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The Investment Environment
CHAPTER 1 The Investment Environment
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Real Assets Versus 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
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Table 1.1 Balance Sheet of U.S. Households, 2007
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Table 1.2 Domestic Net Worth
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A Taxonomy of Financial Assets
Fixed income or debt Money market instruments Bank certificates of deposit Capital market instruments Bonds Common stock or equity Derivative securities
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Financial Markets and the Economy
Information Role The Google effect Consumption Timing Allocation of Risk Separation of Ownership and Management Agency Issues
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Financial Markets and the Economy Continued
Corporate Governance and Corporate Ethics Accounting Scandals Examples – Enron, Rite Aid, HealthSouth Auditors—watchdogs of the firms Analyst Scandals Arthur Andersen Sarbanes-Oxley Act Tighten the rules of corporate governance
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The Investment Process
Asset allocation Choice among broad asset classes Security selection Choice of which securities to hold within asset class Security analysis
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Markets are Competitive
Risk-Return Trade-Off Efficient Markets Active Management Finding mispriced securities Timing the market Passive Management No attempt to find undervalued securities No attempt to time the market Holding a highly diversified portfolio
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The Players Business Firms– net borrowers Households – net savers
Governments – can be both borrowers and savers Financial Intermediaries Investment Companies Banks Insurance companies Credit unions
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The Players Continued Investment Bankers
Perform specialized services for businesses Markets in the primary market
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Table 1.3 Balance Sheet of Commercial Banks, 2007
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Table 1.4 Balance Sheet of Nonfinancial U.S. Business, 2007
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Recent Trends—Globalization
American Depository Receipts (ADRs) Foreign securities offered in dollars Mutual funds that invest internationally Instruments and vehicles continue to develop (WEBs) Exchange Traded Funds (ETFs)
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Figure 1.1 Globalization: A Debt Issue Denominated in Euros
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Recent Trends—Securitization
Mortgage pass-through securities Other pass-through arrangements Car, student, home equity, credit card loans Offers opportunities for investors and originators
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Figure 1.2 Asset-backed Securities Outstanding
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Recent Trends—Financial Engineering
Use of mathematical models and computer-based trading technology to synthesize new financial products Bundling and unbundling of cash flows
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Figure 1.3 Building Creates a Complex Security
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Figure 1.4 Unbundling of Mortgages into Principal- and Interest-Only Securities
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Recent Trends—Computer Networks
Online information dissemination Information is made cheaply and widely available to the public Automated trade crossing Direct trading among investors
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Asset Classes and Financial Instruments
CHAPTER 2 Asset Classes and Financial Instruments
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Major Classes of Financial Assets or Securities
Money market Bond market Equity Securities Indexes Derivative markets
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The Money Market Treasury bills Bid and asked price
Bank discount method Certificates of Deposits Commercial Paper Bankers Acceptances
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The Money Market Continued
Eurodollars Repurchase Agreements (RPs) and Reverse RPs Brokers’ Calls Federal Funds LIBOR Market
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Figure 2.1 Rates on Money Market Securities
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Table 2.1 Major Components of the Money Market
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Figure 2.2 Treasury Bill Yields
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Figure 2.3 The Spread between 3-month CD and Treasury Bill Rates
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The Bond Market Treasury Notes and Bonds
Inflation-Protected Treasury Bonds Federal Agency Debt International Bonds Municipal Bonds Corporate Bonds Mortgages and Mortgage-Backed Securities
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Treasury Notes and Bonds
Maturities Notes – maturities up to 10 years Bonds – maturities in excess of 10 years 30-year bond Par Value - $1,000 Quotes – percentage of par
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Figure 2.4 Lisiting of Treasury Issues
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Federal Agency Debt Major issuers Federal Home Loan Bank
Federal National Mortgage Association Government National Mortgage Association Federal Home Loan Mortgage Corporation
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Municipal Bonds Issued by state and local governments Types
General obligation bonds Revenue bonds Industrial revenue bonds Maturities – range up to 30 years
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Figure 2.5 Tax-exempt Debt Outstanding
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Municipal Bond Yields Interest income on municipal bonds is not subject to federal and sometimes not to state and local tax To compare yields on taxable securities a Taxable Equivalent Yield is constructed
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Table 2.2 Equivalent Taxable Yields Corresponding to Various Tax-Exempt Yields
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Figure 2.6 Ratio of Yields on Tax-Exempt to Taxable Bonds
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Corporate Bonds Issued by private firms Semi-annual interest payments
Subject to larger default risk than government securities Options in corporate bonds Callable Convertible
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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
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Figure 2.7 Mortgage-backed Securities Outstanding, 1979-2007
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Equity Securities Common stock Residual claim Limited liability
Preferred stock Fixed dividends -limited Priority over common Tax treatment Depository receipts
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Figure 2.8 Listing of Stocks Traded on the NYSE
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Stock Market Indexes There are several broadly based indexes computed and published daily There are several indexes of bond market performance Others include: Nikkei Average Financial Times Index
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Dow Jones Industrial Average
Includes 30 large blue-chip corporations Computed since 1896 Price-weighted average
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Example 2.2 Price-Weighted Average
Portfolio: Initial value $25 + $100 = $125 Final value $30 + $ 90 = $120 Percentage change in portfolio value = 5/125 = -.04 = -4% Index: Initial index value (25+100)/2 = 62.5 Final index value ( )/2 = 60 Percentage change in index -2.5/62.5 = -.04 = -4%
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Standard & Poor’s Indexes
Broadly based index of 500 firms Market-value-weighted index Index funds Exchange Traded Funds (ETFs)
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Other U.S. Market-Value Indexes
NASDAQ Composite NYSE Composite Wilshire 5000
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Figure 2.9 Comparative Performance of Several Stock Stock Indexes, 2001-2006
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Foreign and International Stock Market Indexes
Nikkei (Japan) FTSE (Financial Times of London) Dax (Germany) MSCI (Morgan Stanley Capital International) Hang Seng (Hong Kong) TSX (Canada)
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Derivatives Markets Options Basic Positions Call (Buy) Put (Sell)
Terms Exercise Price Expiration Date Assets Futures Basic Positions Long (Buy) Short (Sell) Terms Delivery Date Assets 51
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Figure 2.10 Trading Data on GE Options
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Figure 2.11 Listing of Selected Futures Contracts
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How Securities are Traded
CHAPTER 3 How Securities are Traded
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How Firms Issue Securities
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
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How Firms Issue Securities Continued
Investment Banking Shelf Registration Private Placements Initial Public Offerings (IPOs)
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Investment Banking Underwritten: firm commitment on proceeds to the issuing firm Red herring Prospectus
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Figure 3.1 Relationship Among a Firm Issuing Securities, the Underwriters and the Public
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Shelf Registrations SEC Rule 415 Introduced in 1982
Ready to be issued – on the shelf
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Private Placements Sale to a limited number of sophisticated investors not requiring the protection of registration Allowed under Rule 144A Dominated by institutions Very active market for debt securities Not active for stock offerings
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Initial Public Offerings
Process Road shows Bookbuilding Underpricing Post sale returns Cost to the issuing firm
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Figure 3.2 Average Initial Returns for IPOs in Various Countries
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Figure 3.3 Long-term Relative Performance of Initial Public Offerings
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How Securities are Traded
Types of Markets Direct search Least organized Brokered Trading in a good is active Dealer Trading in a particular type of asset increases Auction Most integrated
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Types of Orders Market—executed immediately Bid Price Ask Price
Price-contingent Investors specify prices Stop orders
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Figure 3.4 The Limit Order Book for Intel on the Archipelago Market, January 19, 2007
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Figure 3.5 Price-Contingent Orders
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Trading Mechanisms Dealer markets
Electronic communication networks (ECNs) Specialists markets
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U.S. Security Markets Nasdaq and NYSE have evolved in response to new information technology Both have increased their commitment to automated electronic trading
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Nasdaq National Market System Nasdaq Small Cap Market
Levels of subscribers Level 1 – inside quotes Level 2 – receives all quotes but they can’t enter quotes Level 3 – dealers making markets
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Table 3.1 Partial Requirements for Listing on NASDAQ Markets
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New York Stock Exchange
Member functions Commission brokers Floor brokers Specialists Block houses SuperDot
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Table 3.2 Some Initial Listing Requirements for the NYSE
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Table 3.3 Block Transactions on the New York Stock Exchange
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Other Systems Electronic Communication Networks
Private computer networks that directly link buyers with sellers National Market System Securities Act of Amendments of 1975 Bond Trading Automated Bond System (ABS)
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Market Structure in Other Countries
London - predominately electronic trading Euronext – market formed by combination of the Paris, Amsterdam and Brussels exchanges Tokyo Stock Exchange Globalization and consolidation of stock markets
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Figure 3.6 Market Capitalization of Major World Stock Exchanges, 2007
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Trading Costs Commission: fee paid to broker for making the transaction Spread: cost of trading with dealer Bid: price dealer will buy from you Ask: price dealer will sell to you Spread: ask - bid Combination: on some trades both are paid
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Buying on Margin Using only a portion of the proceeds for an investment Borrow remaining component Margin arrangements differ for stocks and futures
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Stock Margin Trading 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 that you must put up additional funds
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Margin Trading - Initial Conditions Example 3.1
X Corp $100 60% Initial Margin 40% Maintenance Margin 100 Shares Purchased Initial Position Stock $10,000 Borrowed $4,000 Equity $6,000
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Margin Trading - Maintenance Margin Example 3.1
Stock price falls to $70 per share New Position Stock $7,000 Borrowed $4,000 Equity $3,000 Margin% = $3,000/$7,000 = 43%
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Margin Trading - Margin Call Example 3.2
How far can the stock price fall before a margin call? (100P - $4,000)* / 100P = 30% P = $ * 100P - Amt Borrowed = Equity
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Table 3.4 Illustration of Buying Stock on Margin
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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
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Short Sale – Initial Conditions Example 3.3
Dot Bomb 1,000 Shares 50% Initial Margin 30% Maintenance Margin $100 Initial Price Sale Proceeds $100,000 Margin & Equity ,000 Stock Owed ,000
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Short Sale - Maintenance Margin
Stock Price Rises to $110 Sale Proceeds $10,000 Initial Margin ,000 Stock Owed ,000 Net Equity ,000 Margin % (4000/11,000) %
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Short Sale - Margin Call
How much can the stock price rise before a margin call? ($150,000* P) / (100P) = 30% P = $115.38 * Initial margin plus sale proceeds 88
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Regulation of Securities Markets
Major regulations Securities Act of 1933 Securities Act of 1934 Securities Investor Protection Act of 1970 Self-Regulation Stock markets are largely self-regulating
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Regulation Securities Markets Continued
Regulatory Responses to Recent Scandals Public Company Accounting Oversight Board Financial experts to serve on audit committees of boards of directors CEOs and CFOs personally certify firms’ financial reports Boards must have independent directors Sarbanes-Oxley Act
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Circuit Breakers Trading halts Collars
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Insider Trading Officers, directors, major stockholders must report all transactions in firm’s stock Insiders do exploit their knowledge Leakage of useful information to some traders
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Mutual Funds and Other Investment Companies
CHAPTER 4 Mutual Funds and Other Investment Companies
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Investment Companies These companies perform several important functions for investors: Administration & record keeping Diversification & divisibility Professional management Reduced transaction costs
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Net Asset Value Used as a basis for valuation of investment company shares Selling new shares Redeeming existing shares Calculation Market Value of Assets - Liabilities Shares Outstanding
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Types of Investment Companies
Unit Trusts Managed Investment Companies Open-End Open-end: shares outstanding change when new shares are sold or old shares are redeemed Priced at Net Asset Value(NAV) Closed-End no change in shares outstanding unless new stock is offered Priced at Premium or discount to NAV
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Figure 4.1 Closed-End Mutual Funds
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Types of Investment Companies Continued
Other investment organizations Commingled funds REITs Hedge Funds
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Mutual Funds—Investment Policies
Money Market Equity Sector Bond Balanced Asset Allocation and Flexible Index International
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Table 4.1 U.S. Mutual Funds by Investment Classification
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How Funds Are Sold Direct-marketed funds Sales force distributed
Revenue sharing on sales force distributed Potential conflicts of interest Financial Supermarkets
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Costs of Investing in Mutual Funds
Fee Structure Operating expenses Front-end load Back-end load 12 b-1 charges distribution costs paid by the fund Alternative to a load
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Fees and Mutual Fund Returns
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Fees and Mutual Fund Returns: An Example
Initial NAV = $20 Income distributions of $.15 Capital gain distributions of $.05 Ending NAV = $20.10:
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Table 4.2 Impacts of Costs on Investment Performance
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Trading Scandal with Mutual Funds
Late trading – allowing some investors to purchase or sell later than other investors Market timing – allowing investors to buy or sell on stale net asset values International Net effect is to transfer value from other shareholders to privileged traders Reduction in the rate of return of the mutual fund
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Potential Reforms Strict 4:00 PM cutoff with late orders executed the following trading day Fair value pricing with net asset values being adjusted for trading in open markets Imposition of redemption fees
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Taxation on Mutual Fund Income
Pass-through status under the U.S. tax code Taxes are paid only by the investor High turnover leads to tax inefficiency
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Exchange Traded Funds ETF allow investors to trade index portfolios like shares of stock Examples - SPDRs and WEBS Potential advantages Lower taxes Trade continuously Lower costs Potential disadvantages Prices can depart by small amounts from NAV
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Table 4.3 EFT Sponsors and Products
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Mutual Fund Investment Performance: A First Look
Evidence shows that average mutual fund performance is generally less than broad market performance Evidence that performance is consistent from one period to the next is suggestive but inconclusive
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Figure 4.2 Diversified Equity Funds versus Wilshire 5000 Index
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Table 4.4 Consistency of Investment Results
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Information on Mutual Funds
Wiesenberger’s Investment Companies Morningstar ( Yahoo (biz.yahoo.com/funds) Investment Company Institute ( Directory of Mutual Funds
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