I. Background

A. The Investment Environment

• Investment - current commitment of resources to get future benefits

1. Real assets

• Land, buildings, machines, knowledge

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2. Financial assets

a. Fixed income (debt) securities

• Stream of income from investment

Ex. – Bonds

b. Equity – represents ownership of a company

(1) Dividends – periodic payments of profit to equity holders

(2)  Capital gain – appreciation in the price of a security

• Equity  investment is more risky than debt investment

c. Derivative securities

• Payoffs depend on the performance of other assets

Ex. – Options, futures contracts

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3. Financial markets and the economy

a. Provides information about prospects of companies

b. Consumption timing

• Allows people to consume at different times, either more or less currently

c. Allocation of risk

• Allows matching of investment to risk tolerance

d. Separation of ownership on management

• As companies get large, too complicated for owners to manage

• Owners elect board, board chooses managers

• Agency problems – conflict between interests of management and the interests of owners

e. Corporate governance and ethics

• Firms need to be transparent

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4. The investment process

• Portfolio – collection of investment assets

• Steps:

a. Asset allocation – choice among broad asset classes

b. Security selection – valuation of particular securities

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5. Competitive markets

a. Risk-return trade-off

• Higher returns for higher risk incurred   

b. Efficient markets

• Will rarely find bargains in security pricing

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6. The players

a. Firms – net demanders of capital

b. Households – net suppliers of capital

c. Government – either, although a borrower recently

d. Financial intermediaries  - brook borrowers and suppliers together

e. Investment bankers – help companies sell debt and equity in market

(1) Primary market – new issues of securities first sold in market

(2) Secondary market - trading of previously issued securities

f. Venture capital and private equity

• Equity investment in young, startup companies

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B.  Asset Classes and Financial Instruments

1. Money market

• Very short-term debt

a. Treasury bills

• Government borrows by selling bills to public

b. Certificate of deposit (CD)

• Time deposit with a bank

c. Commercial paper

• Short-term debt of private companies

d. Bankers' acceptances

e. Eurodollars

f. Repurchase agreements (repos) and reverses

g. Federal funds

h. Brokers' calls

i. LIBOR market

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2. Bond market

• Longer-term debt

a. Treasury securities

(1) Notes - between 1 and 10 years

(2) Bonds - greater than 10 years

b. Treasury Inflation-Protected Securities (TIPS)

• Yield protected against inflation

c. Federal agency debt

d. International bonds

e. Corporate bonds

f. Mortgages and mortgage-backed securities

g. Municipal bonds

• Issued by stat and local governments

• Interest is tax exempt

r (1- t) = r_m

r = r_m / (1-t)

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3.  Equity securities

a. Common stock

• Represents ownership of a company

• Owner can vote at annual meeting

• Limited liability - creditors cannot claim assets of shareholders

b.  Preferred stock

• Fixed income, no voting rights

c.  American Depository Receipts (ADRs)

• Represent ownership of a foreign company

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C.  Miscellaneous equity topics

1.  Stock indexes

a. Dow Jones

• Dow Jones Industrial Average (DJIA)

• Price-weighted index

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b.Standard and Poor's

• S&P 500 - 500 largest firms

• Value-weighted index

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c. Other indexes

(1) NASDAQ Composite

• National Association of Security Dealers

• Measures Over-the-Counter stocks

(2) Wilshire

• Wilshire 5000 is the broadest index

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2.  How stocks are traded

a. Types of orders

(1) Market orders

• Buy or sell at the market price

• Bid - selling price

• Ask - purchase price

Ex. -

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(2) Price-contingent orders

• Limit orders - specify price at which to buy or sell

Ex. -

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• Stop orders - similar, but in opposite direction

Ex. -

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• Limit vs. stop orders

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b.  Buying on margin

• Borrow money to buy stocks

• Can increase rate of return or rate of loss

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c.  Short sales

• Sell stock, buy back later

• Done when price expected to drop

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3. Mutual funds

• Open-end investment company - don't buy from or sell to other investors

• Collect funds from individuals and invest in a wide range of securities

• Allows diversification

a.  Types of funds

(1) Money market funds

(2) Equity funds

(3) Sector funds

(4) Bond funds

(5) International funds

(6) Balanced funds

(7) Asset allocation funds

(8) Index funds

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b.  Mechanics

• Funds priced at end of the trading day

• Net Asset Value (NAV) - value of the funds holdings

• Loads - fees charged by mutual fund

(1) Front-end load - fee paid when investing

(2) Back-end load - fee paid when redeeming

• Operating expenses also deducted

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c. Exchange traded funds (ETFs)

• Similar to mutual funds, but can be traded during the trading day

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d.  Mutual fund Information

• Morningstar

• Yahoo!