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
AnalysisFinancial SecuritiesDragon Yongjun
TangJanuary 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