Lecture 3: Financial Securities and Markets
Note:
1. Should have the MarketWatch account up and running by now
and have established the long-short positions.
2. Submit the first trading report on Friday in the Webcourse
Assignments folder.
3. Start to invest in the ETFs you have identified.
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Topics today:
1. Asset Classes and Financial Instruments
a. What are the types of assets that are publicly traded? This is the
starting point of asset allocation decisions
b. Know the (basic) evidence of the returns and risks of the assets
and the relations between the different types of assets.
2. ETFs (and the ETFs from ProShares)
a. Covers many different types of assets, including those that are not
easily accessible to individual investors.
b. Have some unique features – leverage, inverse, exclusion, etc.
3. Can one select these ETFs to form an investment portfolio?
a. Can be done in practice
b. Can be done in professional portfolio management (Windhaven
for example)
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Financial Assets: A very rough picture
3
Money Market Securities and Money Rates
• Money Market (MM) Securities: Short term (≤1 year) debt
securities, typically low risk (?)
• Yields, or interest rates, or promised returns of the MM
securities
- What is the interest rate the Fed has been raising?
• The many different types and rates of MM securities
-
Treasury Bills (T-bills)
Federal Funds
Commercial Papers
Certificates of Deposits (CDs)
Secured Overnight Financing Rate (SOFR), replacing LIBOR.
4
Effective Federal Funds Rate
- The Fed (FOMC) sets the target federal funds rate (2008 on, a
range), what is it?
- Further influence the effective rate through open market operations
- Q: What is the rate now? Is this rate important? How does this rate
influence other rates?
5
3-month T-bill Rate
- This is Yield, not return. Yield is not the return you get, but can be
viewed as expected return here.
- Do not look like “risk-free” from this graph: Yields are very high in
some years, low (close to 0) in others, and definitely are not constant.
- However, can be viewed as risk-free for a one-period investment
problem. You know for certain the return you get for that period if
you hold T-bill till maturity.
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-2
1/1/1934
12/1/1935
11/1/1937
10/1/1939
9/1/1941
8/1/1943
7/1/1945
6/1/1947
5/1/1949
4/1/1951
3/1/1953
2/1/1955
1/1/1957
12/1/1958
11/1/1960
10/1/1962
9/1/1964
8/1/1966
7/1/1968
6/1/1970
5/1/1972
4/1/1974
3/1/1976
2/1/1978
1/1/1980
12/1/1981
11/1/1983
10/1/1985
9/1/1987
8/1/1989
7/1/1991
6/1/1993
5/1/1995
4/1/1997
3/1/1999
2/1/2001
1/1/2003
12/1/2004
11/1/2006
10/1/2008
9/1/2010
8/1/2012
7/1/2014
6/1/2016
5/1/2018
4/1/2020
3/1/2022
What does the investment return of T-bill look like?
T-bill Return
18
16
14
12
10
8
6
4
2
0
Return
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-2.00
1/1/1934
1/1/1936
1/1/1938
1/1/1940
1/1/1942
1/1/1944
1/1/1946
1/1/1948
1/1/1950
1/1/1952
1/1/1954
1/1/1956
1/1/1958
1/1/1960
1/1/1962
1/1/1964
1/1/1966
1/1/1968
1/1/1970
1/1/1972
1/1/1974
1/1/1976
1/1/1978
1/1/1980
1/1/1982
1/1/1984
1/1/1986
1/1/1988
1/1/1990
1/1/1992
1/1/1994
1/1/1996
1/1/1998
1/1/2000
1/1/2002
1/1/2004
1/1/2006
1/1/2008
1/1/2010
1/1/2012
1/1/2014
1/1/2016
1/1/2018
1/1/2020
1/1/2022
Yield and return
T-bill Yield and Return
18.00
16.00
14.00
12.00
10.00
8.00
6.00
4.00
2.00
0.00
Yield
Return
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Ted Spread: 3-month Libor and 3-month T-bills (discontinued)
- Not all short rates are the same.
- LIBOR vs T-bill: both are short term rate, but LIBOR has
credit/default risk.
- Now use 3-Month Commercial Paper Minus Federal Funds Rate
- Q: What explains the spread, and the variations of the spread over
time?
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Treasury Bonds: 10-year T-Bond Yield
- Long-term Treasury securities
- Yields on 10 year Treasury Bonds are typically higher than short
term Treasury securities (e.g., 3-month T-bill), they are riskier, what
risk, and why?
- May contain different information than short-term rate.
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Yield spread between 10-year T-Bonds and 3-month T-bill
- Term spread: measuring expected interest rate and risk?
- Can have an inverted or negative term spread term spread as shown
above
- Note the inverted spreads and the occurrences of economic
recessions (grey bar)
- Does the current inverted yield curve predict a recession?
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Equities and Corporate Bonds
• What are the differences between debt and equity securities?
-
Limited Liability
Priority of cash flow rights
Control rights
Taxation: Capital gains and income
• How do the return and risk characteristics differ for common
stocks and corporate bonds?
- Returns?
- Risks?
- Any relation between the two types of security from the same
company?
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Corporate Bond Yield
- Moody’s BAA: lowest investment grade
- Have both interest risk and credit risk
- Again, this is yield or expected return of corporate bonds.
Question:
1. What does the graph look like for the return of these bonds?
2. What does the graph look like if we were to plot expected return and
return of Equity?
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Credit Risk: BAA bonds and 10-year T-bonds
- Difference in yields between corporate (BAA) and treasury
bonds
- Often called the default spread: measures macro, or market
level credit risks.
- Note this risk is not constant.
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Stock market indices: Measure equity return
• US market:
-
Dow Jones Industrial Average
Standard & Poor’s 500 Composite
NASDAQ Composite (>3,000 stocks)
Wilshire 5000 (>4,000 stocks): total market
• International indexes
- Nikkei index: 225 stocks
- FTSE index (the “Footsie”): 100 stocks
- DAX (30)
Question: equity indexes are mostly at the market segment level. Can we
measure the returns of stocks with different risks, like corporate bonds?
How? Based on what?
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Stock market indices
• Use of indexes
- Track returns (a caveat)
- For long term, note that most indexes measure price, what is
missing?
• Base of derivatives and other financial products (index funds,
ETFs)
• Factors in constructing/using index
- Representative? Of what?
- How is it constructed (weighting/change)?
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Stock market indices
• Price weighting
- The weight is determined by the price of each stock in the
index
- Dow Jones, outdated.
• Value weighting
- wi=MVi/∑(MVi)
- Most indexes are value-weighted
- Best for index funds (ETFs)
• Equal weighting
- wi=1/N
- Can be used for various portfolio strategies
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What does the stock market look like?
Not very informative or useful.
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-10
192607
192805
193003
193201
193311
193509
193707
193905
194103
194301
194411
194609
194807
195005
195203
195401
195511
195709
195907
196105
196303
196501
196611
196809
197007
197205
197403
197601
197711
197909
198107
198305
198503
198701
198811
199009
199207
199405
199603
199801
199911
200109
200307
200505
200703
200901
201011
201209
201407
201605
201803
202001
202111
More useful:
Stock market return
50
40
30
20
10
0
-20
-30
-40
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More Stock Indices
• Based on Market Cap:
- Large/Midcap/Small cap stock indexes
• Based on “Style”
- Value/Growth: S&P value stock index, S&P growth stock
index, etc.
• Based on Industry/Sector
- Financials/info technology/real estate/commodity
• Global and foreign indices (MSCI Indices)
- Global/Regional/Country
- Global style/industry
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ETFs
• Exchange traded funds: based on well-established indexes (other
benchmarks, or strategies)
- Most are passive (track performance of indexes, do not
actively manage).
• ProShare ETFs:
- Long: ultra, ultraPro, etc.
- Short: short, ultrashort
• For our trading simulation:
- Know what those ETFs are!
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ProShare ETFs
• Broad Market, Cap based, Sector based
• International, bonds, etc.
• Ultra:
- 2×rt.
- Note, rt is daily return.
• Short and Ultra-short
- -rt and -2×rt
- Moves in the opposite direction of the index
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How to use ETFs to construct a portfolio?
• Real world example: Windhaven Investment Management
- “Primarily through the use of exchange traded funds (ETFs)”
- Global Tactical Asset Allocation
• For our portfolio:
- “Diversified Aggressive”, not a passive buy and hold
strategy
- Can further take long/short positions to enhance leverage
- Can you develop an approach (may not be in the beginning
of the semester)?
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How to use ETFs to construct a portfolio?
• If you do not have any specific views/opinions about the market,
how would you allocate the $1 million in the Proshare ETFs?
• For your investment, you need to have a view:
- Is the market going up/down or staying level? Do the
different sectors behave differently?
• Construct your portfolio based on your view
- Note, your view can change during the semester
- But you need to write down what you think now.
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Trading Report 1 for the trading simulation: your plan
Due Next Friday (September 1), submit via the Webcourse assignment folder.
Draft a plan for the ETF trading simulation. Please keep a copy for yourself. In this 3-page
(more or less) plan, you should provide point-to-point i.e., concise and direct, answers to
the following questions. You should not discuss the stocks in your long/short pick or other
individual stocks.
(1)
Investment without view: Assume you do not have any specific information and hold no
view about the current/future market condition and only have historical information on the
returns and risks of the different assets (ETFs), how would you invest for the next 3-month
period? i.e., how would do you allocate your $1 million if you were investing in your
retirement account? Briefly explain where to invest and how much you would allocate to the
different ETFs. Cite the evidence your allocation plan is based on.
(2)
Developing your view: What happened for the US stock market during and after the
pandemic and how has the market been doing year to date? What is your expectation for the
overall market and some sectors/segments of the market for the next 3 months (equity/fixed
income, sectors/styles of equity…)? Basically, do you think the returns/risks (market level
or some assets) will be substantially different from historical norms as explained in (1)
above, and if so, how?
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(3)
A short-term investment plan based on your view: Develop your investment plan for this
3-month period based on your views you discussed above. Your investment plan should
differ from your answers in (1) above, because this plan is based on your views and is
designed to have a reasonable chance to achieve returns consistent with your investment
objective (50% return over three months). Your discussions should be specific: list at least
3 ETFs you will invest in and specify the possible long/short positions in the 3 ETFs you
want to establish.
Note: You can update your views and change your investment throughout the semester.
(4)
Do you have any actual investment experience? Discuss how the experience (or the lack of
it) may matter for this simulation.
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