Course 1: Global financial markets and

assets
Timor-Leste Petroleum Fund is an example of a sovereign wealth fund. At the most basic level, a
sovereign wealth fund is a vehicle for moving a country's savings from the present to the future.
According to the IMF, Timor-Leste is the most oil dependent economy in the world. The
government obtains 95% of its revenues from oil and gas and it has nothing else. By placing its
revenue into the fund, the government is protecting itself from fluctuating oil prices. This way, the
country can increase its consumption in a sustainable manner even as its oil reserves are
depleted. In other words, the petroleum fund is a tool that enables Timor-Leste to use its wealth
for current and future generations. 

1)The investment management process starts with setting investment objectives. And these
investment objectives of course should reflect risk return tradeoff between the expected return
the investor wants to achieve, and how much he's willing to assume risk. 2)The second step in the
investment management process is developing an investment policy-a document, that guides all
investment decisions. So, you can think of this as more broadly the asset allocation decision. All
right, how funds are to be divided across different asset classes and then the next step is the
security selection decision which basically deals with the choice of the particular securities to hold
within each class. 3)So the last step in the investment management process is the measuring
and the evaluation of the investment performance. This involves monitoring the portfolio, re-
balancing the portfolio as necessary, and measuring the performance and evaluating that
performance relative to some benchmark. So, in summary, the investment process consists,
one, setting the investment objectives, two, coming up with a policy. Document that guy's old
investment and portfolio decisions. Three, finally reviewing and evaluating the performance of the
portfolio.

Time value of money. How do you compare cash flows that occur at different points in time? So,
time value of money is another way of just that a dollar today is worth more than a dollar
tomorrow. you might want to be compensated for, so postponed consumption. Second, there
might be some expectation or inflation, so that the same $100 may not go as far in the future as it
does today. So you might also want to be compensated for that. Finally, there is some chance that
I might not even pay you back, right? I could skip town, disappear completely. You might never be
able to find me and you'll never get paid back. So you might also want to be compensated for that
risk. So all of these represent an opportunity cost for you. So, this is why we might have a positive
interest rate. So, to make the cashflow of the $100 (when lending money) equivalent to something
in the future, you would probably expect $100 plus some interest to make up for your opportunity
cost. (What Is Opportunity Cost? Opportunity costs represent the potential benefits an individual,
investor, or business misses out on when choosing one alternative over another.)

So how do we find the future value of the cash flow that occurs today? So the future value of a
cash flow is simply the value of the funds invested at your opportunity cost. Interest is
compounded i.e. Future value =Present Value (1+r)n how to compute the future value of cash flow
today, and we also looked at how to find the present value of the cash flow in the future (opp
formula: Present Value= FV/(1+r)n
If you invest $5000 in a CD with an interest rate of 8% per year, how much will you have at the
end of 5 years? VT = 5000(1 + 0.08)5 = 7346.640

If your goal is to maximize your investment value at the end of five years, which option would you
prefer?

Investing $9,000 today at an interest rate of 3 percent per year

Investing $8,000 today at an interest rate of 5 percent per year

Investing $9000 today at an interest rate of 2 percent per year for two years and then at an
interest rate of 4 percent per year for the last three years

Correct

In order to compare these alternatives, we need to find the future value at the end of five years:
9000(1.02)2(1.04)3 =10532.78. This is the highest.

Well, an annuity is a series of fixed equal payments for a specified number of periods. 
We have even cash flows of 3000 for 4 periods. There are lots of examples of annuities
around us. Bond payments are examples of annuities. Your car loan payments are
examples of annuities. Mortgage payments, where you have fixed cash flows. Fixed
payments over a period. 
 Vn= Future value, ACF= Annuity Compound Factor,
ADF = Annuity Discount Factor

Compounding effective annual interest rate

interest rates are typically compounded more

often than once a year. For example, credit card
payments or car loan payments or mortgage
payments are compounded not yearly, but
typically monthly.

APR=Annual percentage rate

2. How much would you have saved in twenty years if you save $5000 every year and can guarantee
earning 6% per year? Round your final answer to three digits after the decimal. State your answer as
'x.xxx'
Answer: The correct answer is 183,927.956. We need to compute the future value of an annuity.
The future value of annuity is given by VT = C × ACF(r,n) where VT = future value of the annuity, C =
$5000, r = 6%, and n = 20 and ACF(r,n) denotes the Annuity Compound Factor.
ACF(r,n) = [(1+r)n −1]/r In this example, ACF(r = 6%, n = 20) = 36.785591
The future value is equal to: VT = 5000 x ACF(r = 6%, n = 20) = 5000 x 36.785591 = 183,927.956

3. You are buying a new car. The car dealer gives you three financing options. If your objective is to
minimize the present value of your car payments and your opportunity cost of capital is 0.5% per
month, which one would you choose?
a. $500 per month for 36 months
We need to compare the present value of each of these payment plans using the present value of
an annuity. V0 = C × ADF(r,n) where V0 = present value of the annuity, C = $500, r = 0.5%, and n = 36
and ADF(r,n) denotes the Annuity Discount Factor. ADF(r,n) = (1−(1+r)-n )/r In this example,
ADF(r=0.5%, n=36) = 32.8710 The present value of the payments is equal to 500 x 32.8710 =
16,435.51. This is not the lowest.

Question 7
What is the effective 3-month return on a 1-year certificate of deposit with a stated annual rate of
8% compounded quarterly?

1 / 1 point

2%

2.67%

4.63%

4.04%

Correct
Since the 3-month period corresponds to a quarter, the 3-month rate is simply the stated annual
rate divided by 4. Therefore, the effective 3-month rate is 8%/4 = 2%

Question 2
What is the effective annual rate on 1 –year CD with a stated annual rate of 8% compounded
quarterly? Round off your final answer to three digits after the decimal point. State your answer
as a percentage 'x.xxx' (i.e. 1.234)

0 / 2 points
458.393
Incorrect
Finding the effective rate involves first finding the rate per compounding period and then figuring
out how many times the rate will get compounded over the period under consideration.

Effective annual rate = (1+APR/m) m −1

where APR is the stated annual rate, m is the number of compounding period per year.

EAR = (1+ 8%/4)4 −1 = 8.243%

3.
Question 3

What is the effective six-month rate if the stated annual rate is 8% compounded quarterly?
Round off your final answer to two digits after the decimal point. State your answer as as
percentage 'x.xx' (i.e. 1.23)

0 / 2 points

65

Incorrect

Finding the effective rate involves first finding the rate per compounding period and then figuring
out how many times the rate will get compounded over the period under consideration.

effective 6-month rate = (1+ 8%/4)2 −1

What is the five-year effective rate if the stated annual rate is 6% compounded semi-annually?
Round off your final answer to three digits after the decimal point. State your answer as a
percentage rate 'x.xxx' (i.e. 1.234)

0 / 2 points
34.391
Incorrect
Finding the effective rate involves first finding the rate per compounding period and then figuring
out how many times the rate will get compounded over the period under consideration.

Five-year effective rate = (1+ 6%/2)10 −1

A perpetuity is a series of equal payments or fixed payments that go on forever

indefinitely. An actual example of a perpetuity is a dividend paying stock.
If this was a dividend paying stock, if the dividends were $1,000, 
how much would you be willing to pay for this stock, for example? V0 = 10,000

Let's say that this the constant growth rate. Let's suppose that the payments are growing
at 5%, let's say that g = 5%. In other words, now the first payment is you get 1,000, then
the next period is going to be 1,000 times 1.05. The next period is going to be 1.05 squared
and so on and so forth. 

For example, you think your salary is going to start at $90,000 next year. 
And it's going to grow by 5% over the next five years. What is the present value of your 
future salary today if the interest rate is 8% per year?
Question 1
How much would you be willing to pay today for the opportunity to receive $10,000 every year
forever if the interest rate is 5% per year? (Assume you can bequest it to someone else). Round
your final answer to the nearest dollar.

2 / 2 points
200000
Correct
In this problem you are asked to calculate the present value (PV) of a perpetuity.

Recall that V0 = C/r

where V0 is the present value of the cash flows, C is the constant payment, and r is the interest
rate per period.

Since we have C = 10,000 and r = 0.05,

V0 = $10000/0.05 = $200,000

2.
Question 2

How much would you be willing to pay today for the opportunity to receive $1000 every month
forever if the interest rate is 5% per year? (Assume you can bequest it to someone else). Round
off your final answer to the nearest dollar.
0 / 2 points

2400000

Incorrect

In this problem you are asked to calculate the present value (PV) of a perpetuity.

Recall that V0 = C/r

where V0 is the present value of the cash flows, C is the constant payment, and r is the interest
rate per period.

Notice however that we need to find the monthly interest rate since the payments are monthly.
Therefore we have r = 0.05/12 = 0.004167 = 0.4167%

Now we have C = 1,000 and r = 0.4167%,

V0 = $1000/0.004167 = $240,000

3.
Question 3

How much would you have to donate to your alma mater so that a scholarship of $2000 that
grows at an annual rate of 2% can be created in your name one year from today if your
endowment can be invested at an annual rate of 4%? Round off your answer to the nearest
dollar.

0 / 2 points

335

Incorrect

In this problem you are asked to calculate the present value (PV) of a growing perpetuity.

Recall that V0 = C/(r−g)

where V0 is the present value of the cash flows, C is the first payment, g is the constant growth
rate and r is the interest rate per period.

V0 = 2,000/(0.04-0.02) = 100,000

Time value of money tools. Most of finance is about moving cash flows across time and 
that's what these tools allow us to do. You learned how to discount to find the present
value of cash flow in the future. You learned how to compound to find the future value of
the cash flow today.
What do financial markets do?
Well, what they do is, help direct the flow of savings and investment in 
the economy from the suppliers of capital to the users of capital. This facilitates the
allocation and deployment of scarce resources across time and space in the economy.
On one hand, they enable individuals like you and me to save for retirement, afford to buy
homes or finance our education. On the other hand, they help entrepreneurs fund their
businesses, grow their businesses and develop new products and technologies. Capital
markets also enable, for example, state and local governments to use the proceeds from
issuing municipal bonds to construct roads, schools and other public facilities.

 Financial markets to find the investors who will fund a project/business. Investors will
need to assess the future prospects of this project and come up with a valuation for Fred's
business. Even if Fred had the savings, he might not want to put all of his savings into this
one risky investment. He might want to keep his savings for some unexpected future event
that might happen in the future. So his distaste for risk and desire for liquidity leave him in
need of a mechanism that will provide him with the liquidity he needs and with the
ability to diversify and share risk with other investors in order to start his project.

What is a financial asset? And how is it different from a real asset?

Well, financial assets are essentially claims. They may be sometimes a piece of paper or
sometimes a computer entry but they are basically, claims to future cash flows, usually
generated by real assets. When we buy these securities from companies, firms in turn 
use this money to pay for real assets, such as plant, equipment, etc.  An investor's returns
on securities ultimately come from this income generated by the real assets that are
financed by the financial securities.

A bond issued by the US Department of Treasury, which is the issuer, in this case the
Treasury, the US government is the issuer and it agrees pay the investor, the owner of the
bond, interest until the bond matures and at maturity the principal, in other words the
amount borrowed. These are all fixed income securities with known fixed cash flows.
A home mortgage loan is also an example of a fixed income security. This time the bank is
the investor and has lent funds to an individual and the loan agreement specifies a
schedule of payments to the bank.

Now a share of common stock issued by Microsoft is an example of an equity security and 
it entitles the investor to dividend payments if Microsoft pays any dividends. It also
entitles the investor to a claim on the pro rata share of the residual value of the company if
it is ever liquidated.

Now there are several ways of classifying financial markets and instruments. One way is
the type of the financial claim. The claims of a financial instrument can either be fixed, 
a fixed amount, or it could be residual claim. Those that have fixed cash flow payments
are called debt instruments and they are traded in the debt market or the fixed income
market. 
Financial assets with a residual claim are called equity instruments and are traded in the
equity or stock market.
Preferred stock is a kind of hybrid instrument because it is a equity instrument with equity
claims, but it entitles the investor to receive a fixed cash flow so it has also debt features.
Alternatively, we can classify financial marketing instruments by the maturity of the
claims. For example, financial assets with short-term maturity are called money market
instruments and the traditional cut-off between short-term and long-term is one year. 
So all instruments less than one year maturity, belong to the money market. A financial
asset with a maturity of more than year is part of the capital market. Since equity is
perpetual, they belong to the capital market.
Derivative securities, as the name suggests, are contracts that derive their value from the
price of the underlying financial assets.

So to summarize. Fixed income securities are financial claims that have a predetermined

stream of cash flows in the future. Those that have maturities less than one year are
traded in the money market and long-term fixed income securities are traded in the debt
market. Equity securities on the other hand, are residual cash flow claims and they
represent ownership in a corporation.

To value any financial asset: 1.Promised or expected cash flows. 2.we need a

appropriately risk-adjusted discount rate. So first, identify the cash flows. Find the risk-
adjusted discount rate, and then discount the cash flows back to today to find the value of
any financial asset today
A bond is a fixed income instrument. Basically it's an IOU, a note that promises to make
specified future cash flows. So governments, the US Treasury, corporations, issue bonds
to borrow from investors. Bonds have typically two cash flows.First, they have the
principal, or the face value, at maturity. Second, a bond may also make periodic payments
that are called coupons.The coupons are specified by the coupon rate.

Suppose there is a one year zero coupon bond with a face value of $10,000. 
And the one year discount rate is 5.35%. So how much would you be willing to pay for this
part? So what should be the market value? What should be the value of the bond today? 
Well, it's simply the discounted value of that 10,000,
For one year, in other words, it's going to be 9,492.17.
 
So suppose we have a 20 year bond, this time, with a face value of $1 million. the price of
this bond is $455,500.So the question is, what is the rate of return you make? What is the
internal rate of return on this bond? Or what is the yield to maturity of this bond. 
If you buy this bond today, hold it till maturity, what is the annual return you've earned.
 

So lets consider a 2-year bond with a face value of a $1,000, it matures in 2 years. 
Its face value is a 1,000, and has a coupon rate of 12% and it has semi-annual coupon
payments.So it will make 12 times 1000,Divided by 2 equals 60. Every $6 in coupon
payments every 6 months.

Money market consist of very short-term fixed income securities. First, it provides
investors, who would like to invest in very liquid assets, a market where they can do
so. Second, it provides those in need of short term liquidity a market where they can
borrow from. And finally, and very importantly, it provides the federal reserve bank, the
US central bank, a channel to conduct its monetary policy by influencing the availability
and cost of liquidity in the money market. 
Let's start with the federal funds market. In the US all banks are required to maintain a
minimum balance of reserves with their local Federal Reserve bank. These are called
federal funds. The amount of reserves that each bank needs to maintain depends on the
amount of the deposits that it has. Now, at any point in time some banks may have more
funds or excess funds than they need, and others may be in need of funds. So those banks
that have excess federal funds can lend to those that have a shortage of federal funds.
The interest rate on these interbank loans, which are typically overnight transactions, is
called the federal fund trade.
Now the equivalent of federal funds rate in the London money market is the LIBOR. LIBOR
is also a key interest rate because it serves as a reference rate to many other financial
contracts, such as derivatives, mortgages, commercial loans, etc. Now interestingly, 
the LIBOR is not derived directly from actual loan transactions. It is calculated based on
responses to a daily market survey or participating banks. It is based on what each bank
estimates their interest rate that it can borrow overnight to be. Now what do you think the
issue with LIBOR is? Well for starters, one concern may be, how truly does the survey-
based measure reflect banks' cost of overnight borrowing, especially at times of financial
distress? Now, indeed, during the financial crisis it appeared that banks underestimated 
their cost of borrowing in order to make themselves appear financially stronger.

More importantly, it also emerged that several participating banks were in fact colluding
to manipulate the LIBOR rate in a way to profit from their derivative trade positions.

Now the most marketable of all my market instruments are treasury bills. The US Treasury
borrows from the public by issuing treasury securities, and T-bills represent the simplest
form of fixed income securities. Now treasuries in general play a special role in financial
markets. Because they are issued by the US Treasury and therefore backed by the US
government, they are viewed all around the world as default free assets, or default risk
free. So the interest rate on Treasuries is considered as the risk free rate for different
maturities. For that reason they are used as benchmark rates for many other fixed income
securities. Now what are treasury bills or T-bills? Well they're essentially zero-coupon
bonds with less than one year to maturity. They are highly liquid, they're easily converted
to cash, and they have very low transaction costs.

A certificate of deposit, or a CD, is a short-term time deposit with a bank. Time deposits
cannot be withdrawn on demand.  And the bank pays the depositor interest and principal
at the end of the fixed term of the CD.
 Now, commercial paper is a short-term unsecured debt instruments that is widely used
by large corporations. Instead of borrowing from a bank directly, commercial papers allow
corporations to borrow from the public markets to meet their short-term financing needs. 
The maturities on commercial paper can be very short, as short as a day or up to 270 days.

The repo market, is a market for traders to borrow and lend cash on very short-term basis.
So what is a repo, or repurchase agreement? Well, essentially, it is the sale of a security
with a promise by the seller to buy the security back at a given price, at a given date.
So for example, the dealer sells T-bills to an investor on an overnight basis, and promises
to buy them back the next day at a slightly higher price. And the increase in the price is the
overnight interest. And the T-bills serve as the collateral on this loan, basically.
A reverse repo is the opposite of this transaction, where the dealer finds an investor with
Treasury bills, buys them back from the investor with an agreement to sell them back on a
higher price on a future date, probably just not the next day. It's actually repo agreements
are collateralized short-term loans where the collateral is a security or pool of securities.

Calculating US Treasury Bill prices:

for example, the bill that we see with the maturity on September 1st, we see that it has a
discount of 0.358. And today it has 86 days to maturity. So what would be the implied
price for $100,000 face value?

So we computed this off the discount that was the quote for the bid price. Now, let's
similarly find the ask price. The ask quote was 0.348.
What is yield to maturity? 
Well you may recall that yield to maturity 
is the rate of return that is promised by the bond today. 
So in other words, if investors buy this bond today at this state, 
collects the coupons, and holds it until maturity collects the face value, 
the investor would earn a rate of return of 1.407% on the bond. 

IRR= internal rate of return,

Bond Equivalent Yield= annual rate

Long Term Debt Instruments

US Treasury bills, which are essentially zero coupon securities, with a maturity of less than
one year. The Treasury also issues Treasury notes and Treasury coupons, which are
coupon securities. Treasury notes and Treasury bonds differ in their maturity. Treasury
notes are issued with a maturity of 2 to 10 years and Treasury bonds are issued with a
maturity of 10 to 30 years. Around the world, governments issue bonds that are linked to
some kind of cost of living index to provide investors with an instrument to hedge for
inflation. In the US, the US treasury issues TIPS, in other words Treasury inflation-
protected securities. How do these work? Well the principal on these bonds is adjusted
periodically in proportion to the increases in the consumer price index, in other words, by
the inflation rate.

Firms can borrow directly from the public at large by issuing corporate bonds. Now,
corporate bonds are typically coupon bonds. In other words, they make coupon payments
every six months, and also pay the face value at maturity to the bond holder. The bond
contract between the issuer and the bond holder is called the bond indenture. Now the
biggest difference between corporate bonds and treasury bonds, is that corporate are
subject to default risk or credit risk. That is, there is some likelihood or probability that the
firm may not be able meets its payments on the bond.This likelihood is evaluated by
credit rating agencies, and is indicated by a credit rating.Of course, the higher the
likelihood of default, or the riskier the bond is, the higher will be the promised rate of
return on the bond. There are many types of corporate bonds. Corporate bonds for
example can have floating rates. This is actually means that the coupon rates on the
bonds are tied to some benchmark rate. So for example, it could be live or plus some
spread and it fluctuates with this benchmark rate.Secured bonds are bonds that are
backed by a specific collateral. In contrast, debentures are unsecured bonds that are not
backed by a specific collateral. And subordinated debentures have lower priority to all
other bond holders. Now there are two important types of corporate bonds that I would
like to talk about. 

These are convertible bonds and callable bonds. So a callable bond is a bond that allows
the issuer to repurchase the bond back from the bond holder. So since the issuer is likely
to do so, when it is favorable to the issuer, these bonds are going to have higher yields, to
compensate the bond holder. In contrast, a convertible bond gives the bond holder the
option to convert the bond into a specific number of equity shares. Now again, since the
bond holder would use this option when it is favorable to do so, the bond holder would
accept a lower yield on such a bond. Now you may have heard the important role played
by mortgage bonds in the last financial crisis. 
So what are mortgage bonds? 
Well, mortgage bonds are essentially an example of asset backed securities, which are
securities that are backed by a pool of loans or other receivables. And this process is called
securitization. In case of mortgage bonds, mortgages are bundled up together and 
as payments of these mortgages are collected in their pool, the mortgage bonds pays it's
interest and principal from this pool of cashflows. Mortgages are not the only type of
loans. Student loans and car loans are also used to create asset backed securities. Another
segment of the long term debt market consists of municipal bonds, often referred as
munis. These are issued by state and local governments. Now, they are especially
attractive to investors in high income brackets because the interest income on munis are
exempt from federal taxes.

There is really no clear classification of international bonds. A Euro bond for example is a
bond that is denominated in a currency other than the country in which it is issues. So for
example, a Euro Yen Bond is a bond that is denominated in Yen but issued outside of
Japan. Sovereign debt issued by governments is also a segment of the international bond
market. These are obligations of a government of a country. They are referred to as the
country's debt, as in the example of Greek debt or emerging market debt.

Equity Securities

So, corporations issue stock to raise equity capital. Equity basically represents ownership
shares in a corporation. So each share of common stock entitles the owner to one vote on
matters of corporate governess, as well as one share in residual cash flows. The
corporation is controlled by a board of directors that is elected by the shareholders. The
board, in turn, hires the management. Now managers have the authority to run the
businesses of the firm, and the board has a mandate to oversee that the management acts
in the best interest of the shareholders. Now this separation of ownership and control,
ownership by shareholders and control by management, can lead sometimes to what we
call agency problems. So that is, managers may try to pursue goals that are
not necessarily in the best interest of shareholders. And may, in fact, be self-
serving. However, there are several mechanisms to limit agency problems. Oversight by
the board of directors is of course one way. Compensation of the management is another
mechanism to align interests.

The two most important features of equity and common stock, are that they represent
residual claims and limited liability. Residual claim means that shareholders have the
lowest priority, and they stand last in line among those that have any claims on the cash
flows of the firm. Limited liability, on the other hand, means that shareholders are not
personally liable for the firm's debt obligations. So, the most they could lose is the value of
their own investment in the shares. Finally, unlike debt, equity does not have any
maturity, so as long as the corporation is in business, equity has an infinite life.
Now, preferred stock, on the other hand, is a bit of a hybrid instrument. It is an equity
instrument, but it also carries bond-like features. So the most important feature of a
preferred stock is that like a bond it makes fixed cash flows, fixed dividend payments. 
However, unlike a debt instrument since firms have no contractual obligation to pay
dividends, failure to pay preferred stock holders dividends does not put the firm into
default. However, when the firm does pay the dividends, preferred stock holders need to 
get all the accumulative dividends before any common stock holder can get paid.
Preferred stock also has no specified maturity. 
Debt claims are senior to equity claims. In other words, bond holders need to get paid
first. And if the firm can't meet its obligation, for example in the event of an early 
liquidation, bond holders will get paid the value of the firm's assets. The second important
difference is that the interest payments made by the firm on its debt obligations are tax
deductible from the firm's income. On the other hand, dividend payments are not. 
In other words, dividends are paid off, out of earnings after taxes. 
You probably see everyday reports on major indices in financial markets. While the Dow
Jones Industrial Average is the oldest and the most well known index. There are several
other stock market indices both in the US and abroad. Now, what you should know about
the Dow Jones Industrial Average is that it is a price weighted average of 30 large blue chip
companies in the US. Furthermore because it is a price weighted average, it can be very
easily dominated by movements of a high priced stock in the index. 
On the other hand, S&P 500 index is a broader market index and it also is market value
weighted average.  In other words, each stock in the index is weighted by its market
capitalization. So you can think of the S&P 500 index as measuring the performance of a
portfolio that holds the same percentage in every stock in terms of its market value. 
Other examples of stock market indices include the NASDAQ of course, the Wilshire 5000,
which is the broader stock market index in the US, and the Russell 2000. The Russell 2000
is considered a small stock index, primarily because it consists of the smallest 2000 stocks
by market capitalization.

Okay, so the return to a common stock holder comes from two parts. The first part of
course, is the dividend, that may or may not be paid because it's not promised. 
And the second part, is the capital gain or loss sometimes. In other words, the change in
the price. So, suppose we buy one share of stock today, at time t and sell it in one year at
time t+1. What is the total return? Well, it will be the price change,
The capital gain or loss on the value of the stock, plus, The dividend that we receive, 
divided by the initial investment or how much we paid for the stock.
Remember, to value any financial asset, we need to find (i) the promised or the expected cash flows,
(ii) the relevant risk-adjusted discount rate, and finally, the fundamental value of the financial asset
is given simply by the present value of the cash flows discounted at the appropriately risk-adjusted
discount rate. Stocks, unlike fixed-income instruments, do not have any promised cash flows.
Companies may or may not pay out dividends to their shareholders. Nevertheless, we can still value
stocks as the present value of the expected cash flows using the Dividend Discount Model
Well, we're going to get that the price today is simply, right, the discounted value of all
future dividends.

So suppose Coke is expected to pay a dividend of $0.71 next year, and the dividend is
expected to grow by 12% forever after that.so if investors require 14.7% return on Coke, 
what should be the share price of Coke stock? 

P0 = Implied growth rate, may not be the actual growth rate in the market

Derivative Securities

So what a derivative instrument? 

Well, a derivative is a financial instrument whose value depends on or derives from the
value of another underlying asset. Derivatives can be dependent on almost anything. 
Can be a commodity, could be an index, could be on interest rate.  Really anything from,
say, price of hogs to the amount of snow falling on a certain ski resort. So there is now
active trading in equity derivatives, as I mentioned like stock derivatives, stock options or
stock index options. Credit derivatives, where the underlying can be fixed income
instrument or an interest rate. Commodity derivatives where the underlying assets can be
an agricultural commodity, say, wheat or oranges. Or precious metals such as gold,
silver. A natural resource like oil. Energy derivatives like electricity derivatives. And there
exist even weather derivatives. Now, derivatives can trade on organized exchanges
or over-the-counter. On exchanges, individuals trade standardized contracts that are
defined by the exchange. In contrast, over-the-counter markets, derivative instruments
are customized, so you have to find another party to transact with. And therefore the
transaction costs are higher. The most important feature of exchange traded derivatives is
the existence of a clearinghouse.

The clearinghouse basically guarantees the performance of the derivative contract. 

So whenever an investor takes a position, the clearinghouse takes the opposite position. 
In other words, the clearinghouse acts as the buyer if it's a sale, or as the seller if it's a
purchase, so that the investor does not have to worry about the counterparty risk. 
Now, this is an important difference from the over-the-counter markets, because when we
trade in over-the-counter markets, there is no clearinghouse, and we face counterparty
risk. They are essentially tools of risk management. So for example, an investor who faces
risk associated with the price of an asset can use derivatives to reduce or eliminate this
risk. On the other hand, derivatives are also very popular with speculators.  So if you
would like to bet on the future movement in the price of an asset, you can use derivatives
to get extra leverage and get higher returns. Finally, derivatives are also used by
arbitrageurs who spot and try to exploit price discrepancies between different assets. 
And so they are very instrumental in making prices efficient.

So, what is an option contract? 

Well, an option contract is a financial instrument that gives its owner the right, but not the
obligation, to do something. Either to buy or sell whatever the underlying asset is, at a
fixed price by a given date. In other words, the holder of the option contract is not
obligated to exercise the option. The writer or the seller of the option however is obligated
if the option is exercised. So there are two kinds of options, a call option gives it's owner
the right but not the obligation to buy the underlying asset by a certain date, for a certain
price. So, the price is called the exercise price, or the strike price. And the expiration, the
date is called the expiration date. A put option, on the other hand, gives its owner this
right, but not the obligation to sell the underlying at the exercise price, by the option's
expiration date. There is a cost to acquiring an option and we call this cost the price of the
option, the option premium. Options can be American options or European
options, depending on when the option has to be exercised. A European option can only
be exercised at the expiration dates. Whereas an American option can be exercised
anytime, up to the expiration date.
Futures & Forwards

Consider a crude oil producer and a manufacturing firm that uses crude oil. Now both are
concerned about the future price of crude oil. The oil producer is concerned that the price
of oil can go down. So it is concerned about the future price that it will be able to sell the
oil. And the manufacturing firm is of course worried that oil prices may go up and that it
might cause more to buy oil in the future. So they both face uncertainty about the future
price of crude oil, and they are both concerned about price risk. Well, forward and futures
contracts are financial instruments that help manage this risk by sharing this price risk
between these two parties. They do so by fixing the future price today. 

So, what is a forward and or a futures contract?

Well, it's an agreement between two parties to buy or sell an asset, the underlying asset,
at a certain future time for a certain price. Now contrast this with a spot contract, right? 
What is a spot contract? 
Well, it's a transaction that takes place today, immediately, when you agree to buy
something or sell something today at the spot today. There is some lingo that goes with
these contracts. The future time is called the delivery date, Or the maturity of the
contract. And the price that is agreed on is called the futures price, or the forward price.
the trader that commits to buying the asset has a long futures position. On the other hand,
we say that the trader that commits to delivering the asset at contact maturity has a short
futures position.
So futures contracts are traded on organized exchanges, and the most prominent ones in
the US are Chicago Board of Trade and the Chicago Mercantile Exchange, but there exists
other exchanges all around the world. Exchange traded future are standardized, as we
saw in the corn contract example, both in terms of the quality of the underlying asset and 
the size of the contract and the maturity date, in order to bring buyers and sellers together
easily. Now the one big advantage of exchanges, as we mentioned before, is the presence
of a clearinghouse, which steps into each transaction to take the opposite end of the deal
in order to eliminate counterparty risk. Now forward contracts are in essence very similar
to futures contracts. The big difference is that forward contracts are traded over the
counter. It's usually between two financial institutions or between a dealer and a client.
Now, while this makes it harder and more costly to trade or to get into forward contracts,
the advantages, they are customized to the specific needs of the investor.
A very popular example of forward contracts, for example, are forward exchange rates,
which are commonly used to hedge currency risk.

Traditional vs Alternative Asset Classes

Typically stocks bonds, cash and cash equivalents are generally viewed as traditional
asset classes. Now, typically, you can think of everything else as being alternative. The
boundary between what is traditional and what is alternative has also shifted over time.
Now the big four alternative asset classes today are real estate commodities, hedge funds,
and private equity funds.

An interesting and growing subclass of real estate is infrastructure investments. These are

investment pools specifically targeted to finance major projects and can offer an
investment alternative to institutional investors with long horizons, right? Infrastructure
investments, what are the sources of risk? Well, construction, operations,
regulations, legal, and political environment can be thought of as diverse sources of risks.
Now commodities are perhaps the best diversifiers of financial assets and also provide the
best inflation hedges.

Organisation of Financial Markets

Reasons to trade: Diversify risks, Liquidity. Trading generates prices that reflect the
market's consensus valuation for an asset. So as buyers and sellers put in their orders, a
consensus price emerges through this trading process. This is what we call the price
discovery process. Price discovery is the speed and accuracy with which transaction
prices incorporate the information available to market participants. And markets have an
amazing ability to locate different pieces of information about recent events, and
incorporate all this information into asset values.

So really how well the price discovery process works depends on the characteristics of the
market structure. So there are two characteristics of market structure that are critical to
this process. The first is transparency, and the other is liquidity. Transparency of a market
refers to the quality and the speed with which size information is disclosed by the trading
venue. Liquidity on the other hand refers to the degree to which an order can be
executed within a short time frame without causing a significant deviation in the price of a
security. So in an ill-equipped market, the best price at which a security can be
bought, the ask price, will be significantly higher than the best price at which a security
can be sold, the bid price. And the difference between these two prices, what we call the
bid ask spread, is typically how we measure the liquidity.

Major Players in Financial Markets

The relative supply of demand of capital determine the price of capital in financial
markets. Households play a key role in financial sector through their borrowing and
investment of funds. Young households are likely to be borrowers as they make
capital goods purchases as they build up their lives. Later on when they become
established households, they're likely to be net savers. This is when many households
probably accumulate funds in different types of assets, such as retirement funds or real
estate when they buy their houses, for example. Finally, later on when the households
become retired, they're likely to liquidate assets to finance their consumption. Now the
particular distribution of these three types of households is likely to vary across countries,
depending on the demography of the country, young countries versus countries where the
population is aging, for example. And this is likely to have an effect on the relative supply
and demand for funds in the markets. Businesses are net demanders of capital in the
markets. They issue debt and equity securities to raise capital in order to pay for their
investments and real assets. Now sometimes they may have excess cash to invest
and may do so by investing in short-term securities. But non-financial business are
predominately net demanders of capital in the financial system. The third major investor
and issuer is the government, right. Governments can be borrowers or lenders,
depending on the amount of tax revenues that they can collect and their expenditures.
Okay, so now we have the suppliers and demanders of capital. 

Who brings them together? 

Well, it's the financial intermediaries, right. Financial intermediaries are financial
institutions who bring together the suppliers and demanders of capital.
Who are they? Well, these include banks, registered and unregistered investment
companies, insurance companies, and credit unions. In the simplest form, for example,
banks raise funds by borrowing. In other words, they take deposits, and then they make
loans to other borrowers. Investment companies are essentially financial institutions that
accept funds from investors with the purpose of investing these funds on their behalf.
They are typically compensated with fees, typically based on their performance and the
portfolio size. Now, one type of managed investment fund is called the closed-end funds.
These are corporations that issue a specified number of shares that trade on organized
exchanges. So if you are an investor in a closed-end fund, for example, you would have to
sell it to another investor, not back to the bond fund, but to another investor. Mutual
funds, on the other hand, are open-end funds. Mutual funds both redeem and issue
additional shares. So if you are invested in a mutual fund, you can buy shares directly from
the fund and redeem your shares back to the fund. Index funds, on the other hand,
employ a passive investment strategy where managers simply try to maintain a fund
composition that matches a particular market index. This is intended to keep the
expenses, the fund management expenses, low since there is no really effort to
outperform the market. Exchange-traded funds, the ETFs. These are basically offshoots
from mutual funds, and they are basically funds whose shares trade on exchanges all the
time. So unlike mutual funds, which can only be bought or sold at the end of the day,
when their net asset value is calculated, investors can trade ETFs throughout the day. So
the first ETF that was introduced was the SPDR, which basically tracked the S&P 500
index. Other well-known ETFs include the Diamonds, which mimic the Dow Jones
Industrial average.

Finally, there are also investment companies that are not registered with the SEC. 
So one example is private equity funds. Private equity refers to asset managers who make
equity investments in companies that are not publicly traded. They are exempt from SEC
registration requirements. So hedge funds are like mutual funds in that they also pool
and invest the money of many investors. But they avoid registration with the SEC by
accepting funds from only qualified investors. And because they do not face the same
regulatory constraints as the mutual funds, hedge funds can pursue different
and sometimes riskier investment strategies.

Primary and Secondary Markets

Primary market is where companies raise funds by issuing new securities. When a private
firm decides that it wants to raise capital from the public at large instead of a group of
small private investors, it decides to go public. This means that it's going to sell it's
securities to the public and that investors will be able to trade these shares freely in
financial markets. So the first issue of shares to the public is called the initial public
offering. Later if the firm decides to go back to the public and issue more shares, 
it will have what we call a seasoned equity offering, or SEO. Trades in existing shares, on
the other hand take place in the secondary market. Now in contrast private firms, in other
words firms that are not publicly owned. That do not have shares being traded in the
markets. Can also raise and can sell shares directly to a small number of institutional or
wealthy investors. And this is called the private placement. Now, for firms, private
placement is easier and less costly because they don’t have to register with the ACC or
release as much financial information. But of course, the down side is that privately held
shares are not traded on a stock exchange or in secondary markets. And therefore they're
not liquid. So you will not be able to trade your privately owned shares. Very recently,
some firms have setup computer networks to enable holders of private company stocks to
trade among themselves. But note that these networks are not regulated by the ACC and 
they do not need to disclose any financial information so there is really very little oversight
of these markets.
So when firms decide to issue new securities they first go hire an investment bank. These
investment bankers are called under writers. So, the role of the underwriter is to advise
the firm on the terms of the securities and also help market the offering to potential
investors. So, typically you will see a group of investment banks coming together 
to form a syndicate which is then led by one lead underwriter to share the responsibility of
the offering. So after the syndicate is formed, and the underwriters hired, the firm files 
a preliminary registration with the SEC, with the Security's Exchange Commission. Now in
the meantime, the investment bankers take the offering on a road show, and this road
show has two purposes. First, it helps publicize the offering by providing information on
the insured, and the financials of the insured, to generate interest in the offering. Second,
the roadshow is also used to gauge interest from potential investors, which is what we call
the book building process. And this process in turn provides information to the
underwriters about the price that potential investors may be willing to pay for the issue.
Once the registration statement is approved by the SEC this registration statement
includes financials, any important information that the firm has to disclose, this becomes
the prospectus of the offering. And at this point, the price at which the securities will be
offered is also announced. Typically, the underwriters will purchase the entire offering
from the issuing company and they'll resell them to the public. In other words, the issuing
company sells the securities to the underwriting syndicate for the offering price, less a
little spread, which is the compensation for the underwrites. This procedure is called a
firm commitment. What is the advantage to the issuer? Well the advantage to the issuer is
that the firm is guaranteed to sell all the issues, all the shares in the offering and raise the
funds. In contrast, underwriters may do best efforts. Which is when they do not purchase
the securities but only help the insured to sell the securities. So the risk is, of course, that
the firm is not going to be able to sell all of the offering at once. 
Types of Orders
Market orders are buy or sell orders that are to be executed immediately at the best
available prices. These are typically the most common types of orders placed by individual
investors. Ask: buy, Bid: sell. Now, there is some uncertainty when investor places a
market order. First, the bid and ask prices might be for specific number of shares
and market order may be more than this number of shares. So the order might actually be
filled at multiple prices. This depends on what we call the average depth of the market
for shares of stock. That is, the total number of shares offered for trading at the best bid
and ask prices. So, this is clearly not an issue for large stocks, but may well be an issue
for stocks with smaller market capitalization. More importantly, however, the best bid
and ask prices can change before the order is executed. So the order may actually be
executed at worse prices or better prices. The point is, while the market basically
guarantees the execution of the order at immediacy to some extent, this comes at the
expense of uncertainty as to the price at which it is executed.

Now, in contrast, limit orders are price-contingent orders. So a limit order is conditional
on the price. So for example, a limit order to buy specifies a maximum price. And a limit
order to sell will specified a minimum price. So a limit order helps control the transaction
price. That is, if you see the price within a range and you're trying to buy or sell at a
favorable price within that range, you put a limit order, but of course it does not guarantee
the execution. So you'd have to bear the risk of the order not being executed at all.

 Stop orders are similar to limit orders in that they`re also conditional on a threshold
price, so they are price contingent orders. So, for example, a stop loss is an order to sell if
the price falls below a certain level. So, clearly as the name suggests, this is used to stop
any losses from accumulating any further. A stop buy order, on the other hand, is an order
to buy if the price rises above a certain limit. So, these stop buy orders are typically used
to get into a short sale position. And they are used to limit loses that can arise from short
positions. 

Margin Transactions

So when investors buy securities, they can either buy with their own cash or they can use
part their own cash and part borrow from the broker. So in other words, buying securities
on margin basically means that you are borrowing part of the purchase price from your
broker. Margin amount is the amount that you provide that the investor provides. And the
securities purchased, basically served as the collateral for this loan. Now, why would you
want to do this in the first place? Well, we'll see that margin buying effectively creates
financial leverage with very important return consequences for the investor. There is a
minimum amount that the margin can decline to, without that investor having to take an
action, this is called a maintenance margin. If your margin falls below this threshold, you
will receive what is called a margin call which is essentially a request for you to add more
cash to your account. In fact, there is a minimum amount margin that must be in the
account when the purchase is made. This is called the initial margin requirement.

Short-Selling

Short-selling is selling securities that you don't actually own at the time. You're essentially
borrowing the security to sell it short. And later you're obliged to replace a security. That
is, you would have to repurchase in the market and replace it. And this is called covering
your short position. Now, what would be the motivation for short-selling a security? Well,
most likely the short seller believes that the price of the security will drop in the future and
would like to profit from this dropping price. So let's look at an example. Suppose you're
bearish about the BubbleNet stock. Its current price right now is $50 per share. But you
think that's too high and you believe that the price is likely to decline in the future. So you
call your broker to sell short 1000 shares. Now let's see what happens. You don't actually
own any BubbleNet stocks to sell. So your broker is going to find these shares, either from
another client or from another broker, and borrow and sell them at the market price. So
you sell 1000 shares at the current market price of $50. So $50,000 is going to be credited
to your account. Now, just like buying on margin, short sellers are required to post
margin. That is, post cash or collateral with their broker. Why? Well, because this is done
to cover potential losses in the case the price moves against them. In other words, if the
price rises during the short sale. So, let’s suppose that the margin requirement is 50%. 
This means that you must have cash or cash-like securities, for example, treasuries, worth
at least $25,000 deposited into your account. So, your short position is 50,000. And you
deposit, or you post, 25,000 in T-bills, let's say. Now let's suppose that you were indeed
right and that a few days later the BubbleNet stock price indeed drops down to $30 per
share. Now you can close out your position. So what does that mean? Well, you buy 1000
shares at the new market price. And replace the ones that you borrowed. So what is your
profit? Well, remember, your account was credited 50000 and you spent 30000 to cover
your short position to buy the ones that you need to replace. Your profit is $20,000. 
So, what is it? Well, it's the decline in the share price times the number of shares you
bought. Now, just like buying on margin, a short-seller can sometimes receive a margin
call if the margin account falls below a certain threshold. Short sales and short-sellers
often come under lot of fire, especially during times of crisis. So for example, short-selling
was widely thought to have contributed to both the 29 and 2008 market crashes. And
short-sellers are often blamed when stock prices plunge as was the case, for example, with
Bear Sterns and Lehman Brothers. The SEC even temporarily banned short-selling of 
nearly 1000 securities in 2008. Of course the thought here is that the short-selling activity
puts downward pressure on prices that is not justified. And this gets worse as short-sellers
may be spreading negative rumors. More often, however, short-selling is a legitimate bet
as investors who believe that a price is too high take positions to profit from that belief. 
Rather than causing the stock price to fall, short-sellers, by anticipating the decline in the
price, help markets reflect this information into prices. So basically, short-selling helps the
pessimistic views of the market participants get reflected in prices. Academic research
also supports this view that short-selling activity contributes to price discovery. At the
same time, the bans lowered market liquidity and increased trading costs.
From a long-run perspective, stocks that are overpriced relative to their fundamental values present
a problem for the economy. The market will eventually correct the mispricing, but in the meantime,
real resources may flow to the overpriced stock or industry. Accordingly, regulators and economists
generally agree that it is good for short-selling to depress stock prices if the stocks are overvalued,
but bad if short-selling pushes stock prices below fundamental values.
Despite concerns that short-selling can artificially drive prices below fundamental values, it is not
easy for investors to make money in this way. Short sales may depress stock prices, but the short-
seller profits only after buying back the shares at low prices to close the position. If purchases and
sales have a symmetric impact, such that a sale of shares moves prices down by about the same
amount as the purchase of the same number of shares would raise prices, prices will rise to their
original levels when the short-seller buys back the shares. In that case, the short-seller will not profit
from this strategy and will instead lose money on trading costs. One way for a short-seller to make a
profit shorting a stock that is not overvalued is to somehow fool other investors into selling him the
shares at a price that is lower than the one he charged the original investors. This is a risky scheme,
however, and may prove very unprofitable. If the short-seller succeeds in moving prices below
fundamental values and investors catch on to his game before he repurchases the shares to cover
his short position, the shortseller can suffer substantial losses as investors drive up share prices.
Moreover, if short-sellers spread false rumors about a company or attempt to manipulate its share
price, they are engaging in illegal activities and the targeted company may fight back.

New Trends in Securities Trading

Algorithmic trading is essentially the use of computer programs to make trading
decisions. In other words, computer programs or algorithms generate the buy or 
sell decisions and make these trades very, very fast. A simple example of algorithmic
trading might be, for example, the use of a computer algorithm by an institutional investor
for orders that are so large that if they are executed at one time that they would have an
excessive price impact. So the computer algorithm essentially breaks up the large order
into many smaller orders in the blink of an eye to get the best execution price.
Probably the most well known type of algorithmic trading is what is called high frequency
trading, HFT. HFT is a form of trading that relies on superfast high speed computing and 
high speed communication, tick by tick data to execute trades in as little as milliseconds.
So the basic idea of high frequency trading is to use clever algorithms and superfast
computers to detect and exploit market movements. So these could be either
sophistically arbitrated strategies or essentially the computer spots, for example, a price
discrepancy among different securities which may may exist for only an instant. This is
why speed is so important. And, of course, because these require numerous very rapid
price comparisons across many securities and sometimes even across markets, this type
of trading or analysis is best suited to computers. So HFTs typically compete for trades
that offer very very small profits. 
But, of course, if these opportunities are numerous enough they can add up to very large
amounts. Now what is most critical in this trades of course is, as I said, speed.
And such is the importance of speed in these trades that even the location of computer
servers can matter. For example, servers that are positioned nearest to a trading venue 
can save milliseconds of a trade and get better prices. The question is, do they make
trading more or less costly for other investors? This debate grew even stronger when on
May 6, 2010, the global financial system was rocked by the flash crash. The Dow Jones
average plunged almost 1000 points within a matter of only a few minutes.
Several blue chip companies dropped down to pennies before the market was able to 
recover most of its lost ground. This very very short lived crash however, raised several
questions about whether markets and trading rules can handle orders in milliseconds. So
we now know that the main trigger for this sudden decline was a very large sell order in
market index futures by a mutual fund. It was an automated algorithmic trade
programmed to take into account trading volume, not time, not price, just trading
volume. And it was executed unusually rapidly, in 20 minutes, instead of the several hours
that would typically take for such an order. This is where the high frequency traders came
in. While they usually zip in and out of shares, holding them for less than a second, their
activities usually also resemble a market maker, who provides liquidity to others. So while
the HFTs initially, in this instance, helped absorb the sell pressure buying the future's
contracts, just a few minutes later they were also heavily selling to reduce their own loan
positions. What happened was, the original sell algorithm then responded to this increase
in volume by increasing it's own rate and therefore creating a sort of feedback loop. So as
market prices tumbled down, finally trading had to be halted for a short period. When
trading once again resumed, buyers came in trying to take advantage of the low prices,
and the market rebounded back almost as quickly as it had crushed.