Investment Alternatives

1
Investment Alternatives

• The money market
• -- The money market is a sub-sector of the
  fixed-income market. It consists of short-term,
  very liquid investments.
• 1. Treasury-bills (T-bills)
• Pure discount instruments
• Typically considered as a "risk-free" asset

2
Investment Alternatives

• The money market
• 2. Certificates of deposits
• Time deposits made with a bank. Federally
  insured up to 100,000.
• 3. Commercial paper
• -- Short-term debt issued by corporations. Gives
  corporations a way to avoid bank debt.

3
Investment Alternatives

• The fixed-income capital market
• 1. Treasury notes and bonds
• Longer maturity government debt
• 2. Federal agency debt
• -- Debt issued by government agencies and
  government sponsored agencies in support of farm
  credit and home mortgages
• - Major issuing agencies include Federal Home
  Loan Bank (FHLB), Federal National Mortgage
  Association (FNMA), Government National Mortgage
  Association (GNMA), Federal Home Loan Mortgage
  Corporation (FHLMC), District Cooperative Banks,
  Federal Land Banks, Federal Intermediate Credit
  Banks

4
Investment Alternatives

• The fixed-income capital market
• 3. Municipal bonds
• Issued by state and local governments
• Income is tax exempt
• 4. Corporate bonds

5
Investment Alternatives

• The fixed-income capital market
• 5. Mortgage-Backed Securities (MBS)
• Gives the holder an ownership claim in a pool of
  mortgages or an obligation that is secured by
  such a pool. There has been an exponential
  growth in the MBS market since 1979 with the
  amount of funds invested approaching 2 trillion
  dollars.

6
Investment Alternatives

• The fixed-income capital market
• 5. Mortgage-backed securities (MBS)
• Securitization involves packaging a set of
  assets together and selling ownership rights to
  the assets. For example, David Bowie sold shares
  in his song portfolio. Any revenues generated
  from his songs are split among the shareholders.
  (By the way, I believe he made a few hundred
  million dollars doing this.)

7
Investment Alternatives

• Equity securities
• 1. Common stock
• Residual claimant
• Limited liability

8
Investment Alternatives

• Equity securities
• 2. Preferred stock
• Promises a fixed dividend to shareholders, but
  non-payment of the dividend will not force the
  company into bankruptcy.

9
Investment Alternatives

• Derivative Markets
• 1. Options
• Right to buy or sell an asset at a specified
  price at a certain time in the future
• 2. Futures
• Obligation to buy or sell an asset at a specified
  price at a certain time in the future
• 3. Swaps
• An agreement between two parties to exchange a
  set of cash flows in a predetermined manner

10
Investment Alternatives

• Investment companies
• 1. Mutual funds
• 2. REITs

11
Investment Alternatives

• International investments
• Developed versus emerging markets

12
What is a market?

• Brings buyers and sellers together to aid in the
  transfer of goods and services
• Does not require a physical location
• Both buyers and sellers benefit from the market

13
Characteristics of a Good Market

• Availability of past transaction information
• must be timely and accurate
• Liquidity
• marketability
• price continuity
• depth
• Low Transaction costs
• Rapid adjustment of prices to new information

14
Security market organization

• Primary markets
• Primary markets are original issue markets where
  capital is acquired by the government and
  corporations.
• Government issues done through an auction process
• Municipal and corporate issues generally use an
  underwriting process

15
Issuing New Securities

• Underwriters
• Investment bankers who help the company issue and
  market new securities
• Roles of underwriters
• Origination
• Issue recommendations
• Due diligence
• Market preparation
• SEC filings
• Help set offer price

16
Issuing New Securities

• Roles of underwriters
• Types of commitments
• Firm commitment
• Underwriter purchases issue from company and
  sells the issue
• Best efforts
• Underwriter does not purchase issue from company
  but provides sales support
• Types of bids
• Competitive
• Company prepares issue and investment banks
  compete to help issue the security
• Negotiated
• Company works with investment bank to reach an
  agreeable price for the banks services

17
Security market organization

• Primary Corporate Issues
• Corporations issue both debt and equity
  securities
• Seasoned issues
• IPOs

18
Security market organization

• Primary Corporate Issues
• IPOs
• New corporate issues are generally underwritten
  by investment banks
• -- Negotiated
• -- Competitive bids (typical for utilities)
• -- Best efforts (for speculative issues)
• Shelf Registration (rule 415)
• Private Placements (rule 144A)

19
What are the steps of an IPO?

• Select investment banker
• File registration document (S-1) with SEC
• Choose price range for preliminary (or red
  herring) prospectus
• Go on roadshow
• Set final offer price in final prospectus

20
Security market organization

• Secondary markets
• Secondary markets are the markets where existing
  securities are traded.
• Trades occur between existing and potential
  owners of securities.
• Proceeds of sales in secondary markets do not go
  to the issuing unit but the owner of the
  security.
• Secondary markets provide liquidity and a current
  market price

21
Security market organization

• Secondary bond markets
• Generally dealer markets where large banks and
  investment banks make markets in the bonds. (OTC
  market)
• Some corporate bonds trade on securities
  exchanges such as the NYSE
• Bond markets are somewhat illiquid for smaller
  investors and the transactions costs involved in
  trading bonds are relatively high.
• There is a push for more uniform reporting of
  bond prices so as to encourage secondary market
  transactions

22
Security market organization

• Secondary equity markets
• 1. National Stock exchanges
• 2. Regional stock exchange
• Provide trading facilities for local companies
  not large enough to qualify for listing on the
  larger exchanges
• Provides "dual-listings" for companies
• 3. Over the counter markets (NASDAQ)
• NASDAQ is the dominant OTC market
• NASDAQ is an association of securities dealers

23
Security market organization

• Differences between OTC and organized exchanges
  trading mechanism
• The specialist in organized exchanges
• 1. Broker
• 2. Quotes bid/ask prices.
• Bid -- Price at which specialist is willing to
  buy (Price at which you can sell)
• Ask -- Price at which specialist is willing to
  sell (Price at which you can buy)
• 3. Dealer
• 4. Maintain limit order book -- Keep track of
  limit orders and execute trades for floor brokers

24
Security market organization

• Differences between OTC and organized exchanges
  trading mechanism
• The dealer in OTC exchanges
• There is no central location in OTC markets so
  dealers take a position in every transaction.
• There are varying numbers of dealers in every OTC
  stock and each dealer quotes a bid and ask price.
• Dealers make money on the difference between the
  bid and the ask price.
• In OTC markets each transaction is completed at
  either the bid or ask.
• In exchanges the specialist rarely takes a
  position so transactions often occur between the
  specialists bid and ask prices.

25
Security market organization

• Off market transactions
• ECNs
• www.island.com
• Private transactions of shares
• In-house trading by brokerage houses

26
Security market trends

• 1. Importance of institutional investors
• No relationship between stock volatility and
  institutional trading
• Has volatility increased???
• Yes, individual stock volatility has increased
• Here's what Peter Lynch has to say about
  institutional trading, "If you invest like an
  institution, you're doomed to perform like one,
  which in many cases isn't very well.

27
Security market trends

• 2. Block trades
• Can move the market
• 3. Technology
• Off market trading
• Rapid order processing
• On-line trading
• 4. Growth of international investments
• Integration between markets

28
Security market trends

• 5. Day trading
• A study by Brad Barber and Terrance Odean
  examined 60,000households with accounts at
  discount brokers from 1991-1996
• Households 15.3 return, Mkt 17.1 return
• Households in top 20 of trading activity 10.1
• Average annual turnover of 80

29
Market Mechanics

• Types of orders
• 1. Market order
• Order to buy or sell a stock at the best
  available price
• Most common order type
• May be issued as a discretionary order, where
  your broker has the right to hold the order in
  order to get a better price.

30
Example 1

• Assume we want to buy 1000 shares of Disney.
• We call our broker and enter a market order for
  Disney.
• At the time of the order the quotes on Disney are
  29½ bid and 29¾ ask.
• This means the highest quote the Disney
  specialist has to buy Disney is 29½ and the
  lowest price anyone will sell at is 29¾.
• Our market order will be filled at 21¾ so our
  transaction will cost 29,750 plus commissions.

31
Example 2

• I am aware of some anecdotal evidence regarding
  an investor who wanted to purchase an internet
  stock.
• A market order was placed for 1000 shares at 9
  (the current price)
• The order was filled at 90
• The stock closed the next day at 40
• 50,000 loss on an anticipated 9,000 purchase

32
Market Mechanics

• Types of orders
• 2. Limit Order
• A limit order is a buy or sell order that is
  executed at a specified price or a more favorable
  price. The limit order is given to the
  specialist who executes the order when the price
  is met.
• Limit orders can be for virtually any time period
  some typical orders are
• instantaneous (fill or kill)
• day order
• open-ended order (good until canceled or GTC)

33
Example

• Assume we again want to buy Disney but do not
  want to unless the price falls to 25.
• We would make a limit buy order with a broker at
  25.
• The broker will transfer the order to the
  specialist who enters the order in a limit book.
• Your order will be filled if the ask price of
  Disney falls to or below 25.

34
Market Mechanics

• Types of orders
• 3. Stop loss order
• This is an order you put in to insure a limited
  loss on a stock. Stop loss orders become a
  market order once the specified price is reached.
  

35
Example

• Assume we buy Disney at 25 and want to insure we
  do not lose too much on the stock.
• We can place a stop loss order at 20 and if
  Disney falls to 20 the order will automatically
  be executed.
• In a SLO the stock might be sold at less than 20

36
Market Mechanics

• Types of orders
• 4. Stop buy order
• Opposite of a stop loss, generally used to cover
  short positions
• 5. Stop limit order
• Combination of a stop and limit order.
• The order becomes a limit order as soon as a bid
  or ask is made at a price equal to or less
  favorable than the stop price.
• With a stop limit order you must give the broker
  two prices a stop price and a limit price.

37
Example

• Suppose that we bought Disney for 29¾. We want
  to protect ourselves against losses so we could
  put a stop limit order with a stop at 20 and a
  limit at 18.
• Once the bid price of Disney falls below 20 a
  limit order of 18 will be placed.
• Thus, the stock will be sold at a price of 18 or
  higher
• This prevents not being able to sell when a stock
  is in free-fall

38
Market Mechanics

• Types of orders
• 6. Market-if-touched
• The order is executed at the best available price
  after a trade occurs at a specified price. This
  differs from a limit order which must be executed
  at the limit price or a more favorable price.

39
Market Mechanics

• Short sales
• A short sale is executed when a trader expects
  the price of a security to fall
• Short sales involve borrowing a security and
  selling it and then buying the security back at a
  lower price and returning it to the owner.

40
Example

• Assume we think the price of Disney is going to
  fall. We will sell Disney short in order to
  benefit from this price decrease
• In order to do this we would borrow 1000 shares
  of Disney and sell it for 29½. We receive
  29,500 for this transaction.
• If Disney falls to a 20 ask price we can buy
  1000 shares of Disney for 20,000 and return it
  to its owner.
• We make 29,500 20,000 9,500 less
  commission and interest on the transaction
• Of course, we dont actually borrow the stock.
  The transaction is a paper transaction with our
  broker.

41
Market Mechanics

• Short sales
• Short sale restrictions
• Short sales can only be made on an up-tick
• The short position owes the owner of the security
  any dividends paid.
• In order to short a stock you must have a margin
  account with a broker

42
Market Mechanics

• Margin accounts
• Margin refers to borrowing part of the cost of a
  security when a purchase is made
• The amount of money that is put up by the
  investor is referred to as the margin.
• Your broker will charge you interest on the
  margin.

43
Market Mechanics

• Margin Accounts
• Initial margin
• Initial margin is the part of the original
  transaction value paid for by the investor
• Currently the initial margin requirement on stock
  is 50 (required by law)
• Brokers can charge higher initial margins

44
Market Mechanics

• Margin accounts
• Investors equity
• The investor's equity position is the market
  value of the stock minus the amount borrowed
• Actual margin
• (investors equity)/(market value)

45
Market Mechanics

• Margins accounts
• Maintenance margin
• Maintenance is the minimum value the actual
  margin can reach before a margin call is made.
  Current requirements call for a minimum
  maintenance margin of 25.
• Margin call
• A margin call occur when actual margin falls
  below maintenance margin

46
Example

• Assume we want to buy 1000 shares of Disney at
  29 using a margin account. The initial margin
  requirement is 50 and the maintenance margin is
  35
• Market value of transaction 29 x 1000
  29,000
• Initial margin .5 x 29,000 14,500
• Amount borrowed 29,000 14,500 14,500

47
Example

• Now assume Disney goes to 35
• Market value 35,000
• Investors equity 35,000 14,500 20,500
• Actual margin 20,500/35,000 59
• Our return would equal 6,000/14,500 41.4
• Without margin the return would equal
  6,000/29,000 20.7
• The leverage factor is 2. Our margin returns
  will always be twice the unlevered returns when
  the initial margin is 50
• The leverage factor 1/initial margin

48
Example

• Now Disney falls to 19
• Market value is 19,000
• The actual margin is 4,500/19,000 24
• A margin call will be made
• Call is payable on demand
• Must restore account to minimum maintenance
  margin
• 19,000.35 6,650
• 6,650-4,500 2,150

49
Example

• At what price will a margin call occur?
• When the actual margin 35
• AM (market value amount borrowed)/market
  value
• .35 (P1000 14,500)/P1000
• 350P 1000P 14,500
• 350P 14,500 1000P
• 14,500 650P
• P 22.31 so a margin call will be made when the
  price falls below 22.31

50
Extra Margin Example

• Margin Problem 4.3
• Suppose you buy a round lot of Maginn Industries
  stock on 55 margin when the stock is selling at
  20 a share. The broker charges a 10 annual
  interest rate and commissions are 3 of the total
  stock value on both purchase and sale. A year
  after purchase you receive a 50 cent dividend and
  sell the stock for 27. What is your rate of
  return on this stock?

51
Extra Margin Example

• 1. Determine investment
• beginning value of investment 100 x 20 2000
• your investment margin x value commission
• (.55 x 2000) .03 x 2000 1160
• 2. Determine the income and capital gain
• ending value of investment 27 x 100 2700
• Capital gain 2700 2000 700
• Dividend income 0.50 x 100 50

52
Extra Margin Example

• 3. Determine profit
• net profit 700 50 interest commission
• 750 (.1 x (.45 x 2000)) ((.03 x 2000)
  (.03 x 2700)) 750 90 141 519
• Percentage return profit/amount invested
  519/1160 44.74
• Percentage return without interest or
  transactions costs 750/1100 68.18
• Percentage return w/o margin 750/2000 37.5

53
Extra Example

• Short sale problem Problem 4.4
• You decide to sell short 100 shares of Charlotte
  Horse Farms when it is selling at its yearly high
  of 56. Your broker tells you that the margin
  requirement is 45 percent and the commission on
  the purchase is 155. While you are short the
  stock, Charlotte pays a 2.50 per share dividend.
  At the end of one year you buy 100 shares of
  Charlotte at 45 to close out your position and
  are charged a commission of 145 and 8 interest
  on the money borrowed. What is your rate of
  return on this investment?

54
Extra Example

• Profit on a short sale beginning value
  ending value dividends transaction costs
  interest
• beginning value 56 x 100 5600
• initial investment margin requirement
  commission (.45 x 5600) 155 2675
• ending value 45 x 100 4500
• dividends 2.50 x 100 250
• Transaction costs 155 145 300
• Interest .08 x (.55 x 5600) 246.40
• Profit 5600 4500 250 300 246.40
  303.60
• Rate of return on your investment 303.6/2675
  11.35