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Investments Class summaries 20/21
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InvestmentsWEEK 1:
Video #2: The functions of financial markets
- Suppliers of funds: wealthy people that are willing to invest their money/savings
- Firms/Entrepreneurs: people who need this money for their investment ideas
- Middle part: financial system of the economy: meant to channel the funds from people who have
the money for investing to the firms
o The equity market: stock market
o The corporate bond market: traded corporate debt (where firms issue bonds)
o The money market: market for short-term debt instruments
o Banks: invite people to deposit money on their bank account and subsequently lend that
money to firms
o Institutional investors: PE, Insurance companies, pension funds, investment funds, VCs
Raise money in various ways (pension/insurance premiums, private equity
investments) and subsequently invest that money to the firms (directly or
indirectly)
Why do we need financial markets?
- Financial markets (+financial intermediation) play a crucial role in the economy:
o Allocation of capital – historically, bankers were known to be very skilled at knowing
where to invest the capital (which firms)
In the case of IPO, the stock market determines the price of the IPO
o Consumption timing / smoothing – it allows individuals to smooth their consumption
over time (early in your life – borrow; late in the life – savings)
o Separation of ownership and management
o Provision of liquidity – need for money in the long-run; however, most investors want to
maintain liquid – financial markets help with that
o Allocation of risk – people who want to take on risk are able to do so by e.g. investing in
riskier securities
o Information aggregation (through prices)
Video #3: Margin trading & Short selling
Margin trading: purchasing securities (in part) by borrowing money
- Margin is capital put up by investor to secure credit from a broker to buy securities
o Refers to money you have to put up yourself for the trade
o It is not possible to finance the trade 100% with borrowed money
- Broker requires investors to put up a certain minimum margin (in US initial margin requirement
is 50% of the total value of the position)
- If margin falls below threshold (maintenance margin; equal to 25% for long positions and 30%
for short positions in the US), the investor gets a margin call and has to put up extra capital
,Balance Sheet representation:
- Long position margin:
o Assets: Value of stock = $P * Q
Quantity remains stable, while price varies and therefore the value of the asset on
the balance sheet will vary
o Liabilities: Loan from broker = $Loan
Loan from the broker (max 50% of your position)
o Equity: Equity = $P * Q - $Loan
o Margin = Equity in account / Market value of position (P * Q)
- Short margin – see BKM example 3.3
Short selling
Short sales allow investors to profit from a decline in security’s price by selling a security that is
borrowed from another investor. Mechanics:
- Borrow stock through a broker
- Sell it and deposit proceeds and margin in an account
- Closing out the position: buy the stock (once the price has declined) and return to the party from
which it was borrowed
- Risky:
o You need to post a margin, you cannot just ask the broker to do it, risk for the broker –
you will not be able to pay back the loan in terms of shares (if the price increases)
o Unlimited potential for loss (as stock prices can increase indefinitely)
Short sale: example
- Two phases in short selling:
o (1) Origination of short sale: broker is looking for a financial institution (e.g. mutual
fund) that is willing to lend you the shares
o Broker deposits the current market value of these shares (here - $3000) with the lender
o Then, the broker goes out and sells those shares in the market for the current market price
(P=30)
, o (2) Covering short sale: broker (on behalf) buys back the 100 shares at the current market
price
o Returns 100 shares to the lender
o $3000 deposit returned to the broker (minus a small fee)
o Broker has made $1000 on behalf of the short seller
- In practice, it is not as clear as this – broker relies upon you to make up for any losses – margins
Example: Short sales & margin
Suppose you want to trade on information that the stock price of Z Corp may go down:
- 100 shares in short position
- 50% initial margin
- 30% maintenance margin
- $100 Initial price
- When you face a situation like this: make a balance sheet account
-
- Sale proceeds: broker borrows 100 shares and sells them at the current market price – cash
position
- Posted margin – cash number
- Stock owed – cost of returning the owed shares (read this as 100 shares * MV(price of share))
- Suppose the stock price rises to $110 (as an investor, you expected it to fall)
- Stock owed changes!! Increases to 11,000 (100shares * $110) -> this is what needs to be returned
- Margin = 4000/11000 = 36% (fall from 50%, but still above 30% so you won’t receive a margin
call)
-
- At what stock price will you get a margin call?
- Margin = equity account / MV(of position) => (15,000 – 100P) / 100P = 30%, P = $115.38
Lecture #1: Security Markets
Part 1: Trading on Financial Markets
Two dominant types of financial markets:
• Dealer markets
a. fixed income, FX (foreign exchange), some derivative markets
• Agency markets / Limit order book
b. most stock, some derivative markets
, Why do we care?
- Type of market determines way of trading
- Trading is important consideration in portfolio management and asset pricing
- Neglected in many courses on asset management
Trading costs/market liquidity
- Trading involves costs
- Since trading is costly, investors are concerned about market liquidity
a. The ability to trade large quantities of a financial asset quickly, at low cost, and with little
impact on price
- Three elements:
a. Transaction costs (fixed, variable)
b. Depth (of the market) – how much demand and supply there is available in the market
c. Price impact – if you buy a lot of stocks, the price will increase (explained later)
Illiquidity can be a source of risk: retail investors pay a higher bid-ask spread than institutional investors
Type #1: Dealer markets
• In dealer markets, buyers and sellers do not trade with each other, but with “dealers” (usually
banks) who act as intermediary and stabilize the market by supplying immediacy
• They charge bid-ask spread as compensation
o Sell at dealer’s bid, buy from dealer’s ask (below: risks that they want to be compensated
for)
Fixed costs: admin, operation, technology
Costs of bearing inventory risk (changing prices!)
Costs of trading against better informed (asymmetric information)
Potentially also counterparty risk
• Competition among different dealers helps to keep bid-ask spreads low
• Bid quote: the other party bids this price to buy from you (selling price)
• Ask quote: what you pay if you want to buy (higher -> bid-ask spread)
Type #2: Agency markets
• In Agency markets, order flow meets at central place (e.g. the stock exchange)
- So buyers and sellers directly trade with each other
• In most agency or auction markets, there is one market maker or specialist for each stock:
- Specialists handle much of the order flow for stocks assigned to them by the exchange
and have the affirmative obligation to make fair and orderly markets for their stocks
i. Specialist does not normally takes positions in the stocks, so is usually not the
middle man
Limit ask orders: all the parties that are interested in selling the stock
Limit bid orders: all parties that are interested in buying the stock
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