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Chapters 1 & 2

Chapters 1 & 2. Investments - Background and Issues Financial Markets and Instruments. Investments & Financial Assets. Essential nature of investment Reduced current consumption Planned later consumption Real Assets Assets used to produce goods and services Financial Assets

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Chapters 1 & 2

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  1. Chapters1 & 2 Investments - Background and Issues Financial Markets and Instruments

  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. The Investment Process • Asset allocation • Security selection • Risk-return trade-off • Market efficiency • Active vs. passive management

  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. 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

  6. 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

  7. 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

  8. Key Trends - Financial Engineering Repackaging Services of Financial Intermediaries • Bundling and unbundling of cash flows • Slicing and dicing of cash flows • Examples: CMOs, principal/interest splits

  9. 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

  10. Major Classes of Financial Assets or Securities • Debt • Money market instruments • Bonds • Common stock • Preferred stock • Derivative securities

  11. Markets and Instruments • Money Market • Debt Instruments • Derivatives • Capital Market • Bonds • Equity • Derivatives

  12. Money Market Instruments • Treasury bills • Certificates of deposit • Commercial Paper • Bankers Acceptances • Eurodollars • Repurchase Agreements (RPs) and Reverse RPs • Federal Funds

  13. 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

  14. - P 10,000 360 x r = BD n 10,000 - 10,000 9,875 360 x r = = 5% BD 90 10,000 Bank Discount Rate (T-Bills) rBD = bank discount rate P = market price of the T-bill n = number of days to maturity Example 90-day T-bill, P = $9,875

  15. 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

  16. P 10,000 - 365 x r = BEY n P 10,000 - 9,875 365 x r = BEY 9,875 90 Bond Equivalent Yield P = price of the T-bill n = number of days to maturity Example Using Sample T-Bill rBEY = .0127 x 4.0556 = .0513 = 5.13%

  17. Effective Annual Rate of Return • Similar to the bond equivalent yield • However, the annualized rate is compounded. r = 10,000-9,875 = 0.0127 9,875 EAR = (1.0127)4 - 1 = 0.0518 = 5.18%

  18. Capital Market - Fixed Income Instruments Publicly Issued Instruments • US Treasury Bonds and Notes • Agency Issues (Fed Gov) • Example FHLB, FNMA • Municipal Bonds • General obligation or revenue Privately Issued Instruments • Corporate Bonds • Mortgage-Backed Securities

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

  20. Stock 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?

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

  22. Examples of Indexes - Int’l • Nikkei 225 & Nikkei 300 • FTSE (Financial Times of London) • Dax • Region and Country Indexes • EAFE • Far East • United Kingdom

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

  24. Options Basic Positions Call (Buy) Put (Sell) Terms Exercise Price Expiration Date Assets Futures Basic Positions Long (Buy) Short (Sell) Terms Delivery Date Assets Derivatives Securities

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