Investments

Week 1: Introduction and

Review

Fall 2015
Professor Albert Wang

Week 1 Agenda
Administrative

Personal / Syllabus
Class List: Student ID, Email
HW1 to-be-emailed this week, due Week 3 (1 Oct 2015)

Introduction

Jobs
What are investments?
Financial securities
How are securities traded?

Finance 101 Review

Time value
Compounding
Equity Valuation and P/E ratios
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Personal Introduction
Education: Upenn Wharton, MIT Sloan
Work: Cornell Dyson, Industry Sellside and
Buyside
Now: Teaching in Taiwan to expose you to the
same course material as the top business
schools in the world
Primarily for those pursuing careers in finance
Also useful for anyone who has or wants money!
Learning standards and expectations will be the
same as any of the top Business Schools in the world

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Syllabus
In-class overview
Will be revised as needed

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Other Information
Prerequisites
College-level math, statistics, and intro
finance*
Junior/Senior Course

Classroom Etiquette:
Do not disturb your classmates
Silent typing if you bring a laptop
Turn off keystroke sounds and volume on any
electronic devices
Set cellphones to vibrate, answer for
emergencies only
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Other Information
Reading Guidelines
Read the main text first
Examples, cases, and appendices are optional

Learn the analytical tools presented in the

text
Ask questions in class

Attendance and Participation

Active participation can increase your
grade
Come prepared with questions and
comments

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Course Overview
This course is NOT

Intro Finance
A survey of all investment types
A specialized course on pricing
A memorization exercise

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Course Overview
This course IS
Investment Analysis
3 main tools of financial management
Increasing/reducing financial exposure
Diversifying financial exposure
Insuring financial exposure

These are tools with which you can

analyze any financial scenario
Each situation calls for different applications
and combinations of tools
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What Job Do You Want?

I-Banking (IBD)
Issue securities (primary market)
Execute and advise on corporate finance transactions
BULGE BRACKET vs. boutique

Sales & Trading (S&T)

Trade securities (secondary market)
Typically part of an investment bank
Broker for institutions and large clients

Investment Management (IM)

Manage investments for others
Hedge funds, Mutual funds, P.E. funds, private wealth
management

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Current Events (14 Sep 2015)

TAIEX Index: 8307.29
S&P500 Index: 1,961.05 (11 Sep)
Recent financial news
August Market Turmoil
Fear of China slowdown/recession
RMB mini-devaluation

US Federal Reserve

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Current Events (Google)

Page 11

What are Investments?

Financial Assets
Wealth storage through time with risk in
transaction price (an alternative to cash)
Consumption transfer from present to future

Wealth creation?
At least welfare improvement no need to
gorge

Ownership claims on assets

Risk allocation and management tools
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Types of Investments
(selected)
Money Market (cash):

T-bills, CDs, commercial paper, bankers acceptances, Eurodollars,

repos, fed funds, brokers calls, LIBOR

Fixed Income

T-notes/bonds, agencies, international, municipals (munis),

corporates, mortgage-backed securities, collateralized

Equities

Common and preferred shares

Currencies
Commodities

Precious metals, agricultural, energy

Real Estate
Derivatives

Options, futures, hybrids, exotics

Others baseball cards, cars, wine, stamps, anything of

value!
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Financial Jargon
Financial Instruments include financial
assets, derivatives, and other contracts
Financial Assets represent ownership of
assets
Stocks, bonds

Derivatives derive value from underlying

instruments and are in Zero Net Supply
Futures, options

Real Assets are valuable non-financial assets

(i.e. those with a real use)
Commodities, real estate, machines, patents,
pollution credits, intellectual property

Page 14

Who Needs Financial

Markets?
Households (individuals)
Primary Role: Invest/lend funds

Businesses (corporates)
Primary Role: Raise Funds for Real
Investments

Governments (sovereigns)
Primary Role: Redistribute Wealth

ALL
Manage Risks
Page 15

Financial Innovations
Globalization
Domestic firms compete in global markets.
Continuous trading in many markets
Performance in regions depends on other regions.

Financial Engineering and Technology

New bundles of existing financial instruments
Computer advancements (algorithmic trading, HFTs)
On-line trading (no longer innovative)
More complete and timely information, and the
ability to act instantly on that information
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Implications of Globalization
Allows international diversification of
investments and business lines
Aligns financial (and therefore political)
incentives of different countries
Imagine if each country has a SWF holding
an identical diversified portfolio
everyone would have identical financial
objectives

Introduces FX risks to both sides of the

balance sheet
Often only risk in Assets is explicitly
considered, but dont forget Liabilities!
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Financial Engineering
Bundling and unbundling of cash
flows
Slicing, allocation, and distribution
of cash flows
Examples: mortgage-backed security
tranches, principal/interest splits,
exotic options, etc.

Done right, allows those with

capacity to hold risk to hold it.
Done wrong

Page 18

Financial Markets and

Trading

Auction a (TWD 30) New Pen

Take out your wallets, examine your cash
Put away all phones, pens, papers, cameras ALL
materials into bags and under tables

START AUCTION, Accept Bids

Minimum price tick = TWD100

Update 1 Market Structure Change

Minimum price tick = TWD1

Update 2 New Information

A 20 digit alphanumeric code to be written on the board for
10 seconds, will be on midterm exam. Only pens for sale
may be used in class for these 10 seconds.

Update 3 New Material Information

The 20 digit code will be worth 0 points on the exam
Page 20

Financial Markets
Forums to transfer risks and
ownership between investors/traders
Example: Pen For Sale!

Primary Market
Public Offerings (IPO, SEO)
IBD

Secondary Market
Exchanges, OTC markets, etc.
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Financial Exchanges
Auction markets with centralized order
aggregation
Dealership function: can be
competitive or assigned by the
exchange (Specialists).
Examples: NYSE, AMEX, Regionals,
CBOE, TSEC

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Costs of Trading
Commission: fee paid to broker for
making the transaction
Bid/Ask Spread: cost of trading against
a limit order

Bid: price dealer will buy from you

Ask: price dealer will sell to you
Spread: ask bid
~ spread is paid on each transaction
(entire spread is paid on a round trip
transaction)
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Types of Orders
Instructions to the brokers on how to
complete the order

Market
Limit (good till specified time)
Stop loss
Programmed strategies
Do not confuse this with program trade, a
trade in a basket of 15+ stocks with market
value $1million+

Hundreds of others, all based on above

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Margin Trading
Owning only a portion of the value of an
investment, and borrowing the rest from the
broker
Shorting any investment in an amount where
the account could go to negative equity (for
stocks, commodities, or FX *any* amount
short requires a margin arrangement)
Margin arrangements differ vastly for
different financial instruments
Stocks ~50%, Futures ~10%, FX ~2%
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Buying and Selling

Simple? Maybe not
Buy (to own)
Buy to Cover buy to close a short position
Sell Long sell to close a long position
Sell Short sell something that is not
currently owned

Page 26

Short Sale
Selling an asset that is not currently owned
A Short position profits from a decline in the price of
a stock or security.
Mechanics of a Short Sale
Borrow security through a dealer or from another
investor who is willing to loan it.
Sell it and deposit proceeds into margin account.
Closing out the position: buy the security and return
the shares to the party from which it was borrowed
instead of into own account.
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Short Sell = Supply

Manipulation
There is only 1 share of SHSE stock. Investor 1 owns it
and is not willing to sell. Broker1 holds it for him.
Investor 2 buys a share from Trader A, who short sells.
BrokerA locates the share at Broker1 and borrows it to
deliver to Broker2. Now the share is deposited at Broker2.
Investor 3 buys a share from Trader B, who short sells.
BrokerB locates the share at Broker2 and borrows it to
deliver to Broker3. Now the share is deposited at Broker3.
Via short-selling, Traders A and B have created new shares,
so that there are now 3 investors who each own a share of
SHSE stock though there is only 1 share in existence!
If Supply increases, then price?

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Regulation of Securities
Markets
Institutions
Government Regulation
Self-Regulation

Reasons
Insider Trading
Corporate dishonesty (accounting
scandals, etc.)

Stay on moral high ground.

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Finance 101 Review

Starting easy, moving fast

Page 30

Review, Time Value

All investments can be represented as a
series of (expected) CASH FLOWS valued with
appropriate RISK-ADJUSTED DISCOUNT RATES
Discount Rate = Cost of Capital = Required Rate
of Return = Relevant Rate =
PV of Future Cash Flows

$1 today is worth more than $1 tomorrow

What must be the case for this to be true?

Try to think of value equivalently at different

points on the time line
Page 31

Review, Time Value

What Is the correct Discount Rate?
Risk-Free Rate applies to Risk-Free cash flows
only (historically US government liabilities, but
in practice whatever the local sovereign is)
WACC = Weighted Average Cost of Capital,
rate applied to all projects when there are
different funding sources with different
relevant rates
Determining the correct discount rate is
extremely complex
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Review, Time Value

Present Value (PV):
PV of $1 from time t is the Discount Factor, DF(t)
DF(t)=1/[1+r(t)]

Future Value (FV):

FV at time t of $1 today
FV(t) = PV*(1+r(t))

No arbitrage rules for discounting (i.e. to

prevent risk-free trading profits)
0 < DF(t) 1 r 0
DF(t) > DF(t+n) when n>0
These no-arbitrage rules have been broken
recently! See CHF interest rates!
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Review, Time Value

Perpetuity
PV = C/r

PV at time t; C at time t+1; fixed discount rate (r)

Imagine you have $1 million. You could spend it all
now. You could invest in a risk-free, fixed-rate
perpetuity. How much would it pay each year?

Growing Perpetuity
PV = C/(r-g)

Fixed cash flow growth rate (g)

Gordon Growth Model

Application of perpetuity formula for equity

pricing
EquityPrice = Div/[r(e)-g(Div)]
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Review, Time Value

Annuity
Derive it from the perpetuity formula and PV rule
One perpetuity with C starting at time 1, less
another perpetuity with C starting at time t+1
PV = [C/r - C/(r(1+r)^t)]
C/r pays out forever, C/(r(1+r)^t) negates payments
from t+1

Growing Annuities
Cash flow grows at a constant rate
PV = C/(r-g)[1-[(1+g)/(1+r)]^t)]
C/(r-g) pays out forever, C[(1+g)/(r(1+r)]^t negates
payments from t+1
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Review, Inflation
Inflation
Same dollar amount buys less in the
future
(1+nominal) = (1+ real)*(1+inflation)
Rule of thumb:
Always convert everything to nominal rates
and nominal cash flows, OR
Always convert everything to real rates and
real cash flows

Page 36

Review, Investment
Decisions
How do we decide if a project is
worthwhile?
3 methods (worst to best) :
3 Payback Period
2 IRR
1 NPV

Page 37

Review, Payback period

Payback Period
Moves linearly and successively through
time
Typically assumes a single negative cash flow
CF0 at the outset of a project
Sum CF0, CF1, CF2 (no discounting) until
sum is greater than zero
Payback period the first period in which
sum0

Rule: Take lower Payback period

Downfalls: Many
Page 38

Review, IRR
IRR

Cost s
CFt
CFt 1
0

...
s
t
t 1
(1 IRR ) (1 IRR ) (1 IRR )

IRR is the discount rate that makes NPV

=0
is to projects what YTM is to bonds
Rule: Take higher IRR
Downfalls: Throws away temporal
information, Multiple Roots

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Review (contd)
NPV=PV(All Project CFs)
NPV
Fair Projects are zero NPV since CFs are
discounted at cost of capital that is appropriate
for the risk taken, i.e. the appropriate opportunity
cost.
Example: if riskfree bonds cash flows are discounted at
the riskfree rate, then the resulting price is fair

Rule: When choosing amongst alternatives,

choose highest NPV
A Good Project has Positive NPV
Choose combination of projects with the highest total
NPV

Downfalls?

Page 40

Review, Compounding
Compounding Conversions and Conventions
Annual Percentage Rate (APR) = Nominal Annual Rate =
periodic rate * periods per year
Continuously Compounded Rate (CCR) = rate if paid
continuously
Effective Annual Rate (EAR, i.e. Annually) = rate if paid
APR n
once annually

EAR (1

) 1

EAR eCCR 1

n = periods per year

Convention is that r represents EAR unless noted

It is easiest to convert all rates to a single
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Review, Compounding
Examples
10% APR compounded monthly =
(1+.1/12)^12-1 = 10.47% Annually
10% continuously compounded =
exp(.1)-1=10.52% Annually
10.52% Annually =
ln(1+.1052)-1 = 10% continuous

Page 42

Price Ratio Valuation

Applying the perpetuity formula and assuming full payout of
Earnings, Price/Earnings ratio is inverse of growth-adjusted
discount rate
E

rg
E/P rg
1
P/E
rg

Hi P/E Low discount rate or else???

Lo P/E High discount rate or else???

In application

we can use past, present, or future P or E

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P/E Valuation Example

You work for MyBank the Ibank, Inc. Firms A, B, and
C are identical in most relevant measures of firm
prospects (growth prospects, industry, size,
location, cash flow, employee quality, management
skill, debt level, accounting measures, etc.). Firms
A and B are trading in secondary markets. P/E(A) =
20; P/E(B) = 21. Firm earnings for C are $1million
per year. Firm C wants you to issue 250K shares of
stock, which will represent ownership of half of the
firm. Assuming Firm C executives would like their
stock to appreciate in value roughly 10% on the
first day of trade, what should the primary market
issuance price per share be?
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P/E Valuation Example

Solution
250K shares = of firm 500K shares = entire firm
$1mm/500K earnings $2/share per year
Comparables Analysis P/E of C should be roughly 20 to
21
P/2 = 20 P = 40
P/2 = 21 P = 42
Shares of C should be worth $40 to $42 each

Want gain of 10%

P(issue)*1.1 = 40 P(issue) = 40/1.1 = P(issue) = 36.36
P(issue)*1.1 = 42 P(issue) = 42/1.1 = P(issue) = 38.18

Recommendation
Issue at 36.36 38.18
What other issues may come up on the day of primary
issuance?
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Conclusions and Assignments

Thats all of our intro finance review
Available for help in Office Hours (see
syllabus)

HW1 to-be-emailed / posted, due in 2

weeks
Read BKM CH22-23 for next week
Form HW Groups Now
Participation documentation sheets?
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