Chapter 1

The Investment Environment

 The Investment Process

• Investors make two types of decisions:

1. Asset allocation
– Choice among broad asset classes
2. Security selection
– Choice of which securities to hold within asset class
– Security analysis to value securities and determine
investment attractiveness

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 Learning Objective 5:
Markets Are Competitive

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 Markets are Competitive (Ctd.)
Active Management Passive Management

• Finding • No attempt to find

mispriced undervalued
securities securities
• Timing the • No attempt to time
market the market
• Holding a highly
diversified portfolio

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23. Asset allocation refers to ____________.
A. choosing which securities to hold based on their valuation
B. investing only in "safe" securities
C. the allocation of assets into broad asset classes
D. bottom-up analysis
E. top-down analysis

C. Asset allocation refers to the allocation of assets into broad asset

classes.

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 24. Security selection refers to ____________.
A. choosing which securities to hold based on their valuation
B. investing only in "safe" securities
C. the allocation of assets into broad asset classes
D. top-down analysis
E. moving assets between stocks and bonds

A. Security selection refers to choosing which securities to hold based

on their valuation.

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 Learning objective 6
The Players

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 The Players

• Business Firms– net borrowers

• Households – net savers

• Governments – can be both borrowers

and savers (tax & expenditures)

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 The Players (Ctd.)
• Financial Intermediaries: Pool and invest funds
– Investment Companies
– Banks
– Insurance companies
– Credit unions

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 Universal Bank Activities
Investment Banking Commercial Banking
• Underwrite new stock
and bond issues • Take deposits and
• Sell newly issued make loans
securities to public in
the primary market
• Investors trade
previously issued
securities among
themselves in the
secondary markets

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25. Investment bankers perform the following role(s) ___________.
A. market new stock and bond issues for firms
B. provide advice to the firms as to market conditions, price, etc
C. design securities with desirable properties
D. make trades for small investors
E. market new stock and bond issues for firms, provide advice to the
firms as to market conditions, price, etc, and design securities with
desirable properties

E. Investment bankers market new stock and bond issues for firms,
provide advice to the firms as to market conditions, price, etc, and
design securities with desirable properties.

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 26. Commercial banks differ from other businesses in that both their
assets and their liabilities are mostly
A. illiquid.
B. financial.
C. real.
D. owned by the government.
E. regulated.

B.

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28. Financial intermediaries exist because small investors cannot
efficiently ________.
A. diversify their portfolios
B. assess credit risk of borrowers
C. advertise for needed investments
D. diversify their portfolios, assess credit risk of borrowers, or advertise
for needed investments
E. diversify their portfolios or assess credit risk of borrowers.

D. The individual investor cannot efficiently and effectively perform any

of the tasks above without more time and knowledge than that available
to most individual investors.

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29. _______ are examples of financial intermediaries.
A. Commercial banks
B. Insurance companies
C. Investment companies
D. Credit unions
E. Commercial banks, insurance companies, investment companies, and
credit unions

E. Banks, insurance companies, investment companies, and credit unions

are institutions that bring borrowers and lenders together.

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 Learning Objective 7 :
Financial Markets:

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 Financial Markets

1. Direct search market

2. Brokered market
3. Dealer market
4. Auction market

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 Types of Markets
Types of Markets:
• Direct search
– The least organized market
– Buyers and sellers seek each other
– Example; selling used cars or
electronics
– Non-standard goods
– Difficult for a company to profit by
specializing in this market

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 Types of Markets
• Brokered markets
– Next in organization
– Goods usually have higher value than direct search
Example : real estate
– The higher value of goods make it worthwhile for
brokers to step in
– Brokers offer search service to buying and sellers
– Brokers also offer specialized knowledge on valuing
assets of this market

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 Types of Markets
• Dealer markets
– When the goods or assets became more actively
traded the market can develop from brokered into
dealer market
– Dealers purchase theses assets for their own account
and later sell them for a profit from their inventory
– The spread between dealer’s buy and sell price is its
profit
– Example: Most bonds trade in dealer markets

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 Types of Markets
• Auction markets
– The most integrated market in which all traders converge at one
place to trade (physically or electronically)
– Example : all active stock exchanges
– Advantage over dealer markets: that one need not search across
dealers to find the best price of a good, and hence safe the spread
cost
– Continuous (stock market) or periodic (art work)
– Continuous market requires a very heavy and frequent trading to
cover the expense of maintaining the market, for this reason stock
exchanges set up listing requirements

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 Learning Objective 8 :
Types of Orders:

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 Bid and Ask Prices
Bid Price Ask Price
• Bids are offers to buy • Ask prices represent
• In dealer markets, the offers to sell
bid price is the price at • In dealer markets, the
which the dealer is asked price is the price
willing to buy. at which the dealer is
willing to sell.

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 Bid and Asked Prices

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 Types of Orders
• Market Order: Executed immediately
• All the order should be filled whatever the price in
the market
– Trader receives current market price
– Here the investor is focusing on the speed of
execution
– and he needs to be sure that all quantity of the
order will be filled
– The disadvantage that he can't control the price
of execution (price uncertainty)

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 Types of Orders
• Price-contingent Order
– Traders specify buying or selling price
– Here the price of the execution has high
importance
– The disadvantage the he can't confirm that all or
part of his order will be filled (execution
uncertainty)

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 Long Position
• When investor buys a stock it is said that
he is long the market or in a long trade
• Long : means that the investor owns the
securities
• So he has exposure to the market price

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 Short Sales
• Short position or short sale: when the investor sells stocks that
he doesn’t own
• Investor needs first to borrow the securities, then sell them in the
market
• the investor eventually have to repurchase the same quantity of
securities (cover)

• Purpose: to profit from a decline in the price of a security

• Mechanism
– Borrow stock through a dealer
– Sell it and deposit proceeds and margin in an account
– Closing out the position: buy the same number of shares
and return to the party from which it was borrowed
– The difference between selling price and buying price is his
return

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 Types of Orders (Sell orders)
• Buy limit order :
– to execute the buy order (accept asks) up to a
maximum price (a limit)
– is placed at or below the current market price
– Buy limit orders provide investors and traders
with a means of precisely entering a position.
For example, a buy limit order could be placed
at $2.40 when a stock is trading at $2.45. If the
price dips to $2.40, the order is automatically
executed.

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Sell limit order:
To sell (accept bids) to a certain minimum price (a limit)
is placed at or above the current market price

you can set a limit order to sell a stock when a specific price is
available. Imagine that you own stock worth $75 per share and
you want to sell if the price gets to $80 per share. A limit order
can be set at $80 that will only be filled at that price or better.
You cannot set a limit order to sell below the current market
price because there are better prices available.

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 Types of Orders (Sell orders)
• Sell stop order (stop loss)
– Usually used to protect a long position
– is placed below the current market price
– The order will only be executed in case the price declined
below a certain point below the current market price.

– A trader buys 100 shares of XYZ for $100 and sets a stop
loss order at $90. The stock declines over the next few
weeks and falls below $90. The traders stop order gets
executed and the position is sold at $89.95.

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Buy Stop Loss stop order
Usually used to protect a short position
Placed above the current market price
Only will be executed if the market price go up and hit a specific point
above the current market price

Consider the price movement of a stock ABC that is poised to break out of
its trading range of between $9 and $10. Let’s a say a trader bets on a price
increase beyond that range for ABC and places a buy stop order at $10.20.
Once the stock hits that price, the order becomes a market order and the
trading system purchases stock at the next available price.

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 Practical Example

• Consider the following order-book. The last trading occurred at a

price of $1.98.
Bid Ask

Price $ Shares Price $ Shares

1.95 3000 2.00 1000
1.93 2500 2.03 2000
1.90 1500 2.05 1500
1.88 2000 2.08 2500
1.85 1000 2.10 4500
1.83 4500 2.13 1500
1. If a market buy order for 5000 share comes in, at what price will it
be filled?
2. Suppose another investor has a short position of the stock at $1.98
, and wants to limit his loss to 0.10 dollars only, what type of order
should he use and what is the price of the order.
 Answer
1) Market order has a specific amount and no specific price, so it
will start filling the best sell order at $2, and going down until
the whole 5000 shares are filled, which should be at $2.08

1) He should use buy-stop order; it is one of the price contingent

orders.
• Since he bought at $1.98 and he wants to limit his loss to $0.10
dollars, then you should place his order at $2.08 (=1.98 + 0.10)