Investments notes videos
Video 1 The functions of financial markets
Why do we need financial markets?
Financial markets (+financial intermediation) play a crucial role in the economy
o Allocation of capital
o Consumption timing/smoothing. It allows individuals to smooth their
consumption over time to determine when during your life you are going to
consume. That could be early in your life you need to borrow then or later on
in your life then you need to save or invest.
o Separation of ownership and management
o Provision of liquidity. Many firms need money for a long run, but most
investor are not willing to part their investments for decades, they want to be
liquid, they want to be easily converting their money back into cash. The
financial system allows for that. If you sell your stock, you don’t affect the
company directly. They can keep their money for the long run and you can
concert your stock into cash at short notice. So you stay liquid.
o Allocation of risk
o Information aggregation (through prices). The stock price should be an
aggregation of all kind of information that different individuals trade on.
Video 2 Margin trading & short selling
Margin trading means that you buy a position in a stock or other financial security in
part with borrowed money.
The margin is the amount of money you have to put up yourself to do the trade. You
cannot borrow 100%.
The broker is from which you borrow the money requires investors to put up a
certain minimum amount of margin (in US initial margin requirement is 50%, you can
only borrow 50% of the position in the stock or other security with borrowed money,
the rest should come from your own account)
At any point in time there is a requirement for the minimum margin that needs to be
in your account at the broker for the position to be maintained. In the US this is
called the maintenance margin which is standard 25% for long positions and 30% for
short positions. If the amount of margin in the account represents less than this
threshold than you will get a so called margin call from the broker. You need to put
up extra cash in your broker account to maintain your position or the broker will
terminate a part of your position so that your maintaince margin is satisfied.
Long position Margin
When you go long, so a long position, when you buy a stock the balance sheet at your broker
account will look like this:
, - The loan, the most you can get is 50% of your position.
We can define the margin in your account:
Equity∈account
Margin=
Market value of position
Go to example 3.3 in the book to see short on margin.
Short sale allows investors to profit from a decline in a security’s price. An investor borrows
a share of stock from a broker and sells it. Later, the short-seller must purchase a share of
the same stock in order to replace the one that was borrowed. The short-seller anticipates
that the stock price will fall, so that the share can be purchased later at a lower price than it
initially sold for; if so, the short-seller will reap a profit. Like investors who purchase stock on
margin, a short-seller must be concerned about margin calls. If the stock price rises, the
margin in the account will fall; if margin falls to the maintenance level, the short-seller will
receive a margin call.
Mechanics:
Borrow stock through a broker
Sell it and deposit proceeds and margin in an account
, Closing out the position: buy the stock and return to the party from which it was
borrowed
There are some risky components to it: first of all you need to post margin, because
the broker is running a risk and that is that you might not be able to pay back the
loan in terms of shares to the broker at some point in time. If the stock price decline
you are going to make profit, but if it is going to increase over time you are going to
face a loss. The loss is potentially unlimited, the stock price can increase forever.
Short sales & margin example: (make a balance sheet with questions like this)
On the liabilities side we don’t have a loan as on the long position balance sheet instead we
have stock owed. Because we borrowed 100 shares and we need to return that and the cost
of returning that is 100*100 (mv of the share).
Suppose the stock price rises to $110.
Sale proceeds $10,000
Initial Margin 5,000
Stock owed 11,000
Net equity 4,000 (the position has fallen due to the price increase) 110*100 = 11,000
(15,000-11,000 = 4,000)
New margin % (4000/11000) 36% but it is still above the 30% margin maintenance
requirement. So you will not receive a margin call
If you have to return those stock you have to pay 11,000 now instead of 10,000
When will you get a margin call?
Margin = (equity in account/(MV of position)
MV of position can be written as = (15,000 -100P) / (100P) = 30% that is the maintenance
margin requirement. If the stock price is equal to p = $115.38 then we would not get a
margin call. But if the stock price would increase by a little bit more than we would get a
margin call, asking you to either post additional margin in form of extra cash or the short
position will be in part terminated, because the margin will fall below the margin threshold.
Do the math to get P.
, Video 3 Prerequisites for Portfolio Theory
Modern portfolio theory has implications for:
Capital/asset allocation: How to optimally allocate your wealth over different assets
Asset pricing: The effects of investor decisions on security prices: specifically, the
relation that should exist between the returns and risk
Two key assumptions underlying MPT:
1. Investors are risk averse:
o it means investors prefer not to run any risk and can potentially be convinced
to run financial risk in their portfolio if they are compensated for such risk
through a risk premium. A risk premium is a higher expected return you will
get on a risk-free investment such a long term US government bond. This is a
reasonable assumption.
o Investors wants to maximize the expected return of their portfolio for a given
level of risk
2. Security returns are normally distributed. So there is a high probability that the
returns are close to the mean and there a lower probability that the returns gets
more extreme: the normal distribution is fully correctarized by two parameters. The
first one is the mean and the second one is the standard deviation. But this
assumption is not really realistic. Because in real life it does happen that returns are
more extreme than the normal distribution.
Investors care about a higher return so a return which is more to the right or the left in the
table of the example but that is riskier.
Mean-variance analysis:
If security returns are Normally Distributed, the shape of the entire distribution of
portfolio returns can be described using 2 variables: E (R) and (R)
This implies that investment analysis can be performed within mean-variance space:
o Investors like E [R] (expected return)
o Investors dislike (R) (standard deviation = risk)
o Another way of saying this, is that investors are mean-variance optimizers in
MPT. They optimize their choices portfolio formation in mean-variance space.
Mean-variance space: