Investments 410

harry markowitz/ will sharp

says that many assets should be held to minimize exposure to one asset

§ Buy American Depository Receipts

§ Purchase foreign securities offered in dollars

§ Buy mutual funds that invest internationally

§ Buy derivatives that depend on foreign prices.

bundled mortgages sold as securities
bank sales to people who then get the payments. bank doesn't think they'll be able to make payments

direct search markets
buyers sellers craigs list
brokered markets
profitable for search services - real estate agesnts
Dealer Markets
car dealership - particular asset - buy and sale for own account
Auction Market - NYSE
everyone together at physical location.

pools of loans in one package = people receive principle on all of them.

household - net savers
firms - net borrowers
Government - borrowers/ lenders

institutions that “connect” borrowers and lenders by accepting funds from lenders and loaning funds to borrowers

Firms specializing in the sale of new securities to the public, typically by underwriting the issue

They raise capital now to pay for investments in plant and equipment. The income generated by those real assets provide the returns to investors who purchase the securities issued by the firm

They purchase the securities issued by firms that need to raise funds.

epending on the relationship between tax revenue and govt. expenditures. Budget deficits; its tax receipts have been less than its expenditures. The govt. borrowed money through T-bills and bonds. In the 90’s there was a surplus and they were able to retire some debt

A security that is issued in connection with a borrowing arrangement. May or may not pay coupon payments.

Represents the initial capital paid into or invested in a company. Represent ownership of a company

Derivatives are contracts between two or more parties. They hedge risk. Their price is dependent on the value of the underlying asset. Futures, forwards, options, and swaps are types of derivatives.

The right to buy an asset at a specific price on or before a specific date.

The right to sell an asset at a specific price on or before a specific date.

Calls for the delivery of an asset on a specific date for an agreed upon price.

Money Market Instruments

Include short-term, highly liquid, and relatively low-risk debt instruments. Less than 1 year of til maturity.

T-bills:

Sold by the government to the public to raise money. T-bills are the simplest form of borrowing, maturities of 28, 91, and 182 days. Sold for $1,000.

T-Notes:

Maturity of up to 10 years. Make semi-annual coupon payments. Sold for $1,000.

T-Bonds:

Maturity up to 30 years. Make semi-annual coupon payments. Sold for $1,000.

CD: A time deposit at a bank. They are treated as a deposit at a bank and insured up to $100,000.

30 large, “blue-chip” corporations

- Measures the return (excluding dividends) on a portfolio that holds one share of each stock. The amount of money invested in each company in that portfolio is therefore proportional to the company’s share price( a price-weighted average). Value is the sum of all the stock prices.

- High price stock can dominate a price-weighted average

-A more broadly based index of 500 firms

- A market value-weighted index

- Advantage over Dow: More firms, and market weighted

When firms need to raise capital they must choose to sell or float securities. These new issue of stocks, bonds, or other securities are marketed to the public by investment bankers.
After they are initially marketed to the public, they are traded amongst the public investors based on future expected value

IPO- initial public offering. This is the phase where the investment bankers buy the stock from the issuing company, and they re-sell them first to preferred customers and then to the rest of the public. Typically Stocks are under priced by about 23%.

After the IPO, sometimes the company will need to issue more stock to raise more capital. This can be done through a secondary offering. It is costly to issue stock so sometimes companies will issue convertable bonds to increase stock.

The primary market is the group of people willing to buy stocks when the company first issues the stock. This market has to deal with brand new stocks.

The group of investors that trade securities after they have been issued in the market.

Underwriting

An investment bank will help a company through an IPO, by buying the stocks and reselling them to the public and the preferred customers.

Kinds
Complete Underwriting - Banker buys all stock, and sells it to the secondary market. Paid directly from sale of stock
Best Efforts - Banker is paid in fees, whatever stock is sold at goes to company

A description of the firm and the security it is issuing.
When companies attempt to sell securities, they have to file preliminary registration statement with the SEC describing the issue and the prospects of the company. This is called preliminary prospectus (red herring). Once it is approved, it is called the prospectus, and the price of the securities is announced to the public

Markets in which traders specializing in particular assets buy and sell for their own accounts.

Profit from the spread between bid prices and ask prices.

Save search costs for the traders since they can easily look up the bid and ask prices.

OTC securities market such as NASDAQ is an example of a dealer market.
NASDAQ is the computer-linked priced quotation system for the OTC market.

Auction Market

Auction market is a market where all traders meet at one place to buy or sell an asset.
The traders can converge to arrive at mutually agreeable prices and save the bid-ask spread.

NYSE is the largest stock exchange in the United States.

Stock exchanges are secondary markets where already-issued securities are bought and sold by members

Buy or sell orders that are to be executed immediately at current market prices.
Trades at the bid and ask prices.

Limit buy (sell) orders
An order specifying a price at which an investor is willing to buy or sell a security.
Limit sell instructs the broker to sell if and when the stock price rises above a specified limit.
Limit buy instructs the broker to buy if the price is at or falls below a stipulated price.

Stop loss orders
Trade is not to be executed unless stock hits a price limit.
Stop-loss: sell stocks if price falls below a stipulated level.
Stop-buy: buy stocks when the price rises above a limit.
Often accompany short sales to limit personal losses.

computer networks that allow direct trading without the need for market makers.

For example: an order to buy a share at a price of $50 or lower would be automatically and immediately executed if there were an outstanding asked price of $50.

Benefits of an ECN
no broker needed, so the bid-ask spread is eliminated
cost less than a penny per share to use
Speed of trade is way faster
Also allows for anonymity in their trades

he or she manages the trading of a security in specialist markets, such as the NYSE. Book definition: a trader who makes a market in the shares of one or more firms and who maintains a “fair and orderly market” by dealing personally in the market.

The specialist will may act as either the broker or the dealer of a security

An employee of a member firm who executes trades on the exchange floor on behalf of the firm's clients.

Basically, floor brokers receive orders from their firms, which have been placed by the firms' clients, and executes these orders at the best possible prices. Floor brokers should not be confused with floor traders who execute orders for their own accounts.

Someone who gets paid by the brokerage company for which he works for each order of securities he executes on a customer's behalf. The commission structure can encourage unethical behavior by unscrupulous commission brokers. For example, a dishonest commission broker may engage in a practice called churning, which means executing multiple trades in a customer's account for the sole purpose of generating more commissions. The additional trades do not benefit the customer.

A trade must be settled with three days of the trading day (T +3 days)

i.e. the purchaser must deliver cash, and the seller must deliver the stock

Explicit cost- You must pay your broker a commission. You must choose between a full-service broker who usually has a staff of researchers and can even make buy/sell decisions for you, or a discount broker, who just does the basic buy/sell, hold, facilitate short sales.

bid-ask spread

When buying securities, you have easy access to a source of debt financing called “broker’s call loans.” The act of taking advantage of these loans is calling “buying on the margin.” The margin is the amount that the investor pays and the remainder is borrowed from the broker. The fed has limited the the amount that can be borrowed to 50% or less, meaning the investor must contribute at least 50% of the purchase price, with the rest borrowed.

Example from in class: we calculated the borrowed amount on a trade to be $35,000. We then took the 35K divided by (1-margin, he gave us the margin which was .4). The answer is $58,330. If the value of the the stocks falls below that amount the investor would get a margin call.

1. Record keeping and administration. Status reports, tracking capital gains, dividends, and investments

2. Diversification and divisibility. Pool money to hold fractional shares of many securities.

3. Professional management. Achieve superior investment results for their investors.

4. Lower transaction costs. Because they handle large securities, they achieve substantial savings on brokerage fees and commissions.

The value of each share one might hold in a mutual fund. It is the fund’s assets minus liabilities expressed on a per-share basis. So the total market value of the funds (assets-liabilities) divided by the total number of shares should give you how much each share is worth: Assets-Liabilities

Shares Outstanding

money pooled from many investors that is invested in a portfolio fixed for the life of the fund. Unmanaged, portfolio compensation fixed.

Managed Investment Companies - Third party management company that manages the portfolio of a company for annual fees. Ex. Vanguard hires Wellingon Management as investment advisers. Two types

Open-end fund: fund that issues or redeems its shares at net asset value

shares may not be redeemed, but instead are traded at prices that can differ from Net asset Value (NAV)

partnerships of investors that pool their funds, i.e. money market fund, a bond fund, and a common stock fund. Traded as units not shares, sold at NAV.

Similar to a close-end fund, invest in real estate or real estate loans. Highly leveraged because of borrowing to raise capital. They focus in either real estate directly or in mortgage and construction loans.

Hedge funds: A private investment pool, open to wealthy or institutional investors, that is exempt from SEC regulation and can therefore pursue more speculative policies than mutual funds.

Mutual funds usually have an underwriter who sells shares in the fund directly to investors (or has brokers help him sell it on his behalf). Brokerage firms are frequently given some kind of kickback (usually $$) for recommending a particular mutual fund group’s investment funds. This revenue sharing is legal as long as the broker discloses his conflict of interest to the client (usually done in the fine print).

Mutual funds can also be bought/sold in “financial supermarkets” where unified record keeping and many different mutual fund groups to pick from make this an attractive, albeit a bit more expensive, option.

expenses required to run the fund. Like administrative expenses, salary to the investment manager, etc. Usually .2%-2% of the fund’s total assets under management. They just take this right off the top so investors never see a bill for this--just their investment is worth a little less (see NAV above). Paid annually.

a commission or sales charge paid to the broker when you buy the shares in a mutual fund. Usually about 3% of the money you pay to invest. So if you invested $15,000, you’d really only invest $14,550 and $450 would go to the broker (with a 3% front load). About half of mutual funds are “no-load” funds. Paid once.

3. Back-end Load-exactly the same as front-load, but at the end. So a percentage charge of the funds you withdraw/sell. Paid once.

ike operating expenses these are taken out of the fund’s assets and reduce its total value (and therefore each shares value). So called “12b-1 funds” use the fund’s money to pay for advertising, annual reports, and the kickbacks to brokers who recommend their funds (see revenue sharing above). Paid annually

How they differ from Mutual Funds –

a. Transparency:

i. Mutual - need to provide public with information on portfolio

ii. Hedge – limited liability partnerships; provide minimal portfolio and strategy information to investors only

b. Investors: Hedge – maximum 100 investors; don’t advertise to public;

c. Investment Strategies:

i. Mutual – pressure to avoid style drift; limit short-selling, leverage and derivatives

ii. Hedge – can partake in any investment strategy; act opportunistically; wide range w/ derivatives, distressed firms, currency speculation; convertible bonds, etc.

d. Liquidity: Hedge – impose lock-up periods(investments cannot be withdrawn); limit liquidity, but returns may be higher and no unanticipated demands

e. Compensation Structure:

i. Mutual – fixed management fee (.5-1.5% of assets annually)

ii. Hedge – fixed management fee(1-2% of assets annually)+incentive fee(typically 20% of investment profits)

a. Compensation structure(^)

b. Incentive fee = call options on portfolio w strike price = current portfolio value *(1+benchmark)

i. Manager receives fee if portfolio value rises, but loses nothing if fall

ii. Figure 20.6

c. High Water Mark – complication w/ compensation structure

i. Previous value of portfolio must be re-attained before hedge fund can charge incentive fees

ii. Give mangers incentive to shut down funds that have performed poorly

d. Funds of Funds – hedge fund that invest in several other hedge funds; fast growing

i. Aka feeder funds

Liquidity

a. Hold more illiquid assets than other funds (like mutual)

i. Symptom is serial correlation in returns

1. Positive = likely to have positive returns; evidence of liquidity problems (mutual funds serial correlation = 0)

b. Speculation that one market sector will outperform others

c.To exploit temporary misalignment in pricing; long position hedged with a short position

To Exploit relative mispricing w/in mkt, but is hedged to avoid taking stance on direction of board mkt

: Bets on mispricing across 2 or more securities; high sources of risk

Use quantitative system to uncover perceived misalignments; ensure profit by averaging over all small bets

g. Pairs Trading: Stocks are paired based on underlying similarities;

h. Data Mining: to uncover systematic patterns that can be exploited

i. Portable alpha: invest in positive alpha position then hedge risk; (alpha transfer)

j. Backfill bias: bias in average returns funds by including past, successful returns

k. Survivorship bias: bias in average returns excluding unsuccessful, past returns

- focused largely on establishing all inputs necessary for decision making

- identify the investors objectives and constraints

- Create an investment policy statement

- forming capital market expectations

- creating strategic asset allocation

fleshes out the details of optimal asset allocation and security selection

- asset allocation

- security selection

- implementation and execution

- monitoring

- rebalancing

- preformance evaluation

- The process of adapting to changes in expectations and objectives as well as changes portfolio composition

- What is the effect this has on my taxes?

- Time

- matching needs with a time frame

- Stocks v bonds (stocks should be long term)

- Risk/Return

- Who is going to repay you?

- Why is the guarenteed rate so high?

- Can I tolerate a loss

- Age

- When do I need this money?

probabilities

- decision between different vehicles

Step where pick individual stocks, bonds, etc.

Mutual Funds--A firm pooling and managing funds of investors

ETF’s--Exchange Traded Fund e.g. SPDR (S&P 500). Low cost, traded on stock market, no loads--just transaction costs

Trusts--Personal Trust when person confers legal title to property to another person/institution, who then manages it. Holder of trust=Trustee.

Active vs. Passive:

monitoring and revising

Typically measure against S&P 500

HPR=Holding Period Return=End Value-Beg Value+Divident/Begin Value

Mutual Fund could be increasing in value, but not at as fast of a rate as S&P or Competitor.

Holding Period Return=End Value-Beg Value+Divident/Begin Value

= risk ratio/ standard deviation

*A line plotted that depicts the risk-return combinations available by varying the asset allocation (choosing different values for y)

*The slope of CAL equals the increase in expected return that an investor can obtain per unit of additional standard deviation

The organizing principle of portfolio theory, which maintains that any risk-averse investor will search for the highest expected return for any particular level of portfolio risk.

Risk factors common to the whole economy
It is the risk that remains even after diversification

Risk that is attributable to market-wide risk sources

Risk that can be eliminated by diversification

An investment with a return that is not guaranteed. Assets carry varying levels of risk. For example, holding a corporate bond is generally less risky than holding a stock. Government bonds are generally not considered risky assets. A risky asset should not be confused with a risk asset.