15.433 INVESTMENTS
Class 1: Introduction
Spring 2003
Outline
• Course Overview
• Market Overview
• Introduction to the Financial System
• Overviews of Equity, Fixed Income, Currencies and Derivatives
• Financial Innovations
• Summary
• Questions for Next Class
Course Mechanics
Course Grade:
Class participation
10%
5 group assignments 20%
Mid-tern exam
30%
Final exam
40%
Course Materials:
• Lecture Notes
• Textbook: Bodie, Kane and Marcus
• Articles in course reading packet
• Additional reading materials and handouts
Course Overview
Broadly speaking, this course will cover the following give themes:
• Financial theories: Portfolio theory, the CAPM and the APT
• Equity and equity options, and empirical evidence
• Fixed income instruments and fixed income derivatives, credit market and credit derivatives
• Market efficiency and active investments
• A brief introduction to behavioral finance
Course Objectives
Through this class I want to help you build the following skills:
• Analytical ability: modeling skills that are important in making
investment decisions,
• Quantitative skills: developing problem solving skills, data analysis,
probability evaluation of uncertain events.
• Empirical knowledge of the financial markets: equity, fixed income
(default-free and defaultable) and their respective derivatives.
The Financial System
The financial system can be viewed from two different angles:
• Institutional perspective: the financial system encompasses the markets, intermediaries, instruments, clients etc.; and
• Functional perspective: the financial system facilitates the allocation
and deployment of economic resources, across time and space and in
uncertain environment.
While its institutional composition changes over time and space (different places on the globe), the basic functions of a financial system are
essentially the same in all economies. The institutional dimension results
from the functional needs.
Functional Perspective
The financial system provides six functions:
• Transferring economic resources across time (e.g. student loans, retirement funds) and space (global financial market, e.g. institutional
investments)
• Clearing and settling payments to facilitate trades: money, check,
ATM cards, mortgages and mortgage interest payments, etc.
• Pooling of resources to undertake large-scale indivisible enterprise
(equities, money market funds, mutual funds etc.)
• Information to coordinate decision-making, facilitating information
flow, ”price discovery”, the normal indices for equities, fixed income
rates, volatilities etc.
• Dealing with agency problems, mitigate moral hazard, adverse selection and principal-agent based problems that are caused by asymmetry information or incentive mis-matches (collateralization, CEO
incentive for company performance etc.).
• Managing risks, bundling, packaging, pooling and tranching of risk
(insurance companies, CMO, CDO, exotic derivatives etc.)
Institutional Perspective
The institutional compositions of the financial system includes:
• Financial markets: equity, fixed income (debt), credits and derivatives
• Financial intermediaries: banks, insurance companies, pension funds,
mutual funds, investment banks, venture capital firms, asset management firms and information providers etc.
• Financial infrastructure and regulation: trading rules, contract enforcement, account system, capital requirements etc.
• Governmental and quasi-governmental organizations: SEC, central
banks (Federal Reserve System), the Bank for International Settlement (BIS), the International Monetary Fund (IMF), the World
Bank, etc.
International markets differ in many ways:
• The US market is currently the only market offering Financial Futures on individual stocks;
• Germany closed the ”Neue Markt”, eliminating a platform for not
very liquid stocks, regarding stock exchanges inexperienced companies, thus rising capital is getting more difficult for young companies;
• Investment attitudes and awareness are subject to national regulations, e.g. pension fund regulation - defined benefit vs. defined
contribution plans.
Stocks
Common stocks, also known as Equities, represent ownership shares of
a corporation.
• Two important characteristics: residual claim and limited liability;
• Sources of returns: dividends and capital gains;
• Calculating returns: buy at time 0 and pay P0 , sell at time T and
receive PT and dividend DT :
– The percentage return is calculated as:
rT =
PT + D T − P 0
PO
– The log-return is calculated as:
�
�
PT + D T
rT = ln
PO
(1)
(2)
For small rT , the log-return and percentage return are close.
Question: Why in some situations should we prefer to use logreturns?
• Some determinants of stock returns:
– Firm-specific condition: management, productivity, earnings, growthpotential, market-liquidity,
– Market condition: market indices (volatility, volume etc.), e.g.
Nasdaq, SP500, DAX, FTSE etc.
– Economic condition: macro-economic variables, e.g. GDP-growth,
inflation, employment rate, business cycles, liquidity, interest
rates etc.
• Some important empirical evidence:
– Patterns in the cross-section of stock return: value (value vs.
growth), size (small vs. large), momentum (low vs. high);
– Time-series behavior of stock returns: time-varying expected returns, predictability, stochastic volatility etc.
9/6/1993
-2%
-7%
-12%
9/6/1993
11/6/1997
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11/6/1993
-2%
-7%
-12%
1/6/1999
3/6/2000
3/6/2000
SBTSY10
Figure 1: Daily returns of SP 500-index, Nasdaq-index and T-Bonds 10 years
9/12/2001
7/12/2001
5/12/2001
3/12/2001
1/12/2001
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3/12/1999
7/6/1998
3%
5/6/1998
8%
7/6/1998
SBTSY10
1/12/1999
CCMP
5/6/1998
3/6/1998
3%
1/6/1998
8%
3/6/1998
SPX
1/6/1998
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CCMP
11/12/1998
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1/12/1995
Stocks and Bonds
SPX
8%
3%
-2%
-7%
-12%
30%
25%
25%
20%
20%
Probability
Probability
30%
15%
10%
15%
10%
5%
5%
0%
0%
-5%
-0.080
-5%
-0.080
-0.060
-0.040
-0.020
-
0.020
0.040
0.060
0.080
Daily Returns
Current Distribution
-0.060
-0.040
-0.020
-
0.020
0.040
0.060
0.080
Daily Returns
Current Distribution
Normal-Distribution
Normal-Distribution
Figure 2: Return distribution of US 10 Year Bond
Data source for Figures 1, 2, and 3: Bloomberg Professional.
Figure 3: Return distribution of S&P 500 Index
Fixed Income
Fixed income, also known as debt-instruments, promise to pay fixed,
pre-determined stream of cash flows in the future: Coupon payments,
Principal amount (denominations), Time to maturity, Sinking fund obligations, etc.
Figure 4: Cash Flows, Source: RiskM etricsT M , Technical Document, p. 109
Figure 5: Discounted Cash Flows, Source: RiskM etricsT M , Technical Document, p. 109
Treasury bills, notes and bonds vary in maturity. T-bonds may also be
callable during a given period.
The value of a bond can be reported in terms of price or yield to maturity. Yield go and price go.
Market Performance
Monthly returns 1926/7 to 2000/12
Equity Portfolio∗ Treasury Bills
Mean
0.99%
0.31%
Standard Deviation
5.50%
0.26%
Total Return
$1’828
$16.27
* Value-Weighted
The Term-Structure of Interest Rates
(Yield-Curve)
9
8
Yield Curves for US Treasury
7
6
5
4
3
2
1
0
3 Mo 6 Mo
1 Yr
1.1.1995
1.1.2001
2 Yr
3 Yr
1.1.1996
1.1.2002
4 Yr
5 Yr
6 Yr
1.1.1997
1.1.2003
7 Yr
1.1.1998
Figure 6: Treasury Yield Curve, Source: Bloomberg Professional.
How do we describe the term-structure:
• Shift
• Twist
• Butterfly
8 Yr
9 Yr
10 Yr 15 Yr 20 Yr 30 Yr
1.1.1999
1.1.2000
The Federal Funds Target Rates (set by FOMC) and the Discount Rates:
8.00
7.00
6.00
5.00
4.00
3.00
2.00
1.00
FOMC
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1/1/1991
0.00
3 Month LIBOR
Figure 7: Short Term Interest Rates FED, Discount rates over the last 4 years, Source Bloomberg Professional.
Corporate Bonds
Corporate bonds are similar in structure to Treasury issues, with one
important difference: default risk.
• Because of the default risk, corporate bonds are cheaper (than their
respective Treasury counterparts), paying higher yields.
• The difference in yields is referred to as credit spread.
• The probability of default varies across firms of different credit qualities (e.g. countries, industries, guarantees etc.)
• The probability of default varies over time!
Figure 8: Standard & Poor’s one year transition matrix, Source: RiskM etrics T M − T echnical Document, p.
69.
Derivatives
Overview of Derivatives by Structure:
• Forward and Futures;
• Options;
• Futures;
• Path dependent (e.g. look-back), etc.
Overview of Derivatives by Underlying:
• Equity Derivatives: stock options, index futures, futures options etc.;
• Fixed-Income Derivatives: caps/floors, swaps, swaptions, etc.;
• Credit Derivatives: credit swap, collateralized loan obligations, etc.;
• Other derivatives: FX, weather, ”exotics”, etc.
Currencies
Currencies are the most liquid financial instrument.
Currency instruments have generally spoken the same type of parameters, however with different characteristics, e.g. currency return volatility, which is not shaped in the same form as the equity return volatility.
Currency positions usually have a much shorter maturity proprietary
traders on Wall Street take positions up to half an hour!
Financial Innovation
Does financial innovation add value? If taken to excess, any virtue can
readily become a vice: The market has seen examples of failed financial
products, erroneous assumption and strategies, abusive usage of derivatives, distressed hedge funds etc. Empirical evidence supports the statement, that financial innovation does provide social wealth:
• It caters to the investment diversity desired by the investors;
• It improves the opportunities for investors to receive efficient riskreturn trade-offs;
• It provides risk management tools for all market participants; and
• It promotes broad distribution and liquidity to economic resources.
Securitization
Figure 9: Securitization of ”stand-alone” mortgages in liquid standardized mortgage-backed securities.
Securitization of the mortgage market: The national mortgage market
and mortgage-backed securities transform the residential house finance
from fragmented, local-based sources to a free-flowing, international base
of capital with depth and usually a higher credit rating.
Other examples: collateralized debt (loan or bond) obligations, asset
backed debt, etc.
Credit Enhancement
FleetBoston plays ”Good Bank/Bad Bank,” unloading $1.35 Billion in
troubled Loans Patriarch Partners LLC, a NY fund management boutique, created a CLO to raise about $1 billion to acquire the loans.
See the following figure how FleetBoston’s problem loans made their way
from Fleet’s books to a special collateralized-loan obligation, funded by
investors.
$ 275 million (face value)
in Ark subordinated securities
$ 725
million cash
FleetBoston
Patriarch
Partner's
Ark CLO
$ 1.35 billion in funded loans plus
$ 150 million in unfunded loans
Figure 10: Setting-up a special purpose vehicle.
$ 925 million in triple-A rated bonds
$ 75.75 million in single-A rated bonds
$ 35.5 million of equity
Patriarch
Partner's
Ark CLO
$ 1.036 billion cash
Summary
What to learn in this course? Analytical modeling skills, quantitative
tools, and empirical knowledge about the financial market and the financial instruments.
How to think about the financial system?
• Functional perspectives: across time and space;
• Institutional compositions: results from the functional needs.
• Does financial innovation add value?
• Sometimes abusive usage of financial innovation causes disruptions.
Overall, however, financial innovation provides diversified in-vestment
opportunities for investors, risk management tools and techniques for
market participants and liquidity to the overall market.
Focus:
BKM Chapters 1 & 2;
• p.16/17 (market structure);
• p.19 (securitization);
• p.28-46 (know the different instruments, e.g. CD, CP, Bankers Acceptances etc.);
• p.48-54 (know the most important market indexes, what kind of
different weighting-schema exist etc.);
Reader: Sharpe (1995);
Type of potential questions: p. 60ff. questions 1, 5, 11, 17, 23
Preparation for Next Class
Please read:
• BKM Chapters 3 & 5,
• Fama (1995), and
• Kritzman (1993).
Questions:
• What is a normal distribution?
• How do we model uncertainty?
• Is variance the only measure of uncertainty?
• What is the average daily return?
• What about the average variability?
• What assumptions did you have to make in order to obtain the
estimates?
• How accurate are your estimates?
• If given more observations (a large N), can you improve the precision
of your estimates?