How to pick stocks?

1. How to pick stocks? • Good company vs good stock • Macroeconomic condition • Profitability and investment

2. Price of Gambles • Gamble #1: You flip a fair coin, head I give you $110, tail I give you $90. How much are you willing to pay me to enter this gamble? • Gamble #2: You flip a fair coin, I give you $100 in a year no matter what happens. How much are you willing to pay me today to enter this gamble?

3. Consumption Preference • Which do you prefer? • A) Starve (nearly to death) on odd days and stuff on even days; or • B) Eat comfortably every day.

4. Help these two ladies • Two old ladies live in the same town. One makes a living by selling umbrellas, the other sells sunglasses. When it rains, the umbrella-selling lady will be happy but the sunglass lady will be upset. When it is sunny, it is the reverse. • How do you make both ladies happier without costing you anything?

5. FINA 2802: Investments and Portfolio AnalysisFinancial SecuritiesDragon Yongjun TangJanuary 14 & 19, 2010

6. Lectures 2 & 3: Financial Securities • Reading: Chapter 2 • Practice Problem Sets: 1,2,3,6,8,9,11,12,13,17

7. Learning Objectives • Distinguish among the major assets that trade in money markets and in capital markets • Describe the construction of stock market indexes • Calculate the profit or losses on investments in options and futures contracts

8. Financial Securities High Risk Low Risk Money Market (Short-term) Bond Market (Long-term) Common Stocks Preferred Stocks Options Futures Index

9. Money Market Instruments üTreasury Bills Certificates of deposit Commercial paper Banker’s acceptances Eurodollars Repos and reverses Brokers’ calls * Federal funds LIBOR

10. Treasury Bills • Most marketable of money market instruments • Face value paid at maturity • Sold at a discount to face via auction • Issue: • - 28 days (1 month), 91 days (3-month) and 182 • days (6 month): weekly • Minimum denomination is $10,000

11. Figure 2.2 Treasury Bills

12. Figure 2.1 Money Rates

13. Figure 2.3 Spreads on CDs and Treasury Bills • Difficult to predict • Widen during crisis

14. Bond Market • Treasury Notes and Bonds • Inflation-Protected Treasury Bonds (TIPS) • Federal Agency Debt • International Bonds • Municipal Bonds • Corporate Bonds • Mortgages and Mortgage-Backed Securities

15. Treasury Notes and Bonds • Maturities • Notes – maturities up to 10 years • Bonds – maturities in excess of 10 years • 30-year bond • 2001 Treasury suspended sales • 2005 resume sales • Par Value - $1,000 • Quotes – percentage of par; in 32nd

16. Figure 2.4 Treasury Notes, Bonds and Bills

17. Federal Agency Debt • Major issuers • Federal Home Loan Bank • Federal National Mortgage Association (“Fannie Mae”) • Government National Mortgage Association (“Ginnie Mae”) • Federal Home Loan Mortgage Corporation (“Freddie Mac”)

18. Figure 2.5 Government Agency & Similar Issues

19. Municipal Bonds • Issued by state and local governments • Types • General obligation bonds • Revenue bonds • Industrial revenue bonds • Maturities – range up to 30 years

20. Municipal Bond Yields • Interest income on municipal bonds is not subject to federal and sometimes state and local tax • To compare yields on taxable securities a Taxable Equivalent Yield is constructed

21. Municipal Bonds Interest is exempt from Federal taxes After-tax return (taxable bond): After-tax return (Municipal bond):

22. Figure 2.7 Ratio of Yields on Tax-exempts to Taxables

23. Equivalent Taxable Yield

24. Table 2.3 Equivalent Taxable Yields

25. Corporate Bonds • Semiannual coupon payments • Nominal value (Par) is $1,000 • Actual percentage used for quote • Current Yield=coupon/close • Volume in Thousands • Subject to larger default risk than government securities • Options on the bonds: Callable and convertibles

26. Figure 2.8 Corporate Bond Prices

27. Bond Market • Treasury Notes and Bonds • Federal Agency Debt • International Bonds: Eurobonds; Yankee Bonds, Samurai bonds; Dragon bonds • Municipal Bonds • Corporate Bonds • Mortgages and Mortgage-Backed Securities

28. Outstanding U.S. Bond Market Debt in 2006 (US$Billions) Source: Securities Industry and Financial Markets Association (www.sifma.org)

29. “mini-bond” • Not well defined! • Official term: credit-linked notes • Credit derivative! • Counterparty risk!

30. Equity Markets • Common stock • Residual claim • Limited liability • Preferred stock • Fixed dividends - limited • Priority over common • Tax treatment • Depository receipts

31. Figure 2.10 Listing of Stocks Traded on the NYSE

32. What is Dow Jones?

33. What is Dow Jones? • Charles Dow; Edward Jones • Inventors of tickers • Publishing WSJ, Barrons, etc.

34. Uses of Stock Indexes • Track average returns • Comparing performance of managers • Base of derivatives

35. Factors for Construction of Stock Indexes • Representative? • Broad or narrow? • How is it weighted?

36. Examples of Indexes – U.S. Domestic • Dow Jones Industrial Average (30 Stocks) • Standard & Poor’s 500 Composite • NASDAQ Composite • NYSE Composite • Wilshire 5000

37. Figure 2-11 Comparative Performance of Several Stock Market Indexes

38. Examples of Indexes - Int’l • Hang Seng Index; Shanghai Composite • Nikkei 225 & Nikkei 300 • FTSE (Financial Times of London) • Dax • Region and Country Indexes • EAFE • Far East • United Kingdom

39. Construction of Indexes • How are stocks selected? • Subjective • How are stocks weighted? • Price weighted (DJIA) • Market-value weighted (S&P500, NASDAQ) • Equally weighted (Value Line Index)

40. Price Weighted Indices • Computed by adding all the prices in the index and dividing by a divisor • Implies one share for each stock • Implies a buy-and-hold strategy • Gives high weight to high price stocks • DJIA is an example

41. Derivation of Price-Weighted Index

42. 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?

43. Value-Weighted Indices • Calculated by adding the total market value of the firms in the index • Implies buy and hold strategy • S&P 500 is an example

44. Derivation of Value-Weighted Index

45. Example of 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.

46. Example of Value-Weighted Index (a) Find the the value-weighted index composed of these two stocks at the final date. Assume the initial level of the index is 100. (b) Now if stock XYZ is split two for one, how will the market value-weighted index be affected?

47. Equally Weighted Indices • Computed by assumingequal dollar amountin each stock • Implies periodic rebalancing of the portfolio (no buy and hold) • CRSP index is an example

48. Derivation of Equally Weighted Index

49. Example of Equally 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.

50. Example of Equally Weighted Index (a) Find the the equally weighted index composed of these two stocks at the final date. Assume initially $100 are invested in each stock. (b) At the final date, how should you rebalance your portfolio to have an equally weighted portfolio?