Principles of Investments Lecture Notes

Principles of Investments Lecture Notes

Set 2

What is Investment

This course looks at investment from the perspective of a saver. That is, the individual that has money that he wants to save and on which he wants to get a rate of return. This is what we term financial investment. This is slightly different from the way investment is used in economics. In economics, investment is from the perspective of the economy. It refers to the creation of capital goods, which are those goods that are used to produce consumption goods. For example, equipment, machinery, buildings, etc. may all be considered capital goods. These two types of investment (financial and economic) are really two sides to the same coin. On one side we have the saver that uses his money in an attempt to get a return by buying stocks, bonds, etc. The other side of that transaction though is the business that acquires the money from the saver in exchange for a future rate of return. Of course, that business will afford to pay this rate of return because it will take the funds from the saver and make economic investment in capital goods. This is displayed in the figure below.

In economics we would be ultimately interested in the investment that occurs at the end of the above transaction. This of course is influenced by savings, financial markets, and technology.

In finance we are interested in investment from the perspective of investors. We will focus on how financial investment actually occurs, and how investors can make good decisions regarding investment.

Some Definitions

Financial Assets: Pieces of paper that are a claim on the company that issued the paper. For example, a bond is a piece of paper that entitles the owner to the principle and interest as specified on the bond. Equity/Stock is a piece of paper that entitle the owner to dividends from the company that issued the equity. Sometimes we refer to financial assets as financial instruments or securities.

Debt vs. Equity: Debt is when a company has borrowed money. It is a liability for the company, and a financial asset for the investor that holds the debt.Equity is a share of ownership of the company. It is a liability for the company, and a financial asset for the holder of the equity. The big difference between these two involve differences in risk and return.

Marketable Securities: Marketable securities are financial assets that are traded on organized markets; for example, stock markets and bond markets.

Derivatives: Derivatives are assets that derive their value from some underlying financial assets. Examples include put options, call options, futures contracts, and swaps.

Portfolio: A portfolio refers to a group of financial assets owned by an investor. We will later talk about the significance of portfolios, and the optimal selection of a portfolio.

Indirect vs. Direct Investment: Direct investment is when the investor owns the financial assets of the issuer. Indirect investment is when the investor deposits savings with a financial intermediary, and the financial intermediary purchases financial assets of the issuer. Essentially, the finanical intermediary makes the investment decisions for the investor.

Financial Intermediaries: Financial intermediaries (or Institutional Investors) are middlemen between savers and firms issuing debt or equity. They accept deposits from individual investors and use the deposits to acquire financial assets. Examples include banks, mutual funds, insurance companies, etc.

Types of Investments

Below we discuss the alterternatives for long-run investment. These are

1. fixed income securities
2. equity
3. indirect investment through mutual funds.

1. Fixed Income Securities

Securities that specify the dates of payments and amounts. Bonds are the most prominent example of fixed income securities and thus most are time is spent discussing bonds.

A bond is a long-term (more than one year) debt instrument. The bond holder is the lender, and the bond issuer is the borrower. Some features of bonds are below.

Bond Features

1. Maturity: The maturity date is when the bond issuer finishes his repayment of debt to the bond holder.
2. Par Value/Face Value: The amount paid to the bond holder at maturity
3. Coupon Bonds: Most bonds are coupon bonds. The coupons represent the interest payments (or coupon payment) prior to maturity. Most coupon bonds pay interest every six months. The interest rate used to calculate the coupon payment is called the coupon rate is specified on the bond, and is applied to the face value, in annual terms, even though the payments are semi-annual. For example, suppose you have a 10 year, RO10,000 coupon bond that has a 5% annual coupon rate. This means the annual coupon payments must equal 5% of RO10,000, or RO500. But since the interest is paid semiannually, each coupon payment will be for RO250.
4. Call Provision: Most bonds have a call provision. This allows the bond issuer to pay off the bond early, before the maturity date. This is a useful provision for the bond issuer in case the market interest rate drops. It allows them to replace higher interest debt with lower interest debt. The call provision usually applies only some period of time after the bond is intially issued. For example, maybe 2 years after a 10 year bond is issued. So when buying a previously issued bond the investor should know if that bond can be called. If it can he needs to calculate the return on the bond under the assumption it is called, or not called.
5. Conventions in Bond Prices: Bond prices are quoted as a percentage of their par value, where it is convention to use 1,000 as the par value. So a price of 90 represents 90% of par value, or 90% of 1,000, which is equal to 900. Of if the price is 105, this means that the price is 105% of 1,000, or 1050.
6. Accrued Interest: Bonds are traded on an accrued interest basis. When you buy a bond, you must pay the price of the bond and the interest that would be owed to seller of the bond if he holds it to the next coupon payment.

Types of Bonds

1. Government: Any government may issue a bond. This includes national governments, and some local governments. For example, in the U.S. both states and cities issue bonds.
2. Corporate: Large corporations issue corporate bonds. Some features and terms relating to bonds one should know are as follows:

1. Senior Securities: This means that the corporation must pay off its bonds before its other obligations.
2. Debenture: A debenture is an unsecured bond; i.e. not backed by an asset.
3. Convertible Bonds: Some bonds are convertible into common stock. These are really two assets in one; a bond and an option on stocks.
4. Bond Ratings: Investor Services (such as Standard and Poor’s) offer ratings of bond meant to provide and investor with the riskiness of debault on the bond. A high rating implies low risk of default, and a low rating implies high risk of default. The ratings are given in letters, with AAA being the best, then AA, then A, BBB, BB, and so forth until you get to the rating of D.
5. Junk Bonds: Bonds rated BB or lower are considered high risk/high return bonds.

An Aside: Asset Backed Securities

Suppose someone buys a large number of assets, such as home mortgages. This person can then issue a security linked to the performance of the portfolio. The security issued is thus an asset backed security.

Why would someone issue an asset backed security? The idea is the the portfolio of assets, say home mortgages, would have a lower default risk than any inidividual home mortgage. For instance, suppose a mortgage has an average default risk of 10%, meaning 10% of the time the borrower will default on the loan. This means a relatively high risk for the lender, so they are less likely to lend without sufficient collateral, strict income requirements, etc. However, if I take 100 different mortgages, all with individual 10% default risk, the portfolio of 100 mortgages in total has a lower than 10% default risk. The reason is, I know with near certainty that 10 of the 100 mortgages will default. So I know almost exactly what will be the payoff to this portfolio; that is, risk is removed. Hence an asset backed security is a relatively lower risk portfolio of individually risky assets.

Because risk is reduced investors tend to invest more in asset backed securities. As a result, lenders would be more eager to issue home mortgages, thus making getting a mortgage easier for borrowers. In fact, the interest rates, collateral, terms of loans, down payments, were all reduced because of asset back securities.

So how did the asset backed securities cause a financial crisis? Basically, the U.S. government subsidized these asset backed securities. Government created lending agencies became a ready market for asset backed securities. The difference was, because the government stood ready to buy these securities, the individual lenders no longer were as concerned about risk of individual mortgages. So instead of the default risk being 10%, the default risk became, say, 25%. In other words, the asset backed securities became a portfolio of individually bad assets. And eventually these assets stopped performing (i.e. high rate of default), and investors in these securities lost billions of dollars.

It should be noted that the primary cause of the financial crisis was NOT asset backed securities. Such securities have existed for almost 30 years. The problem was the U.S. government subsidizing these securities, causing lenders to make risky loans. There is an important lesson for investors. The government backing of investment assets, including banks, on one hand reduces risk becaue the government has the power of taxation to make sure the assets pay off. On the other hand, the government backing of investment assets causes the lenders to make very risky loans, and eventually these loans will not pay off. So if the government is not perfectly committed to supporting these assets, the investors will eventually lose if the assets do not pay off.

2. Equities

Equities represent ownership in the company. When you buy an equity, you buy a share of the company. The company is not obligated, legally, to pay you back anything at any point in time. As a part owner of the company you share in the profits and losses of the company. In other words, you as a part owner are a residual claimant to the company’s assets. That is, only after the company has paid for all other obligations, including debt to bondholders, may the equity holders receive anything.

There are two types of equities, or stocks: Preferred Stock and Common Stock. Common stock is that we have been discussing. Preferred Stock is a kind of mix of both common stock and bonds. Preferred stock promises the stockholder a fixed dividend payment indefinitely into the future. Often the dividend payment is tied to the market interest rate. Like bonds preferred stock can be called by company and retired. Also, there is often an option for converting the preferred stock to common stock.

Common Stock

However most stock is common stock, and we use the term interchangeably with equities. The reason a company issues common stock is to raise funds, usually for some capital investment. When a company issues stock for the public to buy we say the company is “going public”.

Aside: Note that a company can raise funds by either issuing bonds (i.e. borrowing) or by issuing stock (i.e. selling ownership of the company). The question of which is the best decision is a significant question for corporations, and is studied in the field of corporate finance.

If a company issues stock it is either traded on an exchange (if it meets some requirements) or it is traded on the “over-the-counter market”.

A stock holder is a residual claimant, meaning they can only receive dividends after all other obligations are met. Also, if the company fails they can split any assets only after other obligations are satisfied first. However, any stockholder is limited in liability to what he has invested. In other words, as an investor you cannot lose more than what you invested. For this reason, this is attractive to investors and has enabled corporations to be a very successful form of business organization and raise substantial amounts of funds for capital investment.

Characteristics of Common Stock

Market Value: The market value is simply the observed price of the stock.

Dividends: Payments made by the company to stockholders. For instance, if a company pays out $1,000,000 in dividends and there are 100,000 shares, then each share receives $10. Note that dividends is reported as the amount per share. So the dividend in this case is $10. It is important to realize that there is not any obligation for a company to pay dividends.

Dividend Yield: Dividends divided by the current stock price. If the current stock price is $200 and the dividend is $10, then the dividend yield is $10/$200 = 0.05 = 5%

Payout Ratio: Dividends divided by earnings per share. If earnings per share is $20, then the payot ratio is $10/$20 = 50%.

Stock Dividend: While dividends are usually paid in cash, it is possible to declare a dividend and pay it in the equivalent value of stock. Note this is not newly issued stock, but instead reapportions the stock from the company to stockholders. A 5% stock dividend would entitle an owner of 100 shares to 5 more shares.

Stock Split: These are new issues of stock, where the new stock is given to existing stockholders proportional to total shares outstanding. For example, a 2 to 1 stock split means every share will now be worth 2 shares.

Derivative Securities

Derivatives are securities that derive their value from another underlying security. The most important examples are options and futures. Both options and futures contracts are traded on organized stock exchanges.

The main purpose of options and futures is that an investor can manage risk by proper use of these derivatives. While their ultimate purpose is similar, these securities are different. The option security gives the holder of the security the right to either buy or sell the underlying security. A futures contract is an obligation to buy or sell the underlying security.

Options

The are two types of options; an option to buy a stock or an option to sell a stock.

Put Option: A put option is the option sell a specific number of shares of stock at a specified price within a specified period of time. For example, you may have the option to sell 10 shares of microsoft stock at a price of $10/share, and this option lasts for the next three months. So no matter what the current price of the stock is, you can sell at $10/share.

Call Option: A call option is the option to buy a specific number of shares of stock at a specified price within a specified period of time. For example, you may have the option to buy 10 shares of microsoft stock at a price of $10/share, and this option lasts for the next three months. So no matter what the current price of the stock is, you can buy at $10/share.

Option Prices

We first must understand that the value of the option is determined by movements in the price of the underlying stock. If the price of the stock rises in the short-term, then the call option will rise in value (since the call option would give you the right to buy the stock at a below market price). Similarly if the price of the stock falls in the short-term, the call option will decline in value.

If the price of the stock falls in the short-term, then the put option will rise in value (since the put option would give you the right to sell the stock at an above market price). Similarly if the price of the stock rises in the short-term, the put option will decline in value.

Thus we can see that options can be used to speculate on changes in the stock prices. The other implication is that options can be used to reduce, or hedge, risk. For instance, suppose you own a stock. The risk is the stock may fall in value. But if you buy a put option on the stock, the value of the put option will rise when the value of the stock is falling. Hence your portfolio is not nearly as risky. Of course, this also means that you reduce your gains if the value of the stock rises. If your stock rises in value, then your put option would decline in value, meaning you don’t get that gain in the value of the stock. So we see that you can hedge your risk in a portfolio of stocks by buying options on stocks.

Futures

A futures contract will also allow you to hedge risk because its value will also change as the price of the underlying stock changes. For example, if you have a contract in which you must buy mircosoft stock in the future at a particular price, and the price of the stock falls, then the futures contract is worth more. Or if you have a contract in which you must sell microsoft stock at a particular price in the future, and the price of the stock rises, then the futures contract is worth more.