1. Essentials of Investments © 2001 The McGraw-Hill Companies, Inc. All rights reserved. Fourth Edition Irwin / McGraw-Hill Bodie Kane Marcus 1 Chapter 1 Investments - Background and Issues

2. Essentials of Investments © 2001 The McGraw-Hill Companies, Inc. All rights reserved. Fourth Edition Irwin / McGraw-Hill Bodie Kane Marcus 2 Investments & Financial Assets Essential nature of investment –Reduced current consumption –Planned later consumption Real Assets –Assets used to produce goods and services Financial Assets –Claims on real assets

3. Essentials of Investments © 2001 The McGraw-Hill Companies, Inc. All rights reserved. Fourth Edition Irwin / McGraw-Hill Bodie Kane Marcus 3 The Investment Process Asset allocation Security selection Risk-return trade-off Market efficiency Active vs. passive management

4. Essentials of Investments © 2001 The McGraw-Hill Companies, Inc. All rights reserved. Fourth Edition Irwin / McGraw-Hill Bodie Kane Marcus 4 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

5. Essentials of Investments © 2001 The McGraw-Hill Companies, Inc. All rights reserved. Fourth Edition Irwin / McGraw-Hill Bodie Kane Marcus 5 Major Classes of Financial Assets or Securities Debt – Money market instruments – Bonds Common stock Preferred stock Derivative securities

6. Essentials of Investments © 2001 The McGraw-Hill Companies, Inc. All rights reserved. Fourth Edition Irwin / McGraw-Hill Bodie Kane Marcus 6 Investments and Innovation 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

7. Essentials of Investments © 2001 The McGraw-Hill Companies, Inc. All rights reserved. Fourth Edition Irwin / McGraw-Hill Bodie Kane Marcus 7 Key Trends - Globalization International and Global Markets Continue Developing Managing foreign exchange Diversification to improve performance Instruments and vehicles continue to develop Information and analysis improves

8. Essentials of Investments © 2001 The McGraw-Hill Companies, Inc. All rights reserved. Fourth Edition Irwin / McGraw-Hill Bodie Kane Marcus 8 Key Trends - 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

9. Essentials of Investments © 2001 The McGraw-Hill Companies, Inc. All rights reserved. Fourth Edition Irwin / McGraw-Hill Bodie Kane Marcus 9 Key Trends - 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

10. Essentials of Investments © 2001 The McGraw-Hill Companies, Inc. All rights reserved. Fourth Edition Irwin / McGraw-Hill Bodie Kane Marcus 10 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

11. Essentials of Investments © 2001 The McGraw-Hill Companies, Inc. All rights reserved. Fourth Edition Irwin / McGraw-Hill Bodie Kane Marcus 11 Chapter 2 Financial Markets and Instruments

12. Essentials of Investments © 2001 The McGraw-Hill Companies, Inc. All rights reserved. Fourth Edition Irwin / McGraw-Hill Bodie Kane Marcus 12 Major Classes of Financial Assets or Securities Debt – Money market instruments – Bonds Common stock Preferred stock Derivative securities

13. Essentials of Investments © 2001 The McGraw-Hill Companies, Inc. All rights reserved. Fourth Edition Irwin / McGraw-Hill Bodie Kane Marcus 13 Markets and Instruments Money Market –Debt Instruments –Derivatives Capital Market –Bonds –Equity –Derivatives

14. Essentials of Investments © 2001 The McGraw-Hill Companies, Inc. All rights reserved. Fourth Edition Irwin / McGraw-Hill Bodie Kane Marcus 14 Money Market Instruments Treasury bills Certificates of deposit Commercial Paper Bankers Acceptances Eurodollars Repurchase Agreements (RPs) and Reverse RPs Federal Funds

15. Essentials of Investments © 2001 The McGraw-Hill Companies, Inc. All rights reserved. Fourth Edition Irwin / McGraw-Hill Bodie Kane Marcus 15 Money Market Instrument Yields Yields on Money Market Instruments are not always directly comparable Factors influencing yields Par value vs. investment value 360 vs. 365 days assumed in a year (366 leap year) Bond equivalent yield

16. Essentials of Investments © 2001 The McGraw-Hill Companies, Inc. All rights reserved. Fourth Edition Irwin / McGraw-Hill Bodie Kane Marcus 16 Interest rates that arise in connection with money market securities.Bank discount rate (rBD ).This is a rate that is used solely for determining the price of a MM security for trading purposes..Bond equivalent yield (rBEY ).In general, a yield is an interest rate that (under very specific, sometimes unrealistic, assumptions) represents a rate of return..rBEY is such a rate of return. It is an annual percentage rate (APR).For comparing different MM instruments, we often use the effective annual rate (EAR) of the rBEY.

17. Essentials of Investments © 2001 The McGraw-Hill Companies, Inc. All rights reserved. Fourth Edition Irwin / McGraw-Hill Bodie Kane Marcus 17 Bank Discount Rate (T-Bills) r BD = bank discount rate P= market price of the T-bill n= number of days to maturity r BD = 10,000 - P10,000 x 360 n 90-day T-bill, P = $9,875 r BD = 10,000 - 9,875 10,000 x 360 90 =5% Example

18. Essentials of Investments © 2001 The McGraw-Hill Companies, Inc. All rights reserved. Fourth Edition Irwin / McGraw-Hill Bodie Kane Marcus 18 Bond Equivalent Yield Can’t compare T-bill directly to bond –360 vs 365 days –Return is figured on par vs. price paid Adjust the bank discounted rate to make it comparable

19. Essentials of Investments © 2001 The McGraw-Hill Companies, Inc. All rights reserved. Fourth Edition Irwin / McGraw-Hill Bodie Kane Marcus 19 Bond Equivalent Yield P = price of the T-bill n = number of days to maturity r BEY = 10,000 - PP x 365 n r BEY = 10,000 - 9,875 9,875 x 365 90 r BEY =.0127 x 4.0556 =.0513 = 5.13% Example Using Sample T-Bill

20. Essentials of Investments © 2001 The McGraw-Hill Companies, Inc. All rights reserved. Fourth Edition Irwin / McGraw-Hill Bodie Kane Marcus 20 Capital Market - Fixed Income Instruments Publicly Issued Instruments US Treasury Bonds and Notes Agency Issues (Fed Gov) Municipal Bonds Privately Issued Instruments Corporate Bonds Mortgage-Backed Securities

21. Essentials of Investments © 2001 The McGraw-Hill Companies, Inc. All rights reserved. Fourth Edition Irwin / McGraw-Hill Bodie Kane Marcus 21 Capital Market - Equity Common stock –Residual claim –Limited liability Preferred stock –Fixed dividends - limited –Priority over common –Tax treatment

22. Essentials of Investments © 2001 The McGraw-Hill Companies, Inc. All rights reserved. Fourth Edition Irwin / McGraw-Hill Bodie Kane Marcus 22 Uses 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? Stock Indexes

23. Essentials of Investments © 2001 The McGraw-Hill Companies, Inc. All rights reserved. Fourth Edition Irwin / McGraw-Hill Bodie Kane Marcus 23 Examples of Indexes - Domestic Dow Jones Industrial Average (30 Stocks) Standard & Poor’s 500 Composite NASDAQ Composite NYSE Composite Wilshire 5000

24. Essentials of Investments © 2001 The McGraw-Hill Companies, Inc. All rights reserved. Fourth Edition Irwin / McGraw-Hill Bodie Kane Marcus 24 Examples of Indexes - Int’l Nikkei 225 & Nikkei 300 FTSE (Financial Times of London) Dax Region and Country Indexes –EAFE –Far East –United Kingdom

25. Essentials of Investments © 2001 The McGraw-Hill Companies, Inc. All rights reserved. Fourth Edition Irwin / McGraw-Hill Bodie Kane Marcus 25 Construction of Indexes How are stocks weighted? –Price weighted (DJIA) –Market-value weighted (S&P500, NASDAQ) –Equally weighted (Value Line Index)

26. Essentials of Investments © 2001 The McGraw-Hill Companies, Inc. All rights reserved. Fourth Edition Irwin / McGraw-Hill Bodie Kane Marcus 26 Example.Suppose we have two stocks #Shares Stock Pr 9/19/01 Pr 9/20/01 Return Outstand A 100 120 20% 10M B 10 9 –10% 500M.Computation of a price-weighted index (like the Dow).Index on 9/19/01 (100+10)/2 = 55 Index on 9/20/01 (120+9)/2 = 64.5 Return on index 17.27%.This is called a price-weighted index because the index return is the price-weighted average of the component (100/110) x 20% + (10/110) x –10% = 17.27%.Portfolio: one share in each stock.

27. Essentials of Investments © 2001 The McGraw-Hill Companies, Inc. All rights reserved. Fourth Edition Irwin / McGraw-Hill Bodie Kane Marcus 27 Market-value weighted index.A market-value weighted average (like the S&P)..Index on 9/19/01 = “100” (an arbitary base level).Market value of A = $100 x 10M = $1,000M Market value of B = $10 x 500M = $5,000M.Return on index is (1,000/6,000) x 20% + (5,000/6000) x –10% = –5%.Index on 9/20/01 = 100 x (1–5%) = 95.Portfolio: 1/6 in A; 5/6 in B.An equally-weighted index (like the Wilshire 5000).Index on 9/19/01 = “100” (an arbitary base level).Return on index is (20% + –10%)/2 = +5%.Index on 9/20/01 = 100 x (1+5%) = 105.Portfolio: equal amounts in A and B

28. Essentials of Investments © 2001 The McGraw-Hill Companies, Inc. All rights reserved. Fourth Edition Irwin / McGraw-Hill Bodie Kane Marcus 28 Chapter 3 How Securities are Traded

29. Essentials of Investments © 2001 The McGraw-Hill Companies, Inc. All rights reserved. Fourth Edition Irwin / McGraw-Hill Bodie Kane Marcus 29 Primary vs. Secondary Security Sales Primary –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

30. Essentials of Investments © 2001 The McGraw-Hill Companies, Inc. All rights reserved. Fourth Edition Irwin / McGraw-Hill Bodie Kane Marcus 30 Investment Banking Arrangements Underwritten vs. “Best Efforts” –Underwritten: firm commitment on proceeds to the issuing firm –Best Efforts: no firm commitment Negotiated vs. Competitive Bid –Negotiated: issuing firm negotiates terms with investment banker –Competitive bid: issuer structures the offering and secures bids

31. Essentials of Investments © 2001 The McGraw-Hill Companies, Inc. All rights reserved. Fourth Edition Irwin / McGraw-Hill Bodie Kane Marcus 31 Public offerings: registered with the SEC and sale is made to the investing public –Shelf registration (Rule 415, since 1982) Initial Public Offerings (IPOs) –Evidence of underpricing –Performance Public Offerings

32. Essentials of Investments © 2001 The McGraw-Hill Companies, Inc. All rights reserved. Fourth Edition Irwin / McGraw-Hill Bodie Kane Marcus 32 Private placement: sale to a limited number of sophisticated investors not requiring the protection of registration Dominated by institutions Very active market for debt securities Not active for stock offerings Private Placements

33. Essentials of Investments © 2001 The McGraw-Hill Companies, Inc. All rights reserved. Fourth Edition Irwin / McGraw-Hill Bodie Kane Marcus 33 Organization of Secondary Markets Organized exchanges OTC market Third market Fourth market

34. Essentials of Investments © 2001 The McGraw-Hill Companies, Inc. All rights reserved. Fourth Edition Irwin / McGraw-Hill Bodie Kane Marcus 34 Organized Exchanges Auction markets with centralized order flow Dealership function: can be competitive or assigned by the exchange (Specialists) Securities: stock, futures contracts, options, and to a lesser extent, bonds Examples: NYSE, AMEX, Regionals, CBOE

35. Essentials of Investments © 2001 The McGraw-Hill Companies, Inc. All rights reserved. Fourth Edition Irwin / McGraw-Hill Bodie Kane Marcus 35 Types of Orders Instructions to the brokers on how to complete the order Market Limit Stop loss

36. Essentials of Investments © 2001 The McGraw-Hill Companies, Inc. All rights reserved. Fourth Edition Irwin / McGraw-Hill Bodie Kane Marcus 36 Margin Trading Using only a portion of the proceeds for an investment Borrow remaining component Margin arrangements differ for stocks and futures

37. Essentials of Investments © 2001 The McGraw-Hill Companies, Inc. All rights reserved. Fourth Edition Irwin / McGraw-Hill Bodie Kane Marcus 37 Stock Margin Trading 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

38. Essentials of Investments © 2001 The McGraw-Hill Companies, Inc. All rights reserved. Fourth Edition Irwin / McGraw-Hill Bodie Kane Marcus 38 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

39. Essentials of Investments © 2001 The McGraw-Hill Companies, Inc. All rights reserved. Fourth Edition Irwin / McGraw-Hill Bodie Kane Marcus 39 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%

40. Essentials of Investments © 2001 The McGraw-Hill Companies, Inc. All rights reserved. Fourth Edition Irwin / McGraw-Hill Bodie Kane Marcus 40 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

41. Essentials of Investments © 2001 The McGraw-Hill Companies, Inc. All rights reserved. Fourth Edition Irwin / McGraw-Hill Bodie Kane Marcus 41 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

42. Essentials of Investments © 2001 The McGraw-Hill Companies, Inc. All rights reserved. Fourth Edition Irwin / McGraw-Hill Bodie Kane Marcus 42 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

43. Essentials of Investments © 2001 The McGraw-Hill Companies, Inc. All rights reserved. Fourth Edition Irwin / McGraw-Hill Bodie Kane Marcus 43 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%

44. Essentials of Investments © 2001 The McGraw-Hill Companies, Inc. All rights reserved. Fourth Edition Irwin / McGraw-Hill Bodie Kane Marcus 44 Short Sale - Margin Call How much can the stock price rise before a margin call? ($15,000 * - 100P) / (100P) = 30% P = $115.38 * Initial margin plus sale proceeds