Portfolio management sessions 1&2

MGB Portfolio Management I
MASTER OF GLOBAL BUSINESS
PORTFOLIO MANAGEMENT I

THE GLOBAL INVESTMENT ENVIRONMENT

The Case for Global Investing
The case for global investing has never been clearer than in the present
environment. The global financial crisis reinforced the need for the
continuation of increased diversification globally.
The case for global investing is based on powerful secular trends driving
the future of world economies and securities markets:
• The continued rise of emerging countries as the growth engines of the
world economy while the developed world faces deleveraging
headwinds
• The growth of global trade as barriers fall
• The reality of truly global companies whose main earnings derive from
countries and markets far from their home headquarters
• The deepening of capital markets beyond the developed world
• The growing share of global market capitalization outside traditional
centers like the US

While the reasons for global investing are well articulated, many investors
still struggle with how to invest globally and how to address the additional
risks that come with investing beyond one’s domestic market.
Those include:
• Increased complexity of managing currency translation risk
• Liquidity concerns in some foreign markets or illiquid asset classes like
private equity
• Political and fiscal uncertainty in some countries
This uncertainty may explain the persistence of significant home-country
bias in many institutional portfolios around the world. As recently as three
years also, institutional investors in major developed countries like the US,
UK, Germany, Japan, France, and Italy still displayed striking biases to home
equities, according to consultant studies.

MSCI World Index 2003 2009
U.S 52% 42%
Developed International 42% 44%
Emerging International 6% 14%
% of total world market cap
Despite additional complexities, fund managers still prefer international
investing as they perceive greater risks of allocating capital too narrowly
in home markets while global developments are creating long-term
opportunities overseas.

• Why investors should include foreign as well as domestic securities in
their portfolio
• Securities in domestic and global markets (risk-return characteristics)
• Historic risk-return performance of investment instruments from around
the world

Total Investable Capital Markets: 1969 - $2.3 Trillion
U.S. Equity
31%
Cash Equivalent
7%
Japan Equity
2%
U.S. Real Estate
Other Bonds 12%
14%
U.S. Bonds
21%
Japan Bonds
1%
Other Equity
11%
Venture Capital
0%
Dollar Bonds
1%

Japan Equity
5%
All Other Equity
15%
Emerging Market 4%
Japan Bonds
8%
All Other Bonds
Emerging Debt
Market
2%
18%
Cash Equivalent
High Yield Bonds
1%
Dollar Bonds
20%
U.S. Real Estate
5%
Equity
1%
Cash Equivalent
7%
U.S. Equity
21%

1969: US stock and Bond Market = 65% of all securities available in world capital markets
2010: US stock and Bond Market = 42.6% of all securities available in world capital markets

Global Government Bond Annual Rates of Return in US Dollars
1986-2010 Mean Standard Deviation
Canada 10.32 9.77
France 10.39 12.86
Germany 9.28 13.49
Japan 9.14 14.75
UK 9.84 13.28
USA 7.37 6.09

Correlation Coefficients between US$ rates of return on Bonds
in the US and major markets
1986-2010 Correlation Coefficient
with US Bonds
Canada 0.75
France 0.61
Germany 0.63
Japan 0.34
UK 0.59
Average 0.58

Risk-Return Trade-off for International Bond Portfolios

Basic Series: Historical Highlights (1926 - 1997)
Annual Arithmetic Standard
Geometric Mean of Deviation
Mean Rate Annual of Annual
Series of Return Returns Returns
Large company stocks 11.0 % 13.0 % 20.3 %
12.7 17.7 33.9
5.7 6.1 8.7
5.2 5.6 9.2
Small capitalization stocks
Long-term corporate bonds
Long-term government bonds
Intermediate-term government bonds 5.3 5.4 5.7
3.8 3.8 3.2
U.S. Treasury bills
Consumer price index 3.1 3.2 4.5
Source: © Stocks, Bonds, Bills, and Inflation: 1998 YearbookTM, Ibbotson Associates, Chicago
(Annually updates work by Roger G. Ibbotson and Rex A. Sinquefield). Used with permission. All rights reserved.

A Minor Deviation

Covariance
• absolute measure of the extent to which two sets of numbers
move together over time
 i i  j j

N
ij
 
  COV
If we define (i - i) as i and (j - j) as j, then
i j
N
ij
 
  COV

Correlation
• relative measure of a given relationship
COV

ij
i j
ij r
 
 i i

N
i
2  
 

Risk Reduction

Asset Classes and
Available Financial
Instruments
Name of Asset Sub-Assets Liquidity Timeframe Classification Appropriate ROI Risk level
Equities Good 5–6 years
Growth assets (focus on capital growth
and income
medium to
high
Listed
Domestic
Sector basis
Strategy basis
International
Sector basis
Strategy basis
Unlisted
Private Equity
Venture Capital
Fixed Income
Bonds Defensive
Investment-grade
Low -
Medium
Junk (high-yield) High
government 1 – 3 years Low
corporate
Medium -
High
short-term
intermediate
long-term
domestic
foreign
emerging markets
Convertible security

MGB Portfolio Management I Name of
Asset
Sub-Assets Liquidity Timeframe Classification
Appropriate
ROI
Risk level
Cash Unlimited Defensive Low
Real Estate Growth
Direct
Commercial
Residential
Property Trusts
Listed 3 – 5 years
Commercial
Residential
Unlisted
Commercial
Residential
Fiat Currency
Digital
Currency
Very High Growth High Risk
Bitcoin
Litecoin
Namecoin
Alternatives
hedge funds
Opportunistic/distressed
strategies
Commodities
Precious metals
Agriculture
Energy
Broad basket
Collectibles
Art
Asset Classes and
Available Financial
Instruments

Global Investment Choices
• Fixed-income investments
– bonds and preferred stocks
• Equity investments
• Special equity instruments
– warrants and options
• Futures contracts
• Investment companies
• Real assets

Fixed-Income Investments
• Contractual payment schedule
• Recourse varies by instrument
• Bonds
– investors are lenders
– expect interest payment and return of principal
• Preferred stocks
– dividends require board of directors approval

Savings Accounts
• Fixed earnings
• Convenient
• Liquid
• Low risk
• Low rates
• Certificates of Deposit (CDs)
- instruments that require minimum deposits for specified
terms, and pay higher rates of interest than savings
accounts. Penalty imposed for early withdrawal

Money Market Certificates
• Compete against Treasury bills (T-bills)
• Minimum $10,000
• Minimum maturity of six months
• Redeemable only at bank of issue
• Penalty if withdrawn before maturity

Capital Market Instruments
• Fixed income obligations that trade in secondary market
• U.S. Treasury securities
• U.S. Government agency securities
• Municipal bonds
• Corporate bonds

U.S. Treasury Securities
• Bills, notes, or bonds - depending on maturity
– Bills mature in less than 1 year
– Notes mature in 1 - 10 years
– Bonds mature in over 10 years
• Highly liquid
• Backed by the full faith and credit of the U.S.
Government

U.S. Government Agency Securities
• Sold by government agencies
– Federal National Mortgage Association (FNMA or Fannie Mae)
– Federal Home Loan Bank (FHLB)
– Government National Mortgage Association (GNMA or Ginnie
Mae)
– Federal Housing Administration (FHA)
• Not direct obligations of the Treasury
– Still considered default-free and fairly liquid

Municipal Bonds
• Issued by state and local governments usually to finance
infrastructural projects.
• Exempt from taxation by the federal government and by
the state that issued the bond, provided the investor is a
resident of that state
• Two types:
– General obligation bonds (GOs)
– Revenue bonds

Corporate Bonds
• Issued by a corporation
• Fixed income
• Credit quality measured by ratings
• Maturity
• Features
– Indenture
– Call provision
– Sinking fund

Corporate Bonds
• Senior secured bonds
– most senior bonds in capital structure and have the lowest risk of
default
• Mortgage bonds
– secured by liens on specific assets
• Collateral trust bonds
– secured by financial assets
• Equipment trust certificates
– secured by transportation equipment

Corporate Bonds
• Debentures
– Unsecured promises to pay interest and principal
– In case of default, debenture owner can force bankruptcy and
claim any unpledged assets to pay off the bonds
• Subordinated bonds
– Unsecured like debentures, but holders of these bonds may claim
assets after senior secured and debenture holders claims have
been satisfied

Corporate Bonds
• Income bonds
– Interest payment contingent upon earning sufficient
income
• Convertible bonds
– Offer the upside potential of common stock and the
downside protection of a bond
– Usually have lower interest rates

Corporate Bonds
• Warrants
– Allows bondholder to purchase the firm’s common stock at a fixed
price for a given time period
– Interest rates usually lower on bonds with warrants attached
• Zero coupon bond
– Offered at a deep discount from the face value
– No interest during the life of the bond, only the principal payment
at maturity

Preferred Stock
• Hybrid security
• Fixed dividends
• Dividend obligations are not legally binding, but must be
voted on by the board of directors to be paid
• Most preferred stock is cumulative
• Credit implications of missing dividends
• Corporations may exclude 70% of dividend income from
taxable income

International Bond Investing
Investors should be aware that there is a very substantial
fixed income market outside the United States that offers
additional opportunity for diversification

• Bond identification characteristics
– Country of origin
– Location of primary trading market
– Home country of the major buyers
– Currency of the security denomination
• Eurobond
– An international bond denominated in a currency not native to
the country where it is issued

• Yankee bonds
– Sold in the United States and denominated is U.S.
dollars, but issued by foreign corporations or
governments
– Eliminates exchange risk to U.S. investors
• International domestic bonds
– Sold by issuer within its own country in that country’s
currency

Equity Investments
• Returns are not contractual and may be
better or worse than on a bond

Equity Investments
Common Stock
– Represents ownership of a firm
– Investor’s return tied to performance of the company
and may result in loss or gain

Acquiring Foreign Equities
1. Purchase of American Depository Receipts (ADRs)
2. Purchase of American shares
3. Direct purchase of foreign shares listed on a U.S.
or foreign stock exchange
4. Purchase of international mutual funds

American Depository Receipts (ADRs)
• Easiest way to directly acquire foreign shares
• Certificates of ownership issued by a U.S. bank that
represents indirect ownership of a certain number of
shares of a specific foreign firm on deposit in a U.S. bank
in the firm’s home country
• Buy and sell in U.S. dollars
• Dividends in U.S. dollars
• May represent multiple shares
• Listed on U.S. exchanges
• Very popular

Direct Purchase of Foreign Shares
• Direct investment in foreign equity markets- difficult and
complicated due to administrative, information, taxation,
and market efficiency problems
• Purchase foreign stocks listed on a U.S. exchange – limited
choice

Purchase International Mutual Funds
• Global funds - invest in both U.S. and foreign
stocks
• International funds - invest mostly outside the
U.S.
• Funds can specialize
– Diversification across many countries
– Concentrate in a segment of the world
– Concentrate in a specific country
– Concentrate in types of markets

Special Equity Instruments
• Equity-derivative securities have a claim on
common stock of a firm
• Options are rights to buy or sell at a stated price
for a period of time
• Warrants are options to buy from the company
• Puts are options to sell to an investor
• Calls are options to buy from a stockholder

Futures Contracts
• Exchange of a particular asset at a specified
delivery date for a stated price paid at the time of
delivery
• Deposit (10% margin) is made by buyer at
contract to protect the seller
• Commodities trading is largely in futures contracts
• Current price depends on expectations

Financial Futures
• Recent development of contracts on financial instruments
such as T-bills, Treasury bonds, and Eurobonds
• Traded mostly on Chicago Mercantile Exchange (CME) and
Chicago Board of Trade (CBOT)
• Allow investors and portfolio managers to protect against
volatile interest rates
• Currency futures allow protection against changes in
exchange rates

Investment Companies
• Rather than buy individual securities directly from the
issuer they can be acquired indirectly through shares in an
investment company
• Investment companies sell shares in itself and uses
proceeds to buy securities
• Investors own part of the portfolio of investments

• Money market funds
– Acquire high-quality, short-term investments
– Yields are higher than normal bank CDs
– Typical minimum investment is $1,000
– No sales commission charges
– Withdrawal is by check with no penalty
– Investments usually are not insured

• Bond funds
– Invest in long-term government, corporate, or
municipal bonds
– Bond funds vary in bond quality selected for
investment
– Expected returns vary with risk of bonds

• Common stock funds
– Many different funds with varying stated investment
objectives
• Aggressive growth, income, precious metals, international
stocks
– Offer diversification to smaller investors
– Sector funds concentrate in an industry
– International funds invest outside the United States
– Global funds invest in the U.S. and other countries

• Balanced funds
– Invest in a combination of stocks and bonds
depending on their stated objectives

Real Estate Investment Trusts (REITs)
• Investment fund that invests in a variety of real estate
properties
• Construction and development trusts provide builders
with construction financing
• Mortgage trusts provide long-term financing for
properties
• Equity trusts own various income-producing properties

Direct Real Estate Investment
• Purchase of a home
– Average cost of a single-family house exceeds $100,000
– Financing by mortgage requires down payment
– Homeowner hopes to sell the house for cost plus a gain

• Purchase of raw land
– Intention of selling in future for a profit
– Ownership provides a negative cash flow due to
mortgage payments, taxes, and property maintenance
– Risk from selling for an uncertain price and low
liquidity

• Land Development
– Buy raw land
– Divide into individual lots
– Build houses or a shopping mall on it
– Requires capital, time, and expertise
– Returns from successful development can be
significant

Low-Liquidity Investments
• Some investments don’t trade on securities markets
• Lack of liquidity keeps many investors away
• Auction sales create wide fluctuations in prices
• Without markets, dealers incur high transaction costs

Antiques
• Dealers buy at estate sales, refurbish, and sell at a profit
• Serious collectors may enjoy good returns
• Individuals buying a few pieces to decorate a home may
have difficulty overcoming transaction costs to ever
enjoy a profit

Art
• Investment requires substantial knowledge of art and
the art world
• Acquisition of work from a well-known artist requires
large capital commitments and patience
• High transaction costs
• Uncertainty and illiquidity

Coins and Stamps
• Enjoyed by many as hobby and as an investment
• Market is more fragmented than stock market,
but more liquid than art and antiques markets
• Price lists are published weekly and monthly
• Grading specifications aid sales
• Wide spread between bid and ask prices

Diamonds
• Can be illiquid
• Grading determines value, but is subjective
• Investment-grade gems require substantial investments
• No positive cash flow until sold
• Costs of insurance, storage, and appraisal

Risk Return Relationship

FUNCTION AND STRUCTURE OF FINANCIAL
MARKETS

In the Beginning
• Suppose you want to start a business to develop iPhone App,
but you have no start up funds.
• At the same time, Makena has money to invest for retirement.
• If the two of you could get together, perhaps both of your
needs can be met. But how does that happen?
• We will examine the effects of financial markets and institutions on
the economy, and look at their general structure and operations.
─ Function and Structure of Financial Markets
─ Internationalization of Financial Markets
─ Types and Functions of Financial Intermediaries
─ Regulation of the Financial System

Function of Financial Markets
• Channels funds from person or business without
investment opportunities (i.e., “Lender-Savers”) to
one who has them (i.e., “Borrower-Spenders”)
• Improves economic efficiency

Financial Markets Funds Transferees
Lender-Savers
1. Households
2. Business firms
3. Government
4. Foreigners
Borrower-Spenders
1. Business firms
2. Government
3. Households
4. Foreigners

Segments of Financial Markets
1. Direct Finance
• Borrowers borrow directly from lenders in financial
markets by selling financial instruments which are claims
on the borrower’s future income or assets
2. Indirect Finance
• Borrowers borrow indirectly from lenders via financial
intermediaries (established to source both loanable
funds and loan opportunities) by issuing financial
instruments which are claims on the borrower’s future
income or assets

Importance of Financial Markets
• This is important. For example, if you save $1,000, but there
are no financial markets, then you can earn no return on
this—might as well put the money under your mattress.
• However, if a carpenter could use that money to buy a new
saw (increasing her productivity), then he’d be willing to pay
you some interest for the use of the funds.
• Financial markets are critical for producing an efficient
allocation of capital, allowing funds to move from people who
lack productive investment opportunities to people who have
them.
• Financial markets also improve the well-being of consumers,
allowing them to time their purchases better.

Structure of Financial Markets
1. Debt Markets
─ Short-Term (maturity < 1 year)
─ Long-Term (maturity > 10 year)
─ Intermediate term (maturity in-between)
─ Represented $52.4 trillion at the end of 2009.
2. Equity Markets
─ Pay dividends, in theory forever
─ Represents an ownership claim in the firm
─ Total value of all U.S. equity was $20.5 trillion at the end
of 2009.

1. Primary Market
─ New security issues sold to initial buyers
– Who does the issuer sell to in the Primary Market?
2. Secondary Market
─ Securities previously issued are bought
and sold
– Examples include the NYSE and Nasdaq
– Who trades?

Even though firms don’t get any money, per se, from the
secondary market, it serves two important functions:
•Provide liquidity, making it easy to buy and sell the securities of
the companies
•Establish a price for the securities

We can further classify secondary markets as follows:
1. Exchanges
─ Trades conducted in central locations (e.g., New York
Stock Exchange, CBT)
2. Over-the-Counter Markets
─ Dealers at different locations buy and sell
– Best example is the market for Treasury securities
www.treasurydirect.gov
NYSE home page http://www.nyse.com

Classifications of Financial Markets
We can also further classify markets by the maturity of
the securities:
1. Money Market: Short-Term
(maturity <= 1 year)
2. Capital Market: Long-Term
(maturity > 1 year) plus equities

Internationalization of Financial Markets
The internationalization of markets is an important trend. The
U.S. no longer dominates the world stage.
 International Bond Market & Eurobonds
– Foreign bonds
• Denominated in a foreign currency
• Targeted at a foreign market
– Eurobonds
• Denominated in one currency, but sold in a different market
• now larger than U.S. corporate bond market)
• Over 80% of new bonds are Eurobonds.

Internationalization of
Financial Markets
• Eurocurrency Market
– Foreign currency deposited outside of home country
– Eurodollars are U.S. dollars deposited, say, London.
– Gives U.S. borrows an alternative source for dollars.
• World Stock Markets
– U.S. stock markets are no longer always the largest—at
one point, Japan’s was larger

Internationalization of
Financial Markets

Global perspective Relative Decline of U.S.
Capital Markets
 The U.S. has lost its dominance in many industries: auto
and consumer electronics to name a few.
 A similar trend appears at work for U.S. financial markets,
as London and Hong Kong compete. Indeed, many U.S.
firms use these markets over the U.S.
Why?
1. New technology in foreign exchanges
2. 9-11 made U.S. regulations tighter
3. Greater risk of lawsuit in the U.S.
4. Sarbanes-Oxley has increased the cost of being a U.S.-
listed public company

Function of Financial
Intermediaries: Indirect Finance

Instead of savers lending/investing directly with
borrowers, a financial intermediary (such as a
bank) plays as the middleman:
 the intermediary obtains funds from savers
 the intermediary then makes loans/investments
with borrowers

 This process, called financial intermediation, is
actually the primary means of moving funds from
lenders to borrowers.
 More important source of finance than securities
markets (such as stocks)
 Needed because of transactions costs, risk sharing,
and asymmetric information

 Transactions Costs
1. Financial intermediaries make profits by reducing
transactions costs
2. Reduce transactions costs by developing expertise and
taking advantage of economies of scale

• A financial intermediary’s low transaction costs mean that it
can provide its customers with liquidity services
1. Banks provide depositors with checking accounts that
enable them to pay their bills easily
2. Depositors can earn interest on checking and savings
accounts and yet still convert them into goods and
services whenever necessary

Global Perspective
 Studies show that firms in the U.S., Canada, the U.K.,
and other developed nations usually obtain funds
from financial intermediaries, not directly from
capital markets.
 In Germany and Japan, financing from financial
intermediaries exceeds capital market financing 10-
fold.
 However, the relative use of bonds versus equity
does differ by country.

• FI’s low transaction costs allow them to reduce the
exposure of investors to risk, through a process
known as risk sharing
– FIs create and sell assets with lesser risk to one
party in order to buy assets with greater risk from another
party
– This process is referred to as asset transformation,
because in a sense risky assets are turned into safer assets
for investors

 Financial intermediaries also help by providing
the means for individuals and businesses to
diversify their asset holdings.
 Low transaction costs allow them to buy a
range of assets, pool them, and then sell
rights to the diversified pool to individuals.

 Another reason FIs exist is to reduce the impact of
asymmetric information.
 One party lacks crucial information about another
party, impacting decision-making.
 We usually discuss this problem along two fronts:
adverse selection and moral hazard.

Organization and Functioning of Securities Markets
Questions to be answered:
• What is the purpose and function of a market?
• What are the characteristics that determine the
quality of a market?
• What is the difference between a primary and
secondary capital market and how do these
markets support each other?

Organization and Functioning of Securities Markets
• What are the national exchanges and how are the major
security markets becoming linked (what is meant by
“passing the book”)?
• What are the regional stock exchanges and the over-the-counter
(OTC) market?
• What are the alternative market-making arrangements
available on the exchanges and the OCT market?

Organization and Functioning of Securities
Markets
• What are the major types of orders available to investors
and market makers?
• What are the major functions of a specialist on the NYSE
and how does the specialist differ from the central market
maker on other exchanges?
• What are the major factors that have caused the
significant changes in markets around the world in the
past 10 to 15 years?

What is a market?
• Brings buyers and sellers together to aid in the
transfer of goods and services
• Does not require a physical location
• Both buyers and sellers benefit from the market

Characteristics of a Good Market
• Availability of past transaction information
– must be timely and accurate
• Liquidity
– marketability
– price continuity
– depth
• Low Transaction costs
• Rapid adjustment of prices to new information

Organization of the Securities Market
• Primary markets
– Market where new securities are sold and funds go to issuing unit
• Secondary markets
– Market where outstanding securities are bought and sold by investors.
The issuing unit does not receive any funds in a secondary market
transaction

Corporate Bond and Stock Issues
New issues are divided into two groups
1. Seasoned new issues - new shares offered by firms that
already have stock outstanding
2. Initial public offerings (IPOs) - a firm selling its common
stock to the public for the first time

Underwriting Relationships with Investment Bankers
1. Negotiated
– Most common
– Full services of underwriter
2. Competitive bids
– Corporation specifies securities offered
– Lower costs
– Reduced services of underwriter
3. Best-efforts
– Investment banker acts as broker

Why Secondary Financial Markets Are Important
• Provides liquidity to investors who acquire securities in
the primary market
• Results in lower required returns than if issuers had to
compensate for lower liquidity
• Helps determine market pricing for new issues

Secondary Equity Markets
1. Major national stock exchanges
– New York, American, Tokyo, and London stock exchanges
2. Regional stock exchanges
– Chicago, San Francisco, Boston, Osaka, Nagoya, Dublin, Cincinnati
3. Over-the-counter (OTC) market
– Stocks not listed on organized exchange

Trading Systems
• Pure auction market
– Buyers and sellers are matched by a broker at a central
location
– Price-driven market
• Dealer market
– Dealers provide liquidity by buying and selling shares
– Dealers may compete against other dealers

Call Versus Continuous Markets
• Call markets trade individual stocks at specified times to
gather all orders and determine a single price to satisfy the
most orders
• Used for opening prices on NYSE if orders build up overnight
or after trading is suspended
• In a continuous market, trades occur at any time the market is
open

National Stock Exchanges
• Large number of listed securities
• Prestige of firms listed
• Wide geographic dispersion of listed firms
• Diverse clientele of buyers and sellers

Regional Exchanges
• Stocks not listed on a formal exchange
– Listing requirements vary
• Listed stocks
– Allow brokers that are not members of a national
exchange access to securities
• Regional Exchanges in United States
– Chicago, Boston, Cincinnati, Pacific, Philadelphia

Over-the-Counter (OTC) Market
• Not a formal organization
• Largest segment of the U.S. secondary market
• Unlisted stocks and listed stocks (third market)
• Lenient requirements for listing on OTC
• 5,000 issues actively traded on NASDAQ NMS (National
Association of Securities Dealers Automated Quotations National
Market System)
• 1,000 issues on NASDAQ apart from NMS
• 1,000 issues not on NASDAQ

Operation of the OTC
• Any stock may be traded as long as it has a willing
market maker to act a dealer
• OTC is a negotiated market

Third Market
• OTC trading of shares listed on an exchange
• Mostly well known stocks
– GM, IBM, AT&T, Xerox
• Competes with trades on exchange
• May be open when exchange is closed or trading
suspended

Fourth Market
• Direct trading of securities between two parties with no
broker intermediary
• Usually both parties are institutions
• Can save transaction costs
• No data are available regarding its specific size and growth

Exchange Membership
• Specialist
• Commission brokers
– Employees of a member firm who buy or sell for the customers of
the firm
• Floor brokers
– Independent members of an exchange who act as broker for other
members
• Registered traders
– Use their membership to buy and sell for their own accounts

Major Types of Orders
• Market orders
– Buy or sell at the best current price
– Provides immediate liquidity
• Limit orders
– Order specifies the buy or sell price
– Time specifications for order may vary
• Instantaneous - “fill or kill”, part of a day, a full day, several
days, a week, a month, or good until canceled (GTC)

• Short sales
– Sell overpriced stock that you don’t own and purchase it back
later (at a lower price)
– Borrow the stock from another investor (through your broker)
– Can only be made on an uptick trade
– Must pay any dividends to lender
– Margin requirements apply

• Special Orders
– Stop loss
• Conditional order to sell stock if it drops to a given price
• Does not guarantee price you will get upon sale
• Market disruptions can cancel such orders
– Stop buy order
• Investor who sold short may want to limit loss if stock
increases in price

Margin Transactions
• On any type order, instead of paying 100% cash, borrow a
portion of the transaction, using the stock as collateral
• Interest rate on margin credit may be below prime rate
• Regulations limit proportion borrowed
– Margin requirements are from 50% up
• Changes in price affect investor’s equity

Margin Transactions
Buy 200 shares at $50 = $10,000 position
Borrow 50%, investment of $5,000
If price increases to $60, position
– Value is $12,000
– Less - $5,000 borrowed
– Leaves $7,000 equity for a
– $7,000/$12,000 = 58% equity position

Margin Transactions
Buy 200 shares at $50 = $10,000 position
Borrow 50%, investment of $5,000
If price decreases to $40, position
– Value is $8,000
– Less - $5,000 borrowed
– Leaves $3,000 equity for a
– $3,000/$8,000 = 37.5% equity position

Margin Transactions
• Initial margin requirement at least 50%. Set up by the Fed.
• Maintenance margin
– Requirement proportion of equity to stock
– Protects broker if stock price declines
– Minimum requirement is 25%
– Margin call on undermargined account to meet margin
requirement
– If margin call not met, stock will be sold to pay off the loan

Exchange Market Makers U.S. Markets
• Specialist is exchange member assigned to handle
particular stocks
– Has two roles:
– Broker to match buyers and sellers
– Dealer to maintain fair and orderly market
• Specialist has two income sources
– Broker commission, without risk
– Dealer trading income from profit, with risk

Asymmetric Information:
Adverse Selection and Moral Hazard
 Adverse Selection
1. Before transaction occurs
2. Potential borrowers most likely to produce adverse
outcome are ones most likely to seek a loan
3. Similar problems occur with insurance where unhealthy
people want their known medical problems covered

• Moral Hazard
1. After transaction occurs
2. Hazard that borrower has incentives to engage in
undesirable (immoral) activities making it more
likely that won’t pay loan back
3. Again, with insurance, people may engage in risky
activities only after being insured
4. Another view is a conflict of interest

 Financial intermediaries reduce adverse selection and
moral hazard problems, enabling them to make profits.
How they do this is the covered in many of the
chapters to come.
 Because of their expertise in screening and
monitoring, they minimize their losses, earning a
higher return on lending and paying higher yields to
savers.

Types of Financial Intermediaries

Regulatory Agencies

Regulatory Agencies (cont.)

Regulation of Financial Markets
 Main Reasons for Regulation
1. Increase Information to Investors
• Decreases adverse selection and moral hazard problems
• SEC forces corporations to disclose information
2. Ensuring the Soundness of Financial Intermediaries
• Prevents financial panics
• Chartering, reporting requirements, restrictions on assets and
activities, deposit insurance, and anti-competitive measures
3. Improving Monetary Control
• Reserve requirements
• Deposit insurance to prevent bank panics

Regulation Reason:
Increase Investor Information
• Asymmetric information in financial markets means that investors may
be subject to adverse selection and moral hazard problems that may
hinder the efficient operation of financial markets and may also keep
investors away from financial markets
• The Securities and Exchange Commission (SEC) requires corporations
issuing securities to disclose certain information about their sales,
assets, and earnings to the public and restricts trading by the largest
stockholders (known as insiders) in the corporation
• Such government regulation can reduce adverse selection and moral
hazard problems in financial markets and increase their efficiency by
increasing the amount of information available to investors. Indeed, the
SEC has been particularly active recently in pursuing illegal insider
trading.
SEC home page http://www.sec.gov

Regulation Reason: Ensure Soundness of
Financial Intermediaries
 Asymmetric information makes it difficult to evaluate whether
the financial intermediaries are sound or not.
 Can result in panics, bank runs, and failure of intermediaries.
 To protect the public and the economy from financial panics,
the government has implemented six types of regulations:
─ Restrictions on Entry
─ Disclosure
─ Restrictions on Assets and Activities
─ Deposit Insurance
─ Limits on Competition
─ Restrictions on Interest Rates

Regulation: Restriction on Entry
 Restrictions on Entry
─ Regulators have created very tight regulations as to who is allowed to
set up a financial intermediary
─ Individuals or groups that want to establish a
financial intermediary, such as a bank or an insurance company, must
obtain a charter from the state or the federal government
─ Only if they are upstanding citizens with impeccable credentials and a
large amount of initial funds will they be given a charter.

Regulation: Disclosure
 Disclosure Requirements
 There are stringent reporting requirements for
financial intermediaries
─ Their bookkeeping must follow certain strict principles,
─ Their books are subject to periodic inspection,
─ They must make certain information available to
the public.

Regulation: Restriction on
Assets and Activities
 Restrictions on the activities and assets of intermediaries
helps to ensure depositors that their funds are safe and that
the bank or other financial intermediary will be able to meet
its obligations.
– Intermediary are restricted from certain risky activities
– And from holding certain risky assets, or at least from
holding a greater quantity of these risky assets than is
prudent

Regulation: Deposit Insurance
 The government can insure people depositors to a
financial intermediary from any financial loss if the
financial intermediary should fail
 The Federal Deposit Insurance Corporation (FDIC)
insures each depositor at a commercial bank or
mutual savings bank up to a loss of $250,000 per
account.

Regulation: Limits on Competition
 Although the evidence that unbridled competition among
financial intermediaries promotes failures that will harm the
public is extremely weak, it has not stopped the state and
federal governments from imposing many restrictive
regulations
 In the past, banks were not allowed to open up branches in
other states, and in some states banks were restricted from
opening
additional locations

Regulation: Restrictions
on Interest Rates
 Competition has also been inhibited by regulations that
impose restrictions on interest rates that can be paid on
deposits
 These regulations were instituted because of the widespread
belief that unrestricted interest-rate competition helped
encourage bank failures during the Great Depression
 Later evidence does not seem to support this view, and
restrictions on interest rates have
been abolished

Regulation Reason:
Improve Monetary Control
 Because banks play a very important role in determining the
supply of money (which in turn affects many aspects of the
economy), much regulation of these financial intermediaries
is intended to improve control over the money supply
 One such regulation is reserve requirements, which make it
obligatory for all depository institutions to keep a certain
fraction of their deposits in accounts with the Federal Reserve
System (the Fed), the central bank in the United States
 Reserve requirements help the Fed exercise more precise
control over the money supply

International Financial Regulation
 Those countries with similar economic systems also
implement financial regulation consistent with the
U.S. model: Japan, Canada, and Western Europe
─ Financial reporting for corporations is required
─ Financial intermediaries are heavily regulated
 However, U.S. banks are more regulated along
dimensions of branching and services than their
foreign counterparts.

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