FINS5513 L01 - introduce PDF

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FINS 5513

Lecture 01: Overview; Chapters 1, 2 and 3

Main Contacts p

Lecturer-in-Charge (LIC) n n n n n n

p

Mark Humphery-Jenner Email: [email protected] Associate Professor of Finance Started at UNSW in July 2012 Taught in the US (at Tulane), Japan (Kobe), and with the Asian Development Bank Website: https://www.business.unsw.edu.au/ourpeople/markhumphery-jenner

School of Banking and Finance n n

Lecture 1

Email: [email protected] West Wing, Level 3, UNSW Business School Building FINS5513

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Must Do p Read

your UNSW email frequently for course announcements p Read the course announcements p Make

sure you understand the key concepts of each chapter p Do the problem sets and CFA problems of each chapter p Must be able to write your answer clearly, concisely and precisely Lecture 1

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Course Structure p

Introduction: n n

p

6 Parts n n n n n n

p

Course introduction Quantitative review 1. 2. 3. 4. 5. 6.

Introduction to investments (ch 1-4) Portfolio theory and practice (ch 5-8) Equilibrium in capital markets (ch 9-13) Fixed income securities (ch 14-16) Equity valuation models (ch 18) Derivatives (ch 20-23)

Details in course outline and on course Moodle page

Lecture 1

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Assessment Details p p

Tests Final Exam: 50% n n n

Lecture 1

Held during the UNSW Exam Period (date TBA) Check your own myUNSW for the venue 2 hrs; MCQs and written questions; closed book

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Investment, Markets and Securities Trading p

BKM Chapters 1, 2 and 3 n n

p

Skim read the above chapters and do the basic problem sets before the lecture Read the above chapters and do the intermediate problem sets after the lecture

Further readings as indicated on lecture slides

Lecture 1

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Chapter 1

Chapter 1 p p p p p p

Real vs financial assets Roles of financial markets The investment process: top-down vs bottom-up Competitive markets: higher expected return comes with higher risk Major players in the financial markets GFC 2008

Lecture 1

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Assets: Real vs Financial

p

What are real assets? What are financial assets? Is there a relationship between the two?

p

Which is more important, real or financial assets?

p p

n n

Lecture 1

For households: For the country:

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Real Assets vs. Financial Assets Financial Assets

Real Assets •

•

Have Productive Capacity

Examples: Land, buildings, machines, intellectual property

p

Claims on real assets

p

Do not contribute directly to productive capacity

p

Examples: Stocks, bonds

Financial Assets Financial Assets: Claims on Real Assets

Fixed-Income Securities:

Equity:

Promises a fixed stream of income or a stream of income determined by a specified formula; debt

Represents ownership share in a corporation; common Stock

Derivatives: Provide payoffs that are determined by the prices of other assets

Roles of Financial Markets p

p

p

p

Information n Traded prices convey information about a company Consumption Timing n Allows some households to save and defer current consumption while allowing other households to borrow to increase current consumption Allocation of Risk n Investors can choose the level of risk and expected returns for their investments (more in Chapters 6 and 7) Separation of ownership and management n Agency problems n Corporate governance and corporate ethics n Sarbanes-Oxley Act (2002)

Lecture 1

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Main Players p

Household Sector n

p

Business Sector n

p

Net suppliers of capital Net demanders of capital

Government Sector n n

Lecture 1

Can be borrower Can be lender

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Financial Intermediaries p

Commercial Banks n

p p

Investment companies (more in Chapter 4) Investment Banks n n

p

Evolution of banks and financial intermediation

Underwriters in primary markets Also involved in financial innovations and derivatives

Changes in Regulation n n n

Lecture 1

Separation of investment and commercial banking under GlassSteagall Act until 1999 when the Act was repealed From 1999 to Sept. 2008, there were still a few stand-alone investment banks in the U.S. Dodd-Frank Reform Act (2010) places new restrictions on bank activities. FINS5513

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Universal Bank Activities Investment Banking •

Underwrite new securities issues

•

Sell newly issued securities to public in the primary market

Commercial Banking •

Take deposits and make loans

GFC 2008: Cause p p

Attributed to subprime mortgages Changes in housing finance n

Two federal agencies began selling mortgage-back securities in 1970 p p

n

Private firms started to securitized non-forming subprime loans p

p

p

Lecture 1

Fannie Mae (FNMA – Fed Nat Mortgage Association) Freddie Mac (FHLMC – Fed Home Loan Mortgage Corp)

Originating mortgage brokers have little incentive to carry out due diligence as long as the loans could be sold to an investor These loans also have low initial interest rates but revert later to current market rates Packaged together with CDO and CDS to mask the actual risks, the product appeals to many investors FINS5513

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GFC 2008 p

Decline in housing prices became widespread by Fall 2007

p

Crisis peaked in September 2008, triggered by the failure of Freddie Mac and Fannie Mae, both have large holdings of subprime MBS n

p

Led to failure of Lehman Brothers (filed bankruptcy), Merrill Lynch (bought by Bank of America) and AIG (received a bailout by US govt.)

The crisis can be traced to securitization, subprime mortgage loans, CDO (e.g, Lehman Brothers) and CDS (e.g., AIG)

Lecture 1

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Chapter 1 p p p p p p p

Real assets; financial assets; Informational role of financial markets Corporate governance, ethics and scandals Repeal of Glass-Steagall Act in 1999 Corporate scandals and the Sarbanes-Oxley Act (2002) GFC 2008 and the Dodd-Frank Reform Act (2010) Volcker Rule

Lecture 1

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Chapter 2

Chapter 2 p

Money Market Bond Market Equity Market

p

For each of the above markets:

p p

n n n n

p

Types of instruments How to read their prices? Where they are first issued and traded? Where and how to buy and sell?

Market Indices: P-weighted; MV-weighted; Equallyweighted

Lecture 1

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Money Markets Fixed Income Capital Markets Asset Classes

Equity

Derivatives

The Money Market p

Subsector of the fixed-income market n n n n

Short-term Liquid Low risk Often have large denominations

Money Market Instruments p p p p p p p p

Treasury bills (govt); Certificates of deposit (bank) Commercial Paper (company) Bankers Acceptances Eurodollars: dollar-denominated time deposits in banks outside the U.S. Repos and Reverses: Short-term loan backed by government securities. Fed Funds: Very short-term loans between banks Brokers’ Calls and LIBOR Market Money market mutual funds allow individuals to access the money market.

Lecture 1

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The Capital Market (1 of 2) Treasury Notes Treasury Bonds

Corporate Bonds

Municipal Bonds

Capital Markets

International Bonds

Federal Agency Debt

InflationProtected Securities

The Capital Market (2 of 2) p

Subsector of the fixed-income market n n n

Long-Term Liquid Low risk (but not as low as the Money Market)

Bond Markets US Treasury Bonds and Notes n Inflation-Protected Treasury Bonds (TIPS) n Federal Agency Issues: E.g., Fannie Mae and Freddie Mac n International Bonds n

p Eurobonds

and foreign bonds

Municipal Bonds n Corporate Bonds n Mortgage-Backed Securities: majority by Fannie Mae and Freddie Mac n

Lecture 1

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Pricing of US Treasury Instruments p

Treasury bills: prices quoted on an annualized discount percentage

n

Lecture 1

E.g.(Table 2.1): Asked is 0.125% with 156 days till maturity. Discount is 0.125*156/360=0.0542%. A bill with face value $10,000 could be bought from the dealer at $10,000*(10.000542)= $9,994.58

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Equity

Asset Classes

Fixed Income

Common Stock

Equity

Preferred Stock

Derivatives

ADRs

Equity Securities p

Common stock n n n

p

Preferred stock: Perpetuity n n n

p

Residual claim Limited Liability Ownership Fixed dividends Priority over common Perpetuity

American Depository Receipts (ADRs) n

Ownership of shares of foreign firms

n

Easier for foreign firms to satisfy US requirements

Lecture 1

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Stock Market Indices p p p p

Dow Jones Industrial Average: 30 large blue-chip stocks; since 1896; price-weighted S&P 500: 500 firms; market-value-weighted NASDAQ Composite; NYSE Composite; Wilshire 5000 Index not traded but investors can base their portfolios on an index n n n

Lecture 1

Buy an index mutual fund Buy exchange traded funds (ETFs) Equally-weighted index is not popular because of high turnover due to frequent rebalancing of portfolio

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Bond Indices p p p p

p

Many bonds are infrequently traded While a company may have 2 types of stocks, a company may have many types of bonds “Matrix” prices calculated based on bond-valuation models Major indices: Merrill Lynch, Barclay (formerly Lehman Brothers), Salomon Smith Barney (now part of Citigroup) More in Chapter 16 Bond-Index Funds

Lecture 1

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Price-Weighted Average Portfolio: Initial value $25 + $100 = $125 Final value $30 + $90 = $120 Percentage change in portfolio value = 5/125 = -.04 = -4% Index: Initial index value (25+100)/2 = 62.5 Final index value (30 + 90)/2 = 60 Percentage change in index -2.5/62.5 = -.04 = -4% Lecture 1

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Construction of Indexes p

How are stocks weighted? n n n

p

Price weighted (DJIA) Market-value weighted (S&P500, NASDAQ) Equally weighted (Value Line Index)

Price weighted index requires an adjustment factor (divisor) n n

Lecture 1

For stock splits (see example 2.3). More examples in the excel file “PW Index and Stock Split”. When a stock is removed from the index and replaced by another stock

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Averaging Methods p

How returns are averaged? n

Arithmetic p p

n

p

A=10%

B= (-5%)

C = 20%

Arithmetic Average (equally-weighted) n

p

Geometric (Value Line Index)

Example: Components’ Returns n

p

DJIA: price-weighted with a divisor S&P500: value-weighted

[.10 + (-.05) + .2] / 3 = 8.33%

Geometric Average n

Lecture 1

[(1.1) (.95) (1.2)]1/3 - 1 = 7.84% FINS5513

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Derivatives Fixed Income Asset Classes

Equity Options Derivatives Futures

p

A derivative is a security that gets its value from the value of another asset, such as commodity prices, bond and stock prices, or market index values

Comparison Futures Contract

Option p

p

p p

Right, but not obligation, to buy or sell Option is exercised only when it is profitable Options must be purchased The premium is the price of the option

p p

p

Obliged to make or take delivery Long (short) position must buy (sell) at the futures price Futures contracts are entered into without cost

©2018 McGraw-Hill 2-36 Education

Derivatives Markets: Options n

Call Option: p p

n

Put Option: p p

n

Right to buy underlying asset at the strike price Value of calls decreases as strike price increases Right to sell underlying asset at the strike price Value of puts increase with strike price

Both calls and puts increases with time until expiration

Chapter 2 p p

Pricing conventions in the money market Pricing conventions in the bond market n

p

Equity markets n n n

p

More in Chapter 14 Bond Prices and Yields Valuation of common stock (more in Chapter 18) Valuation of preferred stock (more in Chapter 18) ADRs: Why ADR?

Market Indices n n

Lecture 1

How to calculate P-weighted indices? How and when to adjust? How to calculate MV-weighted indices? How & when to adjust?

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Chapter 3

Chapter 3 p p p

How firms issue securities? How Securities are traded? Types of markets (how markets are arranged?) n

p p

Types of orders Trading mechanisms n

p p p

Direct search; brokered; dealer; auction

Dealer markets; ECNs; Specialist markets

Electronic Trading; New strategies; Globalisation Buying on margin; Short Sales Regulation

Lecture 1

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How firms issue securities? p

Primary market n n

New issue and issuer receives the proceeds from the sale Private Placements (private firms) p

p

n

sale to a limited number of sophisticated investors not requiring the protection of registration. Dominated by institutions

Publicly Traded p p

Shelf registration IPOs with investment banks as underwriters § Registered with SEC and sale is made to the public § Usually involves investment bank(s) § Underwritten vs. Best Efforts

Lecture 1

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How securities are traded? p

Secondary market n n n n n

Existing owner sells to another party. Issuing firm doesn’t receive proceeds and is not directly involved. Organized exchanges (e.g., NYSE) OTC market (e.g., NASDAQ) Third Market p p p

p

Lecture 1

Trading of listed securities away from the exchange. Facilitate trades of larger blocks of securities by institutions Involve block brokers, specialized in matching block buyers and sellers Displaced by dark pools where block buyers and sellers can remain hidden from the public FINS5513

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Costs of Trading p p

Commission: fee paid to broker for making the transaction Spread: cost of trading with dealer n n n

Lecture 1

Bid: price dealer will buy from you Ask: price dealer will sell to you Spread: ask - bid

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Types of Orders p p

Market orders Limit orders: limit-buy and limit-sell orders n

p

Stop orders: stop-buy and stop-loss orders n

p

E.g., place a stop-buy order at $40

Conditional orders n n

p

E.g., place a limit-sell order at $40

Time in force Direction of price movement

Read more at: http://en.wikipedia.org/wiki/Order_(exchange)

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Margin Trading p p p

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

Lecture 1

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Stock Margin Trading p

Initial margin n n

p

Maintenance margin n n n

p

Minimum level the investor’s equity margin can be Currently 25% for NYSE, NASDAQ and AMEX stocks http://www.nyse.com/pdfs/joint.pdf

Margin call n

Lecture 1

Currently 50% in the United States Set by the Federal Reserve System

Call for more investor’s equity funds

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Margin Trading Initial Conditions X Corp 50% 40% 1000 Initial Position Stock $70,000

Lecture 1

$70 Initial Margin Maintenance Margin Shares Purchased Borrowed Equity

$35,000 $35,000

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Margin Trading Maintenance Margin Stock price falls to $60 per share Stock $60,000 Borrowed $35,000 Investor’s Equity $25,000 Margin% = $25,000/$60,000 = 41.67% > 40%, no margin call How far can the stock price fall before a margin call? (1000P - $35,000) / 1000P = 0.4; or P = $58.33

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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 it was borrowed.

p

Lecture 1

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Equity % p

Buying on margin n n n n

p

Equity = (Shares portfolio value – Loan) Loan fixed in value; Shares portfolio value would change Equity % = Equity/(Shares portfolio value) See Example 3.1 and 3.2

Short sales n n n n n

Lecture 1

Equity = (Initial Sales Proceeds + Initial Margin – Value of shares borrowed) Initial Sales Proceeds and Initial Margin fixed in value Value of shares borrowed would change Equity % = Equity/(Value of shares borrowed) See Examples 3.3 and 3.4 FINS5513

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Trading Related Issues & Regulation p

Electronic Trading and Related Issues n n

p

Algorithmic trading; HFT Dark pools

Government Regulation n

United States: SEC, CFTC, Federal Reserve, SIPC, FSOC p

n

p

Sarbanes-Oxley Act (2002)

Australia: Australian Securities and Investments Commission (ASIC) and Australian Prudential Regulation Authority (APRA)

Self-Regulation by exchanges n

Lecture 1