FINA 4310 Survey of Investments

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FINA 4310 Survey of Investments

  1. 1. FINA 4310 Survey of Investments Dr. Mayhew Spring 2002 Unit 2: Financial Markets & Instruments
  2. 2. Topics <ul><li>Money Market </li></ul><ul><li>Fixed Income Capital Market </li></ul><ul><li>Equity Markets </li></ul><ul><li>Market Indexes </li></ul><ul><li>Derivative Markets </li></ul>
  3. 3. Financial Markets: Debt Market <ul><li>Money Market </li></ul><ul><li>Fixed Income Capital Market </li></ul><ul><li>Equity Markets </li></ul><ul><li>Derivative Markets </li></ul>Money Market Fixed Income Capital Market
  4. 4. Financial Markets: Capital Market <ul><li>Money Market </li></ul><ul><li>Fixed Income Capital Market </li></ul><ul><li>Equity Markets </li></ul><ul><li>Derivative Markets </li></ul>Fixed Income Capital Market Equity Markets
  5. 5. Outstanding Debt (Billions) Source: Bond Market Association
  6. 6. Who Owns U.S. Treasury Debt? As of 2000:Q4. Source: Bond Market Association
  7. 7. Money Market (BKM 2.1) <ul><li>Short-term debt </li></ul><ul><ul><li>Usually, maturity is one-year or less </li></ul></ul><ul><ul><li>Low Risk </li></ul></ul><ul><ul><li>High Liquidity </li></ul></ul><ul><ul><li>Large Denominations </li></ul></ul><ul><li>“Cash Equivalent” </li></ul><ul><li>Money Market Mutual Funds </li></ul>
  8. 8. Money Market Instruments <ul><li>U.S. Treasury Bills (T-Bills) </li></ul><ul><li>Commercial Paper </li></ul><ul><li>Certificates of Deposit </li></ul><ul><li>Eurodollars </li></ul><ul><li>Federal Funds </li></ul><ul><li>Repurchase Agreements (Repos) </li></ul>
  9. 9. Marketable Short-term Debt Year 2000. Source: Bond Market Association
  10. 10. Treasury Bills ( T-Bills ) <ul><li>Discount Bonds </li></ul><ul><ul><li>No explicit interest rate </li></ul></ul><ul><ul><li>Interest rate implicit in the price </li></ul></ul><ul><li>Initially sold at auction </li></ul><ul><ul><li>Maturities: 4 weeks, 13 weeks, 26 weeks </li></ul></ul><ul><ul><li>52 week T-bills discontinued in Feb 2001 </li></ul></ul><ul><li>Then they trade on secondary market </li></ul>
  11. 12. Commercial Paper <ul><li>Short-term unsecured debt issued by firms </li></ul><ul><ul><li>Typically 30 days or less (can be up to 270) </li></ul></ul><ul><ul><li>Mostly issued by financial firms </li></ul></ul><ul><ul><ul><li>GMAC </li></ul></ul></ul><ul><ul><ul><li>GE Capital </li></ul></ul></ul><ul><ul><ul><li>Ford Motor Credit Co. </li></ul></ul></ul><ul><ul><li>Sold on a discount basis (like T-bills) </li></ul></ul><ul><ul><li>Default is possible </li></ul></ul>
  12. 13. Certificates of Deposit (CDs) <ul><li>Time deposit with a bank </li></ul><ul><ul><li>Maturity and interest rate specified </li></ul></ul><ul><li>Available to individual investors </li></ul><ul><li>Most insured up to $100,000 by FDIC </li></ul><ul><li>More information available from the </li></ul><ul><li>CD FAQ at FISN (a private investment advisory service) </li></ul>
  13. 15. Eurodollars <ul><li>Dollar-denominated deposits in foreign banks or foreign branches of U.S. banks (not just European) </li></ul><ul><li>Not subject to U.S. bank regulations </li></ul><ul><li>Important cash management tool for large institutions </li></ul><ul><li>Denominations of $1 Million or more </li></ul>
  14. 16. Eurodollar Creation <ul><li>Ownership of demand deposits is transferred to a foreign bank </li></ul>U.S. Corporation U.S. Bank U.S. Corporation U.S. Bank Foreign Bank Demand Deposit Demand Deposit Eurodollar Deposit
  15. 17. Eurodollar Loans U.S. Corp. U.S. Bank Foreign Bank Foreign Office of U.S. Bank Foreign Corp. Eurodollar Loan Interbank Eurodollar Deposit Demand Deposit Eurodollar Deposit
  16. 18. Federal Funds <ul><li>Short-term unsecured loans settled in immediately available funds </li></ul><ul><ul><li>Mostly overnight loans </li></ul></ul><ul><ul><li>Large players [Increments of $1 Million] </li></ul></ul><ul><ul><ul><li>Banks & S&Ls </li></ul></ul></ul><ul><ul><ul><li>U.S. Treasury </li></ul></ul></ul><ul><ul><ul><li>Foreign Governments </li></ul></ul></ul><ul><li>Used by banks to meet reserve requirements </li></ul>
  17. 19. Repurchase Agreements (Repos) <ul><li>Like Federal Funds, but collateralized by government securities </li></ul><ul><li>Typically used for overnight borrowing </li></ul>
  18. 20. Money Market Mutual Funds <ul><li>Mutual fund that invests only in money market instruments </li></ul><ul><li>Gives small investors access to money market </li></ul><ul><li>Can be used as a “sweep account” </li></ul><ul><li>Accounting system: Net Asset Value = $1 </li></ul><ul><ul><li>Makes it appear like a cash account </li></ul></ul>
  19. 21. Money Market Mutual Funds Example: Schwab Money Market Fund <ul><li>$45 Billion in Assets (June, 2001) </li></ul><ul><ul><li>45% Commercial Loans </li></ul></ul><ul><ul><ul><li>About 80 Different Issuers </li></ul></ul></ul><ul><ul><ul><li>Commercial Paper and Asset-backed Securities </li></ul></ul></ul><ul><ul><li>42% Certificates of Deposit </li></ul></ul><ul><ul><ul><li>Issued by about 40 different banks </li></ul></ul></ul><ul><ul><li>6% Repurchase Agreements </li></ul></ul><ul><ul><li>3% Bank Notes </li></ul></ul><ul><ul><li>2% Variable Rate Loans </li></ul></ul><ul><ul><li>2% Promissory Notes </li></ul></ul>
  20. 22. Money Market Mutual Funds Example: Schwab Government Money Fund <ul><li>$2.7 Billion in Assets (June, 2001) </li></ul><ul><ul><li>53% Agency Notes </li></ul></ul><ul><ul><ul><li>Federal Home Loan Mortgage Corporation ( Freddie Mac ) </li></ul></ul></ul><ul><ul><ul><li>Federal National Mortgage Association ( Fannie Mae ) </li></ul></ul></ul><ul><ul><ul><li>Federal Home Loan Bank </li></ul></ul></ul><ul><ul><li>47% Repurchase Agreements </li></ul></ul><ul><ul><ul><li>Credit Suisse First Boston </li></ul></ul></ul><ul><ul><ul><li>Salomon Smith Barney </li></ul></ul></ul><ul><ul><ul><li>UBS Paine Webber </li></ul></ul></ul>
  21. 23. Fixed-income Capital Market (Bond Market) (BKM 2.2) <ul><li>Treasury Notes and Bonds </li></ul><ul><li>Agency Bonds </li></ul><ul><li>Municipal Bonds </li></ul><ul><li>Corporate Bonds </li></ul><ul><li>Foreign Government Bonds </li></ul>
  22. 24. Treasury Notes and Bonds <ul><li>Longer-term government debt </li></ul><ul><ul><li>Explicit interest rate (“Coupon rate”) </li></ul></ul><ul><ul><li>Semi-annual coupon payments </li></ul></ul><ul><ul><li>Small increments ($1,000) </li></ul></ul><ul><li>Initially sold to the public by auction </li></ul><ul><li>Active secondary market </li></ul><ul><li>Notes: initial maturity up to 10 years </li></ul><ul><li>Bonds: over 10 years, up to 30 years </li></ul>
  23. 25. Treasury Notes and Bonds <ul><li>Prices are quoted per $100 of face value </li></ul><ul><li>A bond trading for $100 is said to be “trading at par” </li></ul><ul><li>Coupon rate set prior to auction </li></ul><ul><ul><li>Often, rate chosen so bonds will sell near par </li></ul></ul><ul><li>If market interest rates subsequently rise (fall), bond will sell below (above) par </li></ul>
  24. 28. Agency Bonds <ul><li>Debt issued by government-sponsored enterprises or government agencies </li></ul><ul><ul><li>Federal Home Loan Bank System </li></ul></ul><ul><ul><li>Federal Home Loan Mortgage Corporation </li></ul></ul><ul><ul><li>Federal National Mortgage Association </li></ul></ul><ul><ul><li>Student Loan Marketing Association </li></ul></ul><ul><ul><li>Farm Credit System </li></ul></ul>
  25. 30. Municipal Bonds <ul><li>Debt issued by </li></ul><ul><ul><li>state governments </li></ul></ul><ul><ul><li>local governments </li></ul></ul><ul><ul><li>other governmental agencies </li></ul></ul><ul><li>Usually Tax-Free </li></ul><ul><li>Pre-tax yield lower than taxable bond </li></ul><ul><li>Best for those in high tax brackets </li></ul>
  26. 31. Corporate Bonds <ul><li>Debt issued by private companies </li></ul><ul><li>Higher chance of default than government bonds </li></ul><ul><li>Default risk rated by bond rating agencies </li></ul><ul><li>Yield tends to be higher for lower-rated bonds </li></ul>
  27. 33. Equity Markets (Stock Market) (BKM 2.3) <ul><li>Shareholders, as “owners” of the firm </li></ul><ul><ul><li>Decide who will manage the firm </li></ul></ul><ul><ul><li>Participate in important decisions by voting </li></ul></ul><ul><ul><li>Have claim to residual profits </li></ul></ul><ul><ul><li>(after debtholders are paid) </li></ul></ul><ul><li>“ Publicly held” firms </li></ul><ul><ul><li>Anyone may buy shares </li></ul></ul><ul><ul><li>Must adhere to rigorous reporting standards </li></ul></ul><ul><ul><li>Typically trade on exchanges </li></ul></ul>
  28. 34. Market Capitalization of Equity <ul><li>“ Market Cap” </li></ul><ul><ul><li>Measures the total value of all the firm’s stock </li></ul></ul><ul><ul><li>N = number of shares outstanding </li></ul></ul><ul><ul><li>P = current share price </li></ul></ul><ul><ul><li>Market cap = N x P </li></ul></ul><ul><li>Example: General Electric </li></ul><ul><li>Date: 12/28/01 N = 9.93 Billion P = $40.73 </li></ul><ul><li>Market cap = $404.4 Billion </li></ul>
  29. 35. Major Stock Exchanges Market Cap (December 2000) Source: FIBV NYSE: $11.5 Trillion
  30. 36. Preferred Stock <ul><li>Stock with fixed dividend </li></ul><ul><ul><li>Dividends cumulate if not paid </li></ul></ul><ul><ul><li>Cannot pay dividend on common until preferred dividend is paid </li></ul></ul><ul><li>Similar to Corporate Bond </li></ul><ul><li>Due to tax treatment, preferred stock yield is higher for corporate investors </li></ul><ul><li>Does not make sense for an individual investor </li></ul>
  31. 37. Common Stock, Preferred Stock, and Corporate Bonds <ul><li>Common stock, preferred stock, and bonds </li></ul><ul><ul><li>Are securities issued by a firm to raise capital </li></ul></ul><ul><ul><li>Generate cash flow from the firm to investor </li></ul></ul><ul><li>Bonds Preferred Common </li></ul><ul><li>Lifetime: Finite Infinite Infinite </li></ul><ul><li>Cash flows: Fixed Fixed Variable </li></ul><ul><li>Interest Dividend Dividend </li></ul><ul><li>Priority: First Second Third </li></ul>
  32. 38. Market index <ul><li>Weighted average of many security prices </li></ul><ul><li>Measures price level for a particular market </li></ul><ul><li>An index is not a traded asset </li></ul><ul><ul><li>Exchange-traded funds based on an index </li></ul></ul><ul><li>Can be viewed as the price of a hypothetical portfolio </li></ul>
  33. 39. Index characteristics <ul><li>Asset class </li></ul><ul><ul><li>Stock, Bond, Commodity </li></ul></ul><ul><li>Geographic Scope </li></ul><ul><ul><li>Global, Regional, Single-Country </li></ul></ul><ul><li>Diversification </li></ul><ul><ul><li>Whole Market, Sector, Industry </li></ul></ul>
  34. 40. Index characteristics Overview <ul><li>Size (stock indexes) </li></ul><ul><ul><li>Large-cap, Mid-cap, Small-cap </li></ul></ul><ul><li>Style (stock indexes) </li></ul><ul><ul><li>Value, Growth, Blend </li></ul></ul><ul><li>Risk class (bond indexes) </li></ul><ul><ul><li>Government, Investment-grade, High-yield </li></ul></ul><ul><li>Maturity (bond indexes) </li></ul><ul><ul><li>Short, Medium, Long </li></ul></ul>
  35. 41. Market index providers <ul><li>Standard and Poors (S&P 500) </li></ul><ul><li>Dow Jones (DJIA) MSCI </li></ul><ul><li>Russell Datastream </li></ul><ul><li>Barra Goldman Sachs </li></ul><ul><li>Wilshire Lehman </li></ul><ul><li>Salomon S.B. </li></ul><ul><li>Exchanges: NYSE NASDAQ </li></ul>
  36. 42. International stock indexes <ul><li>Japan: Nikkei 225 Overview </li></ul><ul><li>UK: FTSE 100 </li></ul><ul><li>Germany: DAX </li></ul><ul><li>France: CAC 40 </li></ul><ul><li>Canada: TSE 300 </li></ul><ul><li>Hong Kong: Hang Seng </li></ul>
  37. 43. Uses of market indexes <ul><li>Benchmark for portfolio evaluation </li></ul><ul><li>Basis for Index Mutual Funds </li></ul><ul><li>Basis for Exchange-Traded Funds </li></ul><ul><li>Basis for Futures and Option contracts </li></ul><ul><li>Proxy for the Market Portfolio </li></ul><ul><ul><li>Measuring a stock’s Beta </li></ul></ul><ul><ul><li>Measuring Market Risk </li></ul></ul><ul><li>Measuring Value at Risk </li></ul>
  38. 44. Price-weighted index <ul><li>N Stocks </li></ul><ul><li>P i = Price of Stock i </li></ul><ul><li>Example: Dow Jones Industrial Average </li></ul><ul><li>N = 30 </li></ul>
  39. 45. Divisor for price-weighted index <ul><li>For DJIA, originally N=12 and Divisor=12 </li></ul><ul><li>Can be chosen to make index start at 100 </li></ul><ul><li>Adjusted for… </li></ul><ul><ul><li>Changes in the set of stocks </li></ul></ul><ul><ul><li>Stock splits </li></ul></ul><ul><ul><li>Stock dividends </li></ul></ul><ul><ul><li>Spinoffs, mergers </li></ul></ul>
  40. 46. Example of divisor change
  41. 47. High volatility <ul><li>Has the stock market been unusually volatile in the past few years? </li></ul><ul><li>Of the 10 biggest one-day DJIA increases and the 10 biggest one-day decreases, how many have occurred since 1997? </li></ul><ul><li>Look for answer here </li></ul><ul><li>Important to distinguish between point changes and percentage changes </li></ul>
  42. 48. Derivative Markets (BKM 2.5) <ul><li>Traditional derivative securities </li></ul><ul><li>Contract between two parties </li></ul><ul><li>Value derived from value of an “underlying” asset </li></ul><ul><ul><li>Futures </li></ul></ul><ul><ul><ul><li>Commodity Futures </li></ul></ul></ul><ul><ul><ul><li>Currency Futures </li></ul></ul></ul><ul><ul><ul><li>Treasury Bond Futures </li></ul></ul></ul><ul><ul><li>Options </li></ul></ul><ul><ul><li>Swaps </li></ul></ul>
  43. 49. Futures Contracts <ul><li>Two Parties: Long and Short </li></ul><ul><li>Price is negotiated today for a sale of the underlying asset at a specified time in the future </li></ul><ul><li>Long party agrees to buy underlying asset </li></ul><ul><li>Short party agrees to sell underlying asset </li></ul><ul><li>Value of the contract depends on what happens to underlying price </li></ul>
  44. 50. Futures Contracts Example: Corn Futures <ul><li>Short: Jones agrees to sell 5,000 bushels of Corn in July 2002 for $2.23/bushel </li></ul><ul><li>Long: Cargill agrees to buy 5,000 bushels of Corn in July 2002 for $2.23/bushel </li></ul><ul><li>No money changes hands today </li></ul><ul><li>$2.23 is the “Delivery Price” </li></ul>
  45. 51. Corn Example, continued <ul><li>If in July 2002 Corn is at $2.50/bushel: </li></ul><ul><ul><li>Jones has lost .27/bushel on the contract </li></ul></ul><ul><ul><li>Cargill has gained .27/bushel </li></ul></ul><ul><li>If in July 2002 Corn is at $2.00/bushel: </li></ul><ul><ul><li>Jones has gained .23/bushel on the contract </li></ul></ul><ul><ul><li>Cargill has lost .23/bushel </li></ul></ul>
  46. 52. Options <ul><li>Call Option </li></ul><ul><ul><li>Two parties, the buyer and the writer </li></ul></ul><ul><ul><li>Contract specifies: </li></ul></ul><ul><ul><ul><li>Underlying asset </li></ul></ul></ul><ul><ul><ul><li>Strike price </li></ul></ul></ul><ul><ul><ul><li>Expiration date </li></ul></ul></ul><ul><ul><li>Buyer pays a premium to the writer today </li></ul></ul><ul><ul><li>Option buyer has the right to purchase the underlying asset from the writer </li></ul></ul>
  47. 53. Options Example: Microsoft Call Option <ul><li>Mayhew buys a July 70 MSFT call </li></ul><ul><li>Hull Trading writes a July 70 MSFT call </li></ul><ul><ul><li>Mayhew pays $650 premium to Hull </li></ul></ul><ul><ul><li>Mayhew has the right (but not the obligation) to buy 100 shares of Microsoft for $70/share any time prior to the 3 rd Friday of July </li></ul></ul><ul><ul><li>If buyer chooses to exercise the option, writer is obligated to sell the underlying shares </li></ul></ul>
  48. 54. Microsoft Example, cont. <ul><li>If in July, Microsoft is at $80, </li></ul><ul><ul><li>Mayhew exercises option </li></ul></ul><ul><ul><ul><li>Pays (70 x 100 = ) $7000 </li></ul></ul></ul><ul><ul><ul><li>Receives 100 shares of MSFT (worth $8000) </li></ul></ul></ul><ul><ul><ul><li>Payoff = $8,000 - $7,000 = $1,000 </li></ul></ul></ul><ul><ul><ul><li>Profit = $1,000 - $650 = $350 </li></ul></ul></ul><ul><ul><li>Hull is obligated to sell </li></ul></ul><ul><ul><ul><li>Receives $7,000, delivers stock </li></ul></ul></ul><ul><ul><ul><li>Payoff = -$1,000 Profit = -$350 </li></ul></ul></ul>
  49. 55. Microsoft Example, cont. <ul><li>If in July, Microsoft is at $68 </li></ul><ul><ul><li>Mayhew does not exercise option </li></ul></ul><ul><ul><ul><li>Payoff = 0 </li></ul></ul></ul><ul><ul><ul><li>Profit = -$650 </li></ul></ul></ul><ul><ul><li>Hull keeps the premium </li></ul></ul><ul><ul><ul><li>Profit = $650 </li></ul></ul></ul>
  50. 56. Options <ul><li>Put Option </li></ul><ul><ul><li>Buyer pays a premium to the writer today </li></ul></ul><ul><ul><li>Option buyer has the right to SELL the underlying asset to the writer </li></ul></ul>

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