Investments Lecture 1 Introduction to Investments

Class Outline l -- Develop an understanding of the operation of debt, equity, and options markets and the instruments used in these markets l -- Review the investment process in general with a focus on security selection decisions l -- Discuss market efficiency and its implications for speculative strategies

Class Outline l -- Analyze different valuation and analytic techniques for equities l -- Examine investments techniques for equity portfolios l -- Look at mutual funds and other investment companies as vehicles for investment strategies.

My Personal Investment Philosophy §A. Markets are (essentially) efficient l You can not consistently beat the market. l If an investor starts off with this belief, I feel that the investor is better able to assess the validity of proposed "sure fire" investment strategies.

My Personal Investment Philosophy §B. If it sounds too good to be true, it is. l This advice will prevent you from entering into any investment without checking it out first. §C. There is always someone smarter than you. l This will prevent overconfidence and will keep you on your toes.

Introduction to investments §Investing l Definition of an investment: The current commitment of dollars for a period of time in order to derive future payments that will compensate the investor for: 1. The time value of money 2. The expected rate of inflation 3. The risk associated with the investment

Introduction to investments §Speculating l Speculative strategies include: –1. Buying long-term bonds because you feel interest rates will fall –2. Buying a stock because you feel its price will increase due to a takeover attempt –3. Buying stocks you believe are “undervalued” by the market

Introduction to investments §Expected returns versus required returns l The expected return on a security is the return an investor expects to receive over some future time period. l The expected return is estimated by determining an expected future price and income for a security and measuring the return in a manner similar to the actual return calculation.

Introduction to investments §Expected returns versus required returns l Mathematical definition of the expected return: §ER = ((P t+1 -P t ) + income t+1 )/P t

Introduction to investments §Expected returns versus required returns l We can also measure the expected return by estimating several potential outcomes and assigning a probability to each outcome. The expected return in this case would be equal to: §  P i *ER i

Real Assets vs. Financial Assets §Use them to produce goods and services l Property l Plant l Equipment l Knowledge §Claims on real assets or the income generated by real assets l Stocks l Bonds l Derivative securities

Introduction to investments § Risk Risk is the possibility that an investment will earn a return lower than is required. Essentially, for our purposes, risk is the possibility of price variation. l The problem with ignoring risk l -- Things sound too good to be true when risk is ignored. Investments that are much too risky for the average investor appear to be "good" investments if risk is ignored.

Investment Alternatives §The money market l -- The money market is a subsector of the fixed-income market. It consists of short-term, very liquid investments. l 1. Treasury-bills (T-bills) Pure discount instruments Typically considered as a "risk-free" asset

Investment alternatives §The money market l 2. Certificates of deposits Time deposits made with a bank. Federally insured up to $100,000. l 3. Commercial paper -- Short-term debt issued by corporations. Gives corporations a way to avoid bank debt. l 4. Repos l 5. Brokers’ Calls

Investment alternatives §The fixed-income capital market l 1. Treasury notes and bonds Longer maturity government debt l 2. Federal agency debt -- Debt issued by government agencies and government sponsored agencies in support of farm credit and home mortgages –- Major issuing agencies include: Federal Home Loan Bank (FHLB), Federal National Mortgage Association (FNMA), Government National Mortgage Association (GNMA), Federal Home Loan Mortgage Corporation (FHLMC), District Cooperative Banks, Federal Land Banks, Federal Intermediate Credit Banks

Investment Alternatives §The fixed-income capital market l 3. Municipal bonds Issued by state and local governments Income is tax exempt l 4. Corporate bonds

Taxable vs. Tax-Exempt Yields

Investment alternatives §The fixed-income capital market l 5. Mortgage-Backed Securities (MBS) Gives the holder an ownership claim in a pool of mortgages or an obligation that is secured by such a pool. There has been an exponential growth in the MBS market since 1979 with the amount of funds invested approaching 2 trillion dollars.

Investment alternatives §The fixed-income capital market l 5. Mortgage-backed securities (MBS) Securitization involves packaging a set of assets together and selling ownership rights to the assets. For example, David Bowie recently sold shares in his song portfolio. Any revenues generated from his songs are split among the shareholders. (By the way, I believe he made a few hundred million dollars doing this.)

Investment alternatives §Equity securities l 1. Common stock Residual claimant Limited liability l Agency problems Managers are agents for shareholders Interests of principals and agents are often in conflict

Investment alternatives §Equity securities l 2. Preferred stock Promises a fixed dividend to shareholders, but non- payment of the dividend will not force the company into bankruptcy.

Investment alternatives § Derivative Markets l 1. Options Right to buy or sell an asset at a specified price at a certain time in the future l 2. Futures Obligation to buy or sell an asset at a specified price at a certain time in the future l 3. Swaps An agreement between two parties to exchange a set of cash flows in a predetermined manner

Investment alternatives §Investment companies l 1. Mutual funds l 2. REITs §International investments l Developed versus emerging markets

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

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

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

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

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

New Economy vs. Old Economy §Old Economy stocks l AT&T l IBM l McDonald’s l Proctor and Gamble §New Economy stocks l Cisco l Amazon l eBay

Investments and Innovations Technology and Delivery of Service §Computer advancements §More complete and timely information Globalization §Domestic firms compete in global markets §Performance in regions depends on other regions §Causes additional elements of risk

Trends in Financial Markets §Globalization §Securitization §Financial engineering §technology

Globalization International and Global Markets Continue Developing § Managing foreign exchange § Diversification to improve performance § Instruments and vehicles continue to develop (WEBs) § Information and analysis improves

Securitization Securitization & Credit Enhancement §Offers opportunities for investors and originators §Changes in financial institutions and regulation §Improvement in information capabilities §Credit enhancement and its role

Financial Engineering Repackaging Services of Financial Intermediaries §Bundling and unbundling of cash flows §Slicing and dicing of cash flows §Examples: strips, CMOs, dual purpose funds, principal/interest splits

The Future §Globalization continues and offers more opportunities §Securitization continues to develop §Continued development of derivatives and exotics §Strong fundamental foundation is critical §Integration of investments & corporate finance