15.433 investments class 1: introduction · pdf fileclass 1: introduction spring 2003. outline...
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15.433 INVESTMENTS
Class 1: Introduction
Spring 2003
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Outline
• Course Overview
• Market Overview
• Introduction to the Financial System
• Overviews of Equity, Fixed Income, Currencies and Derivatives
• Financial Innovations
• Summary
• Questions for Next Class
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Course Mechanics
Course Grade:
Class participation 10%
5 group assignments 20%
Mid-tern exam 30%
Final exam 40%
Course Materials:
• Lecture Notes
• Textbook: Bodie, Kane and Marcus
• Articles in course reading packet
• Additional reading materials and handouts
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Course Overview
Broadly speaking, this course will cover the following give themes:
• Financial theories: Portfolio theory, the CAPM and the APT
• Equity and equity options, and empirical evidence
• Fixed income instruments and fixed income derivatives, credit mar-
ket and credit derivatives
• Market efficiency and active investments
• A brief introduction to behavioral finance
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Course Objectives
Through this class I want to help you build the following skills:
• Analytical ability: modeling skills that are important in making
investment decisions,
• Quantitative skills: developing problem solving skills, data analysis,
probability evaluation of uncertain events.
• Empirical knowledge of the financial markets: equity, fixed income
(default-free and defaultable) and their respective derivatives.
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The Financial System
The financial system can be viewed from two different angles:
• Institutional perspective: the financial system encompasses the mar-
kets, intermediaries, instruments, clients etc.; and
• Functional perspective: the financial system facilitates the allocation
and deployment of economic resources, across time and space and in
uncertain environment.
While its institutional composition changes over time and space (dif-
ferent places on the globe), the basic functions of a financial system are
essentially the same in all economies. The institutional dimension results
from the functional needs.
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Functional Perspective
The financial system provides six functions:
• Transferring economic resources across time (e.g. student loans, re-
tirement funds) and space (global financial market, e.g. institutional
investments)
• Clearing and settling payments to facilitate trades: money, check,
ATM cards, mortgages and mortgage interest payments, etc.
• Pooling of resources to undertake large-scale indivisible enterprise
(equities, money market funds, mutual funds etc.)
• Information to coordinate decision-making, facilitating information
flow, ”price discovery”, the normal indices for equities, fixed income
rates, volatilities etc.
• Dealing with agency problems, mitigate moral hazard, adverse selec-
tion and principal-agent based problems that are caused by asym-
metry information or incentive mis-matches (collateralization, CEO
incentive for company performance etc.).
• Managing risks, bundling, packaging, pooling and tranching of risk
(insurance companies, CMO, CDO, exotic derivatives etc.)
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Institutional Perspective
The institutional compositions of the financial system includes:
• Financial markets: equity, fixed income (debt), credits and deriva-
tives
• Financial intermediaries: banks, insurance companies, pension funds,
mutual funds, investment banks, venture capital firms, asset man-
agement firms and information providers etc.
• Financial infrastructure and regulation: trading rules, contract en-
forcement, account system, capital requirements etc.
• Governmental and quasi-governmental organizations: SEC, central
banks (Federal Reserve System), the Bank for International Set-
tlement (BIS), the International Monetary Fund (IMF), the World
Bank, etc.
International markets differ in many ways:
• The US market is currently the only market offering Financial Fu-
tures on individual stocks ;
• Germany closed the ”Neue Markt”, eliminating a platform for not
very liquid stocks, regarding stock exchanges inexperienced compa-
nies, thus rising capital is getting more difficult for young companies;
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• Investment attitudes and awareness are subject to national regu-
lations, e.g. pension fund regulation - defined benefit vs. defined
contribution plans.
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� �
Stocks
Common stocks, also known as Equities, represent ownership shares of
a corporation.
• Two important characteristics: residual claim and limited liability;
• Sources of returns: dividends and capital gains;
• Calculating returns: buy at time 0 and pay P0, sell at time T and
receive PT and dividend DT :
– The percentage return is calculated as:
PT + DT − P0 rT = (1)
PO
– The log-return is calculated as:
PT + DT rT = ln (2)
PO
For small rT , the log-return and percentage return are close.
Question: Why in some situations should we prefer to use log-
returns?
• Some determinants of stock returns:
– Firm-specific condition: management, productivity, earnings, growth-
potential, market-liquidity,
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– Market condition: market indices (volatility, volume etc.), e.g.
Nasdaq, SP500, DAX, FTSE etc.
– Economic condition: macro-economic variables, e.g. GDP-growth,
inflation, employment rate, business cycles, liquidity, interest
rates etc.
• Some important empirical evidence:
– Patterns in the cross-section of stock return: value (value vs.
growth), size (small vs. large), momentum (low vs. high);
– Time-series behavior of stock returns: time-varying expected re-
turns, predictability, stochastic volatility etc.
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Stocks and Bonds
SPX
-12%
-7%
-2%
3%
8%
9/6/
1993
11/6
/199
3
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1994
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0
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SPX
CCMP
-12%
-7%
-2%
3%
8%
9/6/
1993
11/6
/199
3
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1994
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0
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CCMP
SBTSY10
-12%
-7%
-2%
3%
8%
1/12
/199
5
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/199
5
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/199
5
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SBTSY10
Figure 1: Daily returns of SP 500-index, Nasdaq-index and T-Bonds 10 years
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30%30%
25%25%
20%20%
5% 5%
0% 0%
-5% -5% -0.080 -0.060 -0.040 -0.020 - 0.020 0.040 0.060 0.080
-0.080 -0.060 -0.040 -0.020 - 0.020 0.040 0.060 0.080 Daily Returns
Daily Returns Current Distribution Normal-Distribution
Current Distribution Normal-Distribution
Figure 2: Return distribution of US 10 Year Bond Figure 3: Return distribution of S&P 500 Index
Data source for Figures 1, 2, and 3: Bloomberg Professional.
Pro
bab
ilit
y
15%
Pro
bab
ilit
y 15%
10% 10%
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Fixed Income
Fixed income, also known as debt-instruments, promise to pay fixed,
pre-determined stream of cash flows in the future: Coupon payments,
Principal amount (denominations), Time to maturity, Sinking fund obli-
gations, etc.
Figure 4: Cash Flows, Source: RiskM etricsTM , Technical Document, p. 109
Figure 5: Discounted Cash Flows, Source: RiskM etricsTM , Technical Document, p. 109
Treasury bills, notes and bonds vary in maturity. T-bonds may also be
callable during a given period.
The value of a bond can be reported in terms of price or yield to matu-
rity. Yield go and price go.
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Market Performance
Monthly returns 1926/7 to 2000/12
Equity Portfolio∗ Treasury Bills
Mean 0.99% 0.31%
Standard Deviation 5.50% 0.26%
Total Return $1’828 $16.27
* Value-Weighted
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The Term-Structure of Interest Rates(Yield-Curve)
Yie
ld C
urve
s fo
r U
S T
reas
ury
9
8
7
6
5
4
3
2
1
03 Mo 6 Mo 1 Yr 2 Yr 3 Yr 4 Yr 5 Yr 6 Yr 7 Yr 8 Yr 9 Yr 10 Yr 15 Yr 20 Yr 30 Yr
1.1.1995 1.1.1996 1.1.1997 1.1.1998 1.1.1999 1.1.2000 1.1.2001 1.1.2002 1.1.2003
Figure 6: Treasury Yield Curve, Source: Bloomberg Professional.
How do we describe the term-structure:
• Shift
• Twist
• Butterfly
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The Federal Funds Target Rates (set by FOMC) and the Discount Rates:
8.00
7.00
6.00
5.00
4.00
3.00
2.00
1.00
0.00
1/1/
1991
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FOMC 3 Month LIBOR
Figure 7: Short Term Interest Rates FED, Discount rates over the last 4 years, Source Bloomberg Professional.
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Corporate Bonds
Corporate bonds are similar in structure to Treasury issues, with one
important difference: default risk.
• Because of the default risk, corporate bonds are cheaper (than their
respective Treasury counterparts), paying higher yields.
• The difference in yields is referred to as credit spread.
• The probability of default varies across firms of different credit qual-
ities (e.g. countries, industries, guarantees etc.)
• The probability of default varies over time!
Figure 8: Standard & Poor’s one year transition matrix, Source: RiskM etricsTM − T echnical Document, p.
69.
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Derivatives
Overview of Derivatives by Structure:
• Forward and Futures;
• Options;
• Futures;
• Path dependent (e.g. look-back), etc.
Overview of Derivatives by Underlying:
• Equity Derivatives: stock options, index futures, futures options etc.;
• Fixed-Income Derivatives: caps/floors, swaps, swaptions, etc.;
• Credit Derivatives: credit swap, collateralized loan obligations, etc.;
• Other derivatives: FX, weather, ”exotics”, etc.
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Currencies
Currencies are the most liquid financial instrument.
Currency instruments have generally spoken the same type of parame-ters, however with different characteristics, e.g. currency return volatil-ity, which is not shaped in the same form as the equity return volatility.
Currency positions usually have a much shorter maturity proprietary traders on Wall Street take positions up to half an hour!
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Financial Innovation
Does financial innovation add value? If taken to excess, any virtue can
readily become a vice: The market has seen examples of failed financial
products, erroneous assumption and strategies, abusive usage of deriva-
tives, distressed hedge funds etc. Empirical evidence supports the state-
ment, that financial innovation does provide social wealth:
• It caters to the investment diversity desired by the investors;
• It improves the opportunities for investors to receive efficient risk-
return trade-offs;
• It provides risk management tools for all market participants; and
• It promotes broad distribution and liquidity to economic resources.
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Securitization
Figure 9: Securitization of ”stand-alone” mortgages in liquid standardized mortgage-backed securities.
Securitization of the mortgage market: The national mortgage market
and mortgage-backed securities transform the residential house finance
from fragmented, local-based sources to a free-flowing, international base
of capital with depth and usually a higher credit rating.
Other examples: collateralized debt (loan or bond) obligations, asset
backed debt, etc.
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Credit Enhancement
FleetBoston plays ”Good Bank/Bad Bank,” unloading $1.35 Billion in
troubled Loans Patriarch Partners LLC, a NY fund management bou-
tique, created a CLO to raise about $1 billion to acquire the loans.
See the following figure how FleetBoston’s problem loans made their way
from Fleet’s books to a special collateralized-loan obligation, funded by
investors.
$ 925 million in triple-A rated bonds $ 275 million (face value)
$ 75.75 million in single-A rated bonds in Ark subordinated securities
$ 35.5 million of equity
FleetBoston Patriarch Patriarch
million c $ 7
ash 25
Partner's Ark CLO
Partner's Ark CLO
$ 1.35 billion in funded loans plus $ 1.036 billion cash $ 150 million in unfunded loans
Figure 10: Setting-up a special purpose vehicle.
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Summary
What to learn in this course? Analytical modeling skills, quantitative
tools, and empirical knowledge about the financial market and the fi-
nancial instruments.
How to think about the financial system?
• Functional perspectives: across time and space;
• Institutional compositions: results from the functional needs.
• Does financial innovation add value?
• Sometimes abusive usage of financial innovation causes disruptions.
Overall, however, financial innovation provides diversified in-vestment
opportunities for investors, risk management tools and techniques for
market participants and liquidity to the overall market.
Focus:
BKM Chapters 1 & 2;
• p.16/17 (market structure);
• p.19 (securitization);
• p.28-46 (know the different instruments, e.g. CD, CP, Bankers Ac-
ceptances etc.);
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• p.48-54 (know the most important market indexes, what kind of
different weighting-schema exist etc.);
Reader: Sharpe (1995);
Type of potential questions: p. 60ff. questions 1, 5, 11, 17, 23
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Preparation for Next Class
Please read:
• BKM Chapters 3 & 5,
• Fama (1995), and
• Kritzman (1993).
Questions:
• What is a normal distribution?
• How do we model uncertainty?
• Is variance the only measure of uncertainty?
• What is the average daily return?
• What about the average variability?
• What assumptions did you have to make in order to obtain the
estimates?
• How accurate are your estimates?
• If given more observations (a large N), can you improve the precision
of your estimates?