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Investments & Financial Assets

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Presentation on theme: "Investments & Financial Assets"— Presentation transcript:

1 Investments & Financial Assets
Essential nature of investment Reduced current consumption Planned later consumption Consumption Timing Allocation of Risk Two main themes of investments Modern Portfolio theory (MPT): Risk-return trade off in the securities markets Efficient diversification Capital asset pricing and valuation Efficient Market Hypothesis (EMH): security price reflects all the information available to investors concerning the value of the securities Real Assets Assets used to produce goods and services Financial Assets Claims on real assets

2 Major Classes of Financial Assets or Securities
Debt Money market instruments Bonds Equity Common stock Preferred stock Derivative securities

3 Agency Issues and Crisis in Corporate Governance
Accounting Scandals Examples – Enron and WorldCom Analyst Scandals Example – Citigroup’s Salomon Smith Barney Initial Public Offerings Credit Swiss First Boston

4 The Agency Problem Agency relationship
Principal hires an agent to represent their interest Stockholders (principals) hire managers (agents) to run the company Two conditions of agency problem: 1. Conflict of interest between principal and agent 2. Asymmetric information Management goals and agency costs Video Note: This video focuses on how one company handled the tough decision to cut jobs and managed to successfully increase shareholder value. It features ABT Co. in Canada. A common example of an agency relationship is a real estate broker – in particular if you break it down between a buyers agent and a sellers agent. A classic conflict of interest is when the agent is paid on commission, so they may be less willing to let the buyer know that a lower price might be accepted or they may elect to only show the buyer homes that are listed at the high end of the buyers price range. Ethics Note: The instructor’s manual provides a discussion of Gillette and the apparent agency problems that existed prior to the introduction of the sensor razor. Direct agency costs – the purchase of something for management that can’t be justified from a risk-return standpoint, monitoring costs. Indirect agency costs – management’s tendency to forgo risky or expensive projects that could be justified from a risk-return standpoint.

5 The Investment Process
A Top-Down Analysis of Portfolio Construction the Capital Allocation decision Choice of safe but low-return money market securities, or risky but higher-return securities (e.g., stocks) the Asset Allocation decision the distribution of risky investments across broad asset classes like stocks, bonds, real estates, foreign assets, and so on. the Security Selection decision the choice of which particular securities to hold within each asset class security analysis involves the valuation of particular securities: must forecast dividends and earnings fundamental/ technical analysis Market efficiency

6 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

7 Major Financial Markets and Assets or Securities
Money market Treasury bills, Certificates of deposits, Commercial Paper, Bankers Acceptances, Eurodollars, Repurchase Agreements (RPs) and Reverse RPs, Brokers’ Calls, Federal Funds, etc. Treasury bills most marketable; highly liquid; discount bond maturities: 28, 91, 182 days minimum denomination: $1,000 Issued weekly

8 Costs of Trading Commission: fee paid to broker for making the transaction Spread: cost of trading with dealer Bid: price dealer will buy from you Ask: price dealer will sell to you Spread: ask - bid Combination: on some trades both are paid

9 Figure 2.2 Treasury Bills

10 T-bill T.B yields are quoted as the “bank discount yield”
rBD = 10,000 - P x 360 10, n where P = the bond price; n = the maturity in days; rBD = the bank discount yield; $10,000 = par value. To determine the T-bill’s true market price: P = 10,000 x [ 1 - rBD x n/360 ] Ex. T-bill sold at $9,500 with a maturity of a half year (182 days): rBD= (500/10,000) x (360/182) = (9.89%) The “bond equivalent yield” of the T-bill = APR (annual percentage rate) rBEY = (10,000 - P)/P x (365/n) = (500/9,500) x (365/182) = % Effective annual yield: reay ( /9,500 ) = (10.8%) note: rBD < rBEY < rEAY What is the asked price, equivalent yield, and effective yield for the T-Bill marked red in previous slide? RBEY = 365*rBD/(360-n*rBD)

11 Major Financial Markets and Assets or Securities
Bond market Treasury Notes and Bonds Maturities Notes – maturities up to 10 years Bonds – maturities in excess of 10 years 2001 Treasury suspended sales Note: 11/1/2001: The Treasury department would no longer sell 30-year bonds, for years the benchmark for the entire $17.7 trillion U.S. bond market – long-term interest rate will decline. Now 10-year Treasury takes over the benchmark title resume sales Par Value - $1,000 Quotes – percentage of par

12 Figure 2.4 Treasury Notes, Bonds and Bills

13 Example12 If a treasury note has a bid price of $982.50, the quoted bid price in the Wall Street Journal would be __________. A) $98:08 B) $98:25 C) $98:50 D) $98:40 The price quotations of treasury bonds in the Wall Street Journal show an ask price of 104:16 and a bid price of 104:08. As a buyer of the bond you expect to pay __________. A) $1,041.60 B) $1,045.00 C) $1,040.80 D) $1,042.50

14 Example 34 Suppose you pay $9,800 for a Treasury bill maturing in two months. What is the annual percentage rate of return for this investment? A) 2% B) 12% C) 12.2% D) 16.4% Suppose you pay $9,700 for a Treasury bill maturing in six months. What is the effective annual rate of return for this investment? A) 3.1% B) 6% C) 6.18% D) 6.28%

15 Municipal Bonds Issued by state and local governments
Interest income is exempt Types General obligation bonds Revenue bonds Industrial revenue bonds Maturities – range up to 30 years

16 Municipal Bond Yields Interest income on municipal bonds is not subject to federal and sometimes state and local tax r = rm / (1 - t), where rm = the rate on municipal bonds; t = the investor’s marginal tax bracket; r = the total before-tax rate of return on taxable bonds. Ex. rm = 10%; t = 28% : then r = %, if t = 36%: then r = % Ex. A municipal bond carries a coupon of 6% and is trading at par; to a taxpayer in a 36% tax bracket, What is the taxable equivalent yield of this bond ?

17 Corporate Bonds Issued by private firms Semi-annual interest payments
Subject to larger default risk than government securities Options in corporate bonds Callable Convertible

18 Figure 2.8 Corporate Bond Prices

19 Example31 The purchase price for a bond is listed as 104 and the annual coupon rate is 4.3%. What is the current yield (annual coupon payment / current price) on this bond? A) 0.00% B) 4.00% C) 4.13% D) 4.30% What is the tax exempt equivalent yield on a 9% bond yield given a marginal tax rate of 28%? A) 6.48% B) 7.25% C) 8.02% D) 9.00%

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

21 Figure 2.10 Listing of Stocks Traded on the NYSE

22 Uses of Stock Indexes Track average returns
Comparing performance of managers Base of derivatives

23 Factors for Construction of Stock Indexes
Representative? Broad or narrow? How is it weighted?

24 Examples of Indexes - Domestic
Dow Jones Industrial Average (30 Stocks) Standard & Poor’s 500 Composite NASDAQ Composite NYSE Composite Wilshire 5000 CurrentlyDJIA: Alcoa, Allied Signal, American Express, American International Group Inc, Boeing, Caterpillar, Citigroup, Coca-Cola, DuPont, Exxon, General Electric, General Motors, Hewlett-Packard, Home Depot, IBM, Intel, Johnson & Johnson, McDonald, Merck, Microsoft, 3M, JP Morgan, Pfizer, Phillip Morris, Proctor& Gamble, SBC Communications, United Technologies, Verizon Communications, Wal-Mart Stores, Walt Disney.

25 Construction of Indexes
How are stocks weighted? Price weighted (DJIA) (p40 example 2.2) Market-value weighted (S&P500, NASDAQ) (p46 example 2.4) S&P 500 Index = [Pit Qit / O.V. ] x 10 where O.V. = original valuation in (i.e., relative to the average value during the period of , which was assigned an index value of 10) 81% of the mkt value of companies on the NYSE Equally weighted (Value Line Index) Stock IP FP shares IV FV ABC 25 30 20 500 600 XYZ 100 90 1 Total 690

26 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

27 Example33 The Chompers Index is a price weighted stock index based on the 3 largest fast food chains. The stock prices for the three stocks are $54, $23, and $44. What is the price weighted index value of the Chompers Index. A) 23.43 B) 35.36 C) 40.33 D) 49.58 A benchmark index has three stocks priced at $23, $43, and $56. The number of outstanding shares for each is 350,000 shares, 405,000 shares, and 553,000 shares, respectively. If the market value weighted index was 970 yesterday and the prices changed to $23, $41, and $58, what is the new index value? A) 960 B) 970 C) 975 D) 985

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