Presentation on theme: "Investments & Financial Assets"— Presentation transcript:
1 Investments & Financial Assets Essential nature of investmentReduced current consumptionPlanned later consumptionConsumption TimingAllocation of RiskTwo main themes of investmentsModern Portfolio theory (MPT):Risk-return trade off in the securities marketsEfficient diversificationCapital asset pricing and valuationEfficient Market Hypothesis (EMH):security price reflects all the information available to investors concerning the value of the securitiesReal AssetsAssets used to produce goods and servicesFinancial AssetsClaims on real assets
2 Major Classes of Financial Assets or Securities DebtMoney market instrumentsBondsEquityCommon stockPreferred stockDerivative securities
3 Agency Issues and Crisis in Corporate Governance Accounting ScandalsExamples – Enron and WorldComAnalyst ScandalsExample – Citigroup’s Salomon Smith BarneyInitial Public OfferingsCredit Swiss First Boston
4 The Agency Problem Agency relationship Principal hires an agent to represent their interestStockholders (principals) hire managers (agents) to run the companyTwo conditions of agency problem:1. Conflict of interest between principal and agent2. Asymmetric informationManagement goals and agency costsVideo 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 Constructionthe Capital Allocation decisionChoice of safe but low-return money market securities, or risky but higher-return securities (e.g., stocks)the Asset Allocation decisionthe distribution of risky investments across broad asset classes like stocks, bonds, real estates, foreign assets, and so on.the Security Selection decisionthe choice of which particular securities to hold within each asset classsecurity analysis involves the valuation of particular securities: must forecast dividends and earningsfundamental/ technical analysisMarket efficiency
6 Active vs. Passive Management Active ManagementFinding undervalued securitiesTiming the marketPassive ManagementNo attempt to find undervalued securitiesNo attempt to timeHolding an efficient portfolio
7 Major Financial Markets and Assets or Securities Money marketTreasury bills, Certificates of deposits, Commercial Paper, Bankers Acceptances, Eurodollars, Repurchase Agreements (RPs) and Reverse RPs, Brokers’ Calls, Federal Funds, etc.Treasury billsmost marketable; highly liquid; discount bondmaturities: 28, 91, 182 daysminimum denomination: $1,000Issued weekly
8 Costs of TradingCommission: fee paid to broker for making the transactionSpread: cost of trading with dealerBid: price dealer will buy from youAsk: price dealer will sell to youSpread: ask - bidCombination: on some trades both are paid
10 T-bill T.B yields are quoted as the “bank discount yield” rBD = 10,000 - P x 36010, nwhere 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 < rEAYWhat 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 marketTreasury Notes and BondsMaturitiesNotes – maturities up to 10 yearsBonds – maturities in excess of 10 years2001 Treasury suspended salesNote: 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 salesPar Value - $1,000Quotes – percentage of par
13 Example12If a treasury note has a bid price of $982.50, the quoted bid price in the Wall Street Journal would be __________.A) $98:08B) $98:25C) $98:50D) $98:40The 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) $1,041.60B) $1,045.00C) $1,040.80D) $1,042.50
14 Example 34Suppose 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 exemptTypesGeneral obligation bondsRevenue bondsIndustrial revenue bondsMaturities – range up to 30 years
16 Municipal Bond YieldsInterest income on municipal bonds is not subject to federal and sometimes state and local taxr = 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 securitiesOptions in corporate bondsCallableConvertible
19 Example31The 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 claimLimited liabilityPreferred stockFixed dividends - limitedPriority over commonTax treatmentDepository receipts
21 Figure 2.10 Listing of Stocks Traded on the NYSE
22 Uses of Stock Indexes Track average returns Comparing performance of managersBase 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 CompositeNASDAQ CompositeNYSE CompositeWilshire 5000CurrentlyDJIA: 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 10where 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 NYSEEqually weighted (Value Line Index)StockIPFPsharesIVFVABC253020500600XYZ100901Total690
27 Example33The 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) 23.43B) 35.36C) 40.33D) 49.58A 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) 960B) 970C) 975D) 985