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Investments: capital markets and products

Kristien Smedts (KULeuven)

Kristien Smedts

KULeuven

2016-2017

Investments

2016-2017 1 / 26
2016-2017
1 / 26

Readings

BKM - Chapter 1: The investment environment BKM - Chapter 2: Asset classes and Önancial instruments

Kristien Smedts (KULeuven)

Investments

2016-2017 2 / 26
2016-2017
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Roadmap

1

Capital markets

2

Capital markets as a part of the Önancial system

3

Mutual funds and other investment companies

4

Basic concepts in this course

Kristien Smedts (KULeuven)

Investments

2016-2017 3 / 26
2016-2017
3 / 26

Capital market instruments

The focus of this course is on Önancial assets that are traded on the capital market

Financial assets versus real assets

real assets require an input of resources today to give an output of resources at a later date (e.g. a factory plant); they determine the productive capacity of an economy

land, machines, buildings, knowledge

Önancial assets are claims to output of real assets; they do not directly contribute to the productive capacity

stocks, bonds

Capital market versus money market

money market instruments are short-term debt securities capital market instruments can be classiÖed as debt securities (bonds), equities and derivative securities

Kristien Smedts (KULeuven)

Investments

2016-2017 4 / 26
2016-2017
4 / 26

Capital market instruments

The focus of this course is on Önancial assets that are traded on the capital market

Financial assets versus real assets

real assets require an input of resources today to give an output of resources at a later date (e.g. a factory plant); they determine the productive capacity of an economy

land, machines, buildings, knowledge

Önancial assets are claims to output of real assets; they do not directly contribute to the productive capacity

stocks, bonds

Capital market versus money market

money market instruments are short-term debt securities capital market instruments can be classiÖed as debt securities (bonds), equities and derivative securities

Each class of instruments is unique in terms of timing of payments and uncertainty of payments

Kristien Smedts (KULeuven)

Investments

2016-2017 4 / 26
2016-2017
4 / 26

ClassiÖcation of money market instruments

Treasury bill: government debt obligation with a maturity < 1 year

CertiÖcate of deposit (CD): time deposit at a bank

Commercial paper (CP): short term unsecured debt issed by a large corporation

Bankersíacceptance: a bank promise to pay a prespeciÖed amount

Repurchase agreement (repo or RP) and reverse repo: a short term loan (usually overnight) using other securities (usually government securities) as collateral

Interbank loans: short term loans among banks (e.g. LIBOR, EURIBOR)

Federal funds: short term deposit of a bank by the Federal Reserve

Eurodollars: dollar-denominated deposit at a foreign bank or a foreign bank branch

Kristien Smedts (KULeuven)

Investments

2016-2017 5 / 26
2016-2017
5 / 26

Money market instruments: risk and liquidity considerations

Money market instruments: risk and liquidity considerations Spread between 3-Month LIBOR based on US dollars and

Spread between 3-Month LIBOR based on US dollars and 3-Month Treasury Bill (credit risk in banking sector)

Kristien Smedts (KULeuven)

Investments

2016-2017 6 / 26
2016-2017
6 / 26

Money market instruments: risk and liquidity considerations

Money market instruments: risk and liquidity considerations Spread between 3-Month CD based on US dollars and

Spread between 3-Month CD based on US dollars and 3-Month Treasury Bill (liquidity risk)

Kristien Smedts (KULeuven)

Investments

2016-2017 7 / 26
2016-2017
7 / 26

ClassiÖcation of capital market instruments

Debt securities: instruments that promise to pay a Öxed stream of income or a stream of income according a Öxed formula

Equities (stocks): ownership share in a corporation, both wrt Önancial beneÖts as voting rights

Derivative securities: instruments that make payments that depend on the values of other Önancial assets

Other types of investments: currencies, in real assets through derivatives

Kristien Smedts (KULeuven)

Investments

2016-2017 8 / 26
2016-2017
8 / 26

The bond market: characteristics

Market for longer-term debt instruments

Various maturities and currencies

Liquidity varies from perfect to almost zero

Often in smaller denominations such that they can be held by retail investors

Wide range of credit qualities: from high credit-quality instruments to low credit-quality (junk) instruments

Often not traded on the exchange, but rather traded over the counter (OTC) via dealers

Typically pay coupon interest (annual or semi-annual)

Expressed as a % of the par value

Performance measurement: yield

Kristien Smedts (KULeuven)

Investments

2016-2017 9 / 26
2016-2017
9 / 26

The bond market: instruments

Treasury notes: government debt obligation with a 1 year < maturity < 10 years

Treasury bonds: government debt obligation with a maturity > 10 years

Treasury ináation-protected securities (TIPS): governemt debt obligation where principal and interest are adjusted for ináation (in US: Larry Summers Bonds)

Federal agency bonds: long-term debt issued or guanranteed by a federal agency

Municipal bonds: long term debt issued by state and local governments (often tax advantages)

Corporate bonds: long-term debt issed by a large corporation; typically larger default risk as compared to government debt; options included (callable, convertible)

Mortgage debt: securitized pools of mortgages; proportional ownership of a mortgage pool;

Kristien Smedts (KULeuven)

Investments

2016-2017 10 / 26
2016-2017
10 / 26

The equity market: characteristics

Equities are issued by corporations

They represent ownership in a Örm

share the distribution of proÖts have voting power at shareholdersímeeting

Equity represents a residual claim: you only receive payout if all other claims (e.g. salaries, debt, taxes) are met

Equity has limited liability: minimum share price is zero or minimum return is

-100%

Di§erent equity instruments: common stock vs preferred stock

Traded in a variety of di§erent ways: via brokers, dealer market, auction market, (see Trading & Exchanges)

Kristien Smedts (KULeuven)

Investments

2016-2017 11 / 26
2016-2017
11 / 26

The derivatives market: characteristics

Instruments that get value from the value of another asset (can be a Önancial asset such as a bond or a stock; or a real asset such as commodities

Traded both on the exchange and over the counter

Marking to market and margin calls to reduce counterparty credit risk

Kristien Smedts (KULeuven)

Investments

2016-2017 12 / 26
2016-2017
12 / 26

The derivatives market: instruments

Option: a right to buy/sell the underlying at or before maturity at the strike or exercise price

call option: right to buy; value decreases with the strike price put option: right to sell; value increases with the strike price standardized options traded on the exchange; non-standardized contracts traded OTC value of the option increases with time to expiration entered into at a cost = option premium

Futures contract: an agreement to trade the underlying at maturity at the forward price;

long position: buy at maturity short position: sell at maturity standardized contracts traded on the exchange; entered into without cost: "fair deal"

Forward contract: non-standardized futures contract, traded OTC

Kristien Smedts (KULeuven)

Investments

2016-2017 13 / 26
2016-2017
13 / 26

Roadmap

1

Capital markets

2

Capital markets as a part of the Önancial system

3

Mutual funds and other investment companies

4

Basic concepts in this course

Kristien Smedts (KULeuven)

Investments

2016-2017 14 / 26
2016-2017
14 / 26

Sketch of the Önancial system

Kristien Smedts (KULeuven) Investments 2016-2017 15 / 26
Kristien Smedts (KULeuven)
Investments
2016-2017
15 / 26

Rationale of the capital market

Capital markets allow to separate the timing of income and the timing of consumption

store wealth to transfer to the future

Capital markets allow to allocate risk by either sharing or transfering

Capital markets allow to allocate resources more e¢ ciently (i.e. to the most productive real investments)

informational role of capital markets: allows capital áowas to corporations with best prospects

Capital markets allow to separate ownership and management

supports large-scale businesses be careful with associated agency problems where managers pursue their own interests instead of maximizing the Örmís value.

Kristien Smedts (KULeuven)

Investments

2016-2017 16 / 26
2016-2017
16 / 26

Rationale of the capital market

Capital markets allow to separate the timing of income and the timing of consumption

store wealth to transfer to the future

Capital markets allow to allocate risk by either sharing or transfering

Capital markets allow to allocate resources more e¢ ciently (i.e. to the most productive real investments)

informational role of capital markets: allows capital áowas to corporations with best prospects

Capital markets allow to separate ownership and management

supports large-scale businesses be careful with associated agency problems where managers pursue their own interests instead of maximizing the Örmís value.

E¢ cient allocation of resources and risk in an economy

Kristien Smedts (KULeuven)

Investments

2016-2017 16 / 26
2016-2017
16 / 26

Sketch of the Önancial system: institutional perspective

Sketch of the Önancial system: institutional perspective Take intermediaries as given and focus on the details

Take intermediaries as given and focus on the details of the institutions

as given and focus on the details of the institutions Kristien Smedts (KULeuven) Investments 2016-2017 17

Kristien Smedts (KULeuven)

Investments

2016-2017

17 / 26

Sketch of the Önancial system: functional perspective

Sketch of the Önancial system: functional perspective Take economic agents as given and focus on their

Take economic agents as given and focus on their needs - by doing so one

can abstract away from the institutional detail

2016-2017 18 / 26
2016-2017
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Kristien Smedts (KULeuven)

Investments

Sketch of the Önancial system: functional perspective

To understand the Önancial system (in casu: capital markets) one needs to Örst understand its functions, only then institutions

Rationale of the Önancial system is rather stable of time; institutions vary considerably - both over time as well as across regions

Long run view: functions determine the Önancial system

Short run view: institutions can have major impact

Kristien Smedts (KULeuven)

Investments

2016-2017 19 / 26
2016-2017
19 / 26

Institutional vs functional perspective: the mortgage market

Functional perspective

savers with excess capital want to invest borrowers with shortage of capital want to buy a house collateralized loan to ensure the loan is repaid = mortgage

Traditional mortgage market: local savings and loans banks - originate to hold

local supply and demand constraints local banks not always expert at managing risks ñ> S&L crisis in 1980 due to rising interest rates

New mortgage market: securitization through MBS issuance - originate to distribute

in principle: improved risk-sharing and innovation as compared to traditional mortgage market in reality: adverse selection and moral hazard of loan originators, di¢ cult pricing of new products ñ> credit crisis in 2008

Kristien Smedts (KULeuven)

Investments

2016-2017 20 / 26
2016-2017
20 / 26

Roadmap

1

Capital markets

2

Capital markets as a part of the Önancial system

3

Mutual funds and other investment companies

4

Basic concepts in this course

Kristien Smedts (KULeuven)

Investments

2016-2017 21 / 26
2016-2017
21 / 26

Functional perspective

Pooling of funds of many individual investors and investment in a wide range of assets

Primary function: transfer funds from savers to borrowers

funds are directed in capital market in a diversiÖed way all risks are borne by the individual investors

Secondary functions

record keeping and administration professional management lower transaction costs

Net asset value of the investment company (NAV) = value of each share in the investment company

market value of assets - liabilities

Kristien Smedts (KULeuven)

shares outstanding

Investments

2016-2017 22 / 26
2016-2017
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Institutional perspective: di§erent investment companies

Unit trusts: Öxed portfolio of uniform assets that are unmanaged Managed Investment Companies

open-end mutual fund: the fund issues new shares when investors buy in and redeem shares when investors cash out

pricing at net-asset-value (NAV)

closed-end mutual fund: there is no change in the shares outstanding as current investors cash out by selling to new investors

pricing at premium/discount to NAV

Other intermediaries with similar purpose, but that are not formally organized or regulated as investment companies

Commingled funds: partnerships of investments, similar in form to open-end mutual funds for very large investors (e.g. retirement accounts) Real estate investment trust (REIT): an investment vehicle to invest in real estate or loans secured by real estate, similar in form to closed-end mutual funds Hedge funds: private partnerships of investments with limited regulation

Exchange traded fund (ETF): o§shoot of a closed end mutual fund that allows investors to trade index portfolios as shares

fund that allows investors to trade index portfolios as shares Kristien Smedts (KULeuven) Investments 2016-2017 23

Kristien Smedts (KULeuven)

Investments

2016-2017

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Roadmap

1

Capital markets

2

Capital markets as a part of the Önancial system

3

Mutual funds and other investment companies

4

Basic concepts in this course

Kristien Smedts (KULeuven)

Investments

2016-2017 24 / 26
2016-2017
24 / 26

The investment proces: key concepts

Portfolio: collection of (investment) assets

Asset allocation: choice among a broad range of asset classes

capital allocation to risky assets: decision on fraction to invest in risky/risk-free assets

Security allocation: choice within a speciÖc asset class

Top-down approach: an investment strategy where Örst the asset allocation is determined; next the security allocation

Bottum-up approach: an investment strategy where the focus is immediately on security allocation

such fragmented focus could result in unintended asset allocations

Kristien Smedts (KULeuven)

Investments

2016-2017 25 / 26
2016-2017
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The investment process: key concepts

Portfolio allocation in line with investor preferences (often mean-variance)

Risk-return tradeo§: expected return as a reward for taking on risk

E¢ cient market: in a fully e¢ cient market, where prices adapt quickly to all relevant information, there should be no consistent underpricing or overpricing ñ> arbitrage

Passive management: belief in e¢ cient markets and thus no active search for undervalued securities and timing; investor holds a highly diversiÖed portfolio

Active management: belief in pricing anomalies and thus an active search for underpriced securities and markeyt timing

Kristien Smedts (KULeuven)

Investments

2016-2017 26 / 26
2016-2017
26 / 26