Portfolio management sessions 1&2

MGB Portfolio Management I

MASTER OF GLOBAL BUSINESS

PORTFOLIO MANAGEMENT I


THE GLOBAL INVESTMENT ENVIRONMENT


The case for global investing has never been clearer than in the present environment. The global financial crisis reinforced the need for the continuation of increased diversification globally.

The case for global investing is based on powerful secular trends driving the future of world economies and securities markets:• The continued rise of emerging countries as the growth engines of the

world economy while the developed world faces deleveraging headwinds

• The growth of global trade as barriers fall• The reality of truly global companies whose main earnings derive from

countries and markets far from their home headquarters• The deepening of capital markets beyond the developed world• The growing share of global market capitalization outside traditional

centers like the US

The Case for Global Investing



While the reasons for global investing are well articulated, many investors still struggle with how to invest globally and how to address the additional risks that come with investing beyond one’s domestic market.

Those include:• Increased complexity of managing currency translation risk• Liquidity concerns in some foreign markets or illiquid asset classes like

private equity• Political and fiscal uncertainty in some countries

This uncertainty may explain the persistence of significant home-country bias in many institutional portfolios around the world. As recently as three years also, institutional investors in major developed countries like the US, UK, Germany, Japan, France, and Italy still displayed striking biases to home equities, according to consultant studies.



MSCI World Index 2003 2009

U.S 52% 42%

Developed International 42% 44%

Emerging International 6% 14%

% of total world market cap

Despite additional complexities, fund managers still prefer international investing as they perceive greater risks of allocating capital too narrowly in home markets while global developments are creating long-term opportunities overseas.



• Why investors should include foreign as well as domestic securities in their portfolio

• Securities in domestic and global markets (risk-return characteristics)• Historic risk-return performance of investment instruments from around

the world


Total Investable Capital Markets: 1969 - $2.3 Trillion

U.S. Equity31%

Cash Equivalent7%

Japan Equity2%

U.S. Real Estate12%Other Bonds

14%

U.S. Bonds21%

Japan Bonds1%

Other Equity11%Venture Capital

0%

Dollar Bonds1%



Japan Equity5%

All Other Equity15%

Japan Bonds8%

Emerging Debt Market

2%

All Other Bonds18% High Yield Bonds

1%

Dollar Bonds20%

U.S. Real Estate5%

Cash Equivalent4%Emerging Market

Equity1%

Cash Equivalent7%

U.S. Equity21%



1969: US stock and Bond Market = 65% of all securities available in world capital markets

2010: US stock and Bond Market = 42.6% of all securities available in world capital markets



Global Government Bond Annual Rates of Return in US Dollars

1986-2010 Mean Standard Deviation

Canada 10.32 9.77

France 10.39 12.86

Germany 9.28 13.49

Japan 9.14 14.75

UK 9.84 13.28

USA 7.37 6.09



Correlation Coefficients between US$ rates of return on Bonds in the US and major markets

1986-2010 Correlation Coefficient with US Bonds

Canada 0.75

France 0.61

Germany 0.63

Japan 0.34

UK 0.59

Average 0.58



Risk-Return Trade-off for International Bond Portfolios


Basic Series: Historical Highlights (1926 - 1997)

Annual Arithmetic Standard

Geometric Mean of Deviation

Mean Rate Annual of Annual

Series of Return Returns Returns

Large company stocks 11.0 % 13.0 % 20.3 %12.7 17.7 33.9

5.7 6.1 8.75.2 5.6 9.2

Intermediate-term government bonds 5.3 5.4 5.73.8 3.8 3.2

Consumer price index 3.1 3.2 4.5

Small capitalization stocksLong-term corporate bondsLong-term government bonds

U.S. Treasury bills

Source: © Stocks, Bonds, Bills, and Inflation: 1998 YearbookTM, Ibbotson Associates, Chicago(Annually updates work by Roger G. Ibbotson and Rex A. Sinquefield). Used with permission. All rights reserved.


A Minor Deviation


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• relative measure of a given relationship

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Risk Reduction


Asset Classes and Available Financial Instruments

Name of Asset Sub-Assets Liquidity Timeframe Classification Appropriate ROI Risk level

Equities Good 5–6 yearsGrowth assets (focus on capital growth and

income

medium to

high

Listed

Domestic

Sector basis

Strategy basis

International

Sector basis

Strategy basis

Unlisted

Private Equity

Venture Capital

Fixed Income

Bonds Defensive

Investment-gradeLow -

Medium

Junk (high-yield) High

government 1 – 3 years Low

corporateMedium -

High

short-term

intermediate

long-term

domestic

foreign

emerging markets

Convertible security

MGB Portfolio Management IName of

AssetSub-Assets Liquidity Timeframe Classification

Appropriate

ROIRisk level

Cash Unlimited Defensive Low

Real Estate Growth

Direct

Commercial

Residential

Property Trusts

Listed 3 – 5 years

Commercial

Residential

Unlisted

Commercial

Residential

Fiat Currency

Digital

CurrencyVery High Growth High Risk

Bitcoin

Litecoin

Namecoin

Alternatives

hedge funds

Opportunistic/distressed

strategies

Commodities

Precious metals

Agriculture

Energy

Broad basket

Collectibles

Art

Asset Classes and Available Financial Instruments


Global Investment Choices

• Fixed-income investments– bonds and preferred stocks

• Equity investments• Special equity instruments

– warrants and options• Futures contracts• Investment companies• Real assets


Fixed-Income Investments

• Contractual payment schedule• Recourse varies by instrument• Bonds

– investors are lenders– expect interest payment and return of principal

• Preferred stocks– dividends require board of directors approval


Savings Accounts• Fixed earnings• Convenient• Liquid• Low risk• Low rates• Certificates of Deposit (CDs)

- instruments that require minimum deposits for specified terms, and pay higher rates of interest than savings accounts. Penalty imposed for early withdrawal


Money Market Certificates

• Compete against Treasury bills (T-bills)

• Minimum $10,000

• Minimum maturity of six months

• Redeemable only at bank of issue

• Penalty if withdrawn before maturity


Capital Market Instruments

• Fixed income obligations that trade in secondary market

• U.S. Treasury securities

• U.S. Government agency securities

• Municipal bonds

• Corporate bonds


U.S. Treasury Securities

• Bills, notes, or bonds - depending on maturity– Bills mature in less than 1 year– Notes mature in 1 - 10 years– Bonds mature in over 10 years

• Highly liquid• Backed by the full faith and credit of the U.S.

Government


U.S. Government Agency Securities

• Sold by government agencies– Federal National Mortgage Association (FNMA or Fannie Mae)– Federal Home Loan Bank (FHLB)– Government National Mortgage Association (GNMA or Ginnie

Mae)– Federal Housing Administration (FHA)

• Not direct obligations of the Treasury– Still considered default-free and fairly liquid


Municipal Bonds

• Issued by state and local governments usually to finance infrastructural projects.

• Exempt from taxation by the federal government and by the state that issued the bond, provided the investor is a resident of that state

• Two types:– General obligation bonds (GOs)

– Revenue bonds


Corporate Bonds

• Issued by a corporation• Fixed income• Credit quality measured by ratings• Maturity• Features

– Indenture– Call provision– Sinking fund


Corporate Bonds

• Senior secured bonds– most senior bonds in capital structure and have the lowest risk of

default

• Mortgage bonds– secured by liens on specific assets

• Collateral trust bonds– secured by financial assets

• Equipment trust certificates– secured by transportation equipment


Corporate Bonds

• Debentures– Unsecured promises to pay interest and principal– In case of default, debenture owner can force bankruptcy and

claim any unpledged assets to pay off the bonds

• Subordinated bonds– Unsecured like debentures, but holders of these bonds may claim

assets after senior secured and debenture holders claims have been satisfied


Corporate Bonds

• Income bonds– Interest payment contingent upon earning sufficient

income • Convertible bonds

– Offer the upside potential of common stock and the downside protection of a bond

– Usually have lower interest rates


Corporate Bonds

• Warrants– Allows bondholder to purchase the firm’s common stock at a fixed

price for a given time period– Interest rates usually lower on bonds with warrants attached

• Zero coupon bond– Offered at a deep discount from the face value– No interest during the life of the bond, only the principal payment

at maturity


Preferred Stock

• Hybrid security• Fixed dividends• Dividend obligations are not legally binding, but must be

voted on by the board of directors to be paid• Most preferred stock is cumulative• Credit implications of missing dividends• Corporations may exclude 70% of dividend income from

taxable income


International Bond Investing

Investors should be aware that there is a very substantial fixed income market outside the United States that offers additional opportunity for diversification



• Bond identification characteristics– Country of origin– Location of primary trading market– Home country of the major buyers– Currency of the security denomination

• Eurobond– An international bond denominated in a currency not native to

the country where it is issued



• Yankee bonds– Sold in the United States and denominated is U.S.

dollars, but issued by foreign corporations or governments

– Eliminates exchange risk to U.S. investors

• International domestic bonds– Sold by issuer within its own country in that country’s

currency


Equity Investments

• Returns are not contractual and may be better or worse than on a bond


Equity Investments

Common Stock– Represents ownership of a firm– Investor’s return tied to performance of the company

and may result in loss or gain


Acquiring Foreign Equities

1. Purchase of American Depository Receipts (ADRs)2. Purchase of American shares3. Direct purchase of foreign shares listed on a U.S.

or foreign stock exchange4. Purchase of international mutual funds


American Depository Receipts (ADRs)

• Easiest way to directly acquire foreign shares• Certificates of ownership issued by a U.S. bank that

represents indirect ownership of a certain number of shares of a specific foreign firm on deposit in a U.S. bank in the firm’s home country

• Buy and sell in U.S. dollars• Dividends in U.S. dollars• May represent multiple shares• Listed on U.S. exchanges• Very popular


Direct Purchase of Foreign Shares

• Direct investment in foreign equity markets- difficult and complicated due to administrative, information, taxation, and market efficiency problems

• Purchase foreign stocks listed on a U.S. exchange – limited choice


Purchase International Mutual Funds

• Global funds - invest in both U.S. and foreign stocks

• International funds - invest mostly outside the U.S.

• Funds can specialize– Diversification across many countries– Concentrate in a segment of the world– Concentrate in a specific country– Concentrate in types of markets


Special Equity Instruments

• Equity-derivative securities have a claim on common stock of a firm

• Options are rights to buy or sell at a stated price for a period of time

• Warrants are options to buy from the company• Puts are options to sell to an investor• Calls are options to buy from a stockholder


Futures Contracts

• Exchange of a particular asset at a specified delivery date for a stated price paid at the time of delivery

• Deposit (10% margin) is made by buyer at contract to protect the seller

• Commodities trading is largely in futures contracts• Current price depends on expectations


Financial Futures

• Recent development of contracts on financial instruments such as T-bills, Treasury bonds, and Eurobonds

• Traded mostly on Chicago Mercantile Exchange (CME) and Chicago Board of Trade (CBOT)

• Allow investors and portfolio managers to protect against volatile interest rates

• Currency futures allow protection against changes in exchange rates


Investment Companies

• Rather than buy individual securities directly from the issuer they can be acquired indirectly through shares in an investment company

• Investment companies sell shares in itself and uses proceeds to buy securities

• Investors own part of the portfolio of investments



• Money market funds– Acquire high-quality, short-term investments– Yields are higher than normal bank CDs– Typical minimum investment is $1,000– No sales commission charges– Withdrawal is by check with no penalty– Investments usually are not insured



• Bond funds– Invest in long-term government, corporate, or

municipal bonds

– Bond funds vary in bond quality selected for investment

– Expected returns vary with risk of bonds



• Common stock funds– Many different funds with varying stated investment

objectives• Aggressive growth, income, precious metals, international

stocks– Offer diversification to smaller investors– Sector funds concentrate in an industry– International funds invest outside the United States– Global funds invest in the U.S. and other countries



• Balanced funds– Invest in a combination of stocks and bonds

depending on their stated objectives


Real Estate Investment Trusts (REITs)

• Investment fund that invests in a variety of real estate properties

• Construction and development trusts provide builders with construction financing

• Mortgage trusts provide long-term financing for properties

• Equity trusts own various income-producing properties


Direct Real Estate Investment

• Purchase of a home– Average cost of a single-family house exceeds $100,000

– Financing by mortgage requires down payment

– Homeowner hopes to sell the house for cost plus a gain



• Purchase of raw land– Intention of selling in future for a profit

– Ownership provides a negative cash flow due to mortgage payments, taxes, and property maintenance

– Risk from selling for an uncertain price and low liquidity



• Land Development– Buy raw land

– Divide into individual lots

– Build houses or a shopping mall on it

– Requires capital, time, and expertise

– Returns from successful development can be significant


Low-Liquidity Investments

• Some investments don’t trade on securities markets• Lack of liquidity keeps many investors away• Auction sales create wide fluctuations in prices• Without markets, dealers incur high transaction costs


Antiques

• Dealers buy at estate sales, refurbish, and sell at a profit• Serious collectors may enjoy good returns• Individuals buying a few pieces to decorate a home may

have difficulty overcoming transaction costs to ever enjoy a profit


Art

• Investment requires substantial knowledge of art and the art world

• Acquisition of work from a well-known artist requires large capital commitments and patience

• High transaction costs• Uncertainty and illiquidity


Coins and Stamps

• Enjoyed by many as hobby and as an investment• Market is more fragmented than stock market,

but more liquid than art and antiques markets• Price lists are published weekly and monthly• Grading specifications aid sales• Wide spread between bid and ask prices


Diamonds

• Can be illiquid• Grading determines value, but is subjective• Investment-grade gems require substantial investments• No positive cash flow until sold• Costs of insurance, storage, and appraisal


Risk Return Relationship


FUNCTION AND STRUCTURE OF FINANCIAL MARKETS


In the Beginning

• Suppose you want to start a business to develop iPhone App, but you have no start up funds.

• At the same time, Makena has money to invest for retirement.

• If the two of you could get together, perhaps both of your needs can be met. But how does that happen?

• We will examine the effects of financial markets and institutions on the economy, and look at their general structure and operations. ─ Function and Structure of Financial Markets─ Internationalization of Financial Markets─ Types and Functions of Financial Intermediaries─ Regulation of the Financial System


Function of Financial Markets

• Channels funds from person or business without investment opportunities (i.e., “Lender-Savers”) to one who has them (i.e., “Borrower-Spenders”)

• Improves economic efficiency


Financial Markets Funds Transferees

Lender-Savers1. Households2. Business firms3. Government4. Foreigners

Borrower-Spenders

5. Business firms6. Government7. Households8. Foreigners


Segments of Financial Markets

1. Direct Finance• Borrowers borrow directly from lenders in financial

markets by selling financial instruments which are claims on the borrower’s future income or assets

2. Indirect Finance• Borrowers borrow indirectly from lenders via financial

intermediaries (established to source both loanable funds and loan opportunities) by issuing financial instruments which are claims on the borrower’s future income or assets


Importance of Financial Markets

• This is important. For example, if you save $1,000, but there are no financial markets, then you can earn no return on this—might as well put the money under your mattress.

• However, if a carpenter could use that money to buy a new saw (increasing her productivity), then he’d be willing to pay you some interest for the use of the funds.

• Financial markets are critical for producing an efficient allocation of capital, allowing funds to move from people who lack productive investment opportunities to people who have them.

• Financial markets also improve the well-being of consumers, allowing them to time their purchases better.


Structure of Financial Markets

1. Debt Markets─ Short-Term (maturity < 1 year)─ Long-Term (maturity > 10 year)─ Intermediate term (maturity in-between)─ Represented $52.4 trillion at the end of 2009.

2. Equity Markets─ Pay dividends, in theory forever─ Represents an ownership claim in the firm─ Total value of all U.S. equity was $20.5 trillion at the end

of 2009.



1. Primary Market─ New security issues sold to initial buyers– Who does the issuer sell to in the Primary Market?

2. Secondary Market─ Securities previously issued are bought

and sold– Examples include the NYSE and Nasdaq– Who trades?



Even though firms don’t get any money, per se, from the secondary market, it serves two important functions:

•Provide liquidity, making it easy to buy and sell the securities of the companies

•Establish a price for the securities



We can further classify secondary markets as follows:1. Exchanges

─ Trades conducted in central locations (e.g., New York Stock Exchange, CBT)

2. Over-the-Counter Markets─ Dealers at different locations buy and sell– Best example is the market for Treasury securities

www.treasurydirect.gov

NYSE home page http://www.nyse.com

http://www.nyse.com/


Classifications of Financial Markets

We can also further classify markets by the maturity of the securities:1. Money Market: Short-Term (maturity <= 1 year) 2. Capital Market: Long-Term (maturity > 1 year) plus equities


Internationalization of Financial Markets

The internationalization of markets is an important trend. The U.S. no longer dominates the world stage. International Bond Market & Eurobonds

– Foreign bonds• Denominated in a foreign currency• Targeted at a foreign market

– Eurobonds• Denominated in one currency, but sold in a different market• now larger than U.S. corporate bond market)• Over 80% of new bonds are Eurobonds.



• Eurocurrency Market– Foreign currency deposited outside of home country– Eurodollars are U.S. dollars deposited, say, London.– Gives U.S. borrows an alternative source for dollars.

• World Stock Markets– U.S. stock markets are no longer always the largest—at

one point, Japan’s was larger




Global perspective Relative Decline of U.S. Capital Markets

The U.S. has lost its dominance in many industries: auto and consumer electronics to name a few.

A similar trend appears at work for U.S. financial markets, as London and Hong Kong compete. Indeed, many U.S. firms use these markets over the U.S.

Why?1. New technology in foreign exchanges2. 9-11 made U.S. regulations tighter3. Greater risk of lawsuit in the U.S.4. Sarbanes-Oxley has increased the cost of being a U.S.-listed

public company


Function of FinancialIntermediaries: Indirect Finance



Instead of savers lending/investing directly with borrowers, a financial intermediary (such as a bank) plays as the middleman: the intermediary obtains funds from savers the intermediary then makes loans/investments

with borrowers



This process, called financial intermediation, is actually the primary means of moving funds from lenders to borrowers.

More important source of finance than securities markets (such as stocks)

Needed because of transactions costs, risk sharing, and asymmetric information



Transactions Costs 1. Financial intermediaries make profits by reducing

transactions costs

2. Reduce transactions costs by developing expertise and taking advantage of economies of scale


• A financial intermediary’s low transaction costs mean that it can provide its customers with liquidity services

1. Banks provide depositors with checking accounts that enable them to pay their bills easily

2. Depositors can earn interest on checking and savings accounts and yet still convert them into goods and services whenever necessary



Global Perspective

Studies show that firms in the U.S., Canada, the U.K., and other developed nations usually obtain funds from financial intermediaries, not directly from capital markets.

In Germany and Japan, financing from financial intermediaries exceeds capital market financing 10-fold.

However, the relative use of bonds versus equity does differ by country.



• FI’s low transaction costs allow them to reduce the exposure of investors to risk, through a process known as risk sharing– FIs create and sell assets with lesser risk to one

party in order to buy assets with greater risk from another party

– This process is referred to as asset transformation, because in a sense risky assets are turned into safer assets for investors



Financial intermediaries also help by providing the means for individuals and businesses to diversify their asset holdings.

Low transaction costs allow them to buy a range of assets, pool them, and then sell rights to the diversified pool to individuals.



Another reason FIs exist is to reduce the impact of asymmetric information.

One party lacks crucial information about another party, impacting decision-making.

We usually discuss this problem along two fronts: adverse selection and moral hazard.


Organization and Functioning of Securities Markets

Questions to be answered:• What is the purpose and function of a market?• What are the characteristics that determine the

quality of a market?• What is the difference between a primary and

secondary capital market and how do these markets support each other?



• What are the national exchanges and how are the major security markets becoming linked (what is meant by “passing the book”)?

• What are the regional stock exchanges and the over-the-counter (OTC) market?

• What are the alternative market-making arrangements available on the exchanges and the OCT market?



• What are the major types of orders available to investors and market makers?

• What are the major functions of a specialist on the NYSE and how does the specialist differ from the central market maker on other exchanges?

• What are the major factors that have caused the significant changes in markets around the world in the past 10 to 15 years?


What is a market?

• Brings buyers and sellers together to aid in the transfer of goods and services

• Does not require a physical location• Both buyers and sellers benefit from the market


Characteristics of a Good Market

• Availability of past transaction information– must be timely and accurate

• Liquidity– marketability– price continuity– depth

• Low Transaction costs• Rapid adjustment of prices to new information


Organization of the Securities Market

• Primary markets– Market where new securities are sold and funds go to issuing unit

• Secondary markets– Market where outstanding securities are bought and sold by investors.

The issuing unit does not receive any funds in a secondary market transaction


Corporate Bond and Stock Issues

New issues are divided into two groups1. Seasoned new issues - new shares offered by firms that

already have stock outstanding2. Initial public offerings (IPOs) - a firm selling its common

stock to the public for the first time


Underwriting Relationships with Investment Bankers

1. Negotiated– Most common– Full services of underwriter

2. Competitive bids– Corporation specifies securities offered– Lower costs– Reduced services of underwriter

3. Best-efforts– Investment banker acts as broker


Why Secondary Financial Markets Are Important

• Provides liquidity to investors who acquire securities in the primary market

• Results in lower required returns than if issuers had to compensate for lower liquidity

• Helps determine market pricing for new issues


Secondary Equity Markets

1. Major national stock exchanges– New York, American, Tokyo, and London stock exchanges

2. Regional stock exchanges– Chicago, San Francisco, Boston, Osaka, Nagoya, Dublin, Cincinnati

3. Over-the-counter (OTC) market – Stocks not listed on organized exchange


Trading Systems

• Pure auction market– Buyers and sellers are matched by a broker at a central

location– Price-driven market

• Dealer market– Dealers provide liquidity by buying and selling shares– Dealers may compete against other dealers


Call Versus Continuous Markets

• Call markets trade individual stocks at specified times to gather all orders and determine a single price to satisfy the most orders

• Used for opening prices on NYSE if orders build up overnight or after trading is suspended

• In a continuous market, trades occur at any time the market is open


National Stock Exchanges

• Large number of listed securities• Prestige of firms listed• Wide geographic dispersion of listed firms• Diverse clientele of buyers and sellers


Regional Exchanges

• Stocks not listed on a formal exchange– Listing requirements vary

• Listed stocks– Allow brokers that are not members of a national

exchange access to securities

• Regional Exchanges in United States– Chicago, Boston, Cincinnati, Pacific, Philadelphia


Over-the-Counter (OTC) Market

• Not a formal organization• Largest segment of the U.S. secondary market• Unlisted stocks and listed stocks (third market)• Lenient requirements for listing on OTC• 5,000 issues actively traded on NASDAQ NMS (National

Association of Securities Dealers Automated Quotations National

Market System) • 1,000 issues on NASDAQ apart from NMS• 1,000 issues not on NASDAQ


Operation of the OTC

• Any stock may be traded as long as it has a willing

market maker to act a dealer

• OTC is a negotiated market


Third Market

• OTC trading of shares listed on an exchange• Mostly well known stocks

– GM, IBM, AT&T, Xerox

• Competes with trades on exchange• May be open when exchange is closed or trading

suspended


Fourth Market

• Direct trading of securities between two parties with no broker intermediary

• Usually both parties are institutions• Can save transaction costs• No data are available regarding its specific size and growth


Exchange Membership

• Specialist• Commission brokers

– Employees of a member firm who buy or sell for the customers of the firm

• Floor brokers– Independent members of an exchange who act as broker for

other members• Registered traders

– Use their membership to buy and sell for their own accounts


Major Types of Orders

• Market orders– Buy or sell at the best current price– Provides immediate liquidity

• Limit orders– Order specifies the buy or sell price– Time specifications for order may vary

• Instantaneous - “fill or kill”, part of a day, a full day, several days, a week, a month, or good until canceled (GTC)



• Short sales– Sell overpriced stock that you don’t own and purchase it back

later (at a lower price)– Borrow the stock from another investor (through your broker)– Can only be made on an uptick trade– Must pay any dividends to lender– Margin requirements apply



• Special Orders– Stop loss

• Conditional order to sell stock if it drops to a given price• Does not guarantee price you will get upon sale• Market disruptions can cancel such orders

– Stop buy order• Investor who sold short may want to limit loss if stock

increases in price


Margin Transactions

• On any type order, instead of paying 100% cash, borrow a portion of the transaction, using the stock as collateral

• Interest rate on margin credit may be below prime rate• Regulations limit proportion borrowed

– Margin requirements are from 50% up

• Changes in price affect investor’s equity


Margin Transactions

Buy 200 shares at $50 = $10,000 positionBorrow 50%, investment of $5,000If price increases to $60, position

– Value is $12,000– Less - $5,000 borrowed – Leaves $7,000 equity for a– $7,000/$12,000 = 58% equity position


Margin Transactions

Buy 200 shares at $50 = $10,000 positionBorrow 50%, investment of $5,000If price decreases to $40, position

– Value is $8,000– Less - $5,000 borrowed – Leaves $3,000 equity for a– $3,000/$8,000 = 37.5% equity position


Margin Transactions

• Initial margin requirement at least 50%. Set up by the Fed.

• Maintenance margin– Requirement proportion of equity to stock– Protects broker if stock price declines– Minimum requirement is 25%– Margin call on undermargined account to meet margin

requirement– If margin call not met, stock will be sold to pay off the loan


Exchange Market Makers U.S. Markets

• Specialist is exchange member assigned to handle particular stocks– Has two roles:– Broker to match buyers and sellers– Dealer to maintain fair and orderly market

• Specialist has two income sources– Broker commission, without risk– Dealer trading income from profit, with risk


Adverse Selection1. Before transaction occurs

2. Potential borrowers most likely to produce adverse outcome are ones most likely to seek a loan

3. Similar problems occur with insurance where unhealthy people want their known medical problems covered

Asymmetric Information: Adverse Selection and Moral Hazard


• Moral Hazard1. After transaction occurs

2. Hazard that borrower has incentives to engage in undesirable (immoral) activities making it more likely that won’t pay loan back

3. Again, with insurance, people may engage in risky activities only after being insured

4. Another view is a conflict of interest




Financial intermediaries reduce adverse selection and moral hazard problems, enabling them to make profits. How they do this is the covered in many of the chapters to come.

Because of their expertise in screening and monitoring, they minimize their losses, earning a higher return on lending and paying higher yields to savers.


Types of Financial Intermediaries


Types of Financial Intermediaries


Regulatory Agencies


Regulatory Agencies (cont.)


Regulation of Financial Markets

Main Reasons for Regulation1. Increase Information to Investors

• Decreases adverse selection and moral hazard problems • SEC forces corporations to disclose information

2. Ensuring the Soundness of Financial Intermediaries• Prevents financial panics• Chartering, reporting requirements, restrictions on assets and

activities, deposit insurance, and anti-competitive measures3. Improving Monetary Control

• Reserve requirements• Deposit insurance to prevent bank panics


Regulation Reason: Increase Investor Information

• Asymmetric information in financial markets means that investors may be subject to adverse selection and moral hazard problems that may hinder the efficient operation of financial markets and may also keep investors away from financial markets

• The Securities and Exchange Commission (SEC) requires corporations issuing securities to disclose certain information about their sales, assets, and earnings to the public and restricts trading by the largest stockholders (known as insiders) in the corporation

• Such government regulation can reduce adverse selection and moral hazard problems in financial markets and increase their efficiency by increasing the amount of information available to investors. Indeed, the SEC has been particularly active recently in pursuing illegal insider trading.

SEC home page http://www.sec.gov

http://www.sec.gov/


Regulation Reason: Ensure Soundness of Financial Intermediaries

Asymmetric information makes it difficult to evaluate whether the financial intermediaries are sound or not.

Can result in panics, bank runs, and failure of intermediaries. To protect the public and the economy from financial panics,

the government has implemented six types of regulations:─ Restrictions on Entry─ Disclosure─ Restrictions on Assets and Activities─ Deposit Insurance─ Limits on Competition─ Restrictions on Interest Rates


Regulation: Restriction on Entry

Restrictions on Entry─ Regulators have created very tight regulations as to who is allowed to

set up a financial intermediary─ Individuals or groups that want to establish a

financial intermediary, such as a bank or an insurance company, must obtain a charter from the state or the federal government

─ Only if they are upstanding citizens with impeccable credentials and a large amount of initial funds will they be given a charter.


Regulation: Disclosure

Disclosure Requirements

There are stringent reporting requirements for financial intermediaries─ Their bookkeeping must follow certain strict principles,─ Their books are subject to periodic inspection,─ They must make certain information available to

the public.


Regulation: Restriction on Assets and Activities

Restrictions on the activities and assets of intermediaries helps to ensure depositors that their funds are safe and that the bank or other financial intermediary will be able to meet its obligations.– Intermediary are restricted from certain risky activities– And from holding certain risky assets, or at least from

holding a greater quantity of these risky assets than is prudent


Regulation: Deposit Insurance

The government can insure people depositors to a financial intermediary from any financial loss if the financial intermediary should fail

The Federal Deposit Insurance Corporation (FDIC) insures each depositor at a commercial bank or mutual savings bank up to a loss of $250,000 per account.


Regulation: Limits on Competition

Although the evidence that unbridled competition among financial intermediaries promotes failures that will harm the public is extremely weak, it has not stopped the state and federal governments from imposing many restrictive regulations

In the past, banks were not allowed to open up branches in other states, and in some states banks were restricted from opening additional locations


Regulation: Restrictions on Interest Rates

Competition has also been inhibited by regulations that impose restrictions on interest rates that can be paid on deposits

These regulations were instituted because of the widespread belief that unrestricted interest-rate competition helped encourage bank failures during the Great Depression

Later evidence does not seem to support this view, and restrictions on interest rates have been abolished


Regulation Reason: Improve Monetary Control

Because banks play a very important role in determining the supply of money (which in turn affects many aspects of the economy), much regulation of these financial intermediaries is intended to improve control over the money supply

One such regulation is reserve requirements, which make it obligatory for all depository institutions to keep a certain fraction of their deposits in accounts with the Federal Reserve System (the Fed), the central bank in the United States

Reserve requirements help the Fed exercise more precise control over the money supply


International Financial Regulation

Those countries with similar economic systems also implement financial regulation consistent with the U.S. model: Japan, Canada, and Western Europe─ Financial reporting for corporations is required─ Financial intermediaries are heavily regulated

However, U.S. banks are more regulated along dimensions of branching and services than their foreign counterparts.

Education

Portfolio management sessions 1&2