AF5353: Security Analysis &

Portfolio Management
Lecture 3
Instructor: Yong (Jimmy) JIN (jimmy.jin@polyu.edu.hk)
Office: M507D, Li Ka Shing Tower
Office Hour: Tuesday 17:20 to 18:20, 21:30 to 22:30; Friday 13:00 to 15:00
 Agenda
• How firms issue securities (private versus public)
– IPOs and SEOs
• Hedge Fund Examples

• The Leverage
– Why it is important?
– Theoretical Results
– Estimation Loss
– In Practice
 How firms issue securities
• Primary vs. Secondary Market Security Sales
• Primary
• New issue created/sold
• Key factor: Issuer receives proceeds from sale
• Public offerings: Registered with SEC; sale made to investing public
• Private offerings: Not registered; sold only to limited number of
investors with restrictions on resale
• Secondary
• Existing owner sells to another party
• Issuing firm doesn’t receive proceeds, is not directly involved
 How firms issue securities
• Publicly Traded Companies
• Sell securities to the general public; allow investors to
trade shares in securities markets
• Initial public offering: First sale of stock by a formerly
private company
• Underwriters (Investment Banks): Purchase securities
from issuing company and resell them
• Prospectus: Description of firm and security being
issued
 Introduction of IPOs
• What is an IPO?
• First sale of stock by a formerly private company

• Who sells the shares and how do investors know

whether or not they want to invest?
• Investment Banker sells the shares
• The “lead firm” markets the shares along with other firms
which form the underwriting syndicate
 Introduction of IPOs
Relationship among a Firm Issuing Securities, the Underwriters,
and the Public
 Introduction of IPOs
Top Underwriters
 Underwriting stocks and bonds
• Underwriter’s service
• Due Diligent
• Filing documents
• Giving advice
• Bookbuilding
• Underwriting, Best efforts, or private placement
 Underwriting stocks and bonds
• Filing Documents (IBD)
• SEC registration (filing) is required for issues greater than
$1.5 million and with a maturity greater than 270 days
• A portion of the registration statement known as the
prospectus is made available to the public
• Giving advice (ECM, DCM)
• Explaining current market conditions in to help determine
why type of security (equity, debt, etc.) to offer
• Assisting in determining when to issue, how many, at what
price (more important with IPOs than SEOs)
 Underwriting stocks and bonds
• Roadshow (IBD, ECM or DCM, Research Analyst)
• Investment banker travels around country publicizing the IPO
• Purposes:
– Generates interest among potential investors and provides
information about the offering
– Provides information to the issuing firm and underwriters about
price at which they will be able to sell

• Bookbuilding (ECM or DCM)

• Large investors communicate their interest in purchasing shares
• underwriters attempt to determine at what price to offer an IPO
based on demand from institutional investors
• A price range will be determined
 Costs of IPOs
Direct costs
• Underwriter usually charges a 7% of proceeds to
issuer
• Direct costs to lawyers, printers, accountants, etc.
can be over $400,000 USD

Indirect costs
• Money left on the table = (End of price on first day -
Offer price) x Number of shares
• Or called “IPO Underpricing”
• Why?
Average first-day return for IPOs
IPO
 Seasonal Equity Offerings
• When companies that have already raised a round
of equity capital choose the last option, it is called
a “Seasoned equity offering (SEO)," or "secondary
offering.“
• Accelerated bookbuilding
• “Dilutive effect“ for existing shareholders
• SEO Underpricing
 An Example of IPO Fund
• Name: ABC Asset Management
• AUM: XYZ millions
• Portfolio Manager: former Investment Bankers
• Strategy
• 1. Get IPO shares (…)
• 2. Short all after first 3-4 days

• Challenge
• 1. Why assign the IPO shares to you?
• 2. Capital restriction (extremely high over-
subscription rate)
 An Example of SEO Fund
• Name: DEF Asset Management
• AUM: K Billions
• Portfolio Manager: former ECM bankers
• Strategy
• 1. Get SEO shares (…)
• 2. Short all after the restriction period

• Challenge
• 1. Why assign the SEO shares to you?
• 2. How to stabilize the stock price?
• 3. Optimal leverage level?
 The Leverage
• Why the leverage matters?
• Help the total wealth grows faster

• An example
• Warren Buffet’s Berkshire Hathaway
• Historical Performance: average excess return
19%, volatility 24.9%
• Historical Leverage: 1.6

• The history
• Kelly’s formula: by John Kelly, Jr.
 The Leverage
• The history

• Kelly’s formula: by John Kelly, Jr.

• Also called Fortune’s Formula

• However, he was a scientist in Bell Labs and

never worked in financial industry
 The Leverage
• The history

• Kelly’s formula: by John Kelly, Jr.

• Also called Fortune’s Formula

• Promoter: Edward Thorp

• First quantitative hedge fund founder
• The author of “Beat the dealer…”

• Followers
• Warren Buffet, James Simons…
 Kelly’s formula
• A simple example:
• Initial Wealth: 𝑉0
• One period project, time 0 and time 1
• Can choose to invest 𝐾 dollars in the project at
time 0
• With 0.5 probability, the investor will obtain 3K at time 1
• With 0.5 probability, the investor will obtain 0K at time 1

• If you have many opportunities to invest in

similar projects, how much should you invest?
 Kelly’s formula
• In mathematics, we define 𝑅𝑖 as the one period
return which follows some distribution

• Fractional Investment (the leverage): at time t,

invest 𝑘 percentage of the initial wealth 𝑉𝑡 .

• Assume that 𝑅𝑓 = 0

• At time 𝑛, the total wealth 𝑉𝑛 is

𝑉𝑛 = 𝑉0 1 + 𝑘𝑅1 1 + 𝑘𝑅2 … (1 + 𝑘𝑅𝑛 )

Kelly’s formula
Kelly’s formula
Black Line: 𝑘 ∗ = 0.25
Red Line: 𝑘 ∗ = 0.01
Green Line: 𝑘 ∗ = 0.1
Brown Line: 𝑘 ∗ = 0.5
Grey Line: 𝑘 ∗ = 1
Kelly’s formula
Kelly’s formula
 Estimation Risk
• However, in real practice the investors cannot
implement the idea directly
• Why?

• In practice, the winning probability 𝑝, the odds, or

the true strategy distribution parameters 𝜇, 𝜎 2 are
unknown!

• How to obtain the parameters?

• We can estimate the parameters using the
historical data
 Estimation Risk
• However, using historical data has several
limitations:
• 1. the historical data is short
• 2. even the historical data is long enough, the
financial market is usually only local stationary
• 3. the parameters estimated are not accurate

• Estimation Risk
• The inaccurate estimated parameters result in
inaccurate estimation of the leverage 𝑘 ∗
 Some Analysis
• Since the estimation risk cannot be omitted, some
analysis should be done:
• The distribution of 𝑘෢∗ can be derived
ෝ −𝑟𝑓
𝜇
෠
• Given 𝑘 = ෢2 ො 𝜎෢2 are the estimated
, and 𝜇,
𝜎
parameters from historical data

1
𝑇 𝑘෠ − 𝑘 →𝑑𝑖𝑠𝑡 𝑁(0, 2 + 2𝑘 2 )
𝜎

• Shrinkage Estimation
• Be conservative