FINS5513 Lecture 1: Investment Overview & Trading Securities PDF

FINS5513 Lecture 1 Investment Overview & Trading Securities Lecture Outline  1.1 Introduction to Assets and Indices  Asset classes  Indices  1.2 Trading Securities  Costs of trading  1.3 Trading on Margin  Buying on margin (“Long”)  Short selling (“Short”) ...

FINS5513 Lecture 1 Investment Overview & Trading Securities Lecture Outline  1.1 Introduction to Assets and Indices  Asset classes  Indices  1.2 Trading Securities  Costs of trading  1.3 Trading on Margin  Buying on margin (“Long”)  Short selling (“Short”)  1.4 Institutional Overview of the Funds Management Industry  Investment company overview  Mutual funds and hedge funds  Exchange Traded Funds (“ETFs”) 2 1.1 Introduction to Assets and Indices FINS5513 Week 1 Asset Classes FINS5513 Week 1 Overview of Asset Classes Debt Securities Promises a fixed stream of income, or a stream of income determined by a specified formula Financial Assets Equity Securities A non-physical, liquid asset that Represents an ownership share derives its value from a claim on in a corporation future cash flows Derivatives Provides payoffs that are determined by the prices of other assets 5 Overview of Asset Classes Money Markets Debt Securities Bond Markets Preferred Stock Financial Equity Securities Assets Common Stock Futures Derivatives Options 6 Definitions  Money market instruments  Maturity of less than 1 year - highly marketable and liquid  Examples include: Treasury Bills (T-Bills), Commercial Paper (CP), LIBOR market  Bond market  Medium to long-term debts (1 – 30+ years)  Examples include: Treasury Notes and bonds, Corporate bonds, Mortgage-Backed Securities (MBS), International bonds  Equity Securities  Common stock – limited liability, perpetual, residual claim etc  Preferred stock – fixed and cumulative dividends, priority over common stock  Derivatives  Futures, forwards and options (put and call) 7 Indices FINS5513 Week 1 Bond Indices  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) 9 Stock Market Indices  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 (Australia); FTSE (UK); Shanghai Index (China); Hang Seng (HK); Nikkei (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 10 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: 𝑃𝑟𝑖𝑐𝑒 𝑤𝑒𝑖𝑔ℎ𝑡𝑒𝑑 𝑖𝑛𝑑𝑒𝑥 = 𝑃𝑊𝐼 =  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 1.1A 11 Price Weighted Index – Changing the Divisor  In the simplest case, the divisor (𝑑) in the PWI is the number of stocks  However, when the stocks comprising the index are changed or a stock in the index undertakes a stock split, the divisor needs to be amended. We do this as follows: 𝑅𝑒𝑣𝑖𝑠𝑒𝑑 𝐷𝑖𝑣𝑖𝑠𝑜𝑟 = 𝑑 = Example 1.1B 12 Value Weighted Indices  A Value Weighted Index (VWI) is calculated based on the market capitalisation of index stocks  Each stock is weighted in the index proportional to its current market capitalisation  In order to calculate we need to be given the base index to calculate future movements in the index over time  Label the current period 𝑡 and the previous period 𝑡 − 1. To calculate 𝑉𝑊𝐼 we need 𝑉𝑊𝐼 : 𝑉𝑊𝐼𝑡 = 𝑉𝑊𝐼𝑡 − 1 × Example 1.1C 13 PWI vs VWI  For the same price movements there may be instances where the PWI and VWI move in opposite directions  This is because high share price stocks have a much greater impact on the PWI, whereas stocks with high market capitalisation have a significantly greater impact on VWI  For 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) Excel 1E1: “PWI vs VWI” 14 1.2 Trading Securities FINS5513 Week 1 Costs of Trading FINS5513 Week 1 Order Types  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) 17 Costs of Trading  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 price to execute trade (small order impact is minimal) 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 18 Spreads and Commissions  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 1.2A Example 1.2B 19 1.3 Trading on Margin FINS5513 Week 1 Buying on Margin (“Long”) FINS5513 Week 1 Buying on Margin  Buying on margin: Investor pays only a portion of an investment and borrows the remaining amount from a broker  The margin loan is the amount borrowed from the broker  Margin (also referred to as “equity”) refers to the residual investment amount after deducting the margin loan from the market value of the asset  Margin arrangements differ for stocks and futures  For stocks, margin trading can be used for long or short positions 22 Key Concepts Key terminology  Initial margin  The initial amount of margin/equity invested when the margin loan is set up  In the US – the initial margin is currently set by the Federal Reserve (Regulation T) with a minimum initial margin of 50%  Maintenance margin  The minimum level an investor’s margin/equity % can fall to  In the US, Regulation T sets minimum maintenance margins of 25% for listed stocks  Any fall in the margin/equity % below the maintenance margin results in a margin call  Margin call  Call for additional investor margin/equity (collateral) to be posted 23 Initial Set Up  The initial position set up (excluding brokerage and other transaction costs) is as follows: Initial Position: Initial Share Portfolio Value # shares purchased x purchase price Initial Margin (Initial Equity) Initial Margin % x Initial Share Portfolio Value Margin Loan (1 – Initial Margin %) x Initial Share Portfolio Value Initial Share Portfolio Value = Initial Margin + Margin Loan  Define margin (equity) as: Variable Fixed Margin = Share Portfolio Value – Margin Loan  Define margin (equity) % as: Margin % = Margin ÷ Share Portfolio Value 24 Long Margin Call  When the share price changes, you need to calculate if you will receive a margin call:  Step #1 – recalculate the Share Portfolio Value SPV (variable)  Step #2 – deduct the margin loan (fixed) from the recalculated SPV (variable) to derive the new margin (variable)  Step #3 – recalculate the new margin % as Margin ÷ SPV  Step #4 – if the recalculated margin % < maintenance margin % → a margin call occurs  To calculate how much collateral must be posted (the “additional margin requirement” or “additional collateral”) when a margin call is made, use the following: Additional Collateral = Recalculated SPV x Maintenance Margin % - Recalculated Margin  The additional collateral pays down the margin loan Example 1.3A 25 Long Margin Call  To calculate how far the price can fall before there is a margin call: ∗ × Solve for P*: Maintenance Margin % = × ∗ Therefore: P* = × % Example 1.3B 26 Short Selling (“Short”) FINS5513 Week 1 Short Selling  Purpose: to profit from a decline in the price of a stock or security. Mechanics are:  Short seller (typically a hedge fund) borrows stocks through an Investment Bank (IB) or broker  Short seller sells stock and deposits proceeds in an account  To “cover” the short: Short seller buys the stock back and returns it to the institutions that lent the stock (though the IB) Pay Dividends, Interest, Pay Dividends +/- Rebate Fee +/- Rebate Fee Institutions Investment Bank / Hedge Fund (Stock Lenders Broker Deposit Cash (Short Seller) Long the stock) (Intermediary) Lend Stock Lend Stock Deposit Receive Sell Stock Pays Interest Cash Cash Mini Case Study: Bank On Market “Herbalife: Battle of the (Not part of (Not part of Hedge Fund Titans” short) short) 28 Why Do Long Institutions Lend Out Stock?  Why do institutions that are long the stock lend it out?  Effectively the institutions are “renting” the stock out to the short seller  They are left no worse off because they receive dividends and all other cashflows associated with ongoing ownership of the stock (paid for by the short seller)  In addition, they receive a portion, all, or more than the interest received on the cash deposit from the sale proceeds of the stock (this is often called rebate or borrow fees, and the amount received by the stock lender often depends on a negotiated agreement) 29 Initial Setup  Most short selling is done on margin  Initial Margin: In the US, Regulation T requires an investor to deposit 50% of the proceeds from the short sale  The sale proceeds and initial margin are fixed (equal to 150% of the cash sale proceeds from the market sale of short shares). We call this the Initial Account Balance and it is also fixed  The initial position set up (excluding brokerage and other transaction costs) is as follows: Initial Position: Initial Sale Proceeds # shares sold x share sale price Initial Margin (Initial Equity) Initial Margin % x Initial Sale Proceeds Initial Account Balance (IAB) (fixed) = Initial Sale Proceeds + Initial Margin Initial Account Balance will equal (1 + Initial Margin %) x Initial Sale Proceeds 30 Post Setup Margin Calulation  Thereafter, the Margin (equity) for a short sale is defined as: Fixed Variable Margin = IAB – Share Portfolio Value  Define margin (equity) % for a short sale as: Margin % = Margin ÷ Share Portfolio Value 31 Short Selling Margin Call  When the share price changes, you need to calculate if you will receive a margin call:  Step #1 – recalculate the Share Portfolio Value SPV (variable)  Step #2 – deduct the recalculated SPV (variable) from the IAB (fixed) to derive the new margin (variable)  Step #3 – recalculate the new margin % as Margin ÷ SPV  Step #4 – if the recalculated margin % < maintenance margin % → a margin call occurs  To calculate how much collateral must be posted (the “additional margin requirement” or “additional collateral”) when a margin call is made, use the following: Additional Collateral = Recalculated SPV x Maintenance Margin % - Recalculated Margin  The additional collateral goes on deposit to re-establish the account balance with sufficient collateral Example 1.3C 32 Short Selling Margin Call  To calculate how far the price can rise before there is a margin call for a short: ∗ × Solve for P*: Maintenance Margin % = × ∗ Therefore: P*= × %  Note that the margin call amount is greater for a given % change in price for short positions, as it is calculated on a rising share price Example 1.3D 33 1.4 Institutional Overview of The Funds Management Industry FINS5513 Week 1 Investment Company Overview FINS5513 Week 1 Investment Company Functions  Pools funds from individuals and companies and invests in a diversified portfolio of securities and/or assets Unit Investment  Benefits of pooling funds include: Trusts  Diversification and divisibility  Lower transaction costs and economies of scale  Record keeping and administration Investment Managed  Professional management Companies Investment  Investment companies can be categorised as: Companies  Unmanaged entities such as Unit Investment Trusts  Managed investment companies Other  Other investment organisations – which, although not Investment regulated as investment companies, perform similar Organisations functions 36  Types of Investment Companies Investment Companies Managed Unmanaged Open (Mutual Fund) Closed  Can grow or reduce size of funds  Size/number of units is fixed  Unit Investment Trusts under management (excluding revaluations)  “Set & Forget” by sponsor  No termination dates (open)  Termination date (eg 10, 20 years)  Fixed portfolio - priced at NAV  Don’t trade continuously  Trade continuously on an exchange (secondary trading)  No asset turnover  No redemptions  No change in units  Redeem once a day at NAV 37 Investment Company Overview  In the U.S., managed investment companies which are open-end are called mutual funds  Mutual funds are by far the most prominent investment companies, comprising around 77% of funds under management, followed by ETFs US Investment Companies by Assets Under  Sold by brokers and financial planners Management $USbns (end 2022)  ETFs have shown the most growth Closed End Unit Investment over the past decade Funds, 252 Trusts, 73  Total funds under management of regulated investment companies in Exchange Traded Funds, 6,477 the U.S. at end 2022 is $US28.9tn, which is almost half of worldwide open-end investment of $US60tn Mutual Funds Mutual Funds, 22,110 Exchange Traded Funds  At over $US2.6tn, Australia is the 6th Closed End Funds largest in the world (behind China $US3.5tn) Unit Investment Trusts 38 Mutual Funds FINS5513 Week 1 Mutual Funds  Common name for open-end investment companies (often called “managed funds” or “superannuation funds” in Australia)  Priced once daily at NAV - issued units fluctuate as the fund accepts new money or redeems  Mutual funds are sold directly by the fund/underwriter or indirectly through brokers (on commission) and financial planners  Fund types by investment sectors:  Equity funds (most common)  Money market funds (maturities