The Investment Environment, Markets, Instruments and Financial Institutions

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Lecture 1 INTRODUCTION

• The Investment Environment, Markets, Instruments
  and Financial Institutions

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Role of Financial Assets and Markets in the
Economy

• Financial assets are claims on real assets. They
  allow for
• Consumption Timing
• Allocation of Risk
• Separation of Ownership

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How the Financial System Meets the Needs of
Participants

• Financial Intermediation
• Investment Banking
• Financial Innovation Derivatives
• Responding to Regulation Taxes

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Key trends

• Globalization
• Securitization
• Financial Engineering

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Three Traditional Barriers to International Stock
Trading
Transaction Costs
Classic Barriers To Capital Flow
Information Costs
Exchange Risk Costs
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The Future

• Globalization continues and offers more
  opportunities
• Securitization continues to develop
• Continued development of derivatives and exotics
• Integration of investments corporate finance

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• Financial Marketsand Instruments

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Major Classes of Financial Assets or Securities

• Debt
• Money market instruments
• Bonds
• Common stock
• Preferred stock
• Derivative securities

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Where are they traded?

• Money Market
• Debt Instruments (Treasury bills, Certificates of
  deposit, Commercial Paper, Bankers Acceptances,
  Eurodollars, Repurchase Agreements (RPs) and
  Reverse RPs,..)
• Derivatives
• Capital Market
• Bonds
• Equity
• Derivatives

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Fixed Income Instruments

• Publicly Issued Instruments
• Treasury Bonds and Notes
• Agency Issues (Gov)
• Municipal Bonds
• Privately Issued Instruments
• Corporate Bonds
• Mortgage-Backed Securities

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Equity

• Common stock
• Residual claim
• Limited liability
• Preferred stock
• Fixed dividends - limited
• Priority over common

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Derivatives Securities

• Options
• Terms
• Exercise Price
• Expiration Date
• Assets

• Futures
• Terms
• Delivery Date
• Assets

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Market Index

• 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?

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Examples

• Dow Jones Industrial Average (30 Stocks),
  Standard Poors 500 Composite, NASDAQ
  Composite, NYSE Composite, Wilshire 5000
• Nikkei 225 Nikkei 300, FTSE (Financial Times of
  London), Dax, Region and Country Indexes (EAFE,
  Far East, United Kingdom)
• BOND INDICES Lehman Brothers, Merrill Lynch,
  Salomon Brothers, Specialized Indexes (Merrill
  Lynch Mortgage)
• SBI 20, PIX, IPT, BIO, SBINT, PUBIX...

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Example SBI20 and BIO
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Construction of an Index

• How are stocks/bonds weighted?
• Price weighted (DJIA)
• Market-value weighted (SP500, NASDAQ)
• Equally weighted (Value Line Index)
• How are returns averaged?
• Arithmetic (DJIA and SP500)
• Geometric (Value Line Index)
• http//en.wikipedia.org/wiki/Dow_Jones_Industrial_
  Average

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Averaging Methods

• Component Return
• A10 B (-5) C 20
• Arithmetic Average
• .10 (-.05) .2 / 3 8.33
• Geometric Average
• (1.1) (.95) (1.2)1/3 - 1 7.84

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• How Securitiesare Traded

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Role of financial markets

• match supply and demand of financial assets.
• stocks, bonds, commodities, derivatives
• Is demand for stocks important?
• there are transaction costs!

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Market capitalization as of GDP (end 2000)
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Classification of markets

• Primary vs. secondary
• IPOs, seasoned offerings
• public offerings vs. private placements
• Money vs. capital markets

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Organization of Secondary Markets

• Organized exchanges
• OTC market
• Third market
• Fourth market

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1. Organized Exchanges

• Auction markets with centralized order flow
• Dealership function can be competitive or
  assigned by the exchange (Specialists)
• Securities stock, futures contracts, options,
  and to a lesser extent, bonds
• Examples NYSE, AMEX, Regionals, CBOE, LSE,
  LJSE, BSE,

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2. OTC Market

• Dealer market without centralized order flow
• NASDAQ largest organized stock market for OTC
  trading information system for individuals,
  brokers and dealers
• Securities stocks, bonds and some derivatives

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3. Third Market

• Trading of listed securities away from the
  exchange
• Institutional market to facilitate trades of
  larger blocks of securities
• Involves services of dealers and brokers

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4. Fourth Market

• Institutions trading directly with institutions
• No middleman involved in the transaction
• Organized information and trading systems
• ECN Development
• INSTINET
• POSIT

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I. Organization of financial markets

• Periodic vs. continuous trading
• Price driven vs. order driven
• Other aspects
• centralization
• transparency
• regulation

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Periodic vs continuous trading

• Periodic trading batch auctions
• often used for initial offerings of stocks and
  bonds
• also for secondary markets with low turnover
• Continuous trading
• for secondary markets with high turnover, like
  equity markets (e.g. AEX), foreign exchange
• Some continuous markets start or close trading
  sessions with a batch auction
• Euronext, NYSE

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A Price / quote driven markets

• Limited number of professional market makers
  provide bid and ask quotes
• buy and sell prices
• Other participants trade with market makers
• Quotes may be firm or indicative
• Market makers trade for own account

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Price driven markets

• Examples
• London Stock Exchange
• NASDAQ
• foreign exchange market
• bond market

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B. Order driven markets

• Limit order market liquidity is provided by
  public limit order book
• continuous double auction
• trading is against these limit orders
• Examples
• Euronext, Xetra (Frankfurt)
• Open outcry markets
• trading on orders provided by trading crowd
• often used in futures and option markets

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Hybrid trading structures

• Pure price and order driven markets are rare,
  most exchanges are mix of both
• NYSE has one specialist for each stock, competes
  with public limit orders
• AEX used to have similar system (hoekman)
• London Stock Exchange and NASDAQ recently
  introduced limit orders that compete with market
  makers

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Recent developments

• General tendency towards hybrid systems and
  separation by order size
• limit order system for small trades
• quote driven systems for large trades
• Motivated by
• competition between exchanges
• execution costs

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II. Quality of markets

• Execution costs
• explicit costs fees, taxes
• implicit cost bid-ask spread
• Liquidity
• price impact of trade
• risk of non-execution
• resiliency (speed of price recovery)
• Price efficiency

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Quality of markets (2)

• Transparency
• large differences in pre-trade and post trade
  transparency among markets
• e.g. EURONEXT very transparent, foreign exchange
  market not at all
• Privileges for specialist
• NYSE only specialist knows limit order book and
  may stop orders

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Quality of markets (3)

• Fragmentation of order flow
• off exchange trading
• dual or multiple listings
• mergers of exchanges

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Ljubljana stock exchange?
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Quality of markets (4)

• Regulation of prices
• priority rules (price/time)
• tick size
• circuit breakers

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Regulation of Securities Markets

• Government Regulation
• Self-Regulation
• Circuit Breakers
• Insider Trading

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Types of Orders

• Instructions to the brokers on how to complete
  the order
• Market
• Limit
• Stop loss

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Margin Trading

• Using only a portion of the proceeds for an
  investment
• Borrow remaining component
• Margin arrangements differ for stocks and futures

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Short Sales

• Purpose to profit from a decline in the price
  of a stock or security
• Mechanics
• Borrow stock through a dealer
• Sell it and deposit proceeds and margin in an
  account
• Closing out the position buy the stock and
  return to the party from which it was borrowed

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• Mutual Funds and Other Investment Companies

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Services of Investment Companies

• Professional management
• Administration record keeping
• Diversification divisibility
• Reduced transaction costs

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Net Asset Value

• Used as a basis for valuation of investment
  company shares
• Selling new shares
• Redeeming existing shares
• Calculation
• Market Value of Assets - Liabilities
• Shares Outstanding

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Types of Investment Organizations

• Unit Trusts
• Managed Investment Companies
• Open-End
• Closed-End
• Other investment organizations
• REITs

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Open-End and Closed-End Funds Key Differences

• Shares Outstanding
• Closed-end no change unless new stock is offered
• Open-end changes when new shares are sold or old
  shares are redeemed
• Pricing
• Open-end Net Asset Value(NAV)
• Closed-end Premium or discount to NAV

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Costs of Investing in Mutual Funds

• Fee Structure
• Front-end load
• Back-end load
• Operating expenses
• Fees and performance

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Exchange Traded Funds

• Allow investors to trade funds based on indexes
  like stock.
• Examples
• SPDRS
• WEBS
• HOLDERS
• Allow sector or regional specialization

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Types of Exchange-Traded Funds (ETFs)

• Cube (QQQQ)
• Tracks Nasdaq100 index
• Traded on Amex
• Investors may speculate on future of technology
  stocks
• Purchase on margin
• Sell short
• Spider (SP Depository Receipt)
• Tracks SP 500 index
• Trade at one-tenth SP 500 Index level
• http//www.morningstar.com/Cover/ETF.html

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A First Look at Fund Performance

• Benchmark Wilshire 5000
• Results
• Most funds underperform
• Not fair comparison because of costs
• Adjusted Benchmark Wilshire 5000 with passive
  management costs considered.
• The majority of funds still under-perform.

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Consistency of Fund Performance

• Do some mutual funds consistently outperform?
• Evidence suggests that some funds show consistent
  stronger performance.
• Depends on measurement interval
• Depends on time period
• Evidence shows consistent poor performance.