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FIN670: Investment Analysis
Chapter 1: Background and Financial Instruments
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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
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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
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Balance Sheet – U.S. Households
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Financial Assets Money Market (Short-term) Bond Market (Long-term)
Common Stocks Preferred Stocks Options Futures
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Role of Financial asset and financial markets in the Economy
Consumption Timing Allocation of Risk Separation of Ownership and Management
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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?
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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)
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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
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The Investment Process
Asset allocation Security selection Risk-return trade-off Market efficiency Active vs. passive management
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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
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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.
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Example of Security Selection
Wal-Mart Nordstroms Sears Bank of America Berkshire Hathaway Citibank
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There is no free lunch!
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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
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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
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Players in the Financial Markets
Business Firms – net borrowers Households – net savers Governments – can be both borrowers and savers Investment Bankers
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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
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Recent Trends Globalization Securitization Financial Engineering
Computer Networks
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Globalization In 1970, US equity market accounted for about 70 percent of equity in the world Currently, only 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
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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
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Figure 1.2 Asset-backed Securities Outstanding
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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
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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.
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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)
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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.
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Subprime Mortgage Crisis: Winners and Losers
Big losers: 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.
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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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2008: Making History
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2008: The End of Wall Street
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Decision Making Perceive the situation Possible actions
Evaluate the outcomes Choose the action with the best outcome
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Investments: Asset classes and financial instruments
CHAPTER 2
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Financial Securities Low Risk High Risk Money Market (Short-term)
Bond Market (Long-term) Common Stocks Preferred Stocks Options Futures Index
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Money Market Instruments
üTreasury Bills Certificates of deposit Commercial paper Banker’s acceptances Eurodollars Repos and reverses Brokers’ calls * Federal funds LIBOR
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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
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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)
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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
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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
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Table 2.2 Components of the Money Market
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Bond Market Treasury Notes and Bonds Federal Agency Debt
International Bonds Inflation-Protected 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 Par Value - $1,000 Quotes – percentage of par, in 32nd
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Figure 2.4 Treasury Notes and Bonds
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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
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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
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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):
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Figure 2.6 Ratio of Yields on Tax-exempts to Taxables, 1955-2006
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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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Figure 2.7 Investment Grade Bond Listings
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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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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
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Figure 2.7 Mortgage-backed Securities Outstanding, 1979-2007
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Equity Markets Common stock Preferred stock Depository receipts
stock market listing
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Equity Markets Common stock Characteristics Right to vote
Right to share benefit Proxy Proxy fight Characteristics Residual claims Limited liabilities
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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
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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
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Figure 2.8 Listing of Stocks Traded on the NYSE
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Uses of Stock Indexes Track average returns
Comparing performance of managers Base of derivatives
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Examples of Other Indexes - Domestic
Dow Jones Industrial Average (30 Stocks) Standard & Poor’s 500 Composite NASDAQ Composite NYSE Composite Wilshire 5000
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Figure 2-10 Comparative Performance of Several Stock Market Indexes
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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
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Table 2.6 Sample of MSCI Stock Indexes
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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)
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Price Weighted Indices
DJIA is an example 30 blue chip companies DJIA = (P1+P P30)/d where d is Dow divisor. Originally d = 30 Currently, d = 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
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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?
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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
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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.
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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
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Table 2.4 Data to Construct Stock Price Indexes
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Bond Index Computed monthly Difficulty in measuring true returns
Best known: Merrill Lynch Lehman Brothers Salomon Smith Barney
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DERIVATIVE MARKETS
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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
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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
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Figure 2.10 Trading Data on GE Options
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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
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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
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Figure 2.11 Listing of Selected Futures Contracts
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There is no free lunch! Derivatives Stocks Corporate Bonds T-Bonds
Money
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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
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