FIN670: Investment Analysis
Chapter 1: Background and Financial Instruments
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What this course is about
Basic knowledge of invesment process and financial
markets
Valuation of bonds and related bond investment
strategies
Portfolio theory: diversification and how it reduces
portfolio risk
Asset pricing models for expected returns
Fundamental and technical analysis
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Investments & Financial Assets
Essential nature of investment
Reduced current consumption
Planned later consumption
How to invest
Real Assets: Assets used to produce goods and
services
• produce income to economy
Financial Assets
• Claims on real assets or income generated by them
• Allocation of income, real assets among investors,
individuals in the economy
Balance Sheet – U.S. Households
Financial Assets
Financial assets
Fixed-income (Bonds)
Money Market
(Short-term)
Bond Market
(Long-term)
Equity (Stocks)
Common Stocks
Preferred Stocks
Derivatives
Options
Futures
Role of Financial asset and financial
markets in the Economy
Consumption Timing
Allocation of Risk
Separation of Ownership and Management
Consumption Timing
Savers
(earn more
than spend)
Financial
assets: stocks,
bonds,
deposits, etc.
Borrowers
(spend more
than earn)
How do you transfer money from when you do not need to
when you need?
Allocation of risk
Example: GM wants to build a new auto plant, it raised
money by issuing stocks and bonds
Stock
Auto plant
High risk
and low risk
Stock investors
(high risk)
GM
Bond
Bond investors
(low risk)
Separation of ownership and
management
Example: GE, total asset is $640 bil
Cannot be single owner, must have many
owners
Selling stocks to market
Currently, GE has 500,000 owners
These owners choose managers
Can easily transfer ownership without any
impact on management
The Investment Process
Asset allocation
Security selection
Risk-return trade-off
Market efficiency
Active vs. passive management
Investment process
Small stock
Stocks
Big stock
corporate bond
Bonds
Broad assets
T-bond, T-bill
Real estate
House
Land
Commodity
(1) Asset allocation
coffee, tea
gold, oil, etc
(2) Security analysis
Example of Asset Allocation
Age
30s
40s
50s
60s
Common
Stocks
70%
60
50
40
Bonds
30%
40
50
60
Example of Security Selection
Your Stock Portfolio
Auto
Retail
Wal-Mart
Nordstroms
Sears
Financial
Bank of America
Berkshire Hathaway
Citibank
There is no free lunch!
Return
more
return
less risk
less
return
more risk
Risk
Market Efficiency
Security prices accurately reflect all relevant
information.
The price in the market is the true price
Earn return just enough to compensate for risk, no
abnormal return
Active vs. Passive Management
Active Management
• Finding undervalued securities
• Timing the market
Passive Management
• No attempt to find undervalued securities
• No attempt to time
• Holding an efficient portfolio
Players in the Financial Markets
Business Firms – net borrowers
Households – net savers
Governments – can be both borrowers
and savers
Investment Bankers
Players in the Financial Markets
borrowers
securities
borrowers
securities
fund
securities
financial
intermediaries
savers
borrowing rate
lending rate
securities
securities
borrowers
Savers
savers
investment bank
fund
fund
get commission fees
Recent Trends
Globalization
Securitization
Financial Engineering
Computer Networks
Globalization
In 1970, US equity market accounted for about 70
percent of equity in the world
Currently, only 20-30 percent
How to invest globally
Purchase ADRs
Invest directly into international market
Buy mutual fund shares that invest in international market
derivative securities with payoff depends on prices of foreign
market
Securitization
(1) more funds available to borrowers
Banks
(2) Transfer risk of loans to
corresponding investors in the
market
pool all loans
Mortgage loans
auto loans
credit card
student loans
other loans
Benefits of securitization
loans are
securitized
securities
Investors
High risk loan
High risk securities
High risk investors
Low risk loan
low risk securities
low risk investors
Figure 1.2 Asset-backed Securities
Outstanding
Financial engineering
refer to creation of new securities
Use of mathematical models and computer-based
trading technology to synthesize new financial products
Bundling: combine more than one security into a
composite security
Unbundling: breaking up and allocating the cash flows
from one security to create several new securities
Collateralized Debt Obligation (CDO)
A CDO is an asset backed security (ABS) whose
underlying collateral is typically a portfolio of bonds
(corporate or sovereign) or bank loan
A CDO cash flow structure allocates
interest income and principal repayments
from a collateral pool of different debt
instruments to a prioritized collection
(tranches) of CDO securities.
Cash CDO Structure Illustration
Mortgage 1
Mortgage 2
Mortgage 3

Tranche 1 (AAA)
Yield = 5%
($25mil)
An
investment
bank creates
a set of
securities
(tranches)
backed by a
mortgage
pool
(CDO)
Mortgage n
Average Yield
12.5%
($100 mil)
Tranche 2 (A)
Yield = 10%
($25mil)
Tranche 3 (BBB)
Yield = 15%
($25mil)
Tranche 4
(junk bond)
Yield = 20%
($25mil)
Investor:
banks,
pension
funds,
college
saving
funds,
universiti
es, cities,
etc.
Collateralized Debt Obligation (CDO)
In normal time, mortgage borrowers are able to make the
mortgage payments, so the investors will get the interest
payments, the values of slices of CDOs increase
When housing bubble busts, mortgage borrowers, especially
subprime mortgage borrowers are not able to make payments,
investors don’t get their money, values of CDOs decrease
substantially. The value decrease is write-down and counted as
loss in the income statement.
For example, investment bank A, equity: $10 mil, borrow $90
mil. Invest all $100 mil in CDOs. When mortgage crisis
happens, the market value of these mortgage backed securities
drops substantially say to $80 mil, that means the income will
go down by $80 mil, and at this point, technically the bank is
insolvent.
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Subprime Mortgage Crisis: Winners and Losers
 Big losers: http://ml-implode.com/
 Bear Stearns: two hedge funds (>$1 billion)
 Australia: Basis Capital ($1 billion?); Absolute Capital ($200 million?);
IKB Deutsche Industriebank …
 May take two more years to completely resolve!
 Big losers:





Citigroup ($18B+)
Merrill Lynch ($11.5B+)
UBS ($17.8B+)
Morgan Stanley ($9.4B+) …
Bank of China (initial estimate $223 million, now could be $4-5B)
Figure 1.3 Building Creates a Complex
Security
Figure 1.4 Unbundling of Mortgages into
Principal- and Interest-Only Securities
Recent Trends—Computer Networks
Online information dissemination
Information is made cheaply and widely
available to the public
Automated trade crossing
Direct trading among investors
2008: Making History
31
2008: The End of Wall Street
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Decision Making
1.
2.
3.
4.
Perceive the situation
Possible actions
Evaluate the outcomes
Choose the action with the best
outcome
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Investments: Asset classes
and financial instruments
CHAPTER 2
Financial Securities
Financial Market
Fixed-income (Bonds)
Equity (Stocks)
High Risk
Low Risk
Money Market
(Short-term)
Derivatives
Bond Market
(Long-term)
Common Stocks
Preferred Stocks
Index
Options
Futures
Money Market Instruments
Treasury Bills
Certificates of deposit
Commercial paper
Banker’s acceptances
Eurodollars
Repos and reverses
Brokers’ calls
* Federal funds
LIBOR
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Money market instruments
T-bill
•
•
•
•
•
Issued by government
most marketable
minimum denomination: $1000
buy at a discount, return at par
issued weekly with maturities 28, 91, 182 days
Certificate of deposit (CD)
•
•
•
•
Pay interest and principal at maturity date
Par value > 100,000: negotiable
Par value <100,000: non-negotiable
Short-term CD (less than 3 months): highly marketable
Money market instruments
Commercial paper
•
•
•
•
Issued by large, well-known corporation
Short term, unsecured debt (less than 270 days),
more than 270 day need SEC registration.
Fairly safe
Fairly liquid
banker acceptance
•
•
an order to a bank by a customer to pay a sum
of money at a future date
safe (guaranteed by bank)
Money market instruments
Eurodollars: dollar denominated at foreign
banks or American banks’ foreign branches
•
•
•
similar to domestic deposit
escape US regulation
riskier, less liquid, offer higher yield than
domestic deposit
Repos (repurchase agreements)
•
short-term sales of government securities with
an agreement to repurchase the securities at a
higher price
Money market instruments
Federal funds
•
•
Funds in the accounts of commercial bank at the
Fed
Federal fund rate: overnight loan rate among
banks
LIBOR market: London Interbank Offer Rate:
lending rate among banks in London market
Table 2.2 Components of the Money
Market
Bond Market
Treasury Notes and Bonds
Federal Agency Debt
International Bonds
Inflation-Protected Bonds
Municipal Bonds
Corporate Bonds
Mortgages and Mortgage-Backed
Securities
Treasury Notes and Bonds
Maturities
Notes – maturities up to 10 years
Bonds – maturities in excess of 10 years
Par Value - $1,000
Quotes – percentage of par, in 32nd
Figure 2.4 Treasury Notes and Bonds
Federal Agency Debt
Major issuers
Federal Home Loan Bank
Federal National Mortgage Association (“Fannie Mae”)
Government National Mortgage Association (“Ginnie
Mae”)
Federal Home Loan Mortgage Corporation (“Freddie
Mac”)
If default, the government will help
safe, yield is similar to T-bill
Municipal Bonds
Issued by state and local governments
Types
General obligation bonds: backed by state, city
Revenue bonds: backed by the revenue of project of state, city
tax exempt from federal tax (for investors)
example: consider 2 bonds
• taxable bond: before tax yield = 8%, tax = 40%
• municipal bond: yield = 6%
• Which one is more attractive to investors?
Maturities – range up to 30 years
Municipal Bonds
Interest is exempt from Federal taxes
After-tax return (taxable bond):
raftertax  rbeforetax 1  t 
After-tax return (Municipal bond):
raftertax  rbeforetax
Figure 2.6 Ratio of Yields on
Tax-exempts to Taxables, 1955-2006
Corporate Bonds
Issued by private firms
Semi-annual interest payments
Subject to larger default risk than
government securities
Options in corporate bonds
Callable
Convertible
Figure 2.7 Investment Grade Bond Listings
Mortgages and
Mortgage-backed Securities
Developed in the 1970s to help liquidity of
financial institutions
Proportional ownership of a pool or a
specified obligation secured by a pool
Market has experienced very high rates of
growth
Mortgage backed securities
fund
fund
payment
payment
Banks
pool all
mortgage loans
securitized
fund
sell
Investors
payment
Mortgage loan
fund
mortgage backed
securities
payment
payment
Borrowers
Mortgage backed securities can be
called pass through securities since the
bank simply pass fund from investors to
borrowers and pass interest payment and
principal payment from borrowers to
investors
Figure 2.7 Mortgage-backed Securities
Outstanding, 1979-2007
Equity Markets
Common stock
Preferred stock
Depository receipts
stock market listing
Equity Markets
Common stock
• Right to vote
• Right to share benefit
• Proxy
• Proxy fight
Characteristics
• Residual claims
• Limited liabilities
Equity Markets
Preferred stocks
Similar to both stocks and bond (hybrid security)
• Similar to bond
• Similar to stock
Priority over common stock
preferred dividend is cumulative
tax treatment
• Preferred stock and bond are similar in the sense that they
are both fixed income and have no voting power.
• Bond has claims before preferred stock
• Obviously preferred stock is riskier, why in practice the yield
on preferred stock is smaller than that of bond
Equity Markets
ADR: claims on ownership in foreign
companies
Trading in the US, similar to US stocks
Total value of ADR currently is 657 (bil),
about 2000 ADRs from 73 countries
Figure 2.8 Listing of Stocks Traded on the
NYSE
Uses of Stock Indexes
Track average returns
Comparing performance of managers
Base of derivatives
Examples of Other Indexes - Domestic
Dow Jones Industrial Average (30 Stocks)
Standard & Poor’s 500 Composite
NASDAQ Composite
NYSE Composite
Wilshire 5000
Figure 2-10 Comparative Performance of
Several Stock Market Indexes
Examples of Indexes - International
Nikkei 225 & Nikkei 300
FTSE (Financial Times of London)
Dax
Region and Country Indexes
EAFE
Far East
United Kingdom
MSCI: index of more than 50 country
indexes
Table 2.6 Sample of MSCI Stock Indexes
Factors for Construction of
Stock Indexes
Representative?
Broad or narrow?
How is it weighted?
Price weighted (DJIA)
Market weighted (S&P 500, NASDAQ)
Equal (Value Line Index)
Price Weighted Indices
DJIA is an example
30 blue chip companies
DJIA = (P1+P2+....+P30)/d where d is Dow divisor.
Originally d = 30
Currently, d = 0.1248 since d is adjusted for stock
split, stock dividends, other corporate action, new
companies coming into the index, old companies
are taken out of the index
Example of Price-Weighted Index
Stock ABC sells initially at $25 a share with 20
million shares outstanding, while XYZ sells for $100 a
share with 1 millions shares outstanding. The final
price for ABC is $30, and the final price for XYZ is
$90.
(a) Find the initial and the final price-weighted index
composed of these two stocks. Assume the initial
divisor is 2.
(b) Now if stock XYZ is split two for one, how should
you adjust the divisor for the index?
DJIA
Most quoted index in the world
• Long history
• easy to understand
• indicates market’s basic trend reliably
• 30 companies account for 24-25% of US equity
Criticisms
• Only 30 stocks
• price weighted index: large price stocks dominate
the index
S&P’s Composite 500
Market Value-Weighted Index
Stock ABC sells initially at $25 a share with
20 million shares outstanding, while XYZ
sells for $100 a share with 1 millions shares
outstanding. The final price for ABC is $30,
and the final price for XYZ is $90.
Find the the value-weighted index
composed of these two stocks at the final
date. Assume the initial level of the index is
100.
Value Line
Equally Weighted Index
Places equal weight on each return
Using data from Table 2.4
Start with equal dollars in each
investment
ABC increases in value by 20%
XYZ decreases by 10%
Need to rebalance to keep equal
weights
Table 2.4 Data to Construct Stock
Price Indexes
Bond Index
Computed monthly
Difficulty in measuring true returns
Best known:
Merrill Lynch
Lehman Brothers
Salomon Smith Barney
DERIVATIVE MARKETS
Derivative 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
Options
Call option - the right to buy an asset at a
specific price (exercise price) on or before
a specific date
Put option - the right to sell an asset at a
specific price (exercise price) on or before a specific date
Figure 2.10 Trading Data on GE Options
Options
Call options
• Same expiration date, exercise price increases,
value of option decreases
• Same exercise price, expiration date increases,
value of option increases
Put options
• Same expiration date, exercise price increases,
value of option increases
• Same exercise price, expiration date increases,
value of option increases
Futures contracts
Obligation to purchase or sell an asset at a
specific price at a specific future date
Long position: trader who commits to buy
commodity/asset at delivery date
Short position: trader who commits to sell
at the delivery date
Option is the right, futures is obligation
Figure 2.11 Listing of Selected
Futures Contracts
There is no free lunch!
Return
Derivatives
more
return
less risk
Stocks more risk
less
return
Corporate Bonds
T-Bonds
Money
Risk
Summary
Differences between real assets and
financial assets
Purpose of investing in financial assets
Players in financial markets
Financial instruments
Financial market indices
Next class: How securities are trades;
Investment companies
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