Inst. Power Point_CH 2_P3.ppt

7/28/2019 Inst. Power Point_CH 2_P3.ppt

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What are derivatives? How can they beused to reduce or increase risk?

A derivative securitys value is derived from the price ofanother security (e.g., options and futures).

Can be used to hedge or reduce risk. For example, an

importer, whose profit falls when the dollar loses value,could purchase currency futures that do well when thedollar weakens.

Also, speculators can use derivatives to bet on the

direction of future stock prices, interest rates, exchangerates, and commodity prices. In many cases, thesetransactions produce high returns if you guess right, butlarge losses if you guess wrong. Here, derivatives can

increase risk. 2-1


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Types of Financial Institutions

Commercial banks Investment banks Financial services corporations

Credit unions Pension funds Life insurance companies

Mutual funds Hedge funds Exchange traded funds

Private equity companies2-2


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Investment banks

Help corporations design securities with features attractive to investors

Buy these securities from corporations

Resell them to savers

Examples:

Bear Stearns collapsed and was later acquired by J.P Morgan

Lehman Brothers went bankrupt

Merrill Lynch was forced to sell out to Bank of America

Commercial banks

Department stores of finance as they serve a variety of savers and borrowers

Helped Federal Reserve System in monitoring money supply by checking accounts

For example Bank of America, Citibank, Wells Fargo, J.P. Morgan2-3


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Financial services corporations

Large conglomerate that combine many different financial institutions within a singlecorporation

Have diversified to cover most of the financial spectrum

Examples: Citigroup owns Citibank (commercial bank), Smith Barney(an investment bankand securities brokerage organization), Insurance companies, and Leasing companies

Credit unions

Cheapest source of funds available to individual borrowers

Cooperative associations whose members have a common bond, such as beingemployees of the same firm

Members savings are loaned to other members to facilitate auto purchases, home

improvement and mortgage loans 2-4


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Pension Funds

Are retirement plans funded by corporations or government agencies for their workers

Are administered by the trust departments of commercial banks and life insurance

companies Invest primarily in bonds, stocks, mortgages, and real estate

Life Insurance Companies

Take savings in the form of annual premiums

Invest them in stocks, bonds, mortgage, real estate

Make payments to beneficiaries of the insurance parties

Also offered a variety of tax deferred savings plans for retiring individuals

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Mutual Funds

Use savers money to buy stocks, long term bonds, or short term debt instruments

Pool funds to reduce risks by diversification

Bond funds for those who prefer safety

Stock funds for those who accept significant risk in the hopes of high returns

Funds that are used as interest bearing checking accounts(money market funds)

Invest primarily in bonds, stocks, mortgages, and real estate

Achieve economies of scale in analyzing securities, managing portfolios and buying andselling securities

Exchange Traded Funds (ETFs)

Operated by mutual fund companies

Buy a portfolio of stock, eg. The S&P 500 or Chinese companies and then sell their ownshares to public

ETFs shares are traded in public markets 2-6


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Hedge Funds

Similar to mutual funds with few exceptions

largely unregulated as compare to mutual funds and ETFs which are registered and

regulated by securities and exchange commission Mutual funds typically target small investments whereas hedge funds have large minimum

investments(often exceeding $1 Million)

Private Equity Companies

Organizations that operate much like hedge funds

Private equity players buy and then manage entire firm

The money used to buy the target companies is borrowed

Examples: Cerberus Capitals buyout of Chrysler and private equity company JC Flowersproposed $25 billion purchase of Sallie Mae, the largest student loan company

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Physical Location Stock Exchanges vs.Electronic Dealer-Based Markets

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Auction market vs.Dealer market

(Exchanges vs.OTC)

NYSE vs. Nasdaq

Differences arenarrowing


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Physical Location Stock Exchanges vs.Electronic Dealer-Based Markets

Physical Location Exchanges

tangible entities, having its own building, allows a limited number of people to trade on itsflour and has an elected governing body.

Exchanges are open on all normal working days with members equipped with telephoneand other electronic equipment to communicate with his or her firm throughout the world.

NYSE is the largest physically located stock exchange

Over the Counter Market

A large collection of brokers and dealers connected electronically by telephones andcomputers that provides for trading in unlisted securities

A dealer market includes all facilities that are needed to conduct security transactions

The dealer quote the price at which pay for the stock (the bid price) and the price at whichthey will sell the shares (the ask price)

The bid-ask spread which is the difference between bid ask prices, represents the dealersmarkup or profit

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Stock Market Transactions

Apple Computer decides to issue additional stockwith the assistance of its investment banker. Aninvestor purchases some of the newly issuedshares. Is this a primary market transaction or a

secondary market transaction?

Since new shares of stock are being issued, this isa primary market transaction.

What if instead an investor buys existing sharesof Apple stock in the open market is this aprimary or secondary market transaction?

Since no new shares are created, this is asecondary market transaction.

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What is an IPO?

An initial public offering (IPO) is where acompany issues stock in the public market forthe first time.

Going public enables a companys owners toraise capital from a wide variety of outsideinvestors. Once issued, the stock trades inthe secondary market.

Public companies are subject to additionalregulations and reporting requirements.

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S&P 500 Index, Total Returns: DividendYield + Capital Gain or Loss, 1968-2007

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Where can you find a stock quote, and whatdoes one look like?

Stock quotes can be found in a variety of printsources (Wall Street Journalor the localnewspaper) and online sources(Yahoo!Finance, CNNMoney, or MSNMoneyCentral).

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What is the Efficient Market Hypothesis(EMH)?

Securities are normally in equilibrium and arefairly priced.

Investors cannot beat the market except

through good luck or better information. Efficiency continuum

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Highly

Inefficient

Highly

Efficient

Small companies not followed

by many analysts. Not much

contact with investors.

Large companies followed by

many analysts. Good

communications with investors.

Inst. Power Point_CH 2_P3.ppt

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