Advanced Investments

1
Advanced Investments

• Week 1
• Financial Instruments, Stock Markets, and
  Securities Trading

2
Investments Financial Assets

• Why invest?
• Essential nature of investment
• Reduced current consumption
• Planned later consumption
• Real Assets
• Assets used to produce goods and services
• Financial Assets
• Claims on real assets

3
Investments US Households

• Own stocks
• 1999 48
• 1995 41
• 1975 12
• Own mutual funds
• 1999 47.4
• 1994 30.7
• 1980 5.7

4
Financial System Clients and Their Needs

• Household Sector
• Primary Need Invest Funds
• Business Sector
• Primary Need Raise Funds
• Government Sector
• Primary Need Raise Funds

5
Meeting the Needs of Participants

• Financial Intermediation
• Investment Banking
• Financial Innovation Derivatives

6
Financial Instruments

• Stocks
• Bonds
• Bank CDs
• Commercial papers
• Mutual funds
• Hedge funds
• Futures
• Options
• MBS (Mortgage-backed securities)
• Still coming

7
Financial Markets

• Money market dealing with short-term securities
• Capital market dealing with long-term securities
• Long-term fixed income capital market (bond
  market)
• Equity market (stock market)
• Options market
• Futures market
• CISDM at UMass (http//cisdm.som.umass.edu/)

8
Money Markets

• Security Maturity
• T-bill
• T-note 1-10 years
• T-bond 10-30 years
• T-bill is sold at discount, and investors get the
  face value at maturity
• Money market mutual funds invest in T-bill, CD,
  commercial paper, Eurodollars, etc.

9
Fixed Income Capital Markets

• T-notes and T-bonds with semi-annual coupon
  payments
• Munis (Municipal bonds) Interests are exempt
  from federal income taxation and the issuing
  state taxation
• Corporate bond
• Callable feature
• Convertible feature

10
MBS (Mortgage-Backed Securities)

• The Government National Mortgage Association
  (GNMA, or Ginnie Mae) and the Federal National
  Mortgage Association (FNMA, or Fannie Mae)
  package the individual home mortgages into some
  homogenous pools, then sell (or pass through )
  these securities to investors. The banks that
  originated the mortgages no longer own the
  mortgage investments.
• Securitization
• Liquidity
• Efficiency
• Credit enhancement (FNMA and GNMA debt issues are
  rated AAA by SP)

11
Equity Markets

• Common stocks
• Stocks are listed on
• NYSE 3,000 (www.nyse.com)
• AMEX 1,000 (www.amex.com)
• NASDAQ 6,000 (www.nasdaq.com)
• Total 10,000
• Preferred (stock) A hybrid security between bond
  and stock

12
The World Equity Markets (in US billions)

• Market 2/28/90 4/28/00
• U.S. 2,839 17,006
• Japan 3,525 4,431
• U.K. 784 2,776
• Germany 353 1,506
• France 316 1,442
• Canada 239 817
• Italy 165 801
• China N/A 483
• Hong Kong 81 341
• All country 16,088 35,249
• World index

13
Municipal Bond Yields

• Interest income on most municipals is not subject
  to tax
• To compare the yields on municipals to other
  bonds use equivalent taxable yield
• (municipal return) / (1 tax rate)
• Or solve for the tax rate that equates the two
  yields
• Tax rate 1 (municipal rate/taxable rate)
• If your tax rate is 30, a corporate bond offers
  8 while the muni offers 6, should you buy the
  muni?

14
The Subprime Crisis (I)

• Subprime loans (B loans)
• Loans granted to borrowers with poor credit
• Higher interests are charged
• 21 of mortgage application from 2004-06 were
  subprime
• 2006 homeownership to a record of 69
• Brokers handle about 70 of the origination
• Big banks and wholesale lenders buy and repackage
  them
• WS firms buy from the big banks and securitize
  into MBS and CDO
• Finally, pension funds, hedge funds and
  institutions buy these structured products

15
The Subprime Crisis (II)

• The crisis
• Exuberant brokers lure borrowers into the deals
  (lax underwriting)
• Appraisers use inflated figures to value stocks
• Lack of government regulation
• Starting from 2006, foreclosure has been
  increased
• Lenders failed-lender stocks are affected
• General panic in the housing market-house prices
  drop-equity value of home mortgage goes down-more
  mortgage default
• Stock market drops more than 6-credit tightened

16
The Subprime Crisis (III)

• The Fed
• On Aug. 10th, 2007, cut the discount rate on
  loans to banks to 5.75
• Pumped in 38 billion of its reserves to keep
  short term interest rate from rising
• Economists estimate the probability of a
  recessions to be 1/4 this year and 1/5 next year
• Further action
• Enhance the law regulate the mortgage industry
• High level of due diligence for screening
  borrowers

17
Stock Market Indexes

• Uses
• Track average returns
• Comparing performance of managers
• Base of derivatives
• Factors in constructing or using an Index
• Representative?
• Broad or narrow?
• How is it constructed?

18
Stock Market Indexes (Domestic)

• The Dow Price weighted average. High price has
  more weight in the index.
• SP 500 is a better index than the Dow
• A broader index
• Value-weighted average
• Russell 3000 index (value weighted)
• Wilshire 5000 index (value weighted of 6,500
  traded stocks)

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Examples of Indexes Intl

• Nikkei 225
• FTSE 100 (Financial Times of London)
• Region and Country Indexes
• MSCI EAFE (www.msci.com)
• MSCI Far East
• MSCI United Kingdom

20
Bond Indexes

• Lehman Brothers
• Merrill Lynch
• Salomon Brothers
• Specialized Indexes
• Merrill Lynch Mortgage

21
Construction of Indexes

• How are stocks weighted?
• Price weighted (DJIA)
• Market-value weighted (SP500, NASDAQ)
• Equally weighted (Value Line Index)
• How returns are averaged?
• Arithmetic (DJIA and SP500)
• Geometric (Value Line Index)

22
Averaging Methods

• Component Return
• A10 B (-5) C 20
• Arithmetic Average
• .10 (-.05) .2 / 3 8.33
• Geometric Average
• (1.1) (.95) (1.2)1/3 - 1 7.84

23
How Securities Are Traded?

• Three types of markets
• Organized stock exchanges like NYSE, AMEX
• Regional exchanges
• Chicago
• Pacific
• Philadelphia
• Boston
• Cincinnati
• Over-the-counter (OTC) market like NASDAQ
• ECNs (Electronic communications network)

24
Organized Exchanges

• Auction markets with centralized order flow.
• Dealership function broker vs. dealer
• (IBM vs. BRKA)
• Securities stock, futures contracts, options,
  and to a lesser extent, bonds.

25
OTC Market

• Dealer market without centralized order flow.
• NASDAQ largest organized stock market for OTC
  trading information system for individuals,
  brokers and dealers.
• Securities stocks, bonds and some derivatives.
• Most secondary bonds transactions

26
Costs of Trading

• Commission fee paid to broker for making the
  transaction
• Spread cost of trading with dealer
• Bid price dealer will buy from you (5.20)
• Ask price dealer will sell to you (5.25)
• Spread ask bid (5.25-5.200.05)
• Combination on some trades both are paid

27
Revaluation On-line Trading

• www.etrade.com
• www.CharlesSchwab.com
• www.Ameritrade.com
• www.Scottrade.com
• www.E-sider.com

28
Type of Orders

• Market order executed immediately at the current
  market price
• Example Bid price (the price at which a dealer
  will buy from you) is 60.2, ask price (the price
  at which a dealer will sell to you) is 60.5.
  Your market buy order will be executed at_____.
• Limit order Investors specify prices at which
  they are willing to trade
• Limit buy order Buy whenever the price falls
  below the limit
• Limit sell order Sell whenever the price goes
  above the limit
• Stop-loss order Stop further loss
• Stop buy order Stop potential loss from short
  sale
• Good-till-canceled order valid for 6 months

29
Margin Trading

• Using only a portion of the proceeds for an
  investment.
• Borrow remaining component.
• Margin arrangements differ for stocks and futures.

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Stock Margin Trading

• Maximum margin
• Currently 50
• Set by the Fed
• Maintenance margin
• Minimum level the equity margin can be
• Margin call
• Call for more equity funds

31
Margin Trading - Initial Conditions

• X Corp 70
• 50 Initial Margin
• 40 Maintenance Margin
• 1000 Shares Purchased
• Initial Position
• Stock 70,000 Borrowed 35,000
• Equity 35,000

32
Margin Trading - Maintenance Margin

• Stock price falls to 60 per share
• New Position
• Stock 60,000 Borrowed 35,000
• Equity 25,000
• Margin 25,000/60,000 41.67

33
Margin Trading - Margin Call

• How far can the stock price fall before a margin
  call?
• (1000P - 35,000) / 1000P 40
• P 58.33
• 1000P - Amount Borrowed Equity

34
Short Sales

• Purpose to profit from a decline in the price
  of a stock or security.
• Mechanics
• Borrow stock through a dealer.
• Sell it and deposit proceeds and margin in an
  account.
• Closing out the position buy the stock and
  return to the party from which it was borrowed.

35
Short Sale - Initial Conditions

• Z Corp 100 Shares
• 50 Initial Margin
• 30 Maintenance Margin
• 100 Initial Price
• Sale Proceeds 10,000
• Margin Equity 5,000
• Stock Owed 10,000 (100 shares)

36
Short Sale - Maintenance Margin

• Stock Price Rises to 110
• Sale Proceeds 10,000
• Initial Margin 5,000
• Stock Owed 11,000
• Net Equity 4,000
• Margin (4000/11000) 36

37
Short Sale - Margin Call

• How much can the stock price rise before a margin
  call?
• (15,000 - 100P) / (100P) 30
• P 115.38
• Initial margin plus sale proceeds

38
The Risk of Short Sale

• What is the potential upside gain?
• What is the potential downside loss?
• What is the potential upside gain for a long
  position?
• What is the potential loss for a long position?