Financial Markets Explained

• Finance helps spread investments through markets
• Time and uncertainty are key in finance
• Real assets produce goods/services and determine wealth
• Financial assets invest in real assets like stocks, allocating claims

Financial Asset Types

• Fixed income securities use formulas for repayment, including interest
• Equity involves owning a share of a company
• Derivative securities are performance-dependent and not fixed

Role of Financial Markets

• They provide information
• Markets reflect investor assessments of current and future firm performance
• Transparency is needed for accurate investor decisions
• Markets enable individuals to shift consumption over time
• Risk is allocated to those most willing to bear it
• Real asset building is facilitated
• Agency problems between management and shareholders are mitigated

Investment Process: Productive Approaches

• Choose a desired risk level to find the highest return asset
• Choose a desired return to find the lowest risk asset

Investment Process: Top Down

• Portfolio: a collection of investment assets
• Broad steps for managing a Investment portfolio:
• Identify investment goals and constraints, specifying risk tolerance of the agent
• Study current financial/economic conditions to form expectations
• Stay updated with the news
• Portfolio construction involves asset allocation
• Asset allocation: selecting broad asset classes like stocks, bonds, real estate
• Security Selection: choosing specific securities within asset classes
• Maximize future return while minimizing uncertainty
• The process is iterative

Investment Process: Bottom Up

• Investors prefer highest expected return investments, but free lunch securities do not exist
• A risk-return trade-off prevails in securities markets
• Riskier assets offer higher expected returns
• Stocks average a 12% return, but lost 46% in 1931
• Bonds average a 6% return, with max loss of 13% in a year

Efficient Market Hypothesis

• As security information becomes available, prices adjust to reflect it

Efficient Market Strategies

• Passive management involves buying/holding a diversified portfolio without seeking mispriced securities
• Active management involves finding mispriced securities or predicting market trends

Key Players

• Firms demand capital
• Households supply capital
• Governments act as borrowers or lenders

Financial Intermediaries

• These connect capital suppliers and demanders (like banks)
• Their primary function is to move household savings to the business sector
• Intermediaries offer expertise on borrowers' businesses
• They use economies of scale to assess risk and diversify across borrowers
• Investment bankers specialize in selling new securities to the public
• IBs market securities in the primary market for new securities
• The secondary market allows investors to trade previously issued securities
• The Glass-Steagall Act, separating investment and commercial banking was repealed in 1999
• By 2008, major standalone U.S. investment banks faced bankruptcy or reorganization

Money Market Securities

• Money market involves short-term (<3 years), highly liquid, low-risk debt securities
• These are used as cash equivalents with a short-term investment horizon, featuring low risk and return
• Money market examples: T-bills, certificates of deposit, commercial paper

Treasury Bills

• Treasury bills are a type of money market instrument with a minimum denomination of $100
• The U.S. government borrows money from the public
• T-bills are the most marketable (liquid) money market security
• Investors buy at a discount
• At maturity, the government pays the investor face value
• Maturity is when investors get the money promised for investment
• Maturities are less than 1 year: 28 days (1 month), 91 days (3 months), 182 days (6 months), 364 days (1 year)

Bid-Ask Spread

• Bid price is the price at which a dealer will buy
• Ask price is the price at which a dealer will sell
• Bid-ask spread: ask-bid
• Bps are basis points (1/100th of a percent) so 1% = 100 bps

Bank Discount Method

• T-bills bid and asked rates are quoted using this method

• Bank discount rate formula: rbd = ((par-price)/par) x (360/days to maturity)

• Price formula: Price = Par(1-rbd x (days to maturity/360)

• Return formula: (New-Old)/Old

• Bond-equivalent yield: the asked yield

Bond-Equivalent Yield

• T-bills are quoted on a 360-day convention
• Bond-equivalent yield formula: rbey = ((Par - Price)/Price) x (365/days to maturity)
• Bank discount rate formula: Rbd = ((Par - Price)/Par) x (360/days to maturity)

Money Market Instruments

• Certificate of Deposit (CD) - is a time deposit with a bank, which cannot be withdrawn on demand
• CD's have higher interest rates than savings accounts
• Commercial paper (CP) is a short-term unsecured debt issued by large corporations
• CP features maturities up to 270 days, but typically less than 2 months
• CP denominations of $100,000 and traded in the secondary market; highly liquid
• Bankers’ acceptance is an order to a bank by a customer to pay money at a future date
• Bankers' acceptance are like a postdated check, very safe, and used in international trade
• Eurodollars are dollar-denominated deposits at foreign banks or foreign branches of American banks
• Repurchase agreements (Repos) are short-term, secured loans and is a kind of short-term borrowing by dealers
• A dealer sells securities to an investor, agreeing to buy them back at a higher price later (next day)
• Securities serve as collateral
• Reverse Repo is the opposite transaction: dealer lends money
• Dealer buys securities from an investor then sells back at a higher price
• Dealer gives cash and investor gives securities
• Federal Funds refers to a bank's required funds on deposit with their Federal Reserve Bank
• The federal funds rate is the interest rate at which banks with excess funds lend to banks with a shortage of funds
• Money market funds are mutual funds that invest in money market instruments
• In 2024, money market funds AUM is over $6.8 trillion and has very low price risk

Capital Markets

• Bond markets involve longer-term borrowing or debt instruments than money markets
• Bond markets are a fixed-income capital market
• Treasury notes and bonds: debt of the U.S. federal government with maturities > 1 year
• T-notes: mature in 1-10 years
• T-bonds: mature in 10-30 years
• Both make semiannual coupon payments
• Yield to maturity: annualized return rate for a bond held until maturity, bought at the asked price

Treasury Inflation-Protected Securities (TIPS)

• TIPS provide a constant income stream in real dollars
• Agency bonds finance activities related to public purposes
• Government Sponsored Enterprises (GSEs) are usually federally chartered but privately owned corporations
• Mortgage-related agencies: Federal Home Loan Bank (FHLB), Federal National Mortgage Association (Fannie Mae), Federal Home Loan Mortgage Corporation (Freddie Mac)
• Federal Government agencies such as Government National Mortgage Association (Ginnie Mae)
• Municipal Bonds are issued by state and local governments; their interest is tax-exempt but still subject to capital gains taxes
• Municipal bonds mainly fund local infrastructure.
• General obligation bonds are backed by the credit of the issuing municipality
• Revenue bonds are backed by the project or the agency driving the project
• Municipal bonds are tax-exempt at the federal level
• People in high tax brackets tend to buy munis
• Corporate bonds are debt issued by corporations and typically makes semiannual coupon payments
• Corporate bonds return face value of the bond at maturity

Muni vs. Corporate Bond

• rtaxable (1-t) = rmuni
• The investor's federal tax rate + local marginal tax rate is where t equals.
• Tax rate of indifference: T = 1 - (rmuni/rtaxable)
• Buy the municipal bond if your tax rate is higher than t and otherwise, buy the corporate bond.
• Common Stock refers to ownership shares in a corporation
• Stockholders are the residual claimants
• Shareholders have limited liability
• A stock market indexes measures the value of a set of stocks within a market
• It is widely used and are signals of “health” of stock market
• Indexes are computed 3 ways

Stock Market Index

• Price-Weighted average adds the prices of stocks and divide a divisor
• PW = ((P1+P2+...+Pn)/d) where d=# of securities in index
• Stocks with higher prices receive greater weight in the index.
• Ex: Dow Jones Industrial Average (DJIA)
• Value-weighted average is the weighted average of each security's returns.
• VW = r1w1 + r2w2 + ...+ rnwn where Wn = (%market cap of stock n/total market cap of portfolio)
• Note: weight is based on the beginning of period market cap. Ex: S&P500 index
• Equal-weighted average is a simple average of returns of securities
• EW = (r1+r2+...+rn/n) where n=number of securities in set

Securities Markets

• Primary market - market for new issues of securities
• Secondary market - market for trading already-issued securities
• Privately held - shares sold directly to small group of investors
• Public - shares sold to general public in established securities markets

Securities Issuances

• Initial Public Offering (IPO) - shares issued for the first time to the public
• Seasoned Equity Offering - additional shares issued for an existing issuance markets
• Shelf registration - firm registers securities to be sold bit holds them and sells then gradually within 2 years

Issuance Process

• Company picks underwriter
• Underwriter - investment bank who markets a public offering of stocks or bonds.
• Typically will buy the securities from the issuing company and then resells to the public
• Advises company on terms and process
• Lead firm forms syndicate
• The underwriter solicits investor interest
• Underwriter develops prospectus and handles IPO registration with SEC
• UW organizes road shows and handles the bookbuilding
• Offering price is established
• UW agrees to purchase new shares to “prop up” price
• IPO underwriter fee: 7% of the funds raised
• Investors purchase securities
• Most IPOs are underpriced
• Early investors reap profits
• Offering Price < first day price
• Securities begin trading
• IPO investors sell their shares on a public exchange
• Big first-day returns (wealth transfer to new shareholders)
• United Parcel Service (UPS) listed publicly on November 10, 1999
• Planned to issue 109.4 million shares at $50
• IPO underpricing: UPS shares were trading at $68.25 at the end of the day

Types of Markets

• Direct search markets involve direct interaction among buyers
• They are the least organized market such as Craigslist
• Brokered markets brokers provide search services to facilitate transactions
• The brokers require a fee such as the real estate market
• Dealer markets are markets where dealers (market makers) specialize, buy sell, hold inventory
• A dealer is a financial intermediary who buys when the customer wants to sell and sells when the customer wants to buy
• The difference between a dealer versus broker: a dealer executes the order against own account while broker represents a customer order
• The stock market is an example
• Auction Markets is a platform (could be electronic) in which all trades converge to buy or sell an asset
• It is the most integrated market such as Ebay or StockX
• Facebook marketplace is a direct search market
• The Brokered Market is the primary market that is considered because when new securities are issued by a company, they are typically sold to investors through investment banks acting as intermediaries (brokers)

Types of Orders

• Make or take
• Market orders - buy or sell orders that are to be executed immediately at market price
• This has no execution risk, but there is price risk
• An investor buys at best ask price
• An investor sells at best bid price
• Price-contingent orders are orders where investors specify prices they are willing to buy or sell because the current market price isn't desired
• Limit buy order - buy at or below specified price that protects prospective buyer from paying too much for an asset
• Limit sell order - sell at or above specified price that protects prospective buyer from selling an asset too cheaply
• Trading Costs include brokerage costs

Trading Costs

• Commisions - compensation for search services and executing transactions
• Full Service brokers such as financial consultants execute orders, facilitate short sales, and provide information
• Discount brokers execute transactions only
• Bid-ask Spread - difference between bid and ask price
• Compensates market makers (dealers) for risk of holding inventory and providing liquidity

The Limit Order Book

• Common priority scheme in the book is price, visibility, and time
• Buying on margin is when investors use loans to purchase a stock
• Margin: portion of the purchase price contributed by the investor. The remainder is borrowed from the broker
• Investor borrows from broker >> brokers borrow from banks

Margin Requirements (Fed. Regulation):

• Initial margin - minimum 50% (at least 50% of purchase price must be paid for in cash)
• Maintenance margin - minimum 30%
• Margin call - issued by broker when margin falls below the maintenance margin; requires investor to deposit additional cash or securities to margin account
• When buying on margin:
• Assets = Value of Stock Purchased
• Liabilities = Loan
• The following equality: Equity in account = Assets - Liabilities
• Margin = Equity in account/Value of Stock
• = (Assets - Liabilities)/Value of Stock
• = (Value of stock - Loan)/Value of stock = (1 - (Loan/Value of stock)) We can solve for Value of Stock: Value of Stock = (Loan/(1 - Margin)) Price of Stock = Value of Stock/# shares purchased
• Short sale - investor borrow shares and sells them, then buys them back later and return the shares. They also pay the lender any dividends paid out during the short sale
• Short-seller believes the stock price will fall in the future
• Increase in price loses money and decrease in price makes money
• Short-sellers required to post margin with the broker to cover losses if stock prices increase

Investing Companies

• Investing has fixed costs:
• Information acquisition - research and analysis
• Trading fees - transaction execution
• Performance tracking - portfolio analysis
• Pooling funds from many small investors generates economies of scale
• Investment companies are financial intermediaries that collect and invest the funds of individual investors in a range of securities
• Each individual investor has a claim to the portfolio established by the investment company
• Investment company value proposition: record keeping and administration
• Funds provide tracking of returns and distributions, simplifying your own accounting
• Diversification and divisibility
• You can invest $100 for 1 share in a mutual fund and be diversified in 100 stocks even if you can't afford 1 share in every stock
• Professional management You benefit from managers specialized in transacting, picking stocks, hedging risks, tracking indexes, etc Lower transaction costs Funds buy and sell large volumes, providing economies of scales on costs

Fund Valuation

• Investors buy shares in investment companies
• Ownership is proportional to the number of shares bought
• Net asset value (NAV) - value of each share
• Net asset value = (Market value of asset minus liabilities)/Shares Outstanding
• Where assets reflects the market value of securities held and liabilities reflects the expenses/fees associated with the management of the funds
• Unit investment trusts - pools of money invested in a portfolio that is fixed for the life of the fund
• The sponsor buys a portfolio of securities and deposits into a trust
• Investors buy shares (units) at a premium
• The fund's trustee pays income and principal payments to shareholders
• Investors who want to liquidate their holdings can ell the shares back to the trustee for net asset value
• The fund is liquidated at the end of the trust's life, with the proceeds distributed to investors
• Managed funds - managed funds are such that shareholders elect board of directors to hire management company for a fee
• These are two types of managed funds
• Open-end funds - a fund that issues or redeems its shares at net asset value.
• Closed-end funds - shares cannot be redeemed; instead, shares are traded on organized exchanges and can be bought through brokers like common stock
• Funds trade at a discount (NAV < sum of value of the assets held in the fund)

Other Investment Organizations

• Commingled fund - partnership of investor pools Management firm
• Realestate investment trust (REIT) - closed-end fund invested in real estate
• Equity trust: Invest in real estate directly
• Mortgage trust
• Hedge fund - private investment pool, lightly regulated, often with lockups
• Very high net worth individuals

Mutual Fund Characteristics

• Managed - portfolio manager oversees fund
• Open-ended fund - buying/selling makes fund size increase/decrease
• Specified investment policy - clear outline of security types and expected risk profile
• Management can be fired if deviates
• Money market funds - invest in money market securities with NAV set at $1 per share
• Equity funds - invest primarily in stock; %5 in money market securities
• Mature funds
• Specialized sector funds - types of equity fund concentrates on a particular industry or a specific country
• Bond funds - focus in fixed-income securities; can further specialize in corporate bonds, T-bonds, or municipal bonds
• Specialized credit risk
• Balanced Funds - hold proportion of equity and fixed income
• Asset allocation/flexible funds - similar to balanced funds; however, asset allocation can change depending on the portfolio managers forecast of the relative performance of each sector.
• Higher-risk investment vehicles
• Market timing
• Index Funds - portfolio weights mirror composition of a specific index
• Super diversified, copies market
• Direct - buy directly from the fund underwriter
• Indirect - buy through broker or financial advisor

Cost of Investing in Mutual Funds: 4 general classes of fees

• Operating expenses - cost of operating the portfolio (administrative expenses and advisory fees paid to the manager, etc.)
• Typically charges 0.2%-1.5% annually
• This is Subtracted from the total assets at the end of the year
• Front-end load - one-time commission paid when purchasing share
• Subtract the load off your cash paid and then buy the shares with the remaining amount Offering price = NAV/(1-Load%) P-PxLoad% = NAV
• P(1-Load%) = NAV Back-end load - exit fee incurred when you sell your shares
• You sell the shares at NAV and then subtract the load off your cash
• 12B-1 - fees charged by the fund to pay for marketing and distribution costs
• This is Subtracted from total assets at the end of the year

Mutual fund Returns

• Denote the NAV at the start data as NAV0 and NAV at the end date as NAV1,
• Rate of return = (NAV1 - NAV0 +Income and capital gain distribution)/NAV0
• (Start: NAV0, End: NAV1)

Taxation of mutual fund income

• Investment returns of mutual funds hold “pass-through status”: taxes are paid by the investor, not by the fund.
• Turnover rate - percent of a fund's value that is traded each year:
• = Value of portfolio bought or sold/Value of assets
• High turnover means capital gains/losses are realized continually and is tax inefficient
• Captial gains tax typically lower than income tax
• Exchange-Traded funds (ETFs) - investment companies that track indexes
• The first ETF was SPDR, or Standard & Poor's Depository Receipt (mathcing S&P 500 Index)
• Unlike conventional mutual funds
• ETFs can be traded continuously
• ETFs do not sell shares directly to investors but shares are traded on
• Stock exchanged at market prices that may differ from NAV
• ETF share created by authorized participants (large broker-dealers) that buys all underlying securities, deposit in a trust, and issues EFT share of equivalent value
• APs then sell ETF shares to investors in the secondary market
• Mutual funds free individual investors from administrative burdens of owning many individual securities
• Mutual funds are a great way to diversify and offer lower trading costs
• Management fees can reduce your rate of return
• Mutual funds categorized by investment policy
• High fund turnover can create high tax exposure
• Active managers rarely beat the market; little evidence that better-peforming funds continue to perform will in the future

Explore the roles of financial intermediaries and market efficiency. Understand price-weighted and value-weighted indexes, and primary vs. secondary markets. Compare active and passive investment strategies, and learn about auction markets and limit orders.