AFM472 INVESTMENTS

Introduction

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Outline

Course overview

Introduction to the Financial System

Overview of Equity

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Course overview

This course covers various aspects in equity investments. We lookat:

the environment in which investors, investment advisors,security analysts, and portfolio managers operate

the techniques used to value assets and manage portfolios

the risk-return relationship

This course is not about teaching you how to make money ormake you rich in 12 weeksrather, we examine how money was made

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Course objectives

We emphasize the following knowledge and skills throughout thecourse:

Analytical ability: modeling skills that are key to makinginvestment decisions

Quantitative and computational skills: data analysis,probability evaluation of uncertain events

Empirical knowledge of the equity markets, and empiricalevaluation of real market data

Fundamental analysis skills

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Course website

arts.uwaterloo.ca/~aghuang/AFM472/

Username: AFM472Password: Invest

A discussion forum will be set up on UWACE

Your marks will be frequently updated on UWACE

Preferred correspondence: directly email toaghuang@uwaterloo.ca

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Course materials

Lecture slides/notes

Textbook: Bodie, Kane, Marcus, Perrakis and Ryan (BKMPR)

Articles as posted on course website

Recommended readings:

Chapter 6 of Trading and Exchanges: Market microstructurefor practitioners, by HarrisQuantitative Equity Investing: Technique and Strategies, byFabozzi, Focardi, and Kolm (FKK)

Read the syllabus carefully!

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Course evaluation

The course mark will be bell curved in the end.

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Class project

You can choose either the Portfolio Project or the StockAnalysis Project

Portfolio project: You use a trading platform to manage ahypothetical $1 million fund

Officially runs from Oct. 1 to Nov. 15; but you can play withit from today as long as you acquire the account

Stock analysis project: You analyze the investment value of afirm acting as if you are a financial analyst

Later at the course after the Mid-term

Due to resources limit, you cannot participate in bothprojects, and you must form a group with five students (unlessthere are not enough students for roundup)

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Poster Competition (15%)

A poster competition will be held for the project at thefollowing tentative time: 16pm, Nov. 25, Friday(More details will be announced.)

It will be judged by faculty members and/or industry experts

Expectation:

A poster summarizing your project, and a brief presentationQ&A within a PanelIf advanced to the second round, presentation in front ofindustry experts

Location TBD

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Class Participation

Class participation is based on group and individualparticipation

70% of the participation mark is determined by the groupanswer30% will be determined by individual contribution both to thegroup and to the classHowever, I reserve the right to alter the distribution based onyour tracked participation

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Forming your Group

You should only attend class at your assigned class section

You should only form groups within your assigned class section

You should form your group by This Friday 4:00pmsend an email, with the subject line AFM472 Group, Section(your section number)

to Meng Wang at m89wang@gmail.com

The decision of which project your group will be doing mustbe made before Sept. 30 and notify Meng by Sept. 30, 4:00pm as well.

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Now...I am gonna take your picture

Starting next Monday, you will be seating at the assigned seat only.Please observe this rule ALL THE TIME. If you sit at somebodyelses seat, he/she may earn your participation mark!

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AFM472 INVESTMENTS

Introduction

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The Financial System

The financial system can be viewed from two different angles:

Institutional perspective: the financial system encompassesthe markets, intermediaries, instruments, clients etc.; and

Functional perspective: the financial system facilitates theallocation and deployment of economic resources, across timeand space and in uncertain environment.

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Institutional compositions of the financial system

Financial markets: equity (AFM472), fixed income (debt)(AFM475), credits and derivatives (AFM474)

Financial intermediaries:banks, insurance companies, mutual funds, investment banks,venture capital firms, and information providers etc.

Financial infrastructure and regulation:trading rules, contract enforcement, account system, capitalrequirements etc.

Governmental and quasi-governmental organizations:central banks (Bank of Canada), the Bank for InternationalSettlement (BIS), the International Monetary Fund (IMF), theWorld Bank, etc.

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The functional viewThe financial system provides six functions:

Transferring economic resources across time (e.g. student loans,retirement funds) and space (global financial market, e.g.institutional investments)

Clearing and settling payments to facilitate trades:money, check, mortgages, etc.

Pooling of resources to undertake large-scale indivisible enterprises(equities, money market funds, mutual funds etc.)

Information to coordinate decision-making & facilitate informationflow and price discovery (e.g., equity indices, interest rates,volatilities etc.)

Dealing with agency problems, mitigate moral hazard, adverseselection and principal-agent based problems that are caused byasymmetric information or incentive mis-matches

Managing risks, bundling & packaging of cash flows (e.g., insurancecompanies, CMO)

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Stocks

Common stocks, aka equities, represent ownership of acorporation

Two most important characteristics: residual claim, limitedliability

Sources of returns: dividends and capital gains;

rT =PT +DT P0

P0

rT holding period return (HPR)

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Major Stock Exchanges

Two major stock exchanges in Canada:TSX: 1,485 companies (2010)TSX Venture Exchange: lists junior companies, i.e., thosewhose assets, business and market capitalization were toosmall to be listed on the TSX. 2,143 companies with $49 bnmarket cap.

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The most memorable market crashes

The Crash of 1929 and the Great Depression October 29 over4 days markets down 62%

One-day panic in 1987 October 19, 1987DJIA down 20%; TSX down 11%

The current credit crisis starting 2007

The Internet bubble in the late nineties and the bearmarket of the new millennium

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Some Review

Optimization

Variance-covariance of variables

Discounted cash flow approach

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Global maximum/minimum of a function

Quadratic function:

f (x) = ax2 +bx + c , a 6= 0

Whats its maximum/minimum?

Taking the first derivative

Taking the second derivative to verify

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Example

f (x) = x2x2

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Variance-covariance

Two variables:

Var(aX +bY ) = a2 Var(X ) +b2 Var(Y ) + 2ab Cov(X ,Y )

Example: A portfolio consists of 30% of Stock X and 70% ofStock Y. The variance-covariance of X & Ys returns are:(

0.09 0.030.03 0.04

)Questions:

Whats the correlation of returns between X and Y?Whats the portfolios standard deviation?

More generally,

Var

(i

aiXi

)=

i

a2i Var(Xi ) +ij 6=i

aiaj Cov(Xi ,Xj)

Try write the variance out for a three-asset portfolio.

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Discounted Cash Flows

A method of valuing a project, company, or asset using theconcepts of the time value of money.

PV =N

t=0

CFt(1 + r)t

Example: Assume that a stocks cash flow per share is 1.00,1.10 and 1.20 for years 20112013 respectively, and 1.40forever after 2013. Whats its ex-dividend price at the end ofyear 2011?

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Preparation for the Next Class

BKMPR Chapters 2 and 3

different methods of market indexing

placing orderswhat types?

Short selling and margin trading

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OutlineCourse overviewIntroduction to the Financial SystemOverview of Equity