Investment class

Financial system

- includes markets and various financial intermediaries that help transfer financial assets, real assets, and financial risks in various forms from one entity to another, from one place to another, and from one point in time to another. ex. set up a bio pharmaceutical firm. You take out a bank loan to finance the construction of a factory and the purchase of equipment.

Types of Financial Intermediaries

-Commercial banks •Investment banks •Insurance companies • Pension funds •Investment companies • Hedge funds • Venture capital • Private equity • Online alternative finance companies

Federal Agency Debt

-Government Agency issues (agencies issue debt securities) •Most are home-mortgage-related Issuers: • The Federal National Mortgage Association (FNMA, or Fannie Mae) • The Federal Home Loan Mortgage Corporation (FHLMC, or Freddie Mac) • The Government National Mortgage Association (GNMA, or Ginnie Mae) • Federal Home Loan Bank (FHLB)

Treasury Notes and Bonds

-Government Issues -Bonds vs. notes • Original maturity Notes: 1-10 years; Bonds: up to 30 years • Interest paid semi-annually, principal at maturity (A treasury note is a marketable U.S. government debt security with a fixed interest rate and a maturity between one and 10 years)

Financial Intermediaries

-Institutions that "connect" borrowers and lenders by accepting funds from lenders and loaning funds to borrowers Net Borrowers: Business Firms • Net Savers (Lenders): Households • Borrowers and Savers (Lenders): Governments Financial intermediaries are distinguished from other businesses in that both their assets and their liabilities are overwhelmingly financial.

US Large commercial banks

-J.P Morgan, bank of america, wells Fargo, Citibank top 4.

Issues with the Construction of Fixed Income Indices

-Large universe of securities • Turnover is high in fixed income indexes Dealer markets and infrequent trading • The large number of fixed income securities results in large differences in the number of index securities among fixed income indexes. • Illiquidity, transactions costs, and high turnover of constituent securities make it both difficult and expensive for fixed income portfolio managers to replicate a fixed income index

Capital Market Instruments

-Longer-term • Riskier • Three segments • Debt • Equity • Derivatives

Nature of Investment

-Reduce current consumption for greater future consumption ex. purchasing shares of stock, going to college

Common Stock

-Residual claim (the right of a shareholder or some other party to the profit of a company after all prior obligations have been paid. ) • Limited liability (person's financial liability is limited to a fixed sum, most commonly the value of a person's investment in a company or partnership.) • Capital gains and dividend yields • Capital gain yield = (Psell - Pbuy) / Pbuy • Dividend yield = Dividend / Pbuy • Total return = Dividend yield + Capital gain yield

Financial Markets

-Spot Markets vs. Forward Markets, Futures Markets, and Options Markets •Primary Market vs. Secondary Market • Money Markets vs. Capital Markets •Private Markets vs. Public Markets •Traditional Investment Markets vs. Alternative Investment Markets

Money Market Instruments

-Treasury Bills • Certificates of Deposit • Commercial Paper • Repos and Reverses • Bankers' Acceptances • Eurodollars • Federal Funds • LIBOR (London Interbank Offer Rate)

Debt instruments

-Treasury notes and bonds • Inflation-protected treasury bonds (TIPS) • International bonds • Federal agency debt • Municipal bonds • Corporate bonds • Mortgage and mortgage-backed securities

Passive Management

-markets are efficient, no attempt to find undervalued securities, no attempt to time market -hold a diversified portfolio ( indexing, constructing efficient portfolio) (associated with mutual and exchange-traded funds (ETF) where a fund's portfolio mirrors a market index.)

Active Managment

-markets are inefficient, actively seeking undervalued stocks (security selection) and market timing for asset allocation ( manager makes specific investments with the goal of outperforming an investment benchmark index or target return.)

Investment company net assets

-most in open ended mutual funds, exchange traded funds, closed ended funds and least in unit investment trusts

Close End Funds

-no change in shares outstanding unless new stock is offered -fund share price may trade at a premium or discount to NAV

Mutual Funds

-public info on portfolio, unlimited investors, follow limited short selling and leverage, limited derivatives usage, redeem shares on demand, fixed percentage of asset fee .5% to 2%.

Money Market Instruments

-short-term • marketable • liquid • low-risk • debt instruments • cash equivalents

Financial Intermediaries exist because

-small investors can't efficiently diversify portfolios, gather info and monitor portfolios

Investment process

-steps in portfolio management process 1.The Planning Step • Understanding the client's needs • Preparation of an investment policy statement (IPS) -document recording the agreements regarding issues relating to how the investor's money is to be managed. 2.The Execution Step • Asset allocation ( dividing your investments among different asset categories) • Security analysis ( finding the proper value of individual securities) • Portfolio construction 3. The Feedback Step • Portfolio monitoring and rebalancing • Performance measurement and reporting

Target Date Fund

A mutual fund in the hybrid category that automatically resets the asset mix of stocks, bonds and cash equivalents in its portfolio according to a selected time frame that is appropriate for a particular investor. ( investment company that seeks to grow assets over a specified period of time for a targeted goal)

The Value and Return of a Price Weighted Index

A price-weighted index adds the market prices of each stock in the index and divides this total by the number of stocks in the index. The divisor, however, must be adjusted for stock splitsand other changes in the index portfolio to maintain the continuity of the series over time.

Total return

A rate of return that is calculated based on a return index.

Market value weighted index- Advantages and Disadvantages

Advantage • Index security weights represent proportions of total market value. • Index reflects the returns to straightforward portfolio strategies. • Disadvantage • The relative impact of a stock's return on the index increases as its price rises and decreases as its price falls.

Equally-Weighted Index- Advantages and Disadvantages

Advantage • Its computation is simple. Disadvantages • Equally-weighted indexes do not correspond to buy and-hold portfolio strategies. A matching portfolio would have to be adjusted periodically (rebalanced) as prices change. • The weights placed on the returns of the securities of smaller capitalization firms are greater than their proportions of the overall market value of the index stocks.

Price Weighted Index- Advantages, Disadvantages

Advantages- computation is simple Disadvantages -Price-weighted average give higher-priced shares more weight in determining the performance of the index. • A stock's weight in the index changes if the firm splits its stock, repurchases stock, or issues stock dividends

Real assets vs. Financial assets

All financial assets (owner of the claim) are offset by a financial liability (issuer of the claim) -When all balance sheets are aggregated, only real assets remain Net wealth of economy: Sum of real assets

Market value weighted index

Also called market capitalization-weighted index. • Weights based on the market capitalization of each index stock as a proportion of the total market capitalization of all the stocks in the index. • An example of a market capitalization-weighted index • The Standard and Poor's 500 (S&P 500) Index • The FTSE 100 Index ( weighted according to the total market value of their outstanding shares. ) -shares outstanding times price equals amount, add up amounts and divide each by total to get percent of each company Market capitalization-market value of a company's outstanding shares

Price-Weighted Index

An arithmetic average of the prices of the securities included in the index. • The divisor of a price-weighted index is adjusted for stock splits and changes in the composition of the index. Two major price-weighted indexes: • The Dow Jones Industrial Average (DJIA) • The Nikkei Dow Jones Stock Average (each stock influences the index in proportion to its price per share.) -add up stock prices and divide by number

Equal Weighting

An equally-weighted index places an equal weight on the returns of all index stocks, regardless of their prices or market values. • The return of an equal-weighted index over a given period is often calculated as a simple average of the returns of the index stocks. current index value = base period index value x (1+ arithmetic average of returns of stocks)

Fundamental-Weighted Index

An index that uses weights based on firm fundamentals, such as sales, earnings, dividends, book value, or cash flow. • Fundamental weights can be based on a single measure or some combination of fundamental measures. • It avoids the bias of market capitalization-weighted indexes toward the performance of the shares of overvalued firms and away from the performance of the shares of undervalued firms. • Example of fundamental-weighted index • The FTSE RAFI US 1000 Index

Eurobond

An international bond that is denominated in a currency not native to the country where it is issued. • E.g. Euro-dollar bonds, Euroyen bonds.

Risk Return Trade off

Assets with higher expected returns have higher risk • Stock portfolio loses money 1 of 4 years on average Bonds (investor loans money to an entity (typically corporate or governmental) which borrows the funds for a defined period of time at a variable or fixed interest rate. ) • Have lower average rates of return • Have not lost more than 13% of their value in any one year

American Depository Receipts (ADRs)

Certificates denominated in U.S. dollars and trade in the United States representing ownership in foreign security (shares in a non-US company that are deposited in an overseas bank.)

Asset Allocation

Choosing among broad asset classes • Primary determinant of a portfolio's return • Percentage of fund in asset classes

Financial Assets

Claims on real assets or claims on real-asset income -Securities, currencies, and derivative contracts

Float-Adjusted Market Capitalization-Weighted Index

Constructed like a market capitalization-weighted index. • The weights are based on the proportionate value of each firm's shares that are available to investors to the total market value of the shares of index stocks that are available to investors. • Better match the index weights of stocks to their proportions of the total value of all the shares of index stocks that are actually available to investors. (number of shares "floating", rather than outstanding)

Major classes of Financial assets or Securities

Debt (fixed income) -money market instruments (give the owner the unconditional right to receive a stated, fixed sum of money on a specified date. ) -Bank certificates of deposit ( savings certificate with a fixed maturity date, specified fixed interest rate ) - T-bills (government security, yielding no interest but issued at a discount on its redemption price.) -commercial paper ( unsecured promissory note with a fixed maturity of not more than 364 days.) - Capital market instruments Bonds • Preferred stock (fixed dividend, whose payment takes priority over that of common-stock dividends.) • Common stock (equity) ( dividends that vary in amount and may even be missed, depending on the fortunes of the company.) Ownership stake in entity, residual cash flow • Derivative securities (financial security with a value that is reliant upon or derived from an underlying asset)

Derivatives

Derivative Asset/Contingent Claim • Security with payoff that depends on the price of other securities •Options •Futures Contract

Index construction

Different weighting methods used in stock index construction • Price weighting • Market value weighting or market capitalization weighting • Equal weighting • Float-adjusted market capitalization weighting • Fundamental weighting

Eurodollars

Dollar-denominated time deposits held outside U.S. • Pay higher interest rate than U.S. deposits (US dollar deposit held in Europe or elsewhere outside the US)

Preferred Stock

Fixed dividends: Limited gains, nonvoting • Priority over common shares • Tax treatment: Preferred/common dividends not tax-deductible to issuing firm; corporate tax exclusions on 70% of dividends earned Taxable income = preferred dividends received × 30% Income tax = taxable income × tax rate After-tax income= preferred dividends received - Income tax After-tax rate of return= After-tax income/Purchasing price

Treasury Bill

Gov. issues, $100 commonly 10,000, matures in 4,13,26 or 56 weeks -liquidity is high, no default risk, discount interest type -taxation is federal owed, exempt from state and local tax

Municipal Bonds

Issuer: • State and local governments •General obligation bonds • Revenue bonds • Industrial development bond •Taxation? • Interest income is exempt from federal income taxation, and is usually exempt from state and local taxation in the issuing state. • Capital gains is not tax-exempt (debt security issued by a state, municipality or county to finance its capital expenditures, including the construction of highways, bridges or schools.)

World's Largest banks

JP Morgan, Industrial and Commercial Bank of China, Bank of America, Wells Fargo top 4

Exchange Traded Funds

Offshoots of mutual funds that allow investor to trade index portfolios Advantages -Trade Continuously throughout the day -Can be sold or purchased on margin -Potentially lower tax rates -Lower costs (no marketing, lower fund expenses) Disadantages -Small deviations from NAV possible -Brokerage commission to buy ETF

Price weighted index vs. Equal weighted index

Price weighted index -The returns on a price-weighted index could be matched by purchasing an equal number of shares of each stock represented in the index. Equal-Weighted Index -The returns on a equal-weighted index could be matched by placing equal dollar values in each stock represented in the index

Open End Mutual Funds

Shares outstanding-change when new shares are sold or old shares are redeemed Fund Share price= Net asset value (NAV) NAV= asset- liabilities per share

Repurchase Agreement

Short-term sales of securities with an agreement to repurchase the securities at higher price • RP is a collateralized loan; many RPs are overnight, though "term" RPs may have a 1-month maturity (dealer sells the government securities to investors, usually on an overnight basis, and buys them back the following day.)

Bottom-up portfolio management

Starts with security selection

Equally-Weighted Index

The arithmetic average return of the index stocks. •Examples of equal-weighted indexes: • S&P 500 equally weighted index • Wilshire 5000 Equal-Weight Index • The Value Line Composite Average • The Financial Times Ordinary Share Index (same weight, or importance, to each stock in a portfolio or index fund, and the smallest companies are given equal weight to the largest companies)

Equivalent Taxable yield

The pretax yield that a taxable bond needs to possess for its yield to be equal to that of a tax free municipal bond r=rm/ 1-t rm is rate of municipal bond, after tax yield , t is marginal tax rate, r is taxable yield, rate on taxable bond

Cutoff tax rate

The tax bracket at which investors are indifferent between taxable and tax-exempt bonds. t=1- rm/r rm= after tax yield r=rate on taxable bond

Types of Investment companies

Unit Investment Trusts • Money pooled from many investors is invested in portfolio fixed for life of fund • Mutual funds (investment program funded by shareholders that trades in diversified holdings and is professionally managed.) -Open-end funds (does not have restrictions on the amount of shares the fund can issue) -Closed-end funds (fixed number of shares - new shares not created) • Exchange Traded Funds (ETF) ( investors a way to pool their money in a fund. This fund makes investments in stocks, bonds, or other assets and, in return, receive an interest in that investment pool.)

Real assets

Used to produce goods and services: Property, plants and equipment, human capital,

Money Market Instrument yields

Yields on money market instruments not always directly comparable Factors influencing "quoted" yields • Par value vs. investment value • 360 vs. 365 days assumed in a year (366 leap year) • Simple vs. compound interest

Market value weighted index

current total market value of index stocks/ base period total market value of index stocks x base period market value weighted index

Asked price

face value x (1- bank discount ask rate)

Return on investment in t-bill

face value-purchase price/ purchase price

Investment banks

firms specializing in the sale of new securities to the public. They also specialize in other large and complex financial transactions.

Model

mathematical equation

Asked yield

return on investment in t-bill x 365/ days to maturity

Price weighted index equation

sum of stock prices/number of index adjusted

10 Most Popular ADRs

teva, alibaba, vale SA

Financial modeling

uses mathematical equations to measure various relationships among financial variables, for example, how to value a stock given all necessary information.

Modeling

using a mathematical equation to measure the relationship, approximation.

Market Capitalization-Weighted Index

• A market capitalization-weighted index return can be matched with a portfolio in which the value of each security position in the portfolio is the same proportion of the total portfolio value as the proportion of that security's market capitalization to the total market capitalization of all of the securities included in the index.

Price return

• A rate of return that is calculated based on a price index.

Banker's Acceptances

• A short-term debt instrument issued by a company that is guaranteed by a commercial bank • Purchaser authorizes a bank to pay a seller for goods at later date (time draft) • When purchaser's bank "accepts" draft, it becomes contingent liability of the bank ( and marketable) ( promised future payment, or time draft, which is accepted and guaranteed by a bank and drawn on a deposit at the bank.)

The Value and Return of an Index

• An index has a numerical value that is calculated from the market prices of its constituent securities at a point in time.

Mortgage-Backed Securities

• Backed by pool of mortgages with "passthrough" of monthly payments; covers defaults • Private banks purchased and sold pools of subprime mortgages • Issuers assumed housing prices would continue to rise

Security selection and analysis

• Choosing specific securities within each asset class

Equity Securities

• Common stock •Preferred stock • Depository receipts

Federal Funds

• Depository institutions must maintain deposits with Federal Reserve Bank • Federal funds—trading in reserves held on deposit at Federal Reserve (central bank of the United States.) reserves-liquid assets held by a bank, company or government in order to meet expected future payments and/or emergency needs. • Key interest rate for economy (overnight borrowings between banks and other entities to maintain their bank reserves at the Federal Reserve)

Investment companies

• Firms that pool and manage the money of many investors • Arise out of economies of scale

Global depository receipts (GDRs)

• GDRs are issued outside the United States and the issuer's home country. • Most GDRs are traded on the London and Luxembourg exchanges. (bank certificate issued in more than one country for shares in a foreign company.)

Return index

• Includes both prices and income from the constituent securities.

Corporate Bonds

• Investment grade vs. Speculative grade (A bond that is speculative-grade has a rating lower than Baa from Moody's Investors Service, a rating lower than BBB from Standard & Poor's or both. Nonrated bonds are also considered speculative-grade. Bonds with ratings of Baa, BBB or higher are termed investment-grade.) -debt security issued by a corporation and sold to investors.

Venture capital

• Investment to finance new firms

Private equity

• Investments in companies not traded on stock exchange ( investors are typically large institutional investors, university endowments, or wealthy individuals.)

Certificates of Deposit

• Issuer: Depository institutions • Denomination: Any, $100,000 or more marketable • Maturity: Varies, typically 14-day minimum • Liquidity: CDs of 3 months or less are liquid if marketable • Default: First $250,000 insured (by FDIC) • Interest type: Add on •Taxation: Interest income fully taxable

Commercial Paper

• Issuer: Large creditworthy corporations, financial institutions • Denomination: Minimum $100,000 • Maturity: Maximum 270 days, usually 1-2 months • Liquidity: CP of 3 months or less is liquid if marketable • Default risk: Unsecured, rated, mostly high quality • Interest type: Discount • Taxation: Interest income fully taxable • New Innovation: Asset-backed commercial paper

LIBOR (London Interbank Offer Rate)

• Rate at which large banks in London (and elsewhere) lend to each other • Base rate for many loans and derivatives

Security market indexes uses

• Reflection of market sentiment • Benchmark of manager performance • Measure of market return and risk • Measure of beta and risk-adjusted return • Model portfolio for index funds ( tool used by investors and financial managers to describe the market, and to compare the return on specific investments. It is computed from the prices of selected stocks (typically a weighted average)

Depository Receipts

• Represent ownership in a foreign firm and are traded in the markets of other countries in local market currencies. ( issued by a bank representing shares in a foreign company traded on a local stock exchange. )

Efficient Markets

• Securities should be neither underpriced nor overpriced on average • Security prices should reflect all information available to investors belief in market efficiency should lead to choice of investment management style

Treasury inflation protected security (TIPS)

• Securities whose principal is tied to the Consumer Price Index (CPI) . • The principal increases with inflation and decreases with deflation. • When the security matures, the U.S. Treasury pays the original or adjusted principal, whichever is greater. • TIPS pay interest every six months. (protection against inflation. The principal of a TIPS increases with inflation and decreases with deflation, as measured by the Consumer Price Index)

Top down portfolio management

• Starts with asset allocation (analysis of alternative economics and sec. markets, then analysis of alternative industries, bottom is analysis of ind. companies and stocks)

Index return

• The percentage change in the index's value over a period of time.

Price index

• Uses only the prices of the constituent securities in the return calculation.

Reverse Repurchase Agreement

• lending money and obtaining security title as collateral

International bonds

•Bonds issued in foreign countries, but in the currency of the investor. • E.g. Yankee bond, Samurai bonds (Yendenominated bonds sold in Japan by nonJapanese issuers).

Investment

current commitment of current resources in the expectation of deriving greater resources in the future

Index return equation

current index value/base period index value - 1

Hedge Funds

-info provided only to investors, less than 100 investors, high dollar minimums, no limitations for strategies, multiple year lock up periods, fixed percent of asset fee (1-2% plus incentive fee= 20% of gains above threshold return) (limited partnership of investors that uses high risk methods, such as investing with borrowed money, in hopes of realizing large capital gains.)

6 Main purposes people use the financial system

1. to save money for the future; 2. to borrow money for current use; 3. to raise equity capital (funds paid into a business by investors in exchange for common or preferred stock. ) 4. to manage risks 5. to exchange assets for immediate and future deliveries 6. to trade on information.

3 Functions of the Financial System

1.the achievement of the purposes for which people use the financial system • 2. the discovery of the rates of return that equate aggregate savings with aggregate borrowings 3. the allocation of capital to the best uses. (distributing financial resources to various sectors to increase efficiency and thereby maximize profits)

Commerical banks

accept deposits and lend the money to other borrowers. • After the Glass-Steagall Act was repealed in 1999, some commercial banks started transforming to "universal banks" which provide the services of both commercial banks and investment banks. • With the passage of the Dodd-Frank Wall Street Reform and Consumer Protection Act in 2010, Glass-Steagall was partially restored via the Volker Rule.

Bank discount asked rate

asked x days to maturity/360