Institutional Background and Investment Fundamentals
Institutional Background
Institutional Investment
Real assets: These determine the productivity and net income of the economy, such as land, machines, etc. Financial assets: These are claims on these Real assets.
Types:
- Fixed income: Payments fixed or determined by a formula
- Money market debt: Short term, highly marketable, and low risk
- Capital market debt: Long term and safe or risky
- Common stock: Equity or ownership in a company
- Derivatives: Value derives from prices of other securities such as stocks and bonds. Used to transfer risk.
The Investment Process
Asset allocation: Choice among broad asset classes
Security allocation: Choice of which securities to hold within asset class. Security analysis to value securities and determine investment attractiveness.
The Players
Business Firms: Net borrowers
Households: Net savers
Governments: Borrowers or savers
Financial intermediaries: Pool and invest funds and are: investment companies, credit unions, banks, and insurance companies.
Universal Bank Activities
Investment: Underwrite new stock and bond issues, sell newly issued securities to the public in the primary market, investors trade previously issued securities among themselves in the secondary market
Commercial: Take deposits and make loans.
Financial Crisis of 2008
Antecedents: The great moderation was a time in which the US had a stable economy with low interest rates.
Changes in housing Finance:
- Old Way: Local thrift institution made mortgage loans to homeowners, thrifts major asset is a portfolio of mortgage loans and liability is the deposits, originate to hold
- New Way: Mortgage-backed securities against the underlying mortgage pool, originate to distribute.
Mortgage Derivatives
Mortgage pool divided into slices or tranches to concentrate default risk:
- Senior: Lower risk, high rating.
- Junior: High risk, low or junk rating.
Problem: Ratings were wrong. Risk was much higher than anticipated, even the senior tranches. Why was credit risk underestimated?
- No one expected the market house to collapse at once
- Geographic diversification did not reduce risk
- Agency problems with ratings agencies
- Credit default swaps did not reduce risk.
Credit Default Swaps
It is an insurance contract against the default of the borrower. Investors used CDS to protect their safety. Some big swap issuers did not have enough capital to back their CDS when the market collapsed so CDS insurance failed.
Systematic Risk
Is a potential breakdown of the financial system in which problems in one market spill over and disrupt others. Banks have a mismatch between the maturity and liquidity of their assets and liabilities:
- Liabilities were short and liquid
- Assets were long and illiquid
- Constant refinance of the asset portfolio.
Then Banks were highly levered, giving them no margin. Solution: Add liquidity to reduce insolvency risk and break a vicious circle of valuation, increase transparency of structure like CDS contracts, change incentives to discourage excessive risk taking and reduce agency problems at rating agencies.
Asset Classes and Financial Instrument
(A) Money Markets
Subsector of the fixed income market: Short term, low risk, liquid, and large denominations. Money market mutual funds allow individuals to access the money market.
- Treasure bills: Short-term debt of US government
- Certificates of deposit: Time deposit with a bank
- Commercial paper: Short term, unsecured debt of a company
- Bankers acceptances: An order to a bank by a banks customer to pay a sum of money on a future date
- Eurodollars: Dollar-denominated time deposits in banks outside the US
- Repos and reverses: Short-term loan backed by government securities
- Fed funds: Very short-term loans between banks.
(B) Bond Market
- Treasury notes and Bonds: Maturities: bonds: 10-30 notes: 10 par value= 1000$ interest paid semiannually quotes are percentage of par
- Inflation protected Treasury Bonds
- Federal agency debt: Debt of mortgage-related agencies
- International bonds: Eurobonds, yankee bonds: Foreign bonds denominated in US dollars and issued in the US by foreign banks and corporations
- Municipal bonds: Issued by state and local bonds. Interest in exempt from federal income tax and sometimes from state and local tax. Types: General obligation: Backed by taxing power of user. Revenue bonds: Backed by projects revenues or by the municipal agency operating the project
- Mortgage backed securities: Proportional ownership of a mortgage pool or a specific obligation secured by a pool produced by securitizing mortgages. Also called pass-through because the cash flows produced by homeowners paying off their mortgages are passed through investors.
(C) Equity securities
- Common stock: Ownership, residual claim, limited liability
- Preferred stock: Fixed dividends, priority over common.
(D) Derivatives markets
- Options:
- Call: Right to buy underlying asset at the strike price or exercise. Value decreases as strike price increases.
- Put: Right to sell underlying asset at the strike price or exercise. Value of puts increase with strike price.
How Securities are Traded
How firms issue securities
: (1) primary market: firms issues new securities through underwriter to public. investros get new securities and firms get funding. (2) secondary market: investors trade previously issued securities among themselves. Stocks: IPO, seasoned offering. Bonds: public offering, private placement.
Investment banking: Underwriter: investment bank heps the firm to issue and market new securities.
Prospectus: describes the issue and the prospects of the firm. Firm commitment: investment bank purchases securities from the issuing company and then resells them to the public. Private Placements: firms uses underwriter to sell securities to wealthy investors, cheaper than public offerings, not traded in secondary mkts. Initial Public Offerings: road shows to publicize new offering, book builgind to determine demand for the new issue, degree of investors interest in the new offering provides valuable pricing information.
Types of Markets I: Direct search: buyers and selers seek each other Brokered markets: brokers search out buyres and sellers. Types of Market II: Dealers mkt: dealers have inventories of assets from which they buy and sell. Auction mkt: traders converge at one place to trade.
Ask Price: represents offers to sell. in the dealer mkt, is the price at which the dealer is willing to sell. investors must pay the ask price to buy the security. Bid Price: offers to buy. in the dealer markets is the price at which the dealre is willing to buy. bid-aske spread is the profit for making a mkt in a security.
Type of orders: Market: executed immediately, trader receive current market price. Price-contingent: traders specify buying or selling price
Trading Mechanism: Dealers markets: where traders specializing in particular commodities buy and sell assets for their own accounts. Electronic communication networks: true trading system that can automatically execute orders. Specialist markets: market in a stock made solely by the specialist, as no public orders and henceforth no depth, exist in market. maintain a fair and orderly market.
Trading costs: (1) brokerage commission: fee paid to broker for making the transaction, explicit cost of trading, full service vs discount brokerage. (2) spread: differnet between the bid and asked prices, implicit cost of trading (3) impact
Buying on Margin: borrowing part of the total purchase price of a position using a loan from a broker . investors contributes the remaining portion.
margin refers to this portion contributed by the investors, you profit when the stock appreciates
Maintenance Margin: minimum equity that must be kep in the margin account. margin call if the value securities fall too much.
Short Sales: Purpose: profit from a decline in the price of a stock or security Mechanics: borrow through a dealer, sell it and deposit proceeds and margin in an account, closing out the position is buy the stock and return to the party from which it was borrowed
1.4 mutual fund and investment companies
Investment companies: pool funds of individual investors and invest in a wide range of securiteis or other assets. Services provided: administation and recor keeping, diversification and divisibility, proffessional management, reduced transportation costs. Types: (1)Uni trust: fixed portffolio of uniform assets, unmanaged (2)managed investment companies: (A)open-end: fund issues new shares when ivestors buy in and redeems shares when investors cash out, priced at NAV (B)closed-end: no change in shares outstanding, old investors cash out by selling to new investors, price at premium or discount NAV (3)REIT: invest in real state or loans secured by real estate andissue shares in such investment, similar too closed and mutual funds (4) hedge funs
How are sold: (1)direct marketed funds (2)sales force distributed: revenue sharing on sales force ditributed, potential conflict of interest (3)financial supermarket: a company offering a wide variety of financial services such as a combination of banking services, investment services and insurance brokerage.
Cost of investing (fee structure): (1)operating expenses: cost incurred by the mutual fund in operating the portfolio (2) fron end load: commission or sales charge paid when you purchase the shares (3)back-end load: redemption or fee incurred when you sell the shares (4) 12 b-1 charge: fund assets may be used to pay for distribution costs advertising, promotional, literacy, annual reports, prospectus and broker commisions.
Late trading: accepting buy or sell orders after the market closes and NAV is determined
Market timing: rapid-in-and-out trading on stale net aset values, net effect is to transfer value from ordinary shareholders to priviledge traders, mutual funds are penalized for improper tradign stale price is an old price of the asset that does not reflect the most recent information.
Exchange traded funds(ETF): potential advantages; trade continously like stocks, can be sold short or purchased on margin, lower costs, tax efficient. potential disadvantages: prices can depart by amounts from NAV, must be purchased from a broker.
1.5 Hedge funds
Mutual Funds: transparency: regulations require public disclosure of strategy and portfolio composition, number of investors is not limited, investment strategy: predictable, stable strategies, stated in prospectus; limited use of shorting, leverage, options; liquidity: can often mover more easily into and out of amutual fund; compensation structure: fees are usually a fixed percentage of assets, typically 0.5% to 1,5%. Hedge Fund: transparency: limited liability, only minimal disclosure of strategy and portfolio composition. often no more than 100 wealthy investors. Investment strategy: very flexible, funds can act opportunistically and make a wide range of investments. often use shorting, leverage, options. liquitdity: often have lock-up periods. Compensation structure: a management fee of 1-2% of assets and an incentive fee of 20% of profits.
Strategies: directional: bets that one sector or another will outperform other sectors. no directional: exploit temporary misalignments in relative valuation across sectors, buy one type of security and sell another. strives to be market neutral.
Statistical arbitrage: uses quantitative systems that seek out many temporary and modest misalignment in prices. involves trading in hundreds of securities a day with short holding periods. pairs trading: pair up similar compnaies whose returns are highly correlated but where one is priced more aggressively. data mining to uncover systematic pricing patterns.
but where one is priced more aggressively. data mining to uncover systematic pricing patterns.Factor Exposure: many hedge funds have directional strategies in which the fund makes an otright bet. a directional fund will have significant betas on the factors on which it bets. market-neutral funds have insignificatn betas. dedicated short bias funds exhibit substantial negative betas on the S&P index. distressed firms have significant exposure to credit condition. global macro funds show negative exposure to a stronger dollar. Betas is the measure of an assets risk in relation to the market or to an alternative benchmark or factors. it represents the type of systematic risk that can not be diversified away.
Hedge fund surviviorship bias: (1)backfill: hedge funds report return only if they choose to and they may do so only when their prior performance is good (2)suvirvoship: failed funds drop out of the database ,hedge fund attrition rates are more than twice as large as those for mutual funds.
Fee structure: 2% of assets polus an incentive fee equal to 20% of invetment profits. incentive fees are fefectively call option on the portfolio with: X=(portfolio value)*(1+ benchmarket return). the manager gets the fee if the portfolio value rises sufficiently, but loses nothing if it falls. the fee struvture can give incentives to shut down a poorly performing fund. if a fund experiences losses, it may not be able to charge an incentive unless it recovers to its previous higher value. with deep losses, this may be too difficult so the fund closes.
2.1 Expected Utility Theory
neoclassical economics: (1)people have rational preferences across possible outcomes or states of nature (2)people maximize utility and firms maximize profits (3)people make independent decisions based on all relevant information. assumptions: completenesss and transitivity.
expected utility: theory is really set up to del with risk not uncertainty: risk is when you know what outcomes could be, and can assign probabilities. uncertaitny is when you cant assign probabilites, or you cant come up with a list of possible outcomes.
prospects: is defined as a series of wealth or income levels associated probabilities. prospect=( PRa, Wa, Wb) U(p)= PRa*u(Wa)+(1-PRa)*u(Wb)
Properties: upward-sloping. unique up to a positive linear transformation. differentiability implying continuity.
Risk aversion: this assumption comes from frequent obsevation that most people most of the time are not willing to accept a fair gamble. risk aversion implies concavity.
certainty equivalents: is defined as that wealth level which leads decision maker to be indifferent between a particular prospect and a certain wealth level.
Problems: a number of violations of expected utility have been discovered. alternative theories have been develped which seek to account for these violations. best-known is prospect theory.
2.2 Asset pricing, Mkt efficiency and Agency relationship
Portfolio risk and return: return is a weighted average of return of individual securiteis. risk is less than a weighted average of risks of individual securiteis, provided correalations are less than one. the lower correlations are, the lower is the risk of a portfolio.
CAPM: is an equilibrium model: it brings all investors together. only risk related to market moverments is priced by market. this is because all other risk can be divesified away. beta is measure of nondiversifiable risk for a security.
Market Efficiency: value is what a security should be worth based on careful analysis. price is what the market says is worth. the relationship between them if markets are efficient: (1)older: value and price are always identical (2)realistic: sometimes differ a little.
Operational definition: financial markets are efficient if no one can consistenly earn excess returns after risk and after-cost( transaction & analysis)are factor in.
What should be true it markets are efficient? security prices shoul respond quickly and accuraately to new information. professional investors should not outperfom net of all fees. simulated trading strategies should fail.
Mkt effiency and available info: weak-form: historical prices and returns. semi-strong: all public info. strong form: all information, including private information.
Joint hypothesis: all test of market efficiency have 2 hypotheses: markets are efficient, a fair return on a security or portfolio is from a particular model. rejection means: markets are not efficient, method for calculationg fair returns is faulty or Both.
Agency problems: agency relationship exist whenever someone (principal) contract with someone else (the agent) to take actions on behalf of the principal and represents the principal’s interest. the agent has authority to make decisions for the principal. an agency problem arises whten the agent´s and principal´s incentives are not aligned.
Agency cost: are cost that are incuredd because managers’ incentives are not consistent with maximizing value of firm. Types: (1) direct: need to monitor managers, including cost of hiring outside auditors. (2) indirect: managers of a firm that is an acquisition target may resit the takeover attempt becasue of concern about keeping their jobs.