Why do individuals invest?
by investing money instead of spending it, individuals trade present consumption for a larger future consumption
real assets
touch and feel (land, buildings, machines, knowledge to produce goods and services)
institutional investors
firms that invest on behalf of individuals such as mutal funds, hedge funds, pension funds
financial assets
stocks and bonds
management
agents of the owners, objective is to maximize shareholders wealth and stock price
agency problem
conflict of interest between management and ownership, managers who are agents of the shareholders may persue their own interests instead of the owners
how to eliminate agency problem
performance bonus, stock options
Bonds
more risk in user of captial, not part of ownership
Stocks
more risk in buyer of capital, part of ownership
corporate governance
rules and procedures that ensure managers use the principles of value based management, and shareholder weatlh is maximized
Investment process (individual investor & firm investors)
What is the investment
Asset Allocation
Security analysis/selection
portfolio analysis
performance evaluation
what is the investment objective
10% return, 70% long term assets & 30% short term assets. Constraints, wont invest in companies who outsource
Asset allocation
how going to alocate assets to different asset classes (bonds, stocks, commodities, money market)
security analysis
choice of which particualr securities to hold within each asset class
portfolio anaylsis
look at it, invest in it, check it from time to time
performance evaluation
how portoflio is doing, need to make changes, change money manager
Investment process (institution)
asset allocation
security selection
risk-return trade off
market efficiency
active v passive managment
risk return
how much risk you're willing to take, determines how much money you put into different assets
market efficiency
drives investment strategy (active or passive)
passive managment
holding higly diversified portfolios without spending effort or resources attempting to improve investment performance through security analysis
no attempt to find undervalued securities, no attempt to time, holding an efficient portfolio
active management
attempt to improve peformance either by identifying/finding undervalued securities or by timing the market
Players in financial market
household, business, and goverment sector
all interact with eachother
household sector
primary need: invest funds
user and supplier of capital, invest more than they borrow (net savors), invest money in stocks, bonds, government financial assts
business sector
primary need: raise funds
borrow & raise money to invest in real assets, borrow more than they invest (net borrowers)
goverment sector
primary need: raise funds
raises money through taxes and borrowing, espenses more than money raised
financial intermediaries
bring lenders and borrows together, what borrower needs is different from what investors expect so third party acts as intermediary to address mistmatch (maturity, risk, amount)
who are financial intermediaries
banks, investment companies, insurance companies, credit unions (they take the risk)
maturity mismatch
borrow invest 10 years, investor invest 1 year intermediary lines up several investors for the borrower
risk mismatch
borrower is to risky for investor, line up sevearl borrowers from one side and several investors form the other side lump them together to set up risk diversification
amount mismatch
line up both borrower and lender to match up what each wants
securitization
creating marketable security by bundling financial assets that arent marketable and doing something different to make it marketable, bundle securities into smaller units
common stock
(aka equity securities) ownership of shares in a corporation, each stock entitiles you to one vote on any matters of corporate governance
characterisitcs of common stock
residual claim: stockholders are last in line of all those who have claim on the assets and income of the corporation
limited liability: most shareholders can lose is their orginal investment
preferred stock
promises to pay a fixed amount of income each year (like a bond) treated as dividends
derivative security
stock or bond where payments depend on financial status of the issuer
bonds
security issued by a borrower that obligates the issuer to make specificed payments to the holder over a specific perdio
money market
includes short term highly liquid and low risk debt instruments maturity 1 year or less
treasury securities, commercial paper (short term debt issued by large corporations)
capital market
bonds (longer than year) equity, common stock (infinite maturity), derivatives
municipal bonds
issued by state and local goverment, scool/park district, itnerest is exempt from federal income tax and home state tax
equivalent taxable yield
compare yields on munis to other taxable bonds, determing interest rate on taxable bonds that would be necessary to provide an after tax return equal to that of munis
equivalent taxable yield equation
after tax yield = yield (interest rate) / 1-tax rate
Stock market indexes uses
track average returns, comparing performance of managers, base of derivatieves, estimating beta
factors in constructing/using an index
representative, broad or narrow, how is it constructed
Construction of indexes (how are stocks weighted)
price weighted: current market price of 30 stocks and calcualte average (ex:DJIA)
market-value weighted: calculate avg, small market less weighted index and large market more weighted (ex: S&P 500, NASDAQ)
equally weighted: index of 100 stocks and equal i
value weighted index example
current date price
shares divided by base period price
shares multiply by 100
Construction of indexes (how returns are averaged)
arithmetic: add and then divide by number, typical way of finding average (ex: DJIA, S&P 500)
geometric: (return A
return B
return C)^1/3 -1 (Value Line Index)
derivative securities
Options and Futures
Options
Basic positions: call (buy) put (sell)
Terms: exercise price, expiration date, assets
Futures
basic positions: long (buy) short (sell)
terms: delivery date, assets
call option
gives holder the right to purchase an asset for a specified price (exercise price) on or before a specified expiration date
call option example
december call option on GE stock with an exercise price of 35 entitiles its owner to purchase GE stock for $35 at any time up to and including the expiration date in december
put option
gives holder the right to sell an asset for a specified exercise price on or before a specfied expiration date
put option example
a december pu ton GE with an exercise price of 35 entitles its owner to sell GE stock to the put wrtie at a price of $35 at any time before expriation in december even if the market price of GE is lower than 35
futures contracts
calls for delivery of an asset at a specified deliviery or maturity date for an agreed upon price to be paid at contract maturity
long position
held by trader who commits to purchasing the asset on the delivery date
short postion
commits to delivering the asset at contract maturity
primary market
new issues of stocks and bonds marketed to the public by investment bankers
secondary market
trading of already issued securities among investorrs, ownership transferred from one investor to another, doesnt generate cash flow, activity helps company when they want to issue more securities in the future, provides liquidity for primary market
organ
investment bankers
help companies make money, involved in bringing new securities into the market (design & package security offering and sell them to the public), find best price for share and how many they can sell
investment banking arragements
nature of commitment & negotiated vs competitive bid
nature of commitment
underwriting: firm commitment, gaurantee
standby agreement: offer new shares to existing owners at discount to allow them to maintain same control over company, leftover shares given to invesment banker to sell
best efforts: no firm commitment
negotiated v competitive bid
negotiated: issuing firm negotiates terms with investment banker, negotiate spread
competivie: ask bankers to submit bids, choose one that doesnt have lowest underwriting and lowest spread
underwriting spread
buy shares from company at one price and sell shares at higher price = underwritting spread
underwriting syndicate
many investment bankers join together to underwrite an issue of securiteis to lower risk, each banker only has to bring in part of investment
Public Offerings
private company sells shares to become public, underperform compared to companies already in market since intial price is high so there is no room to grow
Seasoned new issues
already in the market but has outstand shares and sells more to generate more money
underpricing
sells shares at lower price then actually worth to sell them quickly
shelf registration
firms can register securities (amount of shares to sell) put not set price and have 2 years to actually sell securities
dutch auction
investors submit bid (price) for given number of shares, bids ranked in order of bid price, shares are allocated to highest winning bidders until the entire issue is absorbed
private placements
share information with select group (investors) who wont share it with outsiders (public)
dealer
buy and sell on own account, operate in secondary market, maintain fair and orderly market
brokers
bring buyer and seller together, no risk, dont buy, operate in secondary market
specialist
stand ready to buy and sell, keep track of all conditional orders
commission brokers
employees of a firm who buy or sell for the customers of the firm, execute deal on behalf of client
place order, brokers office contact agent of firm on floor exchange to execute order and representative who does exchange is commission broker
floor brokers
hire independent brokers to execute on their behalf and split commission, used when there are too many orders to fill by themselves, need to hire help, act as broker for other member
registered traders
dealers who buy and sell on their own account
market maker
any stock can trade as long as it has a willing dealer like specialist, any dealer who agrees to buy and sell. Market deal has to be a dealer but not all dealers are market makers
Third market
NASDAQ inter-market, trading of security is taking place outside of the exchange institutional buying and selling, open when exchange is closed or trading suspended
trading halt
Company is going to get big contract (good or bad news), investors overreact, can drive price of security down/up, so suspend trading to give time for investors to react rationally
Outside exchange but still using borkers (third market)
fourth market
institutions trading directly with institutions, no broker involved in the transaction, ECN development
ECN
Electronic Communication Network: like amazon or ebay market place, buyers and sellers can post there and other buys and people who have interest can access it
Commission
both buyer and seller pay, fee paid to broker for making the transaction
Spread
cost of trading with dealer
bid: price dealer will buy from you
ask: price dealer will sell to you
spread: ask - bid
spread covers dealers cost and margin
depth
bid depth: number of shares you are buying
ask depth: number of shares you are selling
types of orders
unconditional: market
conditional: limit, stop, stop limit
market
buy or sell orders that are to be executed immediately at current market prices
limit order
buy $20 means order will be executed at price of $20 or less, sell $30 order will be executed at price of 30 or more (If price is 30 or more then will be sold)
instead of watching price and market do limit order, not a lot of risk
stop order
Inverse of limit order, market price is 25, want to buy at price of 30 (do this when price is stable for awhile want it when it rises), sell when price is 20 (its reducing paper profit, stop loss of paper profit)
stop limit order
buy: limit price 31, stop price 30 buy between 31 & 30
sell: limit price 19, stop price 20 sell between 19 & 20
margin trading
investor borrows part of purchase price of the stock from a broker, half paid by investor half borrowed by broker, margin is down payment paid by investor (must have 50% down payment)
maintenance margin
buy stocks and stock price go up equity goes up, if stock price goes down equity goes down but stock broker wont let equity go down below a certain level (maintenance margin)
Restricted account & margin call
IM = initial margin
MM = maintenance margin
AM = actual margin
IM > AM > MM Restricted
IM > MM > AM Margin Call
margin call
broker calls and ask you do to something, either increase margin have to reduce loan or sell securities (reduce number of shares)
Actual margin
AM = equity in acct/mv of stocks
Maintenance margin
current price * # of share - loan
---------------------------
current price * # of shares
short sale
first sell the shares and then you buy the shares
purpose: profit from a decline in a securities price
mechanics of short sales
borrow stock through broker
sell it
short seller purchase a share of the same stock to replace stock that was borrowed
real v nominal rates approximation
nominal rate (R) = real rate (r) + inflation premium (i)
real rate (r) = nominal rate (R) - inflation (i)
empirical relationship
inflation and interest rates move closely together
expected returns
P (s) = probability of a state
R (s) = return if a state occurs
expected return = P*R for each state added
E (r)
variance
P (s) * (Rs - Expected return) ^2
standard deviation
variance ^1/2, higher returns means higher s.d (positively related)
risk investment
P = probability
W = price
risk aversion
given choice between two assets with equal rate of returns investor will select the asset with the lower level of risk
risk averse
only consider risk free prospects with positive risk premiums
risk neutral
judge risky prospects solely by their expected rates of return (A = 0)
risk seeking
always go for high risk, participate in fair games and gambles (A < 0)
conservative investor
more risk adverse, low risk tolerance
aggressive investor
take small increase in return for large increase in risk, high risk tolerance, less risk adverse
utility
score to competing investment portfolios based on expected return and risk of those portfolios
U= utility E(r) =expected return on portfolio A= coefficient of risk aversion o2= variance of returns
high A
discounting more, lower value for utility, conservative
low A
discounting less, higher value for utility, aggressive, higher expected returns
indifference curve
represents an investors willingness to trade-off return and risk
all risky assets on IC have same utility but different risk-return combo
each investor has different IC because each investor has different utility
expected returns for portfolio (risky & risk free assets)
E(rc) Expected return on combined portfolio
P is risky portfolio, F is risk free asset
Y-risky
Capital Allocation Line
expected return and standard deviation of return for a portfolio consisting of risky & risk free asset are linear combinations, a graph of possible portfolio returns and risks looks like a straight line between the two assets, straight line CAL
Risk aversion and allocation
Greater levels of risk aversion lead to larger proportions of the risk free rate.
Lower levels of risk aversion lead to larger proportions of the portfolio of risky assets
Willingness to accept high levels of risk for high levels of returns would result i
Capital Market Line
when risky asset in the combined portfolio is the market portfolio (S&P 500, Russell 3000) CAL becomes CML
covariance
covariance is a measure of the degree to which two variables move together relative to their individual mean values over time
correlation coefficient
obtained by dividing the covariance by the product of the individual standard deviations
symbol = P
value between -1 and 1
1 = perfectly positively correlated
-1 = perfectly negatively correlated
Security Portfolio: Return
W= proportion of funds in security
R = expected return on security
efficient frontier
The efficient frontier represents the set of portfolios with the maximum rate of return for a given level of risk, AND
the minimum risk for a given level of return
S.D of portfolio return
unsystematic risk: diversifiable, can get rid of it
systematic risk: non diversifiable, cant avoid
more securities, less risk because more likely to be more correlated or low correlated
Beta
measures how sensitive security's return to change in overall market, measures security's volatility relative to the market
how sensitive change in security return is to market return
higher beta is the higher return
Security Market Line
expected return on security = risk free interest rate + beta *(Expected market rate of return - risk free rate of return aka market risk premium)
equilibrium of SML
all assets and all portfolios should plot on SML
Underpriced
any security with an estimated return that plots above the SML
overpriced
any security with an estimated return that plots below the sml
What changes beta
changes in product line
changes in technology
deregulation
changes in financial leverage
stability of beta
beta for individual stocks are not stable
beta for portfolio of stocks are stable
larger portfolio is and longer the period the more stable it is
Determinants of beta
business risk: revenue cycles, operating leverage
financial risk: financial leverage
Advantages of single index model
reduces number of inputs required for deriving the efficient frontier, easier for security analysts to specialize and divide work