Finance Preterm Plan

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Finance Preterm Plan

• Welcome to finance review
• Our schedule
• Today Financial Securities
• Tuesday Financial Markets Trading
• Wednesday Trading Continue Time Value of Money
• Thursday Time Value of Money
• Friday Risk and Random Variables
• We are also the TAs for Finance Theory I
• Amir Khandani khandani_at_mit.edu
• Yichuan Liu yichuan_at_mit.edu

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Today

• Overview of Finance Theory I
• Financial Securities
• Short Term Debt
• Long Term Debt
• Stocks

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Real vs. Financial Assets

• Real Assets
• Claims on the productive capacity of the economy
  land, buildings, machinery, knowledge for
  producing goods, etc.
• Financial Assets
• Claim on the real assets
• Are the following assets real or financial?
• Patents
• MBA education
• Loan to the bank to finance the MBA

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Taxonomy of Financial Assets

• A financial asset is a claim on future payoffs
• Categorized based on the payoff type
• Fixed income assets (Debt Market)
• Promises a fixed stream of payoff but the actual
  stream of payoff is far from fixed in may cases
• Examples Money markets, government bonds
• Equity assets (Stock Market)
• Ownership claim of the company payoff depends on
  the success of the firm
• Examples IBM stock
• Derivative assets (Derivative Market)
• Payoff depends (is contingent) on the price of
  other assets

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Short Term Debt Instruments

• Certificates of Deposit (CDs)
• Money in the Bank but different from saving
  account because it has a specific maturity
• Treasury bill (T-bills)
• Short-term debt obligations of the US government,
  issued to mature in up to 12 months
• Commercial Papers (CPs)
• Short-term debt Issued by large banks and
  corporations with maturities up to 270 days
• LIBOR, Euro Libor, Eurodollars, etc.

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Certificate of Deposit

• Certificate of Deposit
• A certificate of deposit is a promissory note
  issued by a bank. It is a time deposit that
  restricts holders from withdrawing funds on
  demand. Although it is still possible to withdraw
  the money, this action will often incur a
  penalty.

Source WSJ Online
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Treasury Bills

• Also known as T-bills
• Matures in one year or less
• Do not pay interest prior to maturity
  (Zero-coupon)
• Sold at a discount to the par value to create a
  positive yield to maturity
• Least risky investment available to U.S.
  investors
• T-Bills are commonly issued with maturity dates
  of 28, 91, and 182 days
• Sold by single price auctions held weekly

Source WSJ Online
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LIBOR, CP

• LIBOR London Interbank Offered Rate, is the most
  active interest rate market in the world. It is
  determined by rates that banks participating in
  the London money market offer each other for
  short-term deposits. LIBOR is used in determining
  the price of many other financial derivatives,
  including interest rate futures, swaps and
  Eurodollars
• Commercial Paper An unsecured, short-term debt
  instrument issued by a corporation, typically for
  meeting short-term liabilities. Maturities on not
  longer than270 days.

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From WSJ
Source WSJ Paper Edition, August 12
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Long Term Debt

• Typically has a periodic coupon face value at
  maturity
• Face Value (also known as the par value or
  principal) is the amount of money a holder will
  get back once a bond matures. A newly issued bond
  usually sells at the par value.
• Coupon is the amount of interest paid per period
  expressed as a percentage of the face value of
  the bond
• Example 2 year 3 bond maturing on August 23,
  2010 with face value of 100.
• Pays 1.5 Feb 09, Aug 09, Feb 10 101.5 in Aug
  10

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Common Instruments

• Treasury Notes
• Maturity up to 10 years
• Treasury Bonds
• Maturity between 10 to 30 years
• Treasury Inflation Protected Securities
• Coupon amount is linked to the Consumer Price
  Index
• Corporate Bonds, Municipal Bonds, Agency,
  Mortgages, etc.
• Bond Price For the last example, how much is the
  market willing to pay for the stream of 1.5 in
  Feb 09, Aug 09, Feb 10 101.5 in Aug 1. You
  will see how to price this in later sessions

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Treasury Notes and Bills

• Has a coupon value paid every six months
• At maturity will also pay the face value
  (typically 100)
• 10 year note is the widely used benchmark for
  market's take on long-term interest rates
• Treasury stopped issuing the 30 year bonds in
  October 2001 but it was reintroduced in February
  200

Source WSJ Online
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From WSJ
Source WSJ Paper Edition, August 12
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Stocks

• One the most important sources for corporation to
  raise money
• Common stocks, also know as equities, represent
  ownership shares in a corporation
• Residual Claim
• Last in line of all those who have a claim on the
  assets and income of the corporate
• For firms not in bankruptcy, a stock has a claim
  on income after taxes and interest
• If the firm has to go into bankruptcy
  proceedings, bond holder would get paid first
• Limited liability
• No personal liability if the company gets into
  financial trouble
• Other Instruments Preferred Stocks, American
  Depository Receipts (ADRs)

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Microsoft Stock
Source Yahoo Finance
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What is Next?

• WE have seen some securities so far
• Next
• Security Markets
• Securities Trading
• Return Calculation
• Trade Type
• Margin and Leverage
• Short Selling

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US Securities Markets

• Stock Trading
• NASDAQ National Association of Securities
  Dealers Automated Quotation System
• Established in 1971, was originally a price
  quotation systems but has evolved
• Organized stock exchanges
• New York Stock Exchange (NYSE)
• American Stock Exchange (AMEX)
• More recent
• Electronic Communication Network (ECNs) Examples
  are Bloomberg's TradeBook. Archipelago Exchange
  (acquired by the NYSE), Brut (acquired by NASDAQ)
• Crossing Networks Examples are Liquidnet or
  Goldman Sachs' SIGMA X
• Bond Trading
• Mostly over the counter (OTC)

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How Big is US Compare to
The World Bank
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Participants in the Markets

• Players
• Firms, households and the government
• Each can use the markets to raise money, or to
  invest their savings
• Intermediaries
• Banks
• Insurance companies
• Pension funds
• Investment firms mutual funds, hedge funds, etc.
• Investment banks
• Financial advisors

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Returns, Profit Loss

• Example Here are the price of Lehman Brothers
  stock
• I buy 1 share in April at 44.24 and sell in June
  for 19.81
• What is my profit per share? (19.810.17)-44.2
  4-24.26
• What is my rate of return? -24.26/44.24-54
• Profit Loss (PL) The amount of money gained
  or lost
• Rate of return (ROR) or sometimes just return,
  is the ratio of money gained or lost on an
  investment relative to the amount of money
  invested.

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Orders Market vs. Limit

• Market order
• A market order is an order to buy or sell a stock
  at the current market price
• Advantage almost always guaranteed to be
  executed
• Disadvantage you may not always like the price
• Price contingent orders
• Limit orders specifies a price and condition at
  which you are willing to buy or sell
• Advantage You control the price at which you
  buy/sell
• Disadvantage Not guaranteed to be executed
• Example Current MSFT Price 28.24
• Limit-Buy Order Buy shares if price falle below
  28
• Limit-Sell Order Sell if price rise to 29.50
• Stop-Loss Order Sell if price drops to 26
• Stop-Buy Order Buy if prices rise to above 32
• Bid-Ask Spread

Source Yahoo Finance
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Buying on Margin and Leverage

• Purchasing on margin borrow part of the cost of
  buying
• Same idea as taking a loan to buy a house
• Example Use 4000 and borrow 6000 to buy 10000
  of XYZ stock at 100/share
• Securities are held at the broker as the
  collateral for the loan
• May require additional margin if the price start
  moving against me

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Short Selling Concept

• Allows an investor to profit from a drop in price
  Step 1 Borrow the asset and sell it for the
  market price
• Step 2 Buy back the asset and return it to the
  lender
• Responsible for any coupons and dividend the
  asset has paid during this time
• Requires margin to be posted, proceed must be
  kept at the broker

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Short Selling Example

• Lets look at a real case Lehman Brothers (LEH)
• Need to post additional margin
• Why? Because a short position is not a limited
  liability position