Investment analysis
Lecture 1. Chapter 1,2 – investment environment
Chapter 1
Essential nature of investment: reduce current consumption, planned later consumption
- real assets; assets used to produce goods and services
- financial assets; claims on real assets (stocks, bonds)
Success or failure of financial assets depends on performance of underlying real assets
Financial markets play a central role in the allocation of capital resources
They allow players to separate decisions concerning current consumption from
constraints that would be imposed by current earnings
How to choose between options of when to consume? → utility/indifference curves!
These represent the investors preference for income in the two periods
Constructed so that everywhere along the same curve investor is equally happy
The ‘steepness’ of the curve depends on personal preferences, like risk aversion (A).
Portfolio is collection of investment assets:
- asset allocation; choice among broad asset class
- security allocation; choice of securities within each asset class
Security analysis
- top-down; first asset allocation, then pick securities
- bottom-up; look for attractively priced securities, without much concern for asset alloc.
Markets are competitive:
- assets are priced in line with it risks
- would rarely expect to find bargains in security markets (no free lunch)
Active management:
- try to find mispriced securities
- ‘time’ the market
- is it really profitable? (trading costs/management fees)
Passive management:
- no attempt to find undervalued securities
- no attempt to ‘time’ the market
- hold a highly diversified portfolio
- trading costs/management fees much lower
,- funds like ETFs are passive index trackers with low fees → more and more popular
Players in the financial markets:
- firms → net borrowers (want to invest)
- households → net suppliers
- governments → borrowers and/or suppliers
- financial intermediaries – pool investor funds and invest them (investment company,
pension fund, bank, insurance company)
- investment banks (perform specialized services for businesses (i.e. IPO, SEO))
- venture capital (active role in management of start-up)
- private equity (investment in not publicly traded firms)
Presence of risk in financial markets implies that actual returns can differ from expected
returns!
Chapter 2
Financial markets:
- Money markets → short term, liquid, low-risk
- T-bills, certificates of deposit, commercial paper, banker’s acceptance,
Eurodollars, repurchase agreements, federal funds, broker’s calls
- LIBOR is premier short-term interest rate in Euro money market
- Capital markets → longer term, more risky
- Bond market
- treasury notes and bonds, corporate bonds, municipal bonds (tax-free),
mortgage securities, federal agency debt
- Equity market
- common stock (ownership share, 1 share 1 vote, BOD elected by
shareholders, residual claim, limited liability, dividend yield, capital gains)
- preferred stock – features of equity and debt (fixed amount of income, no
voting power, obligation to pay interest but not dividend, payments are
treated as dividends; not tax-deductible)
- stock market indexes (S&P500) are indicators of economic performance
- Derivative market
- options – call/put (right to buy/sell, exercise only when profitable, must
be purchased at a cost)
- futures (obligation to make/take delivery, obligation to buy/sell at future
prices, contracts entered without costs)
Lecture 2. Chapter 3 – how securities are traded
Firms can raise funds by borrowing money or selling shares
- primary market → new issues of securities
- secondary market → trading existing securities on exchanges or OTC markets
Both public and private firms have shares. Public – on markets, private – OTC
Publicly traded companies can issue securities through IPO or SEO
The IPO:
- Road shows (generate interest from investors)
- Boatbuilding (large investors communicate preference for shares)
- Public offerings of stocks/bonds are marketed by underwriters; they bear price risk
- IPOs commonly underpriced (Facebook notable exception)
- Sometimes cannot be fully sold
- IPOs tend to underperform in long-term (Facebook notable exception)
, Special purpose acquisition company (SPAC) is shell company formed to raise capital
through IPO in order to acquire existing company – Virgin Orbit example
- At time of IPO they have no business or targets for acquisition (shell company)
- There only assets are funds raised through IPO
- Investors in SPACs have no idea what they invest in (investors: private equity
firms/general public)
- Money raised through IPO is placed in interest-bearing trust account
- SPAC founders generally have 2 years to acquire a company
- Acquire company within 2 years or return money to investors
Type of markets where securities are traded:
- direct search; least organized – buyers and sellers seek each other
- brokered; broker offers search services to buyers and sellers
- dealer markets; trading in particular type of asset and buy/sell for own accounts
- auction; all traders in an asset meet at one place to buy/sell
Type of orders:
- market; executed immediately
- bid (highest price a buyer will pay)/ask (minimum price a seller wants) price
- price contingent; investors specify prices to buy/sell
- limit buy/sell orders:
- limit buy: buy if stock is at or below specified limit
- limit sell: sell stock when it rises above specified limit
- stop-loss: sell stock if price falls below a specified limit
- stop-buy: buy stock when price rises above a specified limit
There are many more types of orders!
Due to technology, liquidity has increased and spreads have decreased
But not all is good → HFT are ‘gaming’ the market and doing everything to be first
HFT’s:
Instead of transferring buy/sell order to exchange, your order could end up in a ‘dark
pool’ via your broker, where it could be matched with another buyer (without ever ending
up at the exchange)
In 2007, stock trading changed → as soon as you made clear you wanted to sell/buy at a
certain price supply/demand would disappear, and you couldn’t trade at the listed price
anymore. HFTs ‘jump’ in the middle of trades. Chipotle example:
