Financial Asset Valuation Introduction

Chapter 1 - Investments: Background & Issues

 Investment – commitment of current resources in the expectation of deriving greater resources in the
future.
 Real Assets – assets used to produce goods and services.
 Financial Assets – claims on real assets or the income generated by them

While real assets generate net income to the economy, financial assets simply define the allocation of income
or wealth among investors.

It is common to distinguish among 3 broad types of financial assets:

1. Fixed Income;
2. Equity;
3. Derivatives;
 Fixed-income Securities – pay a specified cash flow over a specific period.
 Equity – an ownership share in a corporation.
 Derivative Securities – securities providing payoffs that depend on the values of other assets.

 Agency Problem – conflicts of interest between managers and stockholders.

 Asset Allocation – allocation of an investment portfolio across broad asset classes.
 Portfolio – an investor’s collection of investment assets.
 Security Selection – choice of specific securities within each asset class.

Investment assets can be categorized into broad asset classes, such as stocks, bonds, real-estate, commodities
and so on. Investors make two types of decisions in constructing their portfolios. The asset allocation decision
is the choice among these broad asset classes, while security selection decision is the choice of which particular
securities to hold within each assets class.

 Security Analysis – analysis of the value of securities.

 Risk-return Trade-off – assets with higher expected returns have greater risk.
 Passive Management – buying and holding a diversified portfolio without attempting to identify mispriced
securities.
 Active Management – attempting to identify mispriced securities or to forecast broad market trends.
There are 3 major players in the financial markets:

1. Firms (who are net borrowers)

2. Households (who are net savers)
3. Governments (who can be borrowers or lenders)

About half of all stock is held by large financial institutions such as pension funds, mutual funds, insurance
companies and banks. These financial institutions stand between the security issuer (the firm) and the ultimate
owner of the security (the individual investor). For this reason, they are called financial intermediaries.

 Financial Intermediaries – institutions that “connect” borrowers and lenders by accepting funds from
lenders and loaning funds to borrowers.

These financial intermediaries include banks, investment companies, insurance companies and credit unions.
Financial intermediaries issue their own securities to raise funds to purchase the securities of other companies.

Other examples of financial intermediaries are investment companies, insurance companies and credit unions.
All these firms offer similar advantages in their intermediary role. First, by pooling the resources of many
small investors, they are able to lend considerable sums to large borrowers. Second, by lending to many
borrowers, intermediaries achieve significant diversification, so they can accept loans that individually might
be too risky. Third, intermediaries build expertise through the volume of business they do and can use
economies of scale and scope to assess and monitor risk.

 Investment Companies - Firms managing funds for investors. An investment company may manage
several mutual funds.
 Investment Bankers - Firms specializing in the sale of new securities to the public, typically by
underwriting the issue.
We can differentiate 4 types of markets:

1. Direct Search Markets;

2. Brokered Markets;
3. Dealer Markets;
4. Auction Markets;

 Direct Search Market – the least organized market. Buyers and sellers must seek each other out directly.
An example of a transaction in such a market is the sale of a used refrigerator where the seller advertises
for buyers in a local newspaper.
 Brokered Market – markets where trading in a good is active, brokers find it profitable to offer search
services to buyers and sellers. A good example is the real estate market.
o Primary Market – A market in which new issues of securities are offered to the public.
 Dealer Markets – Markets in which traders specializing in particular assets buy and sell for their own
accounts. Dealers specialize in various assets, purchase these assets for their own accounts, and later sell
them for a profit from their inventory. The spreads between dealers’ buy (or “bid”) prices and sell (or
“ask”) prices are a source of profit.
o Secondary Markets - Already existing securities are bought and sold on the exchanges or in the
OTC market.
 Auction Market – A market where all traders meet at one place to buy or sell an asset. The New York
Stock Exchange (NYSE) is an example of an auction market.

 Globalization – Tendency toward a worldwide investment environment, and the integration of national
capital markets.
 Pass-through Securities – Pools of loans (such as home mortgage loans) sold in one package. Owners of
pass-throughs receive all the principal and interest payments made by the borrowers.
 Securitization – Pooling loans into standardized securities backed by those loans, which can then be traded
like any other security.
 Building, Unbuilding – Creation of new securities either by combining primitive and derivative securities
into one composite hybrid or by separating returns on an asset into classes.
 Financial Engineering – The process of creating and designing securities with custom-tailored
characteristics.
 Chapter 2 - Global Financial Instruments
Financial Markets are traditionally segmented into money markets and capital markets.

 Money Markets – Include short-term, highly liquid, and relatively low-risk debt instruments.
 Capital Markets – Include longer-term, relatively riskier securities.

Securities in the capital market are much more diverse than those found within the money market. For this
reason, we will subdivide the capital market into 4 segments:

1. Longer-term Debt Markets;

2. Equity Markets;
3. Derivative Market for Options;
4. Derivative Market for Futures;

The money market is a subsector of the debt market. It consists of very short-term debt securities that are
highly marketable. Many of these securities trade in large denominations and so are out of the reach of
individual investors. Money market mutual funds, however, are easily accessible to small investors. These
mutual funds pool the resources of many investors and purchase a wide variety of money market securities on
their behalf.

 Treasury Bills – Short-term government securities issued at a discount from face value and returning the
face amount at maturity.

A noncompetitive bid is an unconditional offer to purchase bills at the average price of the successful
competitive bids. The Treasury ranks bids by offering price and accepts bids in order of descending price until
the entire issue is absorbed by the competitive plus noncompetitive bids. Competitive bidders face two
dangers: They may bid too high and overpay for the bills or bid too low and be shut out of the auction.
Noncompetitive bidders, by contrast, pay the average price for the issue, and all noncompetitive bids are
accepted up to a maximum of $1 million per bid.

 Certificates of Deposit – A bank time deposit.

 Commercial Paper – Short-term unsecured debt issued by large corporations.

Sometimes, CP is backed by a bank line of credit, which gives the borrower access to cash that can be used if
needed to pay off the paper at maturity.

 Bankers’ Acceptance – An order to a bank by a customer to pay a sum of money at a future date.
 Eurodollars – Dollar-denominated deposits at foreign banks or foreign branches of American banks.
 Repurchase Agreements (Repos) – Short-term sales of government securities with an agreement to
repurchase the securities at a higher price.
Dealers in government securities use repurchase agreements, also called repos, or RPs, as a form of short-
term, usually overnight, borrowing. The dealer sells securities to an investor on an overnight basis, with an
agreement to buy back those securities the next day at a slightly higher price. The increase in the price is the
overnight interest. The dealer thus takes out a one-day loan from the investor. The securities serve as collateral
for the loan. A term repo is essentially an identical transaction, except the term of the implicit loan can be 30
days or more. Repos are considered very safe in terms of credit risk because the loans are backed by the
government securities. A reverse repo is the mirror image of a repo. Here, the dealer finds an investor holding
government securities and buys them with an agreement to resell them at a specified higher price on a future
date.

 Federal Funds – Funds in the accounts of commercial banks at the Federal Reserve Bank.
 London Interbank Offer Rate (LIBOR) – Lending rate among banks in the London market.

The bond market is composed of longer-term borrowing or debt instruments than those that trade in the money
market. This market includes Treasury notes and bonds, corporate bonds, municipal bonds, mortgage
securities, and federal agency debt. These instruments are sometimes said to comprise the fixed-income capital
market, because most of them promise either a fixed stream of income or stream of income that is determined
according to a specified formula. In practice, these formulas can result in a flow of income that is far from
fixed. Therefore, the term “fixed income” is probably not fully appropriate. It is simpler and more
straightforward to call these securities either debt instruments or bonds.

 Treasury Notes or Bonds – Debt obligations of the federal government with original maturities of one year
or more.

Both bonds and notes make semiannual interest payments called coupon payments, so named because in
precomputer days, investors would literally clip a coupon attached to the bond and present it to an agent of
the issuing firm to receive the interest payment. Aside from their differing maturities at issuance, the only
major distinction between T-notes and T-bonds is that T-bonds may be callable during a given period, usually
the last five years of the bond’s life. The call provision gives the Treasury the right to repurchase the bond at
par value. While callable T-bonds still are outstanding, the Treasury no longer issues callable bonds.

 Eurobond – A Eurobond is a bond denominated in a currency other than that of the country in which it is
issued. For example, a dollar-denominated bond sold in Britain would be called a Eurodollar bond.
Similarly, investors might speak of Euroyen bonds, yen-denominated bonds sold outside Japan. Since the
new European currency is called the euro, the term Eurobond may be confusing. It is best to think of them
simply as international bonds.
 Municipal Bonds – Tax-exempt bonds issued by state and local governments.

Municipal bonds (“munis”) are issued by state and local governments. They are similar to Treasury and
corporate bonds, except their interest income is exempt from federal income taxation. The interest income
also is exempt from state and local taxation in the issuing state. Capital gains taxes, however, must be paid on
munis if the bonds mature or are sold for more than the investor’s purchase price. There are basically two
types of municipal bonds. These are general obligation bonds, which are backed by the “full faith and credit”
(i.e., the taxing power) of the issuer, and revenue bonds, which are issued to finance particular projects and
are backed either by the revenues from that project or by the municipal agency operating the project. Typical
issuers of revenue bonds are airports, hospitals, and turnpike or port authorities. Revenue bonds are riskier in
terms of default than general obligation bonds.

 Corporate Bonds – Long-term debt issued by private corporations typically paying semiannual coupons
and returning the face value of the bond at maturity.

𝐴𝑛𝑛𝑢𝑎𝑙 𝐶𝑜𝑢𝑝𝑜𝑛 𝐼𝑛𝑐𝑜𝑚𝑒

𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑌𝑖𝑒𝑙𝑑 =
𝑃𝑟𝑖𝑐𝑒

 Mortgage-backed Security – an ownership claim in a pool of mortgages or an obligation that is secured by

such a pool.

There are fixed-rate mortgages and adjustable-rate mortgages.

 Common Stock – Ownership shares in a publicly held corporation. Shareholders have voting rights and
may receive dividends.

A corporation whose stock is not publicly traded is said to be closely held.

2 most important features of common stock as an investment are its residual claim and its limited liability
features.

Residual claim means stockholders are the last in line of all those who have a claim on the assets and income
of the corporation. In a liquidation of the firm’s assets, the shareholders have claim to what is left after paying
all other claimants, such as the tax authorities, employees, suppliers, bondholders, and other creditors. In a
going concern, shareholders have claim to the part of operating income left after interest and income taxes
have been paid. Management either can pay this residual as cash dividends to shareholders or reinvest it in the
business to increase the value of the shares. Limited liability means that the most shareholders can lose in
event of the failure of the corporation is their original investment. Shareholders are not like owners of
unincorporated businesses, whose creditors can lay claim to the personal assets of the owner—such as houses,
cars, and furniture. In the event of the firm’s bankruptcy, corporate stockholders at worst have worthless stock.
They are not personally liable for the firm’s obligations: Their liability is limited.

 Preferred Stock – Nonvoting shares in a corporation, usually paying a fixed stream of dividends.

Preferred stock is an equity investment, however. The firm retains discretion to make the dividend payments
to the preferred stockholders: It has no contractual obligation to pay those dividends. Instead, preferred
dividends are usually cumulative; that is, unpaid dividends cumulate and must be paid in full before any
dividends may be paid to holders of common stock. In contrast, the firm does have a contractual obligation to
make the interest payments on the debt. Failure to make these payments sets off corporate bankruptcy
proceedings.

 Price-weighted Average – An average computed by adding the prices of the stocks and dividing by a
“divisor.

“Splits” don’t affect this.

 Market Value-weighted indexes – Computed by calculating a weighted average of the returns of each
security in the index, with weights proportional to outstanding market value.
 Equally Weighted Indexes – An index computed from a simple average of returns.

 Derivative Asset or Contingent Claim – A security with a payoff that depends on the prices of other
securities.
 Call Option – The right to buy an asset at a specified price on or before a specified expiration date.
 Put Option – The right to sell an asset at a specified exercise price on or before a specified expiration date.
 Futures Contract – Obliges traders to purchase or sell an asset at an agreed-upon price at a specified future
date.