Used to produce goods and services. Examples land, building, machines, knowlege, etc.

Determines the wealth of an economy.

Claims to income generated by real assets. 

(Stocks, bonds, cash, lease payments, etc.)

Short term, safe, low risk, low return, easy to access, less than 1 year 

(i.e. CD, Treasury Bills, etc.)

Longterm

(i.e. Treasury Bonds)

Represents ownership share

(Stocks)

*  Common Stock - residual claim (bottom of claimants list), limited liability (no personal liability), voting rights

*  Preferred stock - hybrid security, represents ownership, its a perpetuity, no voting rights, fixed dividends, has qualities like a bond, accommalitive & non cummulative - dividends paid or not paid on non paying years.  Advantage - when one corp. buys another, it pay taxes on only 30%.  Ex:  $10,000 x 30% = $3,000 x 35% tax bracket = tax rate on preferred dividends.  Disadvantage: Preferred stocks are treated as dvidends and not interest.  They are not tax deductable.  This is offset by the 70% tax exclusion.  Preferred yields are lower than bonds.  If an investor can't take advantage fo the 70% tax exclusion, bonds make more sense.

Derived from primitive securities (stock or bond where payment depend only on the financial status of its issuer) to yield returns related to prices of other assets.

(options, futures, etc.)

1.  Asset Allocation -choice of asset classes, i.e. stocks, bonds, etc

2.  Security Selection - which securities to include

a. top down - focuses on broad composition/asset allocation of entire portfolio  with a level of risk consistent with your level of risk tolerance. Disadvantage:  may forfeit potential high returns that could result from undervalued securities. 

b. bottom down - based on price (undervalued securities) but tends to overlook overall composition which may result in an nondiversified portfolio or one with an inconsistent risk level to yours.  Also, this tends to require more active management, most costs.

Pyramid - top economy, industry, securities, bottom

Banks, Insurance companies, investment companies

Good because:

1.  Pools resources

2.  Minimizes Risk

3.  Economies of Scale

Securitization

or Pass-Through Loans

Money Markets

Bonds

Fixed income securities

*  Longer term

*  Greater than 1 year

*  Fixed income stream,

*  Often pays coupon

*  Notes - 1 to 0 years

*  Ratings - Moody's, Standard & Poors - top 4 investment grades, bottom 4 junk bonds

*  Federal agency - Fanny Mae, etc.

*  Municipal Bonds - not subject to fed tax, nor many state or local taxes

*  Beaerer bonds are not recorded.

Income earned is exempt from all state and local taxes.

Sold at a discount from face value and returning the face amount at maturity.

Rm = Rt (1-T)

Rm = yield on tax free muni

Rt =taxable yield

T = tax rates

Example: Suppose a tax bracket of 30%.  Would a 6% taxable return or a 4% tax-free return be better.

.06 (1-.30) = 4.2%

verse 4 %.

Price of stock A + Price of stock B/n

Example:

25+100/2 = 62.5

With price change:

20+110/2 = 65

Percentage change:

65/62.5 = 1.04-1 = 4% or

2.5%/62.5 = 4%

Distinguished largely by their tax exempt status.  Interest payments (but not capital gains) on these securities are exept from fed. income tax.

The equivalent taxable yield is

Rm/(1-t)

Right to buy or sell an asset at a specified price (exercise or strike price) on or before maturity. 

Call options - right to purchase at exercise price

*  will only happen if it yields a profit (value exceeds exercise price) - 

*  profits increase when asset increases in value

*  best in bulish markets

Put options - right to sell at exercise price

*  decrease in value at the price underlying asset increases

Obligation to buy or sell at a stipulated future price at maturity.

Long position - commits to purchasing the asset at set price on delivery date - Pays money now.  Loses if the asset value decreases.  Gains if asset value increases

Short position - Commits to delivering/selling the asset at contract maturity. Takes money now.  - loses if the asset value increases.  Gains if asset value goes down.

Ask price - price dealer will sell (sellers sells), buyer will buy (buyer buys)

Bid price - price dealer will buy (seller buys), buyer will sell

Spread -difference in price

Sold in denominations of 1,000

*  Spreads

*  Commissions

Order by bank's customer to pay a sum usually within 6 months sold at a discount

Like a postdated check

Eurodollars

Dollar-denominated deposits at foreign banks.

Most less than 6 months' maturity.

Less regulation.

Repurchase agreements or Repos

Short term, usually overnight sales of gov't securities with agreement to repurchase at slightly higher price.  Dealer's one day loan.

Safe - Backed by gov't securities.

Reverse repo - the opposite.  Dealer buys.

Funds in a bank's reserve account

Fed Fund Rate - bank to bank

Discount Rate - Fed to bank

London Interbank Offered Rate - rate most banks charge one another

The UK's Fed Fund Rate

Average rate of return that will be earned on a bond if held to maturity.

coupon payment/(1+r)t + Par Value/(1 + r)#of periods

*  Coverage ratio - earnings to fixed costs, low ratio signals possible cash flow difficulties

* Cash flow to debt ratio - total cash to debt

*  Leverage Ratio - debt to equity, too high leverage means excessive indebtedness

*  Liquidity ratio - current asset/current liabilities and current assets less inv/current liabilities, measures ability to pay bills coming due

*  Profitability ratio - measures return on asset, most popular, higher return means ability to raise money

Types of Securities Market

Primary and Secondary Markets

Primary - new issues of secuities are offered to the public. 

Secondary - already existing securities are bought and sold on the exchanges or OTC market from one investor to another.

Direct Search - least organized.  Buyers and sellers seek each other out. Ex: want ads

Broker - an intermediary offers search services to buyers and sellers.  Ex: real estate 

Auction - all traders meet at one place.  Example NYSE

Dealer - Traders specialize in particular commodities. Ex: OTC (over the counter) NASDAQ

Types of Orders - just in secondary market

Market Orders - buys and sells executed immediately at current/prevailing market price.  Bid-ask spread - diff. betweent the price investor can buy (ask) to where investor can sell (bid)

Limit order - investor places an order to buy at a price below, or sell at a price above market price,  Types 1. good til canceled 2. day orders, etc.

Price- Contingent Orders - orders executed at a stipulated price.  Limited orders book are orders waiting to be executed.

Stop orders - trade not to be executed unles the stock hits a price limit. Stop loss orders - sell if price falls below a specific level.  Stop-buys - often used with short sales (borrowed shares)- buy when price rises to a set limit.

• Stocks issued by a formerly privately owned company that is going public. 
• Usually go through an investment firm who assist with registration with SEC and then solicit buyers.  Usually underpriced and goes up the first day of issue.
• Seasoned new issues are offered by companies that already have floated equity.   Like IBM - new shares.

sell order to be executed if the price falls below a given level.

NASDAQ

Nat'l Assoc. of Sec. Dealers Auto. Quot System

automated quotation system for the OTC market for thousands of stocks.

Dealer market.

Margin

Amount invested. 

Stocks purchased with money borrowed from a broker.  Max to borrowed is 50%, meaning that at least 50% of the price must be paid for in cash, with the rest borrowed.   Broker charges interest.

Margin % = New Cash Balance/New Stock Price

Maintenance margin - minimum amount of equity broker sets before you must deposit additional funds.

# of shares x p - borrowed / # of shares x p = maintenance margin %

Margin - notification from the broker to post more money

Margin call - Broker calls the investor to add new cash if marin falls below the maintenance level

Rate of return = initial equity - equity-interest/initial equity

% decline in price = intitial price - new price/initial equity

Sale of shares not owned by the investor but borrowed through a broker and  later repurchased to replace the loan.  Profit from a decline in price (initial price higher than repurchase price).

Profit = initial price - (ending price + dividends)

Maximum loss is unlimited

Maximum gain is shares x price

With stop buy at $128 for shares bought at $120, max loss is $8 x # of shares

Initial Margin + Proceeds - # of shares x P/# of shares x P = maintaince margin

initial equity-loss/new value = actualized maintance margin

• Investment grade
• Speculative grade/junk bonds

• Moody's
• Standard & Poor's
• Fitch

Certificates traded in US markets that represent ownership in shares of a foreign company.

Trading Mechanisms

Dealer Markets - 35,000 securities traded OTC

ECN - Electronic Communication Networks - post market & limit orders over the computer.

Specialist Markets - obligated to provide price continuity in the stocks they specialize, maintains limit order book, like auction, best orders win.

NASDAQ - 3,200 firms divided into 2 sectors, National and SmallCap.

NYSE - 1,366 commission broker seats

Block Sales - blocks of 10,000 shares.  Block houses match buyers and sellers

1. Price weighted - Dow Jones
2. Market Value Weighted  - S&P and Nasdaq
3. Equally weighted - places equal weights on returns - Value line is the only one

• S&P
• Dow Jones
• NASDAQ
• NYSE
• Russell 2000 (sm co)
• Wiltshire 5000 (sm countries)
• DAX - Germany
• EAFE
• Nikkai - Japan

- the extent to which security prices reflect information

- a security should be neither under priced or overpriced

-random walk - security prices reflect information and information is random, so security prices should be random.  Stocks are unpredictable

3 types of Efficient Market Theories

Weak form - Stock prices reflect all past information.

Semi-strong - stock prices reflect all publicly available information

Strong form - stock prices refelct all information (public and private)

1.  supply of funds from savers, households

2.  demand for funds from businesses

3.  gov't net supply or demand or funds by actions of the feds.

Modern Finance dates back from the 1950's.

Finance can be approached from a business or economic perspective.

Markowitz made the first contribution to understanding the relationship between risk and return in portfolio selection. 

Then came Sharpe with CAPM which provides an insight to the nature of risk as it relates to expected rates of return.

Two abnomialies - small companies do better than large and the higher the book to market ratio, the higher the return.  Book/Market.  If the ratio is above 1 then the stock is undervalued;  if it is less than 1,  the stock is overvalued.

The third contribution is the Efficient Market Hypothesis which claims the markets reflect all available informaiton.

The fourth contribution is the Modigliani-Miller capital propostion - value of a firm cannot be determined by how the firm is financed. 

Active - time the market, analyze securties, find undervalued securities

Passive - simply buy-and-hold, no timing.

Sept 1964

Paper written by William Sharpe

Expanded an existing model

of investor behaviors and market equilibrium theory into the CAPM model.

Explained how security prices reflect possible risk to returns.

Expected return = risk free rate + risk premium

Risk premium = risk measurement (beta) x (Rm-Rf)

To reach a desirable return, diversification between risky and less risky assets should be included in a portfolio.

SML - graphically depicts the what the market must price a security of feasible expected returns and risks.  Starts at the risk free rate.

Tendencies of rational investors are to be risk adverse.

Correlation between investment plans.  Plans are positively correlated if there is a positive relationship.  No correction if there is no relation.  Negatively correlated if there is an inverse relation between them.

Point on CML - where a portfolio is fully invested at maximum value.  Investment opportunity curve is tangent with the CAL.  Preferred position below this point indicates lending.  Position above this point indicates borrowing to reach a preffered position. 

Encompasses equilibrium tendencies.  Prices are effected by expected return.  As prices increase, expected return will decrease. If prices decrease, return will increase.

Sharpe received the noble peace prize for his contribution.  CAMP closely studied by finance students. 

Advance registration of securities with the SEC for issue from the shelf up to 2 years following initial registration. 

SEC rule 415. 

A preliminary registration statement filed with the SEC describing the issue and the prospects of the company.  Printed in red - Statements saying that  the company is not attempting to sell the security before the registration is approved is .

Prospectus - final form

Share price $70

Initial Margin 50%

Maintenance Margin 40%

Shares 1,000

Initial Balance

Stocks $70,000

Cash $35,000

Borrow $35,000

Price falls to $60

New Balance

Stocks $60,000

Cash $25,000

Borrow $35,000

Margin% = $25,000/$60,000 = 41.67%

Share Price $100

Initial Margin 50%

Maintanence Margin 30%

Short sell 100 shares

Proceeds 10,000

Equity $5000

If stock rise to $110

Stock owed $11,000 = $110 x 100

Equity: $4000 ($5000 - ($10 increase x # of shares)

Margin % - $4,000/$11,000 = 36%

Growth rate in your money 

real rate (growth in purchasing power)- inflation premium (expected increases in prices)

Exact relationship = 1+R=(1+r)(1+i)

stated rate

Tax liabilities are based on nominal rate

Risk - variability of an asset

Return - gain or los of an investment over time

APR - Annual Percentage rate = (period in year) x (rate per period), annualized using simple vs compound interest, ie credit cards.

EAR - effective annual rate = (1 + rate per period) to n (periods per year) - 1, used for expressing all investment returns, defined as % increase in funds invested over a year.  Computed using compound interest.

Continuous Compounding - diff between APR & EAR,

e (2.71828) to n - 1

Ending price - Begining price + dividend/ beginning price

Ignores reinvestments

dividend yield (% return on dividend) + capital gains yield = HPR

Arithmetic - Add returns and divide by n

Geometric return - [(1+r) x (1+r)... ] to the 1/n - 1

Normal Distribution - bell shaped curve

1.  Mean - expected return

2.  Variance - (sigma 2) risk, standard dev. (sigma)

=probability x (return - expected return)squared + return squared ... then square rooted

3.  Skewness - how far to one side the distribution is shifted

(Return x Probability) + (Return x Probability) ... = %

(Note:  Do not divided by n when probabilities are given.)

Measures attractiveness of investment portfolio

Return/Risk
Risk Premium (expected return - risk free)/Standard Deviation

the higher the better

Risk premium - expected return in excess of risk free rate.

risk 

Standard Deviation of excess return

Equilibrium model that underlies modern financial theories.

Derived using principle of diversification with simplified assumption

Markowitz, Sharpe and Lintner &  Mossin are researchers credited with this

Expected return = Rf + B(Rm-Rf)

Can provide required rate of return that a project needs to yield, to be acceptable to investors. Ex: Investment of $100 million in a firm with beta .6.  T-bill is 6% and market risk premium is 8%.  6 + .6 x 8 = 10.8%.  or 10.8 million. The firm would be allowed to set prices at a level expected to generate these projects.

Embedded in 2 predictions - market portfolis is efficient and SML accurately descibes risk return trade off, alpha is zero.

Adverse - considers risky portfolios only if they provide compensation for risk via a risk premium

Neutral = level of risk irrelevant and considers only expected return

Lover = accept lower expected returns with higher risk.

Capital allocation line (CAL)

Capital Market Line (CML)

CAL - graph showing all feasible risk-return combinations of risky and risk free assets

CML - cap allocation line derived by the market index portfolio

portfolio's risk premium (expected return - risk free) to its standard deviation.

1.  Individual investors are price takers.  They cannot effect prices.  They act as if security prices are unaffected by own trades.

2.  One identical holding period / period horizon.

3. Investments are limited to a universe of pubicly traded financial assets (stock, bonds) and to risk free borrowing and lending.

4. Investors pay no taxes on returns and no transation costs.

5.  Investors are rational mean-variance optimizers.

6.  Information is costless and available to all investors.

7.  Homogeneous expectations - analyze and look at the world in the same way

8.  Investors do not have the same level of risk aversion.

1.  All investors will hold the same portfolio for risky assets market portfolio.

2.  Market portfolio contains all securities.

3.  Risk premium on the market depends on the average risk aversion of all market participants.

4.  Risk premium on an individual security is a function of its covariance with the market and is equal to beta. 

Beta= cov(Ri,Rm)/market's sigma squared

Minimizes risk

Systematic - Risk that can  not be diversified away.

Risk that a security contributes to a well diversified portfolio can be measured by beta. 

beta = cov (i,m)/market's sigma squared

Betas greater than 1 are considered aggressive with above average sensitivity to market swings. 

B = COV(Ri, Rm)/market's sigma 2

Slope of SML = Market risk premium (market's expected return - risk free rate)

SML (security expected return) = risk free rate + beta(market risk premium)

SML graphs individual asset risk premiums as a function of asset risk.

SML provides a benchmarket for the evaluation of investment performance.

SML provides the required rate of return necessary to compensate investors for both risk and well as time.

All fairly priced assets plot exactly on the SML.

All securities must lie on the SML in market equilibrium.

Underpriced stocks plot above the SML.  Expected returns are greater.

Overpriced stocks plot below the line.

% of investment x stock A's beta + % of investment x stock B's beta.

Portfolio's risk premium

= portfolio's expected return - risk free rate = portfolio's beta (market risk premium)

The difference between the fair and actually expected rates of return on a stock.

To make the leap from expected to realized returns, we employ the index model -

Ri = alpha + B(Rm + ei)

alpha = E(r)-Rf+Bp[(E(Rm) - rf]

Models

• CAPM
• Single factor model - acknowledges only one common factor.
• Single index model  - influences on returns into a systematic factor, as measured by the return on a broad market index, and firm specific factors.
• Market model - another version of the index model that breaks down return uncertainty into systematic and nonsystatic components.
• Index Model - model of stock returns using a market index to represent common or systematic risk.  Uses historical data. Ex:  Rapple - Rtbill = Bapple(Rs&p - Rtbill) + E

*  Limitation for CAPM

*  Market portfolio is not directly observable

*  Research shows that other factors affect return

*  Returns are related to factors other than market returns

*  Size

*  Book value relative to market value

* 3 factor model better describe R

E(Ri) = Rf + Bm[E(Rm) - Rf] + Bsize )E(Rsize) + Bb/m E(Rb/m)

Expect return - risk free/standard deviation

the higher the better

return/risk

Rise over run

Sharpe Ratio

E(Rp) - Rf/sigma

Beta

Risk Premium of Market Portfolio

dividend payment/close price

.25 paid quarterly x 4 quarters = $1

closing price $35.35

$1/$35.35 = .028 or 2.8%

E(r) = rf + BxRPx + +ByRPy

Risk free = 4%

Stock x = beta 1.2 with return 6%

Stock y - beta -.3 with -7%

4% + (1.2 x .06) + 4 + (-.3x-.07) = 13.3%

Difference in Change of initial & final value divided by initial value

$600 initial value

$690 Final

$90/$600

weighted average of the returns

Systematic Risk

Nondiversifiable risk

Well-diversified portfolio with equal betas must have equal expected returns or arbitrage opportunities exist.

In efficient markets, profitable arbitrage opportunities will quickly disappear.

If two portfolios are mispriced the investor could buy the low priced portfolio and sell the high priced portfolio

APT applies to well diversified portfolios and not necessarily to individual stocks.

With APT, it is possible for some individual stocks to be mispriced and not lie on the SML.

APT is more general in that it gets to an expected return and beta relationship with the assumption of the market portfolio.

APT can be extended to multifactor models.

One that is diversified over a large enough number of securities with each weight, small enough that for practical purposes the non systematic variance is negligible.

Annual coupon payment/2 x days since last coupon payment/days separating coupon payments

Ex:  $80 annual coupon

$40/40/182 = $8.79

Quoted price on bond is $990 + $8.79 = invoice price.

Bonds with call protection, an initial time bonds cannot be called.

Callable - Allows issuer to repurchase the bond at a call price.  For this risk, they come with a higher coupon and yields but sell for lower price.

Puttable allows the bondholder the option retire the bond or extend the life.  If coupon rate exceeds current, holder willextend the life.

Trade for common stock.

Because of the benefit to profit from price appreciation, this bonds offer lower coupon rates.

Foreign - issued from another country in another currency.

Euro - issued in domestic currency and sold in another country.

Long Term debt instruments.  Do not have ownership.

Inverse relationship between interest rates and price convexity.

When interest rates rise, bond price falls and cash flow falls as well.

YTM - the interest rate that makes the present value of a bond's payment equal to it price.

Current yield - bond's annual coupon payment divided by its price.

Effective Yield=

(1+YTM/m)to the m - 1

or

Yield to Call = Change FV and # of periods

Premium - bonds sell above par.

Discount - bonds sell below par.

BBB or above

junk bonds

lower rated bonds

spreads bond payment burden over several years. 

Differ from conventional bond 1.  firm can only repurchase a limited #

2.  price usually below par

prevents firms from harming bondholders by restricting the amount of additional borrowing.

Subordinate debtholders - inferior priority

Collateral - back by something.

Debenture - no specific collateral

Innovative Bonds

Floating Rate Bonds - Payment tied to some measure of current market rates i.e. t-bills.

Asset Backed

Catastrophe - depends on catastrophe, investor are paid when cat doesn't happen.

Difference between the promised yield and yield of riskless gov't bond.

Credit risk = default risk

Spot - Rate that prevails today.

Short - for a given time period.

Interest rate that would need to prevail to make the long and short term investments equally attractive.

(1 + Yn)n = (1 + Yn-1) x (1 x Rn) 

Forward Interest Rate - rather than future short rates,

Compensates short term investors for the uncertainty about their long term bond.

Long term bonds are most risky.

Investors will demand a premium for long term investments.

Yield curve has an upward bias built into long term rates because of risk.

Forward rates contain a liquidity premium and are not equal to expected future short term rates.

Zero Price

Par/(1+i)n

Ex:  $1000 par bond, YTM 6%, Time to Maturity

1000/(1+.06)10 = $558.39