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