Textbook, 12 edition
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This course
▪ It is not what you want/expect if
▪ get wealthy fast
▪ you are looking for a model answer for investments. It is common
to have conflicted/different views. That means you may not know
what to do or how to proceed at some point.
▪ Help me find out the target price for Tesla/Apple/Amazon
▪ Derivations of quantitative models
▪ you will cover some models from the perspective of applications,
their limitations but the derivations.
▪ Apart from covering some financial
models/theories, we will discuss some
contemporary issues about investments
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Peter Lynch: 10 Mistakes Every Investor Makes
• https://www.youtube.com/watch?v=c-2uuIz_sAQ
• Key points?
• Lesson: buy it when it is cheap?
• You may want to watch it (above) again after you have
started your own investment.
• You would like to watch it again when we deal with
stock valuation
• Peter Lynch: Financial Comedian with 29% Annual
Returns
• https://www.youtube.com/watch?v=OAWqm7MZtoc
• Key points
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Ch. 2
Chapter
Brief accounts on asset
classes and financial
instruments
Notes:
• Complicated financial models* may not always
provide you with good return
• Long-term capital management (LTCM) was a massive
hedge fund led by Nobel Prize-winning economists and
renowned Wall Street traders, what happened?
• Very often, simple models/calculations with sound
vision are more promising.
• You need to find your own strategies
• Class discussions (may be difficult) reinforce your
concepts and applications in practices
*some can be very useful
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Outcome and Q
• Understand the risk and return*
characteristics of different financial
instruments before investing in those
assets
• What rate of return can you get if you
• Deposit money at banks?
• Invest in stocks (big vs small firms)?
• *Note: who cares? As a small individual investor, you may not have
many choices. However, in the future, you may be a fund manager
or be investing for your firm, your choices do matter. Many investors
ignore the risk when they invest. Cryptocurrencies/Luna investment
by say Korean (a sad story) or the bankruptcy of FTX
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Real questions retail investors asked
Is it realistic to get 8-9% return?
I'd like to get an 8-9% return on my money in as safe a method as possible. If it were
you what would you recommend? Mutual funds? Any specific ones you'd recommend
to get that return?
https://www.reddit.com/r/investing/comments/85etoz/is_it_realistic_to_get_89_return/
Can you really make 10% returns yearly?
https://www.reddit.com/r/investing/comments/8k2m4p/can_y
ou_really_make_10_returns_yearly/
https://www.marketwatch.com/story/the-millennials-looking-to-get-rich-or-dietryin-off-one-of-wall-streets-riskiest-oil-plays-2016-03-30
“Y-O-____-LO,” the teen wrote, flashing his trading statement. “900 to 55K in
12 days!”
On Reddit, he’s known as “World Chaos,” a Florida high schooler who earlier
this year multiplied his money by betting against the S&P 500.
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2.1 Asset Classes
Common Stock
Asset
Classes
Derivative Securities
(options to be
covered)
Fixed Income
Securities
• Money Market (more
details)
• Bond Market
• Preferred Stock
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2.1 The Money Market: Instruments
• Treasury Bills
• Repos and
• (Is it risky?)
Reverses
• Certificates of
Deposit
• Commercial Paper
• Bankers’
Acceptances
• Eurodollars
Q: What are their risk and return characteristics?
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2.1 The Money Market: Treasury Bills
Issuer:
Denomination:
Maturity:
Liquidity:
Default Risk:
Interest Type:
Treasury Bills
Federal Government
Commonly $10,000; $1,000
4, 13, 26 or 52 Weeks
High
None, why?
Discount
Do you remember you have learned it from FINA 2010? Check:
https://www.bloomberg.com/markets/rates-bonds/government-bonds/germany,
yields are negative for 2-yr, 5-yr bund German bond in 2018,2020 who would
buy bond with –ve return? 2019: –ve for 10-and 30-yr bond, 2023 Jan: you can
get more than 2.4% for 2-yr to 30-yr bond.
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Turkey- government bonds
• One year Turkey-government bond has a
yield of 24% (August 27, 2018), about
16.25% (Sep. 3, 2019), 13.085% (Sep. 1
2020), 13.290% yield (24 Aug 2022)
• Can the Turkish government print money as
much as she wants like the US
government?
• Source: https://www.investing.com/rates-
bonds/turkey-government-bonds
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2.1 The Money Market: Certificates of Deposit (CDs)
Certificates of Deposit
Issuer: Depository Institutions
Denomination: Any, $100,000 or more
Maturity: Varies, Typically 14-day Minimum
Liquidity: High for CDs <3 months,
Default Risk: First $250,000 Federal Deposit
Insurance Corporation (FDIC) insured
It is a time deposit issued by banks
Maturity can be up to 5 years, you can buy it from brokerage firms.
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T-bills vs CDs
• Should CDs or T-bills (with same maturity)
pay a higher rate of return (yield).?
• Why?
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Figure 2.2 Spreads on CDs and Treasury Bills
5.0
OPEC I
What do you observe?
4.5
4.0
Financial crisis
Percentage points
3.5
OPEC II
3.0
Penn Square
2.5
Market crash
2.0
1.5
LTCM
1.0
0.5
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2014
2012
2010
2008
2006
2004
2002
2000
1998
1996
1994
1992
1990
1988
1986
1984
1982
1980
1978
1976
1974
1972
1970
0.0
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2.1 The Money Market: Commercial Paper
Issuer:
Denomination:
Maturity:
Liquidity:
Default Risk:
Interest Type:
e.g.
CP
Large creditworthy corps.; financial institutions
Minimum $100,000
Maximum 270 days, usually 1-2 months
CP < 3 months, liquid
Unsecured, rated, mostly high quality
Discount
A firm offers investors $1.008 million in face
value in exchange for $1 million in cash
GE relies on commercial paper to help fund its daily operations, and it used
to be one of the biggest issuers of the debt……
https://www.bloomberg.com/news/articles/2018-10-03/ge-downgrade-willlift-its-costs-in-a-debt-market-it-once-ruled
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2.1 The Money Market
• Bankers’ Acceptances
• Maturity between 30 to 180 days
• Purchaser authorizes a bank to pay a seller for goods
at later date (time draft)
• When purchaser’s bank “accepts” draft, it becomes
contingent liability of the bank
• banker’s acceptances function based on the
creditworthiness of the banking institution
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2.1 The Money Market
• Bankers’ Acceptances
• e.g. US firm buys toys from a HK firm
• How to make sure the HK firm will get payment from
the US once toys are shipped to USA?
• Flipped classroom video (1 min. 32 sec):
https://www.investopedia.com/terms/b/bankersacce
ptance.asp
• Eurodollars
• Dollar-denominated time deposits held outside U.S.
• Pay higher interest rate than U.S. deposits
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2.1 The Money Market: Repurchase Agreements
• Repurchase Agreements (RPs or repos)
• Short-term sales of securities with promise to
repurchase at higher price
• So a (short-term) borrowing
• RP is a collateralized loan
• Many RPs are overnight; some may have a 1-month
maturity
• Reverse RPs(the party on the other side of RPs)
• Lending money; obtaining security title as collateral
Video:
https://www.investopedia.com/terms/r/repurchaseagreement.asp
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2.1 The Money Market: Instrument Yields
• Yields on money market instruments not always
directly comparable
• Factors influencing “quoted” yields
• 360 vs. 365 days assumed in a year (366 leap
year)
• Simple vs. compound interest
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Figure 2.1 Treasury Bills (T-Bills)
0.01967%x365/177 =0.041%
Treasury Bills
MATURITY
DAYS TO
MATURITY
BID
ASKED
CHG
ASKED
YIELD
28-Nov-2014
73
0.010
0.005
-0.005
0.005
2-Jan-2015
108
0.015
0.010
0.000
0.010
12-Mar-2015
177
0.045
0.040
0.000
0.041
28-May-2015
254
0.045
0.040
-0.005
0.041
23-Jul-2015
310
0.080
0.075
0.000
0.076
So ask yield of 0.04% means dealer willing to sell the bills at a discount
from face value of 0.04% x (177/360) =0.01967%
i.e. $10,000 x (1-0.01967%) =$________
Source: The Wall Street Journal Online, September 14, 2014. Please try
figure 2.1 in the text using 2017 figures with asked yield 0.911
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2.1 The Money Market
• Bank Discount Rate (T-bill quotes)
r
BD
=
$10,000 − P
$10,000
x
360
n
$10,000 = Par
rBD = bank discount rate
P
= market price of the T-bill
n
= number of days to maturity
• Example: 90-day T-bill, P = $9,875
r BD =
$10,000
- $9,875
$10,000
360
= 5%
×
90
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2.1 The Money Market
• Bond Equivalent Yield (BEY)
• Use BEY because
• We can’t compare T-bill directly to bond
• 360 vs. 365 days
• Return is figured in par vs. price paid
(previous slide)
• Adjust bank discount rate to make it
comparable
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2.1 The Money Market: Bond Equivalent Yield
• Bond Equivalent Yield
rBD = 5%
P = price of the T-bill
n = number of days to maturity
10,000 − P
r
BEY
=
×
365
n
P
• Example Using Sample T-Bill
r
BEY
=
10,000
−
9,875
×
9,875
365
90
rBEY = 0.0127 × 4.0556 = .0513 = 5.13%
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2.1 The Money Market: Effective Annual Yield
• Effective Annual Yield (more accurate)
 $10,000 − P 

rEAY = 1 +
P


365
n
Compare:
−1
P = price of the T-bill
n = number of days to maturity
• Example Using Sample T-Bill
 $10,000 − $9,875 

rEAY = 1 +
$9,875


rBD = 5%
rBEY = 5.13%
rEAY = 5.23%
365
90
−1
rEAY = ______
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2.1 The Money Market: Instrument Yield
Money Market Instrument
Instrument Yield
Treasury Bills
Discount
Certificates of Deposit
Bond Equivalent Yield
Commercial Paper
Discount
Bankers’ Acceptances
Discount
Eurodollars
Bond Equivalent Yield
Repurchase Agreements
Discount
Reverse RPs
Discount
Note: the key point here is: to understand the yield the instrument is referring to
instead of simply investing the one with highest yield,
For exam. purpose, all you need to know is included in this powerpoint
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2.2 The Bond Market
• You should have the basics from FM course.
• We will come back in more details in later chapters
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2.2 The Bond Market: Private Issue
• Before we leave the bond topic, you should know that bonds
are not always safe investments, e.g. corporate bond and the
more recent MBS
• Corporate Bonds
• Investment grade vs. speculative grade
• Mortgage-Backed Securities (MBS),
• see my in-class example or
https://www.investopedia.com/terms/m/mbs.asp
• Backed by pool of mortgages with “pass-through” of monthly
payments; covers defaults
• Private banks purchased and sold pools of subprime mortgages
• Issuers assumed housing prices would continue to rise
• MBS, the second largest segment of the US fixed
income market after US Treasuries
• MBS: total outstanding about $10 trillion in 2019
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2.4 Stock Indexes
• Uses of indexes
• Track average returns
• Compare performance of managers
• Base of derivatives (e.g. Hang Seng Index
futures and options)
• Factors to be considered in
constructing/using index
• Representative?
• Broad/narrow?
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2.4 Stock Indexes
• Construction of Indexes
• How are stocks weighted?
• Price weighted (DJIA)
• https://us.spindices.com/indices/equity/dow-jones-industrialaverage
• https://www.investopedia.com/articles/financialtheory/10/introduction-to-the-dow.asp
• Market value weighted (S&P 500, NASDAQ)
• Equally weighted (Value Line Index)
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2.4 Stock Indexes
• Constructing Market Indexes
• Weighting schemes
• Price-weighted average: Computed by adding
prices of stocks and dividing by “divisor”
• Market value-weighted index: Return equals
weighted average of returns of each
component security, with weights proportional
to outstanding market value
• Equally weighted index: Computed from
simple average of returns
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2.4 Stock Indexes
Price-Weighted
Series
Stock PriceB
QuantityB
P1
Q1
A
$10
40
$15
40
B
50
80
45
80
C
140
50
150
50
• Time 0 index value: (10 + 50 + 140)/3 = 200/3 = 66.7
• Time 1 index value: (15 + 45 + 150)/3=
• Other problems:
• Similar % change movements in higher-price stocks cause
proportionally larger changes in the index
• Splits arbitrarily reduce weights of stocks that split in index
Note: subscript B stands for base price
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2.4 Stock Indexes
Price-Weighted
Series (B: 2 for 1
Stock PriceB
stock split at time 1)
QuantityB
P1
Q1
A
$10
40
$15
40
B
50
80
25
160
C
140
50
150
50
• Time 0 index value: (10 + 50 + 140)/3 = 200/3 = 66.7
• Time 1 index value: (10 + 25 + 140)/Denom = 66.67
• Need to adjust for split
• Denominator = 2.624869
• Time 1 index value: (15 + 25 + 150)/_________ = 72.38
• Other problems:
• Similar % change movements in higher-price stocks cause
proportionally larger changes in the index
• Splits arbitrarily reduce weights of stocks that split in index
Note: subscript B stands for base price
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2.4 Stock Indexes
Stock
PriceB
QuantityB
P1
Q1
A
$10
40
$15
40
B
50
80
25
160
C
140
50
150
50
• Value-Weighted Series
(15  40) + (25 160) + (150  50)
100 = 106.14
IndexV =
(10  40) + (50  80) + (140  50)
• Equal-Weighted Series
A split you get 12
• invest say $300 in each
shares (originally 6
shares)
IndexE = (15  30) + (25 12) + (150  2.143) 100 = 119.05
(10  30) + (50  6) + (140  2.143)
$300 you get 30 shares each of $10
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Equal-Weighted Series (alternative method)
Stock
PriceB
QuantityB
P1
Q1
A
$10
40
$15
40
B
50
80
25
160
C
140
50
150
50
• RA= 15/10-1 =50%
• RB = 0%, price changes only because of the split
• RC=150/140-1=7.14%
• R-Return
=>Equal weighted =(50%+0%+7.14%)/3=19.05%
IndexE will increase from 100 to 119.05
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2.4 Stock Indexes
Case 1
Stock
PB
QB
P1
Case 2
Q1
P1
Q1
A
$10
40
$12
40
$10
40
B
100
80
100
80
100
80
C
50
200
50
200
60
200
• Why do the two differ
(value weighted vs equal weighted)?
• Case 1: 20% change in price of small-cap firm
(12  40) + (100  80) + (50  200)
100 = 100.43
IndexV =
(10  40) + (100  80) + (50  200)
• invest $100 in each stock
(12 10) + (100 1) + (50  2)
IndexE =
100 = 106.67
(10 10) + (100 1) + (50  2)
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2.4 Stock Indexes
Case 1
Stock
PB
QB
P1
Case 2
Q1
P1
Q1
A
$10
40
$12
40
$10
40
B
100
80
100
80
100
80
C
50
200
50
200
60
200
Case 1 VW = 100.43
Case 1 EW = 106.67
• Why do the two differ?
• Case 2: 20% change in price of large-cap firm
(10  40) + (100  80) + (60  200)
IndexV = (10  40) + (100  80) + (50  200) 100 = 110.86
• Assume $100 investment in each stock
(10 10) + (100 1) + (60  2)
IndexE =
100 = 106.67
(10 10) + (100 1) + (50  2)
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2.4 Stock Indexes
• Examples of Indexes
• Dow Jones Industrial Average, DJIA (30 stocks)
• Standard & Poor’s 500 Composite
• NASDAQ Composite (>3,000 firms)
• Wilshire 5000 (>6,000 stocks)
• Hang Seng Index (www.hsi.com.hk)
• Hang Seng China Enterprises Index
Q: Assume Apple and Tesla are added to DJIA,
which stock will have higher impact on the index?
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2.5 Derivative Markets
• Derivative Asset
• Security with payoff that depends on the price
of other securities
• Call Option
• Right to buy an asset at a specified price on or
before a specified expiration date
• Put Option
• Right to sell an asset at a specified exercise
price on or before a specified expiration date
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Figure 2.10 Stock Options on Apple
Let’s try a more volatile stock option: Tesla, put option using August
22, 2017 data OR you want to try Apple (>$2 trillion market value
2020) first?
Source: www.cboe.com, September 17, 2014,
you may try the text example using 2017 figures of Apple
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2.5 Derivative Markets
• Using the Stock Options on Apple (Call)
• The right to buy 100 shares of stock at a stock
price of $95 using the October contract would
cost $635 (ignoring commissions)
• Is this contract “in the money”?
• When should you buy this contract?
• When will you make money?
• When should you write it?
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2.5 Derivative Markets
• Using the Stock Options on Apple (Put)
• The right to sell 100 shares of stock at a stock price of
$95 using the October contract would cost $33 (ignoring
commissions)
• Is this contract “in the money”?
• Why do the two option prices differ? Call vs Put
• Because of the Covid-19, demands for Apple’s product
jumped by say 30% leading to almost 50% increase in
Apple share price to say $150, what happens to the Oct
105 call option?
• What is the return in %?
• Who wins and who suffers?
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2.5 Derivative Markets
• Using the Stock Options on Apple
• Look at Figure 2.10 to answer the following
questions
• How does the exercise or strike price affect
the value of a call option? A put option? Why?
• How does a greater time to contract expiration
affect the value of a call option? A put option?
Why?
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Option: In case you miss our class
• https://www.investopedia.com/terms/s/stock
option.asp
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2.5 Derivative Markets
• Futures Contracts
• Allow you to lock in the buying/selling price of
the underlying asset.
• Your self learning. You are welcome to come to
me for discussion.
• Contract for Differences (CFDs)
https://www.investopedia.com/articles/stocks/09/trade-a-cfd.asp
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