FIN 4504 Chapters 1-5 Notes
FIN 4504 Chapters 1-5 Notes FIN 4504
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This 11 page Study Guide was uploaded by Ruby Oates on Monday February 8, 2016. The Study Guide belongs to FIN 4504 at Florida State University taught by Doug Smimth in Winter 2016. Since its upload, it has received 55 views. For similar materials see Investments in Finance at Florida State University.
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Date Created: 02/08/16
1) Financial Assets a) Financial assets: claims on real assets or the income generated by them. i) Examples: stocks and bonds b) Types of Financial Assets: i) fixedincome (debt) securities: pay a specified cash flow over a specific period. (1) money market: shortterm, highly marketable, low risk (a) US Treasury Bills, or bank CDs, and preferred stock (2) capital market: longterm; issued by federal agencies, state and local municipalities, and corporations (a) range from safe (Treasury bonds) to risky (highyield, or "junk" bonds) (3) preferred stock: ownership in a corporation. (a) predetermined dividends that pile up if not paid (b) no voting rights ii) equity: an ownership share in a corporation (1) equity holders are not promised any particular payment; they receive dividends the firm may pay (residual cash flow) (2) riskier than debt securities because value of equity directly depends on the success of the firm and its real assets iii) derivative securities: securities providing payoffs that depend on the values of other assets (1) call options, futures, and swap contracts (2) they hedge risks (transfer risks to other parties) 2) Asset Allocation Process a) If the people knew what would happen in the future, market prices would equal the fair value estimate of a security's expected future risky cash flows. However, the market is not perfect. There are other mechanisms such as central planning or having Congress make decisions, but markets work better. b) Investors can choose a desired risk level i) bonds (safer) v. stock ii) bank CD (safer) v. company bond iii) The higher the possible (expected) return, the greater the risk c) asset allocation: allocation of an investment portfolio across broad asset classes i) Stocks 60%; Bonds 30%; Alternative Assets 6%; Money Market Securities 4% d) security selection: choice of specific securities within each asset class e) security analysis: analysis of the value of securities f) "Topdown" portfolio: starts with asset allocation then chooses the assets g) "Bottomup" portfolio: chooses securities without worrying about asset allocation i) focuses on assets with the most attractive investment opportunities, but may end up relying heavily on one sector of the market (riskier than topdown) 3) Securitization a) securitization: pooling loans into standardized securities backed by those loans, which can then be traded like any other security i) PPT Words: Loans of a given type such as mortgages are placed into a 'pool' and new securities are issued that use the loan payments as collateral ii) The securities are marketable and are purchased by many institutions (1) "Shadow banking system": refers to the end result of securitization, namely that many institutions now provide the ultimate financing for loans that banks traditionally financed iii) The end result is more investment opportunities for purchasers, and spreading loan credit risk among more institutions b) Securitization has grown rapidly due to: i) changes in financial institutions and regulation permitting its growth, particularly lower capital requirements on securitized loans ii) improvement in information capabilities iii) credit enhancement provided by pool issuers has improved marketability 4) Money Market Instruments a) Treasury Bills: shortterm government securities issued at a discount from face value and returning the face amount at maturity i) issued by: Federal Government ii) Denomination: $100, commonly $10,000 iii) Maturity: 4, 13, 26, or 52 weeks iv) Liquidity: Highly liquid v) Default risk: None vi) Interest Type: Discount vii)Taxation: Federal taxes owed; exempt from state and local taxes b) Certificates of Deposit: a bank time deposit. Lump sum at the end. i) Issued by: Depository Institutions ii) Denomination: Any, $100,000 or more are marketable iii) Maturity: Varies, typically 14 day minimum iv) Liquidity: 3 months or less are liquid if marketable v) Default risk: First $100,000 ($250,000) is insured vi) Interest type: Add on vii)Taxation: Interest income is fully taxable c) Commercial Paper: shortterm, unsecured debt issued by large corporations i) Issued by: Large creditworthy corporations and financial institutions ii) Maturity: maximum 270 days, usually 1 to 2 months iii) Denomination: minimum $100,000 iv) Liquidity: 3 months or less are liquid if marketable v) Default risk: Unsecured, Rated, Mostly high quality vi) Interest type: Discount vii)Taxation: Interest income is fully taxable viii) New Innovation: Asset backed commercial paper is backed by a loan or security. Financial institutions used these to fund projects. In summer 2007, asset backed CP market collapsed when subprime collateral values fell. d) Bankers' Acceptances: an order to a bank by a customer to pay a sum of money at a future date i) Originates when a purchaser of goods authorizes its bank to pay the seller for the goods at a date in the future (time draft) ii) When the purchaser's bank 'accepts' the draft, it becomes a contingent liability of the bank and becomes a marketable security iii) Interest type: Discount iv) Bank acceptances are considered very safe assets because they depend on the bank's credit standing, not the traders' e) Eurodollars: Dollardenominated deposits at foreign banks or foreign branches of American banks i) Pay a higher interest rate than U.S. deposits ii) Mostly large sums are invested for less than six months iii) Eurodollar CD: like a domestic bank CD, except it is the liability of a nonUS bank of a bank, typically a London branch. (1) Holder can sell the asset for cash before maturity (2) Less liquid and riskier than domestic CDs (3) Higher yields iv) Eurodollar bonds: dollardenominated bonds outside the US (1) NOT a money market investment because they have long maturities f) Repos: shortterm sales of government securities with an agreement to repurchase the securities at a higher price i) a RP is a collateralized loan, many are overnight (1) term repos have a one month maturity ii) Reverse Repo: lending money and obtaining security title as collateral Broker's Calls i) Investors who buy stock on margin borrow money from their brokers to purchase stock. The borrowing rate is the call money rate. ii) The loan may be called in by the broker h) Federal Funds: funds in the accounts of commercial banks at the Federal Reserve Bank i) Depository institutions must maintain deposits with the Federal Reserve Bank ii) Federal funds represents trading in reserves held on deposit at the Fed iii) The federal funds rate is the rate at which bank lend money to each other; this is a key interest rate for the economy i) LIBOR (London Interbank Offer Rate): the rate at which banks in the London market lend to each other i) base rate for many loans and derivatives 5) Calculate Taxable/Tax Free Yields i) Yields on money market instruments are not always directly comparable ii) Factors influencing "quoted" yields: (1) Par value v. investment value (2) 360 v. 365 days assumed in a year (3) Simple v. Compound Interest iii) Bank Discount Rate (TBill quotes) (1) Par = $10,000 (2) rBD= bank discount rate = ($10,000 P)/($10,000)*(360/n) (3) P = market price of the Tbill (4) n = number of days to maturity (5) example: 90 day Tbill, P = $9,875 (a) BD = ($10,000$9,875)/($10,000)*(360/90) = 5% iv) Bond Equivalent Yield (1) Can't compare Tbill directly to bond (a) 360 v. 365 days (b) Return is figured on par v. price paid (2) Adjust the bank discount rate to make it comparable (a) BEY = (10,000P)/(P)*(365/n) (b) P = price of Tbill (c) n = number of days to maturity (d) example using same Tbill: rBEY = (10,0009,875)/(9,875)*(365/90) = 5.13% v) Effective Annual Yield (1) rEAY = [1+(10,000P)/P]^(365/n)1 (2) P = price of Tbill (3) n = number of days to maturity (4) example using same Tbill: (a) EAY = [1+(10,0009,875)/9,875]^(365/90)1 = 5.23% vi) Money Market Instruments (1) T bills: Discount (2) CDs: BEY* (3) CP: Discount (4) BAs: Discount (5) Eurodollars: BEY* (6) Fed Funds: BEY* (7) Repos: Discount (8) CD, Euros, and FF use add on which is not quite the same as BEY, since the add on uses a 360 day year. Add on is not covered in the text. To convert from add on to BEY: BEY = Add on*(365/360) b) Municipal bonds: taxexempt bonds issued by state and local governments. i) general obligation bonds: backed by "full faith and credit" of issuer ii) revenue bonds (riskier): issued to finance particular projects; backed by project revenues or municipal agency operating the project (1) t = investor's combined federal plus local marginal tax rate (2) r = total beforetax rate of return available on taxable bonds = taxable yield (3) r(1t) =mr = aftertax rate available on those securities = taxfree (exempt) rate (4) r = m /(1t): taxable yield equals taxfree (exempt) rate over (1t) (5) t = 1(m /r)m r /r = yield ratio. (a) high yield ratio = low cutoff tax bracket = more people want to hold municipal debt 6) Price/Dollar Weighted Averages a) priceweighted average: an average computed by adding the prices of the stocks and dividing by a "divisor" i) DJIA ii) price weighted average assumes buy 1 share of each stock and invest cash and stock dividends proportionately iii) higher prices shares get more weight (1) bad: high price doesn't always mean it is big iv) example in book pg. 41 b) market valueweighted average: index return equals the weighted average of the returns of each component security, with weights proportional to outstanding market value i) Standard & Poor 500, NASDAQ ii) based on the market cap of the firm iii) considers not only price but also number of shares outstanding (1) Money invested in each stock is proportional to market value of each stock c) equally weighted index: an index computed from a simple average of returns i) Value Line Index ii) Each company's returns are weighted equally iii) Invest same amount of money in each stock regardless of market value of stock d) Examples on slides 4548 of chapter 2 7) Residual Claims a) Common stock: i) residual claim: lowest priority in case of bankruptcy. First debt holders, then preferred stock holders, then common stock holders ii) limited liability: can only lose what they invested iii) voting rights iv) returns: (1) capital gain yield: (sellbuy)/buy (2) dividend yield: dividend/buy (3) total return: dividend yield + capital gain yield = (sellbuy+dividend)/buy b) Preferred stock: i) fixed dividends: limited gains, nonvoting ii) priority over common stock c) Tax treatment: i) Preferred and common dividends are not tax deductible to the issuing firm ii) Corporate tax exclusion on 70% dividends earned d) Depository Receipts: i) American Depository Receipts (ADRs) are certificates traded in the US that represent ownership in a foreign security 8) Common Hedging Strategies (Derivative Markets) a) options: i) call option: the right to buy 100 shares of an asset at a specified price on or before a specified expiration date ii) put option: the right to sell 100 shares of an asset at a specified exercise price on or before a specified expiration date iii) call (buy) iv) put (sell) v) exercise price vi) expiration date b) futures contract: obliges traders to purchase or sell an asset at an agreedupon price (futures price) at a specified future date i) long (buy) ii) short (sell) iii) delivery date iv) deliverable item 9) Types of Securities Underwritten by Investment Banks a) underwriters: underwriters purchase securities from the issuing company and resell them to the public b) prospectus: a description of the firm and the security it is issuing; approved by the SEC c) initial public offering (IPO): first sale of stock by a formerly private company i) seasoned equity offering: sale of additional shares in firms that are already publicly traded d) Underwritten v. Best Efforts: i) Underwritten: banker makes a firm commitment on proceeds to the issuing firm ii) Best Efforts: banker helps sell but makes no firm commitment e) Negotiated v. Competitive Bid i) Negotiated: issuing firm negotiates terms with investment banker ii) Competitive bid: issuer structures the offering and secures bids f) Investment bankers organize road shows to travel the country and publicize the future IPO. i) bookbuilding: process of polling potential investors. Usually investment bankers underprice the shares, so the price jumps on the first day of the IPO. 10)Shelf Registration a) SEC Rule 415: security is preregistered and then may be offered at any time within the next two years. i) 24 hour notice, any part or all of the preregistered amount may be offered b) Introduced in 1982 c) Allows timing of the issues 11)Types of Securities Markets a) Direct Search Markets: i) least organized market ii) buyers and sellers locate one another on their own iii) example: sale of a used refrigerator on Craigslist b) Brokered Markets: i) 3rd party assistance (broker) in locating buyer or seller ii) example: real estate market; pay agent to match buyers and sellers iii) important one: primary market: investment bankers act as brokers c) Dealer Markets: i) 3rd party acts as intermediate buyer/seller ii) dealers specialize in various assets, purchase them, and sell them later iii) they buy at a bid and sell at an ask iv) save traders on search costs because participants can easily look up the prices at which they can buy from or sell to dealers v) example: most bonds d) Auction Markets: i) most integrated market ii) brokers and dealers trade in one location iii) trading is more or less continuous iv) physical or electronic v) NYSE vi) Do not need to search across dealers to find the best price. They can arrive at mutually agreeable prices and save the bidask spread 12)Bids/Offers a) bid price: the price at which a dealer or other trader is willing to purchase a security b) ask (offer) price: the price at which a dealer or other trader will sell a security c) bidask spread: the difference between the bid and asked prices 13)Common Aspects to Short Sales a) short sale: the sale of shares not owned by the investor but borrowed through a broker and later purchased to replace the loan. i) allows investors to profit from a decline in a security's price. ii) Mechanics: (1) borrow stock from a broker/dealer, must post margin (2) broker sells stock and deposits proceeds and margin in a margin account (you are not allowed to withdraw the sale proceeds until you 'cover') (3) covering or closing out the position: buy the stock and broker returns the stock title to the party from which it was borrowed iii) Profit = Initial price (Ending price + Dividend) iv) required initial margin: usually 50% but more for low priced stocks v) liable for any cash flows: dividend on stock vi) zero tick, uptick rule (1) eliminated by the SEC in July 2007 vii)margin: describes securities purchased with money borrowed in part from a broker. (1) the margin is the net worth of the investor's account viii) short sale maintenance margin requirements (equity) Price MMR <$2.50 $2.50 $2.50$5.00 100% market value $5.00$16.75 $5.00 >$16.75 30% market value b) Examples: Ch. 3 Slides 5962 c) Round Trip: a purchase and a sale i) long position (1) buy first and then sell later (2) bullish ii) short position (1) sell first and then buy later (2) bearish 14)Investment Organizations a) investment companies: financial intermediaries that invest the funds of individual investors in securities or other assets i) what they do: (1) record keeping and administration (a) period status reports (b) keep track of capital gains distributions, dividends, investments, and redemptions (c) may reinvest dividend and interest income for shareholders (2) diversification and divisibility (a) pool money so investors can hold fractional shares of many different securities (3) professional management (a) fulltime staffs of security analysts and portfolio managers (4) lower transaction costs (a) trade large blocks of securities, so they can save a lot on brokerage fees and commissions ii) types of investment companies (1) unit investment trusts: money pooled from many investors that is invested in a portfolio fixed for the life of the fund (a) unmanaged (b) any interest and/or dividends are distributed immediately to trust certificate holders (c) provide diversification within one sector or area and low cost entry (d) often levered, rates of return can be extreme (e) has a fixed portfolio composition; lack of active management (2) managed investment companies: (a) hires an investment advisor actively managed (b) openend fund (mutual funds): a fund that issues or redeems its shares at net asset value (i) cash out by selling shares back to the fund at NAV (ii) most common (iii) Good: 1. very liquid 2. fund can grow (iv)But: 1. need to keep a cash reserve 2. vulnerable to panics (c) closedend fund: shares may not be redeemed, but instead are traded at prices that can differ from net asset value (i) cash out by selling shares to other investors at agreed upon price (ii) sell on NASDAQ or other exchange b) Other Investment Organizations i) Comingled funds (1) partnerships of investors that pool their funds. (2) designed for trusts or larger retirement accounts to get professional management for a fee. (3) operates similar to a mutual fund. (a) instead of shares, the fund offers units ii) Real Estate Investment Trusts (REITs) (1) similar to closed end funds (2) invest in real estate and real estate loans (a) equity trusts purchase real estate (b) mortgage trusts invest in mortgage and construction loans iii) Hedge Funds (1) similar to mutual funds, but not registered and not subject to SEC regulations (2) rich investors (3) can pursue investment strategies that are not allowed for mutual funds 15)Calculate NAV a) NAV = (Market value of assets minus liabilities)/(Shares outstanding) in $/share 16)Types of Mutual Fund Charges a) Operating Expenses: i) buying and selling commissions, administrative expenses, and advisor fees for the managers ii) 0.2%2% b) FrontEnd Load: i) a commission or sales charge paid when you buy into a fund ii) generally given to the broker who sells the fund iii) ripoff iv) max is 8.5%, but rarely above 6% c) BackEnd Load: i) redemption or exit fee ii) these may be more useful since there are costs to all investors when investors cash out of the fund iii) typically start at 5% or 6% and go down one percent every year of investment d) 12b1 Charges: i) annual fees to pay for marketing and distribution costs ii) alternative to a load, but assessed annually iii) fact is that these fees can have a huge effect on your annual returns iv) high fees generally lower returns v) max used to be 1.25% (1) now it's 0.75%, but you can have a service fee of 0.25% vi) if you are going to hold a fund for a long time, the onetime loan may be preferable to annual 12b1 charges e) Taxation of Mutual Fund Income: i) taxes are paid only by the investor in the mutual fund, as long as the fund meets several requirements (mostly that the fund be sufficiently diversified and that virtually all income is distributed to shareholders) ii) turnover: the ratio of the trading activity of a portfolio to the assets of the portfolio (1) measures the fraction of the portfolio that is "replaced" each year (2) high portfolio turnover rates are tax inefficient because it means that capital gains or losses are being realized constantly (3) equity funds are usually high around 60%, whereas index funds have turnovers as low as 2% f) Fees and Mutual Fund Returns i) expense ratios: (annual expenses)/(average NAV) ii) if well managed, should be under 2% iii) all costs and charges must be revealed in the fund's prospectus iv) rate of return = (NAV1NAV0+income and capital gain distributions)/NAV0 17)Aspects of ETFs a) exchange traded funds (ETFs): offshoots of mutual funds that allow investors to trade index portfolios like shares of stock i) first ETF was "Spider" (SPDR: Standard & Poor's Depository Receipt) ii) can be traded throughout the day, unlike mutual funds, which can only be traded at the end of the day when NAV is calculated iii) can be sold or purchased on margin iv) potentially lower taxes v) no fund redemptions vi) large investors can exchange their ETF shares for shares in the underlying portfolio vii)lower costs (no marketing; lower fund expenses) viii) potential disadvantages: (1) small deviations from NAV are possible (2) must pay a brokerage commission to buy an ETF but a no load index fund may be purchased online for no commission 18)Calculate Holding Period Return a) holding period return (HPR): rate of return over a given investment period i) HPR = [P sPB+CF]/P B (1) P = sale price (or P ) S 1 (2) PB = buy price ($ you put up) (or P 0 (3) CF = cash flow during holding period ii) using percent returns removes size of investment concerns iii) CF should occur at the end of the period, otherwise missing reinvestment of those cash flows. Or the CF cold be the future value of any interim cash flows b) annualizing HPRs: i) for holding periods of greater than one year, with n being number of years held: (1) without compounding (simple or APR): (a) HPR annPR/n (2) with compounding (EAR): (a) HPR = [(1+HPR) ]1 1/n ann ii) for holding periods of less than one year, with n being number of compounding periods per year: (1) without compounding (simple): (a) HPR annPR*n (2) with compounding: (a) HPR ann(1+HPR) ]1n 19)Calculate Real/Nominal Return a) real return (r): the excess of the rate over the inflation rate. The growth rate of purchasing power derived from an investment i) adjusts for inflation (i) b) nominal return (R): the rate in terms of nominal (not adjusted for purchasing power) dollars i) does not adjust for inflation (i) c) 1+r = (1+R)/(1+i), so r = (Ri)/(1+i) 20)Calculate Total Return a) Multiply returns by weight of its asset, and add 21)Calculate Geometric Return n a) GAR = HPR = avg ∏ 1+HPR T ] 1 T=1 22)Calculate Expected Return a) subjective returns i) E(r) = sum of p(s)*r(s) (1) E(r) = Expected Return (2) p(s) = probability of a state (3) r(s) = return if a state occurs (4) 1 to s states 2 ii) variance = sum of p(s)*[r sE(r)] b) Expost Expected Return and standard deviation n i) r avg ∑ HPR /n , with n being number of observations T=1 T r ¿ 2 ¿ 2 ii) = 1/(n1) n ) ∑ ¿ i=1 iii) annual periodperiods iv) annual period √ ¿periods
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