11

How to pick stocks?How to pick stocks?

Good company vs good stockGood company vs good stock Macroeconomic conditionMacroeconomic condition Profitability and investmentProfitability and investment

22

Price of GamblesPrice of Gambles

Gamble #1: You flip a fair coin, head Gamble #1: You flip a fair coin, head I give you $110, tail I give you $90. I give you $110, tail I give you $90. How much are you willing to pay me How much are you willing to pay me to enter this gamble?to enter this gamble?

Gamble #2: You flip a fair coin, I Gamble #2: You flip a fair coin, I give you $100 give you $100 in a yearin a year no matter no matter what happens. How much are you what happens. How much are you willing to pay me willing to pay me todaytoday to enter this to enter this gamble?gamble?

33

Consumption Consumption PreferencePreference Which do you prefer? Which do you prefer? A) Starve (nearly to death) on A) Starve (nearly to death) on

odd days and stuff on even days; odd days and stuff on even days; oror

B) Eat comfortably every day.B) Eat comfortably every day.

44

Help these two ladiesHelp these two ladies

Two old ladies live in the same town. Two old ladies live in the same town. One makes a living by selling One makes a living by selling umbrellas, the other sells sunglasses. umbrellas, the other sells sunglasses. When it rains, the umbrella-selling When it rains, the umbrella-selling lady will be happy but the sunglass lady will be happy but the sunglass lady will be upset. When it is sunny, it lady will be upset. When it is sunny, it is the reverse. is the reverse.

How do you make both ladies happier How do you make both ladies happier without costing you anything?without costing you anything?

FINA 2802: Investments and Portfolio FINA 2802: Investments and Portfolio AnalysisAnalysis

Financial SecuritiesFinancial Securities

Dragon Yongjun TangDragon Yongjun Tang

January 14 & 19, 2010January 14 & 19, 2010

66

Lectures 2 & 3: Lectures 2 & 3: Financial SecuritiesFinancial Securities Reading: Chapter 2Reading: Chapter 2 Practice Problem Sets: Practice Problem Sets:

1,2,3,6,8,9,11,12,13,171,2,3,6,8,9,11,12,13,17

77

Learning Objectives

Distinguish among the major assets that trade in money markets and in capital markets

Describe the construction of stock market indexes

Calculate the profit or losses on investments in options and futures contracts

88

Financial SecuritiesFinancial Securities

Financial Market

Fixed-income (Bonds) Equity (Stocks) Derivatives

Money Market(Short-term)

Common StocksPreferred Stocks

OptionsFutures

Low Risk High Risk

Bond Market(Long-term)

Index

99

Treasury Bills Certificates of deposit Commercial paper Banker’s acceptances Eurodollars Repos and reverses Brokers’ calls* Federal funds LIBOR

Money Market Money Market InstrumentsInstruments

1010

• Most marketable of money market instruments

• Face value paid at maturity

• Sold at a discount to face via auction

• Issue:- 28 days (1 month), 91 days (3-month) and 182 days (6 month): weekly

• Minimum denomination is $10,000

Treasury BillsTreasury Bills

1111

Figure 2.2 Treasury Bills

1212

Figure 2.1 Money Rates

1313

Figure 2.3 Spreads on CDs and Figure 2.3 Spreads on CDs and Treasury BillsTreasury Bills • Difficult to predict

• Widen during crisis

1414

Bond Market

Treasury Notes and BondsTreasury Notes and Bonds Inflation-Protected Treasury Bonds (TIPS)Inflation-Protected Treasury Bonds (TIPS) Federal Agency DebtFederal Agency Debt International BondsInternational Bonds Municipal BondsMunicipal Bonds Corporate BondsCorporate Bonds Mortgages and Mortgage-Backed Mortgages and Mortgage-Backed

SecuritiesSecurities

1515

Treasury Notes and Bonds MaturitiesMaturities

– Notes Notes –– maturities up to 10 years maturities up to 10 years– Bonds Bonds –– maturities in excess of 10 years maturities in excess of 10 years– 30-year bond30-year bond

2001 Treasury suspended sales 2001 Treasury suspended sales 2005 resume sales2005 resume sales

Par Value - $1,000Par Value - $1,000 Quotes Quotes –– percentage of par; percentage of par; in 32ndin 32nd

1616

Figure 2.4 Treasury Notes, Figure 2.4 Treasury Notes, Bonds and BillsBonds and Bills

1717

Federal Agency Debt Major issuersMajor issuers

– Federal Home Loan BankFederal Home Loan Bank– Federal National Mortgage Association (Federal National Mortgage Association (““Fannie MaeFannie Mae””))– Government National Mortgage Association (Government National Mortgage Association (““Ginnie Ginnie

MaeMae””))– Federal Home Loan Mortgage Corporation (Federal Home Loan Mortgage Corporation (““Freddie Freddie

Mac”)Mac”)

1818

Figure 2.5 Government Agency

& Similar Issues

1919

Municipal Municipal BondsBonds

Issued by state and local governmentsIssued by state and local governments TypesTypes

– General obligation bondsGeneral obligation bonds– Revenue bondsRevenue bonds

Industrial revenue bondsIndustrial revenue bonds

Maturities Maturities –– range up to 30 years range up to 30 years

2020

Municipal Bond Yields

Interest income on municipal bonds Interest income on municipal bonds is not subject to federal and is not subject to federal and sometimes state and local taxsometimes state and local tax

To compare yields on taxable To compare yields on taxable securities a Taxable Equivalent Yield securities a Taxable Equivalent Yield is constructedis constructed

Interest is exempt from Federal taxes

After-tax return (taxable bond):

After-tax return (Municipal bond):

trr taxbeforetaxafter 1

taxbeforetaxafter rr

Municipal Bonds

2222

Figure 2.7 Ratio of Yields on Tax-exempts to Taxables

Equivalent Taxable Equivalent Taxable YieldYield

t

rr

rtr

t

r

r

mety

mety

m

ety

1

or

)1(

rateTax

bond municipalon yield

Yield taxableequivalent

2424

Table 2.3 Equivalent Taxable Yields

2525

•Semiannual coupon payments•Nominal value (Par) is $1,000•Actual percentage used for quote•Current Yield=coupon/close•Volume in Thousands•Subject to larger default risk than government Subject to larger default risk than government securities securities •Options on the bonds: Options on the bonds: Callable and convertibles

Corporate BondsCorporate Bonds

2626

Figure 2.8 Corporate Bond Prices

2727

Bond Market

Treasury Notes and BondsTreasury Notes and Bonds Federal Agency DebtFederal Agency Debt International Bonds: Eurobonds; Yankee International Bonds: Eurobonds; Yankee

Bonds, Samurai bonds; Dragon bondsBonds, Samurai bonds; Dragon bonds Municipal BondsMunicipal Bonds Corporate BondsCorporate Bonds Mortgages and Mortgage-Backed Mortgages and Mortgage-Backed

SecuritiesSecurities

2828

Outstanding U.S. Bond Market Debt in 2006 (US$Billions)

Source: Securities Industry and Financial Markets Source: Securities Industry and Financial Markets Association (www.sifma.org)Association (www.sifma.org)

  Municipal Treasury Mortgage Corporate Agency Total

             

Market Size 2,404.10 4,322.90 6,492.40 5,374.20 2,660.10 27,391.60Daily Trading Volume 22.5 524.7 254.6 22.7 74.4 889.8

““mini-bond”mini-bond”

Not well defined!Not well defined! Official term: credit-linked notesOfficial term: credit-linked notes Credit derivative!Credit derivative! Counterparty risk!Counterparty risk!

2929

3030

Equity Markets

Common stockCommon stock– Residual claimResidual claim– Limited liabilityLimited liability

Preferred stockPreferred stock– Fixed dividends - limitedFixed dividends - limited– Priority over commonPriority over common– Tax treatmentTax treatment

Depository receiptsDepository receipts

3131

Figure 2.10 Listing of Stocks Traded on the NYSE

3232

What is Dow Jones?What is Dow Jones?

3333

What is Dow Jones?What is Dow Jones?

Charles Dow; Edward JonesCharles Dow; Edward Jones Inventors of tickersInventors of tickers Publishing WSJ, Barrons, etc.Publishing WSJ, Barrons, etc.

3434

Track average returnsTrack average returns Comparing performance of managersComparing performance of managers Base of derivativesBase of derivatives

Uses of Stock Indexes

3535

Representative?Representative? Broad or narrow?Broad or narrow? How is it weighted?How is it weighted?

Factors for Construction Factors for Construction of of Stock IndexesStock Indexes

3636

Examples of Indexes – U.S. Domestic

Dow Jones Industrial Average (30 Dow Jones Industrial Average (30 Stocks)Stocks)

Standard & PoorStandard & Poor’’s 500 Composites 500 Composite NASDAQ CompositeNASDAQ Composite NYSE CompositeNYSE Composite Wilshire 5000Wilshire 5000

3737

Figure 2-11 Comparative Performance of Several Stock Market Indexes

3838

Examples of Indexes - Int’l

Hang Seng Index; Shanghai Hang Seng Index; Shanghai CompositeComposite

Nikkei 225 & Nikkei 300Nikkei 225 & Nikkei 300 FTSE (Financial Times of London)FTSE (Financial Times of London) DaxDax Region and Country IndexesRegion and Country Indexes

– EAFEEAFE– Far EastFar East– United KingdomUnited Kingdom

3939

Construction of Indexes

How are stocks selected?How are stocks selected?– SubjectiveSubjective

How are stocks weighted?How are stocks weighted?– Price weighted (DJIA)Price weighted (DJIA)– Market-value weighted (S&P500, NASDAQ)Market-value weighted (S&P500, NASDAQ)– Equally weighted (Value Line Index)Equally weighted (Value Line Index)

4040

Price Weighted IndicesPrice Weighted Indices

Computed by adding all the prices in the Computed by adding all the prices in the index and dividing by a divisorindex and dividing by a divisor

Implies one share for each stockImplies one share for each stock Implies a buy-and-hold strategyImplies a buy-and-hold strategy Gives high weight to high price stocksGives high weight to high price stocks DJIA is an exampleDJIA is an example

Derivation of Price-Derivation of Price-Weighted IndexWeighted Index

)1 at timeindex of (Value

) at timeindex of (Value

then

tat timeindex theof Value

at time stock of Price

at timeDivisor

index in the stocks ofnumber

:Let

1

11

1

1

,

tD

PI

tD

PI

I

tiP

tD

N

t

N

it

t

t

N

it

t

t

ti

t

4242

Example of Price-Weighted Example of Price-Weighted IndexIndex

Stock ABC sells initially at $25 a share with 20 Stock ABC sells initially at $25 a share with 20 million shares outstanding, while XYZ sells for $100 a million shares outstanding, while XYZ sells for $100 a share with 1 millions shares outstanding. The final share with 1 millions shares outstanding. The final price for ABC is $30, and the final price for XYZ is price for ABC is $30, and the final price for XYZ is $90.$90.(a) Find the initial and the final price-weighted index (a) Find the initial and the final price-weighted index composed of these two stocks. Assume the initial composed of these two stocks. Assume the initial divisor is 2.divisor is 2.

(b) Now if stock XYZ is split two for one, how should (b) Now if stock XYZ is split two for one, how should you adjust the divisor for the index?you adjust the divisor for the index?

4343

Value-Weighted Value-Weighted IndicesIndices

• Calculated by adding the Calculated by adding the total total market valuemarket value of the firms in the of the firms in the indexindex

• Implies buy and hold strategyImplies buy and hold strategy

• S&P 500 is an exampleS&P 500 is an example

Derivation of Value-Derivation of Value-Weighted IndexWeighted Index

)1 at timeindex of (Value

) at timeindex of (Value

change)not does n (assumingthen

tat timeindex theof Value I

tat time istock of PriceP

market in the tradedstocks i- typeofnumber totaln

index in the included stocks of typesN

:Let

,

1,

1,

1,

1

1,

,

1,

11,

1

11,1

1,

i

t

ti,

i

ti

tiN

ii

ti

tiN

iN

itii

tiiN

itii

N

itii

t

N

itiit

N

itiit

P

Pw

P

P

Pn

Pn

Pn

PnR

tPnI

tPnI

4545

Example of Value-Weighted Example of Value-Weighted IndexIndex

Stock ABC sells initially at $25 a share with 20 Stock ABC sells initially at $25 a share with 20 million shares outstanding, while XYZ sells for $100 million shares outstanding, while XYZ sells for $100 a share with 1 millions shares outstanding. The final a share with 1 millions shares outstanding. The final price for ABC is $30, and the final price for XYZ is price for ABC is $30, and the final price for XYZ is $90.$90.

4646

Example of Value-Weighted Example of Value-Weighted IndexIndex

(a) Find the the value-weighted index composed of (a) Find the the value-weighted index composed of these two stocks at the final date. Assume the initial these two stocks at the final date. Assume the initial level of the index is 100.level of the index is 100.

(b) Now if stock XYZ is split two for one, how will (b) Now if stock XYZ is split two for one, how will the market value-weighted index be affected?the market value-weighted index be affected?

4747

Equally Weighted Equally Weighted IndicesIndices

Computed by assumingComputed by assuming equal dollar equal dollar amountamount in each stockin each stock

Implies periodic rebalancing of the portfolio Implies periodic rebalancing of the portfolio (no buy and hold)(no buy and hold)

CRSP index is an exampleCRSP index is an example

Derivation of Equally Derivation of Equally Weighted IndexWeighted Index

1

)1 at timeindex of (Value

) at timeindex of (Value

then

tat timeindex theof Value

at time stock of Price

stockeach in $ ofAmount

index in the stocks ofnumber

:Let

,

1,

1

1,1 ,1

1

1,1 ,

1

,1 ,

,

ti

tiN

i

ti

N

i ti

t

tt

ti

N

i tit

ti

N

i tit

t

ti

P

P

NMN

PPM

I

IR

tPP

MI

tMNPP

MI

I

tiP

M

N

4949

Example of Equally Weighted Example of Equally Weighted IndexIndex

Stock ABC sells initially at $25 a share with 20 Stock ABC sells initially at $25 a share with 20 million shares outstanding, while XYZ sells for $100 million shares outstanding, while XYZ sells for $100 a share with 1 millions shares outstanding. The final a share with 1 millions shares outstanding. The final price for ABC is $30, and the final price for XYZ is price for ABC is $30, and the final price for XYZ is $90.$90.

5050

Example of Equally Weighted Example of Equally Weighted IndexIndex

(a) Find the the equally weighted index composed of (a) Find the the equally weighted index composed of these two stocks at the final date. Assume initially these two stocks at the final date. Assume initially $100 are invested in each stock.$100 are invested in each stock.

(b) At the final date, how should you rebalance your (b) At the final date, how should you rebalance your portfolio to have an equally weighted portfolio?portfolio to have an equally weighted portfolio?

5151

Hang Seng IndexHang Seng Index

Freefloat-adjusted market capitalization weighted– Exclude shareholdings with lock-up arrangementExclude shareholdings with lock-up arrangement

15% cap on individual stock weightings15% cap on individual stock weightings

Re-capping Q1 & Q3Re-capping Q1 & Q3

H-shares includedH-shares included

5252

Computed monthly

Difficulty in measuring true returns

Best known:Merrill LynchLehman BrothersSalomon Smith Barney

Bond IndexBond Index

5353

Derivatives Securities

OptionsOptions Basic PositionsBasic Positions

– Call (Buy)Call (Buy)– Put (Sell)Put (Sell)

TermsTerms– Exercise PriceExercise Price– Expiration DateExpiration Date– AssetsAssets

Futures Futures Basic PositionsBasic Positions

– Long (Buy)Long (Buy)– Short (Sell)Short (Sell)

TermsTerms– Delivery DateDelivery Date– AssetsAssets

5454

Call option - the right to buy

Put option - the right to sell

Hedgers protect themselvesjust in case

OptionsOptions

600 500 400

200

0

Dow Chemical 85 July Call - Buy 1 Call

Profit

Break even

Loss

Common stock price

Premium = 1 3/8

-137.5 -200

-400 -500

Profit / Loss

Payoff

85 863/8 90 913/8

Long Call Profit or Long Call Profit or LossLoss

5656

Tuesday, January 15, 2002

--- Call --- --- Put --- Option/Strike Exp. Vol. Last Vol. Last AmOnline 25 Apr 20 5.90 10092 1.15 30.03 27.5 Apr 24 4.20 5135 1.80

30.03 30 Jan 5271 0.50 1106 0.50 30.03 32.5 Apr 225 1.70 15218 4.20

30.03 35 Apr 379 1.05 5636 5.80

Option QuotesOption Quotes

5757

Option ValuationOption Valuation

Binomial Tree Approach: Replicating option payoffs with stocks and bonds

C=26.85C=26.85 Black-Scholes FormulaBlack-Scholes Formula

100

200

50

Stock Price

C

75

0

Call Option Value X = 125

Alternative PortfolioBuy 1 share of stock at $100Borrow $46.30 (8% Rate)Net outlay $53.70PayoffValue of Stock 50 200Repay loan - 50 -50Net Payoff 0 150

53.70

150

0

Payoff Structureis exactly 2 timesthe Call

FIN 8330 Lecture 9 10/25/07FIN 8330 Lecture 9 10/25/075858

The Black-Scholes The Black-Scholes FormulaFormula

The Black-Scholes option pricing formulaThe Black-Scholes option pricing formula– For a European call option on a stock paying no dividendFor a European call option on a stock paying no dividend

– N(d) = probability that a random draw from a normal N(d) = probability that a random draw from a normal dist. will be less than d.dist. will be less than d.

– The option value does The option value does notnot depend on the expected return depend on the expected return on the stock (risk-neutral valuation)on the stock (risk-neutral valuation)

210 dNeXdNSC TRFR

TTRFRXd

2Sln

2

1

Tdd 12

5959

Warrant/Put Warrant/Put WarrantWarrant

Essentially, call/put options issued by Essentially, call/put options issued by a a firmfirm

Difference: warrant exercise Difference: warrant exercise requires firm to issue new shares requires firm to issue new shares ((ownership dilution!ownership dilution!))

See page 717 of the textbook for See page 717 of the textbook for more details.more details.

6060

Obligation not right

Agree on price for a future date

Used by hedgers not just speculators

Futures Futures ContractsContracts

6161

Payoff Profile of Futures Payoff Profile of Futures ContractContract

PPTT: Underlying Asset Price at expiration,: Underlying Asset Price at expiration, F: Agreed upon priceF: Agreed upon pricePayoff (profit) at expiration. Payoff (profit) at expiration.

PT

F

F

Payoff=Profit Long: PT – F

Short: F- PT

-F

6262

Friday, November 30, 2001 Open interest reflects previous trading day

INDEX

S&P 500 INDEX (CME) $250 times index Open Open High Low Settle Chg High Low Interest Dec 114430 114450 113500 114000 -450 171,460 93900 411,751 Mar02 114050 114500 113750 114150 -450 134960 94100 140,466 Est vol 74,399; vol Thu 113,669; open int 561,312, +1,760. Idx prl High 1143.57; Low 1135.89; Close 1139.45 –0.75

Futures QuotesFutures Quotes

6363

Spot-futures parity theoremSpot-futures parity theorem - two ways to - two ways to acquire an asset for some date in the futureacquire an asset for some date in the future– Purchase it now and store itPurchase it now and store it– Take a long position in futuresTake a long position in futures– These two strategies must have the same market These two strategies must have the same market

determined costsdetermined costs With a perfect hedge the futures payoff is certain With a perfect hedge the futures payoff is certain

-- there is no risk-- there is no risk A perfect hedge should return the riskless rate of A perfect hedge should return the riskless rate of

returnreturn

Futures PricingFutures Pricing

6464

Help these two ladiesHelp these two ladies

How do you make both ladies How do you make both ladies happier without costing you happier without costing you anything?anything?

Option/Futures contractsOption/Futures contracts Sign an agreement with umbrella-Sign an agreement with umbrella-

selling lady, pay her $5 if it shines, selling lady, pay her $5 if it shines, she pays you $5 if it rains. The she pays you $5 if it rains. The reverse with sunglasses-selling lady.reverse with sunglasses-selling lady.

Weather derivativesWeather derivatives

6565

Key to Derivatives Key to Derivatives Pricing: Pricing: No ArbitrageNo Arbitrage The current prices of asset 1 and asset 2 are 95 The current prices of asset 1 and asset 2 are 95

and 43and 43 Tomorrow, one of two states will come trueTomorrow, one of two states will come true

– A good state where the prices go up orA good state where the prices go up or– A bad state where the prices go downA bad state where the prices go down

Asset1 = 100Asset1 = 100

Asset2 = 50Asset2 = 50

Asset1 = 95Asset1 = 95

Asset2 = 43Asset2 = 43

Asset1 = 80Asset1 = 80

Asset2 = 40Asset2 = 40

Do you see any possibility to make risk-free money Do you see any possibility to make risk-free money out of this situation?out of this situation?

6666

There is no free lunch!There is no free lunch!

Return

Risk

less risk

lessreturn

more risk

morereturn

Money

T-Bonds

Corporate Bonds

Stocks

Derivatives

6767

SummarySummary

Financial securitiesFinancial securities IndicesIndices Next class: Financial Market Next class: Financial Market

TradingTrading