Advanced InvestmentsAdvanced Investments

Week 1 Week 1

Financial Instruments, Financial Instruments, Stock MarketStock Marketss, and , and SecuritSecuritiesies Trading Trading

•Why invest?Why invest?• Essential nature of investmentEssential nature of investment

– Reduced current consumptionReduced current consumption– Planned later consumptionPlanned later consumption

• Real AssetsReal Assets– Assets used to produce goods and Assets used to produce goods and

servicesservices• Financial AssetsFinancial Assets

– Claims on real assetsClaims on real assets

Investments & Financial Investments & Financial AssetsAssets

Investments: Investments: US US HHouseholdsouseholds

Own stocksOwn stocks• 1999: >48%1999: >48%• 1995: 41%1995: 41%• 1975: 12%1975: 12%OOwn wn mutual fundsmutual funds• 1999: 47.4%1999: 47.4%• 1994: 30.7%1994: 30.7%• 1980: 5.7%1980: 5.7%

Financial System Clients and TheirFinancial System Clients and Their

NeedsNeeds

• Household SectorHousehold Sector– Primary Need: Invest FundsPrimary Need: Invest Funds

• Business SectorBusiness Sector– Primary Need: Raise FundsPrimary Need: Raise Funds

• Government SectorGovernment Sector– Primary Need: Raise FundsPrimary Need: Raise Funds

Meeting the Needs of Meeting the Needs of ParticipantsParticipants

• Financial IntermediationFinancial Intermediation

• Investment BankingInvestment Banking

• Financial Innovation & DerivativesFinancial Innovation & Derivatives

Financial InstrumentsFinancial Instruments• StocksStocks• BondsBonds• Bank CDsBank CDs• Commercial papersCommercial papers• Mutual fundsMutual funds• Hedge fundsHedge funds• FuturesFutures• OptionsOptions• MBS (Mortgage-backed securities)MBS (Mortgage-backed securities)• Still coming………Still coming………

Financial MarketsFinancial Markets• Money market: dealing with short-term Money market: dealing with short-term

securitiessecurities• Capital market: dealing with long-term Capital market: dealing with long-term

securitiessecurities• Long-term fixed income capital market Long-term fixed income capital market

(bond market)(bond market)• Equity market (stock market)Equity market (stock market)• Options marketOptions market• Futures marketFutures market

CISDM at UMass CISDM at UMass ((http://cisdm.som.umass.edu/http://cisdm.som.umass.edu/))

Money Money MMarketsarketsSecuritySecurity MaturityMaturityT-billT-bill <=1 year<=1 yearT-noteT-note 1-10 years1-10 yearsT-bondT-bond 10-30 years10-30 years

• T-bill is sold at discount, and investors T-bill is sold at discount, and investors get the face value at maturityget the face value at maturity

• Money market mutual funds invest in Money market mutual funds invest in T-bill, CD, commercial paper,T-bill, CD, commercial paper, Eurodollars, Eurodollars, etc.etc.

Fixed Fixed IIncome ncome CCapital apital MMarketsarkets• T-notes and T-bonds with semi-annual T-notes and T-bonds with semi-annual

coupon paymentscoupon payments

• Munis (Municipal bonds): Interests are Munis (Municipal bonds): Interests are exempt from federal income taxation exempt from federal income taxation and the issuing state taxationand the issuing state taxation

• Corporate bond: Corporate bond:

Callable feature Callable feature

Convertible featureConvertible feature

MBS (Mortgage-MBS (Mortgage-BBacked acked SSecurities)ecurities)

The Government National Mortgage The Government National Mortgage Association (GNMA, or Ginnie Mae) and the Association (GNMA, or Ginnie Mae) and the Federal National Mortgage Association Federal National Mortgage Association (FNMA, or Fannie Mae) package the (FNMA, or Fannie Mae) package the individual home mortgages into some individual home mortgages into some homogenous pools, then sell (or pass homogenous pools, then sell (or pass through ) these securities to investors. The through ) these securities to investors. The banks that originated the mortgages no banks that originated the mortgages no longer own the mortgage investments.longer own the mortgage investments.

• SecuritizationSecuritization• LiquidityLiquidity• EfficiencyEfficiency• Credit enhancement (FNMA and GNMA debt issues are Credit enhancement (FNMA and GNMA debt issues are

rated AAA by S&P)rated AAA by S&P)

Equity Equity MMarketsarkets

Common stocksCommon stocks

Stocks are listedStocks are listed on on::

NYSE: NYSE: 3,0003,000 (www.nyse.com)(www.nyse.com)

AMEX:AMEX: 1,0001,000 (www.amex.com)(www.amex.com)

NASDAQ:NASDAQ: 6,0006,000(www.nasdaq.com)(www.nasdaq.com)

Total:Total: 10,00010,000

Preferred (stock)Preferred (stock): A hybrid security between : A hybrid security between bond and stockbond and stock

The The WWorld orld EEquity quity MMarkets (in US arkets (in US billions)billions)

MarketMarket 2/28/902/28/90 4/28/004/28/00U.S.U.S. 2,8392,839 17,00617,006JapanJapan 3,5253,525 4,4314,431U.K.U.K. 784784 2,7762,776GermanyGermany 353353 1,5061,506FranceFrance 316316 1,4421,442CanadaCanada 239239 817817ItalyItaly 165165 801801ChinaChina N/AN/A 483483Hong KongHong Kong 8181 341341All countryAll country 16,08816,088 35,24935,249World indexWorld index

Municipal Bond YieldsMunicipal Bond Yields• Interest income on most municipals is not Interest income on most municipals is not

subject to taxsubject to tax

• To compare the yields on municipals to other To compare the yields on municipals to other bonds use equivalent taxable yieldbonds use equivalent taxable yield

(municipal return) / (1 – tax rate)(municipal return) / (1 – tax rate)

• Or solve for the tax rate that equates the two Or solve for the tax rate that equates the two yieldsyields

Tax rate = 1 – (municipal rate/taxable rate)Tax rate = 1 – (municipal rate/taxable rate)

If your tax rate is 30%, a corporate bond offers If your tax rate is 30%, a corporate bond offers 8% while the muni offers 6%, should you buy 8% while the muni offers 6%, should you buy the muni?the muni?

The Subprime Crisis (I)The Subprime Crisis (I)• Subprime loans (B loans)Subprime loans (B loans)

– Loans granted to borrowers with poor creditLoans granted to borrowers with poor credit– Higher interests are chargedHigher interests are charged– 21% of mortgage application from 2004-06 were 21% of mortgage application from 2004-06 were

subprimesubprime– 2006 homeownership to a record of 69%2006 homeownership to a record of 69%– Brokers handle about 70% of the originationBrokers handle about 70% of the origination– Big banks and wholesale lenders buy and repackage themBig banks and wholesale lenders buy and repackage them– WS firms buy from the big banks and securitize into MBS WS firms buy from the big banks and securitize into MBS

and CDOand CDO– Finally, pension funds, hedge funds and institutions buy Finally, pension funds, hedge funds and institutions buy

these structured productsthese structured products

The Subprime Crisis (II)The Subprime Crisis (II)• The crisisThe crisis

– Exuberant brokers lure borrowers into the deals Exuberant brokers lure borrowers into the deals (lax underwriting)(lax underwriting)

– Appraisers use inflated figures to value stocksAppraisers use inflated figures to value stocks– Lack of government regulationLack of government regulation– Starting from 2006, foreclosure has been increasedStarting from 2006, foreclosure has been increased– Lenders failed-lender stocks are affectedLenders failed-lender stocks are affected– General panic in the housing market-house prices General panic in the housing market-house prices

drop-equity value of home mortgage goes down-drop-equity value of home mortgage goes down-more mortgage defaultmore mortgage default

– Stock market drops more than 6%-credit tightenedStock market drops more than 6%-credit tightened

The Subprime Crisis (III)The Subprime Crisis (III)• The FedThe Fed

– On Aug. 10On Aug. 10thth, 2007, cut the discount rate on , 2007, cut the discount rate on loans to banks to 5.75%loans to banks to 5.75%

– Pumped in $38 billion of its reserves to keep Pumped in $38 billion of its reserves to keep short term interest rate from risingshort term interest rate from rising

– Economists estimate the probability of a Economists estimate the probability of a recessions to be 1/4 this year and 1/5 next yearrecessions to be 1/4 this year and 1/5 next year

– Further action:Further action:

Enhance the law regulate the mortgage industryEnhance the law regulate the mortgage industry

High level of due diligence for screening High level of due diligence for screening borrowersborrowers

Stock Market IndexesStock Market Indexes• UsesUses

– Track average returnsTrack average returns– Comparing performance of managersComparing performance of managers– Base of derivativesBase of derivatives

• Factors in constructing or using an Factors in constructing or using an IndexIndex– Representative?Representative?– Broad or narrow?Broad or narrow?– How is it constructed?How is it constructed?

Stock Stock MMarket arket IIndexesndexes (Domestic)(Domestic)• The Dow: Price weighted average. High The Dow: Price weighted average. High

price has more weight in the index.price has more weight in the index.

• S&P 500 is a better index than the DowS&P 500 is a better index than the Dow

A broader indexA broader index

Value-weighted averageValue-weighted average

• Russell 3000 index (value weighted)Russell 3000 index (value weighted)

• Wilshire 5000 index (value weighted of Wilshire 5000 index (value weighted of 6,500 traded stocks)6,500 traded stocks)

Examples of Indexes Examples of Indexes –– Int’l Int’l

• Nikkei 225Nikkei 225• FTSE 100 (Financial Times of London)FTSE 100 (Financial Times of London)

• Region and Country IndexesRegion and Country Indexes– MSCI MSCI EAFEEAFE (www.msci.com) (www.msci.com)– MSCI MSCI Far EastFar East– MSCI MSCI United KingdomUnited Kingdom

Bond IndexesBond Indexes

• Lehman BrothersLehman Brothers

• Merrill LynchMerrill Lynch

• Salomon BrothersSalomon Brothers

• Specialized IndexesSpecialized Indexes– Merrill Lynch MortgageMerrill Lynch Mortgage

Construction of IndexesConstruction of Indexes

• How are stocks weighted?How are stocks weighted?– Price weighted (DJIA)Price weighted (DJIA)– Market-value weighted (S&P500, Market-value weighted (S&P500,

NASDAQ)NASDAQ)– Equally weighted (Value Line Index)Equally weighted (Value Line Index)

• How returns are averaged?How returns are averaged?– Arithmetic (DJIA and S&P500)Arithmetic (DJIA and S&P500)– Geometric (Value Line Index)Geometric (Value Line Index)

Averaging MethodsAveraging Methods

Component ReturnComponent Return

A=10%A=10% B= (-5%) B= (-5%) C = 20%C = 20%

Arithmetic AverageArithmetic Average

[.10 + (-.05) + .2] / 3 = 8.33%[.10 + (-.05) + .2] / 3 = 8.33%

Geometric AverageGeometric Average

[(1.1) (.95) (1.2)][(1.1) (.95) (1.2)]1/31/3 - 1 = 7.84% - 1 = 7.84%

How How SSecurities ecurities AAre re TTradedraded??ThreeThree types of markets types of markets

• Organized stock exchanges like NYSE, AMEXOrganized stock exchanges like NYSE, AMEXRegional exchangesRegional exchanges

ChicagoChicagoPacificPacificPhiladelphiaPhiladelphiaBostonBostonCincinnatiCincinnati

• Over-the-counter (OTC) market like NASDAQOver-the-counter (OTC) market like NASDAQ• ECNs (Electronic communications network)ECNs (Electronic communications network)

Organized ExchangesOrganized Exchanges

• Auction markets with centralized Auction markets with centralized order flow.order flow.

• Dealership function: Dealership function: broker vs. dealerbroker vs. dealer(IBM vs. BRKA)(IBM vs. BRKA)

• Securities: stock, futures contracts, Securities: stock, futures contracts, options, and to a lesser extent, options, and to a lesser extent, bonds.bonds.

OTC MarketOTC Market

• Dealer market without centralized Dealer market without centralized order flow.order flow.

• NASDAQ: largest organized stock NASDAQ: largest organized stock market for OTC trading; information market for OTC trading; information system for individuals, brokers and system for individuals, brokers and dealers.dealers.

• Securities: stocks, bonds and some Securities: stocks, bonds and some derivatives.derivatives.– Most secondary bonds transactionsMost secondary bonds transactions

Costs of TradingCosts of Trading• Commission: fee paid to broker for Commission: fee paid to broker for

making the transactionmaking the transaction

• Spread: cost of trading with dealerSpread: cost of trading with dealer– Bid: price dealer will buy from youBid: price dealer will buy from you ($5.20) ($5.20)– Ask: price dealer will sell to youAsk: price dealer will sell to you ($5.25) ($5.25)– Spread: ask Spread: ask –– bid bid (5.25-5.20=$0.05) (5.25-5.20=$0.05)

• Combination: on some trades both are Combination: on some trades both are paidpaid

Revaluation: On-line Revaluation: On-line TradingTrading

• www.etrade.comwww.etrade.com

• www.CharlesSchwab.com www.CharlesSchwab.com

• www.Ameritrade.comwww.Ameritrade.com

• www.Scottrade.comwww.Scottrade.com

• www.E-sider.comwww.E-sider.com

Type of Type of OOrdersrders• Market order: executed immediately at the current Market order: executed immediately at the current

market pricemarket price• Example: Bid price (the price at which a dealer will Example: Bid price (the price at which a dealer will

buy from you) is $60.2, ask price (the price at which a 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 dealer will sell to you) is $60.5. Your market buy order will be executed at_____.will be executed at_____.

• Limit order: Investors specify prices at which they are Limit order: Investors specify prices at which they are willing to tradewilling to trade

Limit buy order: Buy whenever the price falls Limit buy order: Buy whenever the price falls below below the limitthe limit

Limit sell order: Sell whenever the price goes Limit sell order: Sell whenever the price goes above above the limitthe limit

• Stop-loss order: Stop further lossStop-loss order: Stop further loss• Stop buy order: Stop potential loss from short saleStop buy order: Stop potential loss from short sale• Good-till-canceled order: valid for 6 monthsGood-till-canceled order: valid for 6 months

• Using only a portion of the proceeds Using only a portion of the proceeds for an investment.for an investment.

• Borrow remaining component.Borrow remaining component.

• Margin arrangements differ for Margin arrangements differ for stocks and futures.stocks and futures.

Margin TradingMargin Trading

• Maximum marginMaximum margin

– Currently 50%Currently 50%

– Set by the FedSet by the Fed

• Maintenance marginMaintenance margin

– Minimum level the equity margin can Minimum level the equity margin can bebe

• Margin callMargin call

– Call for more equity fundsCall for more equity funds

Stock Margin TradingStock Margin Trading

X CorpX Corp $70$7050%50% Initial MarginInitial Margin40%40% Maintenance MarginMaintenance Margin10001000 Shares PurchasedShares PurchasedInitial PositionInitial PositionStock $70,000 Borrowed Stock $70,000 Borrowed $35,000$35,000 Equity Equity $35,000$35,000

Margin Trading - Initial Margin Trading - Initial ConditionsConditions

Margin Trading - Maintenance Margin Trading - Maintenance MarginMargin

Stock price falls to $60 per shareStock price falls to $60 per share

New PositionNew Position

Stock $60,000 Borrowed Stock $60,000 Borrowed $35,000$35,000

Equity Equity $25,000$25,000

Margin% = $25,000/$60,000 = 41.67%Margin% = $25,000/$60,000 = 41.67%

Margin Trading - Margin Margin Trading - Margin CallCallHow far can the stock price fall before How far can the stock price fall before

a margin call?a margin call?

(1000P - $35,000)* / 1000P = 40%(1000P - $35,000)* / 1000P = 40%

P = $58.33P = $58.33* 1000P - Amount Borrowed = Equity* 1000P - Amount Borrowed = Equity

Short SalesShort Sales

Purpose: to profit from a decline in the price Purpose: to profit from a decline in the price of a stock or security.of a stock or security.

MechanicsMechanics

Borrow stock through a dealer.Borrow stock through a dealer.

Sell it and deposit proceeds and margin in Sell it and deposit proceeds and margin in an account.an account.

Closing out the position: buy the stock and Closing out the position: buy the stock and return to the party from which it was return to the party from which it was borrowed.borrowed.

Short Sale - Initial Short Sale - Initial ConditionsConditionsZ CorpZ Corp 100 Shares100 Shares50%50% Initial MarginInitial Margin30%30% Maintenance MarginMaintenance Margin$100$100 Initial PriceInitial Price

Sale ProceedsSale Proceeds $10,000$10,000Margin & EquityMargin & Equity 5,000 5,000Stock Owed Stock Owed 10,000 (100 shares) 10,000 (100 shares)

Short Sale - Maintenance Short Sale - Maintenance MarginMargin

Stock Price Rises to $110Stock Price Rises to $110

Sale ProceedsSale Proceeds $10,000$10,000Initial MarginInitial Margin 5,000 5,000Stock OwedStock Owed 11,000 11,000Net EquityNet Equity 4,000 4,000Margin % (4000/11000)Margin % (4000/11000) 36% 36%

Short Sale - Margin CallShort Sale - Margin Call

How much can the stock price rise before a How much can the stock price rise before a margin call?margin call?

($15,000* - 100P) / (100P) = 30%($15,000* - 100P) / (100P) = 30%P = $115.38 P = $115.38

* Initial margin plus sale proceeds* Initial margin plus sale proceeds

The Risk of Short SaleThe Risk of Short Sale• What is the potential upside gain?What is the potential upside gain?

• What is the potential downside loss?What is the potential downside loss?

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

• What is the potential loss for a long What is the potential loss for a long position?position?