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Investments Autumn 2019-20: Professor Marcin Kacperczyk
Investments Autumn 2019-20: Professor Marcin Kacperczyk
Autumn 2019-20
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Course Expectations
n Familiarity with concepts and basic tools
n Proficiency at applying the tools
n Understanding current empirical evidence
n Sapere aude!
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Course Materials
n Required
n Lecture notes
n Bodie, Kane, Marcus “Investments” (11th ed.)
n Recommended
n WSJ/FT/NYT/Economist/Bloomberg/CNBC
n Diary from WSJ (posted on Hub daily)
n Supplementary readings (updated weekly)
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Contact
n In class
n Office (PG53 2-02): W 10:00-11:30
n Hub
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Teaching Assistant
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Questions…
Comments…
Controversies…
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Lecture 1
Institutions: Review
Financial Instruments and Markets
Investment Process
n Investment: A current commitment of money or
resources in expectation of future benefits
n Types of assets
n real assets: used to produce goods & services
n example: factory, equipment, talent
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Financial Instruments
n Money market
n Fixed income capital market
n Equities
n Derivatives
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I. Money Market Securities
n Borrowing instrument (issued by reputable agents)
n Short term (up to one year)
n No coupons (interest only)
n Low risk of default (close to risk free)
n Highly liquid (high volume/ low transaction costs)
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Money Market Instruments
n Treasury Bills
n Certificates of Deposit (CDs)
n Commercial Paper
n Repurchase Agreements (Repos)
n Federal Funds
n LIBOR Market
n …
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Commercial Paper Crisis
II. Fixed Income Securities
n Borrowing instruments (Treasury, municipal,
corporate)
n Fixed cash flows: coupons or interest payment
n Cash-flow diagram for buying and holding on to
a 10-year, 8%, semi-annual coupon bond with
$1000 face value
- Price $40 $40 $40 $1,040
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Treasury Bonds
n Types of Treasury bonds
n Treasury Notes (1-10 years maturity)
n Treasury Bonds (10-30 years maturity)
n Semi-annual coupon payments
n Which bond pays a higher interest rate:
10-year T-bond or 1-year T-note?
n Why are government bonds traditionally
seen as safe investment?
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U.S. Debt to GDP
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Municipal Bonds (Munis)
n Issued by state and local governments
n Exempt from federal income tax
n Exempt from (issuing) state local tax
n Types of munis
n General obligation bonds: Backed by the
full faith of credit of the issuer (taxing power)
n Revenue bonds (riskier): Issued to finance
specific projects (airports, hospitals, etc.)
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Muni vs. Treasury Bond
n A (general obligation) muni bond pays 4% interest
n A Treasury bond pays 5% interest
n Which bond would you rather own if your marginal
tax rate on interest payments is 20%?
n What if your marginal tax rate is higher?
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Corporate Bonds
n Corporate bond
n Longer term
n Default risk
n Different seniority classes
n senior
n junior or subordinated
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III. Equity
n Equity
n Ownership in a firm
n Future cash flows (dividends) are uncertain
n Maturity is indefinite
n Involves risk, variable liquidity
n Two main classes of equities
n Common Stock: limited liability, voting rights, junior
n Preferred Stock: fixed dividend, non-voting, senior
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Equity: Aggregate Performance
n Dow Jones Industrial Average
n Price-weighted index
n Includes only 30 blue-chip companies
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Historical US Stock Performance
Average (geometric) Equity Return over the Rolling 10-year Period
20.0%
15.0%
10.0%
5.0%
0.0%
-5.0%
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Markets: Abysmal 2008
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Financial Instruments: Overview
Assets Total Value (2018 Q.4)
Money Market Instruments $25,009 B
Checkable Deposits and Currency $4,542 B
Time and Savings Deposits $12,200 B
Money Market Mutual Fund Shares $3,038 B
Federal Funds and Security Repurchase Agreements $4,133 B
Open Market Paper $ 996 B
Fixed Income Capital Market $43,421 B
Treasury Securities $17,685 B
Agency Securities $9,021 B
Municipal Securities and Loans $3,964 B
Corporate and Foreign Bonds $12,751 B
Corporate Equities $42,971 B
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IV. Derivatives
n Securities whose cash flows depend on
values of other assets
n Examples: Options, Futures, Swaps, Bonds
with option-like feature (convertible or
callable bonds)
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Derivatives: Options and Futures
n Call (Put) Option: Right to buy (sell) the underlying
asset
n At a specified price (strike price)
n On a specified date (maturity)
n Long (Short) Futures: Obligation to buy (sell) the
underlying asset
n At a specified price
n On a specified date
n Two kinds: Commodities or financial
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Financial Markets
Equilibrium Prices
n What determines the price?
n In economic theory? In reality?
n What is the equilibrium price?
n What’s the mechanism that drives prices towards equilibrium?
Price
Supply
P*=40
Demand
n Primary Market
n Market for new issues of securities
n Initial Public Offerings (IPO)
n Seasoned Public Offerings
n Private Placements
n Secondary Market
n Existing securities are traded
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Different Auction Mechanisms
n Consider uniform-price sealed-bid auction versus
multiple-price (discriminatory) sealed-bid auction
P S P S
$50 $__
$49 $__
$48 $__
D D
Q Q
First-
Day
Close
$239.25
IPO-
Price
$30
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# of IPOs (Bars) and Average First-
Day Returns (Diamonds): 1980-2018
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Greece
Sw itzerland
Average first-day returns on (mostly) European IPOs
Sw eden
Germany
Ireland
Cyprus Source: Jay Ritter’s IPO Data web site page provides details for each country
United States
United Kingd om
Italy
Finlan d
Israel
Belgium
Netherlands
Poland
Portugal
France
Turkey
Spain
Denmark
Norway
Austr ia
Russia
0%
60%
50%
40%
30%
20%
10%
-10%
Average first-day returns
Saudi Ara bia
China (A shares)
Jordan
India
Average first-day returns on non-European IPOs
S. Korea
Malaysia
Japan
Hong Kong
Thailand
Taiwan
Sri La nka
Brazil
Indonesia
Sin gapore
Australia
South Afr ica
Philippines
United States
New Zeala nd
Israel
Nigeria
Mexic o
Turkey
Egypt
Chile
Canada
Argentina
0%
80%
60%
40%
20%
240%
220%
200%
180%
160%
140%
120%
100%
Average first-day returns
Long-Term Performance of
IPOs (1980-2017)
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Trading of Securities
n Exchanges
n NYSE-Euronext
n NASDAQ
n Deutsche Bӧrse
n London Stock Exchange
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Trading on Exchanges
n Investor places an order with a broker
n Brokerage firm contacts its commission
broker or independent floor broker to execute
an order
n The specialist makes a market in the shares
of one or more firms
n Maintains a limit order book
n Maintains a fair and orderly market by dealing
personally in the stock
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Example of a Limit Order Book
n Last trade: $50 Buy Orders Sell Orders
n If a market buy for 100 Price Shares Price Shares
shares comes in, what
price will it get? 49.75 500 50.25 100
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Costs of Trading
n Commission
n Fee paid to broker
n Bid-Ask Spread
n Bid: Price dealer will buy from you
n Ask: Price dealer will sell to you
n Market Impact
n Larger orders impact the market price
n Taxes
n Government taxes realized capital gains for
taxable investors
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Bulls and Bears
n Buying on Margin
n Use borrowed funds to invest in securities
n Bullish strategy
n Short Sales
n Sell securities without owning them
n Bearish strategy
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Buying on Margin
n Federal securities law mandates
limitations on borrowing
n Initial margin must exceed 50%
n Maintenance margin must exceed 30%
n The margin is defined as
Equity Value of Security - Loan
Margin = =
Value of Security Value of Security
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Buying on Margin
n Suppose you have $10,000 and you are
very bullish about Microsoft
n You can borrow $10,000 from your
broker at a 10% interest rate
n Buy $20,000 worth of MSFT stock
n What are the returns of this trading
strategy if Microsoft stock increases or
falls by 25% during the next year?
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Return of Buying on Margin
MSFT increases MSFT decreases
25% 25%
Value of Stock
Position
Pay Back Loan
Net Value of
Account
Return
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Risks of Margin Purchases
n Broker gives you a margin call if the
maintenance margin is not met
n Broker can sell your securities without
asking for your permission
n The potential losses can exceed your
initial investment
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Example of Margin Calls
n Suppose that MSFT dropped within a year by
25%. Will you get a margin call?
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Short Sales: Mechanics
•Receive Stock
n Bank profit is FEE •Get dividend
•Lend Stock •Get fee
t=0 t=1
n Investor profit is P0-P1-FEE-Dividends
•Buy Stock for P1
•Return Stock
•Borrow Stock •Pay dividends
•Sell stock for P0 •Pay fee
t=0 t=1
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Margins
n The broker keeps the proceeds and requires
in addition a margin account as collateral
n The short seller needs to add funds to the
margin account if the account balance falls
below the maintenance margin
n Short interest is the number of short
positions relative to the trading volume
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Risks of Short Sales
n Broker can force you to cover short position
n If borrowed stocks are called back from lender
and broker cannot borrow different shares
n If margin call is not satisfied
n Potential losses of short sales are unlimited
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Performance of Securities
Quoted Rates and EAR
n Example
n Interest rate quoted at 10% compounded
semi annually
n Which loan is cheapest?
n 10%: compounded semi annually
n 10%: compounded quarterly
n 10%: compounded daily
n Effective Annualized Rate EAR if interest
is compounded m times a year
n EAR = (1+ quoted rate / m ) m - 1
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Continuous Compounding
n Suppose the quoted rate is given
n Consider increasingly frequent compounding:
annually, quarterly, daily, every second,…
n What happens to the EAR?
n When compounding happens all the time, it
is called continuous compounding
n EAR = exp(quoted rate) - 1
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Continuous vs. Annual Compounding
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Holding-Period Return: Overview
n Suppose that
n at time 0, you buy an investment for V(0) (=PV)
n you reinvest all intermediate cash flows until date T
n at time T, you sell the investment and the reinvested
cash flows for a total price of V(T) (=FV)
n HPR=V(T)/V(0)-1
n The annual holding-period return (ann. HPR)
is the solution to V (0) (1 + ann.HPR)T = V (T )
1/ T
æ V (T ) ö
n Hence, the annual HPR is ann.HPR = çç ÷÷ -1
è V (0) ø
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HPR: Stock Example
§ Holding-period return (HPR)
ending price + cash dividend
HPR = -1
beginning price
§ Annualized holding-period return for a holding
period of T years
n Arithmetic Average
1
( R1 + R2 + R3 + ... + RT )
T
n Useful for forecasting the return next period
n Not equivalent per-period return
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Multiple-Period Realized Return (2)
n Geometric Average
n Gives the equivalent per-period return