Investments & Financial AssetsEssential nature of investment

Reduced current consumptionPlanned later consumptionConsumption TimingAllocation of Risk

Two main themes of investmentsModern Portfolio theory (MPT):

Risk-return trade off in the securities marketsEfficient diversificationCapital asset pricing and valuation

Efficient Market Hypothesis (EMH):security price reflects all the information available to investors concerning

the value of the securities

Real AssetsAssets used to produce goods and services

Financial AssetsClaims on real assets

Major Classes of Financial Assets or Securities

Debt Money market instruments Bonds

EquityCommon stockPreferred stock

Derivative securities

Agency Issues and Crisis in Corporate Governance

Accounting ScandalsExamples – Enron and WorldCom

Analyst ScandalsExample – Citigroup’s Salomon Smith Barney

Initial Public OfferingsCredit Swiss First Boston

The Agency Problem

Agency relationshipPrincipal hires an agent to represent their interestStockholders (principals) hire managers (agents) to run

the companyTwo conditions of agency problem:

1. Conflict of interest between principal and agent2. Asymmetric information

Management goals and agency costs

The Investment ProcessA Top-Down Analysis of Portfolio Construction

the Capital Allocation decisionChoice of safe but low-return money market securities, or risky but

higher-return securities (e.g., stocks)the Asset Allocation decision

the distribution of risky investments across broad asset classes like stocks, bonds, real estates, foreign assets, and so on.

the Security Selection decisionthe choice of which particular securities to hold within each asset

classsecurity analysis involves the valuation of particular securities: must

forecast dividends and earningsfundamental/ technical analysis

Market efficiency

Active vs. Passive Management

Active ManagementFinding undervalued securitiesTiming the market

Passive ManagementNo attempt to find undervalued securitiesNo attempt to timeHolding an efficient portfolio

Major Financial Markets and Assets or Securities

Money marketTreasury bills, Certificates of deposits, Commercial Paper,

Bankers Acceptances, Eurodollars, Repurchase Agreements (RPs) and Reverse RPs, Brokers’ Calls, Federal Funds, etc.

Treasury billsmost marketable; highly liquid; discount bondmaturities: 28, 91, 182 daysminimum denomination: $1,000Issued weekly

Costs of Trading

Commission: fee paid to broker for making the transaction

Spread: cost of trading with dealerBid: price dealer will buy from youAsk: price dealer will sell to youSpread: ask - bid

Combination: on some trades both are paid

Figure 2.2 Treasury Bills

T-billT.B yields are quoted as the “bank discount yield” rBD = 10,000 - P x 360 10,000 nwhere P = the bond price; n = the maturity in days; rBD = the bank discount yield;

$10,000 = par value.

To determine the T-bill’s true market price: P = 10,000 x [ 1 - rBD x n/360 ]

Ex. T-bill sold at $9,500 with a maturity of a half year (182 days):

rBD= (500/10,000) x (360/182) = 0.0989 (9.89%)

The “bond equivalent yield” of the T-bill = APR (annual percentage rate) rBEY = (10,000 - P)/P x (365/n) = (500/9,500) x (365/182) = 10.555% Effective annual yield: reay

( 1 + 500/9,500 )2 - 1 = 0.1080 (10.8%)

note: rBD < rBEY < rEAY

What is the asked price, equivalent yield, and effective yield for the T-Bill marked red in previous slide? RBEY = 365*rBD/(360-n*rBD)

Major Financial Markets and Assets or Securities

Bond marketTreasury Notes and Bonds

MaturitiesNotes – maturities up to 10 yearsBonds – maturities in excess of 10 years

2001 Treasury suspended salesNote: 11/1/2001: The Treasury department would no longer sell 30-

year bonds, for years the benchmark for the entire $17.7 trillion U.S. bond market – long-term interest rate will decline. Now 10-year Treasury takes over the benchmark title. 2005 resume sales

Par Value - $1,000Quotes – percentage of par

Figure 2.4 Treasury Notes, Bonds and Bills

Example12If a treasury note has a bid price of $982.50, the quoted bid price in the Wall Street Journal

would be __________. A) $98:08 B) $98:25 C) $98:50 D) $98:40

The price quotations of treasury bonds in the Wall Street Journal show an ask price of 104:16 and a bid price of 104:08. As a buyer of the bond you expect to pay __________. A) $1,041.60 B) $1,045.00 C) $1,040.80 D) $1,042.50

Example 34Suppose you pay $9,800 for a Treasury bill maturing in two months. What is the

annual percentage rate of return for this investment? A) 2% B) 12% C) 12.2% D) 16.4%

Suppose you pay $9,700 for a Treasury bill maturing in six months. What is the effective annual rate of return for this investment? A) 3.1% B) 6% C) 6.18% D) 6.28%

Municipal Bonds

Issued by state and local governmentsInterest income is exemptTypes

General obligation bondsRevenue bonds

Industrial revenue bonds

Maturities – range up to 30 years

Municipal Bond Yields

Interest income on municipal bonds is not subject to federal and sometimes state and local tax

r = rm / (1 - t),where rm = the rate on municipal bonds; t = the investor’s marginal tax

bracket; r = the total before-tax rate of return on taxable bonds.Ex. rm = 10%; t = 28% : then r = 13.89%, if t = 36%: then r = 15.625%

Ex. A municipal bond carries a coupon of 6% and is trading at par; to a taxpayer in a 36% tax bracket, What is the taxable equivalent yield of this bond ?

Corporate Bonds

Issued by private firms Semi-annual interest paymentsSubject to larger default risk than government

securitiesOptions in corporate bonds

CallableConvertible

Figure 2.8 Corporate Bond Prices

Example31The purchase price for a bond is listed as 104 and the annual coupon rate is 4.3%.

What is the current yield (annual coupon payment / current price) on this bond? A) 0.00% B) 4.00% C) 4.13% D) 4.30%

What is the tax exempt equivalent yield on a 9% bond yield given a marginal tax rate of 28%? A) 6.48% B) 7.25% C) 8.02% D) 9.00%

Equity Markets

Common stockResidual claimLimited liability

Preferred stockFixed dividends - limitedPriority over commonTax treatment

Depository receipts

Figure 2.10 Listing of Stocks Traded on the NYSE

Track average returnsComparing performance of managersBase of derivatives

Uses of Stock Indexes

Representative? Broad or narrow? How is it weighted?

Factors for Construction of Stock Indexes

Examples of Indexes - Domestic

Dow Jones Industrial Average (30 Stocks)Standard & Poor’s 500 CompositeNASDAQ CompositeNYSE CompositeWilshire 5000

CurrentlyDJIA: Alcoa, Allied Signal, American Express, American International Group Inc, Boeing, Caterpillar, Citigroup, Coca-Cola, DuPont, Exxon, General Electric, General Motors, Hewlett-Packard, Home Depot, IBM, Intel, Johnson & Johnson, McDonald, Merck, Microsoft, 3M, JP Morgan, Pfizer, Phillip Morris, Proctor& Gamble, SBC Communications, United Technologies, Verizon Communications, Wal-Mart Stores, Walt Disney.

Construction of IndexesHow are stocks weighted?

Price weighted (DJIA) (p40 example 2.2)Market-value weighted (S&P500, NASDAQ) (p46 example 2.4)

S&P 500 Index = [Pit Qit / O.V. ] x 10where O.V. = original valuation in 1941-1943 (i.e., relative to the average value during the period of 1941-1943, which was assigned an index value of 10) 81% of the mkt value of companies on the NYSE

Equally weighted (Value Line Index)

Stock IP FP shares IV FV

ABC 25 30 20 500 600

XYZ 100 90 1 100 90

Total 600 690

Derivatives Securities

OptionsBasic Positions

Call (Buy)Put (Sell)

TermsExercise PriceExpiration DateAssets

Futures Basic Positions

Long (Buy)Short (Sell)

TermsDelivery DateAssets

Example33The Chompers Index is a price weighted stock index based on the 3 largest fast

food chains. The stock prices for the three stocks are $54, $23, and $44. What is the price weighted index value of the Chompers Index. A) 23.43 B) 35.36 C) 40.33 D) 49.58

A benchmark index has three stocks priced at $23, $43, and $56. The number of outstanding shares for each is 350,000 shares, 405,000 shares, and 553,000 shares, respectively. If the market value weighted index was 970 yesterday and the prices changed to $23, $41, and $58, what is the new index value? A) 960 B) 970 C) 975 D) 985