Essentials of Investments © 2001 The McGraw-Hill Companies, Inc. All rights reserved. Fourth Edition Irwin / McGraw-Hill Bodie Kane Marcus 1 Chapters 1 & 2 Investments - Background and Issues Financial Markets and Instruments

Essentials of Investments © 2001 The McGraw-Hill Companies, Inc. All rights reserved. Fourth Edition Irwin / McGraw-Hill Bodie Kane Marcus 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

Essentials of Investments © 2001 The McGraw-Hill Companies, Inc. All rights reserved. Fourth Edition Irwin / McGraw-Hill Bodie Kane Marcus 3 The Investment Process Asset allocation Security selection Risk-return trade-off Market efficiency Active vs. passive management

Essentials of Investments © 2001 The McGraw-Hill Companies, Inc. All rights reserved. Fourth Edition Irwin / McGraw-Hill Bodie Kane Marcus 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

Essentials of Investments © 2001 The McGraw-Hill Companies, Inc. All rights reserved. Fourth Edition Irwin / McGraw-Hill Bodie Kane Marcus 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

Essentials of Investments © 2001 The McGraw-Hill Companies, Inc. All rights reserved. Fourth Edition Irwin / McGraw-Hill Bodie Kane Marcus 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

Essentials of Investments © 2001 The McGraw-Hill Companies, Inc. All rights reserved. Fourth Edition Irwin / McGraw-Hill Bodie Kane Marcus 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

Essentials of Investments © 2001 The McGraw-Hill Companies, Inc. All rights reserved. Fourth Edition Irwin / McGraw-Hill Bodie Kane Marcus 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

Essentials of Investments © 2001 The McGraw-Hill Companies, Inc. All rights reserved. Fourth Edition Irwin / McGraw-Hill Bodie Kane Marcus 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

Essentials of Investments © 2001 The McGraw-Hill Companies, Inc. All rights reserved. Fourth Edition Irwin / McGraw-Hill Bodie Kane Marcus 10 Major Classes of Financial Assets or Securities Debt – Money market instruments – Bonds Common stock Preferred stock Derivative securities

Essentials of Investments © 2001 The McGraw-Hill Companies, Inc. All rights reserved. Fourth Edition Irwin / McGraw-Hill Bodie Kane Marcus 11 Markets and Instruments Money Market –Debt Instruments –Derivatives Capital Market –Bonds –Equity –Derivatives

Essentials of Investments © 2001 The McGraw-Hill Companies, Inc. All rights reserved. Fourth Edition Irwin / McGraw-Hill Bodie Kane Marcus 12 Money Market Instruments Treasury bills Certificates of deposit Commercial Paper Bankers Acceptances Eurodollars Repurchase Agreements (RPs) and Reverse RPs Federal Funds

Essentials of Investments © 2001 The McGraw-Hill Companies, Inc. All rights reserved. Fourth Edition Irwin / McGraw-Hill Bodie Kane Marcus 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

Essentials of Investments © 2001 The McGraw-Hill Companies, Inc. All rights reserved. Fourth Edition Irwin / McGraw-Hill Bodie Kane Marcus 14 Bank Discount Rate (T-Bills) r BD = bank discount rate P= market price of the T-bill n= number of days to maturity r BD = 10,000 - P10,000 x 360 n 90-day T-bill, P = $9,875 r BD = 10, ,875 10,000 x =5% Example

Essentials of Investments © 2001 The McGraw-Hill Companies, Inc. All rights reserved. Fourth Edition Irwin / McGraw-Hill Bodie Kane Marcus 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

Essentials of Investments © 2001 The McGraw-Hill Companies, Inc. All rights reserved. Fourth Edition Irwin / McGraw-Hill Bodie Kane Marcus 16 Bond Equivalent Yield P = price of the T-bill n = number of days to maturity r BEY = 10,000 - PP x 365 n r BEY = 10, ,875 9,875 x r BEY =.0127 x =.0513 = 5.13% Example Using Sample T-Bill

Essentials of Investments © 2001 The McGraw-Hill Companies, Inc. All rights reserved. Fourth Edition Irwin / McGraw-Hill Bodie Kane Marcus 17 Effective Annual Rate of Return Similar to the bond equivalent yield However, the annualized rate is compounded. r = 10,000-9,875 = ,875 EAR = (1.0127) = = 5.18%

Essentials of Investments © 2001 The McGraw-Hill Companies, Inc. All rights reserved. Fourth Edition Irwin / McGraw-Hill Bodie Kane Marcus 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

Essentials of Investments © 2001 The McGraw-Hill Companies, Inc. All rights reserved. Fourth Edition Irwin / McGraw-Hill Bodie Kane Marcus 19 Capital Market - Equity Common stock –Residual claim –Limited liability Preferred stock –Fixed dividends - limited –Priority over common –Tax treatment

Essentials of Investments © 2001 The McGraw-Hill Companies, Inc. All rights reserved. Fourth Edition Irwin / McGraw-Hill Bodie Kane Marcus 20 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? Stock Indexes

Essentials of Investments © 2001 The McGraw-Hill Companies, Inc. All rights reserved. Fourth Edition Irwin / McGraw-Hill Bodie Kane Marcus 21 Examples of Indexes - Domestic Dow Jones Industrial Average (30 Stocks) Standard & Poor’s 500 Composite NASDAQ Composite NYSE Composite Wilshire 5000

Essentials of Investments © 2001 The McGraw-Hill Companies, Inc. All rights reserved. Fourth Edition Irwin / McGraw-Hill Bodie Kane Marcus 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

Essentials of Investments © 2001 The McGraw-Hill Companies, Inc. All rights reserved. Fourth Edition Irwin / McGraw-Hill Bodie Kane Marcus 23 Construction of Indexes How are stocks weighted? –Price weighted (DJIA) –Market-value weighted (S&P500, NASDAQ) –Equally weighted (Value Line Index)

Essentials of Investments © 2001 The McGraw-Hill Companies, Inc. All rights reserved. Fourth Edition Irwin / McGraw-Hill Bodie Kane Marcus 24 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