investment basics

investment

commitment of current resources in the expectation of deriving greater resources in the future

fixed income or (debt) securities

promise either a fixed stream of income, or income determined by a specified formula, pay a specified cash flow over a specific period

firms (as a player)

net borrowers; they raise capital now to pay for investments in plant and equipment. The income generated by those real assets provides the returns to investors who purchase the securities issued by the firm

households (as a player)

net savers (typically); they purchase the securities issued by firms that need to raise funds

governments (as a player)

borrower or lender, depending on the relationship between tax revenue and government expenditures

venture capital

money invested to finance a new firm, smaller companies, sometimes sources for venture capital are angel investors, often set up as limited partnerships

investors may play an active role in the management of a start-up

don't sell on public stock exchange-private equity investment

globalization

tendency toward a worldwide investment environment, and the integration of international capital markets

pass-through securities

A pool of fixed-income securities backed by a package of assets. Investors receive the interest from said securities

bundling, unbundling

creation of new securities either by combining primitive and derivative securities into one composite hybrid or by separating returns on an asset into classes

financial engineering

the process of creating and designing securities with custom-tailored characteristics

top-down portfolio construction

starts with asset allocation by determining what proportion of portfolio in stocks, bonds, etc, then decided which securities to buy

bottom-up portfolio construction

portfolio is constructed from securities that seem attractively priced with out a much concern on resultant asset allocation

publicly traded, publicly owned, public companies

companies that trade publicly, listed on a stock exchange

private placement

A Primary offering where a private company sells shares directly to institutional or wealthy investors to raise funds.

not required to file with securities exchange commission

less liquid than publicly offered shares because they don't sell on the secondary market

limited to < 2000 investors

some middlemen form partnerships to buy private shares, the partnership counts as 1 investor

Liquidity

ability to trade an asset at a fair price quickly

IPO initial public offerring

first public sale of a private firm to raise capital by selling shares to the general public

investment bankers organize "road show" to attract interest and provide pricing information.
They build a book "book building" of interested large investors which is later used to allocate shares.

IPO's typically underpriced and often price increases the first day of public trading

not typically a good long term portfolio strategy

Types of markets

direct search
brokers market
dealer markets
auction

types of orders

market order
price contingent order

market order

executed immediately at current market price

if order is large, there may be multiple prices depends on "depth" of market

depth of market

total \# of shares offered at best bid and best ask price

S&P 500 typically has more "depth" than Russell 2000, or more shares on the market at best bid and ask prices

Price contingent order types

limit buy
buy \# of shares at below a specified price

limit sell
sell \# of shares if price increases to a specified value

Limit order book (Price contingent order)

list of orders specifying a price at which an investor is willing to buy or sell securities as well of \# of shares

bid price (Price contingent order)

price at which a dealer/trader is willing to purchase a security

ask price (Price contingent order)

price at which dealer/trader is willing to sell a security

bid-ask spread (Price contingent order)

difference between bid- ask prices

inside spread (Price contingent order)

difference between
highest buy - lowest sell prices

for larger orders they often can't be completed at this spread because there aren't enough shares involved, so there is a range of spreads

stop order (Price contingent order)

trade executed only if it hits a specified price limit

- used often for short sells

stop loss (Price contingent order)

sell stock if price falls below specified limit (trying to prevent further losses)

stop buy (Price contingent order)

stop buying stock bought when price increases above a specified value (prevent overpaying for stock)

limit buy order

if stock goes below this limit- investor is willing to buy (sell) a security

limit sell order

if stock goes above a specified value sell it

trading systems in US

over-the-counter dealer markets
electronic communication networks
specialist markets

over-the-counter market (OTC)

informal network of brokers and dealers who negotiate sales of securities.

thousand of brokers registered with SEC-quote prices at which willing to buy/sell securities

NASDAQ

National Association of Securities Dealers Automatic Quotations System

originally formed as a price quotation system

has evolved to NASDAQ Stock Market where electronic trades are executed

NASDAQ Stock Market

~ 3000 firms

3 Levels of subscribers

Level 3 (top)
registered market makers
fastest execution of trades, enter & change bid ask continually these are firms

Level 2
receive bid and ask quotes but can't enter their own, tend to be brokerage firms that execute trades for clients, but not for their own accounts

Level 1
received only the best bid and ask quotes but don't see \# of shares available, tend to be investors that are looking for information and not actively buying/selling

evolved from NASDAQ and is a computer linked price quotation and trade execution system

used to be "fixed commissions" so trading got cheaper, congress wanted to centralize trading and enhance competition

in the 90's traders were colluding to profit and did not make best pricing publicly available-antitrust suit brought agains NASDAQ

Electronic Communication Networks (ECNs)

computer networks that allow direct trading with the need for market makers

Major ECNs
NASDAQ
BATS
NYSE Arca
Direct Edge

direct crossing of trades without using broker-dealer system to eliminate the bid-ask spread

trades automatically executed at minimal cost

speed and anonymity in trades

Specialist Markets

largely replaced by electronic communications networks in last decade

had traders who made a market in the shares of one of more companies who maintained a "fair and orderly" maker by dealing personally in the market- sought to minimize the spread- may actually buy or sell shares from their own inventory to stabilize

NYSE used to be mostly specialist and monopolize trading in its listed stocks- electronic trading networks and regulations resulted in a loss of this monopoly and their marked share in trading decreased from 75% to 25%

Today stocks mostly traded electronically, bonds are still traded in traditional dealer markets

tick size

smallest price increment used in trading,

currently 1 cent,

each time they decreased the tick size over the last decades the bid-ask spread decreased

New York Stock Exchange NYSE

largest US stock exchange based on market value of listed firms

NYSE Arca is their electronic communications network

merged/acquired Archipelago Exchange, Euronext, American Stock Exchange over last 10 years

electronic trading strategies

Algorithmic trading -delegates trading decisions to a computer program

High-frequency trading- special class of algorithmic trading ..some traders try to profit from small transitory differences in prices, so speed is essential

latency is time to accept, process, & deliver a trading order 200 microseconds

Algorithmic trading

represent more than half of equity volume in US

use of computer programs to make trading decisions

high - frequency trading

subset of algorithmic trading that relies on computers to make rapid decisions and execute,
seeking numerous trades that offer small profits

firms that are quickest to notice a profitable bid-ask spread benefit-hence some trading centers are located in close proximity to electronic exchanges to exploit this time

Bond trading

most occurs in over-the-counter market comprised of bond dealers (Bank of America -used to be Merrill Lynch), Citigroup-Salomon Smith Barney, and Goldman Sachs

Dealers don't carry extensive inventories of the wide range of bonds that have been issued to the public- so there is some liquidity risk in the bond market

buying on margin

investor borrows part of the purchase stock price from a broker

the margin in the account is the portion of the purchase price contributed by the investor

broker loans the rest and charges a "call" rate pays a service charge, securities are in the name of the brokerage firm (they are collateral)

feds require that at least 50% of price must be paid in cash by investor

Short sales

sale of shares not owned by the investor but borrowed from a broker and later purchased to replace the loan (called covering the short position

first sell, then buy

allows investors to profit from a decline in price

insider trading

illegal to transact in securities to profit from non public knowledge about a corporation

officers, directors and major stockholders are required to report all transactions in their firms stock

nevertheless-some insider trading does occur-leakage of information, documented by monitoring profits of purchases and sales of insiders

Mutual funds

unit investment trusts
closed-end investment companies
open-end investment companies

Roles of investment companies

record keeping and administration, periodic status reports, capital gains, dividends etc

diversification and divisibility -allows investors to hold fractional shares of many different securities

professional management

lower transaction costs

Net asset value

NAV\= (the market value of the securities minus any liabilities owed) /shares outstanding

or assets minus liabilities expressed on a per share basis

types of investment companies

unit investment trusts
portfolios are fixes "unmanaged"

managed investment companies
seucrities are continually bought and sold "managed"

managed investment companies

open-end or closed-end

board of directors (elected by shareholders) hires a management company to manage the portfolio for a fee (.2-1.55 of assets)

Open-end funds investors can sell their shares back to the fund at the NAV (net asset value)

closed-end do not redeem or issue shares, investors must sell to other investors on organized exchanges and may have different prices than their NAV

Premium or discount on closed-end fund

(price - NAV)/NAV

closed end fund prices can differ from the net asset value (NAV assets - liabilities)

unit investment trusts

money pooled from many investors that is invested in a portfolio fixed for the life of the fund

tend to invest in relatively uniform type of assets, i.e. municipal bonds, corporate bonds

provides investors with a vehicle to purchase a pool of one particular type of asset

decreasing in use relative to mutual funds

Other investment organizations

commingled funds

real estate investment trusts

hedge funds

commingled funds

partnerships of investors that bool funds, i.e. bank, insurance company, retirement accounts that are much larger than individual investors but still too small to arrant managing on a separate basis

similar to open ended mutual funds except instead of shares- the fund offers units,

real estate investment trusts (REITs)

similar to a closed-end fund. usually established by banks, insurance companies, or mortgage companies and then managed for a fee

two types

Equity trusts
invest in real estate directly

Mortgage trust
invest in mortgage and construction loans

Hedge funds

private investment pool open to wealthy or institutional investors, largely exempt from SEC rules. Often have "lock-ups" where funds are committed for several years. This allows them to invest in illiquid assets

Mutual fund

common name for an open-end investment company, about 90% of invest company assets are in mutual funds

mutual funds only bought and sold at beginning and end of day when NAV calculated

money market funds

mutual fund that invest in money market securities, commercial paper, repurchase agreement of certificates of deposits, average maturity in about a month, fixed as $1 share, so no capital gains/losses from redemption of shares

equity funds

mutual fund that invests primarily in stock,
normally about 5% in money market securities to provide some liquidity

income funds hold shares of firms with high dividend yields to provide current income

growth funds are willing to forgo current income and focus on prospects for capital gains
growth stocks are considered riskier than income funds

specialized sector funds

mutual fund concentrated on a particular industry, (i.e. biotech, chemicals, energy) or a particular country

bond funds

mutual fund specialize in fixed income sector

can specialize in different types of bonds
corporate
treasury
mortgage-backed securities
municipal (can even be just one city or state)

or specialize by maturity ranging from short-term to long-term,

or specialize in credit risk of the issuer from very safe to "junk" bonds

international funds

mutual fund
International funds invest in securities outside of the US

Others
(global funds invest in securities worldwide including US)

regional funds concentrate on a particular part of the world

emerging market funds invest in companies of developing nations

balanced fund

mutual funds that hold both equities and fixed income securities, most of these are "funds of funds"

Life cycle funds are balanced funds can have asset mixes that differ based on age, targeted maturity funds change allocations with age, others- static- keep the same allocation

asset allocation and flexible funds

funds of funds but engaged in market timing and not low-risk investment vehicles

index fund

mutual fund that tires to match performance of a broad market index

ex
Vanguard 500 index replicates S&P 500
so purchases shares in each S&P company proportion to the market value of the company's outstanding equity

low cost way for small investors to pursue a passive investment strategy

20% of assets in equity funds are in index funds

Fee structure of investing

operating expenses- deducted from the assets of the fund, range from 0.12% to 1.37%

marketing distribution costs, used to pay brokers or financial advisors

loads
front-end
back-end

12b-1 charges

Note loads are only paid once, but 12b-1 fees are paid annually so if a long term horizon may be better to pay a load

front-end load

commission or sales charge paid when shares are purchased, must not exceed 8.5%

low-load funds are < 3%

no-load funds have no front-end sales charges

back-end load

exit fee incurred when you sell shares

Maybe 5-6%, usually reduced the longer you own the fund

taxation of mutual fund income

pass-through-status

taxes are paid by the investor and not the mutual fund itself

one disadvantage for individual investors is you can't time your capital gains and dividends

investor has no ability to engage in tax management

turnover

ratio of trading activity of a portfolio/portfolio assets

measures fraction of portfolio replaced each year

exchange traded funds (ETFs)

allow investors to trade index portfolios just as they do shares of stock, can be sold throughout the day

common ETFs
SPDR Standard & Poor' Depository receipt- matches S&P 500

QQQ based on NASDAQ 100 index (called cubes)

WEBS world equity benchmarks- shares in portfolios of foreign stock market indices

ishares - several types of EFT's sectors and indexes

now also sector ETFs

benefits of ETFs

sold throughout the day
cheaper than mutual funds-lower management fees

disadvantage of ETFs

purchased from a broker so there is a fee, may be a bid-ask price difference

information on mutual funds

Morningstar's mutual fund sourcebook

www.morningstar.com
finance.yahoo.com/funds

Morningstar Portfolio analysis

style evaluated along two dimensions
size of firms and value/growth dimension

value vs growth is based on price to firm's earnings, book value, sales, cash flow & dividends

value stocks have low ratios of market price per share to various measures of value

growth stocks have high ratios suggesting investors believe the firm will experience rapid growth

bond

a security that obligates the issuer to make specified payments to the holder over a period of time

face value

the payment to the bondholder at the maturity date

coupon rate

a bond's annual interest payment per dollar of par value

zero-coupon bond

a bond paying no coupons that sell at a discount and provides only a payment of par value at maturity

callable bonds

bonds that may be repurchased by the issuer at a specified call price during the call period

convertible bond

a bond with an option allowing the bondholder to exchange the bond for a specified number of shares of common stock in the firm

put bond

a bond that the holder may choose either to exchange for par value at some date or to extend for a given number of years

floating-rate bonds

bonds with coupon rates periodically reset according to a specified market rate

yield to maturity

the discount rate that makes the present value of a bond's payments equal to its price

current yield

annual coupon divided by bond price

premium bonds

bonds selling above par value

discount bonds

bonds selling below par value

realized compound return

compound rate of return on a bond with all coupons reinvested until maturity

horizon analysis

analysis of bond returns over a multiyear horizon, based on forecasts of the bond's yield to maturity and the reinvestment rate of coupons

reinvestment rate risk

uncertainty surrounding the cumulative future value of reinvested bond coupon payments

investment grade bond

a bond rated BBB and above by Standard & Poor's or BAA and above by Moody's

speculative grade or junk bond

a bond rated BB or lower by Standard & Poor's, BA or lower by Moody's or unrated

indenture

the document defining the contract between the bond issuer and the bondholder

sinking fund

a bond indenture that calls for the issuer to periodically repurchase some proportion of outstanding bonds prior to maturity

subordination clauses

restrictions on additional borrowing that stipulate that senior bondholders will be paid first in the event of bankruptcy

collateral

a specific asset pledged against possible default on a bond

debenture

a bond not backed by specific collateral

default premium

the increment to promised yield that compensates the investor for default risk

credit default swap

an insurance policy on the default risk of a corporate bond or loan