Advanced Investments Week 1 Financial Instruments, Stock Market s , and Securit ies Trading
Essential nature of investment
Reduced current consumption
Planned later consumption
Assets used to produce goods and services
Claims on real assets
Investments & Financial Assets
Investments: US H ouseholds
O wn mutual funds
Financial System Clients and Their Needs
Primary Need: Invest Funds
Primary Need: Raise Funds
Primary Need: Raise Funds
Meeting the Needs of Participants
Financial Innovation & Derivatives
MBS (Mortgage-backed securities)
Money market: dealing with short-term securities
Capital market: dealing with long-term securities
Long-term fixed income capital market (bond market)
Equity market (stock market)
CISDM at UMass ( http://cisdm.som.umass.edu/ )
Money M arkets
T-bill <=1 year
T-note 1-10 years
T-bond 10-30 years
T-bill is sold at discount, and investors get the face value at maturity
Money market mutual funds invest in T-bill, CD, commercial paper, Eurodollars, etc.
Fixed I ncome C apital M arkets
T-notes and T-bonds with semi-annual coupon payments
Munis (Municipal bonds): Interests are exempt from federal income taxation and the issuing state taxation
MBS (Mortgage- B acked S ecurities)
The Government National Mortgage Association (GNMA, or Ginnie Mae) and the Federal National Mortgage Association (FNMA, or Fannie Mae) package the individual home mortgages into some homogenous pools, then sell (or pass through ) these securities to investors. The banks that originated the mortgages no longer own the mortgage investments.
Credit enhancement (FNMA and GNMA debt issues are rated AAA by S&P)
Equity M arkets
Stocks are listed on :
NYSE: 3,000 (www.nyse.com)
AMEX: 1,000 (www.amex.com)
NASDAQ: 6,000 (www.nasdaq.com)
Preferred (stock) : A hybrid security between bond and stock
The W orld E quity M arkets (in US billions)
Market 2/28/90 4/28/00
U.S. 2,839 17,006
Japan 3,525 4,431
U.K. 784 2,776
Germany 353 1,506
France 316 1,442
Canada 239 817
Italy 165 801
China N/A 483
Hong Kong 81 341
All country 16,088 35,249
Municipal Bond Yields
Interest income on most municipals is not subject to tax
To compare the yields on municipals to other bonds use equivalent taxable yield
(municipal return) / (1 – tax rate)
Or solve for the tax rate that equates the two yields
Tax rate = 1 – (municipal rate/taxable rate)
If your tax rate is 30%, a corporate bond offers 8% while the muni offers 6%, should you buy the muni?
The Subprime Crisis (I)
Subprime loans (B loans)
Loans granted to borrowers with poor credit
Higher interests are charged
21% of mortgage application from 2004-06 were subprime
2006 homeownership to a record of 69%
Brokers handle about 70% of the origination
Big banks and wholesale lenders buy and repackage them
WS firms buy from the big banks and securitize into MBS and CDO
Finally, pension funds, hedge funds and institutions buy these structured products
The Subprime Crisis (II)
Exuberant brokers lure borrowers into the deals (lax underwriting)
Appraisers use inflated figures to value stocks
Lack of government regulation
Starting from 2006, foreclosure has been increased
Lenders failed-lender stocks are affected
General panic in the housing market-house prices drop-equity value of home mortgage goes down-more mortgage default
Stock market drops more than 6%-credit tightened
The Subprime Crisis (III)
On Aug. 10 th , 2007, cut the discount rate on loans to banks to 5.75%
Pumped in $38 billion of its reserves to keep short term interest rate from rising
Economists estimate the probability of a recessions to be 1/4 this year and 1/5 next year
Enhance the law regulate the mortgage industry
High level of due diligence for screening borrowers
Stock Market Indexes
Track average returns
Comparing performance of managers
Base of derivatives
Factors in constructing or using an Index
Broad or narrow?
How is it constructed?
Stock M arket I ndexes (Domestic)
The Dow: Price weighted average. High price has more weight in the index.
S&P 500 is a better index than the Dow
A broader index
Russell 3000 index (value weighted)
Wilshire 5000 index (value weighted of 6,500 traded stocks)
Examples of Indexes – Int’l
FTSE 100 (Financial Times of London)
Region and Country Indexes
MSCI EAFE (www.msci.com)
MSCI Far East
MSCI United Kingdom
Merrill Lynch Mortgage
Construction of Indexes
How are stocks weighted?
Price weighted (DJIA)
Market-value weighted (S&P500, NASDAQ)
Equally weighted (Value Line Index)
How returns are averaged?
Arithmetic (DJIA and S&P500)
Geometric (Value Line Index)
A=10% B= (-5%) C = 20%
[.10 + (-.05) + .2] / 3 = 8.33%
[(1.1) (.95) (1.2)] 1/3 - 1 = 7.84%
How S ecurities A re T raded ?
Three types of markets
Organized stock exchanges like NYSE, AMEX
Over-the-counter (OTC) market like NASDAQ
ECNs (Electronic communications network)
Auction markets with centralized order flow.
Dealership function: broker vs. dealer
(IBM vs. BRKA)
Securities: stock, futures contracts, options, and to a lesser extent, bonds.
Dealer market without centralized order flow.
NASDAQ: largest organized stock market for OTC trading; information system for individuals, brokers and dealers.
Securities: stocks, bonds and some derivatives.
Most secondary bonds transactions
Costs of Trading
Commission: fee paid to broker for making the transaction
Spread: cost of trading with dealer
Bid: price dealer will buy from you ($5.20)
Ask: price dealer will sell to you ($5.25)
Spread: ask – bid (5.25-5.20=$0.05)
Combination: on some trades both are paid
Revaluation: On-line Trading
Type of O rders
Market order: executed immediately at the current market price
Example: Bid price (the price at which a dealer will buy from you) is $60.2, ask price (the price at which a dealer will sell to you) is $60.5. Your market buy order will be executed at_____.
Limit order: Investors specify prices at which they are willing to trade
Limit buy order: Buy whenever the price falls below the limit
Limit sell order: Sell whenever the price goes above the limit
Stop-loss order: Stop further loss
Stop buy order: Stop potential loss from short sale
Good-till-canceled order: valid for 6 months
Using only a portion of the proceeds for an investment.
Borrow remaining component.
Margin arrangements differ for stocks and futures.
Set by the Fed
Minimum level the equity margin can be
Call for more equity funds
Stock Margin Trading
X Corp $70
50% Initial Margin
40% Maintenance Margin
1000 Shares Purchased
Stock $70,000 Borrowed $35,000
Margin Trading - Initial Conditions
Margin Trading - Maintenance Margin
Stock price falls to $60 per share
Stock $60,000 Borrowed $35,000
Margin% = $25,000/$60,000 = 41.67%
Margin Trading - Margin Call
How far can the stock price fall before a margin call?
(1000P - $35,000)* / 1000P = 40%
P = $58.33
* 1000P - Amount Borrowed = Equity
Purpose: to profit from a decline in the price of a stock or security.
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 it 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 (100 shares)
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 = $115.38
* Initial margin plus sale proceeds
The Risk of Short Sale
What is the potential upside gain?
What is the potential downside loss?
What is the potential upside gain for a long position?