Bonds
Preferred stock
always appear on both sides of the balance sheet. Your financial claim on a firm is an asset, but
the firms issuance of that claim is the firms liability. When we aggregate overall balance sheets,
financial assets will cancel out, leaving only the sum of real assets as the net wealth of the
aggregate economy.
c) Financial assets are created and destroyed in the ordinary course of doing business. E.g. when a
loan is paid off, both the creditors claim and the debtors obligation cease to exist. In contrast, real
assets are destroyed only by accident or by wearing out over time.
Risk-Return Tradeoff: The principle that potential return rises with an increase in risk. Low
levels of uncertainty (low risk) are associated with low potential returns, whereas high levels of
uncertainty (high risk) are associated with high potential returns. According to the risk-return tradeoff, invested money can make higher profits only if it is subject to the possibility of being lost.
Because of the risk-return trade-off, investors must recognize their personal risk tolerance when
choosing investments. Taking on additional risk is the price of achieving potentially higher returns;
therefore, if an investor wants to make money, he or she cannot cut out all risk. The goal instead is to
find an appropriate balance that generates some profit but allows the investor to sleep at night. Low
levels of uncertainty (low risk) are associated with low potential returns. High levels of uncertainty
(high risk) are associated with high potential returns. The risk/return tradeoff is the balance between
the desire for the lowest possible risk and the highest possible return. A higher standard deviation
means a higher risk and higher possible return.
A common misconception is that higher risk equals greater return. The risk/return tradeoff tells us that
the higher risk gives us the possibility of higher returns. There are no guarantees. Just as risk means
higher potential returns, it also means higher potential losses.
Efficient Markets
o
Market efficiency:
Whether we believe markets are efficient affects our choice of appropriate investment
management style.
No attempt to time
Indexing
Constructing an
efficient portfolio
Commercial Banks
Investment companies
Insurance companies
Pension funds
Hedge funds
Perform specialized services for businesses such as issuing securities for firms Markets in the
primary market
Firms that specialize in primary market transactions
Primary market: A market where newly issued securities are offered to the public.
The investment banker typically underwrites the issue.
Secondary market: A market where pre-existing securities are traded among investors.
Definition of 'Financial Engineering'
The use of mathematical techniques to solve financial problems. Financial engineering uses tools and
knowledge from the fields of computer science, statistics, economics and applied mathematics to
address current financial issues as well as to devise new and innovative financial products. Financial
engineering is sometimes referred to as quantitative analysis and is used by regular commercial banks,
investment banks, insurance agencies and hedge funds.
Financial engineering has led to the explosion of derivative trading that we see today. Since the
Chicago Board Options Exchange was formed in 1973 and two of the first financial engineers, Fischer
Black and Myron Scholes, published their option pricing model, trading in options and other
derivatives has grown dramatically.
Investment Bankers: An individual who works in a financial institution that is in the business
primarily of raising capital for companies, governments and other entities, or who works in a large
bank's division that is involved with these activities. Investment bankers may also provide other
services to their clients such as mergers and acquisition advice, or advice on specific transactions, such
as a spin-off or reorganization. In smaller organizations that do not have a specific investment banking
arm, corporate finance staff may fulfill the duties of investment bankers. All investment bankers must
abide by their firm's stipulated code of conduct.
o Commercial and investment banks functions and organizations were separated by law from 1933
to 1999.
o In September 2008 major investment banks either went bankrupt, reorganized as commercial
banks or were purchased by commercial banks as a result of the collapse of the mortgage markets.
o Some investment banks chose to become commercial banks to obtain deposit funding and
government assistance
o All of the major investment banks are now under the much stricter commercial bank regulations.
Financial Engineering
Use of mathematical models and computer-based trading technology to synthesize new financial
products
o Bundling: Combining more than one asset into a composite security, for example securities sold
backed by a pool of mortgages.
o Unbundling: Selling separate claims to the cash flows of one security, for example a CMO
Definition of financial intermediaries
A financial intermediary is a financial institution such as bank, building society, insurance company,
and investment bank or pension fund. A financial intermediary offers a service to help an individual/
firm to save or borrow money. A financial intermediary helps to facilitate the different needs of lenders
and borrowers.
For example, if you need to borrow 1,000 you could try to find an individual who wants to lend
1,000. But, this would be very time consuming and you would find it difficult to know how reliable
the lender was. Therefore, rather than look for individuals to borrow a sum, it is more efficient to go to
a bank (a financial intermediary) to borrow money. The bank raises funds from people looking to
deposit money, and so can afford to lend out to those individuals who need it.
Examples of Financial Intermediaries
1. Insurance Companies: If you have a risky investment. You might wish to insure, against the risk
of default. Rather than trying to find a particular individual to insure you, it is easier to go to an
insurance company who can offer insurance and help spread the risk of default.
2. Financial Advisers: A financial adviser doesnt directly lend or borrow for you. They can offer
specialist advice on your behalf. It saves you understanding all the intricacies of the financial
markets and spending time looking for best investment.
3. Credit Union: Credit unions are informal types of banks which provide facilities for lending and
depositing within a particular community.
4. Mutual funds/ Investment trusts: These are mutual investment schemes. These pool the small
savings of individual investors and enable a bigger investment fund. Therefore, small investors can
benefit from being part of a larger investment trust. This enables small investors to benefit from
smaller commission rates available to big purchases.
Benefits of Financial Intermediaries
1.
2.
Spreading risk.
3.
Economies of scale.
Poor information.
4.
Convenience of Amounts.
Chapter 3
Primary vs. Secondary Market Security Sales
Primary
Public offerings: registered with the SEC and sale is made to the investing public
Private offerings: not registered, and sold to only a limited number of investors, with restrictions
on resale
Secondary
Red Herring: preliminary registration with SEC ( Securities and Exchange Commission)
Public Offerings
Public offerings: registered with the SEC and sale is made to the investing public
Security is preregistered and then may be offered at any time within the next two years.
24 hour notice, any part or all of the preregistered amount may be offered
Introduced in 1982
Figure 3.1 Relationships among a Firm Issuing Securities, the Underwriters and the Public
Sale to a limited number of sophisticated investors not requiring the protection of registration
Initial public offering (IPO) :An initial public offering (IPO) refers to the first time a
company publicly sells shares of its stock on the open market. It is also known as "going public."
Process
Road shows: distribute and gather info
Bookbuilding: finally decide price
Underpricing
Post sale returns
Cost to the issuing firm
Long term poor performer?
How it works/Example:
IPOs are introduced to the market by an underwriting investment bank, which aids the issuing
company by soliciting potential investors. In addition, the underwriter helps the issuing company to
settle on the price at which the stock should be offered to investors. IPOs represent the first time an
issuing company will financially benefit from the public sale of its stock. Following the IPO, shares
trade between buyers and sellers on the open market, whereby the underlying company receives no
compensation.
For a company, the capital earned from selling its shares to the public act can act as a major boost the
the business' growth, making the idea of an initial public offering attractive. For investors, IPOs are a
significantly higher risk as opposed to a currently traded stock.
Types of Secondary Markets: There are four types of financial markets meeting the needs
of particular trader.
1.
A situation in which buyers and sellers, especially of securities but also of other goods and servicessee
k each other out and conducttrades without brokers or other financialinstitutions mediating. This is the
opposite of an intermediated market.
Least organized
2. Brokered Markets:
A marketplace where buyers and sellers are brought together by agents or intermediaries to facilitate
price discovery and transaction execution.
3.
Dealer Markets:
A market in which securities are bought and sold through a network of dealers who buy, sell, and take
positions in various security issues.
4. Auction Markets:
A market in which buyers and sellers gather to transact business through announced bid and ask pr
ices. The organized securities exchangesare examples of auction markets.such as the NewYork Sto
ck Exchange (NYSE) and the Chicago Mercantile Exchange (CME), have traditionally handled bu
ying and selling.
Brokers & dealers trade in one location, trading is more or less continuous
Officers, directors, major stockholders must report all transactions in firms stock
-Criminal conviction
-Leakage of useful information to some traders before public announcement
-Study reports that insiders make abnormal gains over share trade.
'NASDAQ': A global electronic marketplace for buying and selling securities, as well as the
benchmark index for U.S. technology stocks. Nasdaq was created by the National Association of
Securities Dealers (NASD) to enable investors to trade securities on a computerized, speedy and
transparent system, and commenced operations on February 8, 1971. The term Nasdaq is also used
to refer to the Nasdaq Composite, an index of more than 3,000 stocks listed on the Nasdaq exchange
that includes the worlds foremost technology and biotech giants such as Apple, Google, Microsoft,
Oracle, Amazon, Intel and Amgen.
The NASDAQ is an electronic exchange where stocks are traded through an automated network. It
stands for National Association of Securities Dealers Automated Quotations System. As a general rule
of thumb, it is where most technology stocks are traded. A quick way to tell if a company is listed on
the NASDAQ is to check out the ticker symbol... those made up of four letters are listed here (e.g.
Microsoft = MSFT, Dell Computers = DELL, Cisco = CSCO)
NASDAQ: largest organized stock market for OTC trading; information system for individuals,
brokers and dealers
SuperMontage: Centralized limit order book for Nasdaq securities that allows automatic trade
execution
How it works
o Investor sends order to brokers, who contact
o Floor brokers go to
o Specialists try to find party to accept order license of floor broker is bought by the year.
Buying on Margin
o Defined: borrowing money to purchase stock.
o Initial Margin Requirement IMR (minimum set by Federal Reserve under Regulation T), currently
50% for stocks
o The IMR is the minimum % initial investor equity.
o Paying only part of price and borrowing rest from broker
o Margin in the account is part payed by investor
o Broker borrows that money from bank at broker's call rate and charges investor with that rate plus
service charge.
o Securities bought this are kept at brokers as collateral for the loan.
o Margin arrangements differ for stocks and futures
o Using only a portion of the proceeds for an investment
o Borrow remaining component
o Margin arrangements differ for stocks and futures
o Maximum margin is currently 50%; you can borrow up to 50% of the stock value Set by the Fed
o Maintenance margin: minimum amount equity in trading can be before additional funds must be
put into the account
o Margin call: notification from broker you must put up additional funds
Mechanics
Covering or closing out the position: Buy the stock and broker returns the stock title to the party
from which it was borrowed
Purpose: profit from a decline in the price of security
Solution of the problems:
9.
a.
You buy 200 shares of Telecom for $10,000. These shares increase in value by 10%, or
$1,000. You pay interest of: 0.08 $5,000 = $400
The value of the 200 shares is 200P. Equity is (200P $5,000). You will receive a margin
call when:
a.
b.
Total assets are $7,500 ($5,000 from the sale of the stock and $2,500 put up for margin).
Liabilities are 100P. Therefore, equity is ($7,500 100P). A margin call will be issued
when:
(i)
(ii)
% return = 10%
b.
= 13.33%
The value of the 500 shares is 500P. Equity is (500P $5,000). You will receive a margin
call when:
The value of the 500 shares is 500P. But now you have borrowed $10,000 instead of
$5,000. Therefore, equity is (500P $10,000). You will receive a margin call when:
(i)
= 0.1067 = 10.67%
(ii)
= 0.0267 = 2.67%
(iii)
= 0.1600 = 16.00%
The relationship between the percentage return and the percentage change in the price of
Intel is given by:
% return =
For example, when the stock price rises from $40 to $44, the percentage change in price is
10%, while the percentage gain for the investor is:
=10.67%
e.
The value of the 500 shares is 500P. Equity is (500P $5,400). You will receive a margin
call when:
a.
(ii)
c.With a $1 dividend, the short position must now pay on the borrowed shares: ($1/share 500
shares) = $500. Rate of return is now:
[(500 P) 500]/15,000
(i)
(ii)
The broker is instructed to attempt to sell your Marriott stock as soon as the Marriott stock trades
at a bid price of $20 or less. Here, the broker will attempt to execute, but may not be able to sell
at $20, since the bid price is now $19.95. The price at which you sell may be more or less than
$20 because the stop-loss becomes a market order to sell at current market prices.
16.
a.
You will not receive a margin call. You borrowed $20,000 and with another $20,000 of
your own equity you bought 1,000 shares of Disney at $40 per share. At $35 per share, the
market value of the stock is $35,000, your equity is $15,000, and the percentage margin is:
$15,000/$35,000 = 42.9%
Your percentage margin exceeds the required maintenance margin.
b.
Chapter 7
Diversification and Portfolio Risk: A nave Diversification strategy in which you include
additional securities in your portfolio. For example place half your funds in ExxonMobil and half in
Dell. To the extent that the firm specific influences on the two stocks differ, diversification should
reduce portfolio risk. For example oil prices fall hurting ExxonMobil, computer prices rise, helping
Dell. Two effects are offsetting and stabilize portfolio return.
The reduction of risk to very low levels in case of independent risk sources is sometimes called the
insurance principle, because of the notion that the insurance company depends on the risk reduction
achieved through diversification when it writes many policies insuring against many independent
sources of risk, each policy being a small part of the companys overall portfolio.
The risk that remains even after extensive diversification is called market risk, risk that attributable to
market wide risk sources. Such risk is also called systematic risk or non-diversifiable risk. In contrast,
the risk can be eliminated by diversification is called unique risk, Firm-specific risk, Diversifiable or
nonsystematic risk.
_ diversification = investing in a larger number of assets
_ sources of risk:
economy-wide factors (inflation, business cycles, exchange rates etc.) _ market (systematic) risk
firm- or asset-specific factors _ idiosyncratic (nonsystematic) risk
_ if the firm-specific risk of the assets in the portfolio is independent, diversification can reduce the
idiosyncratic risk (to zero), but not the market risk
Security Selection
All portfolios that lie on the minimum-variance frontier from the global minimum-variance
portfolio and upward provide the best risk-return combinations
We now search for the CAL with the highest reward-to-variability ratio
of return
efficient frontier = the set of portfolios on the minimum-variance frontier, with expected return
higher than that of the global minimum variance portfolio when short-sales are allowed, all
individual assets lie inside the minimum-variance frontier
Figure 7.11 The Efficient Frontier of Risky Assets with the Optimal CAL
that
]:
Bonds
Bonds
Stocks
Stocks
225
45
45
900
wMin(S) =
wMin(B) = 1 0.1739 = 0.8261
The minimum variance portfolio mean and standard deviation are:
E(rMin) = (0.1739 .20) + (0.8261 .12) = .1339 = 13.39%
Min =
= [(0.17392 900) + (0.82612 225) + (2 0.1739 0.8261 45)]1/2
= 13.92%
5.
Proportion
Proportion
Expected
Standard
in stock fund
in bond fund
return
Deviation
12.00%
13.39%
13.60%
15.20%
15.61%
16.80%
18.40%
20.00%
15.00%
13.92%
13.94%
15.70%
16.54%
19.53%
24.48%
30.00%
0.00%
17.39%
20.00%
40.00%
45.16%
60.00%
80.00%
100.00%
Graph shown below:
100.00%
82.61%
80.00%
60.00%
54.84%
40.00%
20.00%
0.00%
minimum variance
tangency portfolio
6. The above graph indicates that the optimal portfolio is the tangency portfolio with expected return
approximately 15.6% and standard deviation approximately 16.5%.
7.
The proportion of the optimal risky portfolio invested in the stock fund is given by:
The mean and standard deviation of the optimal risky portfolio are:
E(rP) = (0.4516 .20) + (0.5484 .12) = .1561
= 15.61%
p = [(0.45162 900) + (0.54842 225) + (2 0.4516 0.5484 45)]1/2
= 16.54%
8.
9.
a.
If you require that your portfolio yield an expected return of 14%, then you can find the
corresponding standard deviation from the optimal CAL. The equation for this CAL is:
If E(rC) is equal to 14%, then the standard deviation of the portfolio is 13.04%.
b.
To find the proportion invested in the T-bill fund, remember that the mean of the
complete portfolio (i.e., 14%) is an average of the T-bill rate and the optimal combination of
stocks and bonds (P). Let y be the proportion invested in the portfolio P. The mean of any
portfolio along the optimal CAL is:
Setting E(rC) = 14% we find: y = 0.7884 and (1 y) = 0.2116 (the proportion invested in the T-bill
fund).
To find the proportions invested in each of the funds, multiply 0.7884 times the respective proportions
of stocks and bonds in the optimal risky portfolio:
Proportion of stocks in complete portfolio = 0.7884 0.4516 = 0.3560
Proportion of bonds in complete portfolio = 0.7884 0.5484 = 0.4324
10.
Using only the stock and bond funds to achieve a portfolio expected return of 14%, we must
find the appropriate proportion in the stock fund (wS) and the appropriate proportion in the bond fund
(wB = 1 wS) as follows:
.14 = .20 wS + .12 (1 wS) = .12 + .08 wS wS = 0.25
So the proportions are 25% invested in the stock fund and 75% in the bond fund. The standard
deviation of this portfolio will be:
P = [(0.252 900) + (0.752 225) + (2 0.25 0.75 45)]1/2 = 14.13%
This is considerably greater than the standard deviation of 13.04% achieved using T-bills and the
optimal portfolio.
12.
Since Stock A and Stock B are perfectly negatively correlated, a risk-free portfolio can be
created and the rate of return for this portfolio, in equilibrium, will be the risk-free rate. To find the
proportions of this portfolio [with the proportion w A invested in Stock A and wB = (1 wA ) invested in
Stock B], set the standard deviation equal to zero. With perfect negative correlation, the portfolio
standard deviation is:
P = Absolute value [wAA wBB]
0 = 5 wA [10 (1 wA)] wA = 0.6667
CFA PROBLEMS
1.
a. Restricting the portfolio to 20 stocks, rather than 40 to 50 stocks, will increase the risk of the
portfolio, but it is possible that the increase in risk will be minimal. Suppose that, for
instance, the 50 stocks in a universe have the same standard deviation () and the correlations
between each pair are identical, with correlation coefficient . Then, the covariance between
each pair of stocks would be 2, and the variance of an equally weighted portfolio would be:
The effect of the reduction in n on the second term on the right-hand side would be relatively small
(since 49/50 is close to 19/20 and 2 is smaller than 2), but the denominator of the first term would
be 20 instead of 50. For example, if = 45% and = 0.2, then the standard deviation with 50 stocks
would be 20.91%, and would rise to 22.05% when only 20 stocks are held. Such an increase might
be acceptable if the expected return is increased sufficiently. Hennessy could contain the increase in
risk by making sure that he maintains reasonable diversification among the 20 stocks that remain in
his portfolio. This entails maintaining a low correlation among the remaining stocks. For example,
in part (a), with = 0.2, the increase in portfolio risk was minimal. As a practical matter, this means
that Hennessy would have to spread his portfolio among many industries; concentrating on just a few
industries would result in higher correlations among the included stocks.
2.
Risk reduction benefits from diversification are not a linear function of the number of issues in
the portfolio. Rather, the incremental benefits from additional diversification are most important
when you are least diversified. Restricting Hennessy to 10 instead of 20 issues would increase
the risk of his portfolio by a greater amount than would a reduction in the size of the portfolio
from 30 to 20 stocks. In our example, restricting the number of stocks to 10 will increase the
standard deviation to 23.81%. The 1.76% increase in standard deviation resulting from giving
up 10 of 20 stocks is greater than the 1.14% increase that result from giving up 30 of 50 stocks.
3.
The point is well taken because the committee should be concerned with the volatility of the
entire portfolio. Since Hennessys portfolio is only one of six well-diversified portfolios and is
smaller than the average, the concentration in fewer issues might have a minimal effect on the
diversification of the total fund. Hence, unleashing Hennessy to do stock picking may be
advantageous.
4.
d.