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					     Lecture 1:
  INTRODUCTION
The Investment Environment,
  Markets, Instruments and
    Financial Institutions

                          1
  Role of Financial Assets and
   Markets in the Economy
  Financial assets are claims on real assets.
  They allow for:
• Consumption Timing
• Allocation of Risk
• Separation of Ownership




                                            2
How the Financial System Meets
   the Needs of Participants
•   Financial Intermediation
•   Investment Banking
•   Financial Innovation & Derivatives
•   Responding to Regulation & Taxes




                                         3
              Key trends

• Globalization
• Securitization
• Financial Engineering




                           4
Three Traditional Barriers to
International Stock Trading
                 Transaction
                    Costs




               Classic Barriers
               To Capital Flow


 Information                      Exchange Risk
    Costs                            Costs
                                                  5
             The Future
• Globalization continues and offers more
  opportunities
• Securitization continues to develop
• Continued development of derivatives
  and exotics
• Integration of investments & corporate
  finance



                                            6
7
8
Financial Markets
 and Instruments
                    9
 Major Classes of Financial Assets
           or Securities
• Debt
  – Money market instruments
  – Bonds
• Common stock
• Preferred stock
• Derivative securities



                                     10
      Where are they traded?
• Money Market
  – Debt Instruments (Treasury bills, Certificates of
    deposit, Commercial Paper, Bankers Acceptances,
    Eurodollars, Repurchase Agreements (RPs) and
    Reverse RPs,..)
  – Derivatives
• Capital Market
  – Bonds
  – Equity
  – Derivatives


                                                        11
    Fixed Income Instruments
• Publicly Issued Instruments
  – Treasury Bonds and Notes
  – Agency Issues (Gov)
  – Municipal Bonds
• Privately Issued Instruments
  – Corporate Bonds
  – Mortgage-Backed Securities


                                 12
                    Equity
• Common stock
  – Residual claim
  – Limited liability
• Preferred stock
  – Fixed dividends - limited
  – Priority over common




                                13
        Derivatives Securities
Options               Futures
• Terms               • Terms
  – Exercise Price      – Delivery Date
  – Expiration Date     – Assets
  – Assets




                                          14
            Market Index

• 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?
                                        15
              Examples
• Dow Jones Industrial Average (30 Stocks),
  Standard & Poor’s 500 Composite, NASDAQ
  Composite, NYSE Composite, Wilshire 5000
• Nikkei 225 & Nikkei 300, FTSE (Financial
  Times of London), Dax, Region and Country
  Indexes (EAFE, Far East, United Kingdom)
• BOND INDICES: Lehman Brothers, Merrill
  Lynch, Salomon Brothers, Specialized
  Indexes (Merrill Lynch Mortgage)
• SBI 20, PIX, IPT, BIO, SBINT, PUBIX...
                                              16
Example: SBI20 and BIO




                         17
      Construction of an Index
• How are stocks/bonds weighted?
  – Price weighted (DJIA)
  – Market-value weighted (S&P500, NASDAQ)
  – Equally weighted (Value Line Index)
• How are returns averaged?
  – Arithmetic (DJIA and S&P500)
  – Geometric (Value Line Index)

  http://en.wikipedia.org/wiki/Dow_Jones_Industrial_Average


                                                              18
         Averaging Methods
Component Return
  A=10%          B= (-5%)          C = 20%
Arithmetic Average
  [.10 + (-.05) + .2] / 3 = 8.33%
Geometric Average
  [(1.1) (.95) (1.2)]1/3 - 1 = 7.84%


                                             19
20
How Securities
  are Traded

                 21
     Role of financial markets
• match supply and demand of financial
  assets.
  – stocks, bonds, commodities, derivatives
  – Is demand for stocks important?
• there are transaction costs!




                                              22
     Market capitalization as % of GDP (end
                      2000)                                                Finska
                                                                    242%   Nizozemska
                                                             200%
                                                                           Francija
                                             109%
                                       97%                                 Grčija
                                     89%
                                                                           Evroobmočje
                               79%
                               77%                                         Belgija
                             70%
                                                                           Irska
                            68%
                      56%                                                  Italija
              35%
                                                                           Nemčija
           25%
          21%                                                              Portugalska
         19%
                                                                           Estonija
         15%
        14%                                                                Madžarska
        14%
                                                                           Češka
      8%
     4%                                                                    Poljska

                                                                           Avstrija

                                                                           Slovenija
0%              50%                  100%           150%   200%     250%
                                                                           Litva
                                                                                         23
                                                                           Latvija
     Classification of markets

• Primary vs. secondary
  – IPOs, seasoned offerings
  – public offerings vs. private placements
• Money vs. capital markets




                                              24
     Organization of Secondary
             Markets
•   Organized exchanges
•   OTC market
•   Third market
•   Fourth market




                                 25
     1. 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, LSE, LJSE, BSE, …
                                           26
           2. OTC Market
• Dealer market without centralized order
  flow
• NASDAQ: largest organized stock market
  for OTC trading; information system for
  individuals, brokers and dealers
• Securities: stocks, bonds and some
  derivatives


                                        27
             3. Third Market
• Trading of listed securities away from the
  exchange
• Institutional market: to facilitate trades of
  larger blocks of securities
• Involves services of dealers and brokers




                                                  28
            4. Fourth Market
• Institutions trading directly with institutions
• No middleman involved in the transaction
• Organized information and trading
  systems
• ECN Development:
  – INSTINET
  – POSIT


                                                29
   I. Organization of financial
            markets
• Periodic vs. continuous trading
• Price driven vs. order driven
• Other aspects
  – centralization
  – transparency
  – regulation
                                    30
Periodic vs continuous trading
• Periodic trading: batch auctions
  – often used for initial offerings of stocks and
    bonds
  – also for secondary markets with low
    turnover
• Continuous trading
  – for secondary markets with high turnover,
    like equity markets (e.g. AEX), foreign
    exchange
• Some continuous markets start or close
  trading sessions with a batch auction
  – Euronext, NYSE                               31
 A: Price / quote driven markets
• Limited number of professional market
  makers provide bid and ask quotes
  – buy and sell prices
• Other participants trade with market
  makers
• Quotes may be firm or indicative
• Market makers trade for own account

                                          32
        Price driven markets
• Examples
  – London Stock Exchange
  – NASDAQ
  – foreign exchange market
  – bond market




                               33
    B. Order driven markets
• Limit order market: liquidity is provided
  by public limit order book
  – continuous double auction
• trading is against these limit orders
• Examples:
  – Euronext, Xetra (Frankfurt)
• Open outcry markets
  – trading on orders provided by trading
    crowd
  – often used in futures and option markets   34
     Hybrid trading structures
• Pure price and order driven markets are
  rare, most exchanges are mix of both
  – NYSE has one specialist for each stock,
    competes with public limit orders
  – AEX used to have similar system (hoekman)
  – London Stock Exchange and NASDAQ
    recently introduced limit orders that compete
    with market makers


                                                    35
       Recent developments
• General tendency towards hybrid systems
  and separation by order size
  – limit order system for small trades
  – quote driven systems for large trades
• Motivated by
  – competition between exchanges
  – execution costs


                                            36
   II. Quality of markets
• Execution costs
  – explicit costs: fees, taxes
  – implicit cost: bid-ask spread
• Liquidity
  – price impact of trade
  – risk of non-execution
  – resiliency (speed of price recovery)
• Price efficiency
                                           37
   Quality of markets (2)
• Transparency
  – large differences in pre-trade and post
    trade transparency among markets
  – e.g. EURONEXT very transparent, foreign
    exchange market not at all
• Privileges for specialist
  – NYSE: only specialist knows limit order
    book and may “stop” orders

                                              38
        Quality of markets (3)
• Fragmentation of order flow
  – off exchange trading
  – dual or multiple listings
  – mergers of exchanges




                                 39
Ljubljana stock exchange?

                       Block
         On exchange   trades   Off exchnage
  year       (%)        (%)          (%)

  2002       40         26          34

  2003       37         24          39

  2004       33         22          45

  2005       26         33          41

                                               40
        Quality of markets (4)
• Regulation of prices
  – priority rules (price/time)
  – tick size
  – circuit breakers




                                  41
       Regulation of Securities
              Markets
•   Government Regulation
•   Self-Regulation
•   Circuit Breakers
•   Insider Trading




                                  42
           Types of Orders
  Instructions to the brokers on how to
  complete the order
• Market
• Limit
• Stop loss




                                          43
            Margin Trading
• Using only a portion of the proceeds for an
  investment
• Borrow remaining component
• Margin arrangements differ for stocks and
  futures




                                            44
                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 it was borrowed


                                                      45
Mutual Funds
  and Other
 Investment
 Companies
               46
       Services of Investment
            Companies


•   Professional management
•   Administration & record keeping
•   Diversification & divisibility
•   Reduced transaction costs


                                      47
           Net Asset Value
Used as a basis for valuation of investment
 company shares
  – Selling new shares
  – Redeeming existing shares
Calculation:
 Market Value of Assets - Liabilities
        Shares Outstanding

                                              48
        Types of Investment
           Organizations
• Unit Trusts
• Managed Investment Companies
  – Open-End
  – Closed-End
• Other investment organizations
  – REITs



                                   49
     Open-End and Closed-
   End Funds: Key Differences
Shares Outstanding
• Closed-end: no change unless new stock is
  offered
• Open-end: changes when new shares are sold
  or old shares are redeemed
Pricing
• Open-end: Net Asset Value(NAV)
• Closed-end: Premium or discount to NAV

                                               50
51
  Costs of Investing in Mutual
             Funds

• Fee Structure
   – Front-end load
   – Back-end load
• Operating expenses
• Fees and performance




                                 52
     Exchange Traded Funds
• Allow investors to trade funds based on
  indexes like stock.
• Examples
  – SPDRS
  – WEBS
  – HOLDERS
• Allow sector or regional specialization


                                            53
   Types of Exchange-Traded
         Funds (ETFs)
• Cube (QQQQ)
  – Tracks Nasdaq100 index
  – Traded on Amex
  – Investors may speculate on future of technology
    stocks
     • Purchase on margin
     • Sell short
• Spider (S&P Depository Receipt)
  – Tracks S&P 500 index
  – Trade at one-tenth S&P 500 Index level
  http://www.morningstar.com/Cover/ETF.html
                                                      54
        A First Look at Fund
           Performance
• Benchmark: Wilshire 5000
• Results
  – Most funds underperform
  – Not fair comparison because of costs
• Adjusted Benchmark: Wilshire 5000 with
  passive management costs considered.
  – The majority of funds still under-perform.


                                                 55
        Consistency of Fund
           Performance
  Do some mutual funds consistently
  outperform?
• Evidence suggests that some funds show
  consistent stronger performance.
  – Depends on measurement interval
  – Depends on time period
• Evidence shows consistent poor
  performance.

                                           56

				
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