Summary investments book investments bodie kane marcus PDF

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Summary

1 The investment Environment 2 Asset Classes and Financial Instruments 3 How securities are traded 4 Mutual Funds and other investment companies 5 Learing About Return and Risk from the Historical Record 6 Risk and risk aversion 7 Optimal Risky Portfolios 9 The Capital Asset Pricing Model 10 Arbitra...

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The investment Environment ..................................................................................... 2 Asset Classes and Financial Instruments .................................................................... 5 How securities are traded ......................................................................................... 10 Mutual Funds and other investment companies ..................................................... 12 Learing About Return and Risk from the Historical Record...................................... 15 Risk and risk aversion ................................................................................................ 18 Optimal Risky Portfolios............................................................................................ 19 The Capital Asset Pricing Model ............................................................................... 22 Arbitrage Pricing Theory and multifactor models of risk and return ................... 25 Behavioral Finance and Technical Analysis........................................................... 28 Empirical evidence on security returns ................................................................ 30 Bond Prices and Yields .......................................................................................... 31 The Term Structure of Interest Rates ................................................................... 35 Managing Bond Portfolios .................................................................................... 37 Portfolio Performance Evaluation ........................................................................ 40 Portfolio performance evaluation ........................................................................ 43

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The investment Environment

1.1Investments and financial assets Essential nature of an investment is to: 1: Reduce current consumption 2: Planned for later consumption Real assets are assets to produce goods and services Generate net income to the economy Financial assets are claims on real assets (such as stock and bonds) Allocate income or wealth among investors. Assets Real Assets

Liabilities

Financial Assets Examples: - Patents: - Lease obligations: - Customers goodwill: - A college education: - A $10 bill:

Real Financial Real Real Financial

Financial assets We distinguish among a broad type of financial assets common types are: 1: Fixed income 2: Equity 3: Derivatives Fixed income promise either a fixed stream of income or a stream of income that is determined according to a specified formula. Fixed income securities come in a tremendous variety of maturities and payment provisions. At one extreme the money market this refers to fixed income securities that are short, highly marketable, low risk. In contrast is the capital market includes long term securities (treasury bonds), bonds issued federal agencies, state and local municipalities. Equity or common stock this represent the ownership share in the corporation. Investments in equity tend to be riskier than fixed income, because success depends on the success of the firm Derivative securities. Such as options and futures contracts provide payoffs that are determined by the prices of other assets such as bonds or stock prices (future swap contracts) Financial markets Informational role: investors in the stock market ultimately decide which companies will live and die. Stock prices will reflect their collective judgment. Consumption timing: financial markets allow individual to separate decisions concerning current consumption from constraints that otherwise would be imposed by current earnings. Shift

consumption by saving earnings in high earnings period to low low earnings period -> work life to retirement. Allocation of risk: capital markets allow the risk that is inherent to all investments to be borne by the investors most willing to bear risk. E.G. Investment in Ford plant: low risk (bond) high risk (shares), but both have a different reward system. Separation ownership and management: this structure means that the owners and managers of the firm are different parties. Agency problem (managers who are hires as agents of the shareholders, may pursue their own interest.) Mechanism to solve agency problem are: 1. Compensation plan tie the income of managers to the success of the firm. 2. The board of directors are not defenders of top management they can force out management teams that are under performing. 3 Outsiders (pension funds, security analysts) monitor the firm closely and make the life of poor performers at the least uncomfortable. 4. Bad performers are subject to the threat of a takeover. Shareholders can elect a different board by (proxy contest) Crisis in corporate governance For markets to be efficient there must be enough transparency that allows investors to make well-informed decisions. Accounting scandals example Enron and WorldCom Analyst scandals (overoptimistic research rapports) example City group Salamon Smith Barney Initial public offering credit Swiss first Boston The investments process Asset allocation choosing among broad asset classes such as stocks and bonds Security selection decision is to choice of which particular securities to hold within asset classes Top down portfolio construction technique starts with the asset allocation decision-the allocation of funds across broad asset classes-and the progress to more specific security selection decision. Security analysis involves the valuation of particular securities that might be included in the portfolio  Top down portfolio management In contrast is the bottom-up strategy: this strategy does focus the portfolio on the assets that seem to offer the most attractive investment opportunities. Financial markets are highly competitive. There are implications of the ‘free lunches’ (securities that are underpriced that they represent obvious bargain.) This no-free lunch proposition has several implications: Competition leads to a Risk return trade off , in which securities that offer higher expected return also impose greater risk on investors. The presence of risk, however, implies that actual returns can differ considerably from expected returns at the beginning of the investment period. Completion among security analyst also promotes financial markets that are nearly

informational efficient (Market efficiency) meaning that prices reflect all available information concerning the value of the security. In the efficient market there is a choice between passive and active management: Active management Finding undervalued securities Timing the market Passive management No attempt to finding undervalued securities No attempt to time Holding diversified portfolio Passive investments strategies make sense in nearly efficient markets. Players in financial markets Firms net borrowers Households net savers Government net savers and borrowers Financial intermediaries Financial intermediaries pool investor funds and invest them. Their services are in demand because small investors cannot efficiently gather information, diversity and monitor portfolios. The financial intermediary sells his own securities to the small investors. The intermediary invest the funds thus raised, uses the proceeds to pay back the small investors and profits from the difference (spread) Recent trends Recent trends in financial markets include globalization, securitization, financial engineering of assets, and growth of information and computer networks. Globalization Tendency toward a worldwide investment environment, and the integration of national capital markets Securitization Pooling loans for various purposes into standardized securities backed by those loans, which can then be traded like any other security Financial engineering creating and designing securities with custom-tailored characteristics The financial crisis showed the importance of systematic risk. The risk inherent to the entire market or market segment. Also known as "un-diversifiable risk" or "market risk.

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Asset Classes and Financial Instruments

1) Fixed income market:  Money market: a subsector of the fixed-income market. It consists of very shortterm debt securities that usually are highly marketable. Many of these securities trade in large denominations, and so are out of the reach of individual investors. Money market funds, however are easily accessible to small investors. o Treasury Bills (T-bills, or just bills)  most marketable of all money market instruments. Simplest form of borrowing: The government raises money by selling bills to the public. At maturity the holder gets the face value. T-bills have initial maturities of 28, 91 or 182 days. T-bills are very liquid and sold at low transaction cost and with not much price risk. The asked price is the price you would have to pay to buy a T-bill. The bid price is the slightly lower price you would receive if you wanted to sell a bill to a dealer. The bid-asked spread is the difference between these prices. o Certificates of Deposit (CD)  A time deposit with a bank. Time deposits may not be withdrawn on demand. The bank pays interest and principal to the depositor only at the end of the fixed term of the CD. CEs issued in denominations greater than 100.000. o Commercial Paper  Large, well-known companies often issue their own short-term unsecured debt notes rather than borrow directly from banks. These notes are called commercial papers. Commercial paper maturities range up to 270 days. Usually it is issued in multiples of 100.000. o Bankers’ Acceptances  starts as an order to a bank’s customer to pay a sum of money at a future date, typically within 6 months. When the bank endorses the order for payment as “accepted”, it assumes responsibility for ultimate payment to the holder of the acceptance. At this pint, the acceptance may be traded in secondary markets like any other claim on the bank. Very safe assets. o Eurodollars  are dollar-denominated deposits at foreign banks or foreign branches of American banks. By locating outside the United states, these banks escape regulation by the Federal Reserve. o Repos and Reverses “repos” or “RPs”  The dealer sells government securities to an investor on an overnight basis, with an agreement to buy back those securities the next day at a slightly higher price. Term repo  the same but loan can be 30 days or more. Reverse repo: is the mirror image of a repo. Dealer finds an investor holding government securities and buys them, agreeing to sell them back at a specified higher price on a future date. o Federal Funds.  banks maintain deposits of their own at a federal reserve bank. Each member bank of the federal reserve system (Fed) is required to maintain a minimum balance in a reserve account with the Fed. Funds in the bank’s reserve account are called federal funds, or fed funds. In the federal funds market, banks with excess funds lend to those with a shortage. These loans, which are usually overnight

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transactions, are arranged at a rate of interest called the federal funds rate. o Brokers’ Calls  Individuals who buy stocks on margin borrow part of the funds to pay for the stocks from their broker. The broker in turn may borrow the funds from a bank, agreeing to repay the bank immediately (on call) if the bank requests it. The rate paid on such loans is usually about 1% higher than the rate on short-term T-bills. o The LIBOR Market. The London interbank Offered Rate (LIBOR) is the rate at which large banks in London are willing to lend money among themselves. EURIBOR (European Interbank Offered Rate) at which banks in the euro zone are willing to lend euros among themselves. o Yields on Money market instruments: Although most money market securities are of low risk, they are not risk-free. The bond market  is composed of longer-term borrowing or debt instruments than those trade in the money market. This market includes: o Treasury Notes and Bonds  The U.S. government borrows funds in large part by selling Treasury notes and treasury bonds. T-note maturities range up to 10 years, whereas bonds are issued with maturities ranging from 10 to 30 years. Both make semiannual interest payments called coupon payments. Although notes and bonds are sold in denominations of 1000 par value, the prices are quoted as a percentage of par value (a bid price of 98.5313 should be interpreted as 98.5313 % of par, or 985313 for the 1000 par value security. o Inflation-Protected Treasury Bonds  Least risky. Government bonds that are linked to an index of the cost of living in order to provide their citizens with an effective way to hedge inflation risk. Inflation-protected treasury bonds are called TIPS (Treasury Inflation Protected Securities). The real interest rates you earn on these securities are risk-free if you hold them to maturity. o Federal Agency Dept  Some government agencies issue their own securities to finance their activities. These agencies usually are formed to channel credit to a particular sector of the economy that congress believes might not receive adequate credit through normal private sources. These securities are considered extremely safe assets, and their yield spread above treasury securities is usually small. o International bonds Many firms borrow abroad and many investors buy bonds from foreign issuers. In addition to national capital markets, there is a thriving international capital market, largely centered in London. In contrast to bonds that are issued in foreign currencies, many firms issue bonds in foreign counties but in the currency of the investor. o Municipal Bonds  Are issued by state and local governments. They are similar to Treasury and corporate bonds except that their interest income is exempt from federal income taxation. Like treasury bond, municipal bonds vary widely in maturity. Maturities range up to 30 years. The key feature of municipal bonds is their tax-exempt status. Because investors pay neither federal nor state taxes on the interest proceeds, they are willing to accept lower yields on these securities. r(1-T)= after tax rate available.

Corporate Bonds Corporate bonds are the means by which private firms borrow money directly from the public. These bonds are similar in structure to Treasury issues (they typically pay semi-annual coupons over their lives and return the face value to the bondholder at maturity. They differ most importantly from treasury bonds in the degree of risk.  Secured bonds: which have specific collateral backing them in the event of firm bankruptcy  Debentures: unsecured bonds, which have no collateral  Subordinated debentures, have a lower-priority claim to the firm’s assets in the event of bankruptcy. Corporate bonds sometimes come with options attached.  Callable bonds give the firm the option to repurchase the bond from the holder at a stipulated call price.  Convertible bonds give the bondholder the option to convert each bond into a stipulated number of shares of stock. o Mortgages and Mortgage-backed securities  Until the 1970s almost all home mortgages were written for a long term (15-30 year) with a fixed interest rate over the life of the loan, with equal fixed monthly payments. These so-called conventional mortgages are still the most popular, but a diverse set of alternative mortgage designs has developed. Fixed-rate mortgages have posed difficulties to lenders in years of increasing interest rates. Adjustable rate mortgage: was a response to this interest rate risk. Mortgage-backed security: is either an ownership claim in a pool of mortgages or an obligation that is secured by such a pool. Mortgage lenders originate loans and then sell packages of these loans in the secondary market. For this reason, these mortgage-backed securities are called passtroughs.

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2) Equity securities  Common stock as ownership shares  also known as equity securities or equities, represent ownership shares in a corporation. Each share of common stock entitles its owner to one vote on any matter of corporate governance that are put to vote at a annual meeting and to a share in the financial benefits of ownership. A board of directors elected by the shareholders controls the corporation. The board selects managers who run the corporation on a day-to-day basis. Managers have the authority to make most business decisions without the board’s specific approval. Vote by proxy = empowering another party to vote in their name. The common stock of most large corporations can be bought or sold freely on one or more stock exchanges. A corporation whose stock is not publicly traded is said to be closely held. In most closely held corporations, the owners of the firm also take an active role in its management. Therefore, takeovers are generally not an issue. o Characteristics of Common stock:  1) Residual Claim  stockholders are the last in line of all those who have a claim on the assets and income of the corporation.  2) Limited liability  Unlike owners of unincorporated businesses, whose creditors can lay claim to the personal assets of the owner (house, car, furniture), corporate

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shareholders may at worst have worthless stock. They are not personally liable for the firm’s obligations. Stock market Listings: The NYSE is one of several markets in which investors may buy or sell shares of stock. The dividend yield in only part of the retrun on a stock investment. It ignores prospective capital gains (i.e., price increases) or losses. Low dividend firms presumably offer greater prospects for capital gains. The P/E ratio, or price-earnings ratio is the ratio of the current stock price to last year’s earnings per share. Preferred stock: has features similar to both equity and debt. Like a bond it promises to pay to its holder a fixed amount of income each year. Instead preferred dividends are usually cumulative; that is, unpaid dividends cumulate and must be paid in full before any dividends may be paid to holders of common stock. Preferred stock also differs from bonds in terms of its tax treatment for the firm. Because preferred stock payments are treated as dividends rather than interest, they are not tax deductible expenses for the firm, this disadvantage is somewhat offset by the fact that corporations may exclude 70% of dividends received from domestic corporations in the computation of their taxable income. Individual investors can not use the 70% tax exclusion. Even though preferred stock ranks after bonds in terms of the priority of its claims to the assets of the firm in the event of corporate bankruptcy, preferred stock often sells at lower yields than do corporate bonds. Preferred stock may be callable by the issuing firm, than they are called redeemable. It also may be convertible into common stock at some specified conversion ratio. Depository receipts  American Depository Receipts, or ADRs are certificates traded in U.S. markets that represent ownership in shares of a foreign company.

Stock and bond market indexes.  Dow Jones Averages  30 large “blue-chip” corporations. Since 1896. Dow measures the return (excluding dividentds) on a portfolio that holds one share of each stock, it is called a price-weighted average (example page 41).  Standard & Poor’s Indexes (S&P 500) represent an improvement over the Dow Jones Average in two ways. (1) it is a more broadly based index of 500firms. (2) it is a market value-weighted index. (example blz 45). Actually, most indexes these days use a modified version of market-value weights. Rather than weighting by total market value, they weight by the market value of free float, that is by the value of shares that are freely tradable among investors. For example, this procedure does not count shares held by founding families or governments. The distinction is more important in Japan and Europe, where a higher fraction of shares are held in such nontraded portfolios.  Investors today can easily buy market indexes for their portfolios. One way is to purchase shares in mutual funds that hold shares in proportion to their represe...