FINM3093: Investments
Lecture 1
Dr Sherry Zhou
BNU-HKBU United International College
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Outline
• Investment environment (Textbook Chapter 1)
• Real assets and financial assets
• Financial markets
• Players
• How securities are traded (Textbook Chapter 3)
• How firms issue securities
• How securities are traded
• Buying on margin and short sales
• Investment companies (Textbook Chapter 4)
• Types of investment companies
• Mutual funds
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Investment Environment (Textbook Chapter 1)
❖ Real Assets Versus Financial Assets
➢Real Assets
• Used to produce goods and services
• Determine the productive capacity and net income of the economy
• Example: Land, buildings, machines, intellectual property
➢Financial Assets
• Claims to the income generated by real assets or claims on income
from the government
• Do not directly contribute to the productive capacity of the economy
• Examples: Stocks, bonds
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Self-Check Exercise
• Are the following assets real or financial?
a) Patents
b) Lease obligations
c) Customer goodwill
d) A college education
e) A $5 bill
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Financial Assets
❖Fixed-income or Debt securities
• Promise either a fixed stream of income or a stream of income determined by
a specified formula (e.g., corporate bond)
❖Equity
• Represent an ownership share in the corporation (e.g., common stock)
❖Derivative securities
• Provide payoffs that depends on the value of other financial variables such as
stock prices, interest rates, or exchange rates (e.g., futures, options)
❖Currency
• $2 trillion of currency traded each day in London alone
❖Commodities
• Example: corn, wheat, natural gas
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Financial Markets
❖Money markets
• Made up of short-term, marketable, liquid, low-risk debt securities
❖Capital markets
• Include longer term and riskier securities
• Longer term bond markets
• Equity markets
• Derivative markets
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Financial Markets and the Economy
❖The Informational Role
• Capital flows to companies with best prospects
❖Consumption Timing
• Use securities to store wealth and transfer consumption to the future
❖Allocation of Risk
• Investors can select securities consistent with their tastes for risk, which benefits the
firms that need to raise capital as security can be sold for the best possible price
❖Separation of Ownership and Management
• Agency problems arise when managers start pursuing their own interests instead of
maximizing firm's value
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Financial Markets and the Economy
❖Mechanisms to mitigate agency problems:
• Compensation plans tie the income of managers to the success of the firm
(stock options)
• Monitoring from the board of directors
• Monitoring by large investors and security analysts
• Threat of takeover for poor performers
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The Players
1. Firms
• Net demanders of capital
• Raise capital now to pay for investments in plant and equipment
2. Households
• Typically net suppliers of capital
• Purchase securities issued by firms that need to raise funds
3. Governments
• Can function as borrowers and lenders, depending on the relationship
between tax revenue and government expenditures
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The Players
• Financial Intermediaries: bring the suppliers of capital together with
the demanders of capital
• Investment Companies
• Banks
• Insurance companies
• Credit unions
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How Firms Issue Securities (Textbook Chapter 3)
❖Primary Market
• Market for newly-issued securities
• Firms issue new securities through underwriter (investment banker) to public
• Investors get new securities; firms gets funding
❖Secondary Market
• Investors trade previously issued securities among themselves
• Issuing firm doesn’t receive proceeds
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How Securities are Traded
Types of Markets:
❖Direct search
• Buyers and sellers seek each other
❖Brokered markets
• Brokers search out buyers and sellers
❖Dealer markets
• Dealers have inventories of assets from which they buy and sell
• Spreads between dealers’ buy/bid prices and sell/ask prices are a source of profit
❖Auction markets
• Traders converge at one place (physically or electronically) to trade
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Self-check Exercise
• What types of markets do the following trade in?
a) Used cars
b) Paintings
c) Rare coins
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Types of Orders
❖Market Order:
• Executed immediately
• Trader receives current market price
❖Price-Contingent Order:
• Traders specify buying or selling prices
❖A large order may be filled at multiple prices
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Price-contingent Orders (10 th ed.)
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Self-check Exercise
• What type of trading order might you give to your broker in each of
the following circumstances?
a) You want to buy shares of Microsoft to diversify your portfolio. You believe
the share price is approximately at the “fair” value, and you want the trade
done quickly and cheaply.
b) You want to buy shares of Microsoft, but you believe the current stock price
is too high given the firm’s prospects. If the shares could be obtained at a
price 5% lower than the current value, you would like to purchase shares for
your portfolio.
c) You believe your shares of Microsoft are already priced generously, and you
are inclined to sell them. But there is a chance that price fluctuations might
result in a short-lived increase. If the share price were to rise by $4, you are
convinced that it would be greatly overpriced and you would want to sell it
immediately.
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Trading Mechanisms
❖Dealer markets
• Over-the-counter (OTC) market is an informal network of brokers and dealers
where securities can be traded (not a formal exchange)
❖Electronic communication networks (ECNs)
• True trading systems that can automatically execute orders
❖Specialist/Designated market maker (DMM) markets
• Accepts the obligation to commit its own capital to provide quotes and help
maintain a “fair and orderly market”
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New Trading Strategies
❖Algorithmic Trading
• The use of computer programs to make trading decisions
❖High-Frequency Trading
• Special class of algorithmic trading with very short order execution time
❖Dark Pools
• Trading venues that preserve anonymity, mainly relevant in block trading (i.e.,
very large trades)
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Trading Costs
❖Brokerage Commission: Fee paid to broker for making the transaction
• Explicit cost of trading
• Full service vs. discount brokers
• Some customers allow a full-service broker to make buy and sell decisions for them by
establishing a discretionary account, which allows the broker to trade securities
whenever deemed fit.
• The only information discount brokers provide about the securities they handle is price
quotations.
❖Spread: Difference between the bid and asked prices
• Implicit cost of trading
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Buying on Margin
• Borrowing part of the purchase price of the stock from a broker
• Investor contributes the remaining portion
• Margin refers to the portion of the purchase price contributed by the
investor
• You profit when the stock price rises
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Buying on Margin
❖Initial margin is set by the Fed
• Currently 50%, i.e., at least 50% of purchase price must be paid for in cash,
with the rest borrowed.
❖Maintenance margin
• Minimum equity that must be kept in the margin account
• Margin call if value of securities falls below the maintenance level
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Margin Trading: Initial Conditions
Share price $100
60% Initial Margin
100 Shares Purchased
Initial Position
Stock $10,000 Borrowed $4,000
Equity $6,000
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Margin Trading: Initial Conditions
Stock price falls to $70 per share
New Position
Stock $7,000 Borrowed $4,000
Equity $3,000
Margin% = $3,000/$7,000 = 43%
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Margin Call
How far can the stock price fall before a margin call? Let maintenance margin = 30%
Equity = 100P - $4000
Percentage margin = (100P - $4,000)/100P
(100P - $4,000)/100P = 0.30
Solve to find:
P = $57.14
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Buying on Margin
❖Achieves greater upside potential, but also exposes to greater
downside risk
• An investor with $10,000 to invest buys 100 shares at $100 per share. If the
stock price goes up by 30% during the next year, the expected rate of return
(ignoring dividends) would be _________.
• Assume an investor with $10,000 borrows $10,000 to buy 200 shares at $100
per share. Interest rate on the margin loan = 9% p.a.. What is the rate of
return (ignoring dividends) if stock price increases 30%? Drops by 30%?
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Short Sales
❖Purpose
• To profit from a decline in the price of a stock or security
❖Mechanics
• Borrow stock from a broker
• Sell it and deposit proceeds and margin in an account
• Closing out the position: Buy the stock and return to the party from which it
was borrowed
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Short Sale Mechanics
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Short Sales: Initial Conditions
Dot Bomb 1000 Shares Sale Proceeds $100,000
50% Initial Margin Margin & Equity $50,000
30% Maintenance Margin Stock Owed 1000 shares
$100 Initial Price
Assets Liabilities
$100,000 (sale proceeds) $100,000 (1,000 shares owed)
$50,000 (initial Margin)
Equity
$50,000
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Dot Bomb falls to $70 per share
Assets Liabilities
$100,000 (sale proceeds) $70,000 (buy shares)
$50,000 (initial Margin)
Equity
$80,000
Profit = Ending equity – Beginning equity
= $80,000 - $50,000 = $30,000
= decline in share price x number of shares sold short
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Short Sale: Margin Call
How much can the stock price rise before a margin call?
($150,000* - 1000P)/(1000P) = 30%
P = $115.38
* Initial margin plus sale proceeds
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Investment Companies (Textbook Chapter 4)
❖Pool funds of individual investors and invest in a wide range of
securities or other assets
❖Services provided:
• Record keeping and administration
• Diversification and divisibility
• Professional management
• Lower transaction costs
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Net Asset Value (NAV)
❖Net Asset Value (NAV) is the value of each share in the investment
company
❖Calculation:
Market Value of Assets - Liabilities
Shares Outstanding
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Types of Investment Companies
Unit Investment
Trusts
Managed
Investment
Investment
Companies
Companies
Other
Investment
Organizations
❖Unit Investment Trusts
• Fixed portfolio of uniform assets
• Unmanaged
• Total assets have declined from $105 billion in 1990 to $85 billion in 2017
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Types of Investment Companies
❖Managed Investment Companies
▪ Open-End
• Fund issues new shares when investors buy in and redeems shares
when investors cash out
• Priced at Net Asset Value (NAV)
▪ Closed-End
• No change in shares outstanding; old investors cash out by selling to
new investors
• Priced at premium or discount to NAV
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Types of Investment Companies
❖Other investment organizations
• Commingled Funds
• Real Estate Investment Trust (REITs)
• Hedge Funds
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Mutual Funds
• Common name for open-end investment companies
• Money market funds
• Invest in money market securities
• Equity funds
• Invest primarily in stock
• Sector funds
• Concentrate on a particular industry
• Bond funds
• Specialize in the fixed-income sector
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Mutual Funds
• International funds
• Global, international, regional, and emerging market
• Balanced funds
• Hold both equities and fixed-income securities in relatively stable proportions
• Asset allocation and flexible funds
• Hold both stocks and bonds
• Engaged in market timing; not designed to be low-risk
• Index funds
• Tries to match the performance of a broad market index
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How Funds are Sold
• Direct-marketed funds
• Sales-force distributed
• Broker or financial advisers receive a commission for selling shares
• Potential conflicts of interest
• Financial supermarkets
• Sell shares in funds of many complexes
• Broker splits management fees with the mutual fund company
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Costs of Investing in Mutual Funds
❖Fee Structure:
1. Operating expenses: costs incurred by the mutual fund in operating the
portfolio, including administrative expenses and advisory fees paid to the
investment manager.
2. Front-end load: commission or sales paid when you purchase the shares
3. Back-end load: redemption fee incurred when you sell the shares
❖Fees must be disclosed in the prospectus
• Share classes with different fee combinations
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Fees and Fund Returns
NAV1 − NAV0 + Income + Capital Gain
R=
NAV0
•Example:
•Initial NAV = $20
•Income distributions of $.15
•Capital gain distributions of $.05
•Ending NAV = $20.10
$20.10 − $20.00 + $.15 + $.05
R= = .015 or 1.5%
$20.00
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Fees and Fund Returns
• Expenses reduce net asset values
•Example:
•Initial NAV = $100 million/10 million shares = $10
•No income
•Increase in value by 10%
•Expense ratio = 1% annually
Solution:
Ending NAV = ($100*1.1 million – 1 million expenses)/10 million = $10.9
So R = (10.9 – 10)/10 = 9%
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Exchange Traded Funds (ETFs)
• Offshoots of mutual funds that allow investors to trade index
portfolios just as they do shares of stock
• Potential advantages:
• Trade continuously like stocks
• Can be sold short or purchased on margin
• Lower costs
• Potential disadvantages:
• Prices can depart from NAV
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Summary
• Real assets and financial assets
• Real assets: land, building, machines, intellectual property, etc.
• Financial assets: stocks, bonds, etc.
• Financial assets
a) directly contribute to the country's productive capacity.
b) indirectly contribute to the country's productive capacity.
c) contribute to the country's productive capacity, both directly and indirectly.
d) do not contribute to the country's productive capacity, either directly or
indirectly.
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Summary
• Financial assets
• Fixed-income securities; Equity; Derivative securities; Currency; Commodities
• Financial markets
• Money market; Capital markets
• Agency problem
• Refers to the potential conflict between management and shareholders.
• Which of the following are mechanisms that have evolved to mitigate potential agency
problems?
a) Using the firm's stock options for compensation
b) Hiring bickering family members as corporate spies
c) Boards of directors forcing out underperforming management
d) Security analysts monitoring the firm closely
e) Takeover threats
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Summary
• Primary market and Secondary market
• The trading of stock that was previously issued takes place in the _________
market.
• Firms raise capital by issuing stock in the ___________ market.
• Types of orders
• Market order; Price-contingent order (limit-buy, limit-sell, stop-buy, stop-loss)
• You purchased ABC stock at $130 per share. The stock is currently selling at
$145. Your gains may be protected by placing a ____________ order.
• You sold XYZ stock short at $190 per share. Your losses could be minimized by
placing a ___________ order.
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Summary
• Buying on margin
• Borrowing from a broker, contributing the remaining portion
• Margin: portion of the purchase price contributed by the investor
• You profit when stock price rises/declines.
• You want to purchase KO stock at $60 from your broker using as little of your own
money as possible. If initial margin is 50% and you have $3,000 to invest, how many
shares can you buy?
• Short sales
• borrow stock, sell it and deposit proceeds, close out the position (buy the stock and
return it)
• You profit when stock price rises/declines.
• Assume you sold short 100 shares of common stock at $50 per share. The initial
margin is 60%. The maintenance margin is _______ if a margin call is made at a stock
price of $60.
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Summary
• Net asset value
Market Value of Assets - Liabilities
Shares Outstanding
• Which of the following would increase the net asset value of a mutual fund
share, assuming all other things remain unchanged?
a) An increase in the number of fund shares outstanding
b) An increase in the fund's accounts payable
c) A change in the fund's management
d) An increase in the value of one of the fund's stocks
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Summary
• Costs of investing in mutual funds
• Operating expenses; Front-end load; Back-end load
NAV1 − NAV0 + Income + Capital Gain
R=
NAV0
• You purchased shares of a mutual fund at a price of $20 per share at the
beginning of the year and paid a front-end load of 5.75%. If the securities in
which the fund invested increased in value by 11% during the year, and the
fund's expense ratio was 1.25%, your return if you sold the fund at the end of
the year would be _________.
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