1. McGraw-Hill/Irwin Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 1-4 1. The asset management game: a primer

2. 2-2 Major Types of Securities Debt Money market instruments Bonds Common stock Preferred stock Derivative securities

3. 2-3 Markets and Instruments Money Market Debt Instruments Derivatives Capital Market Bonds Equity Derivatives

4. 2-4 Money Market Instruments Treasury bills Certificates of deposit Commercial Paper Bankers Acceptances Eurodollars Repurchase Agreements (RPs) and Reverse RPs Domestic interbank market LIBOR Market

5. 2-5 Bond Markets Treasury Bonds and Notes Agency Issues International Bonds Municipal Bonds Corporate Bonds Mortgage-Backed Securities

6. 2-6 Derivatives 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

7. 2-7 Capital Market - Equity Common stock Residual claim Limited liability Preferred stock Fixed dividends - limited Priority over common Tax treatment

8. 2-8 Stock Market Indexes 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?

9. 2-9 Examples of Indexes - Domestic Dow Jones Industrial Average (30 Stocks) Standard & Poor’s 500 Composite NASDAQ Composite / NYSE Composite Wilshire 5000 Nikkei 225 & Nikkei 300 FTSE (Financial Times of London) Dax / CAC / MIB / Region and Country Indexes Stoxx

10. 2-10 Bond Indexes Lehman Brothers Merrill Lynch Salomon Brothers Specialized Indexes Merrill Lynch Mortgage

11. 2-11 Construction of Indexes – I How are stocks weighted? Price weighted (DJIA) Market-value weighted (S&P500, NASDAQ) Equally weighted (Value Line Index) How returns are averaged? Arithmetic (DJIA and S&P500) Geometric (Value Line Index)

12. 2-12 Averaging Methods Component Return A=10% B= (-5%) C = 20% Arithmetic Average [.10 + (-.05) +.2] / 3 = 8.33% Geometric Average [(1.1) (.95) (1.2)] 1/3 - 1 = 7.84%

13. 2-13 Construction of Indexes - II How are they updated? intraday (MIB30, S&P/MIB) daily (MIB) How are the constituents chosen? entire security universe (global index) main securities (headline index) securities sharing a common feature sector, size, value source

14. 2-14 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.

15. 2-15 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.

16. 2-16 Public Offerings Public offerings registered with the authority (SEC, CONSOB) sale is made to the investing public. shelf registration (Rule 415, delega amm/tori) Initial Public Offerings (IPOs) Evidence of underpricing Short and long term performance 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.

17. 2-17 Organization of Secondary Markets Organized exchanges Regulated markets ATS / MTF / ECN OTC market Third market Fourth market

18. 2-18 Organized Exchanges Auction (order driven) markets centralized order flow on an electronic (limit) order book Dealer (quote driven) markets competitive dealership function; specialist role based either on issuer’s mandate or exchange designation Stock, futures & options, and to a lesser extent, bonds.

19. 2-19 Other Market OTC Dealer market without centralized order flow. information system for individuals, brokers, dealers Used for bonds, derivatives, stocks. Third Market Trading of listed securities away from the exchange, usually involving services of dealers and brokers. Institutional market: to facilitate trades of larger blocks of securities. Fourth Market Institutions trading directly with institutions (no middleman) Organized information and trading systems ECN Development

20. 2-20 Trading Services & Costs Services Order collection Order routing Execution Confirmation and clearing Central counterparty service Settlement Costs Commission (brokers, exchanges, clearinghouse, CSD) Bid/ask spread Time to execution

21. 2-21 Types of Orders Instructions on how to complete the order Market vs. Limit Stop loss Fill or kill vs. Good till … Market opening / close Margin trading Asset purchase partly based on borrowed money. Margin arrangements differ for stocks and futures. In USA, maximum initial margin 50% set by the Fed Maintenance margin is the minimum level the equity margin can be Margin call: Call for more equity funds

22. 2-22 X Corp1000 shares purchased @ $70 Margin: 50%Initial; 40% Maintenance Initial Position Stock $70,000 Borrowed $35,000 Equity $35,000 New Position if price drops to $60 per share Stock $60,000 Borrowed $35,000 Equity $25,000 Margin% = $25,000/$60,000 = 41.67% Margin Trading - Initial Conditions

23. 2-23 Margin Trading - Margin Call How far can the stock price fall before a margin call? (1000P - $35,000)* / 1000P = 40% P = $58.33 * 1000P - Amount Borrowed = Equity

24. 2-24 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 it was borrowed.

25. 2-25 Short Sale - Initial Conditions Z Corp100 Shares@ $100 Margin: 50% Initial; 30% Maintenance Sale Proceeds $10,000I. Margin 5,000 Stock Owed $10,000Equity 5,000 Stock Price Rises to $110 Sale Proceeds$10,000 Margin$ 5,000 Stock Owed$11,000 Net Equity $ 4,000 Margin % (4000/11000) = 36% > 30% (maintenance m.) How much can the price rise before a margin call? (15,000* - 100P) / (100P) = 30%P = $115.38 * Initial margin plus sale proceeds

26. 2-26 Regulation of Securities Markets Fair and orderly trading Insider trading and market abuse Pre and post trade transparency Order routing (concentration vs. fragmentation) Trading rules (tick size, priority, circuit breakers,…) Conduct of business conflict of interests (prevent, manage, disclose) retail investor protection Regulation Law, Authority Exchange Self-Regulation

27. 2-27 Services Administration & record keeping Diversification & divisibility Professional management Reduced transaction costs Types Unit Trusts Managed Investment Companies Open-End vs. Closed-End Other investment organizations Commingled funds REITs Hedge funds Investment Companies

28. 2-28 Used as a basis for valuation of investment company shares. Selling new shares Redeeming existing shares Calculation Market Value of Assets - Liabilities Shares Outstanding Net Asset Value

29. 2-29 Shares Outstanding Closed-end: no change unless new stock is offered. Open-end: changes when new shares are sold or old shares are redeemed. Pricing Open-end: Net Asset Value(NAV) Closed-end: Premium or discount to NAV Open-End vs. Closed-End Funds

30. 2-30 Money Market Fixed Income Equity Balance & Income Asset Allocation Indexed Specialized Sector Investment Policies

31. 2-31 Fee Structure Front-end loadvs. Back-end load No load Operating expenses 12 b-1 charges distribution costs paid by the fund Alternative to a load Fees Management fees Performance fees (symmetric vs. fulcrum) Bounds, high watermark, frequency Costs of Investing in Mutual Funds

32. 2-32 Exchange Traded Funds Allow investors to trade funds based on indexes like stock. Examples SPDRS WEBS HOLDERS Allow sector specialization

33. 2-33 A First Look at Fund Performance Most funds underperform their benchmark Not fair comparison because of costs Result holds even if passive management costs considered. Do some mf consistently outperform? Some evidence suggests so Depends on measurement interval and on time period Evidence shows consistency of poor performance Correlation with high fees

34. 2-34 Morningstar Press Assogestioni Wiesenberger’s Investment Companies Investment Company Institute Information providers Advisors Sources of Information on Mutual Funds