1. The asset management
game: a primer
Chapter 1-4
McGraw-Hill/Irwin
Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
Major Types of Securities
Debt
Money market instruments
Bonds
Common stock
Preferred stock
Derivative securities
2-2
Markets and Instruments
Money Market
Debt Instruments
Derivatives
Capital Market
Bonds
Equity
Derivatives
2-3
Money Market Instruments
Treasury bills
Certificates of deposit
Commercial Paper
Bankers Acceptances
Eurodollars
Repurchase Agreements (RPs) and
Reverse RPs
Domestic interbank market
LIBOR Market
2-4
Bond Markets
Treasury Bonds and Notes
Agency Issues
International Bonds
Municipal Bonds
Corporate Bonds
Mortgage-Backed Securities
2-5
Derivatives Securities
Options
Basic Positions
Call (Buy)
Put (Sell)
Terms
Exercise Price
Expiration Date
Assets
Futures
Basic Positions
Long (Buy)
Short (Sell)
Terms
Delivery Date
Assets
2-6
Capital Market - Equity
Common stock
Residual claim
Limited liability
Preferred stock
Fixed dividends - limited
Priority over common
Tax treatment
2-7
Stock Market Indexes
Uses
Track average returns
Comparing performance of managers
Base of derivatives
Factors in constructing or using an Index
Representative?
Broad or narrow?
How is it constructed?
2-8
Examples of Indexes - Domestic
Dow Jones Industrial Average (30 Stocks)
Standard & Poor’s 500 Composite
NASDAQ Composite / NYSE Composite
Wilshire 5000
Nikkei 225 & Nikkei 300
FTSE (Financial Times of London)
Dax / CAC / MIB /
Region and Country Indexes
Stoxx
2-9
Bond Indexes
Lehman Brothers
Merrill Lynch
Salomon Brothers
Specialized Indexes
Merrill Lynch Mortgage
2-10
Construction of Indexes – I
How are stocks weighted?
Price weighted (DJIA)
Market-value weighted (S&P500, NASDAQ)
Equally weighted (Value Line Index)
How returns are averaged?
Arithmetic (DJIA and S&P500)
Geometric (Value Line Index)
2-11
Averaging Methods
Component Return
A=10%
B= (-5%)
C = 20%
Arithmetic Average
[.10 + (-.05) + .2] / 3 = 8.33%
Geometric Average
[(1.1) (.95) (1.2)]1/3 - 1 = 7.84%
2-12
Construction of Indexes - II
How are they updated?
intraday (MIB30, S&P/MIB)
daily (MIB)
How are the constituents chosen?
entire security universe (global index)
main securities (headline index)
securities sharing a common feature
sector, size, value source
2-13
Primary vs. Secondary Security Sales
Primary
New issue
Key factor: issuer receives the proceeds
from the sale
Secondary
Existing owner sells to another party.
Issuing firm doesn’t receive proceeds and
is not directly involved.
2-14
Investment Banking Arrangements
Underwritten vs. Best Efforts
Underwritten: firm commitment on
proceeds to the issuing firm.
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.
2-15
Public Offerings
Public offerings
registered with the authority (SEC, CONSOB)
sale is made to the investing public.
shelf registration (Rule 415, delega amm/tori)
Initial Public Offerings (IPOs)
Evidence of underpricing
Short and long term performance
Private placement:
sale to a limited number of sophisticated investors not
requiring the protection of registration.
Dominated by institutions.
Very active market for debt securities.
Not active for stock offerings.
2-16
Organization of Secondary Markets
Organized exchanges
Regulated markets
ATS / MTF / ECN
OTC market
Third market
Fourth market
2-17
Organized Exchanges
Auction (order driven) markets
centralized order flow on an electronic (limit)
order book
Dealer (quote driven) markets
competitive dealership function;
specialist role based either on issuer’s
mandate or exchange designation
Stock, futures & options, and to a lesser
extent, bonds.
2-18
Other Market
OTC
Dealer market without centralized order flow.
information system for individuals, brokers, dealers
Used for bonds, derivatives, stocks.
Third Market
Trading of listed securities away from the exchange, usually
involving services of dealers and brokers.
Institutional market: to facilitate trades of larger blocks of
securities.
Fourth Market
Institutions trading directly with institutions (no middleman)
Organized information and trading systems
ECN Development
2-19
Trading Services & Costs
Services
Order collection
Order routing
Execution
Confirmation and clearing
Central counterparty service
Settlement
Costs
Commission (brokers, exchanges, clearinghouse, CSD)
Bid/ask spread
Time to execution
2-20
Types of Orders
Instructions on how to complete the order
Market vs. Limit
Stop loss
Fill or kill vs. Good till …
Market opening / close
Margin trading
Asset purchase partly based on borrowed money.
Margin arrangements differ for stocks and futures.
In USA, maximum initial margin 50% set by the Fed
Maintenance margin is the minimum level the equity margin can be
Margin call: Call for more equity funds
2-21
Margin Trading - Initial Conditions
X Corp
Margin:
Initial Position
Stock $70,000
1000 shares purchased @ $70
50% Initial; 40% Maintenance
Borrowed $35,000
Equity
$35,000
New Position if price drops to $60 per share
Stock $60,000
Borrowed $35,000
Equity
$25,000
Margin% = $25,000/$60,000 = 41.67%
2-22
Margin Trading - Margin Call
How far can the stock price fall before a
margin call?
(1000P - $35,000)* / 1000P = 40%
P = $58.33
* 1000P - Amount Borrowed = Equity
2-23
Short Sales
Purpose: to profit from a decline in the price
of a stock or security.
Mechanics
Borrow stock through a dealer.
Sell it and deposit proceeds and margin in an
account.
Closing out the position: buy the stock and
return to the party from which it was
borrowed.
2-24
Short Sale - Initial Conditions
Z Corp
Margin:
100 Shares
@ $100
50% Initial;
30% Maintenance
Sale Proceeds $10,000
Stock Owed $10,000
I. Margin 5,000
Equity 5,000
Stock Price Rises to $110
Sale Proceeds
$10,000
Margin
$ 5,000
Stock Owed $11,000
Net Equity $ 4,000
Margin % (4000/11000) = 36% > 30% (maintenance m.)
How much can the price rise before a margin call?
(15,000* - 100P) / (100P) = 30% P = $115.38
* Initial margin plus sale proceeds
2-25
Regulation of Securities Markets
Fair and orderly trading
Insider trading and market abuse
Pre and post trade transparency
Order routing (concentration vs. fragmentation)
Trading rules (tick size, priority, circuit breakers,…)
Conduct of business
conflict of interests (prevent, manage, disclose)
retail investor protection
Regulation
Law, Authority
Exchange
Self-Regulation
2-26
Investment Companies
Services
Administration & record keeping
Diversification & divisibility
Professional management
Reduced transaction costs
Types
Unit Trusts
Managed Investment Companies
Open-End
vs.
Closed-End
Other investment organizations
Commingled funds
REITs
Hedge funds
2-27
Net Asset Value
Used as a basis for valuation of
investment company shares.
Selling new shares
Redeeming existing shares
Calculation
Market Value of Assets - Liabilities
Shares Outstanding
2-28
Open-End vs. Closed-End Funds
Shares Outstanding
Closed-end:
no change unless new stock is offered.
Open-end:
changes when new shares are sold or old shares
are redeemed.
Pricing
Open-end:
Net Asset Value(NAV)
Closed-end:
Premium or discount to NAV
2-29
Investment Policies
Money Market
Fixed Income
Equity
Balance & Income
Asset Allocation
Indexed
Specialized Sector
2-30
Costs of Investing in Mutual Funds
Fee Structure
Front-end load
No load
vs.
Back-end load
Operating expenses
12 b-1 charges
distribution costs paid by the fund
Alternative to a load
Fees
Management fees
Performance fees (symmetric vs. fulcrum)
Bounds, high watermark, frequency
2-31
Exchange Traded Funds
Allow investors to trade funds based on
indexes like stock.
Examples
SPDRS
WEBS
HOLDERS
Allow sector specialization
2-32
A First Look at Fund Performance
Most funds underperform their benchmark
Not fair comparison because of costs
Result holds even if passive management costs
considered.
Do some mf consistently outperform?
Some evidence suggests so
Depends on measurement interval and on time period
Evidence shows consistency of poor performance
Correlation with high fees
2-33
Sources of Information on Mutual Funds
Morningstar
Press
Assogestioni
Wiesenberger’s Investment Companies
Investment Company Institute
Information providers
Advisors
2-34