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 Derivatives

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 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

Primary 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

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How Firms Issue Securities

Investment Banking Shelf Registration Private Placements Initial Public Offerings (IPOs)

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21

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Shelf Registrations

SEC Rule 415 Introduced in 1982 Ready to be issued – on the shelf

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Initial Public Offerings

Process Road shows Bookbuilding

Underpricing Post sale returns Cost to the issuing firm See page 62

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Figure 3.2 Average Initial Returns for IPOs in Various Countries

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Figure 3.3 Long-term Relative Performance of Initial Public Offerings

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Types of Orders

Instructions to the brokers on how to complete the order Market Limit Stop orders Page 63-66

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Figure 3.5 Price-Contingent Orders

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Trading Mechanisms

Dealer markets Electronic communication networks (ECNs)

Specialists markets Page 66-67

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U.S. Security Markets

Nasdaq Small stock OTC

Pink sheets

Organized Exchanges New York Stock Exchange American Stock Exchange Regionals

Electronic Communication Networks (ECNs) National Market System

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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

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Table 3.1 Requirements for Listing on Nasdaq Markets

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New York Stock Exchange

Member functions Commission brokers Floor brokers Specialists

Block houses SuperDot (70% of NYSE trading volume)

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Table 3.3 NYSE Listing Requirements

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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

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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

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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%

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Margin Trading - Margin Call Example 3.2

How far can the stock price fall before amargin 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 Shares50% Initial Margin30% Maintenance Margin$100 Initial Price

Sale Proceeds $100,000Margin & Equity 50,000Stock Owed 100,000What 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?

42Chapter 1: Overview

1-42

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

43Chapter 1: Overview

Figure 1.3 The Case-Shiller Index of U.S. Housing Prices

441-44

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

451-45

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.

461-46

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

471-47

The Shoe Drops

2000-2006: 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

481-48

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

491-49

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