Overview: the course and financial markets
 Overview of the course
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How to run investment (Little book)
The effect of financial crisis
 Capital Markets
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Debt
Common stock
Preferred stock
Derivative securities
 Security Trading
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Trading
Trading Costs
Buy on margin versus short sell
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How to run investments?
 How to make money?
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Have the ability others typically don’t have
Have the information others typically don’t have
What else???
 What may you get from the “little book”?
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A thought in investment – “Joel Greenblatt’s simple notion will likely
retain at least a good deal of its validity even if it becomes widely
followed.”
 What may you learn from this course?
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Other than stocks, what can I do?
When everyone wants to make money, what the world would look like?
Still, what will make you a rich guy?
Chapter 1: Overview
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Making money by using margins
 What is a margin? -- equity/assets
 Say one has $10,000 investable equity. The
required margin is 50%.
 What does this mean?
 Say you borrowed $3,000 and all the money
($13,000)are invested in stocks
 You need spend $3,000 for a different project.
What options do you have? What are the
consequence?
Chapter 1: Overview
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Major Types of Securities
 Debt
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Money market instruments
Bonds
 Common stock
 Preferred stock
 Derivative securities
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Markets and Instruments
 Money Market
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Debt Instruments
Derivatives
 Capital Market
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Bonds
Equity
Derivatives
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Money Market Instruments
 Treasury bills
 Certificates of deposit
 Commercial Paper
 Bankers Acceptances
 Eurodollars
 Repurchase Agreements
 Federal Funds
 LIBOR Market
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Bond Markets
 US
Treasury Bonds and Notes
 Agency Issues (Fed Gov)
 International Bonds
 Municipal Bonds
 Corporate Bonds
 Mortgage-Backed Securities
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Municipal Bond Yields
 Interest income on most municipals is not subject
to tax
 To compare the yields on municipals to other
bonds use equivalent taxable yield
(municipal return) / (1 – tax rate)
 Or solve for the tax rate that equates the two yields
Tax rate = 1 – (municipal rate/taxable rate)
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Capital Market - Equity
 Common stock
 Residual claim
 Limited liability
 Analyzing stocks – finance.yahoo.com
 Preferred stock
 Fixed dividends - limited
 Priority over common
 Tax treatment
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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?
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Examples of Indexes - Domestic
 Dow Jones Industrial Average (30 Stocks)
 Standard & Poor’s 500 Composite
 NASDAQ Composite
 NYSE Composite
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Examples of Indexes - International
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Nikkei 225 & Nikkei 300
FTSE (Financial Times of London)
Dax
Region and Country Indexes
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EAFE
Far East
United Kingdom
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Bond Indexes
 Lehman Brothers
 Merrill Lynch
 Salomon Brothers
 Specialized Indexes
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Merrill Lynch Mortgage
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Construction of Indexes
 How are stocks weighted?
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Price weighted (DJIA)
Market-value weighted (S&P500, NASDAQ)
Equally weighted (Value Line Index)
 How returns are averaged?
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Arithmetic (DJIA and S&P500)
Geometric (Value Line Index)
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Derivatives Securities
Options
 Basic Positions
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Call (Buy)
Put (Sell)
 Terms
 Exercise Price
 Expiration Date
 Assets
Futures
 Basic Positions
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Long (Buy)
Short (Sell)
 Terms
 Delivery Date
 Assets
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Tips on Investment
 Buy under-valued stocks
 Buy recent-past winners
 Don’t over trade – investing in stocks is costly
 You can buy bonds
 Invest in real estates
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Security Trading
 Primary Market versus Secondary Market
 Types of Orders
 Trading Mechanisms
 Buy on margin and short selling
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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
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How Firms Issue Securities
 Investment Banking
 Shelf Registration
 Private Placements
 Initial Public Offerings (IPOs)
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Shelf Registrations
 SEC Rule 415
 Introduced in 1982
 Ready to be issued – on the shelf
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Initial Public Offerings
 Process
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Road shows
Bookbuilding
 Underpricing
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Post sale returns
Cost to the issuing firm
See page 62
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Figure 3.2 Average Initial Returns for IPOs in Various Countries
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Figure 3.3 Long-term Relative Performance of Initial Public Offerings
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Types of Orders
Instructions to the brokers on how to complete the order
 Market
 Limit
 Stop orders
 Page 63-66
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Figure 3.5 Price-Contingent Orders
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Trading Mechanisms
 Dealer markets
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Electronic communication networks (ECNs)
 Specialists markets
 Page 66-67
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U.S. Security Markets
 Nasdaq
 Small stock OTC
 Pink sheets
 Organized Exchanges
 New York Stock Exchange
 American Stock Exchange
 Regionals
 Electronic Communication Networks (ECNs)
 National Market System
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Nasdaq
 National Market System
 Nasdaq SmallCap Market
 Levels of subscribers
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Level 1 – inside quotes (investors)
Level 2 – receives all quotes but they can’t enter
quotes
Level 3 – dealers making markets
SuperMontage
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Table 3.1 Requirements for Listing on Nasdaq
Markets
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New York Stock Exchange
 Member functions
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Commission brokers
Floor brokers
Specialists
 Block houses
 SuperDot (70% of NYSE trading volume)
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Table 3.3 NYSE Listing Requirements
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Costs of Trading
 Commission: fee paid to broker for making the
transaction
 Spread: cost of trading with dealer
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Bid: price dealer will buy from you
Ask: price dealer will sell to you
Spread: ask - bid
 Combination: on some trades both are paid
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Margin Trading
 Using only a portion of the proceeds for an
investment
 Borrow remaining component
 Maximum margin is currently 50%; you can borrow
up to 50% of the stock value
 Set by the Fed
 Maintenance margin: minimum amount equity in
trading can be before additional funds must be put
into the account
 Margin call: notification from broker you must put up
additional funds
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Margin Trading - Initial Conditions Example 3.1
X Corp
$100
60%
Initial Margin
40%
Maintenance Margin
100
Shares Purchased
Initial Position
Stock $10,000 Borrowed $4,000
Equity
$6,000
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Margin Trading - Maintenance Margin Ex. 3.1
Stock price falls to $70 per share
New Position
Stock $7,000
Borrowed $4,000
Equity
$3,000
Margin% = $3,000/$7,000 = 43%
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Margin Trading - Margin Call Example 3.2
How far can the stock price fall before a
margin call? The maintenance margin is 30%.
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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 is was borrowed
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Short Sale - Initial Conditions
Dot Bomb
50%
30%
$100
1,000 Shares
Initial Margin
Maintenance Margin
Initial Price
Sale Proceeds $100,000
Margin & Equity
50,000
Stock Owed
100,000
What if price increases to 110?
How much can the stock price rise before a margin call?
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Short Sale - Margin Call
How much can the stock price rise before a margin call?
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1-42
Financial Crisis of 2008
 Antecedents of the Crisis:

“The Great Moderation”: a time in which the U.S. had
a stable economy with low interest rates and a tame
business cycle with only mild recessions

Historic boom in housing market
Chapter 1: Overview
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Figure 1.3 The Case-Shiller Index of
U.S. Housing Prices
Chapter 1: Overview
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Rise of Systemic Risk
 Systemic Risk: a potential breakdown of the
financial system in which problems in one market
spill over and disrupt others.
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1-44
One default may set off a chain of further defaults
Waves of selling may occur in a downward spiral
as asset prices drop
Potential contagion from institution to institution,
and from market to market
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Rise of Systemic Risk (Ctd.)
 Banks had a mismatch between the maturity and
liquidity of their assets and liabilities.
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Liabilities were short and liquid
Assets were long and illiquid
Constant need to refinance the asset portfolio
 Banks were very highly levered, giving them almost
no margin of safety.
1-45
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Rise of Systemic Risk (Ctd.)
 Investors relied too much on “credit enhancement”
through structured products like CDS
 CDS traded mostly “over the counter”, so less
transparent, no posted margin requirements
 Opaque linkages between financial instruments
and institutions
1-46
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The Shoe Drops
 2000-2006: Sharp increase in housing prices caused
many investors to believe that continually rising
home prices would bail out poorly performing loans
 2004: Interest rates began rising
 2006: Home prices peaked
1-47
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The Shoe Drops
 2007: Housing defaults and losses on mortgage-
backed securities surged
 2007: Bear Stearns announces trouble at its
subprime mortgage–related hedge funds
1-48
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The Shoe Drops
 2008: Troubled firms include Bear Stearns, Fannie
Mae, Freddie Mac, Merrill Lynch, Lehman
Brothers, and AIG
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1-49
Money market breaks down
Credit markets freeze up
Federal bailout to stabilize financial system
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