BM410 Investments
Financial Instruments,
Securities Trading, and
Investment Benchmarks
Objectives

A. Understand assets that trade in the money and
capital markets
 B. Understand the market mechanics of trading
both primary and secondary issues
 C. Identify the various securities markets where
securities are traded and the costs of trading
 D. Understand the types and uses of indices
 E. Understand the mechanics of margin trading and
short-selling
Helpful Dictionaries and Glossaries

Bloomberg (institutional)
• http://www.bloomberg.com/analysis/glossary/bfglos
a.htm

Campbell Harvey (academic)
• http://www.duke.edu/~charvey/Classes/wpg/glossar
y.htm

Contingency Analysis (private institution)
• http://www.riskglossary.com/

New York Stock Exchange (market)
• http://www.nyse.com/
A. Major Assets that Trade in Money and
Capital markets
•
Major Markets and Instruments:
• Money Market
• Market for short-term, liquid, low-risk debt
securities
• Fixed Income Capital market
• Market for longer-term, higher risk debt
securities
• Equity Markets
• Market for common and preferred stocks
• Derivative Markets
• Market for options, futures, forwards, and other
types of “derived” instruments
B. Understand the Market Mechanics of
Primary and Secondary Trading
 1. Primary Markets
• Initial sales of securities
• Funds are received by the issuing company
 2. Secondary Markets
• Resale of securities to others
• No funds are received by issuing company
Key Terminology for Primary Markets

Public offerings
• Registered with the SEC and sale is made to the
investing public. May be initial or follow-up
offerings
• Shelf registration allows firms to register more
shares, and sell them over time (on the shelf)
 Initial Public Offerings (IPOs)
• First offerings by the company
• Evidence of under-pricing initially; however,
generally have been poor long-term performers
 Private Placements
• Sale to a limited number of sophisticated investors
Order Information Flow
for the Primary Market
Lead
Underwriting
Underwriter
Syndicate
Investment
Banker A
Investment
Banker B
Investment
Banker C
Private Investors and Institutions
Investment
Banker D
Trading of Primary Issues
• Primary Issues
• New issue: Issuer receives the proceeds from the sale,
less the expense paid to the underwriters
• There is a major “beauty pageant” among
investment bankers as they compete for the
business
• Being the lead underwriter not only brings huge
fees (sometimes 1-5% of the offering), it also brings
substantial “bragging rights” and prestige to the
lead firm
How IPO’s are Sold
Investment bank gets the mandate
• Research is prepared
• Road Shows are planned and taken
• Indications of Interest are given to the
Underwriting Syndicate (book building)
• Pricing and Shares Offered are finalized
Firm orders and prices are placed
• Syndicate confirms sales and shares issue
Investment Banking Arrangements

Underwritten vs. “Best Efforts”
• Underwritten: Firm commitment on proceeds to the
issuing firm. If can’t sell, has to buy shares.
Best Efforts: No firm commitment.

•
Negotiated vs. Competitive Bid
• Negotiated: Issuing firm negotiates terms with
•
investment banker
Competitive bid: Issuer structures the offering and
secures bids from various investment banks, then
picks most competitive bid.
2.
•
Understand Market Mechanics of
Secondary Trading
Key terminology for Secondary Offerings
• Secondary Security Sales
• Existing owner sells to another party
• Issuing firm doesn’t receive proceeds and is
not directly involved
• In most cases its an electronic entry in a share
registry, although in smaller markets
overseas, it is still delivery of share
certificates
Secondary Security Sales (continued)
 Why does firm care about its share price when
it gets no new money?
•
•
•
•
Prestige
Publicity
Ability to raise new capital in the future
Managers options/salaries are sometimes tied to
share price
• Note: If I ever saw a Reuters or Bloomberg
terminal on the CEO’s desk when visiting
companies, I took it a negative sign. It showed
that he/she was more worried about the price of
the stock than running the company!
Private Investor Order Information Flow
for the Secondary Market
Stock
Exchange
3. Confirms trade
2. Submits Order
3. Confirms Trade
Brokerage
Operations and
Accounting
2. Confirms trade
4. Confirms trade
1. Place Order, regardless of type, to the broker or
through the computer
5. Mails conformation statement
Institutional Order Information Flow
for the Secondary Market
4. Confirms trade
Stock
Exchange
3. Submits Order
3. Confirms Order
Brokerage
Operations and
Accounting
4. Confirms trade
7. Mails conformation statement
5. Confirms trade
2. Combines orders and submits
1. Place Order, regardless of type
6. Confirms trade execution
Company
Traders
Types of Share Orders
(Secondary Markets)
Instructions to the brokers on how to complete the order
 Market Order
• Buy/sell at the current market price
 Limit Order
• Buy/sell at a specified price
 GTC Order
• Buy/sell at a specific price until the order is
cancelled
 Stop loss
• Buy/sell only if the price reaches a specified level
 Program trades
• Buy/sell and entire portfolio at a specified price
Questions

Do we understand the market mechanics of
trading both primary and secondary issues?
Problem 3-1

FBN, Inc., has just sold 100,000 shares in an
initial public offering. The underwriter's
explicit fees were $70,000. The offering price
for the shares was $50, but immediate upon
issue, the share price jumped to $53.
 A. What is your best guess as to the total cost
to FBN of the equity issue?
 B. Is the entire cost of the underwriting a
source of profit of the underwriter?
Answer 3-1


A. In addition to the explicit fees of $70,000, there
appears to have been an implicit underpricing of the
IPO of $3 or $300,000.
B. While the explicit costs are profits to the
underwriters, the implicit costs are not. Generally,
there are reasons, financial (to make sure the entire
IPO is sold), political (to make the underwriters look
good from a successful IPO) and others (to give
investors a quick return to encourage them to continue
to deal with the underwriting firm), to under price
slightly an IPO and to make sure an IPO is sold fully.
C. Securities Markets where Securities are
Traded and the Costs of Trading

1. Organized exchanges
• Auction markets with centralized order flow
 2. OTC market
• Dealer market without centralized order flow

3. Third market
• Trading listed securities away from the market

4. Fourth market
• No middleman—institutions trading with
institutions
1. Organized Exchanges

Auction markets with centralized order flow
• Largest of all the markets
 Dealership function
• Can be competitive or assigned by the exchange
(specialists)
 Securities
• Stocks, futures contracts, options, and to a lesser
extent, bonds
 Examples: NYSE, AMEX, London, Tokyo
• Generally, these exchanges are somewhat archaic
2. OTC Market




Dealer market without centralized order flow
• Generally the direction of future stock markets
Price quotation market rather than trading market:
• Information system for individuals, brokers and
dealers
Securities
• Stocks, bonds and some derivatives
Example: NASDAQ (largest organized stock market
for OTC trading)
3. Third Market


Trading of listed securities OTC away from the
organized exchange
• Organized originally due to high fixed NYSE
trading costs
Institutional market
• To facilitate trades of larger blocks of securities
• Involves services of dealers and brokers
4. Fourth Market



Institutions trading directly with institutions
• No middleman involved in the transaction
Organized information and trading systems
• Through ECNs: Electronic Trading Networks
Example: INSTINET, Island ECN (53bn shares in
2000 worth $1 trillion)m REDIbook, Archipelago
Block Orders

Block transactions (buys/sells) of over 10,000
shares per trade
•
•
•
•
•
•

Year
1965
1975
1985
1995
2000
% Reported Volume Avg Num. Day
3%
9
17%
136
52%
2,139
57%
7,793
52%
21,941
These are growing in importance
Costs of Trading

Explicit
• Commission: fee paid to broker for making
the transaction
• Spread: cost of trading with dealer
• Bid: price dealer will buy from you
• Ask: price dealer will sell to you
• Spread: difference between the ask - bid
• Combination: on some trades both a
commission and spread are paid. You are
responsible to watch and make sure you are
getting the best execution
Costs of Trading (continued)

Implicit
• Market impact: increase (or decrease) in
price resulting from the the size of the order
versus the average daily trading volume.
This can often be greater than all other
costs—Beware!
Questions?

Do you have any questions on the various
securities markets where securities are traded
and the costs of trading?
Problem

You are managing your personal portfolio of
$500,000. Your largest holding, Samsung
Electronics, is getting expensive, so you sell
$50,000 of Samsung and buy $50,000 of Thai
Farmers Bank. Assuming that was your only
trade for the quarter, what what your turnover
for that quarter, and assuming all-in
transactions costs were 90 basis points each
way, how much did you spend to complete that
transaction?
Answer

Turnover is defined as half your sells plus buys
divided by your total portfolio amount.
• $[(50,000 sell + $50,000)/2] / $500,000 = 10%

The cost to you of this transaction is:
•
•
•
•
$50,000 sell * .0090 = $450
$50,000 buy * .0090 = $450
Total transactions cost = $900
Total loss of return from this single trade:
• 900/500,000 = -.2%
Problem 3-5

Do you think it is possible to replace marketmaking specialists with a fully automated,
computerized trade-matching system?
Answer 3-5

Much of what the specialist does—crossing
orders and maintaining the limit order book –
can be accomplished by a computerized
system. In fact, some exchanges us an
automated system for night trading.
 A more difficult issue is whether the more
discretionary activities of specialist that
involve trading for their own accounts, such as
maintaining an orderly market, can be
replicated by a computer system.
D. Understand the Different
Types and Uses of Indices or Benchmarks

Critical areas of Indices
•
•
•
•
•
•
•
How they are used
Asset Class Indices
Rate of Return Indices
Geographic Indices
Company Type Indices
Investment Style Indices
Index Construction
How They Are Used:
The Importance of Understanding Indices

Indices are the standard from which an analyst or
portfolio manager is judged
• Get to know your standard in detail—your career
(and bonus) depends on it!
• How is it weighted?
• How often are the constituents changed?
• Which are the biggest companies in the index?
• What strategies can help you to beat the index?
 If you don’t know what is in your index and how it is
calculated, how can you ever expect to beat it?
• It affects how you advance in your job and get the
raises you want? Knowledge is power!
Uses of Indices


Uses of Indices:
• 1. Tracks average returns for a specific asset class
• 2. Used to compare performance of mutual fund
managers in similar asset classes
• 3. Use as a base on which derivatives are structured
Key Questions in choosing or using an Index:
• Is it representative of the performance or assets
desired?
• Is it broad or narrow, i.e. how many securities in the
index?
• How is it constructed, i.e. price, total return, etc.?
• How is it weighted, i.e. market cap, equal, or float
weighted?
Asset Class Indices
• Asset Class
• Stocks: large cap, small cap., mid cap.,
international, emerging markets, etc.
• Bonds: long-term, short-term, corporate bonds,
government bonds, convertible bonds, etc.
• Other Asset Classes: real estate, currencies,
• Geographical
• Global, Regional, Country, Industry
• Investment Style
• Growth, Blend, Value
Rate of Return Indices
Price
• Includes only price appreciation of the underlying
assets
Price with Gross Dividends (or gross dividends
reinvested)
• Includes both price and dividends in calculating
total return. It does not take into account the
impact of taxes on dividends
Price with Net Dividends (or net dividends reinvested)
• Includes both price and dividends in calculating
total return. It takes into account the impact of
taxes on dividends, and hence you will see a
reduction of return from dividends
Geographic Indices

Global
 Follows the performance of a set of assets from a
specific set of countries, i.e., MSCI World, MSCI
AC Free. International includes only countries
outside the US

Regional
 Follows the performance of a set of assets from a
specific region of the world , i.e., MSCI EAFE, DJ
Asia

Country
 Follows the performance of a specific set of assets
from a specific country , i.e., S&P 500, Russell
5000, Dow Jones
Company Type Indices

Industry
 Follows the performance of a set of assets from a
specific industry, whether global, regional, or
country, i.e. Telecomm, Financial, Retail,
Automotive, Consumer Durable, etc.

Market Capitalization
 Follows the performance of a set of assets with a
specific market capitalization range, i.e. largecapitalization (>$10 bn), mid-capitalization ($210bn), small-capitalization($>2bn), microcapitalization (<250mn), etc.
Investment Style Indices

Growth
 These indices follow a portfolio of stocks that are
expected to achieve accelerated growth, whether
because of increased earnings, dominant market
position, or other factors
 Value
 This indices follow on stocks that are perceived to
be undervalued by the market, i.e. their priceearnings and price-book ratios are lower than the
market. It is generally determined by using pricebook or price-earnings ratios, discounted cash flow
models, or other means.
 Blend
 A combination of both
Index Construction

How are stocks weighted in various benchmarks?
• Price weighted:
• Weight is based on the price of the stock (DJIA,
Nikkei).
• Assumes a higher priced stock is more
valuable than lower priced stock
• Market-value weighted:
• Weight is based on market capitalization (S&P
500, NASDAQ, some MSCI country/regional
indices).
• Assumes market capitalization [price * shares
outstanding] is a viable proxy for size
Index Construction (continued)
• Equally weighted:
• All stocks are equally weighted (Value Line
•
Index, MSCI Equal Weighted Indices).
• Gives a higher weighting to smaller stocks
Float weighted:
• Weight is based on market cap and available
float outstanding (MSCI Emerging Markets
Free).
• Gives a greater weight to companies whose
shares are more available in the marketplace
and who do not have foreign ownership
limits
Finding Data on Indexes

Where do you find these indexes?
 Internet: Any of the many financial sites available:
CNN Money, YahooFinance, etc. Generally these
free indices are without dividends (make sure you
check)
 Proprietary Data Providers: Bloomberg, Reuters,
etc. They will also produce special indexes for a
fee ( i.e. MSCI EM Free ex-Malaysia)
 Data Suppliers: Standard and Poor’s, Morgan
Stanley Capital International, NASDAQ,
Bloomberg, Dow Jones, etc.
Vanguard Sends Notice of Index
Changes

We believe that the new indexes will reflect the
performance of the funds' targeted market segments
more accurately than any other available indexes. We
believe stock indexes should:
• Be constructed according to objective rules, not subjective
judgment.
• Weight their holdings to reflect only "floating" shares,
meaning those that are available and freely traded in the open
market.
• Feature overlapping buffer zones around the breakpoints
between large-, mid-, and small-capitalization segments.
• Assess a variety of factors to identify a stock as "growth" or
"value."
• Rebalance their holdings to reflect market changes in a
gradual and orderly fashion.

From Vanguard Website on 5/6/03:
http://flagship.vanguard.com/VGApp/hnw/web/corpcontent/vanguardviews/jsp/VanViewsNC
Article.jsp?chunk=/freshness/News_and_Views/ALL_benchchange_04032003.html
Questions

Do we understand the importance of indices to
a securities analyst?
Problem

You are an international manager investing in
the asset class called Emerging Markets. Your
clients want the broadest benchmark that is
actually “buyable” and one that is market
capitalization weighted. What should your
benchmark look like and why?
Answer

If your asset class is Emerging Markets, there are two
main benchmark providers: MSCI and S&P/IFC.
Since you want an index that is buyable, both providers
have “Free” indices, that is buyable indices. The
difference between Emerging Markets Free and the
S&P/IFC Emerging Markets Free Index is largely
slight differences in calculation and the number of
companies that are included.
E. Understand the Mechanics of Margin
Trading and Short Selling

Note of Caution:
• I am explaining the mechanics only. I do not
recommend or think it wise or safe for individuals
to use either margin trading or short selling unless it
is money that you can afford to lose or unless you
already have the shares you are selling short!
• But it is important to understand the mechanics
because there is a lot of information in these
areas for the wise investor!
Pretest #1



What is margin trading or buying on margin?
• Margin trading is investing (speculating) with
borrowed money.
If you trade on margin, what percent of your original
investment can you lose?
• With trading on margin, more than your original
investment is at risk.
Can you lose more?
• Yes, you can loose much more
Answer #1


•
What is the most you can lose?
• In fact, your risk is theoretically unlimited.
Is the return worth the risk?
• For most individual investors, the answer is no!
Profit profile (in %)
• Purchase: [(EP * S) + (D * S) – (BP * S)]
(BP * S)
• Buying on Margin: (EP*S) + (D*S) – (Amount
borrowed * interest rate)
Initial investment
BP = Initial Price, EP = Ending Price, S = Shares, D =
Dividend, IV = Initial Investment
Pretest #2



What is short-selling?
• Short selling is borrowing a security you don’t
own and selling it with the hope the price goes
down. You then repurchase and replace the
security (hopefully) at a lower cost
If you short-sell, what percent of your original
investment can you lose?
• With short-selling, more than your original
investment is at risk.
Can you lose more than your original investment?
• Yes, you can lose much more.
Answer #2


•
What is the most you can lose?
• Your risk is also theoretically unlimited.
Is the return worth the risk?
• No. Many investors have gone bankrupt because
they used these tools thinking their risk was limited
when it wasn’t.
Profit profile
• Purchase: (Ending price + dividend) – initial price
initial price
• Short sale: Initial price – (Ending price + dividend)
Margin Trading

Margin Trading:
• Using borrowed money to finance an investment or
to add leverage an existing investment
• You put up a portion of the funds and borrow
remaining component. Margin arrangements
differ for stocks and futures
• Maximum margin: currently 50% (set by the
Fed); you can borrow up to 50%
• Maintenance margin: minimum amount
equity in trading can be before additional
funds must be put into the account
• Margin call: notification from broker that
you must put up additional funds
Problem 1: Margin Trading
Initial Conditions
You have this overwhelming feeling that XYZ Corp is
going to appreciate in value due to some upcoming
event. You only have $35,000 but want to take a larger
(and much riskier) position via buying on margin.
XYZ Corp
$70
50%
Initial Margin (Equity/MV)
40%
Maintenance Margin
1,000
Shares Purchased
Initial Position
Stock $70,000 Money Borrowed
$35,000
Your Equity
35,000
Margin Trading
Maintenance Margin

Suppose you were wrong and the stock price falls to
$60 per share, what is your new margin percentage?
New Position:
Market Value of Stock $60,000
Amount Borrowed
35,000
Your Equity =
$25,000 ($60,000 - 35,000)
Margin = Your Equity in Account / Market Value
Margin % = $25,000/$60,000 = 41.67%
Luckily, you are still above the margin limit so there
is no margin call
Margin Trading
Margin Call
Just to be sure you won’t have to put up more money (that
you don’t have), how far can the stock price fall before
a margin call? Margin % = (Your equity)/(MV)
((Shares x New Price) – Borrowings) = 40%
(Shares x New Price)
solve for New Price (NP)
(1000 * NP - $35,000) / (1000 * NP) = 40%
(1000 * NP - 35,000) = 40% * 1000 * NP
600 * NP = $35,000
NP = $58.33. If the price dropped below $58.33, you
would have to put up more money (that you may
not have) or sell out of your position.
Short Sales
 Short Selling
 The process of borrowing shares and selling them
with the intent to buy them back later at a lower
price after an expected decline in the price of a
stock or security, thereby making a profit from the
decline in price
 Mechanics
 Borrow stock from another investor through a
dealer
 Sell it and deposit proceeds and margin in a
brokerage account (of the broker)
 Close out the position: buy the stock and return it
to the party from which is was borrowed including
reimbursing for any dividends paid
Problem 2: Short Sale
Initial Conditions
While you think XYZ is a good company, you expect the
price to fall dramatically after some bad news hits the
market. You want to profit from this bad news. You
have $5,000 that you are willing to use.
XYZ Corp
100 Shares
50%
Initial Margin
30%
Maintenance Margin
$100
Initial Price
Sale Proceeds
$10,000
Margin
5,000
Equity
5,000
Stock Owed
10,000
Short Sale
Maintenance Margin

Rats! The stock price just rose to $110. What is your
new margin and do you need to put up more money
(margin call is at 30%)?
Sale Proceeds
$10,000 ($100* 100 shares)
Initial Margin
5,000
Stock Owed/MV $11,000 ($110 * $100 shares)
Net Equity
4,000 (5,000 – (11,000 – 10,000)
Your Equity = (5,000 - ((100 shares* $110) - $10,000)
Market Value = (100 shares * $110)
Margin % (4,000/11,000) = 36%
You do not need to put up new equity
Short Sale
Margin Call
You are concerned. How much can the stock price rise
before you will get a margin call at 30%?
Your equity = ((10,000 + 5,000) – 100 New Price)
Market Value
100 * New Price
($15,000* - 100P) / (100P) = 30%
P = $115.38
*Initial margin plus sale proceeds
Questions
Any questions on margin trading and short
selling?
Objectives

A. Understand assets that trade in the money and
capital markets
 B. Understand the market mechanics of trading both
primary and secondary issues
 C. Identify the various securities markets where
securities are traded and the costs of trading
 D. Understand the types and uses of indices
 E. Understand the mechanics of margin trading and
short-selling
Homework Problem

13. Which security should sell at a greater price:
 A 10 year bond with a 9% coupon versus a 10 year 10% coupon
bond?
• a. The higher coupon bond. You are getting a larger coupon payment, so
you would be willing to pay more for the bond.

B. A 3 month call option with an exercise price of $40 or $35?
• b. The call with the lower exercise price. Prices of call options decrease as
the exercise price increases, i.e. the right to purchase shares at higher
prices is less valuable than the right to purchase lower priced shares.

C. A put option on a stock selling at $50 or one selling at $60?
• c. The put on the lower priced stock. Prices of put options increase with
the exercise price, i.e., the right to sell shares at higher prices is more
valuable that the right to sell at lower prices.