Lecture 1 - Introduction to Investments

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Lecture 1 - Introduction to Investments

Transcript of Lecture 1 - Introduction to Investments

  • Lecture 1:

  • Course Delivery:

    One 2-hour lecture each week. Lecture slides will be placed on Wattle prior to the lecture each week.

    One 1-hour workshop each week. Will involve working through additional examples, prior exam questions, and discussion of

    other material relevant to the course. Workshops will commence in Week 2.

    One 1-hour tutorial each week. Tutorial enrolment will take place via the Electronic Tutorial Assistant (ETA) site. Please ensure

    that you only attend the tutorial in which you are enrolled.

    Tutorial questions are required to be completed prior to tutorials each week. Details of these questions are provided on Wattle. These may be a combination of questions drawn from the textbook, and/or other sources.

    Solutions will be made available on Wattle following the related tutorials each week.

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  • Prescribed reading: Lecture slides. These provide an overview of the topics covered

    and the methods used.

    Text: Bodie, Z., Kane, A. and Marcus, A., (2014), Investments 10th

    Ed., Mc-Graw Hill. Provides additional perspective for students. Primary source for tutorial questions.

    CFA Institute Code of Ethics and Standards of Professional Conduct http://www.cfapubs.org/doi/pdf/10.2469/ccb.v2014.n6.1

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  • Assessment:

    Mid-semester examination (20%). This will be a closed book, 90 minute examination covering all topics from Week 1, up to and including the material lectured in Week 5.

    Group assignment (20%). To be completed in groups of 3-4 students. An assignment handout containing further information to be made available on Wattle shortly.

    Final examination (60%). This will be a closed book, 2 hour examination which may include all topics covered throughout the semester, with emphasis placed on the topics covered in weeks 6 to 12.

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  • Teaching StaffLecturer and course convenor:

    Dr Dean Katselas

    Email: [email protected] (preferred contact method)

    Phone: 02 6125 5460

    Location: Room 4.06 in Building 26c

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  • Contact with staff If you have any questions about the structure of the course

    or assessment, please contact Dean via email or during consult.

    All staff on the course will be available for consultation throughout the semester. Please see your tutor during designated consult times if you have questions about tutorial material. The lecturer is also available to address lecture specific questions.

    All consult times will be posted on Wattle once confirmed by the tutors.

    Enrolment related issues should be directed to RSFAS administration (the counter on Level 4 of the CBE Bldg).

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  • Todays lecture is the first of two on theinvestment process. We will discuss:

    What making an investment entails;

    Instruments available for investment;

    The structure of securities markets and howinstruments are traded in them; and,

    The regulation of financial markets.

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  • An investment involves: Foregoing consumption of wealth today and

    investing it with the hope of generating furtherfunds for future consumption;

    Placing this wealth in real assets (eg land,buildings and human capital) or financial assets(claims to income generated by real assets) thatare expected to earn returns in the future; and,

    Assuming a certain level of risk, or probability thatthe investment will yield a lower than expected (oreven negative!) return.

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  • Once initially formed, the portfolio is thenperiodically rebalanced by:

    Selling existing investments and replacing themwith new ones;

    Injecting funds to purchase additionalsecurities; and / or,

    Liquidating current investments withoutreplacement.

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  • When constructing an investment portfolio,investors make two main decisions, namely:

    An asset allocation decision, or choosing betweenbroad asset classes. This decision is made first in atop-down approach; and,

    A security selection decision, or choosing specificsecurities to invest in within each broad assetclass. Selection is assisted by security analysis todetermine value and attractiveness of securities.

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  • Financial assets: Overcome consumption timing issues that can

    be associated with real assets;

    Allow investment risk to be shared in a mannerthat cannot be achieved with real assets; and,

    Allow a separation of ownership and control tooccur.

    These features of financial assets result in them facilitating both

    diversification and liquidity.

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  • However, as investors often dont have control of theassets they own, issues including agency problems canarise. Famous examples include:

    WorldCom: Classified expenses as investments to overstateprofits by US $3.8 billion. Its collapse is regarded as the biggestbankruptcy in US history;

    Enron: Moved debt off its balance sheet to special purposeentities. Its bankruptcy is the USs second largest; and,

    HIH: Reckless and incompetent management and fraudulentbehaviour saw Australias largest corporate collapse andestimated losses of AUD $5.3 billion!

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  • Given this, investors must gain comfort that their assets willbe utilised correctly in other ways such as:

    Corporate governance mechanisms;

    Legal protection of investor rights; and,

    Additional regulations imposed by the exchanges thefinancial assets are traded on.

    There is considerable variation in these factors around the world,and each has the potential to affect both the risk and return of theinvestments traded within a given country.

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  • Financial assets are traded in financial marketsincluding:

    The money market, which facilitates short-termlending and borrowing;

    The capital market, which assists in longer-termlending and borrowing;

    The derivative market, which facilitates thetransference of risk between market participants;and,

    The foreign exchange market, which facilitatesinternational trade.

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  • New securities are issued to raise funds for theissuing firm via a primary market transaction.They could be issued by:

    Public offering, which may be underwritten ina firm commitment or best-efforts arrangementor may not be underwritten at all; or,

    Private placement, which reduces disclosurerequirements, but is subject to size limitations.

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  • Once issued, securities are bought and sold insecondary markets, which can be: Direct search markets: Buyers and sellers have to

    find each other;

    Brokered market: Brokers search out buyers andsellers;

    Dealer markets: Dealers have inventories of assetsfrom which they buy and sell; and,

    Auction markets: Traders converge eitherphysically or electronically to trade in one place.

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  • Before discussing orders, it is important to understand that:

    The bid price is the price the dealer is willing to buy a security;

    The ask price is the price at which the dealer is willing to sell the security; and,

    The bid-ask spread, or the difference between the bid and ask price is the dealers profit.

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  • Investors might want to execute one of twotypes of order through these mechanisms,namely:

    A market order: A buy or sell order that is to beexecuted straight away at the prevailing marketprice; or,

    A price-contingent order: A buy or sell orderonly to be executed at a specified price. Limitorders awaiting execution are known as thelimit order book.

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  • The difference between the highest buy and the lowest sellorder, or the inside quotes, is called the inside spread. In theexample below, the inside spread is $0.01.

    Figure 3.4 The limit order book for FedEx on the NYSE Arca Market

    Source: New York Stock Exchange Euronext, www.nyse.com, June 22, 2012.

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  • Broadly speaking, secondary markets employone of 3 trading mechanisms, namely:

    Dealer, or Over-The-Counter (OTC) Markets;

    Electronic Communication Networks (ECNs);and,

    Formal Exchanges.

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  • 21

    Buyers SellersOrder

    Instructions

    Order

    Instructions

    Broker Broker

    Market makers accept market

    order from customers

    Market makers also trade

    among themselves

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    Buyers SellersOrder

    InstructionsOrder

    Instructions

    A Computer Network that manages

    the limit order book and matches

    buy/sell orders directly without the

    intervention of a broker

  • On formal exchanges such as the NYSE, trading ineach security is managed by a specialist (nowcalled a designated market maker), who acts asbroker or dealer that:

    Maintains a fair and orderly market and is obligated toprovide price continuity to the market

    Intervenes through supplying liquidity, i.e. act as abuyer/seller when no other trader can be found forthe other side of the transaction.

    Trades out of his/her own portfolio; and,

    Earns income from commissions and spreads .

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  • The Australian Securities Exchange (ASX) offersinvestors access to a wide range of productsincluding equities, interest rate securities andderivatives. Further:

    The Australian Stock Exchange was formed in 1987from 6 existing state exchanges;

    The Australian Stock Exchange merged with theSydney Futures Exchange in 2006 to form the ASX;and,

    The ASX was the subject of an $8 billion takeoverbid by the Singapore Exchange. This was blockedby the Australian government in April 2011.

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  • so

    Source: www.asx.com.au

    DateNo. of

    companies(domestic)

    No. ofcompanies

    (foreign)

    No. ofcompanies

    (total)

    No. ofcompanies (incl. debt

    issuers)

    Dec 2013 1951 104 2055 2195

    Dec 2012 1959 97 2056 2188

    Dec 2011 1983 96 2079 2222

    Dec 2010 1986 88 2077 2220

    Dec 2009 1959 84 2043 2181

    Dec 2008 2001 85 2086 2223

    Dec 2007 1992 85 2077 2209

    Dec 2006 1830 78 1908 2014

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  • Trading currently occurs electronically via ASXTrade:

    Unlike the NYSE, no specialists are involved;

    Brokers enter client trades (including thosesubmitted online) on ASX Trade; and,

    Orders are then sent to the market, and seenby all participants, where they are executedbased on price and time priority.

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  • Once a trade has occurred, CHESS effectssettlement within 3 days by Delivery versusPayment (DvP), which involves:

    Transferring title of the instruments betweenthe seller and buyer; and,

    Facilitating the movement of funds betweenthe traders banks accounts.

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  • The ASXs effective monopoly ended in late 2011,when Chi-X Australia opened for business. Chi-XAustralia argues their entry:

    Is owned by Nomura, a Japanese investmentbank, which operates other exchanges aroundthe world;

    Provides market participants with anotherexchange via which to trade ASX-quotedproducts; and,

    Use SecuritEase to access the ASXs trading andsettlement infrastructure in real time.

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  • Chi-X Australia argues their entry to the marketoffers:

    Innovation in order types;

    Reduction in transaction costs; and,

    Improvements in trade efficiency.

    On 4th November 2013, Chi-X Australia enjoyeda one-day record of approximately 25% of thetotal value of equities traded.

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  • Dark trading:

    Allows traders to match orders away from thelit market and disclose them within aspecified timeframe;

    Reduces the price and volatility impact of largetrades resulting from short-term differences inthe demand and supply of instruments; and,

    Is permissible under the rules of marketsincluding the ASX.

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  • Recent technological advances mean many smallertraders now also trade alongside larger investors indark pools. However:

    If dark pools steal too much trade from the lit market,displayed orders may not execute;

    This may make placing orders in the market lessattractive and have liquidity and trading cost impactsfor everyone; and,

    Regulators are concerned there is sufficienttransparent trading to ensure price discovery alongwith market depth and liquidity.

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  • Algorithmic trading is the use of computerisedtrading rules that are programmed to achievecertain objectives. Examples include:

    Iceberging, where large orders are broken downand submitted over time to minimise the priceimpact (often measured by VWAP); and,

    High-frequency trading (HFT), where computersmade decisions based on information submittedto them electronically before humans would beable to analyse and act on it.

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  • Trading costs can be broken down into two components, namely:

    Explicit costs: These refer to brokerage commissions,or fees paid to broker for making the transaction. Theemergence of discount brokerage has reduced themagnitude of these fees dramatically; and,

    Implicit costs: These include the dealers bid-askspread.

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  • Buying on margin involves an investor borrowingpart of a stocks purchase price from a broker andcontributing the remainder themselves. Further,the:

    Margin is the fraction of the price the investorcontributes;

    Maintenance margin is the minimum value thatmust be kept in the maintenance account; and,

    Investor will be subject to a margin call if the valueof the securities falls too much.

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  • Example 3.1 (text)

    Share price: $100 Shares Purchased: 100 Initial Margin: 60% Maintenance Margin: 30%

    Initial position:Stock : $10,000 Borrowed $4,000

    Equity $6,000

    Margin = 6,000/10,000 = 60%

    New Position (when the stock price falls to $70): Stock : $7,000 Borrowed $4,000

    Equity $3,000

    Margin % = $3,000/$7,000 = 43%

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  • Example 3.2 (text)

    If the maintenance margin is 30%, the investor willreceive a margin call if price is less than $57.14, whichcan be found by solving for P:

    (100P 4,000)/100P = 0.30

    At this point:Investors are required to top up the margin account; and,If the investor fails to act, the broker may sell securities fromtheir account and reduce the loan enough to restore the %margin.

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  • Investors borrow on margin when they want topurchase shares costing more than they can fundthemselves. However, by doing so, they:

    Must pay interest on their borrowings; and,

    They magnify their exposure to any upwards ordownward movements in the share price.

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  • Additional ExampleAn investor purchases 400 shares in Cyrus Ltd, currentlytrading for $50 each, funding $10,000 themselves andtaking out a margin loan at a rate of 7.5% p.a. for theremainder. Given this information:

    What is the return for the investor if Cyrus Ltd sharesappreciate in value by 30% over the investment period?

    What would their return be if the price had instead fallenby 30%?

    How would your answers to the questions above change ifthe investor had only purchased as many shares as shecould afford (ie 200 shares)?

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  • Short selling is the selling of borrowed shares withthe intention of profiting from an expecteddecline in the shares price. More specifically, theinvestor:

    Borrows shares through a dealer;Sells the borrowed shares; and,Closes the position by purchasing and returning anequivalent number of shares at a later date.

    Short sales are subject to margin requirements.

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  • Short selling was blamed for the 2008 marketcrash. Further:

    Regulators worldwide banned short selling ofstocks in response to the spillover of the UScredit crisis to the world economy; and,

    In Australia, ASIC banned any short selling forbetween 3 months (non-financials) and 9months (financials) and banned naked shortselling permanently.

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  • To ensure trading is equitable, orderly and there is fulldisclosure, it is regulated by :

    Government agencies: For example: In Australia, ASIC ensures the ASX fulfils the

    requirements set out under the Corporations Act; and,

    In the US, the SEC along with other agencies administerlegislation including the Securities Act, the SecuritiesExchange Act and SOX.

    Industry bodies: This includes securities exchangestogether with professional bodies such as the CFAInstitute.

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  • The CFA Institute have formulated a Code of Ethics andStandards of Professional Conduct. Moreover:

    These guidelines detail the manner in which members andcandidates for membership are expected to behave; and,

    Failure to adhere to them can have ramifications includingtermination of membership or candidacy.

    We will discuss the Code of Ethics and Standards of Professional Conduct more in Week 12.

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  • While investors have the option of directly tradingsecurities:

    They will often outsource responsibility for investmentdecision making to professional investors; and,

    Investing indirectly through investment companies isappealing to investors given the promise of:

    Professional management: Investors have the perception thatprofessional managers have superior skills, experience andaccess to assets that will, in combination, yield higher risk-adjusted returns;

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  • Pooling and collective investment of investors funds: Large-scale investing allows investors to hold fractional shares inmultiple securities and, in doing so, enjoy the benefits ofdiversification;

    Transaction cost savings: Investment companies enjoybrokerage and commission discounts by trading in bulk; and,

    Administrative support and record maintenance: Investmentcompanies track and report on the performance of, anddistributions made by, investment companies. In some cases,they even reinvest the latter.

    Investment companies can be stratified into unit investment trusts, managed investment companies and other organisation types.

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  • Unit investment trusts involve the investment of funds ina fixed-composition (i.e. unmanaged) portfolio.Importantly:

    A trust is formed when the sponsor buys a portfolio ofsecurities and places them in a trust;

    Units in the trust are then sold to investors; Investors will receive any income earned on the portfolio

    as distributed by the funds trustees; Investors can sell their units back to the trustee for net

    asset value (NAV); and, The trustee will either liquidate a portion of the underlying

    portfolio to buy units back from these investors, or will sellthe units to a new investor for a premium.

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  • In contrast to unit investment trust securities, theportfolios of managed investment companies aremanaged. Managed investment companies can befurther categorised as either:

    Open-end funds, more commonly referred to asmutual funds: These funds redeem or issue shares attheir NAV, meaning investors can exit by simply sellingshares back to the fund; or,

    Closed-end funds: These funds do not redeem or issueshares, meaning investors can only exit by selling theirshares to other investors. This is facilitated by theseshares trading on organized exchanges.

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  • Organisations offering similar services but notstructured or regulated in the same way asinvestment companies include:

    Real estate investment trusts (REITs) which are, ineffect, closed-end funds that invest in real estate and /or loans secured by real estate; and,

    Hedge funds, which allow (wealthy) individuals orinstitutions to pool assets that are collectively investedby a professional manager. Funds are typicallystructured as private partnerships, escaping heavyregulation, and often involve lockup periods, withthese features facilitating investment in a wider rangeof (often illiquid) assets.

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  • Mutual funds, the common name for open-end investmentcompanies, are the dominant type of investment company.Funds are often classified based on their investment policy,which defines the type of assets they invest in. Commonexamples include:

    Equity funds, which primary invest in stocks;

    Bond funds, which invest in fixed income securities; and,

    Index funds, which track the performance of a broad market indexsuch as the S&P500.

    Management companies such as Fidelity and Vanguard manage a family of

    mutual funds.

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  • Fees associated with investing in mutual fundsinclude:

    Operating expenses, or fees incurred in running the fund.These fees are deducted from the funds assets and, therefore,reduce portfolio value;

    Front-end load, or commissions paid to brokers who sell thefunds;

    Back-end load, or exit fees paid when shares are sold. Theseare typically a decreasing function of the time money isinvested in the fund; and,

    Distribution costs, or expenses incurred in marketing fundsthat are subsequently recovered from investors.

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  • All buy and sell orders arriving throughout a given dayare executed at the NAV calculated at the end of the day!Against this backdrop:

    Some funds accept orders after the market closes for theday (ie after NAV is determined);

    If news released after the market closes is positive and,thus, is expected to increase such a funds NAV on the nextday, late traders can buy into the fund after market closeand reverse their position the next day at the adjustedNAV!;

    Market timers can take advantage of stale prices in asimilar fashion; and,

    These practices reduce the returns to other investors!

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  • Exchange traded funds (ETFs) allow investorsto trade index portfolios in the same mannerthey do shares. ETFs:

    Can be traded throughout the day, unlike mutual funds;

    Can track broad indexes or industry indexes or becommodity-based;

    Can be short-sold or purchased on margin;

    Have tax advantages over mutual funds; and,

    Enjoy relatively low management and transaction fees.

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