BUSFIN 4221: Midterm Review PT 1

CH. 1

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Investment

• The commitment of current resources in

  the expectation of deriving greater return

  in the future

Real Asset

• Used to produce goods and services

• Can be both

• Tangible- Property, plant and equipment

• Intangible-human capital, patents, royalties, knowledge

Real Asset MORE

• Productive capacity is a function of real assets – Land, buildings, natural resources, knowledge

• generate net income to the economy

Financial Asset

Claims on real assets or claims on real-asset income

Financial Asset MORE

• define the allocation of income or wealth among investors

• Major Classes of Financial Assets or Securities

• Fixed-income (debt) securities

• Common stock (equity)

• Derivative securities

Two decisions are made to build an investment portfolio

– Asset Allocation

– Security Selection

Asset Allocation

the choice among broad array of asset classes

– Stocks, bonds, real estate, commodities,

is probably single most important determinant of portfolio performance

70%-90% of portfolio performance is from

Security Selection

choice of securities within each asset class.

Financial Intermediaries

Bring together suppliers of capital

(investors) and demanders of capital

(corporations and governments)

• Provide SCALE and EFFICIENCY

• Distinguished from other businesses in

that there ASSETS AND LIABILITIES

are primarily financial assets

There are many different types of Financial Intermediaries

• Banks (credit unions etc)- take in deposits

and make loans

• Investment banks-underwrite securities

(debt and equity) and sell to investors

• Investment companies –pool and manage

money of many investors

– Ie mutual funds, hedge funds, pension funds

More different types of financial intermediaries

Insurance companies

• Venture capital- invest in start up

companies that ARE NOT YET PUBLIC.

• Private Equity-typically invest in

established companies that need

restructured

Financial Markets and Economy

• Well developed financial markets facilitate

  the flow of capital from INVESTORS to

  USERS of capital

• Well functioning markets promote

  economic growth

• You cannot have a HIGHLY developed

  economy without well developed financial

  markets

Informational Role of Financial Markets-

direct capital to

firms with greatest perceived potential

Active Investing

• Refers to a portfolio management strategy where the

  manager makes specific investments with the goal of

  outperforming an investment benchmark index.

Passive Investing

• an investing strategy that tracks a market-weighted

  index or portfolio.

Sell Side

• includes

  investment bankers who serve as

  intermediaries between issuers of

  securities and the investing public,

  analysts who perform stock research

  and make ratings, and the market makers

  who provide liquidity in the market.

Sell Side Types Ex

Investment Banks

Corporate Banks

Commercial Banks

Brokerage Firms

– Goldman Sach

– BofAMerrill Lynch

– JP Morgan

– Morgan Stanley

– Key Bank

– Raymond James

– Robert W Baird

Buy Side

• The side of Wall Street

  comprising the investing institutions such as

  mutual funds, pension funds, hedge funds

  and insurance companies that buy securities

  and assets for their own or their clients'

  accounts

Buy Side Types and Ex

- Asset Managers

– Hedge Funds

– Pension Funds

– Insurance Companies

– Endowments

– Private Equity

T Rowe Price

– Fidelity

– Wellington

– Voya

– STRS

– PERS

CH 2

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Financial Instruments

• Fixed Income Instruments (debt)

– Money Market

– Bond Market

• Equities

• Derivatives

Money Market

• A sub sector of the bond market

• Shorter term-less than one year

• Very liquid

• Viewed as being CASH EQUIVALENTS

• Seen as VERY low risk.

-USUALLY!!!!!!!!!!!!!

Types of Money Market Instruments

• T-bills

• CD’s

• CP

• Bankers Acceptances

• Eurodollars

• Repos and Reverse Repos

• Federal Funds & LIBOR

Bonds

Composed of LONGER TERM borrowing

or debt (1 year or longer)

– MONEY MARKET IS LESS THAN 1 YEAR

Money Market Mutual Funds

• is an open-

  ended mutual fund that invests in short-

  term debt securities such as US Treasury

  bills and commercial paper.

  • are widely regarded

  as being as safe as bank deposits yet

  providing a higher yield.

• ARE NOT FDIC INSURED!!!!

• BEWARE DURING A CRISIS

-DON’T BREAK THE BUCK!!

– Ie. LTCM AND 2008

Bond Market Instruments

• Treasury notes and bonds

• TIPS

• Municipal Bonds

• Federal Agency Debt (implicit backing)

• Corporate Bonds

• MBS and ABS

Municipal Bonds

A bond issued by a state or

local government, usually to provide funding for

a specified purpose.

Types of Muni Bonds

• GENERALLY 2 TYPES OF MUNI BONDS

• GENERAL OBLIGATION- backed by full

faith and credit of the issuer.

• REVENUE BONDS- used to finance a

particular project (ie airport, water system,

toll roads etc).

– Backed by revenue of project or municipal

agency that issues them

• GO’’s considered lower risk

GENERAL OBLIGATION-

backed by full

faith and credit of the issuer.

REVENUE BONDS-

used to finance a

particular project (ie airport, water system,

toll roads etc).

Federal Agency Debt –

issued by Federal

Government Agencies

• Primarily mortgage related FHLB, FNMA,

GNMA, FHLMC

– Backing is IMPLICIT rather than EXPLICIT

Implicit

AI: unwritten or assumed guarantee that a powerful entity—such as a government or a parent corporation—will step in to support or bail out a struggling organization, even though there is no formal, legal contract requiring them to do so.

Explicit

AI: a formal, legally binding guarantee or commitment provided by a third party (such as a parent company or a government) to cover a borrower's debt or financial obligations if they default.

Corporate Bonds

debt instrument issued

by PRIVATE companies and which have

specified collateral backing them (cash

flow or assets)

Interest rate risk vs credit risk

Equity: Preferred Stock PT 1

equity ownership with fixed

income like characteristics (ie dividend)

– Promises to pay holder FIXED STREAM OF

INCOME (DIVIDEND)

– Dividend is typically cumulative

Equity: Preferred Stock PT 2

– Preference over equity holders, but subordinate

to bond holders in a liquidation

– No voting power

– Attractive to corporations because of tax

treatment

Common Stock- PT 1

represents ownership in

a corporation

– Holder gets right to vote on corporate

governance matters and share in financial

benefit (ie dividends etc)

Common Stock PT 2

– Represents a RESIDUAL claim in the event of

liquidation

– Limited Liability

Depository Receipts (ADR)- PT 1

certificates traded in the

U.S. representing ownership in SHARES OF A

FOREIGN COMPANY

ADR- you DO NOT actually own the stock,

but rather own a certificate that represents

ownership.

Depository Receipts (ADR)- PT 2

You DO NOT have the same rights as a

common shareholder

– Ie voting rights

• Financial filing requirements are different

for ADR’S

– Typically less stringent

CH. 3

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Primary Market

• New issue created/sold

• Key factor: Issuer receives proceeds from sale

• Public offerings: Registered with SEC; sale made to

investing public

Primary Market MORE

an issuer

seeking new funds issues securities in

exchange for cash from an investor.

– IPO

– Bonds

Secondary Market

• Existing owner sells to another party

• Issuing firm doesn’t receive proceeds, is not directly

involved

Secondary Market MORE

trading of existing

securities among investors

– Stock exchanges etc

Why do companies go public?

• Raise money-to fund expansion of there

business

• Monetize an asset- founders and investors

(venture capital, private equity) “cashing

out”

Initial Public Offering IPO

• First sale of stock by a

  formerly private company

• Sell securities to the general public; allow

  investors to trade shares in securities markets

IPO MORE

• • Issuer and banker put on “road show”

  • Courting

• 
  

  • Purpose: Book building and pricing

• 
  

  • Pricing: “Liar’s Poker”

  • Underpricing- WHY?

• When the stock market does well the IPO

  market does well!!

Direct Listing

Makes existing shares immediately available to the public, meaning people can buy and sell as they wish.

Direct Listing MORE

• Direct Listing

• No underwriter (so no fees)

• Allows existing shareholders to sell but

there are restrictions on how much capital

can be raised. (new shares

Special Purpose Acquisition Corp SPAC / Blank Check Company

• Company with no commercial operations that is formed strictly to raise capital through an IPO for the purpose of acquiring an existing company.

• Alternative to traditional IPO

• Reverse Merger- “Going Public Through

  the Back Door”

Differences IPO, Direct Listing, and SPAC

?

SPAC vs IPO

• Advantages

– Less scrutiny from SEC filings

– Faster- 90 days vs 12 months

• Disadvantages

– Less scrutiny from SEC

Why companies would choose one vs another.

?

Functions of Financial Markets PT 1

• Overall purpose: Facilitate low-cost investment

• Bring together buyers and sellers at low cost

Functions of Financial Markets PT 2

• Provide adequate liquidity by minimizing time and

cost to trade and promoting price continuity

• Set and update prices of financial assets

• Reduce information costs associated with investing

Types of Orders: Market

Execute immediately at best

price

Types of Orders: Price Contingent

• Buy/sell at specified

  price or better

Types of Orders: Limit Order

specifies price at which investor

will buy/sell

Type of Order: Stop Order

not to be executed until stock hits

price limit

Bid Ask Spread

• wall street is NOT a

  charity

  • Stocks are quoted Bid and Ask

• The difference is how Wall Street makes

  money

Ask price:

what you pay when u buy

• price at which dealer will sell security-

Bid price:

what you get when you sell

• price at which dealer (sell side) will buy security-

Trading Costs

EVERY TRADE HAS A COST

Commission

Bid ask Spread

Some trades have both costs, but all have

at least one

Commission:

Fee paid to broker for

executing transaction

Bid ask Spread-

cost of trading with dealer

Buying on Margin: Margin

• the use of debt financing in order

to magnify investment returns

• Borrowing money from a broker to

purchase stock

Buying on Margin: Why?

• WANT TO INVEST MORE MONEY THAN

YOU HAVE

• A way to MAGNIFY gains (and losses)

Margin-

portion of the purchase price contributed by

the investor (%)

– Equity in asset/value of the stock

Initial Margin Requirement (IMR)- (%)

• is the percentage of the purchase price of securities

that can be purchased on margin that the investor must

pay for with his own cash or marginable securities

• Minimum set by Federal Reserve under Regulation T,

currently 50% for stocks

• Minimum % initial investor equity

• 1 − IMR = Maximum % amount investor can borrow

Initial Margin

(%)

• is the percentage of the purchase price of securities

that can be purchased on margin that the investor must

pay for with his own cash or marginable securities

• Minimum set by Federal Reserve under Regulation T,

currently 50% for stocks

• Minimum % initial investor equity

• 1 − IMR = Maximum % amount investor can borrow

Maintenance Margin

• The minimum amount of equity that must be

maintained in a margin account. (%)

• 40% is typical

Margin Call

Notification from broker that you must put up additional

funds or have position liquidated

Price For Margin Call Calculation

?

Short Sales

• The sale of the security that is not owned by the seller or that the seller has borrowed.

• – Bearish bet

  • You benefit from a DECLINE in the stock

  price

  • Can be speculative or used as a hedge

Short Squeeze

• A situation in which a heavily shorted stock or commodity moves sharply higher, forcing more short sellers to close out their short positions and adding to the upward pressure on the stock.

• Short sale risks.