Basic Finance

Investment & Financing

1.

Investment: the current commitment of money or resources in the expectation of future benefits
a. Real Assets: goods and services of use or value; constitute the material wealth of any society
i. Tangible: machinery, factories, offices
ii. Intangible: experience, trademarks, patents
2. Financing: the raising of cash to purchase real assets used in investment decisions
a. Financial Assets (Securities): claims on real assets, with no intrinsic value; do not contribute
directly to the productive capacity of the economy.
i. Financial assets are liabilities of the issuers.
1. Firms are net borrowers
2. Households are net savers
3. Government can be either borrowers or savers
b. Asset Allocation: choosing among the broad classes of financial assets.
c. Security Selection: selecting specific financial assets within these classes.
d. Security Analysis: the valuation of particular securities included in the portfolio.
i. Top-Down Strategy: starts with asset allocation; may pass up high-return stocks.
ii. Bottom-Up Strategy: starts with security selection; may lead to unbalanced portfolio.
[[[Graph of Financial Assets, Firm, Real Assets]]] pp.6, Brealeymyers
3. Functions of Financial Assets
a. They encourage allocation of capital to firms that seem to have the best prospects
b. They allow you to store your wealth, shifting purchasing power to the future.
c. They allow the risk of investments to be borne by investors most willing to bear risk.
d. They separate ownership and management
i. Agency Problems: managers may pursue their own interests. Attempts to mend this are:
1. The income of managers is tied to the success of the firm.
2. The board of directors may force out underperforming management teams.
3. Outside analysts and investors put pressure on managers to perform.
4. Bad performing managers bear the risk of a takeover by other companies.
4. Financial Assets in Markets
a. Risk-Return Trade-Off: generally, higher-risk assets offer higher expected returns.
b. Efficient Market Hypothesis: the price of securities reflects the market consensus of the value.
i. Passive Management: holding highly diversified portfolios without trying to improve
performance through security analysis
ii. Active Management: trying to improve performance by identifying misplaced securities
or timing stocks.
c. Financial Intermediaries: agencies that match borrowers with lenders
i. Financial Intermediaries issue their own securities to raise funds to purchase securities of
other corporations.
1. A bank raises funds by issuing deposits and lending.
2. Investment companies borrow from many households to buy a large portfolio of
securities.
ii. Financial intermediaries move funds from one sector to another; therefore their assets are
largely financial.
d. Investment Bankers: advise the issuing corporation on the prices it can charge for securities
i. Common investment bankers are Goldman Sachs, Merrill Lynch, and Citigroup
ii. Secondary Market: where previously issued securities are traded among investors
e. Securitization: the transfer of mortgages into the security market
i. Pass-Through Securities: aggregate individual home mortgages into homogenous pools,
which are then transformed into securities
ii. Introduced by Ginnie Mae (Govt Natl Mortgage Association)
iii. Main companies: Fannie Mae (Fed Natl Mortgage Association) and Freddie Mac (Fed
Home Loan Mortgage Corporation)
f. Financial Engineering: the use of mathematical models to synthesize new financial products
i. Unbundling: breaking up cash flows from one security to create new securities

ii. Bundling: combining more than one security into one composite security
1. These techniques allow securities to be highly specific and suit different tastes.

Business
1.

2.

3.

4.

A business (enterprise, firm) is an organization that provides goods and services to consumers
a. Sole Proprietorship:
managed by a single individual
b. Partnership:
managed by several people
c. Corporation:
limited liability; separate from its owners
i. Private Corporation: shares are closely held by a small group of investors
ii. Public Company: shares are widely traded by a large group of investors
In a corporation, there is a set management structure:
a. Stockholders:
everyone who possesses ownership in a corporation
b. Board of Directors:
elected by stockholders, oversees managers
c. Top Management:
includes CEO, CFO, COO, etc.
The financial decisions in a corporation are overseen by:
a. CFO:
manages firms overall financial policy and corporate planning
b. Treasurer:
looks after firms cash, raises new capital, and maintains financial ties
c. Controller:
prepares financial statements, manages accounting, handles tax
The separation of management and ownership creates agency costs, where managers do not attempt to
maximize firm value or shareholders incur costs to monitor the managers. Attempts to mend this include:
a. The income of managers is tied to the success of the firm.
b. The board of directors may force out underperforming management teams.
c. Outside analysts and investors put pressure on managers to perform.
d. Bad performing managers bear the risk of a takeover by other companies.

Asset Classes
1.

Fixed Income Security: represents debt; yields either a fixed stream of income or one set by a formula
a. The Money Market: short-term, low-risk securities.
i. Treasury Bills: govt-issued debt; widely considered the most risk-free security
1. The income earned on T-bills is exempt from all state and local taxes.
2. The asked price is the purchasing price, while the bid price is the slightly lower
selling price. The bid-asked spread is the difference, which is also the dealers
profit.
3. In listings, the bid and asked yields are annualized (according to a 360-day
year). Thus, a $1000 T-bill with 180 days to maturity with an asked yield of 4%
will yield a profit of 4 0.5 $ 1000=$ 20 .
4. The Ask Yield is the percentage return the buyer receives. In the above example,
the ask yield is $ 20/ ( $ 1000$ 20 ) 2.04 .
ii. Certificate of Deposit: time deposits in a bank.
1. These deposits may not be withdrawn on demand. Interest and principal are paid
only at the end of the fixed term of the CD.
iii. Commercial Paper: short-term debt notes issued by large, well-known companies.
1. They are usually bought by mutual funds because of their expensive price.
2. They are a fairly safe asset because of the short maturity term.
iv. Bankers Acceptances: an order to a bank by a customer for payment at a future date.
1. They are tradable and will not be bounced unless the bank defaults.
v. Eurodollars: dollar-denominated deposits at foreign banks.
1. They escape regulation by the Federal Reserve.
vi. Repos and Reverses: agreements that state that the seller or buyer of a govt security will
buy or sell it back for a higher price the next day; essentially 1-day loans.
b. The Bond Market: contains longer-term, riskier securities.
i. Treasury Notes and Bonds: long-term bonds that, in addition to the principal income,
pays semiannual interest, called coupon payments, that is annualized in directories.

2.

3.

ii. Inflation-Protected Treasury Bonds: adjusts to match changes in the CPI.

iii. Federal Agency Debt: securities issued by specific govt agencies, usually to channel
credit to a particular sector of the economy.
1. Freddie Mac and Ginnie Mae were organized to provide liquidity to the
mortgage market.
iv. International Bonds: bonds from foreign issuers.
v. Municipal Bonds: bonds issued by state and local govts, exempt from federal and state
taxes but not Capital gains taxes.
1. To compare taxable and tax-exempt bonds, we solve for the equivalent taxable
yield of a tax-exempt bond: r ( 1t )=r m r =r m / ( 1t )
vi. Corporate Bonds: bonds issued by private firms directly to the public
1. Secured Bonds have collateral backing them in case of default; debentures dont.
2. Callable Bonds may be bought back by the firm at a stipulated price.
vii. Mortgage-Backed Securities: an ownership claim in a pool of mortgages.
Equity: stocks or shares, represent ownership shares in a corporation. Generally the price of equity
depends on the performance of the firm, so equities are riskier than bonds.
a. Common Stock: most common form of equity; may or may not pay dividends
i. Residual Claim: stockholders are last in line for claims to assets and income of
corporation.
ii. Limited Liability: the most shareholders can lose in event of default is their original
investment.
iii. Capital Gains: earnings derived from price increases in stocks
iv. Price-Earnings Ratio: ratio of current stock price to last years earnings per share
b. Preferred Stock: does not convey any voting power but guarantees dividend payment.
c. Depository Receipts: certificates traded in U.S. markets representing ownership in a foreign firm
d. Stock Market Indexes: a collection of stocks that measures the performance of the overall market.
i. Price-weighted average: holds one share of each stock; the amt of money invested in
each company is proportional to that companys share price. Example: Dow Jones
Industrial Average
ii. Market-value-weighted index: the amt of money invested in each company is
proportional to its total market value (# of shares price of share). Example:
Standard & Poors Composite 500
iii. Equally-Weighted Index: the amt of money invested in each company is the same.
Derivatives: financial assets whose values derive from the values of other assets
a. Options: gives the buyer the right to buy or sell an asset at the exercise price at a future time.
i. A call option allows the buyer to buy; a put option allows the buyer to sell. The price of
the option is called the premium.
ii. Call options provide greater profits when the price increases; put option provide greater
profits when the price decreases. An option is in the money if its exercise price is
currently profitable; otherwise, it is out of the money.
b. Futures Contract: mandates delivery of an asset at a specified date for an agreed-upon price.
i. The buyer holds the long position, while the seller holds the short position.
ii. The holder of the long position profits upon a price increase; the holder of the short
position profits upon a price decrease.

Managing Securities
1.

The Primary Market: where securities are first issued and sold to the public.
a. Investment Banking: buys securities before they enter the primary market and then sells them.
i. I-Bankers are underwriters: they advise the firm regarding how it should attempt to sell
its securities, purchase the securities from the issuing company, and resells them to the
public. The buy and sell price difference constitutes the profit they receive.
ii. Before they sell they have to send a prospectus outlining the issue and prospects of the
company to the Securities and Exchange Commission (SEC) to be approved.

2.

3.

4.

5.

iii. Firms have a shelf registration limit; they may sell shares gradually for 2 years
following the initial registration.
b. Initial Public Offerings (IPOs): when the company issues stocks to the public for the first time
i. I-Bankers organize road shows to publicize the shares, generating interest among
potential buyers and information about the potential price.
c. Private Placements: private offerings sold directly to a small group of wealthy investors.
i. The main advantage is that they are far cheaper than IPOs.
The Secondary Market: where previously-issued securities are traded amongst investors.
a. Markets (in increasing order of organization)
i. Direct Search Markets: buyers and sellers must seek each other out directly. Examples
are the sale ads on local newspapers.
ii. Brokered Markets: brokers offer search services to buyers and sellers, developing
specialization and thus also efficiency of search.
1. The primary market can be viewed as a brokered market, with i-bankers as
brokers.
iii. Dealer Markets: dealers specialize in various assets, purchase these assets for their own
accounts, and later sell them for a profit from their inventory.
iv. Auction Markets: all traders converge at one location to buy or sell an asset.
b. Orders
i. Market Orders: buy or sell orders that are to be executed immediately at current market
prices.
ii. Price-Contingent Orders: a limit buy order and a stop-sell order will be executed
when the share falls below a given price; a stop-buy order and a limit-sell order will be
executed when it rises above a given price.
c. Mechanisms
i. Over-The-Counter (OTC) Markets: dealers list their buy and sell prices, and brokers
pick out attractive quotes to execute a trade.
1. Example: NASDAQ, which has recently however become more electronic
ii. Electronic Communication Networks (ECNs): allow trading of stocks via computer,
which is less expensive and a lot faster.
iii. Specialist Markets: trading for each security is managed by a specialist, who selects the
highest offered purchase price and lowest selling price to match trades. The specialist
himself may make bids to buy or sell to maintain low price-volatility.
1. Examples: NYSE, AMEX
d. Costs
i. Commission Costs: costs paid to intermediaries, such as brokers.
1. Full service brokers employ a research team that advises in addition to executing
orders.
2. Discount brokers only execute orders, but are less expensive.
ii. Spread Costs: the dealers bid-ask spread.
Buying On Margin: borrowing from the broker to profit from a rise in price
a. The margin is the portion of the purchase price contributed by the investor.
b. The broker may borrow from banks to finance these purchases.
c. If the price of the share drops, the margin decreases. To prevent negative margins, the broker sets a
maintenance level; if the margin drops below this level the broker will issue a margin call
mandating the investor to add new cash. If the investor is unable to do so the broker will sell
securities until the margin is above the maintenance level.
Short Sale: borrowing stocks from the broker to profit from a decline in price
a. Later, the short-seller must cover the short position by buying back the stock.
b. Brokers keep many securities in street name; they hold it for their investors (for example, when
they buy on margin). If they lend a certain security to a short-seller and the owner of the security
decides to sell, the brokers may borrow from another investor. If they are unable to, they force the
short-seller to cover the short position.
c. Short-selling is only allowed when the last recorded stock-price change was positive.
d. Short-sellers are required to post cash or collateral with the broker to cover potential losses.
Regulation of Trade

a.

b.

Circuit-Breakers
i. Trading Halts: if the DJIA falls by a certain % then trading will halt for a specified period
of time.
ii. Collars: if the DJIA moves more than 2% in either direction when the market opens, the
next sale must be above the current price.
Insider Trading
i. Trading based on inside information, or information held by people within the company,
is illegal.

Investment Companies
1.

2.

3.

Investment Companies: financial intermediaries that collect funds from individual investors and invest
those funds in a wide range of securities or other assets
a. Record-keeping and administration: they issue periodic status reports and track investments
b. Diversification and divisibility: allows investors to hold fractional shares by pooling money
c. Professional Management: some have professional, full-time analysts and managers
d. Lower Transaction Costs: from trading large blocks of securities, as opposed to brokering
e. Investors buy shares in investment companies, and ownership is proportional to the number of
shares owned. The value of each share is the net asset value (NAV).
i. NAV (Assets Liabilities) (# Shares)
Types of Investment Companies
a. Unit Investment Trusts: pools of money invested in a fixed portfolio
i. Management fees for these are typically very low
b. Managed Investment Companies
i. Closed-End Funds: do not redeem or issue shares; investors who wish to cash out must
sell their shares to other investors
ii. Open-End Funds: will buy back shares at NAV
c. Hedge Funds: partnerships allowing private investors to pool assets with limited SEC regulation.
They make bets on the misalignment of relative prices.
i. Convergence Arbitrage is blah blah blah
ii. Pure Plays are blah blah blah
iii. Directional Strategies are blah blah blah
d. Comingled Funds: partnerships of investors that pool their funds.
e. Real Estate Investment Trusts (REITs): essentially a closed-end fund investing in real-estate.
Mutual Funds: open-end investment companies
a. Investment Policies
i. Money Market Funds: invest in money-market securities
ii. Equity Funds: invest in stock
1. Income Funds hold shares of firms with high dividend yields
2. Growth Funds hold shares of firms with high prospects for capital gains
3. Sector Funds hold shares of firms in particular industries
iii. Bond Funds: invest in fixed-income securities
iv. International Funds: invest in both foreign and domestic securities
v. Balanced Funds: designed to be low-risk, entire investment portfolios
vi. Asset Allocation Funds: contains both stocks and bonds, but may be high-risk
vii. Index Funds: tries to match the performance of a broad market index
b. Vending Technique
i. Most mutual funds have an underwriter who has exclusive rights to distribute shares to
investors.
ii. Mutual funds are marketed to the public either directly by the underwriter or indirectly
through brokers.
iii. Shares of mutual funds are quoted as NAV and sold at the end of the day.
iv. Exchange-Traded Funds allow investors to trade index portfolios like stocks. ETFs
trade continuously, while mutual funds only trade at the end of the day. ETFs can also be
sold short or purchased on margin.

c.

d.

e.

f.

Costs
i. Front-End Load: a commission paid when shares are purchased
ii. Back-End Load: a fee incurred when the shares are sold; generally reduced for each year
the share is held.
iii. Operating Expenses: costs incurred through management and administration.
iv. 12b-1 Charges: costs incurred through advertising, hiring external brokers, and issuing
annual reports and prospectuses
Profits
i. Rate of Return ( NA V t NA V 0 + Income and Capital Gain Distributions)

( NA V 0 )
ii. Late Trading: the practice of accepting buy or sell orders after the market closes.
iii. Market Timing: buying mutual funds of foreign stocks when their market has closed.
iv. Techniques to prevent the exploitation of stale prices include
1. 4PM Hard Cutoff: strict regulations mandating that all orders are made before 4
2. Fair-Value Pricing: adjusting prices of securities when the market is closed
3. Redemption Fees: a fee charged on mutual fund shares sold within 1 week of
purchase.
Taxation
i. Taxes are paid only by the investor and not by the fund itself.
ii. Turnover: the ratio of trading activity of a portfolio to the assets of the portfolio.
iii. High-turnover mutual funds are tax-inefficient; they are taxed more heavily.
Performance
i. Average performance on diversified funds has historically been below that is a general
market index
ii. However, mutual funds that beat the index have a larger-than-average chance to beat the
index again next year.

Basic Financial Principles

1.

Unifying Principles of Finance

a. The financial market is perfect; it is one in which
i. A large number of securities are being traded
ii. Security contracts are enforceable
iii. There is free access to the market
iv. The trading process is competitive
v. There are no constraints or restrictions in trading
b. There is no arbitrage, which is a risk-free profit at zero cost
i. In particular, the law of one price holds: assets having the same payoff distributions must
be sold at the same price.
c. Each household has a preference, or a complete ranking of cash flows, expressed by its
(expected) utility function.

c ( nt0 , nt1 , ) missing

utility function U : { cash flows } R such that
'
'
c c E [ U ( c ) ] E [U (c )]

i. A cash flow
ii.

iii. Blah blah time parameter??

iv. Given any c and c ' , a household can decide that either
Therefore a preference exists.
v. Transitivity: If a b , b c , then a c
vi. Non-Satiability ( U ' >0 ): More cash is preferred to less.
vii. Impatience ( <1 ): Cash now is preferred to cash later.

c c ' or c ' c .

viii. Risk-Aversion

2.

''

U 0 ): Households will not accept zero-sum games.

d. Each household attempts to optimize their utility.

e. Market in equilibrium
The Opportunity Cost of Capital

Return and Risk

1.

2.

Interest Rates
a. Fisher Equation: 1+r=( 1+ R ) / ( 1+i ) r=Riir Ri
b. At any point you can only infer the expected real rate by subtracting your inferred rate of inflation:
e
e
i.
r R
c. P127 missing stuff
Rates of Return
a. Risk-Free Rate r f : rate earned by leaving money in risk-free assets such as T-bills.
b.

Let

T
c.

P (T ) be the price and r f ( T ) be the risk-free rate of a bond that yields $ m after
years.

P (T ) ( 1+r f ( T ) )=m r f ( T )=[ m/ P ( T ) ]1

i.
Effective Annual Rate (EAR): the percentage increase in funds invested over a 1-year horizon
i.

d.

APR =r f ( T ) /T =

5.
6.

1+ EAR=lim 1+
T0
APR T

4.

m
1 /T= [ ( 1+ EAR )T 1 ] /T
P (T )

Continuous Compounding: when rates are compounded continuously; i.e.

i.

3.

1 /T

Annual Percentage Rate (APR): simply multiplying monthly percentage to obtain a yearly value.
For example, if the trimonthly rate is 3%, then the APR would be 3% 4 12%
i.

e.

1/ T

( 1+ EAR )T =1+r f ( T )=m/P ( T ) EAR=( 1+ r f ( T ) ) = [ m/P ( T ) ]

APR
1/ T

1/ T

T =0 .

=e APR APR=ln ( 1+ EAR )

ii.
r f ( T )=e
1
Risk Premiums
a. Holding Period Return (HPR) (End Price Beginning Price + Dividends)
(Beginning Price)
b. HPR Capital Gains Yield + Dividend Yield
rf
c. Risk Premium Expected HPR
i. Normally, asset classes with higher risk provide higher average returns.
rf
d. Excess Return Actual HPR
e. Risk Aversion: people avoid risk; if the risk premium were 0 people would not invest in the stock.
Historical Analysis
a. Expected Return is the arithmetic average of the sample rates of return
b. The time-weighted return is the geometric average of the Gross HPRs ( 1 + HPR).
This measures, on average, how much a person holding the stock gained historically per year
c. Sharpe Ratio (Risk Premium) ( of Excess Return)
Long-Term Investments
a. In a series with compounding period values, the end result will be lognormal; the logarithm of the
variable will be normally distributed
Non-Normal Distributions
a. Value at Risk (VaR): highlights potential loss from extreme negative returns; the quantile q
of a distribution is the value below which lies q % of the distribution.
b. Conditional Tail Expectation (CTE): finds the expected value of the values in the q %
quantile.

c.

Lower Partial Standard Deviation (LPSD): the standard deviation of the values below the
expected return.

Options
1.

Call Options: let S t be the price of the security at time

call option price.
a. Payoff to Holder max { St X , 0 }

t , X

the exercise price, and

PC the

Profit to Holder

max { St X , 0 } PC
b. Payoff to Writer min {( S t X ) , 0 }

Profit to Writer min ( S t X ) , 0 + P C

c. People purchase call options to profit from a rise in price. People write call options to profit from
anything except a rise in price.
MISSING IMAGES
2. Put Options: same as above, except with PP as put option price.

max { X S t , 0 }
max { X S t , 0 } PP
b. Payoff to Writer min {( X S t ) , 0 }
a.

Payoff to Holder

Profit to Holder

Profit to Writer min ( X S t ) , 0 + P P

c. People purchase put options to profit from a fall in price. People write put options to profit from
anything except a rise in price.
MISSING IMAGES
3. Protective Puts: buying the security and put options on the security.
a. Payoff S t +max { XSt ,0 }=max { X , St }
b.
c.
dsffas
4.

Profit max { X , S t }( S0 + P P )
Bought if an investor would like to invest in a stock but does not want to bear the potential losses.

Covered Call: buying the security and writing call options on the security.
a. Payoff S t +min ( S t X ) ,0 =min { X , S t }

b. Profit min { X , S t } ( S0 + PC )
c. Covers the writing of the call by buying the securities.
Afdagdas
5. Straddle: buying both a call and a put on the security.
a. Payoff max { St X , 0 } + max { XS t ,0 }=max { S t X , XSt }
b.
c.

Profit max { St X , X S t } ( PC + PP )
Profits in sudden movements; loses when stock price stays stagnant.

Asdfsfsafsafs
6. Spread: buying and selling different options on the same security. A money spread purchases one option
and sells another with a different exercise price.
a. Payoff

max { St X 1 , 0 } +min {( St X 2) , 0 }=max {X 1 ,S t } +min { X 2 , St }=min { X 2 , St }min { X 1 , S t }

b.

Profit

( min { X 2 , S t }min { X 1 , S t } ) ( PC + PC )
1

c. Purchased if an investor believes that one option is overpriced relative to another.

Asdfdsafsfasfas
7. Collar:
8. Option-Like Securities
a. Callable Bonds: essentially buying the bond and then writing a call option to the issuer; thus it is
similar to a covered call.
b. Convertible Securities: these securities must sell for at least the conversion value; similar to
purchasing debt and call options.

c.
d.

Warrant: a call option that, if exercised, results in the issuance of new securities.
Collateralized Loan:

Futures
1.

2.

The Futures Contract: requires delivery of good or money at a future date at the futures price. Buyers
hold the long position, and sellers hold the short position.
a. Both parties must establish margin accounts to guarantee their part of the deal.
i. The forward contract did not require margin accounts, and thus traders were forced to
conduct credit checks on parties. Thus there exists a default risk on forward contracts.
ii. As prices change, the value of the accounts changes automatically; this is called marking
to market. If the value falls below the maintenance margin, the contract holder would
be issued a margin call.
b. The Clearinghouse..
c. Futures contracts rarely result in actual delivery of the underlying asset; most traders liquidate
their futures and settle for cash instead.
d. Speculators use futures to profit from price shifts, and hedgers to protect against them. They
purchase/sell futures instead of the actual asset because futures involve less transaction costs and
they may offer leverage; you may purchase much more than you can really afford.
The Spot-Futures Parity Theorem
a. By buying a security and then holding a short futures on it, an investor obtains a return of:

( F 0 + D ) S 0
S0
Since this return is perfectly hedged, it must equal the risk-free return rate:

( F 0 + D ) S 0
S0

=r f F 0=S 0 ( 1+r f )D=S0 ( 1+r f + D /S 0 )

This was for one period; for

F0 =S 0 ( 1+ r f + D /S0 )
3.

4.

5.

periods:

Futures Pricing with Storage Costs

a. Suppose there is a cost C to carrying commodities. Then, using the same method as above for
a commodity priced at P0 blah blah PAGE 838
The Role of Expected Spot Prices
a. Expectations Hypothesis: F0 =E ( PT )
b. Missing Stufff here
Hedging Exchange-Rate Risk
a. A firm exports most of its product to England. It can hedge risk by shorting pound futures.
b. First, a firm would linearly regress profits p against the $/ exchange rate E to obtain
p=a+bE .
i. This means that for every $1 decrease in E , profits (in dollars) decrease by $ b
c. Assume the current exchange rate (and futures price) be E0 $/. Suppose the company shorts

H futures. Then for every $1 decrease of E0 , the company loses $ b and gains
H [ E0( E 01 ) ] =H .
d. If it wants to perfectly hedge exchange-rate risk it should short H=b futures. This value is

6.

called the hedge ratio.

Hedging Interest Rate Risk

a. An investor holds $ m in bonds with yield y and modified duration D .

b. First, he regresses y wrt interest rate i (measured in basis pts = 0.01 ) to obtain
y=a+bi .
i. Therefore, if interest rate decreases by 1 basis pt, yield decreases by b basis pts.

7.

For every 1 basis pt decline in the interest rate, the portfolio loses D b 0.01 m . Thus,

it loses 0.01 ( D m ) per basis point. This value is called the price value of a basis pt
(PVBP).
d. Stuff here blah
Swaps: swaps are multiperiod futures contracts.
a. Blah Blah Notational Principal blah blah
b. The swap dealer charges a bid-asked spread fee
c. Swaps may be priced by averaging out the prices on respective futures contracts.
c.

Common Stocks
1.

2.

3.

Equity: stocks or shares, represent ownership in a firm, depends on firm performance so are usually riskier
a. Common Stock: most common form, may or may not pay dividends
i. Residual Claim: stockholders are last in line for claims to assets and income of
corporation.
ii. Limited Liability: the most shareholders can lose in event of default is their original
investment.
iii. Capital Gains: earnings derived from price increases in stocks
iv. Price-Earnings Ratio: ratio of current stock price to last years earnings per share
b. Preferred Stock: does not convey any voting power but guarantees dividend payment.
c. Depository Receipts: certificates traded in U.S. markets representing ownership in a foreign firm
d. Stock Market Indexes: a collection of stocks that measures the performance of the overall market.
i. Price-weighted average: holds one share of each stock; the amt of money invested in
each company is proportional to that companys share price. Example: Dow Jones
Industrial Average
ii. Market-value-weighted index: the amt of money invested in each company is
proportional to its total market value (# of shares price of share). Example:
Standard & Poors Composite 500
iii. Equally-Weighted Index: the amt of money invested in each company is the same.
The Primary Market: where securities are first issued and sold to the public.
a. Investment Banking: buys securities before they enter the primary market and then sells them.
i. I-Bankers are underwriters: they advise the firm regarding how it should attempt to sell
its securities, purchase the securities from the issuing company, and resells them to the
public. The buy and sell price difference constitutes the profit they receive.
ii. Before they sell they have to send a prospectus outlining the issue and prospects of the
company to the Securities and Exchange Commission (SEC) to be approved.
iii. Firms have a shelf registration limit; they may sell shares gradually for 2 years
following the initial registration.
b. Initial Public Offerings (IPOs): when the company issues stocks to the public for the first time
i. I-Bankers organize road shows to publicize the shares, generating interest among
potential buyers and information about the potential price.
c. Private Placements: private offerings sold directly to a small group of wealthy investors.
i. The main advantage is that they are far cheaper than IPOs.
The Secondary Market: where previously-issued securities are traded amongst investors.
a. Markets (in increasing order of organization)
i. Direct Search Markets: buyers and sellers must seek each other out directly. Examples
are the sale ads on local newspapers.
ii. Brokered Markets: brokers offer search services to buyers and sellers, developing
specialization and thus also efficiency of search.
1. The primary market can be viewed as a brokered market, with i-bankers as
brokers.
iii. Dealer Markets: dealers specialize in various assets, purchase these assets for their own
accounts, and later sell them for a profit from their inventory.
iv. Auction Markets: all traders converge at one location to buy or sell an asset.
b. Orders

4.

5.

6.

i. Market Orders: buy or sell orders that are to be executed immediately at current market
prices.
ii. Price-Contingent Orders: a limit buy order and a stop-sell order will be executed
when the share falls below a given price; a stop-buy order and a limit-sell order will be
executed when it rises above a given price.
c. Mechanisms
i. Over-The-Counter (OTC) Markets: dealers list their buy and sell prices, and brokers
pick out attractive quotes to execute a trade.
1. Example: NASDAQ, which has recently however become more electronic
ii. Electronic Communication Networks (ECNs): allow trading of stocks via computer,
which is less expensive and a lot faster.
iii. Specialist Markets: trading for each security is managed by a specialist, who selects the
highest offered purchase price and lowest selling price to match trades. The specialist
himself may make bids to buy or sell to maintain low price-volatility.
1. Examples: NYSE, AMEX
d. Costs
i. Commission Costs: costs paid to intermediaries, such as brokers.
1. Full service brokers employ a research team that advises in addition to executing
orders.
2. Discount brokers only execute orders, but are less expensive.
ii. Spread Costs: the dealers bid-ask spread.
Buying On Margin: borrowing from the broker to profit from a rise in price
a. The margin is the portion of the purchase price contributed by the investor.
b. The broker may borrow from banks to finance these purchases.
c. If the price of the share drops, the margin decreases. To prevent negative margins, the broker sets a
maintenance level; if the margin drops below this level the broker will issue a margin call
mandating the investor to add new cash. If the investor is unable to do so the broker will sell
securities until the margin is above the maintenance level.
Short Sale: borrowing stocks from the broker to profit from a decline in price
a. Later, the short-seller must cover the short position by buying back the stock.
b. Brokers keep many securities in street name; they hold it for their investors (for example, when
they buy on margin). If they lend a certain security to a short-seller and the owner of the security
decides to sell, the brokers may borrow from another investor. If they are unable to, they force the
short-seller to cover the short position.
c. Short-selling is only allowed when the last recorded stock-price change was positive.
d. Short-sellers are required to post cash or collateral with the broker to cover potential losses.
Regulation of Trade
a. Circuit-Breakers
i. Trading Halts: if the DJIA falls by a certain % then trading will halt for a specified period
of time.
ii. Collars: if the DJIA moves more than 2% in either direction when the market opens, the
next sale must be above the current price.
b. Insider Trading
i. Trading based on inside information, or information held by people within the company,
is illegal.
c. Measures of Company Value
i. Book Value: the net worth of a company as reported on its balance sheet.
ii. The liquidation value measures the amt of money left after breaking up the firm, selling
its assets, and repaying its debt. It can be used as a floor for the stock price.
iii. The replacement cost measures the amt a firm would have to pay to replace its assets. It
can be used as a ceiling because if the market value of the firm is high above the
replacement costs then competitors would attempt to replicate the firm.
1. Nobel Prize winner James Tobin hypothesized that market value would tend to
replacement cost.
iv. Blah blah blah

Fixed Income Securities

1.

2.

3.

4.

Bonds: debt securities issued as borrowing arrangements

a. When a bond matures the issuer repays the debt by paying the bondholder the bonds par value.
b. Bonds may or may not have coupon payments, or interest payments that are typically made semiannually. Coupon rates r C are listed as percentages of the par value.
Bond Indentures (Contracts)
a. Sinking Funds: the issuer establishes a fund to spread the payment burden, either by purchasing a
fraction of outstanding bonds in the open market each year. This fund also allows firms to
purchase random bonds based on a call price.
b. Subordination clauses restrict the amt of addl borrowing. Dividend restrictions limit the
dividends firms may pay.
c. Some firms issue bonds backed by collateral, making them generally safer.
Types of Bonds
a. Treasury Securities
i. US Treasury Securities (T-bills, T-notes, T-bonds)
ii. Bunds, JGBs, U.K. Gilts, etc.
b. Federal Agency Securities
i. FHLB, FNMA, etc.
c. Corporate Securities
i. Commercial Paper
ii. Medium-term Notes (MTNs)
iii. Corporate Bonds
d. Municipal Securities (Munies
e. Mortgage-Backed Securities (MBS)
f. Asset-Backed Securities (ABS)
Classification
a. Issuer
i. US Treasury/US Government
ii. States, Municipalities, Agencies
iii. Corporations
iv. Foreign Governments
b. Bond Term: time to maturity
i. Short Term: T-bills, CDs, TDs, CPs
ii. T-bonds, Corporate Bonds, Consols
c. Price vs. Par Value
i. Par bond
ii. Discount Bond
iii. Premium Bond
d. Coupon
e. Currency
i. Yankee Bonds, Samurai Bonds
ii. Eurobonds
f. Credit Risk
i. Risk Free
ii. Defaultable
g. Seniority and Security
i. Senior, subordinated Senior, Junior
ii. Secured by properties and equipment, other assets of the issuer, income-stream, etc.
iii. Sinking fund provisions
h. Covenants
i. Restrictions
i. Option Provisions
i. Callability
ii. Putability

iii. Convertibility