Investment Analysis
Lecture 1
The essential nature of investment is that you reduce your current consumption, for planned later
consumption. You can invest in real assets (assets used to produce goods and services, like land,
buildings, etc.) or financial assets. Financial assets are claims on real assets (stocks and bonds).
Financial markets play a central role in the allocation of capital resources. It is an informational role.
This financial market allows you to time your consumption, allocate risks via diversification, and the
separation of ownership and management. The latter also creates agency issues. There are quite
some scandals with corporate governance and corporate ethics: accounting scandals, auditing
scandals, analyst scandals (favourable analysis traded for the promise of future investment banking
business). So the rules of corporate governance are tightened to prevent this.
Say there are 2 periods. Each period you have an income of $10.000. Saving and borrowing is
possible at 5% interest rate. You can:
- Consume $10.000 in both periods (B) Consume $10.000 in both periods
- Save all money of the first period, consume Save 10.000 at 5%, leads to $10.500.
everything in the second period (A) Consume $20.500 in period 2.
- Consume $20.000 now (C) Consume $10.000 in period 1 +
max amount I can borrow at 5%
X+0,05X = 10.000. X = $9.524.
So you consume $19524 in period 1
You need to pick a point on the line. Because then you utilize all the consumption
20.500 (A)
Consumption in period
10.000 (B)
10.000 19524 (C)
2
Consumption in period 1
Then you put indeifference curves. The investor does not care whether he obtains point A,B or C
along the curve. If you have not much to consume in period 1, extra period 1 consumption requires
larger efforts
You can see that to consume a bit more in period 2,
Consumption in period
this delta is bigger than the delta of
consumption in period 1
2
1
Consumption in period 1
, The solution is where the first graphs meets the indifference curves (orange dot).
Consumption in period
12.100
2
8.000
Consumption in period 1
A portfolio is a collection of investment assets. Asset allocation refers to the choice among broad
asset classes. Security selections refers to the choice of securities within each asset class.
A security analysis is like the valuation of securities. A top-down approach is first you do asset
allocation, then you pick securities. That’s typically the advice. A bottom-up approach prices
securities that are attractive, without much concern for asset allocation.
Markets are typically competitive. There’s a trade-off between risk and return. Assets are priced in
line with its risks. You would rarely expect to find bargains in security markets. Active management
refers to finding mispriced securities and timing the market. BUT, you have to ask yourself whether
active management is really profitable, because of trading costs and management fees. Passive
management refers to management with no attempt to find undervalued securities, no attempt to
time the market and holding a highly diversified portfolio. Then, trading costs and management fees
are much lower. Funds such as ETFs are passively run ‘index’ trackers with very low fees and are
becoming more popular.
Who are the players in the markets? Firms (net borrowers), households (net savers) and
governments (both borrowers and savers). There are also financial intermediaries (to spread risks
and help with transactions):
- Investment companies mutual funds, hedge funds, etc.. they perform specialized services
for businesses (like IPO: initial public offering).
- Pension funds
- Banks
- Insurance companies
- Venture capital (VC) active role in management of start-up. Financing high-risk firms
(start-ups)
- Private equity investment in not publicly traded firms.
Financial markets are divided in money markets (short term, low risk) and capital markets (longer
term, more risky). LIBOR is the premier short term interest rate in euro ‘money market’. Bond
markets are longer term borrowing or debt instruments.
2
,Equity markets are markets with ownership shares. A common stock has ownership, with 1 share is 1
vote. There is a board of directors, elected by shareholders. Shareholders are the last in line on
assets and income concerning the residual clain. They have limited liability; maximum potential loss
is the original investments. They can earn money by dividend yield and capital gains.
You also have preferred stock – features of equity and debt. For example fixed amount of income, no
voting power, obligation to pay interest (but not dividend), payments are treated as dividends (not
tax-deductible for firms).
A derivative asset is a claim whose value is contingent on the value of some underlying asset. Options
(call/put) and futures). With options you have the right to buy or sell, which you will only exercise if it
is profitable. Options must be purchased. Futures are an obligation to make or take delivery. You also
have an obligation to buy/sell at futures price. The contract is entered without costs.
Firms can raise funds by borrowing money or selling shares. If you issue new securities, you do that
via the primary market (IPO: initial public offering). In the secondary market, you trade existing
securities on exchanges or in the over-the-counter markets. Even when a firm sells more shares to
the markets, it is secondary market, because they need to listen to the market price. Publicly listed
firms have shares traded publicly in markets, while private corporations have shares that are held by
a small number of managers and investors (over the counter).
You have an issuing firm that wants to go to
market. Then you have the lead underwriter, an
investment firm that helps the issuing firm with all
legal requirements and advertising the company’s
IPO. This lead underwriter gets help from
investment bankers to sell the newly issues shares
at a certain price. This all is called the underwriter
syndicate. They get fees from it. They help to
make the IPO a success.
For IPO’s they have road shows, where they advertise the firms at pension funds etc.. They do the
boatbuilding (information documents, why you should invest in the company). The underwriter bears
the price risk. IPOs are commonly under-priced, and sometimes IPOs cannot be fully sold.
Lecture 2
On average, the initial returns for IPOs on the first-day is positive. But, on average, long-term relative
performance of IPOs is a bit lower than the relative performance of non-issuers.
A Special Purpose Acquisition Company (SPAC) is a shell company (lege vennootschap) formed to
raise capital through an IPO in order to acquire an existing company. You do not need to have the
syndicate of investment banks, and all the administrative stuff. At the time of the IPO, SPACs have no
existing business operations or stated targets for acquisitions. Those SPACs did not have any
business, and then they merge with the existing operating company. This company is then listed
through the existing shell company. The money raised in the SPAC will be used to take over another
company. So the money raised can be spent on acquisition within 2 years or to return money to the
investors.
3
, There are several types of orders. Market orders are executed immediately (bid price vs ask price).
You also have price-contingent trades: the investors specify prices to buy or sell, and there is a
certain limit to buy/sell orders. You put in an order, and if the market price does not reach the limit,
then the order will not be executed. The limits of bid prices should be higher than the limits of ask
prices, for the trade to happen.
Due to technology, liquidity has increased and spreads have decreased. But high frequency trading
(HFT) firms are gaming the market in doing anything they can do to be first in the market. In HFT you
need to be the first one to make a profit. Academics refer to HFT as dark trading.
How does it work? Normally you’d have a retail investor, that has an online broker, who goes to the
exchange market. But because of liquidity providers and institutional investors are also going to the
market. In this market there are dark pools. Instead of transferring your buy/sell order to the
exchange, the order can via your broker end up in a ‘dark pool’ where it could be matched with
another buyer/seller without ever ending up at the exchange! If there’s one bank where you have a
client that wants to sell shares and a client that wants to buy shares, you can keep it inside. This
information about who wants to sell/buy, will not be present in the exchange market. That’s why it’s
called dark pool. You do not have to pay the fees for the exchange, and this will be more profitable
for both the bank and the buyer/seller. HFT results in prices changing as soon as you press the button
to sell/buy shares, because there are people that are faster to sell/buy at that time. There are
‘unseen predators’.
in the dark pool, there’s a HFT firms that see what the latest buy order is and what the latest sell
order is. If there’s a difference in price between what people are willing to pay ($100,05 e.g.) and
willing to sell ($100,01 e.g.), then this HFT firms jumps in the middle and buys the ‘cheap’ share
($100,01) and sells it for the price that is bid ($100,05). Thus, the HFT firm makes $0,04 per share.
IEX trading then, is adding an intentional delay to ensure simultaneous order arrival, so that the
order of a HFT firm and the regular investor arrive at the same time.
Then, short sales. The purpose is to profit form a decline in the price of a stock or security. If you
have a long position: a positive investment in a security (positive weight). If you have a short
position: it is a negative investment in a security (negative weight). In a short sale, you sell a stock
that you do not own and then buy that stock back in the future. It is advantageous if you expect a
stock price to decline in the future.
For short sale: you borrow the share and sells it immediately. Then this person has money, and then
after some time the fund that you borrowed the money from wants the share back. Then the person
needs to give back the share, so this person needs to purchase it in the market and give it back to the
fund. If the price indeed dropped, then you have made profit. The fund also wants a little fee for
borrowing the share. So the profit of the short sale is P(t=0) – P(t=1) – borrowing fee.
Even if the price increased, you would need to buy the share back and take your loss.
Lecture 4
The financial crisis of 2008. Before the crisis there was ‘the great moderation’; a time in which the US
had a stable economy with low interest rates and a tame business cycle with only mild recessions.
Also, there was a historic boom in the housing market.
Before the crisis, housing worked as follows. People go to the local bank (local thrift institution),
where they showed evidence that they were able to pay the mortgage. Thrift’s major asset was a
portfolio of long-term mortgage loans. The thrift’s main liability was deposits. Then, there were some
changes. They come up with securitization; another organization buys all those mortgage loans
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