1

Bodie Kane Marcus

Essentials of Investments

Fourth Edition

Chapter 1
Investments - Background and Issues

Irwin / McGraw-Hill

2001 The McGraw-Hill Companies, Inc. All rights reserved.

Bodie Kane Marcus

Essentials of Investments

Fourth Edition

Investments & Financial Assets

Essential nature of investment
Reduced current consumption Planned later consumption

Real Assets
Assets used to produce goods and services

Financial Assets
Claims on real assets

Irwin / McGraw-Hill

2001 The McGraw-Hill Companies, Inc. All rights reserved.

Bodie Kane Marcus

Essentials of Investments

Fourth Edition

The Investment Process

Asset allocation Security selection Risk-return trade-off Market efficiency Active vs. passive management

Irwin / McGraw-Hill

2001 The McGraw-Hill Companies, Inc. All rights reserved.

Bodie Kane Marcus

Essentials of Investments

Fourth Edition

Active vs. Passive Management

Active Management Finding undervalued securities Timing the market Passive Management No attempt to find undervalued securities No attempt to time Holding an efficient portfolio
Irwin / McGraw-Hill
2001 The McGraw-Hill Companies, Inc. All rights reserved.

Bodie Kane Marcus

Essentials of Investments

Fourth Edition

Major Classes of Financial Assets or Securities

Debt
Money market instruments Bonds

Common stock Preferred stock Derivative securities

Irwin / McGraw-Hill

2001 The McGraw-Hill Companies, Inc. All rights reserved.

Bodie Kane Marcus

Essentials of Investments

Fourth Edition

Investments and Innovation

Technology and Delivery of Service Computer advancements More complete and timely information Globalization Domestic firms compete in global markets Performance in regions depends on other regions Causes additional elements of risk
Irwin / McGraw-Hill
2001 The McGraw-Hill Companies, Inc. All rights reserved.

Bodie Kane Marcus

Essentials of Investments

Fourth Edition

Key Trends - Globalization

International and Global Markets Continue Developing Managing foreign exchange Diversification to improve performance Instruments and vehicles continue to develop Information and analysis improves
Irwin / McGraw-Hill
2001 The McGraw-Hill Companies, Inc. All rights reserved.

Bodie Kane Marcus

Essentials of Investments

Fourth Edition

Key Trends - Securitization

Securitization & Credit Enhancement Offers opportunities for investors and originators Changes in financial institutions and regulation Improvement in information capabilities Credit enhancement and its role
Irwin / McGraw-Hill
2001 The McGraw-Hill Companies, Inc. All rights reserved.

Bodie Kane Marcus

Essentials of Investments

Fourth Edition

Key Trends Financial Engineering

Repackaging Services of Financial Intermediaries Bundling and unbundling of cash flows Slicing and dicing of cash flows Examples: strips, CMOs, dual purpose funds, principal/interest splits

Irwin / McGraw-Hill

2001 The McGraw-Hill Companies, Inc. All rights reserved.

10

Bodie Kane Marcus

Essentials of Investments

Fourth Edition

The Future
Globalization continues and offers more opportunities Securitization continues to develop Continued development of derivatives and exotics Strong fundamental foundation is critical Integration of investments & corporate finance

Irwin / McGraw-Hill

2001 The McGraw-Hill Companies, Inc. All rights reserved.

11

Bodie Kane Marcus

Essentials of Investments

Fourth Edition

Chapter 2
Financial Markets and Instruments

Irwin / McGraw-Hill

2001 The McGraw-Hill Companies, Inc. All rights reserved.

12

Bodie Kane Marcus

Essentials of Investments

Fourth Edition

Major Classes of Financial Assets or Securities

Debt
Money market instruments Bonds

Common stock Preferred stock Derivative securities

Irwin / McGraw-Hill

2001 The McGraw-Hill Companies, Inc. All rights reserved.

13

Bodie Kane Marcus

Essentials of Investments

Fourth Edition

Markets and Instruments

Money Market
Debt Instruments Derivatives

Capital Market
Bonds Equity Derivatives

Irwin / McGraw-Hill

2001 The McGraw-Hill Companies, Inc. All rights reserved.

14

Bodie Kane Marcus

Essentials of Investments

Fourth Edition

Money Market Instruments

Treasury bills Certificates of deposit Commercial Paper Bankers Acceptances Eurodollars Repurchase Agreements (RPs) and Reverse RPs Federal Funds
Irwin / McGraw-Hill
2001 The McGraw-Hill Companies, Inc. All rights reserved.

15

Bodie Kane Marcus

Essentials of Investments

Fourth Edition

Money Market Instrument Yields

Yields on Money Market Instruments are not always directly comparable Factors influencing yields Par value vs. investment value 360 vs. 365 days assumed in a year (366 leap year) Bond equivalent yield

Irwin / McGraw-Hill

2001 The McGraw-Hill Companies, Inc. All rights reserved.

16

Bodie Kane Marcus

Essentials of Investments

Fourth Edition

Interest rates that arise in connection with money market securities .Bank discount rate (rBD ) .This is a rate that is used solely for determining the price of a MM security for trading purposes. .Bond equivalent yield (rBEY ) .In general, a yield is an interest rate that (under very specific, sometimes unrealistic, assumptions) represents a rate of return. .rBEY is such a rate of return. It is an annual percentage rate (APR) .For comparing different MM instruments, we often use the effective annual rate (EAR) of the rBEY .

Irwin / McGraw-Hill

2001 The McGraw-Hill Companies, Inc. All rights reserved.

17

Bodie Kane Marcus

Essentials of Investments

Fourth Edition

Bank Discount Rate (T-Bills)

10,000 - P 360 r BD = x n 10,000 rBD = bank discount rate P n = market price of the T-bill = number of days to maturity

Example 90-day T-bill, P = $9,875 10,000 - 9,875 360 r BD = = 5% x 10,000 90

Irwin / McGraw-Hill
2001 The McGraw-Hill Companies, Inc. All rights reserved.

18

Bodie Kane Marcus

Essentials of Investments

Fourth Edition

Bond Equivalent Yield

Cant compare T-bill directly to bond
360 vs 365 days Return is figured on par vs. price paid

Adjust the bank discounted rate to make it comparable

Irwin / McGraw-Hill

2001 The McGraw-Hill Companies, Inc. All rights reserved.

19

Bodie Kane Marcus

Essentials of Investments

Fourth Edition

Bond Equivalent Yield

r BEY 10,000 = P -P 365 x n

P = price of the T-bill

n = number of days to maturity

Example Using Sample T-Bill 10,000 - 9,875 365 r BEY = x 9,875 90 rBEY = .0127 x 4.0556 = .0513 = 5.13%
Irwin / McGraw-Hill
2001 The McGraw-Hill Companies, Inc. All rights reserved.

20

Bodie Kane Marcus

Essentials of Investments

Fourth Edition

Capital Market - Fixed Income Instruments

Publicly Issued Instruments US Treasury Bonds and Notes Agency Issues (Fed Gov) Municipal Bonds Privately Issued Instruments Corporate Bonds Mortgage-Backed Securities
Irwin / McGraw-Hill
2001 The McGraw-Hill Companies, Inc. All rights reserved.

21

Bodie Kane Marcus

Essentials of Investments

Fourth Edition

Capital Market - Equity

Common stock
Residual claim Limited liability

Preferred stock
Fixed dividends - limited Priority over common Tax treatment

Irwin / McGraw-Hill

2001 The McGraw-Hill Companies, Inc. All rights reserved.

22

Bodie Kane Marcus

Essentials of Investments

Fourth Edition

Stock Indexes
Uses Track average returns Comparing performance of managers Base of derivatives Factors in constructing or using an Index Representative? Broad or narrow? How is it constructed?
Irwin / McGraw-Hill
2001 The McGraw-Hill Companies, Inc. All rights reserved.

23

Bodie Kane Marcus

Essentials of Investments

Fourth Edition

Examples of Indexes - Domestic

Dow Jones Industrial Average (30 Stocks) Standard & Poors 500 Composite NASDAQ Composite NYSE Composite Wilshire 5000

Irwin / McGraw-Hill

2001 The McGraw-Hill Companies, Inc. All rights reserved.

24

Bodie Kane Marcus

Essentials of Investments

Fourth Edition

Examples of Indexes - Intl

Nikkei 225 & Nikkei 300 FTSE (Financial Times of London) Dax Region and Country Indexes
EAFE Far East United Kingdom

Irwin / McGraw-Hill

2001 The McGraw-Hill Companies, Inc. All rights reserved.

25

Bodie Kane Marcus

Essentials of Investments

Fourth Edition

Construction of Indexes
How are stocks weighted?
Price weighted (DJIA) Market-value weighted (S&P500, NASDAQ) Equally weighted (Value Line Index)

Irwin / McGraw-Hill

2001 The McGraw-Hill Companies, Inc. All rights reserved.

26

Bodie Kane Marcus

Essentials of Investments

Fourth Edition

Example .Suppose we have two stocks

#Shares Stock Pr 9/19/01 Pr 9/20/01 Return Outstand A 100 120 20% 10M B 10 9 10% 500M .Computation of a price-weighted index (like the Dow) .Index on 9/19/01 (100+10)/2 = 55 Index on 9/20/01 (120+9)/2 = 64.5 Return on index 17.27% .This is called a price-weighted index because the index return is the price-weighted average of the component (100/110) x 20% + (10/110) x 10% = 17.27% .Portfolio: one share in each stock.
Irwin / McGraw-Hill
2001 The McGraw-Hill Companies, Inc. All rights reserved.

27

Bodie Kane Marcus

Essentials of Investments

Fourth Edition

Market-value weighted index .A market-value weighted average (like the S&P). .Index on 9/19/01 = 100 (an arbitary base level) .Market value of A = $100 x 10M = $1,000M Market value of B = $10 x 500M = $5,000M .Return on index is (1,000/6,000) x 20% + (5,000/6000) x 10% = 5% .Index on 9/20/01 = 100 x (15%) = 95 .Portfolio: 1/6 in A; 5/6 in B .An equally-weighted index (like the Wilshire 5000) .Index on 9/19/01 = 100 (an arbitary base level) .Return on index is (20% + 10%)/2 = +5% .Index on 9/20/01 = 100 x (1+5%) = 105 .Portfolio: equal amounts in A and B
Irwin / McGraw-Hill
2001 The McGraw-Hill Companies, Inc. All rights reserved.

28

Bodie Kane Marcus

Essentials of Investments

Fourth Edition

Chapter 3
How Securities are Traded

Irwin / McGraw-Hill

2001 The McGraw-Hill Companies, Inc. All rights reserved.

29

Bodie Kane Marcus

Essentials of Investments

Fourth Edition

Primary vs. Secondary Security Sales

Primary
New issue Key factor: issuer receives the proceeds from the sale

Secondary
Existing owner sells to another party Issuing firm doesnt receive proceeds and is not directly involved

Irwin / McGraw-Hill

2001 The McGraw-Hill Companies, Inc. All rights reserved.

30

Bodie Kane Marcus

Essentials of Investments

Fourth Edition

Investment Banking Arrangements

Underwritten vs. Best Efforts
Underwritten: firm commitment on proceeds to the issuing firm Best Efforts: no firm commitment

Negotiated vs. Competitive Bid

Negotiated: issuing firm negotiates terms with investment banker Competitive bid: issuer structures the offering and secures bids
Irwin / McGraw-Hill
2001 The McGraw-Hill Companies, Inc. All rights reserved.

31

Bodie Kane Marcus

Essentials of Investments

Fourth Edition

Public Offerings
Public offerings: registered with the SEC and sale is made to the investing public
Shelf registration (Rule 415, since 1982)

Initial Public Offerings (IPOs)

Evidence of underpricing Performance

Irwin / McGraw-Hill

2001 The McGraw-Hill Companies, Inc. All rights reserved.

32

Bodie Kane Marcus

Essentials of Investments

Fourth Edition

Private Placements
Private placement: sale to a limited number of sophisticated investors not requiring the protection of registration Dominated by institutions Very active market for debt securities Not active for stock offerings

Irwin / McGraw-Hill

2001 The McGraw-Hill Companies, Inc. All rights reserved.

33

Bodie Kane Marcus

Essentials of Investments

Fourth Edition

Organization of Secondary Markets

Organized exchanges OTC market Third market Fourth market

Irwin / McGraw-Hill

2001 The McGraw-Hill Companies, Inc. All rights reserved.

34

Bodie Kane Marcus

Essentials of Investments

Fourth Edition

Organized Exchanges
Auction markets with centralized order flow Dealership function: can be competitive or assigned by the exchange (Specialists) Securities: stock, futures contracts, options, and to a lesser extent, bonds Examples: NYSE, AMEX, Regionals, CBOE
Irwin / McGraw-Hill
2001 The McGraw-Hill Companies, Inc. All rights reserved.

35

Bodie Kane Marcus

Essentials of Investments

Fourth Edition

Types of Orders
Instructions to the brokers on how to complete the order Market Limit Stop loss

Irwin / McGraw-Hill

2001 The McGraw-Hill Companies, Inc. All rights reserved.

36

Bodie Kane Marcus

Essentials of Investments

Fourth Edition

Margin Trading
Using only a portion of the proceeds for an investment Borrow remaining component Margin arrangements differ for stocks and futures

Irwin / McGraw-Hill

2001 The McGraw-Hill Companies, Inc. All rights reserved.

37

Bodie Kane Marcus

Essentials of Investments

Fourth Edition

Stock Margin Trading

Maximum margin is currently 50%; you can borrow up to 50% of the stock value Set by the Fed Maintenance margin: minimum amount equity in trading can be before additional funds must be put into the account Margin call: notification from broker you must put up additional funds
Irwin / McGraw-Hill
2001 The McGraw-Hill Companies, Inc. All rights reserved.

38

Bodie Kane Marcus

Essentials of Investments

Fourth Edition

Margin Trading - Initial Conditions

X Corp $70 50% Initial Margin 40% Maintenance Margin 1000 Shares Purchased Initial Position Stock $70,000 Borrowed $35,000 Equity 35,000
Irwin / McGraw-Hill
2001 The McGraw-Hill Companies, Inc. All rights reserved.

39

Bodie Kane Marcus

Essentials of Investments

Fourth Edition

Margin Trading - Maintenance Margin

Stock price falls to $60 per share New Position Stock $60,000 Borrowed $35,000 Equity 25,000 Margin% = $25,000/$60,000 = 41.67%

Irwin / McGraw-Hill

2001 The McGraw-Hill Companies, Inc. All rights reserved.

40

Bodie Kane Marcus

Essentials of Investments

Fourth Edition

Margin Trading - Margin Call

How far can the stock price fall before a margin call? (1000P - $35,000)* / 1000P = 40%

P = $58.33 * 1000P - Amt Borrowed = Equity

Irwin / McGraw-Hill
2001 The McGraw-Hill Companies, Inc. All rights reserved.

41

Bodie Kane Marcus

Essentials of Investments

Fourth Edition

Short Sales
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
Irwin / McGraw-Hill
2001 The McGraw-Hill Companies, Inc. All rights reserved.

42

Bodie Kane Marcus

Essentials of Investments

Fourth Edition

Short Sale - Initial Conditions

Z Corp 50% 30% $100 100 Shares Initial Margin Maintenance Margin Initial Price

Sale Proceeds $10,000 Margin & Equity 5,000 Stock Owed 10,000

Irwin / McGraw-Hill

2001 The McGraw-Hill Companies, Inc. All rights reserved.

43

Bodie Kane Marcus

Essentials of Investments

Fourth Edition

Short Sale - Maintenance Margin

Stock Price Rises to $110

Sale Proceeds $10,000 Initial Margin 5,000 Stock Owed 11,000 Net Equity 4,000 Margin % (4000/11000) 36%
Irwin / McGraw-Hill
2001 The McGraw-Hill Companies, Inc. All rights reserved.

44

Bodie Kane Marcus

Essentials of Investments

Fourth Edition

Short Sale - Margin Call

How much can the stock price rise before a margin call? ($15,000* - 100P) / (100P) = 30% P = $115.38 * Initial margin plus sale proceeds
Irwin / McGraw-Hill
2001 The McGraw-Hill Companies, Inc. All rights reserved.