Chapters 1 & 2

Essentials of Investments

© 2001 The McGraw-Hill Companies, Inc. All rights reserved.

Fourth Edition

Irwin / McGraw-Hill

Bodie • Kane • Marcus1

Chapters 1 & 2

Investments - Background and Issues

Financial Markets and Instruments



Fourth Edition

Irwin / McGraw-Hill


Investments & 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



Fourth Edition

Irwin / McGraw-Hill


The Investment Process

• Asset allocation

• Security selection

• Risk-return trade-off

• Market efficiency

• Active vs. passive management



Fourth Edition

Irwin / McGraw-Hill


Active vs. Passive Management

Active Management

• Finding undervalued securities

• Timing the market

Passive Management

• No attempt to find undervalued securities

• No attempt to time

• Holding an efficient portfolio



Fourth Edition

Irwin / McGraw-Hill


Investments and Innovation

Technology and Delivery of Service• Computer advancements• More complete and timely informationGlobalization• Domestic firms compete in global

markets• Performance in regions depends on

other regions• Causes additional elements of risk



Fourth Edition

Irwin / McGraw-Hill


Key Trends - Globalization

International and Global Markets Continue Developing• Managing foreign exchange• Diversification to improve

performance• Instruments and vehicles continue

to develop• Information and analysis improves



Fourth Edition

Irwin / McGraw-Hill


Key Trends - Securitization

Securitization & Credit Enhancement• Offers opportunities for investors and

originators• Changes in financial institutions and

regulation• Improvement in information

capabilities• Credit enhancement and its role



Fourth Edition

Irwin / McGraw-Hill


Key Trends - Financial Engineering

Repackaging Services of Financial Intermediaries

• Bundling and unbundling of cash flows

• Slicing and dicing of cash flows

• Examples: CMOs, principal/interest splits



Fourth Edition

Irwin / McGraw-Hill


The Future

• Globalization continues and offers more opportunities

• Securitization continues to develop

• Continued development of derivatives and exotics

• Strong fundamental foundation is critical• Integration of investments & corporate

finance



Fourth Edition

Irwin / McGraw-Hill


Major Classes of Financial Assets or Securities

• Debt– Money market instruments– Bonds

• Common stock

• Preferred stock

• Derivative securities



Fourth Edition

Irwin / McGraw-Hill


Markets and Instruments

• Money Market– Debt Instruments– Derivatives

• Capital Market– Bonds– Equity– Derivatives



Fourth Edition

Irwin / McGraw-Hill


Money Market Instruments

• Treasury bills

• Certificates of deposit

• Commercial Paper

• Bankers Acceptances

• Eurodollars

• Repurchase Agreements (RPs) and Reverse RPs

• Federal Funds



Fourth Edition

Irwin / McGraw-Hill


Money Market Instrument Yields

• Yields on Money Market Instruments are not always directly comparable

Factors influencing yields

• Par value vs. investment value

• 360 vs. 365 days assumed in a year (366 leap year)

• Bond equivalent yield



Fourth Edition

Irwin / McGraw-Hill


Bank Discount Rate (T-Bills)

rrBDBD = bank discount rate= bank discount rate

PP = market price of the T-bill= market price of the T-bill

nn = number of days to maturity= number of days to maturity

rrBDBD == 10,00010,000 -- PP10,00010,000

xx 360360nn

90-day T-bill, P = $9,87590-day T-bill, P = $9,875

rrBDBD == 10,00010,000 -- 9,8759,875

10,00010,000 x x

360360

9090== 5%5%

ExampleExample



Fourth Edition

Irwin / McGraw-Hill


Bond Equivalent Yield

• Can’t compare T-bill directly to bond– 360 vs 365 days – Return is figured on par vs. price paid

• Adjust the bank discounted rate to make it comparable



Fourth Edition

Irwin / McGraw-Hill


Bond Equivalent Yield

P = price of the T-billP = price of the T-bill

n = number of days to maturityn = number of days to maturity

rr BEYBEY == 10,00010,000 -- PP

PP xx 365365

nn

rrBEYBEY == 10,00010,000 -- 9,8759,875

9,8759,875 x x 365365

9090rrBEYBEY = .0127 x 4.0556 = .0513 = 5.13% = .0127 x 4.0556 = .0513 = 5.13%

Example Using Sample T-BillExample Using Sample T-Bill



Fourth Edition

Irwin / McGraw-Hill


Effective Annual Rate of Return

• Similar to the bond equivalent yield • However, the annualized rate is compounded.

r = 10,000-9,875 = 0.0127

9,875

EAR = (1.0127)4 - 1 = 0.0518

= 5.18%



Fourth Edition

Irwin / McGraw-Hill


Capital Market - Fixed Income Instruments

Publicly Issued Instruments• US Treasury Bonds and Notes• Agency Issues (Fed Gov)

– Example FHLB, FNMA

• Municipal Bonds– General obligation or revenue

Privately Issued Instruments• Corporate Bonds• Mortgage-Backed Securities



Fourth Edition

Irwin / McGraw-Hill


Capital Market - Equity

• Common stock– Residual claim– Limited liability

• Preferred stock– Fixed dividends - limited– Priority over common– Tax treatment



Fourth Edition

Irwin / McGraw-Hill


Uses

• Track average returns

• Comparing performance of managers

• Base of derivatives

Factors in constructing or using an Index

• Representative?

• Broad or narrow?

• How is it constructed?

Stock Indexes



Fourth Edition

Irwin / McGraw-Hill


Examples of Indexes - Domestic

• Dow Jones Industrial Average (30 Stocks)

• Standard & Poor’s 500 Composite

• NASDAQ Composite

• NYSE Composite

• Wilshire 5000



Fourth Edition

Irwin / McGraw-Hill


Examples of Indexes - Int’l

• Nikkei 225 & Nikkei 300

• FTSE (Financial Times of London)

• Dax

• Region and Country Indexes– EAFE– Far East– United Kingdom



Fourth Edition

Irwin / McGraw-Hill


Construction of Indexes

• How are stocks weighted?– Price weighted (DJIA)– Market-value weighted (S&P500,

NASDAQ)– Equally weighted (Value Line Index)



Fourth Edition

Irwin / McGraw-Hill


Derivatives Securities

Options• Basic Positions

– Call (Buy)– Put (Sell)

• Terms– Exercise Price– Expiration Date– Assets

Futures • Basic Positions

– Long (Buy)– Short (Sell)

• Terms– Delivery Date– Assets

Chapters 1 & 2

Documents

Transcript of Chapters 1 & 2