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FIN670: Investment Analysis
Chapter 1: Background and Financial Instruments
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What this course is aboutBasic knowledge of invesment process and financial marketsValuation of bonds and related bond investment strategiesPortfolio theory: diversification and how it reduces portfolio riskAsset pricing models for expected returnsFundamental and technical analysis
Investments & Financial Assets
Essential nature of investmentReduced current consumptionPlanned later consumption
How to investReal Assets: Assets used to produce goods and services• produce income to economy
Financial Assets• Claims on real assets or income generated by
them• Allocation of income, real assets among
investors, individuals in the economy
Balance Sheet – U.S. Households
Financial Assets
Financial assets
Fixed-income (Bonds) Equity (Stocks) Derivatives
Money Market(Short-term)
Common StocksPreferred Stocks
OptionsFutures
Bond Market(Long-term)
Role of Financial asset and financial markets in the Economy
Consumption TimingAllocation of RiskSeparation of Ownership and Management
Consumption Timing
Savers
(earn more than spend)
Borrowers
(spend more than earn)
Financial assets: stocks, bonds, deposits, etc.
How do you transfer money from when you do not need to when you need?
Allocation of riskExample: GM wants to build a new auto plant, it raised money by issuing stocks and bonds
GM
Stock investors
(high risk)
Bond investors
(low risk)
Auto plant
High risk and low risk
Stock
Bond
Separation of ownership and management
Example: GE, total asset is $640 bilCannot be single owner, must have many ownersSelling stocks to market Currently, GE has 500,000 ownersThese owners choose managersCan easily transfer ownership without any impact on management
The Investment Process
Asset allocationSecurity selectionRisk-return trade-offMarket efficiencyActive vs. passive management
Investment process
Broad assets
Stocks
Bonds
Real estate
Commodity
Small stock
Big stock
corporate bond
T-bond, T-bill
House
Land
coffee, tea
gold, oil, etc(1) Asset allocation(2) Security analysis
30s 70% 30%40s 60 4050s 50 5060s 40 60
CommonAge Stocks Bonds
Example of Asset Allocation
Example of Security Selection
Your Stock Portfolio
Auto Retail Financial
Wal-MartNordstroms
Sears
Bank of AmericaBerkshire Hathaway
Citibank
There is no free lunch!Return
Risk
less risk
lessreturn
more risk
morereturn
Market Efficiency
Security prices accurately reflect all relevant information.
The price in the market is the true price
Earn return just enough to compensate for risk, no abnormal return
Active vs. Passive Management
Active Management• Finding undervalued securities• Timing the market
Passive Management• No attempt to find undervalued
securities• No attempt to time• Holding an efficient portfolio
Players in the Financial Markets
Business Firms – net borrowersHouseholds – net saversGovernments – can be both borrowers and saversInvestment Bankers
Players in the Financial Markets
borrowers Savers securities
fund
borrowersfinancial
intermediariessavers
securities
lending rate
securities
borrowing rate
borrowers investment bank savers securities
fund
securities
fund
get commission fees
Recent Trends
GlobalizationSecuritizationFinancial EngineeringComputer Networks
Globalization
In 1970, US equity market accounted for about 70 percent of equity in the worldCurrently, only 20-30 percentHow to invest globally
Purchase ADRsInvest directly into international marketBuy mutual fund shares that invest in international marketderivative securities with payoff depends on prices of foreign market
Securitization
Banks
pool all loans
Mortgage loansauto loanscredit card
student loansother loans
securities
loans are securitized
Investors
Benefits of securitization
(1) more funds available to borrowers
(2) Transfer risk of loans to corresponding investors in the market
High risk loan High risk securities High risk investors
Low risk loan low risk securities low risk investors
Figure 1.2 Asset-backed Securities Outstanding
Financial engineering
refer to creation of new securities Use of mathematical models and computer-based trading technology to synthesize new financial productsBundling: combine more than one security into a composite securityUnbundling: breaking up and allocating the cash flows from one security to create several new securities
Collateralized Debt Obligation (CDO)
A CDO is an asset backed security (ABS) whose underlying collateral is typically a portfolio of bonds (corporate or sovereign) or bank loan
A CDO cash flow structure allocates interest income and principal repayments from a collateral pool of different debt instruments to a prioritized collection (tranches) of CDO securities.
Mortgage 1Mortgage 2Mortgage 3
Mortgage n
Average Yield12.5%
($100 mil)
Tranche 1 (AAA)Yield = 5%
($25mil)
Tranche 2 (A)Yield = 10%
($25mil)
Tranche 3 (BBB)Yield = 15%
($25mil)
Tranche 4 (junk bond)Yield = 20%
($25mil)
Cash CDO Structure Illustration
An investment
bank creates a set of
securities (tranches)
backed by a mortgage
pool
(CDO)
Investor:banks, pension funds, college saving funds, universities, cities, etc.
Collateralized Debt Obligation (CDO)
In normal time, mortgage borrowers are able to make the mortgage payments, so the investors will get the interest payments, the values of slices of CDOs increase
When housing bubble busts, mortgage borrowers, especially subprime mortgage borrowers are not able to make payments, investors don’t get their money, values of CDOs decrease substantially. The value decrease is write-down and counted as loss in the income statement.
For example, investment bank A, equity: $10 mil, borrow $90 mil. Invest all $100 mil in CDOs. When mortgage crisis happens, the market value of these mortgage backed securities drops substantially say to $80 mil, that means the income will go down by $80 mil, and at this point, technically the bank is insolvent.
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Subprime Mortgage Crisis: Winners and Losers
Big losers: http://ml-implode.com/ Bear Stearns: two hedge funds (>$1 billion) Australia: Basis Capital ($1 billion?); Absolute Capital ($200
million?); IKB Deutsche Industriebank … May take two more years to completely resolve!
Big losers: Citigroup ($18B+) Merrill Lynch ($11.5B+) UBS ($17.8B+) Morgan Stanley ($9.4B+) … Bank of China (initial estimate $223 million, now could be $4-5B)
Figure 1.3 Building Creates a Complex Security
Figure 1.4 Unbundling of Mortgages into Principal- and Interest-Only Securities
Recent Trends—Computer Networks
Online information disseminationInformation is made cheaply and widely available to the publicAutomated trade crossing
Direct trading among investors
2008: Making History
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2008: The End of Wall Street
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Decision Making
1. Perceive the situation2. Possible actions3. Evaluate the outcomes4. Choose the action with the best
outcome
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Investments: Asset classes and financial instruments
CHAPTER 2
Financial Securities
Financial Market
Fixed-income (Bonds) Equity (Stocks) Derivatives
Money Market(Short-term)
Common StocksPreferred Stocks
OptionsFutures
Low Risk High Risk
Bond Market(Long-term)
Index
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Treasury Bills Certificates of deposit Commercial paper Banker’s acceptances Eurodollars Repos and reverses Brokers’ calls* Federal funds LIBOR
Money Market Instruments
Money market instruments
T-bill• Issued by government• most marketable• minimum denomination: $1000• buy at a discount, return at par• issued weekly with maturities 28, 91, 182 days
Certificate of deposit (CD)• Pay interest and principal at maturity date• Par value > 100,000: negotiable• Par value <100,000: non-negotiable• Short-term CD (less than 3 months): highly
marketable
Money market instruments
Commercial paper• Issued by large, well-known corporation• Short term, unsecured debt (less than 270
days), more than 270 day need SEC registration.
• Fairly safe• Fairly liquid
banker acceptance• an order to a bank by a customer to pay a
sum of money at a future date• safe (guaranteed by bank)
Money market instruments
Eurodollars: dollar denominated at foreign banks or American banks’ foreign branches
• similar to domestic deposit• escape US regulation• riskier, less liquid, offer higher yield than
domestic deposit
Repos (repurchase agreements)• short-term sales of government securities
with an agreement to repurchase the securities at a higher price
Money market instruments
Federal funds• Funds in the accounts of commercial bank
at the Fed• Federal fund rate: overnight loan rate
among banks
LIBOR market: London Interbank Offer Rate: lending rate among banks in London market
Table 2.2 Components of the Money Market
Bond Market
Treasury Notes and BondsFederal Agency DebtInternational BondsInflation-Protected BondsMunicipal BondsCorporate BondsMortgages and Mortgage-Backed Securities
Treasury Notes and Bonds
MaturitiesNotes – maturities up to 10 yearsBonds – maturities in excess of 10 years
Par Value - $1,000Quotes – percentage of par, in 32nd
Figure 2.4 Treasury Notes and Bonds
Federal Agency Debt
Major issuersFederal Home Loan Bank
Federal National Mortgage Association (“Fannie Mae”)
Government National Mortgage Association (“Ginnie Mae”)
Federal Home Loan Mortgage Corporation (“Freddie Mac”)
If default, the government will helpsafe, yield is similar to T-bill
Municipal Bonds
Issued by state and local governments
TypesGeneral obligation bonds: backed by state, cityRevenue bonds: backed by the revenue of project of state, citytax exempt from federal tax (for investors)example: consider 2 bonds
• taxable bond: before tax yield = 8%, tax = 40%• municipal bond: yield = 6%• Which one is more attractive to investors?
Maturities – range up to 30 years
Interest is exempt from Federal taxes
After-tax return (taxable bond):
After-tax return (Municipal bond):
trr taxbeforetaxafter 1
taxbeforetaxafter rr
Municipal Bonds
Figure 2.6 Ratio of Yields on
Tax-exempts to Taxables, 1955-2006
Corporate Bonds
Issued by private firms Semi-annual interest paymentsSubject to larger default risk than government securitiesOptions in corporate bonds
CallableConvertible
Figure 2.7 Investment Grade Bond Listings
Developed in the 1970s to help liquidity of financial institutionsProportional ownership of a pool or a specified obligation secured by a pool Market has experienced very high rates of growth
Mortgages and Mortgage-backed Securities
Mortgage backed securities
Banks
Mortgage loan
Borrowers
mortgage backed securities
pool all mortgage loans
securitizedInvestors
sell
fund
fund
fund
fund payment
payment
paymentpayment
payment
Mortgage backed securities can be called pass through securities since the bank simply pass fund from investors to borrowers and pass interest payment and principal payment from borrowers to investors
Figure 2.7 Mortgage-backed Securities Outstanding, 1979-2007
Equity Markets
Common stock
Preferred stock
Depository receipts
stock market listing
Equity Markets
Common stock• Right to vote• Right to share benefit• Proxy• Proxy fight
Characteristics• Residual claims• Limited liabilities
Equity Markets
Preferred stocksSimilar to both stocks and bond (hybrid security)
• Similar to bond• Similar to stock
Priority over common stockpreferred dividend is cumulativetax treatment
• Preferred stock and bond are similar in the sense that they are both fixed income and have no voting power.
• Bond has claims before preferred stock• Obviously preferred stock is riskier, why in practice the
yield on preferred stock is smaller than that of bond
Equity Markets
ADR: claims on ownership in foreign companiesTrading in the US, similar to US stocksTotal value of ADR currently is 657 (bil), about 2000 ADRs from 73 countries
Figure 2.8 Listing of Stocks Traded on the NYSE
Track average returnsComparing performance of managersBase of derivatives
Uses of Stock Indexes
Examples of Other Indexes - Domestic
Dow Jones Industrial Average (30 Stocks)Standard & Poor’s 500 CompositeNASDAQ CompositeNYSE CompositeWilshire 5000
Figure 2-10 Comparative Performance of Several Stock Market Indexes
Examples of Indexes - International
Nikkei 225 & Nikkei 300FTSE (Financial Times of London)DaxRegion and Country Indexes
EAFEFar EastUnited Kingdom
MSCI: index of more than 50 country indexes
Table 2.6 Sample of MSCI Stock Indexes
Representative? Broad or narrow? How is it weighted?
Price weighted (DJIA)Market weighted (S&P 500, NASDAQ)Equal (Value Line Index)
Factors for Construction of Stock Indexes
Price Weighted Indices
DJIA is an example
30 blue chip companies
DJIA = (P1+P2+....+P30)/d where d is Dow divisor.
Originally d = 30
Currently, d = 0.1248 since d is adjusted for stock split, stock dividends, other corporate action, new companies coming into the index, old companies are taken out of the index
Example of Price-Weighted Index
Stock ABC sells initially at $25 a share with 20 million shares outstanding, while XYZ sells for $100 a share with 1 millions shares outstanding. The final price for ABC is $30, and the final price for XYZ is $90.(a) Find the initial and the final price-weighted index composed of these two stocks. Assume the initial divisor is 2.
(b) Now if stock XYZ is split two for one, how should you adjust the divisor for the index?
DJIA
Most quoted index in the world• Long history• easy to understand• indicates market’s basic trend reliably• 30 companies account for 24-25% of US
equity
Criticisms• Only 30 stocks• price weighted index: large price stocks
dominate the index
S&P’s Composite 500 Market Value-Weighted Index
Stock ABC sells initially at $25 a share with 20 million shares outstanding, while XYZ sells for $100 a share with 1 millions shares outstanding. The final price for ABC is $30, and the final price for XYZ is $90.Find the the value-weighted index composed of these two stocks at the final date. Assume the initial level of the index is 100.
Value LineEqually Weighted Index
Places equal weight on each returnUsing data from Table 2.4Start with equal dollars in each investmentABC increases in value by 20%XYZ decreases by 10%Need to rebalance to keep equal weights
Table 2.4 Data to Construct Stock Price Indexes
Computed monthly
Difficulty in measuring true returns
Best known:Merrill LynchLehman BrothersSalomon Smith Barney
Bond Index
DERIVATIVE MARKETS
Derivative Securities
OptionsBasic Positions
Call (Buy)Put (Sell)
TermsExercise PriceExpiration DateAssets
Futures Basic Positions
Long (Buy)Short (Sell)
TermsDelivery DateAssets
Call option - the right to buy an asset at a specific price (exercise price) on or before a specific date
Put option - the right to sell an asset at a specific price (exercise price) on or before a specific date
Options
Figure 2.10 Trading Data on GE Options
Options
Call options• Same expiration date, exercise price
increases, value of option decreases• Same exercise price, expiration date
increases, value of option increases
Put options• Same expiration date, exercise price
increases, value of option increases• Same exercise price, expiration date
increases, value of option increases
Futures contracts
Obligation to purchase or sell an asset at a specific price at a specific future dateLong position: trader who commits to buy commodity/asset at delivery dateShort position: trader who commits to sell at the delivery dateOption is the right, futures is obligation
Figure 2.11 Listing of Selected Futures Contracts
There is no free lunch!Return
Risk
less risk
lessreturn
more risk
morereturn
Money
T-Bonds
Corporate Bonds
Stocks
Derivatives
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SummaryDifferences between real assets and financial assetsPurpose of investing in financial assetsPlayers in financial marketsFinancial instrumentsFinancial market indicesNext class: How securities are trades; Investment companies