personal investing 1 real vs. financial assets fed funds and money market common and preferred stock...

Personal Investing 1

Real vs. Financial Assets

Fed Funds and Money Market

Common and Preferred Stock

Equity Trading

Margin Trading and Short Sales

Personal Investing 1 2

Investment process Investment

Finance is just a “time machine” Trade current benefit for future payoff

Bank deposit, stock purchase, education

Real vs Financial Assets Real Assets: assets for generating goods

and services Factory, farm, gas station, restaurant, etc.

Financial Assets: claims on real assets Bank loans, stocks, bonds, options, etc.


Real vs. Financial Assets Why financial assets?

Consumption timing: to shift consumption needs across time

Savings to buy a house Allocation of risk: real asset too risky

Amazon’s stock for the brave and bond for the less adventurous souls

Separation of ownership & management: real asset too big

It’s inefficient for GE’s half-million stock owners to participate day-to-day operations


Fed Funds and Money Market Money Market

Cash equivalents, short-term (maturity 1 year), liquid (marketable), low-risk debt securities

Instruments Federal funds (not a part of money market) Treasury bills (T-bills) Certificate of deposit Commercial paper Eurodollars

Access to money market Checking/saving/NOW accounts Money market mutual Funds


Federal Funds Rate charged for Federal Funds among

the banks Most widely quoted “Fed” rate

Is it set really set by the Fed?

Effective Rate vs. Target Rate (Aug 27, 2008)


Treasury Bills Definition

Short-term Gov. security issued at discount e.g., pay $900 today for 1yr T-bill of $1000 par value

Characteristics Highly liquid Extremely safe (virtually risk free) Exempt of state and local taxes (but not

federal) Initial maturity at 4, 13, 26, and 52 weeks

Pay $900

Today Maturity

Receive $1000 face (par) value


Treasury Bills Example

A 90-day T-Bill of par $10,000 trades at $9,600: n = 90, F = $10,000, P = $9,600

Annualized rate of return (i.e. “yield”):

T-Bills are quoted in Bank Discount Rate, which is NOT the true rate of return:


Treasury Bills Sample quotes from WSJ (Sep 1 2005)

MaturityDays to

MatrurityBid Asked Chg Ask Yield

Nov 10 05 70 3.38 3.37 -0.04 3.44Nov 17 05 77 3.4 3.39 -0.03 3.46Nov 25 05 85 3.42 3.41 -0.05 3.49Dec 01 05 91 3.44 3.43 -0.05 3.51

Actual # days – 2 Bank discount rate Yield, i.e. the true rate of return


Certificates of Deposit (CD)

Issued by Denomination Maturity Liquidity Default risk Interest type Taxation

Depository Institutions

Any, $100,000 or more are marketable

Varies, typically 14 day minimum

3 months or less are liquid, if negotiable

First $100,000 ($250,000) is insured

Add on

Interest income is fully taxable


Commercial Paper Issued by

Maturity Denomination Liquidity Default risk Interest type Taxation

Large creditworthy corporations and

financial institutions

Maximum 270 days, usually 1 to 2 months

Minimum $100,000

3 months or less are liquid if marketable

Unsecured, Rated, Mostly high quality

Discount

Interest income is fully taxable

New Innovation: Asset backed commercial paper is backed

by a loan or security. In summer 2007 asset backed CP

market collapsed when subprime collateral values fell.


Major Components of the Money Market


MMMF and the Credit Crisis of 2008 Between 2005 and 2008 money market mutual funds

(MMMFs) grew by 88%. MMMFs had their own crisis in 2008 when Lehman

Brothers filed for bankruptcy on September 15. Some funds had invested heavily in Lehman’s

commercial paper. On Sept. 16, Reserve Primary Fund “broke the buck.”

What does this mean? A run on money market funds ensued, and unsecured

money market rates jumped up. The U.S. Treasury temporarily offered to insure all

money funds (close to $3.4 trillion) to stop the run.


Spreads on CDs and Treasury Bills


Common Stock Definition

Ownership shares in public companies Characteristics

Voting rights Shareholder can vote for company issues, e.g.,

executive compensation, board of directors, auditing firm, etc.

Residual Claims Last in line of all claimants on the company, e.g.,

owns whatever is left after workers, suppliers, bondholders are paid off.

Limited Liability Lose no more than original investment, e.g., you pay

$90 for a share of IBM, you’ll lose no more than that.


Common Stock A quote from WSJ (or YAHOO these days)

A few questions How much do you have to pay for a share at

close? What is last year’s earning? Is the stock boring?

52 WeeksHi Lo Stock (SYM) YLD% HiDIV P/E Volume Lo

NetChg

17.52 5.73 GenElec (GE) 0.40 2.43 14.68 74,123,574 16.75 16.35

Close

16.44 -0.26

10044.16

0.40$0.10/Quarter

http://quote.yahoo.com/


Preferred Stock Definition

Non-voting share in a corporation Characteristics

Fixed dividend stream (like bond coupon)

Dividend may be skipped yet cumulative

Dividend fully taxable How different is it from a bond?


Trading Stocks on Secondary Market Definition

Markets for investors to buy and sell stocks How are stocks traded?

Q: How do I buy 100 shares of Microsoft? A: Depending on the type of order

Market order: buy immediately at current market price Quick execution with unknown price E.g., last transaction for MSFT is $26.12, so you will be

able to buy at a price around $26.12 immediately. Limit order: buy with a price specified

Slow execution with known price E.g., you submit an order to buy MSFT at $26 (limit price),

and wait until the price drops to $26.


Secondary Market How are stocks traded?

Sell order Market (23.723?) Limit (above 23.74?) Stop-loss (below 23.723?)

Buy order Market (23.74?) Limit (below 23.723?) Stop-buy (above 23.74?)

Limit Order Limit the gain

Stop Order Stop the loss

Where is the price going?

Price 23.733 Orders 47,892

Time 13:34.3 Volume 5,766,868

SHARES PRICE SHARES PRICE

1,720 23.723 100 23.742,000 23.722 3,000 23.74

536 23.721 97 23.749200 23.721 1,000 23.749

1,310 23.72 20,000 23.751,900 23.72 300 23.75

500 23.72 1,000 23.755100 23.71 100 23.76100 23.71 1,720 23.768500 23.71 5,000 23.77

1,000 23.71 1,000 23.77600 23.71 2,000 23.78

1,000 23.71 800 23.787200 23.701 2,400 23.79500 23.7 700 23.799

MSFT (source: Island, 2/25/2003)

LAST MATCH TODAY'S ACTIVITY

BUY ORDERS

(546 more)

SELL ORDERS

(464 more)


Secondary Market Market Buy of 4,100

shares 100 at 23.74 3,000 at 23.74 1,000 at 23.749

Market Sell of 2,000 shares

1,720 at 23.723 280 at 23.722

Limit Buy 100 share at 23.715

100 share appears on the book between 23.71 and 23.72

Price 23.733 Orders 47,892

Time 13:34.3 Volume 5,766,868

SHARES PRICE SHARES PRICE

1,720 23.723 100 23.742,000 23.722 3,000 23.74

536 23.721 1000 23.749200 23.721 1,000 23.749

1,310 23.72 20,000 23.751,900 23.72 300 23.75

500 23.72 1,000 23.755100 23.71 100 23.76100 23.71 1,720 23.768500 23.71 5,000 23.77

1,000 23.71 1,000 23.77600 23.71 2,000 23.78

1,000 23.71 800 23.787200 23.701 2,400 23.79500 23.7 700 23.799

MSFT (source: Island, 2/25/2003)

LAST MATCH TODAY'S ACTIVITY

BUY ORDERS

(546 more)

SELL ORDERS

(464 more)

1,720

100 23.715


Secondary Market Where are stocks traded?

Exchanges NYSE, … Specialist (Designated Market Maker) system

Buyers SellersBrokerage

FirmBrokerage

Firm

Commission Broker

Floor Broker

Commission Broker

Floor Broker

Specialist

http://www.nyse.com/

http://www.nyse.com/equities/nyseequities/1167954368183.html



Over-the-Counter Market NASDAQ Multiple dealer system


FirmBrokerage

Firm

Dealer

Dealer

Dealer

http://www.nasdaq.com/



Electronic Communication Network (ECN) The fourth market Island, ArcaEx, Instinet, … Direct trading among investors on a electronic

limit order book


FirmBrokerage

Firm

ElectronicLimit Order

Book

http://www.isld.com/

http://www.arcaex.com/


Margin Trading and Short Sales Margin Account Trading

Why do investors use margin account? How does margin borrowing affect return

and risk? Short Sale

What purpose does short sale serve? How does short sale work? How does short sale constraint affect stock

return?


Margin Account Trading Definition

Account Values: Asset: total holding of securities including cash Liability: the amount of money owed to others

Either cash (margin borrowing) or stock (short sale) Equity: the investors net worth = Asset - Liability Stock Value: the market value of stock holding

Margin: equity as a percentage of stock value

Initial Margin Requirement: initial margin >= 50% Set by Board of Governors of the Federal Reserve System

Maintenance margin: minimum amount of equity before additional funds to be put into the account

Margin call: notice from broker for additional funds Margin Interest: interest charge on capital borrowed


Margin Account Trading Holding Period Return

E.g., you invest $10,000 and receive $1,000 of dividends at the end of the year. The market value of your stocks at the end of the year is $11,000.

Q: what’s your return for the year? A: the holding period return is


Margin Account Trading Un-leveraged Investment

Invest no more than the capital you have Q: You open an account with $6,000. IBM stock price is $100.

If you invest all your money in IBM What is your HPR if IBM appreciates to $130 in a year? What is your HPR if IBM depreciates to $80 in a year?

A: Since this is a unleveraged position, your return is the same as the stock price appreciation/depreciation

Appreciation

Depreciation


Margin Account Trading Q: Same condition as previous case, but you buy 100 shares

What is your HPR if IBM appreciates to $130 in a year? What is your HPR if IBM depreciates to $80 in a year?

A: 100 shares cost $10,000, you have to borrow $4,000 (at 9%) Initial Position

Asset = stock value = $10,000 Liability = $4,000, Equity = Asset – Liability = $6,000 Initial Margin = Equity/Stock Value = 60%

Final Position when P =$130 Asset = stock value = 100×130 = $13,000 Liability = 4,000×(1+9%) = $4,360, Equity = $8,640

Final Position when P = $80 Asset = $8,000, Liability = $4,360, Equity = $3,640


Margin Account Trading Effects of Margin on Return and Risk

Higher risk Makes more in good times Loses more in bad times

Higher return Margin amplifies the expected return

-100%

-50%

0%

50%

100%

40 60 80 100 120 140 160

Stock Price

Ret

urn

Return w/o margin

Return w/margin


Margin Call Margin Call (for Margin Account)

If equity falls below maintenance margin (25%-30% typical), a margin call for more fund or for liquidation is issued

Assuming 30% maintenance margin What is the margin call price one year later?

Solve the above equation: Pc = $62.29 What is the margin call price today?

Liability = $4,000 (instead of $4,360), so Pc = $57.14 What is the margin call price if the maintenance margin = 40%?

What happens to the investor receiving a margin call? either deposit more fund (increase the equity), or sell some stock (lowers the stock value)


Margin Call - Risks Margin calls happen when your bets go

wrong (at least short-term) The higher the leverage, the higher the chance

of getting margin calls Need to come up with cash (liquidity) - fast

Can not profit from your position if you sell stock

May trigger liquidity crisis Try to use Rev/repos if you can Tough luck, if you can’t come up with cash This is where LTCM failed


Short Sale What purpose does short sale serve?

Gives speculators a tool to profit from bear market Q: Jane believes IBM is going to drop from $100 to $90, what

should she do? A: Jane borrows IBM shares and sells them at $100. She waits

to buy back the shares at $90 to make $10 profit per share.

Provides investors with a vehicle to hedge its portfolio Q: An investor holds a diversified portfolio with huge capital

gains, but is afraid of a market drop. What should she do? A: sell short a market index portfolio like Spider (SPY)

http://finance.yahoo.com/q?s=SPY&d=t


Short Sale How Does Short Sale Work?

Mr Owner buys 1 share of IBM Mr owner has the rights of

Voting Dividend

Short Creation Short borrows share from Owner Short owes Owner a share (IOU) Short sells the share to Ms Long Ms Long has the rights of

Voting Dividend

Mr Owner is still entitled to Dividend

All deals are facilitated by brokers

IBM

Mr Short

Mr Owner

Ms Long

Morgan Stanley Dean Witter

facilitates all the deals

1

share

1 share

1 share

$100

$100

IOU

+ d

ivid

end


Short Sale How does Short Sale Work?

Profit/Loss (so called P/L in industry) Long position on one share of stock

P1 is the ending price P0 is the beginning price D1 dividend during the period paid in the end

Short position on one share of stock short

Q: What’s your profit if you short 200 share of a stock at $34, and cover it at $30, while it pays a $1 dividend?

A: You receive 200×34 = $6,800 at time 0 You pay 200×1= $200 dividends to the one you owed share to You pay 200×30 = $6,000 to buy the share and pay it back.


Short Sale Return and Margin Call

Q: You deposit $50,000 in the brokerage acct, and sell short 1000 share of IBM at $100

What is your initial margin? What is your investment return if IBM falls to $70? What is the margin call price if $2 dividends are paid?

A: Both the margin and return depend on equity Initial margin:

Return:

Assuming maintenance margin of 30%


Short Sale - Constraints Cost of Borrowing

Broker fees Low rebate rates on your collateral cash

Scarcity of shares to borrow (stock “on special”) After IPOs Prior to rumored mergers/acquisitions (acquirer’s

stock is hard to borrow) Risk of involuntary closing a short position

Borrowed stock can be recalled, and the broker may not find a substitution

personal investing 1 real vs. financial assets fed funds and money market common and preferred stock...

Documents

personal investing

target rate

effective rate

quoted fed rate

financial assetsfed

financial institutionsmaximum

annualized rate of return

money marketcommon