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What is an Investment?

Giving up current consumption in hopes of greater future consumption.

Examples:

• Buying stocks

• Going to college

• Purchasing real estate

Real Assets

Produce goods and services.

Examples:

• Land

• Buildings

• Equipment

• Knowledge/technology

Financial Assets

Claims on real assets.

Examples:

• Stocks

• Bonds

• Bank deposits

The net wealth of an economy equals its real assets.

Financial assets are offset by financial liabilities.

Debt (Fixed Income)

• Payments are fixed

• Examples:

  • Treasury Bills

  • Bonds

  • CDs

Equity

• Ownership in a corporation

• Returns depend on firm success

• Example:

  • Common stock

Derivatives

• Value comes from another asset

• Used to transfer risk

• Examples:

  • Options

  • Futures

Roles of Financial Markets Information Role

Prices reflect information about future cash flows.

Roles of Financial Markets Allocation of Capital

Money flows to productive projects.

Roles of Financial MarketsRoles of Financial Markets Consumption Smoothing

Allows saving and investing for the future.

Roles of Financial Markets Risk Allocation

Matches investments with investor risk preferences.

Investment Process 1. Asset Allocation

Choosing among:

• Stocks

• Bonds

• Cash

Most important determinant of portfolio return.

Investment Process Security Selection

Choosing specific securities.

Investment Process Security Analysis

Determining whether securities are attractive investments.

Competitive Markets Risk-Return Tradeoff

Higher expected return = Higher risk

Efficient Markets

Prices reflect all available information

Implications:

• No consistently underpriced securities

• Difficult to beat the market

Passive Management

• Diversified portfolio

• No market timing

• No stock picking

Active Management

• Search for undervalued securities

• Market timing

Financial Intermediaries Investment Companies

Pool investor money.

Financial Intermediaries Investment Bankers

Help firms issue securities.

Financial Intermediaries Venture Capital

Finances new firms.

Financial Intermediaries Private Equity

Investment in private companies.

Systemic Risk

Risk that problems spread through the entire financial system.

Key contributors:

• High leverage

• Illiquid assets

• Over-the-counter trading

Money Market Securities (< 1 Year) Treasury Bills (T-Bills)

Characteristics:

• Issued by U.S. government

• Maturity:

  • 4 weeks

  • 13 weeks

  • 26 weeks

  • 52 weeks

• No default risk

• Sold at discount

Certificates of Deposit (CDs)

• Time deposits with banks

• FDIC insured

• Interest fully taxable

Commercial Paper

• Short-term corporate debt

• Unsecured

• High quality issuers

• Maturity < 270 days

Repurchase Agreements (Repos)

Short-term loan backed by securities.

Repo

Dealer sells securities and agrees to repurchase later.

Reverse Repo

Dealer buys securities and sells them back later.

Federal Funds Rate

Interest rate banks charge each other for overnight reserves.

LIBOR

Rate banks charge each other in London.

Treasury Notes

Maturity less than 10 years

Pay semiannual coupons

• Very low default risk

Treasury Bonds

• Pay semiannual coupons

• Very low default risk

Yield to Maturity (YTM)

Annualized return earned if:

• Bond purchased today

• Held until maturity

Includes:

• Coupon payments

• Capital gain/loss

Treasury Inflation-Protected Securities

• Principal adjusted for CPI

• Protect against inflation

FNMA

Fannie Mae

GNMA

Ginnie Mae

FHLMC

Freddie Mac

Municipal Bonds

Issued by:

• State governments

• Local governments

Advantage

Interest is tax-exempt.

Equity Securities

Common Stock

Characteristics:

• Ownership

• Voting rights

• Dividends

• Limited liability

• Residual claimant

Residual Claimant

Gets paid after everyone else.

Equity Securities Preferred Stock

Characteristics:

• Usually no voting rights

• Fixed dividends

• Higher priority than common stock

Stock Returns

Total Return= Dividend Yield+ Capital Gain Yield

Dividend yield

Dividend / purchase price

Capital Gain yield

Psell -pBUY / Pbuy

Price-Weighted Index

DJIA

Weights based on stock prices.

Higher-priced stocks have greater influence.

Value-Weighted Index

Examples:

• S&P 500

• NASDAQ

Weights based on market value.

Most representative of overall market wealth.

Equally Weighted Index

Every stock receives equal weight.

Most realistic measure of market wealth:

Value-weighted

Derivatives Call Option

Right to BUY.

Profit when stock price rises above strike price.

Derivatives Payoff

If positive ( stock price- strike price

Put Option

Right to SELL.

Profit when stock price falls below strike price.

Futures Contract

Obligation to:

• Buy (long)

• Sell (short)

At a future date.

Futures

Obligation

No premium

Unlimited gain/loss potential

Options

Right

No premium

Premium paid

Unlimited gain/loss potential

Limited loss (premium)

Primary Market

New securities issued.

Examples:

• IPO

• SEO

Issuer receives money.

Secondary Market

Existing securities trade.

Examples:

• NYSE

• NASDAQ

Issuer receives no money.

Issuing Securities Private Placement

Private company sells shares to a few investors.

Advantages:

• Faster

• No SEC registration

Disadvantages:

• Less liquidity

• Investors have bargaining power

IPO (Initial Public Offering)

First sale of shares to public.

SEO (Seasoned Equity Offering)

Additional shares issued by already public company.

Prospectus

Document describing:

• Firm

• Security offering

Required by SEC.

Underwriter

Investment bank that helps issue securities.

Firm Commitment

Investment bank buys issue and resells it.

Investment bank bears risk.

Shelf Registration

SEC Rule 415

Allows firm to:

• Register securities today

• Sell later for up to 2 years

IPO Process

1. Hire investment bank

2. Register with SEC

3. Road show

4. Bookbuilding

5. Determine offer price

6. Sell shares

IPO Underpricing

Very common.

Reason:

• Attract investors

• Ensure successful offering

Market Order

Execute immediately.

Buy at:

• Ask price

Sell at:

• Bid price

Bid-Ask Spread

Spread= Ask − Bid

Limit Buy

Buy only at specified price or lower.

Limit Sell

Sell only at specified price or higher.

Limit Order Book

Collection of pending limit orders.

Inside Quotes

• Highest bid

• Lowest ask

Trading Costs

1. Commission

2. Bid-Ask Spread

Buying on Margin

Borrow money from broker to buy stock.

Purpose :

Increase leverage.

Initial Margin

50%

Maintenance Margin

Minimum margin required.

If margin falls below requirement → Margin Call.

Short Selling

Used when expecting price to fall.

Steps

1. Borrow stock

2. Sell stock

3. Buy back later

4. Return stock