text reference: chapter 1 real vs. financial investment Some Background Material participants in the financial system and their objectives: households: select financial assets to help meet consumption plans businesses: issue securities to finance investment in real assets government: borrowing in debt markets; regulatory framework the foreign sector: businesses & goverments must sometimes market directly to foreign investors; households may want foreign assets for superior diversification/investment objectives 1 financial intermediaries: firms which provide various types of services to individual investors and corporations. Examples include investment dealers (marketing security issues to the public, investment advice, brokerage services), insurance companies (risk pooling), mutual funds (cheap diversification, security selection), etc. financial innovation/engineering: creation of new types or combinations of securities to better meet various demands; often a response to regulations (especially taxes) 2
No word is more overworked these days than revolution. Yet, in its original sense of a major break with the past, the word revolution is entirely appropriate for describing the changes in financial institutions and instruments that have occurred in the past twenty years. As one small example of how far we have come, I can still recall the shock and incredulity of my Belgian colleagues at the University of Leuven in 1966 on learning that I, as an American citizen, could not then legally own monetary gold. Nowadays, of course, we can hold and trade not only gold coins, gold bullion, gold futures, and gold options but literally hundreds of other financial instruments that either didn t exist in 1966 or existed in only rudimentary form. A partial list of major novelties would include, in no particular order: negotiable CDs, Eurodollar accounts, Eurobonds, sushi bonds, floating-rate bonds, putable bonds, zero coupon bonds, stripped bonds, options, financial futures, options on futures, options on indexes, money market funds, cash management accounts, income warrants, collateralized mortgages, home equity loans, currency swaps, floor-ceiling swaps, exchangeable bonds, and on and on. Merton H. Miller, Financial Innovations and Market Volatility, 1991, p. 3. 3 text reference: chapter 2 money market: short term debt Treasury bills CDs commercial paper banker s acceptances Eurodollars repos/reverse repos Financial Market Overview text Table 2.1: average Canadian daily trading volume (4th quarter of 2000) was $3.9 billion for T-bills, $5.4 billion for banker s acceptances, and $10.4 billion for commercial paper 4
quoting conventions for T-bills: Canada uses bond equivalent yields: r BEY $1 000 P P 365 n example: what is the price of a 91 day T-bill with a bond equivalent yield of 6%? the U.S. uses bank discount yields: r BDY $1 000 P $1 000 360 n a 91 day U.S. T-bill selling for $985.26 would be quoted as having a yield of $1 000 $985 26 $1 000 360 91 5 8312% 5 note the following equivalence formula: r BEY 365 r BDY 360 r BDY n for example, if r BDY 5 8312% on a 91 day T-bill, then r BEY 365 058312 360 058312 91 6% also note that bond equivalent yields are annualized using simple interest they are not effective annual rates of return to calculate the effective annual yield: r eff 1 r BEY 365 n 365 n 1 6
fixed income capital market: long term debt government bonds corporate bonds mortgage-backed securities often come with various types of options: callable putable retractable extendible convertible may or may not be secured 7 equity markets common stock a residual claim limited liability preferred stock usually fixed dividends, cumulative higher priority than common taxed more favourably than bonds for investors (but issuers do not get interest deductions as they do for bonds) some have variable rates, or are callable/convertible 8
a security index tracks the performance of a specific portfolio over time e.g. stock indexes (TSE 300, NASDAQ, DJIA), bond indexes (Scotia Capital in Canada, Merrill Lynch/Lehman Brothers/Salomon Brothers in U.S.) used for tracking average returns comparing performance of managers a basis for derivative contracts factors in constructing and using indexes: how representative liquidity index calculation methodology 9 there are 3 different index calculation methodologies 1. A price-weighted index assumes you purchase an equal number of shares (one) of each stock represented in the index (e.g. DJIA): price-weighted index t n 1 n P i t i 1 where n is the number of stocks in the index and P i t is the price of stock i at time t similar to a portfolio having one share of each stock in the index continuous adjustments for splits/additions/deletions 10
2. A value-weighted index assumes you make a proportionate market value investment in each company in the index (e.g. TSE 300) value-weighted index t n i 1 P i t N i t n i 1 P i 0 N i 0 value-weighted index 0 where N i t is the number of shares outstanding of stock i at time t TSE 300 started in 1977 with a base level of 1,000 for the year 1975 problem: impact of firms with large market capitalizations 11 3. An equal-weighted index assumes you make an equal $ investment in each stock in the index (e.g. Value Line Composite Average) equal-weighted index t average of P i t P i 0 in effect, working with % price changes can be either arithmetic average 1 n n i 1 x i or geometric average Π n i 1 x i 1 n, depending on index definition appropriateness of performance comparison to index depends on how your portfolio is structured, e.g. if you hold an equal number of shares of many Canadian companies, it is not really appropriate to compare your performance to the TSE 300 12
example: stock initial price final price shares o/s (millions) A $25 $30 20 B $100 $110 1 What is the return on the price-weighted, value-weighted, and arithmetically averaged equal-weighted indexes? 13 derivative markets: options: a call option gives its holder the right to buy an underlying asset (e.g. a stock) for a specified price (called the exercise price or strike price), on or before a stated date (called the maturity date or expiry date) a put option is similar except that the holder has the right to sell the underlying asset European options can be exercised only on the expiry date; American options can be exercised any time up to and including the expiry date options exist on stocks, bonds, futures contracts, stock indexes, interest rates, etc. many exotic variations are traded in the over-the-counter (OTC) market 14
futures and forward contracts: basically just an agreement to trade in the future at a price specified today (the long party agrees to buy, the short party agrees to sell) futures contracts are standardized, traded on organized exchanges, and marked-to-market forward contracts are customized and traded OTC swaps are portfolios of forward contracts trading volumes in derivative markets are enormous (see http://www.bis.org/publ/otc hy0205.pdf) 15