FIN 261
Lecture Notes Ch. 1, 2
1
Investments
 Nature of Investment
 Reduce current consumption for greater future consumption
 Investors’ perspective
 Maximizing expected welfare



Return is good
Risk is bad
Ex ante risk-return trade-off
 Portfolios
 Asset classes
 Securities
 Decision Process
 Top down
 Bottom up
2
Real versus Financial Assets
 Real Assets
 Used to produce good and services
 Property, plants, equipment, human capital, etc
 Financial Assets
 Claims on real assets or claims on real asset income
 Debt securities, equity, derivatives, mutual fund shares,
insurance, etc
3
Financial Markets and Economy
 Information role of financial markets
 Are market prices fair?
 Consumption timing
 Consumption smoothing over time
 Risk allocation
 Risk-return trade off
 Separation of ownership and management
 Agency problem
 Performance based compensation
 Threat of takeovers
 Board of directors
4
The Players
 Businesses
 Net borrowers
 Households
 Net savers
 Governments
 Financial intermediaries
 Commercial banks, investment companies, insurance
companies, pension funds, hedge funds, etc
 Investment bankers specialize in primary market transactions


Primary market – newly issued securities offered to public
Secondary market – pre-existing securities traded among investors
5
Financial Assets
 Direct investment
 Nonmarketable financial assets
 Money market

Treasury bills, Commercial bills
 Fixed income securities

Bonds
 Equity securities

Common stock, Preferred stock
 Derivatives

Options, Futures
 Indirect investment
 Mutual funds
 Closed-end funds / ETFs
6
Money Market
 A market for the purchase and sale of short term debt instruments
 highly liquid, relatively low risk
 Maturities generally less than 12 months
 Dominated by financial institutions
 Treasury bill
 Sold by the US Treasury at a discount from face value
 Proxy for “risk-free” rate
 Key role in liquidity management
 NZ




Short term low risk Govt debt issued by Crown
Maturities 3, 6, 12 months
Traded in parcels of $1m
Redeemable at par on maturity
7
Treasury Bill Quotes
NZ T-bill
US T-bill (wsj.com)
8
T-Bill Yield
 Investment yield
 Actual annualized yield

 face value - market val ue   365 


  
market val ue

  # of days 
 Discount yield (US)
 Quoted yield

 face value - market val ue   360 


  
face value

  # of days 
 Prices move inversely to yields
9
T-bill Yield Example
 90 day $1000 par value US T-bill issued at $990
 What is the investment yield?
 Investment Yield   1000 - 990    365   4.096% p.a.

  90 
990
 This is an annual percentage rate. What is the effective
annual rate including interest-on-interest?
 Effective Yield  1  1000 - 990 



990

365
90
 1  4.16% p.a.
 What is the quoted yield?

 1000 - 990   360 
Discount Yield  

  4.0%
1000
90

 

10
 A 6-day T-bill is quoted r = 0.04% p.a. How much will
it cost you to buy now?
# of days 

Market Value  Face Value  1  Discount Yield 

360 

6 

 1000  1  0.0004 
  $999.99
360 

 A NZ 182-day bill’s investment yield is r = 5.48% p.a.
How much will it cost you to buy now?
Market Value 

Face Value
1  Investment Yield 
1000
182
1  0.0548 
365
# of days
365
 $973.40
11
 Assume you bought the 182 day bill at a yield of 5.48%
p.a. You then sell it after 122 days at a yield of 4% p.a.
What was your realised return p.a?
Selling price 
Future Value
1000

 $993.47
60
d 

1.04 
1  r 

365
365 

 Psell
 365

Realised Yield (%) 
 1 
 100
P
 122
 buy

 993.47  365
 
1 
 100  6.17% p.a
973
.
40
122


12
Commercial Bill (NZ) / Paper (US)
 Document comprising a promise by the borrower to repay the lender
 Sold at discount from face value
 A source of short term borrowing and lending for companies, financial
institutions, local bodies
 Maturities: usually 90 days, may range from 30-270 days
 Example:
 You wish to borrow so that you repay $500,000 in 90 days



You issue (sell) a 90 day bill at $489,593, and promise to repay face value
($500,000) on maturity
The buyer of the bill lends $489,593 to you
The holder (buyer) usually re-sells (re-discounts) the bill in the market before
maturity
 NZ:
 If repayment of the bill is “accepted” (guaranteed) by a registered bank
it is called a bank bill
13
 How they work:
 If the borrower defaults holders 1 and 2 are
contingently liable to repay the face value of the
bill.
14
 https://www.rbnz.govt.nz/statistics/key-graphs/key-graph-90-day-rate
 If $1,000 par 90 day bank bills are priced to yield
2.77% p.a. What is the market value of the bill?
 1000 / (1+0.0277×90/365) = 993.2162
 If market interest rates increased to 4% p.a. how
does this affect 90 day bill prices?
15
Other Money Market Securities
 (Marketable) CD
 Certificate of deposit from a bank
 Repurchase agreement
 Borrower agrees to sell and repurchase government securities
 Maturity tends to be very short, typically up to 14 days
 Banker’s acceptance
 A time draft drawn on a bank by a customer
 Normally used in international trade.
 Eurodollars
 Dollar-denominated deposits held outside U.S.
16
Other Money Market Securities
 Federal funds
 Depository institutions must maintain deposits with FRB
 Federal funds – trading in reserves held on deposit at Federal
Reserve
 Key interest rate
 LIBOR (London Interbank Offer Rate)
 Rate at which large banks in London lend to each other
 Base rate for many loans and derivatives
 Broker’s calls
 Call money rate applies for investors buying stock on margin
 Loan may be “called in” by broker
17
Fixed Income Securities
 Debt securities which provide a fixed interest (coupon)
rate plus repayment of principal at maturity
 Maturities > 1 year
 Sold by companies/Govt to raise money
 Listed debt traded on NZX Debt Market:
http://www.nzx.com/markets/nzdx
 Quoted on a yield to maturity basis
 The return expected from holding a bond to maturity
and re-investing all cash flows
 Since this return is determined by market prices it also
measures investors’ required rate of return
18
Notes and Bonds Quotes
directbroking.co.nz
wsj.com
19
Bond Price Example
 Assume a bond has a 10% p.a. coupon, a nominal (par or face) value of
$1,000. Interest paid annually on 4/3. Issued on 5/3/08, expires on
4/3/15.
 At what price should the bond sell today (assume 5/3/12) assuming
investors' required rates of return are 6%?
PV2012 
Cash Flow1 ( 2013)
(1  r )1

CF2 ( 2014)
(1  r ) 2

CF3 ( 2015)
(1  r ) 3
100
100
1100


(1  .06)1
(1  .06) 2
(1  0.06) 3
 $1,106. 92  110.69% of face value

 Now assume a year goes by. It is now 5/3/13 and required rates of return have
increased to 7%.
20
 Value at 5/3/13 is:
PV 
100
1100

 $1054.24
1.07 (1.07) 2
 Total return over the year is:
P P
 interest
1054.24  1106.92  100
t
t

1
R 

 4.27%
t
P
1106.92
t 1
 To calculate the holding period returns we use MARKET PRICES
to measure the CHANGE in the VALUE OF THE INVESTMENT
(capital gains) and add INTEREST INCOME
 The investor made the investment EXPECTING a return of 6%.
The ACTUAL return was 4.27%! What caused this difference?
 As interest rates change the realised (actual) return will differ from
the expected return.
21
Bond Characteristics
 Discounts / Premiums
 Related to coupon rate and yield
 Zero coupon bond always sells at a discount

STRIPS
 Call / Put provision
 Gives issuer (buyer) to buy (sell) back
 Can be thought of as a combination of a plain bond and
option
 Security
22
Types of Bonds
 Treasuries
 Notes and bonds
 TIPS (Treasury Inflation-Protected Securities)
 Federal Agency Securities
 Mortgage-backed securities
 Municipal bonds (‘munis’)
 Political entities other than the federal government
 Exempt from federal taxes

Taxable equivalent yield = munis yield / (1 – marginal tax rate)
23
Corporate Bonds
 Default risk
 Credit ratings
 Security

Debentures have no collateral
 Options can be attached


Callable bond
Convertible bond
 International bonds
 Eurobond

Denominated in a foreign currency – e.g., Euro-dollar, Euro-yen
 Yankee bond, Samurai bond denominated in local currencies
24
Equity Securities
 Common stock
 Ownership interest (residual claim) of corporation
 Limited liability
 Voting rights
 Distribution


Dividends – cash, stock (splits)
Repurchase
25
Equity Securities
 Preferred stock
 Known (fixed or variable-rate) dividend
 Seniority between bonds and common stock

Must be paid before common stock
 Often nonvoting
 Depository Receipts
 ADR (American Depository Receipts)
 Certificates traded in the U.S. representing ownership in
foreign security
26
Stock and Bond Market Indexes
 Stock market index is a portfolio of shares used
 to measure the market’s performance, especially over
time
 as a benchmark to assess portfolio performance
 to develop index investment funds
 Different ways of constructing indices
 Price weighted index
 Value weighted index
 Equal weighted index
27
Constructing an Index - Example
Company A
Company B
No. of Shares
100m
10m
Price at start
$2
$1
Price at end
$2.20
$1.50
Return
10%
50%
 Assume
 we have an index comprised of two companies
 no dividends are paid by either company
 the (arbitrary) starting index is 100
Price Weighted Index
 Assumes you hold an equal number of shares of each
company in the index
 Starting dollar value of the portfolio
 $2 + $1 = $3
 Set an arbitrary index level, say 100 for $3
 Ending value of the portfolio
 $2.20 + $1.50 = $3.70
 Return is $3.70/$3 -1 = 23.3%.
 Closing index is 100×($3.70/$3) = 123.3
 Or the return on index = 10%×2/3 + 50%×1/3 = 23.3%
 Influence of a stock return on the index return is
determined by its price
 1% return on high priced stocks more influential
 $1 change in any stock has the same influence on the
index level
 Index must be adjusted for any capital changes made
during the period which affect share price
 share splits, bonus issues, rights issues
 For example, an index based on prices will drop after a
share split, even though nothing economic happened
 As the index should reflect only changes in share price
rather than capital structure, the index value must be
adjusted so that it is not affected by the split
 Divisor
 an arbitrary number that is first defined when an index
is first published.
 Initial use is to divide the total value of the index to
produce an initial index value such as the number '100'.
 For example, the initial divisor for the price weighted
index above is 0.03.
 Divisor is adjusted to ensure continuity

Price-weighted index: stock splits, dividend payment, bonus
issues, component change
 Dow Jones Industrial Average (DJIA)
 30 stocks
Divisor Adjustment Example
 Suppose that Company A splits its stock 2-for-1 right at
the end of the period.
 Then the divisor adjusts to keep the value of index
constant.
 Before the split, Index = (2.2 + 1.5) / 0.03 = 123.33
 After the split, the divisor, d, would adjust to yield


Index = 123.33 = (1.1 + 1.5) / d
d = 0.0211
 We keep 1 share each in our portfolio before and after
the split

Weights will change while keeping the same index level
Value Weighted Index
 Prices are weighted by the value of shares on issue
 Value at start $2(100m) + $1(10m) = $210m
 Value at end $2.2(100m)+ $1.5(10m)=$235m
 Closing index is 100× ($235/$210) = 111.9
 Or return = 10%×200/210 + 50%×10/210 = 11.9%
 Initial divisor = 2.1m
 Divisor adjusts for stock dividends, secondary offerings, and etc
 Influence of a company’s return on the index return is based on
its relative total market value
 Gives more weight to large companies
 Many indices are now based on freely floating shares
 NZX, S&P
Value Weighted Index Examples
 NZX, S&P, NASDAQ, Russell indices
 NZX 10
Equal Weighted Index
 Each share in the index is given equal weight
 an equal dollar amount (say $1,000) is invested in each share
 Thus we buy


500 shares of A @ $2 = $1,000
1000 shares of B @ $1 = $1,000
 Value at end is $2.2(500)+ $1.5(1000)=$2600
 Closing index is 100×($2600/$2000) = 130
 Return is 2600/2000 - 1 = 30%
 Or Return = 10% ×
 Needs rebalancing
 Value Line Index
1
2
1
2
+ 50% × = 30%
NZSX Indexes
 The main share price index is the NZSX 50
 A gross index comprising the largest 50 companies
based on market capitalisation using free float shares
 Other indices include:
 the top 10 domestic companies,
 medium sized companies,
 small companies,
 all listed companies
 science and technology companies
 https://www.nzx.com/markets/indices
Bond Indexes
 Merryl Lynch, Barclays, and Salomon Smith Barney
 Thin trading
 Bonds trade infrequently
 Components that are thinly traded create lumpy
movements in the index, distorting true index values
 Exclusion of infrequently traded components may result
in an index that is less representative of the underlying
market
 Some NZ stocks
37
Derivative Securities
 Options
 Call – right to buy at a pre-determined price
 Put – right to sell at a pre-determined price
 Can be used in variety of strategies
 Futures
 The holder has an obligation to buy/sell an asset in the
future at a price specified now
38
Are the following assets real or
financial?
a. Patents
b. Lease obligations
c. Customer goodwill
d. A college education
e. A $5 bill
39
Table 1.1: Balance Sheet of US
Households
40
Structure of a bond’s cash flows
 A typical bond’s cash flows
$1,025
Coupon rate = ?
Par value = ?
Bond price = ?
0
$25
$25
1
2
$25
$25
$25
$25
$25
$25
$25
9
10
annual time
periods
$1,000
41
Example: Municipal Bond
 A municipal bond carries a yield to maturity of 6.75%
and is trading at par. What would be the taxable
equivalent yield of this bond to a taxpayer in a 35% tax
bracket?
 Taxable equivalent yield = munis yield / (1 – marginal
tax rate)
 Taxable equivalent yield =
6.75%
1−35%
= 10.385%
42
NZ TOP 10 ETF (TNZ)
https://smartshares.co.nz/types-of-funds/new-zealand-shares/tnz
43