1
Bodie • Kane • Marcus
Essentials of Investments
Fourth
Edition
Chapter 1
Investments - Background and
Issues
Irwin / McGraw-Hill
© 2001 The McGraw-Hill Companies, Inc. All rights reserved.
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Bodie • Kane • Marcus
Essentials of Investments
Fourth
Edition
Investments & Financial Assets
• Essential nature of investment
– Reduced current consumption
– Planned later consumption
• Real Assets
– Assets used to produce goods and
services
• Financial Assets
– Claims on real assets
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© 2001 The McGraw-Hill Companies, Inc. All rights reserved.
3
Bodie • Kane • Marcus
Essentials of Investments
Fourth
Edition
The Investment Process
•
•
•
•
•
Asset allocation
Security selection
Risk-return trade-off
Market efficiency
Active vs. passive management
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© 2001 The McGraw-Hill Companies, Inc. All rights reserved.
4
Bodie • Kane • Marcus
Essentials of Investments
Fourth
Edition
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
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© 2001 The McGraw-Hill Companies, Inc. All rights reserved.
5
Bodie • Kane • Marcus
Essentials of Investments
Fourth
Edition
Major Classes of Financial Assets or
Securities
• Debt
– Money market instruments
– Bonds
• Common stock
• Preferred stock
• Derivative securities
Irwin / McGraw-Hill
© 2001 The McGraw-Hill Companies, Inc. All rights reserved.
6
Bodie • Kane • Marcus
Essentials of Investments
Fourth
Edition
Investments and Innovation
Technology and Delivery of Service
• Computer advancements
• More complete and timely information
Globalization
• Domestic firms compete in global
markets
• Performance in regions depends on
other regions
• Causes additional elements of risk
Irwin / McGraw-Hill
© 2001 The McGraw-Hill Companies, Inc. All rights reserved.
7
Bodie • Kane • Marcus
Essentials of Investments
Fourth
Edition
Key Trends - Globalization
International and Global Markets
Continue Developing
• Managing foreign exchange
• Diversification to improve
performance
• Instruments and vehicles continue
to develop
• Information and analysis improves
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© 2001 The McGraw-Hill Companies, Inc. All rights reserved.
8
Bodie • Kane • Marcus
Essentials of Investments
Fourth
Edition
Key Trends - Securitization
Securitization & Credit Enhancement
• Offers opportunities for investors and
originators
• Changes in financial institutions and
regulation
• Improvement in information
capabilities
• Credit enhancement and its role
Irwin / McGraw-Hill
© 2001 The McGraw-Hill Companies, Inc. All rights reserved.
9
Bodie • Kane • Marcus
Essentials of Investments
Fourth
Edition
Key Trends Financial Engineering
Repackaging Services of Financial
Intermediaries
• Bundling and unbundling of cash flows
• Slicing and dicing of cash flows
• Examples: strips, CMOs, dual
purpose funds, principal/interest
splits
Irwin / McGraw-Hill
© 2001 The McGraw-Hill Companies, Inc. All rights reserved.
10
Bodie • Kane • Marcus
Essentials of Investments
Fourth
Edition
The Future
• Globalization continues and offers more
opportunities
• Securitization continues to develop
• Continued development of derivatives and
exotics
• Strong fundamental foundation is critical
• Integration of investments & corporate
finance
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© 2001 The McGraw-Hill Companies, Inc. All rights reserved.
11
Bodie • Kane • Marcus
Essentials of Investments
Fourth
Edition
Chapter 2
Financial Markets and Instruments
Irwin / McGraw-Hill
© 2001 The McGraw-Hill Companies, Inc. All rights reserved.
12
Bodie • Kane • Marcus
Essentials of Investments
Fourth
Edition
Major Classes of Financial Assets or
Securities
• Debt
– Money market instruments
– Bonds
• Common stock
• Preferred stock
• Derivative securities
Irwin / McGraw-Hill
© 2001 The McGraw-Hill Companies, Inc. All rights reserved.
13
Bodie • Kane • Marcus
Essentials of Investments
Fourth
Edition
Markets and Instruments
• Money Market
– Debt Instruments
– Derivatives
• Capital Market
– Bonds
– Equity
– Derivatives
Irwin / McGraw-Hill
© 2001 The McGraw-Hill Companies, Inc. All rights reserved.
14
Bodie • Kane • Marcus
Essentials of Investments
Fourth
Edition
Money Market Instruments
•
•
•
•
•
•
Treasury bills
Certificates of deposit
Commercial Paper
Bankers Acceptances
Eurodollars
Repurchase Agreements (RPs) and
Reverse RPs
• Federal Funds
Irwin / McGraw-Hill
© 2001 The McGraw-Hill Companies, Inc. All rights reserved.
15
Bodie • Kane • Marcus
Essentials of Investments
Fourth
Edition
Money Market Instrument Yields
• Yields on Money Market Instruments
are not always directly comparable
Factors influencing yields
• Par value vs. investment value
• 360 vs. 365 days assumed in a year
(366 leap year)
• Bond equivalent yield
Irwin / McGraw-Hill
© 2001 The McGraw-Hill Companies, Inc. All rights reserved.
16
Bodie • Kane • Marcus
Essentials of Investments
Fourth
Edition
Interest rates that arise in connection with money market
securities
.Bank discount rate (rBD )
.This is a rate that is used solely for determining the
price of a MM security for trading purposes.
.Bond equivalent yield (rBEY )
.In general, a yield is an interest rate that (under very
specific, sometimes unrealistic, assumptions) represents
a rate of return.
.rBEY is such a rate of return. It is an annual percentage
rate (APR)
.For comparing different MM instruments, we often use the
effective annual rate (EAR) of the rBEY .
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© 2001 The McGraw-Hill Companies, Inc. All rights reserved.
17
Bodie • Kane • Marcus
Essentials of Investments
Fourth
Edition
Bank Discount Rate (T-Bills)
10,000 - P 360
r BD =
x
n
10,000
rBD = bank discount rate
P
= market price of the T-bill
n
= number of days to maturity
Example
90-day T-bill, P = $9,875
10,000 - 9,875
360
r BD =
= 5%
x
10,000
90
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© 2001 The McGraw-Hill Companies, Inc. All rights reserved.
18
Bodie • Kane • Marcus
Essentials of Investments
Fourth
Edition
Bond Equivalent Yield
• Can’t compare T-bill directly to bond
– 360 vs 365 days
– Return is figured on par vs. price paid
• Adjust the bank discounted rate to make
it comparable
Irwin / McGraw-Hill
© 2001 The McGraw-Hill Companies, Inc. All rights reserved.
19
Bodie • Kane • Marcus
Essentials of Investments
Fourth
Edition
Bond Equivalent Yield
r BEY
10,000
=
P
-P
365
x n
P = price of the T-bill
n = number of days to maturity
Example Using Sample T-Bill
10,000 - 9,875
365
r BEY =
x
9,875
90
rBEY = .0127 x 4.0556 = .0513 = 5.13%
Irwin / McGraw-Hill
© 2001 The McGraw-Hill Companies, Inc. All rights reserved.
20
Bodie • Kane • Marcus
Essentials of Investments
Fourth
Edition
Capital Market - Fixed Income
Instruments
Publicly Issued Instruments
• US Treasury Bonds and Notes
• Agency Issues (Fed Gov)
• Municipal Bonds
Privately Issued Instruments
• Corporate Bonds
• Mortgage-Backed Securities
Irwin / McGraw-Hill
© 2001 The McGraw-Hill Companies, Inc. All rights reserved.
21
Bodie • Kane • Marcus
Essentials of Investments
Fourth
Edition
Capital Market - Equity
• Common stock
– Residual claim
– Limited liability
• Preferred stock
– Fixed dividends - limited
– Priority over common
– Tax treatment
Irwin / McGraw-Hill
© 2001 The McGraw-Hill Companies, Inc. All rights reserved.
22
Bodie • Kane • Marcus
Essentials of Investments
Fourth
Edition
Stock 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?
Irwin / McGraw-Hill
© 2001 The McGraw-Hill Companies, Inc. All rights reserved.
23
Bodie • Kane • Marcus
Essentials of Investments
Fourth
Edition
Examples of Indexes - Domestic
• Dow Jones Industrial Average (30
Stocks)
• Standard & Poor’s 500 Composite
• NASDAQ Composite
• NYSE Composite
• Wilshire 5000
Irwin / McGraw-Hill
© 2001 The McGraw-Hill Companies, Inc. All rights reserved.
24
Bodie • Kane • Marcus
Essentials of Investments
Fourth
Edition
Examples of Indexes - Int’l
•
•
•
•
Nikkei 225 & Nikkei 300
FTSE (Financial Times of London)
Dax
Region and Country Indexes
– EAFE
– Far East
– United Kingdom
Irwin / McGraw-Hill
© 2001 The McGraw-Hill Companies, Inc. All rights reserved.
25
Bodie • Kane • Marcus
Essentials of Investments
Fourth
Edition
Construction of Indexes
• How are stocks weighted?
– Price weighted (DJIA)
– Market-value weighted (S&P500,
NASDAQ)
– Equally weighted (Value Line Index)
Irwin / McGraw-Hill
© 2001 The McGraw-Hill Companies, Inc. All rights reserved.
26
Bodie • Kane • Marcus
Essentials of Investments
Fourth
Edition
Example
.Suppose we have two stocks
#Shares
Stock Pr 9/19/01
Pr 9/20/01
Return Outstand
A
100
120
20% 10M
B
10
9
–10% 500M
.Computation of a price-weighted index (like the Dow)
.Index on 9/19/01
(100+10)/2 = 55
Index on 9/20/01
(120+9)/2 = 64.5
Return on index 17.27%
.This is called a price-weighted index because the index
return is the price-weighted average of the component
(100/110) x 20% + (10/110) x –10% = 17.27%
.Portfolio: one share in each stock.
Irwin / McGraw-Hill
© 2001 The McGraw-Hill Companies, Inc. All rights reserved.
27
Bodie • Kane • Marcus
Essentials of Investments
Fourth
Edition
Market-value weighted index
.A market-value weighted average (like the S&P).
.Index on 9/19/01 = “100” (an arbitary base level)
.Market value of A = $100 x 10M = $1,000M
Market value of B = $10 x 500M = $5,000M
.Return on index is
(1,000/6,000) x 20% + (5,000/6000) x –10% = –5%
.Index on 9/20/01 = 100 x (1–5%) = 95
.Portfolio: 1/6 in A; 5/6 in B
.An equally-weighted index (like the Wilshire 5000)
.Index on 9/19/01 = “100” (an arbitary base level)
.Return on index is
(20% + –10%)/2 = +5%
.Index on 9/20/01 = 100 x (1+5%) = 105
.Portfolio: equal amounts in A and B
Irwin / McGraw-Hill
© 2001 The McGraw-Hill Companies, Inc. All rights reserved.
28
Bodie • Kane • Marcus
Essentials of Investments
Fourth
Edition
Chapter 3
How Securities are Traded
Irwin / McGraw-Hill
© 2001 The McGraw-Hill Companies, Inc. All rights reserved.
29
Bodie • Kane • Marcus
Essentials of Investments
Fourth
Edition
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
Irwin / McGraw-Hill
© 2001 The McGraw-Hill Companies, Inc. All rights reserved.
30
Bodie • Kane • Marcus
Essentials of Investments
Fourth
Edition
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
Irwin / McGraw-Hill
© 2001 The McGraw-Hill Companies, Inc. All rights reserved.
31
Bodie • Kane • Marcus
Essentials of Investments
Fourth
Edition
Public Offerings
• Public offerings: registered with the
SEC and sale is made to the investing
public
– Shelf registration (Rule 415, since 1982)
• Initial Public Offerings (IPOs)
– Evidence of underpricing
– Performance
Irwin / McGraw-Hill
© 2001 The McGraw-Hill Companies, Inc. All rights reserved.
32
Bodie • Kane • Marcus
Essentials of Investments
Fourth
Edition
Private Placements
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
Irwin / McGraw-Hill
© 2001 The McGraw-Hill Companies, Inc. All rights reserved.
33
Bodie • Kane • Marcus
Essentials of Investments
Fourth
Edition
Organization of Secondary Markets
•
•
•
•
Organized exchanges
OTC market
Third market
Fourth market
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© 2001 The McGraw-Hill Companies, Inc. All rights reserved.
34
Bodie • Kane • Marcus
Essentials of Investments
Fourth
Edition
Organized Exchanges
• Auction markets with centralized
order flow
• Dealership function: can be
competitive or assigned by the
exchange (Specialists)
• Securities: stock, futures contracts,
options, and to a lesser extent, bonds
• Examples: NYSE, AMEX, Regionals,
CBOE
Irwin / McGraw-Hill
© 2001 The McGraw-Hill Companies, Inc. All rights reserved.
35
Bodie • Kane • Marcus
Essentials of Investments
Fourth
Edition
Types of Orders
Instructions to the brokers on how to
complete the order
• Market
• Limit
• Stop loss
Irwin / McGraw-Hill
© 2001 The McGraw-Hill Companies, Inc. All rights reserved.
36
Bodie • Kane • Marcus
Essentials of Investments
Fourth
Edition
Margin Trading
• Using only a portion of the proceeds for
an investment
• Borrow remaining component
• Margin arrangements differ for stocks
and futures
Irwin / McGraw-Hill
© 2001 The McGraw-Hill Companies, Inc. All rights reserved.
37
Bodie • Kane • Marcus
Essentials of Investments
Fourth
Edition
Stock Margin Trading
• 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
Irwin / McGraw-Hill
© 2001 The McGraw-Hill Companies, Inc. All rights reserved.
38
Bodie • Kane • Marcus
Essentials of Investments
Fourth
Edition
Margin Trading - Initial Conditions
X Corp
$70
50%
Initial Margin
40%
Maintenance Margin
1000
Shares Purchased
Initial Position
Stock $70,000 Borrowed $35,000
Equity
35,000
Irwin / McGraw-Hill
© 2001 The McGraw-Hill Companies, Inc. All rights reserved.
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Bodie • Kane • Marcus
Essentials of Investments
Fourth
Edition
Margin Trading - Maintenance Margin
Stock price falls to $60 per share
New Position
Stock $60,000 Borrowed $35,000
Equity
25,000
Margin% = $25,000/$60,000 = 41.67%
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© 2001 The McGraw-Hill Companies, Inc. All rights reserved.
40
Bodie • Kane • Marcus
Essentials of Investments
Fourth
Edition
Margin Trading - Margin Call
How far can the stock price fall before a
margin call?
(1000P - $35,000)* / 1000P = 40%
P = $58.33
* 1000P - Amt Borrowed = Equity
Irwin / McGraw-Hill
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41
Bodie • Kane • Marcus
Essentials of Investments
Fourth
Edition
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
Irwin / McGraw-Hill
© 2001 The McGraw-Hill Companies, Inc. All rights reserved.
42
Bodie • Kane • Marcus
Essentials of Investments
Fourth
Edition
Short Sale - Initial Conditions
Z Corp
50%
30%
$100
100 Shares
Initial Margin
Maintenance Margin
Initial Price
Sale Proceeds $10,000
Margin & Equity
5,000
Stock Owed
10,000
Irwin / McGraw-Hill
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43
Bodie • Kane • Marcus
Essentials of Investments
Fourth
Edition
Short Sale - Maintenance Margin
Stock Price Rises to $110
Sale Proceeds
$10,000
Initial Margin
5,000
Stock Owed
11,000
Net Equity
4,000
Margin % (4000/11000)
36%
Irwin / McGraw-Hill
© 2001 The McGraw-Hill Companies, Inc. All rights reserved.
44
Bodie • Kane • Marcus
Essentials of Investments
Fourth
Edition
Short Sale - Margin Call
How much can the stock price rise before
a margin call?
($15,000* - 100P) / (100P) = 30%
P = $115.38
* Initial margin plus sale proceeds
Irwin / McGraw-Hill
© 2001 The McGraw-Hill Companies, Inc. All rights reserved.
