Advanced Investments Week 1 Financial Instruments, Stock ...


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Advanced Investments Week 1 Financial Instruments, Stock ...

  1. 1. Advanced Investments Week 1 Financial Instruments, Stock Market s , and Securit ies Trading
  2. 2. <ul><li>Why invest? </li></ul><ul><li>Essential nature of investment </li></ul><ul><ul><li>Reduced current consumption </li></ul></ul><ul><ul><li>Planned later consumption </li></ul></ul><ul><li>Real Assets </li></ul><ul><ul><li>Assets used to produce goods and services </li></ul></ul><ul><li>Financial Assets </li></ul><ul><ul><li>Claims on real assets </li></ul></ul>Investments & Financial Assets
  3. 3. Investments: US H ouseholds <ul><li>Own stocks </li></ul><ul><li>1999: >48% </li></ul><ul><li>1995: 41% </li></ul><ul><li>1975: 12% </li></ul><ul><li>O wn mutual funds </li></ul><ul><li>1999: 47.4% </li></ul><ul><li>1994: 30.7% </li></ul><ul><li>1980: 5.7% </li></ul>
  4. 4. Financial System Clients and Their Needs <ul><li>Household Sector </li></ul><ul><ul><li>Primary Need: Invest Funds </li></ul></ul><ul><li>Business Sector </li></ul><ul><ul><li>Primary Need: Raise Funds </li></ul></ul><ul><li>Government Sector </li></ul><ul><ul><li>Primary Need: Raise Funds </li></ul></ul>
  5. 5. Meeting the Needs of Participants <ul><li>Financial Intermediation </li></ul><ul><li>Investment Banking </li></ul><ul><li>Financial Innovation & Derivatives </li></ul>
  6. 6. Financial Instruments <ul><li>Stocks </li></ul><ul><li>Bonds </li></ul><ul><li>Bank CDs </li></ul><ul><li>Commercial papers </li></ul><ul><li>Mutual funds </li></ul><ul><li>Hedge funds </li></ul><ul><li>Futures </li></ul><ul><li>Options </li></ul><ul><li>MBS (Mortgage-backed securities) </li></ul><ul><li>Still coming……… </li></ul>
  7. 7. Financial Markets <ul><li>Money market: dealing with short-term securities </li></ul><ul><li>Capital market: dealing with long-term securities </li></ul><ul><li>Long-term fixed income capital market (bond market) </li></ul><ul><li>Equity market (stock market) </li></ul><ul><li>Options market </li></ul><ul><li>Futures market </li></ul><ul><li>CISDM at UMass ( ) </li></ul>
  8. 8. Money M arkets <ul><li>Security Maturity </li></ul><ul><li>T-bill <=1 year </li></ul><ul><li>T-note 1-10 years </li></ul><ul><li>T-bond 10-30 years </li></ul><ul><li>T-bill is sold at discount, and investors get the face value at maturity </li></ul><ul><li>Money market mutual funds invest in T-bill, CD, commercial paper, Eurodollars, etc. </li></ul>
  9. 9. Fixed I ncome C apital M arkets <ul><li>T-notes and T-bonds with semi-annual coupon payments </li></ul><ul><li>Munis (Municipal bonds): Interests are exempt from federal income taxation and the issuing state taxation </li></ul><ul><li>Corporate bond: </li></ul><ul><li>Callable feature </li></ul><ul><li>Convertible feature </li></ul>
  10. 10. MBS (Mortgage- B acked S ecurities) <ul><li>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. </li></ul><ul><ul><ul><li>Securitization </li></ul></ul></ul><ul><ul><ul><li>Liquidity </li></ul></ul></ul><ul><ul><ul><li>Efficiency </li></ul></ul></ul><ul><ul><ul><li>Credit enhancement (FNMA and GNMA debt issues are rated AAA by S&P) </li></ul></ul></ul>
  11. 11. Equity M arkets <ul><li>Common stocks </li></ul><ul><li>Stocks are listed on : </li></ul><ul><li>NYSE: 3,000 ( </li></ul><ul><li>AMEX: 1,000 ( </li></ul><ul><li>NASDAQ: 6,000 ( </li></ul><ul><li>Total: 10,000 </li></ul><ul><li>Preferred (stock) : A hybrid security between bond and stock </li></ul>
  12. 12. The W orld E quity M arkets (in US billions) <ul><li>Market 2/28/90 4/28/00 </li></ul><ul><li>U.S. 2,839 17,006 </li></ul><ul><li>Japan 3,525 4,431 </li></ul><ul><li>U.K. 784 2,776 </li></ul><ul><li>Germany 353 1,506 </li></ul><ul><li>France 316 1,442 </li></ul><ul><li>Canada 239 817 </li></ul><ul><li>Italy 165 801 </li></ul><ul><li>China N/A 483 </li></ul><ul><li>Hong Kong 81 341 </li></ul><ul><li>All country 16,088 35,249 </li></ul><ul><li>World index </li></ul>
  13. 13. Municipal Bond Yields <ul><li>Interest income on most municipals is not subject to tax </li></ul><ul><li>To compare the yields on municipals to other bonds use equivalent taxable yield </li></ul><ul><li>(municipal return) / (1 – tax rate) </li></ul><ul><li>Or solve for the tax rate that equates the two yields </li></ul><ul><li>Tax rate = 1 – (municipal rate/taxable rate) </li></ul><ul><li>If your tax rate is 30%, a corporate bond offers 8% while the muni offers 6%, should you buy the muni? </li></ul>
  14. 14. The Subprime Crisis (I) <ul><li>Subprime loans (B loans) </li></ul><ul><ul><li>Loans granted to borrowers with poor credit </li></ul></ul><ul><ul><li>Higher interests are charged </li></ul></ul><ul><ul><li>21% of mortgage application from 2004-06 were subprime </li></ul></ul><ul><ul><li>2006 homeownership to a record of 69% </li></ul></ul><ul><ul><li>Brokers handle about 70% of the origination </li></ul></ul><ul><ul><li>Big banks and wholesale lenders buy and repackage them </li></ul></ul><ul><ul><li>WS firms buy from the big banks and securitize into MBS and CDO </li></ul></ul><ul><ul><li>Finally, pension funds, hedge funds and institutions buy these structured products </li></ul></ul>
  15. 15. The Subprime Crisis (II) <ul><li>The crisis </li></ul><ul><ul><li>Exuberant brokers lure borrowers into the deals (lax underwriting) </li></ul></ul><ul><ul><li>Appraisers use inflated figures to value stocks </li></ul></ul><ul><ul><li>Lack of government regulation </li></ul></ul><ul><ul><li>Starting from 2006, foreclosure has been increased </li></ul></ul><ul><ul><li>Lenders failed-lender stocks are affected </li></ul></ul><ul><ul><li>General panic in the housing market-house prices drop-equity value of home mortgage goes down-more mortgage default </li></ul></ul><ul><ul><li>Stock market drops more than 6%-credit tightened </li></ul></ul>
  16. 16. The Subprime Crisis (III) <ul><li>The Fed </li></ul><ul><ul><li>On Aug. 10 th , 2007, cut the discount rate on loans to banks to 5.75% </li></ul></ul><ul><ul><li>Pumped in $38 billion of its reserves to keep short term interest rate from rising </li></ul></ul><ul><ul><li>Economists estimate the probability of a recessions to be 1/4 this year and 1/5 next year </li></ul></ul><ul><ul><li>Further action: </li></ul></ul><ul><ul><li>Enhance the law regulate the mortgage industry </li></ul></ul><ul><ul><li>High level of due diligence for screening borrowers </li></ul></ul>
  17. 17. Stock Market Indexes <ul><li>Uses </li></ul><ul><ul><li>Track average returns </li></ul></ul><ul><ul><li>Comparing performance of managers </li></ul></ul><ul><ul><li>Base of derivatives </li></ul></ul><ul><li>Factors in constructing or using an Index </li></ul><ul><ul><li>Representative? </li></ul></ul><ul><ul><li>Broad or narrow? </li></ul></ul><ul><ul><li>How is it constructed? </li></ul></ul>
  18. 18. Stock M arket I ndexes (Domestic) <ul><li>The Dow: Price weighted average. High price has more weight in the index. </li></ul><ul><li>S&P 500 is a better index than the Dow </li></ul><ul><li>A broader index </li></ul><ul><li>Value-weighted average </li></ul><ul><li>Russell 3000 index (value weighted) </li></ul><ul><li>Wilshire 5000 index (value weighted of 6,500 traded stocks) </li></ul>
  19. 19. Examples of Indexes – Int’l <ul><li>Nikkei 225 </li></ul><ul><li>FTSE 100 (Financial Times of London) </li></ul><ul><li>Region and Country Indexes </li></ul><ul><ul><li>MSCI EAFE ( </li></ul></ul><ul><ul><li>MSCI Far East </li></ul></ul><ul><ul><li>MSCI United Kingdom </li></ul></ul>
  20. 20. Bond Indexes <ul><li>Lehman Brothers </li></ul><ul><li>Merrill Lynch </li></ul><ul><li>Salomon Brothers </li></ul><ul><li>Specialized Indexes </li></ul><ul><ul><li>Merrill Lynch Mortgage </li></ul></ul>
  21. 21. Construction of Indexes <ul><li>How are stocks weighted? </li></ul><ul><ul><li>Price weighted (DJIA) </li></ul></ul><ul><ul><li>Market-value weighted (S&P500, NASDAQ) </li></ul></ul><ul><ul><li>Equally weighted (Value Line Index) </li></ul></ul><ul><li>How returns are averaged? </li></ul><ul><ul><li>Arithmetic (DJIA and S&P500) </li></ul></ul><ul><ul><li>Geometric (Value Line Index) </li></ul></ul>
  22. 22. Averaging Methods <ul><li>Component Return </li></ul><ul><li>A=10% B= (-5%) C = 20% </li></ul><ul><li>Arithmetic Average </li></ul><ul><li>[.10 + (-.05) + .2] / 3 = 8.33% </li></ul><ul><li>Geometric Average </li></ul><ul><li>[(1.1) (.95) (1.2)] 1/3 - 1 = 7.84% </li></ul>
  23. 23. How S ecurities A re T raded ? <ul><li>Three types of markets </li></ul><ul><li>Organized stock exchanges like NYSE, AMEX </li></ul><ul><li>Regional exchanges </li></ul><ul><li>Chicago </li></ul><ul><li>Pacific </li></ul><ul><li>Philadelphia </li></ul><ul><li>Boston </li></ul><ul><li>Cincinnati </li></ul><ul><li>Over-the-counter (OTC) market like NASDAQ </li></ul><ul><li>ECNs (Electronic communications network) </li></ul>
  24. 24. Organized Exchanges <ul><li>Auction markets with centralized order flow. </li></ul><ul><li>Dealership function: broker vs. dealer </li></ul><ul><li>(IBM vs. BRKA) </li></ul><ul><li>Securities: stock, futures contracts, options, and to a lesser extent, bonds. </li></ul>
  25. 25. OTC Market <ul><li>Dealer market without centralized order flow. </li></ul><ul><li>NASDAQ: largest organized stock market for OTC trading; information system for individuals, brokers and dealers. </li></ul><ul><li>Securities: stocks, bonds and some derivatives. </li></ul><ul><ul><li>Most secondary bonds transactions </li></ul></ul>
  26. 26. Costs of Trading <ul><li>Commission: fee paid to broker for making the transaction </li></ul><ul><li>Spread: cost of trading with dealer </li></ul><ul><ul><li>Bid: price dealer will buy from you ($5.20) </li></ul></ul><ul><ul><li>Ask: price dealer will sell to you ($5.25) </li></ul></ul><ul><ul><li>Spread: ask – bid (5.25-5.20=$0.05) </li></ul></ul><ul><li>Combination: on some trades both are paid </li></ul>
  27. 27. Revaluation: On-line Trading <ul><li> </li></ul><ul><li> </li></ul><ul><li> </li></ul><ul><li> </li></ul><ul><li> </li></ul>
  28. 28. Type of O rders <ul><li>Market order: executed immediately at the current market price </li></ul><ul><li>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_____. </li></ul><ul><li>Limit order: Investors specify prices at which they are willing to trade </li></ul><ul><li>Limit buy order: Buy whenever the price falls below the limit </li></ul><ul><li>Limit sell order: Sell whenever the price goes above the limit </li></ul><ul><li>Stop-loss order: Stop further loss </li></ul><ul><li>Stop buy order: Stop potential loss from short sale </li></ul><ul><li>Good-till-canceled order: valid for 6 months </li></ul>
  29. 29. <ul><li>Using only a portion of the proceeds for an investment. </li></ul><ul><li>Borrow remaining component. </li></ul><ul><li>Margin arrangements differ for stocks and futures. </li></ul>Margin Trading
  30. 30. <ul><li>Maximum margin </li></ul><ul><ul><li>Currently 50% </li></ul></ul><ul><ul><li>Set by the Fed </li></ul></ul><ul><li>Maintenance margin </li></ul><ul><ul><li>Minimum level the equity margin can be </li></ul></ul><ul><li>Margin call </li></ul><ul><ul><li>Call for more equity funds </li></ul></ul>Stock Margin Trading
  31. 31. <ul><li>X Corp $70 </li></ul><ul><li>50% Initial Margin </li></ul><ul><li>40% Maintenance Margin </li></ul><ul><li>1000 Shares Purchased </li></ul><ul><li>Initial Position </li></ul><ul><li>Stock $70,000 Borrowed $35,000 </li></ul><ul><li>Equity $35,000 </li></ul>Margin Trading - Initial Conditions
  32. 32. Margin Trading - Maintenance Margin <ul><li>Stock price falls to $60 per share </li></ul><ul><li>New Position </li></ul><ul><li>Stock $60,000 Borrowed $35,000 </li></ul><ul><li>Equity $25,000 </li></ul><ul><li>Margin% = $25,000/$60,000 = 41.67% </li></ul>
  33. 33. Margin Trading - Margin Call <ul><li>How far can the stock price fall before a margin call? </li></ul><ul><li>(1000P - $35,000)* / 1000P = 40% </li></ul><ul><li>P = $58.33 </li></ul><ul><li>* 1000P - Amount Borrowed = Equity </li></ul>
  34. 34. Short Sales <ul><li>Purpose: to profit from a decline in the price of a stock or security. </li></ul><ul><li>Mechanics </li></ul><ul><li>Borrow stock through a dealer. </li></ul><ul><li>Sell it and deposit proceeds and margin in an account. </li></ul><ul><li>Closing out the position: buy the stock and return to the party from which it was borrowed. </li></ul>
  35. 35. Short Sale - Initial Conditions <ul><li>Z Corp 100 Shares </li></ul><ul><li>50% Initial Margin </li></ul><ul><li>30% Maintenance Margin </li></ul><ul><li>$100 Initial Price </li></ul><ul><li>Sale Proceeds $10,000 </li></ul><ul><li>Margin & Equity 5,000 </li></ul><ul><li>Stock Owed 10,000 (100 shares) </li></ul>
  36. 36. Short Sale - Maintenance Margin <ul><li>Stock Price Rises to $110 </li></ul><ul><li>Sale Proceeds $10,000 </li></ul><ul><li>Initial Margin 5,000 </li></ul><ul><li>Stock Owed 11,000 </li></ul><ul><li>Net Equity 4,000 </li></ul><ul><li>Margin % (4000/11000) 36% </li></ul>
  37. 37. Short Sale - Margin Call <ul><li>How much can the stock price rise before a margin call? </li></ul><ul><li>($15,000* - 100P) / (100P) = 30% </li></ul><ul><li>P = $115.38 </li></ul><ul><li>* Initial margin plus sale proceeds </li></ul>
  38. 38. The Risk of Short Sale <ul><li>What is the potential upside gain? </li></ul><ul><li>What is the potential downside loss? </li></ul><ul><li>What is the potential upside gain for a long position? </li></ul><ul><li>What is the potential loss for a long position? </li></ul>