Financial Markets & Instruments

Financial Markets & Instruments
Andrei Simonov (HHS)

Finance I – HHS MBA
Course Outline
• Financial markets and products

• Risk and return
– measure of profitability
– comparison across time
– realized vs expected risk and return
• Idiosyncratic and systematic risk
– diversification
– efficient portfolios
Finance I - HHS MBA - 2

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Course Outline (cont)
• Valuation
– CAPM and other asset pricing models
– anomalies and behavioral finance
• Fixed Income
– duration
– term structure
• Derivatives
– options
– futures

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Administration
• Grading
– class participation
– group assignments
– Exam
• Textbook
– Investments Bodie, Kane and Markus (McGraw-
Hill) latest edition
• My assumptions about you
– You know and understand basic regression and
statistical analysis (what is R2, statistical
significance, etc.)
– You are willing to learn...
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Introduction
• The field of Finance and Investments
– Individual agents making decisions to supply capital
to the markets
– Firms getting capital from the financial markets
(when, where, how?)
– Capital Markets acting as market clearing device.
• Goal of the course:
– To familiarize you with ”real world” of investments.
– To give broad overview of modern investment
issues. By December one should know what does
that mean to be investment professional.
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Financial Assets
• Claims to cash generated by real assets

• Real assets
– those which contribute to economic production
(land natural resources, buildings, machines …)
• Financial assets:
– contribute indirectly to the productive capacity of
the economy
– allocate profits and risks to various market
participants and investors

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Functions of the Financial System
• To allocate funds efficiently by transferring resources
– across time (saving for retirement)
– across distance (investing across countries)
• To provide means of sharing risk
– between households and firms (stocks)
– among firms (futures)
– among households (insurance contracts)
• To provide means of controlling risk
– diversification (mutual funds)
– options, credit derivatives
• To provide and aggregate information about expectations
– on macro variables (exchange rates, inflation etc.)
– on companies
• To efficiently separate ownership and management
• To provide ways to settle payments for goods and services

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Investment process
• Typical investors faces two steps of decisions:
• Asset allocation
– Choice among broad asset classes
(Ex) stocks, bonds, real estate, commodities, etc.
– This requires “economic analysis” (boom or bust) or “industry
analysis”
• Security selection
– Choice of particular securities within each asset class
(Ex) GM, IBM, etc.
– This requires the valuation process of particular securities, so
called, “security analysis”
• Therefore, investors face the following problems:
– Forecasting future returns (or cash flows)
– Identifying sources of risk and measuring risk
– Evaluating whether the expected return compensates for the risk
– Investment decisions
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Principles of the markets
• No-free-lunch rule (or no arbitrage rule)
– Financial markets are competitive enough to rule out any profit
opportunity from investing in obviously underpriced securities
• Risk-return trade-off
– Assets with higher expected returns have greater risk
– Higher-risk assets should be priced lower to offer higher expected
return than lower-risk assets
– How to measure risk?
• Market efficiency hypothesis
– All relevant information is quickly and efficiently reflected in prices
– In reality, however, we observe near-efficient markets where there
may exist profit opportunities for diligent and creative investors.
This provides an incentive for actively managing one’s investment
portfolios
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Financial Markets
• Role of the markets: aggregation of

information
• Primary market for new issues of securities
Company sells shares and bonds directly to investors
– Private placements: offers to a restricted group of investors
– Public offerings: offer to the general investment public
• Secondary market for existing securities
Existing owner sells to another party
Company does not receive proceeds and is not directly
involved

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Primary Market – Public
Offerings
• Investment bank underwrites the issue

performing four tasks
– Origination: information gathering and advice on timing
and pricing of the issue, forming syndicate
– Distribution: selling of the issue
– Risk bearing: buys the security from the firm and then
resell them to clients (in some cases)
– Certification: certify the quality of the issue

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Investment Banking (IB)
• IBs are specialized in advising and marketing public
offerings of stocks or bonds, and are called “underwriters”
– An underwriting syndicate is formed to share the responsibility of
large offerings
• IBs provide services such as valuation, marketing plan,
roadshow, bookbuilding, pricing, allocation, and price
support in aftermarkets
– IBs tend to offer a bargain price to induce potential investors to
submit their interest in the bookbuilding process
• This tendency commonly causes underpricing of IPOs, which is
reflected in price jumps occurring on the first date of trading (“New
Issue Puzzle”)
• Besides underwriting fees of about 7%, such underpricing
is an implicit cost to the issuing firm
– Highly expensive for small firms, and internet IPOs introduced
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Public Offerings
• Underwriting types: Firm commitment vs. Best Efforts

– Firm commitment: IBs buy the issue and assume risk of selling
– Best Efforts: no firm commitment, and act as an intermediary
• Negotiated vs. Competitive Bid
– Negotiated: issuing firm negotiates terms with investment banker
– Competitive: issuer structures the offering and takes bids from IBs
• SEC registration required for new issues to the public
– Registration of new securities must be approved by SEC
(Preliminary prospectus, or Red herring)
– Once approved, “Prospectus” is distributed to the public together
with “Tombstone” advertisements
– Shelf registration (SEC Rule 415, since 1982)

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Private Placements
• Sale to a small number of institutions and

sophisticated investors
– Does not require registration at the SEC (Rule
144A), and thus, cheaper than public offerings
– Very active market for debt securities, but not active
for stock offerings

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How to place an order?
• Instruct your broker the following order

specification
– Online vs. offline
• Name and type of the security to trade
• Indicate a purchase or sale
• Order size – round lots vs. odd lots
• Order type – market vs. limit orders, etc.
• Length of time of the order

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Types of Orders
• Market order
– Buy or sell orders are to be executed immediately at the best price
currently available
• Limit order
– Specify prices at which buy or sell orders are executed
• Stop-loss order
– Sell stocks when price falls below a stipulated level
– This is to stop further losses from a long position
• Stop-buy order
– Buy stocks when price rises above a stipulated level
– This is to limit potential losses from a short position
• Good-till-canceled order
• Fill or Kill order (FOK)
– immediately execute a trade completely, or else, cancel it
• Market-on-close order
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Evolution of limit order book
• Suppose the following limit order book for stock XYZ observed at time 0
on a day.
Sell Price Buy (At time 0) Sell Price Buy (At time 4)
.... .... .... ....
1000 $32 ??? $32
2000 31 ??? 31
30  30
29 29
28 3000 28 ???
27 2000 27 ???
.... .... .... ....
– What will be the trade prices for the following orders?

• At time 1, a market buy order of 1000 shares arrived.
• At time 2, a market buy order of 1500 shares arrived.
• At time 3, a market sell order of 2000 shares arrived.
• At time 4, a limit sell order of 1000 shares at $31 arrived.
– How would the limit order book look like just after time 4?
– What would be the implicit cost of market buying and selling a share
simultaneously just after time 4?
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Costs of Trading
• Brokerage commission
– Fees paid to broker
– Full-service vs. discount broker
– Explicit cost of trading
• Bid-ask spread: implicit cost of trading
– Bid: price that a dealer is willing to buy from you
– Ask: price that a dealer is willing to sell to you
– Typically, Ask > Bid
and the difference “ask – bid” is called as “bid-ask
spread”, which is dealer’s gain for the market-
making service
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Margin Trading
• Only a portion of the investment proceed comes from

your own money
– Remaining portion is borrowed from a broker
• Bet on a rise in the price of the security
• Higher leverage, magnifying upside and downside risks
– Stocks purchased on margin must be maintained with the
broker as collateral for the loan
• Initial margin
– Currently 50%, set by the Fed
– You can borrow up to 50% of the stock value
• Maintenance margin:
– Minimum amount of equity maintained in the account
– Margin call: call from a broker to put up more equity funds
• Margin arrangements differ for stocks and futures
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Margin Trading –
Initial Margin
• X Corp. $70 current price

1,000 Shares Purchased
50% Initial Margin
40% Maintenance Margin
• Initial Position
Stock $70,000 Borrowed $35,000
Equity 35,000

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Margin Trading –
Maintenance Margin
• If stock price falls to $60 per share,

New Position
Stock $60,000 Borrowed $35,000
Equity 25,000
– Margin (%) = Equity in account / Value of stock
= $25,000 / $60,000 = 41.67%
– Rate of return = (25,000 – 35,000)/35,000 = -28.57%

– Rate of return if own money of $35,000 is used to buy 500 shares
= (30,000 – 35,000) / 35,000 = –14.28%
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Margin Trading –
Margin Call
• How far can the stock price fall before getting a

margin call?
Margin (%) = Equity in account / Value of stock
= (1,000P - $35,000) / 1,000P = 40%
 P = $58.33
– If stock price falls below $58.33, one gets a margin call

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Short Sales
• Opposite case of the margin purchase, i.e., only a
portion of the securities are supplied by the seller
– Remaining portion of the securities are borrowed from a broker
• Bet on a decline in the price of the security
• Higher leverage, magnifying upside and downside risks
– The proceeds from the short sale must be maintained with the
broker as collateral
• Mechanics
– Borrow stocks from a broker
– Sell it, and deposit the proceeds and margin money in an
account
– Close out the position by buying the stock and returning it to
the lender
• Short-seller must pay any dividends paid during the short sale to
the lender of the stock
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Short Sale – Initial Conditions
• Z Corp $100 current price

100 Shares sold short
50% Initial Margin
30% Maintenance Margin
• Initial Position
Sale proceeds $10,000 Stock owed $10,000
Margin(cash,etc) 5,000 Equity 5,000

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Short Sale – Maintenance Margin
• If stock price rises to $110,

New Position
Sale proceeds $10,000 Stock owed $11,000
Initial margin 5,000 Equity 4,000
– Margin (%) = Equity in account / Value of stock

= $4,000 / $11,000 = 36.36%
– Rate of return = (4,000 – 5,000) / 5,000 = – 20%

– Rate of return if own 50 shares are sold at $100
= (5,000 – 55,000) / 5,000 = –10%

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Short Sale – Margin Call
• How much can the stock price rise before getting a

margin call?
Margin (%) = Equity in account / Value of stock

= ($15,000 – 100P) / (100P) = 30%
 P = $115.38
– If stock price rises above $115.38, one gets a margin

call

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Secondary Markets
• Organized exchanges
• OTC market
• Third market
• Fourth market

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Organized Exchanges
• Auction markets with centralized order flow

– NYSE, AMEX, and regional exchanges
– Listing requirements
• Dealership function by “Specialists” at NYSE
– Have exclusive right to make the market in a
specified stock on the NYSE
– Must maintain a “fair and orderly market”
– Can be competitive or assigned by the exchange
• Traded securities:
– stock, bonds, futures, options contracts
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OTC Market
• An informal exchange of brokers and dealers

negotiating trades, without centralized order flow
• NASDAQ: largest OTC market since 1971
– Computer-linked system providing information on dealers’
quotation of bid and ask prices
– Nasdaq National Market System
– Nasdaq SmallCap Market
– Lower volume securities
• OTC Bulletin Board
• Pink Sheets from NASD
• Traded securities:
– Stocks, bonds and some derivatives
– Most secondary bonds transactions
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Third Market
• Trading of exchange-listed securities away from

the exchange
• Institutional market, facilitating trades of larger
blocks of securities
• Involves services of dealers and brokers

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Fourth Market
• Investors trading directly with other investors

– Originally developed for institutional trading
– Technological developments lead to individual
investors trading directly, without the need of market
makers
• Advent of ECN
– Computer networks allowing direct trading
– Captures about 30% of the trading volume for
NASDAQ-listed stocks in 2001
• (Ex) INSTINET, POSIT
– Competing with Nasdaq and NYSE for volume
• Implication of future structure of stock exchanges
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Market Mechanics –
Alternative Ways of Trade Execution

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Regulation and Market Trends
• ECNs present new challenges in regulation

• Global markets with alliances are developing
• Current Issues with Insider trading violations
• Agency problems associated with investment
banking and research
– Most of top managers have long been engaged in “earnings
management” with analysts and auditors, and they have been
overly compensated by stock options or performance shares
due to stock price increases
– We are currently seeing Sarbanes-Oxley acts, SEC and FBI
investigations, and criminal/civil actions against corporations,
corporate executives, auditors, investment banks, and analysts
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Regulation and Market Trends 2
• Agency problems associated with investment

banking and research (Continued)
– Market for corp. control (takeovers) cannot solve the problem –
Recent evidence shows value destruction in a large scale
– Equity-based compensation is like throwing gasoline on a fire
– Real solution is to not allow the market price to get
substantially out of line with the true value of the firm, and to
reset the value

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Financial Markets
T-Bills
(Short-term) CD
Money CP
Market BA
Traditional Repos/Reverses
Financial Federal funds
Markets LIBOR market
(Long-term) T-Notes/Bonds
Financial Capital Bonds Municipal bonds
Markets Market Corporate Bonds
ABS/MBS
Stocks
Forward
Futures
Derivatives Option
Swap
Foreign Exchange
Market Whole sales market
Retail market

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1. Money Market - short-term (maturity <= 1yr) fixed-

income instruments
– Certificates of deposits (CD’s)
– Commercial paper
– Treasury bills
2. Fixed-Income – longer term
– Municipal Bonds
– Government Bonds
– Corporate Bonds
– Asset and Mortgage Backed Securities

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3. Equity
– Common stocks
– Preferred stock
– ADRs
4. Derivatives
– Options
– Futures
– Forwards

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Money Market
• Certificate of Deposit (CD)
– time deposit with a bank: funds cannot be withdrawn
– interest and principal at the end of a fixed term
– can be traded (thin market for 3 months or more maturities)
• Commercial Paper (CP)
– short term unsecured debt usually backed up by a line of
credit
– up to 270 days maturity usually 30 to 60 days
• Eurodollars
– dollar denominated deposits at non-US banks or branches
• Bankers’ Acceptances
– bank endorsed postdated checks (maturities ≤ 6 months)
• Treasury Bills (T-Bills)

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T-Bills: issuer and structure
• Debt securities issued by the US Treasury

– Extremely liquid
– Safe (no default risk)
• Pure discount security (no interest payments)
– Investors pay P dollars (e.g. $990) now
– Investors get F dollars (e.g. $1,000) in the future at
maturity
– F > P: trading at discount
• Maturity: 3, 6, 12 months

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Example 1 (Cashflow of T-Bills)
$1,000
Face Value
(par amount)
Today Maturity
(e.g. 3m)
Pay less than $1,000
(e.g. $990)
Initial investment: $990

Payment at maturity: $1,000
Profit: $10 (the interest you earned on the
loan to the government)
Return over 3m: ($1,000-$990) / $990 = 1.01%

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Fixed Income
• Municipal Bonds
– issued by state and local governments
– tax exempt in the US
• Government bonds
– Treasuries
• Corporate Bonds
– credit risk
• Asset Backed securities
– example of securitization

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T-Bonds : issuer and structure
• issued by the US treasury

• T-Notes: 1-10 years, T-Bonds: 10-30 years
• semiannual coupons and principal at maturity
– adjusted for inflation for TIPS (inflation-indexed bonds)
• held by households, firms and financial institutions
• TIPS are mostly held by pension funds,
endowments, individuals saving for retirement

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T-Bills and Bonds: trading and
riskiness
• Initial sale through auction
– a week’s advance notice
– competitive bids: price and quantity
– non-competitive bids: only quantity
– bidding through one of about 50 dealers
– no bid for more than 35% of the total offer
• Subsequent trading through primary dealers on OTC
market
• Riskiness: negligible default risk (backed by
government ability to tax), interest-rate risk

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Corporate Bonds
• Issued by large corporations via investment banks

through underwriting process
• Maturities and coupon payments similar to T-
Bonds
• Traded in a dealer market connected by
computers
• Held by mutual and pension funds and insurance
companies mainly

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Credit Risk
• Unlike treasuries, corporate bonds carry

significant default risk, hence we distinguish
– Secured bonds: specific collateral backing in the
event of default
– Debentures: unsecured bonds (no collateral)
– Subordinated debentures: lower priority claims
than debentures
• Bond covenants: regulate the rights of the
lender and the restriction on the borrower

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Bond Covenants
• Asset covenants
– govern firm acquisition, disposition and use of assets
• Dividend covenants
– restriction of dividend payments
• Financing covenants
– prevents firm from issuing new debt
• Bonding covenants
– mechanism to enforce covenants, e.g. trustee to oversee that
covenants are not violated
• Sinking fund covenants
– certain parts of the bond must be retired by certain dates

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Cash Flow Patterns
• Straight coupon bond (bullet bond)
– fixed rate semiannual coupon, principal paid only at terminal
date (balloon payment)
– Medium term notes (MTN) belong typically to this class
• Zero coupon or pure discount bond
– no periodic payments, single payment at maturity
• Deferred coupon bond
– interest is deferred for a period, so that cash-constrained
firms can fund other projects
• Consol (perpetuity) bond
– bonds that pay only interest forever
• Annuity bond
– pay a mix of principal and interest until maturity

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Bond Options
• Callability
– allows the issuing firm to retire the bond before maturity at a
pre-specified price
• Convertibility
– allows bondholders the option to convert the bond into
another security, typically common stock
• Exchangeability
– allows issuing firm to exchange the bond for a different type
of bond
• Putability
– allows bondholders to sell the bond back to the firm

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Corporate Bond Ratings

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Transition Probability Matrix

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Asset Backed Securities
• Asset securitization
– collect many sufficiently homogeneous assets in the same
pool
– issue securities that are claims on the pool cash flow
– converts illiquid loans into liquid securities that can be bought
by a much wider group of investors
• Many assets are securitized nowadays
– mortgages
– airplane leasing
– credit card loans

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Mortgage Backed Securities
• In the US 80% of mortgages are securitized

• Explosion of the market in the US
• Not yet in Europe
4,500
4,000
3,500
3,000
2,500
Billions
Treasuries
MBS
2,000
1,500
1,000
500
-
1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003
Year

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Equities
• Issued by corporations
• Each share represents ownership in the company
– right to share of dividend
– right to vote at shareholders meetings
• Residual claimant
– get payouts only if all other claims are met
– debt claims are senior to equity claims
• Limited liability
– liability limited to the shareholder’s initial capital deposited

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Equity: Types and Issuance
• Common stock
– Shareholders are residual claimants (lowest priority)
– Represents real ownership in the firm (voting rights)
– Limited liability
• Preferred stocks: hybrid of bond and stock
– Bond-like features
• no voting rights
• promise to pay fixed dividends, often convertible
– Stock like features
• can’t force bankruptcy
• no specified maturity
• low priority

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Equity: Types and Issuance
(cont)
• ADRs: American Depositary Receipts

– receipts for the shares of a foreign base corporation held in the
vault of a US bank and entitling the shareholder to all dividends
and capital gains
• Two ways to raise capital through public equity issues:
– IPO, Initial public offering: first sale of stock by a formerly
private company
– SEO, Seasoned equity offering: subsequent sales of stock by
an already public company

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Options
• Call Option
– gives the holder the right to purchase an asset for a
specified price, called the exercise or strike price on
or before a specified expiration date
• Put Option
– gives the holder the right to sell an asset for a
specified price, called the exercise or strike price on
or before a specified expiration date
• Derivative assets since their value depends on
the value of the underlying asset

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Example - European Call Option
Today
• You buy a 6-month call option on GE, i.e. the right to
purchase GE stock at price X in six months
– notice that the right cannot be exercised before 6 months
In 6 months
• GE stock is worth ST
• If ST<=X, no point in exercising the call: Payoff = 0
• If ST>X, you exercise the option, pay X for the stock,
can resell it at ST : Payoff = ST –X

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Futures
• Delivery of an asset at a specified delivery or maturity

date for an agreed-upon price, the futures price, to be
paid at contract maturity
– long position: obligation to buy the asset
– short position: obligation to deliver the asset
• Options on futures grant the right (not the obligation)
to buy or sell the asset at the exercise price
• Underlying assets can be
– currencies (US$, EURO …)
– goods (oil, wheat …)
– financial assets (e.g. stocks) and indexes (e.g. S&P500)

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Where to get data?
• Easiest: web search engine, financial sites (Yahoo,
Infoseek, msn, etrade, etrade-SE, CNNfn, etc.)
• Bulk suppliers
– Bloomberg, DataStream, CRSP, Reuters, Trust, Commodity
Systems, Inc., Securities Data Corp., etc...
– Look at departamental web site:
http://www.hhs.se/secfi/Databases/Databases.htm
• Dividends
• Volume
• Splits

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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?
– Subjectivity Factor (Bethleham Steel)

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Examples: Stock and Bond Indices
 Dow Jones: price weighted 1. Royal Dutch Petroleum nl e 9,02 26. Alcatel Alshom (Electric&Electronic) f tec1,64
2. Allianz Versicherung g i 5,52 27. Endesa s s 1,64
arithmetic 3. Deutsche Telekom g t 4,06 28. Eaux (Cie Generale des) f s 1,59
 Standard & Poors: value

4. ENI i e 3,63 29. RWE d s 1,46
5. France Telecom f t 3,53 30. Nokia Ab Oy A fintec1,42
weighted arithmetic 6. ING Groep N.V. nl fi 3,16
7. Unilever N.V. nl fo 3,08 31. LVMH Moet-Hennesey Louis Vuitton f fo 1,27
 Specialized indexes: 8. Daimler-Benz g ca 2,97
9. Telecom Italia Ord i t 2,86
32. Rhone-Poulenc SA f p 1,25
33. Paribas (Compagnie Financiere de) f b 1,23
Wilshire, Russell etc. 10. Deutsche Bank g b 2,86 34. Ahold Kon. nl co 1,13
35. Societe Generalee f b 1,09
 European indexes: 11. Siemens g m 2,77
12. Veba g m 2,69
36. Electrabel b s 1,07
37. Akzo Nobel N.V. nl ch 1,03
Eurostoxx 50 13. Bayer g ch 2,50
14. Telefonica de Espane, S.A. i t 2,40
38. Repsol, S.A. s e 1,02
39. Fiat S.p.A. Ord i c 0,95
 Bond indexes: Lehman 15. ABN-AMRO Hldg N.V. nl b 2,35
16. Societe Nationale Elf Aquitaine f e 2,33
40. Elsevier N.V. nl m 0,94
Brothers, Merrill Lynch, 17. Asicurazioni Generali S.p.A. (ENDESA) i i 2,32 41. Compagnie de St. Gobain f bu 0,92
18. AXA-UAP f i 2,30 42. Air Liquide (L') f ch 0,89
Salomon Brothers all value 19. Aegon N.V. nl i 2,24 43. Credito Italiano S.p.A. Ord i b 0,84
weighted 20. L'Oreal (Ordinary) f co 2,23 44. Fortis b i 0,81
45. Portugal Telecom S.A. por t 0,78
21. Banco Bilbao Vizcaya s b 2,06 46. Alliead Irish Banks ire b 0,75
22. Philips Electronics N.V. nl tec1,82 47. Schneider f ind0,69
23. Carrefour f r 1,73 48. Metro g r 0,67
24. Koninklijke PTT Nederland nl t 1,65 49. Petrofina S.A. b e 0,64
25. Mannesmann g ind1,65 50. Dt. Lufthansa g tr 0,54

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Indexes - Methodology
• Price Weighted Indexes
– average price of 1 share of the companies in the
index
– measures the performance of a portfolio with 1
share of each stock in the index
• Value Weighted Indexes
– average market value of the companies in the index
– measures the performance of a portfolio in which
each stock counts as its market capitalization

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Wilshire 5000 Index

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Top 20 companies in S&P500 Index

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Asset Classes Returns: US History

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Asset Classes Returns: Swedish
History
1000000
DMS Global Sweden Bill TR
DMS Global Sweden Inflation
1 SEK invested in 1900
100000
DMS Global Sweden Equity TR
10000
DMS Global Sweden Bond TR
1000
100
10
1
1900 1920 1940 1960 1980 2000
0.1
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Goetzmann&Jorion: International Evidence

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Goetzmann&Jorion: International Evidence
Median Market RR 0.75%

GDP-weighted RR 4%
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Services of Investment Companies
• Administration & record keeping
– Periodic reports on capital gains, dividends,
investments, and redemption
• Diversification & divisibility
– Each investor has a claim to the portfolio in proportion
to his investment
• Professional management
– Full-time staffs of security analysts and portfolio
managers
• Reduced transaction costs
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Net Asset Value
• Value of each share of a mutual fund
– Used as a basis for valuation of mutual funds, e.g.,
when selling new shares or redeeming existing shares
Market Value of Assets - Liabilities

Shares Outstanding
(Example) A mutual fund with 5 mil shares:

Portfolio of securities $120 mil
Investment advisory fees payable $ 4 mil
Other Liab.(rent, wages due, expenses) $ 1 mil
NAV = (120 – 5) / 5 = $23 per share
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Types of Investment Companies
• Investment Company Act of 1940
1.Unit Investment Trusts
• Investment portfolios are fixed and unmanaged (lower operating expenses
than actively managed funds)
2.Managed Investment Companies
• Closed-End vs. Open-End Funds
• Discount puzzle of closed-end funds:
– Various commissions (sales, management, performance fees, etc.)
– Unrealized capital gains and taxes
– Individual investors’ sentiment
Closed-end Open-end
Redemption of Cannot redeem its shares, but Can redeem or issue its shares at
shares traded on stock exchanges NAV, but not listed on exchanges
Shares No change unless new share is Changes daily as new shares are
outstanding offered sold or old shares are redeemed
Pricing Premium or discount to NAV NAV
A. Simonov
Other investment Organizations
• Similar functions, but not formally regulated as investment
companies
• Commingled funds
– Similar to open-end funds, and units are offered
– Money market fund, bond fund, etc, by a bank or insurance
company
• REITs
– Similar to closed-end funds
– Investing in real estate (Equity trusts) or mortgage loans
(Mortgage trusts)
• Hedge Funds
– Private investment pool, not subject to SEC regulation
– Heavy use of derivatives, short sales, and leverage, speculating
on convergence of valuation differences across two sections
A. Simonov
Investment Policies
• Investment policies of mutual funds are described in prospectus
– Get a free prospectus for many mutual funds at
http://usatodayonl.fundinfo.wilink.com/asp/F116_search_ENG.asp
• Various kinds of investment policies (styles)
– Money Market Funds
– Fixed Income Funds
– Balanced & Income Funds
– Equity Funds
– Index Funds: passive strategy, tracking a broad market index
– Asset Allocation Funds: actively engaged in market timing and
forecasting
– Specialized Sector Funds: industry-specific or international stocks

A. Simonov
Costs of Investing in
Mutual Funds
• Front-end vs. Back-end load vs. no-load
– Front-end load: sales commission paid at time of purchase (about 6%)
– Back-end load: redemption fee at time of redemption (about 6%, and
gradually lowers every year)
• Operating expenses
– Administrative expenses and advisory fees paid to the investment
manager (0.2% to 2% of total assets)
– Periodically deducted from the fund assets
• 12 b-1 charges
– Annual fees charged by a fund manager to pay for marketing and
distribution costs of annual reports and prospectuses, and sales broker
commissions (limited to 1% of a fund’s average net assets per year)
– Annually deducted from the fund assets
• Different classes of shares have different fee structures
– Allow investors to choose the best combination of fees, depending on
their investment horizons.
A. Simonov
MF Returns, Fees, and Taxes
• Rate of return before fund expenses
= (NAV1 – NAV0 + Dividend and capital gain distributions) / NAV0
• Fund expenses affect the returns
– Front-end or back-end loads, operating expenses, and 12b-1 charges are
periodically deducted from fund assets, having substantial negative effects
on the rate of return
– Costs incurred in “soft dollars” are difficult to measure
• High trading commissions will eventually reduce fund returns
• The “pass-through” status of fund income
– If at least 90% of all income is distributed to shareholders, and
less than 30% of its income comes from the sale of securities held for less
than three months
• Then, investors (but not the fund) pay income taxes at their own tax rate
– It may be a disadvantage since it is difficult to control when to realize
capital gains and how to manage tax liabilities
• Such a tax management issue is irrelevant if a mutual fund is held in a tax-
deferred retirement account such as an IRA or 401(k) account
A. Simonov
Exchange Traded Funds
• A variant of mutual funds that allow investors to trade
index portfolios like shares of stock
– Examples: SPDRs and Diamonds
• Potential advantages
– Trade continuously, and can be sold short or bought on margin
– Tax advantage over mutual funds
• Redeemable for shares of stocks in the portfolio without selling
them, thus not triggering capital gains taxes
– Investor can buy ETFs through brokers (save sales charges)
– Lower management fees, 0.09%~0.18%
• Potential disadvantages
– Sometimes depart from the NAV, giving arbitrage opportunities
– Trading incurs brokerage fee and bid-ask spreads
A. Simonov
Mutual Fund Performance
• Choice of an appropriate benchmark is difficult
– Must have similar risk characteristics
• A simple comparison with Wilshire 5000 index (Fig 4.3)
– The index has outperformed the median managers in more years
during 1972-2001, and the average difference of annualized
compound returns is 1.09% (12.20% vs. 11.11%)
– This margin could have reduced to 0.79% for passively managed
low-cost index fund, and thus, passive index fund would have
outperformed actively managed funds
• Repeated winners?
– Tab 4.4 shows that 62% of initial winners repeats in the following
period, which is consistent with at least some part of a fund’s
performance is a function of skill as opposed to luck
• Bad performance is more likely to persist than good performance
due to high turnover ratios and expense ratios
A. Simonov
Sources of Information on Mutual
Funds
• Prospectus
– Is required to contain investment objectives, policies, risks, fee
table, portfolio managers, etc.
• Two other sources
– Statement of Additional Information (Part B of Prospectus), and
Annual Report show portfolio composition, financial statements,
etc.
• Which funds to choose?
– Morningstar’s Mutual Fund Sourcebook
– Wiesenberger’s Investment Companies
– Investment Company Institute’s Directory of Mutual Funds
A. Simonov
Recent Fraud in Mutual Fund Industry
• “Late trading” or “market timing” is discouraged or prohibited
– Mutual fund companies state in their prospectuses that they discourage
or prohibit "late trading" and "market timing" by large investors. However,
mutual fund managers were found to permit certain companies to conduct
such trades in exchange for payments and other inducements.
• http://www.usatoday.com/money/perfi/funds/2003-10-02-mym_x.htm
• http://www.usatoday.com/money/perfi/funds/2003-10-02-prospectus_x.htm
• http://www.lieffcabraser.com/mf_main.htm (fraud investigation documents)
– Late trading involves purchasing mutual fund shares at the 4 pm price
after the market closes, a practice which is illegal, and like allowing
betting on a horse race after the horses have crossed the finish line.
– Market timing is a short-term, "in and out" trading of mutual fund shares. It
is designed to exploit market inefficiencies by buying mutual fund shares
at the stale NAV, and realizing a profit later when selling them.
– Typically, funds limit the number of round trips an investor can make
during a 12-month period, and allow exchanges from one fund to another
within the same fund family several times a year for a low or no fee.

A. Simonov
The Future
• Globalization continues and offers more

opportunities
• Securitization continues to develop
• Derivatives and exotics continue to develop
• Strong fundamental foundation is critical

• Integration of investments & corporate finance

A. Simonov

Financial Markets &amp; Instruments

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Financial Markets &amp; Instruments

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Financial Markets & Instruments

Andrei Simonov (HHS)

• Financial markets and products

Finance I - HHS MBA - 2

Finance I - HHS MBA - 3

• Claims to cash generated by real assets

Finance I - HHS MBA - 7

Finance I - HHS MBA - 8

• Role of the markets: aggregation of

Finance I - HHS MBA - 11

• Investment bank underwrites the issue

Finance I - HHS MBA - 12

• Underwriting types: Firm commitment vs. Best Efforts

Finance I - HHS MBA - 14

• Sale to a small number of institutions and

Finance I - HHS MBA - 15

• Instruct your broker the following order

Finance I - HHS MBA - 16

– What will be the trade prices for the following orders?

• Only a portion of the investment proceed comes from

• X Corp. $70 current price

Finance I - HHS MBA - 21

• If stock price falls to $60 per share,

– Rate of return = (25,000 – 35,000)/35,000 = -28.57%

• How far can the stock price fall before getting a

– If stock price falls below $58.33, one gets a margin call

Finance I - HHS MBA - 23

• Z Corp $100 current price

Finance I - HHS MBA - 25

• If stock price rises to $110,

– Margin (%) = Equity in account / Value of stock

– Rate of return = (4,000 – 5,000) / 5,000 = – 20%

Finance I - HHS MBA - 26

• How much can the stock price rise before getting a

Margin (%) = Equity in account / Value of stock

– If stock price rises above $115.38, one gets a margin

Finance I - HHS MBA - 27

Finance I - HHS MBA - 28

• Auction markets with centralized order flow

• An informal exchange of brokers and dealers

• Trading of exchange-listed securities away from

Finance I - HHS MBA - 31

• Investors trading directly with other investors

Finance I - HHS MBA - 33

• ECNs present new challenges in regulation

• Agency problems associated with investment

Finance I - HHS MBA - 35

Finance I - HHS MBA - 36

1. Money Market - short-term (maturity <= 1yr) fixed-

Finance I - HHS MBA - 37

Finance I - HHS MBA - 38

Finance I - HHS MBA - 39

• Debt securities issued by the US Treasury

Finance I - HHS MBA - 40

Initial investment: $990

Finance I - HHS MBA - 41

Finance I - HHS MBA - 42

• issued by the US treasury

Finance I - HHS MBA - 43

Finance I - HHS MBA - 44

• Issued by large corporations via investment banks

Finance I - HHS MBA - 45

• Unlike treasuries, corporate bonds carry

Finance I - HHS MBA - 46

Financial Markets & Instruments

Financial Markets & Instruments