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Salaar - Finance

INVESTMENTS
BBA
SPRING Semester 2012

Lahore School of Economics

Salaar farooq Assistant Professor

Salaar - Finance

Investment

Alternatives

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Understanding Investments

Summary of last class


What is Investments? Why study Investments? What is the terminology of investments?

What is the investment environment?


What is the Investment decision process? What are important considerations in Investment decisions?

Salaar - Finance

Chapter 2 Investment Alternatives Learning Objectives


What are major types of Financial Assets?
Direct Investing Indirect Investing

What are Non-Marketable Financial Assets?


What are Money Market securities? What are Fixed Income securities?

What are Equity Securities?


What are Derivative Securities?

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What are major types of Financial Assets?


There are 2 main types:
Direct Investing Assets

Indirect Investing assets

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What are major types of Financial Assets?


There are 2 main types:
Direct Investing Assets
Primarily Capital market securities & Derivatives
Investors Buy & Sell securities themselves through brokerages Investors have direct control over their investment decisions

Indirect Investing assets


Buying & Selling of shares of investment companies (funds), which hold portfolios of securities Professional managers operate on behalf of investors

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What are major types of Financial Assets? ORGANIZATION


DIRECT INVESTING INDIRECT INVESTING Investment Companies Mutual Funds Stock, Bond Funds Unit Investment Trusts

Non-Marketable securities Money Markets Capital Markets Derivatives Markets

Salaar - Finance

What are major types of Financial Assets? ORGANIZATION DIRECT INVESTING INDIRECT INVESTING Investment Companies Mutual Funds Stock, Bond Funds Unit Investment Trusts

Non-Marketable securities Money Markets Capital Markets Derivatives Markets

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What are major types of Financial Assets? Direct Investing Non-Marketable Securities
Savings Deposits

Certificates of deposits
Money Market deposit accounts
US Savings Bonds DSCs & SSCs

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What are major types of Financial Assets? Direct Investing Money Market Securities
Treasury Bills

Negotiable Certificates of Deposit


Eurodollars Repurchase Agreements

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What are major types of Financial Assets? Direct Investing

Capital Market Securities


Fixed Income (Bonds)
Treasuries
Agencies Municipals Corporates

Equities
Preferred Stock Common Stock

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What are major types of Financial Assets? Direct Investing Derivatives Securities
Options

Futures

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What are major types of Financial Assets? Direct Investing Non-Marketable Securities
Represent personal transactions b/w owner & issuer Safe investments insured by Govt.

Highly Liquid.
Savings Deposits Certificates of deposits

Money Market deposit accounts


US Savings Bonds DSCs & SSCs

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What are major types of Financial Assets?


ORGANIZATION
DIRECT INVESTING INDIRECT INVESTING Investment Companies Mutual Funds Stock, Bond Funds Unit Investment Trusts

Non-Marketable securities Money Markets Capital Markets Derivatives Markets

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What are major types of Financial Assets? Direct Investing Money Market Securities
Money Market characteristics:
Tenor/Maturity? Size? Liquidity level? How do you invest into MM?
Treasury Bills

Negotiable Certificates of Deposit


Commercial Paper Eurodollars Repurchase Agreements Bankers Acceptances

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What are major types of Financial Assets? Direct Investing Money Market Securities
Money Market: Market for short-term, highly liquid, low risk assets issued by govts, financial institutions, & corporations.
Size of transactions are usually large (> $100,000) Owned through MM Mutual funds due to large size Maturities (Tenor) usually b/w 1 day to 1 year
Treasury Bills Negotiable Certificates of Deposit Commercial Paper Eurodollars Repurchase Agreements Bankers Acceptances

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What are major types of Financial Assets? Direct Investing Money Markets Treasury Bills
Priced at what from face value? (FV = $10,000 min) Redeemed at ?

Conventional pricing method?


Money market basis? Discount Yield = ? Investment Yield = ?

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What are major types of Financial Assets? Direct Investing Money Markets Treasury Bills
Priced at DISCOUNT from face value (FV = $10,000 min) Redeemed at Face Value

Discount Yield = conventional pricing method (360d)


Money market basis uses 360 days in a year Discount Yield = ( FV-Pur Px./FV) x (360/maturity in days)
Discount Yield understates the actual yield because of the 360 day basis

Investment Yield = ( FV-Pur Px./PV) x (365/maturity in days)

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What are major types of Financial Assets? Direct Investing M.M Treasury Bills
Discount Yield

Yield Calculations

Money market basis uses 360 days in a year

Discount Yield = ( FV-Pur Px./FV) x (360/maturity in days)


FV = 10,000 Pur Px = 9000 Maturity in days = 270 DY=?

Investment Yield (Bond or coupon equivalent yield)

Invst. Yield = ( FV-Pur Px./PV) x (365/maturity in days)


FV = 10,000 Pur Px = 9000 Maturity in days = 270 IY=?

NOTE: Pakistan T-Bills use 365 days, all other products use Money Market basis (360)

Salaar - Finance

What are major types of Financial Assets? Direct Investing M.M Treasury Bills
Discount Yield

Yield Calculations

Money market basis uses 360 days in a year

Discount Yield = ( FV-Pur Px./FV) x (360/maturity in days)


FV = 10,000 Pur Px = 9000 Maturity in days = 270 DY=?

DY =13.33% Investment Yield (Bond or coupon equivalent yield)

Invst. Yield = ( FV-Pur Px./PV) x (365/maturity in days)


FV = 10,000 Pur Px = 9000 Maturity in days = 270 IY=?

IY = 15.02%
NOTE: Pakistan T-Bills use 365 days, all other products use Money Market basis (360)

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What are major types of Financial Assets? Direct Investing Money Market Securities Treasury Bills (IOU from Treasury, sold in secondary mkts) Negotiable Certificates of Deposit (against deposits, sold in
open markets, typical range 14-days till 1 year, Min size $100,000)

Commercial Paper (Unsecured promissory note, issued by corp, size


$100,000 with maturity <270 days, sold at discount)

Eurodollars (Dollar deposits outside US, <6mths upto 1 year, wholesale


market with large deposits & loans,

Repurchase Agreements (RPs) (Lender sells with a promise to buy


back at a prespecified price on a stated date. Effective interest rate is derived from the difference in both prices. Maturities are very short, from 114 days. Denomination is $100,000. US Govt securities.

Bankers Acceptances

Time draft drawn on a bank by customer where Bank promises to pay a particular amount at specified date. These are negotiable & can be sold at discount in money markets. Used in international trade. Min size $100,000. Maturities range 30-180 days.

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What are major types of Financial Assets?

ORGANIZATION
DIRECT INVESTING INDIRECT INVESTING Investment Companies Mutual Funds Stock, Bond Funds Unit Investment Trusts

Non-Marketable securities Money Markets Capital Markets Derivatives Markets

Salaar - Finance

What are major types of Financial Assets? Direct Investing Capital Market Securities
Fixed Income (Bonds)
Treasuries
Agencies Municipals Corporates

Equities
Preferred Stock Common Stock

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What are major types of Financial Assets? Direct Investing Fixed-Income Securities
Capital Markets: Fixed-Income Securities:

Bonds:

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What are major types of Financial Assets? Direct Investing Fixed-Income Securities
Capital Markets: Where debt & equity capital is raised. Market for long-term
securities (stocks & bonds)

Fixed-Income Securities: Securities with specified payment dates and


amounts, primarily Bonds

Bonds:

Long term debt instrument representing an IOU with a maturity. Called fixed income because they involve coupon (interest) payments with specified dates for the life of the Bond. Future stream of cash flows are known at issue. Principal is paid at maturity. IF, bond is sold before maturity, price will reflect current interest rates. Market interest rates affect Bonds price. Treasuries Agencies Municipals Corporates

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What are major types of Financial Assets? Direct Investing Fixed-Income Securities
Bond Characteristics
Par Value: Term Bond: Term to Maturity:

Coupon:
Coupon Rate: Zero Coupon:

Bond Prices: add zero


Accrued Interest:

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What are major types of Financial Assets? Direct Investing Fixed-Income Securities Bond Characteristics
Par Value: Also Face Value of most Bonds is $1000 paid at maturity

Term Bond: Bonds typically mature on a specified date


Term to Maturity: how much longer the bond will exist Coupon:
Periodic interest paid by issuer to the holder. Typically semi-annual.

Coupon Rate: Is fixed at issuance & cannot vary


Zero Coupon: Bond Prices:
Bond with no coupons sold at discount & redeemed at Face Value

Quoted as a %age of Par Value. Corporations & Treasuries use 100 as conventional par rather than 1,000. So, Price 90 = $900 (90% of 1000). Each point, or a change of 1, represents 1% of 1,000 or $10. Easy conversion: since quoted in %age, just add an extra ZERO to get price. price as well as the interest earned (accrued)

Accrued Interest: Bonds trade on an accrued interest basis. Buyers pay the

Salaar - Finance

What are major types of Financial Assets?

ORGANIZATION
DIRECT INVESTING INDIRECT INVESTING Investment Companies Mutual Funds Stock, Bond Funds Unit Investment Trusts

Non-Marketable securities Money Markets Capital Markets Derivatives Markets

Salaar - Finance

What are major types of Financial Assets? Direct Investing Capital Market Securities
Fixed Income (Bonds)
Treasuries
Agencies Municipals Corporates

Equities
Preferred Stock Common Stock

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What are major types of Financial Assets? Direct Investing Equity Securities
Equity Security: Preferred Stock:

Common Stock:
Voting Rights:

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What are major types of Financial Assets? Direct Investing Equity Securities
Equity Security: Represents an ownership interest in a corporation.
After payment of all obligations to fixed-income claims, provides residual claim. b/w Bonds & common stocks. However, dividends may be deferred as cumulative and must be paid before common stock dividends.

Preferred Stock: Hybrid security: Pays dividends known in advance & falls Common Stock:

Represents ownership interest of corporations or Equity of stock holders (also called Equity securities) in the corp (n=outstanding shares). Entitled to income after all other claims are satisfied

Example: 100 shares of common stock represents 100/n% ownership interest

Voting Rights: Gives C.S. Holders legal control of the Corp.


of Directors as their reps. To run the corp.

Elect the board

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What are major types of Financial Assets? Direct Investing Equity Securities
Common Stock Characteristics
Par Value: Book Value: Limited Liability: Market Value (Cap): Dividends: Dividend Yield: Payout Ratio: Retention Ratio:

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What are major types of Financial Assets? Direct Investing Equity Securities
stock usually sells for more than PAR.

Common Stock Characteristics

Par Value: Not a significant economic variable. Any number can be chosen. New
Book Value: The accounting value of the equity as shown on the Balance Sheet.
Sum of Stock Outstanding, Capital in excess of Par & Retained Earnings.

Limited Liability: Investors cannot lose more than their investment.


have access only to the assets of the corp.

Creditors

Market Value:

Market Capitalization: Price of Stock x Shares outstanding

Dividends: Cash Payments declared & paid to stockholders Dividend Yield: 12 mth dividend / current stock price Payout Ratio: Dividends / Earnings (indicates % of a firms earnings paid out in
cash to stockholders)

Retention Ratio: 1 Payout Ratio (% of firms earnings retained for reinvestment)

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What are major types of Financial Assets? Direct Investing Equity Securities
Stock Example
Coca-Colas 2002 EPS = $1.23. Paid annual dividend DPS of $0.8. If price of KO is $45, calculate the following.
DY?

Payout ratio?

If the company reported $11.8 Billion in Stockholder Equity & the outstanding shares are 2.478 Billion, whats the BVS?

Salaar - Finance

What are major types of Financial Assets? Direct Investing Equity Securities
Stock Example
Coca-Colas 2002 EPS = $1.23. Paid annual dividend DPS of $0.8. If price of KO is $45, calculate the following.

Dividend Yield: 0.8/45 = 1.8%

Payout Ratio: 0.8/1.23 = 65%

If the company reported $11.8 Billion in Stockholder Equity & the outstanding shares are 2.478 Billion, whats the BVS?
BVS = 11.8 / 2.478 = $4.76

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What are major types of Financial Assets? Direct Investing Equity Securities
More Common Stock Characteristics
Stock Dividend:

Stock Split:
P/E Ratio:

Salaar - Finance

What are major types of Financial Assets? Direct Investing Equity Securities
More Common Stock Characteristics
Stock Dividend: Payment of a dividend in the form of stock (instead of cash)

Stock Split: Issuance of stock in proportion to shares outstanding


P/E Ratio:
Stock Price/ EPS (what investors are paying per dollar of earnings)

Example: Price of X = $25, EPS = 1.5 P/E = 25/1.5 = ?

Salaar - Finance

What are major types of Financial Assets? Direct Investing Equity Securities
More Common Stock Characteristics
Stock Dividend: Payment of a dividend in the form of stock (instead of cash)

Stock Split: Issuance of stock in proportion to shares outstanding


P/E Ratio:
Stock Price/ EPS (what investors are paying per dollar of earnings)

Example: Price of X = $25, EPS = 1.5 P/E = 25/1.5 = 16.6

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Salaar - Finance

What are major types of Financial Assets?

ORGANIZATION
DIRECT INVESTING INDIRECT INVESTING Investment Companies Mutual Funds Stock, Bond Funds Unit Investment Trusts

Non-Marketable securities Money Markets Capital Markets Derivatives Markets

Salaar - Finance

What are major types of Financial Assets? Direct Investing Derivative Securities
Derivative: Options (Rights)

Salaar - Finance

What are major types of Financial Assets? Direct Investing Derivative Securities
Derivative: Securities that derive their value from some underlying asset

Options (Rights)
The right (but not the obligation) to buy or sell a stated number of shares of stock within a specified time at a specified price CALL: An option to BUY a specified no. of shares at a specified price within a specified period. PUT: An option to SELL a specified no. of shares at a specified price within a specified period Trade on organized exchanges & are standardized products

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What are major types of Financial Assets? Direct Investing Derivative Securities
Options Characteristics (Equity)
Size: Exercise (Strike) Price: Maturity:

Buyers of Calls bets?


Buyers of Puts bets? Option Writers:

Leveraged Product: (Buyers):

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What are major types of Financial Assets? Direct Investing Derivative Securities
Options Characteristics (Equity)
Size: Typically 100 shares of common stock Exercise (Strike) Price: The price at which the option is exercised. Maturity: The date when the option expires.

Buyers of Calls:

Are betting the price of the stock will rise.

Buyers of Puts: Are betting the stock price will drop Option Writers: Receive a premium for betting on a certain view.

Options Value: Based on maturity, interest rates, volatility of stock px, & strike
price.

Leveraged Product: (Buyers): Loss is limited & gains are magnified.

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What are major types of Financial Assets? Direct Investing Derivative Securities
Futures contract (Obligation)?

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What are major types of Financial Assets? Direct Investing Derivative Securities
Futures contract (Obligation)
Agreement which provides for the future exchange of an asset at a specified price on a specified date.
Used for hedging & speculation Hedger can lock in a future price in advance (reduce uncertainty)

Speculators seek to profit from price uncertainty


Trade on margin Trade on organized exchanges & are standardized products

Salaar - Finance

Chapter 2 Investment Alternatives Summary


What are major types of Financial Assets?
Direct Investing Indirect Investing

What are Non-Marketable Financial Assets?


What are Money Market securities? What are Fixed Income securities?

What are Equity Securities?


What are Derivative Securities?

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END