more than earn)

Financial assets: stocks, bonds, deposits, etc.

How do you transfer money from when you do not need to when you need?

Allocation of riskExample: GM wants to build a new auto plant, it raised money by issuing stocks and bonds

GM

Stock investors

(high risk)

Bond investors

(low risk)

Auto plant

High risk and low risk

Stock

Bond

Separation of ownership and management

Example: GE, total asset is $640 bilCannot be single owner, must have many ownersSelling stocks to market Currently, GE has 500,000 ownersThese owners choose managersCan easily transfer ownership without any impact on management

The Investment Process

Asset allocationSecurity selectionRisk-return trade-offMarket efficiencyActive vs. passive management

Investment process

Broad assets

Stocks

Bonds

Real estate

Commodity

Small stock

Big stock

corporate bond

T-bond, T-bill

House

Land

coffee, tea

gold, oil, etc(1) Asset allocation(2) Security analysis

30s 70% 30%40s 60 4050s 50 5060s 40 60

CommonAge Stocks Bonds

Example of Asset Allocation

Example of Security Selection

Your Stock Portfolio

Auto Retail Financial

Wal-MartNordstroms

Sears

Bank of AmericaBerkshire Hathaway

Citibank

There is no free lunch!Return

Risk

less risk

lessreturn

more risk

morereturn

Market Efficiency

Security prices accurately reflect all relevant information.

The price in the market is the true price

Earn return just enough to compensate for risk, no abnormal return

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

Players in the Financial Markets

Business Firms – net borrowersHouseholds – net saversGovernments – can be both borrowers and saversInvestment Bankers

Players in the Financial Markets

borrowers Savers securities

fund

borrowersfinancial

intermediariessavers

securities

lending rate

securities

borrowing rate

borrowers investment bank savers securities

fund

securities

fund

get commission fees

Recent Trends

GlobalizationSecuritizationFinancial EngineeringComputer Networks

Globalization

In 1970, US equity market accounted for about 70 percent of equity in the worldCurrently, only 20-30 percentHow to invest globally

Purchase ADRsInvest directly into international marketBuy mutual fund shares that invest in international marketderivative securities with payoff depends on prices of foreign market

Securitization

Banks

pool all loans

Mortgage loansauto loanscredit card

student loansother loans

securities

loans are securitized

Investors

Benefits of securitization

(1) more funds available to borrowers

(2) Transfer risk of loans to corresponding investors in the market

High risk loan High risk securities High risk investors

Low risk loan low risk securities low risk investors

Figure 1.2 Asset-backed Securities Outstanding

Financial engineering

refer to creation of new securities Use of mathematical models and computer-based trading technology to synthesize new financial productsBundling: combine more than one security into a composite securityUnbundling: breaking up and allocating the cash flows from one security to create several new securities

Collateralized Debt Obligation (CDO)

A CDO is an asset backed security (ABS) whose underlying collateral is typically a portfolio of bonds (corporate or sovereign) or bank loan

A CDO cash flow structure allocates interest income and principal repayments from a collateral pool of different debt instruments to a prioritized collection (tranches) of CDO securities.

Mortgage 1Mortgage 2Mortgage 3

Mortgage n

Average Yield12.5%

($100 mil)

Tranche 1 (AAA)Yield = 5%

($25mil)

Tranche 2 (A)Yield = 10%

($25mil)

Tranche 3 (BBB)Yield = 15%

($25mil)

Tranche 4 (junk bond)Yield = 20%

($25mil)

Cash CDO Structure Illustration

An investment

bank creates a set of

securities (tranches)

backed by a mortgage

pool

(CDO)

Investor:banks, pension funds, college saving funds, universities, cities, etc.

Collateralized Debt Obligation (CDO)

In normal time, mortgage borrowers are able to make the mortgage payments, so the investors will get the interest payments, the values of slices of CDOs increase

When housing bubble busts, mortgage borrowers, especially subprime mortgage borrowers are not able to make payments, investors don’t get their money, values of CDOs decrease substantially. The value decrease is write-down and counted as loss in the income statement.

For example, investment bank A, equity: $10 mil, borrow $90 mil. Invest all $100 mil in CDOs. When mortgage crisis happens, the market value of these mortgage backed securities drops substantially say to $80 mil, that means the income will go down by $80 mil, and at this point, technically the bank is insolvent.

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Subprime Mortgage Crisis: Winners and Losers

Big losers: http://ml-implode.com/ Bear Stearns: two hedge funds (>$1 billion) Australia: Basis Capital ($1 billion?); Absolute Capital ($200

million?); IKB Deutsche Industriebank … May take two more years to completely resolve!

Big losers: Citigroup ($18B+) Merrill Lynch ($11.5B+) UBS ($17.8B+) Morgan Stanley ($9.4B+) … Bank of China (initial estimate $223 million, now could be $4-5B)

Figure 1.3 Building Creates a Complex Security

Figure 1.4 Unbundling of Mortgages into Principal- and Interest-Only Securities

Recent Trends—Computer Networks

Online information disseminationInformation is made cheaply and widely available to the publicAutomated trade crossing

Direct trading among investors

2008: Making History

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2008: The End of Wall Street

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Decision Making

1. Perceive the situation2. Possible actions3. Evaluate the outcomes4. Choose the action with the best

outcome

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Investments: Asset classes and financial instruments

CHAPTER 2

Financial Securities

Financial Market

Fixed-income (Bonds) Equity (Stocks) Derivatives

Money Market(Short-term)

Common StocksPreferred Stocks

OptionsFutures

Low Risk High Risk

Bond Market(Long-term)

Index

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Treasury Bills Certificates of deposit Commercial paper Banker’s acceptances Eurodollars Repos and reverses Brokers’ calls* Federal funds LIBOR

Money Market Instruments

Money market instruments

T-bill• Issued by government• most marketable• minimum denomination: $1000• buy at a discount, return at par• issued weekly with maturities 28, 91, 182 days

Certificate of deposit (CD)• Pay interest and principal at maturity date• Par value > 100,000: negotiable• Par value <100,000: non-negotiable• Short-term CD (less than 3 months): highly

marketable

Money market instruments

Commercial paper• Issued by large, well-known corporation• Short term, unsecured debt (less than 270

days), more than 270 day need SEC registration.

• Fairly safe• Fairly liquid

banker acceptance• an order to a bank by a customer to pay a

sum of money at a future date• safe (guaranteed by bank)

Money market instruments

Eurodollars: dollar denominated at foreign banks or American banks’ foreign branches

• similar to domestic deposit• escape US regulation• riskier, less liquid, offer higher yield than

domestic deposit

Repos (repurchase agreements)• short-term sales of government securities

with an agreement to repurchase the securities at a higher price

Money market instruments

Federal funds• Funds in the accounts of commercial bank

at the Fed• Federal fund rate: overnight loan rate

among banks

LIBOR market: London Interbank Offer Rate: lending rate among banks in London market

Table 2.2 Components of the Money Market

Bond Market

Treasury Notes and BondsFederal Agency DebtInternational BondsInflation-Protected BondsMunicipal BondsCorporate BondsMortgages and Mortgage-Backed Securities

Treasury Notes and Bonds

MaturitiesNotes – maturities up to 10 yearsBonds – maturities in excess of 10 years

Par Value - $1,000Quotes – percentage of par, in 32nd

Figure 2.4 Treasury Notes and Bonds

Federal Agency Debt

Major issuersFederal Home Loan Bank

Federal National Mortgage Association (“Fannie Mae”)

Government National Mortgage Association (“Ginnie Mae”)

Federal Home Loan Mortgage Corporation (“Freddie Mac”)

If default, the government will helpsafe, yield is similar to T-bill

Municipal Bonds

Issued by state and local governments

TypesGeneral obligation bonds: backed by state, cityRevenue bonds: backed by the revenue of project of state, citytax exempt from federal tax (for investors)example: consider 2 bonds

• taxable bond: before tax yield = 8%, tax = 40%• municipal bond: yield = 6%• Which one is more attractive to investors?

Maturities – range up to 30 years

Interest is exempt from Federal taxes

After-tax return (taxable bond):

After-tax return (Municipal bond):

trr taxbeforetaxafter 1

taxbeforetaxafter rr

Municipal Bonds

Figure 2.6 Ratio of Yields on

Tax-exempts to Taxables, 1955-2006

Corporate Bonds

Issued by private firms Semi-annual interest paymentsSubject to larger default risk than government securitiesOptions in corporate bonds

CallableConvertible

Figure 2.7 Investment Grade Bond Listings

Developed in the 1970s to help liquidity of financial institutionsProportional ownership of a pool or a specified obligation secured by a pool Market has experienced very high rates of growth

Mortgages and Mortgage-backed Securities

Mortgage backed securities

Banks

Mortgage loan

Borrowers

mortgage backed securities

pool all mortgage loans

securitizedInvestors

sell

fund

fund

fund

fund payment

payment

paymentpayment

payment

Mortgage backed securities can be called pass through securities since the bank simply pass fund from investors to borrowers and pass interest payment and principal payment from borrowers to investors

Figure 2.7 Mortgage-backed Securities Outstanding, 1979-2007

Equity Markets

Common stock

Preferred stock

Depository receipts

stock market listing

Equity Markets

Common stock• Right to vote• Right to share benefit• Proxy• Proxy fight

Characteristics• Residual claims• Limited liabilities

Equity Markets

Preferred stocksSimilar to both stocks and bond (hybrid security)

• Similar to bond• Similar to stock

Priority over common stockpreferred dividend is cumulativetax treatment

• Preferred stock and bond are similar in the sense that they are both fixed income and have no voting power.

• Bond has claims before preferred stock• Obviously preferred stock is riskier, why in practice the

yield on preferred stock is smaller than that of bond

Equity Markets

ADR: claims on ownership in foreign companiesTrading in the US, similar to US stocksTotal value of ADR currently is 657 (bil), about 2000 ADRs from 73 countries

Figure 2.8 Listing of Stocks Traded on the NYSE

Track average returnsComparing performance of managersBase of derivatives

Uses of Stock Indexes

Examples of Other Indexes - Domestic

Dow Jones Industrial Average (30 Stocks)Standard & Poor’s 500 CompositeNASDAQ CompositeNYSE CompositeWilshire 5000

Figure 2-10 Comparative Performance of Several Stock Market Indexes

Examples of Indexes - International

Nikkei 225 & Nikkei 300FTSE (Financial Times of London)DaxRegion and Country Indexes

EAFEFar EastUnited Kingdom

MSCI: index of more than 50 country indexes

Table 2.6 Sample of MSCI Stock Indexes

Representative? Broad or narrow? How is it weighted?

Price weighted (DJIA)Market weighted (S&P 500, NASDAQ)Equal (Value Line Index)

Factors for Construction of Stock Indexes

Price Weighted Indices

DJIA is an example

30 blue chip companies

DJIA = (P1+P2+....+P30)/d where d is Dow divisor.

Originally d = 30

Currently, d = 0.1248 since d is adjusted for stock split, stock dividends, other corporate action, new companies coming into the index, old companies are taken out of the index

Example of Price-Weighted Index

Stock ABC sells initially at $25 a share with 20 million shares outstanding, while XYZ sells for $100 a share with 1 millions shares outstanding. The final price for ABC is $30, and the final price for XYZ is $90.(a) Find the initial and the final price-weighted index composed of these two stocks. Assume the initial divisor is 2.

(b) Now if stock XYZ is split two for one, how should you adjust the divisor for the index?

DJIA

Most quoted index in the world• Long history• easy to understand• indicates market’s basic trend reliably• 30 companies account for 24-25% of US

equity

Criticisms• Only 30 stocks• price weighted index: large price stocks

dominate the index

S&P’s Composite 500 Market Value-Weighted Index

Stock ABC sells initially at $25 a share with 20 million shares outstanding, while XYZ sells for $100 a share with 1 millions shares outstanding. The final price for ABC is $30, and the final price for XYZ is $90.Find the the value-weighted index composed of these two stocks at the final date. Assume the initial level of the index is 100.

Value LineEqually Weighted Index

Places equal weight on each returnUsing data from Table 2.4Start with equal dollars in each investmentABC increases in value by 20%XYZ decreases by 10%Need to rebalance to keep equal weights

Table 2.4 Data to Construct Stock Price Indexes

Computed monthly

Difficulty in measuring true returns

Best known:Merrill LynchLehman BrothersSalomon Smith Barney

Bond Index

DERIVATIVE MARKETS

Derivative Securities

OptionsBasic Positions

Call (Buy)Put (Sell)

TermsExercise PriceExpiration DateAssets

Futures Basic Positions

Long (Buy)Short (Sell)

TermsDelivery DateAssets

Call option - the right to buy an asset at a specific price (exercise price) on or before a specific date

Put option - the right to sell an asset at a specific price (exercise price) on or before a specific date

Options

Figure 2.10 Trading Data on GE Options

Options

Call options• Same expiration date, exercise price

increases, value of option decreases• Same exercise price, expiration date

increases, value of option increases

Put options• Same expiration date, exercise price

increases, value of option increases• Same exercise price, expiration date

increases, value of option increases

Futures contracts

Obligation to purchase or sell an asset at a specific price at a specific future dateLong position: trader who commits to buy commodity/asset at delivery dateShort position: trader who commits to sell at the delivery dateOption is the right, futures is obligation

Figure 2.11 Listing of Selected Futures Contracts

There is no free lunch!Return

Risk

less risk

lessreturn

more risk

morereturn

Money

T-Bonds

Corporate Bonds

Stocks

Derivatives

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SummaryDifferences between real assets and financial assetsPurpose of investing in financial assetsPlayers in financial marketsFinancial instrumentsFinancial market indicesNext class: How securities are trades; Investment companies