15.

433 INVESTMENTS Class 1: Introduction

Spring 2003

Outline

Course Overview Market Overview Introduction to the Financial System Overviews of Equity, Fixed Income, Currencies and Derivatives Financial Innovations Summary Questions for Next Class

Course Mechanics

Course Grade:

Class participation

10%

5 group assignments 20% Mid-tern exam Final exam 30% 40%

Course Materials: Lecture Notes Textbook: Bodie, Kane and Marcus Articles in course reading packet Additional reading materials and handouts

Course Overview

Broadly speaking, this course will cover the following give themes: Financial theories: Portfolio theory, the CAPM and the APT

Equity and equity options, and empirical evidence

Fixed income instruments and xed income derivatives, credit market and credit derivatives

Market eciency and active investments

A brief introduction to behavioral nance

Course Objectives

Through this class I want to help you build the following skills: Analytical ability: modeling skills that are important in making investment decisions, Quantitative skills: developing problem solving skills, data analysis, probability evaluation of uncertain events. Empirical knowledge of the nancial markets: equity, xed income (default-free and defaultable) and their respective derivatives.

The Financial System

The nancial system can be viewed from two dierent angles: Institutional perspective: the nancial system encompasses the markets, intermediaries, instruments, clients etc.; and Functional perspective: the nancial system facilitates the allocation and deployment of economic resources, across time and space and in uncertain environment.

While its institutional composition changes over time and space (different places on the globe), the basic functions of a nancial system are essentially the same in all economies. The institutional dimension results from the functional needs.

Functional Perspective

The nancial system provides six functions: Transferring economic resources across time (e.g. student loans, retirement funds) and space (global nancial market, e.g. institutional investments) Clearing and settling payments to facilitate trades: money, check, ATM cards, mortgages and mortgage interest payments, etc. Pooling of resources to undertake large-scale indivisible enterprise (equities, money market funds, mutual funds etc.) Information to coordinate decision-making, facilitating information ow, price discovery, the normal indices for equities, xed income rates, volatilities etc. Dealing with agency problems, mitigate moral hazard, adverse selection and principal-agent based problems that are caused by asymmetry information or incentive mis-matches (collateralization, CEO incentive for company performance etc.). Managing risks, bundling, packaging, pooling and tranching of risk (insurance companies, CMO, CDO, exotic derivatives etc.)

Institutional Perspective

The institutional compositions of the nancial system includes: Financial markets: equity, xed income (debt), credits and derivatives Financial intermediaries: banks, insurance companies, pension funds, mutual funds, investment banks, venture capital rms, asset management rms and information providers etc. Financial infrastructure and regulation: trading rules, contract enforcement, account system, capital requirements etc. Governmental and quasi-governmental organizations: SEC, central banks (Federal Reserve System), the Bank for International Settlement (BIS), the International Monetary Fund (IMF), the World Bank, etc. International markets dier in many ways: The US market is currently the only market oering Financial Futures on individual stocks; Germany closed the Neue Markt, eliminating a platform for not very liquid stocks, regarding stock exchanges inexperienced companies, thus rising capital is getting more dicult for young companies;

 Investment attitudes and awareness are subject to national regulations, e.g. pension fund regulation - dened benet vs. dened contribution plans.

Stocks

Common stocks, also known as Equities, represent ownership shares of a corporation. Two important characteristics: residual claim and limited liability; Sources of returns: dividends and capital gains; Calculating returns: buy at time 0 and pay P0 , sell at time T and
receive PT and dividend DT :
The percentage return is calculated as: rT = PT + D T P 0 PO (1)

The log-return is calculated as: PT + D T rT = ln PO

(2)

For small rT , the log-return and percentage return are close. Question: Why in some situations should we prefer to use logreturns?

Some determinants of stock returns: Firm-specic condition: management, productivity, earnings, growthpotential, market-liquidity,

 Market condition: market indices (volatility, volume etc.), e.g. Nasdaq, SP500, DAX, FTSE etc. Economic condition: macro-economic variables, e.g. GDP-growth, ination, employment rate, business cycles, liquidity, interest rates etc.

Some important empirical evidence: Patterns in the cross-section of stock return: value (value vs. growth), size (small vs. large), momentum (low vs. high); Time-series behavior of stock returns: time-varying expected returns, predictability, stochastic volatility etc.

-2%

-7%
3% 8%

-12%

-7% 3% 8%

-2%

-12%

-12% 3%
9/6/1993 11/6/1993 1/6/1994 3/6/1994 5/6/1994 7/6/1994 9/6/1994 11/6/1994 1/6/1995 3/6/1995 5/6/1995 7/6/1995 9/6/1995 11/6/1995 1/6/1996 3/6/1996 5/6/1996 7/6/1996 9/6/1996 11/6/1996 1/6/1997 3/6/1997 5/6/1997 7/6/1997 9/6/1997
SPX

8%

-7%
9/6/1993 11/6/1993 1/6/1994 3/6/1994 5/6/1994 7/6/1994 9/6/1994

-2%

1/12/1995 3/12/1995 5/12/1995 7/12/1995 9/12/1995 11/12/1995

11/6/1994 1/6/1995 3/6/1995 5/6/1995 7/6/1995 9/6/1995 11/6/1995 1/6/1996 3/6/1996 5/6/1996 7/6/1996 9/6/1996 11/6/1996 1/6/1997 3/6/1997 5/6/1997 7/6/1997 9/6/1997 11/6/1997 1/6/1998 3/6/1998 5/6/1998 7/6/1998 9/6/1998 11/6/1998 1/6/1999 3/6/1999 5/6/1999 7/6/1999 9/6/1999 11/6/1999 1/6/2000 3/6/2000 5/6/2000 7/6/2000 9/6/2000 11/6/2000 1/6/2001 3/6/2001 5/6/2001 7/6/2001 9/6/2001
CCMP

1/12/1996 3/12/1996 5/12/1996 7/12/1996 9/12/1996 11/12/1996 1/12/1997 3/12/1997 5/12/1997 7/12/1997 9/12/1997 11/12/1997 1/12/1998

CCMP

3/12/1998 5/12/1998 7/12/1998 9/12/1998 11/12/1998 1/12/1999 3/12/1999 5/12/1999 7/12/1999 9/12/1999 11/12/1999 1/12/2000 3/12/2000 5/12/2000 7/12/2000 9/12/2000 11/12/2000 1/12/2001 3/12/2001 5/12/2001 7/12/2001 9/12/2001

SPX

SBTSY10

11/6/1997 1/6/1998 3/6/1998 5/6/1998 7/6/1998 9/6/1998 11/6/1998 1/6/1999 3/6/1999 5/6/1999 7/6/1999 9/6/1999 11/6/1999 1/6/2000 3/6/2000 5/6/2000 7/6/2000 9/6/2000 11/6/2000 1/6/2001 3/6/2001 5/6/2001 7/6/2001 9/6/2001

Stocks and Bonds

SBTSY10

Figure 1: Daily returns of SP 500-index, Nasdaq-index and T-Bonds 10 years

30% 25% 20%

Probability

30% 25% 20% 15% 10% 5% 0%

Probability

15% 10% 5% 0% -5% -0.080

-5% -0.080

-0.060

-0.040

-0.020

Daily Returns

0.020

0.040

0.060

0.080

-0.060

-0.040

-0.020

Daily Returns

0.020

0.040

0.060

0.080

Current Distribution

Normal-Distribution

Current Distribution

Normal-Distribution

Figure 2: Return distribution of US 10 Year Bond

Figure 3: Return distribution of S&P 500 Index

Data source for Figures 1, 2, and 3: Bloomberg Professional.

Fixed Income

Fixed income, also known as debt-instruments, promise to pay xed, pre-determined stream of cash ows in the future: Coupon payments, Principal amount (denominations), Time to maturity, Sinking fund obligations, etc.

Figure 4: Cash Flows, Source: RiskM etricsT M , Technical Document, p. 109 Figure 5: Discounted Cash Flows, Source: RiskM etricsT M , Technical Document, p. 109

Treasury bills, notes and bonds vary in maturity. T-bonds may also be callable during a given period.

The value of a bond can be reported in terms of price or yield to maturity. Yield go and price go.

Market Performance

Monthly returns 1926/7 to 2000/12

Equity Portfolio Treasury Bills Mean Standard Deviation Total Return 0.99% 5.50% $1828 0.31% 0.26% $16.27

* Value-Weighted

The Term-Structure of Interest Rates

(Yield-Curve)

9
8
7

Yield Curves for US Treasury

6
5
4
3
2
1
0

3 Mo 6 Mo 1 Yr 2 Yr 3 Yr 4 Yr 5 Yr 6 Yr 7 Yr 8 Yr 9 Yr 10 Yr 15 Yr 20 Yr 30 Yr

1.1.1995 1.1.2001

1.1.1996 1.1.2002

1.1.1997 1.1.2003

1.1.1998

1.1.1999

1.1.2000

Figure 6: Treasury Yield Curve, Source: Bloomberg Professional.

How do we describe the term-structure: Shift Twist Buttery

The Federal Funds Target Rates (set by FOMC) and the Discount Rates:

8.00 7.00 6.00 5.00 4.00 3.00 2.00 1.00 0.00

1/1/1991 7/1/1991 1/1/1992 7/1/1992 1/1/1993 7/1/1993 1/1/1994 7/1/1994 1/1/1995 7/1/1995 1/1/1996 7/1/1996 1/1/1997 7/1/1997 1/1/1998 7/1/1998 1/1/1999 7/1/1999 1/1/2000 7/1/2000 1/1/2001 7/1/2001 1/1/2002 7/1/2002 1/1/2003

FOMC

3 Month LIBOR

Figure 7: Short Term Interest Rates FED, Discount rates over the last 4 years, Source Bloomberg Professional.

Corporate Bonds

Corporate bonds are similar in structure to Treasury issues, with one important dierence: default risk. Because of the default risk, corporate bonds are cheaper (than their respective Treasury counterparts), paying higher yields. The dierence in yields is referred to as credit spread. The probability of default varies across rms of dierent credit qualities (e.g. countries, industries, guarantees etc.) The probability of default varies over time!

Figure 8: Standard & Poors one year transition matrix, Source: RiskM etrics T M T echnical Document, p. 69.

Derivatives

Overview of Derivatives by Structure: Forward and Futures; Options; Futures; Path dependent (e.g. look-back), etc.

Overview of Derivatives by Underlying: Equity Derivatives: stock options, index futures, futures options etc.; Fixed-Income Derivatives: caps/oors, swaps, swaptions, etc.; Credit Derivatives: credit swap, collateralized loan obligations, etc.; Other derivatives: FX, weather, exotics, etc.

Currencies

Currencies are the most liquid nancial instrument. Currency instruments have generally spoken the same type of parameters, however with dierent characteristics, e.g. currency return volatility, which is not shaped in the same form as the equity return volatility. Currency positions usually have a much shorter maturity proprietary traders on Wall Street take positions up to half an hour!

Financial Innovation

Does nancial innovation add value? If taken to excess, any virtue can readily become a vice: The market has seen examples of failed nancial products, erroneous assumption and strategies, abusive usage of derivatives, distressed hedge funds etc. Empirical evidence supports the statement, that nancial innovation does provide social wealth: It caters to the investment diversity desired by the investors; It improves the opportunities for investors to receive ecient riskreturn trade-os; It provides risk management tools for all market participants; and It promotes broad distribution and liquidity to economic resources.

Securitization

Figure 9: Securitization of stand-alone mortgages in liquid standardized mortgage-backed securities.

Securitization of the mortgage market: The national mortgage market and mortgage-backed securities transform the residential house nance from fragmented, local-based sources to a free-owing, international base of capital with depth and usually a higher credit rating.

Other examples: collateralized debt (loan or bond) obligations, asset backed debt, etc.

Credit Enhancement

FleetBoston plays Good Bank/Bad Bank, unloading $1.35 Billion in troubled Loans Patriarch Partners LLC, a NY fund management boutique, created a CLO to raise about $1 billion to acquire the loans.

See the following gure how FleetBostons problem loans made their way from Fleets books to a special collateralized-loan obligation, funded by investors.

$ 275 million (face value) in Ark subordinated securities

$ 925 million in triple-A rated bonds $ 75.75 million in single-A rated bonds $ 35.5 million of equity

$ 725 million cash FleetBoston

Patriarch Partner's Ark CLO

Patriarch Partner's Ark CLO

$ 1.35 billion in funded loans plus $ 150 million in unfunded loans

$ 1.036 billion cash

Figure 10: Setting-up a special purpose vehicle.

Summary

What to learn in this course? Analytical modeling skills, quantitative tools, and empirical knowledge about the nancial market and the nancial instruments. How to think about the nancial system? Functional perspectives: across time and space; Institutional compositions: results from the functional needs. Does nancial innovation add value? Sometimes abusive usage of nancial innovation causes disruptions.

Overall, however, nancial innovation provides diversied in-vestment opportunities for investors, risk management tools and techniques for market participants and liquidity to the overall market.

Focus: BKM Chapters 1 & 2; p.16/17 (market structure); p.19 (securitization); p.28-46 (know the dierent instruments, e.g. CD, CP, Bankers Acceptances etc.);

 p.48-54 (know the most important market indexes, what kind of dierent weighting-schema exist etc.); Reader: Sharpe (1995);
Type of potential questions: p. 60. questions 1, 5, 11, 17, 23

Preparation for Next Class

Please read: BKM Chapters 3 & 5, Fama (1995), and Kritzman (1993). Questions: What is a normal distribution? How do we model uncertainty? Is variance the only measure of uncertainty? What is the average daily return? What about the average variability? What assumptions did you have to make in order to obtain the estimates? How accurate are your estimates? If given more observations (a large N), can you improve the precision of your estimates?