Investments

1
Investments, BKM Ch 2

• Zvi Wiener
• 02-588-3049
• mswiener_at_mscc.huji.ac.il

2
Markets and Instruments

• Money Market (up to 1 year to maturity)
• The Fixed-Income Capital Market
• Equity Securities
• Stock and Bond Market Indexes
• Derivative Markets

3
Money Markets

• US Treasury Bills (T-Bills)
• Certificates of Deposit (CD)
• Commercial paper (CP)
• Bankers acceptances
• Eurodollars
• Repos and Reverses
• Federal Funds

4
US Treasury Bills

• Initial maturities are
• 91-182 days, offered weekly
• 52 weeks, offered monthly
• Competitive and noncompetitive (10-20) bids.
• The investor buys the instrument at discount
• bid-ask (spread) represents the profit for the
  dealer
• quotes use the bank discount yield.
• Exempt of state and local taxes.

5
Bank Discount Yield

• 10,000 par T-bill at 9,600 with 182 DTM.
• 400(360/182) 791.21 thus the bank
  discount yield is 7.91 rBD(10,000-P)/10,00
  0 360/n
• effective annual yield is (1400/9600)2-18.5
  1
• bond equivalent yield is rBEY(10,000-P)/P
  365/n

6
Certificates of Deposit

• Time deposits with commercial banks.
• It may not be withdrawn upon demand.
• Large CDs can be sold prior to maturity.
• Insured by FDIC up to 100,000
• (Federal Depository Insurance Corporation)

7
Commercial Paper

• Unsecured short term debt (corporations).
• Maturity is up to 270 days.
• CP is issued in multiples of 100,000.
• Small investors buy it through mutual funds.
• Most issues have credit rating.
• Treated for tax purposes as regular debt.
• LC backed (letter of credit) optional.
• In summer 1989 three companies defaulted.

8
Bankers acceptances

• Orders to a bank by a customer to pay a given sum
  at a given date.
• Backed by bank.
• Traded in secondary markets.
• Widely used in international commerce, because
  the creditworthiness is supplied by a bank.

9
Eurodollars

• Dollar denominated time deposits in foreign
  banks.
• Most are for large amounts and with maturity of
  less than 6 months.

10
Repos and Reverses

• Repurchase agreements (RPs) used by dealers in
  government securities.
• Term repo has a maturity of 30 days or more.
• Reverse repo is the result of a dealer finding an
  investor buying government securities with an
  agreement to sell them at a specified price at a
  specified future date.
• Failure of dealers in 1985 - credit risk.

11
Federal Funds

• Commercial banks that are members of the Federal
  Reserve System (Fed) are required to maintain a
  minimum reserve balance with Fed.
• Banks with excess reserves lend (usually
  overnight) to banks with insufficient reserves.
• For more on Fed see Siegel-9

12
Brokers Calls

• Brokers borrow funds to loan to investors who
  wish to buy stock on margin.
• The broker agrees to repay the loan upon the call
  of the bank.
• The rate is higher because of the credit risk
  component.

13
LIBOR

• London Interbank Offer Rate (LIBOR) is the rate
  at which the large London banks lend among
  themselves.
• This rate serves often as an anchor for floating
  rate agreements which for example can be set at
  LIBOR 3

14
Yields on Money Market Instruments

• In general, money market instruments are quite
  safe. However, T-bills are the safest of the
  money money instruments.
• As a result the other instruments provide a
  slightly higher yield.

15
Fixed-Income Capital Markets

• T-Notes - initial maturity of 10 years (or less).
• T-Bonds - initial maturities of 10-30 years.
• Par (also called face or principal) 1,000.
• Interest (coupons) paid semiannualy.

16
Rate Mo/Yr Bid Asked Chg. Ask Yld 83/4 Aug
00n 10516 10518 8 7.55
Rate coupon payment 83/4 of 1,000 paid
semiannually 43.75 per bond each 6
mo. Maturity August 2000 n note Bid
10516 means 10516/32105.5 at the price 1055
buyer is willing to buy. Ask10518 means
10518/32105.5625 at the price 1055.625 seller
is willing to sell.
17
Callable Bond Option

• What is this call option?
• Who has this option, who pays for it?
• When is it optimal to exercise the call option?
• Why does it make sense to calculate yields on
  discount bonds to maturity and yields on premium
  bonds to the first call?

18
Federal Agency Debt

• Some federal agencies issue their own debt.
• They are not legally backed by the Treasury.
• Treasury would assist in the event of distress.
• These issues are very safe.
• Yield is only slightly more than Treasury issues.
• FNMA, GNMA, FHLMC

19
Municipal Bonds (Munis)

• Issued by state and local governments and
  agencies. Interest (not capital gains!) is
  exempt from federal taxes.
• General Obligations are backed by the taxing
  power of the issuer.
• Revenue bonds are backed only by revenues from
  specific projects.
• Industrial Development bond is issued to finance
  a private projects.

20
Interest from Munis

• Is not subject to federal income tax.
• Hence the yields are lower.
• r (1- t) rm
• r - before tax return on taxable bond
• rm - return on municipal bond
• t - marginal tax rate
• Attractive to wealthy investors.

21
Corporate Bonds

• Used to generate long-term funds.
• The primary difference is the default risk.
• Backed by specific assets (like mortgages).
• By the financial strength of the firm only
  (debentures).
• Callable at a call price (firm).
• Convertible, may be exchanged to a stock
  (investor).

22
Equities

• Represent ownership in a corporation.
• Each common stock entitles to one vote.
• Shareholders vote for board members.
• A proportional share of financial benefits.
• Management usually solicits for proxy votes.

23
Ownership

• Closely held corporation - stocks are not
  traded.
• Tender offer to buy stocks at a stipulated
  price.
• Owner of more than 5 must report.
• Insiders must report and are restricted.

24
Residual Claim

• government (taxes)
• employees (including pensions)
• bond holders
• other creditors
• Limited liability
• means that the maximum loss is the original
  investment.

25
Preferred Stock

• A hybrid security with characteristics of both
  equity and debt.
• Similar to an infinite bond.
• No voting rights.
• Can not demand for a bankruptcy.
• Cumulative fixed or adjustable dividends.
• May be redeemable or convertible.

26
Dow Jones Average

• Created in the late 19th century by Charles Dow
• initially 10 rails and 2 industrial companies
• 4 years later 18 rails and 2 industrials
• Dow Industrial average, Nay 26, 1896
• 1916 the Dow was increased to 20 stocks
• in 1928 - 30 stocks
• It represents about 20 of the US market

27
Calculation of the DJIA

• sum of prices divided by the number of stocks
• Why is it now 8000?
• the denominator is adjusted when
• there is a split
• a stock pays a large dividend (10 or more)
• a firm is replaced by another
• How to invest in DJIA?

28
SP

• Started on March 4, 1957 calculated back to 1926
• Base value was 10 - average value in 1941-1943
• it covers about 80 of the market capitalization
• it is a market-value-weighted index
• How is it affected by a stock split?
• How one can invest in SP 500?

29
Market Capitalization (1993?)
30
Indexes

• DJIA, 30 stocks, NYSE, price weighted
• SP 500, NYSE, NASDAQ, value weighted
• NYSE all NYSE stock, value weighted
• NASDAQ, all NASDAQ, value weighted
• Wilshire 5000, value weighted
• Value Line, 1700 stocks, price weighted
• Lehman Brothers - bonds
• FTSE, 100 large stocks, value weighted
• Nikkei 225, price weighted

31
Index Arbitrage

• classical arbitrage, used by professional traders
  when the index is not equal to the basket
• it relies on computers to capitalize on such
  discrepancies and execute the baskets quickly.
  Is also known as program trading.

32
Derivatives

• Options
• Call - a right to buy at strike
• Put - a right to sell at strike
• European, American, Exotic.
• Futures and Forwards (obligation)
• long position - will buy
• short position - will sell

33
Summary

• Money market
• US government Notes and Bonds
• Municipal bonds r (1- t) rm
• Common Stocks
• Preferred Stocks
• Stock Market Indexes
• Derivatives (Options, Futures, Forwards)

34
Home Assignment

• read BKM-2
  problems 2, 3, 4, 8, 13 (3rd
  edition)
• problems 2, 3, 4, 10, 16 (5th edition)