Asset Allocation Process of building an investment portfolio by deciding how much money to allocate

to broad classes of assets

Money Market - Cash Equivalent/Cash (short-term, marketable, liquid, low-risk debt securities)
Capital Markets - Longer term bond markets, equity markets, derivative markets for options and
futures (long-term and risk securities)

Economics 122
FINANCIAL ECONOMI CS (LECTURE 2)
M. DEBUQUE - G ONZ ALES
AY2014 -201 5

SO U RCE: BO DIE, Z ., A . KA NE, A ND A . MA RCU S, 2009. INVES TM EN TS . 8TH

E D I T I O N . N Y: M C G R A W - H I L L / I R W I N .
Who, What, Where, Why

How Firms Issue Securities

Firms issue securities to raise capital to finance investment
/sell
Investment bankers market these securities to the public
on the primary market <- Newly-issued securities
◦ They act as underwriters who purchase the securities - Assume risk
from the firm and resell them to the public at a mark-up
Underwriter - buy stuff at a discount, but guarantee will buy and sell at a markup
Already issued securities are traded on the secondary
market (e.g. organized stock exchanges, the over-the-
counter market, or for large trades, through direct
negotiation) Ex: Make some money and sell your shares to another investor
How Firms Issue Securities
Initial public offerings vs. seasoned equity
offerings
o IPOs are stocks issued by a formerly privately owned
company going public for the first time.
o Seasoned equity offerings are offered by companies
that have already floated equity.
Sale of additional shares in firms that already are publicly traded
Seasoned issues/Additional offerings

Check Recording
How Firms Issue Securities
Public offering vs. private placement - Where it is sold privately
o Public offering refers to an issue sold to the general
investing public that can be traded on the secondary
market.
o Private placement refers to an issue that is usually sold
to one or a few institutional investors and is generally
held to maturity.
Cheaper than public offerings.
Less suited for very large offerings.
Not traded in secondary markets like stock exchanges and
therefore less liquid (ergo lower prices).:. cheaper price since less
attractive since less liquid
* Shelf Registration

Investment Banking
Public offerings of both stocks and bonds typically marketed
by investment bankers, playing the role of underwriters.
More than one investment banker markets the securities
Underwriting syndicate – a group of investment bankers
formed by the lead firm to share the responsibility for the
stock issue (pricing and marketing)of the security
Prospectus – describes the issue and the prospects of the
company and states the price at which the securities will be
offered to the public Terms to sell the securities
Firm Commitment minus what they sell
Firm commitment – in a typical underwriting arrangement,
the investment bankers buy the securities from the issuing
company at a price lower than the public offering price
(spread serves as compensation to the underwriters)
 Initial Public Offerings
Road shows – investment bankers travel to
publicize the imminent offering
o Generates interest among potential investors and
provides info about the offering.
o Provides info to the company and its underwriters
about the price at which they can market the securities.
Book - Indications of interest
Book-building – process of polling potential
investors regarding their interest in the offering
o Rewards truth telling since shares of IPOs are allocated
across investors based on the strength of their
expressed interest in the offering.
Useful insights about the market demand for the security & prospects of the firm & competitors
 Initial Public Offerings
IPO underpricing
Bec of first day kick, how much it’ll actually make on the first day
o Common practice as the underwriters need to offer the
security at a bargain price to investors to induce them to
participate in book-building and share their info
(reputation as capital).
o In the Philippines, average 1st-day returns is above 20%
(Ritter, 2005).
o Are people overly optimistic about IPOs?
Such underpricing is reflected in the price jumps that occur on the date when the shares are
first traded in public security markets
Types of Markets
Least organized market. Sporadic participation & low-priced nonstandard goods
Direct search markets – buyers and sellers must seek each
Ex: Craiglist
other out directly (e.g., through newspaper advertisements).
Where trading in a good is active. Develop specialized knowledge on valuing assets
Brokered markets – for a profit, brokers offer search services
to buyers and sellers (e.g., the primary market where
investment bankers serve as brokers) Ex: Real Estate
When trading activity in a particular type of asset increases
Dealer markets – dealers specialize in various assets, buy
them for their own accounts, then sell them for profit from
their inventory (e.g., over-the-counter (OTC) securities
markets); saves on search costs (can easily look up dealers)
market participants are not buying from and
o Bid price – dealers’  buy  price selling to one another directly but through a
o Ask price – dealers’  sell  price dealer, who, in the case of the Nasdaq, is a
market maker.
o The  “bid-ask  spread  “is  the  source  of  profit  of  dealers.
Types of Markets
Auction markets – traders converge at one place
(physically or electronically) to buy or sell an asset (e.g.,
organized stock exchanges)
o One need not search across dealers to find the best price.
o Can arrive at mutually agreeable prices and save the bid-ask
spread.
o Organized stock exchanges are also secondary markets.
Brokerage firms – these firms hold licenses that allow them
to trade on the exchange, sell their services to individuals,
charging commissions for executing trades on their behalf
OTC DEALER markets & stock exchanges are secondary markets.
They are organized for investors to trade existing securities among themselves
Types of Orders Types of Trades

Market orders: Buy or sell orders that are to be executed

immediately at current market prices
Price-contingent orders: These specify prices at which
investors are willing to buy or sell a security
Limit orders
◦ Limit-buy order: instructs the broker to buy some number of
shares if and when the stock may be obtained at or below a
stipulated price
◦ Limit-sell order: instructs the broker to sell some number of
shares if and when the stock price rises above a specified
limit You think it’s already the peak since the price might start to fall
*Limit order book: a collection of limit orders waiting to be
executed (best/highest bid and best/lowest ask price on
top,  called  ‘inside  quotes’)
Types of Orders
Stop orders:
Order lets the stock be sold to stop further losses from accumulating
◦ Stop-loss order: the stock is to be sold if its price falls below
a stipulated level
◦ Stop-buy order: a stock should be bought when its price rises
above a limit
*Note: these trades often accompany short sales (sales of
securities you don't own but have borrowed from your
broker) and are used to limit potential losses from the short
position
Price-contingent orders
Action\Condition Price BELOW the limit Price ABOVE the limit
BUY Limit-Buy Order Stop-Buy Order
SELL Stop-Loss Order Limit-Sell Order
Concept Check
What type of trading order might you give to your broker in each
of the following circumstances?
◦ You want to buy shares of company XXX, Inc. to diversify your
portfolio. You believe the share price is approximately at the
“fair”  value,  and  you  want  the  trade  done  quickly  and  cheaply.    
◦ Answer: Market order (executed immediately and is the
cheapest type of order in terms of brokerage fees)
◦ You want to buy shares of company YYY, Inc. but believe that
the current stock price is too high given the firm's prospects. If
the shares could be obtained at a price 5% lower than the
current value, you would like to purchase shares for your
portfolio.
◦ Answer: Limit-buy order (executed only if the shares can be
obtained at a price about 5% below the current price)
Concept Check
What type of trading order might you give to your broker in each
of the following circumstances?
◦ You plan to purchase a condominium sometime in the next
month or so and will sell your shares of company ZZZ, Inc. to
provide the funds for your down payment. While you believe
that the share price is going to rise over the next few weeks, if
you are wrong and the share price drops suddenly, you will not
be able to afford the purchase. Therefore, you want to hold on
to the shares for as long as possible, but still protect yourself
against the risk of a big loss.
◦ Answer: Stop-loss order (executed if the share price starts
falling, limit or stop price should be close to the current price
to avoid the possibility of large losses)
Concept Check
If you place a stop-loss order to sell 100 shares of stock at
$55 when the price is $62, how much will you receive for
each share if the price drops to $50?
◦ A. $50, B. $55, C. $54.87, D. Cannot tell from info given.
◦ Answer: D. Your broker will sell, at current market price,
after the first transaction at $55 or less.
Concept Check
Here is some price information on Filcorp stock. Suppose that Filcorp
trades in a dealer market.
Bid Asked
$55.25 $55.50
◦ Suppose you have submitted an order to your broker to buy at
market. At what price will your trade be executed?
◦ Answer: $55.50.
◦ Suppose you have submitted an order to your broker to sell at
market. At what price will your trade be executed?
◦ Answer: $55.25.
◦ Suppose you have submitted a limit order to sell at $55.62. What will
happen?
◦ Answer: The trade will not be executed.
◦ Suppose you have submitted a limit order to buy at $55.37. What will
happen?
◦ Answer: The trade will not be executed.
 Trading Mechanisms
Over-the-counter or OTC market
◦ Dealer markets – dealers post bid (the price one would
receive by selling) and ask (what one has to pay in buying)
prices at which they are willing to trade; brokers for
individuals execute trades at the best available prices
◦ Via electronic communication networks – the existing
book of limit orders provides the terms at which trades
can be executed; mutually agreeable offers to buy or sell
securities are automatically crossed by the computer
system operating the market Offer anonymity
Eliminates bid-ask spread

Allows participants to post market and limit orders over computer networks
Doesn’t require intervention of a broker
(Compared to price-quotation systems)
Each security is assigned to only one specialist, each specialist firm makes a market in many securities

Trading Mechanisms
◦ Specialist markets – the specialist, which is assigned
responsibility for specific securities, acts as either broker
or dealer to maintain an orderly market with price
continuity
◦ Specialists maintain a limit-order book of all outstanding
unexecuted limit orders entered by brokers on behalf of clients,
simply executing or crossing trades at market prices (broker role).
Specialists also match trades (where best orders win trades) thus
serving as an auction market.
At a narrower bid-ask spread
◦ In return for the exclusive right to make the market in a specific
stock on the exchange, specialists also buy and sell shares from
their  own  inventories  to  maintain  a  “fair  and  orderly  market”  by  
providing liquidity and price continuity (dealer role).
◦ They earn from commissions for managing orders (as implicit
brokers) and from the spreads at which they buy and sell securities
(as implicit dealers).
Dow Jones?

Trading of Securities
Trading costs
◦ Explicit: Commissions/fees paid to brokers
Sometimes broker is also a dealer in the security being
◦ Implicit: traded & charges no commission but instead collects the fee
Dealer’s  bid-ask spread entirely in the form of bid-ask spread
High effective spread – investor may be forced to make a price
concession for trading in any quantity that exceeds the quantity the
dealer is willing to trade at the posted bid or ask price (effective
spread greater than nominal spread because investors cannot
execute entire trades at the inside price quotes)

Full-service brokers: Basic services, holding securities….routinely provide info and advice relating to
investment alternatives. Can have discretionary account - buy & sell whenever deemed fit
Discount brokers: Buy & sell, hold securities…only info they provide is the price quotations
Buying on Margin
Buying on margin Source of debt financing - Broker’s call loans
◦ Borrowing money from a broker to buy more securities
than can be bought with own money
◦ Investors might be asked to maintain a margin account in
order to be able to pay their liabilities if the market
moves against them
◦ If equity in a margin account falls short of the required
maintenance level, the investor will get a margin call from
the broker
◦ Margin buying magnifies both the upside potential and
the downside risk
Buying on Margin
Mechanics:
The investor borrows part of the purchase price of the stock
from a broker.
◦ The margin in the account is the portion of the purchase
price contributed by the investor.
◦ The remainder is borrowed from the broker.
The broker in turn borrows money from banks (at the call
money rate) to finance these purchases, then charges that
rate plus a service charge for the loan.
All securities purchased on margin must be maintained with
the brokerage firm in street name (i.e., the broker holds the
shares registered in its own name on behalf of the client ),
because the securities are collateral for the loan.
Buying on Margin
Definition of Terms:
Margin requirement
◦ Some assets (e.g. stocks) have to be deposited as collateral for a
given debt, meaning they can be used to pay off debt.
Initial margin requirement
◦ The amount required as collateral at the beginning of the trade,
representing the extent to which stock purchases can be financed
using margin loans (at least X% of the purchase price must be paid
for in cash with the rest borrowed).
Maintenance margin (between value of collateral assets and debt)
◦ This is set by the broker after the initial trade takes place to guard
against  the  possibility  of  the  owners’  equity  becoming  negative  
(i.e., the value of the stock no longer sufficient collateral to cover
the loan from the broker).
Buying on Margin
Margin call
◦ This is issued by the broker if the percentage margin falls below the
maintenance level.
◦ This requires the investor to add new cash or securities to the
margin account.
◦ If not, the broker may sell securities from the account to pay off
enough of the loan to restore the percentage margin to an
acceptable level.
Buying on Margin
Example: Margin call
Investor initially pays $6,000 to buy $10,000 worth of stock (100
shares at $100 per share), borrowing $4,000 form the broker.
o Initial percentage margin = equity in account/value of stock
Net Worth/Market Value of the securities
Assets Liabilities
$10,000 (value of stock) $4,000 (loan from broker)
Equity: $6,000

o Initial percentage margin is 60%

 Buying on Margin
Suppose price falls to $70, assets fall to $7000, equity to $3000

Assets Liabilities
$7,000 (value of stock) $4,000 (loan from broker)
Equity: $3,000

As a result of the price drop from $100 to $70, assets fall to $7000,
and equity to $3000
o Percentage margin after the price fall = 43% (equity in account/value of
stock = $3000/$7000)
o Note that if stock value falls below $4000, the loan  amount,  owner’s  
equity would be negative

Meaning, the value of the stock is no longer sufficient collateral to cover the loan from the broker
Buying on Margin
Suppose the broker sets a maintenance margin of 30%. How far could
the stock price fall before the investor gets a margin call?
◦ Let P be the price of the stock.
◦ At  100  shares,    the  value  of  the  investor’s  assets  is  100*P  and  equity  
in account is 100P-$4,000
◦ Percentage margin = equity in account/value of stock = (100P-
$4,000)/100P
◦ Solving for P at which percentage margin equals the maintenance
margin of 0.3, i.e., (100P-$4,000)/100P = 0.3, gives P=$57.14
◦ Below this price, the investor would get a margin call!
Concept Check
Margin call
Suppose the maintenance margin is 40%. How far can
the stock price fall before the investor gets a margin
call?
◦ Solve for P from (100P-$4,000)/100P = 0.4
Buying on Margin
Why do investors buy securities on margin?
◦ To be able to invest an amount bigger than their own
money allows
◦ To achieve greater upside potential (but also greater
downside risk exposure)
Buying on Margin – Magnified Risk
Example: Magnified risk
Investor bullish on a stock selling for $100 per share, which he
expects to go up in price by 30% during the year (i.e., ignoring
dividends, rate of return would be 30%)
◦ Decides to invest $10,000 to buy 100 shares
◦ Assume that he borrows another $10,000 from broker
◦ Then, total investment would be $20,000 (200 shares)
Suppose the interest rate on the margin loan is 9% per annum,
what will be the ROR now with a 30% run-up in the stock
price?
Buying on Margin – Magnified Risk
Before 30% run-up in stock price:
Assets Liabilities
$20,000 (value of stock) $10,000
Equity: $10,000
After 30% run-up in stock price and taking into account the interest
payment:

Assets Liabilities
$26,000 (value of stock) $10,900
Equity: $15,100
Paying off 10,900 of principal and interest on the margin loan leaves 15,100
Buying on Margin – Magnified Risk
Note how:
◦ The 200 shares are now worth $26,000
( = $100*1.3*200 shares)
◦ Principal plus interest on margin loan is $10,900
( = $10,000*1.09 )
◦ This leaves the investor with $15,100 equity
( = $26,000-$10,900 )
◦ Hence, the ROR is 51%
( = $15,100-$10,000)/$10,000 )
◦ A 30% stock price increase translated to a 51% return on
the $10,000 investment! (Profit or Loss - Orig Investment)
/Original Investment
Buying on Margin – Magnified Risk
Suppose instead that the stock goes down by 30% to
$70 per share
Assets Liabilities
$14,000 (value of stock) $10,900
Equity: $3,100

o The 200 shares will be worth $14,000

o Principal plus interest on margin loan is still $10,900
( = $10,000*1.09 )
o The investor now left with $3,100
( = $14,000-$10,900 )
(Profit or Loss - Orig Investment)
o The ROR is -69%! /Original Investment
( = $3,100-$10,000)/$10,000 )
Concept Check
Magnified risk
◦ Suppose the investor borrows only $5,000 at the same
interest rate of 9% per year. What will the rate of
return be if the price of the stock goes up by 30%?
What if it goes down by 30%? If it remains unchanged?
Concept Check
The investor will purchase 150 shares, with a rate of
return as follows:
Yearend Yearend value of Repayment of Investor’s ROR
change in shares principal and
price interest
30% $19,500 $5450 40.5%
(=$130*150 (=$5,000*1. =[(19,500-5,450)-
shares) 09) 10,000]/$10,000
No $15,000 $5450 -4.5%
change (=$100*150 =[(15,000-5,450)-
shares) 10,000]/$10,000
-30% $10,500 $5450 -49.5% =[(10,500-
(=$70*150 5,450)-
shares) 10,000]/$10,000
Short Sales
Normally, investor would first buy stock then sell it – the order
reversed with a short sale (i.e. sell and then buy the shares)
Short sale allows investors to profit from a decline in  as  security’s  price
Short Sales
Short-selling
◦ The  practice  of  selling  securities  that  the  seller  doesn’t  own
◦ Short-seller borrows the securities sold through a broker and may be
required to cover the short position at any time on demand
◦ Cash proceeds are kept in escrow by the broker, who typically
requires the short seller to deposit additional cash or securities to
serve as margin (collateral) for the short sale
Short Sales
Mechanics:
◦ Borrow a share of stock from a broker and then sell it
◦ Later, buy a share of the same stock in order to replace
the one the share that was borrowed (called “covering  
the  short  position”)
◦ Must not only replace the shares but also pay the lender
of the security any dividends paid during the short sale
Short Sales
In practice, shares loaned out for a short sale typically provided by the
short-seller's brokerage firm, which holds a wide variety of securities of
its other investors in street name (i.e., the broker holds the shares
registered in its own name on behalf of the client )
The owner of the shares need not know that the shares have been lent
to the short-seller (if the owner wishes to sell the shares, the brokerage
firm will simply borrow shares from another investor) and therefore the
short sale may have an indefinite term
However, if the brokerage firm cannot locate new shares to replace the
ones sold, the short-seller will need to repay the loan immediately by
purchasing shares in the market and turning them over to the
brokerage house to close out the loan during the short sale.
Short Sales
Exchange rules require that proceeds from a short sale be
kept on account with the broker
The short-seller cannot invest these funds to generate
income, although large or institutional investors typically
will receive some income from the proceeds of a short
sale being held with the broker
Short-sellers are also required to post margin (cash or
collateral) with the broker to cover losses should the
stock price rise during the short sale.
 Reason for short-seller’s action

Short Sales
Reason for short-seller’s  action:  anticipates  fall in the stock
price (i.e. can buy it later a lower price than it initially sold
form, meaning profit for short-seller)
Short Sales
Cash flows from purchasing shares of stock versus short-selling shares of stock:

Time Action Cash Flow*

Purchase of Stock
0 Buy share – Initial price
1 Receive dividend, sell share Ending price + Dividend
Profit = (Ending price + Dividend) – Initial price
Short Sale of Stock
0 Borrow share; sell it + Initial price
1 Repay dividend and buy share to – (Ending price + Dividend)
replace the share originally
borrowed
Profit = Initial price – (Ending price + Dividend)
* A negative cash flow implies cash outflow
Short Sales
Example: Short-selling
Suppose you are bearish (pessimistic) on a stock, and its
market price is $100 per share, and you tell your broker
to sell short 1,000 shares
◦ Broker borrows 1,000 shares either from another
customer's account or from another broker
◦ $100,000 cash proceeds from the short sale are credited
to your account
Suppose the broker has a 50% margin requirement on
short sales
◦ You must have other cash or securities in your account
worth at least $50,000 that can serve as margin on the
short sale.
Short Sales
◦ If you have $50,000 in Treasury bills, your account with the broker
after the short sale will then be:
Assets Liabilities and Owner’s Equity
Cash $100,000 Short position in the $100.000
stock (1,000 shares
owed)
T-bills $50,000 Equity $50,000

◦ Initial percentage margin = equity in account/value of stock owed =

$50,000/$100,000 = 0.5
Equity in account/Current value of the shares you have borrowed and eventually must return
Short Sales
Suppose forecast turns out to be correct and the stock falls
to $70 per share.
◦ You can now close out your position at a profit
◦ To cover the short sale, buy 1,000 shares to replace the
ones you borrowed
◦ Because the shares now sell for $70, the purchase costs
only $70,000
◦ Because your account was credited for $100,000 when
the shares were borrowed and sold, your profit is $30,000
(i.e., equal to the decline in the share price times the
number of shares sold short)
 Short Sales
Short sales and margin calls
◦ Like investors who purchase stock on margin, a short-seller
must be concerned about margin calls
◦ If the stock price rises, the margin in the account will fall
◦ If margin falls to the maintenance level, the short-seller will
receive a margin call
Suppose broker has maintenance margin of 30% on short sales. This means that equity in your acc must
be at least 30% of the value of your short position at all times. How much can the price of the stock rise
before you get a margin call?

Let P = Price of Stock. Value of shares you must pay back = 1000P and equity in your account is
(150K - 1000P)/1000P = 0.3 which implies that P = 115.38. If stock price rises above, margin call :.
additional cash or cover short position by buying shares to replace old ones borrowed
Short Sales and Margin Calls
Example: Short sales and margin calls
◦ Suppose the stock price in the previous example goes up to $110,
what will the balance sheet look like?

Assets Liabilities and Owner’s Equity

Cash $100,000 Short position in $110,000
the stock (1,000
shares owed)
T-bills $50,000 Equity $40,000
Total-Share/Share
◦ If the short position maintenance margin is 40%, how far can the
stock price rise before the investor gets a margin call?
◦ Solve for P from ($150,000 – 1,000P)/1,000P = 0.4, P = $107.14 per share
Short Sales and Stop-buy Orders
Short sales and stop-buy orders
◦ If the share price falls (say from $100 to $70) you will profit from the
short sale, but if the share price rises, let's say to $130, you will lose
money (by $30 per share)
◦ Stop-buy orders often accompany short sales to protect the short-
seller in case the stock price moves up
◦ Suppose that when you initiate a short sale, you also enter a stop-
buy order at $120
◦ This will be executed if the share price surpasses $120, thereby
limiting your losses to $20 per share
◦ This will never be executed if the stock price drops