Class notes
Finance IIA: Equities Part 1 & 2 (FTX3044F)
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These notes cover the content taught by Philip and Pradeep on Equities Part 1 & 2. They are notes made from the slides.
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EQUITIESInvestment de nition:
• Textbook: An investment is the current commitment of money or other
resources in the expectation of reaping future bene ts.
• Warren Bu et: What is ‘investing’ if it is not the act of seeking value at least
su cient to justify the amount paid? Consciously paying more for a stock than
its calculated value – in the hope that it can soon be sold for a still-higher price
– should be labelled speculation (which is neither illegal, immoral or – in our
view – nancially fattening).
Value: is estimated using some model
Real assets: assets that a business or investor owns (land, buildings)
Financial assets: liquid assets that can easily be converted into cash (stocks,
bonds)
Price: is what the share is trading for on the market
Simple rule:
• Buy when Value > price
• Remember that Value has estimation error
• Therefore, margin of safety is needed
Financial Assets:
• Fixed-income or debt securities promise either a xed stream of income or a
stream of income determined by a speci ed formula
• Equity – represents an ownership share in a corporation (riskier investments
than debt – equity-holders can receive dividends)
• Derivatives – provide payo s that are determined by the prices of other assets
such as bond or stock prices (options, futures, swaps)
Financial Markets & the Economy:
• Stock prices re ect investors’ collective assessment of a rm’s current
performance and future prospects
• When the market is more optimistic about a rm, its share price will rise
• Consumption Timing – owning nancial assets allows individuals to shift their
consumption
• Allocation of Risk – investors select securities that meet their risk preferences
and
enables rms to raise capital to nance investments
• Separation of Ownership and Management – management team appointed by
board
of directions to run the rm
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, - Agency Problem – managers pursue their own interests instead of the
interests of the shareholders
• Corporate Governance & Ethics – independent directors, oversight boards,
auditing
The Investment Process:
• Portfolio – collection of investments
• Asset Allocation Decision – choosing between broad asset classes
• Security Selection Decision – choosing which securities to hold within the classes
• ‘Top-Down’ starts with asset allocation decision
Markets:
• Risk-Return Trade-O – higher-risk assets are priced to o er higher expected
returns than lower risk assets
• E cient Markets – security prices adjust to new information in order to re ect
market consensus estimate value of the security
• Passive Management – holding highly diversi ed portfolios without spending
e ort or other resources attempting to improve investment performance
through security analysis
• Active Management – attempt to improve performance by either identifying mis-
priced securities or by timing the performance of broad asset classes
The Players:
• Firms – net demanders of capital (raise capital to pay for investments)
• Households – net suppliers of capital (purchase securities)
• Governments – borrowers or lenders depending on the relationship between tax
revenue and government expenditure
• Financial Intermediaries – bring suppliers and demanders of capital together
- Investment Companies – pool and manage the money of many investors
▪ Hedge Funds – only open to institutional investors
- Investment Bankers – advise corporations on the prices it can charge for
securities issued & appropriate interest rates, deals in primary market (IPOs)
- Venture Capital – investments in start-up companies
- Private Equity–investments in rms that do not trade publicly
• Cryptocurrency – a digital currency designed to work as a medium of exchange
through a computer network that is not reliant on any central authority to
uphold it
- Blockchain – a system in which a record of transactions made in
cryptocurrency are maintained across several computer that are linked in a
peer-to-peer network
The Financial Crisis of 2008-2009:
• Began with the housing market bubble, created by an overwhelming load of
mortgage-backed securities that bundled high-risk loans
• Reckless lending led to unprecedented numbers of loans in default – leading to
losses that resulted in nancial institutions failing
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, The Money Market:
• Treasury Bills (T-Bills) – a short term government debt obligation with a maturity
of one year or less
• Certi cate of Deposit (CD) – a certi cate issued by a bank to a person depositing
money for a speci ed length of time at a speci ed rate of interest
• Commercial Paper – a short-term unsecured promissory note issued by
companies
• Bankers’ Acceptance – an instrument representing a promised future payment
by a bank with payment accepted and guaranteed by the bank as a time draft to
be drawn on deposit
• Eurodollars – dollar-denominated deposits at foreign banks or foreign branches
of American banks
• Repurchase Agreements (Repos) – a form of short-term borrowing used in
money markets involving the purchase of securities with the agreement to sell
them back at a speci c date, usually for a higher price (reverse repo – represent
the same transaction from the other party’s perspective)
• Federal Funds – overnight borrowings between banks and other entities to
maintain their bank reserves at the Federal Reserve
• Broker’ Call – the interest rate charged by banks on loans made to brokerage
rms
• LIBOR Market – London Interbank O er Rate (LIBOR) is the premier short-term
interest rate quoted in the European money market & serves as a reference rate
for a wide range of transactions
• Yields on Money Market Instruments – generally low-risk but not risk-free
• Money Market Funds – mutual funds that invest in money market instruments
The Bond Market:
• Treasury Notes & Bonds – securities that pay a xed rate of interest every 6
months until maturity (notes maturity <10 years, bonds maturity 20/30 years)
• In ation-Protected Bonds – linked to an in ation index in order to hedge
in ation risk
• Federal Agency Debt – bonds issued by government-sponsored agencies
• International Bonds – Eurobond is a bond denominated in a currency other than
that of the country in which it is issued
• Municipal Bonds – issued by state & local governments
• Corporate Bonds – bonds issued by companies
• Mortgage & Asset Backed Securities – created by pooling together mortgages
and non-mortgage assets such as student loans respectively
Equity Securities:
• Common Stock – represent ownership shares in a corporation
• Residual Claim – stockholders last in line for a claim on assets of business
• Limited Liability – most that stockholders can lose is their original investment
• Capital Gains – pro ts from the sale of an investment
• Preferred Stock – promises to pay a xed amount of income each year and does
not convey voting power to the stockholder (payments treated as dividends –
not tax- deductible for rm)
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, • Depositary Receipts – certi cated traded in markets that represent ownership
shares of a foreign company
Share: part ownership of a business (not true ownership)
Shareholder rights:
• Vote at shareholder meetings
• Receive a dividend
• Share in residual at liquidation
Stock index:
• measures nancial market uctuations - used to tell us movement of a portion
of the market
• Dow Jones Industrial Average (DJIA) – 30 large blue-chip companies
• Standard & Poor 500 (S&P 500) – market-value-weighted index of 500 rms
• Nikkei (Japan), FTSE (UK), DAX (Germany), Hang Seng (Hong Kong), JSE (RSA)
• Bond-Market Indicators – measure the performance of various categories of
bonds
Derivative Markets:
• Option – a nancial instrument based on the value of underlying assets where
the buyer of the option pays a premium
• Call Option – gives the holder the right to purchase an asset for a speci ed
strike price, on or before a speci ed expiration date
- Increases in value as price of underlying asset increases
• Put Option – gives the holder the right to sell an asset for a speci ed strike
price, on or before a speci ed expiration date
- Decreases in value as price of underlying asset increases
• Futures Contract – an obligation to buy or sell an asset at a stipulated futures
prices on a maturity date
- Long Position (Purchasing) – gains if asset value increases
- Short Position (Delivering) – gains if asset value decreases
Primary Market:
• Firms issue new securities through underwriter to public – Investors get new
securities; rm gets funding
Secondary Market:
• Investors trade previously issued securities among themselves
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