FINC3017 Notes PDF

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Lecture notes week 1-3...

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FINC3017 – Investment and Portfolio Management

Week 1 – Introduction Real versus Financial Asset Real assets are physical assets that have an intrinsic worth due to their substance and properties. Real assets include precious metals, commodities, real estate, land, equipment, and natural resources. Real assets provide portfolio diversification , as they often move in opposite directions to financial assets like stocks or bonds. Financial assets are a liquid property that derives value from a contractual right or ownership claim.  

Stocks, bonds, mutual funds, bank deposits, investment accounts, and good old cash are all examples of financial assets. They can have a physical form, like a dollar bill or a bond certificate, or be nonphysical—like a money market account or mutual fund.

Nature of Investment: Reduce current consumption for greater future consumption

Financial Assets = Financial Liabilities 

Financial Assets and Liabilities must balance.

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Aggregated balance sheets  only real asset claims Domestic Net Worth = Sum of real assets

Financial Assets 3 Asset Classes 1. Common Stocks  Ownership stake in entity, residual cash flow 2. Derivative Securities  Contract, value derived from underlying market condition 3. Fixed Income Securities  Money market instruments, bonds, preferred stock

FINC3017 – Investment and Portfolio Management

The Investment Process: Asset Allocation Primary determinant of a portfolio’s return. Top down Investment Strategy starts with Asset Allocation.

The Investment Process: Security Selection Choice of particular securities within asset class Security analysis – Analysis of the value of securities Bottom up Investment Strategy starts with security selection

Markets are Competitive Risk – Return Trade Of   

Assets with higher expected returns have higher risk Stock Portfolios lose money 1 in 4 years on average Bonds  Lower average rates of return (under 6%)  Not lost more than 13% of value in any one year

In an efficient market Securities should be neither underpriced nor overpriced on average and reflect all information available to investors. Belief in Market efficiency will determine choice of investment management style.

The Financial Crisis of 2008 Changes in Housing Finance

FINC3017 – Investment and Portfolio Management Old Ways  Local thrift institutions made mortgage loans to homeowners.  Thrifts possessed a portfolio of longterm mortgage loans  Thrifts’ main liabilities: DEPOSITS  “Originate to Hold”

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New Way  Securitisation: Fannie Mae and Freddie Mac bought mortgage loans and bundled them into large pools  Mortgage – backed securities are tradeable claims against the underlying mortgage pool  “originate to distribute”

Inclusion of nonconforming “subprime” loans Low/NO-documentation loans Rising loan-to-value ratio Adjustable-Rate Mortgages

Case-Shiller Index of U.S. Housing Prices

2008 GFC – The Shoes Drop 

September 7: Fannie Mae and Freddie Mac put into conservatorship

FINC3017 – Investment and Portfolio Management   

Lehman Brothers and Merrill Lynch verged on bankruptcy September 17: Government lends $85 billion to AIG Money Market panic freezes short-term financing market

LIBOR, T-Bill Rates and TED Spread

Cumulative Returns Cumulative returns on a $1 investment in the S&P 500 Index

FINC3017 – Investment and Portfolio Management

The Money Market 

Subsector of the fixed-income market - Short-term - Liquid - Low Risk - Often have large denominations

The Money Market: T-bills

FINC3017 – Investment and Portfolio Management

The Money Market: Certificates of Deposit (CDs)

The Money Market: Commercial Paper

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Asset-backed commercial paper is a new innovation

The Money Market: Instruments Banker’s Acceptances  

Purchaser authorizes a bank to pay a seller for goods at later date (time draft) When purchaser’s bank “accepts” draft, it becomes contingent liability of the bank (and marketable)

Eurodollars  

Dollar-denominated time deposits held outside U.S. Pay higher interest rate than U.S. deposits

Federal Funds

FINC3017 – Investment and Portfolio Management  

Trading in reserves held at the Federal Reserve Key interest rate for economy

LIBOR (London Interbank Offer Rate)  

Rate at which large banks in London (and elsewhere) lend to each other Base rate for many loans and derivates

The Money Market: Repurchase Agreements Repurchase Agreements (RPs)    

Short term sale of securities + promise to repurchase at higher price RP is a collateralized loan Many RPs are overnight “Term” RPs may have a 1-month maturity

Revers RPs  

Lending Money; obtaining security title as collateral Haircuts may be required

The Money Market: Brokers’ Calls  

Call money rate applies for investors buying stock on margin Loan may be “called in” by broker

The Bond Market Capital Market – Fixed-Income Instruments Government Issues-U.S. Treasury Bonds and Notes    

Bonds vs. notes Denomination Interest Type Risk? Taxation?

Treasury Inflation Protected Securities (TIPS)  

Principal adjusted for changes in the Consumer Price Index Marked with a trailing “I” in quote sheets

The Bond Market: Private Issue Corporate Bonds: Investment Grade vs. Speculative Grade A bond that is speculative-grade has a rating lower than Baa from Moody's Investors Service, a rating lower than BBB from Standard & Poor's or both. Nonrated bonds are also considered speculativegrade. Bonds with ratings of Baa, BBB or higher are termed investment-grade. Many institutional investors have policies that require them to limit their bond investments to investment-grade issues. Mortgage-Backed Securities

FINC3017 – Investment and Portfolio Management 

Backed by pool of mortgages with “pass-through” of monthly payments; covers defaults

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Collateral - Traditionally all mortgages conform, since 2006 Alt-A and Subprime mortgages are included in pools.

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Private banks purchased and sold pools of subprime mortgages

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Issuers assumed housing prices would continue to rise

Equity Securities: Instruments Equity Securities -

Common stock

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Residual claim

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Limited liability

Preferred stock -

Priority over common

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Fixed dividends: Limited gains

- Nonvoting

Derivative Markets Derivative Asset/Contingent Claim -

Security with payoff that depends on the price of other securities

Call Option -

Right to buy an asset at a specified price on or before a specified expiration date

Put Option -

Right to sell an asset at a specified exercise price on or before a specified expiration date

Futures Contracts -

Purchaser (long) buys specified quantity at contract expiration for set price Contract seller (short) delivers underlying commodity at contract expiration for agreed upon price

FINC3017 – Investment and Portfolio Management...