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Transcript of 1 How to pick stocks? Good company vs good stock Good company vs good stock Macroeconomic condition...
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How to pick stocks?How to pick stocks?
Good company vs good stockGood company vs good stock Macroeconomic conditionMacroeconomic condition Profitability and investmentProfitability and investment
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Price of GamblesPrice of Gambles
Gamble #1: You flip a fair coin, head Gamble #1: You flip a fair coin, head I give you $110, tail I give you $90. I give you $110, tail I give you $90. How much are you willing to pay me How much are you willing to pay me to enter this gamble?to enter this gamble?
Gamble #2: You flip a fair coin, I Gamble #2: You flip a fair coin, I give you $100 give you $100 in a yearin a year no matter no matter what happens. How much are you what happens. How much are you willing to pay me willing to pay me todaytoday to enter this to enter this gamble?gamble?
33
Consumption Consumption PreferencePreference Which do you prefer? Which do you prefer? A) Starve (nearly to death) on A) Starve (nearly to death) on
odd days and stuff on even days; odd days and stuff on even days; oror
B) Eat comfortably every day.B) Eat comfortably every day.
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Help these two ladiesHelp these two ladies
Two old ladies live in the same town. Two old ladies live in the same town. One makes a living by selling One makes a living by selling umbrellas, the other sells sunglasses. umbrellas, the other sells sunglasses. When it rains, the umbrella-selling When it rains, the umbrella-selling lady will be happy but the sunglass lady will be happy but the sunglass lady will be upset. When it is sunny, it lady will be upset. When it is sunny, it is the reverse. is the reverse.
How do you make both ladies happier How do you make both ladies happier without costing you anything?without costing you anything?
FINA 2802: Investments and Portfolio FINA 2802: Investments and Portfolio AnalysisAnalysis
Financial SecuritiesFinancial Securities
Dragon Yongjun TangDragon Yongjun Tang
January 14 & 19, 2010January 14 & 19, 2010
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Lectures 2 & 3: Lectures 2 & 3: Financial SecuritiesFinancial Securities Reading: Chapter 2Reading: Chapter 2 Practice Problem Sets: Practice Problem Sets:
1,2,3,6,8,9,11,12,13,171,2,3,6,8,9,11,12,13,17
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Learning Objectives
Distinguish among the major assets that trade in money markets and in capital markets
Describe the construction of stock market indexes
Calculate the profit or losses on investments in options and futures contracts
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Financial SecuritiesFinancial Securities
Financial Market
Fixed-income (Bonds) Equity (Stocks) Derivatives
Money Market(Short-term)
Common StocksPreferred Stocks
OptionsFutures
Low Risk High Risk
Bond Market(Long-term)
Index
99
Treasury Bills Certificates of deposit Commercial paper Banker’s acceptances Eurodollars Repos and reverses Brokers’ calls* Federal funds LIBOR
Money Market Money Market InstrumentsInstruments
1010
• Most marketable of money market instruments
• Face value paid at maturity
• Sold at a discount to face via auction
• Issue:- 28 days (1 month), 91 days (3-month) and 182 days (6 month): weekly
• Minimum denomination is $10,000
Treasury BillsTreasury Bills
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Figure 2.3 Spreads on CDs and Figure 2.3 Spreads on CDs and Treasury BillsTreasury Bills • Difficult to predict
• Widen during crisis
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Bond Market
Treasury Notes and BondsTreasury Notes and Bonds Inflation-Protected Treasury Bonds (TIPS)Inflation-Protected Treasury Bonds (TIPS) Federal Agency DebtFederal Agency Debt International BondsInternational Bonds Municipal BondsMunicipal Bonds Corporate BondsCorporate Bonds Mortgages and Mortgage-Backed Mortgages and Mortgage-Backed
SecuritiesSecurities
1515
Treasury Notes and Bonds MaturitiesMaturities
– Notes Notes –– maturities up to 10 years maturities up to 10 years– Bonds Bonds –– maturities in excess of 10 years maturities in excess of 10 years– 30-year bond30-year bond
2001 Treasury suspended sales 2001 Treasury suspended sales 2005 resume sales2005 resume sales
Par Value - $1,000Par Value - $1,000 Quotes Quotes –– percentage of par; percentage of par; in 32ndin 32nd
1717
Federal Agency Debt Major issuersMajor issuers
– Federal Home Loan BankFederal Home Loan Bank– Federal National Mortgage Association (Federal National Mortgage Association (““Fannie MaeFannie Mae””))– Government National Mortgage Association (Government National Mortgage Association (““Ginnie Ginnie
MaeMae””))– Federal Home Loan Mortgage Corporation (Federal Home Loan Mortgage Corporation (““Freddie Freddie
Mac”)Mac”)
1919
Municipal Municipal BondsBonds
Issued by state and local governmentsIssued by state and local governments TypesTypes
– General obligation bondsGeneral obligation bonds– Revenue bondsRevenue bonds
Industrial revenue bondsIndustrial revenue bonds
Maturities Maturities –– range up to 30 years range up to 30 years
2020
Municipal Bond Yields
Interest income on municipal bonds Interest income on municipal bonds is not subject to federal and is not subject to federal and sometimes state and local taxsometimes state and local tax
To compare yields on taxable To compare yields on taxable securities a Taxable Equivalent Yield securities a Taxable Equivalent Yield is constructedis constructed
Interest is exempt from Federal taxes
After-tax return (taxable bond):
After-tax return (Municipal bond):
trr taxbeforetaxafter 1
taxbeforetaxafter rr
Municipal Bonds
Equivalent Taxable Equivalent Taxable YieldYield
t
rr
rtr
t
r
r
mety
mety
m
ety
1
or
)1(
rateTax
bond municipalon yield
Yield taxableequivalent
2525
•Semiannual coupon payments•Nominal value (Par) is $1,000•Actual percentage used for quote•Current Yield=coupon/close•Volume in Thousands•Subject to larger default risk than government Subject to larger default risk than government securities securities •Options on the bonds: Options on the bonds: Callable and convertibles
Corporate BondsCorporate Bonds
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Bond Market
Treasury Notes and BondsTreasury Notes and Bonds Federal Agency DebtFederal Agency Debt International Bonds: Eurobonds; Yankee International Bonds: Eurobonds; Yankee
Bonds, Samurai bonds; Dragon bondsBonds, Samurai bonds; Dragon bonds Municipal BondsMunicipal Bonds Corporate BondsCorporate Bonds Mortgages and Mortgage-Backed Mortgages and Mortgage-Backed
SecuritiesSecurities
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Outstanding U.S. Bond Market Debt in 2006 (US$Billions)
Source: Securities Industry and Financial Markets Source: Securities Industry and Financial Markets Association (www.sifma.org)Association (www.sifma.org)
Municipal Treasury Mortgage Corporate Agency Total
Market Size 2,404.10 4,322.90 6,492.40 5,374.20 2,660.10 27,391.60Daily Trading Volume 22.5 524.7 254.6 22.7 74.4 889.8
““mini-bond”mini-bond”
Not well defined!Not well defined! Official term: credit-linked notesOfficial term: credit-linked notes Credit derivative!Credit derivative! Counterparty risk!Counterparty risk!
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3030
Equity Markets
Common stockCommon stock– Residual claimResidual claim– Limited liabilityLimited liability
Preferred stockPreferred stock– Fixed dividends - limitedFixed dividends - limited– Priority over commonPriority over common– Tax treatmentTax treatment
Depository receiptsDepository receipts
3333
What is Dow Jones?What is Dow Jones?
Charles Dow; Edward JonesCharles Dow; Edward Jones Inventors of tickersInventors of tickers Publishing WSJ, Barrons, etc.Publishing WSJ, Barrons, etc.
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Track average returnsTrack average returns Comparing performance of managersComparing performance of managers Base of derivativesBase of derivatives
Uses of Stock Indexes
3535
Representative?Representative? Broad or narrow?Broad or narrow? How is it weighted?How is it weighted?
Factors for Construction Factors for Construction of of Stock IndexesStock Indexes
3636
Examples of Indexes – U.S. Domestic
Dow Jones Industrial Average (30 Dow Jones Industrial Average (30 Stocks)Stocks)
Standard & PoorStandard & Poor’’s 500 Composites 500 Composite NASDAQ CompositeNASDAQ Composite NYSE CompositeNYSE Composite Wilshire 5000Wilshire 5000
3838
Examples of Indexes - Int’l
Hang Seng Index; Shanghai Hang Seng Index; Shanghai CompositeComposite
Nikkei 225 & Nikkei 300Nikkei 225 & Nikkei 300 FTSE (Financial Times of London)FTSE (Financial Times of London) DaxDax Region and Country IndexesRegion and Country Indexes
– EAFEEAFE– Far EastFar East– United KingdomUnited Kingdom
3939
Construction of Indexes
How are stocks selected?How are stocks selected?– SubjectiveSubjective
How are stocks weighted?How are stocks weighted?– Price weighted (DJIA)Price weighted (DJIA)– Market-value weighted (S&P500, NASDAQ)Market-value weighted (S&P500, NASDAQ)– Equally weighted (Value Line Index)Equally weighted (Value Line Index)
4040
Price Weighted IndicesPrice Weighted Indices
Computed by adding all the prices in the Computed by adding all the prices in the index and dividing by a divisorindex and dividing by a divisor
Implies one share for each stockImplies one share for each stock Implies a buy-and-hold strategyImplies a buy-and-hold strategy Gives high weight to high price stocksGives high weight to high price stocks DJIA is an exampleDJIA is an example
Derivation of Price-Derivation of Price-Weighted IndexWeighted Index
)1 at timeindex of (Value
) at timeindex of (Value
then
tat timeindex theof Value
at time stock of Price
at timeDivisor
index in the stocks ofnumber
:Let
1
11
1
1
,
tD
PI
tD
PI
I
tiP
tD
N
t
N
it
t
t
N
it
t
t
ti
t
4242
Example of Price-Weighted Example of Price-Weighted IndexIndex
Stock ABC sells initially at $25 a share with 20 Stock ABC sells initially at $25 a share with 20 million shares outstanding, while XYZ sells for $100 a million shares outstanding, while XYZ sells for $100 a share with 1 millions shares outstanding. The final share with 1 millions shares outstanding. The final price for ABC is $30, and the final price for XYZ is price for ABC is $30, and the final price for XYZ is $90.$90.(a) Find the initial and the final price-weighted index (a) Find the initial and the final price-weighted index composed of these two stocks. Assume the initial composed of these two stocks. Assume the initial divisor is 2.divisor is 2.
(b) Now if stock XYZ is split two for one, how should (b) Now if stock XYZ is split two for one, how should you adjust the divisor for the index?you adjust the divisor for the index?
4343
Value-Weighted Value-Weighted IndicesIndices
• Calculated by adding the Calculated by adding the total total market valuemarket value of the firms in the of the firms in the indexindex
• Implies buy and hold strategyImplies buy and hold strategy
• S&P 500 is an exampleS&P 500 is an example
Derivation of Value-Derivation of Value-Weighted IndexWeighted Index
)1 at timeindex of (Value
) at timeindex of (Value
change)not does n (assumingthen
tat timeindex theof Value I
tat time istock of PriceP
market in the tradedstocks i- typeofnumber totaln
index in the included stocks of typesN
:Let
,
1,
1,
1,
1
1,
,
1,
11,
1
11,1
1,
i
t
ti,
i
ti
tiN
ii
ti
tiN
iN
itii
tiiN
itii
N
itii
t
N
itiit
N
itiit
P
Pw
P
P
Pn
Pn
Pn
PnR
tPnI
tPnI
4545
Example of Value-Weighted Example of Value-Weighted IndexIndex
Stock ABC sells initially at $25 a share with 20 Stock ABC sells initially at $25 a share with 20 million shares outstanding, while XYZ sells for $100 million shares outstanding, while XYZ sells for $100 a share with 1 millions shares outstanding. The final a share with 1 millions shares outstanding. The final price for ABC is $30, and the final price for XYZ is price for ABC is $30, and the final price for XYZ is $90.$90.
4646
Example of Value-Weighted Example of Value-Weighted IndexIndex
(a) Find the the value-weighted index composed of (a) Find the the value-weighted index composed of these two stocks at the final date. Assume the initial these two stocks at the final date. Assume the initial level of the index is 100.level of the index is 100.
(b) Now if stock XYZ is split two for one, how will (b) Now if stock XYZ is split two for one, how will the market value-weighted index be affected?the market value-weighted index be affected?
4747
Equally Weighted Equally Weighted IndicesIndices
Computed by assumingComputed by assuming equal dollar equal dollar amountamount in each stockin each stock
Implies periodic rebalancing of the portfolio Implies periodic rebalancing of the portfolio (no buy and hold)(no buy and hold)
CRSP index is an exampleCRSP index is an example
Derivation of Equally Derivation of Equally Weighted IndexWeighted Index
1
)1 at timeindex of (Value
) at timeindex of (Value
then
tat timeindex theof Value
at time stock of Price
stockeach in $ ofAmount
index in the stocks ofnumber
:Let
,
1,
1
1,1 ,1
1
1,1 ,
1
,1 ,
,
ti
tiN
i
ti
N
i ti
t
tt
ti
N
i tit
ti
N
i tit
t
ti
P
P
NMN
PPM
I
IR
tPP
MI
tMNPP
MI
I
tiP
M
N
4949
Example of Equally Weighted Example of Equally Weighted IndexIndex
Stock ABC sells initially at $25 a share with 20 Stock ABC sells initially at $25 a share with 20 million shares outstanding, while XYZ sells for $100 million shares outstanding, while XYZ sells for $100 a share with 1 millions shares outstanding. The final a share with 1 millions shares outstanding. The final price for ABC is $30, and the final price for XYZ is price for ABC is $30, and the final price for XYZ is $90.$90.
5050
Example of Equally Weighted Example of Equally Weighted IndexIndex
(a) Find the the equally weighted index composed of (a) Find the the equally weighted index composed of these two stocks at the final date. Assume initially these two stocks at the final date. Assume initially $100 are invested in each stock.$100 are invested in each stock.
(b) At the final date, how should you rebalance your (b) At the final date, how should you rebalance your portfolio to have an equally weighted portfolio?portfolio to have an equally weighted portfolio?
5151
Hang Seng IndexHang Seng Index
Freefloat-adjusted market capitalization weighted– Exclude shareholdings with lock-up arrangementExclude shareholdings with lock-up arrangement
15% cap on individual stock weightings15% cap on individual stock weightings
Re-capping Q1 & Q3Re-capping Q1 & Q3
H-shares includedH-shares included
5252
Computed monthly
Difficulty in measuring true returns
Best known:Merrill LynchLehman BrothersSalomon Smith Barney
Bond IndexBond Index
5353
Derivatives Securities
OptionsOptions Basic PositionsBasic Positions
– Call (Buy)Call (Buy)– Put (Sell)Put (Sell)
TermsTerms– Exercise PriceExercise Price– Expiration DateExpiration Date– AssetsAssets
Futures Futures Basic PositionsBasic Positions
– Long (Buy)Long (Buy)– Short (Sell)Short (Sell)
TermsTerms– Delivery DateDelivery Date– AssetsAssets
5454
Call option - the right to buy
Put option - the right to sell
Hedgers protect themselvesjust in case
OptionsOptions
600 500 400
200
0
Dow Chemical 85 July Call - Buy 1 Call
Profit
Break even
Loss
Common stock price
Premium = 1 3/8
-137.5 -200
-400 -500
Profit / Loss
Payoff
85 863/8 90 913/8
Long Call Profit or Long Call Profit or LossLoss
5656
Tuesday, January 15, 2002
--- Call --- --- Put --- Option/Strike Exp. Vol. Last Vol. Last AmOnline 25 Apr 20 5.90 10092 1.15 30.03 27.5 Apr 24 4.20 5135 1.80
30.03 30 Jan 5271 0.50 1106 0.50 30.03 32.5 Apr 225 1.70 15218 4.20
30.03 35 Apr 379 1.05 5636 5.80
Option QuotesOption Quotes
5757
Option ValuationOption Valuation
Binomial Tree Approach: Replicating option payoffs with stocks and bonds
C=26.85C=26.85 Black-Scholes FormulaBlack-Scholes Formula
100
200
50
Stock Price
C
75
0
Call Option Value X = 125
Alternative PortfolioBuy 1 share of stock at $100Borrow $46.30 (8% Rate)Net outlay $53.70PayoffValue of Stock 50 200Repay loan - 50 -50Net Payoff 0 150
53.70
150
0
Payoff Structureis exactly 2 timesthe Call
FIN 8330 Lecture 9 10/25/07FIN 8330 Lecture 9 10/25/075858
The Black-Scholes The Black-Scholes FormulaFormula
The Black-Scholes option pricing formulaThe Black-Scholes option pricing formula– For a European call option on a stock paying no dividendFor a European call option on a stock paying no dividend
– N(d) = probability that a random draw from a normal N(d) = probability that a random draw from a normal dist. will be less than d.dist. will be less than d.
– The option value does The option value does notnot depend on the expected return depend on the expected return on the stock (risk-neutral valuation)on the stock (risk-neutral valuation)
210 dNeXdNSC TRFR
TTRFRXd
2Sln
2
1
Tdd 12
5959
Warrant/Put Warrant/Put WarrantWarrant
Essentially, call/put options issued by Essentially, call/put options issued by a a firmfirm
Difference: warrant exercise Difference: warrant exercise requires firm to issue new shares requires firm to issue new shares ((ownership dilution!ownership dilution!))
See page 717 of the textbook for See page 717 of the textbook for more details.more details.
6060
Obligation not right
Agree on price for a future date
Used by hedgers not just speculators
Futures Futures ContractsContracts
6161
Payoff Profile of Futures Payoff Profile of Futures ContractContract
PPTT: Underlying Asset Price at expiration,: Underlying Asset Price at expiration, F: Agreed upon priceF: Agreed upon pricePayoff (profit) at expiration. Payoff (profit) at expiration.
PT
F
F
Payoff=Profit Long: PT – F
Short: F- PT
-F
6262
Friday, November 30, 2001 Open interest reflects previous trading day
INDEX
S&P 500 INDEX (CME) $250 times index Open Open High Low Settle Chg High Low Interest Dec 114430 114450 113500 114000 -450 171,460 93900 411,751 Mar02 114050 114500 113750 114150 -450 134960 94100 140,466 Est vol 74,399; vol Thu 113,669; open int 561,312, +1,760. Idx prl High 1143.57; Low 1135.89; Close 1139.45 –0.75
Futures QuotesFutures Quotes
6363
Spot-futures parity theoremSpot-futures parity theorem - two ways to - two ways to acquire an asset for some date in the futureacquire an asset for some date in the future– Purchase it now and store itPurchase it now and store it– Take a long position in futuresTake a long position in futures– These two strategies must have the same market These two strategies must have the same market
determined costsdetermined costs With a perfect hedge the futures payoff is certain With a perfect hedge the futures payoff is certain
-- there is no risk-- there is no risk A perfect hedge should return the riskless rate of A perfect hedge should return the riskless rate of
returnreturn
Futures PricingFutures Pricing
6464
Help these two ladiesHelp these two ladies
How do you make both ladies How do you make both ladies happier without costing you happier without costing you anything?anything?
Option/Futures contractsOption/Futures contracts Sign an agreement with umbrella-Sign an agreement with umbrella-
selling lady, pay her $5 if it shines, selling lady, pay her $5 if it shines, she pays you $5 if it rains. The she pays you $5 if it rains. The reverse with sunglasses-selling lady.reverse with sunglasses-selling lady.
Weather derivativesWeather derivatives
6565
Key to Derivatives Key to Derivatives Pricing: Pricing: No ArbitrageNo Arbitrage The current prices of asset 1 and asset 2 are 95 The current prices of asset 1 and asset 2 are 95
and 43and 43 Tomorrow, one of two states will come trueTomorrow, one of two states will come true
– A good state where the prices go up orA good state where the prices go up or– A bad state where the prices go downA bad state where the prices go down
Asset1 = 100Asset1 = 100
Asset2 = 50Asset2 = 50
Asset1 = 95Asset1 = 95
Asset2 = 43Asset2 = 43
Asset1 = 80Asset1 = 80
Asset2 = 40Asset2 = 40
Do you see any possibility to make risk-free money Do you see any possibility to make risk-free money out of this situation?out of this situation?
6666
There is no free lunch!There is no free lunch!
Return
Risk
less risk
lessreturn
more risk
morereturn
Money
T-Bonds
Corporate Bonds
Stocks
Derivatives