Investments and Financial Markets

Introduction

Master Objectives

Investment and Opportunity Cost

Debt Cycle

Financial Institutions and Intermediation

Financial Instruments

Portfolio Theory

Active Investment Management

Financial Crises

Financial System

Purpose: bring together individuals, businesses, and

government entities (economic units) that generate

and spend funds.

Surplus economic units have funds left

over after spending all they wish to spend.

Deficit economic units need to acquire

additional funds to sustain their

operations.

Financial Markets

Classified according to characteristics of participants

and securities

Primary Market: deficit economic units sell securities to

raise funds.

Secondary market is where investors trade previously

issued securities with each other.

Other types of Markets, e.g. Money and Capital

Markets

Financial Markets

Money Market

Trade short term (1 year or less) debt instruments (e.g. T-Bills, Commercial Paper)

Major money centers in Tokyo, London and New York

Capital Market

Trades long term securities (Bonds, Stocks)

NYSE, ASE, LSE, over-the-counter (NASDAQ and other OTC)

Financial Markets

Intermediaries, such as commercial and investment

banks and insurance companies facilitate the flow of

funds in the financial marketplace. This called

“Financial Intermediation”.

Securities

Securities$$

$$

Market Efficiency

Market efficiency refers to the ease, speed, and

cost of trading securities.

The market for the securities of large

companies is generally efficient: Trades can

be executed in a matter of seconds and

commissions are very low. Somewhat true: rule

generally is still T+3.

The real estate market is not generally efficient:

It can take months to sell a house and the

commission is 6-7% of the price.

Market Efficiency

Why is market efficiency important?

The more efficient the market, the easier it

is to transfer idle funds to those parties that need the

funds.

If funds remain idle, this results in lower growth for the

economy and higher unemployment.

Investors can adjust their portfolios easily

and at low cost as their needs and preferences change.

Securities in the Financial Market

Money Market Securities

Highly liquid, low risk

Treasury Bills (T-Bills)

Certificates of Deposit (CDs)

Commercial Paper

Eurodollars

Banker’s Acceptances

Treasury Bills

T-Bills are short term securities issued by the

Federal Government [USA].

After initial sale, there is an active secondary market.

They are bought at discount and at maturity face

value is paid.

Negotiable Certificate of Deposit

Interest bearing securities issued by financial

institutions.

Maturities of one year or less.

Commercial Paper

Unsecured debt issued by large corporations with

good credit ratings.

Usually bought only by large institutions.

Eurodollars

They are dollar denominated deposits located in

non-US banks.

Buyers and sellers are large institutions.

Banker’s Acceptances

Debt securities guaranteed by a bank.

Used primarily to facilitate international

transactions, e.g. International trade.

Bonds

They are “IOUs” issued by the borrower and sold to

investors.

Issuer promises to pay the face amount of the bond

on the maturity date, plus pay interest each year in

the amount of the coupon rate times the face value.

How many “cash flow” streams does a bond have?

Other types

Treasury bonds issued by Federal Government

Municipal bonds issued by state and local governments

Corporate bonds

Common Stock

Shareholders own a portion of the company and

have right to vote on major decisions

Return on investment: dividends [if paid by company]

and capital gain, if any.

Preferred Stock

Hybrid instrument between bond and common stock.

Accounting purposes, it is equity, not debt.

Dollar value is guaranteed

Dividends paid to preferred shareholders first under

contract

Rarely have voting rights

In event of insolvency, paid off after bondholders but

before common shareholders

Interest Rates

Interest Rates Determined by

Real Rate of Interest

Expected Inflation

Default Risk

Maturity Risk

Liquidity Risk

Real rate of interest

Compensation for lender’s lost opportunity to

consume.

Default Risk

For most securities, there is some risk that the

borrower will not repay the interest and/or principal

on time, or at all.

The greater the chance of default, the greater the

interest rate the investor demands and the issuer

must pay.

Expected Inflation

Inflation erodes the purchasing power of money.

Example: If you loan someone $1,000 and they pay it

back one year later with 10% interest, you will have

$1,100. But if prices have increased by 5%, then

something that would have cost $1,000 at the outset of

the loan will now cost $1,000(1.05) = $1,050.

Maturity Risk

If interest rates rise, lenders may find that their

loans are earning rates that are lower than what

they could get on new loans.

The risk of this occurring is higher for longer

maturity loans.

Lenders will adjust the premium they charge for this risk

depending on whether they believe rates will go up or

down.

Liquidity Risk

Investments that are easy to sell without losing

value are more liquid.

Illiquid securities have a higher interest rate to

compensate the lender for the inconvenience of

being “stuck.”

Determination of Rates

k = k* + IRP + DRP + MP + LP

k = the nominal, or observed rate on security

k* = real rate of interest

IRP = Inflation Risk Premium

DRP = Default Risk Premium

MP = Maturity PremiumLP = Liquidity Premium

Term Structure

Relationship between long and short

term interest rates

Yield curve

Treasury Yield Curve

8.00

%7.50

%7.00

%6.50

%6.00

%

5.00

%

5.50

%

4.50

%4.00

%3.50

% 3 6 1 2 3 5 7 2

0

1

0mos

.

yr. maturities

3 month

T-Bill

Treasury Yield Curve

8.00%

7.50%

7.00%

6.50%

6.00%

5.00%

5.50%

4.50%

4.00%

3.50%3 6 1 2 3 5 7 2010

mos. yr. maturities

Financial versus Real Assets

Essential nature Reduced current consumption

Planned later consumption

Real Assets Assets used to produce goods and services

Financial Assets Claims on real assets

Investment Process

Asset Allocation

Security selection

Risk-return trade-off

Market efficiency

Active vs. passive management

Active versus Passive Management

Active Management

Finding undervalued securities

Timing the market

Passive Management

No attempt to find undervalued securities

No attempt to time

Holding an efficient portfolio

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