1 Bodie Kane Marcus Essentials of Investments Fourth
1 Bodie • Kane • Marcus Essentials of Investments Fourth Edition Chapter 1 Investments - Background and Issues Irwin / Mc. Graw-Hill © 2001 The Mc. Graw-Hill Companies, Inc. All rights reserved.
2 Essentials of Investments Bodie • Kane • Marcus Fourth Edition Investments & Financial Assets • Essential nature of investment – Reduced current consumption – Planned later consumption • Real Assets – Assets used to produce goods and services • Financial Assets – Claims on real assets Irwin / Mc. Graw-Hill © 2001 The Mc. Graw-Hill Companies, Inc. All rights reserved.
3 Bodie • Kane • Marcus Essentials of Investments Fourth Edition The Investment Process • • • Asset allocation Security selection Risk-return trade-off Market efficiency Active vs. passive management Irwin / Mc. Graw-Hill © 2001 The Mc. Graw-Hill Companies, Inc. All rights reserved.
4 Bodie • Kane • Marcus Essentials of Investments Fourth Edition Active vs. Passive Management Active Management • Finding undervalued securities • Timing the market Passive Management • No attempt to find undervalued securities • No attempt to time • Holding an efficient portfolio Irwin / Mc. Graw-Hill © 2001 The Mc. Graw-Hill Companies, Inc. All rights reserved.
5 Essentials of Investments Bodie • Kane • Marcus Fourth Edition Major Classes of Financial Assets or Securities • Debt – Money market instruments – Bonds • Common stock • Preferred stock • Derivative securities Irwin / Mc. Graw-Hill © 2001 The Mc. Graw-Hill Companies, Inc. All rights reserved.
6 Bodie • Kane • Marcus Essentials of Investments Fourth Edition Investments and Innovation Technology and Delivery of Service • Computer advancements • More complete and timely information Globalization • Domestic firms compete in global markets • Performance in regions depends on other regions • Causes additional elements of risk Irwin / Mc. Graw-Hill © 2001 The Mc. Graw-Hill Companies, Inc. All rights reserved.
7 Bodie • Kane • Marcus Essentials of Investments Fourth Edition Key Trends - Globalization International and Global Markets Continue Developing • Managing foreign exchange • Diversification to improve performance • Instruments and vehicles continue to develop • Information and analysis improves Irwin / Mc. Graw-Hill © 2001 The Mc. Graw-Hill Companies, Inc. All rights reserved.
8 Bodie • Kane • Marcus Essentials of Investments Fourth Edition Key Trends - Securitization & Credit Enhancement • Offers opportunities for investors and originators • Changes in financial institutions and regulation • Improvement in information capabilities • Credit enhancement and its role Irwin / Mc. Graw-Hill © 2001 The Mc. Graw-Hill Companies, Inc. All rights reserved.
9 Bodie • Kane • Marcus Essentials of Investments Key Trends Financial Engineering Fourth Edition Repackaging Services of Financial Intermediaries • Bundling and unbundling of cash flows • Slicing and dicing of cash flows • Examples: strips, CMOs, dual purpose funds, principal/interest splits Irwin / Mc. Graw-Hill © 2001 The Mc. Graw-Hill Companies, Inc. All rights reserved.
10 Bodie • Kane • Marcus Essentials of Investments Fourth Edition The Future • Globalization continues and offers more opportunities • Securitization continues to develop • Continued development of derivatives and exotics • Strong fundamental foundation is critical • Integration of investments & corporate finance Irwin / Mc. Graw-Hill © 2001 The Mc. Graw-Hill Companies, Inc. All rights reserved.
11 Bodie • Kane • Marcus Essentials of Investments Fourth Edition Chapter 2 Financial Markets and Instruments Irwin / Mc. Graw-Hill © 2001 The Mc. Graw-Hill Companies, Inc. All rights reserved.
12 Essentials of Investments Bodie • Kane • Marcus Fourth Edition Major Classes of Financial Assets or Securities • Debt – Money market instruments – Bonds • Common stock • Preferred stock • Derivative securities Irwin / Mc. Graw-Hill © 2001 The Mc. Graw-Hill Companies, Inc. All rights reserved.
13 Bodie • Kane • Marcus Essentials of Investments Fourth Edition Markets and Instruments • Money Market – Debt Instruments – Derivatives • Capital Market – Bonds – Equity – Derivatives Irwin / Mc. Graw-Hill © 2001 The Mc. Graw-Hill Companies, Inc. All rights reserved.
14 Bodie • Kane • Marcus Essentials of Investments Fourth Edition Money Market Instruments • • • Treasury bills Certificates of deposit Commercial Paper Bankers Acceptances Eurodollars Repurchase Agreements (RPs) and Reverse RPs • Federal Funds Irwin / Mc. Graw-Hill © 2001 The Mc. Graw-Hill Companies, Inc. All rights reserved.
15 Bodie • Kane • Marcus Essentials of Investments Fourth Edition Money Market Instrument Yields • Yields on Money Market Instruments are not always directly comparable Factors influencing yields • Par value vs. investment value • 360 vs. 365 days assumed in a year (366 leap year) • Bond equivalent yield Irwin / Mc. Graw-Hill © 2001 The Mc. Graw-Hill Companies, Inc. All rights reserved.
16 Bodie • Kane • Marcus Essentials of Investments Fourth Edition Interest rates that arise in connection with money market securities. Bank discount rate (r. BD ). This is a rate that is used solely for determining the price of a MM security for trading purposes. . Bond equivalent yield (r. BEY ). In general, a yield is an interest rate that (under very specific, sometimes unrealistic, assumptions) represents a rate of return. . r. BEY is such a rate of return. It is an annual percentage rate (APR). For comparing different MM instruments, we often use the effective annual rate (EAR) of the r. BEY. Irwin / Mc. Graw-Hill © 2001 The Mc. Graw-Hill Companies, Inc. All rights reserved.
17 Essentials of Investments Bodie • Kane • Marcus Fourth Edition Bank Discount Rate (T-Bills) 10, 000 - P 360 r BD = x n 10, 000 r. BD = bank discount rate P = market price of the T-bill n = number of days to maturity Example 90 -day T-bill, P = $9, 875 10, 000 - 9, 875 r BD = x 10, 000 Irwin / Mc. Graw-Hill 360 90 = 5% © 2001 The Mc. Graw-Hill Companies, Inc. All rights reserved.
18 Essentials of Investments Bodie • Kane • Marcus Fourth Edition Bond Equivalent Yield • Can’t compare T-bill directly to bond – 360 vs 365 days – Return is figured on par vs. price paid • Adjust the bank discounted rate to make it comparable Irwin / Mc. Graw-Hill © 2001 The Mc. Graw-Hill Companies, Inc. All rights reserved.
19 Essentials of Investments Bodie • Kane • Marcus Fourth Edition Bond Equivalent Yield r BEY 10, 000 - P 365 = x n P P = price of the T-bill n = number of days to maturity Example Using Sample T-Bill 10, 000 - 9, 875 365 r BEY = x 9, 875 90 r. BEY =. 0127 x 4. 0556 =. 0513 = 5. 13% Irwin / Mc. Graw-Hill © 2001 The Mc. Graw-Hill Companies, Inc. All rights reserved.
20 Bodie • Kane • Marcus Essentials of Investments Capital Market - Fixed Income Instruments Fourth Edition Publicly Issued Instruments • US Treasury Bonds and Notes • Agency Issues (Fed Gov) • Municipal Bonds Privately Issued Instruments • Corporate Bonds • Mortgage-Backed Securities Irwin / Mc. Graw-Hill © 2001 The Mc. Graw-Hill Companies, Inc. All rights reserved.
21 Essentials of Investments Bodie • Kane • Marcus Fourth Edition Capital Market - Equity • Common stock – Residual claim – Limited liability • Preferred stock – Fixed dividends - limited – Priority over common – Tax treatment Irwin / Mc. Graw-Hill © 2001 The Mc. Graw-Hill Companies, Inc. All rights reserved.
22 Bodie • Kane • Marcus Essentials of Investments Fourth Edition Stock Indexes Uses • Track average returns • Comparing performance of managers • Base of derivatives Factors in constructing or using an Index • Representative? • Broad or narrow? • How is it constructed? Irwin / Mc. Graw-Hill © 2001 The Mc. Graw-Hill Companies, Inc. All rights reserved.
23 Bodie • Kane • Marcus Essentials of Investments Fourth Edition Examples of Indexes - Domestic • Dow Jones Industrial Average (30 Stocks) • Standard & Poor’s 500 Composite • NASDAQ Composite • NYSE Composite • Wilshire 5000 Irwin / Mc. Graw-Hill © 2001 The Mc. Graw-Hill Companies, Inc. All rights reserved.
24 Bodie • Kane • Marcus Essentials of Investments Fourth Edition Examples of Indexes - Int’l • • Nikkei 225 & Nikkei 300 FTSE (Financial Times of London) Dax Region and Country Indexes – EAFE – Far East – United Kingdom Irwin / Mc. Graw-Hill © 2001 The Mc. Graw-Hill Companies, Inc. All rights reserved.
25 Bodie • Kane • Marcus Essentials of Investments Fourth Edition Construction of Indexes • How are stocks weighted? – Price weighted (DJIA) – Market-value weighted (S&P 500, NASDAQ) – Equally weighted (Value Line Index) Irwin / Mc. Graw-Hill © 2001 The Mc. Graw-Hill Companies, Inc. All rights reserved.
26 Bodie • Kane • Marcus Essentials of Investments Fourth Edition Example. Suppose we have two stocks #Shares Stock Pr 9/19/01 Pr 9/20/01 Return Outstand A 100 120 20% 10 M B 10 9 – 10% 500 M. Computation of a price-weighted index (like the Dow). Index on 9/19/01 (100+10)/2 = 55 Index on 9/20/01 (120+9)/2 = 64. 5 Return on index 17. 27%. This is called a price-weighted index because the index return is the price-weighted average of the component (100/110) x 20% + (10/110) x – 10% = 17. 27%. Portfolio: one share in each stock. Irwin / Mc. Graw-Hill © 2001 The Mc. Graw-Hill Companies, Inc. All rights reserved.
27 Bodie • Kane • Marcus Essentials of Investments Fourth Edition Market-value weighted index. A market-value weighted average (like the S&P). . Index on 9/19/01 = “ 100” (an arbitary base level). Market value of A = $100 x 10 M = $1, 000 M Market value of B = $10 x 500 M = $5, 000 M. Return on index is (1, 000/6, 000) x 20% + (5, 000/6000) x – 10% = – 5%. Index on 9/20/01 = 100 x (1– 5%) = 95. Portfolio: 1/6 in A; 5/6 in B. An equally-weighted index (like the Wilshire 5000). Index on 9/19/01 = “ 100” (an arbitary base level). Return on index is (20% + – 10%)/2 = +5%. Index on 9/20/01 = 100 x (1+5%) = 105. Portfolio: equal amounts in A and B Irwin / Mc. Graw-Hill © 2001 The Mc. Graw-Hill Companies, Inc. All rights reserved.
28 Bodie • Kane • Marcus Essentials of Investments Fourth Edition Chapter 3 How Securities are Traded Irwin / Mc. Graw-Hill © 2001 The Mc. Graw-Hill Companies, Inc. All rights reserved.
29 Bodie • Kane • Marcus Essentials of Investments Fourth Edition Primary vs. Secondary Security Sales • Primary – New issue – Key factor: issuer receives the proceeds from the sale • Secondary – Existing owner sells to another party – Issuing firm doesn’t receive proceeds and is not directly involved Irwin / Mc. Graw-Hill © 2001 The Mc. Graw-Hill Companies, Inc. All rights reserved.
30 Bodie • Kane • Marcus Essentials of Investments Fourth Edition Investment Banking Arrangements • Underwritten vs. “Best Efforts” – Underwritten: firm commitment on proceeds to the issuing firm – Best Efforts: no firm commitment • Negotiated vs. Competitive Bid – Negotiated: issuing firm negotiates terms with investment banker – Competitive bid: issuer structures the offering and secures bids Irwin / Mc. Graw-Hill © 2001 The Mc. Graw-Hill Companies, Inc. All rights reserved.
31 Essentials of Investments Bodie • Kane • Marcus Fourth Edition Public Offerings • Public offerings: registered with the SEC and sale is made to the investing public – Shelf registration (Rule 415, since 1982) • Initial Public Offerings (IPOs) – Evidence of underpricing – Performance Irwin / Mc. Graw-Hill © 2001 The Mc. Graw-Hill Companies, Inc. All rights reserved.
32 Essentials of Investments Bodie • Kane • Marcus Fourth Edition Private Placements Private placement: sale to a limited number of sophisticated investors not requiring the protection of registration • Dominated by institutions • Very active market for debt securities • Not active for stock offerings Irwin / Mc. Graw-Hill © 2001 The Mc. Graw-Hill Companies, Inc. All rights reserved.
33 Essentials of Investments Bodie • Kane • Marcus Fourth Edition Organization of Secondary Markets • • Organized exchanges OTC market Third market Fourth market Irwin / Mc. Graw-Hill © 2001 The Mc. Graw-Hill Companies, Inc. All rights reserved.
34 Essentials of Investments Bodie • Kane • Marcus Fourth Edition Organized Exchanges • Auction markets with centralized order flow • Dealership function: can be competitive or assigned by the exchange (Specialists) • Securities: stock, futures contracts, options, and to a lesser extent, bonds • Examples: NYSE, AMEX, Regionals, CBOE Irwin / Mc. Graw-Hill © 2001 The Mc. Graw-Hill Companies, Inc. All rights reserved.
35 Bodie • Kane • Marcus Essentials of Investments Fourth Edition Types of Orders Instructions to the brokers on how to complete the order • Market • Limit • Stop loss Irwin / Mc. Graw-Hill © 2001 The Mc. Graw-Hill Companies, Inc. All rights reserved.
36 Bodie • Kane • Marcus Essentials of Investments Fourth Edition Margin Trading • Using only a portion of the proceeds for an investment • Borrow remaining component • Margin arrangements differ for stocks and futures Irwin / Mc. Graw-Hill © 2001 The Mc. Graw-Hill Companies, Inc. All rights reserved.
37 Essentials of Investments Bodie • Kane • Marcus Fourth Edition Stock Margin Trading • Maximum margin is currently 50%; you can borrow up to 50% of the stock value • Set by the Fed • Maintenance margin: minimum amount equity in trading can be before additional funds must be put into the account • Margin call: notification from broker you must put up additional funds Irwin / Mc. Graw-Hill © 2001 The Mc. Graw-Hill Companies, Inc. All rights reserved.
38 Bodie • Kane • Marcus Essentials of Investments Fourth Edition Margin Trading - Initial Conditions X Corp $70 50% Initial Margin 40% Maintenance Margin 1000 Shares Purchased Initial Position Stock $70, 000 Borrowed $35, 000 Equity 35, 000 Irwin / Mc. Graw-Hill © 2001 The Mc. Graw-Hill Companies, Inc. All rights reserved.
39 Bodie • Kane • Marcus Essentials of Investments Fourth Edition Margin Trading - Maintenance Margin Stock price falls to $60 per share New Position Stock $60, 000 Borrowed $35, 000 Equity 25, 000 Margin% = $25, 000/$60, 000 = 41. 67% Irwin / Mc. Graw-Hill © 2001 The Mc. Graw-Hill Companies, Inc. All rights reserved.
40 Bodie • Kane • Marcus Essentials of Investments Fourth Edition Margin Trading - Margin Call How far can the stock price fall before a margin call? (1000 P - $35, 000)* / 1000 P = 40% P = $58. 33 * 1000 P - Amt Borrowed = Equity Irwin / Mc. Graw-Hill © 2001 The Mc. Graw-Hill Companies, Inc. All rights reserved.
41 Bodie • Kane • Marcus Essentials of Investments Fourth Edition Short Sales Purpose: to profit from a decline in the price of a stock or security Mechanics • Borrow stock through a dealer • Sell it and deposit proceeds and margin in an account • Closing out the position: buy the stock and return to the party from which is was borrowed Irwin / Mc. Graw-Hill © 2001 The Mc. Graw-Hill Companies, Inc. All rights reserved.
42 Essentials of Investments Bodie • Kane • Marcus Fourth Edition Short Sale - Initial Conditions Z Corp 50% 30% $100 Shares Initial Margin Maintenance Margin Initial Price Sale Proceeds $10, 000 Margin & Equity 5, 000 Stock Owed 10, 000 Irwin / Mc. Graw-Hill © 2001 The Mc. Graw-Hill Companies, Inc. All rights reserved.
43 Essentials of Investments Bodie • Kane • Marcus Fourth Edition Short Sale - Maintenance Margin Stock Price Rises to $110 Sale Proceeds $10, 000 Initial Margin 5, 000 Stock Owed 11, 000 Net Equity 4, 000 Margin % (4000/11000) 36% Irwin / Mc. Graw-Hill © 2001 The Mc. Graw-Hill Companies, Inc. All rights reserved.
44 Bodie • Kane • Marcus Essentials of Investments Fourth Edition Short Sale - Margin Call How much can the stock price rise before a margin call? ($15, 000* - 100 P) / (100 P) = 30% P = $115. 38 * Initial margin plus sale proceeds Irwin / Mc. Graw-Hill © 2001 The Mc. Graw-Hill Companies, Inc. All rights reserved.
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