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CHAPTER 1: October 19, 1987 – Monday Dow declined 22.6% in one day. Biggest dropsince black Monday in 1929 when market dropped slightly over 12%. Financialassets aren’t only volatile investments, gold moved from $35 an ounce to $875 andback to $300 in 1998. Silver moved from $5 to $50 to $7, and real estate droppedby 30% in value in late 1980s but has not moved back up. Asset Allocation refersto the division of assets among different classes of investments. An investmentis a commitment of current funds in anticipation of receiving larger future flowof funds. The investor hopes to be compensated for foregoing immediateconsumption and inflation for taking the risk. Real assets are actual tangibleassets that may be seen, felt, held or collected. Include: real estate, preciousmetals, jewels, art, collectibles. Financial assets represent a financial claimon an asset that is usually documented by some form of legal representation. (1)commodity futures – a contract to buy or sell a commodity in the future at a givenprice. (2) creditor claims – a debt instrument offered by institutions,industrial corporations or governments. (3) direct equity claims – representsownership interest including common stock and other instruments like warrants andoptions used to purchase common stock. A warrant is usually a long terminstrument representing one share; while an option is usually a short terminstrument generally based on 100 shares. //// INVESTOR OBJECTIVES: (1) Risk &Safety of Principal: The first factor investors must consider is the amount ofrisk they are prepared to assume. In an efficient and informed capital market,risk tends to be closely correlated with return. There is risk of losing investedcapital directly but also danger of losing purchasing power with inflation in whatyou invest in doesn’t do anything. Risk averse investors may choose more shortterm instruments while more aggressive investors may choose longer-terminvestments and common stock. Diversification is also important to investorsstocks thriving in a positive economy and gold thriving with bad news. Age andeconomic circumstances are important to investors also. (2) Current Appreciationvs. Capital Appreciation – there is usually a tradeoff between growth and income.High-yield utilities pay the dividend each year but expect slow growth in earningsand stock price, while high growth tech stocks probably don’t pay dividends. (3)Liquidity Considerations – liquidity refers to ability of investor to convertinvestment into cash within a relatively short time at its fair market value orwith a minimum capital loss on the transaction. Financial assets usually trade atrelatively low commission, while many real assets have transaction costs from 5-25%. Most financial assets = high liquidity. Real estate = lower. (4) Short-term vs Long-term Orientation – traders engage in short term market tactics oftenusing technical analysis to try to beat the market, and pay more commissions formore activity.(5) Tax Factors – A high tax bracket investor may choose municipalbonds where interest is not taxable, real estate with depreciation and interestwrite-offs, or investments that provide tax credits or limited tax shelters.Taxpayer Relief Act of 1997: increased impact of tax considerations oninvestments, especially capital gains. Now, maximum rate will go down to 20% forassets held at least 18 months, and 18% for assets held at least 5 years. Maximumrates apply to higher income investors, but investors in lower tax brackets weretreated to proportionate capital gains tax relief as well. Dividend income wasgiven not tax relief in 1997 tax act. (6) Ease of Management – look atopportunity costs, should you run it yourself or would it cost less to havesomeone else run it. (7) Retirement & Estate Planning Considerations – IRA -$2000 per year can be deducted from taxable income and invested and allowed togrow tax free until withdrawn at retirement. Measures of risk return: rate ofreturn = ending value - beginning value + income / beginning value. Rate ofreturn = (P1 – Po) + D1 / Po. P1=price at end of period; Po=price at beginning ofperiod; D1 = dividend income. Risk: Wider dispersion of possible outcomes issaid to be riskier: investment can go from –20 to +40. The required rate ofreturn for a given investment is usually relate to the risk associated with theinvestment. Since most investors don’t like risk, they require a higher rate ofreturn to take on the risk. An investor of common stock requires a higher rate of

return than a cd, and this greater return is called the risk premium. ActualConsideration of Required Returns: (1) real rate, (2) inflation, (3) riskpremium. Real Rate of return is the return investors require for allowing othersto use their money for a given time period. Real means value is determined beforeinflation is calculated and before risk is added. Historically real rate has beenbetween 2-3%, 80s 4-6%. Measure real rate only after fact by subtractinginflation from nominal interest rate. Forecasting errors make it difficult todetermine real rate also, especially short-run returns. Inflation – combiningreal rate and inflation = required return on investment before considering risk.For this reason, it is called the risk free rate. Risk free rate = (1+realrate)(1+inflation)-1. The risk free rate applies to any investment as the minimumrequired rate of return to provide real return after inflation. If investoractually receives a lower return, the real rate of return can be quite low or evennegative. Risk premium – For federally insured investments, risk premiumapproaches zero. Then the return to the investor will be the risk-free rate =real rate + inflation. The geometric mean is the compound annual rate of return.The arithmetic mean is an average of yearly rates of return. Over long periods oftime, common stocks generally tend to perform at approximately the same level asreal assets with each tending to show different types of performance in differenteconomic environments – real assets do better in inflationary environments whilestocks and bonds do better with moderate inflation.CHAPTER 2: The Market Environment – deregulation in 80s and 90s allowed banks andsavings & loans to offer discount brokerage services and money market depositaccounts. Insurance companies also entered this market offering mutual funds andannuity products. Investors currently have more investment choices than everbefore. Continuous 24-hour trading is available starting with Tokyo, then London,then New York. By 1997, NASDAQ (over the counter market) was second largestequity market in world based on dollar trading volume. A market is a way ofexchanging assets, usually cash, for something of value. There does not have tobe a central place for this to happen, just that there is an exchange betweenbuyers and sellers and the exchange occurs. An efficient market occurs whenprices respond quickly to new information, and each successive trade is made at aprice close to the preceding price, and when the market can absorb large amountsof assets or securities without changing the price significantly. Liquidity is ameasure of the speed at which an asset can be converted to cash at its fair marketvalue. A liquid market = continuous trading, and as market gets larger pricecontinuity increases along with liquidity. Efficient and liquid markets allowinvestors to utilize new info and change strategy rapidly to accommodate.Secondary markets – are markets for existing assets that are currently tradedbetween investors. They create price and allow for liquidity. Primary markets –participants buy their assets directly from the source of the asset. Pricecompetition in the secondary market between different risk return classes enablethe primary market to price new issues at fair prices to reflect existing risk-return relationships. Most active participant = Investment Banker who acts as amiddleman in the process of raising funds and in most cases takes a risk byunderwriting an issue of securities. Three methods used to sell: (1)Underwriting is the guarantee the investment banking firm gives the selling firmto purchase its securities at a fixed price, thereby eliminating risk of notselling whole issue of securities and having less cash than desired. Underwritingis most widely used method to sell. With underwriting, after security is sold theinvestment banker will usually maintain the market for that security by buying andselling to ensure a continuously liquid market and wider distribution. (2) Theinvestment banker may also sell the issue on a best effort basis where the issuingfirm assumes the risk and simply takes back any securities not sold after a fixedperiod. (3) A very limited number of securities are sold directly by thecorporation to the public. With best effort and sold directly, the firm assumesrisk of not raising enough capital and has no guarantee that a continuous market

will be made in the company’s securities. Private Placement is when a firm sellsits own securities to a financial institution such as an insurance company, apension fund, or a mutual fund or it engages an investment banker to find aninstitution willing to buy a large block of stock or bonds. Most privateplacements involve bonds, not common stock. Investment Banker – on some largeissues, the investment banker does not underwrite it alone, instead forms asyndicate. The larger the offering, usually the larger the participants involved.Glass Stegal Act of 1930 prevents U.S. banks from acting as investment bankers.Firms that are part of syndicate are usually listed on Tombstone advertisement.How much each firm has underwritten is contained in the prospectus – an in depthdocument published by lead managing underwriter. Investment bankers agree topurchase new security at a discount from the public price and sell their allottedshares. Depending on what price shares actually sell at determines whatunderwriters make or lose. Brining private companies public for the first time iscalled an initial public offering (IPO) and distribution costs to the sellingcompany are higher than offerings of additional stock by companies that arealready public. SECONDARY MARKETS: once investment banker or Federal Reserve forU.S. government securities has sold a new issue, it trades on the secondary marketthat provides liquidity, efficiency, continuity and competition. OrganizedExchanges fulfill need for a central location where trading occurs between buyersand sellers. Either national (NYSE or AMEX) or regional (Chicago, Cincinnati,Philadelphia & Boston, Pacific Coast Exchange in San Francisco and Los Angeles).Dual trading is when securities (90%) trade on Pacific and Chicago exchange andare listed on NYSE. Exchanges have a central trading location where securitiesare bought and sold in an auction market by brokers acting as agents for thebuyers and sellers. Stocks usually trade at the various trading posts on thefloor of the exchanges. Brokers are registered members of the exchanges.Consolidated ticker tape instituted on June 16, 1975, allowed brokers on the floorof one exchange to see prices of transactions on other exchanges in the duallylisted stocks. Transactions made at different exchanges are displayed on thistape. This keeps composite price data more efficient and prices more competitivebetween exchanges at all times. Listing Requirements for Firms: (1) demonstratedearning power under competitive conditions of 2M for two previous years and 2.5Mfor most recent year-all three years profitable, (2) net tangible assets of 40M,(3) market value of publicly held shares currently=40M, (4) 1.1M common sharespublicly held, (5) either 2,000 holders of 100 shares or more or 2,200 totalstockholders together with average monthly trading volume for most recent sixmonths of 100,000 shares. Delisting – NYSE removes security from trading when itfails to meet certain criteria. NYSE has 1,366 members who have seats which maybe leased or sold with approval of the NYSE. The price of seats fluctuates goingup with the bull and down with the bear from $35,000 in 1977 to 2.2M in 1998.Members owning seats can be divided into five categories: (1) commission broker –represents commission houses like Merrill Lynch and execute orders on the floorof the exchange for their customers. (2) floor brokers – registered to trade onthe floor but not employees of a member firm. They help commission brokers whenthey are busy and they own their own seats and charge a small fee for theirservices. (3) registered traders – own their own seats and are not associatedwith member firms. They are registered to trade on their own account and do so toearn a profit. (4) odd-lot dealers – dealers own their own inventory and buy andsell for their own accounts. (5) specialists – ¼ of total membership – each stocktraded has a specialist assigned to it, with each specialist responsible for morethan one stock. First they must handle any special orders that commission brokersor floor brokers might give, and second is to maintain continuous, liquid andorderly markets in their assigned stocks, and finally to stabilize the market byguying and selling from their own accounts against the prevailing trend. SuperDot allows NYSE members to electronically transmit all market and limit ordersdirectly to the specialist. Electronic Book – database that covers stocks listedon NYSE and keeps track of limit and market orders for the specialist. Other