FINA 3080

Investment Analysis and

Portfolio Management
Prof. Chao Ying
Lecture 2A
Financial Markets and Instruments

FINA 3080 Prof. Chao Ying 1

 Lecture 2A Overview
• Real assets and Financial assets
• Debt instruments
– Money market securities: short maturity
– Fixed income securities: longer maturity
• Equity instruments
• Indices
– Stock index & Bond index
– Value/equal/price- weighted

FINA 3080 Prof. Chao Ying 2

 What Are Assets?
• Assets cost money today and yield returns later

• Real assets have productive capacity

– Example: land, machines, knowledge...
• Financial assets are claims on the cash flows
generated by real assets
– Example: Debt, equity, and derivatives

• May not buy a Tesla but can buy their stocks

FINA 3080 Prof. Chao Ying 3
 Institutional Players
• Facilitate the meeting of borrowers and lenders
• Financial intermediaries—e.g., banks
– “connect” borrowers and lenders by accepting funds from
lenders and loaning funds to borrowers.
• Investment companies—e.g., mutual funds
– Provide cheap diversification for households
• Investment banks
– Help large firms raise their capital through stocks and bonds
• Venture capital: finance a new firm
• Private equity: private firm that do ◦
not trade publicly
=

FINA 3080 Prof. Chao Ying 4

 Debt
• Money market instruments
– Short-term, usually less than a year
– High liquidity—i.e., easily convertible to cash
• Low transaction costs
• Low price uncertainty
mum

• Fixed-income capital markets (Bond Market)

– Longer maturity higher price uncertainty
( no one knows what the
– May be illiquid fin mkt will become after
.
.

years]
10

FINA 3080 Prof. Chao Ying 5

 Money Market Instruments
• Treasury Bills ( most) common

– Usually mature in 3, 6 or 12 months

– Nearly riskless (assuming US gov’t won’t default)
– Offer no explicit interest payments (
-

_ coupons ) no

– Tax treatment of “interest”

• Pay Federal taxes, but not state and local
t i
¥49s .

Hq federal tax 'T hi

- ok

FINA 3080 Prof. Chao Ying 6

 Other Money Market Securities
• Certificate of Deposit
– A time deposit with a bank: pay interest and principal only at the end
– insured by Federal Deposit Insurance Corporation (FDIC) up to US$250,000

• Commercial paper
– Issued by large corporations to meet short-term obligations instead of
-

borrowing from banks

– Unsecured with short maturity: not backed by collateral
,

• Repurchase Agreements (Repos): overnight borrowing

– Agree to sell Treasury today and promise to buy it back tomorrow
– Important source of funds for large financial institutions in the non-
depository banking sector: investment banks

FINA 3080 Prof. Chao Ying 7

 Other Money Market Securities
• Federal (Fed) funds
– Deposits Used by banks to meet-Fed reserve account - requirements
-

– Overnight borrowing/lending occurs at the Federal funds rate

– Federal open market committee meetings (FOMC): usually 8 times a year
( to adjust Fed Fund rates)
.

– On March 15 2020 (Sunday): Trump forces the Fed to cut the rate to 0
↳ not in the scheduled
meeting
• LIBOR: London Interbank Offer Rate
– The rate for London banks to lend money to each other
– The premier short-term interest rate quoted in the European money market

FINA 3080 Prof. Chao Ying 8

 Money Market Instruments
Type Borrower Lender Time Collateral

Certificate of FDIC up to
Bank Any Short
Deposit $250,000
Commercial
Firm Other firms Up to 270D ✖
paper

→ Depends
Repurchase
Dealer Dealer Up to 48H the details
Agreements on

of the deals
Bank’s Bank’s
÷
.

lateralised
Fed fund reserve reserve Short ✖
account account

LIBOR Bank Bank Short ✖

FINA 3080 Prof. Chao Ying 9

?⃝
 Fixed Income Instruments
• Treasury notes and bonds (US government)
– Notes have maturities between 1 and 10 years
– Bonds have maturities greater than 10 years
– Both make semiannual interest payments
[ face rallies )
– Prices usually quoted in denominations of $1,000
– MEEEEE
Main source of risk is interest rate movements
• TIPS (inflation-protected treasury bonds)
– Hedge inflation risk: provide constant income in real
(inflation-adjusted) dollars. Inflation adjusted than e)
(
FINA 3080 Prof. Chao Ying 10
 Other Fixed Income Securities
• Municipal bonds (munis)
– Interest is tax-free at all levels of gov’t (federal/state/local)
– To compare yields on taxable securities a Taxable
-

-
Equivalent Yield is constructed
1. General obligation bonds: backed by taxing power
2. Revenue bonds (riskier): revenues from projects

• Mortgage-backed securities
– Ownership claim in a pool of mortgages or an obligation that
is secured by such a pool
– Investor buys it is essentially lending money to home buyers.

FINA 3080 Prof. Chao Ying 11

 Table 2.2 Equivalent Taxable Yields

Tax-Exempt Yield (Municipal bonds)

Marginal Tax Rate 1% 2% 3% 4% 5%
20% 1.25% 2.50% 3.75% 5.00% 6.25%
30 1.43 2.86 4.29 5.71 7.14
40 1.67 3.33 5.00 6.67 8.33
50 2.00 4.00 6.00 8.00 10.00

capital gains tax

rtax exempt = rtaxable x (1 – All Tax rates)
rtax exempt > rtaxable x (1 – All Tax rates), then munis

FINA 3080 Prof. Chao Ying

 Corporate Bonds
• Issued by corporations: Private firms borrow

=
money directly from the public

• Corporate default risk can be significant

-

– Investors require higher returns on corporates

1. Callable through repurchase (by corporation)

2. Convertible to stocks (by bondholder)

FINA 3080 Prof. Chao Ying 13
 Equity
• Risky financial assets
– Residual claim on the firm’s cash flows t.EE#Tdz$)
– Firm becomes better, the value increases.
• Cash flows distributed in three events
– Dividend payment
– Stock repurchase
– Liquidation
• There is really no promise to pay out cash (
limited
liab .
)
– Shareholder rights and protection become crucial
FINA 3080 Prof. Chao Ying 14
 Equity Markets
• Common stock: one share = one vote ( rights )
– Residual claim: the last to receive money ( drawbacks)
– Limited liability: only lose the investment
• Preferred stock (v.s. common stock)
– Fixed dividends – limited liability
– Priority over common stock on dividends
– Not tax-deductible (v.s. interest on debt) ( Ves )
– No voting power ( Ves)
• Depository receipts: represent ownership in
shares of a foreign company
FINA 3080 Prof. Chao Ying 15
 Stock Indices
• Usually value-weighted ( e.g. google has large
)
– E.g., S&P 500, Nasdaq, etc. proportion
– Interpretation: portfolio with market weights
• Can be price-weighted
– E.g., Dow Jones and Nikkei 225
– Interpretation: portfolio with equal shares
• Equal-weighted indices are not common
=
– Invest same amount money for each asset
mm

FINA 3080 Prof. Chao Ying 16

 Stock Index (Value/Price/Equal weighted)

• Market price stock A/B/C: 10, 20, and 25.

• Total shares: 100, 200, and 300 take of f- n

of shares
• You have 1000 dollars in total. priest
= no . ×

each share
• Value weighted: weight d- firm :
¥¥f¥he
– 10*100+20*200+25*300=12500 on
firms .

10∗100 20∗200 25∗300

– 𝑤𝑤𝐴𝐴 = = 8%; 𝑤𝑤𝐵𝐵 = = 32%; 𝑤𝑤𝐶𝐶 = = 60%
12500 12500 12500
– 𝑀𝑀𝐴𝐴 = 1000 ∗ 8% = 80; 𝑀𝑀𝐵𝐵 = 1000 ∗ 32% = 320; 𝑀𝑀𝐶𝐶 = 1000 ∗
60% = 600;
80 320 600
– 𝑆𝑆𝐴𝐴 = = 8; 𝑆𝑆𝐵𝐵 = = 16; 𝑆𝑆𝐶𝐶 = = 24
10 20 25

FINA 3080 Prof. Chao Ying 17

 Stock Index (Value/Price/Equal weighted)

• Market price stock A/B/C: 10, 20, and 25.

• Total shares: 100, 200, and 300
• You have 1000 dollars in total.
• Price weighted (buy the same share for each):
c-

– 1000/(10+20+25) =18.18 shares of each stock

– 𝑀𝑀𝐴𝐴 = 18.18 ∗ 10 = 181.8; 𝑀𝑀𝐵𝐵 = 18.18 ∗ 20 = 363.6; 𝑀𝑀𝐶𝐶 = 18.18 ∗

25 = 454.5

FINA 3080 Prof. Chao Ying 18

 Stock Index (Value/Price/Equal weighted)

• Market price stock A/B/C: 10, 20, and 25.

• Total shares: 100, 200, and 300
• You have 1000 dollars in total.
• Equal weighted (invest same amount money):or

– 1000/3 =333.33 dollars on each stock

333.33 333.33 333.33

– 𝑆𝑆𝐴𝐴 = = 33.33; 𝑆𝑆𝐵𝐵 = = 16.67; 𝑆𝑆𝐶𝐶 = = 13.33
10 20 25

FINA 3080 Prof. Chao Ying 19

 Bond Indices
• Nearly all are value-weighted
run

• Major: Salomon(Citi), Lehman(Barclays), and Merrill

• Measurement problems from illiquid bonds

– Bonds trade infrequently: hard to get up-to-date prices
– Use valuation models to infer prices

FINA 3080 Prof. Chao Ying 20

 FINA 3080
Investment Analysis and
Portfolio Management
Prof. Chao Ying
Lecture 2B
Issuing and Trading Securities

FINA 3080 Prof. Chao Ying 21

 Lecture 2B Overview
• Issuing securities (primary market)
– Investment Banking: large firms
– IPO / Shelf Registration/ Private Placements

• Trading securities (secondary market)

– How are they traded (market/limit order)
– Where are they traded (exchanges/OTC/ECNs)
– Trading costs

FINA 3080 Prof. Chao Ying 22

 How Firms Issue Securities
• Private firms: Private Placements
– Sold to a limited number of sophisticated investors
– Not tradable in the secondary market, illiquid
– Up to 499 shareholders, want to go public
Élan
• Initial Public Offerings (IPOs)
– First sale of stock by a formerly private company
– Involve many parties (more details in the next slide)

• Shelf Registration (seasoned offerings): register

securities in Securities and Exchange Commission
(SEC) so they can be sold on short notice. heed to ,
no

FINA 3080 Prof. Chao Ying sell all at once 23

• Underwriter: investment banks
– More than one investment bank: lead underwriter
– The investment banks sell securities to the public (investors)
1. Road interest
shows (marketing & pricing) by underwriter
④ gain among potential
investors
, provide info Atte tiny ②
.
•

2. Bookbuilding (large investors reveal their true

interest to underwriter) then tell the
→

FINA 3080 Prof. Chao Ying

 Robinhood after IPO

IPO underpricing: the underwriter needs to offer the security at a bargain

price to the investors to induce them to participate in bookbuilding and
share their information

FINA 3080 Prof. Chao Ying

IPO underpricing

FINA 3080 Prof. Chao Ying

IPO underpricing

FINA 3080 Prof. Chao Ying

Can you sell IPOs immediately?
haunting
to law )

• Yes! as long as you are not employees of this

company
• Robinhood: warn investors not to sell shares within
the first 30 days of offerings.
-? and you'll be
• Otherwise, it's considered "flipping"
restricted from participating in IPOs for 60 days.
• In addition, recently especially during the covid, the
IPOs are usually not underpricing…
or

FINA 3080 Prof. Chao Ying 28

 IPO overpricing in the long run
• Despite their typically attractive first-day returns, IPOs have
been poor long-term investments.

=
• If you buy equal amounts of each U.S. IPO between 1980 and
2016 at the close of trading on the first day the stock is listed and
hold each position for three years.

• That portfolio underperforms the broad U.S. stock market by

18.4% for three-year holding periods

FINA 3080 Prof. Chao Ying 29

 How Securities are Traded
• Four Types of Markets
– Direct search: Least organized (used books)
– Broker: trades on behalf of investors
• Offer search services to buyers and sellers (Real Estate)
– Dealer: trades on behalf of itself
• Traders specialize in particular assets buy and sell
• Charge bid-ask spread (buy-sell) as profits
– Auction: all traders converge at one place
• Most integrated (such as NYSE)
• Do not need to search across dealers to find the
best price so that can save the bid-ask spread

FINA 3080 Prof. Chao Ying 30

 Trading - The Type of Order
• Market order is an order to buy (at ask) or sell (at bid) a
fixed quantity at the current market price
-
-

• Limit (Price-Contingent) order is an order to buy (sell) a

fixed quantity at a price below (above) the limit price
• Stop order: Similar to limit order that no trade unless
the stock hits a price limit but differ actions (Talk later)
Orders are matched or crossed in the “book”
– Priority is determined by price and then time
• Terms: bid, ask, bid-ask spread
Ask price
– Bid: price dealer will buy from you always
– Ask: price dealer will sell to you > bid price
FINA 3080 Prof. Chao Ying 31
 Example of a Limit Order Book
• Consider a broker with the limit order book described below. If you want to
sell 200 shares, how many shares can you sell and at what average price?
[Ignore the possibility of price improvement]

Bid: price dealer will buy Ask: price dealer will sell to
from you you
Quantity Price Quantity Price
100 33 100 34

{
Can't
sell
Ein 50 32 200 35
280 100 31 100 36
to
dealer
• (33*100+32*50+31*50)/200=32.25
t.kz#qtb
FINA 3080 Prof. Chao Ying 32
Figure 3.5 Price-Contingent Orders
• Stop-loss order: let the stock be
sold to stop further losses from
accumulating
• Stop-buy order: accompany
short sales and are used to limit
potential losses from short
positions.
• Short sales: sales of securities
you don’t own but have
borrowed from your broker

FINA 3080 Prof. Chao Ying 33

 Exchanges (Specialist Markets)
• Physical locations where trading occurs
• Members trade on the floor at posts
– Must own a seat to be a commission or floor broker
• Specialists “make markets” at their trading post
– Act as both a broker and a dealer
-
= =

– Broker match orders, usually for a fee

– Dealer trades for his own account and earn spreads
– Strive to maintain a narrow bid-ask spread
• Examples:
– NYSE, AMEX, and others

FINA 3080 Prof. Chao Ying 34

 OTC Markets (Dealer Markets)
• Investors trade without a central location.
• Many dealers interact via phone, internet, etc.
• SEC rules on Nasdaq dealers
– Best price quotes and size must be publicly displayed
• Example:
– Nasdaq, Pinksheet (easier listing than Nasdaq)
– Majority of bond trading

FINA 3080 Prof. Chao Ying 35

 Electronic Communication networks
(ECNs)
• Private computer networks that directly link buyers
with sellers info
Helps protect personal
•①
.

No unique physical place

a-
• Investors (and dealers) interact directly
• Potential advantage is trade anonymously
• E-trading challenges the traditional exchanges
– e.g. NYSE Arca, London, Euronext use E-trading
– Now it dominates other trading markets

FINA 3080 Prof. Chao Ying 36

 New Trading Strategies
• Algorithmic Trading
• Use of computer programs to make rapid trading decisions
• High-frequency trading: a subset of algorithmic Trading

• Dark Pools
• ECNs where participants can buy/sell large blocks of securities
anonymously: to avoid their intensions become public and
hmmm
price moves again them.
• Blocks: Transactions of at least 10,000 shares

FINA 3080 Prof. Chao Ying

 Costs of Trading
• Commission: fee paid to broker for making the
transaction

• Bid-ask Spread: cost of trading with dealer

– Bid: price dealer will buy from you
– Ask: price dealer will sell to you
– Spread: ask – bid (the profit dealer made)

• Combination: on some trades both are paid

FINA 3080 Prof. Chao Ying 38

 Where Are the Costs Lowest?
• It depends on your desired trade
• Some traders want the lowest commissions
– Use discount brokers who route to Nasdaq
• Some traders want quickest execution
– Use full-service brokers with NYSE seats
• Informed traders want to trade anonymously
– Use ECNs that allow direct trading

FINA 3080 Prof. Chao Ying 39

 Lecture 2: Assignments
• Ensure that you have all the course materials
• Read chapters 1.1-6, 2.1-4, 3.1-5, 7-9 skim 10.1-4
– Practice problems in BKM:
• PS (Problem Sets) : Ch. 1 (5-7); Ch. 2 (1-10, 12, 14); Ch. 3
(1-6, 8-9, 21);
• CC (Concept Check): Ch. 1 (1); Ch. 2 (1-5); Ch.3 (4-5); Ch.
10 (1-4)

FINA 3080 Prof. Chao Ying 40

 Questions?
• Please keep social distance when you ask
questions to avoid Covid-19
– If you have any questions, just raise your arm and ask sitting
on your chair.

– You can also ask questions through email

– Wear masks during my office hours

FINA 3080 Prof. Chao Ying 41

 Problem sets
1. f. Diff .
between real assets & fin assets .
!

Real assets are assets that generates productive capacity examples ,

include factories , knowledge etc ,

,
while fin . assets are
just claims on

cash flows such as stocks and bonds .

1- 6
Investment
specialisebanks on
the sale of new securities -6

the
general pwbtc typically by under witty
,
the issue
,
while Gawain

banks accepts deposits and lend * to other borrowers .

1. ? a. Create real asset ( fairy ) ,

create tin assets [ the
.
loan to
the bank )
b.
destroy fin asset.

c. Used fin asset [ cash ) to for red ants ( spare

auto
parts)
pay
.
 ( partial ownership of firn )
listed
I that is
publicly
.

↑
2-1 Common stock :
Equity claims residual cash flows Have divided
, may ,

issued
by firn 1hr voting rights

Puttered sbdi shares fixed steam of

non
why usually with
.

,
dividends
Corporate knob ! Issued
by corporate long-term ,
bonds
, typically
annul it & return face cute at bond matan
pay Seni
try
-

2.2 .

Wilshire tooo covers tooo

companies , better
represents the wkt .

Don
jones ind.org .

only to
up
.

/
too shall
avenge
2.3
wkt traded often short
.

Morey securities
low risk
: more mark
-4 term
,

relatively ,
high liquidity ,
unit vahe almost here
clap .

2.4
Major corporals of wkt :
money
.

of
certificate
Deposits ( bank time deposit )
Commercial bonds
papers ( Corps s .
-1 .

,
used to heel sit .

obligations )
 T bills
-

( 3/6/12 month no issued

by gov't )
, coupons ,

Repos ( sell treasuries

large institutions
-6dg ,
to raise St .

capital ,
then
pwr
.
securities back at higher price )
funds ( lend -6 mkt with insnttiñae
Fed excess reserves
, participants
teserves at fed fund rate )
2 b-
,

2.6 Mun is from ted & state tax

exempt
.
=

higher the tax bracket

,
more valuable is the tax -

etnpt
feature
2.1 LIBOR =
London Interbank Attend Rate
int .
rate for overnight hmouip of tin .
institution in London
Ted Fund rate
tin
int .
rate for
overnight home
got .
kettles in us A

2.8 . General Obigatr bnd : backed

by taxing power
sate
b- d
Municipal Rev
'

proceeds attached
specific projects
'
.

to
 riskier
expect higher yield
2. to Ltd When $ and back,
liab !
owing can't
pay
hat .

only
need to aht invested ✓
repay
The most that shareholders can lose an event of the failure
of the Corp .
is their original investment

Because market securities

extremely liquid
2. 12
are and he
money ,
can

very easily ,
cash thus equities
converted -6
they are regarded as
cash
+
price are stable low transact costs
,
_

2.13 .
E-
gimlet taxable yield = 63-4%74 -

D- %) =
10.385%
2. 14

✓
.
3. 1
Ipo =
first time a
private firm issue shows to public mk -6 .

Sfo : Additional shams available for people to buy in public ✓

IPO : first the a
formerly -

private firm sell stork to the public

SEO rt stocks twin has alr
: Issuance a
coup
.
who .

undergone Epo

3.2 . Effective pine paid / received includes !

Bid ask spread
-

, brokerage
fees , commissions
,
taxes
Reduce an out received by seller & increase cost incurred by buyers .

3.3 where stocks are sold for the first the

.

Primary markets :

CHO & SEO ) , buy stocks

being more stocks available
=
publicly in 2kt

Secondary markets : where stocks are traded between ppl& institutions

,

3.4 .

Security dealers earn profit by purchasing stocks at bid

price , and

at ask where bid pñu { ask

selling them
pna, pricey
dealers main source of iron is the bid ask
spread
'

security
-
 When the
3.5 .

public don't show great interest in the

company during
book
building ✗ & when
pru
d- shares is too low for the
company to

angst .

When firm of securities & wishes avoid the

a is a

willing buyer to

extensive time and cost associated with

pre party a
public issue it
,
shares privately
may issue .

3.6 .

Limit sell order : limits