BM 410 Investments Financial Instruments, Securities Trading, and Investment Benchmarks
Objectives A. Understand assets that trade in the money and capital markets ü B. Understand the market mechanics of trading both primary and secondary issues ü C. Identify the various securities markets where securities are traded and the costs of trading ü D. Understand the types and uses of indices ü E. Understand the mechanics of margin trading and short-selling ü
Helpful Dictionaries and Glossaries ü Bloomberg (institutional) • http: //www. bloomberg. com/analysis/glossary/bfglo sa. htm ü Campbell Harvey (academic) • http: //www. duke. edu/~charvey/Classes/wpg/glossar y. htm ü Contingency Analysis (private institution) • http: //www. riskglossary. com/ ü New York Stock Exchange (market) • http: //www. nyse. com/
A. Major Assets that Trade in Money and Capital markets • Major Markets and Instruments: • Money Market • Market for short-term, liquid, low-risk debt securities • Fixed Income Capital market • Market for longer-term, higher risk debt securities • Equity Markets • Market for common and preferred stocks • Derivative Markets • Market for options, futures, forwards, and other types of “derived” instruments
B. Understand the Market Mechanics of Primary and Secondary Trading ü 1. Primary Markets • Initial sales of securities • Funds are received by the issuing company ü 2. Secondary Markets • Resale of securities to others • No funds are received by issuing company
Key Terminology for Primary Markets Public offerings • Registered with the SEC and sale is made to the investing public. May be initial or follow-up offerings • Shelf registration allows firms to register more shares, and sell them over time (on the shelf) ü Initial Public Offerings (IPOs) • First offerings by the company • Evidence of under-pricing initially; however, generally have been poor long-term performers ü Private Placements • Sale to a limited number of sophisticated investors ü
Order Information Flow for the Primary Market Lead Underwriting Underwriter Investment Banker A Investment Banker B Syndicate Investment Banker C Private Investors and Institutions Investment Banker D
Trading of Primary Issues • Primary Issues • New issue: Issuer receives the proceeds from the sale, less the expense paid to the underwriters • There is a major “beauty pageant” among investment bankers as they compete for the business • Being the lead underwriter not only brings huge fees (sometimes 1 -5% of the offering), it also brings substantial “bragging rights” and prestige to the lead firm
How IPO’s are Sold üInvestment bank gets the mandate • Research is prepared • Road Shows are planned and taken • Indications of Interest are given to the Underwriting Syndicate (book building) Pricing and Shares Offered are finalized • üFirm orders and prices are placed • Syndicate confirms sales and shares issue
Investment Banking Arrangements ü Underwritten vs. “Best Efforts” • Underwritten: Firm commitment on proceeds to the issuing firm. If can’t sell, has to buy shares. Best Efforts: No firm commitment. ü • Negotiated vs. Competitive Bid • Negotiated: Issuing firm negotiates terms with • investment banker Competitive bid: Issuer structures the offering and secures bids from various investment banks, then picks most competitive bid.
2. • Understand Market Mechanics of Secondary Trading Key terminology for Secondary Offerings • Secondary Security Sales • Existing owner sells to another party • Issuing firm doesn’t receive proceeds and is not directly involved • In most cases its an electronic entry in a share registry, although in smaller markets overseas, it is still delivery of share certificates
Secondary Security Sales (continued) ü Why does firm care about its share price when it gets no new money? • • Prestige Publicity Ability to raise new capital in the future Managers options/salaries are sometimes tied to share price • Note: If I ever saw a Reuters or Bloomberg terminal on the CEO’s desk when visiting companies, I took it a negative sign. It showed that he/she was more worried about the price of the stock than running the company!
Private Investor Order Information Flow for the Secondary Market Stock Exchange 3. Confirms trade 2. Submits Order 3. Confirms Trade Brokerage Operations and Accounting 2. Confirms trade 4. Confirms trade 1. Place Order, regardless of type, to the broker or through the computer 5. Mails conformation statement
Institutional Order Information Flow for the Secondary Market Stock Exchange 4. Confirms trade 3. Submits Order 3. Confirms Order 4. Confirms trade Brokerage Operations and Accounting 7. Mails conformation statement 5. Confirms trade 2. Combines orders and submits 1. Place Order, regardless of type 6. Confirms trade execution Company Traders
Types of Share Orders (Secondary Markets) Instructions to the brokers on how to complete the order ü Market Order • Buy/sell at the current market price ü Limit Order • Buy/sell at a specified price ü GTC Order • Buy/sell at a specific price until the order is cancelled ü Stop loss • Buy/sell only if the price reaches a specified level ü Program trades • Buy/sell and entire portfolio at a specified price
Questions ü Do we understand the market mechanics of trading both primary and secondary issues?
Problem 3 -1 FBN, Inc. , has just sold 100, 000 shares in an initial public offering. The underwriter's explicit fees were $70, 000. The offering price for the shares was $50, but immediate upon issue, the share price jumped to $53. ü A. What is your best guess as to the total cost to FBN of the equity issue? ü B. Is the entire cost of the underwriting a source of profit of the underwriter? ü
Answer 3 -1 A. In addition to the explicit fees of $70, 000, there appears to have been an implicit underpricing of the IPO of $3 or $300, 000. ü B. While the explicit costs are profits to the underwriters, the implicit costs are not. Generally, there are reasons, financial (to make sure the entire IPO is sold), political (to make the underwriters look good from a successful IPO) and others (to give investors a quick return to encourage them to continue to deal with the underwriting firm), to under price slightly an IPO and to make sure an IPO is sold fully. ü
C. Securities Markets where Securities are Traded and the Costs of Trading 1. Organized exchanges • Auction markets with centralized order flow ü 2. OTC market ü • Dealer market without centralized order flow ü 3. Third market • Trading listed securities away from the market ü 4. Fourth market • No middleman—institutions trading with institutions
1. Organized Exchanges Auction markets with centralized order flow • Largest of all the markets ü Dealership function • Can be competitive or assigned by the exchange (specialists) ü Securities • Stocks, futures contracts, options, and to a lesser extent, bonds ü Examples: NYSE, AMEX, London, Tokyo ü • Generally, these exchanges are somewhat archaic
2. OTC Market Dealer market without centralized order flow • Generally the direction of future stock markets ü Price quotation market rather than trading market: • Information system for individuals, brokers and dealers ü Securities • Stocks, bonds and some derivatives ü Example: NASDAQ (largest organized stock market for OTC trading) ü
3. Third Market Trading of listed securities OTC away from the organized exchange • Organized originally due to high fixed NYSE trading costs ü Institutional market • To facilitate trades of larger blocks of securities • Involves services of dealers and brokers ü
4. Fourth Market Institutions trading directly with institutions • No middleman involved in the transaction ü Organized information and trading systems • Through ECNs: Electronic Trading Networks ü Example: INSTINET, Island ECN (53 bn shares in 2000 worth $1 trillion)m REDIbook, Archipelago ü
Block Orders ü Block transactions (buys/sells) of over 10, 000 shares per trade • Year • 1965 • 1975 • 1985 • 1995 • 2000 ü % Reported Volume Avg Num. Day 3% 9 17% 136 52% 2, 139 57% 7, 793 52% 21, 941 These are growing in importance
Costs of Trading ü Explicit • Commission: fee paid to broker for making the transaction • Spread: cost of trading with dealer • Bid: price dealer will buy from you • Ask: price dealer will sell to you • Spread: difference between the ask - bid • Combination: on some trades both a commission and spread are paid. You are responsible to watch and make sure you are getting the best execution
Costs of Trading (continued) ü Implicit • Market impact: increase (or decrease) in price resulting from the size of the order versus the average daily trading volume. This can often be greater than all other costs —Beware!
Questions? ü Do you have any questions on the various securities markets where securities are traded and the costs of trading?
Problem ü You are managing your personal portfolio of $500, 000. Your largest holding, Samsung Electronics, is getting expensive, so you sell $50, 000 of Samsung and buy $50, 000 of Thai Farmers Bank. Assuming that was your only trade for the quarter, what your turnover for that quarter, and assuming all-in transactions costs were 90 basis points each way, how much did you spend to complete that transaction?
Answer ü Turnover is defined as half your sells plus buys divided by your total portfolio amount. • $[(50, 000 sell + $50, 000)/2] / $500, 000 = 10% ü The cost to you of this transaction is: • $50, 000 sell *. 0090 = $450 • $50, 000 buy *. 0090 = $450 • Total transactions cost = $900 • Total loss of return from this single trade: • 900/500, 000 = -. 2%
Problem 3 -5 ü Do you think it is possible to replace marketmaking specialists with a fully automated, computerized trade-matching system?
Answer 3 -5 Much of what the specialist does—crossing orders and maintaining the limit order book – can be accomplished by a computerized system. In fact, some exchanges us an automated system for night trading. ü A more difficult issue is whether the more discretionary activities of specialist that involve trading for their own accounts, such as maintaining an orderly market, can be replicated by a computer system. ü
D. Understand the Different Types and Uses of Indices or Benchmarks ü Critical areas of Indices • How they are used • Asset Class Indices • Rate of Return Indices • Geographic Indices • Company Type Indices • Investment Style Indices • Index Construction
How They Are Used: The Importance of Understanding Indices are the standard from which an analyst or portfolio manager is judged • Get to know your standard in detail—your career (and bonus) depends on it! • How is it weighted? • How often are the constituents changed? • Which are the biggest companies in the index? • What strategies can help you to beat the index? ü If you don’t know what is in your index and how it is calculated, how can you ever expect to beat it? • It affects how you advance in your job and get the raises you want? Knowledge is power! ü
Uses of Indices: • 1. Tracks average returns for a specific asset class • 2. Used to compare performance of mutual fund managers in similar asset classes • 3. Use as a base on which derivatives are structured ü Key Questions in choosing or using an Index: • Is it representative of the performance or assets desired? • Is it broad or narrow, i. e. how many securities in the index? • How is it constructed, i. e. price, total return, etc. ? • How is it weighted, i. e. market cap, equal, or float weighted? ü
Asset Class Indices • Asset Class Stocks: large cap, small cap. , mid cap. , international, emerging markets, etc. • Bonds: long-term, short-term, corporate bonds, government bonds, convertible bonds, etc. • Other Asset Classes: real estate, currencies, • Geographical • Global, Regional, Country, Industry • Investment Style • Growth, Blend, Value •
Rate of Return Indices Price • Includes only price appreciation of the underlying assets Price with Gross Dividends (or gross dividends reinvested) • Includes both price and dividends in calculating total return. It does not take into account the impact of taxes on dividends Price with Net Dividends (or net dividends reinvested) • Includes both price and dividends in calculating total return. It takes into account the impact of taxes on dividends, and hence you will see a reduction of return from dividends
Geographic Indices ü Global ü Follows the performance of a set of assets from a specific set of countries, i. e. , MSCI World, MSCI AC Free. International includes only countries outside the US ü Regional ü Follows the performance of a set of assets from a specific region of the world , i. e. , MSCI EAFE, DJ Asia ü Country ü Follows the performance of a specific set of assets from a specific country , i. e. , S&P 500, Russell 5000, Dow Jones
Company Type Indices ü Industry ü Follows the performance of a set of assets from a specific industry, whether global, regional, or country, i. e. Telecomm, Financial, Retail, Automotive, Consumer Durable, etc. ü Market Capitalization ü Follows the performance of a set of assets with a specific market capitalization range, i. e. largecapitalization (>$10 bn), mid-capitalization ($210 bn), small-capitalization($>2 bn), microcapitalization (<250 mn), etc.
Investment Style Indices Growth ü These indices follow a portfolio of stocks that are expected to achieve accelerated growth, whether because of increased earnings, dominant market position, or other factors ü Value ü This indices follow on stocks that are perceived to be undervalued by the market, i. e. their priceearnings and price-book ratios are lower than the market. It is generally determined by using pricebook or price-earnings ratios, discounted cash flow models, or other means. ü Blend ü A combination of both ü
Index Construction ü How are stocks weighted in various benchmarks? • Price weighted: • Weight is based on the price of the stock (DJIA, Nikkei). • Assumes a higher priced stock is more valuable than lower priced stock • Market-value weighted: • Weight is based on market capitalization (S&P 500, NASDAQ, some MSCI country/regional indices). • Assumes market capitalization [price * shares outstanding] is a viable proxy for size
Index Construction (continued) • Equally weighted: • All stocks are equally weighted (Value Line • Index, MSCI Equal Weighted Indices). • Gives a higher weighting to smaller stocks Float weighted: • Weight is based on market cap and available float outstanding (MSCI Emerging Markets Free). • Gives a greater weight to companies whose shares are more available in the marketplace and who do not have foreign ownership limits
Finding Data on Indexes ü Where do you find these indexes? ü Internet: Any of the many financial sites available: CNN Money, Yahoo. Finance, etc. Generally these free indices are without dividends (make sure you check) ü Proprietary Data Providers: Bloomberg, Reuters, etc. They will also produce special indexes for a fee ( i. e. MSCI EM Free ex-Malaysia) ü Data Suppliers: Standard and Poor’s, Morgan Stanley Capital International, NASDAQ, Bloomberg, Dow Jones, etc.
Vanguard Sends Notice of Index Changes ü We believe that the new indexes will reflect the performance of the funds' targeted market segments more accurately than any other available indexes. We believe stock indexes should: • Be constructed according to objective rules, not subjective • • ü judgment. Weight their holdings to reflect only "floating" shares, meaning those that are available and freely traded in the open market. Feature overlapping buffer zones around the breakpoints between large-, mid-, and small-capitalization segments. Assess a variety of factors to identify a stock as "growth" or "value. " Rebalance their holdings to reflect market changes in a gradual and orderly fashion. From Vanguard Website on 5/6/03: http: //flagship. vanguard. com/VGApp/hnw/web/corpcontent/vanguardviews/jsp/Van. Views. NC Article. jsp? chunk=/freshness/News_and_Views/ALL_benchchange_04032003. html
Questions ü Do we understand the importance of indices to a securities analyst?
Problem ü You are an international manager investing in the asset class called Emerging Markets. Your clients want the broadest benchmark that is actually “buyable” and one that is market capitalization weighted. What should your benchmark look like and why?
Answer ü If your asset class is Emerging Markets, there are two main benchmark providers: MSCI and S&P/IFC. Since you want an index that is buyable, both providers have “Free” indices, that is buyable indices. The difference between Emerging Markets Free and the S&P/IFC Emerging Markets Free Index is largely slight differences in calculation and the number of companies that are included.
E. Understand the Mechanics of Margin Trading and Short Selling ü Note of Caution: • I am explaining the mechanics only. I do not recommend or think it wise or safe for individuals to use either margin trading or short selling unless it is money that you can afford to lose or unless you already have the shares you are selling short! • But it is important to understand the mechanics because there is a lot of information in these areas for the wise investor!
Pretest #1 What is margin trading or buying on margin? • Margin trading is investing (speculating) with borrowed money. ü If you trade on margin, what percent of your original investment can you lose? • With trading on margin, more than your original investment is at risk. ü Can you lose more? • Yes, you can loose much more ü
Answer #1 What is the most you can lose? • In fact, your risk is theoretically unlimited. ü Is the return worth the risk? • For most individual investors, the answer is no! • Profit profile (in %) • Purchase: [(EP * S) + (D * S) – (BP * S)] (BP * S) • Buying on Margin: (EP*S) + (D*S) – (Amount borrowed * interest rate) Initial investment ü BP = Initial Price, EP = Ending Price, S = Shares, D = Dividend, IV = Initial Investment
Pretest #2 What is short-selling? • Short selling is borrowing a security you don’t own and selling it with the hope the price goes down. You then repurchase and replace the security (hopefully) at a lower cost ü If you short-sell, what percent of your original investment can you lose? • With short-selling, more than your original investment is at risk. ü Can you lose more than your original investment? • Yes, you can lose much more. ü
Answer #2 What is the most you can lose? • Your risk is also theoretically unlimited. ü Is the return worth the risk? • No. Many investors have gone bankrupt because they used these tools thinking their risk was limited when it wasn’t. • Profit profile • Purchase: (Ending price + dividend) – initial price • Short sale: Initial price – (Ending price + dividend) ü
Margin Trading ü Margin Trading: • Using borrowed money to finance an investment or to add leverage an existing investment • You put up a portion of the funds and borrow remaining component. Margin arrangements differ for stocks and futures • Maximum margin: currently 50% (set by the Fed); you can borrow up to 50% • Maintenance margin: minimum amount equity in trading can be before additional funds must be put into the account • Margin call: notification from broker that you must put up additional funds
Problem 1: Margin Trading Initial Conditions You have this overwhelming feeling that XYZ Corp is going to appreciate in value due to some upcoming event. You only have $35, 000 but want to take a larger (and much riskier) position via buying on margin. XYZ Corp $70 50% Initial Margin (Equity/MV) 40% Maintenance Margin 1, 000 Shares Purchased Initial Position Stock $70, 000 Money Borrowed $35, 000 Your Equity 35, 000
Margin Trading Maintenance Margin Suppose you were wrong and the stock price falls to $60 per share, what is your new margin percentage? New Position: Market Value of Stock $60, 000 Amount Borrowed 35, 000 Your Equity = $25, 000 ($60, 000 - 35, 000) Margin = Your Equity in Account / Market Value Margin % = $25, 000/$60, 000 = 41. 67% Luckily, you are still above the margin limit so there is no margin call ü
Margin Trading Margin Call Just to be sure you won’t have to put up more money (that you don’t have), how far can the stock price fall before a margin call? Margin % = (Your equity)/(MV) ((Shares x New Price) – Borrowings) = 40% (Shares x New Price) solve for New Price (NP) (1000 * NP - $35, 000) / (1000 * NP) = 40% (1000 * NP - 35, 000) = 40% * 1000 * NP 600 * NP = $35, 000 NP = $58. 33. If the price dropped below $58. 33, you would have to put up more money (that you may not have) or sell out of your position.
Short Sales Short Selling ü The process of borrowing shares and selling them with the intent to buy them back later at a lower price after an expected decline in the price of a stock or security, thereby making a profit from the decline in price ü Mechanics ü Borrow stock from another investor through a dealer ü Sell it and deposit proceeds and margin in a brokerage account (of the broker) ü Close out the position: buy the stock and return it to the party from which is was borrowed including reimbursing for any dividends paid ü
Problem 2: Short Sale Initial Conditions While you think XYZ is a good company, you expect the price to fall dramatically after some bad news hits the market. You want to profit from this bad news. You have $5, 000 that you are willing to use. XYZ Corp 100 Shares 50% Initial Margin 30% Maintenance Margin $100 Initial Price Sale Proceeds $10, 000 Margin 5, 000 Equity 5, 000 Stock Owed 10, 000
Short Sale Maintenance Margin ü Rats! The stock price just rose to $110. What is your new margin and do you need to put up more money (margin call is at 30%)? Sale Proceeds $10, 000 ($100* 100 shares) Initial Margin 5, 000 Stock Owed/MV $11, 000 ($110 * $100 shares) Net Equity 4, 000 (5, 000 – (11, 000 – 10, 000) Your Equity = (5, 000 - ((100 shares* $110) - $10, 000) Market Value = (100 shares * $110) Margin % (4, 000/11, 000) = 36% You do not need to put up new equity
Short Sale Margin Call You are concerned. How much can the stock price rise before you will get a margin call at 30%? Your equity = ((10, 000 + 5, 000) – 100 New Price) Market Value 100 * New Price ($15, 000* - 100 P) / (100 P) = 30% P = $115. 38 *Initial margin plus sale proceeds
Questions Any questions on margin trading and short selling?
Objectives A. Understand assets that trade in the money and capital markets ü B. Understand the market mechanics of trading both primary and secondary issues ü C. Identify the various securities markets where securities are traded and the costs of trading ü D. Understand the types and uses of indices ü E. Understand the mechanics of margin trading and short-selling ü
Homework Problem 13. Which security should sell at a greater price: ü A 10 year bond with a 9% coupon versus a 10 year 10% coupon bond? ü • a. The higher coupon bond. You are getting a larger coupon payment, so you would be willing to pay more for the bond. ü B. A 3 month call option with an exercise price of $40 or $35? • b. The call with the lower exercise price. Prices of call options decrease as the exercise price increases, i. e. the right to purchase shares at higher prices is less valuable than the right to purchase lower priced shares. ü C. A put option on a stock selling at $50 or one selling at $60? • c. The put on the lower priced stock. Prices of put options increase with the exercise price, i. e. , the right to sell shares at higher prices is more valuable that the right to sell at lower prices.
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