Transcript Class Outline - Villanova University

Investments
Lecture 1
Introduction to Investments
Class Outline



-- Develop an understanding of the operation of
debt, equity, and options markets and the
instruments used in these markets
-- Review the investment process in general
with a focus on security selection decisions
-- Discuss market efficiency and its
implications for speculative strategies
Class Outline



-- Analyze different valuation and analytic
techniques for equities
-- Examine investments techniques for equity
portfolios
-- Look at mutual funds and other investment
companies as vehicles for investment strategies.
My Personal Investment
Philosophy
 A. Markets are (essentially) efficient


You can not consistently beat the market.
If an investor starts off with this belief, I feel
that the investor is better able to assess the
validity of proposed "sure fire" investment
strategies.
My Personal Investment
Philosophy
 B. If it sounds too good to be true, it is.

This advice will prevent you from entering into
any investment without checking it out first.
 C. There is always someone smarter than
you.

This will prevent overconfidence and will keep
you on your toes.
Introduction to investments
 Investing

Definition of an investment: The current
commitment of dollars for a period of time in
order to derive future payments that will
compensate the investor for:
• 1. The time value of money
• 2. The expected rate of inflation
• 3. The risk associated with the investment
Introduction to investments
 Speculating

Speculative strategies include:
– 1. Buying long-term bonds because you feel interest rates
will fall
– 2. Buying a stock because you feel its price will increase
due to a takeover attempt
– 3. Buying stocks you believe are “undervalued” by the
market
Introduction to investments
 Expected returns versus required returns


The expected return on a security is the return
an investor expects to receive over some future
time period.
The expected return is estimated by
determining an expected future price and
income for a security and measuring the return
in a manner similar to the actual return
calculation.
Introduction to investments
 Expected returns versus required returns

Mathematical definition of the expected return:
 ER = ((Pt+1-Pt) + incomet+1)/Pt
Introduction to investments
 Expected returns versus required returns

We can also measure the expected return by
estimating several potential outcomes and
assigning a probability to each outcome. The
expected return in this case would be equal to:
  Pi*ERi
Real Assets vs. Financial Assets
 Use them to produce
goods and services




Property
Plant
Equipment
Knowledge
 Claims on real assets
or the income
generated by real
assets



Stocks
Bonds
Derivative securities
Introduction to investments
 Risk -- -- Risk is the possibility that an
investment will earn a return lower than is
required. Essentially, for our purposes, risk
is the possibility of price variation.


The problem with ignoring risk
-- Things sound too good to be true when risk is
ignored. Investments that are much too risky
for the average investor appear to be "good"
investments if risk is ignored.
Investment Alternatives
 The money market

-- The money market is a subsector of the
fixed-income market. It consists of short-term,
very liquid investments.

1. Treasury-bills (T-bills)
• Pure discount instruments
• Typically considered as a "risk-free" asset
Investment alternatives
 The money market

2. Certificates of deposits
• Time deposits made with a bank. Federally insured up to
$100,000.

3. Commercial paper
• -- Short-term debt issued by corporations. Gives corporations
a way to avoid bank debt.


4. Repos
5. Brokers’ Calls
Investment alternatives
 The fixed-income capital market

1. Treasury notes and bonds
• Longer maturity government debt

2. Federal agency debt
• -- Debt issued by government agencies and
government sponsored agencies in support of farm
credit and home mortgages
– - Major issuing agencies include: Federal Home Loan
Bank (FHLB), Federal National Mortgage Association
(FNMA), Government National Mortgage Association
(GNMA), Federal Home Loan Mortgage Corporation
(FHLMC), District Cooperative Banks, Federal Land
Banks, Federal Intermediate Credit Banks
Investment Alternatives
 The fixed-income capital market

3. Municipal bonds
• Issued by state and local governments
• Income is tax exempt

4. Corporate bonds
Taxable vs. Tax-Exempt Yields
MunicipalYield
ET Y 
1  MarginalT ax Rate
Investment alternatives
 The fixed-income capital market

5. Mortgage-Backed Securities (MBS)
• Gives the holder an ownership claim in a pool of
mortgages or an obligation that is secured by such a
pool. There has been an exponential growth in the
MBS market since 1979 with the amount of funds
invested approaching 2 trillion dollars.
Investment alternatives
 The fixed-income capital market

5. Mortgage-backed securities (MBS)
• Securitization involves packaging a set of assets
together and selling ownership rights to the assets.
For example, David Bowie recently sold shares in
his song portfolio. Any revenues generated from his
songs are split among the shareholders. (By the
way, I believe he made a few hundred million
dollars doing this.)
Investment alternatives
 Equity securities

1. Common stock
• Residual claimant
• Limited liability

Agency problems
• Managers are agents for shareholders
• Interests of principals and agents are often in
conflict
Investment alternatives
 Equity securities

2. Preferred stock
• Promises a fixed dividend to shareholders, but nonpayment of the dividend will not force the company
into bankruptcy.
Investment alternatives
 Derivative Markets

1. Options
• Right to buy or sell an asset at a specified price at a
certain time in the future

2. Futures
• Obligation to buy or sell an asset at a specified price
at a certain time in the future

3. Swaps
• An agreement between two parties to exchange a set
of cash flows in a predetermined manner
Investment alternatives
 Investment companies


1. Mutual funds
2. REITs
 International investments

Developed versus emerging markets
Uses of Stock Indexes
 Track average returns
 Comparing performance of managers
 Base of derivatives
Factors for Construction of Stock
Indexes
 Representative?
 Broad or narrow?
 How is it weighted?
Examples of Domestic Indexes





Dow Jones Industrial Average (30 Stocks)
Standard & Poor’s 500 Composite
NASDAQ Composite
NYSE Composite
Wilshire 5000
Examples of International Indexes




Nikkei 225 & Nikkei 300
FTSE (Financial Times of London)
Dax
Region and Country Indexes



EAFE
Far East
United Kingdom
Construction of Indexes
 How are stocks weighted?



Price weighted (DJIA)
Market-value weighted (S&P500, NASDAQ)
Equally weighted (Value Line Index)
New Economy vs. Old Economy
 Old Economy stocks




AT&T
IBM
McDonald’s
Proctor and Gamble
 New Economy stocks



Cisco
Amazon
eBay
Investments and Innovations
Technology and Delivery of Service
 Computer advancements
 More complete and timely information
Globalization
 Domestic firms compete in global markets
 Performance in regions depends on other regions
 Causes additional elements of risk
Trends in Financial Markets




Globalization
Securitization
Financial engineering
technology
Globalization
International and Global Markets Continue
Developing
 Managing foreign exchange
 Diversification to improve performance
 Instruments and vehicles continue to
develop (WEBs)
 Information and analysis improves
Securitization
Securitization & Credit Enhancement
 Offers opportunities for investors and
originators
 Changes in financial institutions and
regulation
 Improvement in information capabilities
 Credit enhancement and its role
Financial Engineering
Repackaging Services of Financial
Intermediaries
 Bundling and unbundling of cash flows
 Slicing and dicing of cash flows
 Examples: strips, CMOs, dual purpose
funds, principal/interest splits
The Future
 Globalization continues and offers more
opportunities
 Securitization continues to develop
 Continued development of derivatives and
exotics
 Strong fundamental foundation is critical
 Integration of investments & corporate
finance