Business and Economics

AFF5040 : ADVANCED SECURITY ANALYSIS

COURSE OVERVIEW

Advanced Security Analysis Contacts

John Vaz (Markets, Equity Analysis, Technical and Behavioural finance) Week 1-6 Office: Building H level 3 Telephone 9903 4185 Consultation hours Mon 3-6, Fri 3-6pm
Office: Building H level 4

Fiona McNabb (fixed income, forwards, arbitrage: week 7-9)

Consultation hours Tues 4-6

Nick Stavrou (derivatives and risk pricing: week 10-12)

Tutors
Fiona McNabb Vincent Xiang Albert Hu Amanda Li

Tutors will advise their consult times

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ASSESSMENT TASK
Assessment Task 1: Assignment Assessment Task 2: Class test Assessment Task 3: Options trading Assessment Task 4: Weekly Work and Tutorial participation (Tests Objectives 14) Final Examination (Tests Objectives 1, 36)

VALUE
25% 10% 5% 10%

DUE DATE
Noon Monday Week 10 In tutorial Week 6 Week 11 Noon Monday each week based on lecture program Official Examination Period

50%

To pass AFF5040 you must the exam and total assessments.

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 Submit attempts to problems each week Submissions are not marked for correctness but must be your own reasonable attempt of the majority of problems/cases You must attempt the pre-test as part of your tutorial work. 1 mark per submission in blackboard as well as attendance

No extensions possible Feedback via solutions posted on Tuesday Tutorial Times [See Allocate +] You must attend your registered tute you cannot swap without being registered unless it is changed in allocate+
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 Choose your team, Form groups early of 3-4 people by week two. Appoint a group boss that will be the interface Consider meeting times time commitments Agree on task allocations This assignment is a challenge on your own Complaints of non-participation must be raised early and no later than 2 weeks prior to due date

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LECTURE 1

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 Enable a rapid refresher of markets and investment environment Review financial securities and how securities are transacted Evaluate investment performance and market measures

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 Asset allocation
Choice among broad asset classes

Security analysis Security selection

Choice of which securities to hold within asset class

Monitoring

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Real Assets
Determine the productive capacity and net income of the economy Examples: Land, buildings, machines, knowledge used to produce goods and services

Financial Assets - Claims on real assets

1. Common stock or equity 2. Fixed income or debt 3. Derivative securities
1-10

 Common stock

Residual claim Limited liability

Preferred stock

Fixed dividends Priority over common Tax treatment

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 Payments fixed or determined by a formula Money market debt: short term, highly marketable, usually low credit risk Capital market debt: long term bonds, can be safe or risky

112

 Treasury Notes Certificates of Deposit (CD) Commercial Paper Bank Accepted Bills (BAB) Repos and Reverses BBSR LIBOR

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 US Treasury Bonds Commonwealth Treasury Bonds Semi-Government/Municipal Bonds Corporate Bonds Mortgage-Backed Securities Bond funds

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Options Basic Positions Call (Buy) Put (Sell) Terms Exercise Price Expiration Date Assets
Buy Sell Call Put

Futures Basic Positions Long (Buy) Short (Sell) Terms Delivery Date Assets Standard Contract
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 American Depository Receipts (ADRs) Foreign securities offered in dollars Mutual funds that invest internationally Instruments and vehicles continue to develop (WEBs) Exchange Traded Funds (ETFs)

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 Developed in the 1970s to help liquidity of financial institutions Proportional ownership of a pool or a specified obligation secured by a pool Market has experienced very high rates of growth Mortgage pass-through securities Other pass-through arrangements
Car, student, home equity, credit card loans

Offers opportunities for investors and originators

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Risk-Return Trade-Off Efficient Markets? Active Management Finding mispriced securities Timing the market Passive Management No attempt to find undervalued securities No attempt to time the market Holding a highly diversified portfolio
118

 Types of Markets Direct search Least organized Brokered Trading in a good is active Dealer Trading in a particular type of asset increases Auction Most integrated

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 At least 400 holders of shares Profit test 3 years of Audited financial statements At least 1 million aggregrated profit over last 3 years NYSE listing:

http://www.asx.com.au/ListingRules/chapters/Chapter01.pdf
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 Approximately 9500 professionally managed funds in Australia Collect funds and invest on behalf of others Each investor has a joint claim Benefits of large-scale investing Many are super funds Active vs Index (passive) Hedge Funds

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 ETF allow investors to trade index portfolios like shares of stock Examples - SPDRs and WEBS Potential advantages Lower taxes Trade continuously Lower costs Potential disadvantages Prices can depart by from NAV (market value of shares vs owned assets)

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 Commission: fee paid to broker for making the transaction Spread: cost of trading with dealer Bid: price dealer will buy from you Ask: price dealer will sell to you Spread: ask bid Combination: on some trades both are paid

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Marketexecuted immediately

Bid Price Ask Price

Price-contingent

Investors specify prices Stop orders

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 Using only a portion of the proceeds for an investment Borrow remaining component Margin arrangements differ for stocks and futures Margin is currently 50%; you can borrow up to 50% of the stock value (regulated) Maintenance margin: minimum amount equity in trading can be before additional funds must be put into the account Margin call: notification from broker that you must put up additional funds
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X Corp 60% 40% 100 Initial Position

$100 Initial Margin Maintenance Margin Shares Purchased

Stock $10,000 Borrowed Equity

$4,000 $6,000

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Stock price falls to $70 per share New Position Stock $7,000 Borrowed $4,000 Equity $3,000 Margin% = $3,000/$7,000 = 43%

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How far can the stock price fall before a margin call? (100P - $4,000)* / 100P = 30% P = $57.14 * 100P - Amt Borrowed = Equity

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Purpose: to profit from a decline in the price of a stock or security Mechanics Borrow stock through a dealer Sell it and deposit proceeds and margin in an account Closing out the position: buy the stock and return to the party from which is was borrowed
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Dot Bomb 1,000 Shares 50% Initial Margin 30% Maintenance Margin $100 Initial Price Sale Proceeds Margin & Equity Stock Owed $100,000 $50,000 $100,000

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Stock Price Rises to $110 Sale Proceeds $100,000 Initial Margin 50,000 Stock Owed 110,000 Net Equity 40,000 Margin % (40,000/110,000) 36%
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How much can the stock price rise before a margin call? ($150,000* - 1000P) / (1000P) = 30% P = $115.38 Initial margin plus sale proceeds Potential losses are infinite

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 Dow Jones Industrial Average (Price weighted) Includes 30 large blue-chip corporations Computed since 1896 as Price-weighted average All Ordinaries (value weighted) It measures the performance of 500 companies Market indicator index, 95% of total value S&P/ASX 300 Performance benchmark index Exclusion of smaller companies Ideal for large investors and Large quantity trading
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Nikkei (Japan) FTSE (Financial Times of London) Dax (Germany) MSCI (Morgan Stanley Capital International) Hang Seng (Hong Kong) TSX (Canada)

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Supply Households Demand Businesses Governments Net Supply and/or Demand Reserve Bank Actions

Taxation effects
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Rates of Return: Single Period

P1 P0 + D1 HPR = P0
HPR = Holding Period Return P0 = Beginning price P1 = Ending price D1 = Dividend during period one
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TV

= (1 + r1 )(1 + r2 ) x x = (1 + rn )

TV = Terminal Value (or future value) of Investment

g = TV

1/ n

g= geometric average rate of return

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State 1 2 3 4 5

Prob. of State .1 .2 .4 .2 .1

r in State -.05 .05 .15 .25 .35

E(r) = (.1)(-.05) + (.2)(.05) + (.1)(.35) E(r) = .15

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Variance:
2 s

= p ( s ) [ r ( s ) E (r ) ]
Using Our Example:

Standard deviation = [variance]1/2 Var =[(.1)(-.05-.15)2+(.2)(.05- .15)2+ .1(.35-.15)2] Var= .01199 S.D.= [ .01199] 1/2 = .1095
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 Series Sm Stk Lg Stk LT Gov T-Bills Inflation

Geom. Mean% 11.6 10.0 5.4 3.8 3.1

Arith. Mean% 17.7 12.0 5.7 3.8 3.1

Standard. Dev.% 39.3 20.6 8.2 3.2 4.4

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Sharpe Ratio for Portfolios =

Risk Premium SD of Excess Return

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 Investment management is easier when returns are normal.

Standard deviation is a good measure of risk when returns are symmetric. If security returns are symmetric, portfolio returns will be, too. Future scenarios can be estimated using only the mean and the standard deviation.

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 What if excess returns are not normally distributed?

Standard deviation not a complete measure of risk Sharpe ratio is not a complete measure of portfolio performance Need to consider skew and kurtosis

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 A measure of loss most frequently associated with extreme negative returns VaR is the quantile of a distribution below which lies q % of the possible values of that distribution
The 5% VaR , commonly estimated in practice, is the return at the 5th percentile when returns are sorted from high to low.

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 Also called conditional tail expectation (CTE) More conservative measure of downside risk than VaR
VaR takes the highest return from the worst cases ES takes an average return of the worst cases

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 Issues:
Need to consider negative deviations separately Need to consider deviations of returns from the risk-free rate.

LPSD: similar to usual standard deviation, but uses only negative deviations from rf Sortino Ratio replaces Sharpe Ratio

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