FIN 485 Notes Module One These are short notes for the eighth edition Essentials of Investments.

Chapter 1 Investments: Background and Issues

Taxonomy of Financial Assets: 1. Fixed-Income Securities 2. Equity 3. Derivative Securities Important Margin Notes: 1. 2. 3. 4. 5. 6. 7. Page Page Page Page Page Page Page 2 3 5 10 11 13 14 Key Page: 1. Page 2, though the definition used in exams and class is slightly different (see Definitions on BB). 2. Page 5, is basis of the text-type questions and relation to lectures and supplementary notes (again, Margin notes). 3. Page 9, becomes primary in decision for investment. 4. Page 10-11, past studies, lecture notes and the risk-return relationship to price, in an efficient marketplace. 5. Page 11-14, for future study of investment companies (Chapter 4) and investment banker (Chapter 3) and their role in the investment field.

Problems for study: consider 9, 10, 20, 21, and 22.

Chapter 2 Asset Classes and Financial Instruments

Markets: 1. 2. 3. 4. 5. 6. 7. Money Market vs. Capital Market Treasuries Bond Market Municipal Bonds Equity Markets Average vs. Index Derivative Markets Important Margin Notes: 1. 2. 3. 4. 5. 6. Page Page Page Page Page Page 24 (note change and distinction) 26-28 (note exceptions) 32 39 42-43 (note distinction) 45-46 (More important in Module 3) Key Page: 1. Page 26, though the example is better shown in the Blackboard example. 2. Page 32-33, is basis of the problems related to tax effect problems. Problems for study: consider 3, 6, 7, 9, 12-19, 21-23.

Chapter 3 Securities Markets

Trading Fundamentals and Financial Leverage 1. 2. 3. 4. 5. 6. 7. 8. 9. Investment Banking Markets: Primary vs. Secondary IPO Methods Orders: Market, Limit, Stop Markets: Dealer vs. Auction Specialist OTC (NASDAQ) vs. Exchanges Margin and Shorts (Leverage Effects) Regulation (three primary laws) Important Margin Notes: 1. 2. 3. 4. 5. 1. 2. 3. 4. Page Page Page Page Page 53 57-60 61 68 70 Key Page: Page 53, Figure 3.1 about structure of Investment Banking Operations. Page 57, types of orders. Page 59-60, distinction of Dealer vs. Specialist operations. Page 68-71, Margin buying and Short sale mechanics (check Blackboard example of Margin Buying).

Problems for study: consider 1-22 tend to all have merit. Additional are recommended.

Chapter 4 Mutual Funds and Other Investment Companies

Mutual Funds: 1. 2. 3. 4. 5. 6. 7. 1. 2. 3. 4. 5. 1. 2. 3. 4. 5. NAV Open-End vs. Closed-End Load Fund Types 12b-1 fees Morningstar ETF Important Margin Notes: Page Page Page Page Page 84 85 86 91 95 Key Page: Page Page Page Page Page 84, calculations simple. 85-86, description of open vs. closed-end funds and NAV. 90-91, regarding fees and special treatment of 12b-1 fees. 95, ETF and relation to current trading tendencies. 100, importance of Morningstar.

Problems for study: consider 1-10 (questions more than problems)11-28 (to combine previous methods including tax effects), be selective as many are redundant.

Chapter 10 Bond Prices and Yields

Bond Characteristics: 1. Par, Face, or Maturity Value (assumed in class to be $1000) 2. Coupon Rate 3. Maturity Date (class assumption is that all bonds are annual bonds, unless told differently) Important Margin Notes: 1. 2. 3. 4. 5. 6. 7. 8. Page 288 Page 290 Page 298 Page 300 Page 301 Page 308 Page 315 Page 316 (which made the class consider EMH, on page 229 and its forms page 231-32) Key Page: 1. Page 294-295, study the example of calculating the price of a bond, especially using the third row that is in the footnote, rather than the formula. 2. Page 298-300, that shows an example of the YTM calculation and an example using the calculator. 3. Note that the preferred stock is mentioned in this chapter, page 291. The text is descriptive, and does not offer a quantitative example, which you will be required to work. See the notes for Chapter 13 for a statement of help. Problems to work for study: 5, 6, 8, 9, 10 (note we are not considering effective rates early in the semester), 13, 14, and 26.

Chapter 13 Equity Valuation

Major Forms of Equity: 1. Preferred Stock 2. Common Stock Important Margin Notes: 1. 2. 3. 4. 5. Page Page Page Page Page 399 400 402 403 410 Key Page: 1. Page 399-402, study the example of calculating the price of a stock from the formula on page 399. 2. Note that the preferred stock is not mentioned here, but is the same basic formula where g=0 because preferred stock have a fixed (though not guaranteed) dividend. Remember the similarity of a preferred stock to a bond (the characteristics) Important Formulas: 1. DDM, page 400, 13-4 2. P/E, page 411, 13-8. Problems to work for study: 10, 11, 13, 16 (note this is the CAPM model using beta, you should remember it from FGB 380), 11, and others that repeat the basic model. Note that there are none in this chapter for preferred stock, but be prepared.

Chapter 14 Financial Statement Analysis

Major Financial Statements: 1. 2. 3. 4. Balance Sheet Income Statement Statement of Cash Flows (or Cash Flow Statement) Statement of Retained Earnings (not mentioned in the text) Important Margin Notes: 1. 2. 3. 4. 5. 6. 7. Page Page Page Page Page Page Page 436 437 441 443 447 448 449 Key Page: 1. Page 450, study the ratios, note many may be called by other names (i.e. P/E ratio) Important Ratio: 1. DuPont, page 443. Problems to work for study: 8, 9, 10, and 11.

Notes Module Two Chapter 5 Risk and Return: past and Prologue
Return Models: 1. 2. 3. 4. 5. 1. 2. 3. 4. 5. HPR Arithmetic Average Geometric Average Dollar-Weighted Average Annual Percentage Rate (APR) vs. Effective Annual Rate (EAR)

Risk Considerations: Scenario (establish probabilities) Expected Return (Mean, Average), E[r] Variance (Average of the squared deviates) , 2 Standard Deviation (Square Root of the Variance), Coefficient of Variation (C.V. equation in the formulas on Blackboard), Risk relative to Return 6. Sharpe Model (page 121, equation 5.15), Risk Premium Return relative to Risk (P) Important Margin Notes: 1. 2. 3. 4. 5. 6. Page 111-112 Page 114-115 Page 119-121 Page 128 Page 135 Page 136 (Note distinction from class notes, and Class Lecture on CAPM development) Key Page: 1. Page 130-132, though this is more appropriate to the next chapter and class lecture regarding portfolio composition, it develops the basics for weighting the assets (asset allocation) to achieve required (or expected goal) returns. 2. Page 134-135, The Capital Allocation Line is somewhat confusing (I sometimes strongly suggest that the student NOT read the section), as the Class Lecture and notes refer to the three lines of Finance used to develop the CAPM. The CAL (in the text) is a special case, not included in the general theory. Note that the text refers to future chapters and the development of the Capital Market Line, which is the basis for the CAPM. (There are several warnings in Chapter 5 about the use of the text explanations, as they are somewhat specific and not to be used in general cases. See the last part of the Sharpe Model text explanation referring to portfolio and NOT individual analysis. Remember the lecture warning as well) Problems to work for study: 2, 5-7, 11-14 (ignore part d of #12).

Chapter 6 Efficient Diversification

Diversification and Portfolio Risk: 1. Market (Systematic, Non-Diversifiable) vs. Diversifiable (Non-Systematic, Firm-Specific) Risk 2. Covariance and Correlation Coefficient 3. Rules of Portfolios (Averages and Correlation Coefficient, pg 153) 4. Mean Variance Criterion (lecture about Theory of Dominance) 5. Add Risk-Free Asset (CAL in Text) 1st Line of Finance in CAPM lecture 6. Separation Property 7. Alpha (extra return, not Market related) 8. Beta: Measure of RELATIVE Market Risk 9. Security Characteristic Line (2nd Line of Finance) Risk Formula Considerations: Covariance (page 151) Expected Portfolio return and Variance (page 153, see BB formulas) Variance (then resultant Standard Deviation, page 154, see BB long formula and Dr. Scotts Notebook for example with solution, remember the twos) Sharpe ratio relationship (back to Chapter 5) with the portfolio Important Margin Notes: 7. Page 146 8. Page 163 9. Page 167 Key Page: 5. Page 148-151. 6. Page 153-156, in conjunction with Dr. Scotts Notebook. Problems to work for study: 1-4, for thought-type, and just about al the others that do not require graphing (or reference to on-line material).

1. 2. 3. 4.

Chapter 7 Capital Asset Pricing and Arbitrage Pricing Theory

CAPM: 1. Three Lines of Finance from notes 2. The Theory of Dominance from lecture Multifactor Models: 1. Merton two-factor (added T-bill effect) 2. Fama-French three-factor model (added firm size and book to market ratio) 3. Arbitrage 4. Ross APT (Multi-Beta model) Important Margin Notes: 1. 2. 3. 4. 5. Page Page Page Page Page 190-191 195-196 201 207 213 Key Page: 1. Page 190-192, in conjunction with the lecture (with graphs, from the theory of Dominance). 2. Page 195-196, regarding the implication of the SML (remember if the security plots above or below the SML, what would a rational investor do?) 3. Page 208, about Merton. Problems to work for study: 4-15 (no graphing or external references).

Chapter 8 The Efficient Market Hypothesis

EMH: 1. 2. 3. 4. 5. Random Walk (Price CHANGES) Cant CONSISTENTLY beat the market Weak Form Semi-Strong Form Strong Form

Technical vs. Fundamental Analysis: 1. History Repeats 2. Determinants of value 3. Chartists a. Support Line b. Resistance Line c. Channel Trends Important Margin Notes: 1. 2. 3. 4. Page Page Page Page 229 231-234 239 242 Key Page: 1. Page 233-234, in conjunction with the lecture regarding Technical vs. Fundamental Analysis. 2. Page 238-239, regarding the trend tendencies (remember the lecture about Sir Isaac Newton) 3. Page 252, author conclusion. Problems to work for study: no preference, most are just thought questions, not problems.

Chapter 9 Behavioral Finance and Technical Analysis

Trends: 1. Dow Theory a. Tertiary or Minor b. Secondary or intermediate c. Primary 2. Trin Statistic a. Bull b. Bear Models or Methods: 1. Dollar-Cost-Averaging 2. Point and Figure Charts Important Margin Notes: 1. 2. 3. 4. Page Page Page Page 261 264 271 277 Key Page: 1. Page 271, considering the Grandfather of technical analysis. 2. Page 272-273, practice the point and figure method (remember the examples in Dr. Scotts Notebook) Problems to work for study: again not many, except the Point and Figure practice, and some conceptual-type questions.

Notes Module Three Chapter 15 Options Markets

Contracts: 1. Rights: a. Pre-Emptive Right b. Conversion Right c. Warrant d. Forward vs. Futures Contracts e. Options 2. Call 3. Put 4. American vs. European Options 5. Valuation Intrinsic vs. Theoretical a. In the Money b. Out of the Money c. At the money 6. Strategies a. Straddle b. Strip c. Strap d. Strangle e. Spread Important Margin Notes: 1. 2. 3. 4. 5. 6. Page Page Page Page Page Page 475 476 478 486 489-491 496 Key Page: 1. Page 475, basic terms for options. 2. Page 480-482, examples of straight valuation and returns of calls and puts. Combine with lecture and terms to prepare. 3. Page 486-492, note term covered and writing as well as strategy outcomes. Problems to work for study: 1-8 have thought-type questions and basic problem sets that repeat calculation and help with practice. Try others as complete problems that include options to hedge other assets in a portfolio. 14 and 15 are interesting as advanced problems.

Chapter 16 Option Valuation

Concepts: 1. Intrinsic vs. Time vs. Theoretical vs. Speculative Values: 2. Determinants of Value a. Underlying Asset Price b. Exercise Price of the Option c. Volatility of the Underlying Asset Price d. Time to Expiration e. Interest Rate f. Dividend Rate on the Underlying Asset 3. Binomial Option Pricing Model a. Hedge ratio b. Call Written? 4. Black-Scholes Option Pricing Model a. Hedge Ratio or Delta? b. Option Elasticity? Important Margin Notes: 1. 2. 3. 4. 5. 6. Page Page Page Page Page Page 510 517 518 525 528 529 Key Page: 1. Page 512-515, Binomial Option Pricing example. 2. Page 518-523, Black-Scholes Pricing example. 3. Page 527, Put valuation example. Problems to work for study: 1-4 have thought-type questions that require basic calculations and definitions. 5 is a similar repeating problem for concepts. 7-12, good practice, and, consider 28-31.

Chapter 17 Futures Markets and Risk Management

Terms: 1. Forward vs. Futures Contracts. 2. Long vs. Short Position (for Futures Contracts, there is a difference) 3. Clearinghouse 4. Mark to Market 5. Convergence 6. Cash Settlement 7. Hedge vs. Arbitrage 8. Basis and Basis Risk 9. Spot-Futures Parity Theorem or Cost-of-Carry Relationship 10.Cross-Hedging Important Margin Notes: 1. 2. 3. 4. 5. 6. 7. Page Page Page Page Page Page Page 544 545 550-553 556 559 566 567 Key Page: 1. 2. 3. 4. 5. Page 544-547, Futures terms and basic example. Page 549-553, Basic Mechanics of Futures trading. Page 554-556,Risk and Hedging. Page 557, Spot-Futures Parity (may not cover in depth). Page 567-569, Swaps (probably wont cover, good example for institutions class)

Problems to work for study: 1-7 have thought-type questions that require basic calculations and definitions (check term contract multiplier). Most of the rest are confusing, but terms are more likely street-type, not directly related to the general problems.