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FINS5513 Lecture 1A
Financial Instruments and Securities Trading ❑ 1.1 Financial Instruments ➢ Overview ➢ Debt Securities • Money market • Bonds and bond indices ➢ Equity Securities • Equity indices (price weighted vs value weighted) ➢ Derivatives ❑ 1.2 Securities Trading ➢ Issuing Securities ➢ Costs of Trading • Order types • Spreads and commissions Lecture Outline 2 1.1 Financial Instruments FINS5513 Introduction FINS5513 Overview of Asset Classes Financial Assets A non-physical, liquid asset that derives its value from a claim on future cash flows Debt Securities Promises a fixed stream of income or a stream of income determined by a specified formula Equity Securities Represents an ownership share in a corporation Derivatives Provide payoffs that are determined by the prices of other assets 5 Overview of Asset Classes Financial Assets Debt Securities Equity Securities Derivatives Money Markets Bond Markets Preferred Stock Common Stock Futures Options 6 Debt Securities FINS5513 Short term debts (maturity of less than 1 year), highly marketable and liquid: ❑ Treasury bills – T-Bills (Government issued) ❑ Certificates of Deposit - CDs (Bank issued) ❑ Commercial Paper - CP (Company issued) ❑ Bankers Acceptances ❑ Eurodollars: dollar-denominated deposits in banks outside the U.S. ❑ Repos and reverse repos: Short-term loan (typically overnight) backed by government securities ❑ Fed Funds: Overnight loans between banks for Fed deposits ❑ Brokers’ Calls – rate brokers borrow from banks ❑ LIBOR Market – interbank lending. Reference rate for many loans Money Market Instruments 8 ❑ LIBOR (London Inter-Bank Offer Rate) has historically been an important reference rate for a wide variety of transactions, both in the interbank market and the corporate loan market ➢ Based on a survey of rates reported by participating banks rather than actual transactions ➢ Interbank lending has become more sparse recently, resulting in less reference points ➢ As the sample size is decreasing and following a scandal arising from manipulation of the rate in 2012, the search for a replacement is on ❑ LIBOR proposed to be phased out by 2021 and replaced by averages using actual transactions ➢ SONIA: Sterling overnight interbank average rate (GBP) ➢ SOFR: Secured overnight funding rate (USD) ➢ TONA/ TONAR: Tokyo overnight average rate (JPY) ➢ ESTER / €STR: Euro short term rate (EUR) ➢ AONIA: RBA interbank overnight cash rate (“cash rate”) (AUD) Money Market Instruments Further Reading 1AR1: “Understanding the LIBOR Scandal” 9 Medium to long term debts (1 - 30+ years) ❑ US Treasury Notes and Bonds (T-Notes and T-Bonds) ❑ Inflation-Protected Treasury Bonds (TIPS) ❑ Federal Agency Issues eg Federal Home Loan Bank (FHLB), Fannie Mae, Freddie Mac ❑ International Bonds ➢ Eurobonds – bond denominated in a currency different to the country where it’s issued • E.g. Dollar bond issued in UK = Eurodollar bond ➢ Foreign bonds – same currency as the country of issue but issued by a foreign borrower • E.g. Yankee bond = dollar bond, sold in US, by non-US issuers ❑ Municipal Bonds – tax advantaged ❑ Corporate Bonds ❑ Mortgage-Backed Securities Bond Markets 10 ❑ Major indices: Merrill Lynch, Barclays, Citigroup ❑ Challenges: ➢ Wider universe: While a company may have 1 or 2 types of stocks, a company may have numerous bonds on issue (10+) ➢ Illiquid: A significant number of bonds are illiquid and infrequently traded ➢ Turnover: Bond indices turn over more than stock indices as the bonds mature (highly dynamic) Bond Indices 11 Equity Securities FINS5513 ❑ Common stock ➢ Limited liability ➢ Residual claim ➢ Perpetuity – no fixed term ❑ Preferred stock: Fixed dividends ➢ Dividend is cumulative (and commonly fixed) ➢ Priority over common stock ➢ Often a perpetuity ❑ American Depository Receipts (ADRs) ➢ Certificates traded on US exchanges representing ownership of shares in foreign firms ➢ Created as a simplified way for foreign firms to satisfy US security registration requirements ➢ Most common way for US investors to trade shares in foreign corporations Equity Securities 13 ❑ Many stock market indices exist: ➢ Dow Jones Industrial Average (DJIA) – 30 large U.S. blue-chip stocks ➢ S&P500 – 500 largest U.S. stocks by market capitalisation ➢ NASDAQ Composite; NYSE Composite; Wilshire 5000 ➢ ASX200 for Australia; FTSE for UK; Shanghai Index for China; Hang Seng for Hong Kong; Nikkei for Japan ❑ How are stocks weighted? ➢ Price weighted (DJIA) ➢ Market-value weighted (S&P500, NASDAQ) ➢ Equally weighted (Value Line Index) ❑ Indices are not traded – however investors can buy into funds which track an index such as: ➢ Index mutual funds – see 1.4 ➢ Exchange traded funds (ETFs) – see 1.4 Stock Market Indices 14 Price Weighted Index ❑ Price Weighted Index = average price of all stocks in the index ❑ In its simplest form, add up all the prices of stocks in the index and divide by the number of stocks in the index: ℎ = = ℎ ℎ ❑ The % change in a price weighted index is equal to the return on a portfolio that invests in one share in each stock in the index ❑ Example 1A1: Calculate the change in a price weighted index of the following stocks: ➢ Step #1: Calculate PWI in Period 1 = (370 + 55 + 135 + 160) / 4 = 180.0 ➢ Step #2: Calculate PWI in Period 2 = (350 + 45 + 140 + 165) / 4 = 175.0 ➢ Change / return on a 4-stock portfolio = 175 / 180 - 1= -2.78% or (175 – 180) / 180 = -2.78% Period GS KO APPL JNJ Period 1 $370 $55 $135 $160 Period 2 $350 $45 $140 $165 15 ❑ In the simplest case, the divisor (d) in the PWI is the number of stocks ❑ However, when stocks are replaced in the index or undertake a stock split, the divisor needs to be amended. We do this as follows: Revised divisor = = ℎ ℎ ℎ ℎ ℎ ❑ Example 1A2: Suppose Coca-Cola (KO) were replaced in the index by Microsoft (MSFT). Keep all other prices equal. Calculate the PWI divisor: ➢ Step #1: Calculate PWI in Period 1 = (370 + 55 + 135 + 160) / 4 = 180.0 ➢ Step #2: Calculate revised divisor (from above) d = (370 + 280 + 135 + 160) / 180.0 = 5.25 ➢ Verify revised divisor 5.25 (from 4 previously) gives the same PWI as before the replacement of KO with MSFT: (370 + 280 + 135 + 160) / 5.25 = 180.0 Price Weighted Index Period GS KO MSFT APPL JNJ Pre-change prices $370 $55 N/A $135 $160 Post-change prices $370 N/A $280 $135 $160 16 ❑ A Value Weighted Index (VWI) is calculated based on market capitalisation of index stocks ❑ Each stock is weighted in the index proportional to its current market capitalisation ❑ Label the current period t and the previous period t-1. To calculate we need − 1 : = − 1 × ℎ ℎ ℎ ℎ −1 ❑ Example 1A3: The index value of the S&P500 in the previous period (t-1) was 4000. Based on the prices and market capitalisations below, calculate the S&P500 in the current period (t) Value Weighted Index Period GS KO APPL JNJ # of Shares mn 340 4,300 16,700 2,630 Price MV $bn Price MV $bn Price MV $bn Price MV $bn Period t-1 $370 125.8 $55 236.5 $135 2,254.5 $160 420.8 Period t $350 119.0 $45 193.5 $140 2,338.0 $165 433.95 17 ➢ Use formula to calculate revised S&P500: = 4000 × 119.0 + 193.5 + 2,338 + 433.95 = 3084.45 125.8 + 236.5 + 2,254.5 + 420.8 = 3,037.6 ➢ VWIt = 4,061.7 which is an increase of 4061.7 / 4000 -1 = +1.54% ❑ Price movements were the same as for the PWI, but the PWI index moves down -2.78%, while the VWI moves up +1.54% ➢ This is because Apple moving up has a much greater impact on the VWI due to its market cap being significantly greater than the other stocks ❑ The example demonstrates that in a VWI, larger companies account for much of the movement; while for a PWI, smaller companies have more of an impact ❑ VWI do not have to be adjusted for events such as stock splits, dividends etc ❑ As fund managers focus on maximising the risk-adjusted value of their portfolios they are significantly more likely to benchmark against a VWI (S&P500) than a PWI (DJIA) PWI vs VWI Video 1AV1: “Here’s how stocks get booted from the Dow” Excel 1AE1: “1A PWI vs VWI” 18 Derivatives FINS5513 ❑ Derivatives are securities whose value is dependent on the value of other assets, such as commodity prices, bond and stock prices, or market index values ❑ Forward – a deferred-delivery sale/purchase of an asset with the sales price agreed on today ❑ Futures – similar to a forward ➢ Carries an obligation to make or take delivery of an underlying asset at a price determined today but settled at a future date ➢ Stipulates the quantity and specifications of the underlying asset ➢ Differences to a forward include: • Standardised contract – more liquid and tradeable • Trades on an exchange – mitigates counterparty risk (the exchange is the counterparty) • Marked to market, with (daily) margin requirements – see 1.3 Futures and Forwards 20 Options ❑ A call (put) option gives the holder the right (but not the obligation) to buy (sell) an underlying asset: ➢ At the exercise or strike price ➢ On or before the expiration date (depending on the type) ❑ Exercise the call option to buy the asset if market value > strike ❑ Exercise the put option to sell the asset if market value < strike ❑ The purchase price of the option is called the premium (both calls and puts) ➢ Buyer pays the premium / Seller (writer) receives the premium ❑ If the holder exercises the option, the option writer must make (call) or take (put) delivery of the underlying asset 21 1.2 Securities Trading FINS5513 Issuing Securities FINS5513 ❑ Public companies ➢ Issued stock is publicly listed on an exchange such as the NYSE, ASX ➢ Known as publicly traded, public companies, or listed companies ❑ Private companies ➢ Issued stock do not trade on an exchange – also known as unlisted companies ➢ Lower liquidity and less public disclosures ❑ Primary Market ➢ Market for newly-issued securities ➢ Proceeds raised from the issue flow directly to the company ➢ Firms issue new securities to the public (often through an underwriter) ❑ Secondary Market ➢ Investors trade previously issued securities among themselves ➢ Proceeds flow between investors that purchase/sell securities and not to the company Security Issues 24 Primary vs Secondary Market ❑ The primary market (first time issue of securities) consists of: ➢ Initial Public Offerings (IPOs) ➢ Follow-on offerings (or a “seasoned equity offering”) ❑ Follow-on offerings refer to any issuance of new shares for companies already listed on an exchange (i.e. any new share offering subsequent to an IPO) ➢ For example: rights issues, private placements of new shares etc ➢ Proceeds raised from the issue flow directly to the company ❑ The secondary market consists of: ➢ Trading amongst investors on exchanges ➢ Secondary market offerings • Shares sold by existing shareholders (often called “block trades”) • Non-dilutive to shareholders as the share count stays the same (they sell directly to each other and the company receives none of the proceeds) Further Reading 1AR2: “IPOs: Profiles are high: Returns?” 25 Costs of Trading FINS5513 ❑ Market orders: ➢ No price indication – trade at the prevailing market price ➢ An instruction to trade a quantity at the best price currently available in the market ➢ Market order example: Buy 1000 shares in BHP at market ➢ Advantage: timely, executes immediately. Avoids price moving to a disadvantageous level ➢ Disadvantage: must pay the bid-ask spread. Price may move to a more advantageous level ❑ Limit orders: ➢ Price indication – trade at the best price available if it is no worse than the specified limit price ➢ Limit order example: Buy 1000 shares in BHP at $46.50 ➢ Advantage: may get a good price for the trade. Avoids paying the bid-ask spread ➢ Disadvantage: the trade may not execute (execution risk) Order Types 27 ❑ Explicit costs – direct costs of trading such as: ➢ Commission - fee paid to the broker for facilitating the transaction • Calculated based on the total transaction size • Range from 0% - 0.1% for online trading platforms to 1%+ for full-service brokers ➢ Transaction taxes, stamp duties, exchange fees etc ❑ Implicit costs – indirect costs such as: ➢ Bid-ask spread • The difference between the bid and ask prices ➢ Market impact costs • The effect of the trade on market prices • Large buyers (sellers) must raise (lower) prices to encourage other investors to trade. Minimal impact from small orders • Delay costs (slippage) – suboptimal prices paid/received arising from delayed execution of a trade due to its size or opportunity costs – profits not realised due to unfilled trades Costs of Trading Further Reading 1AR3: “How no-fee stock trading is changing the stock market” 28 ❑ Bid-Ask spread – cost of trading with a counterparty directly (or through a broker/dealer): ➢ Bid: price at which the counterparty is willing to buy ➢ Ask: price at which the counterparty is willing to sell ➢ Bid-Ask spread: Ask - Bid ❑ Market orders – buy at the ask price / sell at the bid price ❑ Limit orders – place an order at a preferred bid (ask) price if you wish to buy (sell) ❑ Example 1A4: Using the transaction information below, calculate the trading costs (assume the full cost of the spread) and net proceeds paid/received from a market offer trade Spreads and Commissions Buyer Seller Bid-Ask $52.00 - $52.50 $32.70 - $33.00 # of Shares 0.5 million 2 million Commission 0.20% 0.15% 29 ➢ Market offer - the buyer buys at (“hits”) the ask and the seller sells at (“hits”) the bid ➢ For the buyer, commissions add to the cost of the trade. For the seller, commissions reduce the proceeds from the trade ➢ Buyer Pays: 0.5m x 52.50 x (1 + 0.2%) = $26,302,500 Cost of trade: Spread = 52.50 – 52.00 = 50c 0.5m x 52.50 x 0.2% + 0.5m x 50c = $52,500 + $250,000 = $302,500 ➢ Seller Receives: 2m x 32.70 x (1 – 0.15%) = $65,301,900 Cost of trade: Spread = 33.00 – 32.70 = 30c 2m x 32.70 x 0.15% + 2m x 30c = $98,100 + $600,000 = $698,100 Spreads and Commissions Ask price Bid price 30 ❑ BKM Chapters 3 and 4 ❑ 1.3 Trading on Margin: Long and Short ❑ 1.4 Asset Management Industry: Investment Companies, Hedge Funds and ETFs Next Lecture