Introduction to Investments FINAN 3050

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1 Introduction to Investments FINAN 3050 : Introduction (Syllabus) Investments Background and Issues (Chapter 1) Financial Securities (Chapter 2) Syllabus General Information The course is going to be organized through WebCT: distribution of information (slides, homework assignments, ) Office hours: after class and by appointment via Contact me: Open door policy Prerequisite: FINAN 3040 Always bring a calculator Book: Essentials of Investment by Z. Bodie. A. Kane and A. Markus (6 th edition) Slide 2 Syllabus Assessment Two exams: midterm and a final Closed book Multiple choices You can use a one page cheat sheet Four homework assignments In-class participation: Class attendance is not required (but recommended) You can earn credit for active participation Slide 3 1

2 Syllabus Homework Exercises Each student has to turn in a written solution (make a copy for yourself) on time (no late submissions) Standardized cover page: on the first page you have to only write Name and UId Indicate the exercises that you solved Each student has to be prepared to present his solutions in class when we discuss the exercises (this implies that you have to be in class) If you are unable to explain your solution, you loose all the points from the homework assignment Slide 4 Investments and Financial Assets Essential nature of investment Reduced current consumption Planned later consumption Real Assets: Assets used to produce goods and services Define the wealth of an economy Financial Assets: Claims on real assets Just pieces of paper or electronic documents (computer entries) Define the wealth of investors Slide 5 Major Classes of Financial Assets or Securities Debt: Money market instruments Bonds Common stock Preferred stock Derivative securities Slide 6 2

3 Real vs. Financial Assets Exercise Are the following assets real of financial: Patents Lease obligations Customer goodwill A college education A $5 bill Slide 7 Financial Markets and the Economy Consumption timing Allocation of risk Separation of ownership and management agency issues Slide 8 The Investment Process Asset allocation Security selection Risk-return trade-off Market efficiency Active vs. passive management Active management: security picking and timing of your investment decisions Passive management: holding an efficient (broadly diversified) portfolio Slide 9 3

4 The Investment Process Exercises The average rate of return on investments in large stocks has outpaced that on investments in Treasury bills by over 8% since Why, then, does anyone invest in Treasury bills? You see an advertisement for a book that claims to show how you can make $1 million with no risk and with no money down. Will you buy the book? Slide 10 Players in the Financial Markets Business firms: primary need to raise funds net borrowers Households: primary need to invest funds net savers Governments: can be both borrowers and savers Financial intermediaries (e.g., investment banks) and financial markets: link borrowers and savers Slide 11 Household Financial Assets: U.S. vs. Japan Slide 12 4

5 Key Trends Globalization: markets become more integrated (for financial and real assets) Positive effects: international diversification Negative effects: burst of the U.S. real estate market influences world markets Securitization: securities with new underlyings Credit card balances or mortgages Natural catastrophes like earthquakes Financial engineering: repackaging services of financial intermediaries and creating new financial securities Slide 13 Major Classes of Financial Assets Fixed Income Products: Money market: short-term (up to three months) Bond market: long-term (up to 50 years or even infinity) Equity markets: shares of companies Indexes: pools of (usually) similar assets (e.g., S&P 500, Dow Jones) Derivative markets: claim on another financial asset Slide 14 Money Market Instruments Treasury Bills Certificates of deposit Repurchase agreements and Reverse Repurchase Agreements Federal Funds LIBOR Market (also EURIBOR, VIBOR) Slide 15 5

6 Treasury Bills T-Bills with initial maturities up to 28, 91 and 182 days are issued weekly. T-Bills are highly liquid. Quotation in the WSJ: bankdiscount method Example: highlighted T-Bill ( 91 ) 1.24% = % 360 P= $1000 ( ) = $ Slide 16 Spreads on CDs and Treasury Bills Slide 17 Bond Market Treasury notes (maturities up to 10 years) and bonds (maturities > 10 y.) Federal agency debt: issued by e.g., Federal Home Loan Bank International bonds Municipal bonds (maturities < 30 y.): issued by state and local governments General obligation bonds or revenue bonds Interest income is not subject to federal and sometimes state tax Corporate bonds: Issued by private firms Subject to larger default risk Mortgages and mortgage-backed securities (securitization) Slide 18 6

7 Quotation of Treasury Bonds, Notes and Bills Rate: coupon paid by bond Bid price, ask price and change in units of 1/32 of a point quoted as percentage of par value Yield to maturity based on ask price: annualized rate of return to an investor who buys the bond and holds it until maturity Slide 19 Quotation of Treasury Bonds, Notes and Bills Exercises What were the bid price, ask price and yield to maturity of the 13.25% May 2014 Treasury bond displayed on the previous slide? What was its ask price on the previous day? Slide 20 Municipal Bonds Equivalent Taxable Yields To compare yields on taxable securities a Taxable Equivalent Yield must be constructed: r ( 1 t) rm r= 1 t = r m Slide 21 7

8 Equivalent Taxable Yields - Exercises Given the equations on the previous slide show that: rm t=1 r Suppose your tax bracket is 28%. Would you prefer to earn a 6% taxable return or a 4% tax-free yield? What is the equivalent taxable yield of the 4% tax-free yield? Slide 22 Equity Markets Common stock: Residual claim: in the case of default all other claimholders (e.g., debt holders) are serviced before Limited liability: equity holders cannot be forced to put in more money Preferred stock: Fixed dividends Priority over common Tax treatment Depository receipts: e.g. international cross-listings Slide 23 Equity Markets Exercises If you buy 100 shares of IBM common stock, to what are you entitled? What is the most money you can make over the next year? If you pay $95 per share, what is the most money you could lose over the year? Slide 24 8

9 Listing of Stocks Traded on the NYSE Slide 25 Traded Stocks Exercise Examine the stocks listed on the previous slide: For how many of these stocks is the 52-week high price at least 50% greater than the 52-week low price? What do you conclude about the volatility (risk) of prices on individual stocks? Slide 26 Stock Indexes Track average returns Comparing performance of managers Base of derivatives Characteristics of indexes: Representative for a certain markets Broad vs. narrow Weighting of individual index components: price weighted, market value weighted, or equally weighted Examples: Dow Jones Industrial Average (30 Stocks) Standard & Poor s 500 Composite Nikkei (Japan), FTSE (London), Dax (Frankfurt) Slide 27 9

10 Performance of Several Stock Indexes Slide 28 Derivatives Securities Options: American call option: the right to buy an asset at a specified price (i.e., the strike price) on or before a specified expiration date American put option: the right to sell an asset at a specified price (i.e., the strike price) on or before a specified expiration date European options: can only be exercised at the specified expiration date Futures: obligation to buy (long) or sell (short) in the future Slide 29 Options Exercises Consider the following information for an option on IBM: Expiration: Oct Strike: $90 Price of call: $3.50 Price of put: $4.80 What would be the profit or loss per share of stock to an investor who bought this IBM call option if the IBM stock price at expiration of the options is $94? What about the purchaser of the put option? Why do call options with exercise prices higher than the price of the underlying stock sell for positive prices? Slide 30 10

11 Further Exercises Which security should sell at a greater price? (A) A 10-year Treasury bond with a 9% coupon rate or (B) a 10-year T-bond with a 10% coupon. (A) A three-month maturity call option with an exercise price of $40 or (B) a three-month call on the same stock with an exercise price of $35. (A) A put option on a stock selling at $50 or (B) a put option on another stock selling at $60 (All other relevant features of the stocks and options are assumed to be identical.) Slide 31 11

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