Investments

Autumn 2019-20

Professor Marcin Kacperczyk

Course Outline
n Institutions: review
n markets, instruments, players, performance
n Equity markets
n portfolio theory, CAPM, arbitrage, factor models
n Fixed income markets
n bonds, pricing, interest rate risk
n Derivatives
n options

2
Course Expectations
n Familiarity with concepts and basic tools
n Proficiency at applying the tools
n Understanding current empirical evidence
n Sapere aude!

3
 Course Materials
n Required
n Lecture notes
n Bodie, Kane, Marcus “Investments” (11th ed.)
n Recommended
n WSJ/FT/NYT/Economist/Bloomberg/CNBC
n Diary from WSJ (posted on Hub daily)
n Supplementary readings (updated weekly)

4
 Contact
n In class
n Office (PG53 2-02): W 10:00-11:30
n Hub

5
 Teaching Assistant

n Salim Baz: salim.baz09@ic.ac.uk

n Excellent PhD student at Imperial
n Office hours (Wednesday, 3-4pm CAGB500)
n Will hold weekly tutorials:
n MSc IWM Group 1: Friday 9-10am (LG101-LGR)
MSc IWM Group 2: Friday 10-11am (LG101-LGR)
MSc Finance Group 1: Friday 1-2pm (LG19A)
MSc Finance Group 2: Friday 2-3pm (LG19A)
6
Grades
n Homework: 20% (two assignments: due
October 31st and December 5th)
n Final Exam: 80%
n Grades distributed according to Imperial
rules

7
 Questions…

Comments…

Controversies…
8
 Lecture 1
Institutions: Review
Financial Instruments and Markets
 Investment Process
n Investment: A current commitment of money or
resources in expectation of future benefits
n Types of assets
n real assets: used to produce goods & services
n example: factory, equipment, talent

n financial assets: claims on real assets

n example: stocks, bonds, options

11
Financial Instruments

n Money market
n Fixed income capital market
n Equities
n Derivatives

12
 I. Money Market Securities
n Borrowing instrument (issued by reputable agents)
n Short term (up to one year)
n No coupons (interest only)
n Low risk of default (close to risk free)
n Highly liquid (high volume/ low transaction costs)

13
Money Market Instruments
n Treasury Bills
n Certificates of Deposit (CDs)
n Commercial Paper
n Repurchase Agreements (Repos)
n Federal Funds
n LIBOR Market
n …

14
Commercial Paper Crisis
 II. Fixed Income Securities
n Borrowing instruments (Treasury, municipal,
corporate)
n Fixed cash flows: coupons or interest payment
n Cash-flow diagram for buying and holding on to
a 10-year, 8%, semi-annual coupon bond with
$1000 face value
- Price $40 $40 $40 $1,040

t=0 t=0.5 t=1.0 t=9.5 t=10.0

16
Treasury Bonds
n Types of Treasury bonds
n Treasury Notes (1-10 years maturity)
n Treasury Bonds (10-30 years maturity)
n Semi-annual coupon payments
n Which bond pays a higher interest rate:
10-year T-bond or 1-year T-note?
n Why are government bonds traditionally
seen as safe investment?
17
U.S. Debt to GDP

18
 Municipal Bonds (Munis)
n Issued by state and local governments
n Exempt from federal income tax
n Exempt from (issuing) state local tax
n Types of munis
n General obligation bonds: Backed by the
full faith of credit of the issuer (taxing power)
n Revenue bonds (riskier): Issued to finance
specific projects (airports, hospitals, etc.)

19
 Muni vs. Treasury Bond
n A (general obligation) muni bond pays 4% interest
n A Treasury bond pays 5% interest
n Which bond would you rather own if your marginal
tax rate on interest payments is 20%?
n What if your marginal tax rate is higher?

20
Corporate Bonds
n Corporate bond
n Longer term
n Default risk
n Different seniority classes
n senior
n junior or subordinated

21
 III. Equity
n Equity
n Ownership in a firm
n Future cash flows (dividends) are uncertain
n Maturity is indefinite
n Involves risk, variable liquidity
n Two main classes of equities
n Common Stock: limited liability, voting rights, junior
n Preferred Stock: fixed dividend, non-voting, senior

22
Equity: Aggregate Performance
n Dow Jones Industrial Average
n Price-weighted index
n Includes only 30 blue-chip companies

n Standard & Poor’s Composite 500 Index

n Value-weighted index
n Includes 500 firms

23
 Historical US Stock Performance
Average (geometric) Equity Return over the Rolling 10-year Period
20.0%

15.0%

10.0%

5.0%

0.0%

-5.0%

24
 Markets: Abysmal 2008

Stocks are risky, in 1933 the return was +57.5%, but in

1931 the return was -44.4% (2008: -38.3%)
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 Markets: Stock Investment
n The past century the average return on US
stocks was about 10.22%
n If you invested $10 in 1900 you would have
had 10*1.1022100*$1=$168,280 in 2000
n This does not correct for changes in
purchasing power (inflation)

26
Financial Instruments: Overview
Assets Total Value (2018 Q.4)
Money Market Instruments $25,009 B
Checkable Deposits and Currency $4,542 B
Time and Savings Deposits $12,200 B
Money Market Mutual Fund Shares $3,038 B
Federal Funds and Security Repurchase Agreements $4,133 B
Open Market Paper $ 996 B
Fixed Income Capital Market $43,421 B
Treasury Securities $17,685 B
Agency Securities $9,021 B
Municipal Securities and Loans $3,964 B
Corporate and Foreign Bonds $12,751 B
Corporate Equities $42,971 B

Source: Flow of Funds (Federal Reserve Board):

September 20, 2019

27
IV. Derivatives
n Securities whose cash flows depend on
values of other assets
n Examples: Options, Futures, Swaps, Bonds
with option-like feature (convertible or
callable bonds)

28
Derivatives: Options and Futures
n Call (Put) Option: Right to buy (sell) the underlying
asset
n At a specified price (strike price)
n On a specified date (maturity)
n Long (Short) Futures: Obligation to buy (sell) the
underlying asset
n At a specified price
n On a specified date
n Two kinds: Commodities or financial

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Financial Markets
 Equilibrium Prices
n What determines the price?
n In economic theory? In reality?
n What is the equilibrium price?
n What’s the mechanism that drives prices towards equilibrium?
Price

Supply
P*=40

Demand

Q*=20,000 40,000 Quantity

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Asset Markets

n Primary Market
n Market for new issues of securities
n Initial Public Offerings (IPO)
n Seasoned Public Offerings
n Private Placements
n Secondary Market
n Existing securities are traded

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 Different Auction Mechanisms
n Consider uniform-price sealed-bid auction versus
multiple-price (discriminatory) sealed-bid auction
P S P S
$50 $__
$49 $__
$48 $__
D D

Q Q

n What do the three bidders with highest prices bid?

n What is the shaded area?
n Which auction would you prefer as the auctioneer?
33
Issuing Securities
n Issuing Securities
n Initial Public Offering (IPO)
n Seasoned Equity Offering (SEO)
n Investment Banks
n Underwrite public offerings in syndicates
n Prepare prospectus to get approval from the
Securities and Exchange Commission
n Underwriting arrangements
n Firm commitment
n Best efforts
34
 LNUX (Linux)
Stock Price Performance

First-
Day
Close
$239.25

IPO-
Price
$30

35
# of IPOs (Bars) and Average First-
Day Returns (Diamonds): 1980-2018

Source: Jay Ritter’s website 36

IPO Profile

37
 Greece
Sw itzerland
Average first-day returns on (mostly) European IPOs

Sw eden
Germany
Ireland
Cyprus Source: Jay Ritter’s IPO Data web site page provides details for each country
United States
United Kingd om
Italy
Finlan d
Israel
Belgium
Netherlands
Poland
Portugal
France
Turkey
Spain
Denmark
Norway
Austr ia
Russia

0%
60%

50%

40%

30%

20%

10%

-10%
Average first-day returns
 Saudi Ara bia
China (A shares)
Jordan
India
Average first-day returns on non-European IPOs

S. Korea
Malaysia
Japan
Hong Kong
Thailand
Taiwan
Sri La nka
Brazil
Indonesia
Sin gapore
Australia
South Afr ica
Philippines
United States
New Zeala nd
Israel
Nigeria
Mexic o
Turkey
Egypt
Chile
Canada
Argentina

0%
80%
60%
40%
20%
240%
220%
200%
180%
160%
140%
120%
100%
Average first-day returns
 Long-Term Performance of
IPOs (1980-2017)

Source: Ritter (2019) 40

Two IPO Puzzles

n IPO stocks experience on average large

returns on the first day of trading
n IPO stocks underperform relative to
comparable publicly traded companies
over the next five years

41
Trading of Securities
n Exchanges
n NYSE-Euronext
n NASDAQ
n Deutsche Bӧrse
n London Stock Exchange

n The Over-the-Counter (OTC) Market

n Bond market
n OTC Bulletin Board
n Pink Sheets
42
Types of Orders
n Market order
n Orders are executed immediately at best price
n Limit order
n Buy if price is at, or below, limit
n Sell if price is at, or above, limit
n Stop order
n Buy if price increases above limit
n Sell if price falls below limit

43
Trading on Exchanges
n Investor places an order with a broker
n Brokerage firm contacts its commission
broker or independent floor broker to execute
an order
n The specialist makes a market in the shares
of one or more firms
n Maintains a limit order book
n Maintains a fair and orderly market by dealing
personally in the stock

44
 Example of a Limit Order Book
n Last trade: $50 Buy Orders Sell Orders
n If a market buy for 100 Price Shares Price Shares
shares comes in, what
price will it get? 49.75 500 50.25 100

n At what price will the 49.50 800 51.50 100

next market buy be filled?
49.25 500 54.75 300
n If you were the specialist,
would you want to or 49.00 200 58.25 100
your inventory?
48.50 600

45
Costs of Trading
n Commission
n Fee paid to broker
n Bid-Ask Spread
n Bid: Price dealer will buy from you
n Ask: Price dealer will sell to you
n Market Impact
n Larger orders impact the market price
n Taxes
n Government taxes realized capital gains for
taxable investors
46
Bulls and Bears
n Buying on Margin
n Use borrowed funds to invest in securities
n Bullish strategy
n Short Sales
n Sell securities without owning them
n Bearish strategy

47
Buying on Margin
n Federal securities law mandates
limitations on borrowing
n Initial margin must exceed 50%
n Maintenance margin must exceed 30%
n The margin is defined as
Equity Value of Security - Loan
Margin = =
Value of Security Value of Security

48
Buying on Margin
n Suppose you have $10,000 and you are
very bullish about Microsoft
n You can borrow $10,000 from your
broker at a 10% interest rate
n Buy $20,000 worth of MSFT stock
n What are the returns of this trading
strategy if Microsoft stock increases or
falls by 25% during the next year?
49
Return of Buying on Margin
MSFT increases MSFT decreases
25% 25%
Value of Stock
Position
Pay Back Loan

Net Value of
Account
Return

50
Risks of Margin Purchases
n Broker gives you a margin call if the
maintenance margin is not met
n Broker can sell your securities without
asking for your permission
n The potential losses can exceed your
initial investment

51
 Example of Margin Calls
n Suppose that MSFT dropped within a year by
25%. Will you get a margin call?

52
 Short Sales: Mechanics
•Receive Stock
n Bank profit is FEE •Get dividend
•Lend Stock •Get fee

t=0 t=1
n Investor profit is P0-P1-FEE-Dividends
•Buy Stock for P1
•Return Stock
•Borrow Stock •Pay dividends
•Sell stock for P0 •Pay fee

t=0 t=1

53
Margins
n The broker keeps the proceeds and requires
in addition a margin account as collateral
n The short seller needs to add funds to the
margin account if the account balance falls
below the maintenance margin
n Short interest is the number of short
positions relative to the trading volume

54
 Risks of Short Sales
n Broker can force you to cover short position
n If borrowed stocks are called back from lender
and broker cannot borrow different shares
n If margin call is not satisfied
n Potential losses of short sales are unlimited

55
Performance of Securities
 Quoted Rates and EAR
n Example
n Interest rate quoted at 10% compounded
semi annually
n Which loan is cheapest?
n 10%: compounded semi annually
n 10%: compounded quarterly
n 10%: compounded daily
n Effective Annualized Rate EAR if interest
is compounded m times a year
n EAR = (1+ quoted rate / m ) m - 1
57
Continuous Compounding
n Suppose the quoted rate is given
n Consider increasingly frequent compounding:
annually, quarterly, daily, every second,…
n What happens to the EAR?
n When compounding happens all the time, it
is called continuous compounding
n EAR = exp(quoted rate) - 1

58
Continuous vs. Annual Compounding

n Suppose R=5%, PV=1000

n Annual compounding
n 1 year: FV=1000*1.051=1050
n 2 years: FV=1000*1.052=1102.5
n T years: FV=PV*(1+R) T=1000*1.05T
n Continuous compounding
n 1 year: FV=1000*e0.05=1051.27
n 2 years: FV=1000*e0.05*2=1105.17
n T years: FV=PV*eR*T=1000*e0.05*T

59
 Holding-Period Return: Overview
n Suppose that
n at time 0, you buy an investment for V(0) (=PV)
n you reinvest all intermediate cash flows until date T
n at time T, you sell the investment and the reinvested
cash flows for a total price of V(T) (=FV)
n HPR=V(T)/V(0)-1
n The annual holding-period return (ann. HPR)
is the solution to V (0) (1 + ann.HPR)T = V (T )
1/ T
æ V (T ) ö
n Hence, the annual HPR is ann.HPR = çç ÷÷ -1
è V (0) ø
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 HPR: Stock Example
§ Holding-period return (HPR)
ending price + cash dividend
HPR = -1
beginning price
§ Annualized holding-period return for a holding
period of T years

ann. HPR = (1 + HPR )1 / T - 1 =

1/ T
æ ending price + cash dividend ö
= çç ÷÷ -1
è beginning price ø
61
HPR and Annualized HPR
§ You bought GE shares for $28.00 on
07/18/2008 and sold them 6 months later on
01/16/2009 for $13.96. Suppose there was no
dividend payment in these 6 months. What is
the HPR? What is the annualized HPR?
§ You bought GE shares for $36.95 on
01/19/2007 and sold them 2 years later for
$13.96. Assume that the only dividend is paid
at the end of year 2 of $1.24. What is the HPR?
What is the annualized HPR?
62
HPR: Zero-Coupon Bond
n FV=$1000, PV = $435, T=10 years
n R = (1000/435)(1/10)-1= 0.0868 = 8.68%
n This R is YTM, but also AHPR if you
hold a bond until maturity
n What about HPR if you sell ZCB early?
n after 1 year for $472.758?
n after 1 year for $480?
n after 1 year for $460?
63
Multiple-Period Realized Return (1)

n Arithmetic Average
1
( R1 + R2 + R3 + ... + RT )
T
n Useful for forecasting the return next period
n Not equivalent per-period return

64
 Multiple-Period Realized Return (2)

n Geometric Average
n Gives the equivalent per-period return

[(1 + R1 )(1 + R2 )(1 + R3 )...(1 + RT )] 1/ T

-1
1/ T
é accumulated valueT ù
= ê ú -1
ë value0 û
65
 Multiple-Period Return: Example
n Suppose the return for an emerging-market fund in
year 1 is 100% and in year 2 is -50%
n We forecast next year’s return to be
n (+100%-50%)/2=25% (arithmetic average)
n Annualized HPR
n $100 invested grows to $100*(1+1.00)*(1-0.50)=100,
so annualized HPR is (100/100)1/2-1=0%
n Shorter, use geometric average of gross returns
(2*0.5)1/2-1=0%
n Without reinvesting gains/losses the investor would
have gained $100 in year 1 and lost $50 in year 2, or
$50 in total over two years. This 25% return is the
arithmetic average (untouched by human hands)
66