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Capital Market
Capital markets (IE Universidad)
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Capital Market
Power Point 1/Ch.1

(Introduction to Capital Markets)
Define an investment:
 Current commitment of money (or other resources) in the expectations of reaping
future benefits.
 Initial resources/time/benefit/ risk
 Sacrifice something of value now, expecting to benefit from that sacrifice later
 We will focus on investments in securities such as bonds stocks an derivatives
Distinguish between real assets and financial assets:

 Real assets: resources as land, building, equipment, and knowledge that can be used to
produce goods and services
o Real assets generate net income and financial assets define the allocation of net
income or wealth among investors.
 Financial assets: resources as money invested in stocks and bonds. Sheets of paper or
computer entries that do not contribute to producing goods and services directly. Claim
on real assets or the income generated by them.
o Financial assets are a really easy way to invest money and get a return in the
future. Consume the wealth in the future versus consume the wealth today.
Focus in Financial Assets:

 Fixed income (Debt): Pay a specific cash flow over a specific period
 Stocks (Equity): An ownership share in a corporation. Receive dividend but equity
holders are not promised any particular payment
 Derivatives securities (future and options): Financial assets that providing payoff that
depends on the value of other assets (real assets and financial assets)

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Financial Markets and The Economy

 Financial markets as an information role about future evolution of corporate and
economy
 Play an important role in the allocation of capital in economy. Investment in the firms
with the greatest “perceived” potential
 Consumption timing: shifts of the purchasing power from high-earnings to low-earnings
periods of life.
 Allocation of risk: Financial assets have a different risk/return characteristics that best
suits investors preferences
 It’s easier for corporate raise to capital to finance their real assets/investments
 Separation of ownership and Management:
o Easy buy and sell shares to other investors without impact on the management
of a company
o Agency problems: conflicts of interest between managers and stockholders
 Solution 1: Compensation plans linked to the success of the firm (in form
of shares or stock options)
 Solution 2: The board of directors/general stockholders meeting, can
force out management team that are underperforming (proxy fights for
control of the board of directors)
 Solution 3: Institutional investors “activist investors” and security analyst
monitor the firm closely
 Solution 4: Bad performance are subject to the threat of takeover
o Corporate Governance and Corporate Ethics: The allocation capital will be
efficient only if investors are acting on accurate information for investors to make
correct information
Portfolio Investment process:

 Asset Allocation: Allocation of an investment portfolio across broad asset classes
 Security/Selection analysis: Choose of specific securities within each asset class
 “Top Down” versus “Bottom up”
o Top-down investing is an approach that focuses first on macroeconomic factors
such as the performance of a national economy or broad industry sectors to
guide investment choices.
o Bottom-up investing is an investment approach that focuses on the analysis of
individual stock
 Securities selection is the process of determining which financial securities are included
in a specific portfolio.
Characteristics of financial markets:

 No free-lunch securities implications
o Risk/return trade off: Assets with higher expected return entails greater risk

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o Efficient Markets: Financial markets process all available information about

securities quickly and efficiently, that is the security Price reflects all the
information available to investors
o Passive versus Active management
Market Players:
 From supply/demand view:
o Firms are net demanders of capital
o Investors are suppliers of capital
o Government can be borrowers or lenders, depending on deficit/surplus
o Intermediaries
 Financial Intermediaries: Institutions that “connect” borrowers and
lenders by accepting funds from lenders and loaning funds to borrowers.
Financial intermediaries are distinguished from other businesses in that
both, assets and liabilities are financial.
o Commercial Banks: raise funds (taking deposits) and lending that money to
others borrowers (consumer credit)
o Investment Companies: Mutual Funds, Pension Funds which pool and manage
the money of many investors. The have advantage of large-scale trading and
portfolio management.
o Hedge Funds is also a pool and invest the money of many institutional investors
or wealthy individuals.
o Investment Bankers: Firms specializing in the sale of new securities to the public
(investors), typically by underwriting the issue. Advice an issuing corporation on
the price it can charge for the securities issued. Handles the marketing of the
new securities offered to the investors
o Primary market: new issues of securities are offered to the public.
o Secondary market: markets in which previously issued securities are traded
among investors.

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o Venture capital: Money invested to finance a new and young companies,

privately held firm. Venture Capital Funds, wealthy individuals known as “angels
investors” and institutional investors. They take an active role in the management
of a start-up firm.
o Private Equity: Investment companies whose shares are not traded in public
stock markets.
 CDOs (Collateral Debt Obligation): Its were designed as credit/default risk of a

bundle of loans on one class of investment. The sophistication of CDOs include
the idea to prioritize claims on loans payment into senior and junior slices, called
tranches of CDO.
 CDS (Credit Default Swaps) is an insurance contract against the default of one or
more borrowers. The buyer pays an annual premium and the seller pay the cash
flow of the underlining asset in case of default.
 Financial crises 2008 (powerpoint)
Power Point 2/Ch.2

(Asset Classes and Financial Instruments)

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Financial markets segments:

 Financial markets are traditionally segmented into Fixed Income, Equity and Derivatives
markets. Fixed Income is subdivided into Money Markets and Bonds Markets.
 Money Markets include short term, marketable, liquid, low risk securities and some
times are called cash equivalent
 Bond markets include long term and riskier fixed income securities
Fixed Income: The Money Markets (MM):

 Fixed income securities (debt securities), short term, highly liquid and low risk securities
and some times are called cash equivalent
 Bond markets include long-term and riskier fixed income securities
o Treasury Bills:
 are short term government securities issued at a discount from face
value and returning the face amount at maturity.
 The investors can purchase them directly from the Treasury (primary
market), secondary market or indirectly by MM Mutual funds. MM
instruments trade based in yields and not in prices, its use bank-discount
method (annualized based on 360 day per year).
 The asked price is the price you have to pay to buy a Treasury Bill, the bid
price is what you would receive if you sell a bill and the bid-asked spread
is the difference in these price.
o Certificate of Deposit (CD):
 a time deposit with a bank, i.e., the issuer is a financial institution. The
Bank pays interest and principal to the investor only at the end of the
fixed term. Its are not a discount securities, the interest add on to
principal at maturity.
o Commercial Paper (CP):
 Large well-know companies often issue their own short term unsecured
debt notes for working capital, directly to the public, rather than
borrowing from the banks.
 CP trade similar to Treasury Bill (Bid-Offer yields and discount interest
rate).
o Banker’s Acceptances:
 It is like a post-dated check. An order to the bank by a customer to pay a
sum of money at a future date.
 Acceptances sell at a discount from the face value of the payment order,
just as Treasury Bill and CP.
o Eurodollars:
 Dollar denominated deposits banks traded at domestic money market
outside of U.S and pay higher interest rate than U.S. domestic deposits.
o Repo and Reverse Repo:

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 Repurchase agreements (Repo) are short term (usually overnight) sales of

securities with an agreement to repurchase the securities at a higher
price. The dealer sells securities to an investor on an overnight basis, with
an agreement to buy back those securities the next day at a slightly
higher price.
 The securities serve as a collateral for the loan. A reverse repo is the
mirror image of a repo, the dealer buys a security from investor with an
agreement to resell at a specified price on a future price.
 The broker in turn may borrow the funds from a bank, agreeing to repay
the bank if the bank request it.
o Federal Funds:
 Funds maintained by commercial banks at the Federal Reserve Bank
(FED).
 Banks with excess funds lend to those with a shortage (short term loans
among U.S. financial institutions).
 These loans, which are usually overnight transactions are arranged at a
rate of interest called Federal Funds rate (key rate for the economy as
leading indicator of Monetary Policy).
o LIBOR:
 London Interbank Offer Rate. Lending rate among banks in the London
market. It was designed to reflect the rate at which banks lend among
themselves.
 LIBOR is a crucial benchmark for many financial contracts. Similar LIBOR
in Europe is called Euribor, in Japan Tibor,…. They are based on surveys of
rates reported by participating banks rather than actual transactions.
 The surveys is an incentive to try manipulate LIBOR and then manipulate
the contracts linked it.
o Although most MM securities are low risk, they are not risk free. Most of MM
securities trade with a premium over risk free (Treasury Bill).
o MM mutual funds invest in MM securities and have become major sources of
funding to that sector.

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**Discount yield computes the expected return of a bond purchased at a discount and
held until maturity.
**(BEY) is a metric that lets investors calculate the annual percentage yield for fixed-
come securities, even if they are discounted short-term plays that only pay out on a
monthly, quarterly, or semi-annual basis.
 Calculations:

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Fixed Income: The bond Market

 The bond market is composed of long term borrowing and includes Treasury notes and
bonds, corporate bonds, municipal bonds, mortgage securities and Federal agency debt.
 They promise a fixed stream of income or stream of income that is determined
according to specific formula
 The “fixed income” is not fully appropriated term because some times the flow of
income is far from fixed (floating rate notes, inflation link bonds, callable or putable
bonds…..)
 Bond Example; Treasury Notes and Bonds (and how they work):
1. Debt obligations of the government with original maturities of one year or more.
2. The governments borrows funds in large part by issuing Treasury notes and
bonds that make periodically payments called coupon payments.
3. The price are quoted as a percentage of face value or nominal (different to
Treasury Bill, that quoted by bank discount).

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4. The yield to maturity (YTM) is a measure of the annualized rate of return to an

investor who buys the bond for the asked price and holds it until maturity.
5. The yield accounts for coupon income as well the difference between the
purchase price of the bond and the face value or nominal at maturity.
 Bond Example; Inflation Protected Bonds (TIPS)
o Debt obligations of the government that are linked to an index of the cost of living in
order to provide the investors with an effective way to hedge inflation risk.
o The principal amount (face value or nominal) is adjusted in proportion to increase in
the Consumer Price Index. They provide a constant stream of income real dollars
because the adjusted in the principal amount compensate the increase of inflation
and then coupon we can to considerate like a good approximation to real return or
real yield.
 Bond Example; Federal Agency Debt
o Some government agencies issue their own securities to finance their activities.
 An example of federal agency are Federal National Mortgage Association
(Fannie Mae), Federal Home Loan Bank (FHLB), Federal Home Loan
Mortgage (Freddie Mac).
o The debt of federal agencies was never explicitly insured by de government but
the investors have assumed that the government would assist an agency nearing
of default.
 Bond Example; International Bonds:
o A Eurobond is a bond denominated in a currency other than that of the country
in which it is issued (dollar denominated bond sold in Britain would be called
Euro-dollar bond).
o Many corporates issue bonds in foreign countries in the currency of local country
and in this case the bonds have specific names like Yankee bond (dollar
denominate bond issued in U.S. by non U.S. corporates).
 Bond Example; Municipal Bonds:
o Tax exempt bonds issued by state and local governments. Their interest income is
exempt from taxation. Capital gains taxes, however, must to be paid.
o There are two types of municipal bonds: General Obligation Bonds are backed by
the full faith and credit of the issuer and Revenue Bonds issued to finance
particular projects and are backed either by the revenues from that project
(airports, hospitals, port authorities).
o Revenue Bonds are riskier than General Obligation Bonds. An investor choosing
between taxable and tax exempt bonds needs to compare after tax returns on
each bond.
o The rate a taxable bond would need to offer in order to match the after tax yield
on the tax free municipal the below relation
Return Taxable (1-tax bracket) = Return Tax free

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 Bond Example; Corporate Bonds:

o Long term debt issued by private corporations typically paying coupons and
returning the face value or nominal of the bond at maturity.
o Private firms borrow money directly from the investors.
o The most important difference form Treasury bonds is in risk. We can distingue
among secured bonds (which have specific collateral backing them), unsecured
bonds (called debentures) and subordinated debentures which have a lower
priority claim to the firm’s assets in the event of bankruptcy.
o Corporate bonds sometime incorporate options attached (callable bonds, put
able bonds, convertible bonds).
 Bond Example; Mortgage and Asset-Backed Securities:
o ( Described in Chapter 1 summary )
Equity Securities: Common Stocks
 Common Stocks are ownership shares in a publicly held corporation. Shareholders have
voting rights and may receive dividends.
 Each share of common stock entitle its owners to one vote at the corporation’s annual
meeting and to a share in the financial benefits of ownership (dividends). Shareholders
who do not attend the annual meeting can vote by proxy, empowering another party to
vote in their name.
 The two more important characteristics of common stocks are its residual claim and
limited liability features.
o Residual claims means stockholders are the last in line of all those who have a
claim on the assets and income of the corporation. Shareholders have claim to
the part of operating income left after interest and taxes have been paid. Limited
liability means that in the event of the firm’s bankruptcy, corporate stockholders
at worst have worthless stock. They are not personally liable for the firm’s
obligations.

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Equity Securities: Preferred Stock

 Nonvoting shares in a corporation, usually paying a fixed stream of dividends.
 It has features similar to both equity and bond. Like a bond, it pay a fixed stream of
income each year.
 It is similar to an infinite maturity bond (perpetual bond). Like a bond, it has not voting
power.
 The firm retains discretion to make dividend payments to the preferred stockholders,
like common stocks. Instead, preferred stocks pay cumulative dividends, unpaid
dividends cumulate and must be paid in full before any dividends may be paid to
common stockholders. Preferred stock payments are treated as dividends rather than
interest on debt.
 The firm retains discretion to make dividend payments to the preferred stockholders,
like common stocks. Instead, preferred stocks pay cumulative dividends, unpaid
dividends cumulate and must be paid in full before any dividends may be paid to
common stockholders. Preferred stock payments are treated as dividends rather than
interest on debt.
Equity Securities: Depositary Receipts (ADRs)

 American Depositary Receipts (ADRs) are certificates traded in U.S. markets that
represent ownership in shares of a foreign company. They are the most common way for
U.S. investors to directly invest in and trade the shares of foreign corporations.
Equity Securities: Stock Market Indexes

 Price Weighting Average Index (Dow Jones Industrial Average Index):
o An average computed by adding the prices of the stocks and dividing by a
“divisor”.
o The amount of money invested in each company in that portfolio is therefore
proportional to the company’s share price.
o The portfolio will have the same number of shares on each stock.
o The high price stock can dominate the index performance.
o Corporate actions like splits modified the index divisor and can to give a no real
representation of index performance.
 Market Value Weighted Index (Standard & Poor’s 500 Index):
o Index return equals the weighted average of the returns of each component
security, with weights proportional to outstanding market value (capitalisation
market value each component).
o The Index mutual funds and ETF’s (Exchange Traded Funds) yield a return equal
to that of the particular index and provide a low cost passive investment strategy
for investors.
 Equal Weighted Index:

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o Computed from a simple average of returns each stock in the index. The strategy
places equal dollar values in each stock. Unlike others indexes, equal weighted
indexes do not correspond to a buy and hold strategy
Capital Gains and dividend yields
Ex. Buy a share of stock for $50, hold for 1 year, collect $1 dividend, and sell stock for $54 What
were dividend yield, capital gain yield, and total return?
P S ell - P B u y + D i v $54 - 50 +1
T o ta l R e tu rn = = =1 0 %
P B uy $50
D iv $1
D iv id e n d Y ie ld = = =2%
P B uy $ 5 0
P S ell - P B u y $54 - 50
C a p ita l G a in s Y ie ld = = =8%
P B uy $50
Derivative Markets: Stock Market Indexes

 A security with a payoff that depends on the prices of other securities as commodities,
bond, stock, interest rates, market indexes… (underlying securities).
 Call Option:
o Gives its holder the right to purchase an asset for a specified price (exercise or
strike price) on or before some specified expiration date.
o It make sense to exercise only if the market value of underlying exceeds the
exercise price.
o The buyer has to pay a premium for the right to purchase the asset in advance.
o The performance of a call option will be positive if the underlying price increase
and the maximum lost will be the premium paid.
o The price of call options decrease as the exercise price increases and conversely,
put price increase with the exercise price.
 Put Option:
o Gives its holder the right to sell an asset for a a specified exercise price on or
before a specified expiration date.
o Put options increase value when the underlying asset value falls.
o The put option is exercised only if its holder can deliver an asset worth less than
exercise price.
 Option price increase with time until expiration (both of them, call options and put
options).
 Future contracts:
o Obliges investors to purchase or sell an asset at an agreed upon price (future
price) at specified future date (obligation in futures versus right in options).

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o The long position is held by who commits to purchasing the contract and the
investor take short position (sell contract) commits to delivering the underlying
asset at contract maturity.
o Future investments are entered into without cost versus options pay a premium.
PowerPoint 3/Ch.3
(Securities Markets)
How firms Issue Securities:

 Firms need to raise new capital to pay for investment projects. They can raise funds by
borrowing money (bonds or by selling shares in the firm (equity)
 Investment bankers are hired to manage the sale of these securities in what is called
primary market
 Trades in existing securities take place in the so-called secondary markets
 Exist publicity traded publicly owned or public companies and private corporations,
whose shares are held by small number of investors. Private companies have not yet
chosen to make their shares available to the public
Private Held Firms:

 Privately held firms have fewer obligations to release financial statements an other
information to the public. They are free of shareholders pressure.
 When private firms raise funds, they sell shares in a private placement, i.e., primary
offerings in which shares are sold directly to a small group of institutional or wealthy
investors. Shares are not trade in secondary market such as a stock exchange and this
reduces their liquidity ( Liquidity refers to the ability to trade an asset at a fair price on
short notice).
Publicly Traded Companies:

 When a private company decides raise capital from a wide range of investors, it may
decide to go public. This first issue of shares to the public is called Initial Public Offering
(IPO).
 A Seasoned Equity Offering (SEO) is the sale of additional shares in firms that already are
publicly traded.
 Public offering (bonds and stocks) are marketed by investment bankers who in this role
are called underwriters. Underwriters purchase securities from the issuing company and
resell them to the investors.
 Investment bankers advise the firm regarding the terms on which it should sell the
securities. A preliminary registration statement must be filed with the regulator,
describing the issue, it is called prospectus.
Shelf Registration:
 Shelf registration allows firms to register securities and gradually sell them to the public
for two years following the initial registration

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Initial Public Offering (IPO):

 First all, it is necessary the registration statement and a preliminary prospectus has to be
distributed to interested investors.
 Them the investment bankers organize road shows with two purposes: First, generate
interest among potential investors and provide information about the offering. Second,
provide information to the issuing firm and its underwriters about the price at which the
investors will be able to market the securities.
 Large investors communicate their interest in IPO to the underwriters and this process of
polling potential investors is called book building.
 It is possible to revise the initial offering price and the number of shares offered based
on feedback from investors.
 Shares of IPOs are allocated across investors based on the strength of each investor
expressed interest. This process is called shares allocation.
 The underwriters usually offer the security at a bargain price to induce the investors to
participate in book building.

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Types of Markets:
 Direct Search markets: it is the least organized market. Buyers and sellers must seek
each other out directly.
 Brokered markets: an intermediary (Broker) offer search services to buyers and sellers.
o Ex. Real estate market or the primary market where new issues of securities are
offered to de public by an intermediary (investment bankers).
 Dealers markets: markets in which traders specializing in particular assets buy and sell
for their own accounts. The bid-ask spread prices are a source of profit. Market
participants can easy look up the prices at which they can buy from or sell to dealers.
 Auction markets: An exchange or electronic platform where all traders can convene to
buy or sell an asset. An advantage of auction markets over dealer markets is that one
need not search across dealers to find the best price for a security.
 Commission: Fee paid to broker for making transaction
 Spread: Cost of trading with dealer
o Bid: Price at which dealer will buy from you
o Ask: Price at which dealer will sell to you
Types of Orders:
 Market orders: market orders are buy or sell orders that are to be executed immediately
at current market prices
 Price contingent orders: An order specifying a price at which an investor is willing to buy
or to sell a security. A collection of limit orders is called limit order book

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Trading Mechanisms:
 Dealer Markets or Over The Counter (OTC): An informal network of brokers and
dealers who negotiate sales of securities. These brokers and dealers are called
market makers too.
 Electronic Communication Networks (ECNS): Computer networks that allow
direct trading without the need for market makers. ECNS is very important
execution speed and anonymity. Latency is the time it takes to accept, process
and deliver a trading order.
 Specialist markets: a company that makes a market in the shares of one or more
firms and that maintains a “fair and orderly market” by trading for its own
inventory of shares.
Concepts:
 Algorithmic trading: the use of computer programs to make rapid trading decisions as
short trends or pairs trading.
 High Frequency trading: a subset of algorithmic trading that relies on computer
programs to make very rapid trading decisions. Trades offer very small profits but if
those opportunities are numerous enough, the can accumulate to big money.
 Flash Crash: extreme movement in a security motived by low liquidity in the market.
 Blocks: large transactions in which at important number of shares are bought or sold.
 Dark Pool: electronic trading networks where participants can anonymously buy or sell
large blocks of securities.
Trading Cost:
 Full service: payment for basic services of executing orders, holding securities for
safekeeping, extending margin loans, facilitating short sales and provide information and
service relating to investment alternatives. Make specific buy or sell recommendations.
 Discount brokers: offer basic services but they do not advise about buy or sell
recommendations.
o In addition to the explicit trading cost (brokerage fees) there is an implicit
commission bid-ask spread.
Buying on Margin (excel):

 Margin describes securities purchased with money borrowed in part from a broker.
o The margins is the net worth of the investor’s account.
o If the percentage margin falls below the maintenance level, the broker will issue
a margin call, which requires the investor add new cash to the account. If the
investor does not act, the broker may sell securities to pay off enough of the
loan to restore the margin to an acceptable level.
Short Sales(excel):

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 The sale of shares not owned by the investor but borrowed through a broker and later
purchased to replace the loan. Short sales is a profitable strategy if the price of securities
falls.
Insider Information:
 Non public knowledge about a corporation possessed by corporate officers, major
owners or other individuals with privileged access to information about the firm.
 Regulations prohibit insider information. It is illegal for anyone to transact in securities to
profit from insider information.
PowerPoint 4/Ch.12
(Macroeconomics and Industry Analysis)
Fundamental Analysis:
 Focuses on the analysis of determinants of firms value such as prospects of earnings and
dividends
 Valuation analyses must consider the business environment in which the firm operates,
macroeconomics and industry circumstances might have a greater influence
 Makes sense to start with the broad economic environment for a firm analysis (the
global economy)
The Global Economy:

 Stock market returns do not always align with macroeconomic expectations. The stock
returns are driven by performance relative to previous expectations.
 Exchange rate is the rate which domestic currency can be converted into foreign
currency.
o Appreciation or depreciation means expensive or cheaper goods and services
from others countries.

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o An appreciation of a domestic currency increase the power purchase of foreign

goods
The Domestic Macroeconomy (economic statistics):

 It is very important to review some of the key economic statistics used to describe the
state of macroeconomy because macroeconomy is the environment where firms
operate.
o Gross Domestic Product (GDP): the market value of goods and services
produced over a period of time. Growing GDP indicates an opportunity for a firm
to increase sales.
o Industrial production provides a measure of economic activity more narrowly
focused on the manufacturing side of the economy.
o Employment rate: the ratio of the number of the number of people classified as
unemployment to the total labor force.
o Capacity utilization rate is the ratio of actual output from factories to potential
output.
o Inflation is the rate at which the general level of prices for goods and services is
rising. High rates often are associated with overheated economies.
o Budget deficit is the amount by which government spending exceeds
government revenues. Any budgetary shortfall must be offset by government
borrowing and excessive borrowing will crowd out private borrowing by forcing
up interest rates.
o Sentiment: consumers and producers optimism or pessimism concerning the
economy are important determinants of economic performance. Beliefs
influence how much consumption and investment will be pursued and affect the
aggregate demand for goods and services.
o Interest rates: directly affect returns in the fixed income market and
unanticipated increases in rates generally are associated with stock market
declines.
 If your expectation is that rates will increase by more than the consensus
view, you will want to shy away from fixed income securities and specially
from longer-term bonds.
 Factors that determine the level of interest rates:
 The supply of funds from savers, primarily households.
 The demand for funds from business to finance physical
investment in plant, equipment and inventories.
 The government’s net supply and/or demand for funds.
 The expected rate of inflation.
 To obtain the nominal interest rate, one needs to add the
expected inflation rate to the equilibrium real rate.
 The real rate equilibrium can be affected by government fiscal an
monetary policies.

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o Demand Shocks: An event that affects the demand for goods and services in the
economy.
 Ex. a positive demand shocks are reductions in tax rates, increases in the
money supply, increase in government spending or increases in foreign
export demand.
 Demand Shocks usually are characterized by aggregate output moving in
the same direction as interest rates and inflation.
o Supply Shocks: An event that influences production capacity and cost in the
economy.
 Ex. of supply shocks are changes in energy prices, freezes, floods,
changes in the educational level of workforce or changes in the wage
rates.
 Supply Shocks usually are characterized by aggregate output moving in
the opposite direction of inflation and interest rates.
o You would like to identify the industries that will be most helped or hurt in a
particular macroeconomic shock.
Federal government Policy:

 Fiscal Policy: the use of government spending and taxing for the specific purpose of
stabilizing the economy. Fiscal policy is cumbersome to implement but has a fairly direct
impact on the economy.
 Monetary Policy: Actions taken by the central bank to influence the money supply or
interest rates. Monetary policy is easily formulated and implemented but has a less
immediate impact. The most widely used tool is the open market operation, in which the
central bank buys or sells treasury bonds for its own account.
 Discount rate is the interest rate that Central Bank charges banks on short term loans.
 Reserve requirement is the fraction of deposit that banks must hold as cash on hand or
as deposits with the Central Bank.
 Supply-Side Policies treat the issue of productive capacity of the economy. The goal is to
create an environment in which workers and owners of capital have the maximum
incentive and ability to produce and develop goods.
Business Cycles:
 The economy recurrently experiences periods of expansion and contraction, these
recurring patterns of recession and recovery are called business cycles.
 Peak: is the transition from end of an expansion to the start of a contraction.
 Trough: occurs at the bottom recession just as the economy enters a recovery.
 Cyclical Industries are those with above average sensitivity to the state of economy.
Examples of cyclical industries are producers of durable goods such automobiles, large
household appliances or produces of capital goods.
 Defensive Industries are those with below average sensitivity to the state of the
economy. Defensive industries include food producers, pharmaceutical firms and public
utilities. These industries will outperform others when the economy enters a recession.

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 Economic Indictors
o Leading Indicators: economic series that tend to rise or fail in advance of the rest
of the economy. We will be focus in leading indicators versus coincident
indicators and lagging indicators.
Sensitivity to Business Cycle:

 Once the analyst forecast the state of the macro economy, it is necessary to determinate
the implication of that forecast for specific industries because not all industries are
equally sensitive to the business cycle.
 Three factors determine the sensitivity of a firm’s earnings to the business cycle:
o Sensitivity of sales
o Operating leverage, which refers to the division between fixed and variable cost.
Profits of firms with greater amounts of variable as opposed to fixed costs will be
less sensitive to business conditions.
o Financial leverage, which is the use of borrowing. Interest payments on debt
must be paid regardless of sales.
 Sector Rotation: an investment strategy that entails shifting the portfolio into industry
sectors that are expected to outperform others based on macroeconomic forecast.
Industry Life Cycles:

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 Stages through which firms typically pass as they mature.

 Start up stage, characterized by extremely rapid growth.
 Consolidation stage, characterized by growth that is less rapid but still faster than that of
the general economy.
 Maturity stage, characterized by growth no faster than the general economy.
 Decline stage, in which the industry grows less rapidly than the rest of the economy.
Industry Structure and Performance:

 Michael Porter examine the relationship between industry structure, competitive
strategy and profitability.
 Threat of entry: high prices and profit margins will encourage entry by new competitors.
Therefore barriers to entry can be a key determinant of industry profitability.
 Rivalry between exiting competitors: when there are several competitors in an industry,
there will generally be more price competition and lower profit margins as competitors
seek to expand their share of the market.
 Pressure from substitute products: mean that the industry faces competition from firms
in related industries. The availability of substitutes limits the prices that can be charged
to customers.
 Bargaining power of buyers: if buyers have a considerable bargaining power the can
demand price concessions. This reduces the profitability of the industry.
 Bargaining power of suppliers: they can demand higher prices for the good and squeeze
profits out of the industry. The key factor determining the bargaining power of supplies
is the availability of substitute products.
PowerPoint 5/ Ch.13
(Equity Valuation)
Balance Sheet Models:

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 The models study the Balance Sheet components for the equity valuation. The
information used by the models a current information and not take future expectations
about the firm
 Book Value is the net worth of common equity according to a firm’s balance sheet.
 Liquidation Value is the net amount can be realized by selling the assets of a firm and
paying off the debt. It is a better measure of a floor for the stock price. If market
capitalization drops below the liquidation value of firm, the firm becomes attractive as a
takeover target.
 Replacement Cost is the total cost to replace a firm’s assets less liabilities. The ratio of
market price to replacement cost is known as Tobin’s q.
Concepts previous to Dividend Discount Models:

 Intrinsic Value: present value of a firm’s expected future net cash flows discounted by
the required rate of return (market capitalization rate).
 Market Capitalization Rate: discount rate for a firm’s cash flow (required rate of return
from previous concept).
Dividend Discount Models (DDM):

 A formula stating that the intrinsic value (Vo) of a firm equals the present value (k is the
discount rate) of all expected future dividends (D).
 We considerate a no end firm (firm with a infinite life). This model is no very useful
because requires dividend forecast to every year into the indefinite future. We need
introduce more simple premises for using DDM
1) The Constant Growth DDM or Gordon’s Model : The premise is that dividends will grow
at a constant and perpetual rate called “g”.

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** The constant growth DDM is valid only when “g” is lower than “k”
 If the growth dividend is constant we can see that the expected return for a stock
investment is:
 This formula allows us to infer the market capitalization rate of a stock (k) when we are
using a Constant Growth Model (DDM)
2) The Two Stage Dividend Discount Model: The premise is that the constant growth
dividend is assumed at some future date
o The dividend growth has two different periods, one of them with a high growth
(g1) and other to a constant growth (g2).
o This model allow for year by year forecast of dividends for the short term with a
final period of sustainable growth.
3) Multistage Dividend Discount Model: Allow dividends per share to grow at several
different rates as firm matures. The formula is similar to Two Stage Model by using
multiple “g” ( g1,g2,g3,….)
Price Earning Ratio Model (P/E):

 Price Earning Ratio = Po / E1
 The value of the stock is obtained by multiplying projected earnings per share by a
forecast of the price earning ratio.
Po = E1 * (P/E1) = E1 * Price Earning Ratio
 The model needs forecasting earnings and P/E. Both of them change across industries
and across business cycle stage.

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 Po/E1 might serve as a useful indicator of expectations of growth opportunities and

reflects the market optimism concerning a firm’s growth.
 From below P/E formula is easy to verify that a high ROE (Return over Equity) increase
the price earning ratio. A high ROE projects give the firm good opportunities for growth.
 A higher plowback ratio (b), higher growth rate ( g = ROE * b), but a higher plowback
ratio does not necessarily mean a higher P/E ratio.
o Higher plowback increase P/E only if investments undertaken by the firm offer an
expected rate of return higher than the market capitalization rate.
o One important implication of any stock valuation model is that (holding all else
equal) riskier stocks will have lower P/E multiples.
 The practice of using flexibility in accounting rules to manipulate the apparent
profitability of the firm is a important pitfall in P/E analysis.
 Other valuation ratios are: Price to Book ratio, Price to Cash Flow ratio, Price to sales
ratio,….
 PEG ratio is the ratio P/E to “g”.
 PEG = (P/E) / g
 Some investors believe that stocks with a PEG ratio less than one are a good investment
opportunity.
Free Cash Flow for Firm Model (FCFF):

 An alternative approach to the dividend discount model values the firm using free cash
flow, that is, cash flow available to the firm (FCFF).
 The model discount the free cash flow for de firm (FCFF) at the weighted average cost of
capital to find de value of the whole firm.

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 Subtracting the value of debt then results in the value of equity
Free Cash flow to equity holders Model (FCFE):

 Another approach is to focus from start on the free cash flow equity holders (FCFE),
discounting those directly at the cost of equity to obtain the market value equity
More Concepts:
 The most popular approach to valuing the overall stock market (Index) is the earnings
multiplier approach applied at the aggregate level.
o The first step is to forecast corporate profits for the coming period.
o Then we derive an estimate of the earnings multiplier, the aggregate P/E ratio,
based on a forecast of long term interest rate.
o The product of the two forecast is the estimate of the end of period level of the
market.
 Dividend pay-out ratio: fraction of earnings paid out as dividends.
 Plowback ratio or earnings retention ratio: proportion of the firm’s earnings that is
reinvested in the business as no paid out as dividends.
 Present value of growth opportunities (PVGO): net present value of a firm’s future
investment.
 Price of stock = Po = price with no growth + PVGO = (E1/k) + PVGO

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 Po/E1 = 1/k + PVGO/E1 = 1/k * ( 1+ PVGO/(E1/k)). P/E ratio serve as a useful indicator of
expectations of growth opportunities. The ratio PVGO to E1/k has a straightforward
interpretation, it is the ratio of the component of firm value reflecting growth
opportunities to the value of assets already in place.
PowerPoint 6/ Ch.15
(Option MARKETS)
Intro
 Target: Calculate the profits to different option positions and strategies to modify
portfolio risk-return profile
 Derivatives: Are securities whose prices are determined by the price of others securities.
Options, Futures and swaps are derivatives.
Call options:
 The right to buy an asset at specified exercise price on or before a specified expiration
date
 Exercise or strike: price set for calling (buying) an asset
 Premium: purchase price of an option
 A call option will be exercised only if underlying share exceeds the strike price.
o If the share price remains below the strike price, the option will be left
unexercised.
o If not exercised before the expiration date, a option (call or put) simply expires
and becomes valueless.
 Call Value: If the stock price is greater than the exercise price on the expiration date, the
call value equals the difference between the stock price and the exercise price, but if the
stock price is less than the exercise price, the call expires worthless.
 The net profit on the call is the value of the option minus the price originally paid to
purchase it (premium).
o Sellers of a option (call or put), who are said to write options, receive the
premium as income.
Put Options:
 The right to sell an asset at a specified exercise price on or before a specified expiration
date.
 Exercise or strike: price set for putting (selling) an asset.
 Premium: purchase price of an option.
o A put option will be exercised only if underlying share price is less than the strike
price.
o If the share price is higher than the strike price, the option will be left
unexercised. If not exercised before the expiration date, a option (call or put)
simply expires and becomes valueless.

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 Put Value: If the stock price is less than the exercise price on the expiration date, the put
value equals the difference between the exercise price and the stock prices, but if the
stock price is greater than the exercise price, the put expires worthless.
 The net profit on the put is the value of the option minus the price originally paid to
purchase it (premium).
o Sellers of a option (call or put), who are said to write options, receive the
premium as income.
 Spot price is the current price in the marketplace at which a given asset such as a
security, commodity, or currency can be bought or sold for immediate delivery.
o Spot price = Instinct value + potential value
 If you increase the price you need to increase the contract = the primum is lower
o EX. Premium value
Instinct value = (underlying stock price – strike)
Potential value = Premium (call) – Instinct ÓÓvalue
Values of options at Expiration:

 St = Underlying Price
 X = strike price
Payoff options: Zero game between holder and writer
Call option:
 Underline price is lower than strike price payoff is zero
 If the underly price higher then it is the value of underline minus the strike
 With this strategy you have a LIMIT loss and then the profit can be whatever
o This strategy is for a Bull market (buying on margin)

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Put option:
 Underline price is higher than strike price payoff is zero
 If the underly price lower then it is the value of underline minus the strike
o This strategy is for a Bear market (short selling)
Option Contracts:
 Underline = Strike = (payoff is positive, right side is in the money, left is out the money)
 In the money: if an option were exercise would generate a positive cash flow.
 Out of the money: an option which if exercised, would produce a negative cash flow.
Out of the money options are therefore never exercised.
 At the money: an option where the exercise price equals the underlying asset price
(cash flow equals zero).
o At the money = underline = strike (for puts and calls)
 OTC markets (Over The Counter) no official exchanges markets. Offers the advantage
that the terms of the option contract (exercise price, expiration date,…) can be tailored
to the needs of the investors. The contra party risk is high.
 Official exchanges markets: usually the options are traded on official markets and are
standardized by allowable expiration dates and exercise prices for each listed option. The
contra party risk is low.
 The premium of the call is lower when the exercise price is higher and conversely, put
options are worth more when the exercise price is higher.
 The option premium (call and put) increase if the maturity is longer .
 American options: can be exercised on or before its expiration.
o Always more expensive than European options

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 European options: can be exercised only at expiration.

 Index Options: the underlying is an index. In contrast to stock Options, index options a
cash settlement procedure is used. The payoff is equal to the difference between the
exercise price of the option and the value of the index.
 Future Options, Foreign Currency Options and Interest rate Options are another
possible types of options with different underlying that stock options.
Equity increases = profit increases

Equity decreases = profit decreases
traddle- best strategy for volatility
Option Strategies:
 Protective Put: an asset combined with a put option that guarantees minimum proceeds
equal to the put’s exercise price.
o Ex. Imagine you would like to invest in a stock but you are unwilling to bear
potential losses beyond some given level.
o With a protective put strategy you are guaranteed a payoff at least equal to the
put option’s exercise price because the put gives you the right to sell the share
for the exercise price even if the stock price is below that value.

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 Covered Call:
o Covered Call is writing a call on an assert together with buying the asset
 Straddle:
o a combination of a call and a put, each with the same exercise price and
expiration date.
o Long straddle is established by buying both a call and a put on a stock, each with
the same exercise price, X and the same expiration date, T.
o Straddle are useful strategies for investors who believe a stock will move a lot in
price but are uncertain about the direction of the move.
 Spread:

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o a combination of two or more call options or put options on the same asset with
differing exercise prices or times to expiration.
o Some options are bought, while others are sold or written.
o A money spread involves the purchase of one option and the simultaneous sale
of another with different exercise price but the same expiration dates.
o A time spread refers to the sale and purchase of options with different expiration
dates.
 Collars:
o An option strategies that brackets the value of a portfolio between two bonds.
o The lower bound can be placed on the value of the portfolio by buying a
protective put
o To raise the money to pay for the put, the investor might write a call option
which placed the higher bound of the portfolio
 Securities with implicit options:

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o Callable Bonds: a combination of a straight bond (a bond with no option

features) held by the investor and a call held by the bond issuing firm.
o Convertible Securities: gives its holder the right to exchange each bond or share
of preferred stock for a fixed number of shares of common stock, regardless of
the market prices of the securities at the time. The value convertible bonds will
be the straight debt plus call option premium.
o Warrants: an option issued by the firm to purchase shares of the firm’s stock. The
different between calls and warrants is that exercise of a warrant requires the
firm to issue a new share of stock and the total number of shares outstanding
increase.
o Asian Options: are options with payoffs that depend on the average price rather
than final price.
o Currency Translated Options: the exercise price is denominated in a foreign
currency.
o Digital Options or binary options: have a fixed payoffs that depend on whether a
condition is satisfied by the price of the underlying asset.
PowerPoint 7/ Ch.16
(Option Valuation)
 Target: Factors affecting the value of an option and analytical models of option pricing
 Option Valuation: Introduction:
o Premium option or Option price = Intrinsic value + Time value
 Intrinsic value: The value an option would have if it were about to expire.
Instinct value is set equal to zero for out of the money or at the money
option
 Time value: Difference between an option price and its intrinsic value
o Determinants of Option Values: We can identify at least six factors that should
affect the value of an option: the stock price, the exercise price, the volatility of
the stock, the time to expiration, the interest rates and the dividend rate.
o The difference between the value prior to expiration and the exercise or
instinct value is the time value of the call.
 The time value option is a ‘wasting asset’ that loses value as expiration
approaches. The time value incorporates the probability that underlying
asset will be in the money before expiration option.

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Binominal Option Pricing Model:

 Binomial Model is an option valuation model predicated on the assumption that stock
prices can move to only two value over the short time period
o Break up year into two intervals
o Subdivide further using the same pattern
 Black Sholes Model is a formula to value an option that uses the stock price, the risk
free interest rate, the time to expiration and the standard deviation of the stock return
 Implied Volatility is the standard deviation of

stock returns that is consistent with an option
market price. It is a good indicator of stress
sceneries in the market

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The put-call parity relationship:

 In many important cases, put prices can be derived simply from the prices of calls
o Prices of European put and call options are linked together in an equation knows
as the put-call parity relationship. Therefore, once you know the vale of a call,
finding the value of the put is easy
Hedge ratios and the black-scholes formula:

 Hedge ratio or delta is the number of shares of stock required to hedge the price risk of
holding one option. Is the change in the option, thefore, has a positive hedge ratio and a
put option has a negative hedge ratio
 Black Scholes hedge ratio are particularly easy to compute. The hedge ratio for a call is
N(d1) in Black Scholes formula and hedge ratio for a put is N(d1) – 1. Therefore, the call
option hedge ratio is negative and has smaller absolute value than 1
 Option elasticity is the percentage change in option price per percentage change in
stock price
Portfolio Insurance:
 A portfolio insurance are strategies that limit investment losses while maintaining
upside potential
PowerPoint 8/ Ch.17
(The futures contract)
 An arrangement calling to future delivery of asset at an agreed upon price
 The futures contract call for delivery of underlying asset at a specified maturity date, for
an agree upon price, called the future price, to be rapid at contract maturity
 Long position: You initiate a long trade when you buy an asset with the expectation to
sell it at a higher price in the future and make a profit.
o The investor in the long position buy a contract.
 You buy the asset
 You hold the asset and wait to sell at a higher price
 You profit from sale of the asset
 Short position A short trade is initiated by borrowing an asset to sell it, with the intent
to repurchase it at a lower price, take a profit, and return the shares to the owner.
o The investor in the short position sell a contract
 You borrow an asset and sell it
 You wait for a lower price
 You buy the asset back, make a profit and give it back to the lender

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 At the time the contract is entered into, no money changes hands (for options, the
holder pay the premium to the writer)
 Profit to long = Spot price at maturity underlying – Initial futures price on the contract
 Profit to short = Initial futures price on the contract – Spot price at maturity underlying
 The futures contract therefore is a zero sum game

 Unlike options, there is no need to distinguish payoff from benefit on future contracts
(remember that futures contract has no premium and therefore, no change in money is
done)
 Futures and forward are traded on a wide variety of goods on four broad categories:
Agricultural commodities, metals and minerals (including energy), foreign currencies and
financial assets (interests rate, single stock and index.)
Different Futures Markets Concepts

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 Clearinghouse (official markets): Established by exchanges to facilitate trading. The

clearinghouse interposes itself as an intermediary between buyer and seller.
o The clearinghouse becomes the seller of the contract for the long position and
the buyer of the contract for the short position.
o The clearinghouse position is neutral and eliminates counterparty default risk.
o It is possible to liquate positions easily. The investor can enter in a reverse trade
(for initial long position enter in a short position), reducing net positions to zero.
The zero net position eliminates the need to fulfill at maturity either the original
long or reversing short position
o Open interest: Is the number of contracts outstanding. The clearinghouse
position nets out to zero so it is not counted in the computation of open interest.
o At initial execution of a trade, each investor establishes a initial margin account
that ensures the investors will be able to satisfy the obligations of future
contract.
 Marking to market: The daily settlement of obligations on future positions. On any day
that contract trade, futures prices may rise or fall. Instead of waiting until the maturity
date to realize all gains and losses, the clearinghouse requires all positions recognize
profits as they accrue daily. Marking to market is the major way in which futures and
forward contracts differ. Forward contract are simply held until maturity and no funds
are transferred until the date.
 Maintenance Margin: an established value below which an investor margin may not fall.
Reaching the maintenance margin triggers a margin call.
 Convergence property: the convergence of futures prices and spot prices at the maturity
of the futures contract.
 Cash Settlement: the cash value of the underlying asset (rather than the asset itself) is
delivered to satisfy the contract.

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 Basis: the difference between the futures price and the sport price.
 Basis risk: risk attributable to uncertain movements in the spread between a futures
price and a spot price.
 Spread strategy: taking a long position in a futures contract of one maturity and a short
position in a contract of a different maturity, both on the same asset.
Futures Prices:
 The relationship between the current spot underlying price and the futures price is
called spot-futures parity theorem or cost of carry relationship. Violation of the parity
relationship gives rise to arbitrage opportunities (get a sure profit with zero risk).
F0 = S0 (1 + rf)T
Futures price = Spot price – Cost of carry
 Stock-Index Futures contracts are settled by a cash amount equal to the value of the
stock index in question on the contract maturity date times a multiplier that scales the
size of the contract.
 Index arbitrage is the strategy that exploits divergences between actual futures prices
and their theoretically correct parity values to make a riskless profit.
Swaps:
 Cross hedging is a hedging position in one asset by establishing an offsetting position in

a related, but different asset.
 Swaps are multi period extension of forward contracts that are packaged together.
 Foreign exchange swap is an agreement to exchange a sequence of payments
denominated in one currency for payments in another currency at an exchange rate
agreed to today.
 Interest rate swaps are contracts between two parties to trade cash flows corresponding
to different interest rates (one party agrees to pay the counterparty a fixed rate of
interest in exchange for paying a variable rate of interest or vice versa; no principal is
exchanged).

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Capital markets (IE Universidad)

Studocu no está patrocinado ni avalado por ningún colegio o universidad.

Power Point 1/Ch.1

Distinguish between real assets and financial assets:

Focus in Financial Assets:

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Financial Markets and The Economy

Portfolio Investment process:

Characteristics of financial markets:

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o Efficient Markets: Financial markets process all available information about

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o Venture capital: Money invested to finance a new and young companies,

 CDOs (Collateral Debt Obligation): Its were designed as credit/default risk of a

Power Point 2/Ch.2

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Financial markets segments:

Fixed Income: The Money Markets (MM):

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 Repurchase agreements (Repo) are short term (usually overnight) sales of

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Fixed Income: The bond Market

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4. The yield to maturity (YTM) is a measure of the annualized rate of return to an

Return Taxable (1-tax bracket) = Return Tax free

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 Bond Example; Corporate Bonds:

o ( Described in Chapter 1 summary )

Equity Securities: Common Stocks

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Equity Securities: Preferred Stock

Equity Securities: Depositary Receipts (ADRs)

Equity Securities: Stock Market Indexes

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Derivative Markets: Stock Market Indexes

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How firms Issue Securities:

Private Held Firms:

Publicly Traded Companies:

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Initial Public Offering (IPO):

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Buying on Margin (excel):

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The Global Economy:

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o An appreciation of a domestic currency increase the power purchase of foreign

The Domestic Macroeconomy (economic statistics):

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Federal government Policy:

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Sensitivity to Business Cycle:

Industry Life Cycles:

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 Stages through which firms typically pass as they mature.

Industry Structure and Performance:

Balance Sheet Models:

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Concepts previous to Dividend Discount Models:

Dividend Discount Models (DDM):

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