The Capital Markets Prof. Ian Giddy New York University New York University/ING Barings.

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Presentation transcript:

The Capital Markets Prof. Ian Giddy New York University New York University/ING Barings

Copyright ©1999 Ian H. Giddy Capital Markets 2 The Money and Capital Markets l The players l Stocks and bonds: the instruments and markets l The economy and the market l Constructing a portfolio l Picking stocks The Portfolio Project

Copyright ©1999 Ian H. Giddy Capital Markets 3 The Project l Part I: Construct a well balanced portfolio for a client l Part II: Analyze a company to add to the portfolio

Copyright ©1999 Ian H. Giddy Capital Markets 4 Finance Theory... l Time Is Money l Same Thing, Same Price l Risk Is Rewarded

Copyright ©1999 Ian H. Giddy Capital Markets 5 Applied Finance Theory... Price Value versus

Copyright ©1999 Ian H. Giddy Capital Markets 6 Buy, Sell or Hold? l How and where do I trade? l What should I buy? When? Why? l How can I estimate the value of a bond? A stock? An IPO? An option or other derivative? l How should I combine investments? l When is it time to sell?

Copyright ©1999 Ian H. Giddy Capital Markets 7 Stock and Bond Issues Stocks & Bonds Secondary Market Primary Market

Copyright ©1999 Ian H. Giddy Capital Markets 8 Primary Market for Equities Initial Public Offering (IPO) Subsequent Offering Private Equity Placement Stock Buyback? Management Buyout?

Copyright ©1999 Ian H. Giddy Capital Markets 9

Copyright ©1999 Ian H. Giddy Capital Markets 10 Investment Banking Arrangements l Underwritten vs. “Best Efforts”  Underwritten: firm commitment on proceeds to the issuing firm  Best Efforts: no firm commitment l Negotiated vs. Competitive Bid  Negotiated: issuing firm negotiates terms with investment banker  Competitive bid: issuer structures the offering and secures bids

Copyright ©1999 Ian H. Giddy Capital Markets 11 Secondary Market Trading Secondary Market for Equities Initial Public Offering (IPO) Subsequent Offering Private Equity Placement

Copyright ©1999 Ian H. Giddy Capital Markets 12 Institutional Investors and Money Managers Institutional InvestorsMoney Managers Mutual Funds Insurance Companies Pension Funds Hedge funds, Central banks, etc. Stocks and bonds Money managers

Copyright ©1999 Ian H. Giddy Capital Markets 13 Mutual Funds Open-EndClosed-End Stocks and bonds Variable number of shares n Not traded on an exchange n Price = NAV (less fees) Stocks and bonds Variable number of shares n Traded on a stock exchange n Price may not = NAV

Copyright ©1999 Ian H. Giddy Capital Markets 14 Active vs. Passive Management Active Management l Finding undervalued securities l Timing the market Passive Management l No attempt to find undervalued securities l No attempt to time l Holding an efficient portfolio

Copyright ©1999 Ian H. Giddy Capital Markets 15 Instruments and Markets What Investments? Treasury Bills? (risk-free) Treasury Bills? (risk-free) Stocks and Bonds? (risky) Stocks and Bonds? (risky)

Copyright ©1999 Ian H. Giddy Capital Markets 16 Risky Investments? Return Risk

Copyright ©1999 Ian H. Giddy Capital Markets 17 Capital Allocation Possibilities: Treasuries or an Equity Fund? Expected Return Risk THE EQUITY FUND Return 17% Risk 27% THE EQUITY FUND Return 17% Risk 27% THE US TREASURY BOND Return 7% Risk Zero THE US TREASURY BOND Return 7% Risk Zero

Copyright ©1999 Ian H. Giddy Capital Markets 18 Capital Allocation Possibilities: Treasuries or an Equity Fund? r f =7% E(r P ) =17%  = 27% 10% P Expected Return Risk 7% THE EQUITY FUND

Copyright ©1999 Ian H. Giddy Capital Markets 19 We Can Buy Some T-bills and Some of the Risky Fund SLOPE=0.37 E(R) Risk (Standard Deviation) 17% 14% 18.9%27% ONE PORTFOLIO: 30% Bills, 70% Fund E(R)=.3X7+.7X17=14% SD=.7X27=18.9% r f =7%

Copyright ©1999 Ian H. Giddy Capital Markets 20 Financial Institutions and Markets l The Money Market  The operation of the Money Market  Participants in the Money Market  The Eurocurrency Market l The Capital Market  Domestic bonds, Eurobonds  Equities l Foreign Exchange

How do Securities Trade?

Copyright ©1999 Ian H. Giddy Capital Markets 22 Key Securities l Money market instruments - Short-term debt instruments, like deposits and bills l Bonds - used by businesses and governments to raise money l Common Stock - Units of ownership, interest, or equity l Preferred Stock, Convertibles - A form of ownership with features of both debt and common stock

How do Securities Trade? Efficient Inefficient Unregulated Regulated

Copyright ©1999 Ian H. Giddy Capital Markets 24 Foreign Exchange: How Much Does a Dollar Buy? Cost? An over-the-counter market Spot Forward Forwards Futures, Options Forwards Futures, Options

Copyright ©1999 Ian H. Giddy Capital Markets 25 Organized Securities Exchanges are organizations that act as markets for previously issued securities l They are secondary markets - for stocks traded after they have been issued in the public market l Trading is accomplished through an auction process l Once placed, an order to buy or sell is usually executed in a matter of minutes l Examples: NYSE, American, London, Tokyo Major Securities Markets

Copyright ©1999 Ian H. Giddy Capital Markets 26 World Stock Exchanges

Copyright ©1999 Ian H. Giddy Capital Markets 27 l Create a continuous, liquid market in which demanders of funds can obtain needed financing l Design and enforce rules of conduct so that trading is fair l Create an efficient market that allocates funds to their most productive uses l A key to the efficient allocation of funds is the rate of return on an investment The Role of Securities Exchanges

Copyright ©1999 Ian H. Giddy Capital Markets 28 Let’s Play the Game l Trading stocks l Trading bonds l Derivatives l Evaluating performance l Next: Constructing a portfolio

Copyright ©1999 Ian H. Giddy Capital Markets 29 Let’s Play the Game l Trading stocks l Trading bonds l Derivatives l Evaluating performance l Next: Constructing a portfolio

Copyright ©1999 Ian H. Giddy Capital Markets 30 Let’s Play the Game Costs of trading l Commission: fee paid to broker for making the transaction l Spread: cost of trading with dealer  Bid: price dealer will buy from you  Ask: price dealer will sell to you  Spread: ask - bid l Combination: on some trades both are paid

Copyright ©1999 Ian H. Giddy Capital Markets 31 Types of Orders Instructions to the brokers on how to complete the order l Market l Limit l Stop loss

Copyright ©1999 Ian H. Giddy Capital Markets 32 Margin Trading l Using only a portion of the proceeds for an investment l Borrow remaining component l Margin arrangements differ for stocks and futures

Copyright ©1999 Ian H. Giddy Capital Markets 33 Stock Margin Trading l Maximum margin is currently 50%; you can borrow up to 50% of the stock value l Set by the Fed l Maintenance margin: minimum amount equity in trading can be before additional funds must be put into the account l Margin call: notification from broker you must put up additional funds

Copyright ©1999 Ian H. Giddy Capital Markets 34 Margin Trading - Initial Conditions X Corp$70 50%Initial Margin 40%Maintenance Margin 1000Shares Purchased Initial Position Stock $70,000 Borrowed $35,000 Equity 35,000

Copyright ©1999 Ian H. Giddy Capital Markets 35 Margin Trading - Maintenance Margin Stock price falls to $60 per share New Position Stock $60,000 Borrowed $35,000 Equity 25,000 Margin% = $25,000/$60,000 = 41.67%

Copyright ©1999 Ian H. Giddy Capital Markets 36 Margin Trading - Margin Call How far can the stock price fall before a margin call? (1000P - $35,000) * / 1000P = 40% P = $58.33 * 1000P - Amt Borrowed = Equity

Copyright ©1999 Ian H. Giddy Capital Markets 37 Short Sales Purpose: to profit from a decline in the price of a stock or security Mechanics l Borrow stock through a dealer l Sell it and deposit proceeds and margin in an account l Closing out the position: buy the stock and return to the party from which is was borrowed

Copyright ©1999 Ian H. Giddy Capital Markets 38 Short Sale - Initial Conditions Z Corp100 Shares 50%Initial Margin 30%Maintenance Margin $100Initial Price Sale Proceeds$10,000 Margin & Equity 5,000 Stock Owed 10,000

Copyright ©1999 Ian H. Giddy Capital Markets 39 Short Sale - Maintenance Margin Stock Price Rises to $110 Sale Proceeds$10,000 Initial Margin 5,000 Stock Owed 11,000 Net Equity 4,000 Margin % (4000/11000) 36%

Copyright ©1999 Ian H. Giddy Capital Markets 40 Short Sale - Margin Call How much can the stock price rise before a margin call? ($15,000 * - 100P) / (100P) = 30% P = $ * Initial margin plus sale proceeds

Copyright ©1999 Ian H. Giddy Capital Markets 41 Let’s Play the Game l Trading stocks l Trading bonds l Derivatives l Evaluating performance l Next: Constructing a portfolio

Copyright ©1999 Ian H. Giddy Capital Markets 42 Instruments and Markets Governments Treasuries Agencies, Mortgage-backed Securities

Copyright ©1999 Ian H. Giddy Capital Markets 43 Instruments and Markets Governments Treasuries Agencies, Mortgage-backed Securities

Copyright ©1999 Ian H. Giddy Capital Markets 44 Benchmark Bonds

Copyright ©1999 Ian H. Giddy Capital Markets 45 Corporate Bonds: Spread over Benchmark

Copyright ©1999 Ian H. Giddy Capital Markets 46 US Bond Markets

Copyright ©1999 Ian H. Giddy Capital Markets 47 Instruments and Markets Corporate Bonds Domestic International

Copyright ©1999 Ian H. Giddy Capital Markets 48 International Capital Markets l The Eurobond Market is the market for bonds issued outside the country of the currency l The Foreign Bond Market is one in which a foreign corporation or government issues bonds in a domestic market in the local currency l An International Equity Market has emerged that allows corporations to sell large blocks of shares simultaneously to investors in several different countries Major Securities Markets

Copyright ©1999 Ian H. Giddy Capital Markets 49 International Bond Markets are Linked l Issuers and investors compare terms in the domestic and Eurobond markets, which are linked across currencies via currency swaps BOND MARKETS WITHIN COUNTRY OF CURRENCY BOND MARKETS OUTSIDE COUNTRY OF CURRENCY Currency Swaps Long-dated Forward Exchange Domestic US -Gov't -Corporate Foreign Bonds "Yankee" Domestic Japanese -Gov't -Corporate Foreign Bonds "Samurai" Eurodollar Bond Market Euroyen Bond Market

Copyright ©1999 Ian H. Giddy Capital Markets 50 Let’s Play the Game l Trading stocks l Trading bonds l Derivatives l Evaluating performance l Next: Constructing a portfolio

Copyright ©1999 Ian H. Giddy Capital Markets 51 Interest Rate Swap The typical interest-rate swap is an exchange of a fixed for a floating interest rate for a period of time. Effectively, it involves paying the difference between a fixed rate and a floating rate like Libor: GE Chase 8% Fixed 3-mo Libor, floating

Copyright ©1999 Ian H. Giddy Capital Markets 52 Derivatives l Derivatives are, by definition, derived from cash instruments, like bonds, stocks, currencies or commodities l Example: foreign exchange SPOT FOREX CONTRACTS l FX Forwards, futures, swaps l Currency options l Knock-ins, PERLS

Copyright ©1999 Ian H. Giddy Capital Markets 53 The Chicago Mercantile Exchange

Copyright ©1999 Ian H. Giddy Capital Markets 54 Let’s Play the Game l Trading stocks l Trading bonds l Derivatives l Evaluating performance l Next: Constructing a portfolio

Copyright ©1999 Ian H. Giddy Capital Markets 55 Managing a Portfolio

Copyright ©1999 Ian H. Giddy Capital Markets 56 Long-Term Returns on Investments

Copyright ©1999 Ian H. Giddy Capital Markets 57 The Economy and the Markets l How much should I pay for a bond? l Interest rates and inflation l Growth and employment l How much should I pay for a stock? l Corporate profits and equity values

Copyright ©1999 Ian H. Giddy Capital Markets 58 Emerging Equity Markets

Copyright ©1999 Ian H. Giddy Capital Markets 59 Corporate Profits Drives Stock Prices

Copyright ©1999 Ian H. Giddy Capital Markets 60 Performance Benchmarking: Buy Kellogg?

Copyright ©1999 Ian H. Giddy Capital Markets 61 Performance Benchmarking: Buy Kellogg?

Copyright ©1999 Ian H. Giddy Capital Markets 62 Performance Benchmarking: Buy Kellogg?

Copyright ©1999 Ian H. Giddy Capital Markets 63 Performance Benchmarking: Buy Kellogg?

Copyright ©1999 Ian H. Giddy Capital Markets 64 Performance Benchmarking: Buy Kellogg?

Copyright ©1999 Ian H. Giddy Capital Markets 65 Performance Benchmarking: Buy Kellogg? Conclusion: Benchmarks are needed because performance is relative

Copyright ©1999 Ian H. Giddy Capital Markets 66 How Can We Know About a Company? l Financial statements l Web resources l Forecasting and comparative Example: n J&J company report n Pharma industry report

Copyright ©1999 Ian H. Giddy Capital Markets 67

Copyright ©1999 Ian H. Giddy Capital Markets 68

Copyright ©1999 Ian H. Giddy Capital Markets 69

Copyright ©1999 Ian H. Giddy Capital Markets 70 Ian H. Giddy Ian Giddy NYU Stern School of Business Tel ; Fax