Introduction to Investments

Financial markets, instruments, trading of securities & the Mutual Fund Industry in only 24,079 words

Disclaimer: Content is summarised from Part 1 (Chapter 1 to 4) of 'Investments' 11th Edition by Zvi Bodie, Alex Kane & Alan J. Marcus

Contents:

1. Investment Environment • Real Assets vs Financial Assets • Financial Assets • Financial Markets & the Economy • Investment Process • Markets Are Competitive • Players

• Financial Crisis of 2008

• Summary

2. Asset Classes & Financial Instruments • Money Market • Bond Market • Equity Securities • Stock & Bond Market Indexes • Derivative Markets • Summary

3. How Securities Are Traded • How Firms Issue Securities • How Securities Are Traded

• Rise of Electronic Trading • US Markets

• New Trading Strategies • Globalisation of Stock Markets

• Trading Costs • Buying on Margin

• Short sales

• Regulation of Securities Markets

• Summary 4. Mutual Funds & Other Investment Companies • Investment Companies • Types of Investment Companies

• Mutual Funds • Costs of Investing in Mutual Funds

• Taxation of Mutual Fund Income • Exchange-Traded Funds

• Mutual Fund Investment Performance: A First Look • Info on Mutual Funds

• Summary

1. Investment Environment

1.1 Real Assets vs Financial Assets

Real assets of the economy like land, buildings, machines & knowledge that can be used to produce g&s.

Financial assets like stocks & bonds: securities are no more than sheets of paper / computer entries that do not contribute directly to the productive capacity of the economy but are claims to income generated by real assets (or claims on income from the government).

E.g. rather than owning an auto plant (a real asset), we can buy shares in Ford (financial assets) & thereby share in the income derived from the production of automobiles.

When investors buy securities from companies, firms use money raised to pay for real assets, like plants, equipment, tech, inventory. Investors’ returns on securities ultimately come from income produced by real assets financed by issuance of those securities.

1.2 Financial Assets

3 broad types of Fixed Assets: fixed income, equity & derivatives.

Fixed-income / debt securities

Fixed stream of income / a stream of income determined by a specified formula. E.g. corporate bond promises bondholder will receive a fixed amount of interest each year.

Other floating-rate bonds promise payments dependent on current i/r. E.g. a bond may pay an i/r fixed at 2% above rate paid on U.S. Treasury bills. Unless borrower is declared bankrupt, payments are either fixed / determined by formula. Hence, performance of debt securities typically is least closely tied to financial condition of issuer.

(a) Money market refers to debt securities that are short term, highly marketable & generally of very low risk, (E.g. U.S. Treasury bills / bank certificates of deposit).

(b) Fixed-income capital market includes long-term securities like Treasury bonds & bonds issued by federal agencies, state & local municipalities & corporations. Ranges from very safe in terms of default risk (like Treasury securities) to relatively risky (like high-yield / “junk” bonds). Designed with extremely diverse provisions regarding payments provided to investor & protection against the bankruptcy of the issuer.

Common stock / equity

Represents ownership share in corporation. Equity holders are not promised payment. Receive dividends firm may pay out & have prorated ownership in real assets of the firm. If firm is successful, value of equity will increase. Performance is tied directly to success of firm & its real assets, hence it tends to be riskier than debt securities.

Derivative Securities

Provide payoffs determined (derived) by prices of other assets like bond / stock prices (E.g. options & futures contracts). Call option on a share of Intel might be worthless if Intel’s share price remains below a threshold / “exercise” price like $30 a share, but it can be quite valuable if stock price rises above that level. (A call option is the right to buy a share at a given exercise price on / before option’s expiration date. If market price of Intel remains below $30 a share, right to buy for $30 will turn out to be valueless. If share price rises above $30 before option expires, option can be exercised to obtain the share for only $30.)

Other important derivative securities are futures & swap contracts. Integral to investment environment. Primary use: hedge risks / transfer them to other parties. Use of these securities for risk management is so commonplace that the multitrillion-dollar market in derivative assets is routinely taken for granted. Derivatives also can be used to take highly speculative positions. Huge losses in hundreds of millions of dollars are the exception to the more common use as risk management tools. They will continue to play an important role in portfolio construction & the financial system.

Investors might invest directly in real assets. E.g. commodities are traded on exchanges like New York Mercantile Exchange / Chicago Board of Trade. Commodity & derivative markets allow firms to adjust their exposure to various business risks. E.g. a construction firm may lock in the price of copper by buying copper futures contracts, thus eliminating risk of a sudden jump in price of its raw materials. Wherever there is uncertainty, investors may be interested in trading, to speculate / to lay off their risks, & a market may arise to meet that demand.

1.3 Financial Markets & the Economy

Financial assets allow us to make the most of the economy’s real assets.

The Informational Role of Financial Markets

Stock prices reflect investors’ collective assessment of a firm’s current performance & future prospects. Higher optimism causes higher price which allows firm to raise capital & thus encourage investment. Stock prices play a major role in allocation of capital in market economies, directing capital to the firms with the greatest perceived potential. But capital markets do not always channel resources to the most efficient use. Think about the dot-com bubble in 2000. No one knows with certainty which ventures will succeed or fail. You may be skeptical about resource allocation via markets but what alternatives are there?

Consumption Timing

In high-earnings periods, invest savings. In low-earnings periods, sell these assets to provide funds for consumption needs. Hence, you “shift” your consumption across your lifetime, allocating your consumption to periods that provide greatest satisfaction.

Allocation of Risk

Virtually all real assets involve some risk. E.g. cannot know for sure what cash flows plants will generate. Capital markets allow risk that is inherent to be borne by investors most willing to bear that risk. When investors are able to select security types with risk-return characteristics that suit their preferences, each security can be sold for the best possible price. This facilitates process of building economy’s stock of real assets.

E.g. if Toyota raises funds to build its auto plant via stocks & bonds, more optimistic / risk-tolerant investors can buy shares of its stock, while more conservative ones can buy bonds.

Separation of Ownership and Management

With global markets & large-scale production, size & capital requirements of firms have skyrocketed. Corporations of such size elect a board of directors that hires & supervises management of the firm. If stockholders wish to sell their shares, management of the firm will not be impacted. Financial assets & ability to buy / sell them in financial markets allow for easy separation of ownership & management.

Agency problems (conflict of interest): managers, hired as agents of shareholders, may pursue their own interests e.g. avoid risky projects to protect their own jobs / over-consume luxuries reasoning that the cost of such perquisites is largely borne by shareholders. Mitigations: 1. compensation plans tying income of managers to success of the firm like shares / stock options (but options can create an incentive for managers to manipulate info to prop up a stock price temporarily) 2. boards of directors may force out underperforming management teams. 3. outsiders like security analysts & large institutional investors like mutual funds / pension funds monitor firm closely & make life of poor performers uncomfortable. 4. bad performers are subject to the threat of takeover. If board of directors is lax in monitoring management, unhappy shareholders in principle can elect a different board via launching a proxy contest in which they seek to obtain enough proxies (i.e., rights to vote shares of other shareholders) to take control of the firm & vote in another board. Historically, this threat was usually minimal but, in recent years, odds of a successful proxy contest have increased along with the rise of "activist investors". (large & deep-pocketed investors, often hedge funds, that identify firms they believe to be mismanaged).

Real takeover threat is from other firms. If a firm observes another underperforming, it can acquire the underperforming business & replace management with its own team. Stock price should rise to reflect prospects of improved performance, providing incentive for firms to engage in takeovers.

Corporate Governance & Corporate Ethics

Markets need to be transparent for investors to make informed decisions. From 2000 to 2002 unending series of scandals collectively signalled a crisis in corporate governance & ethics. E.g. WorldCom overstated its profits by at least $3.8 billion by improperly classifying expenses as investments. Other firms like Enron, Rite Aid, HealthSouth, Global Crossing & Qwest Communications manipulated accounts by billions. Other scandals included stock market analysts being compensated not for accuracy / insight, but for their role in garnering investment banking business for their firms. Also, IPOs were allocated to corporate executives as a quid pro quo for personal favours / the promise to direct future business back to the manager of the IPO. Auditors were overly lenient in their auditing work due to skewed incentives. E.g. Enron’s (now-defunct) auditor Arthur Andersen earned more money consulting for Enron than by auditing it.

In 2002, Congress passed SarbanesOxley Act. E.g. it requires corporations to have more directors who are not themselves managers (or affiliated with managers). Also requires each CFO to personally vouch for the corporation’s accounting statements, provides for an oversight board to oversee the auditing of public companies & prohibits auditors from providing various other services to clients.

1.4 Investment Process

Portfolio: collection of investment assets. Asset classes include stocks, bonds, real estate, commodities, etc. 2 types of decisions in constructing portfolios:

Asset allocation: choice among asset classes

Security selection: choice of which particular securities within each asset class

"Top-down”: starts with asset allocation. E.g. first decide what proportion of overall portfolio to move into stocks, bonds etc.

Security analysis involves valuation of particular securities that might be included in the portfolio. E.g. investor might ask whether Merck / Pfizer is more attractively priced. Valuation is far more difficult for stocks as a stock’s performance usually is far more sensitive to the condition of the issuing firm.

“Bottom-up”: starts with securities that seem attractively priced. May result in lack of diversification. E.g. portfolio may end up with a very heavy representation of firms in one industry, from one part of the country, or with exposure to one source of uncertainty.

1.5 Markets Are Competitive

Thousands of intelligent & well-backed analysts scour securities markets searching for the best buys. Hence, we should expect to find few, if any, “free lunches” securities that represent obvious bargains. No-free-lunch proposition has several implications.

The Risk-Return Trade-Off

Actual / realised returns almost always deviates from expected return anticipated. E.g. in 1931, S&P 500 index fell by 46%. In 1933, it gained 55%. No-free-lunch rule tells us that all else cannot be held equal. For higher expected returns, you will have to pay a price in terms of accepting higher investment risk. If expected returns increases prices drive up (making the investment less attractive) until expected return is no more than commensurate with risk. At this point, investors can anticipate a “fair” return relative to the asset’s risk, but no more. If returns were independent of risk, high-risk assets prices would fall, getting more attractive. There should be a risk-return trade-off in the securities markets, with higher-risk assets priced to offer higher expected returns than lower-risk assets.

With diversified portfolios, consider interplay among assets & the effect of diversification on the risk of entire portfolio. Diversification: many assets are held so that exposure to any particular asset is limited.

Efficient Markets Hypothesis

EMH: Hypothesis that security price usually reflects all info available to investors concerning its value, that security price = market consensus estimate of value of security. Hence there would be no underpriced / overpriced securities.

Passive management: holding highly diversified portfolios without spending effort attempting to improve investment performance via security analysis

Active management: improve performance by identifying mispriced securities / timing the performance of asset classes. E.g. increasing commitment to stocks when one is bullish on stock market. If markets are efficient, passive strategies may be better as there would be no point in active security analysis. But, without ongoing security analysis, prices eventually depart from “correct" values, creating new incentives for experts to move in. Hence, we may observe only near efficiency & profit opportunities may exist for especially diligent & creative investors.

1.6 Players

3 major players in financial markets: 1. Firms are net demanders of capital. Raise capital for investments in plant & equipment. Income generated by real assets provides returns to investors. 2. Households typically are net suppliers of capital. Purchase securities issued by firms. 3. Governments can be borrowers / lenders, depending on relationship between tax revenue & government expenditures. Since WWII, U.S. government typically has run budget deficits, (tax revenue < expenditures) Hence, they borrow funds to cover. Issuance of Treasury bills, notes & bonds for government to borrow funds from the public.

Corporations & governments do not sell all / most of their securities directly to individuals. E.g. ~ half of all stock is held by large financial institutions like pension funds, mutual funds, insurance companies & banks. As these financial institutions stand between security issuer (firm) & ultimate owner of security (individual investor), they are "financial intermediaries".

Financial Intermediaries

Households want desirable investments but with low initial capital. Small investors do not advertise that they are willing lenders nor are they able to diversify across borrowers to reduce risk or be equipped to assess & monitor credit risk of borrowers. Hence, financial intermediaries have evolved to bring suppliers of capital (investors) together with demanders of capital (primarily corporations & federal government). Financial intermediaries include banks, investment companies, insurance companies & credit unions. They issue their own securities to raise funds to purchase securities of other corporations. E.g. bank raises funds by borrowing (taking deposits) & lending that money to other borrowers. Spread between i/r paid to depositors & rates charged to borrowers is source of the bank’s profit. Lenders & borrowers do not need to contact each other directly. Financial intermediaries are distinguished from other businesses as their assets & liabilities are overwhelmingly financial. Table 1.3 presents the aggregated balance sheet of commercial banks which includes very small amounts of real assets.

Compare to Table 1.4 which shows aggregated balance sheet of the non-financial corporate sector.

Intermediaries simply move funds from one sector to another. Primary social function of intermediaries is to channel household savings to business sector. Other e.g. of financial intermediaries are investment companies, insurance companies & credit unions. Advantages in their intermediary role: 1. Pooling resources allows them to lend considerable sums to large borrowers. 2. By lending, they achieve significant diversification, so they can accept loans that individually might be too risky. 3. They build expertise via volume of business they do & use economies of scale to assess & monitor risk.

Mutual funds have advantage of large-scale trading & portfolio management, while participating investors are assigned a prorated share of total funds according to size of investment. This gives small investors advantages they are willing to pay for via a management fee.

Investment companies also can design portfolios for large investors with particular goals. Mutual funds are sold in the retail market & their investment philosophies are differentiated mainly by strategies that are likely to attract a large number of clients.

Hedge funds also pool & invest money of clients but are open only to institutional investors like pension funds, endowment funds, or wealthy individuals. More likely to pursue complex & higher-risk strategies. Typically they keep a portion of trading profits (fees), while mutual funds charge a fixed % of assets under management. Economies of scale also explain proliferation of analytic services available to investors. Investors want info, but with small portfolios to manage, they do not find it economical to personally gather all of it. Hence, a firm performs this service for many clients & charges for it.

Investment Bankers

Economies of scale & specialisation creates profit opportunities for financial intermediaries & niches for firms that perform specialised services for businesses. As firms do not frequently sell securities, investment bankers can offer their services at a cost below that of maintaining an in-house security issuance division. They are "underwriters". Investment bankers advise issuing corporation on prices it can charge for securities issued, appropriate i/r etc. Investment banking firm handles marketing of security in "primary market" (where new

issues of securities are offered to the public). Later, investors can trade previously issued securities among themselves in "secondary market". Wall Street was until 2008 comprised of large, independent investment banks like Goldman Sachs, Merrill Lynch & Lehman Brothers. In September 2008, all remaining major U.S. investment banks were absorbed into commercial banks, declared bankruptcy, or reorganised as commercial banks. (Separating Commercial Banking from Investment Banking)

Venture Capital & Private Equity

Large firms can raise funds from stock & bond markets with help of investment bankers. Smaller, younger firms that have not issued securities rely on bank loans & investors who invest for an ownership stake. Equity investment in these young companies: venture capital (VC). Sources of VC: dedicated VC funds, wealthy individuals "angel investors" & institutions like pension funds.

Most VC funds are set up as limited partnerships: Management company starts with its own money & raises additional capital from limited partners like pension funds. That capital may then be invested in start-up companies. Management company usually sits on the start-up company’s board of directors, helps recruit senior managers & provides business advice. Charges a fee to VC fund for overseeing investments. After e.g. 10 years, fund is liquidated & proceeds are distributed to investors. VC investors commonly take an active role in management of a start-up firm. Other active investors may engage in similar hands-on management but focus on firms that are in distress / firms that may be bought up, “improved” & sold for a profit. These investments in firms that do not trade on public stock exchanges are "private equity investments".

1.7 Financial Crisis of 2008

Antecedents of the Crisis

Last significant macro threat was the dot com bubble 2000 to 2002. Federal Reserve responded to an emerging recession by aggressively reducing i/r.

Figure 1.1 shows Treasury bill rates dropped drastically 2001 to 2004, & LIBOR rate (i/r at which major money-center banks lend to each other), fell in tandem. Actions appeared to have been successful: recession was short-lived & mild. By mid-decade the economy was apparently healthy once again.

Stock market declined substantially 2001 to 2002, but Figure 1.2 shows it reversed direction. Banking sector seemed healthy. Spread between LIBOR rate & Treasury-bill rate (at which U.S. government borrows), a common measure of credit risk in the banking sector (often referred to as the TED spread; Treasury–Eurodollar spread), was only ~ 0.25% in early 2007, suggesting that fears of default / “counter party” risk in banking sector were extremely low. Apparent success of monetary policy in this recession, & in the last 30 years more generally, had engendered a new term, the “Great Moderation,” to describe the fact that recent business cycles (recessions in particular) seemed so mild compared to past experience. Some observers wondered whether we had entered a golden age for macroeconomic policy in which the business cycle had been tamed. Dramatically reduced i/r & an apparently stable economy fed a historic boom in housing market.

Figure 1.3 shows that U.S. housing prices began rising in the late 1990s & accelerated after 2001 as i/r plummeted. But newfound confidence in power of macro policy to reduce risk, impressive recovery of economy from high-tech implosion & housing price boom following aggressive reduction in i/r may have sown seeds for GFC. Fed’s policy of reducing i/r had resulted in low yields on a wide variety of investments & investors were hungry for higher-yielding alternatives. But low volatility & optimism about macro prospects encouraged greater tolerance for risk in search for these higher-yielding investments. U.S. housing & mortgage finance markets were at the center of a gathering storm.

Changes in Housing Finance

Before 1970, most mortgage loans came from a local lender like a neighbourhood savings bank / credit union. Homeowner would repay the loan over ~ 30 years. Thrift institution's major asset: portfolio of long-term home loans. Major liability: accounts of its depositors.

This began to change when Fannie Mae (FNMA; Federal National Mortgage Association) & Freddie Mac (FHLMC; Federal Home Loan Mortgage Corporation) began buying mortgage loans from originators & bundling them into large pools that could be traded like any other financial asset. These pools (essentially claims on underlying mortgages) were soon dubbed mortgage-backed securities & process was "securitisation". Fannie & Freddie quickly became behemoths of the mortgage market, buying ~ half of all mortgages originated by the private sector.

Figure 1.4 illustrates how cash flowed from original borrower to ultimate investor in a mortgage-backed security. Loan originator, e.g. savings & loan, makes a $100,000 home loan to a homeowner. Homeowner would repay principal & interest (P&I) over 30 years. Originator then sells mortgage to Freddie Mac / Fannie Mae & recovers cost of the loan. Originator could continue to service the loan (collect monthly payments from homeowner) for a small servicing fee, but the loan payments net of that fee would be passed along to the agency. Freddie / Fannie (agency) pools the loans into mortgage-backed securities & sell them to investors like pension funds / mutual funds. Fannie / Freddie typically would guarantee credit / default risk for the loans in each pool, for which it would retain a guarantee fee before passing along rest of the cash flow to ultimate investor. Since mortgage cash flows were passed along from homeowner to lender to Fannie / Freddie to investor, the mortgage backed securities were called "pass-throughs".

Vast majority of securitised mortgages were held / guaranteed by Freddie Mac / Fannie Mae. These were low-risk conforming mortgages, thus eligible loans for agency securitisation could not be too big & homeowners had to meet underwriting criteria establishing their ability to repay the loan. E.g. ratio of loan amount to house value could be < 80%. But securitisation gave rise to a new market niche for mortgage lenders: “originate to distribute” (vs originate to hold) business model.

Once securitisation model took hold, it created an opening for a new product: securitisation by private firms of non-conforming “subprime” loans with higher default risk. Important difference between government agency pass-throughs & "private-label" pass-throughs: investor in private-label pool would bear risk that homeowners might default on their loans. Thus, originating mortgage brokers had little incentive to perform due diligence on loan as long as loans could be sold to an investor. These investors had no direct contact with borrowers & could not perform detailed underwriting concerning loan quality, relying on borrowers’ credit scores, which steadily came to replace conventional underwriting. A strong trend toward low-documentation & no-documentation loans soon emerged. Other subprime underwriting standards quickly deteriorated. E.g. allowed leverage on home loans (measured by loan-to-value ratio) rose dramatically. By 2006, the majority of subprime borrowers purchased houses by borrowing the entire purchase price. When housing prices began falling, these loans were quickly “underwater”: house was worth less than loan balance & many homeowners decided to walk away from their loans.

Adjustable-rate mortgages (ARMs) grew in popularity: these loans offered borrowers low initial / “teaser” i/r, but these rates eventually would reset to current market interest yields, e.g. Treasury bill rate + 3%. Many of these borrowers “maxed out” their borrowing capacity at teaser rate. Once loan rate was reset, their monthly payments would soar.

Despite these obvious risks, ongoing increase in housing prices lulled many investors into complacency, with belief that continually rising home prices would bail out poorly performing loans. From 2004, ability of refinancing to save a loan started diminishing. First, higher i/r put payment pressure on homeowners who had taken out adjustable-rate mortgages. Second, housing prices peaked by 2006, so homeowners’ ability to refinance a loan using built-up equity in the house declined. In 2007, mortgage default rates & losses on mortgage-backed securities started rising. Crisis was ready to shift into high gear.

Mortgage Derivatives

Securitisation, restructuring & credit enhancement. New risk-shifting tools enabled investment banks to carve out AAA-rated securities from original-issue “junk” loans. Collateralised debt obligations (CDOs), were important & damaging. CDOs were designed to concentrate credit (e.g. default) risk of a bundle of loans on one class of investors, leaving other investors in the pool relatively protected from that risk. Idea was to prioritise claims on loan repayments by dividing pool into senior vs junior slices, "tranches". (CDOs & related securities; "structured products". “Structured” means that original cash flows are sliced up & reapportioned across tranches). Senior tranches had first claim on repayments from the entire pool before junior tranches. E.g. pool divided into 2 tranches, 70% allocated to senior tranche & 30% allocated to junior, senior investors would be fully repaid once 70% / more of loans in pool performed. Even with pools of risky subprime loans, default rates above 30% seemed extremely unlikely, thus senior tranches were frequently granted highest (AAA) rating by major credit rating agencies, Moody’s, Standard & Poor’s & Fitch. Structure of CDOs provided far less protection to senior tranches than anticipated. When housing prices began to fall, defaults in all regions increased & hoped-for benefits from spreading risks geographically never materialised. How rating agencies underestimated credit risk: 1. Default probabilities had been estimated using historical data from an unrepresentative period characterised by a housing boom & an uncommonly prosperous & recession-free macroeconomy. 2. Ratings analysts had extrapolated historical default experience to a new sort of borrower pool (one without down payments, with exploding-payment loans, & with low / no-documentation loans). 3. Cross-regional diversification to minimise risk engendered excessive optimism. 4. Agency problems became apparent. Ratings agencies were paid to provide ratings by the issuers of securities, not the purchasers. Faced pressure from issuers, who could shop around for the most favourable treatment, to provide generous ratings.

Credit Default Swaps (CDS)

Market in CDS exploded too. CDS: insurance contract against default of 1≤ borrowers. Purchaser of swap pays an annual premium (like insurance premium) for protection from credit risk. CDS became an alternative method of credit enhancement, seemingly allowing investors to buy subprime loans & insure their safety. But some swap issuers ramped up their exposure to credit risk to unsupportable levels, without sufficient capital to back those obligations. E.g. insurance company AIG alone sold more than $400 billion of CDS contracts on subprime mortgages.

Rise of Systemic Risk

Many large banks & related financial institutions adopted an apparently profitable financing scheme: borrowing short term at low i/r to finance holdings in higher-yielding, long-term illiquid assets & treating i/r differential between assets & liabilities as economic profit. By relying primarily on shortterm loans for their funding, they constantly needed to refinance their positions (borrow additional funds as loans matured), or else face necessity of quickly selling off less-liquid asset portfolios, which would be difficult in times of financial stress.

These institutions were also highly leveraged with little capital to buffer losses. Large investment banks on Wall Street had sharply increased leverage. Even small portfolio losses could drive their net worth negative, at which point no one would be willing to renew outstanding loans / extend new ones.

Widespread investor reliance on “credit enhancement” via products like CDOs also caused fragility. Many of assets underlying these pools were illiquid, hard to value & highly dependent on forecasts of future performance of other loans. In a widespread downturn, with rating downgrades, they would be difficult to sell.

Filled with systemic risk, a potential breakdown of the financial system when problems in 1 market spill over. When lenders like banks have limited capital & afraid of further losses, they may rationally choose to hoard capital instead of lending, thus exacerbating funding problems for customary borrowers.

The Shoe Drops

Housing price declines were widespread, mortgage delinquencies increased, & stock market entered its own free fall. Many investment banks, which had large investments in mortgages, began to totter. Crisis peaked in September 2008. On 7 September, federal mortgage agencies Fannie Mae & Freddie Mac were put into conservatorship. Failure of these 2 mainstays of U.S. housing & mortgage finance industries threw financial markets into a panic. On 14 September, Merrill Lynch was sold to Bank of America, again with the benefit of government brokering & protection against losses. The next day, Lehman Brothers, which was denied equivalent treatment, filed for bankruptcy protection. Two days later, the government reluctantly lent $85 billion to AIG, reasoning that its failure would have been highly destabilising to the banking industry, which was holding massive amounts of its credit guarantees (CDS contracts). The next day, Treasury unveiled its first proposal to spend $700 billion to purchase “toxic” mortgagebacked securities.

Lehman had borrowed considerable funds by issuing very short-term debt, "commercial paper". Among the major customers in commercial paper were money market mutual funds, which invest in short-term, high-quality debt of commercial borrowers. When Lehman faltered, Reserve Primary Money Market Fund, which was holding large amounts of (AAA-rated) Lehman commercial paper, suffered investment losses that drove value of its assets below $1 per share. Fears spread that other funds were similarly exposed & money market fund customers across the country rushed to withdraw their funds. The funds rushed out of commercial paper into safer and more liquid Treasury bills, essentially shutting down short-term financing markets.

Freezing up of credit markets was the end of any dwindling possibility that the financial crisis could be contained to Wall Street. Larger companies that relied on commercial paper market were now unable to raise short-term funds. Banks similarly found it difficult to raise funds. (Figure 1.1: TED spread, a measure of bank insolvency fears, skyrocketed in 2008.) With banks unwilling / unable to extend credit to customers, thousands of small businesses that relied on bank lines of credit became unable to finance normal business operations. Turmoil in financial markets had spilled over into the real economy & Main Street had joined Wall Street in a bout of protracted misery.

Housing markets throughout the world fell & many European banks had to be rescued by their governments, which were themselves heavily in debt. As cost of bank bailouts mounted, ability of these governments to repay their own debts came into doubt. Banking crisis spiralled into a sovereign debt crisis. Greece was the hardest hit. Its government debt of ~ $460 billion was more than its annual GDP. In 2011, it defaulted on debts totalling ~ $130 billion. Despite a series of rescue packages from the EU, ECB& IMF, it was still on shaky ground in 2016.

Dodd-Frank Reform Act

In 2010, Dodd-Frank Wall Street Reform & Consumer Protection Act was passed. Stricter rules for bank capital, liquidity & risk management practices, especially as banks become larger & potential failure would be more threatening to other institutions. With more capital supporting banks, potential for one insolvency to trigger another could be contained. When banks have more capital, they have less incentive to ramp up risk, as potential losses come at their expense & not the FDIC’s. Attempts to limit risky activities in which banks can engage. "Volcker Rule" prohibits banks from trading for their own accounts & limits total investments in hedge funds / private equity funds. Incentive issues were also addressed: proposals to force employee compensation to reflect longer-term performance. E.g. public companies must set “claw-back provisions” to take back executive compensation if it was based on inaccurate financial statements. This is to discourage excessive risk-taking by large financial institutions where big bets can be wagered with attitude that a successful outcome results in a big bonus, while a bad outcome will be borne by the company / taxpayers. Act creates an Office of Credit Ratings within the Securities & Exchange Commission to oversee credit rating agencies. Implementation of Dodd-Frank is still subject to considerable interpretation by regulators & act is still under attack by some members of Congress. Crisis surely has made clear the essential role of financial system in functioning of the real economy.

1.8 Summary

1. Real assets create wealth. Financial assets represent claims to parts / all of that wealth. FA determines how ownership of RA is distributed among investors.

2. FA can be categorised as fixed income / equity / derivative instruments. Top-down portfolio construction starts with asset allocation decision (allocation of funds across broad asset classes) & then progress to more specific security-selection decisions.

3. Competition in financial markets leads to a risk-return trade-off, where securities that offer higher expected rates of return impose greater risks on investors. Presence of risk implies that actual returns can differ considerably from expected returns. Competition among security analysts promotes financial markets that are nearly informationally efficient (prices reflect all available info concerning value of the security). Passive investment strategies may make sense in nearly efficient markets.

4. Financial intermediaries pool investor funds & invest them. Such services are in demand as small investors cannot efficiently gather information, diversify, and monitor portfolios. The financial intermediary sells its own securities to the small investors. The intermediary invests the funds thus raised, uses the proceeds to pay back the small investors, and profits from the difference (the spread).

5. Investment banking brings efficiency to corporate fundraising. Investment bankers develop expertise in pricing new issues and in marketing them to investors. By the end of 2008, all the major stand-alone U.S. investment banks had been absorbed into commercial banks or had reorganised themselves into bank holding companies. In Europe, where universal banking had never been prohibited, large banks had long maintained both commercial and investment banking divisions.

6. The financial crisis of 2008 showed the importance of systemic risk. Systemic risk can be limited by transparency that allows traders and investors to assess the risk of their counterparties; capital requirements to prevent trading participants from being brought down by potential losses; frequent settlement of gains or losses to prevent losses from accumulating beyond an institution’s ability to bear them; incentives to discourage excessive risk taking; and accurate and unbiased analysis by those charged with evaluating security risk.

2. Asset Classes & Financial Instruments

2.1 Money Market

Sub-sector of fixed-income market. Consists of very shortterm debt securities that usually are highly marketable.

Table 2.1 lists outstanding volume in 2015 for major instruments in the Money Market. These securities trade in large denominations; out of reach of individual investors. But, money market funds are easily accessible to small investors.

US Treasury Bills

Most marketable of all money market instruments. Represents simplest form of borrowing: government raises money by selling bills to public. Investors buy bills at a discount from stated maturity value. At maturity, government pays investor face value of bill. T-bills are issued with initial maturities of 4, 13, 26, or 52 weeks. Purchased directly / at auction / on secondary market from a government securities dealer. Highly liquid & sold at low transaction cost & with not much price risk. Most money market instruments sell in min. denominations of $100,000, while T-bills sell in min. denominations of $100, although $10,000 denominations are far more common. Income earned on T-bills is exempt from state & local taxes.

Figure 2.1 is a partial listing of T-bill rates. Rather than providing prices of each bill, financial press reports yields based on those prices. Ask price: price to buy a T-bill from a securities dealer. Bid price: price received to sell a bill to a dealer. Bid-ask spread: difference in these prices, which is dealer’s source of profit. Figure 2.1 yields are reported using the bank-discount method: bill’s discount from its maturity / face value is “annualised” based on a 360-day year, & then reported as a % of face value.

E.g. highlighted bill: days to maturity is 171, yield under “ASKED” is 0.340%. Meaning that a dealer was willing to sell bill at a discount from face value of 0.340% * (171/360) = 0.1615%. Bill with $10,000 face value could be purchased for $10,000 * (1 - 0.001615) = $9,983.85. Similarly, on the basis of the bid yield of .350%, a dealer would be willing to purchase the bill for $10,000 × (1 − .00350 × 171/360) = $9,983.375.

Bank discount method for computing yields has a long tradition, but it is flawed: 1. Assumes that year has 360 days. 2. Computes yield as a fraction of par value rather than of price investor paid for the bill.

Investor gain = 171 * ($10,000/$9,983.85) = 1.001618, gain of 0.1618%. Value under "ASKED YIELD" (T-bill's bond-equivalent yield) = 0.1618% × (365/171) = 0.345%.

Certificate of Deposit (CD)

CD: time deposit with a bank. May not be withdrawn on demand. Bank pays interest & principal at end of fixed term. Issued in denominations greater than $100,000 are usually negotiable & can be sold to another investors. Short-term CDs are highly marketable, but market significantly thins out for maturities of 3 months or more. CDs are treated as bank deposits by Federal Deposit Insurance Corporation, hence are currently insured for up to $250,000 in event of a bank insolvency.

Commercial Paper (CP)

Large, well-known companies often issue short-term unsecured debt notes (CP) rather than borrow directly from banks. Very often, CP is backed by a bank line of credit, giving borrower access to cash that can be used (if needed) to pay off the paper at maturity. CP maturities range up to 270 days, but most often less than 1 / 2 months. Usually, it is issued in multiples of $100,000. (only accessible via money market mutual funds for small investors). CP is considered to be a fairly safe asset as a firm’s condition presumably can be monitored & predicted over a short term. Most CP is issued by non-financial firms, but there has been a recent sharp increase in asset-backed CP issued by financial firms like banks used to raise funds for investment in other assets, (most notoriously, subprime mortgages). These assets were used as collateral for CP; hence labelled “asset backed.”

Banker's Acceptance

Starts as an order to a bank by a bank’s customer to pay a sum of money at a future date, typically within 6 months. When bank endorses order for payment as “accepted,” it assumes responsibility for ultimate payment to holder of the acceptance. At this point, it may be traded in secondary markets like any other claim on the bank. Bankers’ acceptances are considered very safe assets as traders can substitute bank’s credit standing for their own. Used widely in foreign trade where creditworthiness of one trader is unknown to the trading partner. Acceptances sell at a discount from face value of the payment order, just as T-bills sell at a discount from par value.

Eurodollars

Dollar-denominated deposits at foreign banks / foreign branches of American banks. Locating outside US, they escape regulation by Federal Reserve. Most Eurodollar deposits are for large sums & most are time deposits of less than 6 months’ maturity. Variation on Eurodollar time deposit is the Eurodollar certificate of deposit, which resembles a domestic bank CD except that it is the liability of a non-U.S. branch of a bank, typically a London branch. Advantage of Eurodollar CDs over Eurodollar time deposits: holder can sell asset to realise its cash value before maturity. Eurodollar CDs are less liquid & riskier than domestic CDs, but thus offer higher yields. Firms also issue Eurodollar bonds (but bonds are not a money market investment due to long maturities).

Repurchase Agreements (Repos; RPs) & Reverses

Used by dealers in government securities, usually overnight, borrowing. Dealer sells government securities to an investor on an overnight basis, with an agreement to buy back those securities next day at a slightly higher price. Increase in price is "overnight interest". Dealer thus takes out a 1-day loan from investor & securities serve as collateral. Term repo: identical transaction but term of implicit loan can be 30 days or more. Repos are considered very safe in terms of credit risk as loans are backed by government securities. Reverse repo: dealer finds an investor holding government securities & buys them, agreeing to sell them back at a specified higher price on a future date.

Federal Funds

Just as most of us maintain deposits at banks, banks maintain deposits at a Federal Reserve bank. Each member bank of “the Fed” is required to maintain a min. balance in a reserve account with the Fed. Required balance depends on total deposits of bank’s customers. Funds in bank’s reserve account: "federal funds". At any time, some banks have more funds than required at the Fed. Other banks, primarily big banks in New York & other financial centers, tend to have a shortage of federal funds. Banks with excess funds lend to those with a shortage. These loans, which are usually overnight transactions, are arranged at a rate of interest; "federal funds rate".

Although fed funds market arose as a way for banks to transfer balances to meet reserve requirements, today market has evolved to the point that many large banks use federal funds in a straightforward way as one component of their total sources of funding. Hence, fed funds rate is simply: rate of interest on very short-term loans among financial institutions. Most investors cannot participate in this market, but fed funds rate serves as a key barometer of monetary policy.

Brokers’ Calls

Individuals who buy stocks on margin, borrow from their broker. Broker may borrow funds from a bank, agreeing to repay immediately (on call) if bank requests it. Rate paid is usually ~ 1% higher than rate on short-term T-bills.

London Interbank Offered Rate (LIBOR) Market

Rate at which large banks in London are willing to lend money among themselves. Is the premier short-term i/r quoted in the European money market, & serves as a reference rate for a wide range of transactions. E.g. a corporation might borrow at a floating rate = LIBOR + 2%. LIBOR i/r may be tied to currencies E.g. LIBOR rates are widely quoted for transactions denominated in British pounds, yen, euros etc. It is a key reference rate in the money market, & many trillions of dollars of loans & derivative assets are tied to it. Therefore, the 2012 scandal involving the fixing of LIBOR deeply shook these markets. European Interbank Offered Rate (EURIBOR): rate at which banks in euro zone are willing to lend euros among themselves

Yields on Money Market Instruments

Most money market securities are low risk (but not risk-free). Securities of the money market promise yields greater than default-free T-bills, at least in part due to greater relative riskiness. Many investors require more liquidity; thus will accept lower yields on securities like T-bills.

Figure 2.2 shows that bank CDs, consistently have paid a premium over T-bills. Moreover, that premium increased with economic crises like the energy price shocks associated with the 2 OPEC disturbances, failure of Penn Square bank, stock market crash in 1987, collapse of Long Term Capital Management in 1998 & GFC. From Figure 1.1 in Chapter 1, TED spread, (difference between LIBOR rate & Treasury bills), also peaked during periods of financial stress. Money market funds are mutual funds that invest in money market instruments & have become major sources of funding to that sector.

2.2 Bond Market

Composed of longer term borrowing / debt instruments vs money market.

Treasury Notes & Bonds

U.S. government borrows funds in large part by selling Treasury notes & Treasury bonds. T-notes maturities range up to 10 years, while bond maturities range from 10 to 30 years. Notes & bonds may be issued in increments of $100 but far more commonly trade in denominations of $1,000. Notes & bonds make semiannual interest payments; "coupon payments".

Figure 2.3 is a listing of Treasury issues. Bid price of highlighted note, which matures in May 2019, is 99.8125. (decimal version of 99104 ⁄128. Min. tick size in T-bond market, is generally 1⁄128 of a point) Bonds are typically traded in denominations of $1,000 par value, but prices are quoted as a % of par. Thus, bid price should be interpreted as 99.8125% of par or $988.125 for $1,000 par value bond. Ask price is 99.8281% of par or $998.281. "-0.0859" change: closing price on this day fell by .0859% of par value from previous day’s close. Yield to maturity based on the ask price is 0.933%. Yield to maturity reported in the last column is calculated by determining semiannual yield & then doubling it (rather than compounding). Use of a simple interest technique to annualise means that yield is quoted on an annual percentage rate (APR) basis rather than as an effective annual yield.

Inflation-Protected Treasury Bonds

Governments of many countries have issued bonds linked to an index of cost of living to provide citizens with an effective way to hedge inflation risk. In US, inflation-protected Treasury bonds are Treasury Inflation Protected Securities (TIPS). Principal amount is adjusted in proportion to increases in Consumer Price Index. Yields on TIPS bonds should be interpreted as real / inflation-adjusted i/r.

Federal Agency Debt

Some government agencies issue their own securities to finance their activities. Major mortgage-related agencies are Federal Home Loan Bank (FHLB), Federal National Mortgage Association (FNMA / Fannie Mae), Government National Mortgage Association (GNMA, / Ginnie Mae) & Federal Home Loan Mortgage Corporation (FHLMC / Freddie Mac). FHLB borrows money by issuing securities & lends this money to savings & loan institutions to be lent to individuals borrowing for home mortgages. Though debt of federal agencies was never explicitly insured by federal government, it had long been assumed that government would assist an agency nearing default. Those beliefs were validated when Fannie Mae & Freddie Mac were on the brink of insolvency & government put them both into conservatorship & assigned Federal Housing Finance Agency to run the firms; however, it did in fact agree to make good on the firm’s bonds.

International Bonds

Many firms borrow abroad & many investors buy bonds from foreign issuers. In addition to national capital markets, there is a thriving international capital market, largely centered in London. Eurobond is a bond denominated in a currency other than that of the country in which it is issued. E.g. a dollar-denominated bond sold in Britain would be called a Eurodollar bond. Similarly, investors might speak of Euroyen bonds, yen-denominated bonds sold outside Japan. Best to think of Eurobonds simply as international bonds. Firms issue bonds in foreign countries but in the currency of the investor. E.g. a Yankee bond is a dollar-denominated bond sold in the United States by a non-U.S. issuer. Similarly, Samurai bonds are yen-denominated bonds sold in Japan by non-Japanese issuers.

Municipal Bonds

Issued by state & local governments. Similar to Treasury & corporate bonds but interest income is exempt from federal income tax. Interest income is usually exempt from state & local tax. But, capital gains taxes must be paid on “munis” when bonds mature / if they are sold.

General obligation bonds are backed by “full faith and credit” (taxing power) of issuer. Revenue bonds are issued to finance particular projects & are backed either by revenues from that project / by particular municipal agency operating the project. Typical issuers of revenue bonds: airports, hospitals & turnpike / port authorities. Revenue bonds are riskier in terms of default than general obligation bonds.

Figure 2.4 plots outstanding amounts of both types of municipal securities. Industrial development bond is a revenue bond issued to finance commercial enterprises like construction of a factory operated by a private firm. These bonds give firms access to the municipality’s ability to borrow at tax-exempt rates & the federal government limits amount of these bonds that may be issued. Like Treasury bonds, municipal bonds vary widely in maturity.

A good deal of the debt issued is in the form of short-term tax anticipation notes, which raise funds to pay for expenses before actual collection of taxes. Other municipal debt is long term & used to fund large capital investments. Maturities range up to 30 years.

Key feature of municipal bonds: tax-exempt status. This is why investors are willing to accept lower yields on these securities.

Taxable vs tax-exempt bonds: let t = investor’s combined federal & local marginal tax & r-taxable = total before-tax rate of return, then r-taxable * (1 - t) = after-tax rate available. If this value exceeds rate on municipal bonds, r-muni, investor does better holding taxable bonds.

One way to compare bonds is to determine i/r on taxable bonds that would be necessary to provide an after-tax return = to that of municipals. Set after-tax yields equal & solve for equivalent taxable yield of tax-exempt bond. This is the rate a taxable bond must offer to match the after-tax yield on the tax-free municipal.

Equivalent taxable yield = tax-free rate divided by 1 - t. Table 2.2 presents equivalent taxable yields for several municipal yields & tax rates. This demonstrates to high-tax-bracket investors that municipal bonds offer highly attractive equivalent taxable yields. Each entry is calculated from Equation 2.2. If equivalent taxable yield exceeds actual yields offered on taxable bonds, investor is better off after taxes holding municipal bonds. Notice: equivalent taxable i/r increases with investor’s tax bracket; higher bracket = more valuable tax-exempt feature of municipals. Thus, high-tax-bracket investors tend to hold municipals. Equation 2.1 / 2.2 can be used to find tax bracket at which investors are indifferent between taxable & tax-exempt bonds (which is how we get 2.3) Thus, yield ratio r-muni /r-taxable is a key determinant of attractiveness of municipal bonds.

Figure 2.5 plots ratio of 20-year municipal debt yields to yield on BAA-rated corporate debt. Default risk of these corporate & municipal bonds may be comparable, but certainly will fluctuate over time. E.g. sharp run-up in ratio in 2011 reflects increased concern about precarious financial condition of several states & municipalities, leading to higher credit spreads on their bonds.

Mortgages & Mortgage-Backed Securities (MBS)

With of the explosion in MBS, almost anyone can invest in a portfolio of mortgage loans, & they have become a major component of fixed-income market. Most pass-throughs have traditionally been comprised of conforming mortgages: loans must satisfy certain underwriting guidelines before they may be purchased by Fannie Mae / Freddie Mac.

Figure 2.6 illustrates explosive growth of agency & private-label mortgage-backed securities, until the crisis. In effort to make housing more affordable to low-income households, Fannie & Freddie had been encouraged to buy subprime mortgage securities. These loans turned out to be disastrous: Freddie & Fannie lost billions on subprime mortgage pools. From Figure 2.6, starting in 2007, market in private-label mortgage passthroughs began to shrink rapidly. Despite these troubles, few believe that securitisation itself will cease, although practices in this market are likely to remain far more conservative than in previous years, particularly with respect to the credit standards that must be met by ultimate borrower. Indeed, securitisation has become an increasingly common staple of many credit markets. E.g. car loans, student loans, home equity loans, credit card loans & even debt of private firms now are commonly bundled into pass-through securities that can be traded in the capital market.

Figure 2.7 shows rapid growth of non-mortgage asset-backed securities until 2007. After GFC, market contracted as perceived risks of credit card & home equity loans skyrocketed, but the asset-backed market is still substantial.

2.3 Equity Securities

Common Stock as Ownership Shares

Common stocks (aka equity securities / equities) are ownership shares in a corporation. Each share of common stock entitles owner to 1 vote on any matters of corporate governance at corporation’s annual meeting & to a share in financial benefits of ownership. Corporation is controlled by a board of directors elected by shareholders. Board selects managers who run the corporation on daily basis. Managers have authority to make most business decisions without board’s specific approval. Board’s mandate: oversee management to ensure it acts in best interests of shareholders. Members of the board are elected at annual meeting. Shareholders who do not attend annual meeting can vote by proxy, empowering another party to vote in their name. Management usually solicits proxies of shareholders & normally gets a vast majority of these proxy votes. Thus, management usually has considerable discretion to run the firm as it sees fit. Such separation of ownership & control can give rise to “agency problems” where managers act in self interest. But, there are several mechanisms that alleviate these agency problems: compensation schemes linking success of manager to the firm, oversight by board of directors & outsiders like security analysts / creditors / large institutional investors, threat of a proxy contest where unhappy shareholders attempt to replace current management team or threat of a takeover by another firm. Common stock of most large corporations can be bought / sold freely on stock exchanges. A corporation whose stock is not publicly traded is "private". In most privately held corporations, owners of the firm also take an active roles in management. Thus, takeovers are generally not an issue.

Characteristics of Common Stock

Most important characteristics of common stock: 1. Residual claim: stockholders are last in line of all those who have a claim on assets & income of the corporation. In a liquidation of firm’s assets, shareholders have a claim to what is left after all other claimants like tax authorities, employees, suppliers, bondholders & other creditors have been paid. For a firm not in liquidation, shareholders have claim to the part of operating income left over after interest & taxes have been paid. Management can either pay this as cash dividends to shareholders / reinvest it to increase value of the shares. 2. Limited liability: most shareholders can lose in event of failure of corporation is their original investment. Unlike owners of unincorporated businesses, whose creditors can lay claim to personal assets of the owner (house, car, furniture), corporate shareholders may at worst have worthless stock. They are not personally liable for the firm’s obligations.

Stock Market Listings

Figure 2.8 presents key trading data for a small sample of stocks traded on New York Stock Exchange. NYSE is one of several markets where investors buy / sell shares of stock. Consider highlighted listing for General Electric. Table provides ticker symbol (GE), closing price of stock ($29.87) & its change (-$0.25) from previous trading day. About 26.5 million shares of GE traded on this day. Listing provides highest & lowest price GE has traded in the last 52 weeks. 0.92 value in Dividend: last quarterly dividend payment was $0.23 per share, consistent with annual dividend payments of $0.23 * 4 = $0.92. Annual dividend yield (annual dividend per dollar paid) = 0.92/29.87 = 0.0308 or 3.08%. Low-dividend firms presumably offer greater prospects for capital gains. Figure 2.8 shows that dividend yields vary widely across companies. Price-earnings (P/E) ratio: ratio of current stock price to last year’s earnings per share. P/E ratio tells us how much stock purchasers must pay per dollar of earnings that the firm generates. For GE, P/E ratio is 30.68. Where dividend yield & P/E ratio are not reported in Figure 2.8, firms have 0 dividends/ 0 or negative earnings. Last, we see GE’s stock price has decreased by 4.11% since beginning of the year.

Depositary Receipts

American Depositary Receipts (ADRs): certificates traded in U.S. markets that represent ownership in shares of a foreign company. Each ADR may correspond to ownership of a fraction of a foreign share / 1 share / several shares of foreign corporation. ADRs were created to make it easier for foreign firms to satisfy U.S. security registration requirements.

2.4 Stock & Bond Market Indexes

Stock Market Indexes

Dow is the best-known measure of performance of stock market but it is only one of several indicators. Ever-increasing role of international trade & investments has made indexes of foreign financial markets part of general news too. E.g. Nikkei Average of Tokyo & Financial Times index of London.

Dow Jones Industrial Average (DJIA)

DJIA of 30 large, “blue-chip” corporations has been computed since 1896. Its long history probably accounts for its preeminence in the public mind. Originally, it was calculated as average price of stocks in the index. As Dow corresponds to a portfolio that holds 1 share of each component stock, investment in each company in that portfolio is proportional to company’s share price. Thus, Dow is a “price-weighted average”.

E.g. 2.2: Consider Table 2.3 for a hypothetical 2-stock version of DJIA.

Portfolio:

Initial value = $25 + $100 = $125

Final value = $30 + $90 = $120

Percentage change in portfolio value = -5/125 = -0.04 = -4%

Index:

Initial index value = (25 + 100)/2 = 62.5

Final index value = (30 + 90)/2 = 60

Percentage change in index = -2.5/62.5 = -0.04 = -4%

Portfolio & index have identical 4% declines in value. Notice that price-weighted averages give higher-priced shares more weight in determining performance of index. E.g. though ABC increased by 20%, while XYZ fell by only 10%, index dropped in value as 20% increase in ABC represented a smaller price gain ($5 per share) than the 10% decrease in XYZ ($10 per share). “Dow portfolio” has 4 times as much invested in XYZ as in ABC since XYZ’s price is 4 times ABC. T, XYZ dominates the average. Thus, a high-price stock can dominate a price-weighted average.

You might wonder why DJIA is in late 2016, at a level of about 19,000 if it is supposed to be average price of the 30 stocks. DJIA no longer equals average price of the 30 stocks as averaging procedure is adjusted whenever a stock splits / pays a stock dividend of more than 10% / when 1 company of the 30 industrial firms is replaced by another. When these events occur, divisor used to compute “average price” & is adjusted to leave the index unaffected by the event.

E.g. 2.3: Suppose XYZ were to split 2 for 1 so that its share price fell to $50. We would not want the average to fall, as that would incorrectly indicate a fall in general level of market prices. Following a split, divisor must be reduced to a value that leaves average unaffected.

Table 2.4 illustrates this: XYZ, which was $100 in Table 2.3, falls to $50 if stock splits at beginning of period. Notice that number of shares outstanding doubles, leaving market value of total shares unaffected. Finding the new divisor as follows: index value before stock split = 125/2 = 62.5. We solve for d in the following equation:

This implies that divisor must fall from its original value of 2.0 to a new value of 1.20. As split changes price of stock XYZ, it also changes the relative weights of the 2 stocks in the price-weighted average. Thus, return of index is affected by the split. At period-end, ABC will sell for $30, while XYZ will sell for $45, representing same negative 10% return it was assumed to earn in Table 2.3. New value of the price-weighted average is (30 + 45)/1.20 = 62.5, same as its value at start of the year; thus, rate of return is zero, rather than the -4% calculated in absence of a split. Split reduces relative weight of XYZ as its initial price is lower; since XYZ is the poorer performing stock, performance of the average is higher. This illustrates that the implicit weighting scheme of a price-weighted average is somewhat arbitrary, being determined by prices rather than by outstanding market values (price per share times number of shares) of the shares in the average.

In the same way that the divisor is updated for stock splits, if 1 firm is dropped from average & another firm with a different price is added, divisor has to be updated to leave the average unchanged. By 2016, divisor for DJIA had fallen to a value of about 0.146. AS Dow Jones averages are based on small numbers of firms, care must be taken to ensure that they are representative of the broad market. Hence. composition of the average is changed every so often to reflect changes in the economy.

Table 2.5 shows composition of the Dow industrials in 1928 & mid-2016. It presents striking evidence of changes in U.S. economy in the last 85 years. Many of the “bluest of the blue chip” companies in 1928 no longer exist, & the industries that were the backbone of the economy in 1928 have given way.

Standard & Poor’s 500 Index (S&P 500)

S&P 500 represents an improvement over DJIA in 2 ways: 1. Is a more broadly based index of 500 firms. 2. Is a market-value-weighted index. From E.g. 2.2, S&P 500 would give ABC 5 times weight given to XYZ as market value of its outstanding equity is 5 times larger. S&P 500 is computed by calculating total market value of the 500 firms & total market value of those firms on previous day of trading. % increase in total market value from one day to the next represents increase in index. Rate of return of index = rate of return earned by an investor holding a portfolio of all 500 firms in proportion to their market values (index does not reflect cash dividends). Most indexes today use a modified version of market-value weights. Rather than weighting by total market value, they weight by market value of free float: value of shares freely tradable among investors. E.g. this procedure does not count shares held by founding families / governments. The distinction is more important in Japan & Europe, where a higher fraction of shares are held in such nontraded portfolios.

E.g. 2.4: Final value of all outstanding stock in 2-stock universe is $690 million. Initial value was $600 million. Thus, if initial level of a market-value-weighted index of stocks ABC & XYZ were set equal to an arbitrarily chosen starting value like 100, index value at year-end would be 100 * (690/600) = 115. Increase in index reflects 15% return earned on a portfolio consisting of those 2 stocks held in proportion to outstanding market values. Unlike the price-weighted index, value-weighted index gives more weight to ABC. Total market value of outstanding XYZ stock decreases from $100 million to $90 million regardless of stock split, thus rendering the split irrelevant to performance of index.

A nice feature of both market-value-weighted & price-weighted indexes: they reflect returns to straightforward portfolio strategies. If one were to buy shares in each component firm in index in proportion to its outstanding market value, valueweighted index would perfectly track capital gains, while price-weighted index tracks returns on a portfolio comprised of an equal number of shares of each firm. Investors today can easily buy market indexes for their portfolios. Purchase shares in mutual funds that hold shares in proportion to their representation in indexes. These index funds yield a return equal to that of the index & thus provide a low-cost passive investment strategy for equity investors. Another approach is to purchase an exchange-traded fund, or ETF, which is a portfolio of shares that can be bought / sold as a unit, just as one can buy or sell a single share of stock. Available ETFs range from portfolios that track extremely broad global market indexes all the way to narrow industry indexes.

Other U.S. Market-Value Indexes

NYSE publishes a market-value-weighted composite index of all NYSE-listed stocks & subindexes for industrial, utility, transportation & financial stocks. These indexes are even more broadly based than S&P 500. NASDAQ computes a Composite index of more than 3,000 firms traded on the NASDAQ market. NASDAQ 100 is a subset of larger firms in the Composite Index, but it accounts for a large fraction of its total market cap. Ultimate U.S. equity index so far computed is Wilshire 5000 index with market value of essentially all actively traded stocks in the U.S. At one point, it included more than 5,000 stocks, but today, there are fewer than 4,000 stocks in the index. A similar comprehensive index is published by CRSP (the Center for Research in Security Prices at the University of Chicago).

Equally Weighted Indexes

Market performance is sometimes measured by an equally weighted average of the returns of each stock in an index. Such an averaging technique, by placing equal weight on each return, corresponds to an implicit portfolio strategy that invests equal dollar values in each stock. In contrast to both price weighting (equal numbers of shares of each stock) & market-value weighting (investments in proportion to outstanding value). Equally weighted indexes do not correspond to buy-and-hold portfolio strategies. E.g. start with equal dollar investments in ABC & XYZ. As ABC increases in value by 20% while XYZ decreases by 10%, portfolio is no longer equally weighted. To reset portfolio to equal weights, rebalancing is needed: Sell off some ABC stock and/or purchase more XYZ stock.

Foreign & International Stock Market Indexes

Development in financial markets includes construction of indexes for markets like: Nikkei (Japan), FTSE (U.K), DAX (Germany), Hang Seng (Hong Kong & TSX (Canada). A leader in the construction of international indexes has been MSCI (Morgan Stanley Capital International), which computes dozens of country indexes & several regional indexes.

Table 2.6 presents many indexes computed by MSCI.

Bond Market Indicators

Several bond market indicators measure performance of various categories of bonds. 3 most well-known indexes: Merrill Lynch, Barclays & Citi Broad Investment Grade Bond Index. 

Figure 2.9 shows components of U.S. fixed-income market in 2016. Major problem with bond market indexes: true rates of return on many bonds are difficult to compute as infrequency of bond trades means that reliable up-to-date prices is difficult to obtain. Some prices must be estimated from bond-valuation models. These “matrix” prices may differ from true market values.

2.5 Derivative Markets

Futures, options & related derivatives contracts provide payoffs that depend on values of other variables like commodity prices, bond & stock prices, i/r or market index values. These instruments are derivative assets as their values are derived from values of other assets. These assets are "contingent claims" as their payoffs are contingent on value of other values.

Options

Call option: gives holder the right to purchase an asset for a specified price ("exercise"/ "strike" price), on / before a specified expiration date. E.g. July call option on IBM stock with an exercise price of $150 entitles its owner to purchase IBM stock at $150, any time up to &including expiration date in July. Each option contract is for purchase of 100 shares. Quotations are made on a per-share basis. Holder of the call need not exercise the option; it will be profitable to exercise only if market value of asset exceeds exercise price. When market price exceeds the exercise price, option holder may “call away” the asset for the exercise price & reap a payoff equal to difference between stock price & exercise price. Otherwise, option will be left unexercised. If not exercised before expiration date of the contract, option expires & no longer has value. Calls thus represent bullish investment vehicles.

Put option: gives its holder the right to sell an asset for a specified exercise price on / before a specified expiration date. E.g. July put on IBM at $150 entitles its owner to sell IBM stock to the put writer at $150, any time before expiration in July, even if market price of IBM is lower than $150. Put is exercised only if holder can deliver an asset worth less than exercise price in return for the exercise price.

Table 2.7 presents prices of IBM options on May 10, 2016. Price of IBM shares on this date was $149.97. First 2 columns gives expiration month & exercise (or strike) price for each option. E.g. July 2016 expiration call with exercise price $150 last traded at $4.43, meaning that an option to purchase 1 share of IBM at an exercise price of $150 sold for $4.43. Each option contract (on 100 shares) thus cost $443. Notice prices of call options decrease as exercise price increases as the right to purchase a share at a higher price is less valuable. Conversely, put prices increase with exercise price. Option prices also increase with time until expiration. E.g. call with exercise price $150 expiring in July sells for $4.43 vs $3.31 for the June call.

Futures Contracts

Futures contract calls for delivery of an asset (in some cases, its cash value) at a specified delivery / maturity date for an agreed-upon price, "futures price", to be paid at contract maturity. Long position is held by trader who commits to purchasing asset on delivery date. Trader who takes short position commits to delivering asset at contract maturity.

Table 2.8 presents corn futures contracts. Each contract calls for delivery of 5,000 bushels of corn. First entry is for nearest term / “front” contract, with maturity in July 2016. Futures price for delivery in May was $3.81 per bushel. Trader holding long position profits from price increases. E.g. at contract maturity, corn is selling for $3.83 per bushel. Long position trader who entered contract at futures price of $3.81 on May 10 would pay the previously agreed-upon $3.81 for each bushel of corn, which at contract maturity would be worth $3.83. Thus profit = 5,000 * ($3.83 − $3.81) = $1,000. The short position must deliver 5,000 bushels for the previously agreed-upon futures price. Short position’s loss = long position’s profit. Right to purchase the asset at an agreed-upon price, vs obligation, distinguishes call options from long positions in futures contracts. Futures contract obliges long position to purchase asset at futures price while call option conveys right to purchase asset at exercise price. Purchase will be made only if it yields a profit. Clearly, a holder of a call has a better position than holder of a long position on a futures contract with a futures price equal to the option’s exercise price. This advantage comes only at a price. Call options must be purchased (premium); futures contracts are entered into without cost. Premium represents compensation the purchaser of the call must pay for ability to exercise option only when it is profitable to do so. Difference between a put option & a short futures position is the right, vs obligation, to sell an asset at an agreed-upon price.

2.6 Summary

1. Money market securities are very short-term debt obligations. They are usually highly marketable & relatively low credit risk. Low maturities & low credit risk ensures minimal capital gains / losses. They are traded in large denominations, but may be purchased indirectly via money market funds.

2. Much of U.S. government borrowing is in form of Treasury bonds & notes. These are coupon-paying bonds usually issued at / near par value. Treasury notes & bonds are similar in design to coupon-paying corporate bonds.

3. Municipal bonds are distinguished largely by tax-exempt status. Interest payments (but not capital gains) on these securities are exempt from federal income taxes. Equivalent taxable yield offered by a municipal bond equals r-muni/(1 - t), where r-muni is municipal yield & t is investor’s tax bracket.

4. Mortgage pass-through securities are pools of mortgages sold in 1 package. Owners receive principal & interest payments made by borrowers. Originator that issued the mortgage merely services it & “passes through” the payments to purchasers of the mortgage. A federal agency may guarantee payments of interest & principal on mortgages pooled, but these guarantees are absent in private-label pass-throughs.

5. Common stock is an ownership share in a corporation. Each share entitles its owner to 1 vote on matters of corporate governance & to a prorated share of dividends paid to shareholders. Stock / equity, owners are residual claimants on income earned by the firm.

6. Preferred stock usually pays fixed dividends for life of the firm. A firm’s failure to pay dividend due on preferred stock, however, does not precipitate corporate bankruptcy. Instead, unpaid dividends simply cumulate. Variants of preferred stock include convertible & adjustable-rate issues.

7. Many stock market indexes measure performance of overall market. Dow Jones averages are price-weighted indexes. Today, many broadbased, market-value-weighted indexes are computed daily like S&P 500, NYSE index, NASDAQ index, Wilshire 5000 index & indexes of many non-U.S. stock markets.

8. Call option: right to purchase an asset at a stipulated exercise price on / before an expiration date. Put option: right to sell an asset at exercise price. Calls increase in value while puts decrease in value as price of underlying asset increases.

9. Futures contract is an obligation to buy / sell an asset at stipulated futures price on a maturity date. Long position (commits to purchasing) gains if asset value increases. Short position (which commits to delivering) loses.

3. How Securities Are Traded

3.1 How Firms Issue Securities

Firms raise new capital to pay for investment projects. They can raise funds by borrowing money / selling shares. Investment bankers are generally hired to manage sale of these securities in a "primary market" for newly issued securities which after issuing can then be traded among investors. Trades in existing securities takes place in "secondary market". Shares of publicly listed firms trade continually in markets like NYSE & NASDAQ Stock Market. Private corporations: shares are held by small numbers of managers & investors & shares do not trade in public exchanges. While many private firms are relatively young companies that have not yet chosen to make their shares generally available to the public, others may be more established firms that are still largely owned by the company’s founders or families, and others may simply have decided that private organization is preferable.

Privately Held Firms

Privately held company is owned by a relatively small number of shareholders. They have fewer obligations to release financial statements & other info to the public. This saves money & frees firm from disclosing info that might be helpful to competitors. Some also believe that eliminating requirements for quarterly earnings announcements gives them more flexibility to pursue long-term goals free of shareholder pressure. When they wish to raise funds, they sell shares directly to institutional / wealthy investors in a private placement. Rule 144A of SEC allows them to make these placements without preparing extensive & costly registration statements required of a public company. While this is attractive, shares in privately held firms do not trade in secondary markets like a stock exchange (although large financial institutions can trade unregistered securities among themselves) & this greatly reduces their liquidity & presumably reduces the prices that investors will pay for them. Liquidity: generally refers to ability to buy / sell an asset at a fair price on short notice. Until recently, private firms were allowed to have only up to 499 shareholders. This limited their ability to raise large amounts of capital from a wide base of investors. Thus, almost all of the largest companies in the U.S. have been public corporations. As firms increasingly chafed against informational requirements of going public, federal regulators came under pressure to loosen the constraints entailed by private ownership. The JOBS (Jumpstart Our Business Startups) Act, which was signed into law in 2012, increased no.of shareholders a company may have before being required to register its common stock with the SEC and file public reports from 500 to 2,000. It also loosened rules limiting degree to which private firms could market their shares to the public. Some firms have set up computer networks to enable holders of private-company stock to trade among themselves. However, unlike public stock markets regulated by SEC, these networks require little disclosure of financial info & provide correspondingly little oversight of the operations of the market. Skeptics worry that investors cannot obtain a clear view of the firm, interest among other investors in the firm / process by which trades in the firm’s shares are executed.

Publicly Traded Companies

Going public: sell securities to general public & allow those investors to freely trade them in established securities markets. First issue of shares: initial public offering (IPO). Seasoned equity offering: sale of additional shares in firms that already are publicly traded. Public offerings of stocks & bonds typically are marketed by investment bankers, "underwriters". A lead firm forms an underwriting syndicate of other investment bankers to share the responsibility for stock issue. Investment bankers advise firm for terms on which it should attempt to sell the securities. A preliminary registration statement must be filed with SEC, describing the issue & prospects of the company. When statement is in final form & accepted by SEC, it is a "prospectus". At this point, the price at which securities will be offered to the public is announced. In a typical underwriting arrangement, investment bankers purchase securities from issuing company & resell them to the public. Issuing firm sells securities underwriting syndicate for public offering price less a spread that serves as compensation to underwriters (firm commitment). Investment banker also may receive shares of common stock / other securities of the firm.

Figure 3.1 depicts relationships among firm issuing security, lead underwriter, underwriting syndicate & public.

Shelf Registration

In 1982, SEC approved Rule 415 for seasoned offerings: allows firms to register securities & gradually sell them to public for 3 years following initial registration. As the securities are already registered, they can be sold on short notice, with little additional paperwork. They can also be sold in small amounts without incurring substantial flotation costs. The securities are “on the shelf”, ready to be issued.

IPOs

Investment bankers manage issuance of new securities to the public. Once SEC has commented on registration statement & a preliminary prospectus has been distributed to interested investors, investment bankers organise road shows where they travel the country to publicise the offering to generate interest among potential investors, provide info about the offering & provide info to the issuing firm & its underwriters about price at which they will be able to market the securities. Large investors communicate interest in purchasing shares of the IPO to underwriters ("book"), & process of polling potential investors is "book building". Book provides useful info to issuing firm as institutional investors often will have useful insights about market demand for security & prospects of firm & competitors. Investment bankers frequently revise initial estimates of offering price & number of shares offered based on feedback from investing community. Why do investors truthfully reveal their interest in an offering? Shares are allocated across investors in part based on strength of each investor’s expressed interest. If a firm wishes to get a large allocation when it is optimistic, it needs to reveal its optimism. In turn, underwriter needs to offer it at a bargain price to induce investors to participate in book building & share their info. Thus, IPOs commonly are underpriced compared to the price at which they could be marketed. Such underpricing is reflected in price jumps that occur on date when shares are first traded in public security markets. While explicit costs of an IPO tend to be ~ 7% of funds raised, such underpricing should be viewed as another cost. Nevertheless, underpricing seems to be a universal phenomenon.

Figure 3.2 presents average first-day returns on IPOs of stocks. Results consistently indicate that IPOs are marketed to investors at attractive prices. Pricing of IPOs is not trivial & not all IPOs turn out to be underpriced. Some do poorly after issue. E.g. Facebook’s 2012 IPO: within a week of its IPO, share price was 15% below $38 offer price & 5 months later, its shares were selling at ~ half offer price. (but note that those who held on to their shares longer profited)

Underwriters left with unmarketable securities are forced to sell them at a loss on secondary market. Thus, investment banker bears price risk for an underwritten issue. Despite their typically attractive first-day returns, IPOs have been poor long-term investments. Professor Jay Ritter, a leading expert in the field, has calculated returns to a hypothetical investor buying equal amounts of each U.S. IPO from 1980 & 2014 at close of trading on first day stock is listed & holding each for 3 years. Portfolio underperforms broad U.S. stock market on average by 17.8% for 3-year holding periods & underperforms “stylematched” portfolios of firms with comparable size & ratio of book value to market value by 6.3%.

3.2 How Securities Are Traded

Types of Markets

1. Direct Search Markets: least organised market. Buyers & sellers seek each other out directly. E.g. sale of a used refrigerator where seller advertises for buyers in a newspaper / Craigslist. These are characterised by sporadic participation & non-standard goods. Firms would find it difficult to profit by specialising in such an environment.

2. Brokered Markets: Markets where trading in a good is active, brokers find it profitable to offer search services to buyers & sellers. E.g. real estate market, where economies of scale in searches for available homes & for prospective buyers make it worthwhile for participants to pay brokers to help them conduct searches. Brokers in particular markets develop specialised knowledge on valuing assets traded in that market. Another E.g. primary market, where new issues of securities are offered to public. In primary market, investment bankers who market a firm’s securities act as brokers.

3. Dealer Markets: When trading activity in a particular type of asset increases, dealer markets arise. Dealers specialise in various assets, purchase these assets for their own accounts & later sell them for a profit. Spreads between dealers’ buy (“bid”) prices & sell ( “ask”) prices are a source of profit. Dealer markets save traders on search costs as market participants can easily look up prices at which they can buy from / sell to dealers. A fair amount of market activity is required before dealing in a market is an attractive source of income. Most bonds trade in over-the-counter dealer markets.

4. Auction Markets: Most integrated market, where all traders converge at one place to buy / sell an asset. E.g. NYSE. Advantage of auction markets over dealer markets: one need not search across dealers to find the best price for a good. If all participants converge, they can arrive at mutually agreeable prices & save the bid-ask spread. Notice: over-the-counter dealer markets & stock exchanges are secondary markets. They are organised for investors to trade existing securities among themselves.

Types of Orders

1. Market Orders: buy / sell orders executed immediately at current market prices. Complications: (a) posted price quotes actually represent commitments to trade up to a specified number of shares. If market order is for more than this number of shares, order may be filled at multiple prices. E.g. if ask price is good for orders up to 300 shares & investor wishes to purchase 500 shares, it may be necessary to pay a slightly higher price for the last 200 shares.

Figure 3.3 shows average depth of markets for shares of stock (total no. of shares offered for trading at best bid & ask prices). Depth is considerably higher for large stocks in S&P 500 than for the smaller stocks that constitute Russell 2000 index. Depth is another component of liquidity. (b) Another trader may reach quote first, thus order would then be executed at a worse price. (c) Best price quote may change before order arrives, causing execution at a different price.

2. Price-Contingent Orders: order that specify prices to buy / sell a security. Limit buy order: broker to buy shares if & when at / below a stipulated price. Limit sell: broker to sell if & when price rises above a specified limit. Collection of limit orders waiting to be executed: "limit order book".

Figure 3.4 is a portion of the limit order book for Facebook from BATS exchange. Best orders are at top of the list. $118.34 & $118.36: "inside quotes"(highest buy & lowest sell orders). Inside spread at this time was only 2 cents. Note that order sizes at inside quotes can be fairly small.

Trading Mechanisms

1. Dealer Markets: ~35,000 securities trade on OTC market. Thousands of brokers register with SEC as security dealers. Dealers quote prices they are willing to buy / sell securities. Broker executes a trade by contacting a dealer listing an attractive quote. Before 1971, all OTC quotations were recorded manually & published daily on "pink sheets". In 1971, National Association of Securities Dealers introduced its Automatic Quotations System / NASDAQ, to link brokers & dealers in a computer network where price quotes could be displayed & revised. Difference in these prices, bid-ask spread, was the source of dealer’s profit. Brokers representing clients could examine quotes over the computer network, contact dealer with best quote & execute a trade. While brokers could survey bid & ask prices for trading opportunities, actual trades required direct negotiation (often over the phone) between investor’s broker & dealer in the security. NASDAQ is no longer a mere price quotation system. NASDAQ Stock Market allows for electronic execution of trades.

2. Electronic Communication Networks (ECNs): allow participants to post market & limit orders over computer networks. Limit-order book is available to all participants. E.g. of such an order book from BATS, a leading ECN, appears in Figure 3.4. Orders that can be “crossed”, matched against another order, are auto-executed without intervention of a broker. E.g. order to buy at $50 / lower is auto-executed if there is an outstanding ask price of $50. Thus, ECNs are true trading systems, not merely price-quotation systems. Advantages: (a) Direct crossing of trades eliminates bid-ask spread, instead, trades are auto-crossed at a modest cost, ~ less than a penny per share. (b) Speed of execution of trades. (c) Offers investors considerable anonymity in trades.

3. Specialist Markets: specialist systems have been largely replaced by ECNs, but as recently as two decades ago, they were still the dominant means by which stocks were traded. Exchanges like NYSE assigns responsibility for managing trading in each security to a specialist. Brokers wishing to buy / sell shares for their clients direct the trade to specialist’s post on floor of the exchange. While each security is assigned to 1 specialist, each specialist firm makes a market in many securities. Specialist maintains limit order book. When orders can be executed at market prices, specialist executes/ “crosses” the trade. Highest outstanding bid price & lowest outstanding ask price “wins” the trade. Specialists are also mandated to maintain a “fair & orderly” market when book of limit buy & sell orders is so thin that spread between highest bid price & lowest ask price becomes too wide. In this case, specialist firm would be expected to offer to buy & sell shares from its own inventory at a narrower bid-ask spread. In this role, specialist serves as a dealer in the stock & provides liquidity to other traders. In this context, liquidity providers are those who stand willing to buy securities from / sell securities to other traders.

3.3 Rise of Electronic Trading

NASDAQ was primarily an OTC dealer market & NYSE was a specialist market. Today, both are primarily electronic markets due to new technologies & regulations. Regulations: brokers to compete for business, dealers no longer had monopoly over info on best-available bid & ask prices, forced integration of markets & allowed securities to trade in ever-smaller price increments ("ticks"). Technology: traders to rapidly compare prices across markets. Resulting competition drove down cost of trade execution to a tiny fraction of its level just a few decades ago. In 1975, fixed commissions on NYSE were eliminated, which freed brokers to compete for business by lowering their fees & congress amended the Securities Exchange Act to create National Market System to at least partially centralise trading across exchanges & increase competition among different market makers. Implement centralised reporting of transactions & a centralised price quotation system to give traders a broader view of trading opportunities across markets. Aftermath of a 1994 scandal at NASDAQ turned out to be a major impetus in further evolution & integration of markets. NASDAQ dealers were found to be colluding to maintain wide bid-ask spreads. E.g. if a stock was listed at $30 bid-$30.5 ask, a retail client who wished to buy shares from a dealer would pay $30.5 while a client who wished to sell shares would receive only $30. Dealer would pocket 1⁄2-point spread as profit. Better quotes were not made available to the public, enabling dealers to profit from artificially wide spreads. Anti-trust lawsuit was brought against NASDAQ. SEC instituted new order-handling rules. Published dealer quotes now had to reflect limit orders of customers, allowing them to effectively compete with dealers to capture trades. As part of the antitrust settlement, NASDAQ agreed to integrate quotes from ECNs into its public display, enabling electronic exchanges to also compete for trades. SEC adopted Regulation ATS (Alternative Trading Systems), giving ECNs right to register as stock exchanges. Not surprisingly, they captured an ever-larger market share & in the wake of this new competition, bid-ask spreads narrowed. Even more dramatic narrowing of trading costs came in 1997, when the SEC allowed min. tick size to fall from one-eighth of a dollar to one-sixteenth. In 2001, “decimalisation” allowed tick size to fall to 1 cent. Bid-ask spreads again fell dramatically.

Figure 3.5 shows estimates of “effective spread” (cost of transaction) defined by min tick size. Technology also changed trading practices. First ECN, Instinet, was established in 1969. By 1990s, exchanges around the world were rapidly adopting fully electronic trading systems. National Association of Securities Dealers (NASD) spun off the NASDAQ Stock Market as a separate entity in 2000, which quickly evolved into a centralised limit-order matching system, effectively a large ECN. NYSE acquired electronic Archipelago Exchange in 2006 & renamed it NYSE Arca. In 2005, SEC adopted Regulation NMS (National Market System), which was fully implemented in 2007. Goal was to link exchanges electronically, thereby creating 1 integrated electronic market. Regulation required exchanges to honour quotes of other exchanges when they could be auto-executed. Exchanges that could not handle a quote electronically would be labeled a “slow market” under Reg NMS & could be ignored by other market participants. NYSE, which was still devoted to specialist system, was particularly at risk of being passed over & thus moved aggressively toward automated execution of trades. Electronic trading networks & integration of markets in the wake of Reg NMS made it easier for exchanges around the world to compete; NYSE lost its effective monopoly in trading of its own listed stocks & by end of the decade, its share in trading of NYSElisted stocks fell from ~ 75% to 25%. While specialists still exist, trading today is overwhelmingly electronic for stocks. Bonds are still traded in more traditional dealer markets.

3.4 US Markets

NASDAQ

NASDAQ Stock Market lists ~ 3,000 firms. Steadily introduced ever-more sophisticated trading platforms, which today handle great majority of its trades. NASDAQ Market Center consolidates NASDAQ’s previous electronic markets into 1 integrated system. NASDAQ merged in 2007 with OMX, a Swedish-Finnish company that controls 7 Nordic & Baltic stock exchanges to form NASDAQ OMX Group. It also maintains several stock markets in Europe & an options & futures exchange in U.S. NASDAQ has 3 levels of subscribers: Level 3 subscribers (highest), are registered market makers. These are firms that make a market in securities, maintain inventories of securities & post bid & ask prices where willing to buy / sell shares. They can enter & change bid-ask quotes continually & have fastest execution of trades, profiting from bid-ask spreads. Level 2 subscribers receive all bid & ask quotes but cannot enter their own quotes. They can see which market makers are offering best prices. These tend to be brokerage firms that execute trades for clients but do not actively deal in stocks for their own account. Level 1 subscribers receive only inside quotes, but do not see how many shares are being offered. They tend to be investors who are not actively buying / selling but want info on current prices.

NYSE

Largest U.S. stock exchange as measured by market value of listed stocks. Daily trading volume is ~ a billion shares. In 2006, NYSE merged with Archipelago Exchange to form a publicly held company, NYSE Group & in 2007, it merged with European exchange Euronext to form NYSE Euronext. Firm acquired American Stock Exchange in 2008, which was renamed NYSE Amex & focuses on small firms. NYSE Arca is the firm’s electronic communications network & is where bulk of ETFs trade. In 2013, NYSE Euronext was purchased by InternationalExchange (ICE). ICE has retained the NYSE Euronext name. NYSE was long committed to its specialist trading system, which relied heavily on human participation in trade execution. It began transitioning to electronic trading for smaller trades in 1976 with its DOT (Designated Order Turnaround) & later SuperDOT systems, which could route orders directly to the specialist. In 2000, it launched Direct+, which could auto-cross smaller trades (up to 1,099 shares) & in 2004, it began eliminating size restrictions on Direct+ trades. Change of emphasis dramatically accelerated in 2006 with NYSE Hybrid Market, which allowed brokers to send orders for immediate electronic execution / to the specialist, who could seek price improvement from another trader. Hybrid system allowed NYSE to qualify as a fast market for the purposes of Regulation NMS, but still offer advantages of human intervention for more complicated trades. In contrast, NYSE’s Arca marketplace is fully electronic.

ECNs

Over time, more fully automated markets have gained market share at the expense of less automated ones like NYSE. Brokers that have an affiliation with an ECN have computer access & can enter orders in limit order book. As orders are received, system determines whether there is a matching order & auto-cross. Originally, ECNs were open only to other traders using the same system. But with Reg NMS, ECNs began listing limit orders on other networks. Traders could use their computer systems to sift through limit order books of many ECNs & instantly route orders to market with the best prices. Those cross-market links have become the impetus for one of the more popular strategies of "highfrequency traders", which seek to profit from even small, transitory discrepancies in prices across markets. Speed if of the essence here & ECNs compete in terms of the speed they can offer. Latency:time it takes to accept, process & deliver a trading order. E.g. BATS advertises latency times of ~ 200 microseconds.

3.5 New Trading Strategies

Algorithmic Trading

Use of computer programs to make trading decisions. More than half of all equity volume in U.S. is believed to be initiated by computer algorithms. Many of these exploit small discrepancies in security prices & entail numerous & rapid cross-market price comparisons suited to computer analysis. These would not have been feasible before decimalisation of min tick size. Some attempt to exploit very short-term trends as new info about a firm / more controversially, about intentions of other traders, becomes available. Others use versions of pairs trading: normal price relations between pairs (or larger groups) of stocks seem temporarily disrupted & offer small profit opportunities as they move back into alignment. Others attempt to exploit discrepancies between stock prices & prices of stock-index futures contracts. Some involves activities akin to traditional market making. Traders seek to profit from bid-ask spread by buying a stock at bid price & rapidly selling it at the ask price before price can change. These algorithmic traders are not registered market makers & so do not have an affirmative obligation to maintain bid & ask quotes. If they abandon a market during a period of turbulence, shock to market liquidity can be disruptive. This seems to have been a problem during flash crash of May 6, 2010, when stock market encountered extreme volatility, with Dow Jones Industrial Average falling by 1,000 points before recovering ~ 600 points in intraday trading.

High-Frequency Trading

Subset of algorithmic trading that relies on computer programs to make rapid decisions. Compete for trades that offer very small profits. 1 strategy entails a sort of market making, attempting to profit from the bid-ask spread. Another relies on cross-market arbitrage, where even tiny price discrepancies across markets allow firm to buy a security at 1 price & simultaneously sell at a slightly higher price. Competitive advantage in these strategies lies with firms that are quickest to identify & execute these profit opportunities. There is a tremendous premium on being first to “hit” a bid / ask price. Trade execution times for high-frequency traders are measured in milliseconds, even microseconds. This has induced trading firms to “co-locate” their trading centers next to computer systems of the electronic exchanges. When execution / latency periods are less than a millisecond, extra time it takes for a trade order to travel from a remote location to a New York exchange would be enough to make it nearly impossible to win the trade. ECNs today claim latency periods considerably less than 1 millisecond, so an order from Chicago could not possibly compete with 1 launched from a co-located facility. In some ways, co-location is a new version of an old phenomenon. Think about why, even before the advent of the telephone, so many brokerage firms originally located their headquarters in New York: They were “co-locating” with NYSE so that their brokers could bring trades (on foot!) to exchange quickly & efficiently. Today, trades are transmitted electronically, but competition among traders for fast execution means that the need to be near the market (now embodied in computer servers) remains.

Dark Pools

Many large traders seek anonymity. They fear that if others see them executing, their intentions will become public & prices will move against them. Very large trades ("blocks" trade of more than 10,000 shares) traditionally were brought to “block houses” brokerage firms specialising in matching block buyers & sellers. These brokers discreetly arrange large trades. Block trading today has been displaced to a great extent by dark pools, private trading systems where participants can buy / sell large blocks of securities without showing their hand. Limit orders are not visible to public & traders’ identities can be kept private. Trades are not reported until after they are crossed. But, this ideal has not always been realised. In 2011, Pipeline LLC, which operated a dark pool, was accused of enabling high-frequency traders to participate in its market & to gauge intentions of other participants. In 2014, Barclays was accused of misrepresenting the level of high-frequency trading in a dark pool that it operated. There are lingering concerns regarding extent to which dark pools provide protections from other traders. Dark pools are somewhat controversial as they contribute to fragmentation of markets. When many orders are removed from consolidated limit order book, there are fewer orders left to absorb fluctuations in demand for the security & public price may no longer be “fair” in the sense that it reflects all the potentially available info about security demand. Another approach to dealing with large trades is to split them into many small trades. This trend has led to rapid decline in average trade size, which today is less than 300 shares.

Bond Trading

In 2006, NYSE obtained regulatory approval to expand its bond-trading system to include debt issues of any NYSE-listed firm. Until then, each bond needed to be registered before listing & such a requirement was too onerous to justify listing most bonds. In conjunction with these new listings, NYSE has expanded its electronic bond-trading platform, NYSE Bonds & is the largest centralised bond market of any U.S. exchange. Vast majority of bond trading occurs in OTC market among bond dealers, even for bonds listed on NYSE. This market is a network of bond dealers like Merrill Lynch, Salomon Smith Barney & Goldman Sachs that is linked by a computer quotation system. But since these dealers do not carry extensive inventories of wide range of bonds issued to the public, they cannot necessarily offer to sell bonds from their inventory to clients / even buy bonds for their own inventory. They may instead work to locate an investor who wishes to take opposite side of a trade. In practice, however, corporate bond market often is quite “thin,”: may be few investors interested in trading a specific bond at any particular time. Hence, bond market is subject to a type of liquidity risk.

3.6 Globalisation of Stock Markets

Figure 3.7 shows NYSE-Euronext is the largest equity market by total market value of listed firms. All major stock markets today are effectively electronic. Securities markets have come under increasing pressure in recent years to make international alliances / mergers due to electronic trading. Traders view stock markets as computer networks that link them to other traders & there are increasingly fewer limits on securities around the world that they can trade thus it becomes more important for exchanges to provide cheapest & most efficient mechanism for execution & clearing of trades. This argues for global alliances to facilitate nuts & bolts of crossborder trading & benefit from economies of scale. Exchanges feel that they eventually need to offer 24-hour global markets & platforms that allow trading of different security types e.g. stocks & derivatives. Companies want to be able to go beyond national borders when they wish to raise capital thus a broad trend toward market consolidation. In U.S., NYSE merged with Archipelago ECN in 2006 & in 2008 it acquired American Stock Exchange. In Europe, Euronext was formed by the merger of Paris, Brussels, Lisbon & Amsterdam exchanges & purchased Liffe, the derivatives exchange based in London. NYSE Group & Euronext merged in 2007 & was acquired by ICE in 2013. NASDAQ acquired Instinet in 2005 & Boston Stock Exchange in 2007. It merged with OMX, which operates 7 Nordic & Baltic stock exchanges, to form NASDAQ OMX Group in 2007. In derivatives market, Chicago Mercantile Exchange acquired Chicago Board of Trade in 2007 & New York Mercantile Exchange in 2008, thus moving almost all futures trading in U.S. to 1 exchange. In 2008, Eurex took over International Securities Exchange (ISE), to form a major options exchange.

3.7 Trading Costs

Part of cost of trading a security is obvious & explicit. Broker is paid a commission. Individuals may choose from 2 kinds of brokers: full-service / discount brokers. Full-service brokers: account executives / financial consultants. They carry out basic services of executing orders, holding securities for safekeeping, extending margin loans & facilitating short sales, brokers routinely provide info & advice relating to investment alternatives. They usually depend on a research staff that prepares analyses & forecasts of general economic, industry & company conditions & often makes specific buy / sell recommendations. Some customers allow a full-service broker to make buy & sell decisions for them by establishing a discretionary account. In this account, broker can buy & sell pre-specified securities whenever deemed fit. Discount brokers: provide “no-frills” services. They buy & sell securities, hold them for safekeeping, offer margin loans & facilitate short sales. Only info they provide is price quotations. Increasingly available in recent years. Many banks, thrift institutions & mutual fund management companies now offer these as part of a general trend toward creation of 1-stop “financial supermarkets.” Stock trading fees have fallen steadily over the last decade & discount brokerage firms like Schwab, E*Trade & TD Ameritrade offer low commissions.

Implicit cost: dealer’s bid-ask spread. Sometimes broker is also the dealer & charges no commission but instead collects bid-ask spread. Another implicit cost: price concession an investor may be forced to make for trading in quantities greater than those associated with posted bid / ask price.

3.8 Buying on Margin

Investors have easy access to a source of debt financing: "broker’s call loans". Buying on margin is to take advantage of broker’s call loans. Investor borrows part of purchase price of stock from a broker. Brokers borrow money from banks at call money rate to finance these purchases & charge their clients that rate + a service charge. Securities purchased on margin must be maintained with brokerage firm in street name, as securities are collateral for the loan. Board of Governors of the Federal Reserve System limits extent to which stock purchases can be financed using margin loans.

E.g. 3.1: % margin: ratio of net worth / “equity value” of account vs market value of securities. Investor pays $6,000 for purchase of $10,000 worth of stock with $4,000 borrowed from a broker:

Initial % margin = 60%

If price declines to $70 per share:

% margin = 3,000/7,000 = 43%

If stock value were to fall below $4,000, owners’ equity is negative, thus value of stock is no longer sufficient collateral to cover loan from broker. To guard against this, broker sets a maintenance margin. If % margin falls below maintenance level, broker issues a margin call: investor has to add new cash / securities to margin account if not broker may sell securities to pay off enough of the loan to restore % margin to an acceptable level.

Investors use margin for greater upside potential, but expose themselves to greater downside risk.

E.g. investor is bullish on FinCorp stock ($100 per share). Ignoring dividends, expected rate of return would be 30% if the investor invested $10,000 to buy 100 shares. Investor borrows $10,000 from broker. Total investment = $20,000 (for 200 shares). Assuming i/r on margin loan of 9% per year, what is investor’s rate of return be if stock price increases 30%?

200 shares will be worth $26,000. $10,900 of principal & interest on margin loan leaves $15,100 ($26,000 - $10,900). Rate of return = 51%

If stock price drops by 30% to $70 per share. 200 shares will be worth $14,000 & investor is left with $3,100 after $10,900 of principal & interest. Thus return of -69%

Table 3.1 summarises possible results.

3.9 Short Sales

First, you sell & then you buy the shares. Allows investors to profit from a decline in a security’s price. Investor borrows a share of stock from a broker & sells it. Later, short-seller must purchase a share of same stock to replace that was borrowed (covering the short position).

Table 3.2 compares stock purchases to short sales. Short-sellers replace shares & pay lender of security any dividends paid during short sale. In practice, shares loaned out for a short sale are typically provided by shortseller’s brokerage firm & broker holds shares registered in its own name on behalf of client. Owner of the shares need not know that shares have been lent to shortseller. If owner wishes to sell shares, brokerage firm simply borrows shares from another investor. Thus, short sale may have an indefinite term. But, if brokerage firm cannot locate new shares to replace the ones sold, short-seller will need to repay loan immediately by purchasing shares in market & turning them over to brokerage house to close the loan. Exchange rules require that proceeds from a short sale must be kept on account with the broker. Short-seller cannot invest these funds to generate income, but large / institutional investors typically will receive some income from proceeds of a short sale being held with broker. Short-sellers also are required to post margin (cash / collateral) with the broker to cover losses should stock price rise.

E.g. 3.3: bearish on Dot Bomb stock & market price is $100 per share. Tell broker to sell short 1,000 shares. Broker borrows 1,000 shares from another customer’s account / from another broker. $100,000 cash proceeds from short sale are credited to your account. Broker has a 50% margin requirement on short sales. Thus, you must have other cash / securities in your account worth at least $50,000 serving as margin on the short sale. You have $50,000 in Treasury bills. Account with broker after the short sale:

Initial % margin is ratio of equity in the account to current value of the shares borrowed & eventually must return: Percentage margin = 50,000 / 10,000 =50%

If Dot Bomb falls to $70 per share, you can close out your position at a profit. You buy 1,000 shares to replace the ones borrowed. Purchase costs $70,000. As your account was credited for $100,000 when shares were borrowed & sold, profit is $30,000.

Short-selling periodically comes under attack during times of financial stress when share prices fall. E.g. post-GFC, SEC voted to restrict short sales in stocks that decline by at least 10% on a given day, allowing them to be shorted on that day & next only at a price greater than highest bid price across national stock markets.

3.10 Regulation of Securities Markets

Self-Regulation

Most important overseer is Financial Industry Regulatory Authority (FINRA), the largest non-governmental regulator of all securities firms in US. FINRA was formed in 2007 via consolidation of National Association of Securities Dealers (NASD) with self-regulatory arm of NYSE. Broad mission: fostering of investor protection & market integrity. It examines securities firms, writes & enforces rules concerning trading practices & administers a dispute-resolution forum for investors & registered firms. Community of investment pros provides another layer of self-regulation. E.g. CFA Institute has developed standards of professional conduct that govern behaviour of members with Chartered Financial Analysts (CFA) designation.

Sarbanes-Oxley Act

Scandals of 2000 to 2002 centered on 3 broad practices: allocations of shares in IPOs, tainted securities research & recommendations put out to the public & misleading financial statements & accounting practices. Sarbanes-Oxley Act (SOX), was passed by Congress in 2002. Key reforms: (a) Creation of Public Company Accounting Oversight Board to oversee auditing of public companies. (b) Rules requiring independent financial experts to serve on audit committees of a firm’s board of directors. (c) CEOs & CFOs must now personally certify that firms’ financial reports “fairly represent, in all material respects, operations & financial condition of company” & are subject to personal penalties if those reports turn out to be misleading. (d) Auditors may no longer provide several other services to clients to prevent potential profits on consulting work from influencing quality of audit. (e) Board of Directors must be composed of independent directors & hold regular meetings of directors where company management is not present.

More recently, there has been pushback on Sarbanes-Oxley. Many believe that compliance costs associated with law are too onerous, especially for smaller firms & that heavy-handed regulatory oversight is giving foreign locales an undue advantage over US when firms decide where to list their securities. Moreover, efficacy of single-country regulation is being tested in face of increasing globalisation & ease with which funds can move across national borders.

Insider Trading

Regulations prohibit insider trading. Inside info refers to private info held by officers / directors / major stockholders. While it is obvious that CFO of a firm is an insider, it is less clear whether firm’s biggest supplier can be considered an insider. Yet a supplier may deduce firm’s near-term prospects from significant changes in orders. These ambiguities plague security analysts, whose job is to uncover as much info as possible concerning firm’s expected prospects. Dividing line between legal private info & illegal inside info can be fuzzy. SEC requires officers, directors & major stockholders to report all transactions in their firm’s stock to track any implicit vote of confidence / no confidence made by insiders. Evidence on insider trading: (a) Well-publicised convictions of principals in insider trading schemes. (b) Considerable evidence of “leakage” of useful info to some traders before any public announcement. E.g. share prices of firms announcing dividend increases commonly increase in value a few days before public announcement of the increase. (c) Returns earned on trades by insiders. Researchers have examined SEC’s summary of insider trading to measure performance of insiders. Jaffee examined abnormal return of stocks over months following purchases / sales by insiders. For months where insider purchasers of a stock exceeded insider sellers of the stock by 3 or more, stock had an abnormal return in following 8 months of about 5%. Moreover, when insider sellers exceeded insider buyers, stock tended to perform poorly.

3.11 Summary

1. Firms issue securities to raise capital to finance their investments. Investment bankers market these securities to public on primary market. Investment bankers act as underwriters who purchase securities from the firm & resell them to public at a markup. Before securities are sold to public, firm must publish an SEC-approved prospectus that provides info on firm’s prospects.

2. Already-issued securities are traded on secondary market (organised stock markets), on OTC market & occasionally for very large trades via direct negotiation. Brokerage firms holding licenses to trade on security exchanges sell their services to individuals, charging commissions for executing trades.

3. Trading may take place in dealer markets, via ECN / in specialist markets. In dealer markets, security dealers post bid & ask prices at which they are willing to trade. Brokers for individuals execute trades at best available prices. In electronic markets, existing book of limit orders provides terms at which trades can be executed. Mutually agreeable offers to buy / sell securities are auto-crossed by computer system operating the market.

4. NASDAQ was traditionally a dealer market where a network of dealers negotiated directly for sales of securities. NYSE was traditionally a specialist market. Today, trading in both markets is overwhelmingly electronic.

5. Buying on margin means borrowing money from a broker to buy more securities than can be purchased with one’s own money alone. Investor magnifies upside potential & downside risk. If equity in a margin account falls below required maintenance level, investor gets a margin call from broker.

6. Short-selling is of selling securities that seller does not own. Short-seller borrows securities sold via a broker & may be required to cover short position at any time on demand. Cash proceeds of a short sale are kept in escrow by broker who usually requires that short-seller deposit additional cash / securities to serve as margin (collateral).

7. Securities trading is regulated by SEC, other government agencies & via self-regulation of exchanges. Many important regulations have to do with full disclosure of relevant info concerning securities. Insider trading rules prohibit traders from attempting to profit from inside info.

4. Mutual Funds & Other Investment Companies

4.1 Investment Companies

They are financial intermediaries that collect funds from individual investors & invest those funds in a potentially wide range of securities / other assets. Pooling of assets is the key idea behind investment companies. They perform several important functions for investors: (a) Record keeping & administration. Issue periodic status reports, keeping track of capital gains distributions, dividends, investments & redemptions & may reinvest dividend & interest income for shareholders. (b) Diversification & divisibility. By pooling, they enable investors to hold fractional shares of many different securities. They can act as large investors even if any individual shareholder cannot. (c) Professional management. Full-time staffs of security analysts & portfolio managers attempt to achieve superior investment results for investors. (d) Lower transaction costs. As they trade large blocks of securities, investment companies can achieve substantial savings on brokerage fees & commissions. Investors ownership is proportional to no. of shares purchased. Value of each share is "net asset value" (NAV).

4.2 Types of Investment Companies

Unit Investment Trusts

Pools of money invested in a portfolio that is fixed for life of fund. A sponsor, typically a brokerage firm, buys a portfolio of securities that are deposited into a trust & then sells shares / “units” in the trust, "redeemable trust certificates". All income & payments of principal from portfolio are paid out by fund’s trustees (bank / trust company) to shareholders. Little active management as once established, portfolio composition is fixed & thus "unmanaged". Trusts tend to invest in relatively uniform types of assets; E.g. municipal bonds, corporate bonds. Uniformity of portfolio is consistent with lack of active management. Trusts provide investors a vehicle to purchase a pool of one particular type of asset that can be included in an overall portfolio as desired. Sponsors earn profit by selling trust shares at a premium to cost of acquiring underlying assets. For investors to liquidate holdings of a unit investment trust, they may sell shares back to trustee for NAV. Trustees can sell enough securities from asset portfolio to obtain cash necessary to pay investor / instead sell shares to a new investor. Unit investment trusts have steadily lost market share to mutual funds in recent years. Assets have declined from $105 billion in 1990 to $94 billion in 2016.

Managed Investment Companies

2 types of managed companies: closed-end & open-end. Fund shareholders elect board of directors which hires a management company to manage portfolio for an annual fee ~ 0.2% to 1.25% of assets. In many cases, management company is firm that organised the fund. E.g. Fidelity Management & Research Corporation sponsors many Fidelity mutual funds & is responsible for managing portfolios. In other cases, a mutual fund will hire an outside portfolio manager. E.g. Vanguard has hired Wellington Management as investment adviser for its Wellington Fund. Most management companies have contracts to manage several funds.

Open-end funds stand ready to redeem / issue shares at NAV (though purchases & redemptions may involve sales charges). Investors in open-end funds wish to “cash out” their shares, selling them back to the fund at NAV. Investors in closed-end funds who wish to cash out must sell their shares to other investors. Shares of closed-end funds are traded on organised exchanges & can be purchased via brokers like other common stock; thus prices can differ from NAV.

Figure 4.1 is a listing of closed-end funds. Premium / discount = % difference between price & NAV. Notice these funds are all selling at discounts to NAV. Last column shows 52-week return based on % change in share price + dividend income. Common divergence of price from NAV, often by wide margins, is a puzzle that has yet to be fully explained. Fund could profit if it were to sell all assets in portfolio at NAV. Moreover, fund premiums / discounts tend to dissipate over time, selling at a discount allows for a boost to their rate of return as discount shrinks. Pontiff estimates a fund selling at a 20% discount would have an expected 12-month return more than 6% greater than funds selling at NAV. While many closed-end funds sell at a discount from NAV, prices of these funds when originally issued are often above NAV. It is hard to explain why investors would purchase these newly issued funds at a premium to NAV when the shares tend to fall to a discount shortly after issue. Price of open-end funds cannot fall below NAV, as these funds stand ready to redeem shares at NAV. Offering price will exceed NAV if fund carries a load. A load is a sales charge. Load funds are sold by securities brokers & directly by mutual fund groups. No. of outstanding shares of these funds changes daily for open-end funds.

Other Investment Organisations

1. Commingled Funds: Partnerships of investors that pool funds. Management firm that organises partnership (e.g. bank / insurance company) manages funds for a fee. Typical partners might be trust / retirement accounts with portfolios much larger than those of most individual investors, but still too small to warrant managing on a separate basis. These are similar to open-end mutual funds. But, instead of shares fund offers units, bought & sold at NAV. Bank / insurance company may offer an array of different commingled funds e.g. a money market fund, a bond fund & a common stock fund.

2. Real Estate Investment Trusts (REITs): Similar to a closed-end fund. Invest in real estate / loans secured by real estate. Raise capital by issuing shares & borrowing from banks & issuing bonds / mortgages. Most are highly leveraged, with a typical debt ratio of 70%. 2 principal kinds of REITs. Equity trusts invest in real estate directly, whereas mortgage trusts invest primarily in mortgage & construction loans. REITs generally are established by banks / insurance companies / mortgage companies, which then serve as investment managers to earn a fee.

3. Hedge Funds: Like mutual funds, they are vehicles that allow private investors to pool assets, invested by a fund manager. But, they are commonly structured as private partnerships & thus subject to only minimal SEC regulation. Usually open only to wealthy / institutional investors. Many require investors to agree to initial “lock-ups”: several years where investments cannot be withdrawn which allows funds to invest in illiquid assets without worrying about meeting demands for redemption of funds. With low regulation, managers can pursue investment strategies involving like heavy use of derivatives, short sales & leverage; (strategies that typically are not open to mutual fund managers). They are by design empowered to invest in a wide range of investments, with various funds focusing on derivatives, distressed firms, currency speculation, convertible bonds, emerging markets, merger arbitrage etc. Other funds may jump from one asset class to another as perceived investment opportunities shift. Hedge funds assets under management: ~ $50 billion in 1990 to ~ $3 trillion in 2016.

4.3 Mutual Funds

Investment Policies

Management companies manage a family / “complex” of mutual funds. They organise an entire collection of funds & collect a management fee for operating them. By managing a collection of funds under 1 umbrella, these companies make it easy for investors to allocate assets across market sectors & switch assets across funds while still benefiting from centralised record keeping. Famous management companies: Fidelity, Vanguard, Barclays, & T. Rowe Price.

1. Money Market Funds: Money market securities like commercial paper, repurchase agreements, certificates of deposit. Average maturity of these assets ~ a bit more than 1 month. These funds usually offer check-writing features & NAV is fixed at $1 per share, thus no tax implications like capital gains / losses associated with redemption of shares.

2. Equity Funds: Invest primarily in stock or hold fixed-income / other types of securities at portfolio manager’s discretion. Hold 4% to 5% of total assets in money market securities to provide liquidity necessary to meet potential redemption of shares. Stock funds are classified by emphasis on capital appreciation vs current income. Thus, income funds tend to hold shares of firms with consistently high dividend yields. Growth funds are willing to forgo current income, focusing on prospects for capital gains. In practice, more relevant distinction concerns level of risk these funds assume. Growth stocks are typically riskier & respond more dramatically to changes in economic conditions.

3. Sector Funds: Concentrate on a particular industry. E.g. Fidelity markets dozens of “select funds” each investing in a specific industry like biotech, utilities, energy or telecomm. Other funds specialise in securities of particular countries.

4. Bond Funds: Specialise in fixed-income sector. Some will concentrate on corporate bonds, Treasury bonds, mortgagebacked securities or municipal (tax-free) bonds. Some municipal bond funds invest only in bonds of a particular state / city for investors to avoid local & federal taxes on interest income. Many funds specialise by maturity, (short-term to intermediate to long-term) / by credit risk of issuer (very safe to high-yield / “junk” bonds)

5. International Funds: Global funds invest in securities worldwide. International funds invest in securities of firms located outside US. Regional funds concentrate on a particular part of the world & emerging market funds invest in companies of developing nations.

6. Balanced Funds: Some funds are designed for an individual’s entire investment portfolio. These funds hold equities & fixed-income securities in relatively stable proportions. Life-cycle funds are balanced funds where asset mix can range from aggressive (younger investors) to conservative (older investors). Static allocation life-cycle funds maintain a stable mix across stocks & bonds, while targeted-maturity funds become more conservative as investor ages. Many balanced funds are funds of funds: mutual funds that primarily invest in shares of other mutual funds. Balanced funds of funds invest in equity & bond funds in proportions suited to their investment goals.

7. Asset Allocation & Flexible Funds: Similar to balanced funds as they hold stocks & bonds. Asset allocation funds may greatly vary proportions allocated to each market in accord with portfolio manager’s forecast. Thus, these funds are engaged in market timing (higher risk).

8. Index Funds: Tries to match performance of a broad market index. Fund buys shares in securities included in a particular index in proportion to each security’s representation in that index. E.g. Vanguard 500 Index Fund replicates composition of S&P 500 stock price index. As S&P 500 is a value-weighted index, fund buys shares in each S&P 500 company in proportion to market value of that company’s outstanding equity. Investment in an index fund is a low-cost way for small investors to pursue a passive investment strategy. More than 20% of equity funds in 2016 were indexed. Index funds can be tied to non-equity indexes as well. E.g. Vanguard offers a bond index fund & real estate index fund.

Table 4.1 breaks down no. of mutual funds by investment orientation. Sometimes a fund name describes its investment policy. E.g. Vanguard’s GNMA fund invests in mortgage-backed securities, Municipal Intermediate fund invests in intermediate-term municipal bonds & High-Yield Corporate bond fund invests largely in speculative grade / “junk” bonds with high yields. But, names of common stock funds often reflect little / nothing about their investment policies: e.g. Vanguard’s Windsor & Wellington funds.

How Funds are Sold

Mutual funds are generally marketed directly by fund underwriter / indirectly by brokers acting on behalf of underwriter. Direct-marketed funds are sold via mail, over the phone or Internet. Investors contact fund directly to purchase shares. Brokers / financial advisers receive a commission for selling shares to investors. Advice from brokers to investors may suffer from a conflict of interest if broker receives compensation for directing the sale to a particular fund.

Many funds are sold by “financial supermarkets” that sell shares in funds of many complexes. Instead of a sales commission, broker splits management fees with mutual fund company. Advantage: unified record keeping for all funds purchased from supermarket, even if the funds are offered by different complexes. But, many contend that these supermarkets result in higher expense ratios as mutual funds pass costs of participating in these programs in form of higher management fees.

4.4 Costs of Investing in Mutual Funds

Fee Structure

1. Operating Expenses: Costs incurred by mutual fund in operating portfolio, including admin expenses & advisory fees paid to investment manager. Usually expressed as a % of total AUM, ~ 0.2% to 2%. Shareholders do not receive an explicit bill for these though expenses periodically are deducted from assets of fund. Shareholders pay for these via reduced value of portfolio. Larger funds tend to have lower expense ratios. Average expense ratio of actively managed funds is considerably higher than that of indexed funds, 0.84% vs 0.11%.

There are also fees for marketing & distribution costs for brokers / financial advisers who sell funds to public. Investors can avoid these expenses by buying shares directly from fund sponsor, but many investors are willing to incur these distribution fees in return for advice from their broker.

2. Front-End Load: Commission / sales charge paid when purchasing shares. Used primarily to pay brokers who sell funds, may not exceed 8.5%, but in practice are rarely higher than 6%. Low-load funds: loads up to 3% of invested funds. No-load funds: no front-end sales charges. Loads effectively reduce amount of money invested. E.g. each $1,000 paid for a fund with a 6% load results in fund investment of only $940.

3. Back-End Load: Redemption / “exit” fee incurred when selling shares. Usually starts at 5% / 6% & reduces by 1% every year funds are left invested. Aka “contingent deferred sales loads.”

4. 12b-1 Charges: SEC allows managers of 12b-1 funds to use fund assets to pay for distribution costs like advertising, promotional literature like annual reports & prospectuses, & commissions paid to brokers who sell fund to investors. These 12b-1 fees are named after SEC rule that permits use of these plans. Funds may use 12b-1 charges instead of / in addition to, front-end loads to generate the fees with which to pay brokers. For operating expenses, investors are not explicitly billed for 12b-1 charges (fees are deducted from assets of fund) Thus, 12b-1 fees (if any) must be added to operating expenses to obtain true annual expense ratio of the fund. SEC requires that all funds include in prospectus a consolidated expense table that summarises all relevant fees. 12b-1 fees are limited to 1% of a fund’s average net assets per year. Many funds offer “classes” that represent ownership in same portfolio of securities, but with different combinations of fees. Class A shares have front-end loads & a small 12b-1 fee ~ 0.25%. Class C shares rely on larger 12b-1 fees, ~ 1% & often charge a modest back-end load. Class I shares are sold to institutional investors (aka class Y) & carry no loads / 12b-1 fees.

Each investor must choose best combination of fees. Pure no-load no-fee funds are cheapest alternative & makes most sense for knowledgeable investors. But, many investors are willing to pay for financial advice & commissions paid to advisers are most common form of payment. Investors may choose to hire a fee-only financial manager who charges directly for services. They can help investors select portfolios of low / noload funds & provide other financial advice. Independent financial planners have become increasingly important distribution channels for funds in recent years. If you do buy a fund via a broker, choice between paying a load & 12b-1 fees will depend on expected time horizon. Loads are paid only once for each purchase (for holding), while 12b-1 fees are paid annually.

Fees & Mutual Fund Returns

E.g. fund has an initial NAV of $20, makes income distributions of $0.15, capital gain distributions of $0.05 & ends with NAV of $20.10 has 1.5% returns.

Note that this ignores any commissions like front-end loads paid. Rate of return is affected by fund’s expenses & 12b-1 fees. Investor’s rate of return = gross return on underlying portfolio - total expense ratio.

Table 4.2 considers an investor who starts with $10,000 & can choose among 3 funds that all earn an annual 12% return on investment before fees. A: total operating expenses of 0.5%, no load & no 12b-1 charges (might represent a low-cost producer like Vanguard). B: no load but has 1% in management expenses & 0.5% in 12b-1 fees (charges is typical of actively managed equity funds) C: 1% in management expenses, has no 12b-1 charges, but 8% front-end load on purchases. Differential is greater for longer investment horizons.

Difficult for investor in a mutual fund to measure true expenses accurately due to practice of paying for some expenses in soft dollars. Portfolio manager earns soft-dollar credits with a brokerage firm by directing fund’s trades to that broker. On basis of those credits, broker will pay for some of mutual fund’s expenses like databases / computer hardware / stock-quotation systems. Softdollar arrangement means stockbroker effectively returns part of trading commission to fund. Purchases made with soft dollars are not included in fund’s expenses. Fund may have paid its broker needlessly high commissions to obtain its soft-dollar “rebate.” Impact of higher trading commission shows up in net investment performance rather than reported expense ratio.

4.5 Taxation of Mutual Fund Income

Granted “pass-through status” under U.S. tax code: taxes are paid only by investor in the mutual fund, not by fund itself. Income is treated as passed through to investor if fund meets several requirements, most notably that virtually all income is distributed (passed through) to shareholders. 1 important disadvantage: if you manage your own portfolio, you decide when to realise capital gains & losses on any security thus, you can time those realisations to efficiently manage tax liabilities. With a mutual fund, timing of sale of securities from portfolio is not in your control, reducing ability to engage in tax management. Fund with a high portfolio turnover rate: “tax inefficient.” Turnover: ratio of trading activity of a portfolio to assets of the portfolio. Measures fraction of portfolio that is “replaced” each year. E.g. $100 million portfolio with $50 million in sales of some securities & purchases of other securities has turnover rate of 50%. High turnover: capital gains / losses are being realised constantly thus investor cannot time realisations to manage overall tax obligation. Turnover rates in equity funds in last decade ~ 50% when weighted by AUM. Low-turnover fund like an index fund may have it at 2%: tax-efficient & economical with respect to trading costs.

4.6 Exchange-Traded Funds (ETFs)

Introduced in 1993, ETFs are offshoots of mutual funds that allow investors to trade index portfolios like shares of stock. First ETF was “spider” SPDR (Standard & Poor’s Depository Receipt), a unit investment trust holding a portfolio matching S&P 500 Index. Mutual funds can be bought / sold only at end of day when NAV is calculated while spiders can be traded throughout the day. Similar products to Spider: “diamonds” (DJIA, ticker DIA), “cubes” (the NASDAQ 100 index, ticker QQQ) & “WEBS” (World Equity Benchmark Shares, shares in portfolios of foreign stock market indexes). By 2016, ~ $2.1 trillion was invested in 1,600 U.S. ETFs.

Table 4.3 shows some major sponsors of ETFs & types of funds offered.

Figure 4.2 shows rapid growth in ETF market. Until 2008, most ETFs were required to track specified indexes & ETFs tracking broad indexes still dominate the industry. But there are dozens of industry-sector ETFs & a many commodity, bond & international ETFs. 

Figure 4.3 shows that ETFs have captured a significant portion of AUM in investment company universe. Barclays Global Investors was long the market leader in ETF market, using product name iShares. Since Barclays’s 2009 merger with BlackRock, iShares has operated under BlackRock. The firm sponsors ETFs for several dozen equity index funds, including many broad U.S. equity indexes, broad international & single-country funds & U.S. & global industry sector funds. BlackRock also offers several bond ETFs & a few commodity funds like ones for gold and silver.

Leveraged ETFs: daily returns that are a targeted multiple of returns on an index. Inverse ETFs: move in opposite direction to an index. Actively managed ETF: like actively managed mutual funds, attempts to outperform passive indexes. These funds had to report portfolio holdings on a daily basis, making it easy for competitors to take advantage of their buying & selling programs. In 2014, SEC gave permission to Eaton Vance to offer an actively managed “non-transparent” ETF required to report portfolio composition once each quarter (like mutual funds). At end of 2015, there were 134 actively managed ETFs registered with SEC.

Synthetic ETFs like exchange-traded notes (ETNs) / exchange-traded vehicles (ETVs): nominally debt securities, but with payoffs linked to performance of an index. Often that index measures performance of an illiquid & thinly traded asset class, so ETF gives investor opportunity to add that asset class to portfolio. However, rather than invest in those assets directly, ETF achieves this exposure by entering a “total return swap” with an investment bank where bank agrees to pay ETF return on index in exchange for a relatively fixed fee. These are controversial, as ETF is exposed to risk that in a period of financial stress investment bank will be unable to fulfil its obligation, leaving investors without promised returns.

ETF advantages vs mutual funds: (a) Investors of mutual funds can only buy / sell shares once a day as NAV is quoted once a day, while ETFs trade continuously. (b) Unlike mutual funds, ETFs can be sold short / purchased on margin. (c) ETFs offer a potential tax advantage over mutual funds. In mutual funds, when many investors redeem their shares, fund must sell securities. This can trigger capital gains taxes, which are passed through to & must be paid by remaining shareholders. In ETFs, when small investors wish to redeem position, they simply sell shares to other traders, with no need for fund to sell any of underlying portfolio. Large investors can exchange ETF shares for shares in underlying portfolio; also avoiding a tax event. (d) ETFs are often cheaper. ETF investors buy via brokers instead of directly from fund. Thus, fund saves cost of marketing itself directly to small investors which may translate to lower management fees.

Disadvantages to ETFs: (a) Mutual funds can be bought at no expense from no-load funds, ETFs are purchased from brokers for a fee. Since ETFs trade as securities, prices can depart from NAV & these discrepancies can easily swamp cost advantage that ETFs otherwise offer. Spikes can occur when markets are stressed. E.g. flash crash of May 6, 2010, when DJIA fell by 583 points in 7 minutes & recovered more than 600 points in next 10 minutes. Stock exchanges canceled many trades that had gone off at what were viewed as distorted prices. Around one-fifth of all ETFs changed hands on that day at prices less than one-half of their closing price, & ETFs accounted for about two-thirds of all canceled trades. Problems shown: When markets are not working properly, it can be hard to measure NAV of ETF portfolio, especially for ETFs that track less liquid assets. Some ETFs may be supported by very few dealers. If they drop out of market during a period of turmoil, prices may swing wildly.

4.7 Mutual Fund Investment Performance: A First Look

1 benefit of mutual funds for investor is ability to delegate management of portfolio to investment pros. Investor chooses % of portfolio to invest in bond funds vs equity funds vs money market funds etc & can leave specific security selection decisions to managers of each fund. Investment record of mutual fund industry is deceptively difficult to answer as we need a standard against which to evaluate performance (in terms of risk taken). This is complicated & will be covered in Part 2 & 3.

We shall first ignore more subtle issues of risk differences across funds. Returns on Wilshire 5000 index will be benchmark for performance of equity fund managers as it corresponds to a simple passive investment strategy: Buy all shares in index in proportion to outstanding market value. Moreover, this is a feasible strategy even for small investors as Vanguard Group offers an index fund designed to replicate performance of Wilshire 5000 index. Casual comparisons of performance of Wilshire 5000 index vs that of managed mutual funds reveal disappointing results for active managers.

Figure 4.4 shows that average return on diversified equity funds was below return on Wilshire index from 1971 to 2015. Average return on index 12.1%, 1% greater than average mutual fund. 1 might argue there are good & bad managers & that good managers can outperform. But are "good" managers likely to repeat that performance in following years? Do funds with investment returns in top half of sample in 1 period continue to perform well?

Table 4.4 presents analysis from a study by Malkiel. Table shows fraction of “winners” in each year that turn out to be winners / losers the following year. Table shows that at least part of a fund’s performance is a function of skill as opposed to luck, thus relative performance tends to persist. But this relationship does not seem stable across different sample periods as pattern of persistence in performance disappears in Panel B. Evidence that performance is consistent from one period to the next is suggestive, but inconclusive.

Other studies suggest: if anything, bad performance is more likely to persist than good performance. It is easy to identify fund characteristics that will result in consistently poor investment performance, notably high expense ratios & high turnover ratios with associated trading costs. But it is far harder to identify secrets of successful stock picking. Thus, consistency we do observe in fund performance may be due in large part to the poor performers. Hence, real value of past performance data: avoid truly poor funds, even if identifying future top performers is still a daunting task.

4.8 Info on Mutual Funds

SEC requires that prospectus describes fund’s investment objectives & policies in a concise “Statement of Investment Objectives” & in lengthy discussions of investment policies & risks. Fund’s investment adviser & portfolio manager are described. Sales charges like front-end & back-end loads, annual operating expenses like management fees & 12b-1 fees are detailed in the fee table. Funds provide info about themselves in 2 other sources. Statement of Additional Information (SAI), AKA Part B of prospectus, includes list of securities in portfolio at end of fiscal year, audited financial statements, a list of directors & officers of fund (& their personal investments in fund), & data on brokerage commissions paid by the fund. Investors do not receive SAI unless they specifically request it. Fund’s annual report includes portfolio composition, financial statements & discussion of factors that influenced fund performance over last reporting period.

Consider Morningstar’s report on Fidelity’s Magellan Fund, in Figure 4.5. Left table labeled “Performance”: fund’s quarterly returns last few years & over longer periods. Compare returns to 2 benchmarks ( Russell 1000 & S&P 500) in rows labeled +/− Bmark, & its percentile rank within its comparison (“Mstar category”) group. Middle column: data on fees, expenses & several measures of fund’s risk & return characteristics. Fund has provided good returns compared to risk in last 3 years, earning it a 4-star rating, but its 10-year performance has been disappointing. Disclaimer “past performance is not a reliable measure of future results” is presumably true as well of Morningstar’s star ratings. Past results have little predictive power for future performance, as we saw in Table 4.4. Line graph compares growth of $10,000 invested in fund vs its first benchmark over last 10 years. Below graph are boxes for each year that depict relative performance of fund for that year. Shaded area on the box shows quartile where fund’s performance falls relative to other funds with same objective. Shaded band is top of box: firm was a top quartile performer. Table below bar chart: historical data on year-byyear performance of fund. “Portfolio Analysis” table: asset allocation of fund & Morningstar’s style box: style along 2 dimensions: size of firms held in portfolio by market value of outstanding equity & value/growth measure. Morningstar defines value stocks: low ratios of market price per share to various measures of value. Puts stocks on a growth-value continuum based on ratios of stock price to firm’s earnings, book value, sales, cash flow & dividends. Value stocks: low price relative to these measures of value. Growth stocks: high ratios, suggesting that investors must believe that firm will experience rapid growth to justify prices at which the stocks sell. Shaded box shows that Magellan Fund tends to hold larger firms (top row) & growth stocks (right column). Tables in right column provide info on current composition of portfolio.

4.9 Summary

1. Unit investment trusts, closed-end management companies & open-end management companies are all classified & regulated as investment companies. Unit investment trusts are unmanaged: portfolio once established, is fixed. Managed investment companies may change composition of portfolio as deemed fit by portfolio manager. Closed-end funds are traded like other securities; they do not redeem shares for their investors. Open-end funds will redeem shares for NAV at request of investor.

2. NAV = market value of assets held by a fund minus liabilities of fund, divided by shares outstanding.

3. Mutual funds free individual from many admin burdens of owning individual securities, offer pro management of portfolio & advantages available only to large-scale investors like discounted trading costs. But, management fees & other expenses reduce investor’s rate of return. Funds also eliminate some of individual’s control over timing of capital gains realisations.

4. Mutual funds are often categorised by investment policy. Major policy groups include money market funds; equity funds (further grouped by emphasis on income vs growth / specialisation by sector); bond funds; international funds; balanced funds; asset allocation funds & index funds.

5. Costs of investing in mutual funds: front-end loads (sales charges); back-end loads (redemption fees or more formally, contingent-deferred sales charges); fund operating expenses; & 12b-1 charges (recurring fees for expenses of marketing fund to public)

6. If fund meets certain requirements for pass-through status, income is treated as being earned by the investors in fund.

7. Average rate of return of average equity mutual fund in last 4 decades has been below passive index fund holding a portfolio like S&P 500 / Wilshire 5000. Some reasons: costs incurred by actively managed funds, like expense of conducting research to guide stock-picking activities & trading costs due to higher portfolio turnover. Record on consistency of fund performance is mixed. In some sample periods, better-performing funds continue to perform well; in other sample periods they do not.