Tran Ly

Finance II Notes
Intro to Investments
Basics
-

Definition: An investment is the current commitment of money or other resources in the

expectation of future benefits. Ex: Stocks, real estates
Real assets: Assets that are used to produce goods & services
Ex: Land, building, machines, human capital
Determine productive capacity and net income of the economy
Financial assets: Claims on real assets on computer engines or sheet of paper
Ex: Cash, stock, bond
Real vs. Financial Assets:
Investors buy financial assets to use this money to pay for real asset: tech, land,
building,
Return on Financial Assets: Income produced by real assets

Types of Financial Assets

Fixed-Income (Debt Securities):
-

Definition: Promise to pay a fixed stream of income or a stream of income determined by

a formula (Federal Funds Rate)
Payment: Payments must be made unless the borrower is declared bankrupt.
Two broad categories:
Money Market: Short-term: T-bills, certificate of deposit
Capital Market: Long-term: federal government bond, corporate bond

Common Stock (Equity):

-

Definition: securities that represent ownership in a corporation

Payment: no contractual obligation to make dividend payment
Value: value of the common stock => Depend on company performance; Its success of
utilizing its real assets.

Derivatives:
-

Definition: Financial securities that derive their values from the price of other assets
Use: Hedging/Speculation
Example: Oil futures: A contract to buy or sell oil at some point in the future
Buy: March 2016 oil futures fix the price; Speculation => Make money

Example: Lanni Products is a start-up computer software development firm. It currently

owns computer equipment worth $30,000 and has cash on hand of $20,000 contributed by
its owners. Show the effect of each transaction on a balance sheet and discuss whether there
are any financial assets created or destroyed.
a. Lanni takes out a bank loan. It receives $50,000 in cash and signs a note promising to pay
back the loan over 3 years:
Assets
Cash:
Computer Equipment:
Total:

$70,000
$30,000
$100,000

Liabilities & Stockholders Equity

Bond:
$50,000
Equity:
$50,000
Total:
$150,000

Created financial assets: Promissory note ($100,000)

b. Lanni uses the cash from the bank plus $20,000 of its own funds to finance the
development of new financial planning software by software developers:
Assets
Software:
Computer Equipment:
Total:

$70,000
$30,000
$100,000

Liabilities & Stockholders Equity

Bond:
$50,000
Equity:
$50,000
Total:
$150,000

No financial asset was created or destroyed.

c. Lanni sells the software product to Microsoft, which will market it to the public under the
Microsoft name. Lanni accepts payment in the form of 1,500 shares of Microsoft stock
that are worth $80 per share:
Assets
Liabilities & Stockholders Equity
Microsoft Shares:
$120,000 Bond:
$50,000
Computer Equipment: $30,000
Equity:
$100,000
Total:
$150,000 Total:
$150,000
Anything destroyed/created?
Yes if new shares were issued
No if existing shares were used
d. Lanni sells the shares of stock for $80 per share and uses part of the proceeds to pay off
the bank loan:
Assets
Liabilities & Stockholders Equity
Microsoft Shares:
$70,000
Bond:
$0
Computer Equipment: $30,000
Equity:
$100,000
Total:
$100,000 Total:
$100,000
Nothing was created. The bank loan got destroyed.
Role of Financial Markets: financial markets play a role in the creation and utilization of real
assets

Information Role:
Investors are optimistic about a company => Increase share prices => Money flow
to most promising companies => Allocate capital
Imperfect system
Consumption Timing:
Young: Buy financial assets
Old: derive income or sell financial assets
Transferring purchasing power
Allocation of risk:
Issue bonds
Issue stocks
Separate of ownership and management:
Millions of shareholders but separate management.
One day, you decided to sell your shares => no change in management.

Investment Process
-

Portfolio: a collection of investment assets

Decisions by investors: Asset allocation and security selection
Asset allocation: Choice among abroad asset class: money in the bank (certificate of
deposit), stocks, bonds, real estate, etc.
Security selection: Choice of securities within each asset class:
Stocks? Which stock? FB? GE? GM?
Bond? Which bond? GM? Detroit?
Approaches to Investment: Top-down and Bottom-up
Top-down approach: Start with asset allocation and proceed with security selection
Risk-tolerance: is factored in decision-making
Foregoing potential high returns
Asset allocation becomes a major determinant of portfolio performances
Bottom-Up approach:
Do a security selection based on price attractiveness
Chasing good deals
Issues with Diversification: may not be well-diversified
Too much/Too little risk
More active management => more trading cost!
You can make mistake

Equity Trading
Common Stocks:
-

Definition: A financial security that represent ownership in a corporation

Alternative names: Equities, Security equities
Dividends:

No contractual obligation to pay dividends

Corporations are assumed to pay dividends at some point in the future
Limited liability: Loss is limited to -100%
Taxation:
Dividends are not tax deductible for corporations. Dividends are paid with after
tax income.
Shareholders pay tax on dividends
Exception: corporation may exclude 70% of dividends from domestic
corporations in the computation of their taxable income
Voting:
Shareholders => Elect Board of Directors => Select Management
Some share having voting rights; some dont.
BRK-A: $203,680.22 => 1 vote
BRK-B: $135.04 => 1/200 vote
Proxy voting: Shareholders empower another party to vote in their names
Proxy fight:
Unhappy shareholders attempting to replace management (Syngenta)
Activist Investor: Carl Icahn *corporate raider
Reality: not much success

Example: General Dynamics:

Name

Symbol

Close

Net Chg

Volume

General
Dynamics

GD

64.69

0.65

1359120

52 Wk
High
74.54

52 Wk
Low
53.95

Div

Yield

P/E

2.04

3.15

9.31

a. How many shares could you buy for $1000?

5000/64.69 = 77.29 => 77 shares
b. What would be annual dividend income from those shares?
77 * $2.04 = $157.08
c. What must be GD earnings per share?
P/E = Price per Share / EPS = 9.31
EPS = 64.69/9.31 = $6.96
d. What was the firms closing price on the day before the listing?
Todays Price = Previous Day + Change in Price
Previous Day = 64.69 0.65 = $64.04
Preferred Stock
-

A stock that promises to pay a fixed amount of income to its holders.

Similar to infinite maturity bond (perpetuity bond). Similar to bonds, it has no voting
power.
Dividends:
Promised fixed dividend, no contractual obligation to pay them. If you miss a
coupon payment on a bond, this sets off bankruptcy proceedings.

Preferred Dividends are accumulative: unpaid dividends cumulate and must be

paid in full before dividend is paid to common stock holders.
Example: Berkshire Hathaway Goldman Sachs
$5 billion in preferred stock
10% annual dividend
Redeemable: buy back at market price

American Depository Receipts (ADRs):

-

Definition: Certificate traded in the US that represent ownership in a foreign corporation

Correspondence: ore ADR => of a foreign share; 1 foreign share
Trading in USD: BP, Alibaba, etc.

Buying on Margin:
-

Buying on Margin: Investor borrows part of the purchase price from the broker
Where do brokers get their money? Borrow their money from banks, and they charge
interest to the investor
Pros and Cons: Higher upside potential; Greater downside risk
Margin in the account: Portion of purchase price contributed by the investor
Percentage Margin = Equity in Account (Net Worth) / Value of Stock Position
Value of Stock Position = Number of Shares Purchased * Price per Share
Restriction: Fed: At least 50% of the purchase price must be paid by the investor in cash.

Example: An investor puchases 100 shares of a stock with each share trading at $10.
Investor pays $6,000 out of her pocket and borrows the rest from her broker. Suppose that
the maintenance margin on this stock is 30%. How far can the stock fall before the investor
would get a margin call?
Assets
Stocks:

$10,000

Total:

$10,000

Percentage Margin =

6000
10000

Liabilities & Stockholders Equity

Loan:
$4,000
Equity:
$6,000
Total:
$10,000

= 60%

What if the stock price increases to $130 per share (i.e., the stock goes by 30%)?
Assets
Stocks:

$13,000

Total:

$13,000

Liabilities & Stockholders Equity

Loan:
$4,000
Equity:
$9,000
Total:
$13,000

Percentage Margin =

9000
13000

= 69.23%

Equity goes up by 50%

What if the stock price declines to $70 per share (i.e., the stock drops 30%)?
Assets
Stocks:

$13,000

Total:

$13,000

Percentage Margin =

3000
7000

Liabilities & Stockholders Equity

Loan:
$4,000
Equity:
$9,000
Total:
$13,000

= 42.86%

Equity goes down by 50%

What if the stock price declines to $40 per share (i.e., the stock drops 60%)?
Assets
Stocks:

$4,000

Total:

$4,000

Percentage Margin =

0
4000

Liabilities & Stockholders Equity

Loan:
$4,000
Equity:
0
Total:
$4,000

=0

Equity goes down by 100%

What if the stock price declines to < $40 per share?
Stocks < $40,000 => Negative Equity: You lost more than your original investment
Maintenance Margin:
-

Definition: Minimum percentage margin that an investor must maintain in the margin
account
Margin call: If the percentage margin falls below the maintenance margin the broker will
issue a margin call
Required action: You need to add new cash or securities to your account
Consequence of no-action:
Broker may close your account
Broker can sell securities from the account to pay off the loan

% Margin = 20%; Maintenance margin = 30$ => Broker can sell $40 worth of stock and pay a
portion of the loan.
Maintenance margin:

Definition: Minimum percentage margin that an investor must maintain in the margin
account.
Margin call: If the percentage margin falls below the maintenance margin, the broker will
issue a margin call.
Required action: You need to add new cash or securities to your account.
Consequence of no-action: Broker may close your account. Broker can sell securities
from the account to pay off the loan.
Assets
Stocks:

$100

Liabilities & Stockholders Equity

Loan:
$80
Equity:
$20

% Margin = 20%
Maintenance margin = 30%
Broker can sell $40 worth of stock, and pay a portion of the loan.
Example: An investor purchases 100 shares of a stock with each share trading at $100.
Investor pays $6000 out of her pocket and borrows the rest from her broker. Suppose that
maintenance margin on a stock is 30%. How far can the stock fall before the investor
would get a margin call?
Initial percentage margin = Equity/Value of Stock Position = 6000/10000 = 60%
Solve for P:
0.30 = (100P 4000)/(100P)
30P = 100P 4000
70P = 4000
P = $571.14
Example: Suppose you want to invest in ABC stock that does not pay any dividends. A
share is trading at $100. You put $10,000 of your own money and borrow $10,000 from
your broker at 9% per year to purchase a total of 200 shares. Calculate the rate of return
on this position:
a. The stock goes up 30% in the following 12 months:
ABC Stock
No dividends
Price = $100
Value of stock position = Number of Shares * Price/Share
= 200 * (100 + 100 * 30%)
= $26,000
Payment to Broker = Principal + Interest
= $10,000 + $10,000 * 9%

= $10,900
Proceedings to Investor = Value of Stock Position Payment to Broker
= 26,000 10900
= $15,100
Proceedings
'

Rate of Return = InvestorInvesto r s Initial Equity

'
Investo r s Inital Equity
=

15,10010,000
10,000

= 51%

Buying on margin boosted return from 30% to 51%.

If Return > Cost of Loan: margin will help.
b. The stock goes down by 30% in the following 12 months:
Value of Stock Position = 200 * (100 100*30%) = $14,000
Payment to Broker = $10,900
Proceedings to Investor = $14000 - $10900 = $3100
310010000
Rate of Return =
x 100 = -69%
10000
c. The stock goes down by 60% in the following 12 months:
Value of Stock position = 200 x $40 = $8000
Payment to Broker = $10,900
Proceedings to Investor = $8000 - $10,900 = $2,900
290010000
Rate of Return =
x 100 = -129%
10000

Short Sales (Short Selling)

-

You borrow shares of corporation from your broker. You sell those shares in the market at
the market price. Later you buy the shares back, and return them to your broker.
Expectation: You anticipate a decline in stock price. You hope you can buy the shares
back at lower price than you originally sold them for.
Example: Bill Ackman (Pershing Square) Herbalife
Short: Overvalued Stock
Hedge Fund: Private investigation using public information

Mechanics of Short Selling (Decay of Time)

-

Margin: You need to post margin collateral.

Proceeds from a short sale: must be kept in an account with the broker.
Profit per share: Purchasing vs. Short-selling a dividend-paying stock

Purchase of a stock
Time Action
Cash Flow
0
Buy a share
-Initial Price
1
Receive dividend & sell the stock Ending Price + Dividend
Profit per share = (Ending Price + Dividend) Initial Price
Short sale of a stock
Time Action
Cash Flow
0
Borrow a share and sell it
+ Initial Price
1
- Repay Dividend
-(Ending Price + Dividend)
- Buy a share to replace the one you borrowed
(covering your position)
Profit per share = (Ending Price + Dividend) Initial Price
Example: Suppose that you sell short 1,000 shares of Intel, currently selling for $20 per
share, and give your broker $15,000 to establish your margin account. Assume that you
earn no interest on the funds in your margin account.
a. If the maintenance margin is 25%, how high can Intels price rise before you get a
margin call?
Assets
Liabilities & Stockholders Equity
Proceeds $20,000 Liability
$20,000
Collateral $15,000 Initial Equity:
$15,000
Total:
$35,000 Total:
$35,000
Assets
Proceeds
$20,00
0
Collateral $15,00
0
Total:
$35,00
0

Liabilities & Stockholders Equity

Liability
1000P
Initial Equity:

$35,000 1000P

Total:

$35,000

Liability
= (Proceeds + Collateral) 1000P
= 35,000 1000P
Equity
Value of Stock Position = 0.25 = Maintenance Margin
35,0001000 P
1000 P

= 0.25

Proceeds = $20 x 1000

shares = $20,000
Equity = Asset

P = $28
b. What will be your rate of return after 1 year if Intel stock has paid $1 a share dividend and is
selling at the following year-end prices: (i) $22; (ii)$18?
i.
Price = $22:
Profit per Share = 20 (22 + 1) = -$3
Profit on 1000 shares = -$3 x 1000 shares = -$3,000
Rate of Return = -3000/15000 x 100% = -20%
ii.
Price = $18:
Profit per Share = 20 (18 + 1) = $1
Profit on 1000 shares = $1 x 1000 shares = $1000
Rate of Return = 1000/15,000 x 100% = 6.67%
The less money you put it, the more risk.
Buying on Margin vs. Short Selling:
Buying on margin:
- Liability: Dollars value of your liability is not affected by future stock prices.
- Limit for losses: your initial investment, loan, interest
- Limit for Profit: No limit
Short selling:
- Liability: Dolalr value of your liability is affected by future stock prices
- Limit for losses: No limit
- Limit for profit: Profit per share = Initial Price (Ending Price + Dividend)
Short Sales in Practice
Short Interest:
- Definition: Total number of shares of a security that have been shorted (sell short)
- Importance: Sentiment Indicator: Bullish or Bearish
Background on different types of shares:
- Authorized shares: Maximum numbers of shares that they can issue
- Outstanding shares: Shares that the company already issued.
Float: Shares hold by public, available for trading.
Restricted: held by company insiders. Not available for trade.
Short interest as a percentage of the float:
-

Definition: Short Interest as % of float =

Importance: Reflects investor sentiment

shares sold short

Float

Example: ABC stock has 25 million shares of float, and its 5 million shares are sold short. What
is the short interest as a percentage of float?
SI as % of float = 5,000,000/25,000,000 = 0.20 or 20%

Days to cover:
Current Short Interest
Daily Share Volume

Definition:

Importance: Indicator of short squeeze => Push to cover/close short positions.

Acceptable range: Up to 8 days.
Volkswagen Story: Porsche acquire Volkswagen (43% of stocks) etc.
Economist.com/node/12523898

Example: If a company has average daily volume of 1 million shares and 8 million shares are
currently sold, calculate days to cover?
Days to cover =

8 million shares
1million shares

How to interpret Days to cover?

= 8 days

EQUITY TRADING
Main actors in trading
-

Broker: a licensed intermediary who buy and sell securities on a clients behalf.
Dealer (specialist, market maker):
Exchange members
Under obligation to maintain liquidity to their assigned stocks.
Stand ready to buy and sell at all times from/to customers

Price Quotes in Trading:

-

Bid Price: Price at which you sell an asset to a dealer

Ask Price: Price at which you buy an asset from a dealer
Ask Price > Bid Price => Dealers buy low sell high.

Bid_Ask Spread: Ask Price Bid Price:

Bid_Ask Spread Percentage: 100 x
-

Ask PriceBid Price

Ask Price

Example: Apple 109.19/109.22; Biogen: 300.88/305.20

Apple:
Bid_ Ask Spread price: 109.22 109.19 = 0.03
0.03
Spread % = 100 x 109.22 = 0.03%
Biogen:
Bid_ Ask Spread price: 305.88 300.88 = $4.32
4.32
Spread % = 100 x 305.20 = 1.42%

Why is it important? Bid-Ask Spread is a cost to investors

Ask PriceBid Price
Percentage Spread = 100 x
Ask Price
Liquid stocks: smaller
Illiquid stocks: larger

Market Orders:
-

Motivation: simply want to execute your trade

Buy: An order to buy at the current market price (ask-price)
Sell: An order to sell at the current market price (bid-price)
Downside: Price at which your order is filled can be very different from the time at which
you placed your orders.
Upside: guaranteed a trade.

Limited orders:
-

Motivation: you want your trade to be executed if the price is right for you.
Limit-buy order:
Action: Buy the stock if the price falls down to/below a stipulated price.
Example: Apple: $112.15 (current), Limit-buy: $108.25 => you will buy the stock
if the price falls to $108.25 or lower.
Limit-sell order:
Action: Sell the stock if the price rises to/above a stipulated price.
Example: Apple: $112.15; Limit-sell: $118.15 => you will sell the stock if the
price rises to $118.15 or higher.
Upside: You are guaranteed a price or better.
Downside: Your trade is not guaranteed to be executed if the price is not right.

Stop Orders:
-

Motivation: Protection against large changes in stock prices.

Stop-loss order:
Action: The stop is to be sold if the price falls to/below a stipulated price. Once
this target is reached your order becomes a market order.
Reason: To limit your losses.
Apple: $112.25
Stop-loss: $95
Stop-buy order:
Action: The stock is to be bought if the price rises to/above a stipulated price.
Reason: It allows companies short sales stop-buy: $125 to limit losses.
Downside: Overall, your order will be filled; but price moving end up being too high or
too low.

Stop-Limit Orders: Combining Stop and Limit Orders

-

Motivation: Avoid unreasonable prices

Stop-limit buy:
Action: Stop-order coupled with Limit Buy
Apple: $125 stop / $135 limit
Example: Once price reaches $125 or above, limit buy is triggered at $135 =>
You buy if the price reaches to/below $135.
Stop-Limit sell:
Action: Stop-loss + Limit-sell
Example: $90 stop / $65 limit once the price falls to $90 or below, order will be
triggered: limit sell at $65

Example: FinCorp Stock: Bid: $55.25; Ask: $55.50

a. Suppose you have submitted an order to your broker to buy at market. At what price will
your trade be executed? Ask-Price = $55.50
b. Suppose you have submitted an order to sell at market. At what price will your trade be
executed? Bid-Price: $55.25
c. Suppose you have submitted a limit order to sell at $55.62. What will happen?
The trade wont go through because $55.62 > $55.25
d. Suppose you have submitted a limit order to buy at $55.37. What will happen?
The trade wont go through b/c $55.37 < $55.50