Investments: capital markets and products

Kristien Smedts
KULeuven

2016-2017

Kristien Smedts (KULeuven)

Investments

2016-2017

1 / 26

Readings

BKM - Chapter 1: The investment environment

BKM - Chapter 2: Asset classes and nancial instruments

Kristien Smedts (KULeuven)

Investments

2016-2017

2 / 26

Roadmap

Capital markets

Capital markets as a part of the nancial system

Mutual funds and other investment companies

Basic concepts in this course

Kristien Smedts (KULeuven)

Investments

2016-2017

3 / 26

Capital market instruments

The focus of this course is on nancial 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

nancial 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 classied as debt securities (bonds), equities
and derivative securities

Kristien Smedts (KULeuven)

Investments

2016-2017

4 / 26

Capital market instruments

The focus of this course is on nancial 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

nancial 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 classied 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

Classication of money market instruments

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

Certicate of deposit (CD): time deposit at a bank
Commercial paper (CP): short term unsecured debt issed by a large
corporation
Bankersacceptance: a bank promise to pay a prespecied 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

Money market instruments: risk and liquidity

considerations

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

Money market instruments: risk and liquidity

considerations

Spread between 3-Month CD based on US dollars and 3-Month Treasury

Bill (liquidity risk)

Kristien Smedts (KULeuven)

Investments

2016-2017

7 / 26

Classication of capital market instruments

Debt securities: instruments that promise to pay a xed stream of income or

a stream of income according a xed formula
Equities (stocks): ownership share in a corporation, both wrt nancial
benets as voting rights
Derivative securities: instruments that make payments that depend on the
values of other nancial assets
Other types of investments: currencies, in real assets through derivatives

Kristien Smedts (KULeuven)

Investments

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

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 ination-protected securities (TIPS): governemt debt obligation
where principal and interest are adjusted for ination (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

The equity market: characteristics

Equities are issued by corporations

They represent ownership in a rm
share the distribution of prots
have voting power at shareholdersmeeting

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%
Dierent equity instruments: common stock vs preferred stock
Traded in a variety of dierent ways: via brokers, dealer market, auction
market,.. (see Trading & Exchanges)

Kristien Smedts (KULeuven)

Investments

2016-2017

11 / 26

The derivatives market: characteristics

Instruments that get value from the value of another asset (can be a nancial
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

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

Roadmap

Capital markets

Capital markets as a part of the nancial system

Mutual funds and other investment companies

Basic concepts in this course

Kristien Smedts (KULeuven)

Investments

2016-2017

14 / 26

Sketch of the nancial system

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 owas 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 rms value.

Kristien Smedts (KULeuven)

Investments

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 owas 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 rms value.

E cient allocation of resources and risk in an economy

Kristien Smedts (KULeuven)

Investments

2016-2017

16 / 26

Sketch of the nancial system: institutional perspective

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

Kristien Smedts (KULeuven)

Investments

2016-2017

17 / 26

Sketch of the nancial system: functional perspective

Take economic agents as given and focus on their needs - by doing so one
can abstract away from the institutional detail

Kristien Smedts (KULeuven)

Investments

2016-2017

18 / 26

Sketch of the nancial system: functional perspective

To understand the nancial system (in casu: capital markets) one needs to
rst understand its functions, only then institutions
Rationale of the nancial system is rather stable of time; institutions vary
considerably - both over time as well as across regions
Long run view: functions determine the nancial system
Short run view: institutions can have major impact

Kristien Smedts (KULeuven)

Investments

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 > 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 > credit crisis in 2008

Kristien Smedts (KULeuven)

Investments

2016-2017

20 / 26

Roadmap

Capital markets

Capital markets as a part of the nancial system

Mutual funds and other investment companies

Basic concepts in this course

Kristien Smedts (KULeuven)

Investments

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 diversied 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
shares outstanding

Kristien Smedts (KULeuven)

Investments

2016-2017

22 / 26

Institutional perspective: dierent investment companies

Unit trusts: xed 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): oshoot of a closed end mutual fund that
allows investors to trade index portfolios as shares
Kristien Smedts (KULeuven)

Investments

2016-2017

23 / 26

Roadmap

Capital markets

Capital markets as a part of the nancial system

Mutual funds and other investment companies

Basic concepts in this course

Kristien Smedts (KULeuven)

Investments

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 specic asset class

Top-down approach: an investment strategy where rst 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

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 > arbitrage
Passive management: belief in e cient markets and thus no active search for
undervalued securities and timing; investor holds a highly diversied 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