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Summary of the core course: Investments, from the RSM MSc Finance & Investments
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Main summary of investments courseLecture 1: Security markets
Video 2: The function of financial markets
Total overview: (Suppliers of funds are people that saved money and want to invest)
Whole middle of the picture is the entire financial market. This whole financial system is there for
channeling money from one place to the other.
Why do we need financial markets: Financial markets (+financial intermediation) play a crucial role in
the economy.
Allocation of capital E.g if there is a IPO, the stock market will determine how much money
the company gets.
Consumption timing/smoothing. That allows individuals to determine when in your live you
want to consume. When to save, when to invest, etc.. through financial markets.
Separation of ownership and management. Companies mainly runed by professional
managers and not by owners that much anymore.
Provision of liquidity. Many companies need money to expand. Investors want to make it
easy to trade shares. Convert from stock to cash in short notice, stay liquid.
Allocation of risk
Information aggregation (through prices mechanism on financial markets) Stock price should
be a mix of all the information. (Is not always perfect).
Capital allocation: investing in the right projects.
Size of global financial markets:
Global public equity = 67 $ Trillion
Global corporate bonds = 49 $ Trillion
Global derivatives = (underlying value) = 553 $ Trillion
Global equity trading each year = 114 $ Trillion per annum
Global bond trading = 33 $ Trillion per annum
Global FX trading = 4 $ Trillion every single day.
For comparison: Size of global GDP = 78 $ Trillion
Video 3: Margin trading & short selling
, Margin trading: purchasing securities (in part) with borrowed money.
Margin is capital put up by investor to secure credit form broker to buy securities.
Not possible to finance 100% of trade with borrowed money, need some of yourself.
Broker requires investors to put up a certain minimum margin (in US initial margin requirement is
50%).
If margin falls below threshold (maintenance margin: equal to 25% for long positions and 30% for
short positions in the US), the investor gets a margin call and has to put up extra capital. If you
don’t do it, then the broker will determinate (part of) your position. (Sells it).
Margin calls created a big role in the 2008 financial crisis.
Make a balance sheet representation.
o Long position Margin
Loan = most you can get is 50% of your position
Equity = market price * shares – loan
So divide the equity in account / market value of position.
Short selling
Short sales allow investors to profit from a decline in security’s price by selling a security that
is borrowed from another investor.
Mechanics:
borrow stock through a broker
Sell it and deposit proceeds and margin in an account.
Closing out the position: buy the stock and return to the party from which it was borrowed.
Risk = post a margin, loss if unlimited (no cap on a stock price).
Lender demands a certain fee for lending out the shares.
In practice it is not that clean, because the broker has to return the shares to the lender.
Trust will be there because of the margin that is in the account.
Short sales & Margin example.
Suppose you want to trade on information that the stock price of Z corp may go down.
Z CORP 100 SHARES
50% initial margin
30% Maintenance margin
100$ Initial price.
,What happens to the margin if stock goes to 110 and did not fall.
Sale proceeds $10,000
Initial margin 5,000 (how much you are going to borrow and the percentage of total). 5k of
10k = 50%
Stock owed becomes 11,000
Net equity becomes $4,000
New margin % = equity/market value of position = 4000/11000 = 36%
When will you get a margin call?
Margin = equity in account / market value of position
($15,000 – 100(Q)*p) / (100(Q)*p) = 30%. If the stock would increase above it you will get a
margin call. For long position
If math is done then $115.38, then margin falls below requirement and you will receive a
margin call.
Formula for margin call price short position = (total assets (sale of stock + initial margin) –
q*p)/q*p
Formula for margin call price Long position = (Market value position-own equity)/ MV
First class lecture week 1.
How are financial markets organized?
Two dominant types:
1. Dealer markets: fixed income markets, FX markets, some derivative markets
2. Agency markets / Limited order book: most stock markets, some derivative markets
Why do we care?
Type of markets determines way of trading
Trading is important considerations in portfolio management and asset pricing
Neglected in many courses on asset management
Trading costs / market liquidity
Trading involved costs
Since trading is costly, investors are concerned about market liquidity
o “the ability to trade large quantities of a financial asset quickly, at low cost, and with
little impact on the price”.
Three elements:
1. Transaction costs (fixed, variable)
2. Depth of a market
3. Price impact
Liquidity can be a source of risk. Can’t sell your assets fast enough, limited options to sell.
, Dealer markets
In dealer markets, buyers and sellers do not trade with each other, but with “dealers”(usually
banks) who act as intermediary and stabilize the market by supplying immediacy
The charge bid-as spread as compensation
o Sell to dealer’s bid, buy from deal’s ask.
Why? Dealers have costs
Fixed costs: admin, operation, technology
Costs of bearing inventory risk (changing prices)
Cost of trading against better informed (asymmetric information / adverse selection)
Potentially also counterparty risk
Competition among different dealers helps to keep bid-ask spreads low.
3. Agency market
In agency markets, order flow meets at central place (e.g. the stock exchange)
o So buyers and sellers directly trade with each other
In most agency or auction markets there is one market maker or specials for each stock:
specialists handle much of the order flow for stocks assigned to them by the exchange and
have the affirmative obligation to make fair orderly markets for their stocks.
o Specialists does not normally takes positions in the stock, so is usually not the middle
man. They receive a fee for this part and are allowed to make a profit.
Three recent trends
1. Automated / high frequency trading
2. Sustainable investing
1. HFT
In recent years, HFTs have come under increased scrutiny
• They are blamed for increasing excess volatility (e.g., the flash crash) and for exploiting small retail
investors
• In part by exploiting the increased fragmentation of financial markets
• The empirical evidence suggests that HFT help liquidity and price discovery
• But we know little about their behavior in times of stress more generally
• And their “distributional effects” in the sense of transferring wealth
from retail investors to institutions
2. Sustainable investing:
According to the Global Sustainable Investment Alliance (GSIA, 2020), US$ 35.3 trillion of ESG
(Environmental, Social & Governance) investments in five major developed markets
United Nations’ Principles for Responsible Investment (PRI)
• “Responsible investment is an approach to investing that aims to incorporate environmental, social
and governance (ESG) factors into investment decisions, to better manage risk and generate
sustainable, long-term returns.”
• “Signing the internationally-recognized Principles for Responsible Investment allows your
organisation to publicly demonstrate its commitment to responsible investment, and places it at the
heart of a global community.”
• >4,800 signatories representing >US$100 trillion AUM
The roles of sustainable finance
At least three key roles finance can play.
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