Markets
Returns
Dr. Khaled Obaid
Ch 2: Financial Markets and Institutions
Securities
Returns
Securities
Markets
Outline
Markets
Securities
Returns
Securities
Returns
I Individuals and organizations come to borrow/raise capital
and lend/invest capital
I Provide rate of return for suppliers of capital, and
necessary funds for demanders to finance their projects
I Allocating capital efficiently is beneficial to the overall
economy (less money wasted); allocating capital to the
projects with the most promise
Financial Markets
Markets
Securities
I
I
I
I
Returns
Fixed payments (coupon & principal)
Contractual
No voting/control
e.g. US treasury bills (short-term), corporate bonds
(long-term)
I Fixed income/Debt
Securities Classifications
Markets
Securities
I
I
I
I
I
Returns
Ownership in the firm
Residual claim (last in line)
Limited liability
Voting power (control)
Various share classes with di↵erent voting rights (e.g.
Founders’ shares in Facebook provide 10x voting power
relative to standard share)
I Equities/common stock
Securities Classifications
Markets
Securities
Returns
I No voting power
I Higher priority compared to common stock in bankruptcy
I Cumulative dividends paid in perpetuity; usually fixed
I Preferred stock
Securities Classifications
Markets
Securities
Returns
I Raise capital
I Refinance debt or change capital structure
I Exploit private information
I Firms raise capital by issuing bonds (borrowing) and/or
stock (selling stake in the firm)
I IPO: process through which the firm o↵ers its shares to the
public
I Reasons for IPO:
How securities appear?
Markets
Securities
Returns
I Board approval
I Pick an underwriter
I Assess exchange listing requirements & perform due
diligence
I File prospectus and register with SEC (S1 Statement)
I Road show (get investors excited) & book building (take
tentative orders to gauge demand)
I Decide on price (usually fixed) and complete registration
with SEC
I Distribute shares (shares start trading on an exchange)
I Lockup period expiration (usually 3 to 6 months after IPO
date after which early investors such as founders, angel
investors, and venture capital investors can sell)
I IPO process:
How securities appear?
Markets
IPO
Markets
I Roughly a third of the company is sold in the IPO ($20
and $100 million)
I Two thirds of firms that do an IPO never pursue a SEO
I Familiar with legal and regulatory process and have access
to an investor base receptive to newly issued shares
I E.g. Goldman Sachs, Merrill Lynch
I Underwriters form a syndicate for large/risky IPOs
Returns
I In a traditional IPO (i.e. firm commitment), the
underwriters purchases all newly issued shares from the
company for a fixed price and resell to public investor.
Here, the underwriter absorbs any price risk
I Fees can range between 0.5%-1% for very large issues (>$1
billion) and 10% for very small issues (<$10 million)
I Underwriters
Securities
IPO
Markets
Returns
I Rights issue: entitle existing shareholders to buy additional
shares usually at a discount
I Private placement: sell shares to sophisticated investors
directly (not through public exchanges), why?
I Best e↵ort: investment bank does not underwrite, but
promise to do their best to sell as many shares as possible
I Dutch auction: taking all bids in first, then selecting the
best ones (e.g. Google’s IPO)
I Direct listing: a company sells existing shares directly to
public investors in a single transaction on the first day of
trading (more shares can be issued after the company is
public). Benefits include lower fees (no middle man) and
potentially capture first day pop in price (think of ABNB or
DASH). Potentially higher risk (how much will you get for
each share?). E.g. Spotify’s IPO
I Alternatives to traditional IPO process
Securities
Securities
Returns
I S1 was filed on 2/1/2012 (see it HERE)
I Roadshow
I Final prospectus is drawn up and IPO on 5/18/2012 at $38
per share (raised about $16 billion)
I Underwriters charged Facebook around 1% of the
transaction
I The price went up to $42.05 after the stock started trading
I Underwriters exercised an overallotment option (i.e.
‘Greenshoe’ option): sold additional 63 million shares to the
public in order to stabilize the price
I Lockup period expired on 10/31/2012
I Timeline
Facebook’s IPO
Markets
Securities
Returns
I Underwriter wants to reward clients and make their job
easier
I Reduce legal liability
I Information asymmetry (insiders know more than outsiders)
I 10% to 15% is considered normal underpricing (Facebook’s
underpricing was roughly 11%); why?
I E.g., SNOW initially priced its IPO between $75 to $85 a
share, finally agreeing to $120 a share
I Closed at $253.93 after first day of trading
I 110% IPO underpricing! The company could have generated
more than double from selling their shares at $250+
I Di↵erence between price of the stock at the end of the first
trading day and the IPO o↵er price
IPO Underpricing
Markets
Securities
Returns
I Created the Securities and Exchange Commission (SEC)
I Empowers the SEC to regulate all aspects of the securities
industry (register, regulate, and oversee brokerage firms and
securities exchanges like NYSE and NASDAQ, and require
companies to regularly report key financials to investors)
I 1934
I Investors receive financial and other significant information
concerning securities being o↵ered to the public
I Prohibit deceit, misrepresentations, and other fraud in the
sale of securities
I Prior to the 1929 stock market crash, misinformation was
rampant
I Many of the filings companies have to make with the SEC
are due to this law
I 1933
Securities Exchange Acts 1933/1934
Markets
Securities
Returns
I Firm is purchased by another firm and taken private
I Bankruptcy or liquidation (fail to meet minimum listing
requirements); e.g. HTZ after filing for Ch 11 bankruptcy
(restructuring) in 2020
I Via delisting
I Firms may reduce their outstanding shares by paying out
earnings in share repurchases
I Via share repurchases
How securities disappear?
Markets
I We expect our money to grow, i.e. we expect the
investment to generate a positive rate of return
Securities
Returns
I
I
I
I
Stocks of small firms tend to be very risky
Government treasury bills tend to be very safe
Real Estate, etc . . .
Precious metals (gold, silver), not income generating asset,
but shown to have positive expected returns . . .
I The riskier the stock or bond, the higher the compensation
we require (risk aversion)
I Risk and return characteristics vary by asset class
I Why do we invest our money in bonds and stocks?
Return
Markets
Securities
S&P 500 Returns (Large U.S. firms)
Markets
Returns
Securities
Returns
I We will learn the di↵erent ways to compute returns
I How did my investment perform over the past 10 years?
Average versus overall return
Return
Markets
Securities
PN
Returns
Q
I r =( N
t=1 (1 + rt )) 1 = ((1 + r1 ) ⇥ (1 + r2 ) · · · ⇥ (1 + rN )) 1
t Pt 1
I r = Pt +D
, where Pt is the price at end of investment
Pt 1
period, Pt 1 is the price at the start of the investment
period, and Dt is any dividend received during the
investment period
I Holding period return (HPR)
ri
N
I Arithmetic average return r = i=1
= r1 +r2 +···+r
N
N
I Geometric average return (time-series): takes into account
QN
compounding r = ( t=1 (1 + rt ))1/N 1 =
((1 + r1 ) ⇥ (1 + r2 ) · · · ⇥ (1 + rN ))1/N 1 (same idea behind
Compound Annual Growth Rate, CAGR))
I Where rt or ri is the period or security return, respectively,
and N is the number of returns in our sample
I Types of average returns (r )
Return
Markets
Securities
Returns
I For purposes of calculating average returns across di↵erent
stocks (equal-weighted portfolio returns), you want to work
with arithmetic average rates of returns
I For computing average past performance, you want to work
with geometric average rates of return (takes into account
compounding)
I HPR is for calculating the total performance of an
investment
Return
Markets
Securities
rAAPL
26.00%
4.00%
-7.00%
rIBM
-21.00%
-13.00%
12.00%
rSony
-10.00%
5.00%
47.00%
Returns
What is the return on your portfolio for the following years: 1991, 1992,
and 1993? What is the average annual return observed from holding this
portfolio over these years?
Year
1991
1992
1993
Assume you had equal weights in these three securities:
Example
Markets
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Securities
library('scales')
R_1991=(0.26-0.21-0.10)/3
R_1992=(0.04-0.13+0.05)/3
R_1993=(-0.07+0.12+0.47)/3
Avg=((((R_1991+1)*(R_1992+1)*(R_1993+1)))^(1/3))-1
Solution
Markets
Returns
[1] "4.42%"
> percent(Avg, 0.01)
[1] "17.33%"
> percent(R_1993, 0.01)
[1] "-1.33%"
> percent(R_1992, 0.01)
[1] "-1.67%"
> library('scales')
> percent(R_1991, 0.01)
Solution
Markets
Securities
Returns
Securities
Returns
I Earlier, we said that we should use the arithmetic average
rates of returns for calculating portfolio returns
I What happens if the portfolio is not equally weighted?
P
I r= N
i=1 wi ⇥ ri
I For example, say you hold $200 in PEP, $300 in KO, and
$500 in NFLX. Your total investment is $1,000, and your
portfolio investment weights are 20% in PEP, 30% in KO,
and 50% in NFLX. If the rate of return on PEP is 5%, the
rate of return on KO is 2%, and the rate of return on
NFLX is -7%, then the rate of return on your overall
portfolio (P) is:
I rP = wPEP ⇥ rPEP + wKO ⇥ rKO + wNFLX ⇥ rNFLX
Portfolio Returns
Markets
Securities
Returns
[1] "-1.90%"
> library('scales')
> return_p=(200/1000)*0.05+(300/1000)*0.02+(500/1000)*-0.07
> percent(return_p, 0.01)
Solution
Markets
Securities
Returns
I Example: You want to compare two investments; (i) 2%
over 20 days; and (ii) 7% over 60 days
I APR (annual percentage rate) = T1 ⇥ r where T is the
period length in years and r is the period return
I APY (annual percentage yield) = (1 + r )1/T 1
I APY with continuous compounding = e r ⇥ T1 1
I Annualizing returns: apples to apples
Annualizing Return
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Securities
library('scales')
APR_1=(0.02)*(1/(20/365))
APY_1=(1+0.02)^(1/(20/365))-1
APR_2=(0.07)*(1/(60/365))
APY_2=(1+0.07)^(1/(60/365))-1
Solution
Markets
Returns
Securities
[1] "50.92%"
> percent(APY_2, 0.01)
[1] "42.58%"
> percent(APR_2, 0.01)
[1] "43.53%"
> percent(APY_1, 0.01)
[1] "36.50%"
> library('scales')
> percent(APR_1, 0.01)
Solution
Markets
Returns
Securities
Returns
If a borrower takes out a two-week payday loan in the amount of $300
and the lender charges a $45 fee, what is the APR and APY for this
loan?
Payday Loan Example
Markets
Securities
[1] "3 723.66%"
> APY_1=(1+(45/300))^(1/(14/365))-1
> percent(APY_1, 0.01)
[1] "391.07%"
> library('scales')
> APR_1=(45/300)*(1/(14/365))
> percent(APR_1, 0.01)
Solution
Markets
Returns
I Riskier asset classes
Securities
Returns
I No
I Do assets with a positive average rate of return always
make you money?
I Broadly, yes
I Is there a risk-return relationship?
I Stocks and especially small stocks
I Which asset class is the most risky?
I Which asset classes generally o↵er higher average rates of
returns?
Returns
Markets
Securities
Asset Class
Short-Term U.S. Government Treasury Bills
Long-Term U.S. Government Treasury Bonds
Long-Term Corporate Bonds
Large Firm Stocks
Small Firm Stocks
Risk and Return trade-o↵
Markets
AvgReturn
4%
5.5%
6%
10%
15%
Returns
Risk
3%
10%
9%
20%
30%