Francis & IbbotsonChapter 1: The Investment Setting1 1What is Investing?Criteria used to determine whether an investment of money is investing or something else, including:Is it short-term or long-term?Is it productive or unproductive?Is it legal or illegal?Is it rational or irrational?Francis & IbbotsonChapter 1: The Investment Setting2 2Gambling vs. SpeculatingGambling occurs whenOutcome is determined very quickly (a roll of the dice, for instance)A source of entertainmentOutcome is not based on an economic endeavor, but, rather, random outcomesCreates risk without expectation of economic benefitSpeculation occurs whenAn asset is purchased with hope that price will rise rapidly, leading to quick profitNot based on random outcomesExample: Buying an IPO of a stock on the first day hoping to sell it in several days at a higher priceFrancis & IbbotsonChapter 1: The Investment Setting3 3Assets of ChoiceMajor asset classes includePrimary securities such as common and preferred stock, government bonds, corporate bonds, Treasury bills, commercial paperDerived instruments such as mutual funds, put and call options, forward and futures contractsPhysical assets such as houses, land, buildings, diamonds, goldFrancis & IbbotsonChapter 1: The Investment Setting4 4Other IssuesLarge international corporations have their securities traded somewhere in the world 24 hours a dayWhile other areassuch as China and Africa have a larger population than the U.S., the U.S. has the highest Gross National Product (GNP) a measure of a nations incomeHowever, when allocating a countrys GNP across the countrys population, the U.S. ranks 6thBut after adjusting for each countrys cost of living, the U.S. ranks 2nd behind LuxembourgFrancis & IbbotsonChapter 1: The Investment Setting5 5The Worlds Equity CapitalWorlds equity capital is concentrated in North America, western and central Europe and the Pacific Rim (mostly Japan)Because market prices are rather volatile, this situation can change rapidly. For instance, from 1989-1990 Japans stock market was worth more than the U.S. stock market.Francis & IbbotsonChapter 1: The Investment Setting6 6The Worlds Bond MarketFrancis & IbbotsonChapter 1: The Investment Setting7 7The Worlds Bond MarketFrancis & IbbotsonChapter 1: The Investment Setting8 8Worlds Real & Human CapitalValue of worlds real assets financial assetsWorlds human capital greatly exceeds combined worlds real and financial capitalIncome from human capital is 80% of the worlds incomeHuman capital represents the stock of ideas and information possessed by humansFor instance, the capital contained within a tool doesnt come from the tool itself, but from the knowledge of how to build and use the toolFrancis & IbbotsonChapter 1: The Investment Setting9 9The U.S. Financial MarketsResidential real estate is one of the larger investments made by U.S. citizens. However, this may change in the future.Francis & IbbotsonChapter 1: The Investment Setting1010U.S. Equity InvestorsIndividual investorsOver 50 million in the U.S.Typically own only a few stocks with aggregate value of $15,000Have a small impact on U.S. equities marketMostly amateurs who play the marketInstitutional investorsInclude pension funds, mutual funds, life insurance companies, commercial bank trust departments, etc.In 1998 controlled 60% of market value of U.S. equities with individual investors controlling remainderHouseholds own much of the money managed by institutional investorsFrequently buy shares in blocks of 10,000 or moreBlock trades account for 51% of volume on NYSEFrancis & IbbotsonChapter 1: The Investment Setting1111U.S. Market for BondsFrancis & IbbotsonChapter 1: The Investment Setting1212The Bottom LineIn determining whether a gamble, a speculation or an investment has occurred, it is useful to examine the length of the holding periodEven though there are millions of individual investors, their impact on the U.S. equities market is smallInstitutional investors (such as pension funds, insurance companies, mutual funds) have a much greater impact on the U.S. marketsFrancis & IbbotsonChapter 1: The Investment Setting1313Appendix: Opportunities and Salaries in InvestmentsFrancis & IbbotsonChapter 2: Rates of Return1414Chapter 2Rates of ReturnFrancis & IbbotsonChapter 2: Rates of Return1515BackgroundInvestors want to maximize their returns (or wealth)Chapter discussesThe calculation of a returnHistorical returns offered by different types of investmentsFrancis & IbbotsonChapter 2: Rates of Return1616The Investors GoalGoal is to maximize what is earned relative to the amount put into an investmentMaximize either theRate of returnInvestments terminal valueEquivalentFrancis & IbbotsonChapter 2: Rates of Return1717The Investors GoalSome claim wealth-maximizing investors are performing harmful greedy activitiesLaw abiding wealth maximization is beneficial to both investor and general populationSeek out securities issued by firms producing high quality goods and servicesCapital is used to benefit general populationInvestors can request management actions at stockholder meetingsHelps nation compete internationallyCreates new job opportunitiesFrancis & IbbotsonChapter 2: Rates of Return1818Ethics Box: The Need for Ethics in InvestmentSome level of ethics is necessaryEthics concerned with standards of right and wrongConcepts of trust and fairness are relevant to investmentsInvestors trust investment firms to act in their best interest and to safeguard their assetsFairness means a level playing field and the absence of fraudDecreasing information asymmetry increases efficiency and fairnessAn investment professional shouldBe loyalAct with due careKeep information confidentialAvoid conflicts of interestFrancis & IbbotsonChapter 2: Rates of Return1919The One-Period Rate of ReturnRate of return measures change in an investors wealth over timeMeasures the success or failure of the investmentMeasures holding period returnDefined asFrancis & IbbotsonChapter 2: Rates of Return2020Examples: One Period ReturnYou purchased one share of Coca-Cola one year ago for $54. You sold it today for $64, and you received dividends of $0.80 during the yearYour income from dividends = 80Your capital gain is $10 ($64 - $54)Your return is $10.80 $54 = 20%Francis & IbbotsonChapter 2: Rates of Return2121Examples: One Period ReturnYou purchased a U.S. T-bond for $900. One year later you sold the bond for $910. You received $35 in interest during the year. Your rate of return isYou bought a six-month T-bill for $9,800 with a maturity value of $10,000. After the bond matures your six-month return is-Since there are two six-month periods in one year, your annual return is2 1 = 1.0412 1 = 4.12%Francis & IbbotsonChapter 2: Rates of Return2222Figure 2-1:Figure 2-1:Wealth Indices for Average U.S. Investments in Different Asset Classes Wealth Indices for Average U.S. Investments in Different Asset Classes Compared to Inflation, 1926-99Compared to Inflation, 1926-99If you had invested $1 on December 31, 1925 in each of the following, you would haveIn some years inflation exceeds T-bill returnsleading to a drop in purchasing power for T-bill investors.Small company stocks are the most risky, but offer the highest return.T-bills are the least riskysmoothest growth path, but lowest return.Francis & IbbotsonChapter 2: Rates of Return2323Table 2-1:Table 2-1:Average Annual Rate of Return and Risk Statistics for Asset Classes and Average Annual Rate of Return and Risk Statistics for Asset Classes and Inflation in the U.S., 1926-99Inflation in the U.S., 1926-99Noticeable tendency for higher risk assets to offer the higher return.Francis & IbbotsonChapter 2: Rates of Return2424Realized One-Period Rates of ReturnWe can calculate one period rates of change for the indexes Includes dividends, coupon interest on bondsFrancis & IbbotsonChapter 2: Rates of Return2525Average Rates of ReturnArithmetic mean return (AMR) measures average historical one-period rates of returnCompound average rate of return, or geometric mean return (GMR) isAMR GMR because compound interest grows more rapidly than simple interestFrancis & IbbotsonChapter 2: Rates of Return2626Example: Average Rates of ReturnA three-year investment earned the following annual returns:If you placed $100 in this investment at the beginning of year 1, at the end of the third year it would be worth -$100 (1.0428)3Francis & IbbotsonChapter 2: Rates of Return2727Assessing RiskAn asset is riskier ifIts one-period rates of return fluctuate over a wide rangeSuch as small company stocksMeasures of risk includeVariancethe average of squared deviations from AMR-Standard deviationsquare root of varianceBoth measure total riskFrancis & IbbotsonChapter 2: Rates of Return2828Example: Variance & SDCalculate the variance and standard deviation of the previous exampleFrancis & IbbotsonChapter 2: Rates of Return2929Risk RankingsBoth standard deviation and variance result in the same risk rankingsAdvantages of standard deviationConsiders every outcomeUnlike range which only considers high and low valuesWell known by statisticiansProgrammed into calculators and softwareMeasures the wideness of probability distributionsMeasure of dispersion around arithmetic meanAlso widely used in mathematics, econometrics, etc.Francis & IbbotsonChapter 2: Rates of Return3030Interpreting Historical Return and RiskExamining the historical returns and risk leads to the following observations:Large company common stocksEarn higher returns than bondsIf a firm is declared bankrupt, all creditors are paid in full before common stockholders receive any proceedsCommon stockholders usually receive nothing which makes it more risky than debtStockholders demand a higher average rate of returnFrancis & IbbotsonChapter 2: Rates of Return3131Interpreting Historical Return and RiskSmall company stocksEarned highest returns of all other investmentsBut, riskier than any of the other investmentsThe percentage of small firms declared bankrupt is greater than the percentage of large firmsInvestors require a higher rate of return for investing in a small firmLong-term corporate bondsBonds issued by the U.S. Treasury are unlikely to be defaultedHowever, bonds issued by corporations are more likely to be defaultedFrancis & IbbotsonChapter 2: Rates of Return3232Interpreting Historical Return and RiskLong-term U.S. Treasury bondsMature about 20 years from initial offering dateInvolve no default riskIntermediate-term U.S. Treasury BondsMature about 5 years after issue dateExperience smaller price fluctuations than long-term U.S. Treasury bondsU.S. Treasury billsMature in less than one yearNo horizon premium necessaryU.S. Treasury is unlikely to defaultNo default premium neededAKA risk-free assetsProbably no other security in world with less riskFrancis & IbbotsonChapter 2: Rates of Return3333Interpreting Historical Return and RiskOpportunity costWhat it could earn in its highest paying alternative useExample: The opportunity cost of attending college includes foregone wagesLess obvious expenses than out-of-pocket expensesExample: The opportunity cost of holding cash rather than investing in large company stocks was 13.3% a yearFrancis & IbbotsonChapter 2: Rates of Return3434Required Rate of ReturnShould only invest if you expect to earn a return greater than your cost of capitalInterest expense paid for borrowed fundsCash dividend payment paid to stockholdersOpportunity costsAKA required rate of returnMinimum rate of return an investment must earn to increase investors wealthRRR r leads to a wealth decreaseFrancis & IbbotsonChapter 2: Rates of Return3535Combining Risk Premiums To Compute Required Rate of ReturnFrancis & IbbotsonChapter 2: Rates of Return3636Combining Risk Premiums To Compute Required Rate of ReturnFrancis & IbbotsonChapter 2: Rates of Return3737The Largest Investors in the WorldU.S. pension funds are the largest investors in the worldHire professional money managersOwners/sponsors of largest pensionsFrancis & IbbotsonChapter 2: Rates of Return3838The Largest Investors in the WorldFirms hired to manage pension assets includeFrancis & IbbotsonChapter 2: Rates of Return3939Ethics and Pension FundsManagers of defined benefit plans (guarantee fixed income in retirement)Have duty to maintain sufficient funds for future obligationsSome funds become overfundedShould these funds be allowed to divest excess funds?Managers of defined contribution plans (employee and employer contributions accumulate in individual accounts)Must offer at least three different fundsMust seek to maximize risk-adjusted returnHave a fiduciary duty to vote funds stock solely in beneficiaries interestsFrancis & IbbotsonChapter 2: Rates of Return4040The Bottom LineInvestors wish to maximize their wealth (return) over the long-runArithmetic mean is not a compounded return like the geometric meanAMR GMRRealized returns represent historical dataInvestors desire investments with an expected return greater than their required rate of return or hurdle rateFrancis & IbbotsonChapter 3: Introduction to Valuation4141Introduction to ValuationChapter 3Francis & IbbotsonChapter 3: Introduction to Valuation4242BackgroundDetermining current price of a security is easyAsk the sellerLook in newspaper, television, InternetMuch more difficult to determine the value of an investmentHow much is an investment worth?Need to know so you can determine if the investment is over- or under-valuedChapter presents the discounted present value model to estimate value of an investmentDemonstrates examples of valuing stock, bond and rental propertyFrancis & IbbotsonChapter 3: Introduction to Valuation4343BackgroundSecurity price fluctuations may appear chaoticResponses to markets reaction to random arrival of new informationWhen you buy or sell a security you are part of marketHedging is a technique that reduces riskOne form of hedging is arbitrageAligns prices with respect to law of one priceInformed buying, selling, hedging and arbitrage tends to make a securitys price move closer to its valueFrancis & IbbotsonChapter 3: Introduction to Valuation4444Time Value of MoneyOne-period rate of returnRearranging this equation gives us the time value modelThe two models are equivalent because-The interest rate on the investment equals lenders one-period rate of returnThe present value of an investment is Francis & IbbotsonChapter 3: Introduction to Valuation4545Time Value of MoneyIf the rate of return differs from the discount rate, we can rewrite the equation asSituations in which the discount rate (k) differs from the rate of return (r) are common-Different people have different opinions, different resources, etc.If k E(r) asset is over-priced-Present value of asset its priceIf k its priceFrancis & IbbotsonChapter 3: Introduction to Valuation4646An ExchangeFrancois deposits 100 euros in a French bankHe receives a negotiable CD with a maturity value of 105 eurosExpects to earn 5% a year for one yearAn American has a required rate of return of 3%Economic conditions are not the same in U.S. as they are in FranceYou and Francois are not concerned with exchange rate riskBelieve that exchange rate will remain constant over the next yearFrancis & IbbotsonChapter 3: Introduction to Valuation4747An ExchangeFrancois values the CD atYou decide to offer to buy Francois CD today-What price are you willing to pay?Will Francois be willing to sell?-Yes, because it is worth only 100 to himHe would get more than he thinks it is worthAre both parties pleased with the transaction?-Yes!Francis & IbbotsonChapter 3: Introduction to Valuation4848Valuing Coca-Cola at Different Discount RatesCoca-Cola (ticker symbol: KO) is currently selling for $54You expect the selling price in one year to be $64 and that KO will pay $0.80 in dividends during the yearBased on that information, your expected rate of return would beFrancis & IbbotsonChapter 3: Introduction to Valuation4949Valuing Coca-Cola at Different Discount RatesIf your required rate of return were 19%, you would think that KO was underpriced at $54The most you are willing to pay, which is greater than the current price of $54.If your required rate of return were 20%, you would think that KO was correctly priced at $54Francis & IbbotsonChapter 3: Introduction to Valuation5050Valuing Coca-Cola at Different Discount RatesIf your required rate of return were 21%, you would think that KO was over-priced at $54The most you are willing to pay, which is less than the current price of $54.Francis & IbbotsonChapter 3: Introduction to Valuation5151Time Value of Money: Multi-Period ModelsPresent value model can value investments that span multiple time periodsSince some cash flows can be expected to last forever, sometimes the terminal time period is infinityThe value of a cash flow series is the discounted present value of all future cash flows-Where the discount rate, k, represents the cash flows appropriate required rate of returnFrancis & IbbotsonChapter 3: Introduction to Valuation5252Time Value of Money: Multi-Period ModelsCash flows can beCash dividendsCoupon interestRent income from real estateAssets selling price, etc.Francis & IbbotsonChapter 3: Introduction to Valuation5353Example: PV of a BondBond investors receive periodic coupon payments and a principal repayment upon maturityFor a three-year T-note this can be represented asFrancis & IbbotsonChapter 3: Introduction to Valuation5454Example: PV of a BondThe discount rate is the rate that equates the PV of all future cash flows to the bonds current market valueYield to maturityPar value represents the principal, or face value, of the bondCoupon represent the periodic interest paymentCoupon % par valueFrancis & IbbotsonChapter 3: Introduction to Valuation5555Example: PV of a BondIf the bond has a coupon rate of 6%, a yield to maturity of 5.5%, and a par value of $1,000 the bonds present value isIf the bond can be purchasedfor less than this amount itis a good investment.Francis & IbbotsonChapter 3: Introduction to Valuation5656Present Value of a PerpetuityPerpetual investments pay fixed cash flows foreverNo principal repaymentSimilar to buying a perpetual annuity that can be sold to another ownerPerpetuities are valued using the following formulaFrancis & IbbotsonChapter 3: Introduction to Valuation5757Example: Valuing a ConsolA Consol is a bond that pays a constant coupon to infinity with no repayment of principalYou are considering investing in a Consol with a yield to maturity of 5.9%The bond pays an annual coupon of 70What price would you be willing to pay for the bond?Most you are willing to pay.Francis & IbbotsonChapter 3: Introduction to Valuation5858Example: Estimating Value of StockYou are considering purchasing stockYou think you should earn a required rate of return of 14.5% based on the stocks risk levelYou expect to sell the stock for $40 in two yearsYou expect to receive $2 in cash dividends each year for the next 2 yearsWhat is the most you would be willing to pay for the stock?Francis & IbbotsonChapter 3: Introduction to Valuation5959Example: Stock With Constant Perpetual Growth RateYou are considering purchasing stock in a large corporation with the following attributesYou believe the current dividend of $3 will grow at a 3% rate in the foreseeable futureYou think 13% is a fair discount rate for stock of its risk levelWhat is the most you would be willing to pay for the stock?You should decide to not purchase the stock because it is priced far above the maximum you are willing to pay.Francis & IbbotsonChapter 3: Introduction to Valuation6060Example: Estimating Value of Perpetual Preferred StockThe current market price of a share of preferred stock is $50The stock pays an annual cash dividend rate of 4.5% of its $100 par valueThe annual cash dividend is fixedYou believe the appropriate required rate of return on stock of this level of risk is 13%What is the most you would be willing to pay for the stock?You should decide to not purchase the stock because it is priced far above the maximum you are willing to pay.Francis & IbbotsonChapter 3: Introduction to Valuation6161Example: Valuing a Real Estate InvestmentYou are thinking about buying a house and renting itThe annual net rental income will be $10,000You think you can sell the house for $110,000 three years from nowWhat is the most you would be willing to pay for the house if the discount rate is 10%?Should not pay more than this amount for the rental property.Francis & IbbotsonChapter 3: Introduction to Valuation6262Making Buy-Sell DecisionsProfessional investors use their value estimates to make buy-sell decisionsIf an investor could compute the value of an investment with certainty, the following simplified buy-sell rules would applyIf a securitys price value it is overpriced and the investor should sell (or sell short)Francis & IbbotsonChapter 3: Introduction to Valuation6363Making Buy-Sell DecisionsSelling overpriced securities brings their price downBuying underpriced securities brings their price upSecurity prices are constantly changing as new information arrivesIn a world of uncertainty it is impossible to know the value of an asset with certaintyFrancis & IbbotsonChapter 3: Introduction to Valuation6464Making Buy-Sell DecisionsSome investors enjoy a competitive advantage over other investorsBetter educatedHave access to more financial informationReceive information sooner It is rational for investors to behave as though a securitys price is equal to its valueOtherwise, you may be betting against anonymous experts with deep pocketsSecurity analysts are paid millions of dollars to provide value estimates for a few securitiesWill develop a track record (professional reputation)Francis & IbbotsonChapter 3: Introduction to Valuation6565Long PositionsSimplest investment strategy Buy securities you think are underpriced and hold them in anticipation of a price increaseRate of returnFrancis & IbbotsonChapter 3: Introduction to Valuation6666Short PositionsA short sale would be used if an investor thought a security were overpriced (and the investor did not currently own that security) and would fall in valueInvolves selling a security you do not ownBorrow the security from a third partyMost brokerages are happy to lend shares to short sellersThe short seller will eventually cover his position by buying the stockAt a lower price than it was sold (hopefully)Short seller sells first and buys later, whereas a long buyer buys first and sells laterFrancis & IbbotsonChapter 3: Introduction to Valuation6767Short PositionsRate of returnExample:-Some time ago, you thought that at its then-current price of $64 the stock for ABC Company was overpriced. You sold the stock short at $64.Francis & IbbotsonChapter 3: Introduction to Valuation6868Example: Return from Short PositionNow the stock is selling for $66.50 and you think that, unfortunately, the stock price will rise even more. -You decide to cover your short sale. -Also, during the time that you had shorted the stock, the new owner received $3.90 in dividends. You are required to reimburse the third party from whom you borrowed the shares by the amount of the dividends.What is your realized return from this transaction?Francis & IbbotsonChapter 3: Introduction to Valuation6969Complications with Short PositionsIf common stock pays a dividend while on loan to short seller, short seller must reimburse lender for the amount of cash dividendsShort seller may be required to put up margin moneyRepresents a good-faith depositMay total as much as 100% of the value of the borrowed shares if you are a small individual investorFrancis & IbbotsonChapter 3: Introduction to Valuation7070Gain-Loss IllustrationsMr. Optimist buys a long positionMr. Pessimist sells shortGainLoss$0-$10$40Purchase price, $50$ Market PriceGainLoss$0Short sale price, $50$ Market Price$10$40Slope of line is +1, meaning one dollar of profit (loss) is made for each dollar the market price rises (falls).Slope of line is -1, meaning one dollar of profit (loss) is made for each dollar the market price falls (rises).Enjoys unlimited potential for gains.Losses are unbounded (if price rises infinitely high).Francis & IbbotsonChapter 3: Introduction to Valuation7171Gain-Loss IllustrationsThe long buyer also enjoys limited liabilityMost investor can lose is the amount of the invested funds (100%)The short seller can only gain a maximum of 100%If the underlying asset become worthless and it costs the short seller nothing to cover his positionFrancis & IbbotsonChapter 3: Introduction to Valuation7272A More Realistic Valuation And Investment ProcedureIn reality the valuation process is complexFor example, a securitys risk can change which affects its valueIt is also never-endingFrancis & IbbotsonChapter 3: Introduction to Valuation7373Figure 3-3:A Flowchart of the Endless Valuation ProcessFrancis & IbbotsonChapter 3: Introduction to Valuation7474How Price and Value InteractConsider two hypothetical groups of investorsLiquidity tradersBuy securities when they have excess liquidityPerhaps due to income tax refund, inheritanceSell securities when they need liquidityBuy a house, finance childs educationUsually do not buy or sell at times selected to be advantageousOften do not investigate whether a security is over-, under-, or correctly-pricedMillions of liquidity traders, but their daily trading does not usually impact market pricesRandom transactions cancel outFrancis & IbbotsonChapter 3: Introduction to Valuation7575How Price and Value InteractInformation tradersHave resources to discover new informationForm estimates of security valuesRecognize significant deviations of the market price away from the consensus estimate of a securitys valueMake informed buy-sell transactions based on whether they think security is over- or under-valuedAttempt to maximize their trading profitsVolume of trading tends to align market price with its valueFrancis & IbbotsonChapter 3: Introduction to Valuation7676Comparing Differences Between Prices and ValuesConsensus value estimateWill be narrow if most security analysts have similar value estimatesSecuritys price will fluctuate in a narrow range around this value estimateWill be wide if there is a great deal of variability in security analysts value estimatesSecuritys price will fluctuate wildlyFrancis & IbbotsonChapter 3: Introduction to Valuation7777Figure 3-4:Figure 3-4:Illustration of Three Different Hypothesized Price-Value RelationshipsIllustration of Three Different Hypothesized Price-Value RelationshipsOnly a moderate number of investors were making informed buy-sell decisions.Price never deviates from value because numerous (all) investors are making rational, informed buy-sell decisions.Francis & IbbotsonChapter 3: Introduction to Valuation7878Information Content of PricesWeakly efficient priceReflects all historical informationDoes not reflect current information or insider informationSemi-strongly efficient priceReflects all historical informationReflects all current informationDoes not reflect inside informationPerfectly efficient priceReflects all historical informationReflects all current informationReflects all inside informationFrancis & IbbotsonChapter 3: Introduction to Valuation7979Information Content of PricesIf the market is inefficient with respect to new informationSecurities analysts would earn huge profits from their buy-sell decisionsFrancis & IbbotsonChapter 3: Introduction to Valuation8080Passive Vs. Active Investment ManagementEvidence suggests that the U.S. securities markets are not perfectly efficientSecurities analysts can profit from finding under- and over-valued securitiesEncourages many investors to follow active management techniquesFrancis & IbbotsonChapter 3: Introduction to Valuation8181Active Investment ManagementExample: You estimate the following values for KOFrancis & IbbotsonChapter 3: Introduction to Valuation8282Active Investment ManagementYour expected price in year 2003 isYour estimate of KOs value in 2000 isFrancis & IbbotsonChapter 3: Introduction to Valuation8383Passive Investment ManagementMany studies suggest that the market is efficient in the semi-strong formSuggests that the search for incorrectly-valued stocks may be too much troubleMany passive investors invest in index fundsMutual funds designed to track a particular market indexS&P500 Composite Index is the most popularFrancis & IbbotsonChapter 3: Introduction to Valuation8484HedgingHedging is usually undertaken to reduce losses from adverse price movementsA perfect hedge is a combination of long and short positions with the objective of eliminating riskGainLossMarket Price$0$44$26-$26-$44$44ShortLongLong Profits at $70Short Losses at $70$70An investor takes a long (and a short) position in a stock with a purchase (sell) price of $44. If the company goes bankrupt, investor will lose (win) $44 on his long (short) position, leaving him with a $0 loss.If the price rises to $70, the investor will win on his long position but lose the same amount on his short position, leaving him with a $0 profit.Francis & IbbotsonChapter 3: Introduction to Valuation8585Imperfect HedgesA hedge is imperfect if a profit or loss resultsExample: KOs stock is selling for $40 in London and $41 on the NYSE. Arbitrageurs would buy the stock on the London exchange (because it is cheaper than the NYSE) and short sell the stock on the NYSE.This would bid up the price on the London exchange and drive down the price on the NYSEThis would continue until the prices on both the London exchange and the NYSE were equalFrancis & IbbotsonChapter 3: Introduction to Valuation8686ArbitrageArbitrage involves buying a long position and selling a short position In the same asset or different (but related) assetsTo capitalize on unrealistic price differencesEnforces the economic law of one pricePrice of the same asset is the same in all free marketsPrices may actually differ due to transaction costsBrokers commissionsForeign exchange feesGovernmental foreign exchange controlsTelephone costsFrancis & IbbotsonChapter 3: Introduction to Valuation8787ArbitrageWho benefits from arbitrage?EveryoneArbitrage makes security prices respond rationally, efficiently and uniformly to new informationKeeps the price of a good that is scarce in one location but plentiful in another reasonableHelps allocate resources geographically and through timeFrancis & IbbotsonChapter 3: Introduction to Valuation8888The Bottom LineValue estimates form the basis for wealth-maximizing investment decisionsSecurity prices fluctuate due to changing value estimates by investors Some investors follow an active investment strategy while others follow a passive oneMarket prices adjust to rapidly reflect new informationActions taken by profit-seeking speculators, short sellers, hedgers and arbitrageurs help allocate scarce resourcesFrancis & IbbotsonChapter 4: Analysis of Financial Statements8989Analysis of Financial StatementsChapter 4Francis & IbbotsonChapter 4: Analysis of Financial Statements9090BackgroundFinancial statements aid in the process of fundamental analysisFundamental analysts evaluate financial ratios as an aid to determine if a security is over- or under-pricedThe efficient market theory suggests that publicly available financial statements offer nothing of valueProfessional security analysts have already discovered pertinent information and traded based on that informationFrancis & IbbotsonChapter 4: Analysis of Financial Statements9191Financial StatementsLarge public firms issue quarterly financial statementsSmall firms may only issue annual statementsClosely-held corporations may not issue public financial statementsMain financial statementsBalance sheetIncome and expense statementStatement of cash flowsFrancis & IbbotsonChapter 4: Analysis of Financial Statements9292Balance SheetRepresents historical value of firms assets, liabilities and stockholders equity on the day the accounting period endsAssets = Liability + Stockholders EquityStockholders Equity represents firms net worth (Book value of owners equity)Most firms end the fiscal year on December 31Francis & IbbotsonChapter 4: Analysis of Financial Statements9393KOs Balance SheetFrancis & IbbotsonChapter 4: Analysis of Financial Statements9494Income & Expense StatementReport the flows that occurred during the accounting periodAKA profit and loss statementSales Total Expenses = Income (Loss)Francis & IbbotsonChapter 4: Analysis of Financial Statements9595KOs Income & Expense StatementFrancis & IbbotsonChapter 4: Analysis of Financial Statements9696Statement of Cash FlowsCash flows are the net cash remaining after all reinvestments have been deductedCash flow is not affected byAccelerated depreciation rulesArbitrary inventory valuation rulesAccrual methods of accountingAccounting income is more ambiguous than a firms cash flowsFrancis & IbbotsonChapter 4: Analysis of Financial Statements9797KOs Statement of Cash FlowsFrancis & IbbotsonChapter 4: Analysis of Financial Statements9898KOs Statement of Cash FlowsFrancis & IbbotsonChapter 4: Analysis of Financial Statements9999KOs Cash FlowsKO generates tremendous cash flows from operationsKO uses its large cash flows for reinvesting within the firm, joint ventures, stock repurchases and cash dividends.Francis & IbbotsonChapter 4: Analysis of Financial Statements100100Sources of Financial StatementsPublicly traded companies in the U.S. are required to make full disclosure of their financial statementsUsually a phone call or letter is all that is needed & firm will mail statements to youSECs Electronic Data Gathering Analysis and Retrieval (EDGAR) System has the information for free at Not user friendlyEDGAR Online at and FreeEDGAR at are more user friendly but not all the data is freeHoovers On-Line at , PR Newswire at and Yahoo!Finance at offer additional information Francis & IbbotsonChapter 4: Analysis of Financial Statements101101Common-Sized Financial StatementsExpress each item as a percentage of a common base number Such as Assets or SalesUseful when comparingA firm over timeDifferent sized firmsFirms from different countriesFrancis & IbbotsonChapter 4: Analysis of Financial Statements102102KOs Common-Sized Balance SheetFrancis & IbbotsonChapter 4: Analysis of Financial Statements103103KOs Common-Sized Income & Expense StatementFrancis & IbbotsonChapter 4: Analysis of Financial Statements104104Analysis of Sales and CompetitionKO manufactures syrups for the following productsCoke Products (70% of total sales)Classic CokeDiet CokeDecaffeinated Diet CokeCherry CokeDiet Cherry CokeNon-Coke soft drinks (21% of total sales)SpriteFantaTABNestea Diet SpriteMr. PiBBFrescaPOWERaDEMello YelloLiftBarqsSpecialty local drinksFrancis & IbbotsonChapter 4: Analysis of Financial Statements105105Analysis of Sales and CompetitionFood SalesFruit juices generate 9% of total salesMinute Maid juiceHi-CFruitopiaIn the 1970s and 80s KO also soldWinesStrawsPlastic cupsWater conditioning equipmentDiscontinued these product lines to focus on core business.Francis & IbbotsonChapter 4: Analysis of Financial Statements106106Analysis of Sales and CompetitionKO products made up 18% of the non-alcoholic soft drinks purchased in the world in 1999Sales have grown at 6% annually for the last decadeEPS grew at 4.8% during the same periodFrancis & IbbotsonChapter 4: Analysis of Financial Statements107107Analysis of Sales and CompetitionKO sells its products in 200 countriesOnly 21% are made in the U.S. where KO is headquartered.Francis & IbbotsonChapter 4: Analysis of Financial Statements108108Analysis of Sales and CompetitionCompany strengthsMultinational diversificationDifferentiated product lineExecutives forecast a continuation of past growthMain competitorPepsiCoOnly weak line is the food products lineFrancis & IbbotsonChapter 4: Analysis of Financial Statements109109Financial RatiosA financial ratio combines multiple values to produce a new, meaningful valueUsed to quantify, summarize and interpret financial dataTypes of ratiosSolvency or liquidity ratioMeasure firms ability to meet short-term obligationsTurnover ratiosMeasure rate of activityCoverage ratiosMeasure extent to which the firms earnings can cover debt-related expensesFrancis & IbbotsonChapter 4: Analysis of Financial Statements110110Financial RatiosLeverage ratiosMeasure extent to which firm has been financed by creditorsProfitability ratiosMeasures productivity of money invested in firmPer share dataExamines items that affect common stocks market price per shareGrowth ratiosMeasures contribution of various items to firms developmentRisk analysis ratiosMeasures variability Francis & IbbotsonChapter 4: Analysis of Financial Statements111111Solvency (Liquidity) RatiosCurrent RatioFormulaCurrent Assets Current LiabilitiesValuesFor every $1 in current liabilities the firm had $0.66 in current assets. KO did not quite have enough current assets to pay its bills.If the firms inventory becomes worthless, KO does not have enough liquid current assets to pay its bills.Quick ratio is more discriminating than Current Ratioonly includes the most liquid assets.Quick RatioFormula(Current Assets Inventory) Current LiabilitiesValuesFrancis & IbbotsonChapter 4: Analysis of Financial Statements112112Solvency (Liquidity) RatiosEven though KO has experienced huge cash flows, the firms current and quick ratios are quite lowThus, the solvency ratios did not tell the whole storyFrancis & IbbotsonChapter 4: Analysis of Financial Statements113113Turnover RatiosInactive assets might not be generating earningsTurnover ratios help pinpoint the non-earning assetsReceivables Turnover RatioFormulaAnnual credit sales Accounts receivableValuesReceivables turn over slightly less than once a month. Is this too low/high? Cannot be determined without knowing firms credit policy and industry customs.Francis & IbbotsonChapter 4: Analysis of Financial Statements114114Inventory TurnoverFormulaAnnual sales (at cost) Average Inventory (at cost)ValuesTurnover RatiosCollection PeriodFormulaAccounts receivable Average days salesValues1997: 31.71 days1998: 32.32 days1999: 33.14 daysAcceptable value depends on product being sold and credit terms.Need more informationbefore we can evaluate these values.Francis & IbbotsonChapter 4: Analysis of Financial Statements115115Turnover RatiosAsset Turnover RatioFormulaAnnual Sales Total AssetsValuesNeeds to be compared to competitors values.Equity turns over faster than assets because firm uses financial leverage.Equity Turnover RatioFormulaAnnual Sales EquityValuesFrancis & IbbotsonChapter 4: Analysis of Financial Statements116116Coverage RatiosTimes Interest EarnedFormulaAnnual operating income Annual interest paymentSome financial analysts prefer to use the pre-tax gross income instead of operating incomeSome analysts use all debt-service charges, lease payment and cash dividends on preferred stock instead of interest payment alone.KOs income can fall98.07% (1 (1/51.7 times) before it will be insufficient to cover the firms interest expense. ValuesFrancis & IbbotsonChapter 4: Analysis of Financial Statements117117A Cash Flow RatioTwo values from the Income & Expense Statement can be used to define a companys cash flowEarnings before interest and taxes (EBIT)Depreciation/AmortizationAllocates an assets cost over its useful lifeA non-cash expense deducted from revenueReduces taxesKOs 1999 cash flow isEBIT of $3,982 + Depreciation of $792 = $4,774Can now calculate the Cash flow-to-long-term-debt ratio4,774 Francis & IbbotsonChapter 4: Analysis of Financial Statements118118Financial Leverage RatiosTotal Debt to Total Asset RatioFormulaTotal debt Total assetsValuesTotal Debt to Total EquityFormulaTotal debt Total equityValuesFrancis & IbbotsonChapter 4: Analysis of Financial Statements119119Financial Leverage RatiosLong-term Debt to EquityFormulaLong-term debt EquityValuesLong-term Debt to CapitalizationFormulaLong-term debt CapitalizationValuesSum of permanent current liabilities, long-term debt, preferred stock and stockholders equity.Francis & IbbotsonChapter 4: Analysis of Financial Statements120120Financial Leverage RatiosTotal Asset to Equity RatioFormulaTotal assets EquityValues1997: 231.7%1998: 227.8%1999: 227.3%Financial ratios are sometimes calculated with market values rather than book valuesOften more realistic and relevantFrancis & IbbotsonChapter 4: Analysis of Financial Statements121121Profitability RatiosNet Profit MarginFormulaNet income SalesValues1997: 0.22 or 22%1998: 0.19 or 19%1999: 0.12 or 12%An appropriate standard is needed to interpret a profit margin.A dollars worth of assets yielded about 11 of after-tax earnings in 1999.Return on AssetFormulaNet income Total assetsValues1997: 0.24 or 24%1998: 0.18 or 18%1999: 0.11 or 11%Francis & IbbotsonChapter 4: Analysis of Financial Statements122122Profitability RatiosReturn on Equity (ROE)FormulaNet income EquityValues1997: 0.57 or 57%1998: 0.42 or 42%1999: 0.26 or 26%If a firm has zero debt, its ROA and ROE are equal.If the rate does not exceed current interest rates, the firm is not earning enough to pay its debts.Long-Term Capitals Pretax Rate of ReturnFormula(Interest + Pretax earnings) CapitalizationValues1997: 0.75 or 75%1998: 0.58 or 58%1999: 0.37 or 37%Francis & IbbotsonChapter 4: Analysis of Financial Statements123123Per Share Data for Common StockEarnings Per Share (EPS)FormulaNet income # of common shares outstandingValuesCash Dividend Per ShareFormulaTotal corporate dividend # of common shares outstandingValuesFrancis & IbbotsonChapter 4: Analysis of Financial Statements124124Per Share Data for Common StockPayout RatioFormulaCash dividends per share EPSValues1997: 0.336 or 33.6%1998: 0.419 or 41.9%1999: 0.653 or 65.3%Measures the percentage of earnings the firm pays out as a dividend.Measures the percentage of earnings the firm retains.Retention RateFormulaRetained Earnings Net incomeValues1997: 0.664 or 66.4%1998: 0.581 or 58.1%1999: 0.350 or 35.0% Francis & IbbotsonChapter 4: Analysis of Financial Statements125125Per Share Data for Common StockPrice-Earnings Ratio (P-E)FormulaMarket price per share EPSValues1997: Low of 32 to high of 471998: Low of 36 to high of 56 1999: Low of 48 to high of 72Francis & IbbotsonChapter 4: Analysis of Financial Statements126126Analyzing and Interpreting RatiosDuPont AnalysisAllows for a thorough analysis of ROEFrancis & IbbotsonChapter 4: Analysis of Financial Statements127127KOs DuPont AnalysisProfit Margin rose and then fell over the decade.Asset Turnover rose and then fell over the decade.The increased use of financial leverage increased ROE through 1996.Francis & IbbotsonChapter 4: Analysis of Financial Statements128128Analysis of GrowthCommon stock price appreciation depends on various factorsGrowth financed internally depends on the amount of retained earningsA corporations growth rate depends on the return on equityGrowth rate = RR x ROESubstituting the three-part DuPont ROE equation, we obtainShows that multiple factors influence growthone factor can rise and another fall and growth can remain unchanged.Francis & IbbotsonChapter 4: Analysis of Financial Statements129129Risk AnalysisAs a firms risk increasesInvestors demand higher interest rates (returns)Thus, the price of the firms bonds and stocks will drop (inverse relationship)How do you measure risk?Coefficient of variationStandard deviation average valueRescales different-size standard deviations to make them easily comparableFrancis & IbbotsonChapter 4: Analysis of Financial Statements130130Risk AnalysisBusiness riskDetermined by volatility of operating incomeArises from fluctuations in sales and production costsFinancial riskArises due to the use of financial leverage (debt)Francis & IbbotsonChapter 4: Analysis of Financial Statements131131Ratio Standards of ComparisonCross-Sectional standardsCompare a firms financial ratios to other firms or industry averageIndustry averages are published by companies such asMoodysStandard & PoorsFitchsValue LineDuff and PhelpsDunn and BradstreetCan reveal a firms strengths/weaknesses compared to other firmsFrancis & IbbotsonChapter 4: Analysis of Financial Statements132132Ratio Standards of ComparisonTime-Series standardsCompare a firm to its own ratios from other yearsHelps highlight trends/changes that have occurredFrancis & IbbotsonChapter 4: Analysis of Financial Statements133133Potential Problems with Financial AnalysisInflation distortionsCan be a serious problem with the balance sheetSome fixed assets are reported at their historical costsAfter several years of high inflation historical costs can be irrelevantVague definition of accounting incomeA firm can modify its accounting income depending upon certain actionsSuch as which depreciation method or inventory valuation technique is usedFrancis & IbbotsonChapter 4: Analysis of Financial Statements134134Potential Problems with Financial AnalysisConsolidated financial statementsWhen a firm owns a subsidiary corporation accounting issues arise when considering minority interestsGoodwillWhen a company merges, oftentimes goodwill is then reflected on the consolidated balance sheetThis intangible asset cannot be measured with precisionFrancis & IbbotsonChapter 4: Analysis of Financial Statements135135The Bottom LineFinancial ratios are computed using basic financial statements like the balance sheet, income and expense statement and the statement of cash flowsFinancial ratios include solvency ratioscoverage ratiosturnover ratiosprofitability ratioscash flow ratiosleverage ratiosgrowth ratiosper share datastatistical risk analysisFrancis & IbbotsonChapter 4: Analysis of Financial Statements136136The Bottom LineComparison of a firms ratios can be done on a Cross-sectional basisTime-series basisMany additional ratios exist that were not covered in this chapterSome analysts like to restate ratiosSome industries have ratios peculiar to that industryFinancial ratios can be distorted byInflationDifferent accounting methodsMergersFrancis & IbbotsonChapter 5: Primary Securities and Their Issuers137137Primary Securities and Their IssuersChapter 5Francis & IbbotsonChapter 5: Primary Securities and Their Issuers138138BackgroundCorporations typically issue stocks and bonds to finance expansionGovernments usually issue debt to pay for deficit spendingChapter examinesMoney market securitiesBondsCommon and preferred stocksFrancis & IbbotsonChapter 5: Primary Securities and Their Issuers139139Money Market SecuritiesDebts that matures in less than one year from the origination dateShort-term and high qualityOnly involve moderate default riskActively traded at or near face valuesAKA cash equivalentsMoney market is an informal telephone networkFast-moving Used by large organizationsSmall, medium-sized and local firms are unable to issue money market securitiesLack a well-known reputationFrancis & IbbotsonChapter 5: Primary Securities and Their Issuers140140Component of U.S. Money MarketOver $200 billion are traded on average trading day.Francis & IbbotsonChapter 5: Primary Securities and Their Issuers141141U.S. Treasury BillsU.S. Treasury has issued more debt than any other organization in the worldMost of debt is financed by short-term bonds called Treasury BillsU.S. Treasury offers T-bills at public auctionsOffers denominations of $1,000, $10,000, $15,000, $50,000, $100,000, $500,000 and $1 millionFrancis & IbbotsonChapter 5: Primary Securities and Their Issuers142142U.S. Treasury BillsWeekly auctions of T-bills with initial maturities of 13 weeks and 26 weeksCompetitive bids are submitted in form of price discountsExample: U.S. offers a six-month T-bill with a $10,000 maturity value at an 8.0% price discount (or bank discount)T-bill is being offered at a price of $9,595.56, not $9,200Because convention is to assume 360 days in the yearMonthly auctions of T-bills with initial maturity of 52 weeksFrancis & IbbotsonChapter 5: Primary Securities and Their Issuers143143Figure 5-1:Figure 5-1:Newspaper Excerpt Showing Treasury Bill Price QuotationsNewspaper Excerpt Showing Treasury Bill Price QuotationsNumber of days to maturity are two days less than the time between the date of quotation and the expiration date due to skip-day convention.Bid yield represents the highest rate of interest buyers offered to pay.Asked yield represents the lowest interest rate sellers offered to accept.Asked yield represents annualized bond-equivalent-yield if T-bill purchased at asked price and held to maturity.Francis & IbbotsonChapter 5: Primary Securities and Their Issuers144144Certificates of Deposit (CDs)Sold by banks to obtain personal savings of retail clientsA secondary market does not exist for non-negotiable CDsNegotiable CDs are a receipt from a commercial bank for a deposit of $100,000 or moreProvisions attached to negotiable CD includeDeposit will not be withdrawn prior to maturity dateCould limit attractiveness of CD if a secondary market did not existFrancis & IbbotsonChapter 5: Primary Securities and Their Issuers145145Certificates of Deposit (CDs)Buyers of negotiable CDs can negotiate interest rate and maturity dateCan obtain fixed or floating rate CDsEuro CDs Denominated in foreign currenciesActively traded in LondonTerm CDs Maturities of 2 to 5 yearsYankee CDsNegotiable CDs issued by non-U.S. banks operating within U.S. to pull in deposits of U.S. dollarsFrancis & IbbotsonChapter 5: Primary Securities and Their Issuers146146Bankers AcceptancesUsed to expedite foreign trade between importers and exportersExporters bank will guarantee that acceptable goods will be shipped on timeImporters bank guarantees full payment will be made when buyer receives goodsFrancis & IbbotsonChapter 5: Primary Securities and Their Issuers147147Bankers AcceptancesBank signs bankers acceptanceAssumes legal responsibility for payment of amount stipulatedThis makes bankers acceptances liquid money market securitiesIf buyer or seller defaults, owner can collect from bank that accepted A loan that must be paid Bank order promising to pay specified amount to another bank on maturity date occurring within one yearFrancis & IbbotsonChapter 5: Primary Securities and Their Issuers148148Federal FundsOvernight loans between commercial banksInformal inter-bank networkVia phoneFunds are transferred via Fed wireRun by Federal Reserve SystemIf a bank holds excess reserves (over Federal Reserves minimum legal requirement) will lend this amount to a bank that has a reserve shortageLarge banks are typically borrowers and small banks lendersInterest rate is called the fed funds rateTerm fed funds are fed funds which last 1 day Francis & IbbotsonChapter 5: Primary Securities and Their Issuers149149LIBOR MarketEnglish law requires banks to maintain minimum reservesEnglish banks also borrow/lend reservesThe London Interbank Offer Rate (LIBOR) is the rate charged on these loansSimilar to fed funds rate in U.S.Market also exists for 3, 6 and 9-month LIBOR fundsLIBOR rate has become the reference rate on many multi-national loansFrancis & IbbotsonChapter 5: Primary Securities and Their Issuers150150EurodollarsU.S. dollar denominated bank deposits outside the U.S.Can be made in a non-U.S. bank or a foreign branch of U.S. bankTypically large denomination time deposits of less than one yearEurodollar CDs similar to ordinary CDs except money goes to a non-U.S. bankCan be traded in active secondary market unlike Eurodollar time depositsFrancis & IbbotsonChapter 5: Primary Securities and Their Issuers151151Repurchase Agreements (REPOS)Used by large securities dealers to finance multi-million dollar inventories of marketable securitiesExample: Merrill Lynch ends a trading day with an unexpected $10 million increase in marketable securitiesneeds a way to finance this increase overnightPays a finder fee to a repo broker to find an investor with $10 million of cash it needs to invest overnightMerrill Lynch sells securities to that investor with an agreement to repurchase them the next day at a slighter higher price (interest income to purchaser)Purchaser is making an overnight loan to Merrill Lynch with the marketable securities as collateralFrancis & IbbotsonChapter 5: Primary Securities and Their Issuers152152Repurchase Agreements (REPOS)Term reposrepos lasting longer than overnightCan last 30 days or longerReverse repoborrower buys securities from lender and promises to sell them back the next dayRepo rate is the market rate of interest on a repoFrancis & IbbotsonChapter 5: Primary Securities and Their Issuers153153Commercial PaperShort-term, unsecured promissory notes with maturities of 5 to 270 daysBacked only by issuers credit ratingno collateralOnly issued by large, creditworthy institutionsDenomination starts at $100,000GMAC, Ford Motor Credit Corporation and Chrysler Credit Corporation are large borrowers in commercial paper marketLargest investors in this market are money market mutual fundsFrancis & IbbotsonChapter 5: Primary Securities and Their Issuers154154Capital Market SecuritiesMoney market securities Mature within one year or lessCapital market securitiesMaturity dates range from 1 year to infinityInclude following securitiesDebtPreferred stockCommon stockFrancis & IbbotsonChapter 5: Primary Securities and Their Issuers155155Fixed Income SecuritiesInclude all debt issued by governments and corporationsMost fixed income securities are marketable legal contractsPromise to pay interest payments periodically (usually)Some pay interest quarterly, some pay fluctuating payments, most pay fixed semi-annual payments, some never pay interest (zeros)Promise repayment of principal at maturityFrancis & IbbotsonChapter 5: Primary Securities and Their Issuers156156Fixed Income SecuritiesBonds can have eitherImplicit interest paymentsAre sold at a discount and buyer experiences price appreciation until bonds mature and pay the principal amountExplicit interest paymentsCoupon bonds that are issued at face value and buyer receives periodic interest paymentsFrancis & IbbotsonChapter 5: Primary Securities and Their Issuers157157Features of Bond IssuesCoupon PaymentsCoupon rate multiplied by face (par or principal) of bondFixed payments, usually made semi-annuallyFloating rate bonds pay varying coupons from payment to paymentBond maturitiesBonds often classified based on length of time until maturityMoney market securities mature in less than one yearShort-term bonds within one to five yearsMedium-term bonds within five to ten yearsLong-term bonds within 10 or more yearsWalt Disney issued bonds with maturity of up to 100 years but are callable after 30 yearsFrancis & IbbotsonChapter 5: Primary Securities and Their Issuers158158Features of Bond IssuesCallable and convertible bondsCall provision allows issuer to redeem the bond at a specified price before maturityInvestor incurs contraction risk because bond may not remain outstanding for its entire original lifeThese types of bonds must pay a higher interest rate than identical non-callable bondsConvertible bonds allow investors to convert bonds into issuers common stock under certain circumstancesIf stock price rises substantially, bond investors can capture some of the gain by converting bonds to stockInvestor must be willing to receive a slightly lower coupon rate on convertible bondsFrancis & IbbotsonChapter 5: Primary Securities and Their Issuers159159Features of Bond IssuesSinking funds allow issuer to retire bond in an orderly mannerIssuer pays a certain amount each year into a sinking fund used to redeem the bondsSinking fund agent (bank) accumulates funds until they are neededUses funds to purchase outstanding bonds when they mature according to pre-specified scheduleFrancis & IbbotsonChapter 5: Primary Securities and Their Issuers160160U.S. Government SecuritiesNon-Marketable U.S. Treasury IssuesCannot be traded in any marketnon-transferableCannot be used as collateral for a loanCan only be purchased or redeemed from U.S. GovernmentFrancis & IbbotsonChapter 5: Primary Securities and Their Issuers161161U.S. Government SecuritiesSeries EE savings bonds30-year Treasury bonds with maturity values ranging from $50 to $10,000Sold at a deep original issue discount (OID)Pay implicit interestSeries HH U.S. Savings BondsDenominations begin at $500Can be obtained only by exchanging EE bonds and/or the interest payments from other savings bondsSeries I U.S. Savings BondsRecently introducedOffer features to nullify inflationFrancis & IbbotsonChapter 5: Primary Securities and Their Issuers162162Marketable U.S. Treasury SecuritiesMature in one year or longerActively traded in capital marketsIssued and redeemed at face valuenot original issue discount bondsMake periodic coupon interest paymentsMarket prices fluctuate Francis & IbbotsonChapter 5: Primary Securities and Their Issuers163163Treasury Notes and BondsTreasury notesSemi-annual fixed coupon paymentsMature between one and ten years from issueTreasury bondsMature between 10 and 30 years from issueSome issues are callableFrancis & IbbotsonChapter 5: Primary Securities and Their Issuers164164U.S. Federal Agency SecuritiesAgencies of U.S. governmentQuasi-government institutionsAllowed to issue their own debt obligationsInterest income is taxed at the federal levelGovernment does not usually explicitly guarantee these federal agency bondsPay a slightly higher yield than U.S. Treasury bondsGovernment has occasionally stepped in to pay obligations of agenciesExamples includeGovernment National Mortgage Association (GNMA or Ginnie Mae)Federal National Mortgage Association (FNMA or Fannie Mae)Francis & IbbotsonChapter 5: Primary Securities and Their Issuers165165ZerosBrokers started buying multi-million dollar blocks of Treasury Bonds and stripping the coupons from the principalSold small-denomination debt certificatesBacked by pool of stripped coupons and principal from U.S. Treasury bondsEssentially sold the Treasury bonds in piecesEarned fee by selling pieces for more than they costBut allowed small investors ability to buy pieces of a Treasury bondThe stripped certificates are called zerospay no couponFrancis & IbbotsonChapter 5: Primary Securities and Their Issuers166166STRIPSU.S. Treasury introduced STRIPS in 1985Separate Trading of Registered Interest and Principal of SecuritiesBasically allowed the coupon payments and the principal payments to be separated and trade separatelyTook the business away from brokers who created the zerosBuy the zeros at a deep original issue discountPrice gain equals investors interest incomeInvestor receives nothing for months or years until maturity date arrivesFrancis & IbbotsonChapter 5: Primary Securities and Their Issuers167167STRIPSExampleTreasury bonds issued in July 2002 with a maturity date of July 2014 are stripped of their coupon and sold. They have a face value of $10,000. What price would an investor pay if the investor had an annual desired rate of return of 6%?Implicit income of $5,030.31 ($10,000 $4,969.69) is received when bond matures.This income is taxable each year even though no cash inflows are received.Francis & IbbotsonChapter 5: Primary Securities and Their Issuers168168Price Quotations for TreasuriesThe bid price is the highest dollar price (as a % of face value) any potential investor is willing to pay.The asked price (offer price) is the lowest price any potential seller is willing to accept.Yield represents the yield to maturity buyer would earn if security is purchased at asked price and held to maturity.Francis & IbbotsonChapter 5: Primary Securities and Their Issuers169169Price Quotations for TreasuriesCoupon income (ci) and notional principal (np) face or par valueFrancis & IbbotsonChapter 5: Primary Securities and Their Issuers170170Inflation-Indexed U.S. Treasury SecuritiesU.S. government begin issuing inflation-indexed securities in 1997 Called TIPSTreasury Inflation Protected SecuritiesIndexed to Consumer Price IndexPay lower interest rates than similar Treasury securitiesReduce risk to investorsGovernment hopes toLower inflation-adjusted cost of financing federal debtIncrease savings rate in U.S.Make it possible to discern expected inflation rate Compare inflation-indexed bond yields to bond yields that are not inflation-indexedFrancis & IbbotsonChapter 5: Primary Securities and Their Issuers171171Municipal BondsIssued by states, counties, parishes, cities, towns, boroughs, villages and special tax districts (college dormitory authorities, sewer districts, etc.)Coupon income is exempt from federal income taxesMakes them popular for investors in high tax bracketsCapital gain income is not exempt from federal income taxesFrancis & IbbotsonChapter 5: Primary Securities and Their Issuers172172Municipal BondsSince the interest income on a muni is tax-exempt, it does not have to pay as high a rate as a comparable taxable bond-Example: You are in the 33% tax bracket and you are indifferent between a tax-exempt municipal bond yielding 10% or an equivalent taxable corporate bond yielding 15%You are indifferent because both bonds offer the same after-tax return of 10%Francis & IbbotsonChapter 5: Primary Securities and Their Issuers173173Municipal BondsGeneral Obligation BondsAKA full faith and credit bondsBacked by ability of municipality to tax to meet its obligationsLimited Obligation (LO) BondsIssued by a municipality with a limited ability to raise revenues to pay its debtsRevenue bonds are the most popular type of LO bondRevenue generated by a specific property is used to pay cash flows on bondUsed to finance projects such as toll bridges, college dorms, toll roadsFrancis & IbbotsonChapter 5: Primary Securities and Their Issuers174174Municipal BondsInsured Municipal bondsInvestors tend to avoid bonds with default riskBonds that do not receive high ratings are difficult to sellSeveral insurance firms sell bond insurance to municipalities that do not merit high credit ratingsRating agencies agree to give insured municipal bonds a quality rating equal to that of the bonds bond-insurerBecause insurer guarantees the bond paymentsFrancis & IbbotsonChapter 5: Primary Securities and Their Issuers175175Corporate BondsFederal Bankruptcy Act in the U.S. requires bankrupt firms to pay off debtholders before stockholdersThus, corporate bonds are the senior securities of a firmTrust Indenture Act of 1939 requires each bond issue to have an indenture contractSpecifies all terms of the issue, such as Coupon paymentsCollateral provisionsSinking fund provisionsConversion stipulationsOther protective provisionsA trustee must be appointed to ensure issuer upholds indenture provisionsTrustee will sue issuer if issuer doesnt uphold agreementFrancis & IbbotsonChapter 5: Primary Securities and Their Issuers176176Secured BondsBond is secured or collateralized if a lien on designated property is providedGives secured bond investors right to sell pledged property and use proceeds to satisfy debts unpaid interest/principalCollateral makes bonds more attractiveHowever, in reality collateral is rarely soldInstead new junior securities are issued to replace the defaulted bondsFrancis & IbbotsonChapter 5: Primary Securities and Their Issuers177177Secured BondsCategories of collateralized bondsMortgage bondlien on real property or buildingsBlanket mortgage exists if all the assets of firm are collateralA first mortgage is the most seniorall later mortgages are subordinated mortgagesOpen-end mortgageMore bonds can be issued on same mortgage contractCollateral trust bondsCollateral consists of stocks and bonds issued by other companiesFrancis & IbbotsonChapter 5: Primary Securities and Their Issuers178178Unsecured BondsUnsecured bonds (AKA debentures) are those with no collateral provisionsConsidered a claim on earnings, not assetsClaims are junior to claims from collateralized creditorsHas an effect on interest rate bond investors can expectFrancis & IbbotsonChapter 5: Primary Securities and Their Issuers179179Equity SecuritiesRepresent a claim on earnings and assets of a corporationIncludes common and preferred stockCommon stock is the first security issued in a corporation and the last security retired in bankruptcyCommon and preferred stock have No maturity datesNo claims on specific corporate assetsNo claims on specific sources of corporate earningsFrancis & IbbotsonChapter 5: Primary Securities and Their Issuers180180Common StockRiskiest security issued by corporationsProbability of getting anything from a bankrupt firm is near zeroIf firm is profitable, shareholders enjoy unlimited potential for price appreciation and dividend incomeFrancis & IbbotsonChapter 5: Primary Securities and Their Issuers181181Common StockStockholders rightsRight to a stock certificate which statesThe number of shares purchasedPar value per share (if any)Transfer agent for the issueVoting rightsElect Board of Directors and vote on major issuesMost stockholders vote by mail Can delegate vote via proxyGrants a third party authority to vote for stockholderUsually a top corporate executive who may try to gain control of enough proxy votesFrancis & IbbotsonChapter 5: Primary Securities and Their Issuers182182Stockholders RightsRight to buy and sellMost investors have the securities held in the street nameWhen you hold securities in street nameCannot lose your securitiesCan easily sell securitiesCash dividends/interest income can be easily swept into an interest-bearing account at brokerageReduces costs by reducing paperworkWhen you hold the securities themselvesCannot participate in some DRIP plansMay be able to negotiate a better commission Moving your securities to another broker can take weeks or monthsEducational value for child to actually see the securitiesFrancis & IbbotsonChapter 5: Primary Securities and Their Issuers183183Stockholders RightsPre-emptive rightGives existing stockholders the right-of-first-refusal on any new stock issueGuaranteed right to maintain their portion of shares outstandingPrevents dilution of old stockholders ownershipRight to informationQuarterly and annual financial reportsMinutes from Board of Directors meetingsLists of stockholdersFrancis & IbbotsonChapter 5: Primary Securities and Their Issuers184184Stockholders RightsRight to receive cash dividendsNot guaranteedMost companies determine cash dividend policy based on their growth expectations for the firmFast-growing firms tend to pay small or no cash dividendsFrancis & IbbotsonChapter 5: Primary Securities and Their Issuers185185Stock Splits and DividendsStock dividendsPay dividends in shares of stock rather than cashStock splitsCompany divides its sharesFor instance, for every 1 share of stock in existence, there are now 2 shares of stockAdjusts market price of stock proportionallyFrancis & IbbotsonChapter 5: Primary Securities and Their Issuers186186Other Aspects of Common StockPar value per shareArbitrary value assigned to share of stockMost companies set the value to $1Book value per shareCorporations net worth divided by the number of shares of common stock outstandingFrancis & IbbotsonChapter 5: Primary Securities and Their Issuers187187Other Aspects of Common StockClassified Common StockClass Atypically pays cash dividends and is sold to publicInvestors may have limited or no voting powerClass Busually voting stock held by management Entitled to reduced or zero cash dividendsManagers usually take as payment for founding, merging or reorganizing corporationStock Price QuotationsFrancis & IbbotsonChapter 5: Primary Securities and Their Issuers188188Classified Common StockTop executives can control every aspect of the firm without investing any moneyAre free to set their own salaries and fringe benefitsRecently has been used to stop corporate raiders from tendering an unwanted offerManagers issue Class A stock to outside investorsRaises funds for business but has limited or no voting powerManagers grant themselves Class B stock with voting powerFrancis & IbbotsonChapter 5: Primary Securities and Their Issuers189189Other Aspects of Common StockTracking StocksIssued by corporations that want separate listings for specific divisions of the firmExamples: GM created tracking stocks for EDS, Donaldson, Lufkin & Jenrette has a tracking stock for its electronic brokerageDLJdirectOffers investors a convenient way to own growth stocks without taking risk generally associated with small rapidly growing firmsInitial studies suggest tracking stocks do not deliverFrancis & IbbotsonChapter 5: Primary Securities and Their Issuers190190Figure 5-8:Tombstone for IPO of Common StockFrancis & IbbotsonChapter 5: Primary Securities and Their Issuers191191Preferred StockHas some characteristics of debt and equityHas legal priority over common stockholders with respect to claim on firms assetsIn a junior position relative to bondholdersUsually limited in the amount of cash dividend paidEven if firm is prosperous, preferred stockholders only receive stipulated dividendFrancis & IbbotsonChapter 5: Primary Securities and Their Issuers192192Rights of Preferred StockholdersPreferred stockholders have fewer rights than common stockholdersCumulative cash dividendsOmitted dividends accumulate and must be paid before common stockholders receive a dividendNoncumulative dividendsPreferred stockholders only receive dividends if issuing corporation earns enough to cover that years dividend paymentMissed dividends do not accumulateFixed and adjustable dividendsCash dividends fluctuate to reflect changing market conditionsFrancis & IbbotsonChapter 5: Primary Securities and Their Issuers193193Rights of Preferred StockholdersFederal Income Tax ExemptionTriple taxation exists in the U.S.Partially-owned subsidiary pays income taxes on operating incomeParent corporation pays income taxes on cash dividend income from investment in subsidiaryInvestor in parent corporation pays personal income taxes on income from parent corporationTo reduce triple taxation IRS exempts 70% of inter-corporate cash dividend payments by both common and preferred stockThus, most preferred stockholders are corporationsFrancis & IbbotsonChapter 5: Primary Securities and Their Issuers194194Rights of Preferred StockholdersVoting rightsRecent trend is to allow preferred shareholders full voting rightsAlso, nonvoting preferred stock may become voting stock if dividends are missed for a specified length of timeRight to receive stock certificate if desiredRight to buy/sell stock at any timeRight to receive information about issuerFrancis & IbbotsonChapter 5: Primary Securities and Their Issuers195195Other Aspects of Preferred StockPar valueDividend rights and call prices are generally stated in terms of par valueOr, explicitly stated if stock has no par valueCall featureAllows redemption by issuing corporation of preferred stock after a public announcement is madeGenerally a call premium of 5 to 20% is paidRedemptionNearly every issue of preferred stock is redeemableSinking fund, call provision or conversion provisionFrancis & IbbotsonChapter 5: Primary Securities and Their Issuers196196Types of Preferred StockParticipating preferred stockEntitled to fixed rate of cash dividends and a share of earnings available to common stockholdersUncommonAdjustable rate preferredsAdjustable cash dividendsDividend rates typically tied to LIBOR or other interest rateMay have a floor or ceiling attachedMoney market preferred stockRe-issued with a new cash dividend frequentlyBehaves like an adjustable rate preferredShort life & large denominationsFrancis & IbbotsonChapter 5: Primary Securities and Their Issuers197197The Bottom LineMoney Market SecuritiesMature in less than one yearInvolve very little default riskPay low rates of interestActively traded in liquid marketsImplicit vs. Explicit interest paymentsImplicit interest payments occur when debt securities are sold at original issue discountsGradual price gains provide income to investorsFrancis & IbbotsonChapter 5: Primary Securities and Their Issuers198198The Bottom LineFixed Income SecuritiesInclude securities issued by U.S. Treasury, government agencies, municipalities and corporationsEquity SecuritiesInclude common and preferred stockCommon stockholders have a residual claim on corporate earnings and the last claim on assets if corporation goes bankruptPreferred stocks participate in corporate earnings to a limited extent Francis & IbbotsonChapter 6: The Global Stock Market199199The Global Stock MarketChapter 6Francis & IbbotsonChapter 6: The Global Stock Market200200BackgroundA variety of different stock markets existFor instance, Germanys market is over 400 years old while Tanzanias began in 1998Macedonia has only two companies trading on its stock exchange while India has 5,840The market capitalization of the U.S. is $10 trillion while that of Guatemala is only $2 billion (in U.S. dollars)Many stock markets also trade other financial instrumentsConsolidations are merging stock markets and technology is pulling national markets togetherFrancis & IbbotsonChapter 6: The Global Stock Market201201The Global Stock MarketAggregate market capitalization of equity shares in the world grew from $9.6 trillion in 1990 to over $35 trillion in 2000An average rate of 14.8% annuallyFinancial capital is very mobileIn 1990 the Tokyo Stock Exchange was 30.5% of the global market but only 12.7% in 1999North America increased its share of the world equity market from 28.0% (1990) to 50.28% (1999)Francis & IbbotsonChapter 6: The Global Stock Market202202The Global Stock MarketTechnological advances are automating experienced stock exchange employees out of jobsStock markets are active in every time zoneFrancis & IbbotsonChapter 6: The Global Stock Market203203Brokerage ServicesBrokersSales people (earning a commission) employed by dealersHave no money invested in the dealers security inventoryHelp create markets by buying and selling from employers inventoryBrokerage firms extend credit (margin accounts) to clientsEnables client to do more securities tradingFrancis & IbbotsonChapter 6: The Global Stock Market204204Brokerage ServicesTypes of stock brokerage servicesFull-serviceTake buy and sell ordersExtend margin credit to customersHold clients securities in safe keepingCollect cash dividendsProvide free investment researchPerform hand-holding servicesPleasant telephone conversationsInvestment counselingBirthday cardsAll paid for by clients trading commissionsRange from $30 - $150 for one common stock transactionExamplesMerrill LynchGoldman SachsPaineWebberMorgan Stanley Dean WitterSalomon Smith BarneyFrancis & IbbotsonChapter 6: The Global Stock Market205205Brokerage ServicesDiscount BrokersSimply take ordersOffer little or no investment adviceNo hand-holding services providedLittle opportunity for churningLower commissionsRange from $20 to $50ExamplesCharles Schwab & CompanyQuick & ReillyMuriel SiebertJack White & CompanyFidelity InvestmentsVanguard Brokerage ServicesFrancis & IbbotsonChapter 6: The Global Stock Market206206Brokerage ServicesElectronic brokersTake buy and sell orders via InternetNo hand-holding servicesMay provide investment researchMay or may not be free Low commissionsRange from almost free to $35 a tradeExamplesDiscover BrokerageDLJdirectE*TradeArchipelagoBloomberg TradebookAccutradeAmeritradeCharles SchwabSURETRADEWall Street AccessFrancis & IbbotsonChapter 6: The Global Stock Market207207TransactingWhen making a trade, the investor must specifyType of orderWhether or not margin will be involvedFrancis & IbbotsonChapter 6: The Global Stock Market208208Types of Trading OrdersMarket orderorder to buy or sell ASAP at the current market priceSimplest, most common order typeExecuted immediately with virtual certaintyLimit orderorder to buy or sell with a limitLimit as to the maximum price paid for a buy orderLimit as to the minimum price received for a sell orderIf order cannot be immediately transacted, it is recorded in the market-makers limit order book and held for possible future executionOrder may never be executed if limit price is not reached May attach a time frame to the limit orderFrancis & IbbotsonChapter 6: The Global Stock Market209209Types of Trading OrdersStop ordersTo buy (sell) are written at prices greater (lower) than the current market priceActivated when (if) the market price reaches the stop priceOnce activated becomes a market orderDangers with stop ordersExecution price cannot be known in advanceInvestor may be whip-sawed in volatile marketVariation on stop orderStop limit ordersWhen stop order is activated it becomes a limit order rather than a market orderFrancis & IbbotsonChapter 6: The Global Stock Market210210Types of Trading OrdersScale orderRequires buying or selling part of the order at each price as market prices changeCumbersome and not all brokers accept themFill or kill (FOK) orderSpecifies price at which order must be filled or order is immediately canceledGood till canceled orderRemains in effect until canceledDay ordermust be filled on the day order is issuedMarket on close ordercan only be executed at the days closing priceFrancis & IbbotsonChapter 6: The Global Stock Market211211Trading on MarginWhen opening a new account with a brokerage firm, can have eitherCash accountMust pay cash for securitiesMargin accountOffers ability to buy securities on creditMoney put forth by investor serves as a down paymentAmount investors may borrow is controlled by the Federal Reserve Board of GovernorsFor example, the Fed may stipulate a 60% margin, meaning the investor must put forth at least 60% of the purchase priceFrancis & IbbotsonChapter 6: The Global Stock Market212212Trading on MarginFederal Reserves margin requirements for stocksVaried from 10% (1929) to 100% (1940)In recent years has been 50%Margin requirements are different for different types of securitiesFrancis & IbbotsonChapter 6: The Global Stock Market213213How Margin WorksExample: You wish to purchase 100 shares of XYZ Company for a price of $100 per share. The initial margin requirement is 50%.Purchase price is $100 x 100 shares = $10,000You put forth 50%, or $5,000Borrow the remaining $5,000 from your brokerBroker charges you the brokers call rate for a margin loanFrancis & IbbotsonChapter 6: The Global Stock Market214214How Margin WorksAssume that the market value of the stock rises to $150 a shareYour total profit will be $50 a share times 100 shares, or $5,000, ignoring interest (on margin loan), taxes and commissionsYour return is 100%: Profit of $5,000 Investment of $5,000If you had not used margin, you could have only afforded 50 shares, and your profit would only have been $2,500Your return would have been 50%: Profit of $2,500 Investment of $5,000 Francis & IbbotsonChapter 6: The Global Stock Market215215How Margin WorksAssume that the market value of the stock falls to $50 a shareCurrent market value of the investment is now only $5,000 (which exactly equals the amount that was borrowed from the broker)Your total loss will be $50 a share times 100 shares, or $5,000, ignoring interest (on margin loan), taxes and commissionsYour return is -100%: Loss of $5,000 Investment of $5,000If you had not used margin, you could have only afforded 50 shares, and your loss would only have been $2,500Your return would have been -50%: Loss of $2,500 Investment of $5,000 Francis & IbbotsonChapter 6: The Global Stock Market216216Maintenance MarginIf a margined portfolio decreases sufficiently in value, investor will receive a margin callInvestor must put up more margin money ASAPOtherwise, broker liquidates enough of the investors securities to bring account up to the required minimum marginEasy for broker to do because investor with a margined account must keep securities at the brokers office as collateral for their loanThe NYSE has a maintenance margin requirement of 25%Investors equity cannot fall below 25% of the accounts market valueOr, investors loan amount cannot exceed 75% of the accounts market valueFrancis & IbbotsonChapter 6: The Global Stock Market217217Maintenance MarginContinuing the example, if you had purchased $10,000 of stock with a 50% margin, you would face a margin call when Because your loan of $5,000 cannot exceed 75% of the market value of portfolio75% X = $5,000Some brokers set a higher maintenance margin than the 25% minimumFrancis & IbbotsonChapter 6: The Global Stock Market218218Investment Banks Make Primary MarketsInitial public offerings (IPOs) occur when corporations and governments issue new securities into the primary marketSometimes corporations and governments with existing securities raise additional capital by issuing a new issue of seasoned securitiesInvestment bankers find buyers for both IPOs and seasoned new issuesFrancis & IbbotsonChapter 6: The Global Stock Market219219Investment BanksA few thousand investment banking firms exist in the U.S., includingMerrill Lynch & Co.Morgan Stanley Dean WitterLehman BrothersCredit Suisse First BostonGoldman, Sachs & Co.Salomon Smith BarneyBear Stearns Cos.Paine WebberFrancis & IbbotsonChapter 6: The Global Stock Market220220Investment Bankers FunctionsEach public offering has four stepsConsulting with the issuerCarrying out administrative dutiesUnderwriting the issueDistributing the securities to investorsFrancis & IbbotsonChapter 6: The Global Stock Market221221ConsultingThe investment bank that serves as the IPOs originator must analyze the clients needs and suggest a financing planWhat type of security should be issued?How much financing is needed?When should the new securities be issued?The originator will also manageThe underwriting syndicateRanges from 5 to 200 investment banking firms that share the financing and underwriting riskThe selling groupInvestment banks and brokerage firms that sell the securities to investorsFrancis & IbbotsonChapter 6: The Global Stock Market222222AdministrationDeals with legal issues associated with an IPOHelps obtain necessary government permissionsHas the prospectus printedMakes public announcementsFrancis & IbbotsonChapter 6: The Global Stock Market223223UnderwritingAn underwriter guarantees the issuer will receive a pre-specified amount of cash for the new securitiesDays or weeks from the time the underwriter buys the securities from the issuer till they sell the securities to the investors are very risky to underwriterMarket conditions may fluctuate and underwriter may lose money on the securities because they have to sell them at a lower priceIt is important to set the right price for an IPOIf price is too high, underwriters may not be able to sell securitiesIf price is too low, issuer may find it costly to issue securitiesFrancis & IbbotsonChapter 6: The Global Stock Market224224DistributionInvestment banker may sell securities to a wide group of investorsOr may act as intermediary between issuer and buyer in a private placementThe difference between the investment bankers cost and the sale price is known as the spreadRanges from 5 16% for stocksAbout 4% for bondsFrancis & IbbotsonChapter 6: The Global Stock Market225225Electronic Investment BankersThere are several investment banking firms offering internet servicesDLJdirectFreidman, Billings, Ramsey GroupE*OfferingOpenIPOE-InvestmentBankWit CapitalVary in size and sophisticationFrancis & IbbotsonChapter 6: The Global Stock Market226226Full DisclosureIn U.S. the SEC requires most primary issues be accompanied by a prospectus10 to 20 page document that fully discloses, among other itemsPurpose for which the proceeds of the issue will be spentOffering price to the publicOffering price for special groups, in anyUnderwriters feesNet proceeds to the issuerInformation on the issuers products, history and locationNames and remuneration of officersDetailed statement of capitalizationDetailed financial statementsDetails about any pending litigationFrancis & IbbotsonChapter 6: The Global Stock Market227227Full DisclosureApproval of a prospectus by the SEC does not mean the investment is a good value, but that all the necessary information required by the SEC has been disclosedFull disclosure allows investors to estimate value of new securitiesFrancis & IbbotsonChapter 6: The Global Stock Market228228Secondary MarketOnce securities are issued in the primary market, they can begin trading in the secondary marketTypes of secondary marketsOrganized exchange run by dealers (NYSE)Electronic market in which dealers compete with one another (Nasdaq)Electronic communication networksFrancis & IbbotsonChapter 6: The Global Stock Market229229NYSENew York Stock Exchange () lists approximately3000 common and preferred stocks issued by American corporations300 foreign stocks250 American Depository Receipts (ADRs)Also trades bondsFrancis & IbbotsonChapter 6: The Global Stock Market230230NYSEEach stock traded on the NYSE is assigned a specialist who mustContinuously post bid and ask prices for the stocks in which they make a marketStand at assigned posts on the trading floorAct as market-makers (dealer)Always ready to buy at their bid price and sell at their ask (or offer) priceInvest their own capital (risky) but may earn a returnExecute orders for others (broker)Earn the bid-ask spread on every transactionFrancis & IbbotsonChapter 6: The Global Stock Market231231DecimalizationA tick represents the minimum amount by which a price can changePrior to 1997 the tick was 1/8 but then became 1/16However the tick size is now 1 since the exchanges instituted decimalizationExpected to reduce the bid-ask spread and trading costsFrancis & IbbotsonChapter 6: The Global Stock Market232232NYSE Listing RequirementsTo be listed on the NYSE must haveA minimum taxable annual income of $2.5 millionA minimum net tangible assets of $18 millionA minimum of 1.1 million shares of publicly held stock with a minimum market value of $18 millionA minimum number of 2,000 investors owning round-lots (100 shares)One specialistFrancis & IbbotsonChapter 6: The Global Stock Market233233NYSE OperationsApproximately 460 specialists with about 8 stocks assigned to each specialists trading postAbout 1,500 trading booths with telephones surround the perimeter of the trading floorAllows for order transmission and confirmation between brokers offices and exchange floorNYSE has 1,366 members who must own a seat on the exchangeAlmost all members are either specialists or floor brokersFrancis & IbbotsonChapter 6: The Global Stock Market234234Floor BrokersBuy and sell securities for the clients of brokerage houses or for their own accountsOrder processBroker receives order via phone from the brokerageWalks to trading floor and executes transaction at the specialists postPhones brokerage and provides confirmationFrancis & IbbotsonChapter 6: The Global Stock Market235235SpecialistsAccepts obligation to make a fair and orderly market bySelling shares out of their own inventory if there are more buy orders than sell orders (or by raising the price of the security they control)Buying shares for their own inventory if there are more sell orders than buy orders (or by lowering the price of the stock)Keeps a limit order book (LOB) for each stock in which they make a marketFrancis & IbbotsonChapter 6: The Global Stock Market236236Limit Order BookToday is kept on a computerRecords buy and sell orders from potential tradersOutlines the supply and demand curves that determine market price of securityHelps specialists earn trading profitsFrancis & IbbotsonChapter 6: The Global Stock Market237237NYSENYSE has lagged behind other organizations in terms of technologyUses Super Designated Order Turnaround (SuperDOT) system Routes small market orders and limit orders directly from member firms to specialistsBypasses floor brokersSpecialists usually let PCs execute SuperDOT transactions automaticallyFrancis & IbbotsonChapter 6: The Global Stock Market238238Block TradesA single transaction involving 10,000 or more shares Increased steadily throughout the 1960s-1980s but leveled off in the 1990sSpecialists are not involved in block trades that occur outside the NYSE by block positionersSpecial brokers/dealers that line up multiple buyers for a large blockSome large investment banks have a block positioning departmentHave the capital to carry a large block for a few days and the connections to distribute itThe upstairs marketEconomies of scale lead to small commissions per shareFrancis & IbbotsonChapter 6: The Global Stock Market239239Nasdaq MarketElectronic, over-the-counter (OTC) marketLists over 15% of the worlds stock market capitalizationOver 6,400 common and preferred stocksAbout 320 foreign stocksAbout 140 ADRsFrancis & IbbotsonChapter 6: The Global Stock Market240240Nasdaq MarketNational Association of Securities Dealers Automated Quotations (Nasdaq) is the communications network that services the OTC marketAbout 61,000 computer terminals are connected to Nasdaqs mainframe via phone linesCan obtain current bid and ask prices for all Nasdaq stocksUpdated continuously by about 540 competing Nasdaq market-makers (dealers)Investors broker can access the system to find the best bid/ask price for a securityBroker then calls dealer to execute transaction as trades cannot be executed via Nasdaq computerFrancis & IbbotsonChapter 6: The Global Stock Market241241Nasdaq MarketCentralizes a geographically dispersed market into a mainframe computerWhen a broker or dealer inquires about a securitys price, bid-ask quotes are instantly provided even if the dealers are many miles apartDesigned to handle up to 20,000 stocksCurrently lists about 6,500 actively traded stocksIn 1999 Nasdaq merged with AMEXNasdaq plans to cross-list stocks with various international exchangesPositioning itself to more effectively compete with NYSEFrancis & IbbotsonChapter 6: The Global Stock Market242242CQS, ITS and Law of One PriceSEC requires that the Consolidated Quotation System (CQS) report current transactions for NYSE, OTC, AMEX, regional U.S. stock exchanges and the third marketHelps investors find the best pricesCQS cannot perform executionsSEC urged NYSE to create the Intermarket Trading System (ITS)Electronic trading network linking various U.S. marketsNasdaq supplemented ITS with an electronic communications network called PrimexGives faster access to NYSE-listed stocksCombining CQS with ITS and Primex allows arbitrageurs to enforce the law of one priceFrancis & IbbotsonChapter 6: The Global Stock Market243243Non-Nasdaq National Quotation Bureau (NQB)To be included in Nasdaqs national daily list, a stock must haveAt least two market makersA minimum of 1,500 stockholdersSignificant investor interestA stock not meeting these requirements are listed with the National Quotation Bureau (NQB)NQB lists 3,600 stocks, some of which are not actively tradedIncludesDomestic U.S. micro-cap stocksShares in foreign corporations that cannot be listed on an organized exchangeADRS and GDRs for stocks that do not meet the accounting standards for listing on an organized exchangeFrancis & IbbotsonChapter 6: The Global Stock Market244244Third U.S. MarketThird marketsubset of OTC market where exchange-listed stocks are tradedCompetes with organized exchangesOffers cost savings in the form of better bid-ask pricesNasdaq and regional stock exchanges are the core of the third marketFor instance, in 1999 Chicago Stock Exchange (CHX) traded over 90% of the NYSE-listed stocksMajority of CHXs trading volume is from dual listingsCHX pays for order flowSpecialists take a penny or so (per share) from their bid-ask spread and give it to brokers to encourage brokers to execute their orders on the CHX rather than NYSEFrancis & IbbotsonChapter 6: The Global Stock Market245245Fourth U.S. MarketFourth marketa network of market-makers, block traders and institutionsBypass normal dealer services and negotiate directly with each otherInstinet (short for Institutional Network) has operated in the fourth market since 1970Has computer terminals in over 5,000 subscribers officesMillions of shares are traded in secrecy daily via InstinetCommissions range from 2 to 8 a shareFrancis & IbbotsonChapter 6: The Global Stock Market246246Order Crossing NetworksAn electronic communication network that tries to match buy and sell ordersThe price may beThe last reported price from an organized exchangeMidway between the current bid-ask prices on an organized exchangeTraders may pay a fixed annual fee to use alternative market systemsVariable trading costs are zeroRapid executions are possible if the other half of the transaction is already present in networkOffers anonymitySometimes the network is not operating when it is neededOr the other half of the transaction is unavailableFrancis & IbbotsonChapter 6: The Global Stock Market247247Order Crossing NetworksInstinet operates the Crossing Network and competes with Investment Technology Groups (ITG) Portfolio System for Institutiional Trading (POSIT)Bloomberg runs Tradebooka continuous matching system mainly for Nasdaq stocksIn 1999 Bloomberg & ITG created SuperECNOffers a crossing network with a larger order flowOther crossing networks includeInvestors Liquidity Network by Fidelity Investors E-Crossnet is for European stocksFrancis & IbbotsonChapter 6: The Global Stock Market248248Electronic Order Working SystemsElectronic order working systemsScreen telecommunication networks, capture current market information and use it to make ongoing transactionsNeeds the following informationSecurities that are to be tradedLimit order pricesQuantities available at different pricesBinding time limitsMarkets where the securities are tradedAny additional informationFrancis & IbbotsonChapter 6: The Global Stock Market249249Electronic Order Working SystemsVarious EOWS includeQuantEX by Investment Technology GroupOrder Management System by InstinetLattice Trading System by Credit Suisse First BostonREDIBookArchipelago ExchangeFrancis & IbbotsonChapter 6: The Global Stock Market250250Electronic Stock ExchangesArizona Stock Exchange (AZX)Formed in 1990 in PhoenixPeriodic call marketAutomated auction process that attempts to equate the supply and demand for a broad list of common stocks at a few specified times each trading dayClient submits order as if it were a limit orderThe limit order book is open to all participants, but anonymity of participants is maintainedEach time an auction occurs, the AZX computer calculates supply and demand curves for each security being auctionedThe intersection of the curve determines the securitys market clearing priceAll sell (buy) orders below (above) the market clearing price are matchedOn a daily basis, about two dozen institutional investors used the AZX system, trading several hundred thousand sharesFrancis & IbbotsonChapter 6: The Global Stock Market251251Electronic Stock ExchangesEuropean Association of Securities Dealers Automated Quotations (EASDAQ)Based in BrusselsNasdaq acquired EASDAQ in 2001Lists and trades about 50 technology stocksPrimexPatterned after NYSETakes a customers buy or sell order to the NYSE and other competing exchanges in search of best available priceAllows users to haggle for the best pricesFrancis & IbbotsonChapter 6: The Global Stock Market252252Electronic Stock ExchangesTradepointConducts auctions for U.K. equitiesOperates with a transparent order bookJiwayStockbrokers can transact with each other in over 6,000 European and American stocksAuctions off the right to be the designated market-maker for each stock in its system to member firmsProvides custody services, etc.Francis & IbbotsonChapter 6: The Global Stock Market253253Electronic Stock ExchangesEuropean AllianceInformal alliance of eight stock exchanges, includingLondon Stock ExchangeAmsterdam Stock ExchangeBrussels Stock ExchangeReg ATS ExchangesSEC rule that allows alternative trading systems in the U.S. to register as stock exchangesExchanges must report their prices via the Consolidated Quotation SystemOperate as a self-regulating organizationParticipate in the intermarket trading systemFrancis & IbbotsonChapter 6: The Global Stock Market254254The Twenty-First CenturyIn 1999 NYSE and Nasdaq announced that they are interested in reorganizing as for-profit corporationsWould allow them to raise outside capital in order to obtain better technologyIn 2000 Merrill Lynch started an electronic brokerage subsidiarythe last full-service brokerage in U.S. to do soIn 2000 several companies submitted a joint proposal to SEC to establish a central limit order bookWould reduce market fragmentation and increase transparency within U.S.Francis & IbbotsonChapter 6: The Global Stock Market255255The Twenty-First CenturyElectronic technology will continue to accelerate changeTrading volume will increase as transaction costs fallThere will be pressure on stock exchanges and ECNs to consolidateA global market will eventually emergeFrancis & IbbotsonChapter 6: The Global Stock Market256256LiquidityPerfectly liquid assets are highly marketableDo not suffer from a decline in price if they are liquidated quicklyFor example, the U.S. dollar is perfectly liquid whereas most real estate is not becauseTo quickly sell a house, seller must offer a price discountReal estate brokers commonly have commissions of 6% of the property valueFrancis & IbbotsonChapter 6: The Global Stock Market257257Liquidity ContinuumAssets categorized from most liquid to least liquidU.S. dollar billsU.S. Treasury bondsNYSE-listed stocks and large Nasdaq stocks (such as Microsoft)Nasdaq stocksCorporate bondsMost municipal bondsMost real estateArt objects and collectiblesInvestors pay a liquidity premium for the convenience of owning liquid assets.Francis & IbbotsonChapter 6: The Global Stock Market258258Liquidity in Securities MarketsA liquid securities market possesses the following qualitiesDepthbuy-sell orders exists both above and below the price at which the security is transactingA market lacking depth is shallowBreadthwhen a large amount of buy-sell orders as described above existMarkets lacking breadth are called thin marketsResiliencyif new orders occur in response to price changes due to temporary order imbalancesFrancis & IbbotsonChapter 6: The Global Stock Market259259Transaction CostsDirect transaction costsBrokers commissionsIncome taxesTransfer feesCustodial feesOutlays for research informationIndirect transaction costsBid-ask spreaddetermined by the cost of market-making expenses such as Interest expense for financing inventory of securitiesRisk premium for investing capitalAdministrative costsFrancis & IbbotsonChapter 6: The Global Stock Market260260Transaction CostsIndirect transaction costsMarket impactBuying (selling) tends to bid up (down) the price of a security Large transactions tend to move prices more than smaller transactionsOpportunity cost (implicit)Decay of information value of a trade incurred when market moves against a trader waiting to tradeTends to increase with time between decision to trade and the actual execution of the tradeFrancis & IbbotsonChapter 6: The Global Stock Market261261Transaction CostsTotal transactions costs can range from less than 1% of the value to much of the investors return (in countries with high capital gains taxes)The cost of transaction varies inversely with the markets liquidityLarge cap stocks are usually more actively traded than small capThus, small cap stocks generally have a higher transaction costLarge industrialized nations generally have lower transaction costs because The stock markets are more activeMore political stabilityMore efficient legal systemsFrancis & IbbotsonChapter 6: The Global Stock Market262262The Bottom LineSmall and large stock markets provide varying degrees of liquidityInstitutional investors may use block positioners to execute large tradesFull-service brokers charge high commissionsDiscount brokers, electronic brokers or ECNs offer less costly servicesMost trades are market orders, however other order types existFrancis & IbbotsonChapter 6: The Global Stock Market263263The Bottom LineInvestors may buy on margineffectively borrowing money from their brokerageMargin trading enhances gains and lossesInvestment bankers assist their clients in raising money in the primary marketOrganizing distribution syndicatesUnderwriting the issueDistributing the securities使用使用时，直接，直接删除本除本页！精品精品课件，你件，你值得得拥有有！精品精品课件，你件，你值得得拥有有！使用使用时，直接，直接删除本除本页！精品精品课件，你件，你值得得拥有有！精品精品课件，你件，你值得得拥有有！使用使用时，直接，直接删除本除本页！精品精品课件，你件，你值得得拥有有！精品精品课件，你件，你值得得拥有有！Francis & IbbotsonChapter 6: The Global Stock Market267267The Bottom LineNYSE is the largest stock market in the worldContinuous auction marketSpecialistsNASDAQ is a large electronic marketECNs involve several different categories of market technologyTechnology isIncreasing the array of brokerage servicesIncreasing the competition between brokerageReducing transaction costsSpeeding executionsCreating new types of stock exchangesAltering the IPO processIntegrating the worlds stock markets into a global one