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INTRODUCTION TO DERIVATIVES MARKETS (INVESTMENTS BACKGROUND) SPRING 2006

INTRODUCTION TO DERIVATIVES MARKETS (INVESTMENTS BACKGROUND) SPRING 2006. REAL VS. FINANCIAL ASSETS. A. REAL ASSETS Plant and Equipment=Physical Capital Growth Opportunities: e.g. R&D, Patents, New Ventures Human Capital=Expertise, Labor Services

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INTRODUCTION TO DERIVATIVES MARKETS (INVESTMENTS BACKGROUND) SPRING 2006

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  1. INTRODUCTION TO DERIVATIVES MARKETS (INVESTMENTS BACKGROUND) SPRING 2006

  2. REAL VS. FINANCIAL ASSETS A. REAL ASSETS • Plant and Equipment=Physical Capital • Growth Opportunities: e.g. R&D, Patents, New Ventures • Human Capital=Expertise, Labor Services • Contribute Directly to the Productive Capacity of the Economy (i.e. to GNP Growth)

  3. REAL VS. FINANCIAL ASSETS B. FINANCIAL ASSETS • Stocks, Bonds, Hybrid Securities • Are Claims to the After-Tax Earnings Streams Generated by Real Assets • Provide an Incentive to Invest in Real Assets by Providing Liquidity • Establishes a Pricing (Valuation) Mechanism for Real Assets • Thereby Contribute Indirectly to the Productive Capacity of the Economy

  4. CLIENTS OF THE FINANCIAL SYSTEM • THE HOUSEHOLD SECTOR (INDIVIDUALS)The financial assets households desire to hold depend on their tax status, investment horizons, need for liquidity, cash-flow needs, and risk preferences. • THE BUSINESS SECTOR (CORPORATIONS) Raises money by debt and equity issues in primary capital markets. The business sector raises money efficiently by using investment bankers and by keeping securities simple. • THE GOVERNMENT SECTOR (STATE, FEDERAL, AND MUNICIPALAGENCIES ) Can only borrow through debt issues and taxation,but regulates the financial sector.

  5. FLOW OF CASH BETWEEN CAPITAL MARKETS AND FIRM’S OPERATIONS 2 .CASH INVESTED IN FIRM 1. CASH RAISED FROM INVESTORS FIRM’S OPERATIONS CAPITAL MARKETS FINANCIAL MANAGER 5.CASH RE- INVESTED 3. CASH GENERATED BY OPERATIONS 4. CASH RETURNED TO INVESTORS

  6. MONEY MARKET INSTRUMENTS • U.S. TREASURY BILLS • FEDERAL FUNDS • EURODOLLARS • REPOS AND REVERSES • BROKER CALLS • THE LIBOR MARKET • COMMERCIAL PAPER • BANKER’S ACCEPTANCES

  7. TREASURY BILL PRICING CONVENTIONS • FOR PURPOSES OF DISCOUNTING, THE TREASURY USES 360 DAYS AS ITS YEAR • BOND YIELDS, ON THE OTHER HAND, ARE QUOTED ON THE BASIS OF A 365 DAY YEAR • HENCE ADJUSTMENTS MUST BE MADE

  8. TREASURY BILL TERMINOLOGY • P=CURRENT PRICE • F=FACE VALUE • N=NUMBER OF DAYS TO MATURITY • BDY=BANK DISCOUNT YIELD • BEY=BOND EQUIVALENT YIELD

  9. PRICING U.S. TREASURY BILLS • STEP #1. DETERMINE THE NUMBER OF DAYS TO MATURITY: N. • STEP #2. CALCULATE THE DOLLAR DISCOUNT CORRESPONDING TO N. THIS IS CALLED THE DOLLAR BANK DISCOUNT YIELD; D=(BDY*F*N)/360 • STEP #3. THE CURRENT PRICE P=F-D • STEP #4. CALCULATE THE HOLDING PERIOD YIELD, HPY=D/P • STEP #5 CALCULATE THE BOND EQUIVALENT YIELD, BEY=HPY*365/N

  10. TREASURY BILL PRICING FORMULAE • CURRENT PRICE, P=F(1-BDY*N/360) • BOND EQUIVALENT YIELD (BEY) BEY=365*BDY/(360-BDY*N)

  11. U.S. TREASURY BILLS ‘PRICE’ QUOTE • (SOURCE: www.bloomberg.com)

  12. MONEY RATES (SOURCE: WSJ 01/06/03) See BKM Text p. 32 Figure 2.1

  13. MEDIUM TO LONG-TERM FIXED INCOME INSTRUMENTS • U.S. TREASURY NOTES AND BONDS • FEDERAL AGENCY DEBT • MUNICIPAL BONDS (MUNIS) • CORPORATE BONDS • MORTGAGES • MORTGAGE-BACKED SECURITIES

  14. TREASURY BOND PRICING CONVENTIONS • TREASURY BONDS ARE QUOTED IN DOLLARS PLUS 32ND’S PER FACE VALUE. THE LATTER ARE CALLED BOND POINTS • E.G. A BOND POINT (1/32) TRANSLATES INTO $1,000/32=$31.25 FOR EACH $1,000 OF FACE VALUE • BOND YIELD TO MATURITY (YTM) IS THE BOND’S IRR BASED ON A 365 DAY YEAR

  15. (SOURCE:WSJ(01/06/03) See Text BKM Figure 2.3 Page 37) 4.750 Nov08n 107:25 107:26 1 3.27 US TREASURY BOND PRICE QUOTATIONS

  16. U.S. T-BOND CALCULATIONS • HIGHLIGHTED BOND (06/01/03): • Coupon Rate = 4.75%; coupon payment; 4.75 % of face value paid annually; coupon payments are paid every six months (i.e. semi-annually) • Maturity = November 2008. • Bid Price = 107:25 NOTE: this means 107 25/32per each $100 of face value. • Ask Price = 107:26 or107 26/32 per $100 of face value • 1 = ask price up by 1/32 from previous day’s ask price. • Ask yield = the yield to maturity (IRR) of the bond based on the asked price=3.27%

  17. CORPORATE BOND QUOTATIONS See text BKM Figure 2.7, page 42

  18. READING CORPORATE BOND QUOTATIONS • HIGHLIGHTED BOND: • Bond =ATT, 73/4% coupon, maturing in 2007. • Interest paid semiannually; $77.50 per $1,000 of face value. • Current yield = $77.50/$1060 =7.3 % = annual coupon / current bond price. • Trading volume = 54 $1000 face value bonds traded that day. • Closing price =$1060 per $1,000 of face value (i.e. a premium bond). • Net change =closing price 1/2% up from closing price on the previous day.

  19. READING STOCK MARKET QUOTATIONS(SOURCE WSJ (09/08/97) See text BKM Figure 2.9, page 46

  20. READING STOCK MARKET QUOTES • HIGHLIGHTED FIRM (GE CORP.) • 52 week high and low stock price per share:$41.24 and $21.40 respectively. • Dollar Dividends: $.76 /share annually. • Dividend Yield: annual dividend/current price=3.0 %=.76/25.40 • PE: price earnings ratio=16. • Volume: 100’s of shares traded that day =148191 • High and low for that trading day : see www.nyse.com • Closing Price=$25.40 per share. • Net change: -$.08 per share from previous day’sclose.

  21. STOCK AND BOND MARKET INDICES STOCK INDICES : • DJIA • S&P 500 • NYSE • AMEX • NASDAQ • WILSHIRE 5000 • VALUELINE • CRSP VW* • CRSP EW** BOND INDICES: • SOLOMON BROTHERS • LEHMAN BROTHERS * Center for Research on Security Prices, value-weighted ** Center for Research on Security Prices, equally-weighted

  22. STOCK MARKET INDICES: EXAMPLES • DJIA: 30 “blue chip” stocks; NYSE traded: price weighted: divisor adjustment produces a large number average with large movements; overly influenced by higher priced stocks; oldest; most frequently quoted. • S&P 500: 500 stocks - industrials, transportation, utilities, financials -- NYSE and NASDAQ traded, value weighted.. • NYSE: All NYSE-listed stocks; value weighted. • NASDAQ: All stocks listed on NASDAQ; value weighted.. • WILSHIRE 5000:Value weighted; all exchange listed and NASDAQ listed stocks; most comprehensive, readily available stock index. • VALUELINE: 1,700 stocks; price weighted, no divisor manipulation; geometric average.

  23. THREE TYPES OF STOCK MARKET INDICES PRICE-WEIGHTED • implies one share of each stock is purchased, • therefore overweights the higher priced stocks in the index, VALUE-WEIGHTED • implies that stocks are held in the index in proportion to their relative market values, EQUALLY-WEIGHTED • implies that equal dollar amounts of each stock are purchased.

  24. IN-CLASS PROBLEM ON THE TYPES OF INDICES Use the following information to answer questions 1-4: BASE YEAR Stock PriceShares A $40 10,000,000 B $50 20,000,000 C $60 30,000,000

  25. CURRENT YEAR Stock Price Shares A $22 20,000,000 B $55 20,000,000 C $66 30,000,000 1. What is the percentage change in a price-weighted index ? 2. What is the percentage change in a market value-weighted index ? 3. What is the percentage change in an equally-weighted index ? 4. What is the geometric average of the returns? CONTINUED

  26. SOLUTION TO IN-CLASS PROBLEM • 1. A price-weighted index simply adds up the prices of the individual stocks underlying the Index’s construction and divides by the number of such stocks. • Therefore, the initial value of the Index is: $40+$50+$60/3=$50. • If we did the same in the current year we would obtain: $22+$55+$66/3=47.67 which represents a -4.67% decline in the index. But did it decline ?

  27. IN-CLASS SOLUTION (CONT.) • Since there are double the number of shares outstanding in the current year compared to the base year, the stock must have split 2 for 1. Part of the decline in the Index was caused by this stock split and therefore does not represent a true decline in the market. To account for this, the divisor used in calculating the Index must be adjusted: let x be the new value of the divisor. Then x is given as the solution to: • $20+$50+$60/x=$40+$50+$60/3 • x=2.6

  28. IN-CLASS SOLUTION (CONT.) • In computing the new value of the Index we use the adjusted divisor 2.6 instead of 3.0 • Index in current year= $22+$55+$66/2.6=$55 • The percentage change in the Index (representing the true increase in the market) is $55-$50/$50=10%

  29. IN-CLASS SOLUTION (CONT.) • 2. A value-weighted Index multiplies each price by the number of shares outstanding and therefore automatically adjusts for stock splits. • Value of the Index in the base year: $40*10mm+$50*20mm+$60*30=3200mm • Usually, this is set to a standard number in the base year, e.g. 100 Index points by dividing by 32. The value of the Index in the base year is 100.

  30. IN-CLASS SOLUTION (CONT.) • Value of the Index in the current year: $22*20mm+$55*20mm+$66*30=3520mm • Note the automatic adjustment for the stock split. The value of the Index in the base year is 3520/32=110 • Clearly the Index increased by 110-100/100=10%

  31. IN-CLASS SOLUTION (CONT.) • 3. An equally- weighted Index requires that the same dollar investment be placed in each stock in the Index. The least common divisor of the stock prices in the base-year $40, $50, and $60 is $ 2400. • $2400 purchases 60 shares of stock A (60*$40=$2400), 48 shares of stock B (48*$50=$2400), and 40 shares of stock C (40*$60=$2400). • The adjustment for stock splits • occurs naturally because in the current year you own 120 shares

  32. IN-CLASS SOLUTION (CONT.) • The value of the Index in the base-year is just the value of the dollars invested in it: • $2400+$2400+$2400=$7200 • Normalize to 100 Index points by dividing by 72 . • The value of the Index in the current year is 120*$22+48*$55+40*$66=$7920 • Divide by 72 to obtain 110. • This represents a $10% increase as before. • 4. Stock A increased by 10% after adjusting for the stock split ($20 to $22), Stock B by 10% ($50 to $55) and Stock C by 10% ($60 to $66). The geometric average is 10%.

  33. MARGINING OF LONG EQUITY POSITIONS INITIAL MARGINS • SET BY THE FEDERAL RESERVE • CURRENTLY EQUALS 50% • INITIAL MARGIN=INVESTOR’S EQUITY/MARKET VALUE OF SECURITIES HELD • E.G. AN INVESTOR PURCHASES $10,000 WORTH OF COMMON STOCKBY PUTTING $6,000 DOWN AND BORROWING $4,000 • HIS INITIAL MARGIN=$6,000/$10,000=60%.

  34. MARGINS (CONT.) MAINTENANCE MARGINS • SET BY BROKERS • CURRENTLY 30% • E.G. SUPPOSE THAT THE MARKET VALUE OF THE STOCKS HELD FALLS TO $5,000. THE LOSS COMES OUT OF THE CUSTOMER’S EQUITY, HENCE THE ACTUAL MARGIN=$1,000/$5,000=20% THIS REQUIRES AN ADDITIONAL $5,00 FROM THE INVESTOR TO RESTORE THE MAINTENANCE MARGIN LEVEL TO 30% OR THE BROKER CAN SELL OFF $1,667 OF THE INVESTMENT

  35. THE MECHANICS OF SHORT SALES • The way it’s supposed to work: • STEP 1: BORROW STOCK FROM BROKER, • STEP 2: SELL STOCK AT CURRENT PRICE (SAY, 100 DOLLARS A SHARE), • STEP 3: HOPEFULLY, BUY BACK STOCK AT LOWER PRICE (SAY, 80 DOLLARS PER SHARE, • STEP 5: ENJOY 20 DOLLAR PROFIT. • The way it could work: • STEP 1: BORROW STOCK FROM BROKER, • STEP 2: SELL STOCK AT CURRENT PRICE (SAY, 100 DOLLARS A SHARE), • STEP 3.THE STOCK PRICE KEEPS GOING UP. SO YOU GIVE UP AND BUY STOCK AT HIGHER PRICES (SAY, 120 DÓLLARS PER SHARE), • STEP 4 .RETURN SHARES TO BROKER, • STEP 5. WEEP OVER 20 DOLLAR LOSS.

  36. THE MARGIN CALL PRICE ON LONG POSITIONS • How low can the security price fall before the investor receives a margin call ? • Let L= the amount borrowed from the broker. • Let N= the number of shares purchased • Let M= the maintenance margin level • Then Pm=(L/N(1-M)) • E.g. Pm=(4000/(100x(1-0.30))=57.14

  37. THE MARGIN CALL PRICE ON SHORT POSITIONS • Let N = the number of shares sold short, • P0=the price per share at the time of the short sale, • P1=the price per share when the short sale is covered, I.e. the shares are bought back. • IM=the initial margin • M= the maintenance margin level • Then Pm=(Nx P0+IM)/(Nx(M+1))

  38. THE MARGIN CALL PRICE ON SHORT POSITIONS: EXAMPLE • Suppose that you sell short 100 shares at 100 dollars per share. You post 5,000 in initial margin, • The maintenance margin requirement is 30 %, • Then the margin call price is • (10,000+5000)/(100x(0.3+1))= 115.38

  39. We need a definition of ‘investment’ sufficiently general to encompass investments in real assets and investment in financial assets. Further, it should apply to explaining the connection between the two. The following definition serves: THE SACRIFICE OF (CERTAIN) PRESENT CONSUMPTION FOR FUTURE (GENERALLY UNCERTAIN) CONSUMPTION DEFINING INVESTMENTS: A GENERAL DEFINITION

  40. THE PROBLEM SOLVED BY INVESTMENTS • Re-allocating consumption claims (certain and uncertain) across time and under conditions of uncertainty

  41. ONE MAIN REASON FOR INVESTING • IN ORDER TO REALLOCATE CONSUMPTION CLAIMS IN THE PRESENT AND IN THE FUTURE FROM GIVEN PATTERNS INTO PREFERRED PATTERNS. • THE PRICING MECHANISM GIVES THE RATES AT WHICH THIS IS POSSIBLE IN THE MARKET THROUGH A VARIETY OF FINANCIAL VEHICLES.

  42. Consumption later CONSUMPTION CHOICES 2.5 2.2 Invest in tennis facility 1.4 1.1 Invest in the bank Consumption now (millions) Villa in Spain 2.0 2.3 2.5

  43. BORROWING AND LENDING ENLARGE CHOICES Dollars, period 1 H Interest rate lines shows cash flows from borrowing or lending F O B D Dollars, period 0 By borrowing OF, an individual can consume an extra BD today; by lending OB, he can consume an extra FH tomorrow.

  44. THE EFFECT OF INVESTMENT IN REAL ASSETS Consumption, period 1 Investment opportunities line shows cash flows from investing in real assets Consumption, period 1 Notice the diminishing return on additional units of investment

  45. HOW INVESTMENT IN REAL ASSETS IMPROVES WELFARE Consumption, period 1 The miser can spend more today and the next period M H L G ... and so can the prodigal O J D K Consumption, period 0 The miser and prodigal have initial wealth of OD. Both are better off if they invest JD in real assets and then borrow or lend in the capital markets.

  46. KEY QUESTIONS ADDRESSED BY INVESTMENT ANALYSIS • 1. WHAT TYPES OF RE-ALLOCATIONS ARE AVAILABLE IN THE MARKETS FOR FIXED INCOME, EQUITIES, HYBRIDS, ETC. ? • 2. WHAT ARE THE RISK/EXPECTED RETURN CHARACTERISTICS OF THESE MECHANISMS (OPPORTTUNITY COSTS) ? • 3. HOW CAN THESE INVESTMENT VEHICLES BE RISK-MANAGED ? • E.G. THROUGH PORTFOLIO DIVERSIFICATION, AND THE CORRECT USES OF DERIVATIVES .

  47. DEFINING VIABLE INVESTMENT PROGRAMS • 1. THE SET OF AVAILABLE ‘RISK-FREE’ INVESTMENT ALTERNATIVES. • 2. THE SET OF AVAILABLE RISKY INVESTMENT ALTERNATIVES. • 3. SUBJECTIVE PREFERENCES FOR THE RISK/EXPECTED RETURN TRADEOFFS EMBODIED IN FINANCIAL INSTRUMENTS AS INVESTMENT VEHICLES.

  48. OBJECTIVES OF INVESTMENT ANALYSIS • 1. MAP OUT THE RISK/RETURN CHARACTERISTICS OF ALTERNATIVE INVESTMENT STRATEGIES. • 2. SIFT OUT WHAT CAN ACTUALLY BE DONE BY PORTFOLIO MANAGERS FOR THEIR CLIENTS FROM WHAT CAN’T BE DONE SO AS TO SATISFY THEIR SUBJECTIVE RISK/RETURN PREFERENCES.

  49. TYPES OF INVESTMENT STRATEGIES • 1. MARKET TIMING. • 2. STATIC PORTFOLIO DIVERSIFICATION. • 3. DYNAMIC PORTFOLIO DIVERSIFICATION. • 4. ASSET ALLOCATION.

  50. BASIC ASSET ALLOCATION STRATEGIES • ALLOCATING FUNDS BETWEEN CASH EQUIVALENTS, BONDS, AND EQUITIES. • E.G. CAPITAL ALLOCATION LINE STRATEGIES--HOW MUCH IN THE BANK =, HOW MUCH IN A SINGLE RISKY ASSET MUTUAL FUND

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