FINC3017 NOTES
WEEK 1: INTRODUCTION
REAL VERSUS FINANCIAL ASSETS
• Nature of Investment: Reduce current consumption for greater future consumption
• Financial Assets = Financial Liabilities
• Financial Assets and Liabilities must balance.
• Aggregated balance sheets à only real assets remain
• Domestic Net Worth = Sum of real assets FINANCIAL ASSETS
ASSET CLASSES
• Common Stock
o Ownership stake in entity, residual cash flow
• Fixed Income Securities
o Money market instruments, bonds, preferred stock
• Derivative Securities
o Contract, value derived from underlying market condition THE INVESTMENT PROCESS
ASSET ALLOCATION
• Primary determinant of a portfolio's return
• Percentage of fund in asset classes, for example:
• Top Down Investment Strategy starts with Asset Allocation
SECURITY SELECTION
• Choice of particular securities within asset class
• Security Analysis
o Analysis of the value of securities
• Bottom Up Investment Strategy starts with Security Selection MARKETS ARE COMPETITIVE
• Risk-Return Trade-Off
o Assets with higher expected returns have higher risk
Average Annual Return Minimum (1931) Maximum (1933)
Stocks About 12% −46% 55%
o Stock portfolios lose money 1 in 4 years on average o Bonds
§ Lower average rates of return (under 6%)
§ Not lost more than 13% of value in any one year
• Risk-Return Trade-Off
o How do we measure risk?
o How does diversification affect risk?
• In Efficient Markets Securities should
o Be neither under-priced nor overpriced on average o Reflect all information available to investors
• Your Belief in Market Efficiency à Choice of Investment Management Style Active Management Passive Management Markets are... Inefficient Efficient
Security Selection: Actively Seek Undervalued Stocks No Attempt to Find Undervalued Securities Asset Allocation Market Timing No Attempt to Time Market
THE FINANCIAL CRISIS OF 2008
CHANGES IN HOUSING FINANCE
• Old Way
o Local thrift institutions made mortgage loans to homeowners o Thrifts possessed a portfolio of long-term mortgage loans o Thrifts’ main liabilities: Deposits
o “Originate to hold”
• New Way
o Securitisation: Fannie Mae and Freddie Mac bought mortgage loans and bundled them into large pools o Mortgage-backed securities are tradable claims against the underlying mortgage pool
o “Originate to distribute”
• Securitisation:
• Inclusion of nonconforming “subprime” loans
• Low/No-documentation loans
• Rising loan-to-value ratio
• Adjustable-Rate Mortgages
CASE-SHILLER INDEX OF U.S. HOUSING PRICES
THE FINANCIAL CRISIS OF 2008
• The Shoe Drops
o September 7: Fannie Mae and Freddie Mac put into conservatorship o Lehman Brothers and Merrill Lynch verged on bankruptcy
o September 17: Government lends $85 billion to AIG o Money market panic freezes short-term financing market LIBOR, T-BILL RATES AND THE TED SPREAD
CUMULATIVE RETURNS
Cumulative returns on a $1 investment in the S&P 500 index
THE MONEY MARKET
• Subsector of the fixed-income market o Short-term
o Liquid o Low risk
o Often have large denominations
TREASURY BILLS Treasury Bills
Issuer: Federal Government
Denomination: Commonly $10,000; $1,000 Maturity: 4, 13, 26 or 52 weeks
Liquidity: High Default Risk: None Interest Type: Discount
Taxation: Owed: Federal; Exempt: State, Local CERTIFICATES OF DEPOSIT (CDS)
Certificates of Deposit Issuer: Depository Institutions
Denomination: Any, $100,000 or more marketable Maturity: Varies, Typically 14-day Minimum Liquidity: High for CDs <3 months, if marketable Default Risk: First $250,000 FDIC insured Interest Type: Add on
COMMERCIAL PAPER Commercial Paper
Issuer: Large creditworthy corps., financial institutions Denomination: Minimum $100,000
Maturity: Maximum 270 days, usually 1-2 months Liquidity: CP < 3 months liquid if marketable Default Risk: Unsecured, rated, mostly high quality Interest Type: Discount
Taxation: Owed: Federal, State, Local
• New innovation: Asset-backed commercial paper INSTRUMENTS
• Bankers’ Acceptances
o Purchaser authorises a bank to pay a seller for goods at later date (time draft)
o When purchaser’s bank “accepts” draft, it becomes contingent liability of the bank (and marketable)
• Eurodollars
o Dollar-denominated time deposits held outside U.S.
o Pay higher interest rate than U.S. deposits
• Federal Funds
o Trading in reserves held at the Federal Reserve*
o Key interest rate for economy
• LIBOR (London Interbank Offer Rate)
o Rate at which large banks in London (and elsewhere) lend to each other o Base rate for many loans and derivatives
• *Depository institutions must maintain deposits with Federal Reserve Bank
REPURCHASE AGREEMENTS
• Repurchase Agreements (RPs)
o Short-term sale of securities + promise to repurchase at higher price o RP is a collateralised loan
o Many RPs are overnight
o “Term” RPs may have a 1-month maturity
• Reverse RPs
o Lending money; obtaining security title as collateral o “Haircuts” may be required
BROKERS’ CALLS
• Brokers’ Calls
o Call money rate applies for investors buying stock on margin o Loan may be “called in” by broker
THE BOND MARKET
• Capital Market—Fixed-Income Instruments
• Government Issues—U.S. Treasury Bonds and Notes o Bonds vs. notes
o Denomination o Interest type o Risk? Taxation?
• Treasury Inflation Protected Securities (TIPS)
o Principal adjusted for changes in the Consumer Price Index o Marked with a trailing “i” in quote sheets
PRIVATE ISSUE
• Corporate Bonds
o Investment grade vs. speculative grade
• Mortgage-Backed Securities
o Backed by pool of mortgages with “pass-through” of monthly payments; covers defaults o Collateral
§ Traditionally all mortgages conform, since 2006 Alt-A and subprime mortgages are included in pools o Private banks purchased and sold pools of subprime mortgages
o Issuers assumed housing prices would continue to rise MORTGAGE-BACKED SECURITIES OUTSTANDING
ASSET-BACKED SECURITIES OUTSTANDING
THE U.S. FIXED-INCOME MARKET
EQUITY SECURITIES
INSTRUMENTS
• Equity Securities o Common stock
§ Residual claim
§ Limited liability
• Preferred stock
o Priority over common
o Fixed dividends: Limited gains o Nonvoting
DERIVATIVE MARKETS
• Derivative Asset/Contingent Claim
o Security with payoff that depends on the price of other securities
• Call Option
o Right to buy an asset at a specified price on or before a specified expiration date
• Put Option
o Right to sell an asset at a specified exercise price on or before a specified expiration date
• Futures Contracts
o Purchaser (long) buys specified quantity at contract expiration for set price
o Contract seller (short) delivers underlying commodity at contract expiration for agreed- upon price
WEEK 2: INVESTMENT VEHICLES HOW FIRMS ISSUE SECURITIES
PRIMARY VS. SECONDARY
Primary Secondary
New Issue Created/Sold Current owner sells to another party
Issuer Receives Proceeds from Sale Issuer Does Not Receive Proceeds from Sale PRIVATE VS. PUBLIC
Privately Held Publicly Traded
Definition Ownership help by a small group of investors Securities sold to the general public; investors to trade shares
Shareholders Up to 2000 shareholders Unlimited number Financial
Statements
Fewer obligations to release financial statements to public
Obligated to release financial statements to the public
Primary Offering Sold Directly to a Small group of Investors Sold to the Public (often with an Underwriter) HOW SECURITIES ARE TRADED
FINANCIAL MARKETS
• Overall purpose: Facilitate low-cost investment o Bring together buyers and sellers at low cost o Provide adequate liquidity
§ Minimise time to trade
§ Promotes price continuity o Set and update prices of financial assets
• Reduce information costs associated with investing MARKET TYPES
• Direct Search Markets
o Buyers and sellers locate one another on their own
• Brokered Markets
o Third-party assistance in locating buyer or seller
• Dealer Markets
o Third party acts as intermediate buyer/seller
• Auction Markets
o Brokers and dealers trade in one location o Trading is more or less continuous ORDER TYPES
• Market order:
o Execute immediately at best price
o Bid price: price at which dealer will buy security o Ask price: price at which dealer will sell security
• Price-contingent order:
o Limit buy/sell order: specifies price at which investor will buy/sell o Stop order: not to be executed until price point hit
GLOBALISATION OF STOCK MARKETS
• Moving to automated electronic trading
• Current trends will eventually result in 24-hour global markets
• Moving toward market consolidation
MARKET CAPITALISATION OF WORLD STOCK EXCHANGES, 2016
TRADING COSTS
• Commission:
o Fee paid to broker for making transaction
• Spread:
o Cost of trading with dealer
o Bid: Price at which dealer will buy from you o Ask: Price at which dealer will sell to you o 𝑆𝑝𝑟𝑒𝑎𝑑 = 𝑃𝑟𝑖𝑐𝑒!"#− 𝑃𝑟𝑖𝑐𝑒$%&
• Combination:
o On some trades both are paid BUYING ON MARGIN
• Margin: Describes securities purchased with money borrowed in part from broker o Net worth of investor’s account
• Initial Margin Requirement (IMR)
o Minimum set by Federal Reserve under Regulation T, currently 50% for stocks o Minimum % initial investor equity
o 1 − 𝐼𝑀𝑅 = 𝑀𝑎𝑥𝑖𝑚𝑢𝑚 % 𝑎𝑚𝑜𝑢𝑛𝑡 𝑖𝑛𝑣𝑒𝑠𝑡𝑜𝑟 𝑐𝑎𝑛 𝑏𝑜𝑟𝑟𝑜𝑤
• Equity
o 𝑃𝑜𝑠𝑖𝑡𝑖𝑜𝑛 𝑉𝑎𝑙𝑢𝑒 − 𝐵𝑜𝑟𝑟𝑜𝑤𝑖𝑛𝑔 + 𝐴𝑑𝑑𝑖𝑡𝑖𝑜𝑛𝑎𝑙 𝐶𝑎𝑠ℎ
• Maintenance Margin Requirement (MMR)
o Minimum amount equity can be before additional funds must be put into account o Exchanges mandate minimum 25%
• Margin Call
o Notification from broker that you must put up additional funds or have position liquidated
• If Equity / Market value ≤ MMR, then margin call occurs o '()#*+ -(./*0$1))12*&
'()#*+ -(./* ≤ 𝑀𝑀𝑅
• Solve for market value
• A margin call will occur when:
o 𝑀𝑎𝑟𝑘𝑒𝑡 𝑉𝑎𝑙𝑢𝑒 ≤$1))12*&
30''4
• Margin Trading: Initial Conditions o X Corp: Stock price = $70 o 50%: Initial margin o 40%: Maintenance margin o 1000 shares purchased
