Overview: the course and financial markets Overview of the course How to run investment (Little book) The effect of financial crisis Capital Markets Debt Common stock Preferred stock Derivative securities Security Trading Trading Trading Costs Buy on margin versus short sell

How to run investments? How to make money? Have the ability others typically don’t have Have the information others typically don’t have What else??? What may you get from the “little book”? A thought in investment – “Joel Greenblatt’s simple notion will likely retain at least a good deal of its validity even if it becomes widely followed.” What may you learn from this course? Other than stocks, what can I do? When everyone wants to make money, what the world would look like? Still, what will make you a rich guy? Chapter 1: Overview

Making money by using margins What is a margin? -- equity/assets Say one has $10,000 investable equity. The required margin is 50%. What does this mean? Say you borrowed $3,000 and all the money ($13,000)are invested in stocks You need spend $3,000 for a different project. What options do you have? What are the consequence? Chapter 1: Overview

Major Types of Securities Debt Money market instruments Bonds Common stock Preferred stock Derivative securities

Markets and Instruments Money Market Debt Instruments Derivatives Capital Market Bonds Equity

Money Market Instruments Treasury bills Certificates of deposit Commercial Paper Bankers Acceptances Eurodollars Repurchase Agreements Federal Funds LIBOR Market

Bond Markets US Treasury Bonds and Notes Agency Issues (Fed Gov) International Bonds Municipal Bonds Corporate Bonds Mortgage-Backed Securities

Municipal Bond Yields Interest income on most municipals is not subject to tax To compare the yields on municipals to other bonds use equivalent taxable yield (municipal return) / (1 – tax rate) Or solve for the tax rate that equates the two yields Tax rate = 1 – (municipal rate/taxable rate)

Capital Market - Equity Common stock Residual claim Limited liability Analyzing stocks – finance.yahoo.com Preferred stock Fixed dividends - limited Priority over common Tax treatment

Stock Market Indexes Uses Factors in constructing or using an Index Track average returns Comparing performance of managers Base of derivatives Factors in constructing or using an Index Representative? Broad or narrow? How is it constructed?

Examples of Indexes - Domestic Dow Jones Industrial Average (30 Stocks) Standard & Poor’s 500 Composite NASDAQ Composite NYSE Composite

Examples of Indexes - International Nikkei 225 & Nikkei 300 FTSE (Financial Times of London) Dax Region and Country Indexes EAFE Far East United Kingdom

Bond Indexes Lehman Brothers Merrill Lynch Salomon Brothers Specialized Indexes Merrill Lynch Mortgage

Construction of Indexes How are stocks weighted? Price weighted (DJIA) Market-value weighted (S&P500, NASDAQ) Equally weighted (Value Line Index) How returns are averaged? Arithmetic (DJIA and S&P500) Geometric (Value Line Index)

Derivatives Securities Options Basic Positions Call (Buy) Put (Sell) Terms Exercise Price Expiration Date Assets Futures Basic Positions Long (Buy) Short (Sell) Terms Delivery Date Assets

Tips on Investment Buy under-valued stocks Buy recent-past winners Don’t over trade – investing in stocks is costly You can buy bonds Invest in real estates

Security Trading Primary Market versus Secondary Market Types of Orders Trading Mechanisms Buy on margin and short selling

Primary vs. Secondary Security Sales New issue Key factor: issuer receives the proceeds from the sale Secondary Existing owner sells to another party Issuing firm doesn’t receive proceeds and is not directly involved

How Firms Issue Securities Investment Banking Shelf Registration Private Placements Initial Public Offerings (IPOs)

Shelf Registrations SEC Rule 415 Introduced in 1982 Ready to be issued – on the shelf

Initial Public Offerings Process Road shows Bookbuilding Underpricing Post sale returns Cost to the issuing firm See page 62

Figure 3.2 Average Initial Returns for IPOs in Various Countries

Figure 3.3 Long-term Relative Performance of Initial Public Offerings

Types of Orders Instructions to the brokers on how to complete the order Market Limit Stop orders Page 63-66

Figure 3.5 Price-Contingent Orders

Trading Mechanisms Dealer markets Specialists markets Page 66-67 Electronic communication networks (ECNs) Specialists markets Page 66-67

U.S. Security Markets Nasdaq Small stock OTC Organized Exchanges Pink sheets Organized Exchanges New York Stock Exchange American Stock Exchange Regionals Electronic Communication Networks (ECNs) National Market System

Nasdaq National Market System Nasdaq SmallCap Market Levels of subscribers Level 1 – inside quotes (investors) Level 2 – receives all quotes but they can’t enter quotes Level 3 – dealers making markets SuperMontage

Table 3.1 Requirements for Listing on Nasdaq Markets

New York Stock Exchange Member functions Commission brokers Floor brokers Specialists Block houses SuperDot (70% of NYSE trading volume)

Table 3.3 NYSE Listing Requirements

Costs of Trading Commission: 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 Combination: on some trades both are paid

Margin Trading Using only a portion of the proceeds for an investment Borrow remaining component Maximum margin is currently 50%; you can borrow up to 50% of the stock value Set by the Fed Maintenance margin: minimum amount equity in trading can be before additional funds must be put into the account Margin call: notification from broker you must put up additional funds

Margin Trading - Initial Conditions Example 3.1 X Corp $100 60% Initial Margin 40% Maintenance Margin 100 Shares Purchased Initial Position Stock $10,000 Borrowed $4,000 Equity $6,000

Margin Trading - Maintenance Margin Ex. 3.1 Stock price falls to $70 per share New Position Stock $7,000 Borrowed $4,000 Equity $3,000 Margin% = $3,000/$7,000 = 43%

Margin Trading - Margin Call Example 3.2 How far can the stock price fall before a margin call? The maintenance margin is 30%.

Short Sales Purpose: to profit from a decline in the price of a stock or security Mechanics Borrow stock through a dealer Sell it and deposit proceeds and margin in an account Closing out the position: buy the stock and return to the party from which is was borrowed

Short Sale - Initial Conditions Dot Bomb 1,000 Shares 50% Initial Margin 30% Maintenance Margin $100 Initial Price Sale Proceeds $100,000 Margin & Equity 50,000 Stock Owed 100,000 What if price increases to 110? How much can the stock price rise before a margin call?

Short Sale - Margin Call How much can the stock price rise before a margin call?

Financial Crisis of 2008 Antecedents of the Crisis: “The Great Moderation”: a time in which the U.S. had a stable economy with low interest rates and a tame business cycle with only mild recessions Historic boom in housing market Chapter 1: Overview

Figure 1.3 The Case-Shiller Index of U.S. Housing Prices Chapter 1: Overview

Rise of Systemic Risk Systemic Risk: a potential breakdown of the financial system in which problems in one market spill over and disrupt others. One default may set off a chain of further defaults Waves of selling may occur in a downward spiral as asset prices drop Potential contagion from institution to institution, and from market to market

Rise of Systemic Risk (Ctd.) Banks had a mismatch between the maturity and liquidity of their assets and liabilities. Liabilities were short and liquid Assets were long and illiquid Constant need to refinance the asset portfolio Banks were very highly levered, giving them almost no margin of safety.

Rise of Systemic Risk (Ctd.) Investors relied too much on “credit enhancement” through structured products like CDS CDS traded mostly “over the counter”, so less transparent, no posted margin requirements Opaque linkages between financial instruments and institutions

The Shoe Drops 2000-2006: Sharp increase in housing prices caused many investors to believe that continually rising home prices would bail out poorly performing loans 2004: Interest rates began rising 2006: Home prices peaked

The Shoe Drops 2007: Housing defaults and losses on mortgage-backed securities surged 2007: Bear Stearns announces trouble at its subprime mortgage–related hedge funds

The Shoe Drops 2008: Troubled firms include Bear Stearns, Fannie Mae, Freddie Mac, Merrill Lynch, Lehman Brothers, and AIG Money market breaks down Credit markets freeze up Federal bailout to stabilize financial system