Title: What is Dow Jones? Charles Dow; Edward Jones. Inventors o
1How to pick stocks?
- Good company vs good stock
- Macroeconomic condition
- Profitability and investment
2Price 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?
3Consumption Preference
- Which do you prefer?
- A) Starve (nearly to death) on odd days and stuff
on even days or - B) Eat comfortably every day.
4Help 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?
5FINA 2802 Investments and Portfolio
AnalysisFinancial SecuritiesDragon Yongjun
TangJanuary 14 19, 2010
6Lectures 2 3 Financial Securities
- Reading Chapter 2
- Practice Problem Sets 1,2,3,6,8,9,11,12,13,17
7Learning 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
8Financial Securities
High Risk
Low Risk
Money Market (Short-term)
Common Stocks Preferred Stocks
Options Futures
Bond Market (Long-term)
Index
9Money Market Instruments
üTreasury Bills Certificates of deposit
Commercial paper Bankers acceptances
Eurodollars Repos and reverses Brokers
calls Federal funds LIBOR
10Treasury 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
11Figure 2.2 Treasury Bills
12Figure 2.1 Money Rates
13Figure 2.3 Spreads on CDs and Treasury Bills
- Difficult to predict
- Widen during crisis
14Bond Market
- Treasury Notes and Bonds
- Inflation-Protected Treasury Bonds (TIPS)
- Federal Agency Debt
- International Bonds
- Municipal Bonds
- Corporate Bonds
- Mortgages and Mortgage-Backed Securities
15Treasury 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
16Figure 2.4 Treasury Notes, Bonds and Bills
17Federal 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)
18Figure 2.5 Government Agency Similar Issues
19Municipal Bonds
- Issued by state and local governments
- Types
- General obligation bonds
- Revenue bonds
- Industrial revenue bonds
- Maturities range up to 30 years
20Municipal 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
21Municipal Bonds
Interest is exempt from Federal taxes After-tax
return (taxable bond) After-tax return
(Municipal bond)
22Figure 2.7 Ratio of Yields on Tax-exempts to
Taxables
23Equivalent Taxable Yield
24Table 2.3 Equivalent Taxable Yields
25Corporate 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
26Figure 2.8 Corporate Bond Prices
27Bond 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
28Outstanding U.S. Bond Market Debt in 2006
(USBillions)
- Source Securities Industry and Financial Markets
Association (www.sifma.org)
29mini-bond
- Not well defined!
- Official term credit-linked notes
- Credit derivative!
- Counterparty risk!
30Equity Markets
- Common stock
- Residual claim
- Limited liability
- Preferred stock
- Fixed dividends - limited
- Priority over common
- Tax treatment
- Depository receipts
31Figure 2.10 Listing of Stocks Traded on the NYSE
32What is Dow Jones?
33What is Dow Jones?
- Charles Dow Edward Jones
- Inventors of tickers
- Publishing WSJ, Barrons, etc.
34Uses of Stock Indexes
- Track average returns
- Comparing performance of managers
- Base of derivatives
35Factors for Construction of Stock Indexes
- Representative?
- Broad or narrow?
- How is it weighted?
36Examples of Indexes U.S. Domestic
- Dow Jones Industrial Average (30 Stocks)
- Standard Poors 500 Composite
- NASDAQ Composite
- NYSE Composite
- Wilshire 5000
37Figure 2-11 Comparative Performance of Several
Stock Market Indexes
38Examples 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
39Construction of Indexes
- How are stocks selected?
- Subjective
- How are stocks weighted?
- Price weighted (DJIA)
- Market-value weighted (SP500, NASDAQ)
- Equally weighted (Value Line Index)
40Price 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
41Derivation of Price-Weighted Index
42Example 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?
43Value-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
44Derivation of Value-Weighted Index
45Example 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.
46Example 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?
47Equally 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
48Derivation of Equally Weighted Index
49Example 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. -
50Example 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?
51Hang 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
52Bond Index
Computed monthly Difficulty in measuring true
returns Best known Merrill Lynch Lehman
Brothers Salomon Smith Barney
53Derivatives 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
54Options
Call option - the right to buy Put option - the
right to sell Hedgers protect themselves just in
case
55Long 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
56Option Quotes
57Option 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
58The 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)
59Warrant/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.
60Futures Contracts
Obligation not right Agree on price for a future
date Used by hedgers not just speculators
61Payoff 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
62Futures Quotes
63Futures 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
64Help 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
65Key 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?
66There is no free lunch!
Derivatives
Stocks
Corporate Bonds
T-Bonds
Money
67Summary
- Financial securities
- Indices
- Next class Financial Market Trading