1 How to pick stocks? Good company vs good stock Good company vs good stock Macroeconomic condition Macroeconomic condition Profitability and investment Profitability and investment

2 Price of Gambles Gamble #1: You flip a fair coin, head I give you $110, tail I give you $90. How much are you willing to pay me to enter this gamble? Gamble #1: You flip a fair coin, head I give you $110, tail I give you $90. How much are you willing to pay me to enter this gamble? Gamble #2: You flip a fair coin, I give you $100 in a year no matter what happens. How much are you willing to pay me today to enter this gamble? Gamble #2: You flip a fair coin, I give you $100 in a year no matter what happens. How much are you willing to pay me today to enter this gamble?

3 Consumption Preference Which do you prefer? Which do you prefer? A) Starve (nearly to death) on odd days and stuff on even days; or A) Starve (nearly to death) on odd days and stuff on even days; or B) Eat comfortably every day. B) Eat comfortably every day.

4 Help these two ladies Two old ladies live in the same town. One makes a living by selling umbrellas, the other sells sunglasses. When it rains, the umbrella-selling lady will be happy but the sunglass lady will be upset. When it is sunny, it is the reverse. Two old ladies live in the same town. One makes a living by selling umbrellas, the other sells sunglasses. When it rains, the umbrella-selling lady will be happy but the sunglass lady will be upset. When it is sunny, it is the reverse. How do you make both ladies happier without costing you anything? How do you make both ladies happier without costing you anything?

FINA 2802: Investments and Portfolio Analysis Financial Securities Dragon Yongjun Tang January 14 & 19, 2010

6 Lectures 2 & 3: Financial Securities Reading: Chapter 2 Reading: Chapter 2 Practice Problem Sets: 1,2,3,6,8,9,11,12,13,17 Practice Problem Sets: 1,2,3,6,8,9,11,12,13,17

7 Learning Objectives Distinguish among the major assets that trade in money markets and in capital markets Describe the construction of stock market indexes Calculate the profit or losses on investments in options and futures contracts

8 Financial Securities Financial Market Fixed-income (Bonds) Equity (Stocks) Derivatives Money Market (Short-term) Common Stocks Preferred Stocks Options Futures Low Risk High Risk Bond Market (Long-term) Index

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

10 Most marketable of money market instruments Face value paid at maturity Sold at a discount to face via auction Issue: - 28 days (1 month), 91 days (3-month) and 182 days (6 month): weekly Minimum denomination is $10,000 Treasury Bills

11 Figure 2.2 Treasury Bills

12 Figure 2.1 Money Rates

13 Figure 2.3 Spreads on CDs and Treasury Bills Difficult to predict Widen during crisis

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

15 Treasury Notes and Bonds Maturities Maturities –Notes – maturities up to 10 years –Bonds – maturities in excess of 10 years –30-year bond 2001 Treasury suspended sales 2001 Treasury suspended sales 2005 resume sales 2005 resume sales Par Value - $1,000 Par Value - $1,000 Quotes – percentage of par; in 32nd Quotes – percentage of par; in 32nd

16 Figure 2.4 Treasury Notes, Bonds and Bills

17 Federal Agency Debt Major issuers Major issuers –Federal Home Loan Bank –Federal National Mortgage Association ( “ Fannie Mae ” ) –Government National Mortgage Association ( “ Ginnie Mae ” ) –Federal Home Loan Mortgage Corporation ( “ Freddie Mac”)

18 Figure 2.5 Government Agency & Similar Issues

19 Municipal Bonds Issued by state and local governments Issued by state and local governments Types Types –General obligation bonds –Revenue bonds Industrial revenue bonds Industrial revenue bonds Maturities – range up to 30 years Maturities – range up to 30 years

20 Municipal Bond Yields Interest income on municipal bonds is not subject to federal and sometimes state and local tax Interest income on municipal bonds is not subject to federal and sometimes state and local tax To compare yields on taxable securities a Taxable Equivalent Yield is constructed To compare yields on taxable securities a Taxable Equivalent Yield is constructed

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

22 Figure 2.7 Ratio of Yields on Tax-exempts to Taxables

Equivalent Taxable Yield

24 Table 2.3 Equivalent Taxable Yields

25 Semiannual coupon payments Nominal value (Par) is $1,000 Actual percentage used for quote Current Yield=coupon/close Volume in Thousands Subject to larger default risk than government securitiesSubject to larger default risk than government securities Options on the bonds:Options on the bonds: Callable and convertibles Corporate Bonds

26 Figure 2.8 Corporate Bond Prices

27 Bond Market Treasury Notes and Bonds Treasury Notes and Bonds Federal Agency Debt Federal Agency Debt International Bonds: Eurobonds; Yankee Bonds, Samurai bonds; Dragon bonds International Bonds: Eurobonds; Yankee Bonds, Samurai bonds; Dragon bonds Municipal Bonds Municipal Bonds Corporate Bonds Corporate Bonds Mortgages and Mortgage-Backed Securities Mortgages and Mortgage-Backed Securities

28 Outstanding U.S. Bond Market Debt in 2006 (US$Billions) Source: Securities Industry and Financial Markets Association ( MunicipalTreasuryMortgageCorporateAgencyTotal Market Size2, , , , , , Daily Trading Volume

“mini-bond” Not well defined! Not well defined! Official term: credit-linked notes Official term: credit-linked notes Credit derivative! Credit derivative! Counterparty risk! Counterparty risk! 29

30 Equity Markets Common stock Common stock –Residual claim –Limited liability Preferred stock Preferred stock –Fixed dividends - limited –Priority over common –Tax treatment Depository receipts Depository receipts

31 Figure 2.10 Listing of Stocks Traded on the NYSE

32 What is Dow Jones?

33 What is Dow Jones? Charles Dow; Edward Jones Charles Dow; Edward Jones Inventors of tickers Inventors of tickers Publishing WSJ, Barrons, etc. Publishing WSJ, Barrons, etc.

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

35 Representative? Representative? Broad or narrow? Broad or narrow? How is it weighted? How is it weighted? Factors for Construction of Stock Indexes

36 Examples of Indexes – U.S. Domestic Dow Jones Industrial Average (30 Stocks) Dow Jones Industrial Average (30 Stocks) Standard & Poor ’ s 500 Composite Standard & Poor ’ s 500 Composite NASDAQ Composite NASDAQ Composite NYSE Composite NYSE Composite Wilshire 5000 Wilshire 5000

37 Figure 2-11 Comparative Performance of Several Stock Market Indexes

38 Examples of Indexes - Int ’ l Hang Seng Index; Shanghai Composite Hang Seng Index; Shanghai Composite Nikkei 225 & Nikkei 300 Nikkei 225 & Nikkei 300 FTSE (Financial Times of London) FTSE (Financial Times of London) Dax Dax Region and Country Indexes Region and Country Indexes –EAFE –Far East –United Kingdom

39 Construction of Indexes How are stocks selected? How are stocks selected? –Subjective How are stocks weighted? How are stocks weighted? –Price weighted (DJIA) –Market-value weighted (S&P500, NASDAQ) –Equally weighted (Value Line Index)

40 Price Weighted Indices Computed by adding all the prices in the index and dividing by a divisor Computed by adding all the prices in the index and dividing by a divisor Implies one share for each stock Implies one share for each stock Implies a buy-and-hold strategy Implies a buy-and-hold strategy Gives high weight to high price stocks Gives high weight to high price stocks DJIA is an example DJIA is an example

Derivation of Price- Weighted Index

42 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. 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? (b) Now if stock XYZ is split two for one, how should you adjust the divisor for the index?

43 Value-Weighted Indices Calculated by adding the total market value of the firms in the indexCalculated by adding the total market value of the firms in the index Implies buy and hold strategyImplies buy and hold strategy S&P 500 is an exampleS&P 500 is an example

Derivation of Value- Weighted Index

45 Example of 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. 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.

46 Example of Value-Weighted Index (a) Find the the value-weighted index composed of these two stocks at the final date. Assume the initial level of the index is 100. (b) Now if stock XYZ is split two for one, how will the market value-weighted index be affected? (b) Now if stock XYZ is split two for one, how will the market value-weighted index be affected?

47 Equally Weighted Indices Computed by assuming equal dollar amount in each stock Computed by assuming equal dollar amount in each stock Implies periodic rebalancing of the portfolio (no buy and hold) Implies periodic rebalancing of the portfolio (no buy and hold) CRSP index is an example CRSP index is an example

Derivation of Equally Weighted Index

49 Example of Equally 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. 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.

50 Example of Equally Weighted Index (a) Find the the equally weighted index composed of these two stocks at the final date. Assume initially $100 are invested in each stock. (a) Find the the equally weighted index composed of these two stocks at the final date. Assume initially $100 are invested in each stock. (b) At the final date, how should you rebalance your portfolio to have an equally weighted portfolio? (b) At the final date, how should you rebalance your portfolio to have an equally weighted portfolio?

51 Hang Seng Index Freefloat-adjusted market capitalization weighted –Exclude shareholdings with lock-up arrangement 15% cap on individual stock weightings 15% cap on individual stock weightings Re-capping Q1 & Q3 Re-capping Q1 & Q3 H-shares included H-shares included

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

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

54 Call option - the right to buy Put option - the right to sell Hedgers protect themselves just in case Options

Dow Chemical 85 July Call - Buy 1 Call Profit Break even Loss Common stock price Premium = 1 3/ Profit / Loss Payoff / /8 Long Call Profit or Loss

56 Option Quotes

57 Option Valuation Binomial Tree Approach: Replicating option payoffs with stocks and bonds  C=26.85 Black-Scholes Formula Black-Scholes Formula Stock Price C 75 0 Call Option Value X = 125 Alternative Portfolio Buy 1 share of stock at $100 Borrow $46.30 (8% Rate) Net outlay $53.70 Payoff Value of Stock Repay loan Net Payoff Payoff Structure is exactly 2 times the Call

FIN 8330 Lecture 9 10/25/07 58 The Black-Scholes Formula The Black-Scholes option pricing formula The Black-Scholes option pricing formula –For a European call option on a stock paying no dividend –N(d) = probability that a random draw from a normal dist. will be less than d. –The option value does not depend on the expected return on the stock (risk-neutral valuation)

59 Warrant/Put Warrant Essentially, call/put options issued by a firm Essentially, call/put options issued by a firm Difference: warrant exercise requires firm to issue new shares (ownership dilution!) Difference: warrant exercise requires firm to issue new shares (ownership dilution!) See page 717 of the textbook for more details. See page 717 of the textbook for more details.

60 Obligation not right Agree on price for a future date Used by hedgers not just speculators Futures Contracts

61 Payoff Profile of Futures Contract P T : Underlying Asset Price at expiration, P T : Underlying Asset Price at expiration, F: Agreed upon price F: Agreed upon price Payoff (profit) at expiration. Payoff (profit) at expiration. PTPT F F Payoff=Profit Long: P T – F Short: F- P T -F

62 Futures Quotes

63 Spot-futures parity theorem - two ways to acquire an asset for some date in the future Spot-futures parity theorem - two ways to acquire an asset for some date in the future –Purchase it now and store it –Take a long position in futures –These two strategies must have the same market determined costs With a perfect hedge the futures payoff is certain -- there is no risk With a perfect hedge the futures payoff is certain -- there is no risk A perfect hedge should return the riskless rate of return A perfect hedge should return the riskless rate of return Futures Pricing

64 Help these two ladies How do you make both ladies happier without costing you anything? How do you make both ladies happier without costing you anything? Option/Futures contracts Option/Futures contracts Sign an agreement with umbrella-selling lady, pay her $5 if it shines, she pays you $5 if it rains. The reverse with sunglasses-selling lady. Sign an agreement with umbrella-selling lady, pay her $5 if it shines, she pays you $5 if it rains. The reverse with sunglasses-selling lady. Weather derivatives Weather derivatives

65 Key to Derivatives Pricing: No Arbitrage The current prices of asset 1 and asset 2 are 95 and 43 The current prices of asset 1 and asset 2 are 95 and 43 Tomorrow, one of two states will come true Tomorrow, one of two states will come true –A good state where the prices go up or –A bad state where the prices go down Asset1 = 100 Asset2 = 50 Asset1 = 95 Asset2 = 43 Asset1 = 80 Asset2 = 40 Do you see any possibility to make risk-free money out of this situation?

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

67 Summary Financial securities Financial securities Indices Indices Next class: Financial Market Trading Next class: Financial Market Trading