Chapter 1 - Investments: Background and Issues

 Investment vs. investments

 Real assets vs. financial assets
 Financial markets and the economy
 Investment process
 Competitive markets
 Players in investment markets
 Financial crisis of 2008
 Recent trends
 Investments as a profession

 Investment vs. investments

Investment: the commitment of current resources in the expectation of deriving
greater resources in the future (you scarify current consumption in order to derive
more wealth in the future)

For example:
You cut current consumption to purchase stocks and anticipate that stock prices
will rise in the future
You forgo current leisure and income to take the investments class and expect that
a degree in finance from CSUN will enhance your future career

Investments
The detailed study of the investment process - focus of this class

 Real assets vs. financial assets

Real assets: assets used to produce goods and services
Financial assets: claims on real assets or income generated by real assets - focus

Financial assets
Fixed-income securities: paying a fixed stream of income over a specified period -
CDs, bonds, T-bills, etc.
Equity securities: ownership in a corporation - stocks
Derivative securities: their payoffs depend on the values of other assets - futures,
options, swaps, etc. (FIN 436 - Futures and Options for more details)

Balance sheet for U.S. households, 2011 (Table 1.1)

Real assets: $23,085 billion (32.1%) Liabilities: $13,875 billion (19.3%)

Financial assets: $48,847 billion (67.9%) Net worth: $58,058 billion (80.7%)
Total $71,932 billion (100%) Total $71,932 billion (100%)

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 Financial markets and the economy
Informational role of financial markets
Consumption timing
Allocation of risk
Separation of ownership and management: agency problem
Agency problem: potential conflicts between two groups of people
Agency problems exist between managers and shareholders
Agency problems exist between bondholders and shareholders
Corporate governance and corporate ethics
Accounting scandal - WorldCom overstated its profit by at least $3.8 billion
Analyst scandal - systematically misleading and overly optimistic research reports
in exchange for future business
IPO share allocation - to corporate executives in exchange for personal benefit or
future business

 Investment process
(1) Investment policy: objective, risk-return trade-off
(2) Asset allocation: choice of broad asset classes
(3) Security selection: choice of particular securities to be held in the portfolio
(4) Security analysis: valuation of securities
(5) Portfolio construction, management and analysis: selection of the best
portfolio (combination)
(6) Portfolio rebalancing: adjustment of the portfolio

 Competitive markets
Risk-return trade off: no free lunch rule indicates that assets with higher expected
returns entail greater risk

Efficient markets: security prices should reflect all the information available in
the market quickly and efficiently

Three forms of market efficiency

Week-form efficiency - reflect past trading information (past prices, returns, and
volumes)
Semi-strong form efficiency – reflect publicly available information
Strong-form efficiency – reflect all information, including public and private
information

Passive vs. active portfolio management

Passive strategy - buying and holding a diversified portfolio
Active strategy - attempting to identify mispriced securities or to forecast market
trends

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 Players in investment markets
Government: federal, state, and local

Business: firms and corporations, including financial intermediaries

Individuals: individual investors, institutional investors

Financial intermediaries: institutions that connect borrowers and lenders such as

banks, investment companies, insurance companies, and credit unions, etc.

Investment companies (mutual funds): firms managing funds for investors

Investment bankers: firms specializing in the sale of new securities to the public
by underwriting the issue

Underwriting: a process by which an investment banker raises investment capital

from investors on behalf of a corporation that is issuing securities

Role of an investment banker: advising, underwriting, and distributing

Primary markets vs. secondary markets

Primary markets are markets for new issues of securities

Secondary markets are markets for trading previously issued securities

Venture capital and private equity

Venture capital: money invested to finance a new firm (start-ups)

Private equity: investments in companies that are not traded on a stock exchange

Organizational life cycle

Birth

Growth

Maturity

Decline

Death

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 Financial crisis of 2008
Antecedents of the crisis: after the collapse of the high-tech bubble in 2000-2002,
the Fed aggressively reduced interest rates to boost the economy
Housing market boomed and housing prices kept rising

Changes in housing finance: securitization, nonconforming (subprime) loans,

ARMs, interest only loans, etc.

Mortgage derivatives: investment securities developed by the financial industry to

provide different risk and interest-rate profiles from pools of mortgages

Systematic risk: risk of breakdown in the financial system

The congress passes several laws and regulations to protect investors and to
mitigate systematic risk

 Recent trends
Globalization: integration of global financial markets
Securitization: pooling loans into standardized securities
Financial engineering: creation of new securities by combining primitive and
derivative securities into one composite hybrid (for example, combining stocks
and options) or by separating returns on an asset into classes (for example,
separating principal from interest payment in a fixed income security)
Computer network

 Investments as a profession
Investment bankers
Investment companies
Traders and brokers
Security analysts and/or CFA (Chartered Financial Analyst)
Portfolio managers
Financial planners
Financial managers

 ASSIGNMENTS

1. Concept Checks and Summary

2. Key Terms
3. Intermediate: 9, 10 and 14

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 Chapter 2 - Asset Classes and Financial Instruments

 Money market and its securities

 Bond market and its securities
 Equity market and its securities
 Market indexes
 Derivative markets

 Money market and its securities

Money markets vs. capital markets
Money markets: short-term, highly liquid, and less-risky debt instruments
Capital markets: long-term debt and stocks

Securities in money markets:

T-bills: short-term government securities issued at a discount from face value and
returning the face amount at maturity

T-bills are issued weekly with initial maturities of 4 weeks, 13 weeks, 26 weeks,
and 52 weeks. The minimum denomination is $100, even though $10,000
denominations are more common. It is only subject to federal taxes and is tax
exempt from state and local taxes.

Bid vs. asked price

Bid price is the price you will receive if you sell a T-bill to a dealer
Asked price is the price you pay to buy a T-bill from a dealer
Asked price > bid price, the difference is called bid-ask spread - profit for a dealer

T-bills are quoted in yields based on prices (Figure 2.1)

For example, a 245 day T-bill sells to yield 0.07% (asked) means that a dealer is
willing to sell the T-bill at a discount of 0.07%*(245/360) = 0.04764% from its
face value of $10,000, or at $9,995.236 = [10,000*(1 – 0.0004764)]. If an investor
buys this T-bill, the return over 245 days will be ($10,000/$9,995.236) – 1 =
0.04764%. The annualized return will be 0.04764%*(365/245) = 0.07097% =
0.071% (asked yield). T-bills are quoted based on 360 days per year.

Similarly, a dealer is willing to buy the 245 day T-bill at a discount of 0.085%
(bid) or at $9,994.215 = [10,000*(1 – 0.00085(245/360))] for a face value of
$10,000.

Bid-asked spread = 9,995.236 – 9994.215 = $1.021/T-bill (profit for the dealer)

CDs: a bank time deposit

Commercial paper: a shot-term unsecured debt issued by large corporations

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 Banker’s acceptance: an order to a bank by a customer to pay a sum of money in 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 buy them back later at a higher price

Federal funds: funds in the accounts of commercial banks at the Federal Reserve
Bank. To meet the Fed requirement (minimum balance depends on the total
deposits of the banks’ customers, reserve ratio) banks may borrow or lend money
at the Federal funds rate.

LIBOR: London Interbank Offer Rate, which is the rate among big banks in the
London market

Other short-term debts

 Bond market and its securities

T-notes and T-bonds: debt issued by the federal government with original
maturity of more than one year. The minimum denomination is $1,000.

T-notes: up to 10 years in maturity and pay semiannual interests

T-bonds: up to 30 years in maturity and pay semiannual interests

Coupon rate and coupon payments

Prices are quoted as a percentage of $100 face value (more often traded in
denominations of $1,000 (Figure 2.3)

For example, a bond maturing on Nov. 15, 2015 and quoted at 113.0000 (asked
price) means you pay a price of $113.00 for a face value of $100, or $1,130 for a
face value of $1,000. The coupon rate is 4.5% per year and yield to maturity for
the bond is 1.410%.

Inflation-protected T-bonds (TIPS): the principal amount is adjusted in proportion

to increases in the Consumer Price Index to earn a constant stream of income in
real dollars

Municipal bonds (munis): issued by state or local governments and tax-exempt

from federal and state

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 Equivalent taxable yield: r = rm / (1 – t)

After tax return: rm = r*(1 – t)

Example: suppose your marginal tax rate is 28%. Would you prefer to earn a 6%
taxable return or 4% tax-free return? What is the equivalent taxable return of the
4% tax-free return?

Answer: 6%*(1-28%) = 4.32% or 4% / (1-28%) = 5.56%

You should prefer 6% taxable return because you get a higher return after tax,
ignoring the risk

Federal agency debt: issued by government agencies, such as Freddie Mac,

Fannie Mac, and Ginnie Mac

Corporate bonds: issued by corporations (rated from AAA, AA, A, BBB, BB, …)

Callable bonds: give the issuing firm the right to buy back its bonds before bonds
mature

Mortgages and mortgage-backed securities

Mortgage lenders originate different loans, including fixed or variable loans and
then bundle them in packages and sell them in the secondary market.

Debentures: bonds with no collateral

International bonds

 Equity market and its securities

Common stock: ownership of a corporation

Characteristics: residual claim and limited liability

Stock market listing (Figure 2.8)

Stock Symbol (GE)
Close (Closing price is $19.30)
Net Change ($0.25, the change from the closing price on the previous day)
Volume (trading volume is 44,235,766 shares exchanging hands on the day)
52 week high and low (range of price, for GE, $21.65 - $13.96)
Dividend ($0.60 is the annual dividend, or $0.15 last quarter)
Dividend yield (0.60/19.30 = 3.11%)
P/E ratio (price per share to earnings per share ratio is 15.32)
Year-to-date (YTD) % change (GE’s price has increased by 5.52% since the
beginning of the year)

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 Preferred stock: hybrid security with both bond and common stock features

Cumulative and. non-cumulative preferred stocks

Tax treatment for firms: 70% of preferred stock dividends received by a firm is
tax-exempt (70% exclusion)

70% exclusion doesn’t apply to individuals

 Market indexes
Averages vs. indexes

Averages: reflect general price behavior in the market using the arithmetic
average of stock prices (price weighted)
Indexes: reflect general price behavior in the market relative to a base value
(market value weighted)

Dow Jones Industrial Average (DJIA): a stock market average made up of 30

high-quality industrial stocks and believed to reflect the overall stock market

Current Dow Companies (Table 2.5)

Closing P1 + Closing P2 + ------ + Closing P30

DJIA = ----------------------------------------------------------
DJIA divisor

The divisor must be adjusted for stock dividends and stock splits. In a similar
way, if one firm is dropped from the average and another firm with a different
stock price is added, the divisor has to be updated to leave the average unchanged.

S&P 500 index: a market value-weighted index made up of 500 big company
stocks and is believed to reflect the overall market

 Current closing market value of stocks

S&P indexes = ------------------------------------------------------------
 Based period closing market value of stocks

Market value (market cap) = market price * number of shares outstanding

Note: stocks in DJIA and S&P indexes can change

Index funds and exchange-traded funds (ETFs)

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Other averages and indexes

Dow Jones transportation average (20 transportation stocks, price weighted)

Dow Jones utility average (15 utility stocks, price weighted)

Dow Jones composite average (65 stocks, including 30 industrial, 20

transportation, and 15 utility stocks, price weighted)

NYSE composite index: behavior of stocks listed on the NYSE (value weighted)

Nasdaq 100 index: OTC market stock behavior (value weighted)

Russell 2000 index: small stock behavior (value weighted)

Wilshire 5000 index (NYSE and OTC): overall stock market behavior (value
weighted)

Foreign and international stock market indexes: Nikei 225 (Japan), FTSE 100
(UK), DAX 30 (Germany), Hang Seng 48 (Hong Kong), and TSX 60 (Toronto)

Bond market indicators: Merrill Lynch, Barclays (formerly Lehman Brothers) and
Salomon Smith Barney (now part of Citigroup)

Market indexes, example 1

You are given the following information regarding stocks X, Y, and Z:

Stock price # of shares outstanding

Date X* Y Z X* Y Z
0 $50 $50 $50 100 100 100
1 26 51 51 200 100 100
2 27 52 52 200 100 100

* Stock X has a 2-for-1 stock split before trading on day 1. Date 0 is the base date.
The current divisor is 3.0 and the base value for an S&P type of index is supposed
to be10.

Q1. What would be the value of an S&P type index at the end of date 1?

26*200 + 51*100 + 51*100

S&P index = ------------------------------------- x 10 = 10.27
50*100 + 50*100 + 50*100

Rate of return on date 1 = (10.27/10) – 1 = 2.7%

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 Q2. What would be the value of an S&P type index at the end of date 2?

27*200 + 52*100 + 52*100

S&P index = ------------------------------------- * 10 = 10.53
50*100 + 50*100 + 50*100

Rate of return on two days = (10.53/10) – 1 = 5.3%

Q3. What would be the value of a DJIA type average at the end of date 2?

At the end of date 0: DJIA type average = (50 + 50 + 50) / 3 = 50

Before date 1: DJIA type average = (25 + 50 + 50) / d = 50, solve for d = 2.5
(Rational: A 2-for-1 stock split for stock X will split the price in half but it should
not affect the average itself. Therefore, the divisor should be adjusted.)

At the end of date 2: DJIA type average = (27 + 52 + 52) / 2.5 = 52.4

Rate of return on two days = (52.4 / 50) – 1 = 4.8%

Market indexes, example 2

Consider a price weighted market average composed of three securities, A, B, and
C, with prices of 20, 30 and 40 respectively. The current divisor is 3.00. What will
be the new divisor if stock B issues a 10% stock dividend?

Answer: closing average before stock dividend = (20 + 30 + 40) / 3.00 = 30.00

Adjust the price of stock B: 30 / (1 + 0.1) = 27.27 (new stock price for B if B
issues 10% stock dividend)

Calculate the new divisor: (20 + 27.27 + 40) / d = 30.00 (stock dividend should
not affect the closing average) and solve for the new divisor, d = 2.91

 Derivative markets
Derivative assets or contingent claims: payoffs depend on the prices of other
(underlying) assets

Options: the rights to buy or sell an asset at a specified price on or before a

specified expiration date (rights)

A call option gives the right to buy an asset

A put option gives the right to sell an asset

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 Example1 - you buy an October 200 IBM call option at $5.00
Call option: right to buy
Stock option: underlying asset is IBM stock (current stock price is $191)
Contract size: 100 shares
Exercises price: $200 to buy one share of IBM stock
Expiration date: the third Friday in October
Option premium: $500
Rationale: you expect IBM stock price is going to rise - speculating

Example 2 - you buy an October 23 Intel put option for $2.50

Put option: right to sell
Stock option: underlying asset is Intel stock (current stock price is $22.80)
Contract size: 100 shares
Exercises price: $23 to sell one share of Intel stock
Expiration date: the third Friday in October
Option premium: $250
Rationale: you expect that Intel stock price is going to fall - speculating

Futures contracts: call for the exchange of certain goods for cash at an arranged-
upon price (future’s price) at a specified future date (obligations)

Example 3 - you buy an October gold futures contract at $1,350 per ounce
Commodity futures contract: underlying asset is gold (commodity)
Contract size: 100 ounces
Futures price: $1,350 per ounce to buy gold (current spot price is $1,290 per
ounce)
Delivery month: October
Rationale: you expect gold price is going to rise - speculating

Example 4 - a farmer sells an October corn futures contract at 525

Commodity futures contract: underlying asset is corn (commodity)
Contract size: 5,000 bushels
Futures price: $5.25 per bushel to sell corn (current spot price is $5.50 per bushel)
Delivery month: October
Rationale: the farmer wants to lock in the price - hedging

 ASSIGNMENTS

1. Concept Checks and Summary

2. Key Terms
3. Intermediate: 12, 13, 14, 18, 19,21, 22 and CFA1

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 Chapter 3 - Securities Markets

 New issues
 How securities are traded
 U.S. securities markets
 Trading costs
 Margin trading and short sales
 Regulations

 New issues
Recall primary markets and secondary markets

Primary markets: for new issues, either IPOs or existing firms issuing new
securities (seasoned offerings)

IPOs: initial public offerings, shares being sold to the public for the first time

Investment banker: firm specializing in the sale of new securities

Underwriters: purchase new shares from the issuing firm and resell the shares to
the public

Prospectus: a document that describes the firm issuing the security and provides
the information about the firm

Selling process for large new issues: the role of investment bankers
Underwriting; Advising; Distributing

Best efforts vs. underwritten issues

Underwriting syndicate: a group of investment bankers formed by a leading

underwriter to spread the financial risk associated with selling new securities

Issuing firm (Figure 3.1)

Leading underwriter Underwriting

Syndicate

Investment banker A Investment banker B Investment banker C

Individual/Private investors

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 Private placement: new securities are sold directly to a small group of individuals
or wealthy investors

Initial return of IPOs: very high first day returns all over the world - Figure 3.2

 How securities are traded

Types of markets

Direct search markets: buyers and sellers seek each other directly, which are the
least organized markets, for example, a student buys a used car from another
student

Brokered markets: brokers offer search services for profits/commissions, for

example, the real estate market

Dealer markets: dealers specializing in particular assets buy and sell them in their
own accounts for profits, for example, the over-the-counter (OTC) markets

Auction markets: traders converge at one place to buy and sell assets, for
example, the New York Stock Exchange (NYSE). Auction markets are the most
efficient markets because all traders will get the best price possible.

Types of brokers
Full service broker vs. discount broker

Types of accounts
Cash account vs. margin account (without or with borrowing capacity)

Bid price - the highest price a dealer is willing to pay for a given security
Asked price - the lowest price a dealer is willing to sell a given security
Bid-ask spread: the difference of the two prices, which is the profit for a dealer

Types of orders:
Market order: to buy or sell at the best price available

Limit order: to buy at or below a specified price or sell at or above a specified

price

Stop order (stop-loss order): to sell when price reaches or drops below a specified
level or to buy when price reaches or rises above a specified level. It becomes a
market order when the stop price is reached.

Stop-limit order: a combination of a stop order and a limit order

Examples

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 Comparison of a limit order and a stop order (Figure 3.5)

Price falls below the limit Price rises above the limit
Buy Limit-buy order Stop-buy order
Sell Stop-loss order Limit-sell order

Trading mechanics
Dealer markets: trade through dealers, for example, in OTC markets
Electronic communication networks (ECNs): direct trade over computer network
without market makers or dealers
Specialist markets: trade through specialists, for example, in NYSE

Specialist: a trader who makes a market in the shares of one or more stocks and
maintains a fair and orderly market by dealing personally in the market

 U.S. securities markets

Nasdaq: National Association Security Dealers Automated Quotations System
Nasdaq stock market: a computer-linked price quotation system for the OTC
markets with about 3,200 firms listed for trading

NYSE: New York Stock Exchange, the largest exchange in the U.S. with more
than 3,000 firms listed for trading

Block trade: a large transaction in which at least 10,000 shares of stock are bought
or sold

Program trade: a coordinated purchase or sale of an entire portfolio

Settlement: a trade must be settled in 3 working days, called T+3 settlement

 Trading costs
Full service brokers charge more than discount brokers

Fixed-commission schedule - small transactions, for example, $9.95 for a trade up

to 1,000 shares

Negotiated commissions - large transactions (block trade)

Explicit vs. implicit cost

Commissions are explicit costs while bid-ask spread is an implicit (hidden) cost

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 Margin trading and short sales
Types of transactions:
Long purchase - direct buy
Short selling - sale of borrowed securities

Margins:
Margin trading - borrow money and buy stock to magnify returns by reducing the
amount of capital that must be put in by investors

Margin requirements - the minimum amount of equity put in by an investor

Initial margin - the minimum amount of equity that must be provided by an

investor at the time of purchase, 50% minimum

Maintenance margin - the minimum amount of equity that must be maintained in

the margin account at all time, 25% minimum

Margin call - notification of the need to bring additional equity

(1) Buying on margin (borrow money and buy stock)

Rational: you believe the stock is currently underpriced in the market and expect
the price will rise in the future.

Market value of stock - Loan Equity in account

Margin = -------------------------------------- = ------------------------------ (1)
Market value of stock Market value of stock

Buying on margin, example 1

Suppose you bought 100 shares of XYZ at $50.00 per shares in your margin
account. The initial margin is 50% and the maintenance margin is 25%.
a) At what price, will you receive a margin call?
b) If the price drops to $40, what will happen to your account?
c) If the price drops to $30, how much money should you provide to retain the
minimum margin requirement?

a) 100*50 = $5,000 (total cost to purchase 100 shares)

Equity = $2,500 (the amount you provide which is 50% of total cost)
Loan = $2,500 (the amount you borrow which is 50% of total cost)

Let P be the price at which your maintenance margin drops to 25%, using (1),
100*P - 2,500
----------------------- = 0.25, solve for P = $33.33
100*P
If the price drops below $33.33, you will receive a margin call.

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b) If the price drops to $40 > $33.33, your account is restricted (losing money)
but there is no margin call.

c) Let X be the amount of money you need to provide (to reduce the loan) to keep
the maintenance margin, using (1)
100*30 - (2,500 - X)
------------------------------ = 0.25, solve for X = $250
100*30
You need to add, at least, $250 to reduce the loan amount to $2,250 in order to
keep the maintenance margin of 25%.

(2) Short sale on margin (you borrow shares from your broker and sell them now)

Rational: you believe the stock is currently overpriced in the market and expect
the price will drop in the future.

Up-tick (a price that is higher than that of the previous trade)

Up-tick rule in short sale: a rule designed to restrict short selling from further
driving down the price of a stock that has dropped more than 10% in one day. At
that point, short selling would be permitted if the price of the security is above the
current national best bid (uptick). It will enable long sellers to stand in the front of
the line and sell their shares before any short sellers once the circuit breaker (a
10% drop in one day) is triggered.

Value of assets - Loan Equity

Margin = ---------------------------------- = -------------- (2)
Value of stock owed Loan

Short sale on margin, example 2

Suppose you short sell 100 shares of ABC at $100 per share in your margin
account. The initial margin is 60% and the maintenance margin is 30%.
a) At what price, will you receive a margin call?
b) What will happen if the price rises to $110 per share?
c) If the price drops to $80 per share after your short sale, what is the return from
short sale if the interest charge totals $500?

a) 100*100 = $10,000 (short sale proceeds)

10,000*60% = $6,000 (the initial margin you should provide which is 60% of
short sale proceeds)
Value of assets = $16,000

Let P be the price at which your margin drops to 30%, using (2),
16,000 - 100*P
------------------------ = 0.30, solve for P = $123.08
100*P
If the price rises above $123.08 you will receive a margin call.

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 b) If the price rises to $110 < $123.08, your account is restricted (losing money)
but you will not receive a margin call.

Money made 100*(100 - 80) - 500

c) Rate of return = ---------------------- = ------------------------------ = 25%
Money invested 6,000

 Regulations
Government regulations
Securities Act of 1933: requires full disclosure of relevant information related to
the issue of new securities

Securities Exchange Act of 1934: establish the Securities Exchange Commission

(SEC)

Securities Investor Protection Act: establish the Securities Investor Protection

Corporation (SIPC)

Self-regulations: by industries and exchanges themselves

The Sarbanes-Oxley Act: passed by Congress in 2002 to enhance corporate

governance
Creation of the Public Company Accounting Oversight Board
CEO and CFO must personally certify their firms’ financial reports
Auditors may no longer provide several other services
The board of directors much be composed of independent directors

Insider trading: trading with insider information, which is prohibited

 ASSIGNMENTS

1. Concept Checks and Summary

2. Key Terms
3. Intermediate: 15, 16, 17, 20, 21, CFA 1 and 2

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 Chapter 4 - Mutual Funds and Other Investment Companies

 Investment companies
 Mutual funds
 Costs of investing in mutual funds
 Mutual fund returns
 Investing in mutual funds
 Exchange-traded funds

 Investment companies
An investment company is a type of financial intermediary. It sells itself to the
public and uses the funds to invest in a portfolio of securities.

Mutual funds are investment companies (open-end).

Advantages of investing in mutual funds:

Economies of scale
Professional management
Diversification and divisibility
Record keeping and administration

NAV: the underlying value on a per share basis of a mutual fund

It is determined by the closing-bell prices and it varies every day

NAV = (market value of assets - liabilities) / number of shares outstanding

For example, a mutual fund has $120 million in assets and 5 million of liabilities.
If it has 5 million shares outstanding, the net asset value (NAV) is $23 per share.

Managed investment companies: open-end vs. closed-end

Open-end fund: investors can buy shares from or sell shares back to the fund at
NAV (it may involve in purchase or redemption charges), with no limit on the
number of shares the fund can issue

Closed-end fund: it is traded at prices that can differ from NAV and the number
of shares outstanding is fixed

Unit investment trust: money pooled from many investors that is invested in a
portfolio fixed for the life of the fund

Hedge fund: a private investment pool, open to wealthy or institutional investors,

that is exempt from SEC regulations

Real estate investment trusts (REITs): similar to closed-end funds that invest in
real estate or loans secured by real estate

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 Mutual funds
Mutual funds are common names for open-end investment companies

More than 90% of mutual funds are open-end funds

Capital gains vs. current income

Investment policy: each fund has its policy contained in the fund’s prospectus

Money market funds: invested in short-term and low-risk instruments

Equity funds: mainly invested in stocks, growth funds vs. income funds

Balanced funds: a balanced return from fixed income securities and long-term
capital gains

Bond funds: invested in various bonds, more current income

Index funds: mimic market indexes (for example, S&P 500 index)

Sector funds: restrict investments in particular sectors (for example, financial

service sector)

International funds: invested in international stocks

U.S. mutual funds by investment classification (Table 4.1)

 Costs of investing in mutual funds

Operating expenses: costs to operate the fund, including administrative expenses,
ranging from 0.2% to 2.0%

Loads: commission charges, sales charges, or redemption charges

Front-end load: deduct a % charge from the initial investment (for example, 5%)

Low-load fund: less than 3% of front charge

Offering price = NAV / (1 – load) or NAV = offering price * (1 - load)

No-load fund: selling at NAV, or offering price = NAV

Back-end load: a commission change on the sale of shares

Other fees: for example, 12b-1 fees to cover marketing and distribution costs

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 Mutual fund returns
Sources of return: dividend income; capital gains distributions; unrealized capital
gains

NAV1 – NAV0 + I1 + G1
Rate of return = -------------------------------------
NAV0

I1: income distribution during the period

G1: capital gains distribution during the period

Note: All fees are deducted directly from NAV

Example on return of a mutual fund, problem 4-21

At the start of the year: $200 million in assets with no liabilities and 10 million
shares outstanding
At the end of the year: dividend income $2 million; no capital gains distribution;
fund price rises by 8%, and 1% of 12b-1 fees is charged at the end of the year

Answer:
NAV0 = $20
NAV1 = 20(1.08)*(1-0.01) = $21.384
I1 = $0.2 and G1 = 0

21.384 – 20.00 + 0.2

Rate of return = ------------------------------ = 7.92%
20.00

 Investing in mutual funds

Wealth accumulation
Diversification
Professional management
Low cost

Speculation and short-term trading

Selection process
Objectives
What a fund offers – investment policy
Main holdings
Load vs. no-load funds
Open-end vs. closed-end funds

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 Taxation on mutual fund income

Long-term capital gains

Short-term capital gains
Dividends

If it is a retirement account (Roth IRA, regular IRA, 401K or 403B): all taxes are
either exempt or deferred

Turnover ratio: the ratio of the trading activity of a portfolio to the assets of the
portfolio

Example: see concept check 4.3

A portfolio is currently worth $1,000,000. During the year, the investor sells
1,000 shares of FedEx at $90 per share and 5,000 shares of Cisco at $15 per share.
The proceeds are used to buy 1,000 shares of IBM at $165 per share.

a) What was the portfolio turnover ratio?

The turnover ratio is 16.50% (1,000*90 + 5,000*15 = $165,000 in a
$1,000,000 portfolio)
b) If the shares of FedEx were purchased for $80 per share and those of Cisco
were purchased at $12.50 per share, and if the investor’s marginal tax rate is
15%, how much taxes the investor has to pay?
The realized capital gains for FedEx is (90 - 80)*(1,000) = $10,000
The realized capital gains for Cisco is (15 - 12.50)*(5,000) = $12,500
Total realized capital gains = $22,500
Capital gains tax = 22,500*(0.15) = $3,375

 Exchange-traded funds (ETFs)

ETFs are offshoots of mutual funds that allow investors to trade index portfolios
as if they were individual stocks

Most popular ETFs

Spider (SPDR) for S&P 500
Diamonds (DIA) for Dow Jones Industrial Average
Qubes (QQQ) for NASDAQ 100

 ASSIGNMENTS

1. Concept Checks and Summary

2. Key Terms
3. Intermediate: 11, 12, 13, 21, 22 and 24

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 Chapter 5 - Return and Risk
 Rates of return
 Risk and risk premium
 Historical return
 Inflation and real return
 Asset allocation

 Rates of return
Components of return: cash dividend and capital gains (or capital losses)

Total return ($) = return from cash dividend + return from capital gains (or losses)

Total return (%) = dividend yield + capital gain yield

Holding period return (HPR):

Ending price – Beginning price + Cash dividend

HPR = --------------------------------------------------------------
Beginning price

Example
Dividend = $4
P0 = $100 P1= $110

0 1

HPR = (110 – 100 + 4) / 100 = (10 + 4) / 100 = 10% + 4% = 14%

Capital gains yield: % change in price, 10%

Dividend yield: % return from dividend, 4%

Returns over multiple periods

Table 5-1: Quarterly cash flows and rates of return of a mutual fund
1st quarter 2nd quarter 3rd quarter 4th quarter
Assets at the start of quarter 1.0 mil 1.2 mil 2.0 mil 0.8 mil
Holding period return (HPR) 10.0% 25.0% (20.0%) 20.0%
Total assets before net inflow 1.1 mil 1.5 mil 1.6 mil 0.96 mil
Net inflow 0.1 mil 0.5 mil (0.8 mil) 0.6 mil
Assets at the end of quarter 1.2 mil 2.0 mil 0.8 mil 1.56 mil

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 Arithmetic mean: simple average, the sum of returns in each period divided by the
number of periods - best forecast of performance in the future

Arithmetic mean = (10 + 25 – 20 + 20) / 4 = 8.75%

Geometric mean: time-weighted average return (considers compounding)

(1 + 0.1)*(1 + 0.25)*(1 - 0.2)*(1 + 0.20) = (1 + rG)4

Solve for rG = 7.19%

Dollar-weighted average return: internal rate of return for a project

Quarter
0 1 2 3 4
Net cash flow -1.0 -0.1 -0.5 0.8 0.96

IRR = 3.38%

APR (annual percentage rate) vs. EAR (effective annual rate)

APR n
EAR  (1  ) 1
n

For example, APR = 6%, n = 4 (quarterly compounding), EAR = 6.14%

 Risk and risk premium

Probability distribution: a list of possible outcomes with associated probabilities

Expected return: the mean value of the distribution

Variance and standard deviation: measure of dispersion around the mean (risk)

Example
State of the Economy Scenario, s Probability, p(s) HPR, r(s)
Boom 1 0.25 44%
Normal 2 0.50 14%
Recession 3 0.25 - 16%

S
Expected return = E (r )   p( s) * r ( s) = 14%
s 1
S
Variance =  2   p( s) *[r ( s)  E (r )] 2 = 450;
s 1

Standard deviation =    2  450 = 21.21%

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 Risk premium: expected return in excess of the risk-free rate, an additional return
to compensate for taking risk

Risk aversion: reluctant to accept risk

E (r p )  r f
E (rp )  r f  1 2 A 2p , where A is the risk aversion coefficient or A 
1
2  2p

For example, if the risk premium is 8%, the standard deviation is 20%, then the
risk aversion coefficient A = 4. The higher the risk aversion is for an investor, the
higher the value of A, and the higher the risk premium.

E (rp )  r f 8%
Sharpe (Reward-to-Volatility) ratio = S = = = 0.4
p 20%
(More discussions in Chapter 18)

 Historical return
Using historical data to estimate mean and standard deviation

Example: MO

Historical returns: summary statistics for the U.S market and the world during
1926 - 2010 (Table 5.2)

Interpretation of the numbers

Normal distribution: 68.26% (1  rule), 95.44% (2  rule), and 99.74% (3  rule)
(Figure 5.1)

68. 26%

95. 44%

99. 74%

Mean-2  Mean+2 
Mean

Size effect: average returns generally are higher as firm size declines

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 Inflation and real return
Nominal interest rate vs. real interest rate
r  R – i (the real rate, r is approximately equal to the nominal rate, R minus the
inflation rate, i)

R = r + E(i)
Nominal interest rate = the real interest rate + expected inflation rate

Inflation rate is measured by consumer price index (CPI)

U.S. history of interest rates, inflation, and real interest rates

(Figure 5.5 and Table 5.3)

 Asset allocation
Asset allocation: portfolio choice among different investment classes

Risky assets vs. risk-free assets

All risky assets form a value-weighted risky portfolio, P
All risk-free assets form a risk-free asset with a risk-free rate, rf

Complete portfolio: a portfolio including risky assets and risk-free assets

Complete portfolio’s expected return and risk:

E(rc )  y * E(r p )  (1  y) * r f and  c  y * p

Where E(rc) and c are the expected rate of return and standard deviation for a
complete portfolio, E(rp) and p are the expected rate of return and standard
deviation for the risky assets, rf is the return on the risk-free asset, y is the weight
on risky-assets, and 1-y is the weight on the risk-free asset. The capital allocation
line (CAL): a plot of risk-return combinations available by varying portfolio
allocation (weights) between the risk-free asset and the risky portfolio.

E(rc)

P
E(rp) y = 1.5
CAL
rf
y = 0.5

p 

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 Example: if E(rp) = 15%, p = 22%, rf = 7%, y = 50%, then

15%  7%
E(rc) = 11%, c = 11%, the Sharpe measure = S   0.36
22%

Challenge: if y = 1.5 what will happen to the complete portfolio? Where is it

located on CAL? What is S? What does it mean (y = 1.5)?

Passive investment strategy: holding a combination of a well-diversified market

portfolio and a risk-free portfolio, assuming all risky assets are fairly priced.

Capital market line (CML): a capital allocation line using the market index
portfolio as the risky portfolio

E(rc)

M
E(rM) y = 1.5
CML
rf
y = 0.5

M 

Capital Asset Pricing Model (CAPM) and its applications – a review of Fin 303

E (ri )  r f   i [ E (rm )  r f ] CAPM model

E(ri)

SML
Slope = E(rm) - rf
rf

i

 ASSIGNMENTS

1. Concept Checks
2. Key Terms
3. Intermediate: 5, 6, 12-16 and CFA 1-6

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