Investment management

Transcription

1 Investment management N. Instefjord FN3023, Undergraduate study in Economics, Management, Finance and the Social Sciences This is an extract from a subject guide for an undergraduate course offered as part of the University of London International Programmes in Economics, Management, Finance and the Social Sciences. Materials for these programmes are developed by academics at the London School of Economics and Political Science (LSE). For more information, see:

2 This guide was prepared for the University of London International Programmes by: N. Instefjord, PhD, Associate Graduate Director, Essex Business School, University of Essex. This is one of a series of subject guides published by the University. We regret that due to pressure of work the author is unable to enter into any correspondence relating to, or arising from, the guide. If you have any comments on this subject guide, favourable or unfavourable, please use the form at the back of this guide. University of London International Programmes Publications Office Stewart House 32 Russell Square London WC1B 5DN United Kingdom Website: Published by: University of London University of London 2009 Reprinted with minor revisions 2011 The University of London asserts copyright over all material in this subject guide except where otherwise indicated. All rights reserved. No part of this work may be reproduced in any form, or by any means, without permission in writing from the publisher. We make every effort to contact copyright holders. If you think we have inadvertently used your copyright material, please let us know.

3 Contents Contents Chapter 1: Introduction... 1 Subject guide structure and use... 1 Aims and objectives... 1 Learning outcomes... 2 Syllabus... 2 Reading advice... 3 Online study resources... 4 Examination structure... 5 Chapter 2: Financial markets and instruments... 7 Learning outcomes... 7 Essential reading... 7 Further reading... 7 Guide to readings... 7 Introduction... 7 Money and bond markets... 8 Money market instruments... 9 Bond market instruments Equity markets Equity instruments Derivatives markets Managed funds Exchange traded funds Exchange trading and over-the-counter (OTC) trading Clearing, settlement, margin trading, short sales and contingent orders Working out the profitability of margin trades Regulation of financial markets Summary Activities A reminder of your learning outcomes Sample examination question Chapter 3: The history of financial markets Learning outcomes Essential reading Further reading Introduction A history of financial innovation Recent financial innovations Investment returns in equity and bond markets The equity premium puzzle Summary Activities A reminder of your learning outcomes Sample examination question i

4 23 Investment management Chapter 4: Fund management and investment Learning outcomes Essential reading Further reading Introduction Historical mutual fund performance Market effciency and behavioural finance Return based trading strategies Hedge funds Performance of hedge funds Algorithmic or program trading (statistical arbitrage) Summary Activities A reminder of your learning outcomes Sample examination question Chapter 5: Market microstructure Learning outcomes Essential reading Further reading Introduction Limit order markets Bid-ask bounce: the Roll model Glosten-Milgrom Kyle Discrete version of the Kyle model Why market microstructure matters Summary Activity A reminder of your learning outcomes Sample examination question Chapter 6: Diversification Learning outcomes Essential reading Further reading Introduction Expected portfolio return and variance Definition of risk premium Numerical example Asset allocation: Two assets Mean variance preferences Optimal asset allocation with a risk free asset CARA utility and normal returns The portfolio frontier Expected returns relationships Estimation issues Diversification: The single index model The Treynor Black model Factor models ii

5 Contents Asset allocation over longer time horizons Summary Activities A reminder of your learning outcomes Sample examination question Chapter 7: Portfolio immunisation Learning outcomes Essential reading Introduction Bond maths The term structure Duration Numerical example Convexity Immunisation of bond portfolios Convexity and immunisation Immunisation of equity portfolios Hedge ratios futures trading Summary Activity A reminder of your learning outcomes Sample examination question Chapter 8: Risk and performance measurement Learning outcomes Essential reading Further reading Introduction Types of risk Risk decomposition Value-at-Risk The Sharpe ratio Treynor s ratio More portfolio performance measures Sharpe vs Treynor Changing risk Market timing Summary Activity A reminder of your learning outcomes Sample examination question Chapter 9 Risk management Learning outcomes Essential reading Further reading Introduction Risk management for investors Risk management for corporations Risk management for banks Put option protection Put protection vs VaR iii

6 23 Investment management Portfolio insurance with calls Non-linear pay-offs Extreme risk Hedging credit risk Hedging volatility Risk capital allocation Summary A reminder of your learning outcomes Sample examination question Chapter 10: Important concepts Investment returns Averages: geometric vs arithmetic Taylor approximation Optimisation Regression methods Utility theory Risk aversion coefficient Expected utility maximisation Variance aversion and the portfolio frontier Standard normal distribution American vs European options Chapter 11: Sample examination paper Appendix 1: Technical terms Averages: geometric vs arithmetic Investment returns A review of regressions methods Utility theory Risk aversion coefficient Expected utility maximisation CARA utility functions iv

7 Chapter 1: Introduction Chapter 1: Introduction Finance is essentially about pricing financial assets, but in this subject guide we will focus more on what we use pricing theory for from an investment perspective. We will seek to apply pricing theory (among other things) to tell us something about how to invest our money optimally in financial assets rather than for pricing itself. We will spend some time looking at how to protect our investments using techniques from the area of risk management. For those who want a more thorough overview of pricing theory, see the subject guide for course 92 Corporate finance. Subject guide structure and use This subject guide is not a course text. Wider reading is essential as you are expected to see the area of study from an holistic point of view, and not just as a set of limited topics. The structure of the subject guide is as follows. Chapter 2 introduces you to financial markets and instruments. Chapter 3 surveys some of the history behind the innovation of new financial markets and instruments and the return that investors have historically achieved from holding various classes of financial assets. Chapter 4 surveys some of the empirical findings regarding active fund management and investment strategies. We look at the performance of mutual funds, the performance of certain popular contrarian and momentum investment strategies, and finally we look at the investment strategies of hedge funds. Chapter 5 surveys some of the literature on market microstructure, with the emphasis on how the bid-ask spread is formed in financial markets and on how speculators seek to optimally benefit from their information advantage. Chapter 6 discusses optimal investment for investors using optimal diversification strategies. Chapter 7 discusses risk immunisation strategies to remove some or all risk factors from the investor s portfolio. Chapter 8 discusses risk and performance measurement. Chapter 9 looks at portfolio insurance strategies and value-at-risk based risk management strategies. Aims and objectives This subject guide is designed to introduce you to the investment environment in the role of a private or professional investor. This course does not cover pricing theory, which is a major part of 92 Corporate finance. Instead, it emphasises the use of pricing theory in investment management. It aims to: provide an overview of institutional details linked to financial markets and the trading process provide an overview of historical trends and innovations in financial instruments and trading processes 1

8 23 Investment management provide an overview of various financial instruments provide insight into the use of finance theory in investment management provide a guide to the measurement and analysis of risk of financial investments provide a guide to the measurement of performance of fund management address key issues in risk management. Learning outcomes At the end of this course, and having completed the Essential reading and activities, you should be able to: list given types of financial instruments and explain how they work in detail Syllabus contrast key characteristics of given financial instruments briefly recall important historical trends in the innovation of markets, trading and financial instruments name key facts related to the historical return and risk of bond and equity markets relate key facts of the managed fund industry define market microstructure and evaluate its importance to investors explain the fundamental drivers of diversification as an investment strategy for investors aptly define immunisation strategies and highlight their main applications in detail. discuss measures of portfolio risk-adjusted performance in detail and critically analyse the key challenges in employing them competently indentify established risk management techniques used by individual investors and corporations. Exclusions: This course has replaced course 121 International financial markets and may not be taken if you are taking or have passed course 121 International financial markets. If you have failed course 121 and wish to transfer to course 23, your fail on course 121 will count as one of the three chances you have to pass the new course. Prerequisites: If you are taking this course as part of a BSc degree, you must have already taken course 24 Principles of banking and finance (or course 94 Principles of banking for students registered before 1 September 2005). Course 92 Corporate finance must also be taken with or before this course. The syllabus comprises the following topics: 1. Financial markets and instruments: money and bond markets; equity markets; derivative markets; managed funds; margin trading; regulation of markets. 2. History of financial markets: historical and recent financial innovation; historical equity and bond market returns; equity premium puzzle. 2

9 Chapter 1: Introduction 3. Fund management and investment: historical mutual fund performance; market efficiency and behavioural finance; return based trading strategies; hedge funds. 4. Market microstructure: types of markets; bid-ask bounce: the Roll model; Glosten-Milgrom model; Kyle model; discrete version of the Kyle model; limit order markets; statistical arbitrage (algorithmic trading, program trading); why market microstructure matters. 5. Diversification: expected portfolio return and variance; definition of risk premium; asset allocation two assets: mean-variance preferences; optimal asset allocation with a risk free asset; CARA utility and normal returns; portfolio frontier; expected return relationships; estimation issues; diversification the single index model; Treynor-Black model; factor models; statistics of asset allocation. 6. Portfolio immunisation: bond math; term structure; duration; numerical examples; immunisation of bond portfolios; convexity and immunisation; immunisation of equity portfolios. 7. Risk and performance management: types of risk; risk decomposition; hedge ratios; Value-at-Risk; Sharpe ratio; Treynor s ratio; more portfolio performance measures; Sharpe vs Treynor; portfolios with changing risk; market timing; non-linear pay-offs; extreme risk. 8. Risk management: risk management for investors; risk management for corporations; risk management for banks; delta hedging; put option protection; put protefction vs VaR; portfolio insurance with calls; hedging credit risk; hedging volatility; risk capital allocation. Reading advice At the start of each chapter in this subject guide your recommended reading appears in two categories, Essential reading and Further reading, to be found in both textbooks and journal articles. Essential reading The course uses two essential textbooks as listed below: Bodie, Z., A. Kane and A.J. Marcus Investments. (Boston, Mass.; London: McGraw-Hill Irwin, 2008) eighth edition [ISBN ]. Elton, E.J., M.J. Gruber, S.J. Brown and W.N. Goetzmann Modern Portfolio Theory and Investment Analysis. (New York; Chichester: John Wiley & Sons, 2010) eighth edition [ISBN ]. Detailed reading references in this subject guide refer to the editions of the set textbooks listed above. New editions of one or more of these textbooks may have been published by the time you study this course. You can use a more recent edition of any of the books; use the detailed chapter and section headings and the index to identify relevant readings. Also check the VLE regularly for updated guidance on readings. Further reading Please note that as long as you read the Essential reading you are then free to read around the subject area in any text, paper or online resource. You will need to support your learning by reading as widely as possible and by thinking about how these principles apply in the real world. To help you read extensively, you have free access to the virtual learning environment (VLE) and University of London Online Library (see below). 3

10 23 Investment management Books Other useful texts for this course include: Allen, F. and D. Gale Financial Innovation and Risk Sharing. (Cambridge, Mass.; London: MIT Press, 1994) [ISBN ]. Campbell, J.Y. and L.M. Viceira Strategic Asset Allocation. (New York: Oxford University Press, 2002) [ISBN ] Chapter 2. Duffe, D. and K.J. Singleton Credit Risk: Pricing, Measurement and Management. (Princeton, NJ: Princeton University Press, 2003) [ISBN ] Chapter 1. Embrechts, P., C. KlÄuppelberg, and T. Mikosch Modelling Extremal Events. (New York; Berlin; Heidelberg: Springer-Verlag, 1997) [ISBN ]. Note that this book is very advanced and is not really drawn on except for some initial observations made in the very beginning of Chapter 8 of the guide. Grinblatt, M. and S. Titman Financial Markets and Corporate Strategy. (Boston, Mass.; London: McGraw-Hill Irwin, 2008) [ISBN ]. Please note that at the time of going to print there is a new edition of this textbook due to be published. Hasbrouck, J. Empirical Market Microstructure. (Oxford: Oxford University Press, 2007) [ISBN ]. A relatively current textbook on market microstructure which forms the basis for the chapter on market microstructure. Lo, Andrew W. Hedge Funds. (Princeton, NJ: Princeton University Press, 2008) [ISBN ]. Pole, Andrew Statistical Arbitrage. (Hoboken, NJ: Wiley Finance, 2007) [ISBN ]. MacKenzie, Donald An Address in Mayfair. (London Review of Books) co.uk/v30/n23/mack01.html Stultz, R. Risk Management and Derivatives. (Mason, Ohio: Thomson South- Western, 2003) [ISBN ]. This book specifically deals with risk management. Journals There are a number of important journal articles that deal with investment management - those listed here are just a few: Elton, E.J. and M.J Gruber Modern portfolio theory: 1950 to date, Journal of Banking and Finance 21(11 12) 1997, pp Elton, E.J., M.J. Gruber and C.R. Blake Survivorship bias and mututal fund performance, Review of Financial Studies 9(4) 1996, pp Mehra, R. and E.C. Prescott The Equity Premium: A Puzzle, Journal of Monetary Economics 15(2) 1985, pp Sharpe, W.F. Asset Allocation: Management Style and Performance Measurement, Journal of Portfolio Management 30(10) 1992, pp Online study resources In addition to the subject guide and the Essential reading, it is crucial that you take advantage of the study resources that are available online for this course, including the virtual learning environment (VLE) and the Online Library. You can access the VLE, the Online Library and your University of London account via the Student Portal at: 4 You should receive your login details in your study pack. If you have not, or you have forgotten your login details, please uolia.support@ london.ac.uk quoting your student number.

11 Chapter 1: Introduction The VLE The VLE, which complements this subject guide, has been designed to enhance your learning experience, providing additional support and a sense of community. It forms an important part of your study experience with the University of London and you should access it regularly. The VLE provides a range of resources for EMFSS courses: Self-testing activities: Doing these allows you to test your own understanding of subject material. Electronic study materials: The printed materials that you receive from the University of London are available to download, including updated reading lists and references. Past examination papers and Examiners commentaries: These provide advice on how each examination question might best be answered. A student discussion forum: This is an open space for you to discuss interests and experiences, seek support from your peers, work collaboratively to solve problems and discuss subject material. Videos: There are recorded academic introductions to the subject, interviews and debates and, for some courses, audio-visual tutorials and conclusions. Recorded lectures: For some courses, where appropriate, the sessions from previous years Study Weekends have been recorded and made available. Study skills: Expert advice on preparing for examinations and developing your digital literacy skills. Feedback forms. Some of these resources are available for certain courses only, but we are expanding our provision all the time and you should check the VLE regularly for updates. Making use of the Online Library The Online Library contains a huge array of journal articles and other resources to help you read widely and extensively. To access the majority of resources via the Online Library you will either need to use your University of London Student Portal login details, or you will be required to register and use an Athens login: ollathens The easiest way to locate relevant content and journal articles in the Online Library is to use the Summon search engine. If you are having trouble finding an article listed in a reading list, try removing any punctuation from the title, such as single quotation marks, question marks and colons. For further advice, please see the online help pages: ac.uk/summon/about.php Examination structure Important: the information and advice given here are based on the examination structure used at the time this guide was written. Please note that subject guides may be used for several years. Because of this we strongly advise you to always check both the current Regulations for relevant information about the examination, and the virtual learning 5

12 23 Investment management environment (VLE) where you should be advised of any forthcoming changes. You should also carefully check the rubric/instructions on the paper you actually sit and follow those instructions. Remember, it is important to check the VLE for: up-to-date information on examination and assessment arrangements for this course where available, past examination papers and Examiners commentaries for the course which give advice on how each question might best be answered. The Investment management examination paper is three hours in duration and you are expected to answer four questions, from a choice of eight. You should ensure that you answer four questions, allow yourself an approximately equal amount of time to answer each question and attempt all parts or aspects of a question. Remember to devote some time to planning your answer. A full sample examination paper appears at the end of this guide. You are required to answer any four of these eight questions, each of which carries 25 marks. A typical question contains three sub-questions which may not be drawn from the same area, the first of which is relatively less diffcult than the other and carries a weight of five marks against 10 marks for the other two. 6

13 Chapter 2: Financial markets and instruments Chapter 2: Financial markets and instruments Learning outcomes By the end of this chapter, and having completed the Essential reading and activities, you should be able to: accurately distinguish key characteristics between equity and debt claims clearly express the main differences between IPOs (initial public offerings) and SPOs (seasoned public offerings) contrast exchange traded securities and OTC (over-the-counter) securities in detail adequately describe given money market and bond market instruments differentiate clean and dirty bond prices and aptly explain how accrued interest is calculated cogently discuss the importance of financial markets regulations Essential reading Bodie, Z., A. Kane and A.J. Marcus Investments. (Boston, Mass.; London: McGraw-Hill Irwin, 2008) Chapters 1, 2, 3, 4, 14, 20, 22 and 23. Elton, E.J., M.J. Gruber, S.J. Brown and W.N. Goetzmann Modern Portfolio Theory and Investment Analysis. (New York; Chichester: John Wiley & Sons, 2010) Chapters 2 and 3. Further reading Grinblatt, M. and S. Titman Financial Markets and Corporate Strategy. (Boston, Mass.; London: McGraw-Hill Irwin, 2008) Chapters 1, 2 and 3. Guide to readings This chapter is an introductory chapter and contains a great deal of background readings from both the Essential and the Further readings. The Essential reading for the general material in this chapter is contained in Bodie, Kane and Marcus Chapters 1 through to 4. Here you can read the material relatively quickly as there are few technical details to remember. Some of the more technical material in this chapter is covered in Bodie, Kane and Marcus Chapters 14, 20, 22 and 23. Here you can be more selective in your reading, but you may also have to read the material more carefully so that you are sure you understand it properly. Introduction Financial assets are distinct from real assets in that they do not generate a productive cash flow that is what real assets do. Examples of real assets are: a block of flats that can be let to provide the owner with future rental income; the rights to manufacture and sell a particular product generating future sales revenue; or a particular piece of computer software that generates future sales and registration income. Examples of financial assets are: a loan that is used to fund the acquisition of the block of 7

14 23 Investment management 8 flats and whose payments are financed by the rental income; or equity capital used to fund the research and development costs for the consumer software products mentioned above. The equity holders benefit in terms of future dividends or capital gains that are generated from the future sales income of the products. From the point of view of cash flow generation, therefore, financial assets do not have much of a role to play. Financial assets are not neutral in the sense that they transform the cash flow of real assets for the holder. For instance, the loan generates a relatively stable income even though the underlying cash flow is risky. Also, the loan might have enabled the investor to raise suffcient funds for investment in the first place. We trade financial assets, therefore, to repackage or transform the cash flow of real assets, either through time or across states of nature. Financial assets also do another important job they enable us to separate the functions of ownership and control of real assets. As a rule, real assets do not just passively generate a cash flow they need to be managed. A company owns a collection of real assets. The job of managing these is highly specialised and it is necessary that it is done by a professional. This individual may or may not be the owner of the real assets, so it makes sense for the company to keep the ownership and control functions separate. This can be done by issuing equity with claims on the real assets of the company the owners of the company s equity then become the owners of the company so that the company can hire a professional manager to manage its pool of real assets. Who uses financial markets? There are three key sectors: The household sector you and me who need to invest for retirement income or mortgages for house acquisitions and various insurance products, for instance. The business sector consisting of firms that need to issue financial claims on their future cash flow to finance current investments which need to manage the risk of their business through derivatives trading and insurance products. The government sector that has a need to finance public expenditure. This sector is special as it sometimes also intervenes in financial markets to provide a public policy objective for instance, influence the interest rate to manage inflation and additionally by acting as a regulator of the activity in financial markets. On the other hand, financial markets are not the only way these sectors are served by financial instruments. Financial intermediaries also provide services. These are companies such as banks and investment houses which can lend money to, and help companies issue securities, and collect deposits or lend to households, or manage households and companies funds. In this chapter, we shall discuss a relatively broad range of financial assets (also known as financial instruments), and their key defining characteristics. Money and bond markets The simplest form of claim is a bond. A bond is a fixed claim meaning that it promises a particular cash flow normally a coupon payment that is an annual or semi-annual payment measured as a percentage of the principal amount, and then ultimately at maturity the principal repayment is made. For instance, a 10-year 5% bond with principal 100, will pay a coupon payment of 5% of 100 each year until maturity, or five, and additionally at maturity, in year 10, it pays the principal of 100.

15 Chapter 2: Financial markets and instruments The cash flow promised to bond holders comes from the cash flow generated by real assets. Since the cash flow of real assets is often risky, it may be that there is not enough to pay the promised amount at all times. If this happens, the bond may default. In the example above, for instance, the coupon promises a cash flow of 100 to be paid to the bond holders, but if the corporate cash flow available in year 10, after coupon repayments are made, is only 70 the bond holders stand little chance of receiving their promised repayment of 100. The bond defaults, therefore, and the bond holders can expect to receive at most only 70. Some bonds are, however, practically default-free for instance, bonds issued by the government (government bonds they are often called treasury bonds in the USA and gilts in the UK). Bond instruments are traded in the money market or the bond market. The distinction between these markets is essentially that of the original maturity of the instrument. If a bond was issued with very short maturity normally less than six months it will be traded in the money market. If a bond has longer maturity it is traded in the bond market. Another distinction is the denomination of the claim. Normally, money market instruments are traded in large denominations so as to be out of reach of normal households. They are used by banks and corporations to lend and borrow in the short term. Bonds, on the other hand, can be held by households. Money market instruments The money market consists of fixed-income instruments of relatively short maturity. This market also tends to be highly liquid, and instruments can be in very high denominations, making it impractical for ordinary people to trade. The players who operated in this market are normally private banks, the central bank and corporations. There are a number of risk free instruments traded, which are issued by the government, such as US treasury bills, certificates of deposits and commercial papers. Treasury bills (T-bills) initially have a maturity of 28, 91 or 182 days (approximately one, three and six months). Treasury bills have two atypical characteristics that set them apart from many of the other money market instruments. They normally sell in low denominations of US$ 10,000, making them tradeable by individuals. A certificate of deposit (CD) is a deposit with a bank that has a clearly defined time limit, so cannot be withdrawn on demand. These are, therefore, very similar to T-bills except they are issued by a private bank instead of the government. CDs are in denominations of US$100,000 or greater, and in maturities of three months or shorter. Although there is a theoretical default risk on CDs, they are treated as normal bank deposits, so will be subject to governmental deposit insurance schemes. A commercial paper is another short term fixed income security that is similar to the ones we have looked at above but is issued by corporations. There is a default risk associated with these instruments, but often they are backed up by a bank line of credit so the borrower can access funds to pay off the commercial paper at maturity. These instruments are also often rolled over at maturity, such that the old commercial paper is paid off by issuing a new one. The denominations are in multiples of US$100,000 so commercial papers are rarely traded by individuals. An important source of very short term financing used to trade government bonds is the repo market (and the mirror reverse market). A repo (RP) is a repurchase agreement where a dealer sells government 9

16 23 Investment management 10 securities overnight to an investor and promises to buy the security back the next day at a given (and slightly higher) price. The transaction is, therefore, equivalent to a one-day loan agreement, since the agreement provides a cash inflow today to the seller (as will be the case with a loan) against a specified cash outflow tomorrow (as will be the case when repaying a loan). These agreements are also very secure to the buyer in the agreement (in this case he plays the role of a lender), who holds the government bond overnight which serves as collateral in case the borrower cannot raise suffcient funds to buy back the bond as promised. A reverse repo is the mirror image, a buy transaction held overnight under the promise of selling the securities the next day. Longer agreements are called term repos, and are used for loans up to 30 days or more. Another important short term financing market is the market (the London Interbank Offered Rate) which is the rate at which large banks in London are willing to borrow and lend money. Access to this LIBOR market is of course restricted, but the LIBOR rate has become very important as a reference rate, and many short-term fixed income instruments with a floating rate tie their rates to the LIBOR (i.e. the rate is LIBOR plus a margin). Bond market instruments The bond market also offers fixed income securities, only at longer maturities than the money market instruments. A very large part of this market consists of government bonds which are debt instruments with payments guaranteed by the government. These bonds are important because they offer investors claims that are in effect risk free, and they are important to the government because they provide an important source of borrowing. Common bonds are Treasury bonds and bills (issued by the US government) and gilts (issued by the UK government). The UK government bond market also trades two very unique types of bonds: consol bonds (bonds with no redemption date, they are in effect a perpetual loan that pays a coupon rate forever); and index linked bonds (bonds where the repayments coupons and capital repayments are index linked to the inflation rate). The yield of index linked bonds is the closest we get to a direct estimate of the real interest rate. Zero-coupon bonds are bonds that have no coupon payments. These bonds always trade below par value (the nominal value of the loan) because of the time value of money. If the interest rate is 5%, the value of a five-year zero coupon bond equals the discounted capital repayment. If the par value is 100, the current price of the bond is 78.35: Price = 78:35 = The convention in quoting bond prices is to adjust for accrued interest the clean price. This means that the bond price you actually pay is in general not equal to the bond price that is quoted in the financial pages. The price you pay is the quoted price plus the accrued interest the dirty price. The adjustment for accrued interest involves stripping the bond price of the first coupon payment. Consider two bonds: one bond has maturity 11 years less one day and the other maturity 10 years plus one day. Both bonds have an annual coupon with rate of 5% prices the holders of the first bond has just received a coupon payment one day ago, and the holders of the second bond is due a coupon payment shortly in one day s time. Suppose the discount rate is also 5%. The actual prices of the two bonds are:

17 Chapter 2: Financial markets and instruments Price first bond = = /365 Price second bond = = /365 At the time of the next coupon payment, the bonds trade at exactly par value since the coupon rate equals the discount rate. But because of the difference in the timing of the coupon the actual prices are different. The accrued interest for the two bonds is given by the formula: Accrued interest = coupon payment days since last coupon payment days separating coupon payments We find, therefore, the following quoted prices for the two bonds: 1 Quoted price first bond = = Quoted price second bond = = The adjustment for accrued interest makes the prices comparable. Bonds are fixed securities but they often feature call provisions. Gilts often have call provisions determining the redemption date so that the UK government may retain flexibility to redeem the bond within given time intervals. It is common in these circumstances to treat the redemption date as the first date in the redemption interval if the coupon rate is greater than the current market rate (so that the loan is relatively expensive compared to the current rate for the UK government) and conversely as the last date in the redemption interval if the coupon rate is less than the current market rate. Equity markets Equity is, as opposed to a fixed claim like a bond, a residual claim. This means that it has a cash flow that is in the form of the residual cash flow of the real asset after all fixed claims with promised payments are paid off. For instance, if a business is financed by a 10-year bond in addition to its equity, the equity holders have a claim on the business net of the cash flow that is promised to the bond holders. The equity claim is the means by which ownership and control for corporations are separated. When we refer to the owners of a corporation we mean the owners of the corporate equity and not the owners of the corporate debt, although both have claims on the cash flow of the firm. The owners of the equity are, however, normally not directly involved in the running of the corporation this is the job of the executive manager who is hired to do precisely this job. Therefore, the ownership is separated from the control function in corporations. The manager is hired on a long-term basis (although he may be fired at short notice) whereas the owners of the equity can decide for themselves whether they wish to invest long-term or short-term in the corporation. The separation of ownership and control is, therefore, a simple way to achieve a long-term stable management structure even if the owners of equity are all short-term investors. In partnerships (such as many accounting and legal practices) it would create a great deal of operational upheaval to have ongoing ownership changes taking place. 11

18 23 Investment management We can say, however, that the equity holders have more influence on the running of the company than the debt holders. The direct influence of an individual equity holder is nonetheless limited. An equity holder normally gets the right to vote in general meetings. This means in practice that he gets the chance to influence a few very important decisions such as large investment projects or decisions related to corporate mergers and takeover through his vote, and also to influence the choice of who sits on the non-executive board of directors (NED). The NED has a direct oversight on the executive management team of the corporation, and it is essentially through representation on the NED that shareholders have their main influence in the running of the firm. A lot of measures aimed at strengthening corporate governance are aimed at making the NED more effective in overseeing the executive management team. Initially, companies issue equity that is owned privately (i.e. it is not listed on a stock exchange) by an entrepreneur, a family, or by venture capitalists. The process of making private equity public normally involves the corporation seeking listing of its equity on a stock exchange. The equity can thereafter be traded freely by all investors. The first time a company seeks a listing is called an Initial Public Offering (IPO). Subsequent equity issues are called seasoned issues, and these are much less involved than the IPO since the equity has been traded for a while before the issue. If the company sells existing equity (for instance, if the government sells equity that is already issued but fully state owned) in the IPO or during a seasoned issue, we call it a secondary issue. If new equity is issued, we call it a primary issue. Sometimes the company needs to raise additional capital when it goes public, and in this case it is necessary to make some of the issued equity a primary issue. Otherwise, the issue is primarily a process of transferring equity from the initial owners to the new investors. Equity instruments Equity instruments consist of stocks common stocks or preferred stocks in publicly traded companies. The two most distinctive features are that they are residual claims and that an owner can exercise the right to limited liability (i.e. the owner can decide to relinquish his claim on the real underlying assets and instead hand these over to the other claim holders). A residual claim is a claim that is unspecified, it will be determined as the residual of the total corporate cash flow net of all fixed claims. Therefore, if the corporate cash flow is 100m, on which the debt holders have a fixed claim of 75m, the residual cash flow due to the equity holders is the residual 100m 75m = 25m. The implication of the fact that equity is a residual claim is that its value can never exceed the value of the total real assets of the firm. The implication of the fact that the equity holders can exercise the right to limited liability is that the value of the equity can never become negative. Common stock and preferred stock differ in two respects. First, common stock holders normally have voting power in general meetings whereas preferred stock holders have not. Second, the claim of preferred stock holders has seniority over that of common stock holders. Thus, if the company wishes to pay dividends to its common stock holders it must first pay a dividend to its preferred stock holders. Common stock is often split into two classes (dual-class shares), usually called A and B shares. These classes differ in their voting power, where one class (normally A shares) have superior voting power relative to the other class. The reason dual-class share structures are introduced is 12

19 Chapter 2: Financial markets and instruments that a controlling family may wish to retain the majority of the voting power whilst at the same time may diversify by selling B shares to outside investors. Dual-class share structures are relatively rare in the USA and the UK but can frequently be found in Europe and Japan. Derivatives markets Bonds and equity claims are claims that perform a dual role. For the issuer (businesses, banks or governments), these claims are a means of raising capital used for investment or expenditure. For the investors, these claims are means of smoothing real cash flows across time and states. Derivatives are instruments that do not really play a direct role as a means of raising capital that is, these instruments are in zero net supply. If no buyer exists for a particular derivative instrument, then also no seller exists. Derivatives are, therefore, almost exclusively used for risk management purposes. Derivatives are also sometimes called contingent claims. The cash flow of derivatives is almost always linked to the price of a primary asset such as a bond or an equity claim the underlying asset. In this sense, therefore, the cash flow is a function of, or contingent on, what happens to the price of the underlying asset. However, recently we also observed derivatives that had a cash flow contingent on other events, such as the event that a bond defaults (credit derivatives), or the event that the weather is bad (weather derivatives). There are three broad types of derivative claims: futures (forwards), options and swaps. If you enter into a futures or forward agreement, you effectively undertake the obligation to buy or sell an asset at a specified price in the future. An option is like a futures agreement, except that you have the right to buy or sell rather than an obligation. This implies that you have the right to opt out of the transaction if you own an option, but must always carry out the transaction if you own a futures contract. A swap is an undertaking to swap one cash flow for another cash flow. Managed funds Managed funds represent, in essence, a delegation of the investment decision from the individual investor to a professional fund manager. We distinguish between active and passive funds, fixed income and equity funds, and open-end and closed-end funds. An active fund is one where the fund manager typically makes investment decisions that are in the form of bets the manager might think that certain sectors or certain stocks are better bets than others and influences the investments of funds to these sectors or stocks. A passive fund is one where the fund manager typically attempts to mimic a broad stock market index (like the FTSE 100 in London and the Standard & Poor 500 in New York). This normally amounts to physically holding the index or a large number of stocks in the index. Open-end funds are funds where the investors clear their holding directly with the fund. Therefore, if a new investor comes in to buy units of the fund the fund simply issues new units. The price the investor pays is the Net Asset Value (NAV) less charges. The NAV is calculated as the total net value of the fund divided by the number of units issued to investors. Closed-end funds are funds which have a fixed number of units issued. If an investor wishes to buy units in 13

20 23 Investment management the fund he needs to trade with existing investors. Units in closed-end funds have, therefore, a value which is independent of the value of the assets held by the fund. There have historically been price discrepancies between the total value of outstanding units, and the total net value of assets held by the fund, where units have traded at a considerable discount relative to their theoretical value. Exchange traded funds A fairly new innovation for private investors is the so-called exchange traded funds (ETFs). These are typically index tracker style funds, but they are exchange traded like a stock. This makes it possible for small investors to hold an index cheaply and effciently without having to physically diversify by trading a large number of stocks in small quantities. Examples of exchange traded funds are the DIAMONDS fund on the NYSE, which delivers the Dow Jones Industrial Average Stock Index, and the iftse100 fund on the London Stock Exchange, which delivers the FTSE 100 Index. Exchange trading and over-the-counter (OTC) trading The process by which financial assets are traded can be divided, broadly speaking, into exchange trading and over-the-counter (OTC) trading. Exchange trading involves investors submitting buy-and-sell orders that are aggregated into some system that allows buyers and sellers to be matched directly. OTC trading involves investors submitting buy-and-sell orders to a dealer who acts as an intermediary in the trade. The dealer will normally take proprietary positions in the stock and thereby expose himself to inventory risk, but over time these inventories cancel out as investors execute trades at both the buy and sell side of the dealer s inventory. Large stock markets such as the NYSE (New York Stock Exchange) and the LSE (London Stock Exchange) are executing exchange trading of securities, whereas the NASDAQ stock market is an OTC market with a panel of dealers offering bid and ask prices for the listed stocks. In a perfect world in which each trader is able to trade at the competitive prices at all times the difference in market structure does not translate into any real differences in the execution of the trade. However, the OTC market structure has been criticised for allowing trading at the bid and ask prices when there exist limit orders inside the spread that could trade at a better price (so-called trading through), and large markets such as the NASDAQ market are working to improve their system. In 1997, the LSE carried out a conversion from OTC trading (much like the NASDAQ market structure) to exchange trading using a fully computerised limit order system (the SETS system). There is no intermediary at all in this market. The NYSE operates a system in which a limit order book executes most trades but that also a significant portion of the trading volume is executed by an intermediary (the so called specialist) who might improve on the quotes implied by waiting limit orders. The benefit of having such an intermediary is that relatively competitive quotes are also offered in stocks that are thinly traded. Chapter 3 of Bodie, Kane and Marcus describes the securities trading process in more detail. 14

21 Chapter 2: Financial markets and instruments Clearing, settlement, margin trading, short sales and contingent orders The trading process of stocks has become increasingly sophisticated. All transactions taking place on a stock exchange are cleared once a day, where the net positions are to be settled. If, for instance, you both buy and sell the same security over the course of a single day, it is only the net trading that needs to be settled. Settlement takes place within three working days on the NYSE, so that if you have bought net stock on Monday, you will receive your share certificates and pay the outstanding amount on Thursday. You can also trade stock on margin, which means that you only pay for a part of the purchase price and you borrow the rest from your broker. The broker normally has a working relationship with a bank or a financing house to finance loans made through margin trading. A margin needs to be maintained over time. For instance, if you purchase shares initially worth 10,000 on a 60% percentage margin, you need to pay only 6,000 and you borrow the remaining 4,000 from your broker. Suppose your account stipulates a 50% maintenance margin. If the shares decline in value, suppose they drop to 7,000, your margin would have decreased below 60% also. The margin is now (7,000 4,000)/7,000 = 43%, so you need to inject more money into your account to maintain a margin of 50%. After the repayment, your margin is worth 3,500 and the loan is 3,500. You can sell a stock you do not own to take advantage of price drops. Technically, it is illegal to sell a stock you do not own but you can circumvent these rules by borrowing share certificates from somebody who already owns the stock, which are then short sold. The owner of the share certificates will normally demand a fee. Fund managers who manage large funds (such as pension funds) are often lending their certificates to investors who wish to go short in the stock, since these funds do not normally plan to sell the stock anyway. Short selling is used particularly by hedge funds as an integral part of the investment strategy. You can also instruct your broker to execute contingent buy-and-sell orders. The most common of these are called limit orders, where you instruct your broker to buy a certain amount of stock as long as the purchasing price is below a certain limit, or to sell a certain amount of stock as long as the selling price is above a certain limit. You can also use so-called stop loss and stop buy orders. A stop loss order is an instruction to sell a quantity of a stock as long as the price remains below a certain limit, and a stop buy order is an instruction to buy a quantity of a stock as long as the price remains above a certain limit. These are used to limit the loss potential of long and short positions. For instance, if you own a large quantity of a stock that has already appreciated in value, you may wish to protect your profit by giving a stop loss order. The sell order comes into effect if the stock price goes below a certain limit. Similarly, if you have a large short position and you wish to protect the existing profit you may be giving a stop buy order. Working out the profitability of margin trades When you are trading on margin you are in effect taking a leveraged position, where the total return is shared between the broker (who borrows or lends money from you on his margin account) and yourself. It can become complicated sometimes to work out the return on these trades, so we will go through a couple of examples here of a long trade 15