2007 FINANCIAL MESS: REASONS
• US. And European housing market bubble:
‐ Interest rates too low
L k f b ki l i i h• Lack of banking regulations in the:
‐ Hedge funds and Investment banks;
‐ Derivative markets (Credit‐default‐swaps) and;Derivative markets (Credit default swaps) and;
• Home‐ownership obsession:
‐ Crazy lending (subprime);
‐ Tax subsidizing.
i i l i fl f hi• Massive Capital inflows from China
• Rational markets –speculation‐
• US fiscal policy tax cutting and enormously war spendingUS fiscal policy, tax cutting and enormously war spending
• Credit Agencies:
• ‐ High rating to untested new securities such
as the Collateral Debt Obligations (CDOs).
• Lehman Brothers bankruptcy
KEY EU BANKS STOCK´s PERFORMANCE SINCE 01/02/2011
KEY EU BANKS STOCK s PERFORMANCE SINCE 01/02/2011
• DEXIA (59.08 %)
• SOCIÉTÉ GÉNÉRALE (55.15 %)
• UNICREDIT (52.03 %)
• CRÉDIT AGRÍCOLE (50.53 %)
BNP (43 91 %)• BNP (43.91 %)
• INTESA (41.86 %)
• DEUTSCHE BANK (36.99 %)DEUTSCHE BANK (36.99 %)
• ING (32.47 %)
• SANTANDER (25.40 %)
• BBVA (22.00 %)
KEY USA BANKS STOCK´s PERFORMANCE SINCE 01/02/2011
KEY USA BANKS STOCK s PERFORMANCE SINCE 01/02/2011
• BANK of AMERICA (56.75 %)
• J.P MORGAN CHASE (31.37 %)
• CITIGROUP (after the June split 1:10) (32.78 %)
WELLS FARGO (24 42 %)• WELLS FARGO (24.42 %)
• B. of NY MELLON (58.53 %)
WHY EUROPEAN STOCK MARKETS FALL?
WHY EUROPEAN STOCK MARKETS FALL?
• Sovereign debt, bond yield spreads and CDS:
Fears of a sovereign debt crisis of some European states members, Greece,Fears of a sovereign debt crisis of some European states members, Greece,
Portugal, Ireland, and Spain (called PIGS). In the EU, in countries where
sovereign debts have increased sharply due to bank bailouts, a crisis of
confidence has emerged with the widening of bond yield spreads and riskconfidence has emerged with the widening of bond yield spreads and risk
insurance on credit default swaps (CDS) between these countries and
• Toxic Assets:
Held in EU banking Assets such as: Greek debt mortgages and loans toHeld in EU banking Assets such as: Greek debt, mortgages and loans to
subprime borrowers, and foreclose mortgage‘s properties valued much
higher than the market value.
• European countries and USA double deep recession fears:
Europe GDP growth forecast for 2011 at 1 5 %; USA: 2 5 %Europe GDP growth forecast for 2011 at 1.5 %; USA: 2,5 %
‐Deficit from 10.5 % of GDP in 2010 to 8.5 % in 2011
‐Will miss target deficit in 2011and 2012
‐Public debt: 142.8 % of GDP.
• Banking stocks are the biggest fallers in EU, on concerns
about their exposure to Greek government debt Greeceabout their exposure to Greek government debt . Greece
needs the 8bn Euro' installment to avoid going bankrupt
this month, October 2011.
• Bankruptcy would put severe pressure on the eurozone,
damage EU bank finances and possibly have a serious knock‐damage EU bank finances and possibly have a serious knock
on effect on the world economy.
• Portugal might be the next: Spain:
Portugal might be the next: Spain:
‐Deficit: 9.1 % of GDP ‐Deficit: 9.2% of GDP
‐Public debt: 93 % of GDP ‐Public debt: 60.1 % of GDP
• Germany: Italy:• Germany: Italy:
‐Deficit: 5 % of GDP ‐Deficit: 6 % of GDP
‐Public debt: 83.2 % of GDP ‐Public debt: 120 % of GDP
F UK• France: UK:
‐Deficit: 8.5 % of GDP ‐Deficit 6 % of GDP
‐Public debt: 81.7 % of GDP ‐Public debt: 80 % of GDP
‐Federal Deficit: 10 % of GDP
‐Federal debt: 92 % of GDP
Note: All deficit and public debt are related to 2010
EU TARGETS for 2011: Debt not higher than 60 % of GDP,EU TARGETS for 2011: Debt not higher than 60 % of GDP,
Deficit not higher than 3% of GDP, and
Inflation not higher than 1.5 % above German inflation
• Stock market or equity market: is a concept of the mechanism that
q y p
enables the trading of company stocks, the world‐wide size: ~$ 52
trillions, and other securities such as bonds and derivatives, these
are securities listed and traded in the stock exchange.are securities listed and traded in the stock exchange.
• Bonds are traded in the OTC (over‐the‐counter) bonds market, the size is
~ $ 46 trillions. Commodities are traded in the commodities markets.
• Derivative instrument: A security or contract whose value is derived• Derivative instrument: A security or contract whose value is derived
or dependent from the value of some other underlying asset. The main
classes of derivatives are: forwards, futures, options, and swaps.
Th d i ti t t i diti itiThere are derivative contracts on currencies, commodities, equities,
interest rates and others. Futures are traded on specific exchange
markets such as: Chicago Board of Trade (CBT), EUREX, LIFFE, MATIF,
• Trading: Participants in the stock market can range from individual
g p g
stock investors to large hedge fund traders. Some exchanges are
physical locations where transaction are carried out on a trading floor by
a method known as an open outcry (stocks and commodity exchanges)a method known as an open outcry (stocks and commodity exchanges)
the other method is via computer terminals. Actual trades are based on
an auction market, where potential buyer bids a specific price for a
stock and potential seller asks a specific price for the stock Buying orstock and potential seller asks a specific price for the stock. Buying or
selling at market means you will accept any ask price or bid for the
• Function : Stock market is one of the most important sources for
companies to raise money, this allows business to go public andcompanies to raise money, this allows business to go public and
raise additional capital for expansion.
• The Liquidity that an exchange market provides affords investors the
ability to quickly and easily sell a securities as compared to less liquid
investment as real state.
• Are the corporate stock markets including: common stocks, preferred stocks,
convertibles securities, warrants etc. and long‐term‐debt markets such as the
Primary markets:Primary markets:
• Are the markets in which corporations raise new capital.
The IPO markets:
• The initial public offering market is a subset of the Primary market. Here firms
“ bli ” b ff i h t th bli f th fi t ti“go public” by offering shares to the public for the first time.
DEFINITIONS and KEY RATIOS
Market price : EPS x PER
EPS (Earnings per share): Net Income –Preferred Stock dividends
Number of shares outstanding
PER (a multiple): Share Price / EPS
Market CAP: Market Price x nº Shares outstanding
Price / Book: Stock Price
Book Value per share
Book Value: Total Assets – Intangible Assets – Liabilities
E t i V l M k t CAP P f d St k D bt C h• Enterprise Value: Market CAP +Preferred Stock + Debt – Cash
or Cash equivalent (Marketable securities)
• Enterprise Value / Revenues: Enterprise Value
• Enterprise Value / EBITDA: Enterprise Value
EBITDA: Earnings before Interest, Taxes, Depreciation and Amortization
• Profit Margin (ROS): Net Income• Profit Margin (ROS): Net Income
• Operating Margin: EBIT .
T t l S lTotal Sales
• ROE: Net Income
EBIT: Earnings before Interest and taxes
Securities: Stocks and debt securities (bonds debentures)
Securities: Stocks and debt securities (bonds, debentures)
Indexes: NYSE, Nasdaq, STOXX50E, DAX, FTSE, IBEX, Nikkei..
ll k k i d iBull market: Average stock indexes are going up
Bear market: The opposite of bull market
Rally: Temporary appreciation in value of stocks or bonds
Correction: Temporary depreciation in value of stocks or bonds
Sell off: Temporary correction of stocks or bonds
Fly to quality: Sell stocks and purchase Government bondsFly to quality: Sell stocks and purchase Government bonds
Overpriced: Current market prices are above acceptable P/E ratio.
U d i d Th i f i dUnderpriced: The opposite of overpriced
Sell short: Selling a stock without owing the stock (borrowed).
Not allowed in some European countries.Not allowed in some European countries.
• S&P Futures: Indication on how the market will open (webs: CNN‐Money, p ( y,
• GDP, CPI, PPI: Gross Domestic Product, Consumer Price Index and Production
Price IndexPrice Index
• Commodities: Follow the price of crude oil and copper
IF the crude oil is going up the US $ will weaken against the €g g p g
• Reports: Consumer confidence and unemployment reports
• Recession: Two or more consecutives quarters of negative GDP• Recession: Two or more consecutives quarters of negative GDP
• Stagnation: No growth in terms of GDP and low inflation
• Higher inflation: Interest rates will be moving up
• Interest rates up: Stocks prices down and Yield bonds up, then the bond prices
will go downwill go down
• Lower inflation: The opposite of above
• Is the relationship between two variables, the stock and the associatedp
Index, for example IBM versus NYSE Index.
• Stocks with a reduce correlation helps to minimize the RISK in theStocks with a reduce correlation helps to minimize the RISK in the
portfolio. Stocks highly correlated to the Index will perform similarly to
the Index. Correlation moves between ‐1 and 1.
• When correlation figures are close to ‐1, it means the the stock and the
Index moves in opposite way (negative correlation).
• Correlation close to 1, it means that the stock and the Index move in
the same direction. Close to zero both the stocks and Index move in
It is calculated by comparing the standard deviation of the stock´s monthly retur
to its appropriated Index.
HOW COMMON STOCKS ARE VALUED
Cash payoff to owners of Common stocks comes in two
• Cash dividends and Capital gains or losses
Rate of Return:Rate of Return:
The return that investors expect from this stock over next year is
defined as the expected Dividend per share DIV1 plus the expected
price appreciation of the stock (P1–P0) divided by the purchase
1) M k t C it li ti t DIV1+ ( P1 P0)1) Market Capitalization rate: r = DIV1+ ( P1 – P0)
2) r = DIV1 + g (Dividend growth)2) r DIV1 g (Dividend growth)
PRICE OF THE STOCK:
If investors have the forecast on Dividends and
the Market Capitalization rate the Price of thethe Market Capitalization rate, the Price of the
stock P0 would be:
1) Price P0 = DIV1 + P1 2) Price P0 = DIV1) )
1 + r r – g
3) Price P0 = EPS1 / (r +PVGO) ‐General formula‐
k i li ir: Market capitalization Rate
g: Dividend growth
PV GO : PV of growth opportunities = NPV1 / r ‐ gPV GO : PV of growth opportunities = NPV1 / r g
Lessons of Market Efficiency
• Market have no memoryMarket have no memory
• Trust market prices
• There are no financial illusions such as: stock splits and dividends, and
accounting changesaccounting changes.
• Corporate finance alternatives, such as: issue debt or common stock.
• Fair return for its risk, in which the demand for one company’s stock
h ld b l ti if ti i k i i l l ti tshould be very elastic, if a prospective risk premium is lower relative to
its risk than other stocks, nobody will want to hold that stock.. If it
is higher, everybody will want to hold it.
EFFICIENT CAPITAL MARKETS
EFFICIENT CAPITAL MARKETS
• If Capital Markets are efficient, then purchase or sale of any security at the
ili k t i i NPV t ti i ll l t dprevailing market price is a zero‐NPV transaction, since all relevant and
ascertainable information is already reflected in security prices.
NPV = ‐ P0 (stock price) + DIV1 + (P1 ‐ P0) = zero
11 + r
RETURNS and RISK PREMIUMS:
Average annual Risk Standardg
Rate of Return Premium Deviation
1. Common stocks (S&P 50) 11.3 8.8 22.4 %1. Common stocks (S&P 50) 11.3 8.8 22.4 %
2. Corporate bonds 4.2 1.7 5.6
3. Government bonds 3.5 1.0 5.7
4 Treasury bills (T bs) 2 5 0 2 14. Treasury bills (T‐bs) 2.5 0 2.1
‐Average Returns since 1929 University of Chicago.
Example: Probability Distribution in business
Outcome Probab.x Invest.(1) ER% ERR(2) (1‐2) Squared x Probab.=Variance
strong 0 3 40 % 12 10 30 900 0 3 270strong 0.3 40 % 12 10 30 900 0,3 270
normal 0.4 25 10 10 15 225 0,4 90
week 0.3 ‐40 ‐12 10 ‐50 2500 0,3 750
1 0 10% 1 1101.0 10% 1.110
ER = Average Expected Return
ERR = Expected Rate of Return (mean)ERR Expected Rate of Return (mean)
VARIANCE = 1.110
STANDARD DEVIATION (σ ) = √ 1.100 = 33.32 %( )
CV: (Coefficient of Variation) =3,33 (Standard Deviation / ERR)
STOCK MARKET ALTERNATIVES:
• Investing in Stock, bonds or Treasury Bills (T‐bs)
• Investing in Investment/Mutual funds
• Investing in Stock OptionsInvesting in Stock Options
• Investing in Futures to HEDGE Long position in Stocks
Investing in Stocks: Highest Return, Risk and Risk Premium
• Market Prices and its Index, if you invest in top European companies iny p p p
€, the Index would be the EUROXX50E. Beta 1 means same return as
• 52‐week high and 52 week low (buy low and sell high) and key returns
and statistics (web: Yahoo finance USA or local).
• Look into the Futures market in USA for the expected opening S&P,
NASDAQ and NYSE (webs: CNN‐Money, Bloomberg, and Barchart).
• If the USA’s stocks trend is up European stock will follow or vise‐versa
NYSE, NASDAQ, S&P 52‐week high and low.
(if markets are at 52‐week high, these may have a correction).
To make money invest in November and sell in April (statistics).
However, In a recession scenarios do not invest in stocks.,
Investing in Bonds/ T‐bills Lowest Return, Risk and Risk Premium
• The trend in interest rates since higher Yields means lower Prices• The trend in interest rates, since higher Yields means lower Prices
• For bonds , the Coupon is fixed up to Redemption date ( if the bond is
ll bl ) i hi h i b d id i knot callable). Invest in a higher rating bonds to avoid risk. AAA or AA
In a recession scenarios invest in Bonds / T‐bills or cash.
Investing in Investment/Mutual Funds
Medium Return, Risk and Risk Premium
• Lower risk than investing in individual stocks
• Diversification and liquidity
• Select the top market funds.
INVESTMENT FUNDS / MUTUAL FUNDS
• Is a type of a company that brings together a group of investors and
invests their money in stocks, bonds, and other securities. Each investor
owns shares (Mutual) or participations (Investment funds) which represent aowns shares (Mutual) or participations (Investment funds), which represent a
portion of the holdings of the fund.
• Investors purchase funds because they don’t have the time or the expertiseInvestors purchase funds because they don t have the time or the expertise
to manage their own portfolios. It is relatively inexpensive for a small
Th i i i d h l l f RISK h h i i illi k• The investments is suited to the level of RISK that the investor is willing to take.
RISK is spread outRISK is spread‐out.
• Economies of scale:
Its transaction costs are lower that what any individual would pay forIts transaction costs are lower that what any individual would pay for
• Liquidityq y
If you decide to sale the holdings, the cash value will be credited into your
account in 48+ hours.
I ti i St k O ti
Investing in Stock Options:
• Option Definition: A contract that grants the Holder the right (not the
bli ti ) t BUY (C ll O ti ) SALE (P t O ti ) STOCK t ifi iobligation) to BUY (Call Option) or SALE (Put Option) a STOCK at specific price
(striking price) for specific period of time, for a PREMIUM payable up front.
B B k S llBuyer Banks Seller
HOLDERS OTC market WRITERS
Buyer of a CALL (Long Call) Seller of a CALL (Short Call)
Risk Cost Expectation Risk Income Expectation
Non Premium up Limited Premium down
(if owns the stock)
(if naked or uncovered)( )
Buyer of a PUT (Long Put) Seller of a PUT (Short Put)
Risk Cost Expectation Risk Income ExpectationRisk Cost Expectation Risk Income Expectation
Non Premium down Unlimited Premium up
Who can EXERCISE an OPTION ?
• ONLY the HOLDER who pays a PREMIUM up front to the WRITER• ONLY the HOLDER, who pays a PREMIUM up front to the WRITER,
through a bank‐OTC‐market, the Premium cost is the maximum loss for
• IF a CALL Option is exercised by the Holder, the Writer has to sell the
stock at striking price.
• IF a PUT Option is exercised by the Holder, the Writer has to buy the
stock at striking price.
• A CALL Option will be exercised if the striking price < Market price
• A PUT Option will be exercised if the striking price > Market price• A PUT Option will be exercised if the striking price > Market price
• If a CALL or PUT Option is not exercised the Option is worthless
For a Call Option:
For a Call Option:
IF striking price is < than market price = In‐the‐money **
IF striking price is = than market price = At‐the‐money
IF iki i i h k i O f hIF striking price is > than market price = Out‐of‐the‐money
** the Call Option will be exercised at “In‐the‐money”
For a PUT Options:
IF striking price is > than the market price = In‐the‐money **
IF striking price is = than the market price = At‐the‐money
IF striking price is < than the market price = Out‐of‐the‐moneyIF striking price is < than the market price Out of the money
** the PUT Option will be exercised at “ In‐the‐money “
Invest in the Futures market
• Futures markets are used by institutional investors, pension funds,
investment/mutual funds and investors to HEDGE their Long portfolio
iti i t k itiposition in stocks or securities.
• If a portfolio manager fears that a bear market is imminent and wishes
t HEDGE hi tf li i t th t ibilit t t ld bto HEDGE his portfolio against that possibility, one strategy would be
to liquidate the portfolio and place the proceeds into short‐term debt
instruments, however, the transaction cost would be quite high. Such
plan is infeasible.plan is infeasible.
• The European manager, however, could use the STOXX50E Index futures
contract in the EUREX market. By SELLING future contracts (Shortcontract in the EUREX market. By SELLING future contracts (Short
Hedge) the manager could be able to offset the effect of the bear
market on the portfolio by generating gains in the future markets.
• Futures markets are not OTC (over‐the‐counter) markets, the Futures
k t t li d i ifi h t d d k t h
markets are centralized in specific exchange traded markets such as:
EUREX (Zurich, Frankfurt), CBT (Chicago Board of Trade),
LIFFE London International Financial Futures),
LCE (London Commodity Exchange) ,
NYFE (NY Futures Exchange),
IPE‐ICE (International Petroleum Exchange) . . .( g )
• The Margins required and daily mark‐to‐market settlements are key
requirements in the Futures markets.
• HEDGER: Is the trader that enters the Futures markets in order to reduce
a pre‐existing risk.
• ESPECULATOR: Is a trader who enters the Futures markets in search of a
profit and, by so doing, willingly accepts increased risk.