FIN670: Investment Analysis Chapter 1: Background and Financial Instruments

What this course is about Basic knowledge of invesment process and financial markets Valuation of bonds and related bond investment strategies Portfolio theory: diversification and how it reduces portfolio risk Asset pricing models for expected returns Fundamental and technical analysis

Investments & Financial Assets Essential nature of investment Reduced current consumption Planned later consumption How to invest Real Assets: Assets used to produce goods and services produce income to economy Financial Assets Claims on real assets or income generated by them Allocation of income, real assets among investors, individuals in the economy

Balance Sheet – U.S. Households

Financial Assets Money Market (Short-term) Bond Market (Long-term) Common Stocks Preferred Stocks Options Futures

Role of Financial asset and financial markets in the Economy Consumption Timing Allocation of Risk Separation of Ownership and Management

Consumption Timing Financial assets: stocks, bonds, deposits, etc. Savers (earn more than spend) Borrowers (spend more than earn) How do you transfer money from when you do not need to when you need?

Allocation of risk Example: GM wants to build a new auto plant, it raised money by issuing stocks and bonds Stock investors (high risk) Stock Auto plant High risk and low risk GM Bond Bond investors (low risk)

Separation of ownership and management Example: GE, total asset is $640 bil Cannot be single owner, must have many owners Selling stocks to market Currently, GE has 500,000 owners These owners choose managers Can easily transfer ownership without any impact on management

The Investment Process Asset allocation Security selection Risk-return trade-off Market efficiency Active vs. passive management

Investment process Small stock Big stock Stocks Bonds Real estate Commodity corporate bond T-bond, T-bill Broad assets House Land coffee, tea gold, oil, etc (1) Asset allocation (2) Security analysis

Example of Asset Allocation Common Age Stocks Bonds 30s 70% 30% 40s 60 40 50s 50 50 60s 40 60 Given the increased life expectancies, today’s typical retiree probably has ample time to wait out market cycles and thus might wish to invest more heavily in common stocks. In addition, the common stocks provide a hedge against inflation which is an important consideration for a retiree on a fixed income.

Example of Security Selection Wal-Mart Nordstroms Sears Bank of America Berkshire Hathaway Citibank

There is no free lunch!

Market Efficiency Security prices accurately reflect all relevant information. The price in the market is the true price Earn return just enough to compensate for risk, no abnormal return

Active vs. Passive Management Active Management Finding undervalued securities Timing the market Passive Management No attempt to find undervalued securities No attempt to time Holding an efficient portfolio

Players in the Financial Markets Business Firms – net borrowers Households – net savers Governments – can be both borrowers and savers Investment Bankers

Players in the Financial Markets securities Savers borrowers fund securities securities savers financial intermediaries borrowers borrowing rate lending rate securities securities savers borrowers investment bank fund fund get commission fees

Recent Trends Globalization Securitization Financial Engineering Computer Networks

Globalization In 1970, US equity market accounted for about 70 percent of equity in the world Currently, only 20-30 percent How to invest globally Purchase ADRs Invest directly into international market Buy mutual fund shares that invest in international market derivative securities with payoff depends on prices of foreign market

Securitization Benefits of securitization more funds available to borrowers Transfer risk of loans to corresponding investors in the market Banks pool all loans Mortgage loans auto loans credit card student loans other loans loans are securitized securities Investors High risk loan High risk securities High risk investors Low risk loan low risk securities low risk investors

Figure 1.2 Asset-backed Securities Outstanding

Financial engineering refer to creation of new securities Use of mathematical models and computer-based trading technology to synthesize new financial products Bundling: combine more than one security into a composite security Unbundling: breaking up and allocating the cash flows from one security to create several new securities

Collateralized Debt Obligation (CDO) A CDO is an asset backed security (ABS) whose underlying collateral is typically a portfolio of bonds (corporate or sovereign) or bank loan A CDO cash flow structure allocates interest income and principal repayments from a collateral pool of different debt instruments to a prioritized collection (tranches) of CDO securities.

Cash CDO Structure Illustration Tranche 1 (AAA) Yield = 5% ($25mil) Mortgage 1 Mortgage 2 Mortgage 3  Mortgage n Average Yield 12.5% ($100 mil) Investor: banks, pension funds, college saving funds, universities, cities, etc. An investment bank creates a set of securities (tranches) backed by a mortgage pool (CDO) Tranche 2 (A) Yield = 10% ($25mil) Tranche 3 (BBB) Yield = 15% ($25mil) Tranche 4 (junk bond) Yield = 20% ($25mil)

Collateralized Debt Obligation (CDO) In normal time, mortgage borrowers are able to make the mortgage payments, so the investors will get the interest payments, the values of slices of CDOs increase When housing bubble busts, mortgage borrowers, especially subprime mortgage borrowers are not able to make payments, investors don’t get their money, values of CDOs decrease substantially. The value decrease is write-down and counted as loss in the income statement. For example, investment bank A, equity: $10 mil, borrow $90 mil. Invest all $100 mil in CDOs. When mortgage crisis happens, the market value of these mortgage backed securities drops substantially say to $80 mil, that means the income will go down by $80 mil, and at this point, technically the bank is insolvent.

Subprime Mortgage Crisis: Winners and Losers Big losers: http://ml-implode.com/ Bear Stearns: two hedge funds (>$1 billion) Australia: Basis Capital ($1 billion?); Absolute Capital ($200 million?); IKB Deutsche Industriebank … May take two more years to completely resolve! Big losers: Citigroup ($18B+) Merrill Lynch ($11.5B+) UBS ($17.8B+) Morgan Stanley ($9.4B+) … Bank of China (initial estimate $223 million, now could be $4-5B) will not calculate until another chapter.

Figure 1.3 Building Creates a Complex Security

Figure 1.4 Unbundling of Mortgages into Principal- and Interest-Only Securities

Recent Trends—Computer Networks Online information dissemination Information is made cheaply and widely available to the public Automated trade crossing Direct trading among investors

2008: Making History

2008: The End of Wall Street

Decision Making Perceive the situation Possible actions Evaluate the outcomes Choose the action with the best outcome

Investments: Asset classes and financial instruments CHAPTER 2

Financial Securities Low Risk High Risk Money Market (Short-term) Bond Market (Long-term) Common Stocks Preferred Stocks Options Futures Index

Money Market Instruments üTreasury Bills Certificates of deposit Commercial paper Banker’s acceptances Eurodollars Repos and reverses Brokers’ calls * Federal funds LIBOR

Money market instruments T-bill Issued by government most marketable minimum denomination: $1000 buy at a discount, return at par issued weekly with maturities 28, 91, 182 days Certificate of deposit (CD) Pay interest and principal at maturity date Par value > 100,000: negotiable Par value <100,000: non-negotiable Short-term CD (less than 3 months): highly marketable

Money market instruments Commercial paper Issued by large, well-known corporation Short term, unsecured debt (less than 270 days), more than 270 day need SEC registration. Fairly safe Fairly liquid banker acceptance an order to a bank by a customer to pay a sum of money at a future date safe (guaranteed by bank)

Money market instruments Eurodollars: dollar denominated at foreign banks or American banks’ foreign branches similar to domestic deposit escape US regulation riskier, less liquid, offer higher yield than domestic deposit Repos (repurchase agreements) short-term sales of government securities with an agreement to repurchase the securities at a higher price

Money market instruments Federal funds Funds in the accounts of commercial bank at the Fed Federal fund rate: overnight loan rate among banks LIBOR market: London Interbank Offer Rate: lending rate among banks in London market

Table 2.2 Components of the Money Market

Bond Market Treasury Notes and Bonds Federal Agency Debt International Bonds Inflation-Protected Bonds Municipal Bonds Corporate Bonds Mortgages and Mortgage-Backed Securities

Treasury Notes and Bonds Maturities Notes – maturities up to 10 years Bonds – maturities in excess of 10 years Par Value - $1,000 Quotes – percentage of par, in 32nd

Figure 2.4 Treasury Notes and Bonds

Federal Agency Debt Major issuers If default, the government will help Federal Home Loan Bank Federal National Mortgage Association (“Fannie Mae”) Government National Mortgage Association (“Ginnie Mae”) Federal Home Loan Mortgage Corporation (“Freddie Mac”) If default, the government will help safe, yield is similar to T-bill

Municipal Bonds Issued by state and local governments Types General obligation bonds: backed by state, city Revenue bonds: backed by the revenue of project of state, city tax exempt from federal tax (for investors) example: consider 2 bonds taxable bond: before tax yield = 8%, tax = 40% municipal bond: yield = 6% Which one is more attractive to investors? Maturities – range up to 30 years

Municipal Bonds Interest is exempt from Federal taxes advantage Interest is exempt from Federal taxes After-tax return (taxable bond): After-tax return (Municipal bond):

Figure 2.6 Ratio of Yields on Tax-exempts to Taxables, 1955-2006

Corporate Bonds Issued by private firms Semi-annual interest payments Subject to larger default risk than government securities Options in corporate bonds Callable Convertible

Figure 2.7 Investment Grade Bond Listings

Mortgages and Mortgage-backed Securities Developed in the 1970s to help liquidity of financial institutions Proportional ownership of a pool or a specified obligation secured by a pool Market has experienced very high rates of growth

Mortgage backed securities fund fund payment payment payment pool all mortgage loans Banks sell mortgage backed securities Investors securitized fund payment Mortgage backed securities can be called pass through securities since the bank simply pass fund from investors to borrowers and pass interest payment and principal payment from borrowers to investors Mortgage loan fund payment Borrowers

Figure 2.7 Mortgage-backed Securities Outstanding, 1979-2007

Equity Markets Common stock Preferred stock Depository receipts stock market listing

Equity Markets Common stock Characteristics Right to vote Right to share benefit Proxy Proxy fight Characteristics Residual claims Limited liabilities

Equity Markets Preferred stocks Similar to both stocks and bond (hybrid security) Similar to bond Similar to stock Priority over common stock preferred dividend is cumulative tax treatment Preferred stock and bond are similar in the sense that they are both fixed income and have no voting power. Bond has claims before preferred stock Obviously preferred stock is riskier, why in practice the yield on preferred stock is smaller than that of bond

Equity Markets ADR: claims on ownership in foreign companies Trading in the US, similar to US stocks Total value of ADR currently is 657 (bil), about 2000 ADRs from 73 countries

Figure 2.8 Listing of Stocks Traded on the NYSE

Uses of Stock Indexes Track average returns Comparing performance of managers Base of derivatives

Examples of Other Indexes - Domestic Dow Jones Industrial Average (30 Stocks) Standard & Poor’s 500 Composite NASDAQ Composite NYSE Composite Wilshire 5000

Figure 2-10 Comparative Performance of Several Stock Market Indexes

Examples of Indexes - International Nikkei 225 & Nikkei 300 FTSE (Financial Times of London) Dax Region and Country Indexes EAFE Far East United Kingdom MSCI: index of more than 50 country indexes

Table 2.6 Sample of MSCI Stock Indexes

Factors for Construction of Stock Indexes Representative? Broad or narrow? How is it weighted? Price weighted (DJIA) Market weighted (S&P 500, NASDAQ) Equal (Value Line Index)

Price Weighted Indices DJIA is an example 30 blue chip companies DJIA = (P1+P2+....+P30)/d where d is Dow divisor. Originally d = 30 Currently, d = 0.1248 since d is adjusted for stock split, stock dividends, other corporate action, new companies coming into the index, old companies are taken out of the index

Example of Price-Weighted Index Stock ABC sells initially at $25 a share with 20 million shares outstanding, while XYZ sells for $100 a share with 1 millions shares outstanding. The final price for ABC is $30, and the final price for XYZ is $90. (a) Find the initial and the final price-weighted index composed of these two stocks. Assume the initial divisor is 2. (b) Now if stock XYZ is split two for one, how should you adjust the divisor for the index?

DJIA Most quoted index in the world Criticisms Long history easy to understand indicates market’s basic trend reliably 30 companies account for 24-25% of US equity Criticisms Only 30 stocks price weighted index: large price stocks dominate the index

S&P’s Composite 500 Market Value-Weighted Index Stock ABC sells initially at $25 a share with 20 million shares outstanding, while XYZ sells for $100 a share with 1 millions shares outstanding. The final price for ABC is $30, and the final price for XYZ is $90. Find the the value-weighted index composed of these two stocks at the final date. Assume the initial level of the index is 100.

Value Line Equally Weighted Index Places equal weight on each return Using data from Table 2.4 Start with equal dollars in each investment ABC increases in value by 20% XYZ decreases by 10% Need to rebalance to keep equal weights

Table 2.4 Data to Construct Stock Price Indexes

Bond Index Computed monthly Difficulty in measuring true returns Best known: Merrill Lynch Lehman Brothers Salomon Smith Barney

DERIVATIVE MARKETS

Derivative 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

Options Call option - the right to buy an asset at a specific price (exercise price) on or before a specific date Put option - the right to sell an asset at a specific price (exercise price) on or before a specific date

Figure 2.10 Trading Data on GE Options

Options Call options Put options Same expiration date, exercise price increases, value of option decreases Same exercise price, expiration date increases, value of option increases Put options Same expiration date, exercise price increases, value of option increases

Futures contracts Obligation to purchase or sell an asset at a specific price at a specific future date Long position: trader who commits to buy commodity/asset at delivery date Short position: trader who commits to sell at the delivery date Option is the right, futures is obligation

Figure 2.11 Listing of Selected Futures Contracts

There is no free lunch! Derivatives Stocks Corporate Bonds T-Bonds Money

Summary Differences between real assets and financial assets Purpose of investing in financial assets Players in financial markets Financial instruments Financial market indices Next class: How securities are trades; Investment companies