Transcript No Slide Title

Investments, BKM Ch 2
Zvi Wiener
02-588-3049
[email protected]
Spring-03
http://pluto.mscc.huji.ac.il/~mswiener/zvi.html
Investments
Markets and Instruments
Money Market (up to 1 year to maturity)
The Fixed-Income Capital Market
Equity Securities
Stock and Bond Market Indexes
Derivative Markets
Zvi Wiener
BKM Ch 2
slide 2
Money Markets
US Treasury Bills (T-Bills)
Certificates of Deposit (CD)
Commercial paper (CP)
Bankers’ acceptances
Eurodollars
Repos and Reverses
Federal Funds
Zvi Wiener
BKM Ch 2
slide 3
US Treasury Bills
Initial maturities are
91-182 days, offered weekly
52 weeks, offered monthly
Competitive and noncompetitive (10-20%) bids.
The investor buys the instrument at discount
bid-ask (spread) represents the profit for the dealer
quotes use the bank discount yield.
Exempt of state and local taxes.
Zvi Wiener
BKM Ch 2
slide 4
Bank Discount Yield
$10,000 par T-bill at $9,600 with 182 DTM.
$400(360/182) = $791.21
thus the bank discount yield is 7.91%
rBD=(10,000-P)/10,000 ·360/n
effective annual yield is:
(1+400/9600)2-1=8.51%
bond equivalent yield is:
rBEY=(10,000-P)/P ·365/n
Zvi Wiener
BKM Ch 2
slide 5
Certificates of Deposit
Time deposits with commercial banks.
It may not be withdrawn upon demand.
Large CDs can be sold prior to maturity.
Insured by FDIC up to $100,000
(Federal Depository Insurance Corporation)
Zvi Wiener
BKM Ch 2
slide 6
Commercial Paper
Unsecured short term debt (corporations).
Maturity is up to 270 days.
CP is issued in multiples of $100,000.
Small investors buy it through mutual funds.
Most issues have credit rating.
Treated for tax purposes as regular debt.
LC backed (letter of credit) optional.
In summer 1989 three companies defaulted.
Zvi Wiener
BKM Ch 2
slide 7
Bankers’ acceptances
Orders to a bank by a customer to pay a given
sum at a given date.
Backed by bank.
Traded in secondary markets.
Widely used in international commerce,
because the creditworthiness is supplied by a
bank.
Zvi Wiener
BKM Ch 2
slide 8
Eurodollars
Dollar denominated time deposits in foreign
banks.
Most are for large amounts and with maturity
of less than 6 months.
Zvi Wiener
BKM Ch 2
slide 9
Repos and Reverses
Repurchase agreements (RPs) used by dealers
in government securities.
Term repo has a maturity of 30 days or more.
Reverse repo is the result of a dealer finding
an investor buying government securities with
an agreement to sell them at a specified price at
a specified future date.
Failure of dealers in 1985 - credit risk.
Zvi Wiener
BKM Ch 2
slide 10
Federal Funds
Commercial banks that are members of the
Federal Reserve System (Fed) are required to
maintain a minimum reserve balance with
Fed.
Banks with excess reserves lend (usually
overnight) to banks with insufficient reserves.
For more on Fed see Siegel-9
Zvi Wiener
BKM Ch 2
slide 11
Brokers’ Calls
Brokers borrow funds to loan to investors who
wish to buy stock on margin.
The broker agrees to repay the loan upon the
call of the bank.
The rate is higher because of the credit risk
component.
Zvi Wiener
BKM Ch 2
slide 12
LIBOR
London Interbank Offer Rate (LIBOR) is the
rate at which the large London banks lend
among themselves.
This rate serves often as an anchor for floating
rate agreements which for example can be
set at LIBOR + 3%
Zvi Wiener
BKM Ch 2
slide 13
Yields on Money Market
Instruments
In general, money market instruments are
quite safe. However, T-bills are the safest of
the money money instruments.
As a result the other instruments provide a
slightly higher yield.
Zvi Wiener
BKM Ch 2
slide 14
Fixed-Income Capital Markets
T-Notes - initial maturity of 10 years (or less).
T-Bonds - initial maturities of 10-30 years.
Par (also called face or principal) $1,000.
Interest (coupons) paid semiannualy.
Zvi Wiener
BKM Ch 2
slide 15
Rate Mo/Yr
83/4 Aug 00n
Bid Asked Chg. Ask Yld
105:16 105:18 +8 7.55
Rate coupon payment 83/4% of $1,000;
paid semiannually; $43.75 per bond each 6 mo.
Maturity = August 2000
n = note
Bid =105:16 means 10516/32=105.5%
at the price $1055 buyer is willing to buy.
Ask=105:18 means 10518/32=105.5625%
at the price $1055.625 seller is willing to sell.
Zvi Wiener
BKM Ch 2
slide 16
“Callable Bond” Option
What is this call option?
Who has this option, who pays for it?
When is it optimal to exercise the call option?
Why does it make sense to calculate yields on
discount bonds to maturity and yields on
premium bonds to the first call?
Zvi Wiener
BKM Ch 2
slide 17
Federal Agency Debt
Some federal agencies issue their own debt.
They are not legally backed by the Treasury.
Treasury would assist in the event of distress.
These issues are very safe.
Yield is only slightly more than Treasury
issues.
FNMA, GNMA, FHLMC
Zvi Wiener
BKM Ch 2
slide 18
Municipal Bonds (Munis)
Issued by state and local governments and
agencies. Interest (not capital gains!) is
exempt from federal taxes.
General Obligations are backed by the taxing
power of the issuer.
Revenue bonds are backed only by revenues
from specific projects.
Industrial Development bond is issued to
finance a private projects.
Zvi Wiener
BKM Ch 2
slide 19
Interest from Munis
Is not subject to federal income tax.
Hence the yields are lower.
r ·(1- t) = rm
r
- before tax return on taxable bond
rm
- return on municipal bond
t
- marginal tax rate
Attractive to wealthy investors.
Zvi Wiener
BKM Ch 2
slide 20
Corporate Bonds
Used to generate long-term funds.
The primary difference is the default risk.
Backed by specific assets (like mortgages).
By the financial strength of the firm only
(debentures).
Callable at a call price (firm).
Convertible, may be exchanged to a stock
(investor).
Zvi Wiener
BKM Ch 2
slide 21
Equities
Represent ownership in a corporation.
Each common stock entitles to one vote.
Shareholders vote for board members.
A proportional share of financial benefits.
Management usually solicits for proxy votes.
Zvi Wiener
BKM Ch 2
slide 22
Ownership
Closely held corporation - stocks are not traded.
Tender offer to buy stocks at a stipulated price.
Owner of more than 5% must report.
Insiders must report and are restricted.
Zvi Wiener
BKM Ch 2
slide 23
Residual Claim
government (taxes)
employees (including pensions)
bond holders
other creditors
Limited liability
means that the maximum loss is the original
investment.
Zvi Wiener
BKM Ch 2
slide 24
Preferred Stock
A hybrid security with characteristics of both
equity and debt.
Similar to an infinite bond.
No voting rights.
Can not demand for a bankruptcy.
Cumulative fixed or adjustable dividends.
May be redeemable or convertible.
Zvi Wiener
BKM Ch 2
slide 25
Dow Jones Average
Created in the late 19th century by Charles Dow
initially 10 rails and 2 industrial companies
4 years later 18 rails and 2 industrials
Dow Industrial average, May 26, 1896
1916 the Dow was increased to 20 stocks
in 1928 - 30 stocks
It represents about 20% of the US market
Zvi Wiener
BKM Ch 2
slide 26
Calculation of the DJIA
sum of prices divided by the number of stocks
Why is it now 8000?
the denominator is adjusted when
there is a split
a stock pays a large dividend (10% or more)
a firm is replaced by another
How to invest in DJIA?
Zvi Wiener
BKM Ch 2
slide 27
S&P
Started on March 4, 1957; calculated back to 1926
Base value was 10 - average value in 1941-1943
it covers about 80% of the market capitalization
it is a market-value-weighted index
How is it affected by a stock split?
How one can invest in S&P 500?
Zvi Wiener
BKM Ch 2
slide 28
Market Capitalization (1993?)
Rank
1-500
501-1000
1001-1500
1501-2000
2001-2500
2501-3000
Zvi Wiener
% of Market
80.0
11.3
4.6
2.3
1.2
0.7
BKM Ch 2
Value (Billions)
77.13-1.46
1.46-0.53
0.53-0.25
0.25-0.13
0.13-0.08
0.08-0.04
slide 29
Indexes
DJIA, 30 stocks, NYSE, price weighted
S&P 500, NYSE, NASDAQ, value weighted
NYSE all NYSE stock, value weighted
NASDAQ, all NASDAQ, value weighted
Wilshire 5000, value weighted
Value Line, 1700 stocks, price weighted
Lehman Brothers - bonds
FTSE, 100 large stocks, value weighted
Nikkei 225, price weighted
BKM Ch 2
Zvi Wiener
slide 30
Index Arbitrage
classical arbitrage, used by professional traders
when the index is not equal to the basket
it relies on computers to capitalize on such
discrepancies and execute the baskets quickly.
Is also known as program trading.
Zvi Wiener
BKM Ch 2
slide 31
Derivatives
Options
Call - a right to buy at strike
Put - a right to sell at strike
European, American, Exotic.
Futures and Forwards (obligation)
long position - will buy
short position - will sell
Zvi Wiener
BKM Ch 2
slide 32
Summary
Money market
US government Notes and Bonds
Municipal bonds r ·(1- t) = rm
Common Stocks
Preferred Stocks
Stock Market Indexes
Derivatives (Options, Futures, Forwards)
Zvi Wiener
BKM Ch 2
slide 33
Home Assignment
• read BKM-2
• problems 2, 3, 4, 8, 13 (3rd edition)
• problems 2, 3, 4, 10, 16 (5th edition)
Zvi Wiener
BKM Ch 2
slide 34