Chapter 1

1. Chapter1 Investments - Background and Issues

2. 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

3. The Investment Process • Asset allocation • Security selection • Risk-return trade-off • Market efficiency • Active vs. passive management

4. 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

5. Major Classes of Financial Assets or Securities • Debt • Money market instruments • Bonds • Common stock • Preferred stock • Derivative securities

6. 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

7. 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

8. 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

9. 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

10. 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

11. Chapter2 Financial Markets and Instruments

12. Major Classes of Financial Assets or Securities • Debt • Money market instruments • Bonds • Common stock • Preferred stock • Derivative securities

13. Markets and Instruments • Money Market • Debt Instruments • Derivatives • Capital Market • Bonds • Equity • Derivatives

14. Money Market Instruments • Treasury bills • Certificates of deposit • Commercial Paper • Bankers Acceptances • Eurodollars • Repurchase Agreements (RPs) and Reverse RPs • Federal Funds

15. 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

16. 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 .

17. - P 10,000 360 x r = BD n 10,000 - 10,000 9,875 360 x r = = 5% BD 90 10,000 Bank Discount Rate (T-Bills) 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

18. 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

19. P 10,000 - 365 x r = BEY n P 10,000 - 9,875 365 x r = BEY 9,875 90 Bond Equivalent Yield P = price of the T-bill n = number of days to maturity Example Using Sample T-Bill rBEY = .0127 x 4.0556 = .0513 = 5.13%

20. 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

21. Capital Market - Equity • Common stock • Residual claim • Limited liability • Preferred stock • Fixed dividends - limited • Priority over common • Tax treatment

22. 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?

23. Examples of Indexes - Domestic • Dow Jones Industrial Average (30 Stocks) • Standard & Poor’s 500 Composite • NASDAQ Composite • NYSE Composite • Wilshire 5000

24. Examples of Indexes - Int’l • Nikkei 225 & Nikkei 300 • FTSE (Financial Times of London) • Dax • Region and Country Indexes • EAFE • Far East • United Kingdom

25. Construction of Indexes • How are stocks weighted? • Price weighted (DJIA) • Market-value weighted (S&P500, NASDAQ) • Equally weighted (Value Line Index)

26. 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.

27. 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

28. Chapter3 How Securities are Traded

29. 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

30. 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

31. 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

32. 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

33. Organization of Secondary Markets • Organized exchanges • OTC market • Third market • Fourth market

34. 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

35. Types of Orders Instructions to the brokers on how to complete the order • Market • Limit • Stop loss

36. Margin Trading • Using only a portion of the proceeds for an investment • Borrow remaining component • Margin arrangements differ for stocks and futures

37. 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

38. 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

39. 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%

40. Margin Trading - Margin Call How far can the stock price fall before amargin call? (1000P - $35,000)* / 1000P = 40% P = $58.33 * 1000P - Amt Borrowed = Equity

41. 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

42. Short Sale - Initial Conditions Z Corp 100 Shares 50% Initial Margin 30% Maintenance Margin $100 Initial Price Sale Proceeds $10,000 Margin & Equity 5,000 Stock Owed 10,000

43. 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%

44. 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