1. Overview: the course and financial markets
Overview of the course
How to run investment (Little book)
The effect of financial crisis
Capital Markets
Debt
Common stock
Preferred stock
Derivative securities
Security Trading
Trading
Trading Costs
Buy on margin versus short sell

2. How to run investments? How to make money?
Have the ability others typically don’t have
Have the information others typically don’t have
What else???
What may you get from the “little book”?
A thought in investment – “Joel Greenblatt’s simple notion will likely retain at least a good deal of its validity even if it becomes widely followed.”
What may you learn from this course?
Other than stocks, what can I do?
When everyone wants to make money, what the world would look like?
Still, what will make you a rich guy?
Chapter 1: Overview

3. Making money by using margins
What is a margin? -- equity/assets
Say one has $10,000 investable equity. The required margin is 50%.
What does this mean?
Say you borrowed $3,000 and all the money ($13,000)are invested in stocks
You need spend $3,000 for a different project. What options do you have? What are the consequence?
Chapter 1: Overview

4. Major Types of Securities
Debt
Money market instruments
Bonds
Common stock
Preferred stock
Derivative securities

5. Markets and Instruments
Money Market
Debt Instruments
Derivatives
Capital Market
Bonds
Equity

6. Money Market Instruments
Treasury bills
Certificates of deposit
Commercial Paper
Bankers Acceptances
Eurodollars
Repurchase Agreements
Federal Funds
LIBOR Market

7. Bond Markets US Treasury Bonds and Notes Agency Issues (Fed Gov)
International Bonds
Municipal Bonds
Corporate Bonds
Mortgage-Backed Securities

8. Municipal Bond Yields
Interest income on most municipals is not subject to tax
To compare the yields on municipals to other bonds use equivalent taxable yield
(municipal return) / (1 – tax rate)
Or solve for the tax rate that equates the two yields
Tax rate = 1 – (municipal rate/taxable rate)

9. Capital Market - Equity
Common stock
Residual claim
Limited liability
Analyzing stocks – finance.yahoo.com
Preferred stock
Fixed dividends - limited
Priority over common
Tax treatment

10. Stock Market Indexes Uses Factors in constructing or using an Index
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?

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

12. Examples of Indexes - International
Nikkei 225 & Nikkei 300
FTSE (Financial Times of London)
Dax
Region and Country Indexes
EAFE
Far East
United Kingdom

13. Bond Indexes Lehman Brothers Merrill Lynch Salomon Brothers
Specialized Indexes
Merrill Lynch Mortgage

14. Construction of Indexes
How are stocks weighted?
Price weighted (DJIA)
Market-value weighted (S&P500, NASDAQ)
Equally weighted (Value Line Index)
How returns are averaged?
Arithmetic (DJIA and S&P500)
Geometric (Value Line Index)

15. 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

16. Tips on Investment Buy under-valued stocks Buy recent-past winners
Don’t over trade – investing in stocks is costly
You can buy bonds
Invest in real estates

17. Security Trading Primary Market versus Secondary Market
Types of Orders
Trading Mechanisms
Buy on margin and short selling

18. Primary vs. Secondary Security Sales
New issue
Key factor: issuer receives the proceeds from the sale
Secondary
Existing owner sells to another party
Issuing firm doesn’t receive proceeds and is not directly involved

19. How Firms Issue Securities
Investment Banking
Shelf Registration
Private Placements
Initial Public Offerings (IPOs)

22. Shelf Registrations SEC Rule 415 Introduced in 1982
Ready to be issued – on the shelf

23. Initial Public Offerings
Process
Road shows
Bookbuilding
Underpricing
Post sale returns
Cost to the issuing firm
See page 62

24. Figure 3.2 Average Initial Returns for IPOs in Various Countries

25. Figure 3.3 Long-term Relative Performance of Initial Public Offerings

26. Types of Orders
Instructions to the brokers on how to complete the order
Market
Limit
Stop orders
Page 63-66

27. Figure 3.5 Price-Contingent Orders

28. Trading Mechanisms Dealer markets Specialists markets Page 66-67
Electronic communication networks (ECNs)
Specialists markets
Page 66-67

29. U.S. Security Markets Nasdaq Small stock OTC Organized Exchanges
Pink sheets
Organized Exchanges
New York Stock Exchange
American Stock Exchange
Regionals
Electronic Communication Networks (ECNs)
National Market System

30. Nasdaq National Market System Nasdaq SmallCap Market
Levels of subscribers
Level 1 – inside quotes (investors)
Level 2 – receives all quotes but they can’t enter quotes
Level 3 – dealers making markets
SuperMontage

31. Table 3.1 Requirements for Listing on Nasdaq Markets

32. New York Stock Exchange
Member functions
Commission brokers
Floor brokers
Specialists
Block houses
SuperDot (70% of NYSE trading volume)

33. Table 3.3 NYSE Listing Requirements

34. 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

35. Margin Trading Using only a portion of the proceeds for an investment
Borrow remaining component
Maximum margin is currently 50%; you can borrow up to 50% of the stock value
Set by the Fed
Maintenance margin: minimum amount equity in trading can be before additional funds must be put into the account
Margin call: notification from broker you must put up additional funds

36. Margin Trading - Initial Conditions Example 3.1
X Corp $100 60% Initial Margin 40% Maintenance Margin 100 Shares Purchased Initial Position Stock $10,000 Borrowed $4,000 Equity $6,000

37. Margin Trading - Maintenance Margin Ex. 3.1
Stock price falls to $70 per share New Position Stock $7,000 Borrowed $4,000 Equity $3,000 Margin% = $3,000/$7,000 = 43%

38. Margin Trading - Margin Call Example 3.2
How far can the stock price fall before a margin call? The maintenance margin is 30%.

39. Short Sales
Purpose: to profit from a decline in the price of a stock or security
Mechanics
Borrow stock through a dealer
Sell it and deposit proceeds and margin in an account
Closing out the position: buy the stock and return to the party from which is was borrowed

40. Short Sale - Initial Conditions
Dot Bomb 1,000 Shares 50% Initial Margin 30% Maintenance Margin $100 Initial Price Sale Proceeds $100,000 Margin & Equity 50,000 Stock Owed 100,000 What if price increases to 110? How much can the stock price rise before a margin call?

41. Short Sale - Margin Call
How much can the stock price rise before a margin call?

42. Financial Crisis of 2008 Antecedents of the Crisis:
“The Great Moderation”: a time in which the U.S. had a stable economy with low interest rates and a tame business cycle with only mild recessions
Historic boom in housing market
Chapter 1: Overview

43. Figure 1.3 The Case-Shiller Index of U.S. Housing Prices
Chapter 1: Overview

44. Rise of Systemic Risk
Systemic Risk: a potential breakdown of the financial system in which problems in one market spill over and disrupt others.
One default may set off a chain of further defaults
Waves of selling may occur in a downward spiral as asset prices drop
Potential contagion from institution to institution, and from market to market

45. Rise of Systemic Risk (Ctd.)
Banks had a mismatch between the maturity and liquidity of their assets and liabilities.
Liabilities were short and liquid
Assets were long and illiquid
Constant need to refinance the asset portfolio
Banks were very highly levered, giving them almost no margin of safety.

46. Rise of Systemic Risk (Ctd.)
Investors relied too much on “credit enhancement” through structured products like CDS
CDS traded mostly “over the counter”, so less transparent, no posted margin requirements
Opaque linkages between financial instruments and institutions

47. The Shoe Drops
: Sharp increase in housing prices caused many investors to believe that continually rising home prices would bail out poorly performing loans
2004: Interest rates began rising
2006: Home prices peaked

48. The Shoe Drops
2007: Housing defaults and losses on mortgage-backed securities surged
2007: Bear Stearns announces trouble at its subprime mortgage–related hedge funds

49. The Shoe Drops
2008: Troubled firms include Bear Stearns, Fannie Mae, Freddie Mac, Merrill Lynch, Lehman Brothers, and AIG
Money market breaks down
Credit markets freeze up
Federal bailout to stabilize financial system