Investments Lecture 1 Introduction to Investments.

Investments

Lecture 1

Introduction to Investments

Class Outline

-- Develop an understanding of the operation of debt, equity, and options markets and the instruments used in these markets

-- Review the investment process in general with a focus on security selection decisions

-- Discuss market efficiency and its implications for speculative strategies

Class Outline

-- Analyze different valuation and analytic techniques for equities

-- Examine investments techniques for equity portfolios

-- Look at mutual funds and other investment companies as vehicles for investment strategies.

My Personal Investment Philosophy

A. Markets are (essentially) efficient You can not consistently beat the market. If an investor starts off with this belief, I feel

that the investor is better able to assess the validity of proposed "sure fire" investment strategies.

My Personal Investment Philosophy

B. If it sounds too good to be true, it is. This advice will prevent you from entering into

any investment without checking it out first.

C. There is always someone smarter than you. This will prevent overconfidence and will keep

you on your toes.

Introduction to investments

Investing Definition of an investment: The current

commitment of dollars for a period of time in order to derive future payments that will compensate the investor for:

• 1. The time value of money

• 2. The expected rate of inflation

• 3. The risk associated with the investment

Introduction to investments

Speculating Speculative strategies include:

– 1. Buying long-term bonds because you feel interest rates will fall

– 2. Buying a stock because you feel its price will increase due to a takeover attempt

– 3. Buying stocks you believe are “undervalued” by the market

Introduction to investments

Expected returns versus required returns The expected return on a security is the return

an investor expects to receive over some future time period.

The expected return is estimated by determining an expected future price and income for a security and measuring the return in a manner similar to the actual return calculation.

Introduction to investments

Expected returns versus required returns

Mathematical definition of the expected return:

ER = ((Pt+1-Pt) + incomet+1)/Pt

Introduction to investments

Expected returns versus required returns We can also measure the expected return by

estimating several potential outcomes and assigning a probability to each outcome. The expected return in this case would be equal to:

Pi*ERi

Real Assets vs. Financial Assets

Use them to produce goods and services

Property Plant Equipment Knowledge

Claims on real assets or the income generated by real assets

Stocks Bonds Derivative securities

Introduction to investments

Risk -- -- Risk is the possibility that an investment will earn a return lower than is required. Essentially, for our purposes, risk is the possibility of price variation. The problem with ignoring risk -- Things sound too good to be true when risk is

ignored. Investments that are much too risky for the average investor appear to be "good" investments if risk is ignored.

Investment Alternatives

The money market -- The money market is a subsector of the

fixed-income market. It consists of short-term, very liquid investments.

1. Treasury-bills (T-bills)• Pure discount instruments

• Typically considered as a "risk-free" asset

Investment alternatives

The money market 2. Certificates of deposits

• Time deposits made with a bank. Federally insured up to $100,000.

3. Commercial paper• -- Short-term debt issued by corporations. Gives corporations

a way to avoid bank debt. 4. Repos 5. Brokers’ Calls

Investment alternativesThe fixed-income capital market

1. Treasury notes and bonds• Longer maturity government debt

2. Federal agency debt• -- Debt issued by government agencies and government

sponsored agencies in support of farm credit and home mortgages

– - Major issuing agencies include: Federal Home Loan Bank (FHLB), Federal National Mortgage Association (FNMA), Government National Mortgage Association (GNMA), Federal Home Loan Mortgage Corporation (FHLMC), District Cooperative Banks, Federal Land Banks, Federal Intermediate Credit Banks

Investment Alternatives

The fixed-income capital market 3. Municipal bonds

• Issued by state and local governments

• Income is tax exempt 4. Corporate bonds

Taxable vs. Tax-Exempt Yields

RateTax Marginal1

Yield MunicipalETY

Investment alternatives

The fixed-income capital market 5. Mortgage-Backed Securities (MBS)

• Gives the holder an ownership claim in a pool of mortgages or an obligation that is secured by such a pool. There has been an exponential growth in the MBS market since 1979 with the amount of funds invested approaching 2 trillion dollars.

Investment alternatives

The fixed-income capital market 5. Mortgage-backed securities (MBS)

• Securitization involves packaging a set of assets together and selling ownership rights to the assets. For example, David Bowie recently sold shares in his song portfolio. Any revenues generated from his songs are split among the shareholders. (By the way, I believe he made a few hundred million dollars doing this.)

Investment alternatives

Equity securities 1. Common stock

• Residual claimant

• Limited liability Agency problems

• Managers are agents for shareholders

• Interests of principals and agents are often in conflict

Investment alternatives

Equity securities 2. Preferred stock

• Promises a fixed dividend to shareholders, but non-payment of the dividend will not force the company into bankruptcy.

Investment alternatives

Derivative Markets 1. Options

• Right to buy or sell an asset at a specified price at a certain time in the future

2. Futures• Obligation to buy or sell an asset at a specified price at a

certain time in the future 3. Swaps

• An agreement between two parties to exchange a set of cash flows in a predetermined manner

Investment alternatives

Investment companies 1. Mutual funds 2. REITs

International investments Developed versus emerging markets

Uses of Stock Indexes

Track average returnsComparing performance of managersBase of derivatives

Factors for Construction of Stock Indexes

Representative? Broad or narrow? How is it weighted?

Examples of Domestic Indexes

Dow Jones Industrial Average (30 Stocks)Standard & Poor’s 500 CompositeNASDAQ CompositeNYSE CompositeWilshire 5000

Examples of International Indexes

Nikkei 225 & Nikkei 300FTSE (Financial Times of London)DaxRegion and Country Indexes

EAFE Far East United Kingdom

Construction of Indexes

How are stocks weighted? Price weighted (DJIA) Market-value weighted (S&P500, NASDAQ) Equally weighted (Value Line Index)

New Economy vs. Old Economy

Old Economy stocks AT&T IBM McDonald’s Proctor and Gamble

New Economy stocks Cisco Amazon eBay

Investments and Innovations

Technology and Delivery of ServiceComputer advancementsMore complete and timely information

GlobalizationDomestic firms compete in global marketsPerformance in regions depends on other regionsCauses additional elements of risk

Trends in Financial Markets

GlobalizationSecuritizationFinancial engineeringtechnology

Globalization

International and Global Markets Continue Developing

Managing foreign exchange Diversification to improve performance Instruments and vehicles continue to

develop (WEBs) Information and analysis improves

Securitization

Securitization & Credit EnhancementOffers opportunities for investors and

originatorsChanges in financial institutions and

regulationImprovement in information capabilitiesCredit enhancement and its role

Financial Engineering

Repackaging Services of Financial Intermediaries

Bundling and unbundling of cash flowsSlicing and dicing of cash flowsExamples: strips, CMOs, dual purpose

funds, principal/interest splits

The Future

Globalization continues and offers more opportunities

Securitization continues to develop Continued development of derivatives and

exoticsStrong fundamental foundation is criticalIntegration of investments & corporate

finance