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What is Dow Jones? Charles Dow; Edward Jones. Inventors o

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Title: What is Dow Jones? Charles Dow; Edward Jones. Inventors o


1
How to pick stocks?
  • Good company vs good stock
  • Macroeconomic condition
  • Profitability and investment

2
Price of Gambles
  • Gamble 1 You flip a fair coin, head I give you
    110, tail I give you 90. How much are you
    willing to pay me to enter this gamble?
  • Gamble 2 You flip a fair coin, I give you 100
    in a year no matter what happens. How much are
    you willing to pay me today to enter this gamble?

3
Consumption Preference
  • Which do you prefer?
  • A) Starve (nearly to death) on odd days and stuff
    on even days or
  • B) Eat comfortably every day.

4
Help these two ladies
  • Two old ladies live in the same town. One makes a
    living by selling umbrellas, the other sells
    sunglasses. When it rains, the umbrella-selling
    lady will be happy but the sunglass lady will be
    upset. When it is sunny, it is the reverse.
  • How do you make both ladies happier without
    costing you anything?

5
FINA 2802 Investments and Portfolio
Analysis Financial Securities Dragon Yongjun
Tang January 14 19, 2010
6
Lectures 2 3 Financial Securities
  • Reading Chapter 2
  • Practice Problem Sets 1,2,3,6,8,9,11,12,13,17

7
Learning Objectives
  • Distinguish among the major assets that trade in
    money markets and in capital markets
  • Describe the construction of stock market indexes
  • Calculate the profit or losses on investments in
    options and futures contracts

8
Financial Securities
High Risk
Low Risk
Money Market (Short-term)
Common Stocks Preferred Stocks
Options Futures
Bond Market (Long-term)
Index
9
Money Market Instruments
üTreasury Bills Certificates of deposit
Commercial paper Bankers acceptances
Eurodollars Repos and reverses Brokers
calls Federal funds LIBOR
10
Treasury Bills
  • Most marketable of money market instruments
  • Face value paid at maturity
  • Sold at a discount to face via auction
  • Issue
  • - 28 days (1 month), 91 days (3-month) and 182
  • days (6 month) weekly
  • Minimum denomination is 10,000

11
Figure 2.2 Treasury Bills
12
Figure 2.1 Money Rates
13
Figure 2.3 Spreads on CDs and Treasury Bills
  • Difficult to predict
  • Widen during crisis

14
Bond Market
  • Treasury Notes and Bonds
  • Inflation-Protected Treasury Bonds (TIPS)
  • Federal Agency Debt
  • International Bonds
  • Municipal Bonds
  • Corporate Bonds
  • Mortgages and Mortgage-Backed Securities

15
Treasury Notes and Bonds
  • Maturities
  • Notes maturities up to 10 years
  • Bonds maturities in excess of 10 years
  • 30-year bond
  • 2001 Treasury suspended sales
  • 2005 resume sales
  • Par Value - 1,000
  • Quotes percentage of par in 32nd

16
Figure 2.4 Treasury Notes, Bonds and Bills
17
Federal Agency Debt
  • Major issuers
  • Federal Home Loan Bank
  • Federal National Mortgage Association (Fannie
    Mae)
  • Government National Mortgage Association (Ginnie
    Mae)
  • Federal Home Loan Mortgage Corporation (Freddie
    Mac)

18
Figure 2.5 Government Agency Similar Issues
19
Municipal Bonds
  • Issued by state and local governments
  • Types
  • General obligation bonds
  • Revenue bonds
  • Industrial revenue bonds
  • Maturities range up to 30 years

20
Municipal Bond Yields
  • Interest income on municipal bonds is not subject
    to federal and sometimes state and local tax
  • To compare yields on taxable securities a Taxable
    Equivalent Yield is constructed

21
Municipal Bonds
Interest is exempt from Federal taxes After-tax
return (taxable bond) After-tax return
(Municipal bond)
22
Figure 2.7 Ratio of Yields on Tax-exempts to
Taxables
23
Equivalent Taxable Yield
24
Table 2.3 Equivalent Taxable Yields
25
Corporate Bonds
  • Semiannual coupon payments
  • Nominal value (Par) is 1,000
  • Actual percentage used for quote
  • Current Yieldcoupon/close
  • Volume in Thousands
  • Subject to larger default risk than government
    securities
  • Options on the bonds Callable and convertibles

26
Figure 2.8 Corporate Bond Prices
27
Bond Market
  • Treasury Notes and Bonds
  • Federal Agency Debt
  • International Bonds Eurobonds Yankee Bonds,
    Samurai bonds Dragon bonds
  • Municipal Bonds
  • Corporate Bonds
  • Mortgages and Mortgage-Backed Securities

28
Outstanding U.S. Bond Market Debt in 2006
(USBillions)
  • Source Securities Industry and Financial Markets
    Association (www.sifma.org)

29
mini-bond
  • Not well defined!
  • Official term credit-linked notes
  • Credit derivative!
  • Counterparty risk!

30
Equity Markets
  • Common stock
  • Residual claim
  • Limited liability
  • Preferred stock
  • Fixed dividends - limited
  • Priority over common
  • Tax treatment
  • Depository receipts

31
Figure 2.10 Listing of Stocks Traded on the NYSE
32
What is Dow Jones?
33
What is Dow Jones?
  • Charles Dow Edward Jones
  • Inventors of tickers
  • Publishing WSJ, Barrons, etc.

34
Uses of Stock Indexes
  • Track average returns
  • Comparing performance of managers
  • Base of derivatives

35
Factors for Construction of Stock Indexes
  • Representative?
  • Broad or narrow?
  • How is it weighted?

36
Examples of Indexes U.S. Domestic
  • Dow Jones Industrial Average (30 Stocks)
  • Standard Poors 500 Composite
  • NASDAQ Composite
  • NYSE Composite
  • Wilshire 5000

37
Figure 2-11 Comparative Performance of Several
Stock Market Indexes
38
Examples of Indexes - Intl
  • Hang Seng Index Shanghai Composite
  • Nikkei 225 Nikkei 300
  • FTSE (Financial Times of London)
  • Dax
  • Region and Country Indexes
  • EAFE
  • Far East
  • United Kingdom

39
Construction of Indexes
  • How are stocks selected?
  • Subjective
  • How are stocks weighted?
  • Price weighted (DJIA)
  • Market-value weighted (SP500, NASDAQ)
  • Equally weighted (Value Line Index)

40
Price Weighted Indices
  • Computed by adding all the prices in the index
    and dividing by a divisor
  • Implies one share for each stock
  • Implies a buy-and-hold strategy
  • Gives high weight to high price stocks
  • DJIA is an example

41
Derivation of Price-Weighted Index
42
Example of Price-Weighted Index
  • Stock ABC sells initially at 25 a share with
    20 million shares outstanding, while XYZ sells
    for 100 a share with 1 millions shares
    outstanding. The final price for ABC is 30, and
    the final price for XYZ is 90.
  • (a) Find the initial and the final
    price-weighted index composed of these two
    stocks. Assume the initial divisor is 2.
  • (b) Now if stock XYZ is split two for one,
    how should you adjust the divisor for the index?

43
Value-Weighted Indices
  • Calculated by adding the total market value of
    the firms in the index
  • Implies buy and hold strategy
  • SP 500 is an example

44
Derivation of Value-Weighted Index
45
Example of Value-Weighted Index
  • Stock ABC sells initially at 25 a share with
    20 million shares outstanding, while XYZ sells
    for 100 a share with 1 millions shares
    outstanding. The final price for ABC is 30, and
    the final price for XYZ is 90.

46
Example of Value-Weighted Index
  • (a) Find the the value-weighted index composed
    of these two stocks at the final date. Assume the
    initial level of the index is 100.
  • (b) Now if stock XYZ is split two for one,
    how will the market value-weighted index be
    affected?

47
Equally Weighted Indices
  • Computed by assuming equal dollar amount in each
    stock
  • Implies periodic rebalancing of the portfolio (no
    buy and hold)
  • CRSP index is an example

48
Derivation of Equally Weighted Index
49
Example of Equally Weighted Index
  • Stock ABC sells initially at 25 a share with
    20 million shares outstanding, while XYZ sells
    for 100 a share with 1 millions shares
    outstanding. The final price for ABC is 30, and
    the final price for XYZ is 90.

50
Example of Equally Weighted Index
  • (a) Find the the equally weighted index
    composed of these two stocks at the final date.
    Assume initially 100 are invested in each stock.
  • (b) At the final date, how should you
    rebalance your portfolio to have an equally
    weighted portfolio?

51
Hang Seng Index
  • Freefloat-adjusted market capitalization weighted
  • Exclude shareholdings with lock-up arrangement
  • 15 cap on individual stock weightings
  • Re-capping Q1 Q3
  • H-shares included

52
Bond Index
Computed monthly Difficulty in measuring true
returns Best known Merrill Lynch Lehman
Brothers Salomon Smith Barney
53
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

54
Options
Call option - the right to buy Put option - the
right to sell Hedgers protect themselves just in
case
55
Long Call Profit or Loss
Dow Chemical 85 July Call - Buy 1 Call
Premium 1 3/8
600 500 400 200 0
Payoff
Profit Break even Loss
-137.5 -200 -400 -500
Profit / Loss
85 863/8 90 913/8
Common stock price
56
Option Quotes
57
Option Valuation
  • Binomial Tree Approach Replicating option
    payoffs with stocks and bonds
  • ? C26.85
  • Black-Scholes Formula

150
200
75
Alternative Portfolio Buy 1 share of stock at
100 Borrow 46.30 (8 Rate) Net outlay
53.70 Payoff Value of Stock 50 200 Repay
loan - 50 -50 Net Payoff 0
150
53.70
C
100
0
0
50
Payoff Structure is exactly 2 times the Call
Call Option Value X 125
Stock Price
58
The Black-Scholes Formula
  • The Black-Scholes option pricing formula
  • For a European call option on a stock paying no
    dividend
  • N(d) probability that a random draw from a
    normal dist. will be less than d.
  • The option value does not depend on the expected
    return on the stock (risk-neutral valuation)

59
Warrant/Put Warrant
  • Essentially, call/put options issued by a firm
  • Difference warrant exercise requires firm to
    issue new shares (ownership dilution!)
  • See page 717 of the textbook for more details.

60
Futures Contracts
Obligation not right Agree on price for a future
date Used by hedgers not just speculators
61
Payoff Profile of Futures Contract
  • PT Underlying Asset Price at expiration,
  • F Agreed upon price
  • Payoff (profit) at expiration.

Long PT F
PayoffProfit
Short F- PT
F
F
PT
-F
62
Futures Quotes
63
Futures Pricing
  • Spot-futures parity theorem - two ways to acquire
    an asset for some date in the future
  • Purchase it now and store it
  • Take a long position in futures
  • These two strategies must have the same market
    determined costs
  • With a perfect hedge the futures payoff is
    certain -- there is no risk
  • A perfect hedge should return the riskless rate
    of return

64
Help these two ladies
  • How do you make both ladies happier without
    costing you anything?
  • Option/Futures contracts
  • Sign an agreement with umbrella-selling lady, pay
    her 5 if it shines, she pays you 5 if it rains.
    The reverse with sunglasses-selling lady.
  • Weather derivatives

65
Key to Derivatives Pricing No Arbitrage
  • The current prices of asset 1 and asset 2 are 95
    and 43
  • Tomorrow, one of two states will come true
  • A good state where the prices go up or
  • A bad state where the prices go down
  • Asset1 100
  • Asset2 50
  • Asset1 95
  • Asset2 43
  • Asset1 80
  • Asset2 40
  • Do you see any possibility to make risk-free
    money out of this situation?

66
There is no free lunch!
Derivatives
Stocks
Corporate Bonds
T-Bonds
Money
67
Summary
  • Financial securities
  • Indices
  • Next class Financial Market Trading
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