CHAPTER 1 The Investment Environment Investments 8 th

CHAPTER 1 The Investment Environment Investments, 8 th edition Bodie, Kane and Marcus Slides by Susan Hine Mc. Graw-Hill/Irwin Copyright © 2009 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Real Assets Versus 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 1 -2

Table 1. 1 Balance Sheet of U. S. Households, 2007 1 -3

Table 1. 2 Domestic Net Worth 1 -4

A Taxonomy of Financial Assets • Fixed income or debt – Money market instruments • Bank certificates of deposit – Capital market instruments • Bonds • Common stock or equity • Derivative securities 1 -5

Financial Markets and the Economy • Information Role – The Google effect • Consumption Timing • Allocation of Risk • Separation of Ownership and Management – Agency Issues 1 -6

Financial Markets and the Economy Continued • Corporate Governance and Corporate Ethics – Accounting Scandals • Examples – Enron, Rite Aid, Health. South – Auditors—watchdogs of the firms – Analyst Scandals • Arthur Andersen – Sarbanes-Oxley Act • Tighten the rules of corporate governance 1 -7

The Investment Process • Asset allocation – Choice among broad asset classes • Security selection – Choice of which securities to hold within asset class • Security analysis 1 -8

Markets are Competitive • Risk-Return Trade-Off • Efficient Markets – Active Management • Finding mispriced securities • Timing the market – Passive Management • No attempt to find undervalued securities • No attempt to time the market • Holding a highly diversified portfolio 1 -9

The Players • Business Firms– net borrowers • Households – net savers • Governments – can be both borrowers and savers • Financial Intermediaries – Investment Companies – Banks – Insurance companies – Credit unions 1 -10

The Players Continued • Investment Bankers – Perform specialized services for businesses – Markets in the primary market 1 -11

Table 1. 3 Balance Sheet of Commercial Banks, 2007 1 -12

Table 1. 4 Balance Sheet of Nonfinancial U. S. Business, 2007 1 -13

Recent Trends—Globalization • • American Depository Receipts (ADRs) Foreign securities offered in dollars Mutual funds that invest internationally Instruments and vehicles continue to develop (WEBs) • Exchange Traded Funds (ETFs) 1 -14

Figure 1. 1 Globalization: A Debt Issue Denominated in Euros 1 -15

Recent Trends—Securitization • Mortgage pass-through securities • Other pass-through arrangements – Car, student, home equity, credit card loans • Offers opportunities for investors and originators 1 -16

Figure 1. 2 Asset-backed Securities Outstanding 1 -17

Recent Trends—Financial Engineering • Use of mathematical models and computerbased trading technology to synthesize new financial products • Bundling and unbundling of cash flows 1 -18

Figure 1. 3 Building Creates a Complex Security 1 -19

Figure 1. 4 Unbundling of Mortgages into Principal- and Interest-Only Securities 1 -20

Recent Trends—Computer Networks • Online information dissemination • Information is made cheaply and widely available to the public • Automated trade crossing – Direct trading among investors 1 -21

CHAPTER 2 Asset Classes and Financial Instruments Investments, 8 th edition Bodie, Kane and Marcus Slides by Susan Hine Mc. Graw-Hill/Irwin Copyright © 2009 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Major Classes of Financial Assets or Securities • • • Money market Bond market Equity Securities Indexes Derivative markets 1 -23

The Money Market • Treasury bills – Bid and asked price – Bank discount method • Certificates of Deposits • Commercial Paper • Bankers Acceptances 1 -24

The Money Market Continued • Eurodollars • Repurchase Agreements (RPs) and Reverse RPs • Brokers’ Calls • Federal Funds • LIBOR Market 1 -25

Figure 2. 1 Rates on Money Market Securities 1 -26

Table 2. 1 Major Components of the Money Market 1 -27

Figure 2. 2 Treasury Bill Yields 1 -28

Figure 2. 3 The Spread between 3 -month CD and Treasury Bill Rates 1 -29

The Bond Market • • Treasury Notes and Bonds Inflation-Protected Treasury Bonds Federal Agency Debt International Bonds Municipal Bonds Corporate Bonds Mortgages and Mortgage-Backed Securities 1 -30

Treasury Notes and Bonds • Maturities – Notes – maturities up to 10 years – Bonds – maturities in excess of 10 years – 30 -year bond • Par Value - $1, 000 • Quotes – percentage of par 1 -31

Figure 2. 4 Lisiting of Treasury Issues 1 -32

Federal Agency Debt • Major issuers – Federal Home Loan Bank – Federal National Mortgage Association – Government National Mortgage Association – Federal Home Loan Mortgage Corporation 1 -33

Municipal Bonds • Issued by state and local governments • Types – General obligation bonds – Revenue bonds • Industrial revenue bonds • Maturities – range up to 30 years 1 -34

Figure 2. 5 Tax-exempt Debt Outstanding 1 -35

Municipal Bond Yields • Interest income on municipal bonds is not subject to federal and sometimes not to state and local tax • To compare yields on taxable securities a Taxable Equivalent Yield is constructed 1 -36

Table 2. 2 Equivalent Taxable Yields Corresponding to Various Tax-Exempt Yields 1 -37

Figure 2. 6 Ratio of Yields on Tax-Exempt to Taxable Bonds 1 -38

Corporate Bonds • Issued by private firms • Semi-annual interest payments • Subject to larger default risk than government securities • Options in corporate bonds – Callable – Convertible 1 -39

Mortgages and Mortgage-Backed Securities • Developed in the 1970 s to help liquidity of financial institutions • Proportional ownership of a pool or a specified obligation secured by a pool • Market has experienced very high rates of growth 1 -40

Figure 2. 7 Mortgage-backed Securities Outstanding, 1979 -2007 1 -41

Equity Securities • Common stock – Residual claim – Limited liability • Preferred stock – Fixed dividends -limited – Priority over common – Tax treatment • Depository receipts 1 -42

Figure 2. 8 Listing of Stocks Traded on the NYSE 1 -43

Stock Market Indexes • There are several broadly based indexes computed and published daily • There are several indexes of bond market performance • Others include: – Nikkei Average – Financial Times Index 1 -44

Dow Jones Industrial Average • Includes 30 large blue-chip corporations • Computed since 1896 • Price-weighted average 1 -45

Example 2. 2 Price-Weighted Average Portfolio: Initial value $25 + $100 = $125 Final value $30 + $ 90 = $120 Percentage change in portfolio value = 5/125 = -. 04 = -4% Index: Initial index value (25+100)/2 = 62. 5 Final index value (30 + 90)/2 = 60 Percentage change in index -2. 5/62. 5 = -. 04 = -4% 1 -46

Standard & Poor’s Indexes • Broadly based index of 500 firms • Market-value-weighted index • Index funds • Exchange Traded Funds (ETFs) 1 -47

Other U. S. Market-Value Indexes • NASDAQ Composite • NYSE Composite • Wilshire 5000 1 -48

Figure 2. 9 Comparative Performance of Several Stock Indexes, 2001 -2006 1 -49

Foreign and International Stock Market Indexes • Nikkei (Japan) • FTSE (Financial Times of London) • Dax (Germany) • MSCI (Morgan Stanley Capital International) • Hang Seng (Hong Kong) • TSX (Canada) 1 -50

Derivatives Markets Options • Basic Positions – Call (Buy) – Put (Sell) • Terms – Exercise Price – Expiration Date – Assets Futures • Basic Positions – Long (Buy) – Short (Sell) • Terms – Delivery Date – Assets 1 -51

Figure 2. 10 Trading Data on GE Options 1 -52

Figure 2. 11 Listing of Selected Futures Contracts 1 -53

CHAPTER 3 How Securities are Traded Investments, 8 th edition Bodie, Kane and Marcus Slides by Susan Hine Mc. Graw-Hill/Irwin Copyright © 2009 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

How Firms Issue Securities • 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 1 -55

How Firms Issue Securities Continued • Investment Banking • Shelf Registration • Private Placements • Initial Public Offerings (IPOs) 1 -56

Investment Banking • Underwritten: firm commitment on proceeds to the issuing firm • Red herring • Prospectus 1 -57

Figure 3. 1 Relationship Among a Firm Issuing Securities, the Underwriters and the Public 1 -58

Shelf Registrations • SEC Rule 415 • Introduced in 1982 • Ready to be issued – on the shelf 1 -59

Private Placements • Sale to a limited number of sophisticated investors not requiring the protection of registration • Allowed under Rule 144 A • Dominated by institutions • Very active market for debt securities • Not active for stock offerings 1 -60

Initial Public Offerings • Process – Road shows – Bookbuilding • Underpricing – Post sale returns – Cost to the issuing firm 1 -61

Figure 3. 2 Average Initial Returns for IPOs in Various Countries 1 -62

Figure 3. 3 Long-term Relative Performance of Initial Public Offerings 1 -63

How Securities are Traded • Types of Markets – Direct search • Least organized – Brokered • Trading in a good is active – Dealer • Trading in a particular type of asset increases – Auction • Most integrated 1 -64

Types of Orders • Market—executed immediately – Bid Price – Ask Price • Price-contingent – Investors specify prices – Stop orders 1 -65

Figure 3. 4 The Limit Order Book for Intel on the Archipelago Market, January 19, 2007 1 -66

Figure 3. 5 Price-Contingent Orders 1 -67

Trading Mechanisms • Dealer markets • Electronic communication networks (ECNs) • Specialists markets 1 -68

U. S. Security Markets • Nasdaq and NYSE have evolved in response to new information technology • Both have increased their commitment to automated electronic trading 1 -69

Nasdaq • National Market System • Nasdaq Small Cap Market • Levels of subscribers – Level 1 – inside quotes – Level 2 – receives all quotes but they can’t enter quotes – Level 3 – dealers making markets 1 -70

Table 3. 1 Partial Requirements for Listing on NASDAQ Markets 1 -71

New York Stock Exchange • Member functions – Commission brokers – Floor brokers – Specialists • Block houses • Super. Dot 1 -72

Table 3. 2 Some Initial Listing Requirements for the NYSE 1 -73

Table 3. 3 Block Transactions on the New York Stock Exchange 1 -74

Other Systems • Electronic Communication Networks – Private computer networks that directly link buyers with sellers • National Market System – Securities Act of Amendments of 1975 • Bond Trading – Automated Bond System (ABS) 1 -75

Market Structure in Other Countries • London - predominately electronic trading • Euronext – market formed by combination of the Paris, Amsterdam and Brussels exchanges • Tokyo Stock Exchange • Globalization and consolidation of stock markets 1 -76

Figure 3. 6 Market Capitalization of Major World Stock Exchanges, 2007 1 -77

Trading Costs • Commission: fee paid to broker for making the transaction • Spread: cost of trading with dealer – Bid: price dealer will buy from you – Ask: price dealer will sell to you – Spread: ask - bid • Combination: on some trades both are paid 1 -78

Buying on Margin • Using only a portion of the proceeds for an investment • Borrow remaining component • Margin arrangements differ for stocks and futures 1 -79

Stock Margin Trading • 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 that you must put up additional funds 1 -80

Margin Trading - Initial Conditions Example 3. 1 X Corp $100 60% Initial Margin 40% Maintenance Margin 100 Shares Purchased Initial Position Stock $10, 000 Borrowed Equity $4, 000 $6, 000 1 -81

Margin Trading - Maintenance Margin Example 3. 1 Stock price falls to $70 per share New Position Stock $7, 000 Borrowed $4, 000 Equity $3, 000 Margin% = $3, 000/$7, 000 = 43% 1 -82

Margin Trading - Margin Call Example 3. 2 How far can the stock price fall before a margin call? (100 P - $4, 000)* / 100 P = 30% P = $57. 14 * 100 P - Amt Borrowed = Equity 1 -83

Table 3. 4 Illustration of Buying Stock on Margin 1 -84

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 1 -85

Short Sale – Initial Conditions Example 3. 3 Dot Bomb 50% 30% $100 1, 000 Shares Initial Margin Maintenance Margin Initial Price Sale Proceeds $100, 000 Margin & Equity 50, 000 Stock Owed 100, 000 1 -86

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 % (4000/11, 000) 36% 1 -87

Short Sale - Margin Call How much can the stock price rise before a margin call? ($150, 000* - 1000 P) / (100 P) = 30% P = $115. 38 * Initial margin plus sale proceeds 1 -88

Regulation of Securities Markets • Major regulations – Securities Act of 1933 – Securities Act of 1934 – Securities Investor Protection Act of 1970 • Self-Regulation – Stock markets are largely self-regulating 1 -89

Regulation Securities Markets Continued • Regulatory Responses to Recent Scandals – Public Company Accounting Oversight Board – Financial experts to serve on audit committees of boards of directors – CEOs and CFOs personally certify firms’ financial reports – Boards must have independent directors – Sarbanes-Oxley Act 1 -90

Circuit Breakers • Trading halts • Collars 1 -91

Insider Trading • Officers, directors, major stockholders must report all transactions in firm’s stock • Insiders do exploit their knowledge • Leakage of useful information to some traders 1 -92

CHAPTER 4 Mutual Funds and Other Investment Companies Investments, 8 th edition Bodie, Kane and Marcus Slides by Susan Hine Mc. Graw-Hill/Irwin Copyright © 2009 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Investment Companies • These companies perform several important functions for investors: – Administration & record keeping – Diversification & divisibility – Professional management – Reduced transaction costs 1 -94

Net Asset Value • Used as a basis for valuation of investment company shares – Selling new shares – Redeeming existing shares Calculation Market Value of Assets - Liabilities Shares Outstanding 1 -95

Types of Investment Companies • Unit Trusts • Managed Investment Companies – Open-End • Open-end: shares outstanding change when new shares are sold or old shares are redeemed • Priced at Net Asset Value(NAV) – Closed-End • no change in shares outstanding unless new stock is offered • Priced at Premium or discount to NAV 1 -96

Figure 4. 1 Closed-End Mutual Funds 1 -97

Types of Investment Companies Continued • Other investment organizations – Commingled funds – REITs – Hedge Funds 1 -98

Mutual Funds—Investment Policies • • Money Market Equity Sector Bond Balanced Asset Allocation and Flexible Index International 1 -99

Table 4. 1 U. S. Mutual Funds by Investment Classification 1 -100

How Funds Are Sold • Direct-marketed funds • Sales force distributed • Revenue sharing on sales force distributed – Potential conflicts of interest • Financial Supermarkets 1 -101

Costs of Investing in Mutual Funds • Fee Structure – Operating expenses – Front-end load – Back-end load – 12 b-1 charges • distribution costs paid by the fund • Alternative to a load 1 -102

Fees and Mutual Fund Returns 1 -103

Fees and Mutual Fund Returns: An Example Initial NAV = $20 Income distributions of $. 15 Capital gain distributions of $. 05 Ending NAV = $20. 10: 1 -104

Table 4. 2 Impacts of Costs on Investment Performance 1 -105

Trading Scandal with Mutual Funds • Late trading – allowing some investors to purchase or sell later than other investors • Market timing – allowing investors to buy or sell on stale net asset values – International • Net effect is to transfer value from other shareholders to privileged traders – Reduction in the rate of return of the mutual fund 1 -106

Potential Reforms • Strict 4: 00 PM cutoff with late orders executed the following trading day • Fair value pricing with net asset values being adjusted for trading in open markets • Imposition of redemption fees 1 -107

Taxation on Mutual Fund Income • Pass-through status under the U. S. tax code – Taxes are paid only by the investor • High turnover leads to tax inefficiency 1 -108

Exchange Traded Funds • ETF allow investors to trade index portfolios like shares of stock • Examples - SPDRs and WEBS • Potential advantages – Lower taxes – Trade continuously – Lower costs • Potential disadvantages – Prices can depart by small amounts from NAV 1 -109

Table 4. 3 EFT Sponsors and Products 1 -110

Mutual Fund Investment Performance: A First Look • Evidence shows that average mutual fund performance is generally less than broad market performance • Evidence that performance is consistent from one period to the next is suggestive but inconclusive 1 -111

Figure 4. 2 Diversified Equity Funds versus Wilshire 5000 Index 1 -112

Table 4. 4 Consistency of Investment Results 1 -113

Information on Mutual Funds • Wiesenberger’s Investment Companies • Morningstar (www. morningstar. com) • Yahoo (biz. yahoo. com/funds) • Investment Company Institute (www. ici. org) • Directory of Mutual Funds 1 -114