Essentials of Investments
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Chapter 1
Investments - Background and Issues
Essentials of Investments
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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
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The Investment Process
• Asset allocation
• Security selection
• Risk-return trade-off
• Market efficiency
• Active vs. passive management
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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
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Major Classes of Financial Assets or Securities
• Debt– Money market instruments– Bonds
• Common stock
• Preferred stock
• Derivative securities
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Investments and Innovation
Technology and Delivery of Service• Computer advancements• More complete and timely informationGlobalization• Domestic firms compete in global
markets• Performance in regions depends on
other regions• Causes additional elements of risk
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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
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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
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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
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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
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Chapter 2
Financial Markets and Instruments
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Major Classes of Financial Assets or Securities
• Debt– Money market instruments– Bonds
• Common stock
• Preferred stock
• Derivative securities
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Markets and Instruments
• Money Market– Debt Instruments– Derivatives
• Capital Market– Bonds– Equity– Derivatives
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Money Market Instruments
• Treasury bills
• Certificates of deposit
• Commercial Paper
• Bankers Acceptances
• Eurodollars
• Repurchase Agreements (RPs) and Reverse RPs
• Federal Funds
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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
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Interest rates that arise in connection with money market securities.Bank discount rate (rBD ).This is a rate that is used solely for determining theprice of a MM security for trading purposes..Bond equivalent yield (rBEY ).In general, a yield is an interest rate that (under veryspecific, sometimes unrealistic, assumptions) representsa rate of return..rBEY is such a rate of return. It is an annual percentagerate (APR).For comparing different MM instruments, we often use theeffective annual rate (EAR) of the rBEY .
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Bank Discount Rate (T-Bills)
rrBDBD = bank discount rate= bank discount rate
PP = market price of the T-bill= market price of the T-bill
nn = number of days to maturity= number of days to maturity
rrBDBD == 10,00010,000 -- PP10,00010,000
xx 360360nn
90-day T-bill, P = $9,87590-day T-bill, P = $9,875
rrBDBD == 10,00010,000 -- 9,8759,875
10,00010,000 x x
360360
9090== 5%5%
ExampleExample
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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
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Bond Equivalent Yield
P = price of the T-billP = price of the T-bill
n = number of days to maturityn = number of days to maturity
rr BEYBEY == 10,00010,000 -- PP
PP xx 365365
nn
rrBEYBEY == 10,00010,000 -- 9,8759,875
9,8759,875 x x 365365
9090rrBEYBEY = .0127 x 4.0556 = .0513 = 5.13% = .0127 x 4.0556 = .0513 = 5.13%
Example Using Sample T-BillExample Using Sample T-Bill
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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
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Capital Market - Equity
• Common stock– Residual claim– Limited liability
• Preferred stock– Fixed dividends - limited– Priority over common– Tax treatment
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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?
Stock Indexes
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Examples of Indexes - Domestic
• Dow Jones Industrial Average (30 Stocks)
• Standard & Poor’s 500 Composite
• NASDAQ Composite
• NYSE Composite
• Wilshire 5000
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Examples of Indexes - Int’l
• Nikkei 225 & Nikkei 300
• FTSE (Financial Times of London)
• Dax
• Region and Country Indexes– EAFE– Far East– United Kingdom
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Construction of Indexes
• How are stocks weighted?– Price weighted (DJIA)– Market-value weighted (S&P500,
NASDAQ)– Equally weighted (Value Line Index)
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Example.Suppose we have two stocks
#SharesStock Pr 9/19/01 Pr 9/20/01 Return OutstandA 100 120 20% 10MB 10 9 –10% 500M.Computation of a price-weighted index (like the Dow).Index on 9/19/01 (100+10)/2 = 55Index on 9/20/01 (120+9)/2 = 64.5Return on index 17.27%.This is called a price-weighted index because the indexreturn is the price-weighted average of the component(100/110) x 20% + (10/110) x –10% = 17.27%.Portfolio: one share in each stock.
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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 = $1,000MMarket 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
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Chapter 3
How Securities are Traded
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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
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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
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• 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
Public Offerings
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Private placement: sale to a limitednumber of sophisticated investors notrequiring the protection of registration• Dominated by institutions
• Very active market for debt securities
• Not active for stock offerings
Private Placements
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Organization of Secondary Markets
• Organized exchanges
• OTC market
• Third market
• Fourth market
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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
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Types of Orders
Instructions to the brokers on how tocomplete the order
• Market
• Limit
• Stop loss
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Margin Trading
• Using only a portion of the proceeds for an investment
• Borrow remaining component
• Margin arrangements differ for stocks and futures
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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
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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
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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 = 41.67%
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Margin Trading - Margin Call
How far can the stock price fall before amargin call?
(1000P - $35,000)* / 1000P = 40%
P = $58.33
* 1000P - Amt Borrowed = Equity
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Short SalesPurpose: to profit from a decline in the
price of a stock or securityMechanics
• 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
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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
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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%
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Short Sale - Margin Call
How much can the stock price rise before a margin call?
($15,000* - 100P) / (100P) = 30%
P = $115.38
* Initial margin plus sale proceeds